Chapter 12

Financial Statement
Analysis
 Learning Objectives
After studying this chapter, you should be able to:
 Locate and use the many sources of information about company
performance.
 Analyze the components of a company using trend analysis and other
techniques.
 Use the basic financial ratios to guide your thinking.
 Evaluate corporate performance using ROA, ROE, and EVA.
 Calculate EPS when a company has preferred stock or dilutive
securities.
 Adjust for nonrecurring items.
 Sources of Information
About Companies
 Financial statement analysis - using financial
statements to assess a company’s performance.

 Information about publicly traded companies comes in

many forms and may be found in many places.
• Annual reports
• SEC filings and databases
• Company press releases
• Articles that appear in the financial press
 Sources of Information
About Companies
 The annual report is important to investors because of its
completeness and its reliability due to the audit performed
by an independent auditor.

• The annual report includes:

• Financial statements
• Footnotes to the financial statements
• A summary of accounting principles used
• Management’s discussion and analysis of the financial results
• The auditor’s report
• Comparative financial data for a series of years
• Narrative information about the company
 Sources of Information
About Companies
 Other information sources include:
• Company press releases available on web
• New coverage available on corporate websites and sites like
Google finance
• Quarterly conference calls of corporations with analysts and
investors
 Announce quarterly results
• Discuss new developments
• Live and archived webcasts
 The Internet is changing the way that people make investments- Much of
the market information is available electronically, usually for free from
various sources
 Sources of Information
About Companies
 Large investors often require pro forma
statements which are carefully formulated
expressions of predicted results.

 Any investor should take the time to gather as

much information about potential investments
as possible.
 Objectives of Financial Statement
Analysis
 Although different investors demand different returns, they
all use financial statement analysis for common reasons.

• To predict their expected returns

• To assess the risks associated with those returns

 Financial statement analysis focuses on past

performance to predict future performance.
 Objectives of Financial Statement
Analysis
 Creditors want to know about short-term
liquidity and long-term solvency.

• Short-term liquidity - an organization’s ability to

meet current payments as they become due.

• Long-term solvency - an organization’s ability to

generate enough cash to repay long-term debts as
they mature.
 Objectives of Financial Statement
Analysis
 Equity investors are more concerned with returns in
the form of dividends and increased market price of
the stock.

• These investors are naturally more interested in

profitability.
• Profits spur both dividends and increased
stock prices.
 Evaluating Trends and Components of
the Business
 Evaluating trends and components of a business are two
ways of looking at financial information.

 Trend analysis involves comparing financial trends from

one year to another.

 Evaluating components of a business can be done in more

than one way.

• Relationships among elements of the financial statements may be

examined.
• Components may also be thought of as separate business units or
segments. These components may be examined.
 Trend Analysis
 Trends are predictable patterns that have been
observed in the past and are expected to continue
into the future.

• A pattern must be identified, and expectations of

whether the trend will continue must be formed.

• Trends can be shown as changes in amounts from year

to year or as percentage changes from year to year.
 Trend Analysis

 The dollar amount of the change is simply

the current year minus the previous year.

 The percentage change is computed as

follows:
(𝐴𝑚𝑜𝑢𝑛𝑡 𝑖𝑛 2021 −𝐴𝑚𝑜𝑢𝑛𝑡 𝑖𝑛 2020)
= * 100
𝐴𝑚𝑜𝑢𝑛𝑡 𝑖𝑛 2020
Compound Annual Growth Rate (CAGR)

 Year-over-year growth rate over a

specified period of time
F  Ending sales value 
(1/# of years )
CAGR  
Beginning sales value 
-1
 
 Trend Analysis

STELLAR CORPORATION
Income Statements
for the Years Ended December 31, 2019 and 2018
2019 2018 Increase % Increase
(Decrease) (Decrease)
Sales $ 98,600 $ 89,500 $ 9,100 10.2%
Expenses:
Wages expense 45,800 42,900 2,900 6.8
Rent expense 12,000 12,000 0 0.0
Utilities expense 6,500 6,450 50 0.8
Depreciation expense 5,000 5,900 (900) (15.3)
Total expenses 69,300 67,250 2,050 3.0
Net income $ 29,300 $ 22,250 $ 7,050 31.7
 Trend Analysis
 Changes in dollar amounts and percentage terms help to
expose patterns.

