Financial Statement Analysis Flashcards

Introduction to Financial Statement Analysis

Financial statement analysis involves evaluating financial statements to extract critical insights about an organization's financial health, efficiency, and future prospects. It addresses key strategic and operational questions:

• Solvency and Creditor Risk: Can the firm meet its debt obligations and repay creditors on time?
• Trend Identification: What patterns exist within the firm's revenues, expenses, and profit margins over time?
• Competitive Benchmarking: How is the firm performing relative to its direct competitors and industry standards?
• Operational Efficiency: Which operational segments or business units are performing most efficiently, and which are lagging?

Cash Flow and Financial Statements

At its core, a commercial enterprise engages in two fundamental activities: generating cash and spending cash. The balance between these operations dictates the firm's cash position.

The Cash Flow Identity

Cash flows across a firm obey the fundamental accounting identity: $\text{Cash Flow from Assets} = \text{Cash Flow to Creditors} + \text{Cash Flow to Stockholders}$

Sources and Uses of Cash

Financial statements track the continuous movement of funds through source and use classifications:

• Sources of Cash: Activities that result in a net inflow of cash.
  • Asset Account Decreases: A net decrease in an asset account indicates that assets were sold or converted into cash.
  • Liability or Equity Account Increases: A net increase in a liability or equity account indicates that the firm raised cash by borrowing or issuing additional equity.
• Uses of Cash: Activities that result in a net outflow of cash.
  • Asset Account Increases: A net increase in an asset account indicates that the firm purchased or acquired new assets.
  • Liability or Equity Account Decreases: A net decrease in a liability or equity account indicates that the firm paid down principal debt or repurchased equity.

Financial Statements Case Study: Prufrock Corporation

Analyzing complete financial statements provides a detailed view of a firm's financial position, operating performance, and cash movements.

Balance Sheets

The balance sheet offers a point-in-time snapshot of assets, liabilities, and owners' equity.

Asset Structure (in $ millions)

• Current Assets:
  • Cash: $84\,\text{million}$ in 2020; $146\,\text{million}$ in 2021; Change: +$62\,\text{million}$
  • Accounts Receivable: $165\,\text{million}$ in 2020; $188\,\text{million}$ in 2021; Change: +$23\,\text{million}$
  • Inventory: $393\,\text{million}$ in 2020; $422\,\text{million}$ in 2021; Change: +$29\,\text{million}$
  • Total Current Assets: $642\,\text{million}$ in 2020; $756\,\text{million}$ in 2021; Change: +$114\,\text{million}$
• Fixed Assets:
  • Net Plant and Equipment: $2731\,\text{million}$ in 2020; $2880\,\text{million}$ in 2021; Change: +$149\,\text{million}$
• Total Assets: $3373\,\text{million}$ in 2020; $3636\,\text{million}$ in 2021; Change: +$263\,\text{million}$

Liabilities and Owners' Equity (in $ millions)

• Current Liabilities:
  • Accounts Payable: $312\,\text{million}$ in 2020; $344\,\text{million}$ in 2021; Change: +$32\,\text{million}$
  • Notes Payable: $231\,\text{million}$ in 2020; $196\,\text{million}$ in 2021; Change: -$35\,\text{million}$
  • Total Current Liabilities: $543\,\text{million}$ in 2020; $540\,\text{million}$ in 2021; Change: -$3\,\text{million}$
• Long-Term Debt: $531\,\text{million}$ in 2020; $457\,\text{million}$ in 2021; Change: -$74\,\text{million}$
• Owners' Equity:
  • Common Stock and Paid-in Surplus: $500\,\text{million}$ in 2020; $550\,\text{million}$ in 2021; Change: +$50\,\text{million}$
  • Retained Earnings: $1799\,\text{million}$ in 2020; $2089\,\text{million}$ in 2021; Change: +$290\,\text{million}$
  • Total Owners' Equity: $2299\,\text{million}$ in 2020; $2639\,\text{million}$ in 2021; Change: +$340\,\text{million}$
• Total Liabilities and Owners' Equity: $3373\,\text{million}$ in 2020; $3636\,\text{million}$ in 2021; Change: +$263\,\text{million}$

Sources and Uses of Cash Summary

Sources of Cash (in $ millions)

• Increase in Accounts Payable: $32\,\text{million}$
• Increase in Common Stock: $50\,\text{million}$
• Increase in Retained Earnings: $290\,\text{million}$
• Total Sources: $372\,\text{million}$

Uses of Cash (in $ millions)

• Increase in Accounts Receivable: $23\,\text{million}$
• Increase in Inventory: $29\,\text{million}$
• Decrease in Notes Payable: $35\,\text{million}$
• Decrease in Long-Term Debt: $74\,\text{million}$
• Net Fixed Asset Acquisitions: $149\,\text{million}$
• Total Uses: $310\,\text{million}$
• Net Addition to Cash: $372\,\text{million} - 310\,\text{million} = 62\,\text{million}$

Income Statement

The income statement measures financial performance over a designated accounting period.

