CH 12

Financial Statement Analysis
CHAPTER
wps.prenhall.com/wps/media/objects/1838/.../po werpoints/ch_12.ppt
12
2006 Prentice Hall Business Publishing
Introduction to Financial Accounting, 9/e
Horngren/Sundem/Elliott/Philbrick
Learning Objectives
After studying this chapter, you should be able to
1. Locate and use sources of information about company performance 2. Analyze the performance of a company using trend analysis, common-size financial statements and segment reporting 3. Use the basic financial ratios to guide your thinking 4. Evaluate corporate performance using various metrics, including ROA, ROE, and EVA 5. Calculate EPS when a company has preferred stock or dilutive securities
2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 2 of 45
Learning Objectives
After studying this chapter, you should be able to
6. Understand the nature of nonrecurring items and how to adjust for them 7. Use financial information to help assess a companys value
3 of 45
Sources of Information About Companies

Company annual reports include:
The financial statements Footnotes to the financial statements A summary of the accounting principles used Managements discussion and analysis (MD&A) The auditors report Managements report on its responsibility for the financial statements Comparative financial data for a series of years Narrative information about the company
Sources of Information About Companies

Companies also prepare reports for the Securities and Exchange Commission (SEC)
Form 10-K (annual report) Form 10-Q (quarterly report)
Other sources of information:

Company press releases Company Websites The general financial press Trade and industry publications Financial services
Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 5 of 45
Objectives of Financial Statement Analysis

Investors use financial statement analysis to
Predict expected returns Assess the risks associated with those returns
Creditors are primarily concerned with

Short-term liquidity how much cash a company has on hand to meet current payments when due Long-term solvency a companys ability to generate cash to repay long-term debts when due
Equity investors are more concerned with profitability and future security prices
Trend Analysis
Trend analysis compares financial statement changes over time and identifies predictable patterns that have occurred To compute percentage changes, the dollar change for an item (like net sales) is divided by the base year amount: Percentage change =
2002 $ - 2001 $
2001 $
x 100
7 of 45
Trend Analysis
Using the income statement for Eli Lily in Exhibit 12-1 in the text, the change in net sales is: $11,077.5 - $11,542.5 x 100 Percentage change = $11,542.5 = - 4%
8 of 45
Trend Analysis
The companys explanation for some trends can be found in the Management Discussion and Analysis (MD&A) in the annual report The MD&A includes disclosures about
Capital resources and liquidity Results of operations (including sales and expenses) Contractual obligations and commitments Critical accounting estimates Adoption of new accounting policies
9 of 45
Trend Analysis
The compound annual growth rate (CAGR) is the year-over year growth rate over a specific period of time A future value table must be used to compute the CAGR (Chapter 9)
10 of 45
Common-Size Statements
Common-size statements simplify the comparison of different companies because their amounts are stated in percentages On a common-size income statement, each item is expressed as a percentage of sales In the balance sheet, the common size is total assets
Balance sheet items are referred to as component percentages because they measure each component of the statement as a percentage of the total
11 of 45
Segment Reporting
Companies must report information about segments of the business in a footnote to the financial statements Segment information includes information on sales, profits, and assets Reportable segments can be broken down by product line, geographical location, and major customer
12 of 45
Financial Ratios
The following exhibit summarizes the most popular financial ratios (from previous chapters) grouped into four categories:
Short-term liquidity Long-term solvency Profitability ratios Market price and dividend ratios
Examples are provided from the Eli Lilly data in the text
13 of 45
Financial Ratios
14 of 45
Financial Ratios
15 of 45
Evaluating Financial Ratios

Financial ratios can be used for three types of comparisons:
1. Time-series comparisons comparisons with a companys own historical ratios 2. Benchmarks comparisons with general rules of thumb 3. Cross-sectional comparisons comparisons with other companies or with industry averages
Industry averages can be found in services such as Dun & Bradstreet and Standard & Poors
Evaluating Financial Ratios

Specific competitor companies can be found for ratio comparisons by using the
North American Industry Classification System (NAICS), or the Standard Industry Classification Code (SIC)
Changes in ratios over time alert investors and creditors to possible problems
17 of 45
Operating Performance and Financing Decisions

