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Chapter 5:

Using Financial Statement

Information

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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 company’s managers.

– They help to predict a company’s

future earnings and cash flows.

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Book Value vs. True Value

Financial statements do not reflect the company’s 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.

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Framework for Financial Statement Analysis

Book Value

Add adjustments for:

(1) business environment

(2) unrecorded events

(3) management bias

= True Value

6

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.

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Assessing the Business Environment

What is the nature of the company’s operations?

What strategy is being employed to generate profits?

What is the company’s industry?

Who are the major players? Competition?

What are the relationships between the company and its customers and suppliers?

How are the company’s sales and profits affected by changes in the economy?

8

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.

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Assessing Earnings Quality

Earnings quality may be affected by a

number of strategies managers use to

influence accounting numbers. Four

major strategies are discussed:

– Overstating operating performance

– “Taking a bath”

– Creating hidden reserves

– Employing off-balance-sheet

financing

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Assessing Earnings Quality

Overstating operating performance through the acceleration of recognition of revenue - shift the timing of revenue from a future period to the current period, through legitimate or questionable activities.

Overstating operating performance through the allocation and estimation of expenses - shift the recognition of expenses through the use of “taking a bath” and “creating hidden reserves.”

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Assessing Earnings Quality

Taking a bath (also called “big bath”) - large losses and expenses this year may increase income in future years.

Rationale: if the current year is going to be disappointing to investors anyway, increase the loss to make next year look better. For example:

– Excessive write-downs of equipment will lead to lower depreciation expense in future years.

– Excessive write-downs of inventory will lead to lower cost of goods sold next year.

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Assessing Earnings Quality

Creating hidden reserves - expenses may be shifted from one year to another year by overestimating expense accrual.

Excessive bad debt expense or warranty expense in the current year will lead to reduced estimates in future years, as the “reserve” is used up.

Note that these “reserves” have nothing to do with cash reserves; they simply reserve some of the “income” to future periods.

13

Assessing Earnings Quality

Employing off-balance-sheet financing - this relates to certain economic transactions that are not reflected in the balance sheet.

Managers prefer to keep certain liabilities off the balance sheet when GAAP permits it, primarily because of potential debt covenant violations, and because of the effect on certain ratios.

Examples include: – treatment of leases as operating leases (Radio

Shack) – unconsolidated investments (Enron’s

“partnerships”) which do not separate assets from liabilities.

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Analyzing the Financial Statements

Comparisons across time

Comparisons within the industry

Comparisons across different countries

Comparisons within the financial statements:

common-size statements and ratio analysis – Profitability ratios

– Leverage ratios

– Solvency ratios

– Asset turnover ratios

– Market ratios

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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.

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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

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Common-Size Financial Statements

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Comparisons Within

the Financial Statements

Common-size financial statements

Ratio analysis

– Profitability ratios

– Leverage ratios

– Solvency ratios

– Asset turnover ratios

– Market ratios

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Common-Size Income Statement for La-Z-Boy, Inc. (Figure 5-2)

Income Statement (in millions) 2008 % 2007 %

Net sales $1,227 100 $1,451 100

Cost of sales (888) 72 (1,057) 73

Expenses and charges (460) 37 (408) 28

Net income $ (121) (9) $ (14) (1)

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.

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Profitability Ratios

These ratios are designed to measure a

firm’s 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.

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Return on Net Income

Equity Average Shareholders’ Equity

This ratio measures the effectiveness at

managing capital provided by the shareholders.

Profitability Ratios

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Return on Net Income + Interest Expense (1-tax rate)

Assets Average Total Assets

This ratio measures the effectiveness at managing capital

provided by all investors (stockholders and creditors).

Profitability Ratios

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Profitability Ratios

Return on Net Income + Interest Expense (1-tax rate)

Sales Net Sales

This ratio provides an indication of a company’s ability to

generate and market profitable products and control its

costs; also called the Profit Margin.

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Leverage Ratios

Leverage refers to using borrowed

funds to generate returns for

stockholders.

Leverage is desirable because it

creates returns for shareholders without

using any of their money.

Leverage increases risk by committing

the company to future cash obligations.

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Leverage Ratios Common Net Income

Equity Net Income + Interest Expense (1-tax rate)

Leverage

This ratio compares the return available to the

shareholders to returns available to all capital providers.

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Leverage Ratios

Capital Average Total Assets

Structure Average Stockholders’ Equity

Leverage

This ratio measures the extent to which a company

relies on borrowings (liabilities).

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Debt to Equity Average Total Liabilities Ratio Average Shareholders’ Equity This ratio compares liabilities to shareholders’ equity and is another measure of capital structure leverage.

Leverage Ratios

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Leverage Ratios

Long-term Long-Term Debt Debt Ratio Total Assets This ratio measures the importance of long-term debt as a source of asset financing.

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Solvency Ratios

Solvency refers to a company’s ability to

meet its current debts as they come

due.

There is pressure on companies with

high levels of leverage to manage their

solvency.

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Solvency Ratios

Current Current Assets

Ratio Current Liabilities

This ratio measures solvency in the sense that current

assets can be used to meet current liabilities.

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Solvency Ratios

Quick Cash + Marketable Securities + A/R

Ratio Current Liabilities

Similar to the current ratio, this ratio provides a more

stringent test of a company’s solvency.

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Solvency Ratios

Interest Net Income + Tax Expense + Interest Expense

Coverage Interest Expense

This ratio compares the annual funds available to meet

interest to the annual interest expense.

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Solvency Ratios

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.

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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.

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Asset Turnover Ratios

Receivables Net Credit Sales

Turnover Average Accounts Receivable

This ratio reflects the number of times the trade

receivables were recorded, collected, and recorded

again during the period.

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Asset Turnover Ratios

Inventory Cost of Goods Sold

Turnover Average Inventory

This ratio measures the speed with which

inventories move through operations.

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Asset Turnover Ratios

Fixed Assets Sales

Turnover Average Fixed Assets

This ratio measures the speed with which fixed assets

are used up.

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Asset Turnover Ratios

Total Asset Sales

Turnover Average Total Assets

This ratio measures the speed with which all assets

are used up in operations.

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Market Ratios

These additional ratios are used by the

financial community to assess company

performance.

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Market Ratios

Earnings Net Income

per Average Number of Common Shares

Share Outstanding

This ratio, according to the financial press, is the

primary measure of a company’s performance. It

calculates the amount of income that is earned for

each shareholder.

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Market Ratios Price/Earnings Market Price per Share

Ratio Earnings per Share

This ratio is used by many analysts to assess the

investment potential of common stocks.

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Market Ratios Dividend Yield Dividends per Share

Ratio Market Price per Share

This ratio indicates to cash return on the

shareholders’ investment.

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Market Ratios

Stock Market Price1 - Market Price0 + Dividends

Price Market Price0

Return

This ratio measures the pretax performance of an

investment in a share of common stock.

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Comparisons Across Different Countries

Investors interested in comparing the financial performance and condition of companies from different countries often must contend with two difficult issues:

– If the companies use different accounting standards (e.g., U.S. GAAP vs. IFRS), the reported values must be adjusted to a common basis so that reasonable comparisons can be made.

– Adjusting financial statements to a common basis by itself may not be sufficient to achieve meaningful comparisons. In other words, not only must the financial statements of a foreign-based company be adjusted, but the resulting numbers can only be interpreted through an understanding of the foreign environment.

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Appendix 5A

DuPont (ROE) Model: Return On Equity = Return on Assets X Capital Structure

Leverage X Common Equity Leverage

Return on Assets = Profit margin X Asset Turnover

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Solvency Assessment (Figure 5A-6)

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