• Understanding these patterns is most important.

• The answers to why items changed tell a lot about how a company is
run, how it will perform in the future, and whether or not it would
be a good investment.

 Analysts generally look at several years’ worth of

financial information to discover trends.
 Management’s Discussion and
Analysis (MD&A)
 Management’s discussion and analysis - a required
section of the annual report that concentrates on
explaining the major changes in the income
statement, liquidity, and capital resources.

• Management’s discussion often includes a

discussion of trends and analysis of
components.
Management Discussion and Analysis
MD&A)

 Includes:
 Changes in revenue and expense
 Explanation of unusual or infrequent events
 Disclosures about contractual obligations and
commitments
 Discussion of critical accounting policies and
estimates
 Impact of adoption of new accounting policies
 Common-Size Statements
 Common-size statements - financial statements expressed in
component percentages to compare performance over time as
well as to compare companies of different sizes.

• The income statement is expressed as a percentage of sales.

• This makes it easy to compare percentages to those of other
companies because percentages are a common index.

• The balance sheet is expressed as a percentage of total assets.

• This is often referred to as component percentages because they measure
each component as a percentage of the total.
Common-Size Statements
 For the income statement, sales is set at 100%
and each other element is expressed as a
percentage of the sales figure.

 For the balance sheet, the total assets

amount is set at 100%, and each other
element is expressed as a percentage of the
total assets figure.
Common-Size Statements
STELLAR CORPORATION
Income Statements
for the Years Ended December 31, 2019 and 2020
2019 2020
Sales $ 98,600 100% $ 89,500 100%
Expenses
Wages expense 45,800 46% 42,900 48%
Rent expense 12,000 12% 12,000 13%
Utilities expense 6,500 7% 6,450 7%
Depreciation expense 5,000 5% 5,900 7%
Total expenses 69,300 70% 67,250 75%
Net income $ 29,300 30% $ 22,250 25%
 Segment Reporting
 Many large companies are involved in more than one
type of business activity or market.

• Each individual type of business activity or market may

be considered a segment.

• Segment reporting helps to assess performance of each

segment individually and helps management in taking
strategic decisions
Segment Reporting
 When analyzing segment data, two
things should be considered.

• Evaluating segment data forces us to ask important questions

that help us to truly understand the business.

• Truly understanding the business means not only

understanding what is sold and how much is made but also
interpreting how financial reports summarize dynamic
changes in the business.
Financial Ratios

 The cornerstone of financial statement analysis is the use of

ratios.
 Used by both managers and investors
 Managers use ratios:
 To guide, measure, and reward workers such as criteria for
bonuses
 As elements in contracts such as debt covenants
 To manage the business by examining year to year
changes and the causes
Evaluating Financial Ratios

 Uses of financial ratios typically

involve comparisons
 Time-series comparisons: Compare the
company’s ratios with its own historical ratios
 Benchmark comparisons: Compare the
company’s financial ratios with benchmarks
 Cross-sectional comparisons: Compare the
company’s financial ratios with the ratios of
other companies or industry averages
 Evaluating Financial Ratios

 Caution in using comparisons

 Time-series analysis - Be aware of structural shifts
in a company, for example, mergers and
acquisitions.

