Chapter 18: Financial Statement Analysis Flashcards
Liquidity
The measure of the ability of the firm to meet its immediate, current financial obligations
Solvency
The firm’s ability to have sufficient assets to meet its debts in the long term
Basics of Financial Statement Analysis
Characteristics: Liquidity, profitability, solvency
Comparison Basis: Intracompany, Industry averages, Intercompany
Tools of analysis: horizontal, vertical, ratio
Horizontal Analysis
AKA: Trend Analysis
Evaluating a series of financial statement data over a period of time - sees increases or decreases.
Commonly applied to the balance sheet, income statement, and statement of retained earnings
Vertical Analysis
AKA: Common-size Analysis
Technique that expresses each financial statement item as a percentage of a base amount. Enables comparisons of companies of different sizes.
Commonly applied to balance sheet and income statement
Balance sheet: Assets = 100%, Liabilities + Stockholders’ Equity = 100%
Income Statement: Net Sales = 100%
Ratio Analysis
Requires comparison for meaning: Intra-company, inter-company or industry average.
Expresses the relationship among selected items of financial data.
Liquidity ratios: measure the short-term ability of the company to may maturing obligations and meet unexpected needs for cash
Profitability Ratios: measure income or operating success of a company for a period of time
Solvency ratios: measure the ability of a company to survive over a long period of time
Sustainable Income
The most likely level of income to be obtained by the company in the future.
Excludes unusual revenues, expenses, gains and losses (ex: gains and losses on discontinued items)
These are all disclosed and reported Net of Income tax
Analysis-Distorting Issues
Irregular Items
Discontinued Operations
Extraordinary items
“Irregular” Items
Can distort financial analysis Reported separated out on income statement - Discontinued Operations - Extraordinary items - Must be reported net of income taxes - changes in accounting principle (must disclose in notes) - Comprehensive Income (OC) items - Improper Revenue Recognition
Discontinued Operations
Can distort financial analysis
- Disposal of a significant component of the business
- Income (or loss) reported in two parts:
Income (or loss) from discontinued operations
Gain (or loss) on disposal
Both reported net of tax
Change in accounting principle
Can distort financial analysis
- occurs when the principle used in current year differs from proceeding year.
- allowable if change is justified (operations/ situation changes)
- only ever reported retroactively
Comprehensive Income
Can distort financial analysis
All changes in stockholders’ equity EXCEPT those resulting from investment by stockholders and distributions to stockholders
- Reported in unrealized equity
- Ex: unrealized gains and losses on available-for-sale securities
Quality of Earnings
A company that provides full and transparent information that will not confuse the users of financial statements = high quality of earnings
Reduced by the variability of application of GAAP that hampers comparability
Pro Forma Income
Usually excludes items that the company thinks are unusual and non-recurring.
(this is a flexibility in reporting that is sometimes abused)
Improper Recognition
Often occurs when there is pressure to continually increase earnings
- improper recognition of revenue
- improper capitalization of operating expenses
- failure to report all liabilties
Extraordinary Items
Can distort financial analysis
Must be BOTH: of an unusual nature (some judgement call in this) and occur infrequently
Reported net of tax
ex: expropriated property or rare weather/ geological events
Benford’s Law
In a random collection of numbers the frequency of lower digits (1,2,3) should be much higher than the higher digits (7,8,9)
Discontinued Operations on Income Statement
Reported on income statement after income from continuing operations
Extraordinary items on income Statement
Reported on income statement after income from continuing operations (and after discontinued operations if exist)
Always reported net of tax
Comprehensive Income on Statement of Comprehensive Income
Shows net income + or - comprehensive items. (unrealized gains/losses on available for sale securities)
Also shown on balance sheet
These are reported separately from net income to remove the market volatility from income but included in reports to give information to users (eg: income if the securities were to be sold)
Times Interest Earned
A Solvency ratio
AKA: Interest coverage
Indicates the company’s ability to meet interest payments as they come due
= (Net income + interest expense + income tax expense) / interest expense
Net of Income Taxes
= item x (1 - tax rate) (check)
Debt to total assets ratio
A solvency ratio
measures the percentage of total assets that creditors provide
= total liabilities (aka total debt) / total assets
Solvency Ratios
Ratios that measure the ability of a company to survive over a long period of time
- Debt to total assets ratio
- times interest earned
(both show debt paying ability of the company)
Payout Ratio
A profitability Ratio
Measures the percentages of earnings distributed in the form of cash dividends
= cash dividends declared on common stock / net income
Price Earnings Ratio
A profitability ratio
AKA P-E ratio
Reflects the investors assessment of a company’s future earnings
= market price per share of stock / earnings per share
Earnings Per Share
A profitability ratio
AKA: EPS
Measures net income earned on each share of stock
= Net income (less preferred dividends) / weighted-average common shares outstanding
Weighted average common shares outstanding = (beginning + ending)/2
Per FASB earnings per share must be shown on income statement
Return on common stockholders’ equity
A profitability ratio
Shows how many dollars of net income the company earned for each dollar invested by the owners (profitability of owner’s investment)
= Net income (less preferred dividends) / Average common stockholders equity
(Average common stockholders’ equity = (beginning + ending)/2)
Return on Assets
A profitability ratio
AKA: Return on total assets
An overall measure of profitability of assets
= Net Income / Average Total Assets
(Average total assets = (beginning assets + ending assets)/ 2)
Per book: Net income= Net income + interest expense ( this determines real return on income regardless of financing choices)
Asset Turnover
A profitability ratio
Measures how efficiently a company uses its assets to generate sales
= Net sales / Average total assets
(Average total assets = (beginning assets + ending assets)/ 2)
Profit Margin
A profitability ratio
Measures the percentage of each dollar of sales that results in net income
= Net income / net sales
(expressed as a percentage)
Profitability Ratio
Measures the income or operating success of a company over a given period of time.
