Income Statement. Balance Sheet. Table 14.2 Consolidated Balance Sheet. CHAPTER 14 Financial Statement Analysis

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1 CHAPTER 14 Financial Statement Analysis 14.1 THE MAJOR FINANCIAL STATEMENTS Income Statement Table 14.1 Consolidated Statement of Income Four broad classes: Cost of goods sold General and administrative expenses Interest expense Taxes on earnings Common Sizing Balance Sheet Table 14.2 Consolidated Balance Sheet Assets Current Long-term Liability and stockholders equity Common Sizing

2 Statement of Cash Flows Table 14.3 Consolidated Statement of Cash Flows Recognizes only transactions in which cash changes hands Accounting Versus Economic Earnings 14.2 ACCOUNTING VERSUS ECONOMIC EARNINGS Accounting earnings Affected by several conventions regarding the valuation of assets Economic earnings Earnings above or below a trend line Past Versus Future ROE 14.3 PROFITABILITY MEASURES Data from recent past may provide information regarding future performance Analysts should always keep an eye on the future Expectations of future dividends and earnings determine intrinsic value of stock

3 Financial Leverage and ROE The relationship among ROE, ROA, and leverage: 14.4 RATIO ANALYSIS ROE (1 Tax rate) ROA ( ROA Interest rate) Debt = + Equity Ratio Analysis Decomposition of ROE Purpose of Ratio Analysis Uses Trend analysis Comparative analysis Combination Use by External Analysts Important information for investment community Important for credit markets Net Profit ROE = Pretax Profit x Pretax Profit EBIT x EBIT x x Assets Assets Equity (1) x (2) x (3) x (4) x (5) Tax Burden x Interest Burden x Margin x Turnover x Leverage Type of Financial Ratios Profitability Ratios Profitability Ratios Turnover or Asset Utilization Ratios Liquidity Ratios Leverage Ratios Market Price Ratios Net Profit Margin % Net Income Operating Return on Assets % Earnings Before Int. & Taxes Total Assets

4 Profitability Ratios (cont.) Return on Equity % Net Income Common Equity Operating Margin After Depreciation % Operating Profit Activity or Management Efficiency Ratios Inventory Turnover or Cost of Goods Sold Inventory Total Asset Turnover Total Assets Activity or Management Efficiency Ratios (cont.) Average Collection Period Accounts Receivable Per Day Days to Sell Inventory Inventory Per Day Liquidity Ratios Current Ratio Current Assets Current Liabilities Quick Ratio Current Assets - Inventory Current Liabilities Leverage Ratios Leverage Ratios (cont.) Times Interest Earned Earnings Before Int. & Taxes Interest Expense Fixed Charge Coverage Ratios Lease Payments Principal Repayments Preferred Dividends Debt to Assets % Long Term Debt Assets Debt to Equity % Long Term Debt Shareholders Equity

5 Market Price Ratios Figure 14.1 DuPont Decomposition for Hewlett-Packard Price to Earnings Market Price of Stock Earnings Market-to to-book-value Market Price of Stock Book Value Per Share Economic Value Added 14.5 ECONOMIC VALUE ADDED Approach to compare accounting profitability with the cost of capital Definition ROA-K K (Capital Invested in the firm) K = opportunity cost for capital Ties accounting to return by investors Table Economic Value Added, AN ILLUSTRATION OF FINANCIAL STATEMENT ANALYSIS

6 Table Key Financial Ratios of Growth Industries Inc. Table Growth Industries Statement of Cash Flows Comparability Problems 14.7 COMPARABILITY PROBLEMS Inventory valuation LIFO and FIFO Depreciation Inflation and interest expense Quality of Earnings: Areas of Accounting Choices Allowance for bad debts Non-recurring items Earnings smoothing Stock options Revenue recognition Off-balance sheet assets and liabilities International Accounting Conventions Reserving practices Depreciation Intangibles

7 Figure 14.2 Adjusted Versus Reported Price-Earnings Ratios 14.8 VALUE INVESTING: THE GRAHAM TECHNIQUE Benjamin Graham Graham believed careful analysis of a firm s s financial statements could turn up bargain stocks He developed many different rules for determining the most important financial ratios

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