Chapter 13 PDF

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Chapter notes for financial accounting with David Deeds...

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Chapter 13: Analyzing and Interpreting Financial Statements

Basics of Analysis ● Financial statement analysis applies analytical tools to general-purpose financial statements and related data for making business decisions ● Transforms accounting data into more useful information ● Financial statement analysis provides us an effective and systematic basis for making business decisions Purpose of Analysis ● Internal users use financial statement analysis to provide strategic information to improve company efficiency and effectiveness in providing goods and services ● Internal users: ○ Managers ○ Officers ○ Internal auditors ○ Consultants ○ Budget directors ○ Market researchers ● External users rely on financial statement analysis to make better and more informed decisions in pursuing their own goals ● External users: ○ Shareholders ○ Lenders ○ Directors ○ Customers ○ Suppliers ○ Regulators ○ Lawyers ○ Brokers ○ Press Building Blocks of Analysis ● Financial statement analysis focuses on one or more elements of a company’s financial condition or performance ● Four building blocks of financial statements: ○ Liquidity and efficiency: ability to meet short-term obligations and to efficiently generate revenues ○ Solvency: ability to generate future revenues and meet long-term obligations ○ Profitability: ability to provide financial rewards sufficient to attract and retain financing ○ Market prospects: ability to generate positive market expectations Information for Analysis ● General-purpose financial statements consists of: ○ Income statement

○ Balance sheet ○ Statement of stockholders equity (or statement of retained earnings) ○ Statement of cash flows ○ Notes to these statements ● Financial reporting refers to the communication of financial information useful for making investment, credit, and other business decisions ○ Financial reporting includes information from SEC 10-K or other filings, press releases, shareholders’ meetings, forecasts, management letters, auditors’ reports, and webcasts Standards for Comparisons ● To interpret measures from financial statements we must indicate good, bad, or average performance ○ To do this, we use standards (benchmarks) ● Intracompany: the company under analysis can provide standards for comparisons based on its own prior performance and relations between its financial items ● Competitor: one or more direct competitors of the company being anlyzed can provide comparisons ● Industry: industry statistics can provide standards of comparisons ● Guidelines (rules of thumb): general standards of comparisons can develop from experience (e.g. 2:1 level for the current ratio or 1:1 level for the acid-test ratio) Tools of Analysis ● Horizontal analysis: comparison of a company’s financial condition and performance across time ● Vertical analysis: comparison of a company’s financial condition and performance to a base amount ● Ratio analysis: measurement of key relations between financial statement items Horizontal Analysis Comparative Statements ● Comparing amounts for two or more successive periods often helps in analyzing financial statements ● Comparative financial statements show financial amounts in side-by-side columns on a single statement, called a comparative format Computation of Dollar Changes and Percent Changes ● Comparing financial statements over relatively short time periods-two to three years- is often done by analyzing changes in line items ○ Change analysis includes analyzing absolute dollar amount changes and percent changes ● To compute dollar change: ○ Dollar change = analysis period amount - base period amount ● Analysis period: point or period of time for the financial statements under analysis ● Base period: point or period of time for the financial statements used for comparison

purposes ○ The prior year is commonly used as based period ● To compute percent change: ○ % change = analysis period amount-base period amount / base period amount ● When a negative amount is in the base period and a positive amount in the analysis period (vice versa), we can’t compute a meaningful percent change ● When no value is in the base period, no percent change is computable ● When an item has a value in the base period and zero in the analysis period, the decrease is 100 % ● Horizontal analysis compares amounts to either median or average values from prior periods ● Percents and ratios should be rounded to one or two decimal places Comparative Balance Sheets ● Consists of balance sheet amounts from two or more balance sheet dates arranged side by side ● Analysis of comparative financial statements begins by focusing on items that show large dollar or percent changes ○ Then determine the reasons for these changes, and determine whether they are favorable or unfavorable ● (read example about Apple on page 595) Comparative Income Statements ● Amounts for two or more periods are placed side by side, with additional columns for dollar and percent changes ● (read example about Apple on page 595) Financial Statement Analysis Ratios Liquidity and Efficiency ● Current ratio: measure of short-term debt-paying ability ○ Current assets / current liabilities ● Acid-test ratio: measure of immediate short-term debt paying ability ○ Cash + short-term investments + current receivables / current liabilities ● Accounts receivable turnover: measure of efficiency of collection ○ Net sales / average accounts receivable, net ● Inventory Turnover: measure of efficiency of inventory management ○ COGS / average inventory Solvency ● Debt-to-equity ratio: debt versus equity financing ○ Total liabilities / total equity Profitability ● Profit margin ratio: measure of net income in each sales dollar ○ Net income / net sales

● Gross margin ratio: measure of gross margin in each sales dollar ○ Net sales - COGS / net sales ● Basic earnings per share: measure of net income per common share ○ Net income - preferred dividends / weighted-average common shares outstanding Market Prospects ● Price-earnings ratio: measure of market value relative to earnings ○ Market price per common share / earnings per share ● Dividend yield: measure of cash return per common share ○ Annual cash dividends per share / market price per share...