Income level affects the company’s ability to obtain debit and equity financing = the ability for the company to grow
Ratios:
- Profit Margin
- Asset Turnover
- Return on Assets
- Return on Common Stockholders’ Equity
- Earnings-per-Share
- Price-Earnings ratio
- Payout Ratio
Days in inventory
A liquidity ratio
A variant of inventory turnover
Measures average number of dates inventory is held (varies considerably by industry)
= Total days in period (usually 365) / Inventory Turnover
Average Collection Period
A liquidity ratio
A variant of receivables turnover ratio
Measures average days to collect receivables
= Total Days in period (usually 365) / Receivables Turnover
Inventory Turnover
A liquidity ratio
Measures the average number of times the inventory is sold during a period. (the liquidity of the inventory)
= cost of goods sold / average inventory
(Average inventory = (beginning inventory + ending inventory)/2)
Accounts Receivable Turnover
A liquidity ratio
Measures the average number of times a company collects receivables during a period (the liquidity of receivables)
= Net Credit Sales / Average Net Accounts Receivable
Net credit sales generally = net sales
Net accounts receivable = net of allowance for doubtful accounts
Average Net Accounts Receivable = (Beginning A/R + Ending A/R)/ 2
Acid Test Ratio
A liquidity ratio
Measures Immediate liquidity
= (Cash + Short Term + Net Accounts Receivable)/ Current Liabilities
Ignores inventory and prepaid accounts (not considered liquid enough)
Net accounts receivable = net of allowance for doubtful accounts
Current Ratio
A liquidity ratio
Measures the amount of current assets for every dollar of current liabilities (short-term debt paying ability)
= current assets / current liabilities
Liquidity Ratios
Measure the short term ability of a company to pay its maturing obligations and to meet unexpected needs for cash.
Often of interest to short-term creditors (bankers and suppliers)
Ratios:
- Current Ratio
- Acid Test Ratio
- Receivables Turnover
- Inventory Turnover
Financial Analysis under IFRS
Basic tools of financial analysis are the same under IFRS and GAAP
Presentation of comprehensive income must be reported in statement of comprehensive income
Red Flags in Financial Statements
- Movement of Sales, merchandise inventory, and receivables (usually move in synch)
- Earnings problems
- Decreased cash flow
- Too much Debt
- inability to collect receivables
- Buildup of merchandise inventories
Treading on the Equity
AKA using leverage
Earning more income on borrowed money than the related interest expense, thereby increasing earnings for the owners of the business
EBIT
Earnings before interest and taxes
= Net income + interest expense + income tax expense
Benchmarking
The practice of comparing a company’s performance with best practices from other companies
Generally benchmarked against a key competitor or against the industry average
Common-Size statements
A financial statement that reports only percentages (no dollar amounts)
Dollar Value Bias
The bias one sees from comparing numbers in absolute (dollars) rather than relative (percentage) terms
Trend Analysis
A form of horizontal analysis in which percentages are computed by selecting a base period as 100% and expressing the amounts for following periods as a percentage of the base period amounts.
Trend % = (any period amount / base period amount) x100
determines if trend in net sales revenue (or other) is positive or negative over a longer period of time (several years)
Parts of an annual report
- Business Overview
- Management Discussion and Analysis of Financial Condition and Results of Operations (MD&A)
- Report of independent registered public accounting firm (will issue unqualified, qualified or adverse opinion)
- Financial Statements
- Notes to financial statements
Annual Reports
Provides information about company’s financial positions
SEC requires that publicly traded companies file annual and quarterly reports
Dividend Payout
Measures percentage of earnings paid annually to common stockholders as cash dividends
= annual dividend per share / earnings per share
Dividend Yield
Ratio of annual dividends per share of stock to the stock market price per share. Measures percentage of a stock’s market value that is returned annually as dividends to stockholders.
= Annual dividends per share / market price per share
Debt to Equity Ratio
Measures the proportion of total liabilities to total equity (measuring financial leverage)
= Total Liabilities / total equity
>1 = financing more assets with debt than equity <1 = financing more assets with equity than debt
Gross Profit Percentage
AKA Gross margin percentage
Measures the profitability of each sales dollar above cost of goods sold
= gross profit / net sales revenue
Gross profit = net sales revenue - cost of goods sold
(aka gross margin)
Cash Ratio
A measure of the company’s ability to pay current liabilities from cash and cash equivalents.
= (cash + cash equivalents)/ total current liabilities
Cash Equivalents = investments that can be converted to cash in three months or less
Working Capital
A measure of a businesses ability to meet its short-term obligations with its current assets
= current assets - current liabilities
Base Period
The earlier period in a financial report. Used as base for computing percentages.
Horizontal analysis % = (dollar amount of change / base period amount ) x 100
