Chapter 5: Using Financial Statement Information

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2 Chapter 5: Using Financial Statement Information 2

3 Control and Prediction Financial accounting numbers are useful in two fundamental ways: They help investors and creditors influence and monitor the business decisions of a company s managers. They help to predict a company s future earnings and cash flows. 3

4 Book Value vs. True Value Financial statements do not reflect the company s prospects within its business environment Statements are backward looking, not focusing on the future prospects. Financial statements are inherently limited Statements leave out some current and historical information such as human resources and the effects of inflation. Management prepares the financial statements in a biased manner Managers often choose accounting methods and estimates that make them look good. 4

5 Framework for Financial Statement Analysis Book Value Add adjustments for: (1) business environment (2) unrecorded events (3) management bias = True Value 5

6 Five Steps of Financial Statement Analysis Assessing the business environment. Reading and studying the financial statements and footnotes. Assessing earnings quality. Analyzing the financial statements. Predicting future earnings and/or cash flow. 6

7 Assessing the Business Environment What is the nature of the company s operations? What strategy is being employed to generate profits? What is the company s industry? Who are the major players? Competition? What are the relationships between the company and its customers and suppliers? How are the company s sales and profits affected by changes in the economy? 7

8 Reading and Studying the Financial Statements and Notes Read the audit report. Identify significant transactions major acquisitions, discontinuance or disposal of a business segment, unresolved litigation, major write-downs of receivables or inventories, etc. Read the financial statements and footnotes. 8

9 Assessing Earnings Quality Earnings quality may be affected by a number of strategies managers use to influence accounting numbers. Four major strategies are discussed: Overstating operating performance Taking a bath Creating hidden reserves Employing off-balance-sheet financing 9

10 Assessing Earnings Quality Overstating operating performance through the acceleration of recognition of revenue - shift the timing of revenue from a future period to the current period, through legitimate or questionable activities. Overstating operating performance through the allocation and estimation of expenses - shift the recognition of expenses through the use of taking a bath and creating hidden reserves. 10

11 Assessing Earnings Quality Taking a bath (also called big bath ) - large losses and expenses this year may increase income in future years. Rationale: if the current year is going to be disappointing to investors anyway, increase the loss to make next year look better. For example: Excessive write-downs of equipment will lead to lower depreciation expense in future years. Excessive write-downs of inventory will lead to lower cost of goods sold next year. 11

12 Assessing Earnings Quality Creating hidden reserves - expenses may be shifted from one year to another year by overestimating expense accrual. Excessive bad debt expense or warranty expense in the current year will lead to reduced estimates in future years, as the reserve is used up. Note that these reserves have nothing to do with cash reserves; they simply reserve some of the income to future periods. 12

13 Assessing Earnings Quality Employing off-balance-sheet financing - this relates to certain economic transactions that are not reflected in the balance sheet. Managers prefer to keep certain liabilities off the balance sheet when GAAP permits it, primarily because of potential debt covenant violations, and because of the effect on certain ratios. Examples include: treatment of leases as operating leases (Radio Shack) unconsolidated investments (Enron s partnerships ) which do not separate assets from liabilities. 13

14 Analyzing the Financial Statements Comparisons across time Comparisons within the industry Comparisons across different countries Comparisons within the financial statements: common-size statements and ratio analysis Profitability ratios Leverage ratios Solvency ratios Asset turnover ratios Market ratios 14

15 Comparisons Across Time Financial accounting numbers can be made more meaningful if they are compared across time. GAAP require side-by-side comparison of the current and the preceding years in published financial reports. 15

16 Comparisons Within the Industry Financial accounting numbers can also be made more meaningful if they are compared to those of similar companies. Comparison of financial accounting numbers with industry averages is also helpful. Sources of industry information include: Dun & Bradstreet Robert Morris Associates Moody Standard & Poor 16

17 Common-Size Financial Statements 17

18 Comparisons Within the Financial Statements Common-size financial statements Ratio analysis Profitability ratios Leverage ratios Solvency ratios Asset turnover ratios Market ratios 18

19 Common-Size Income Statement for La-Z-Boy, Inc. (Figure 5-2) Income Statement (in millions) 2008 % 2007 % Net sales $1, $1, Cost of sales (888) 72 (1,057) 73 Expenses and charges (460) 37 (408) 28 Net income $ (121) (9) $ (14) (1) On the income statement, cost of goods sold, expenses, and net income are often expressed as percentages of net sales. On the balance sheet, assets and liabilities can be expressed as percentages of total assets. 19

20 Profitability Ratios These ratios are designed to measure a firm s earnings power. Net income, the primary measure of the overall success of a company, is compared to other measures of financial activity or condition to assess performance as a percent of some level of activity or investment. 20

