Chapter 2 Financial Statement And Ratio Analysis
M02 MCNA8932 01 SE C02.indd Page 2-1 25/10/13 7:42 PM f-w-155/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 9Chapter 2Financial Statement andRatio AnalysisLEARNING OBJECTIVES LO1Know the hree FinancialStatements Needed forFinancial Analysis LO2Know the Goals ofFinancial StatementAnalysis LO3Perform FinancialStatement Analysis
M02 MCNA8932 01 SE C02.indd Page 2-2 25/10/13 7:42 PM f-w-155Financial Statement and Ratio Analysis/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 9IntroductionIntroductionEarlier, we learned that the goal of the financial manager is to maximize shareholderwealth, which occurs when the firm’s share price is maximized. In this chapter, we wantto get more pragmatic. How does the financial manager know that he or she is movingthe company in the right direction, and how do investors in the firm’s shares evaluate theperformance of the managers? The stakeholders look at the firm’s financial statements foranswers to these and other questions. Firm managers use accounting information to helpthem manage the firm. Investors and creditors use accounting information to evaluatethe firm.This chapter focuses on the interpretation and analysis of financial statements. To performfinancial analysis, you will need to know how to use common-sized financial statements,financial ratios, and the Du Pont ratio method. In addition, you will learn market-basedratios that provide insight about what the market for shares and bonds believes aboutfuture prospects of the firm.Financial analysis is the process of using financial information to assist in investmentand financial decision making. Financial analysis helps managers with efficiency analysis and identification of problem areas within the firm. Also, it helps managers identifystrengths on which the firm should build. Externally, financial analysis is useful for creditmanagers evaluating loan requests and investors considering security purchases.
M02 MCNA8932 01 SE C02.indd Page 2-3 25/10/13 7:42 PM f-w-155Financial Statement and Ratio AnalysisLO1/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 9LO1 The Financial Statements1.1 The Balance SheetThe Financial StatementsThree financial statements are critical to financial statement analysis: the balance sheet, theincome statement, and the statement of cash flows. We provide a brief overview of eachstatement and describe what information it contains.1.1 The Balance SheetThe balance sheet provides the details of the accounting identity.Assets Liabilities Owners equityorInvestments Investments paid for with debt Investments paid for with equityThe balance sheet is a financial snapshot of the firm, usually prepared at the end of thefiscal year. That is, it provides information about the condition of the firm at one particularpoint in time. By reviewing a series of balance sheets from different years, the analyst canidentify changes in the firm over time. Table 2.1 shows a sample balance sheet, and thevideo discusses its content.
M02 MCNA8932 01 SE C02.indd Page 2-4 25/10/13 7:43 PM f-w-155Financial Statement and Ratio Analysis/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 9LO1 The Financial Statements1.1 The Balance SheetTable 2.1 Sample Balance SheetAssetsLiabilities and EquityCurrent AssetsCashMarketable securitiesAccounts receivableInventoriesTotal current assetsCurrent LiabilitiesAccounts payableAccrued expensesShort-term notesFixed AssetsLong-Term LiabilitiesMachinery and equipmentBuildingsLandLong-term notesMortgagesTotal fixed assetsTotal current liabilitiesTotal long-term liabilitiesOther AssetsEquityInvestmentsPatentsPreferred sharesCommon sharesPar valuePaid in capitalRetained earningsTotal equityTotal other assetsTotal AssetsTotal Liabilities and Equity
M02 MCNA8932 01 SE C02.indd Page 2-5 25/10/13 7:43 PM f-w-155Financial Statement and Ratio AnalysisLO1 The Financial Statements/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 91.2 The Income StatementIt is important to note that assets are owned only for the income they can produce for thefirm. Liabilities and owners’ equity provide the funds for the purchase of these assets.1. Assets generate income (the left-hand side)The left-hand side of the balance sheet lists the firm’s assets. The only reason for a firmto hold an asset is if it produces income. The assets of the firm produce the firm’sincome. There is no reason for a firm to hold an asset if it is not going to produce income.2. Financing the assets (the right-hand side)For every dollar in assets the firm has, there will either be a dollar of liability or a dollarof equity on the right-hand side of the balance sheet. The right-hand side of the balancesheet shows how the firm is financing its assets. By adjusting the mix of debt and equity,the lowest cost of financing can be achieved.In summary, the left-hand side of the balance sheet reports the assets that earn income andthe right-hand side reports how these assets are financed.1.2 The Income StatementUnlike the balance sheet, which tells us the state of the firm at one point in time, the incomestatement tells us how the firm has performed over a period of time.