2021 Income Statement Figures (in $ millions)

• Sales: $2311\,\text{million}$
• Cost of Goods Sold: $1344\,\text{million}$
• Depreciation: $276\,\text{million}$
• Earnings Before Interest and Taxes (EBIT): $691\,\text{million}$
• Interest Paid: $141\,\text{million}$
• Taxable Income: $550\,\text{million}$
• Taxes (21% tax rate): $116\,\text{million}$
• Net Income: $435\,\text{million}$
• Dividends Paid: $145\,\text{million}$
• Addition to Retained Earnings: $290\,\text{million}$

Statement of Cash Flows and Cash Source Categorization

Statement of Cash Flows (in $ millions)

• Cash at Beginning of Year: $84\,\text{million}$
• Operating Activities:
  • Net Income: $435\,\text{million}$
  • Plus Depreciation: $276\,\text{million}$
  • Plus Increase in Accounts Payable: $32\,\text{million}$
  • Less Increase in Accounts Receivable: -$23\,\text{million}$
  • Less Increase in Inventory: -$29\,\text{million}$
  • Net Cash from Operating Activity: $691\,\text{million}$
• Investment Activities:
  • Fixed Asset Acquisitions: -$425\,\text{million}$ (calculated as Net Fixed Asset Acquisitions of $149\,\text{million}$ plus Depreciation of $276\,\text{million}$)
  • Net Cash from Investment Activity: -$425\,\text{million}$
• Financing Activities:
  • Decrease in Notes Payable: -$35\,\text{million}$
  • Decrease in Long-Term Debt: -$74\,\text{million}$
  • Dividends Paid: -$145\,\text{million}$
  • Increase in Common Stock: $50\,\text{million}$
  • Net Cash from Financing Activity: -$204\,\text{million}$
• Net Increase in Cash: $691\,\text{million} - 425\,\text{million} - 204\,\text{million} = 62\,\text{million}$
• Cash at End of Year: $146\,\text{million}$

Categorized Sources and Uses Statement (in $ millions)

• Cash at Beginning of Year: $84\,\text{million}$
• Sources of Cash:
  • Operations: Net Income ($435\,\text{million}$) + Depreciation ($276\,\text{million}$) = $711\,\text{million}$
  • Working Capital: Increase in Accounts Payable = $32\,\text{million}$
  • Long-Term Financing: Increase in Common Stock = $50\,\text{million}$
  • Total Sources of Cash: $793\,\text{million}$
• Uses of Cash:
  • Working Capital: Increase in Accounts Receivable ($23\,\text{million}$) + Increase in Inventory ($29\,\text{million}$) + Decrease in Notes Payable ($35\,\text{million}$)
  • Long-Term Financing: Decrease in Long-Term Debt = $74\,\text{million}$
  • Fixed Asset Acquisitions: $425\,\text{million}$
  • Dividends Paid: $145\,\text{million}$
  • Total Uses of Cash: $731\,\text{million}$
• Net Addition to Cash: $793\,\text{million} - 731\,\text{million} = 62\,\text{million}$
• Cash at End of Year: $146\,\text{million}$

Standardized Financial Statements

Comparing raw financial data between companies or across time periods is difficult when firm sizes differ. Standardizing financial statements converts financial values into relative percentage formats, eliminating size distortions.

Standardization Methods

• Common-Size Statements: Expresses line items as percentages of a universal benchmark.
  • Common-Size Balance Sheet: Expresses every line item as a percentage of Total Assets.
  • Common-Size Income Statement: Expresses every line item as a percentage of Total Sales or Net Revenue.
  • Common-Size Statement of Cash Flows: Expresses items as percentages of Total Sources or Total Uses.
• Common-Base Year Statements (Trend Analysis): Expresses all figures relative to a baseline value from a designated base year.

