978-1133939283 Chapter 16 Lecture Note

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Chapter 16

Financial Statement Analysis

Learning Objectives

1. Describe the concepts, standards of comparison, and sources of information used in

measuring nancial performance.

2. Apply horizontal analysis, vertical analysis, and ratio analysis to nancial statements.

3. Apply nancial ratio analysis in a comprehensive evaluation of a company’s nancial

performance.

4. Dene quality of earnings, and identify the factors that a#ect quality of earnings and

related management compensation issues.

Section 1: Concepts

Concepts

 Relevance

 Predictive Value

 Comparability

 Timeliness

Lecture Outline

I. Financial performance measurement comprises all the techniques that users of

nancial statements employ to show relationships in an organization’s nancial

statements and to relate those relationships to the organization’s nancial objectives.

II. Users of nancial statements are classied as either internal or external.

A. Internal users include top managers who set and strive to achieve nancial

performance objectives, middle-level managers of business processes, and

employee stockholders.

B. External users include creditors and investors wanting to assess how well

managers accomplished their nancial objectives and customers forming

cooperative agreements with the company.

III. Management is responsible for devising, executing, monitoring, and reporting on a

complete nancial plan for a business that focuses on the following:

A. Protability—ability to earn a satisfactory net income

B. Total Asset Management—and use assets to maximize revenue

C. Liquidity—ability to pay bills when due and to meet unexpected needs for

cash

D. Financial Risk – the risk involved in making a loan or investment.

E. Operating Asset Management – using current assets and current liabilities in a

way that supports revenue growth and minimizes investment

IV. Standards of Comparison.

A. Rule-of-thumb measures, which include:

1. Current ratio.

2. Current liabilities to net worth ratio.

B. Analysis of past performance

C. Comparison with industry norms

1. Industry norms as standards have limitations in that:

or posted to a publicly accessible website, in whole or in part.

Chapter 16: Financial Statement AnalysisInstructor’s Manual, p. 2

a. Disparity in operations between companies may a#ect comparability.

b. Companies may not use same accounting procedures.

c. Diversied companies may operate in more than one industry.

V. Major sources of information include:

A. A company’s annual report.

B. Interim nancial statements, which may indicate recent changes in earnings.

C. Business periodicals

D. Credit and investment advisory services, such as Moody’s.

Summary

Financial statement analysis, or nancial performance measurement, encompasses all the

techniques that users employ to show key relationships in a company’s nancial statements and

how they bear on the company’s nancial objectives.

Users of nancial statements are classied as either internal or external. Internal users include

top managers who set and strive to achieve nancial performance objectives, middle-level

managers of business processes, and employee stockholders. External users are primarily

creditors and investors who want to assess the degree to which managers accomplished their

nancial objectives and customers who form cooperative agreements with the company.

Management is responsible for devising, executing, monitoring, and reporting on a complete

nancial plan for a business that focuses on the following protability, total asset

management, liquidity, nancial risk, and operating asset management. Protability is the

ability to earn a satisfactory net income. Total Asset Management is the ability to use

assets to maximize revenue. Liquidity is the ability to pay bills when due and to meet

unexpected needs for cash

Financial Risk – the risk involved in making a loan or investment. Operating Asset

Management is using current assets and current liabilities in a way that supports revenue

growth and minimizes investment

Information about the past and present aids in making projections about the future.

Moreover, the easier it is to predict future performance, the less the associated risk becomes

and, therefore, the lower the amount of compensation an investor or creditor requires.

Decision makers assess performance by several means: (1) rule-of-thumb measures, (2)

analysis of the company’s past performance, and (3) comparison with industry norms.

1. Rule-of-thumb measures, such as current ratio and current liabilities to net worth, are

useful, but they should not be the sole basis for making a decision. For example, a

company may report high earnings per share but lack su@cient assets to pay current

debts.

2. A company’s past performance is helpful in disclosing trends. The skill lies in the

analyst’s ability to predict whether a trend will continue or reverse itself.

3. Comparing a company’s performance with the performance of other companies in the

same industry is also helpful, but there are three limitations to using industry norms as

standards. First, no two companies are exactly the same. Second, many companies,

called diversied companies or conglomerates, operate in unrelated industries, so that

comparison is di@cult. (However, recent requirements that conglomerates report

nancial information by segments have eased the problem somewhat.) Third, di#erent

companies often use di#erent accounting procedures for recording similar items.

The chief sources of information about publicly held corporations are reports published by the

company, SEC reports, business periodicals, and credit and investment advisory services.

or posted to a publicly accessible website, in whole or in part.