21 Profitability Ratios Return on Equity Net Income Average Shareholders Equity This ratio measures the effectiveness at managing capital provided by the shareholders. 21

22 Profitability Ratios Return on Assets Net Income + Interest Expense (1-tax rate) Average Total Assets This ratio measures the effectiveness at managing capital provided by all investors (stockholders and creditors). 22

23 Profitability Ratios Return on Sales Net Income + Interest Expense (1-tax rate) Net Sales This ratio provides an indication of a company s ability to generate and market profitable products and control its costs; also called the Profit Margin. 23

24 Leverage Ratios Leverage refers to using borrowed funds to generate returns for stockholders. Leverage is desirable because it creates returns for shareholders without using any of their money. Leverage increases risk by committing the company to future cash obligations. 24

25 Common Equity Leverage Leverage Ratios Net Income Net Income + Interest Expense (1-tax rate) This ratio compares the return available to the shareholders to returns available to all capital providers. 25

26 Leverage Ratios Capital Structure Leverage Average Total Assets Average Stockholders Equity This ratio measures the extent to which a company relies on borrowings (liabilities). 26

27 Leverage Ratios Debt to Equity Ratio Average Total Liabilities Average Shareholders Equity This ratio compares liabilities to shareholders equity and is another measure of capital structure leverage. 27

28 Leverage Ratios Long-term Debt Ratio Long-Term Debt Total Assets This ratio measures the importance of long-term debt as a source of asset financing. 28

29 Solvency Ratios Solvency refers to a company s ability to meet its current debts as they come due. There is pressure on companies with high levels of leverage to manage their solvency. 29

30 Solvency Ratios Current Ratio Current Assets Current Liabilities This ratio measures solvency in the sense that current assets can be used to meet current liabilities. 30

31 Solvency Ratios Quick Ratio Cash + Marketable Securities + A/R Current Liabilities Similar to the current ratio, this ratio provides a more stringent test of a company s solvency. 31

32 Solvency Ratios Interest Coverage Net Income + Tax Expense + Interest Expense Interest Expense This ratio compares the annual funds available to meet interest to the annual interest expense. 32

33 Solvency Ratios Accounts Payable Turnover Cost of Goods Sold Average Accounts Payable This ratio measures the extent to which accounts payable is used as a form of financing. 33

34 Asset Turnover Ratios Asset turnover ratios are typically computed for total assets, accounts receivable, inventory, and fixed assets. These ratios measure the speed with which assets move through operations or reflect the number of times during a given period that these specific assets are acquired, used, and replaced. 34

35 Asset Turnover Ratios Receivables Turnover Net Credit Sales Average Accounts Receivable This ratio reflects the number of times the trade receivables were recorded, collected, and recorded again during the period. 35

36 Asset Turnover Ratios Inventory Turnover Cost of Goods Sold Average Inventory This ratio measures the speed with which inventories move through operations. 36

37 Asset Turnover Ratios Fixed Assets Turnover Sales Average Fixed Assets This ratio measures the speed with which fixed assets are used up. 37

38 Asset Turnover Ratios Total Asset Turnover Sales Average Total Assets This ratio measures the speed with which all assets are used up in operations. 38

39 Market Ratios These additional ratios are used by the financial community to assess company performance. 39

40 Market Ratios Earnings per Share Net Income Average Number of Common Shares Outstanding This ratio, according to the financial press, is the primary measure of a company s performance. It calculates the amount of income that is earned for each shareholder. 40

41 Price/Earnings Ratio Market Ratios Market Price per Share Earnings per Share This ratio is used by many analysts to assess the investment potential of common stocks. 41

42 Dividend Yield Ratio Market Ratios Dividends per Share Market Price per Share This ratio indicates to cash return on the shareholders investment. 42

43 Market Ratios Stock Market Price 1 - Market Price 0 + Dividends Price Market Price 0 Return This ratio measures the pretax performance of an investment in a share of common stock. 43

44 Comparisons Across Different Countries Investors interested in comparing the financial performance and condition of companies from different countries often must contend with two difficult issues: If the companies use different accounting standards (e.g., U.S. GAAP vs. IFRS), the reported values must be adjusted to a common basis so that reasonable comparisons can be made. Adjusting financial statements to a common basis by itself may not be sufficient to achieve meaningful comparisons. In other words, not only must the financial statements of a foreign-based company be adjusted, but the resulting numbers can only be interpreted through an understanding of the foreign environment. 44

45 Appendix 5A DuPont (ROE) Model: Return On Equity = Return on Assets X Capital Structure Leverage X Common Equity Leverage Return on Assets = Profit margin X Asset Turnover 45

46 Solvency Assessment (Figure 5A-6) 46

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