Notes: FIN 303 Spring 09, Part 14 – Financial Statement Analysis Professor James P. Dow, Jr. 126 Part 14. Financial Statement Analysis As we saw in the last section, investors often need to forecast the future earnings of a company when making a decision about whether to invest. One source of information about a company is its financial statements. Using financial statements to evaluate a company’s performance and to forecast its future prospects is called financial statement analysis. An important part of financial statement analysis is the calculation of financial ratios. In this section we will examine some of the most common financial ratios and see how they are used. Major Financial Statements We will be concerned with the three major financial statements: the balance sheet, the income statement, and the statement of cash flows. You should be familiar with these statements from financial accounting, Balance Sheet The balance sheet looks at the financial position of the company at a point in time. The financial relationship given by the balance sheet is summarized by the equation: Assets = Liabilities + Equity From our perspective, this shows how much of the assets (which drive the company’s business) were financed from equity or debt (liabilities). Equity is the value of the company in terms of its financial statements, which is why it is called the “book value” of the company. The market value of the company is given by the “market capitalization”, the market value of its stock. The balance sheet will provide details on the various types of assets and liabilities. Generally, assets and liabilities are listed in order of increasing maturity. Assets and liabilities with maturities of less than one year are called “current”. Income Statement The income statement measures the earnings generated over a year. The basic relationship it captures is given by the equation: Revenues – Expenses = Earnings Revenues and expenses are often broken down by type. This can be very useful when analyzing the financial position of a company because it gives clues about what might happen in the future. A software company might break its costs down into manufacturing and research and development. This is a useful distinction because manufacturing costs tend to be variable costs while research costs are fixed with respect to production. If we wanted to know how profits would change if there was an increase in sales, we would want to treat these costs differently.Notes: FIN 303 Spring 09, Part 14 – Financial Statement Analysis Professor James P. Dow, Jr. 127Statement of Cash Flows In some ways, the statement of cash flows is similar to the income statement; however, it focuses on actual cash payments rather than accounting earnings. For example, when you make a capital purchase, the accounting treatment will spread the costs over time by creating a “depreciation cost” for several years, even if the asset was completely paid for in the first year. On the other hand, the statement of cash flows will record the cash out in the first year but no other costs in subsequent years. Cash flow is usually divided into three types: Operations Investment activities (buying and selling assets) Financing (raising money) This distinction can be very important. Say that a company shows a positive cash flow of $100 million. How likely is this to continue into the future? If the cash flow was generated from operations, then it would continue as long as the business of the company is successful. If the cash flow was generated by selling off a factory (investment activities) then it would be less promising for the future – there are only so many factories that it could sell, and selling them would likely hurt its future business. If the cash flow was generated by borrowing money (financing) then again it might not continue. There is a limit to how much debt a company can raise without increasing its cash flow from operations. Financial Ratios Imagine that we are comparing two different companies: Company A has $100 million of debt. Company B has $10 million of debt. For which company is debt a bigger problem? It wouldn’t make sense to compare them directly. The first company could have more debt but still be in a better financial position since the amount of debt could be small relative to the revenue generated. Because of this problem, it is typical in financial statement analysis to express financial numbers not in absolute dollar amounts but as ratios. For example, we could calculate the amount of debt relative to assets. If company A had $200 million of assets and B had $20 million of assets both would have debt-to-asset ratios of 0.5. It is important to realize that financial ratios often do not mean much by themselves. In our example, Company A had a debt-to-assets ratio of 0.5. Is that too much? By itself this number does not tell us much. We need to compare it to something else, for example: 1) We could compare the number to other companies in the same industry. If it was typical for companies in this industry to have debt-to-assets ratios of 0.2 then we might be concerned since our company has more debt than typical. Why do we compare it to companies within the same industry? There are a variety of factors that determine the optimal amount of debt (remember the section on corporate finance) and these factors can vary across industries. It wouldn’t be good to compare a company in an industry that typically has little debt with companies in an industry where it desirable to have more debt. 2) We could also compare the debt-to-asset ratio to past values for the same company. If we see a pattern where the use of debt has been increasing over the last five years, it might raise concerns that debt will continue to increase into the future and so might be a problem down the line.Notes: FIN 303 Spring 09, Part 14 – Financial Statement Analysis Professor James P. Dow, Jr. 128In this class we will only look a few financial ratios. In practice there are scores of different ratios. How do you know which are important and which are not? Typically, financial ratios are used in two different ways. In the first approach, we have a specific question in mind; for example, does a company have too much debt? We use the financial ratios that are designed with this in mind. Even within this area there are a