Financial Statement Analysis
There are several basic financial statements that all business people must be understand. These reports are generally included in the companies annual report.
The Balance Sheet is an organized list of the firm's assets, liabilities. The difference between these is the owners' net worth. This gives way to the balance sheet identity: assets= liabilities + equity. This is often modeled as a t-account with assets on the left hand side and liabilities and equity on the right hand side. The numbers on this represent a snap-shot at a given time.
Within the balance sheet, there are various subcatergories such as current assets, and current liabilities.
The Income Statement measures the firm's income (accounting profit) over some period of time. Unlike the balance sheet this is a longer time frame measure. Generally companies report earnings quarterly as well as yearly. Earnings are typically calculated using many assumptions. Most firms use GAAP (generally accepted accounting principles) but there is still leeway in what to include and what to not include. Recently, companies have been under fire for their accounting practices which has led some to define profit as an "accountant's fiction."
Another financial report is the cash flow statement. This is often more important than the income statement as this is what investors generally are most concerned with. To see why, let's look at depreciation. Depreciation is a non-cash expense. Firms that attempt to maximize earnings will lower their depreciation. This will cause taxes to increase which will cause cash flow available to shareholders to decrease. Thus, profit maximization is not a worthy goal for a manager whose intent is to maximize shareholder value.
Although highly correlated with profit, a firm's cash flow statement is less open to assumptions than is their income statement. The beginning calculation is to find Net Income but then adjust for non-cash items (example depreciation is added back in), additions to working capital are taken out, and investment and financing activities are taken into account.
Reviewing financial statements can be quite time-consuming. In an attempt to speed the process and to allow better analysis within and outside the firm, many investors and managers use ratio analysis. Ratio analysis useful because it controls for size differences and can be used to quickly spot trends, strengths, or weaknesses.
Ratio analysis is generally broken down into one of several catergories. Liquidity Ratios, Asset Management ratios, Debt management Ratios (leverage), profitability ratios, and market based ratios. (Page 75 of the text provides a nice comparision chart showing how each ratio is calculated.
The Du Pont analysis can be used to tie these together. It is
calculated by finding ROA = Profit margin * Total Asset Turnover
Multplying ROA by the firms' equity multipler (total assets/common
equity) yields the firm's ROE.
Compartaive Ratios and Benchmarking
The key thing here is to be careful interpreting any ratio. Ratios
are only useful when looking for trends or when making comparisions of
like firms. They should serve as a "red flag" demanding more attention,
not as the sole means of evaluating a firm's performance. This is
especially true because managers can influence the numbers (engage in window
dressing) and where international comparisions are being made.
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