Analyzing and Interpreting Financial Statements
The objective of accounting is to provide relevant and timely information to support the decision-making needs of financial statement users. Bankers, creditors, and investors all rely on financial statements to provide insight into a company's financial c
liquidity, solvency, profitability
General-purpose financial statements are distributed to a wide range of potential users, providing each group with valuable information about a company's economic performance and financial condition. Users typically evaluate this information along three d
Analytical methods, Ratios
Financial statement users rely on the following techniques to analyze and interpret a company's financial performance and condition:
?
Analytical methods
s* examine changes in the amount and percentage of financial statement items within and across period
Analytical Methods
Users analyze a company's financial statements using a variety of analytical methods. Three such methods are:
? Horizontal analysis
? Vertical analysis
? Common-sized statements
horizontal analysis
The analysis of increases and decreases in the amount and percentage of comparative financial statement items is called
horizontal analysis
. Each item on the most recent statement is compared with the same item on one or more earlier statements in terms
vertical analysis
The percentage analysis of the relationship of each component in a financial statement to a total within the statement is called
vertical analysis
. Although vertical analysis is applied to a single statement, it may be applied on the same statement over
common-sized statement
In a
common-sized statement
, all items are expressed as percentages, with no dollar amounts shown. Common-sized statements are often useful for comparing one company with another or for comparing a company with industry averages.
Analyzing Liquidity
Liquidity analysis evaluates the ability of a company to convert current assets into cash. Banks and other short-term creditors rely heavily on liquidity analysis, because they are interested in evaluating a company's ability to repay loans and short-term
Current position analysis, working capital, current ratio, quick ratio, Quick assets
Current position analysis
evaluates a company's ability to pay its current liabilities. This information helps short-term creditors determine how quickly they will be repaid. This analysis includes:
? Working capital
? Current ratio
? Quick ratio
Working
accounts receivable analysis, accounts receivable turnover, number of days' sales in receivables
A company's ability to collect its accounts receivable is called
accounts receivable analysis
. It includes the computation and analysis of the following:
? Accounts receivable turnover
? Number of days' sales in receivables
Collecting accounts receivable
inventory analysis, inventory turnover, number of days' sales in inventory
A company's ability to manage its inventory effectively is evaluated using
inventory analysis
. It includes the computation and analysis of the following:
? Inventory turnover
? Number of days' sales in inventory...
Inventory Turnover
The
inventory turnov
Analyzing Solvency
Solvency analysis evaluates a company's ability to pay its long-term debts. Bondholders and other long-term creditors use solvency analysis to evaluate a company's ability to (i) repay the face amount of debt at maturity and (ii) make periodic interest pa
ratio of fixed assets to long-term liabilities
Fixed assets are often pledged as security for long-term notes and bonds. The
ratio of fixed assets to long-term liabilities
provides a measure of how much fixed assets a company has to support its long-term debt. This measures a company's ability to repa
ratio of liabilities to stockholders' equity
The
ratio of liabilities to stockholders' equity
measures how much of the company is financed by debt and equity. It is computed as follows:
Ratio of Liabilities to Stockholders' Equity = Total Liabilities / Total Stockholders' Equity.
times interest earned
The
times interest earned
, sometimes called the
coverage ratio
, measures the risk that interest payments will not be made if earnings decrease. It is computed as follows:
Times Interest Earned = (Income Before Income Tax + Interest Expense) / Interest E
Profitability
Profitability analysis evaluates the ability of a company to generate future earnings. This ability depends on the relationship between the company's operating results and the assets the company has available for use in its operations. Thus, the relations
asset turnover
The
asset turnover
ratio measures how effectively a company uses its assets. It is computed as follows:
Asset Turnover = Sales / Average Total Assets (excluding long-term investments)
Note that long-term investments are excluded in computing asset turnove
return on total assets
The
return on total assets
measures the profitability of total assets, without considering how the assets are financed. In other words, this rate is not affected by the portion of assets financed by creditors or stockholders. It is computed as follows:
Re
return on stockholders' equity, Leverage
The
return on stockholders' equity
measures the rate of income earned on the amount invested by the stockholders. It is computed as follows:
Return on Stockholders' Equity = Net Income / Average Total Stockholders' Equity...
