Notes on Financial Statements and Analysis Techniques

Common Size Financial Statements: These facilitate the analysis and interpretation of financial data across different companies and over time for a single company.

Financial Statement Analysis Importance: Understanding how transactions are recorded and compiled into financial statements is crucial, especially as these statements are publicly available from companies that file with the SEC.

SEC Filings:

• 10-K: An annual filing that includes comprehensive details about a company's financial performance.
• 10-Q: A quarterly filing with less detailed information than a 10-K, required from companies with more than $10 million in assets.

Financial Analysis Techniques: Key techniques for analyzing financial statements include vertical and horizontal analyses, enabling comparisons and trends.

Vertical Analysis: Each account item is presented as a percentage of a base amount, e.g., total assets for a balance sheet, or sales for an income statement.

• Income Statement Example: If sales are $100, cost of goods sold (COGS) is 65%, gross margin is $35, which means 65% of revenue is consumed by COGS.

• Balance Sheet Example: Each line item shows the percentage of total assets, e.g., cash might represent 6% of total assets.

Horizontal Analysis: This shows trends over time by comparing financial statements across multiple periods, useful for spotting trends in revenues, expenses, and profits.

Auditing: Auditors typically review the balance sheet as it contains verifiable financial data about assets and liabilities versus the income statement, which involves estimates and expenses that change over time.

Financial Ratios:

• Return on Assets (ROA): Measures the efficiency of a company's use of its assets to generate earnings. ROA is calculated as net income divided by average total assets.
• Return on Equity (ROE): Measures profitability relative to shareholder equity, calculated as net income divided by average shareholders' equity.

Leverage Impact: A higher ROE than ROA indicates efficient use of debt in operations, where companies generate more profit compared to the cost of debt incurred.

Profitability Ratios: Examples include net profit margin (net income/sales), gross profit margin (sales-COGS/sales), and asset turnover ratios which indicate efficiency in generating sales relative to total assets.

Analysis Context: Metrics should be contextualized with industry standards and competitors’ performance to derive meaningful insights. For example comparing Nike and Adidas requires consideration of their market segments, sales strategies, and geographic considerations.

Debt Considerations: When analyzing companies with different debt levels, assess the balance between leveraging for growth and the risks of incurring debt based on interest obligations.

Revenue Trends: Review the changes over multiple periods for sales, operating profits, and trends such as operating expenses increases to derive conclusions on company performance and health.

Efficiency Analysis: Metrics like receivable turnover ratio and inventory turnover provide insights into operational effectiveness and cash flow management.

Market Competitiveness: Understanding gross profit margin and how cost structures compare between competitors can reveal pricing strategies, market position, and competitive advantages.