Financial accounting 9th jamie pratt chapter 05

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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 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: 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, 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 Asset Turnover Ratios (cont’d) Fixed Assets = Sales Turnover Average Fixed Assets This ratio measures the speed with which fixed assets are used up Asset Turnover Ratios (cont’d) Inventory Turnover = Cost of Goods Sold Average Inventory This ratio measures the speed with which inventories move through operations Asset Turnover Ratios (cont’d) Total Asset Turnover = Sales Average Total Assets This 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 Other Ratios (cont’d) Earnings = Net Income 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) Price/Earnings = Market Price per Share Ratio Earnings per Share This ratio is used by many analysts to assess the investment potential of common stocks Other Ratios (cont’d) Dividend Yield = Dividends per Share Ratio Market Price per Share This ratio indicates to cash return on the shareholders’ investment Other Ratios (cont’d) Stock = Market Price1 - Market Price0 + Dividends Price Market Price0 Return This ratio measures the pretax performance of an investment in a share of common stock Predict Future Earnings and Cash Flow • 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 • 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 Determinants of Value Creation: Analyzing Return on Equity *Appendix 5A To create shareholder value, ROE must exceed cost of equity 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 *Appendix 5A - Cash Flow Analysis • 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) *Appendix 5A - Projecting Future Financial Statements  Financial analysis includes attempting to project future financial statements To 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 Copyright Copyright © 2014 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 .. .Chapter 5: Using Financial Statement Information Control and Prediction  Financial accounting numbers are useful in two fundamental ways:... 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... Elements of Financial Statement Analysis  Five Issues: Assessing the business environment Reading and studying the financial statements and footnotes Assessing earnings quality Analyzing the financial
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