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Part 2. Financial Analysis and the Statement of Cash Flows

8. Financial Statement Analysis

As you know, this text provides a substantial amount of material about accounting principles, and anyone wishing to study it with due diligence can learn valuable insights about accounting. Does the mere fact that this text exists mean that everyone with access now knows about accounting principles? Obviously not. Does it mean that everyone who happens to "read it" will learn about accounting? Again, no. By analogy, the same can be said about financial information. Companies, especially public companies, spend substantial amounts of money preparing and presenting financial statements that are readily available (the reports for U.S. public companies are freely available at sec.gov). Does this mean that everyone with internet access now has in-depth knowledge about these companies? For that matter, if you print the annual report of a company that you find interesting, does this really help you? My point is that some degree of study is required to benefit from information.

It is important for you to know that CPAs and the SEC provide safeguards to protect the integrity of reported information, but this is entirely different than suggesting that reporting companies are necessarily good investments. For example, a company could report that its revenue stream is in decline, expenses are on the rise, and significant debt is coming due without a viable plan for making the payments. The financial statements may fully report this predicament with perfect integrity, painting a rather gloomy picture. But, if financial statement users choose to ignore that report, only they are to blame.

The moral of the preceding point is that you must be very thorough in examining the financial statements of companies in which you are considering making an investment. It is not sufficient to merely determine that reports exist and look nice; you must study them, drill down in the detail, and think carefully about what you are observing. Sometimes, the evaluation of complex situations can be assisted by utilization of key metrics or ratios. For example, a doctor will consider your health in conjunction with measurements of your blood pressure, heart rate, cholesterol level, etc. Likewise, you measure a company's health by considering certain important ratios.

The following ratios have been presented throughout this book series and are summarized below.

LIQUIDITY AND DEBT SERVICE RATIOS

Current Ratio

Current Assets/ Current Liabilities

A measure of liquidity; the ability to meet near-term obligations

Quick Ratio

(Cash + Short-term Investments + Accts. Receivable)/ Current Liabilities

A narrow measure of liquidity; the ability to meet near-term obligations

Debt to Total Assets Ratio

Total Debt/ Total Assets

Percentage of assets financed by long-term and short-term debt

Debt to Total Equity Ratio

Total Debt/ Total Equity

Proportion of financing that is debt-related

Times Interest Earned Ratio

Income Before Income Taxes and Interest/ Interest Charges

Ability to meet interest obligations

TURNOVER RATIOS

Accounts Receivable Turnover Ratio

Net Credit Sales/ Average Net Accounts Receivable

Frequency of collection cycle; to monitor credit policies

Inventory Turnover Ratio

Cost of Goods Sold/ Average Inventory

Frequency of inventory rotation; to monitor inventory management

PROFITABILITY RATIOS

Net Profit on Sales Ratio

Net Income/ Net Sales

Profitability on sales; for comparison and trend analysis

Gross Profit Margin Ratio

Gross Profit/ Net Sales

Gross profit rate; for comparison and trend analysis

Return on Assets Ratio

(Net Income + Interest Expense)/ Average Assets

Asset utilization in producing returns

Return on Equity Ratio

(Net Income - Preferred Dividends)/ Average Common Equity

Effectiveness of equity investment in producing returns

OTHER INDICATORS

EPS

Income Available to Common/ Weighted-Average Number of Common Shares

Amount of earnings attributable to each share of common stock

P/E

Market Price Per Share/ Earnings Per Share

The price of the stock in relation to earnings per share

Dividend Rate/Yield

Annual Cash Dividend/ Market Price Per Share

Direct yield to investors through dividend payments

Dividend Payout Ratio

Annual Cash Dividend/ Earnings Per Share

Proportion of earnings distributed as dividends

Book Value

"Common" Equity/ Common Shares Outstanding

The amount of stockholders' equity per common share outstanding

 
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