Leverage
involves using debt t
return on common stockholders' equity
The
return on common stockholders' equity
measures the rate of profits earned on the amount invested by the common stockholders. It is computed as follows:
Return on Common Stockholders' Equity = (Net Income - Preferred Dividends) / Average Common Stockho
Earnings per share (EPS) on common stock
Earnings per share (EPS) on common stock
measures the share of profits that are earned by a share of common stock. Earnings per share must be reported on the income statement. As a result, earnings per share (EPS) is often reported in the financial press.
price-earnings (P/E) ratio
The
price-earnings (P/E) ratio
on common stock measures a company's future earnings prospects. It is often quoted in the financial press and is computed as follows:
Price-Earnings (P/E) Ratio = Market Price per Share of Common Stock / Earnings per Share o
Dividends per share
Dividends per share
measures the extent to which earnings are being distributed to common shareholders. It is computed as follows:
Dividends per Share = Dividends on Common Stock / Shares of Common Stock Outstanding...
Dividends per share are often report
dividend yield
The
dividend yield
on common stock measures the rate of return to common stockholders from cash dividends. It is of special interest to investors whose objective is to earn revenue (dividends) from their investment. It is computed as follows:
Dividend Yie
Summary of Analytical Measures
Exhibit 13 shows a summary of the solvency and profitability measures discussed in this chapter. The type of industry and the company's operations usually affect which measures are used. In many cases, additional measures are used for a specific industry.
Corporate Annual Reports
Public corporations issue annual reports summarizing their operating activities for the past year and plans for the future. Such annual reports include the financial statements and the accompanying notes. In addition, annual reports normally include the f
Management's Discussion and Analysis (MD&A)
Management's Discussion and Analysis (MD&A)
is required in annual reports filed with the Securities and Exchange Commission. It includes management's analysis of current operations and its plans for the future. Typical items included in the MD&A are as fo
Report on Internal Control
The Sarbanes-Oxley Act of 2002 requires a report on internal control by management. The report states management's responsibility for establishing and maintaining internal control. In addition, management's assessment of the effectiveness of internal cont
Report on Fairness of the Financial Statements
All publicly held corporations are required to have an independent audit (examination) of their financial statements. The Certified Public Accounting (CPA) firm that conducts the audit renders an opinion, called the
Report of Independent Registered Public
Appendix 1 Unusual Items on the Income Statement
Generally accepted accounting principles require that unusual items be reported separately on the income statement. This is because such items do not occur frequently and are typically unrelated to current operations. Without separate reporting of these i
Unusual Items Affecting the Current Period's Income Statement
Discontinued operations are an unusual item that affects the current period's:
? Income statement presentation
? Earnings per share presentation
Discontinued operations are reported separately on the income statement for any period in which they occur.
In
...
An unusual item may occur that affects a prior period's income statement. Two such items are as follows:
? Errors in applying generally accepted accounting principles
? Changes from one generally accepted accounting principle to another
If an error is dis
Appendix 2 Fair Value and Comprehensive Income
Many companies acquire assets that are required by GAAP to be reported on the balance sheet at a different measurement basis called
fair value
. When a company reports assets at fair value, the financial reporting becomes complex. In the following section
Fair value
Fair value
is the price that could be received for an asset if it were sold today. This differs from historical cost, in that the amount reported on the balance sheet changes each period to reflect the asset's fair (current) value at the balance sheet dat
other comprehensive income, comprehensive income, unrealized gain, accumulated other comprehensive income
When a change in an asset's fair value is not recorded as a gain or loss on the income statement, it is recorded as an element of
other comprehensive income
. These include changes in the fair value of certain investment securities, foreign currency expos