Operating management is concerned with the daily activities that generate revenues and expenses Financial management is concerned with where the company gets cash and how it uses that cash to its benefit
18 of 45
Operating Performance
EBIT Rate of return on = Average total assets total assets (ROA)
Where EBIT = Earnings before interest and taxes
ROA can be decomposed into the (1) EBIT to sales ratio and (2) total asset turnover ratio:
EBIT Average total assets
= (EBIT / Sales) x (Sales / Average total assets)
19 of 45
These ratios for Ely Lilly are:
EBIT EBIT to Sales Ratio $3,537.40
Sales $11,077.50 Sales $11,077.50
31.9%
ROA =
Total Asset Turnover 0.624 Times
Average Total Assets $17,738.05
20 of 45
Industries likely to display high EBIT to sales ratios and low total asset turnover ratios have high barriers to entry:
Utilities Communications
Industries likely to display low EBIT to sales ratios and high total asset turnover ratios have low barriers to entry:
Retail grocery
21 of 45
Financing Decisions
Companies finance long-term investments with either
Long-term debt or Stock
Debt is attractive because

Interest payments are tax deductible, but dividend payments are not Present shareholders profits and voting rights are not diluted
22 of 45
Financing Decisions
Capitalization (capital structure) refers to the mix of debt and equity financing Trading on the equity (financial leverage) means using debt at a fixed interest rate to try to increase the rate of return on stockholders equity (ROE)
23 of 45
Financing Decisions
EBIT Rate of return on = Average total assets total assets (ROA) EBIT Rate of return on = Average stockholders equity total assets (ROE) When a company is debt free, ROE = ROA
When ROA > interest rate, ROE > ROA (favorable financial leverage)
When ROA < interest rate, ROE < ROA
Economic Value Added

Economic value added (EVA) measures the residual wealth of a company after deducting its cost of capital from operating profit
A firm must earn more than it pays if it is to increase in value The cost of capital here refers to a weighted average cost of interest on debt and returns to equity investors
EVA is used as an internal management tool to help allocate and manage scarce capital resources such as equipment and real estate
Economic Value Added

If a company has a capitalization of $1 million, 10% cost of capital, and operating profit of $120,000:
EVA = Operating profit Cost of capital
EVA = $120,000 ($1,000,000 x 10%) EVA = $20,000
26 of 45
Measuring Safety
Interest coverage (times interest earned) measures a companys ability to make interest payments and repay debt on schedule
Interest coverage =
EBIT
Interest expense
Rule of thumb: interest coverage should be at least 5 times
27 of 45
Earnings Per Share

In its simplest form, EPS is the net income divided by the number of common shares outstanding
EPS =
Net income
Number of common shares outstanding
The following slides address several complicating issues in the computation
28 of 45
Weighted Average Shares

The denominator should actually use the weighted-average number of common shares outstanding
EPS =
Net income
Weighted-average common shares outstanding
29 of 45
Weighted Average Shares

Example: 750,000 shares were outstanding at the beginning of the year and 200,000 additional shares were issued 3 months before the yearend. The weighted average number of shares would be:
750,000 x 9/12 = 562,500 950,000 x 3/12 = 237,500 800,000
The denominator must also be adjusted retroactively for any stock splits and stock dividends
Preferred Stock
If the company has nonconvertible preferred stock outstanding, net income must be reduced since the numerator should reflect just the net income that is available to common stockholders
Net income Preferred dividends Weighted-average common shares outstanding
EPS =
31 of 45
Basic and Diluted EPS

Companies with convertible securities and stock options must report two EPS calculations:
Basic EPS Diluted EPS
Assume the following data:

Convertible preferred stock at 5%, $100 par, each share convertible into two common shares: 100,000 shares Common stock: 1,000,000 shares Net income $10,500,000

The basic EPS calculation would be:
$10,500,000 $500,000 1,000,000 = $10.00
EPS =
33 of 45