M02 MCNA8932 01 SE C02.indd Page 2-6 25/10/13 7:43 PM f-w-155Financial Statement and Ratio AnalysisLO1 The Financial Statements/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 91.2 The Income StatementIncome statements usually have two sections. The first section reports the results of operating activities or operating income. This includes sales minus operating expenses. Financingactivities are reported in the second section, where interest expense, taxes, and preferreddividends are subtracted to arrive at net income. Table 2.2 provides a sample income statement, and the video discusses the content of the income statement.Table 2.2 Sample Income StatementSales- Cost of goods soldGross ProfitOperating Activities- Selling expense- Administrative expense- Depreciation expenseEarnings Before Interest and Taxes (EBIT)- Interest expenseEarnings Before TaxesFinancing Activities- TaxesNet Income Before Preferred Dividends- Preferred share dividendsNet Income Available to Common Shareholders
M02 MCNA8932 01 SE C02.indd Page 2-7 25/10/13 7:43 PM f-w-155Financial Statement and Ratio AnalysisLO1 The Financial Statements/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 91.3 Statement of Cash Flows1.3 Statement of Cash FlowsMany students are not as comfortable with the statement of cash flows as they are with theincome statement and balance sheet. It does, however, provide insight not readily availablefrom the other statements. In finance, we are particularly concerned with cash flows ratherthan accounting earnings. Table 2.3 shows a sample statement of cash flows. The Explain Itvideo explains the content of the statement of cash flows.
M02 MCNA8932 01 SE C02.indd Page 2-8 25/10/13 7:43 PM f-w-155Financial Statement and Ratio Analysis/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 9LO1 The Financial Statements1.3 Statement of Cash FlowsTable 2.3 Sample Statement of Cash FlowsCash Flow from OperationsNet profit after taxes Depreciation Decrease in accounts receivable Decrease in inventories Increase in accounts payable Decrease in accrualsCash provided by operationsCash Flow from InvestmentsIncrease in fixed assetsChange in business ownershipCash provided by investment activitiesCash Flow from Financing Activities Decrease in notes payable Increase in long-term debt Changes in shareholders’ equity- Dividends paidCash provided by financing activitiesNet increase/decrease in cash and marketable securities
M02 MCNA8932 01 SE C02.indd Page 2-9 25/10/13 7:43 PM f-w-155Financial Statement and Ratio Analysis/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 9LO1 The Financial StatementsSTOPReady to doLO1topic homework 1?MyFinanceLab
M02 MCNA8932 01 SE C02.indd Page 2-10 25/10/13 7:43 PM f-w-155Financial Statement and Ratio AnalysisLO2/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 9LO2 The Goals of Financial AnalysisThe Goals of Financial AnalysisExactly what can we hope to accomplish by analyzing the financial aspects of a firm?Financial analysis is a powerful tool to help drive investment and management decisions.However, we will not find many absolute answers. What we may find is a number of redflags that help focus our attention.Outsiders will conduct financial analysis differently than managers, also referred to asinsiders. Clearly, insiders have access to information unavailable to others in the market.This gives them an advantage when ratios raise questions. For example, suppose a firmdiscovers it has a falling profit margin. It has also found that its inventory is not sellingas quickly as in the past. Insiders can order an analysis to determine which specific itemsare not moving well. Outsiders may only speculate about the quality of the inventory mix.However, both insiders and outsiders have a common goal of attempting to identify thestrengths and weaknesses of the firm.Identify Company WeaknessesOne goal of financial analysis is to identify problems that affect the firm. By identifying problems early, managers can make corrections to improve firm performance. Someproblems may be hard to identify. A firm that seems to be earning profits but is constantlyshort of cash may turn to financial analysis to identify why this is occurring.
