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Financial Statement Analysis
McGraw-Hill/Irwin
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Objective of a Business
Create value for its shareholders while maintaining a sound financial position. Return on investment. Sound financial position. Other important objectives include:
Employee satisfaction. Social responsibility. Ethical considerations.
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Overview
GAAP does not define ratios. Multiple equally valid approaches to ratios and analysis. Managers (e.g. division manager, sales manager) should be measured to items that they control. Investors and top management are most interested in overall performance or broadest measures of performance.
Understanding less broad measures of performance may give additional insight into overall performance
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Structure of analysis
From broadest to more specific levels. Principal value of financial analysis:
Suggests questions not answers.
Ratio comparisons start with supposition that all other things are equal. (They rarely are.)
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Making comparisons
Finding the appropriate standard is difficult. A high ratio (e.g. current ratio, ROI) may be good or bad. It cant be viewed in isolation.
Is a high CR good or bad? Is a high ROI always good?
Overall Measures
Return on investment (ROI) = net income / investment
Possible definitions of investment: assets, owners equity, invested capital. Possible definitions of return: net income, net income -preferred dividends, net income + interest expense (1-tax rate). Use income generated from pool of funds before considering cost of funds in pool.
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Variations
Average or weighted average investment is more representative (e.g. (beginning + ending) 2). Tangible assets instead of total assets. To determine tax rate, can use total tax rate or tax rate excluding deferred taxes.
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Profitability measures
Profit margin = net income/net sales = a measure of overall profitability. Common size financial statements = Vertical analysis:
Express each item on the income statement as a percentage of net sales.
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Investment turnover
Asset turnover = Sales revenue/total assets. Invested capital turnover = Sales revenue/invested capital. Equity turnover = Sales revenue/shareholders equity.
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Capital intensity
Less encompassing than investment turnover. Capital intensity ratio = sales revenue/PPE = fixed asset turnover.
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Days receivables = Receivables/(sales 365) Days inventory = inventory/(cost of goods sold 365)
Inventory turnover = cost of goods sold/inventory
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Liquidity
Ability to meet current obligations.
Tests for size and relationship between current liabilities and current assets.
Liquidity measures:
Current ratio = current assets/current liabilities. Acid Test (or quick) ratio = monetary current assets / current liabilities
Monetary current assets = current assets inventory - prepaid assets.
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Solvency
Ability to meet interest costs and repayment schedules associated with long-term debt. Solvency measures
Debt/equity ratio = total liabilities/shareholders equity
Alternatively, Debt/equity ratio = long-term liabilities/shareholders equity. Debt/capitalization ratio = long-term debt/total invested capital.
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Dividend policy
Dividend yield = dividends per share/ market price per share Dividend pay-out = dividends/net income Provides info on how growth is financed.
Less dividends paid means more earnings are retained to fund growth.
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Growth measures
Key accounting items for which growth is computed: sales, net income, earnings per share. Average growth = (growth per year for n years)/n Compound growth rate = based on present value concepts.
May be misleading due to abnormally high or low beginning or ending year.
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Historical standards. Prior periods results adjusted for changes in accounting methods. External benchmarks. Competitor, industry average
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