Using Financial Statement Information: Electronic Presentations For Chapter 3

Using Financial
Statement Information
Electronic Presentations for Chapter 3
Key Points
Using financial accounting numbers to influence

management decisions and predict future events.
Five steps of financial statement analysis.
Assessing the business environment.
Assessing earnings quality and persistence.
Analyzing financial statements.
Difficulties involved in using annual report information to
identify mispriced securities.
Difficulties involved in using financial statements to compare
the performance of companies operating in different
countries.
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 companys
managers
They help to predict a companys future earnings
and cash flows
Book Value vs. True Value
Financial statements do not reflect the companys

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.
Limitations of Financial
Accounting Information
True
TrueCompany
CompanyValue
Value
Reported
ReportedBook
BookValue
Value
True
TrueCompany
CompanyValue
Value
Objective
Objectiveand
andappropriate
appropriate
GAAP
GAAPbook
book value
value
Legitimate
Legitimatediscretion
discretion
Fraudulent
Fraudulent reporting
reporting
Reported
ReportedBook
BookValue
Value
True
TrueCompany
CompanyValue
Value
Objective
Objectiveand
andappropriate
appropriate
GAAP
GAAPbook
book value
value
Legitimate
discretion
Fraudulent
reporting
Reported
ReportedBook
BookValue
Value
Inherent
InherentGAAP
GAAP
limitation
limitation
True
TrueCompany
CompanyValue
Value
Objective
Objectiveand
andappropriate
appropriate
GAAP
GAAPbook
book value
value
Legitimate
discretion
Fraudulent
reporting
Reported
ReportedBook
BookValue
Value
Inherent
InherentGAAP
GAAP
limitation
limitation
Management
Management
bias
bias
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.
Assessing the Business

Environment
What is the nature of the companys operations?

What strategy is being employed to generate
profits?
What is the companys industry?
Who are the major players? Competition?
What are the relationships between the company
and its customers and suppliers?
How are the companys sales and profits affected
by changes in the economy?
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.
Assessing Earnings Quality
Overstating operating performance

Taking a bath
Creating hidden reserves
Employing off-balance-sheet financing
Earnings quality and inherent financial
statement limitations
Analyzing the Financial

Statements
Comparisons across time

Comparisons within the industry
Comparisons within the financial statements:
common-size statements and ratio analysis
Profitability ratios
Leverage ratios
Solvency ratios
Asset turnover ratios
Market ratios
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.
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
Comparisons Within
the Financial Statements
Common-size financial statements

Ratio analysis
Profitability ratios
Leverage ratios
Solvency ratios
Asset turnover ratios
Market ratios
Common-Size Income Statement

for PepsiCo Inc.
Net sales
Cost of sales
Expenses
Net income
1996
$31,645
(15,383)
(15,113)
$1,149
%
1995
100 $28,351
49 (14,886)
48 (11,859)
3 $1,606
%
100
53
42
5
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.
Profitability Ratios
These ratios are designed to measure a firms

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.
Return on
equity
Net Income
Average Stockholders Equity
This ratio measures the effectiveness at

managing capital provided by owners.
Return on
equity
Net Income
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.
Return on
equity
Net Income
Return on
assets
Net Income +
Return on sales
(profit margin)
Net Income +
Net Sales
This ratio provides an indication of a

companys ability to generate and market
profitable products and control its costs.
Leverage Ratios
Leverage refers to using borrowed funds to

generate returns for stockholders.
Leverage is desirable because it creates
returns for stockholders without using any of
their money.
Leverage increases risk by committing the
company to future cash obligations
Leverage Ratios
Common
equity
leverage
Net Income
Net Income +
This ratio compares the return available to the

stockholders to returns available to all capital
providers.
Leverage Ratios
Common
equity leverage
Capital
structure
leverage
Net Income
Net Income +
Average Stockholders' Equity
This ratio measures the extent to which a

company relies on borrowings (liabilities).
Leverage Ratios
Common
equity
leverage
Net Income
Net Income +
Capital
structure
leverage

Debt/equity
ratio
Average Liabilities
This ratio compares liabilities to stockholders

equity and is another measure of capital
structure leverage.
Leverage Ratios
Common
equity
leverage
Net Income
Net Income +
Capital
structure
leverage

Debt/equity
ratio
Average Liabilities
Long-term debt
ratio
Long-Term Debt
Total Assets
This ratio measures the importance of longterm debt as a source of asset financing.
Solvency Ratios
Solvency refers to a companys ability to meet

its current debts as they come due.
There is pressure on companies with high
levels of leverage to manage their solvency.
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
Solvency Ratios
Current ratio
Quick ratio
Current Assets
Current Liabilities
Cash +Marketable Securities +
Accounts Receivable
Current Liabilities
Similar to the current ratio, this ratio provides a

more stringent test of a companys solvency.
Solvency Ratios
Current ratio
Quick ratio
Interest
coverage
Current Assets
Current Liabilities
Accounts Receivable
Current Liabilities
Net Income +Tax Expense +
Interest Expense
Interest Expense
This ratio compares the annual funds available to

meet interest to the annual interest expense.
Solvency Ratios
Current ratio
Quick ratio
Interest
coverage
Current Assets
Current Liabilities
Accounts Receivable
Current Liabilities
Net Income +Tax Expense +
Interest Expense
Interest Expense
Accounts
Cost of Goods Sold
payable
Average Accounts Payable
turnover
This ratio measures the extent to which accounts
payable is used as a form of financing.
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.