M02 MCNA8932 01 SE C02.indd Page 2-11 25/10/13 7:43 PM f-w-155Financial Statement and Ratio Analysis/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 9LO2 The Goals of Financial AnalysisInvestors are also interested in identifying companies with problems as early as possible.No one wants to stay on a sinking ship any longer than necessary. Analysts hope they canidentify firms with problems before other investors so they can sell their shares before theprice drops.Identify Company StrengthsAnother equally important purpose of financial analysis is to identify company strengths sothose strengths can be enhanced and used to their greatest potential. For example, in theearly 1970s, falling inventory turnover ratios and return on equity ratios told JCPenney thatit was not able to compete successfully with high volume discount stores; however, it wasable to sell good quality clothing. This discovery led to a major refocusing of the firm thatinvolved discontinuing its automotive, appliance, and furniture departments and up-scalingits clothing lines. Because of these changes, it succeeded where many of its competitorsfailed.
M02 MCNA8932 01 SE C02.indd Page 2-12 25/10/13 7:43 PM f-w-155Financial Statement and Ratio Analysis/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 9LO2 The Goals of Financial AnalysisSTOPReady to doLO2topic homework 1?MyFinanceLab
M02 MCNA8932 01 SE C02.indd Page 2-13 25/10/13 7:43 PM f-w-155Financial Statement and Ratio AnalysisLO3/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 9LO3 Financial Statement AnalysisFinancial Statement AnalysisIn this section, we introduce and briefly discuss a number of the more common financialratios. This is not an exhaustive list by any standard. There are many ratios that can be used.In fact, it is common for analysts to create specialized ratios to look at a factor peculiar to afirm or industry. For example, revenues and costs per kilometre flown are often computedfor airlines.The formulas presented here for each ratio may differ from those reported elsewhere. Aneffort has been made within this section to locate the most common definition for eachformula, but for some there is simply no consensus among reporting agencies. This meansthat, when you compare ratios computed by different sources, you must be sure they are allcomputed in the same way.Cross-Sectional AnalysisMost financial ratios mean little when viewed in isolation. For example, an inventory turnover ratio tells us how many times per year the company’s inventory is sold (we discuss thisratio later in the chapter). A value of 20 is not interesting until we learn that other firms inthe industry have an inventory turnover ratio of 3. Similarly, gross profit margins, liquidityratios, and activity ratios all vary substantially depending on the industry. Clearly, a grocerystore will turn over its inventory more frequently than an auto dealer will.
M02 MCNA8932 01 SE C02.indd Page 2-14 25/10/13 7:43 PM f-w-155Financial Statement and Ratio Analysis/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 9LO3 Financial Statement AnalysisCross-sectional analysis is the comparison of one firm to other similar firms. A cross-sectionof an industry is used as a comparison for the firm’s numbers. There are a variety of sourcesof cross-sectional information. Value Line, Risk Management Association, and Mergent allpublish industry average ratio statistics. One way to identify a firm’s industry is by itsStandard Industrial Classification (SIC) code. SIC codes are four-digit codes given to firmsby the government for statistical reporting purposes.Many firms do not have any clear industry to use for comparison, such as conglomeratesthat do business in dozens of different industries. There are no good guidelines for pickingcomparison numbers for these types of firms. In other cases, the firm under study so dominates the industry that the industry ratios are simply mirroring that firm. Consider GeneralMotors (GM). With so few firms in the auto manufacturing business, what happens to GMhappens to the industry.One solution to the problem of finding good comparison numbers is to create your own listof competitors. Compare the firm under analysis to the averages found from this list. Often,this approach yields far superior comparison numbers than can be found in the publishedreference materials.