Chapter 16: Financial Statement AnalysisInstructor’s Manual, p. 3

1. A company’s annual report provides pertinent nancial information. It contains the

following sections: (a) analysis of the past year’s operations, (b) the nancial

statements, (c) notes to the nancial statements, including accounting procedures, (d)

the auditors’ report, and (e) a ve- or ten-year summary of operations (nancial

highlights).

2. Interim nancial statements may indicate signicant changes in a company’s

earnings trend. They consist of limited nancial information for a period of less than a

year (usually a quarter).

3. Publicly held corporations are required to le an annual report (Form 10-K), a quarterly

report (Form 10-Q), and a current report of signicant events (Form 8-K) with the SEC.

These reports are available to the public and are valuable sources of nancial

information. Many SEC reports are now available on the Internet.

4. Financial analysts obtain information from such sources as The Wall Street Journal,

Forbes, Barron’s, Fortune, and Yahoo Finance.

Relevant Examples and Exhibits

 Exhibit 1 Selected Segment Information for Goodyear Tire & Rubber Company

Teaching Strategy

If possible, secure or have students secure a copy of a nancial statement of a local company

for each member of the class. Ask students what they would look at if they were thinking of

buying the stock or bonds of the corporation.

List the standards of comparison and the problems associated with each standard. Short

Exercise 1, Exercise 1A, and Cases 1 and 2 apply to this section.

Section 2: Accounting Applications

Accounting Applications

 Analyzing nancial statements

oHorizontal analysis

oTrend analysis

oVertical analysis

oRatio analysis

 Evaluating protability and total asset management

oProt margin

oAsset turnover

oReturn on assets

 Evaluating liquidity

oCash How yield

oCash Hows to sales

oCash Hows to assets

oFree cash How

 Evaluating nancial risk

oDebt to equity ratio

oReturn on equity

or posted to a publicly accessible website, in whole or in part.

Chapter 16: Financial Statement AnalysisInstructor’s Manual, p. 4

oInterest coverage ratio

 Evaluating operating asset management

oInventory turnover

oDays’ inventory on hand

oReceivable turnover

oDays’ sales uncollected

oPayables turnover

oDays’ payable

oFinancing period

oCurrent ratio

oQuick ratio

 Evaluating market strength

oPrice/earnings (P/E)

oDividend yield

Lecture Outline

I. Horizontal analysis shows absolute and percentage changes from one year to the

next.

II. Trend analysis is an application of horizontal analysis over several consecutive years.

III. Vertical analysis calculates percentage relationships within a single statement.

A. The result is a common-size statement.

1. On a common-size balance sheet, total assets and total

liabilities and equity in their respective areas of the balance sheet

are labeled 100 percent.

2. On a common-size income statement, net sales or net revenues

are labeled 100 percent.

3. Common-size statements can be presented in comparative

form.

IV. Ratio analysis shows meaningful relationships between nancial statement

components.

V. There are several categories of ratios used in a comprehensive nancial ratio

analysis.

A. Protability and total asset management ratios:

1. Prot margin

2. Asset turnover

3. Return on assets

B. Liquidity ratios:

1. Cash How yield

2. Cash Hows to sales

3. Cash Hows to assets

4. Free cash How

C. Financial risk ratios:

1. Debt to equity ratio

2. Return on equity

3. Interest coverage ratio:

D. Operating asset management ratios:

1. Inventory turnover

2. Days’ inventory on hand

3. Receivables turnover

4. Days’ sales uncollected

5. Payables turnover

6. Days’ payables

or posted to a publicly accessible website, in whole or in part.

Chapter 16: Financial Statement AnalysisInstructor’s Manual, p. 5

7. Financing period

E. Supplemental nancial ratios for asset management and liquidity:

1. Current ratio

2. Quick ratio

F. Market strength ratios:

1. Price/earnings ratio

2. Dividend yield

Summary

The ratios used in ratio analysis provide information about a company’s protability, liquidity,

nancial risk, operating asset management, and market strength. The most common ratios are

listed in the following table.

Table of Ratios

Ratio Components Use of Meaning

Protability Ratios

Prot margin Net Income

Net Sales

Measure of net income

produced by each dollar of

sales

Asset turnover Net Sales

Average Total Assets

Measure of how e@ciently

assets are used to produce

sales

Return on assets Net Income

Average Total Assets

Measure of overall earning

power, or protability

Liquidity Ratios

Cash #ow yield Net Cash Flows from

Operating Activities

Net Income

Measure of the ability to

generate operating cash

Hows in relation to net

income

Cash #ows to sales Net Cash Flows from

Operating Activities

Net Sales

Measure of the ability of

sales to generate operating

cash Hows

Cash #ows to assets Net Cash Flows from

Operating Activities

Average Total Assets

Measure of the ability of

assets to generate operating

cash Hows

Free cash #ow Net Cash Flows from

Operating Activities –

Dividends

– Net Capital Expenditures

Measure of cash generated

or cash deciency after

providing for commitments

Ratio Components Use of Meaning

Financial Risk Ratios

or posted to a publicly accessible website, in whole or in part.