Common-Size Balance Sheets (Prufrock Corporation 2023–2024)

Current Assets Relative to Total Assets

• Cash: $2.5\%$ in 2023; $4.0\%$ in 2024; Change: +$1.5\%$
• Accounts Receivable: $4.9\%$ in 2023; $5.2\%$ in 2024; Change: +$0.3\%$
• Inventory: $11.7\%$ in 2023; $11.6\%$ in 2024; Change: +$0.0\%$
• Total Current Assets: $19.0\%$ in 2023; $20.8\%$ in 2024; Change: +$1.8\%$

Fixed Assets Relative to Total Assets

• Net Plant and Equipment: $81.0\%$ in 2023; $79.2\%$ in 2024; Change: -$1.8\%$
• Total Assets: $100.0\%$ in 2023; $100.0\%$ in 2024; Change: $0.0\%$

Current Liabilities Relative to Total Assets

• Accounts Payable: $9.2\%$ in 2023; $9.5\%$ in 2024; Change: +$0.2\%$
• Notes Payable: $6.8\%$ in 2023; $5.4\%$ in 2024; Change: -$1.5\%$
• Total Current Liabilities: $16.1\%$ in 2023; $14.9\%$ in 2024; Change: -$1.2\%$

Long-Term Liabilities and Equity Relative to Total Assets

• Long-Term Debt: $15.7\%$ in 2023; $12.6\%$ in 2024; Change: -$3.2\%$
• Common Stock and Paid-in Surplus: $14.8\%$ in 2023; $15.1\%$ in 2024; Change: +$0.3\%$
• Retained Earnings: $53.3\%$ in 2023; $57.5\%$ in 2024; Change: +$4.1\%$
• Total Owners' Equity: $68.2\%$ in 2023; $72.6\%$ in 2024; Change: +$4.4\%$
• Total Liabilities and Owners' Equity: $100.0\%$ in 2023; $100.0\%$ in 2024; Change: $0.0\%$

Common-Size Income Statement (Company ABC 2018–2020)

Dollar and Common-Size Performance (2018–2020)

• Net Revenue:
  • 2018: $34934998\,\text{dollars}$ ($100\%$
  • 2019: $56302067\,\text{dollars}$ ($100\%$
  • 2020: $112209172\,\text{dollars}$ ($100\%$
• Direct Costs:
  • 2018: $27046450\,\text{dollars}$ ($77\%$
  • 2019: $43728157\,\text{dollars}$ ($78\%$
  • 2020: $89365467\,\text{dollars}$ ($80\%$
• Gross Profit:
  • 2018: $7888548\,\text{dollars}$ ($23\%$
  • 2019: $12573909\,\text{dollars}$ ($22\%$
  • 2020: $22843705\,\text{dollars}$ ($20\%$
• Sales & Marketing:
  • 2018: $200000\,\text{dollars}$ ($1\%$
  • 2019: $415500\,\text{dollars}$ ($1\%$
  • 2020: $454000\,\text{dollars}$ ($0\%$
• General & Admin:
  • 2018: $626000\,\text{dollars}$ ($2\%$
  • 2019: $782000\,\text{dollars}$ ($1\%$
  • 2020: $992000\,\text{dollars}$ ($1\%$
• Research & Development:
  • 2018: $50000\,\text{dollars}$ ($0\%$
  • 2019: $55000\,\text{dollars}$ ($0\%$
  • 2020: $110000\,\text{dollars}$ ($0\%$
• Other Expenses:
  • 2018: $50000\,\text{dollars}$ ($0\%$
  • 2019: $50200\,\text{dollars}$ ($0\%$
  • 2020: $52400\,\text{dollars}$ ($0\%$
• Depreciation:
  • 2018: $217500\,\text{dollars}$ ($1\%$
  • 2019: $525487\,\text{dollars}$ ($1\%$
  • 2020: $1199008\,\text{dollars}$ ($1\%$
• Operating Costs:
  • 2018: $1143500\,\text{dollars}$ ($3\%$
  • 2019: $1828187\,\text{dollars}$ ($3\%$
  • 2020: $2807408\,\text{dollars}$ ($3\%$
• Earnings Before Interest and Taxes (EBIT):
  • 2018: $6745048\,\text{dollars}$ ($19\%$
  • 2019: $10745723\,\text{dollars}$ ($19\%$
  • 2020: $20036296\,\text{dollars}$ ($18\%$
• Interest Expense:
  • 2018: $99515\,\text{dollars}$ ($0\%$
  • 2019: $73237\,\text{dollars}$ ($0\%$
  • 2020: $104649\,\text{dollars}$ ($0\%$
• Tax Charge:
  • 2018: $1395562\,\text{dollars}$ ($4\%$
  • 2019: $2241222\,\text{dollars}$ ($4\%$
  • 2020: $4185646\,\text{dollars}$ ($4\%$
• Net Profit:
  • 2018: $5249971\,\text{dollars}$ ($15\%$
  • 2019: $8431264\,\text{dollars}$ ($15\%$
  • 2020: $15746001\,\text{dollars}$ ($14\%$

