Accounting Chapter 13: Financial Analysis (588)

What are comparative financial statements?

Show financial amounts in side-by-side column on a single statement. Used in horizontal analysis.

What are the analytical tools used in financial statement analysis?

- Horizontal analysis: Comparing a company's financial condition and performance over time. Covers more than one year - Vertical Analysis: Comparing a company's financial condition and performance to a base amount. Evaluates finanical items in terms of a specific base amount. Covers one year. The base for an income statementis usally revenue and total assets for a balance sheet. - Ratio Analysis: Measurement of key relations between financial statement items

Basics of analysis

- Tries to reduce uncertainty: helps people make decisons from looking at financial statements - application of analytical tools - Involves transforming data

When interpreting financial statements we use standards of comparison that include:

1. Intracompany: The company's current perfromance is compared to its prior performance and its relations between financial items. (Ex. Apple's net income can be compared to its prior year net income and its revenues or total assets) 2. Competitor: The benchmark of a select competitor is often seen as the best Ex. Comparing Pepsi's profit margin with the Coca Cola's 3. Industry: Industry statistics provide standards for comparisons. Ex. Intel's profit margin can be ompared to the industry's profit margin 4. Guidelines: Standards of comparison can develop from experince. Ex. 2:1 level for the current ratio and 1:1 level for the acid-test ratio

Ratio analysis: Four building blocks of financial statement and analysis for company's fianacial performance

1. Liquidity and efficiency: ability to meet short term obligations and to efficently generate revenue 2. Solvency: Solid, financial stable enough to keep exsisting Ability to generate future revenues and meet long term obligations 3. Profitability: ability to provide financial rewards to attract and retain financing 4. Market prospects: Information driven by what the market thinks about your company; do they hold a positive view or not? Ability to generate positive market expectations

What is percent change?

Analysis period-base period/base period X 100

What is financial statement analysis?

Applies analytical tools to financial statements and related data for making business decisions.

Ratio analysis: Solvency

Assets= liabilities (long and short term debt for financing) + equidity (common stock and retained earnings for financing) - Debt ratio: Expreesses total liabilites as a percent of total assets. Provides complementary information by expressing total equidity as a percent of total assets. equity ratio expresses total equity as a percent of total assets. Debt-to equity-ratio is the measure of total liabiltes to equity. - Times inerest eanred: The most common measure of the ability of a company's operations to pay back loans to long-term creditors with interest. The larger this ratio, the less risky for creditors. Income before interest expense and income taxes (sales-everything under sale and above income tax and interest expense on income statement/interest expense.

What are general-purpose financial statements?

Includes income statement, balance sheet, statement of stockholder's equity, statement of cash flows, and notes to these statements. Used in financial analysis.

Ratio analysis: Liquidity and Efficiency

Liquidity: ability to convert assets to cash without them losing value. Balance sheet is set up in terms of liquidity because it starts with cash. It is affected by the timing of cash inflows and outflows, along with the prospect of future performance. To creditors, a lack of liquidity can yeild delays in collecting payments, as well as the inefficent use of assets. 1. Working capital: A company needs it to meet current debts, to carry sufficent inventories, and to take advantage of cash discounts. A company with inadaquete working captial is unlikely to meet current obligations. A ratio of 2:1 is deemed a good credit risk in the short run (however, a compny can rpobably operate on a current ratio of less than 1:1 if its revenues genrate enough cash to pay its current liablites). When evaluating a company's working captial, we look at the current ratio. Current ratio=current assets (assets expected to be collected, sold, or used up within one year-everything above plant assets on balance sheet)/ current liabilites (every liability above long term liabilites). Similar to cash inflows-cash outflows. Current ratio: Current assets/current liabilites. Shows how many current assets for each dollar owed. 3. Acid Test Ratio (Quick ratio): Like the current ratio but exludes current assets such as inventories and prepaid expenses that are more difficult to convert into cash quickly. A ratio of 1:1 is deemed a good credit risk in the short run. Cash + short-term investments + current recevibles/current liabilites 4. Accounts recievable turnover: Meausres how many times a company converts it recievables into cash each year, which affects working capital. Accounts recev= net sales/ average account rec (accounts recievble + previous year account recevible+current note recevible+previous note recevible/2) 5. Inventory turnover: ratio measures the number of times merchandise is sold and replaced each year; affects working capital. Some of our cash is tied up if merchandise is sitting on the shelf. inventory turnover= cost of goods sold/average inventory ( beg+ end invnetory/2) 6. Days sales uncollected: The number of days it takes to collect its account recievable: Acct rec/net sales X 365. 7. Day's sales in inventory: ratio is a useful measure in evaluating inventory liquidity. If a product is demanded by customers, this formula estimates how long it takes to sell inventory. Day's sales in inventory= ending inventory/cost of goods sold X 365 8. Total asset turnover: Ratio refelcts a company's ability to use its assets to generate sales. It is important indication of operating efficentcy

Ratio Analysis: Profitability

Refers to a company's ability to earn an adequate return on invested capital. Judged by asseing earnings relative to the level and soruces of financing. - Profit margin: Reflects a company's ability to earn a net income from sales. Measured by expressing net income as a percentage of sales. Profit margin=net income/net sales - Total return on assets: Return on assets= net sales/averge total assets(assets +assets in previous year/2) - Return on total assets: net income/average total assets - Return on stockholder's equity: Measures a company's sucess in reaching the goal of earning income for its owners. Return on stockholder's equity= net income-preffered​ dividends/average common stockholder's equity (common stock+retained earnings from in current year+common stock +retained earnings from second year/2).

Horizontal Analysis:

See problem 1 on Connect QS 13-3,4 for comparative balance sheets and income statements - Percent change: Analysis Period is the point or period of time for the financial statement under analysis, and the Base Period is the point or period,; it is commonly the prior year. We compute the percent change by analysis period-base period/base period X 100 - Trend analysis: a form of horizontal analysis that can reveal patterns in data across successive periods; computes trend percents for a series of financial numbers and is a variation of percent changes without subtracting the base period from the analysis period. It is done by: 1. Selecting a base period and assigning each item in the base period a weight of 100%. Express financial numbers as a percent of their base period number. Trend percent: Analysis period amount/base period amount X 100.

Vertical analysis:

See problem 4 on Connect QS 13-3,4 - Common-Size Financial statements: shows changes in relative importance of each financial statement item. All individual items in common-size statements are redefined in terms of common-size percents, with the base being 100. A common size percent is measured by dividing each indivdiual financial statement amount under analysis by its base amount. Common size percent= analysis amount/base amount X 100.

What is financial reporting?

The communication of financial information useful for making invetment, credit, and business decisions.

Ratio analysis: market prospects

Useful for analyzing corporations with publicly traded stock. - Price earnings ratio: price-earnings ratio=market price per common share/earnings per share. - Dividend yeild: Used to compare the dividend-paying performance of different companies. Dividend yeild= annual cash dividends per share/market price per share

Ratio analysis:

Widely used in financial analyis because they help us uncover conditons and trends difficult to detect by looking at individual amounts. Financial ratios are organized into the four building blocks of financial statement analysis: liquidity and efficentcy, solvency, profitablity, and market prospects.

Growth stock vs income stock

low dividend ratio vs high dividends - Growth increases market price and you make moeny from buying and selling it