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Financial Statement Analysis

This lesson deals with the analysis of financial statements by investors, creditors and other interested parties. Management is always one of those interested parties, because how others perceive the company will effect their business and stock price.

The financial ratios described in this lesson are used on a daily basis by thousands of investors. There's really nothing difficult about them, and all the information you need is required disclosure in the financial statements prepared under GAAP.

After you learn this material you should be able to analyze the financial statements of any company, including all publicly traded companies. Many students use this information to help understand and analyze their company retirement plans. Even if you're not an investor today, chances are that someday you will be. If you already have a portfolio or retirement plan, this information will be extremely valuable to you.

Investing in the Stock Market and Evaluating Management

When investors purchase stock in a company they are investing in future earnings. You can't invest in past income, because it is past. That's like betting on yesterday's horse race or ball game. So all investing is actually a bet on the future prospects of a business.

The PE ratio (Price/Earnings) is a direct reflection of looking to the future. Essentially the PE ratio is a measure of how confident investors are about the future prospects of a business. The higher the PE ratio, the more confident investors are. But only to a certain extent.

Each unit of PE basically represents one year of earnings, paid forward, in advance to purchase one share of stock. So a PE of 5 means investors are willing to pay forward an amount equal to 5 years of earnings to buy a share of that company's stock. A PE of 10 represents buying forward 10 years of earnings. It's common to see PE ratios that range 12-20 years.

The PE ratio is so important that it's listed every day in the Wall Street Journal for every stock they list. So what has that got to do with evaluating management?

There are a number of ratios that can be used to evaluate a company's management. And when investors look at those ratios they decide how good a job management is doing. If the ratios go up, investors are willing to pay more for the stock, resulting in a higher PE ratio. If ratios go down the opposite happens.

Since a PE of 10 represents 10 years forward earnings, you have to feel like management is going to do a good job over the next 10 years to recoup your investment.

How to Analyze a Financial Statement

There are a couple of steps, and a caution to observe, when you analyze financial statements. And after you've done an analysis you still have to interpret the meaning of your analysis, and the significance of your analysis. First, the caution...

Several ratios use an average. When an average is used it is a simple average. In all these ratios you will take the balance in an account at the start and end of year, add them together and divide by 2. That's a simple average. For instance, the Receivable Turnover Rate is:

    Net Sales    
Average Accounts Receivable

Average accounts receivable is:

AR start of year balance + AR end of year balance
2

Some people calculate these using the end of year balance, rather than an average. The textbook shows one possible set of formulae. If you search the Internet you will find many other formulae that can be used to evaluate financial information.

Steps to Financial Statement Analysis

All financial ratios and measures use information from the balance sheet and/or income statement. Many of the use either an average, discussed above, or a significant subtotal, such as current assets, quick assets or current liabilities. You should be able to identify and calculate these amounts before beginning.

Current Assets

Current assets are those that will be available to conduct business and pay bills in the near future, within the coming year. Long term assets are those that will benefit the company beyond the current year. In a classified balance sheet, the current assets will be subtotaled already.

Current assets consist of:

  • Cash
  • Accounts Receivable
  • Notes Receivable
  • Short Term Investments
  • Inventory
  • Prepaid Expenses

Quick Assets are used to calculate the Quick Ratio. Cash, Accounts and Notes Receivable, and Short Term Investments are quick assets.

Current Liabilities

Current liabilities are those that will come due within the next year. They are matched to current assets, because the money generated from current assets will pay the current liabilities.

Current liabilities consist of:

  • Current portion of Notes Payable
  • Accounts Payable
  • Accrued Expenses Payable (taxes, interest, payroll)
  • Unearned Revenue

In order to calculate ratios you should be able to identify the current and quick assets, and current liabilities in any balance sheet.

Measures of Liquidity

Liquidity refers to how quickly a company can turn its assets into cash, and its ability to pay it's current debts on time. Highly liquid assets can be turned into cash very quickly. Some of these are called cash equivalents, because they are very liquid. For instance, a US Treasury bill or note can be converted into cash immediately at almost any bank, so it is considered equivalent to cash.

Other assets can be turned into cash, but more slowly. The company expects to collect its accounts and notes receivable, but that may take 30-60 days, or longer. Inventory takes even longer to turn into money. It could take six months or more to convert inventory into cash, depending on the type of merchandise. Automobiles and jewelry sell slower than eggs and milk.