Financial Ratio Analysis

Financial ratios state relationships between accounting line items, eliminating size differences to allow comparison across companies or across time.

Note: Formulas and definitions can vary slightly across financial institutions and literature, leading to potential inconsistencies when comparing multi-source analyses.

Financial ratios are grouped into five primary categories:

1. Short-term solvency, or liquidity, ratios
2. Long-term solvency, or financial leverage, ratios
3. Asset management, or turnover, ratios
4. Profitability ratios
5. Market value ratios

Short-Term Solvency and Liquidity Ratios

Short-term solvency ratios assess the firm's ability to pay its short-term obligations as they come due without incurring undue stress.

Current Ratio

$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$

• Measures short-term liquidity. Creditors prefer higher ratios, while a very high current ratio may indicate inefficient working capital management.
• A current ratio of at least $1.0$ is generally expected.

Quick Ratio (Acid-Test Ratio)

$\text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}$

• Calculated similarly to the current ratio, but excludes inventory because inventory is generally the least liquid current asset.
• Relatively large inventories relative to current liabilities often indicate short-term operational or sales friction.

Cash Ratio

$\text{Cash Ratio} = \frac{\text{Cash}}{\text{Current Liabilities}}$

• Evaluates immediate liquidity; primarily utilized by short-term creditors.

Net Working Capital to Total Assets

$\text{Net Working Capital to Total Assets} = \frac{\text{Net Working Capital}}{\text{Total Assets}}$

• Low values indicate low liquidity relative to total assets.

Interval Measure

$\text{Interval Measure} = \frac{\text{Current Assets}}{\text{Average Daily Operating Costs}}$

• Estimates the duration (in days) a business can sustain operational expenditures without generating additional current assets.

Long-Term Solvency and Financial Leverage Ratios

Long-term solvency ratios measure the firm's long-term capital structure and its capacity to satisfy long-term financial obligations.

Total Debt Ratio

$\text{Total Debt Ratio} = \frac{\text{Total Assets} - \text{Total Equity}}{\text{Total Assets}}$

• Considers all debt across all maturities to all creditors. Related variations include:
  • Debt-Equity Ratio:         $\text{Debt-Equity Ratio} = \frac{\text{Total Debt}}{\text{Total Equity}}$
  • Equity Multiplier:         $\text{Equity Multiplier} = \frac{\text{Total Assets}}{\text{Total Equity}}$

Long-Term Debt Ratio

$\text{Long-Term Debt Ratio} = \frac{\text{Long-Term Debt}}{\text{Long-Term Debt} + \text{Total Equity}}$

• Measures long-term debt relative to permanent capital (long-term debt plus total equity).

Times Interest Earned (TIE) Ratio

$\text{Times Interest Earned Ratio} = \frac{\text{EBIT}}{\text{Interest}}$

• Also referred to as the interest coverage ratio, this metric measures how comfortably operating earnings cover fixed interest expenses.

Cash Coverage Ratio

$\text{Cash Coverage Ratio} = \frac{\text{EBIT} + \text{Depreciation}}{\text{Interest}}$

• Measures cash flow available to satisfy interest obligations by adding non-cash depreciation back to EBIT (forming EBITD).

Asset Management and Turnover Ratios

Asset management ratios measure how efficiently a firm uses its operational assets to generate revenues.

Inventory Turnover and Days' Sales in Inventory

• Inventory Turnover:     $\text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Inventory}}$
  • Indicates how many times inventory is sold out and replaced during a given timeframe.
• Days' Sales in Inventory:     $\text{Days' Sales in Inventory} = \frac{365\,\text{days}}{\text{Inventory Turnover}}$
  • Calculates the average number of days inventory sits on hand before being sold.

