Chapter 5 Study Guide Basic Approaches Time series analysis helps identify financial trends over time for a single company or business unit Cross sectional analysis helps identify similarities and differences across companies or business units at a single moment in time Benchmark comparison measures a company s performance or health against some predetermined standard Financial Statement Analysis and Accounting Quality The data needed for a complete and faithful picture does not always reach the financial reports because the information is filtered by GAAP rules and management s accounting decisions Management discretion clouds financial analysis in many ways Management manipulates the way they report accounting numbers to their advantage whether it is to manipulate financial ratios or meet financial incentives tied to bonuses Although it helps management it doesn t offer financial statement users the most accurate window into the company Conflicts of interest another threat to the quality of financial reports Arise when what is good for one party i e Management isn t necessarily good for another party lenders or outside investors For example taking out bank loans in the name of the company but using them for personal expenditures Companies have an obligation to disclose business transactions that involve potential conflicts of interest Common Size and Trend Analysis Income Statements Common size income statements portrays each financial statement item as a percentage of sales Ex what percentage of sales cost of goods sold was operating income etc etc Trend statements also restates each statement item as a percentage but they use a base year number for each respective category For example lets say 2007 is the base year for sales cost of goods sold operating income 2008 and 2009 numbers in each of these categories show how much of an increase there was relative to the 2007 numbers Goodwill the acquisition price premium paid for a target company over and above the value of its identifiable assets The price you pay above the book value of the company this is considered the goodwill For example if you bought the McDonalds company and all of its assets were worth 15 billion you might pay 18 billion just because the McDonalds name and branding and reliability it has already built with its customers is worth the extra 3 billion Trend statements often indicate a company s growth and decline more clearly than common size statements do Common Size and Trend Analysis Cash Flow Statements The common size statements are constructed by dividing each cash flow item by sales for the year Financial Ratios and Profitability Analysis Financial ratios are useful tools that analysts use in evaluating profit performance and assessing credit risk ROA Earnings before interest EBI Average Assets Average assets represent the average book value of total assets over that same time period Before calculating the ROA analysts may adjust the company s reported earnings and asset figures There are three categories for these adjustments 1 Adjustments aimed at isolating a company s sustainable profits by removing nonrecurring items from reported income 2 An adjustment that eliminates after tax interest expense from the profit calculations so that profitability comparisons over time or across companies are not clouded by differences in financial structure 3 Adjustments for distortions related to accounting quality concerns which involve potential adjustments to both earnings and assets for items such as the off balance sheet operating leases A company that wants to increase its rate of return on assets can do so in two different ways 1 By increasing the profit margin Either cut costs or raise the sales price or both 2 By increasing the intensity of asset utilization by offering more ways for people to buy your product Both are reflected in the ROA equivalent ROA Earnings before interest EBI EBI x Sales Average Assets Sales Average Assets Profit margin x Asset Turnover Changes in the profit yield per sales dollar show up as changes in the profit margin and changes in the amount of sales generated from each asset dollar are reflected as asset turnover changes The current asset turnover ratio helps the analyst spot efficiency gains from improved accounts receivable and inventory management the long term asset turnover ratio captures information about property plant and equipment utilization ROA and Competitive Advantage Companies that consistently earn rates of return above the average for the competition are said to have a competitive advantage They may have this advantage due to unique products or services or innovative production technologies distribution channels or sales and marketing efforts However if a company has a higher rate of return compared to the industry this will invite more competition and the profitability and Competitive advantage will eventually erode Two strategies for achieving superior performance in any business One strategy is product and service differentiation the other is low cost leadership Differentiation focuses on unique product or service qualities to gain brand loyalty Essentially people are willing to pay premium prices for things they value and can t get anywhere else Low cost leadership focuses customer attention on product pricing the goal is to become the lowest cost producer in the market place so the business can under price the competition Differences in business strategies companies adopt give rise to economic differences which are reflected as differences in profit margins asset utilization and profitability Return on common equity and financial leverage ROCE measures a company s performance in using capital provided by common shareholders to generate earnings It shows how the company finances its assets ROCE Net income preferred dividends average common shareholders equity Profitability influences the return that common shareholders earn in their investment in the company as well as financial leverage Financial leverage benefits shareholders whenever the cost of the debt interest rate charged is less than what the company earns on the borrowed funds If the cost of debt becomes to high however financial leverage can hurt shareholders Components of ROCE ROCE ROA x common earnings leverage x financial structure leverage EBI average assets x net income available to common shareholders EBI x average assets average common shareholders equity net income available to common