Chapter 16: Financial Statement AnalysisInstructor’s Manual, p. 6

Debt to equity ratio Total Liabilities

Stockholders’ Equity

Measure of capital structure

and leverage

Return on equity Net Income

Average Stockholders’

Equity

Measure the protability of

stockholders’ investments

Interest coverage ratio Income Before Income Taxes

+ Interest Expense

Interest Expense

Measure of creditors’

protection from default on

interest payments

Operating Asset Management Ratios

Inventory turnover Cost of Goods Sold

Average Inventory

Measure of relative size of

inventory

Days’ inventory on hand Days in Year

Inventory Turnover

Measure of average days

taken to sell inventory

Receivable turnover Net Sales

Average Accounts

Receivable

Measure of relative size of

accounts receivable and

e#ectiveness of credit

policies

Days’ sales uncollected Days in Year

Receivable Turnover

Measure of average days

taken to collect receivables

Payables turnover Cost of Goods Sold +/−

Change in Inventory

Average Accounts Payable

Measure of relative size of

accounts payable

Days’ payable Days in Year

Payables Turnover

Measure of average days

taken to pay accounts

payable

Financing Period Days’ inventory on hand

+ days’ sales uncollected

– days’ payable

The number of days of

nancing that must be

provided

Current ratio Current Assets

Current Liabilities

Measure of short-term

debt-paying ability

Quick ratio Cash + Marketable

Securities + Receivables

Current Liabilities

Measure of short-term

debt-paying ability

Ratio Components Use of Meaning

Market Strength Ratios

Price/earnings (P/E) ratio Market Price per Share

Earnings per Share

Measure of investor

condence in a company

or posted to a publicly accessible website, in whole or in part.

Chapter 16: Financial Statement AnalysisInstructor’s Manual, p. 7

Dividends yield Dividends per Share

Market Price per Share

Measure of the current return

to an investor in a stock

Relevant Examples and Exhibits

 Exhibit 2 Comprehensive Balance Sheets with Horizontal Analysis

 Exhibit 3 Comparative Income Statements with Horizontal Analysis

 Exhibit 4 Trend Analysis

 Exhibit 5 Graph of Trend Analysis Shown in Exhibit 4

 Exhibit 6 Common-Size Balance Sheets Presented Graphically

 Exhibit 7 Common-Size Balance Sheets

 Exhibit 8 Common-Size Income Statements Presented Graphically

 Exhibit 9 Common-Size Income Statements

 Ratio: Prot Margin

 Ratio: Asset Turnover

 Ratio: Return on Assets

 Ratio: Cash Flow Yield

 Ratio: Cash Flows to Sales

 Ratio: Cash Flows to Assets

 Ratio: Debt to Equity

 Ratio: Return on Equity

 Ratio: Interest Coverage

 Ratio: Inventory Turnover

 Ratio: Days’ Inventory on Hand

 Ratio: Receivables Turnover

 Ratio: Days’ Sales Uncollected

 Ratio: Payables Turnover

 Ratio: Days’ Payable

 Ratio: Current Ratio

 Ratio: Quick Ratio

 Ratio: Price/Earnings (P/E)

 Ratio: Dividend Yield

 Exhibit 10 Relationships of Financial Ratios

or posted to a publicly accessible website, in whole or in part.

Chapter 16: Financial Statement AnalysisInstructor’s Manual, p. 8

Teaching Strategy

Discuss horizontal and vertical analysis using Exhibits 2 through 9.

After explaining the procedures for horizontal, trend, and vertical analysis, simplify the

procedures as follows: For horizontal analysis, divide by the earliest year being compared. For

trend analysis, divide by the earliest year being compared. For vertical analysis, divide every

amount for a single year by the largest amount appearing for that year (total assets on the

balance sheet and sales on the income statement).

Walk through and discuss each of the ratios. Simplify the chore of memorizing the ratios by

pointing out the following:

1. The liquidity ratios involve only current balance sheet accounts.

2. There are four turnover ratios, and the only reason the asset turnover ratio is not a

liquidity ratio is that it includes noncurrent balance sheet accounts.

3. All the “return on” ratios have net income as the numerator; prot margin is the

same as “return on” sales.

Refer students to the answer to the review problem.

1. Explain the answer for the current ratio as having $1.50 in current assets for every

$1.00 in liabilities. Do the same for the quick ratio.

2. Explain the receivable, inventory, payables, and asset turnover answers as times per

year.

