CH10 Flashcards
Major Financial Statements
Corporate shareholder annual and quarterly
reports must include
Balance sheet
Income statement
Statement of cash flows
Balance Sheet
Shows resources (assets) of the firm and how
it has financed these resources
Indicates current and fixed assets available at
a point in time
Financing is indicated by its mixture of current
liabilities, long-term liabilities, and owners’
equity
Income Statement
Contains information on the profitability of the
firm during some period of time, in contrast to
the balance sheet at a fixed point in time
Indicates the flow of sales, expenses, and
earnings during the time period
Statement of Cash Flows
Shows the effects on the firm’s cash flow of
income flows and changes in various items on
the balance sheet
Cash Flow from Operating Activities: the sources
and uses of cash that arise from the normal
operations of a firm
Cash Flow from Investing Activities: change in
gross plant and equipment plus the change in the
investment account
Cash Flow from Financing Activities: financing
sources minus financing uses
Purpose of
Financial Statement Analysis
It seeks to evaluate the current management
performance and to provide insights that will
help project future management performance,
specifically in the following three areas:
Profitability
Efficiency
Risk
Analysis of Financial Ratios
-Ratios are more informative than raw numbers
Ratios provide meaningful relationships between
individual values in the financial statements
-Importance of relative financial ratios: Compare
a firm’s financial ratios to other entities
The aggregate economy
Its industry or industries
Its major competitors within the industry
Its past performance (time-series analysis)
-Comparison to the Aggregate Economy
Most firms are influenced by economic expansions
and contractions in the business cycle
Analysis helps you estimate the future performance
of the firm during subsequent business cycles
-Comparison to the Industry
Most popular comparison
Different industries affect the firms within them
differently, but the relationship is always significant
The industry effect is strongest for industries with
homogenous products
-Comparison to its Major Competitors
Industry averages may not be representative
Select a subset of competitors to compare to using
cross-sectional analysis, or
Construct a composite industry average from
industries the firm operates in
-Comparison to its Own Historical Records
Determine whether it is progressing or declining
Helpful for estimating future performance
Consider trends as well as averages over time
The Five Categories of Financial Ratios
-Common size statements
-Internal liquidity (solvency)
-Operating performance
Operating efficiency, Operating profitability
-Risk analysis
Business risk, Financial risk, External liquidity risky
-Growth analysis
Common Size Statements
Normalize balance sheets and income
statement items to allow easier comparison of
different size firms
Common size statements also give insight into
a firm’s financial condition
A common size balance sheet expresses
accounts as a percentage of total assets
A common size income statement expresses
all items as a percentage of sales
Evaluating Internal Liquidity
Internal liquidity (solvency) ratios indicate the
ability to meet future short-term financial
obligations
They compare near-term financial obligations,
such as accounts payable or notes payable, to
current assets or cash flows that will be
available to meet these obligations.
Current Ratio
Quick
Cash
Receivables Turnover
Av. Rec. Collection Period
Inventory Turnover
Cash Conversion Cycle
Evaluating Operating Performance
Ratios that measure how well management is
operating a business
Operating Efficiency Ratios: Examine how the
management uses its assets and capital, measured
in terms of sales dollars generated by asset or
capital categories
TAT
Eq T
Operating Profitability Ratios: Analyze profits as a
percentage of sales and as a percentage of the
assets and capital employed
- The rate of profit on sales (profit margin)
- The percentage return on capital
Gross PM
net PM
OP PM
Return on total Cap
Return on owners equity
ROE
An extended DuPont System
provides
additional insights into the effect of financial
leverage on the firm and pinpoints the effect
of income taxes on ROE
We begin with the operating profit margin
(EBIT divided by sales) and introduce
additional ratios to derive an ROE value
Risk Analysis
Risk analysis examines the uncertainty of
income flows for the total firm and for the
individual sources of capital
Debt
Preferred stock
Common stock
Total risk of a firm has two components:
Business risk
The uncertainty of income caused by the firm’s
industry
Generally measured by the variability of the firm’s
operating income over time
Financial risk
Additional uncertainty of returns to equity holders
due to a firm’s use of fixed obligation debt securities
The acceptable level of financial risk for a firm
depends on its business risk
Balance Sheet Ratios
Proportion of Debt (Balance Sheet) Ratios:
Indicate what proportion of the firm’s capital is
derived from debt compared to other sources
of capital, such as preferred stock, common
stock, and retained earnings
Debt-Equity Ratio
Long-Term Debt/Total Capital Ratio
Total Debt-Total Capital Ratios
Earnings or Cash Flow Ratios
Earnings or Cash Flow Ratios: Relate the flow
of earnings or cash available to meet the
required interest and lease payments
Cash Flow Coverage Ratios: Relate the flow of
cash available from operations to either interest
expense, total fixed charges, or the face value
of outstanding debt
Cash Flow–Long-Term Debt Ratio
Cash Flow–Total Debt Ratio
