Chapter 13 Analyzing and Interpreting Financial Statements Basics of Analysis Financial statement analysis applies analytical tools to general purpose financial statements and related data for making business decisions transforms accounting data into more useful information reduces our reliance on hunches Purpose internal users can provide strategic information to improve company efficiency and effectiveness in providing products services Purpose external users can make better and more informed decisions in pursing their own goals Common goal evaluate company performance and financial condition evaluate past and current performance current financial position and future performance and risk Building blocks of analysis o Liquidity efficiency ability to meet short term obligations and to efficiently generate revenues o Solvency ability to generate future revenues and meet long term o Profitability ability to provide financial rewards sufficient to attract obligations and retain financing o Market prospects ability to generate positive market expectations Applying the building blocks of financial statement analysis involves determining the objectives of analysis and the relative emphasis among the building blocks General purpose financial statements include income statement balance sheet statement of retained earnings statement of cash flows notes to these statements Financial reporting refers to the communication of financial information useful for making investment credit and other business decisions Standards for comparisons o Intracompany compare current net income to net income from the previous year o Competitor Coke s profit margin compared to Pepsi s profit margin o Industry o Guidelines general standards from experience Tools of analysis o Horizontal analysis comparison of a company s financial condition o Vertical analysis comparison of a company s financial condition and o Ratio analysis measurement of key relations between financial and performance across time performance to a base amount statement items Horizontal Analysis Comparative financial statements facilitates the comparison of two or more successive periods amounts by showing financial amounts in side by side columns on a single statement comparative format Computation of dollar changes and percent changes o Reference to dollar amounts is necessary to retain a proper perspective and to assess the importance of changes o Dollar change analysis period amount base period amount o Percent change dollar change base period amount 100 o Negative amount appears in the base period and a positive amount in the analysis period or vice versa no percent change is computable o Any value in base period and 0 in the analysis period decrease 100 o No value in base period no percent change is computable Comparative balance sheets comparative income statements show each item s dollar change and percent change bc it highlights large changes o Focus on items that show large dollar or percent changes then identify the reasons for these changes determine whether they are favorable or unfavorable follow up on items with small changes when we expected them to be large Trend analysis aka trend percent analysis or index number trend analysis a form of horizontal analysis that can reveal patterns in data across successive periods trend analysis does not subtract the base period amount in the numerator like percent change does o Select a base period and assign each item in the base period a weight of 100 o Express financial numbers as a percent of their base period number o Trend percent analysis period amount base period amount 100 Vertical Analysis Key base figure for income statements is usually revenue and for balance sheets is usually total assets Vertical analysis aka common size analysis Common size financial statements reveal changes in the relative importance of each financial statement item Common size percent analysis amount base amount 100 Tools o Trend analysis of common size statements same for that of comparative statements discussed under vertical analysis only difference is the substitution of common size percents for trend percents o Graphical analysis useful to identify sources of financing and focuses of investing activities Ratio Analysis Future oriented often adjusted for their probable future trend and magnitude Liquidity and efficiency o Liquidity refers to the availability of resources to meet short term cash requirements o Efficiency refers to how productive a company is in using its assets o Working capital current assets current liabilities o Current ratio current assets current liabilities Measures short term debt paying ability High strong liquidity ability to meet current obligations Too high means a company has invested too much in current assets compared to its current obligations 2 1 good ratio however depends on type of business composition of current assets and turnover rate of current asset components Type of business a company that grants little credit carries few inventories can operate on a current ratio of less than 1 1 An excessive amount of receivables and inventory weakens a company s ability to pay current liabilities o Acid test ratio cash short term investments current receivables current liabilities Measures immediate short term debt paying ability o Accounts receivable turnover net sales average accounts receivable net How frequently a company converts its receivables into cash High when accounts receivables are quickly collected Good to be high but should not be too high Measures efficiency of collection o Inventory turnover costs of goods sold average inventory High turnover requires a smaller investment in inventory but inventory turnover can be too high and can restrict sales volume Measures efficiency of inventory management o Days sales uncollected accounts receivables net net sales 365 Measures liquidity of receivables o Days sales in inventory ending inventory cost of goods sold 365 Measures liquidity of inventory o Total asset turnover net sales average total assets A company s ability to use its assets to generate sales and is an important indication of operating efficiency Measures efficiency of assets in producing sales Solvency o Solvency refers to a company s long run financial viability and its ability to cover long term obligations o Important component of solvency composition of a company s capital structure o Debt and equity ratios assets Capital structure refers to a
View Full Document
Unlocking...