Inventory Turnover Rate

Turnover refers to how often a sales or collection cycle happens in a given year. Let's think about grocery store inventory for a minute. Milk spoils quickly and a grocery store will only stock enough milk to meet its demand for a short period of time, perhaps one week. If they store sells its entire stock of milk each week, we would say that their milk inventory turns over 52 times each year. The number of days sales in inventory for milk would be 7. Let's recap:

Milk inventory:
Turnover = 52 times
Days in Inventory = 7 days

A company may analyze a single product, like milk, because they have detailed inventory records. The information contained in financial statements relates to the entire inventory. So you, and other investors, can only draw some large, general inferences. However, a few rules of thumb hold true:

  • A higher turnover rate is better
  • Fewer days in inventory is better

These would indicate better inventory management.

Financial statements don't tell the whole story. A high turnover rate is a good thing, but empty shelves can mean lost sales, and that's a bad thing. Good inventory management means stocking an adequate supply of merchandise to meet demand, but not too much excess.

Inventory is an asset with it's own problems. It must be stored and protected until it is sold. It must often be paid for before it is sold. It can be damaged, stolen or become spoiled or obsolete. These are all risks associated with inventory and the cost of these losses have to be made up from revenues.

Ratios tell part of a story, but not the whole story. How can you answer some of these questions? You would probably have to visit the store on a regular basis, and observe how they handle inventory, note the condition of merchandise, how well the shelves are stocked and tended, and check the dumpsters to see how much spoiled or damaged goods are being thrown away each week.

Accounts Receivable Turnover Rate

AR turnover is similar to inventory turnover. It is the other end of the sales cycle - the collections side. The AR turnover tells us how good a job management is doing collecting accounts receivable. If the company has a 30 day payment policy, their AR turnover rate should be about 12 (once a month), and their number of days in AR should be around 30.

If the turnover rate is too low (days in AR too high), the company is having problems enforcing its credit policies. This is the credit manager's responsibility. The company needs to review its credit policy and start enforcing it. They might also have too many old, uncollectible accounts receivable that need to be turned over to a collection agency.

EBIT means Earnings Before Interest and Taxes. It is also referred to as Operating Income, and is used in these ratios:

  • Interest coverage ratio,
  • Operating expense ratio, and
  • Return on assets

Stock Pricing and P/E Ratio

Stock price is a difficult thing to predict. Many subtle factors can effect a stock's price, but they all have one thing in common. They all have to do with the future. A stock investment give the stockholder rights to future earnings, not past earnings. As a matter of fact, the entire financial market is about the future.

The P/E ratio is integral to stock pricing. It's so important to investors that the Wall Street Journal publishes the P/E ratio for every stock, on a daily basis. If you check the Journal, the P/E ratio is right next to the stock price.

The P/E ratio is also called the Price-Earnings ratio. It is the market price divided by the most current earnings per share (EPS). A P/E ratio from 12 to 20 is about average. What are we really saying here? If the P/E is 12, that means the investor is willing to pay 12 times the current DPS to buy one share of stock. That's the same as paying forward for 12 years of future earnings, just to get on the ride.

An Example of Financial Statement Analysis

Let's say a company has 10,000,000 shares of stock outstanding, and a P/E ratio of 15. If EPS is $2.00 then the price of the stock is $2.00 x 15 = $30.00 per share. To make it easier, let's also assume that the company expects to have the same earnings in the coming year.

Assume the company loses a lawsuit and must pay $1,000,000 in damages. What effect will this have on stock price? There are a couple of ways to calculate this. Previous earnings must have been $20,000,000 (10,000,000 shares x $2.00 EPS).

We can recalculate current earnings as follows:

Expected earnings
$20,000,000 
Less: loss from lawsuit
( $1,000,000)
Revised earnings
$19,000,000 

The revised EPS is $19,000,000 / 10,000,000 shares = $1.90.

The revised stock price is $1.90 x 15 = $28.50 per share.

What happened to EPS?

The lawsuit had the following impact on earnings per share:

Lawsuit $1,000,000 / 10,000,000 shares = $0.10 per share.

Original EPS
 $2.00
Less: loss from lawsuit
($0.10)
Revised EPS
 $1.90

Here's another way we can use the PE ratio to calculate the effect of the lawsuit on stock price:

Effect of lawsuit on EPS = $0.10 x 15 P/E = $1.50 per share

Original stock price per share
 $30.00
Less: effect of lawsuit on stock price
($1.50)
Revised stock price per share
$28.50

If you look over the calculations above, you will see there are several ways to arrive at the solution. They all reflect the relationships between a company's earnings, the number of shares outstanding, and investors' perception of the company's future earnings potential (P/E ratio).

If investors think the company's earning potential is improving they are willing to pay more for the stock, which is reflected in a higher P/E ratio. The opposite is also true. If they think the company's earnings are impaired the P/E ratio will go down. That is a much more complex discussion that we have time for here, but investors look at a large variety of things to determine P/E ratio - strength of the market for the company's product, the quality of the company's management, likelihood of continued business success, etc.

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