Principles of Accounting Module 10

types of financial statement analyses

-all of these analyses rely on comparisons or relationships of data that enhance the utility or the practical value of financial accounting information 1. such comparisons or relationships of financial statement items may be expressed as: -absolute increases and decreases for an item from one period to the next -percentage increases and decreases for an item from one period to the next -percentages of single items to an aggregate total -trend percentages -ratios

short-term creditors: acid test ratio

1. short-term creditors are particularly interested in this ratio, which relates the pool of cash and immediate cash inflows to immediate cash outflows 2. in deciding whether the acid-test ratio is satisfactory, investors consider the quality of the marketable securities and receivables 3. an accumulation of poor-quality marketable securities or receivables, or both, could cause an acid-test ratio to appear deceptively favorable 4. when referring to marketable securities, poor quality means securities likely to generate loss when sold in the future 5. poor-quality receivables depends primarily on their age, which can be assessed by preparing an aging schedule

trend percentages

1. similar to horizontal analysis except that comparisons are made to a selected base year or period 2. trend percentages are useful for comparing financial statements over several years because they disclose changes and trends occurring through time

factors influencing financial ratios

1. standing alone, a single financial ratio may not be informative 2. invest gain greater insight by computing and analyzing several related ratios for a company 3. financial analysis relies heavily on informed judgment

marketable securities

1. temporary investments such as short-term ownership of stocks and bonds of other companies 2. such investments do not qualify as cash equivalents 3. these investments earn additional money on cash that the business does not need at present but will probably need within one year

major sections of an annual report: reports of independent accountants

1. the Securities and Exchange Commission (SEC) requires the financial statements of certain companies, including publicly listed companies listed on a stock exchange, to be audited 2. this provides assurance that the financial statements prepared by the company have been audited and are free of material misstatements 3. may include a paragraph highlighting the significant accounting policies that the company has changed recently 4. another report in this section includes the results of the independent accountants review of the company's internal controls, as well as management's report and responsibility regarding, internal controls

profitability

1. the ability of a company to generate income 2. profitability is measured by analyzing the company's income statement

solvency

1. the ability of a company to pay its debts as they come due 2. solvency is measured by analyzing the balance sheet

comparative financial statements: horizontal analysis

1. the calculation of dollar changes or percentage changes in the statement items or totals 2. this analysis detects changes in a company's performance and highlights trends including positive and negative trends

profitability ratios

1. profitability is an important measure of a company's operating success 2. two areas we are concerned with when evaluating profitability -relationship on the income statement that indicate a company's ability to cover operating costs and expenses -relationships of income to various balance sheet measures that indicate the company's relative ability to earn income on assets employed

major sections of an annual report: management discussion and analysis

1. provides management's view of the performance of the company 2. the analysis is based on the financial statements, the conditions of the industry, and ratios among other items -publicly held companies must file detailed annual reports (form 10-k), quarterly reports (form 10-Q), and special events reports (form 8-K) with the SEC -these reports are available to the public for a small charge and sometimes contained more detailed information than the published reports 3. financial statement information is often more meaningful when users compare it with industry normals 4. two firms that provide information on individual companies and industries are Moody's Investors Service and Standard and Poor's -business publications also report industry financial news

factors influencing financial ratios: accounting standards

1. relationships between financial statement items also become more meaningful when standards are available for comparison 2. comparisons with standards provide a starting point for the analyst's thinking and lead to further investigations and ultimately, to conclusions and business decisions 3. such standards consist of: -those in the analyst's own mind as a result of experience and observations -those provided by the records of past performance and financial position of the business under study -those provided about other enterprises -research organizations, trade associations 4. even within an industry, variations may exist

return on assets

1. return on assets = net income -------------- total assets 2. significance: effectiveness of the use of assets in generating income 3. the best measure of earnings performance without regard to the sources of assets is the relationship of net income (on the income statement) to total assets (on the balance sheet), the return on assets 4. this ratio shows the earning power of the company on its operating assets 5. the rate of return on assets measures the profitability of the company in carrying out its primary business functions 6. the theory is, a firm should be able to earn a return on its assets that exceeds its cost of capital or its cost of debt (borrowings) from the bank in most cases or situations

