Financial Statement Analysis - Liquidity and Comparison and Techniques

Course Schedule and Important Dates

  • May 18: Chapter 3 Part 1 discussion (Financial Statement Analysis).

  • Next Monday: Chapter 3 Part 2 discussion.

  • May 29 (Friday): Second online quiz covering Chapter 3.

  • June 1 and June 8 (Mondays): Chapter 4 discussion (split into two parts).

  • June 20: Final on-site exam.

Introduction to Financial Statement Analysis

  • Accounting Steps: Recording, classifying, and summarizing are performed by the accountant. Interpreting and analyzing the resulting numbers is the most critical part of decision-making.

  • External Users: Includes shareholders, potential investors, creditors, suppliers, and rank-and-file employees. They rely on General Purpose Financial Statements (GPFS), which include the balance sheet, income statement, and statement of cash flow.

  • Internal Users: Managers responsible for planning, implementation, and control. They utilize Special Purpose reports tailored to specific decisions.

  • Objectives of Analysis:

    • Assessment of Performance: Uses past performance as an indicator of future trends and current position.

    • Predictive Value: Connected to the qualitative characteristic of relevance.

    • Assessment of Risk: Analysis helps investors predict earnings per share and help creditors determine debt-paying ability.

    • Risk-Return Tradeoff: Higher risk typically correlates with a higher return on investment (ROI).

Standards for Comparison

  • Rule of Thumb: General benchmarks used by analysts (e.g., a current ratio of 2:12:1). These must be used with care as they are not absolute for all companies.

  • Past Performance: Intra-comparability involving the comparison of the same company across different accounting periods to identify trends.

  • Industry Norms: Comparing a company against others in the same industry. Limitations include differences in business models (e.g., dealer vs. manufacturer) and accounting methods (e.g., straight-line vs. sum-of-the-years-digits depreciation).

Tools and Techniques of Analysis

  • Horizontal Analysis: Compares figures across two or more consecutive periods to compute peso and percentage changes. The earlier period is typically the base year.

    • Peso Change Calculation: Most Recent Value−Base Period Value\text{Most Recent Value} - \text{Base Period Value}

    • Percentage Change Calculation: Most Recent Value−Base Period ValueBase Period Value×100%\frac{\text{Most Recent Value} - \text{Base Period Value}}{\text{Base Period Value}} \times 100\%

  • Vertical Analysis (Common Size Statements): Compares components within a single period by expressing them as a percentage of a base amount (100%100\%).

    • Base Amount (Balance Sheet): Total Assets.

    • Base Amount (Income Statement): Net Sales.

    • Common Size Percentage: Individual AmountBase Amount×100%\frac{\text{Individual Amount}}{\text{Base Amount}} \times 100\%

Liquidity Ratios and Formulas

  • Working Capital: Measures the difference between current assets and current liabilities.

    • Working Capital=Current Assets−Current Liabilities\text{Working Capital} = \text{Current Assets} - \text{Current Liabilities}

  • Current Ratio: Measures ability to pay short-term obligations (2:12:1 is often considered ideal).

    • Current Ratio=Current AssetsCurrent Liabilities\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}

  • Quick Ratio (Acid-Test Ratio): Measures immediate liquidity using only quick assets (cash, trading securities, and current receivables).

    • Quick Ratio=Quick AssetsCurrent Liabilities\text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}}

  • Accounts Receivable Turnover (ARTO): Measures the frequency of collecting receivables.

    • ARTO=Net SalesAverage Accounts Receivable\text{ARTO} = \frac{\text{Net Sales}}{\text{Average Accounts Receivable}}

  • Average Collection Period (ACP): Represents average days to collect receivables.

    • ACP=365ARTO\text{ACP} = \frac{365}{\text{ARTO}} or Average Accounts ReceivableAverage Daily Sales\frac{\text{Average Accounts Receivable}}{\text{Average Daily Sales}}

  • Inventory Turnover: Measures how many times inventory is sold during a period.

    • Inventory Turnover=Cost of Goods SoldAverage Inventory\text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}

  • Average Days in Inventory: Measures average duration inventory is held.

    • Average Days in Inventory=365Inventory Turnover\text{Average Days in Inventory} = \frac{365}{\text{Inventory Turnover}} or InventoryAverage Daily Cost of Sales\frac{\text{Inventory}}{\text{Average Daily Cost of Sales}}

  • Operating Cycle Ratio (OCR): The total time to convert inventory back into cash.

    • OCR=Average Days in Inventory+Average Collection Period\text{OCR} = \text{Average Days in Inventory} + \text{Average Collection Period}

Questions & Discussion

  • Standard Values: Arthur and Vince discussed the quick ratio for Mido Corporation (1.241.24), noting it is a good indicator because it is above 11.

  • Calculation Methodology: Kyle and the instructor clarified that if prior year data is available, an "Average" (Beginning + Ending / 22) should be used for turnover denominators.

  • Alternative Formulas: Ashley inquired about the average days in inventory formula. The instructor confirmed the alternative is 365365 divided by inventory turnover.

  • Formula Sheet: The instructor confirmed students will be provided a formula sheet for the final exam and can use open notes for the online quiz.