3. Explain the prot margin answer as having $.034 in prot for every $1.00 in sales.

4. Explain the debt to equity answer as having $.90 in debt for every $1.00 in equity.

Exercises 5A through 9A can be used for classroom illustration of the various ratios.

Section 3: Business Applications

Business Applications

 Evaluate quality of earnings

oAccounting methods

oAccounting estimates

oOne-time items

oFree cash How

 Determining management compensation

or posted to a publicly accessible website, in whole or in part.

Chapter 16: Financial Statement AnalysisInstructor’s Manual, p. 9

Lecture Outline

I. The quality of earnings refers to the substance of earnings and their sustainability

into future periods.

A. Accounting methods a#ect a rm’s operating income:

1. Inventory How assumptions and depreciation methods a#ect

reported income.

2. Except for income taxes, accounting methods have minimal

impact on cash Hows.

3. The conventions of full disclosure and consistency minimize the

impact di#erent accounting methods have on nancial statements.

B. Accounting estimates that impact reported income:

1. Expected useful life of assets.

2. Residual value of assets

3. Uncollectible accounts receivable

4. Sales returns

5. Total units of production

6. Total recoverable units of natural resources

7. Amortization periods

8. Warranty claims

9. Environmental cleanup costs

C. One-time items that increase or decrease earnings that will not have

sustained impacts into the future include:

1. Gains and losses.

2. Write-downs and restructurings.

3. Nonoperating items.

II. Performance measurement impacts management compensation.

A. The components of executive compensation include:

1. Annual base salary.

2. Annual incentive bonuses.

3. Long-term incentive compensation (stock option awards).

B. Incentive bonuses and stock options for top executives are typically based on

the company’s achievement of certain nancial goals.

C. For public companies, a compensation committee of independent directors

must establish remuneration policy for top-level executives.

D. The components and criteria of the remuneration policy must be reported to

the SEC.

Summary

Net income is the measure most commonly used to evaluate a company’s protability.

Quality of earnings is the substance and sustainability of earnings into future periods.

Quality of earnings is a#ected by accounting methods, accounting estimates, and one-time

items.

Accounting methods a#ect operating income. Accounting methods include inventory

methods such as FIFO, LIFO, average cost; depreciation methods; revenue recognition

methods, and methods for making estimates. Exhibit 11 shows the e#ects of di#erent

accounting methods.

Areas requiring accounting estimates include useful life of assets, residual value of assets,

uncollectible accounts receivable, sales returns, total units of production, total recoverable

units of natural resources, amortization periods, warranty claims, and environmental

clean-up costs. Full disclosure requires management to explain, in a not to the nancial

statements, the signicant accounting policies used. Consistency requires that the same

accounting procedures be used from year to year. Management must explain the nature of

or posted to a publicly accessible website, in whole or in part.

Chapter 16: Financial Statement AnalysisInstructor’s Manual, p. 10

any change in accounting procedures and its monetary e#ect in a note to the nancial

statements.

One-time items impact earnings for a single accounting period and include gains, losses,

write-downs, restructurings, and nonoperating items. When a company has both continuing

and discontinues operations, the operating income section is called income from continuing

operations. Income from continuing operations may include gains or losses on the sale of

assets, write-downs, and restructuring. The section of the income statement that follows

income taxes may contain such operating items as discontinued operations, segments

that are no longer part of a company’s operations – and gains (or losses) on the sale or

disposal of these segments.

The compensation of top executives typically includes incentive bonuses and stock options

that are based on the company’s attainment of certain nancial objectives. Under

Sarbanes-Oxley, the board of directors of a public company must appoint a compensation

committee composed of outside directors to determine the compensation of top

management, and details of the policy must be reported to the SEC. The purpose of this

requirement is to help ensure that managers will not engage in practices that are counter to

the best interests of the company and its stockholders.

Relevant Examples and Exhibits

 Exhibit 11 E#ects of Di#erent Accounting Methods

 Exhibit 12 Corporate Income Statement

Teaching Strategy

This objective is best taught by illustration. Use Short Exercises 11 and 12 and Exercises 10A

and 11A for classroom illustration.

Student Engagement Tactics

1. Assign Case 6 to small groups in class. Use previously established groups or assign

groups randomly. Each group should select a representative to speak for the group.

2. Be clear on the expected output of the learning activity. Identify questions to address

and determine whether written answers are necessary. For example, ask one person

from each group to present one alternative and explain why that alternative would be

best.

3. Elicit as many alternatives as possible for the class to consider. After each group has

presented one alternative, if time permits, ask if any other alternatives might be

available.

4. Allow groups one or two minutes to consider which alternative they prefer and why. Poll

the class as to their preferred response.

or posted to a publicly accessible website, in whole or in part.