Financial Statements: Analysis & Reporting

• Financial accounting provides a standardized way to report a company's financial performance to external parties
• Managerial accounting provides information to managers inside the organization to assist them in decision making
• Financial statement analysis involves reviewing a company's financial statements to make better-informed business decisions

Key Financial Statements

• The balance sheet, income statement, statement of cash flows, and statement of retained earnings are key financial statements
• The balance sheet provides a snapshot of a company's assets, liabilities, and equity at a specific point in time following the accounting equation
• Assets are a company’s resources
• Liabilities are a company’s obligations to others
• Equity represents the owners’ stake in the company
• The income statement reports a company's financial performance over a period of time, calculating net income/loss by subtracting expenses from revenues
• The statement of cash flows tracks the movement of cash both into and out of a company over a period of time, categorized by operating, investing, and financing activities
• The statement of retained earnings shows the changes in a company's retained earnings (accumulated profits not distributed as dividends) over a period

Generally Accepted Accounting Principles (GAAP)

• GAAP are a common set of accounting rules, standards, and procedures issued by the Financial Accounting Standards Board (FASB)
• GAAP aims to ensure financial statements are relevant, reliable, and comparable

Financial Statement Analysis Techniques

• Ratio analysis involves calculating and comparing various financial ratios to assess a company's performance
• Common-size analysis involves expressing financial statement items as a percentage of a base amount to facilitate comparison
• Trend analysis involves analyzing financial data over time to identify patterns and predict future performance

Ratio Analysis

• Liquidity ratios measure a company's ability to meet its short-term obligations
• Solvency ratios measure a company's ability to meet its long-term obligations
• Profitability ratios measure a company's ability to generate profits
• Efficiency ratios measure how effectively a company is using its assets
• Market value ratios relate a company's market value to its accounting values

Important Ratios

• Current Ratio = Current Assets / Current Liabilities (Liquidity)
• Quick Ratio = (Current Assets - Inventory) / Current Liabilities (Liquidity)
• Debt-to-Equity Ratio = Total Debt / Total Equity (Solvency)
• Times Interest Earned Ratio = EBIT / Interest Expense (Solvency)
• Gross Profit Margin = (Revenue - Cost of Goods Sold) / Revenue (Profitability)
• Net Profit Margin = Net Income / Revenue (Profitability)
• Return on Equity (ROE) = Net Income / Average Stockholder's Equity (Profitability)
• Asset Turnover Ratio = Revenue / Average Total Assets (Efficiency)
• Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory (Efficiency)
• Earnings Per Share (EPS) = (Net Income - Preferred Dividends) / Weighted Average Common Shares Outstanding (Market Value)
• Price-to-Earnings (P/E) Ratio = Market Price per Share / Earnings per Share (Market Value)

Common-Size Analysis

• Common-size income statements express each item as a percentage of revenue
• Common-size balance sheets express each item as a percentage of total assets
• This allows for easy comparison of different companies or the same company over different time periods

Trend Analysis

• Comparing financial statement data over several periods (e.g., 3-5 years) to identify trends
• Helps to assess a company's growth, stability, and potential future performance

Analyzing Profitability

• Gross profit margin shows how well a company is managing its production costs
• Net profit margin indicates how much of each sales dollar is left after all expenses are paid
• Return on assets (ROA) measures how efficiently a company is using its assets to generate profit
• Return on equity (ROE) measures the return to shareholders

Analyzing Liquidity and Solvency

• Current and quick ratios indicate a company's ability to pay its short-term debts
• Debt-to-assets and debt-to-equity ratios show the extent to which a company is financed by debt
• Times interest earned ratio measures a company's ability to cover its interest payments

DuPont Analysis

• The DuPont analysis decomposes ROE into profit margin, asset turnover, and equity multiplier
• ROE = Net Profit Margin * Asset Turnover * Equity Multiplier
• Equity Multiplier = Total Assets / Total Equity
• Helps to identify the drivers of ROE and compare the performance of different companies

Limitations of Financial Statement Analysis

• Financial statements are based on historical data
• Subject to management estimates and accounting methods used
• Differences in accounting policies can make comparisons difficult
• Does not incorporate non-financial information
• Can be affected by economic and industry-specific factors

Importance of Notes to Financial Statements

• Notes provide additional details about the items in the financial statements
• They explain the accounting policies used
• Disclose contingent liabilities and other important information

Impact of Accounting Standards

• Changes in accounting standards can impact the way financial statements are prepared and analyzed
• Understanding the applicable accounting standards is essential for accurate financial analysis

Earnings Quality

• Earnings quality refers to the reliability and sustainability of a company's reported earnings
• High-quality earnings are sustainable and accurately reflect a company's performance
• Low-quality earnings may be the result of aggressive accounting practices or one-time gains

Red Flags in Financial Statement Analysis

• Unusual or unexpected changes in financial ratios
• Unexplained changes in accounting policies
• Large amounts of related-party transactions
• Rapid growth in revenue or earnings that is not supported by underlying business fundamentals

Using Financial Statement Analysis for Decision Making

• Investors use financial statement analysis to assess a company's investment potential
• Creditors use financial statement analysis to assess a company's creditworthiness
• Managers use financial statement analysis to identify areas for improvement and make strategic decisions

Free Cash Flow

• Free cash flow (FCF) represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets
• FCF is a measure of profitability that excludes the non-cash expenses of the income statement and includes investments in working capital and equipment
• FCF = Net Operating Profit After Tax - Investment in Operating Capital

Enterprise Value

• Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market capitalization
• EV = Market Capitalization + Total Debt - Cash and Cash Equivalents

Earnings Management

• Earnings management involves using accounting techniques to produce financial statements that present an overly positive view of a company's business activities
• While not always illegal, aggressive earnings management can mislead investors

Sustainable Growth Rate

• Sustainable growth rate is the maximum rate of growth that a company can sustain without raising additional equity
• Sustainable Growth Rate = ROE * (1 - Dividend Payout Ratio)

Off-Balance-Sheet Financing

• Off-balance-sheet financing refers to the practice of keeping debt off the balance sheet through various means
• This can make a company's financial position appear stronger than it actually is

Importance of Industry Analysis

• Understanding the industry in which a company operates is crucial for effective financial statement analysis
• Industry-specific factors can significantly impact a company's performance