 Benchmark comparisons
 Identifying the right benchmarks for meaningful
comparisons
 Rules of thumb vary according to industry and change
over time
Evaluating Financial Ratios

 Cross-sectional comparisons
 Requires the identification of appropriate comparable
companies.
 Segment disclosures may allow the comparison of an
element of a larger company to a comparable smaller
company.
 Industry codes such as SIC (Standard Industry
Classification) help identify comparable companies.
 NSE classification of industries:
https://www.nseindia.com/products-services/industry-classification
Financial Ratios

 Financial ratios are sometimes grouped into

four categories:
• Short-term liquidity ratios
• Long-term solvency ratios
• Profitability ratios
• Market price and dividends ratios
 Financial Ratios
Short-term liquidity ratios
Name of Ratio Numerator Denominator

Current ratio Current assets Current liabilities

Quick ratio Current assets-Inventory Current liabilities

Average collection Average accounts Sales

period in days receivable x 365
Inventory turnover Cost of goods sold Average inventory at
cost
Financial Ratios

Long-term solvency ratios

Name of Ratio Numerator Denominator

Total debt to total assets Total liabilities Total assets

Total debt to equity Total liabilities Stockholders’ equity

Interest coverage Income before interest Interest expense

and taxes
 Financial Ratios
Profitability ratios
Name of Ratio Numerator Denominator
Return on common stockholders' Net income-Preference Dividend Average stockholders' equity
equity(ROE)

Gross profit rate or percentage Gross profit or gross margin Sales

Return on sales Net Income Sales

Total assets turnover Sales Average total assets available

Pre-tax return on assets (ROA) Earnings before interest and Average total assets available
tax

Earnings per share Net income less dividends on Average common shares
preferred stock, if any outstanding
 Financial Ratios
Market price and dividend ratios
Name of Ratio Numerator Denominator

Price-earnings Market price of common Earnings per share

stock
Dividend yield Dividends per common Market price of common
share stock
Dividend-payout Dividends per common Earnings per share
share
 Ratios
 Ratios mean different things to different groups.
• A creditor might think that a high current ratio is
good because it means that the company has the cash
to pay the debt.

• However, a manager might think that a high current

ratio is undesirable because it could mean that the
company is carrying too much inventory or is
allowing its receivables to get too high.
 Ratios
 Because financial ratios may be interpreted
differently by different users, the users of
the financial ratios must understand the
company and the business before drawing
conclusions.
Operating Performance and Financing
Decisions

 Financial management: Decisions

concerned with where the company gets
cash and how it uses that cash to its benefit.

 Operating management: Decisions

concerned with the day-to-day activities
that generate revenues and expenses
Operating Performance

 Overall success of investment measured

= Income
Rate of return o n investment
In vest ed capital

 Forms of income
 Net income, income from operations, or
earnings before interest and taxes (EBIT)
 Forms of invested capital
 Common stockholders’ equity or total capital
provided
Operating Performance

 Pretax and pre-interest return on total

assets: Version of ROA defined as earnings
before interest and taxes divided by
average total assets Pretax ROA = EBIT
Average total assets

 Measuring return on assets (ROA) after

taxes
 Independent of financing
After-tax ROA = {Profit after tax + [Interest expense × (1 − tax rate)]}
Average total assets
Operating Performance

 Pre-tax ROA decomposed to understand

what drives operating performance of a
company
𝐸𝐵𝐼𝑇 𝐸𝐵𝐼𝑇 𝑆𝑎𝑙𝑒𝑠
= 𝑆𝑎𝑙𝑒𝑠 ＊𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

Total asset
EBIT-to-
turnover
sales
Operating Performance

 “Dupont” decomposition of calculation of return on

equity (ROE):
 Numerator includes after-tax net income
 Invested capital includes average common
stockholders’ equity
ROE = Net income × Sales × Average total assets
Sales Average total assets Average stockholders' equity

Return on Total asset Financial

sales turnover leverage
Operating Performance

 DuPont analysis isolates elements of ROE

 Return on Sales -focuses on a profit margin
concept
 Asset turnover- focuses on the efficient use of
assets to generate sales
 Leverage - emphasizes the impact of financing
decisions on ROE
 Financing Decisions

 Strong financial performance requires

balancing debt and equity financing.

 Debt benefits companies because

 Interest payments are tax deductible but
dividends are not.
 New debt does not change the voting and rights
to profits of existing shareholders, but new stock
issuance would
 Financing Decisions

 Capitalization or capital structure: Total long-

term financing of a company, consisting of long-
term debt and stockholders’ equity.