return on sales

1. return on sales = net incomes ---------------- net sales 2. significance: indicator of the amount of net profit on each amount of sales 3. the return on sales (also called rate of return on sales or net income to net sales) ratio is another measure of a company's profitability 4. this ratio measures the proportion of the sales dollar that remains after deducting all expenses 5. although the return on sales ratio indicates that the net amount of profit increased on each sales dollar, exercise care in using and interpreting this ratio 6. the net income includes all non-operating items that may occur only in a particular period; therefore, net income includes the effects of items as interest income and interest expenses 7. also, since interest expense is deductible in the determination of net income while dividends are not, the methods used to finance a company's assets affect net income

introduction to the module

1. the three primary financial statement performance objectives of every business are solvency, liquidity, and profitability 2. internally, management analyzes a company's financial statements as do external third parties including investors, creditors, and regulatory agencies 3. although these users have different immediate goals, their overall objective in performing financial statement analysis is the same---to make predictions about an organization as an aid in important decision-making

earnings per share of common stock (EPS)

1. EPS = earnings available to common stockholder's --------------------------------------------------- weighted-average # of common shares outstanding. 2. significance: measure of the return to investors per share 3. probably the measure used most widely to appraise a company's operations is earnings per share (EPS) of common stock 4. the financial press regularly publishes actual and forecasted EPS amounts for publicly traded corporations, together with period-to-period comparisons 5. the Accounting Principles Board noted the significance attached to EPS by requiring that such amounts be reported on the face of the income statement 6. the calculation of EPS may be fairly simple or highly complex depending on a corporation's capital structure -a company has a simple capital structure if it has no outstanding securities (e.g., convertible bonds, convertible preferred stocks, warrants, or options) that can be exchanged for common stock 7. if a company has such securities outstanding, it has a complex capital structure 8. the amount of earnings available to common stockholders is equal to net income minus the current year's preferred dividends, whether such preferred dividends have been declared or not

liquidity ratio: acid-test (quick ratio)

1. Formula quick assets (cash + marketable securities + net receivables) acid-test = -------------------------------------- current liabilities 2. significance: test of immediate short-term debt paying ability 3. acid-test: the ratio of quick assets (cash, marketable securities, and net receivables) to current liabilities 4. analysts exclude inventories and prepaid expenses from current assets to compute quick assets because inventories and prepaid expenses might not be readily convertible into cash

Vertical Analysis

1. a vertical analysis of the company's balance sheet discloses each account's significance to total assets (almost like a ratio) -this comparison aids in assessing the importance of the changes in each balance sheet account 2. the comparative statements of income and owner's equity provide the information needed to analyze Synotech's (example) comparative statements of income and owner's equity -such a statement merely combines the income statement and the statement of owner's equity into one continuous statement

determining the weighted-average number of common shares

1. amount of capital stock outstanding ----------------------------------------- value per share

forecasting

1. analyzing past financial statements, including the balance sheet and the income statement, can help an accountant or a financial analyst to also forecast operating results (the income statement) as well as changes in the balance sheet

major sections of an annual report: financial statements

1. balance sheet with 2 years of comparative data 2. income statement with 3 years of comparative data 3. statement of cash flows with 3 years of comparative data 4. statement of shareholder's equity with 3 years of comparative data

financial statement analysis

1. consists of applying analytical tools and techniques to financial statements and other relevant data to obtain useful information 2. this analysis reveals significant relationships between data and trends in those data that assess the company's past performance and current financial position 3. the information shows the results or consequences of prior management decisions 4. in addition, analysts use the information obtained from this analysis to make predictions that may have a direct effect on decisions made by users of financial statements

