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Chapter 16

Analyzing Financial Statements

Book Version 3
By Boundless
Boundless Accounting
Accounting
by Boundless
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Section 1
Overview of Financial Statement Analysis
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Using Financial Statements to Understand a Business

Internal and external users rely on a company's financial statements to get an in-depth understanding of the company's financial position.

Section 2
Standardizing Financial Statements
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Income Statements

Income statement is a company's financial statement that indicates how the revenue is transformed into the net income.

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Balance Sheets

A standard balance sheet has three parts: assets, liabilities, and ownership equity; Asset = Liabilities + Equity.

Section 3
Ratio Analysis Overview
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Classification

Ratio analysis consists of calculating financial performance using five basic types of ratios: profitability, liquidity, activity, debt, and market.

Section 4
Using Financial Ratios for Analysis
Limitations of Financial Statement Analysis

Financial statement analyses can yield a limited view of a company because of accounting, market, and management related limitations of such analyses.

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Trend Analysis

Trend analysis consists of using ratios to compare company performance on an indicator over time, often to forecast or inform future events.

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Benchmarking

Comparing the financial ratios of a company to those of the top performer in its class is a type of benchmarking.

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Industry Comparisons

While ratio analysis can be quite helpful in comparing companies within an industry, cross-industry comparisons should be done with caution.

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Evaluating Financial Statements

With a few exceptions, the majority of the data used in ratio analysis comes from evaluation of the financial statements.

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Selected Financial Ratios and Analyses

Financial ratios and their analysis provide information on a firm's profitability and allow comparisons between the firm and its industry.

Section 5
Liquidity Ratios
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Current Ratio

Current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months.

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Quick Ratio (Acid-Test Ratio)

The Acid Test or Quick Ratio measures the ability of a company to use its assets to retire its current liabilities immediately.

Section 6
Debt-Management Ratios
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Times-Interest-Earned Ratio

Times Interest Earned ratio (EBIT or EBITDA divided by total interest payable) measures a company's ability to honor its debt payments.

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Total Debt to Total Assets

The debt ratio is expressed as Total debt / Total assets.

Section 7
Profitability Ratios
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Basic Earning Power (BEP) Ratio

The Basic Earning Power ratio (BEP) is Earnings Before Interest and Taxes (EBIT) divided by Total Assets.

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Return on Common Equity

Return on equity (ROE) measures how effective a company is at using its equity to generate income and is calculated by dividing net profit by total equity.

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Return on Total Assets

The return on assets ratio (ROA) measures how effectively assets are being used for generating profit.

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Profit Margin

Profit margin measures the amount of profit a company earns from its sales and is calculated by dividing profit (gross or net) by sales.

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Operating Margin

The operating margin is a ratio that determines how much money a company is actually making in profit and equals operating income divided by revenue.

Section 8
Market-Value Ratios
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Price/Earnings Ratio

Price to earnings ratio (market price per share / annual earnings per share) is used as a guide to the relative values of companies.

Market/Book Ratio

The price-to-book ratio is a financial ratio used to compare a company's current market price to its book value.

Section 9
Considering Inflation's Distortionary Effects
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Deflation

Deflation is a decrease in the general price level of goods and services and occurs when the inflation rate falls below 0%.

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Disinflation

Disinflation is a decrease in the inflation rate; a slowdown in the rate of increase of the general price level of goods, services.

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Impact of Inflation on Financial Statement Analysis

General price level changes creates distortions in financial statements. Inflation accounting is used in countries with high inflation.

Section 10
The DuPont Equation, ROE, ROA, and Growth
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Assessing Internal Growth and Sustainability

Sustainable-- as opposed to internal-- growth gives a company a better idea of its growth rate while keeping in line with financial policy.

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Dividend Payments and Earnings Retention

The dividend payout and retention ratios offer insight into how much of a firm's profit is distributed to shareholders versus retained.

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Relationships between ROA, ROE, and Growth

Return on assets is a component of return on equity, both of which can be used to calculate a company's rate of growth.

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The DuPont Equation

The DuPont equation is an expression which breaks return on equity down into three parts: profit margin, asset turnover, and leverage.

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ROE and Potential Limitations

Return on equity measures the rate of return on the ownership interest of a business and is irrelevant if earnings are not reinvested or distributed.

Section 11
Asset-Management Ratios
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Fixed Assets Turnover Ratio

Fixed-asset turnover is the ratio of sales to value of fixed assets, indicating how well the business uses fixed assets to generate sales.

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Total Assets Turnover Ratio

Total asset turnover is a financial ratio that measures the efficiency of a company's use of its assets in generating sales revenue.

Days Sales Outstanding

Days sales outstanding (also called DSO or days receivables) is a calculation used by a company to estimate their average collection period.

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Inventory Turnover Ratio

Inventory turnover is a measure of the number of times inventory is sold or used in a time period, such as a year.

Section 12
Other Distortions
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Extraordinary Gains and Losses

Extra gains or losses are nonrecurring, onetime, unusual, non-operating gains or losses that are recorded by a business during the period.

Discrepancies

Accounting discrepancies are unintentional mistakes in the delivery a financial statement.

Section 13
Next Steps in Financial Statement Analysis
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Interpreting Ratios and Other Sources of Company Information

Financial statement analysis uses comparisons and relationships of data to enhance the utility or practical value of accounting information.

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Chapter 16
Analyzing Financial Statements
  • Overview of Financial Statement Analysis
  • Standardizing Financial Statements
  • Ratio Analysis Overview
  • Using Financial Ratios for Analysis
  • Liquidity Ratios
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