A Framework for Financial Statement AnalysisChapter 11

Why Financial Statements Are AnalyzedIn order for financial information to be useful, it must be interpreted.

Why Financial Statements Are AnalyzedA comprehensive set of ratios allows the user to make sense of all the financial information reported in the financial statements.

Users of Financial Information Users of financial information may be current or future users.

Users of Financial Information InvestorsManagersCustomersPotential suppliers and creditorsGovernment regulatorsEmployee unionsPublic interest and community groupsSome of the users of financial information are the following:

Sources of Financial InformationThe major source of financial information is a firm's annual report.

The following are elements of most annual reports:Management discussion and analysisIndependent auditor's report Primary financial statementsSecondary financial statementsNotes to the financial statements

Other Sources of InformationReports filed with regulatory agencies (special, quarterly, and annual)Business periodicals (magazines, newspapers, newsletters)Investment advisory services (Standard & Poor, Moody's, etc.)

Basis of ComparisonWhen analyzing financial reports, one of the first decisions is to identify the basis of comparison.

Data may be compared with the following: The firm's own data from prior yearsData from another firm in the same industryData from another firm in which the analyst may investIndustry averagesBenchmarks or targets

Restatements May Be NecessaryThe statements may need to be restated when significant unusual events have occurred which would distort comparisons.

Restatements May Be NecessarySuch events include, among others, mergers or acquisitions, discontinued operations, changes in accounting principles, and extraordinary items.

More Comparability Is BetterComparability is enhanced when firms' size, capital structure, and product mix are similar.

A summary of the steps:Identify the purpose and objectives of analysis.

A summary of the steps:Review the financial statements, notes, and audit opinion to identify any unusual events or characteristics and to become familiar with the nature of the firms operation.

A summary of the steps:Determine whether any restatements due to mergers, discontinued operations, etc., are necessary to enhance comparability of the firms financial statements.

A summary of the steps:Determine whether the firms size, capital structure, and product mix are sufficiently comparable (between firms or time periods) to proceed with the ratio calculations.

Financial Statement Analysis Ratios & FrameworkThe analyst usually performs horizontal and vertical analyses of the financial statements.

Financial Statement Analysis Ratios & FrameworkHorizontal analysis focuses on changes or growth, year to year, for each major element on the income statement and the balance sheet.

Financial Statement Analysis Ratios & FrameworkVertical analysis examines the percentage composition of the income statement and the balance sheet: It uses common-size financial statements for this analysis.

Categories of Financial RatiosRatios are usually grouped into broad categories.

Categories of Financial RatiosFour widely used major headings are liquidity, profitability, capital structure, and investor.

Liquidity RatiosLiquidity ratios indicate the short-term solvency of the firm.

Liquidity RatiosThey also indicate how effectively the firm is managing its working capital.

Liquidity Ratios The following are commonly used liquidity ratios:

Liquidity Ratios The following are commonly used liquidity ratios:

Liquidity Ratios The following are commonly used liquidity ratios:

Liquidity Ratios The following are commonly used liquidity ratios:

Liquidity Ratios The following are commonly used liquidity ratios:

Profitability RatiosProfitability ratios measure how profitable a firm is.

Profitability RatiosThis is very important for investors who want to invest in a firm which can return their investment to them.

Profitability RatiosThe following are commonly used profitability ratios:

Profitability RatiosThe following are commonly used profitability ratios:

Profitability RatiosThe following are commonly used profitability ratios:

Profitability RatiosThe following are commonly used profitability ratios:

Profitability RatiosThe following are commonly used profitability ratios:

Profitability RatiosThe following are commonly used profitability ratios:

Capital Structure RatiosCapital structure ratios help in assessing a firm's strategies for financing its assets.

Capital Structure RatiosCapital structure indicates the relative amounts of debt and equity capital.

Capital Structure RatiosPercentage composition analysis is the starting point for any analysis of capital structure.

Capital Structure RatiosPercentage composition analysis describes the relative amounts of capital obtained from each major source of financing.

Capital Structure RatiosCurrent liabilities, long-term debt, deferred taxes and other similar liabilities, and shareholders' equity all will be divided by the total of total liabilities and shareholders' equity.

Capital Structure RatiosPercentage composition analysis is the starting point for any analysis of capital structure.

Capital Structure RatiosPercentage composition analysis is the starting point for any analysis of capital structure.

Capital Structure RatiosPercentage composition analysis is the starting point for any analysis of capital structure.

Capital Structure RatiosPercentage composition analysis is the starting point for any analysis of capital structure.

Capital Structure RatiosThe following capital structure ratios are also computed:

Capital Structure RatiosThe following capital structure ratios are also computed:

Investor RatiosInvestor ratios all relate to an external dimension of ownership interest.Most indicate how a firm is performing with regard to the market value of its shares.

Investor RatiosThe following are commonly used investor ratios:

Investor RatiosThe following are commonly used investor ratios:

Investor RatiosThe following are commonly used investor ratios:

Financial Statement Analysis FrameworkThe financial statement analysis framework includes the following steps.

Financial Statement Analysis FrameworkIdentify the purpose and objectives of the analysis.

Financial Statement Analysis FrameworkReview the financial statements, notes and audit opinion.

Financial Statement Analysis FrameworkDetermine whether restatements are necessary to enhance the comparability of the statements.

Financial Statement Analysis FrameworkDetermine whether the firm's size, capital structure, and product mix are appropriate to proceed with the ratio calculations.

Financial Statement Analysis FrameworkConduct horizontal and vertical analyses of each financial statement, with special emphasis on the income statement.

Financial Statement Analysis FrameworkCalculate the basic liquidity ratios.

Financial Statement Analysis FrameworkCalculate profitability ratios based on net income and on cash flow from operating activities. Evaluate trends.

Financial Statement Analysis FrameworkEvaluate the firm's capital structure with special emphasis on trends in the percentage composition ratios.

Financial Statement Analysis FrameworkExamine the firm's market performance using the investor ratios.

Financial Statement Analysis FrameworkExamine any inconsistencies in the ratio results, review notes, and recalculate the ratios.

Limitations of Financial Statement AnalysesFinancial statement analysis is limited due to several items.

Limitations of Financial Statement AnalysesGAAP presents some limits.

Limitations of Financial Statement AnalysesGAAP presents some limits.Managers often have the ability to select favorable accounting methods.

Limitations of Financial Statement AnalysesMany major factors affecting profitability and survival of the firm are not included in the financial statements.

Limitations of Financial Statement AnalysesMany major factors affecting profitability and survival of the firm are not included in the financial statements.A perfect example is human resources.

Limitations of Financial Statement AnalysesMany major factors affecting profitability and survival of the firm are not included in the financial statements.While employees are often a firm's most important asset, a value for employees does not appear on the balance sheet.

Limitations of Financial Statement Analyses"Real" events are often hard to distinguish from the effects of alternative accounting methods or principles.

Limitations of Financial Statement AnalysesFinancial statement analysis relies on past numbers, and the past may not be a reliable indication of the future.

A Framework for Financial Statement AnalysisEnd of Chapter 11