potential creditors

1. creditors are more concerned with a company's solvency 2. the liquidity (the state of possessing liquid assets like cash) of the company affects its short-term solvency 3. because companies must pay short-term debts soon, liquid assets must be available for their payment 4. long-term creditors are interested in a company's long term solvency, which is usually determined by the relationship of a company's assets to its liabilities 5. generally, we consider a company to be solvent when its total assets exceed its total liabilities so that the company has a positive stockholders' equity 6. the larger the total assets are in relation to the total liabilities, the greater the long-term solvency of the company 7. thus, the company's assets could shrink significantly before its liabilities would exceed its assets and significantly reduce the company's solvency

liquidity ratio: current ratio

1. current ratio = current assets ---------------------- current liabilities 2. significance: test of short term debt paying ability 3. the current ratio is also called the working capital ratio -working capital: the excess total current assets over total current liability working capital= current assets-current liabilities 4. relates total current assets to total current liabilities 5. the current ratio indicates the ability of a company to pay its current liabilities from current assets, and thus, shows the strength of the company's working capital position 6. generally, a current ratio of greater than 1 is desirable, however, it is important to know the industry average in order to compare the company's current operations with its competitors 7. comparing ratios to industry averages helps financial statement users get a better picture of the overall financial health of a company and allows for comparison across the industry

debt to equity ratio

1. debt to equity ratio = stockholder's equity ------------------------ total debt 2. significance: measure of the relative proportion of stockholder's and of creditor's equities 3. analysts express the relative equities of owners and creditors in several ways -another way of expressing this relationship is the total stockholder's equity to total debt ratio 4. this ratio is often inverted and called the stockholder's equity to debt ratio 5. some analysts use only long-term debt rather than total debt in calculating these ratios 6. these analysts do not consider short-term debt to be part of the capital structure since it is required to be repaid within one year

potential investors

1. present and potential investors wish to predict future dividends and changes in the market price of the company's common stock -since both dividends and price changes are likely to be influenced y earnings, investors may predict future earnings 2. need the past earnings record to start 3. concerned with profitability

comparative financial statements

1. present the same company's financial statements for one or two successive periods in side by side columns 2. absolute increases and decreases for an item from one period to the next and percentage increases and decreases for an item from one period to the next, make use of comparative financial statements

Equity Ratio

1. equity ratio = stockholder's equity --------------------------- total assets or total equities 2. significance: index of long run solvency and safety 3. the two basic sources of assets in a business are owners (stockholders) and creditors -the combined interests of the two groups are total equity 4. in ratio analysis, however, the term "equity" generally refers only to stockholder's equity 5. thus, the equity (stockholder's equity) ratio indicates the proportion of total assets (or total equities) provided by stockholders (owners) on any given date 6. from a creditor's point of view, a high proportion of stockholder's equity is desirable -a high equity ratio indicates the existence of a large protective buffer for creditors in the event a company suffers a loss 7. from an owner's point of view, a high proportion of stockholder's equity may or may not be desirable -if the business can use borrowed funds to generate income in excess of the net after tax cast fo the interest on such funds, a lower percentage of stockholder's equity may be desirable 8. however, too low a percentage of stockholder's equity (too much debt) has its dangers -financial leverage magnifies losses per share as well as EPS since there are fewer shares of stock over which to spread the losses

ratios

1. expressions of logical relationships between items in the financial statements of a single period 2. a ratio can show a relationship between two items on the same financial statement or between two items on different financial statements 3. the only limiting factor in choosing ratios is the requirement that the items used to construct a ratio have a logical relationship to one another

sources of information for financial statement analysis

1. financial information about publicly owned corporations can come from different sources such as published reports, government reports, financial service information, business publications, newspapers, and periodicals 2. public corporations must publish annual financial reports

common-sized statements

1. financial statements that show only percentages and no absolute dollar amounts 2. all percentage figures in a common-sized balance sheet are percentages of total assets, while all the items in a common-sized income statement are percentages of net sales 3. the use of common-sized statements facilitates vertical analysis of a company's financial statements