 Trading on equity (financial leverage,

leveraging, gearing): Using interest-bearing
debt to enhance the rate of return on common
stockholders’ equity
 Trading on Equity
Trading on equity (leverage) is the use of borrowed funds carrying a
fixed charge in expectation of higher return to equity-holders.
 Income Tax Effects of Financing Decisions

 Long-term debt versus preferred stock

 Interest tax deductible, not dividends
 Using debt makes net income lower

 Interest is an expense, not preferred dividends

 Using preferred shares makes net income higher

 Failure to pay interest can lead to bankruptcy

 Failure to pay dividends has less severe
consequences
Earning per
share

 Earnings on a per share basis (EPS)

calculated as
Earnings per share of = Net income
common stock Weighted-average number of common shares outstanding during the period

 Weighted-average - Based on number of

months shares were outstanding
Weighted-Average Shares

 Example: 750,000 shares outstanding at

beginning of a year; 200,000 shares added 3
months before end of year

750,000 × Weighting of 12/12 = 750,000

200,000 × Weighting of 3/12 = 50,000
Weighted Average shares 800,000
EPS –Fully Diluted & with preferred Stock

 For Fully diluted EPS adjust weighted- average

shares outstanding “as if” shares were increased

 Increase due to:

 Exercise of stock options
 Conversion of convertible debt or equity
EPS –Fully Diluted & with preferred
Stock

 EPS for nonconvertible preferred stock

outstanding calculated as

Earnings per share of Net Income- Preference Dividends

=
common stock Weighted average number of common shares
outstanding during the period
 Basic and Diluted
EPS
 Calculation of EPS for companies having convertible
securities: Basic EPS
Convertible preferred stock at 5 %, $ 1 0 0
1 0 0 , 0 0 0 shares
par, e a c h share convertible into t w o
c o m m o n shares
Ave r a ge c o m m o n shares outstanding 1 , 0 0 0 , 0 0 0 shares

Co mp u tation of earnings per share

Net income $10,500,000
Less: Preferred dividends (0.05 × $ 1 0 0 ×
1 0 0 , 0 0 0 shares) 500,000
N e t i n c o m e available t o c o m m o n st o c k h o lder s $10,000,000
Earnings per share of c o m m o n stock
( $ 1 0 , 000, 000 ÷ 1 , 0 0 0,000 shares) $ 1 0 .0 0
Copyright © 2014 Pearson Education, Inc. Publishing as Prentice
Hall.
 Basic and Diluted
EPS
 Diluted
EPS
Net Income $ 10,500,000
Less: Preference Dividends 0
Net Income available to common stockholders $10,500,000
Earnings per share of common stock- assuming conversion
($ 10,50,000 ÷ 1,200,000 shares) $ 8.75
Disclosure of Irregular Items

 To predict future prospects, we must distinguish ordinary

recurring activities from irregular, non-recurring activity
 Irregular items
 Unusual in nature or infrequent
 Nonrecurring items
 Extraordinary items
 Discontinued operations
 Changes in accounting principle
Disclosure of Irregular Items

 Nonrecurring (unusual) item: Income statement item that

is either unusual in nature or infrequent in occurrence but
not both
 Classified as operating expense; examples include
Impairment of property, plant and equipment
Impairment of goodwill
Restructuring charges
Disclosure of Irregular Items

 Extraordinary items: Both unusual in nature

and infrequent in occurrence that are shown
separately, net of tax, on the income statement
 Example - Financial effects of earthquake or
government expropriation
 Each item presented on a separate line on the
income statement
Disclosure of Irregular Items

 Discontinued operations: Occur when a company

disposes of a component distinguishable from rest of the
entity
 Report results of continuing operations separately
and disclose results for discontinued operation
Separately report gain or loss from the disposal
Disclosure enhances forecasting of future
performance
International Issues

 Internationally, factors that complicate analysis are differences in:

 Accounting methods
U.S. GAAP and IFRS
 Currency of measurement
 Structures for security markets
 Tax laws