Analysis and Interpretation of Financial Statements
Read this chapter, which discusses how to analyze financial statements and demonstrates the use of ratios and the horizontal and vertical analysis tools that everyone from creditors to investors, vendors, and top management use when they want to identify the strengths and weaknesses in an organization. Analysis tools can help you compare companies of different sizes, companies in different industries, and the same company over time.
Understanding the learning objectives
• A company's financial statements are analyzed internally by management and externally by investors, creditors, and regulatory agencies.
• Management's analysis of financial statements primarily relates to parts of the company. Management is able to obtain specific, special-purpose reports to aid in decision making.
• External users focus their analysis of financial statements on the company as a whole. They must rely on the general-purpose financial statements that companies publish.
• Financial statement analysis consists of applying analytical tools and techniques to financial statements and other relevant data to obtain useful information.
• This information is the significant relationships between data and trends in those data assessing the company's past performance and current financial position.
• The information is useful for making predictions that may have a direct effect on decisions made by many users of financial statements.
• Present and potential company investors use this information to assess the profitability of the firm.
• Outside parties and long-term creditors sometimes are interested in a company's solvency, and thus use the information in predicting the company's solvency.
• Published reports are one source of financial information. Published reports include financial statements, explanatory notes, letters to stockholders, reports of independent accountants, and management's discussion and analysis (MDA).
• Government reports are another source of financial information and include Form 10-K, Form 10-Q, and Form 8-K. These reports are available to the public for a small charge.
• Financial service information, business publications, newspapers, and periodicals offer meaningful financial information to external users. Moody's Investors Services; Standard & Poor's; Dun & Bradstreet, Inc.; and Robert Morris Associates all provide useful industry information. Business publications, such as The Wall Street Journal and Forbes, also report industry financial news.
• Horizontal analysis is the calculation of dollar changes or percentage changes in comparative statement items or totals. Use of this analysis helps detect changes in a company's performance and highlights trends.
• Vertical analysis consists of a study of a single financial statement in which each item is expressed as a percentage of a significant total. Use of this analysis is especially helpful in analyzing income statement data such as the percentage of cost of goods sold to sales or the percentage of gross margin to sales.
• Trend analysis compares financial information over time to a base year. The analysis is calculated by:
(a) Selecting a base year or period.
(b) Assigning a weight of 100 per cent to the amounts appearing on the base-year financial statements.
(c) Expressing the corresponding amounts shown on the other years' financial statements as a percentage of base-year or period amounts. The percentages are computed by dividing nonbase-year amounts by the corresponding base-year amounts and then multiplying the results by 100.
Trend analysis indicates changes that are taking place in an organization and highlights the direction of these changes.
• Liquidity ratios indicate a company's short-term debt-paying ability. These ratios include (1) current, or working capital, ratio; (2) acid-test (quick) ratio; (3) cash flow liquidity ratio; (4) accounts receivable turnover; (5) number of days' sales in accounts receivable; (6) inventory turnover; and (7) total assets turnover.
• Equity, or long-term solvency, ratios show the relationship between debt and equity financing in a company. These ratios include (1) equity (stockholders' equity) ratio and (2) stockholders' equity to debt ratio.
• Profitability tests are an important measure of a company's operating success. These tests include (1) rate of return on operating assets, (2) net income to net sales, (3) net income to average common stockholders' equity, (4) cash flow margin, (5) earnings per share of common stock, (6) times interest earned ratio, and (7) times preferred dividends earned ratio.
• Market tests help investors and potential investors assess the relative merits of the various stocks in the marketplace. These tests include (1) earnings yield on common stock, (2) price-earnings ratio, (3) dividend yield on common stock, (4) payout ratio on common stock, (5) dividend yield on preferred stock, and (6) cash flow per share of common stock.
• For a complete summary and a graphic depiction of all liquidity, long-term solvency, profitability, and market test ratios, see Exhibit 135 and Exhibit 136.
• Need for comparative data: Analysts must be sure that their comparisons are valid - especially when the comparisons are of items for different periods or different companies.
• Influence of external factors: A single important event, such as the unexpected placing of a product on the market by a competitor, may affect the interpretation of the financial statements. Also, the general business conditions and the possible seasonal nature of the business must be taken into consideration, since these factors could have an impact on the financial statements.
• Impact of inflation: Since financial statements fail to reveal the impact of inflation on the reporting entity, one must make sure that the items being compared are all comparable; that is, the impact of inflation has been taken into consideration.
• Need for comparative standards: In financial statement analysis, remember that standards for comparison vary by industry, and financial analysis must be carried out with knowledge of specific industry characteristics.