Horizontal Analysis

1. if the change between the two dates is an increase from year 1 to year 2, the change is a positive figure 2. if the change is a decrease, the change is a negative figure and is shown in parentheses (6) = -6 % change = current year- prior year ---------------------------- prior year 3. studying the percentages sometimes are more informative than absolute amounts

objectives of financial statement analysis: external users

1. investors, creditors, and regulatory agencies generally focus their analysis of financial statements on the company as a whole 2. since they cannot request special-purpose reports, external users must rely on the general purpose financial accounting statements that companies publish 3. these general-purpose financial accounting statements include a balance sheet, an income statement, a statement of stockholder's equity, a statement of cash flows, and the explanatory notes (footnotes) that accompany the financial statements

leverage ratios

1. leverage, or equity, ratios show the relationship between debt and equity financing in a company 2. two leverage ratios are the equity ratio and the debt to equity ratio

liquidity ratios

1. liquidity ratios indicate a company's short term debt-paying ability 2. thus, these ratios show interested parties the company's capacity to meet (pay) maturing current liabilities 3. the current ratio and the acid-test (quick ratio) are examples of liquidity ratios

ratio analyses

1. logical relationships exist between certain accounts or items in a company's financial statements 2. we set up the dollar amounts of the related accounts or items in fractional form called ratios 3. these ratios include: -liquidity ratios -equity, or long-term solvency, ratios -profitability tests -market tests

objectives of financial statement analysis

1. management's analysis of financial statements primarily relates to parts of the company 2. using this approach, management can plan, evaluate, and control operations within the company 3. management obtains any information it wants about the company's operations by requesting special-purpose reports 4. it uses this information to make difficult decisions, such as which employees to layoff and when to expand operations

liquidity

1. measures how soon a company can convert assets to cash in order to pay liabilities that come due

major sections of an annual report: letters to stockholders

1. most annual reports are introduced with a letter to the stockholders 2. often includes information about the company's past history, its mission current year operating results, and the company's future goals

factors influencing financial ratios: analysts

1. must be sure that their comparisons are valid 2. companies must follow consistent accounting practices 3. should calculate the company's ratios in the same manner as the reporting service 4. must consider general business conditions within the industry of the company under study

factors influencing financial ratios: investors

1. must consider the seasonal nature of some businesses 2. must consider the market risk associated with the prospective investment 3. should realize that acquiring the ability to make informed judgments is a long process and does not occur overnight

major sections of an annual report: notes to financial statements

1. notes to financial statements provide an in-depth look into the numbers contained in the financial statements 2. usually contain sections on significant accounting policies, long-term debt, leases, stock option plans, etc 3. allows stockholders to look beyond the numbers to the events that triggered the dollar amounts recorded in the financial statements

common-sized financial statement: vertical analysis

1. percentages of single items to an aggregate total -single financial statement 2. the study of a single financial statement in which each item is expressed as a percentage of a significant total -like sales 3. vertical analysis is especially helpful in analyzing income statement data such as the percentage of cost of goods sold to sales

Explanatory notes

1. users of financial statements need to pay particular attention to the explanatory notes, or the financial review (also called Management's Discussion and Analysis), provided by management in annual reports 2. this integral part of the annual report provides insight into the scope of the business, the results of operations, liquidity and capital resources, the impact of new accounting standards, and geographic area financial performance data 3. moreover, this financial review provides an economic outlook that an analyst may find very helpful when considering the possible future profitability of the company

current ratio continued

8. the ratio is usually stated as a number of dollars of current assets to one dollar of current liabilities (although the dollar signs usually are omitted) 9. the current ratio provides a better index of a company's ability to pay current debts than does the absolute amount of working capital 10. short-term creditors are particularly interested in the current ratio since the conversion of inventories and accounts receivable into cash is the primary source from which the company obtains the cash to pay short-term creditors 11. long-term creditors are also interested in the current ratio because a company that is unable to pay short term debts may also be unable to pay long-term debts and therefore be forced into bankruptcy -for this reason, many bond indentures, or contracts, contain a provision requiring that the borrower maintain at least a certain minimum current ratio at all times 12. a company must guard against a current ratio that is too high, especially if the high current ratio is caused by idle cash, slow paying customers, and/or slow-moving inventory -decreased net income can result when too much capital that could be used profitability elsewhere is tied up unnecessarily in current assets

Module 10

Interpreting Financial Statements