M02 MCNA8932 01 SE C02.indd Page 2-15 25/10/13 7:43 PM f-w-155Financial Statement and Ratio AnalysisLO3 Financial Statement Analysis/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 93.1 The RatiosTime-Series AnalysisAnother equally important method of financial analysis is time-series analysis, whichinvolves comparing the firm’s current performance to prior periods. This method allowsthe analyst to identify trends, changes over time that are more or less consistent in onedirection. Unless the firm has undergone some type of major restructuring, prior periodnumbers are a near perfect comparison against today’s figures.Both cross-sectional and time-series analyses are important. For this reason, analystsshould use both.3.1 The RatiosThe ratios are presented in groups to facilitate understanding. We have grouped the ratiosinto five categories: Profitability ratiosLiquidity ratiosActivity ratiosFinancing ratiosMarket ratiosDifferent firms put different levels of emphasis on the categories. For example, servicefirms are very concerned with how rapidly they collect on accounts receivable, but suchfirms are not overly concerned with inventory usage, since inventory is usually a minor
M02 MCNA8932 01 SE C02.indd Page 2-16 25/10/13 7:43 PM f-w-155Financial Statement and Ratio AnalysisLO3 Financial Statement Analysis/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 93.2 Profitability Ratioscost factor. Manufacturing firms, however, must pay close attention to their inventory,whereas collections are often not a problem.As you review this section, pay attention to what the ratio is intended to measure andwhether it is generally better if the ratio is higher or lower. Also note the unit of measureand what change might improve the ratio.3.2 Profitability RatiosWe begin our discussion of ratio analysis with the profitability ratios, since they are ultimately the most important. If a firm is generating acceptable profits, analysts tend to bemore forgiving of deviations in other ratios. For example, low inventory turnover may bedue to high prices. If this is a corporate strategy that produces high profits, investors areunlikely to complain. Conversely, if the profits are not there, low inventory turnover is viewedas a serious shortcoming.Profitability ratios measure how effectively the firm uses its resources to generate income.The first three of the ratios reported here are probably the best known and most widelyused of all financial ratios. Investors are happier the greater the profitability ratios grow.
M02 MCNA8932 01 SE C02.indd Page 2-17 25/10/13 7:43 PM f-w-155Financial Statement and Ratio Analysis/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 9LO3 Financial Statement Analysis3.2 Profitability RatiosTable 2.4 Profitability RatiosRatio NameEquationNumber EquationExampleReturn onEquity (ROE)Eq. 2.1Net income after taxCommon shareholders equityROE 1.2 0.1091 11Return onAssets (ROA)Eq. 2.2Net income after taxTotal assetsROA 1.2 0.02 50Gross ProfitMarginEq. 2.3Gross profitSales - Cost of goods sold SalesSalesGross profit margin OperatingEq. 2.4Profit MarginOperating profitsSalesNet ProfitMarginNet income after taxSalesEq. 2.5 9 0.3 30Operating profit margin 4 0.13 30Net profit margin 1.2 0.04 30
M02 MCNA8932 01 SE C02.indd Page 2-18 25/10/13 7:43 PM f-w-155Financial Statement and Ratio Analysis/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 9LO3 Financial Statement Analysis3.2 Profitability RatiosTaken together, these profitability ratios give the analyst insight into the performance of thefirm. For example, if the return on equity is not acceptable, you can review the various profitmargin accounts to determine whether the problem lies with cost of goods sold, operatingexpenses, or financing cost.It’s Time to Do a Self-Test1. You have reviewed the ratios for Bongo Corp. and find the ROE is lower than the industry.After further investigation, you determine that net profit margin is low despite normal grossand operating profit margins. What else might you look at to confirm the source of BongoCorp.’s problem? Answer2. Practise computing the Return on Equity.Answer3. Practise computing the Return on Assets.Answer4. Practise computing the Gross Profit Margin.Answer5. Practise computing the Operating Profit Margin.6. Practise computing the Net Profit Margin.AnswerAnswer
