Financial accounting 9th jamie pratt chapter 05

Financial Accounting Numbers as Prediction Aids Financial statements do not reflect the company’s prospects within its business environment  Statements are backward looking, not focusi

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Chapter 5:

Using Financial Statement

Information

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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.

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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.

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Framework for Financial Statement Analysis

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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.

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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?

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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

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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

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Assessing Earnings Quality

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.

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Assessing Earnings Quality

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

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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

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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.

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Analyzing the Financial Statements

 Comparisons within the financial statements:

common-size statements and ratio analysis

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

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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

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Comparisons Within the Financial Statements

 Common-size financial statements

Common-Size Income Statement for La-Z-Boy, Inc

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 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.

Figure 5-2

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Profitability Ratios

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Return on = Net Income + Interest Expense (1-tax rate)

Sales 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 (cont’d)

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Equity = Net Income + Interest Expense (1-tax rate)

Leverage

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

Leverage Ratios (cont’d)

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Capital Average Total AssetsStructure = Average Stockholders’ EquityLeverage

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

Leverage Ratios (cont’d)

Leverage Ratios (cont’d)

Solvency Ratios (cont’d)

Solvency Ratios (cont’d)

Solvency Ratios (cont’d)

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Interest = Net Income + Tax Expense + Interest Expense

This ratio compares the annual funds available to meet interest to the annual interest expense

Solvency Ratios (cont’d)

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Accounts = Cost of Goods SoldPayable Average Accounts PayableTurnover

This ratio measures the extent to which accounts payable is used as a form of financing

Asset Turnover Ratios

 Asset turnover ratios are typically computed for total assets, accounts receivable, inventory, and fixed assets

 These ratios measure the speed with which assets move through operations or reflect the number of times during a given period that

these specific assets are acquired, used, and replaced

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Asset Turnover Ratios (cont’d)

Asset Turnover Ratios (cont’d)

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Fixed Assets = Sales Turnover Average Fixed AssetsThis ratio measures the speed with which fixed assets are used up

Asset Turnover Ratios (cont’d)

Asset Turnover Ratios (cont’d)

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Total Asset = Sales Turnover Average Total AssetsThis ratio measures the speed with which all assets are used up in operations

Other Ratios

 These additional ratios are used by the financial community to assess company performance

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Other Ratios (cont’d)

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per Share Average Number of Common Shares

Outstanding

This ratio, according to the financial press, is the primary measure of a company’s performance It calculates the amount of income that is earned for each shareholder

Other Ratios (cont’d)

Other Ratios (cont’d)

Other Ratios (cont’d)

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Stock = Market Price1 - Market Price0 + DividendsPrice Market Price0

ReturnThis ratio measures the pretax performance of an investment in a share of common stock

Predict Future Earnings and Cash Flow

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• After previous analysis mathematical models

can be used to predict future earnings and future earnings This is used to:

• Predict stock price

• Determine credit worthiness

Comparisons Across Different Countries

and condition of companies from different countries often must contend with two difficult issues:

U.S GAAP vs IFRS), the reported values must be adjusted

to a common basis so that reasonable comparisons can be made.

may not be sufficient to achieve meaningful comparisons In other words, not only must the financial statements of a

foreign-based company be adjusted, but the resulting numbers can only be interpreted through an understanding

of the foreign environment.

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Determinants of Value Creation: Analyzing Return on Equity *Appendix 5A

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DuPont (ROE) Model:

Return On Equity = Return on Assets X Capital Structure Leverage X Common Equity Leverage

Return on Assets = Profit margin X Asset Turnover

To create shareholder value, ROE must exceed cost of equity

*Appendix 5A - Cash Flow Analysis

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• Analyzing a company’s cash flow tells

us a great deal about company performance and financial position.

• Operating performance

• Financial flexibility

• Liquidity

• The statement of cash flows can be

used to develop a cash flow profile

* Appendix 5A Solvency Assessment (Figure 5A-6)

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*Appendix 5A - Projecting Future Financial Statements

 Financial analysis includes attempting to project future financial statements To do so:

 Predict future sales

 Predict future profit margins

 Based on sales predictions, estimate the level of assets necessary to support that level of sales

 Choose a target financing mix

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