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Financial Statement Analysis

Financial statements

Financial analysis involves the use of various financial statements. These statements do several things. First, the balance sheet summarizes the assets, liabiiities, and owners' equity of. business at a moment in time, usually the end of a year or a quarter. Next, the income statement summarizes the revenues and expenses of the firm over a particular period of tin.rr. again usually a year or a quarter. Though the balance sheet represents a snapshot of the firmfinancial position at a moment in time, the income statement depicts a summary of the firmprofitability over time. From these two statements (plus, in some cases, a little additionainformation), certain derivative statements can be produced, such as a statement of retainec earnings, a sources and uses of funds statement, and a statement of cash flows. (We conside: the latter two in the next chapter.)


Speaking In Tongues

Forget esperanto. Too straightforward. The lingua L'franca that is increasingly spanning the globe is a tongue-twisting accounting-speak that is forcing even Americans to rethink some precious notions of financial sovereignty.


Balance Sheet Information

For many years in the US and other countries, cash was combined with cash equivalents under the heading "cash and cash equivalents" on a company's balance sheet and statement of cash flows. In an attempt to simplify accounting standards the US Financial Accounting Standards Board voted approval in early 2007 to change this heading to simply "cash." Items previously classified as cash equivalents would now be classified in the same way as other short-term investments. An implementation date has yet to be set, but in anticipation of this change, we will use the new terminology in the financial statements presented in this text. However, unless there is official implementation and guidance on this issue, "cash and cash equivalents" must be used in actual practice.


Income Statement Information

The income (earnings, or profit and loss) statement shows Aldine's revenues, expenses, and net profits for the two fiscal years under discussion. The cost of goods sold represents the cost of actually producing the products that were sold during the period. Included here are the cost of raw materials, labor costs associated with production, and manufacturing overhead related to products sold. Selling, general, and administrative expenses as well as interest expense are shown separately from the cost of goods sold because they are viewed as period expenses rather than product costs.


A Possible Framework for Analysis

A number of different approaches might be used in analyzing a firm. Many analysts have: favorite procedure for coming to some generalizations about the firm being analyzed. At the risk of treading on some rather sacred ground, we present a conceptual framework that lends itself to situations in which external financing is contemplated.


Use of Financial Ratios

To evaluate a firm's financial condition and performance, the financial analyst needs to perform "checkups" on various aspects of a firm's financial health. A tool frequently used during these checkups is a financial ratio, or index, which relates two pieces of financial data by dividing one quantity by the other.


Types of Ratios

The commonly used financial ratios are of essentially two kinds. The first kind summarizes some aspect of the firm's "financial condition" at a point in time - the point at which a balance sheet has been prepared. We call these balance sheet ratios, quite appropriately, because both the numerator and denominator in each ratio come directly from the balance sheet. The second kind of ratio summarizes some aspect of a firm's performance over a period of time, usually a year. These ratios are called either income statement or income statement/balance sheet ratios. Income statement ratios compare one "flow" item from the income statement with another flow item from the income statement. Income statement/balance sheet ratios compare a flow (income statement) item in the numerator with a "stock" (balance sheet) item in the denominator. Comparing a flow item with a stock item poses a potential problem for the analyst. We run the risk of a possible mismatch of variables. The stock item, being a snapshot taken from the balance sheet, may not be representative of how this variable looked over the period during which the flow occurred. (Would a photograph of you taken at midnight on New Year's Eve be representative of how you look, on average?) Therefore, where appropriate, we may need to use an "average" balance sheet figure in the denominator of an income statement/balance sheet ratio to make the denominator more representative of the entire period. (We will have more to say on this later.)


Liquidity Ratios

Liquidity ratios are used to measure a firm's ability to meet short-term obligations. The compare short-term obligations with short-term (or current) resources available to meet these obligations. From these ratios, much insight can be obtained into the present cash solvency of the firm and the firm's ability to remain solvent in the event of adversity.


Financial Leverage (Debt) Ratios

Debt-to-Equity Ratio. To assess the extent to which the firm is using borrowed money, we may use several different debt ratios. The debt-to-equity ratio is computed by simply dividing the total debt of the firm (including current liabilities) by its shareholders equity.


Coverage Ratios

Coverage ratios are designed to relate the financial charges of a firm to its ability to service, or cover, them. Bond rating services, such as Moody's Investors Service and Standard & Poor's, make extensive use of these ratios. One of the most traditional of the coverage ratios is the interest coverage ratio, or times interest earned. This ratio is simply the ratio of earnings before interest and taxes for a particular reporting period to the amount of interest charges for the period; that is,


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