Outline Financial Statement Analysis
Transforming data into useful information for decision making. A. Purpose of Analysis To help users (both internal and external) make better business decisions. 1. Internal users (managers, officers, internal auditors, consultants, budget officers, and market researchers) make the strategic and operating decisions of a company. 2. External users (shareholders, lenders, directors, customers, suppliers, regulators, lawyers, brokers, and the press) rely on financial statement analysis to make decisions in pursuing their own goals.
The common goal of all users is to evaluate: a. Past and current performance. b. Current financial position. c. Future performance and risk. B. Building Blocks of Analysis The four areas of inquiry or building blocks are: 1. Liquidity and efficiency—ability to meet short-term obligations and to efficiently generate revenues. 2. Solvency—ability to generate future revenues and meet long-term obligations. 3. Profitability—ability to provide financial rewards sufficient to attract and retain financing. 4. Market Prospects—ability to generate positive market expectations.
Information for Analysis 1.
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Most users rely on general purpose financial statements that include: a. Income statement b. Balance sheet c. Statement of changes in stockholders’ equity (or statement of retained earnings) d. Statement of cash flows e. Notes related to the statements 2. Financial reporting—is the communication of financial information useful for making investment, credit, and other business decisions. Includes information from SCE 10-K or other filings, press releases, shareholders’ meetings, forecasts, management letters, auditor’s reports, and Webcasts.
Standards for Comparisons Used to determine if analysis measures suggest good, bad, or average performance. Standards can include the following types of comparisons: 1. Intracompany—based on prior performance and relationships between its financial items. 2. Competitor—compared to one or more direct competitors (often best). 3. Industry—published industry statistics (available from services like Dun & Bradstreet, Standard and Poor’s, and Moody’s). 4. Guidelines (rules-of-thumb)—general standards developed from past experiences. E.
Tools of Analysis – includes horizontal, vertical and ratio analysis. II. Horizontal Analysis — Tool to evaluate changes in financial statement data across time. This analysis utilizes: A. Comparative Statements — reports financial amounts for more than one period placed side by side in columns on a single statement. 1. Computation of Dollar Changes and Percentage Changes—usually shown in line items. a. Dollar change = Analysis period amount minus Base period amount. b. Percent change = Analysis period amount minus Base period amount divided by Base period amount times 100.
Notes: (1) When a negative amount appears in the base period and a positive amount in the analysis period (or vice versa)— a meaningful percentage change cannot be computed. (2) When there is no value in the base period—percentage change is not computable. (3) When an item has a value in the base period and zero in the next period—the decrease is 100 percent. 2. Comparative balance sheets a. Consist of balance sheet amounts from two or more balance sheet dates arranged side by side. b. Usefulness is improved by showing each item’s dollar change and percent change to highlight large changes.
Comparative income statements a. Amounts for two or more period are placed side by side. b. Additional columns are included for dollar and percent changes. B. Trend Analysis — used to reveal patterns in data across successive periods. Involves computing trend percents (or index number) as follows: 1. Select a base period and assign each item in the base period a weight of 100%. 2. Express financial numbers as a percent of their base period number. 3.
Trend percent equals analysis period amount divided by base period amount times 100. III. Vertical Analysis — Comparing financial condition and performance to a base amount. The analysis tools include: A. Common-Size Statements — reveal changes in the relative importance of each financial statement item. All amounts are redefined in terms of common-size percents. 1. Common-size percentage equals analysis amount divided by base amounts multiplied by 100. 2. Common-size balance sheets—base amount is usually total assets.
Common-size income statements—base amount is usually revenues. B. Common-Size Graphics Graphical analysis (e. g. , pie charts and bar charts) of common-size statements that visually highlight comparison information. IV. Ratio Analysis — Using key relationships among financial statement items. Ratios organized into the four (items A through D below) building blocks of analysis: A. Liquidity and Efficiency 1. Liquidity refers to the availability of resources to meet short-term cash requirement. 2.
Efficiency refers to how productive a company is in using its assets. Efficiency is usually measured relative to how much revenue is generated for a certain level of assets. 3. Ratios in this block: a. Working capital—the excess of current assets over current liabilities. b. Current ratio—current assets divided by current liabilities; describes a company’s ability to pay its short-term obligations. c. Acid-test ratio—similar to current ratio but focuses on quick assets (i. e. , cash, short-term investments and current receivables) rather than current assets.
