Financial accounting 9th jamie pratt chapter 05

Chapter 5:
Using Financial Statement
Information


Control and Prediction
 Financial accounting numbers are useful

in two fundamental ways:

 They help investors and creditors

influence and monitor the business
decisions of a company’s managers.

 They help to predict a company’s

future earnings and cash flows.


Financial Accounting Numbers as Prediction Aids
 Financial statements do not reflect the company’s

prospects within its business environment

 Statements are backward looking, not focusing on the future

prospects.

 Financial statements are inherently limited

 Statements leave out some current and historical information

such as human resources and the effects of inflation.

 Management prepares the financial statements in a

biased manner

 Managers often choose accounting methods and estimates

that make them look good.


Framework for Financial Statement
Analysis
Book Value

Add adjustments for:
(1) business environment
(2) unrecorded events
(3) management bias

= True Value


Elements of Financial Statement Analysis

 Five Issues:

1. Assessing the business environment.

2. Reading and studying the financial

statements and footnotes.

3. Assessing earnings quality.
4. Analyzing the financial statements.
5. Predicting future earnings and/or cash

flow.


Assessing the Business Environment
 What is the nature of the company’s operations?
 What strategy is being employed to generate

profits?

 What is the company’s industry?
 Who are the major players? Competition?
 What are the relationships between the company

and its customers and suppliers?

 How are the company’s sales and profits affected

by changes in the economy?


Reading and Studying the Financial
Statements and Notes

 Read the audit report.
 Identify significant transactions.
 major acquisitions, discontinuance or

disposal of a business segment, unresolved
litigation, major write-downs of receivables or
inventories, tender offers, extraordinary gains
and losses, or changes in accounting
principles

 Identify and analyze important segments.
 Read the financial statements and footnotes.


Assessing Earnings Quality
 Earnings quality may be affected by a

number of strategies managers use to
influence accounting numbers. Four major
strategies:





Overstating operating performance
Taking a bath
Creating hidden reserves
Employing off-balance-sheet financing

Assessing Earnings Quality
 Overstating operating performance

through the acceleration of recognition of
revenue - shift the timing of revenue from a
future period to the current period, through
legitimate or questionable activities.


Assessing Earnings Quality
 Taking a bath - large losses and expenses

this year may increase income in future years.

 Rationale: if the current year is going to be

disappointing to investors anyway, increase
the loss to make next year look better. For
example:
 Excessive write-downs of equipment will lead to

lower depreciation expense in future years.
 Excessive write-downs of inventory will lead to
lower cost of goods sold next year.


Assessing Earnings Quality
 Creating hidden reserves - expenses may be

shifted from one year to another year by
overestimating expense accrual.

 Excessive bad debt expense or warranty expense

in the current year will lead to reduced estimates in
future years, as the “reserve” is used up.

 Note that these “reserves” have nothing to do with

cash reserves; they simply reserve some of the
“income” to future periods.


Assessing Earnings Quality
•

Employing off-balance-sheet financing - this relates to certain
economic transactions that are not reflected in the balance sheet.
• Managers prefer to keep certain liabilities off the balance sheet when
GAAP permits it, primarily because of potential debt covenant violations,
and because of the effect on certain ratios.
• Examples include:
• Treatment of leases as operating leases (Radio Shack)
• Unconsolidated investments (Enron’s “partnerships”) which do not
separate assets from liabilities.


Analyzing the Financial Statements
 Comparisons across time

 Comparisons within the industry
 Comparisons within the financial statements:

common-size statements and ratio analysis






Profitability ratios
Leverage ratios
Solvency ratios
Asset turnover ratios
Other ratios


Comparisons Across Time
 Financial accounting numbers can be made

more meaningful if they are compared across
time.

 GAAP require side-by-side comparison of the

current and the preceding years in published
financial reports.


Comparisons Within the Industry

 Financial accounting numbers can also be made

more meaningful if they are compared to those of
similar companies.

 Comparison of financial accounting numbers with

industry averages is also helpful.

 Sources of industry information include:





Dun & Bradstreet
Robert Morris Associates
Moody
Standard & Poor


Comparisons Within the Financial
Statements
 Common-size financial statements
 Ratio analysis






Profitability ratios
Leverage ratios
Solvency ratios
Asset turnover ratios
Other ratios


Common-Size Income Statement for La-Z-Boy, Inc.
Figure 5-2



On the income statement, cost of goods sold, expenses, and
net income are often expressed as percentages of net sales.



On the balance sheet, assets and liabilities can be expressed
as percentages of total assets.


Profitability Ratios
 These ratios are designed to measure a firm’s

earnings power.

 Net income, the primary measure of the overall

success of a company, is compared to other

measures of financial activity or condition to assess
performance as a percent of some level of activity or
investment.


Profitability Ratios
Return on
Equity

=

Net Income
Average Shareholders’ Equity

This ratio measures the effectiveness at
managing capital provided by the shareholders.


Profitability Ratios
Return on = Net Income + Interest Expense (1-tax rate)
Assets
Average Total Assets
This ratio measures the effectiveness at managing
capital provided by all investors (stockholders and
creditors).


Profitability Ratios
Return on =
Sales

Net Income + Interest Expense (1-tax rate)

Net Sales

This ratio provides an indication of a company’s ability
to generate and market profitable products and control
its costs; also called the Profit Margin.


Leverage Ratios
 Leverage refers to using borrowed funds to
generate returns for stockholders.
 Leverage is desirable because it creates returns
for shareholders without using any of their
money.
 Leverage increases risk by committing the
company to future cash obligations.


Leverage Ratios (cont’d)
Common
Equity
=
rate)
Leverage

Net Income
Net Income + Interest Expense (1-tax

This ratio compares the return available to the
shareholders to returns available to all capital providers.


Leverage Ratios (cont’d)
Capital
Structure
Leverage

Average Total Assets
= Average Stockholders’ Equity

This ratio measures the extent to which a company
relies on borrowings (liabilities).