BU227 Chapter 13 – Analyzing Financial Statements Week 12
The Investment Decision
-Analysts are information intermediaries who interpret audited financial information and advise their
clients on whether they should buy, hold, or sell shares
-Analysts’ recommendations shift over time as new information is released and actual performance
becomes observable
-In addition to analyzing a company’s financial statements, analysts consider other factors that might
affect the future operating performance of the company and its financial situation – these include
global, economic, and industry factors that are not controllable by the company and management’s
ability to adapt is business plans in response to the uncertainties and risks associated with these
uncontrollable factors
-When considering an investment in shares, the investor should evaluate the future profit and growth
potential of the business on the basis of three factors:
1. Economy-wide factors – The overall health of the economy has a direct impact on the
performance of an individual business. Prudent investors must consider data such as the
unemployment rate, general inflation rate, and changes in interest rates
2. Industry factors – Certain events have a major impact on each company within an industry,
but have only a minor impact on other companies outside the industry
3. Individual company factors – To properly analyze a company, you should learn as much as you
can about it. Good analysts do not rely solely on the information contained in the financial
statements
-Investors should understand a company’s business strategy when evaluating its financial statements
Understanding A Company’s Strategy
-Business strategy Operating decisions Transactions Financial statements
-A useful starting point for financial statement analysis is the return on equity profit driver analysis
which shows a logical relationship among the three ratios: net profit margin, asset turnover, and
financial leverage
-Businesses can earn a high rate of return for the owners by following these two fundamental strategies;
1. Product differentiation – Companies offer products with unique benefits, such as high quality
or unusual features or style
2. Cost advantage – Companies attempt to operate more efficiently than their competitors,
allowing them to offer lower prices to attract customers
Financial Statement Analysis
-Analyzing financial data without a basis of comparison is impossible
-Financial results cannot be evaluated in isolation
-There are two benchmarks for making financial comparisons: BU227 Chapter 13 – Analyzing Financial Statements Week 12
1. Time series analysis – Information for a single company is compared over time
2. Comparison with similar companies – By comparing a company with another one in the same
line of business, an analyst can obtain better insight into its performance
-The governments developed the North American Industry Classification System for use in reporting
economic data
-The system assigns a specific industry code to each corporation, based on its business operations
Ratio and Percentage Analyses
-Ratio (percentage) analysis – an analytical tool designed to identify significant relationships; it measures
the proportional relationship between two financial statement amount
Component Percentages
-Component percentage – expresses each item on a particular financial statement as a percentage of a
single base amount
-To compute component percentages for the income statement, the base amount is net sales revenue –
each expense is expressed as a percentage of net sales revenue
-In addition to component percentages, analysts use ratios to compare related items from the financial
statements
-For consistency, we always use average amounts
Tests of Profitability
-Tests of Profitability – compare profit with one or more primary activities
-Several tests of profitability focus on measuring the adequacy of profit by comparing it to other items
reported on the financial statements
1. Return on Equity (ROE)
-Related profit to the investment made by the owners
-Investor expect to earn more money if they invest more money
-A higher ROE means you produced a better ROE
2. Return on Assets (ROA)
-A better measure of management’s ability to utilize assets effectively because it is not affected by the
way in which the assets were financed
-A higher ROA means that a company utilizes its assets more effectively
Financial Leverage Percentage
-Measures the advantage or disadvantage that occurs when a company’s return on equity differs from
its return on assets
ROE – ROA
-The financial leverage percentage describes the relationship between the return on equity and the
return on assets
-Leverage is positive when the rate of return on a company’s assets exceeds the average after-tax
interest rate on its borrowed funds
-Most companies have a positive leverage
-The difference is available to the shareholders BU227 Chapter 13 – Analyzing Financial Statements Week 12
-Financial leverage can be enhanced either by investing effectively or borrowing effectively
-If a decrease in ROE signals future growth despite a temporarily negative financial leverage percentage
investors may not be too alarmed by negative leverage
-An increase in ROA is the result of borrowing at high interest rates, investors could well interpret
negative leverage as reflecting bad news BU227 Chapter 13 – Analyzing Financial Statements Week 12
3. Earning per Share (EPS)
-A measure of the return on investment that is based on the number of shares outstanding instead of
the dollar amounts reported on the statement of financial position
-Closely watched over
4. Quality of Earnings
-A quality of earnings ratio higher than 1 is considered to indicate higher-quality earnings because each
dollar of profit is supported by at least one dollar of cash flow
-A ratio below 1 indicates that accruals represent a significant portion of profit, which suggests that
earnings are of lower quality than if the ratio exceeded 1
5. Profit Margin
-The profit margin measures the percentage of each sales dollar on average, that represents profit
-It is difficult to compare profit margins for companies in different industries
-Ex. Profit margins are low in the food industry, but they are high in the jewelry business
6. Fixed Asset Turnover
-Compares sales volume with a company’s investment in fixed assets
-If a fixed asset turnover is lower than other companies, that means that other companies have a
competitive advantage over that company in terms of their ability to effectively utilize fixed assets to
generate revenue
-Ex. If asset turnover = 1.61 than the company was able to generate $1.61 in revenue for each dollar
invested in the company’s assets
ROE Profit Driver Analysis
-Shows the sources of change in ROE and can provide useful insights into a business strategy
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Tests of Liquidity
-Liquidity refers to a company’s ability to meet its currently maturing debts
-Tests of liquidity focus on the relationship between current assets and current liabilities
-A company’s ability to pay its current liabilities is an important factor in evaluating its short-term
financial strengt
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