M02 MCNA8932 01 SE C02.indd Page 2-19 25/10/13 7:43 PM f-w-155Financial Statement and Ratio Analysis/204/PHC00100/9780132758932 MCNALLY/MCNALLY CORPORATE FINANCE ONLINE CFO01C SE 9LO3 Financial Statement Analysis3.3 Liquidity Ratios3.3 Liquidity RatiosA liquid firm is a firm that can meet its various short-term debt and credit obligations.Those who extend credit to a firm are particularly concerned with the firm’s liquidity. It isnot unusual for a firm to show a profit on its income statement but still not have sufficientcash to pay creditors—that is, the firm has an unhealthy liquidity ratio. The followingliquidity ratios point out problems of this nature.Table 2.5 Liquidity oEquationExampleEq. 2.6Current assetsCurrent liabilitiesCurrent ratio Eq. 2.7Current assets - InventoryCurrent liabilitiesQuick ratio 23.5 1.42 16.5 23.5 - 7.5 16.5 0.97There is a great deal of disagreement among analysts as to how liquid a firm should be. It isnot necessarily bad for a firm to have low current and quick ratios if the firm is able to meetits obligations. Consider which firm you would rather own, one that could make 100 ofsales with only 5 of inventory or one that could make that same 100 of sales but requiresonly 1 of inventory.
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Three fi nancial statements are critical to fi nancial statement analysis: the balance sheet, the income statement, and the statement of cash fl ows. We provide a brief overview of each statement and describe what information it contains. 1.1 The Balance Sheet The balance sheet provides the details of the accounting identity.
Part One: Heir of Ash Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Chapter 18 Chapter 19 Chapter 20 Chapter 21 Chapter 22 Chapter 23 Chapter 24 Chapter 25 Chapter 26 Chapter 27 Chapter 28 Chapter 29 Chapter 30 .
TO KILL A MOCKINGBIRD. Contents Dedication Epigraph Part One Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Part Two Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Chapter 18. Chapter 19 Chapter 20 Chapter 21 Chapter 22 Chapter 23 Chapter 24 Chapter 25 Chapter 26
DEDICATION PART ONE Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 PART TWO Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Chapter 18 Chapter 19 Chapter 20 Chapter 21 Chapter 22 Chapter 23 .
About the husband’s secret. Dedication Epigraph Pandora Monday Chapter One Chapter Two Chapter Three Chapter Four Chapter Five Tuesday Chapter Six Chapter Seven. Chapter Eight Chapter Nine Chapter Ten Chapter Eleven Chapter Twelve Chapter Thirteen Chapter Fourteen Chapter Fifteen Chapter Sixteen Chapter Seventeen Chapter Eighteen
18.4 35 18.5 35 I Solutions to Applying the Concepts Questions II Answers to End-of-chapter Conceptual Questions Chapter 1 37 Chapter 2 38 Chapter 3 39 Chapter 4 40 Chapter 5 43 Chapter 6 45 Chapter 7 46 Chapter 8 47 Chapter 9 50 Chapter 10 52 Chapter 11 55 Chapter 12 56 Chapter 13 57 Chapter 14 61 Chapter 15 62 Chapter 16 63 Chapter 17 65 .
HUNTER. Special thanks to Kate Cary. Contents Cover Title Page Prologue Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Chapter
Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Chapter 18 Chapter 19 Chapter 20 . Within was a room as familiar to her as her home back in Oparium. A large desk was situated i
A financial statement that has been audited and represents all components of a financial statement including balance sheet, cash flow statement, and income statement. An unaudited financial statement for which the financial data has been assembl