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.

Receivables
turnover
Inventory
turnover
Net Credit Sales

Cost of Goods Sold
Average Inventory
This ratio measures the speed with which

inventories move through operations.

Receivables
turnover
Inventory
turnover
Fixed assets
turnover
Net Credit Sales

Cost of Goods Sold
Average Inventory
Sales
Average Fixed Assets
This ratio measures the speed with which fixed

assets are used up.

Receivables
turnover
Inventory
turnover
Net Credit Sales

Cost of Goods Sold
Average Inventory
Fixed assets
turnover
Sales
Average Fixed Assets
Total asset
turnover
Sales
This ratio measures the speed with which all

assets are used up in operations.
Market Ratios
These additional ratios are used by the

financial community to assess company
performance.
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 companys performance.
Market Ratios
Earnings per
share
Price/earnings
ratio
Net Income
Average Number of Common
Shares Outstanding
Market Price per Share
Earnings per Share
This ratio is used by many analysts to assess the

investment potential of common stocks.
Market Ratios
Earnings per
share
Net Income
Shares Outstanding
Price/earnings
ratio

Earnings per Share
Dividend yield
ratio
Dividends per Share

This ratio indicates to cash return on the

stockholders investment.
Market Ratios
Earnings per
share
Net Income
Shares Outstanding
Price/earnings
ratio

Earnings per Share
Dividend yield
ratio
Dividends per Share

Annual return on
investment
Market Price 1 - Market Price 0 +

Dividends
Market Price 0
This ratio measures the pretax performance of an

investment in a share of common stock.
Solvency Assessment
Ability to Generate Cash
Cash Requirements
Operating Performance
Financial Flexibility
Solvency Assessment
Cash Requirements
Operating Revenue
Sale of Goods
Sale of Service
Creation of Operating Receivables
(timing difference)
Cash Inflows from Operations
Solvency Assessment
Cash Requirements
Operating Revenue
Sale of Goods
Sale of Service
(timing difference)
Operating Costs
Cost of Goods Sold
Operating Expense
Creation of Operating Payables
(timing difference)
Cash Outflows from Operations
Solvency Assessment
Cash Requirements
Operating Revenue
Sale of Goods
Sale of Service
(timing difference)
Operating Costs
Cost of Goods Sold
Operating Expense
(timing difference)
Ability to create short-term debt
Ability to create long-term debt
Ability to issue equity
Ability to liquidate assets Liquidity
Solvency Assessment
Cash Requirements
Operating Revenue
Sale of Goods
Sale of Service
(timing difference)
Operating Costs
Cost of Goods Sold
Operating Expense
(timing difference)
Payments for short-term debt

Payments for long-term debt
Payments for dividends
Payments for asset
replacement
Solvency Assessment
Cash Requirements
Operating Revenue
Sale of Goods
Sale of Service
(timing difference)
Operating Costs
Cost of Goods Sold
Operating Expense
(timing difference)
Timing of Cash Inflows
Payments for short-term debt

Payments for long-term debt
Payments for dividends
Payments for asset
replacement
Timing of Cash Outflows

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Using Financial Statement Information: Electronic Presentations For Chapter 3

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Using Financial

Electronic Presentations for Chapter 3

Using financial accounting numbers to influence

Control and Prediction

Financial accounting numbers are useful in

Book Value vs. True Value

Financial statements do not reflect the companys

Financial statements are inherently limited

Management prepares the financial statements in

Assessing the business environment.

Assessing the Business

What is the nature of the companys operations?

Reading and Studying the

Read the audit report.

Assessing Earnings Quality

Overstating operating performance

Analyzing the Financial

Comparisons across time

Comparisons Across Time

Financial accounting numbers can be made

Financial accounting numbers can also be made more

Common-size financial statements

Common-Size Income Statement

On the income statement, cost of goods sold,

These ratios are designed to measure a firms

This ratio measures the effectiveness at

This ratio measures the effectiveness at

This ratio provides an indication of a

Leverage refers to using borrowed funds to

This ratio compares the return available to the

This ratio measures the extent to which a

Average Total Assets

This ratio compares liabilities to stockholders

Average Total Assets

Solvency refers to a companys ability to meet

This ratio measures solvency in the sense that

Similar to the current ratio, this ratio provides a

This ratio compares the annual funds available to

Asset Turnover Ratios

Asset turnover ratios are typically computed

Asset Turnover Ratios

Net Credit Sales

This ratio reflects the number of times the trade

Asset Turnover Ratios

Net Credit Sales

This ratio measures the speed with which

Asset Turnover Ratios

Net Credit Sales

This ratio measures the speed with which fixed

Asset Turnover Ratios

Net Credit Sales

This ratio measures the speed with which all

These additional ratios are used by the

This ratio, according to the financial press, is the

This ratio is used by many analysts to assess the

Market Price per Share

Dividends per Share

This ratio indicates to cash return on the

Market Price per Share

Dividends per Share

Market Price 1 - Market Price 0 +

This ratio measures the pretax performance of an

Payments for short-term debt