Financial Statement Analysis

Principles of Managerial Finance

• The document discusses chapters 2 & 3 of the 16th edition of "Principles of Managerial Finance" by Zutter and Smart.
• The topics covered include understanding financial statements and financial statement analysis.
• The outline for chapter 2 and 3 includes mandatory financial reports of public companies, firms' disclosure of financial information, income statements, balance sheets, statements of cash flows, statements of retained earnings, financial statement analysis, and a chapter quiz.
• Learning goals include reviewing the contents of a company's financial statements, understanding who uses financial ratios, analyzing firm liquidity and activity, discussing the relationship between debt and financial leverage, and analyzing firm profitability and market value.
• The health of a business can be assessed using lagging and leading indicators; lagging indicators assess the current state, while leading indicators predict future conditions.
• Generally Accepted Accounting Principles (GAAP) are authorized by the Financial Accounting Standards Board (FASB).
• The Sarbanes-Oxley Act of 2002 was designed to improve the accuracy of information provided to boards and shareholders. Key goals include overhauling incentives and independence in the auditing process, increasing penalties for false information, and requiring companies to validate their internal financial control processes.
• Form 10-K is an annual report filed with the SEC that contains a company's audited financial statements and detailed information.
• Annual reports provide basic financial information and promotional materials to attract investors.
• The letter to stockholders is the most important communication from management, explaining significant events of the year, management philosophy, and future plans.
• Financial statements answer three basic questions: how much profit was generated, what are the assets and liabilities, and what were the cash flows.
• Financial statements include profit & loss accounts, balance sheets, and cash flow statements.
• The Securities Act of 1933 and the Securities Exchange Act of 1934 created the Securities and Exchange Commission (SEC).
• The SEC requires public companies to report financial statements quarterly.
• A personal finance income statement example is provided for a couple, Jan and Jon Smith.

The Income Statement

• The income statement summarizes a company's financial performance over a specific period.
• Revenue, gains, expenses, and losses are included. A gain is an increase in the value of an asset, while an expense is a cost incurred to generate revenue. A loss represents a decrease in the value of an asset.
• Income statement components are gross profit, operating income, earnings before interest and taxes (EBIT), pretax income, and net income.
• An example income statement for a firm called "Excel Sports" is shown.

The Balance Sheet

• The balance sheet reports a company's assets, liabilities, and equity at a specific point in time.
• Assets are listed on the left side, and liabilities and equity are on the right side.
• Examples of assets are cash, accounts receivable, inventories, and prepaid expenses.
• Liabilities are items such as accounts payable, short-term debt, and long-term debt. Equity represents the owners' stake in the company.
• Current Assets are those expected to be converted to cash within a year.
• Long-term assets are used for a period greater than a year.
• A personal balance sheet is provided as an example.

The Statement of Cash Flows

• This statement shows the movement of cash in and out of a company over a period.
• Cash flows are categorized into operating, investing, and financing activities.
• Operating activities include day-to-day business transactions.
• Investing activities involve the purchase and sale of long-term assets (plant and equipment).
• Financing activities involve debt and equity transactions (e.g. issuing new stock, repaying debt, dividends).
• Examples are provided to illustrate the statement of cash flows.

The Statement of Retained Earnings

• This statement explains how a company's retained earnings have changed over a period.
• It tracks cumulative profits or losses that have been retained after dividend payments.
• An example of this statement, tracking figures for a company called Global Corporation over the years 2020, 2019, and 2018, is shown.

Financial Statement Analysis

• Investors utilize financial statements to make comparisons to themselves (trend analysis) and other firms in the same industry (peer group analysis)
• Internal financial analysis can used to review employee performance, compare divisions, and conduct financial projections relative to competitors.
• External financial analysis determines a firm's credit worthiness or investment attractiveness. This analysis can be conducted by lenders, suppliers, credit rating agencies, and individual investors.
• Financial ratios provide a standardized method for comparing financial information to peer firms or to past performance.
• The fundamental categories of issues to analyze include liquidity, capital structure, asset management efficiency (turnover), profitability, and market value.

Liquidity Ratios

• Liquidity refers to a company's ability to pay off its short-term obligations.
• Current ratio compares a firm's current assets to its current liabilities.
• Quick ratio or acid-test ratio excludes inventory from assets to assess the firm's ability to pay off short-term liabilities, using only liquid assets.
• Cash ratio is the amount of cash and readily available assets compared to total current liabilities.

Capital Structure Ratios

• These ratios assess how a firm funds its assets using debt and equity.
• Debt-to-equity ratio: Total Debt / Total Equity
• Debt-to-capital ratio is Total Debt / (Total Debt + Total Equity)
• This metric shows what proportion of operating assets are financed using debt and what proportion using equity.

Profitability Ratios

• Profitability ratios evaluate the return on investments.
• Gross profit margin: Gross Profit / Sales
• Operating profit margin: Operating Profit / Sales
• Net profit margin: Net Income / Sales
• Return on Assets (ROA): Net Income / Total Assets
• Return on equity (ROE): Net Income / Shareholders' Equity

Asset Management Efficiency Ratios

• These ratios indicate how effectively a firm utilizes assets to generate sales.
• Total asset turnover: Sales / Total Assets
• Fixed asset turnover: Sales / Net Plant and Equipment

Ratio Analysis

• Ratio analysis is a method to evaluate financial performance on a relative basis. This uses various ratios against industry averages, or from prior period values.
• Time-series analysis analyzes a firm's ratios over a period to check for trends.
• Peers analysis compares a firm's ratios to others within the same industry.

Chapter Quiz

• The questions included in the chapter quiz cover topics like the role of auditors, depreciation calculations, high debt to equity ratio implications, understanding earnings, P/E ratio, difference between cash and profit, information in notes, and the Sarbanes-Oxley Act. Further instructions for an additional chapter quiz require using two publicly listed Malaysian companies, and comparing ratios for 2022 including current, quick, and cash ratios, debt to equity, debt to capital ratios, gross profit, net profit, return on assets, return on equity, and assets turnover.

Test your knowledge of financial statement analysis. Covers the calculation of gross profit, operating income, EBIT, pretax income, net sales, taxes percentage, and stockholders' equity. Includes balance sheet equations and liabilities.