Diluted EPS assumes conversion of the preferred stock to common stock Accordingly, no preferred dividends are deducted in the numerator and additional shares of common are added in the denominator
EPS = = $8.75 $10,500,000
1,000,000 + 200,000
34 of 45
Disclosure of Nonrecurring Items

Nonrecurring items fall into four major categories:
1. 2. 3. 4. Special items Extraordinary items Discontinued operations Accounting changes
35 of 45
Special Items
Special items are revenues or expenses that are large enough and unusual enough to warrant separate disclosure on the income statement
Examples:
Impairment of PP&E Impairment of goodwill Restructuring charges
They appear with the operating expenses

Extraordinary Items
Extraordinary items are gains and losses resulting from events that are both
Unusual in nature Infrequent in occurrence
They are reported net-of-tax on a separate line on the income statement
37 of 45
Discontinued Operations
Discontinued operations occur when a company disposes of an entire segment of the business Segments must have assets and activities that are physically and operationally distinguishable from the remaining entity Gains or losses from discontinued operations must be shown separately on the income statement net-of-tax
Changes in Accounting Method

A change in accounting method can occur when
The FASB issues a new pronouncement The company changes to a preferred method of GAAP
The cumulative effect of the change in method on all previous years income is reported net-oftax on a separate line on the income statement
39 of 45
Valuation Issues
Accounting data are important in determining the value of a company The price-earnings (P-E) ratio is a useful valuation tool Value investors believe that
Low P-E stocks may be undervalued High P-E stocks may be overvalued
Growth investors believe that high P-E stocks are likely to be growth stocks
Valuation Issues
The price-earnings growth (PEG) ratio relates P-E ratios directly to earnings growth rates
PEG = P-E ratio Earnings growth rate
The earnings growth rate can be based on historical earnings, current earnings, or forecasted earnings Many analysts prefer a current P-E ratio and a forecasted 5-year earnings growth rate
Valuation Issues
Some rules of thumb on using the PEG:
.50 or less Buy .50 to .65 Look to buy
.65 to 1.00 Hold

1.00 to 1.30 Look to sell 1.30 to 1.70 Consider shorting Over 1.70 Short
Source: Motley Fool Website (www.fool.com)
42 of 45
Relating Cash Flow and Net Income

Many valuation models use estimated cash flows rather than forecasted earnings There are four possible combinations of positive and negative net income and cash flow from operations:
Relationship Cash flow from operations Net income 1 + + 2 + 3 + 4 -
43 of 45

When these relationships persist over multiple periods, it implies (in each case):
1. A company has positive profitability 2. A growth company is incurring large depreciation charges 3. A company is either Rapidly growing and collections are lagging, or Experiencing serious cash flow problems 4. Negative profitability is confirmed
44 of 45

Analysts use the relationship between cash flow and net income as one indicator of earnings quality Earnings quality means that revenues are not recognized prematurely and expenses are not deferred improperly One ratio used to assess earnings quality is cash flow from operations divided by net income (it should be consistently greater than 1)

CH 12

Загружено:

Сведения о документе

Оригинальное название

Авторское право

Доступные форматы

Поделиться этим документом

Поделиться или встроить документ

Параметры публикации

Этот документ был вам полезен?

Это неприемлемый материал?

Авторское право:

Доступные форматы

CH 12

Загружено:

Авторское право:

Доступные форматы

Financial Statement Analysis

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Sources of Information About Companies

Sources of Information About Companies

Other sources of information:

2006 Prentice Hall Business Publishing

Objectives of Financial Statement Analysis

Creditors are primarily concerned with

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Evaluating Financial Ratios

2006 Prentice Hall Business Publishing

Evaluating Financial Ratios

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Operating Performance and Financing Decisions

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

= (EBIT / Sales) x (Sales / Average total assets)

Introduction to Financial Accounting, 9/e

Sales $11,077.50 Sales $11,077.50

Total Asset Turnover 0.624 Times

Average Total Assets $17,738.05

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Debt is attractive because

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Economic Value Added

Economic Value Added

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Rule of thumb: interest coverage should be at least 5 times

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Earnings Per Share

The following slides address several complicating issues in the computation

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Weighted Average Shares