Receivables Turnover and Days' Sales in Receivables

• Receivables Turnover:     $\text{Receivables Turnover} = \frac{\text{Sales}}{\text{Accounts Receivable}}$
  • Measures how quickly outstanding credit accounts are collected and reinvested.
• Days' Sales in Receivables:     $\text{Days' Sales in Receivables} = \frac{365\,\text{days}}{\text{Receivables Turnover}}$
  • Represents the average collection period required to turn credit sales into cash.

Working Capital and Asset Turnover Ratios

• Net Working Capital (NWC) Turnover:     $\text{NWC Turnover} = \frac{\text{Sales}}{\text{NWC}}$
  • Measures sales generated per dollar of working capital.
• Fixed Asset Turnover:     $\text{Fixed Asset Turnover} = \frac{\text{Sales}}{\text{Net Fixed Assets}}$
  • Measures sales generated per dollar of net fixed assets.
• Total Asset Turnover:     $\text{Total Asset Turnover} = \frac{\text{Sales}}{\text{Total Assets}}$
  • Measures overall operational productivity per dollar of total assets.

Profitability Ratios

Profitability ratios evaluate how effectively a firm converts revenue into net earnings.

Profit Margin

$\text{Profit Margin} = \frac{\text{Net Income}}{\text{Sales}}$

• Measures profit generated per dollar of sales. Higher profit margins are preferred, though standard margins vary across industries.

Return on Assets (ROA)

$\text{ROA} = \frac{\text{Net Income}}{\text{Total Assets}}$

• Measures net income generated per dollar of total assets.

Return on Equity (ROE)

$\text{ROE} = \frac{\text{Net Income}}{\text{Total Equity}}$

• Measures net earnings generated per dollar of owners' equity.
• ROA and ROE are accounting rates of return and represent return on book assets and return on book equity.

Market Value Ratios

Market value ratios combine market price metrics with accounting financial statements.

Price-Earnings (PE) Ratio

$\text{Price-Earnings Ratio} = \frac{\text{Price per Share}}{\text{Earnings per Share}}$

• Measures how much investors pay per dollar of current earnings. In 2020, a typical large U.S. company traded at a PE ratio between $15$ and $20$.
• Higher PE ratios suggest expected growth, but can also result from artificially low current earnings.

Price-Earnings-to-Growth (PEG) Ratio

$\text{PEG Ratio} = \frac{\text{Price-Earnings Ratio}}{\text{Earnings Growth Rate (\%)}}$

• Adjusts the PE ratio relative to the company's expected earnings growth rate.

Price-Sales Ratio

$\text{Price-Sales Ratio} = \frac{\text{Price per Share}}{\text{Sales per Share}}$

• Used to value companies with temporary or prolonged negative net income, where PE ratios are undefined.

Market-to-Book Ratio

$\text{Market-to-Book Ratio} = \frac{\text{Market Value per Share}}{\text{Book Value per Share}}$

• Compares the market equity valuation to historical accounting costs. A ratio below $1.0$ may indicate the firm has failed to create value for its shareholders overall.

Tobin's Q Ratio

$\text{Tobin's Q Ratio} = \frac{\text{Market Value of Assets}}{\text{Replacement Cost of Assets}}$

• Compares total asset market valuation to the cost of replacing those assets.

Enterprise Value-EBITDA Ratio

$\text{EV-EBITDA Ratio} = \frac{\text{Enterprise Value}}{\text{EBITDA}}$

• Measures market enterprise valuation relative to pre-tax operational cash flow (EBITDA).

Challenges and Limitations of Financial Statement Analysis

When evaluating financial performance across multiple entities, several analytical challenges arise:

• Lack of Underlying Theory: No universal theory dictates precise target benchmark values for specific financial ratios.
• Conglomerate Operations: Multiline conglomerates operate across varied industries, rendering consolidated financial statements unsuited for single-industry benchmark metrics.
• Global Benchmarking and GAAP: Industry peers operate globally; non-U.S. firm disclosures do not necessarily adhere to U.S. GAAP standards.
• Accounting Procedure Variances: Direct comparability suffers due to differences in inventory valuation methods (e.g., LIFO vs. FIFO) and depreciation schedules.
• Fiscal Year Timing Differences: Firms within the same sector may operate on differing fiscal year cycles.
• Transient Events: Non-recurring or unusual financial events can distort one-year performance metrics.