Financial accounting in an economic context 8e chapter 05

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1 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 Book Value vs True Value    Financial statements 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 BookValue Value Add Addadjustments adjustments for: for: (1) (1)business business environment environment (2) (2)unrecorded unrecorded events events (3) (3)management managementbias bias == True True Value Value Five Steps of Financial Statement Analysis Assessing the business environment  Reading and studying the financial statements and footnotes  Assessing earnings quality  Analyzing the financial statements  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, etc  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 are discussed: – 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  Overstating operating performance through the allocation and estimation of expenses - shift the recognition of expenses through the use of “taking a bath” and “creating hidden reserves.”  10 Solvency Ratios Accounts Payable Turnover Cost of Goods Sold Average Accounts Payable This ratio measures the extent to which accounts payable is used as a form of financing 33 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  34 Asset Turnover Ratios Receivables Turnover Net Credit Sales Average Accounts Receivable This ratio reflects the number of times the trade receivables were recorded, collected, and recorded again during the period 35 Asset Turnover Ratios Inventory Turnover Cost of Goods Sold Average Inventory This ratio measures the speed with which inventories move through operations 36 Asset Turnover Ratios Fixed Assets Turnover Sales Average Fixed Assets This ratio measures the speed with which fixed assets are used up 37 Asset Turnover Ratios Total Asset Turnover Sales Average Total Assets This ratio measures the speed with which all assets are used up in operations 38 Market Ratios  These additional ratios are used by the financial community to assess company performance 39 Market Ratios Earnings per Share Net Income 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 40 Market Ratios Price/Earnings Ratio Market Price per Share Earnings per Share This ratio is used by many analysts to assess the investment potential of common stocks 41 Market Ratios Dividend Yield Ratio Dividends per Share Market Price per Share This ratio indicates to cash return on the shareholders’ investment 42 Market Ratios Stock Price Return Market Price1 - Market Price0 + Dividends Market Price0 This ratio measures the pretax performance of an investment in a share of common stock 43 Comparisons Across Different Countries  Investors interested in comparing the financial performance and condition of companies from different countries often must contend with two difficult issues: – If the companies use different accounting standards (e.g., U.S GAAP vs IFRS), the reported values must be adjusted to a common basis so that reasonable comparisons can be made – Adjusting financial statements to a common basis by itself 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 44 Appendix 5A 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 45 Solvency Assessment (Figure 5A-6) 46 Copyright Copyright © 2011 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein 47 [...]... 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  15 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... 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... with industry averages is also helpful Sources of industry information include: – Dun & Bradstreet – Robert Morris Associates – Moody – Standard & Poor 16 Common-Size Financial Statements 17 Comparisons Within the Financial Statements Common-size financial statements  Ratio analysis  – Profitability ratios – Leverage ratios – Solvency ratios – Asset turnover ratios – Market ratios 18 Common-Size Income...Assessing Earnings Quality   Taking a bath (also called “big 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... as operating leases (Radio Shack) – unconsolidated investments (Enron’s “partnerships”) which do not separate assets from liabilities 13 Analyzing the Financial Statements     Comparisons across time Comparisons within the industry Comparisons across different countries Comparisons within the financial statements: common-size statements and ratio analysis – – – – – Profitability ratios Leverage ratios... Return on Assets Net Income + Interest Expense (1-tax rate) Average Total Assets This ratio measures the effectiveness at managing capital provided by all investors (stockholders and creditors) 22 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;... Statement for La-Z-Boy, Inc (Figure 5-2) Income Statement (in millions) Net sales 2008 % $1,227 100 Cost of sales (888) 72 Expenses and charges (460) 37 $ (121) (9) Net income 2007 % $1,451 100 (1 ,057 ) 73 (408) 28 $ (14) (1) 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... stringent test of a company’s solvency 31 Solvency Ratios Interest Coverage Net Income + Tax Expense + Interest Expense Interest Expense This ratio compares the annual funds available to meet interest to the annual interest expense 32 Solvency Ratios Accounts Payable Turnover Cost of Goods Sold Average Accounts Payable This ratio measures the extent to which accounts payable is used as a form of financing... 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  20 Profitability Ratios Return on Equity Net Income Average Shareholders’ Equity This ratio measures the effectiveness at managing capital provided by the... also called the Profit Margin 23 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  24 Leverage Ratios Common Equity Leverage Net Income Net Income + Interest Expense (1-tax rate)
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