Days’ sales in inventory—ending inventory divided by cost of goods sold multiplied by 365; measures how many days it will take to convert the inventory on hand at the end of the period into accounts receivable or cash. h. Total asset turnover—net sales divided by average total assets; describes the ability to use assets to generate sales. B. Solvency 1. Solvency refers to a company’s long-run financial viability and its ability to cover long-term obligations. Capital structure is one of the most important components of solvency analysis. 2. Capital structure refers to a company’s sources of financing.
Ratios in this block: a. Debt ratio—total liabilities divided by total assets. b. Equity ratio—total stockholders’ equity divided by total assets. Note: A company is considered less risky if its capital structure (equity and long-term debt) is composed more of equity. c. Debt-to-Equity Ratio – total liabilities divided by total equity; measure of solvency. A larger debt-to-equity ratio implies greater risk. d. Times interest earned—income before interest expense and income taxes divided by interest expense; reflects the risk of loan repayments with interest to creditors.
Profitability refers to a company’s ability to generate an adequate return on invested capital. 2. Return is judged by assessing earnings relative to the level and sources of financing. 3. Ratios in this block: a. Profit margin—net income divided by net sales; describes the ability to earn net income from sales. b. Return on total assets—net income divided by average total assets; a summary measure of operating efficiency; comprises profit margin (net income divided by net sales) and total asset turnover (net sales divided by average total assets).
Return on common stockholders’ equity—net income less preferred dividends divided by average common stockholders’ equity; measures the success of a company in earning net income for its owners. D. Market Prospects 1. Market measures are useful for analyzing corporations with publicly traded stock. 2. Market measures use stock price in their computation. 3. Ratios in this block: a. Price-earnings ratio—market price per common stock divided by earnings per share; used to evaluate the profitability of alternative common stock investments.
Dividend yield—annual cash dividends paid per share of stock divided by market price per share; used to compare the dividend-paying performance of different investment alternatives. E. Summary of Ratios Exhibit 13. 16 sets forth the names of each of the common ratios by category, and includes the formula and a description of what is measured by each ratio. F. Global View 1. Horizontal and Vertical Analysis – horizontal and vertical analysis helps eliminate many differences between GAAP and IFRS when analyzing and interpreting financial statements.
Ratio Analysis – ratio analysis has many of the advantages and disadvantages of horizontal and vertical analysis. The ratios applied are fine, with some possible changes in interpretation depending on what and what is not included in certain accounting measures across GAAP and IFRS. V. Decision Analysis—Analysis Reporting Goal of financial statement analysis report is to reduce uncertainty through rigorous and sound evaluation. A good analysis report usually consists of six sections: 1. Executive summary. 2. Analysis overview. 3. Evidential matter. 4. Assumptions. 5. Key factors. 6. Inferences
When a company’s activities involve income-related events that are not part of its normal, continuing operations, it often separates the income statement into different sections as follows: A. Continuing Operations Reports the revenues, expenses, and income generated by the company’s continuing operations. B. Discontinued Segments 1. A business segment is a part of a company’s operations that serves a particular line of business or class of customers. 2. A company’s gain or loss from selling or closing down a segment is separately reported as follows: a.
Income from operating the discontinued segment for the current period prior to its disposal. b. The gain or loss from disposing of the segment’s net assets. C. Extraordinary Items 1. Extraordinary gains and losses are those that are both unusual and infrequent. a. An unusual gain or loss is abnormal or otherwise unrelated to the company’s regular activities and environment. b. An infrequent gain or loss is not expected to recur given the company’s operating environment. 2. Reporting extraordinary items in a separate category helps users predict future performance, absent the effects of the extraordinary items.
Items that are either unusual or infrequent, but not both, are reported in the income statement but after the normal revenues and expenses. D. Earnings per Share (EPS) — is the amount of income earned by each share of outstanding common stock and is reported in the final section of income statement. One of the most widely cited items of accounting information. E. Changes in Accounting Principles 1. The consistency principle requires a company apply the same accounting principles across periods (examples in this context: (include inventory or depreciation methods).
Changes in accounting principles are acceptable if justified as improvements in financial reporting. 2. Cumulative effect of the change on prior periods’ incomes should be reported on the income statement (net of taxes) below extraordinary items. 3. A footnote should describe and justify the change and report what income would have been under the old method. F. Comprehensive Income is net income plus certain gains and losses that bypass the income statement. The change in equity for the period, excluding investments from and distributions to its stockholders.