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Chapter 6: Financial Statement Analysis•Study objectives

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Chapter 6: Financial Statement Analysis
•Study objectives
–Review financial statements
–A possible framework for analysis
–Balance sheet ratios
–Income statement and income statement/balance sheet ratios
–Trend analysis
–Common size and index analysis
1.What is financial analysis
•Analysis is to interpret certain information for decision purpose
•Financial analysis involves analyzing financial statements prepared in accordance with
generally accepted accounting principles to ascertain information concerning the
magnitude, timing, and riskness of future cash flows
Different purpose of financial analysis
•The firm itself and outside providers of capital---creditors and investors---all undertake
financial analysis. The type of analysis varies according to the specific interests of the
party involved
•Trade creditors (suppliers) are interested in the liquidity of a firm
•The claims of bondholders (bankers or other creditors) are more interested in the cash-
flow ability of the firm to service debt over a long period of time
•Investors in a company’s common stock are principally concerned with present and
expected future earnings as well as with the stability of these earnings about a trend line
•Management also employ financial analysis for the purpose of internal control and to
better provide what capital suppliers seek in financial condition
Financial statements
•See page 128-129 balance sheet and income statement
•The probable defect of financial statements analysis: window dress (see page 135)
3.Use of financial ratios
•Financial ratio is an index that relates two accounting numbers and is obtained by
dividing one number by the other
–Financial statements give the analyst a lot of accounting numbers, so why bother with a
ratio? For the reason of comparison among firms
3.1Internal comparisons
•The analysis of financial ratios involves two types of comparison.
the comparison of a present ratio with past and expected future ratio for the same
company
–comparing the ratios of one firm with those of similar firms or with industry averages at
the same point in time
•The meaning of internal comparison
–when financial ratios are arrayed over a period of years, the analyst can study the
composition of change and determine whether there has been an improvement or
deterioration in the firm’s financial condition and performance overtime
3.2External comparisons

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•The purpose of external comparison
gives insight into the relative financial condition and performance of the firm; helps us
identify any significant deviation from any applicable industry average (or standard).
3.3Types 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. We call these balance sheet ratios, 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. These ratio are called either income statement or income statement/balance
sheet ratios
•Income statement ratios compare one flow item from the income statement to another
flow item from the income statement
•Income statement/balance sheet ratio compare a flow (income statement) item in the
numerator to a stock item in the denominator
–Comparing a flow item to a stock item poses a potential problem for the analyst. We run
the risk of a possible mismatch of variables. 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
3.4Types of ratios
•Additionally, we further subdivide our financial ratios into five distinct types: liquidity,
financial leverage, coverage, activity, and profitability ratios (see figure 6-2 page 134)
•No one ratio gives us sufficient information by which to judge the financial condition and
performance of the firm.
3.5Balance sheet ratios
•What is liquidity? the ability of an asset to be converted into cash without a significant
price concession
•Liquidity ratios: ratios that measure a firm’s ability to meet short-term obligations
–Liquidity ratios compare short-term obligations to short-term resources available to meet
these obligations
–Short-term creditors pay attention to these ratios, because they indicate the present
cash solvency of the firm
3.6Liquidity ratios
•Current ratio: current assets divided by current liabilities.
–Assumption: the current liability will be due within a year, and current assets will change
into cash within a year, so the current liabilities will be paid back by current assets
–Example: Aldine Manufacturing company page 134,
–Comparisons with industry averages are meaningful in identifying companies that are
out of line
–The current ratio is regarded as a crude measure because it does not take into account
the liquidity of the individual components of the current assets
•Acid-test (quick) ratio: current assets less inventories divided by current liabilities.
–Assumption: the current liabilities will be due in a short time, so only those assets with

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Chapter 6: Financial Statement Analysis -Study objectives -Review financial statements -A possible framework for analysis -Balance sheet ratios -Income statement and income statement/balance sheet ratios -Trend analysis -Common size and index analysis 1.What is financial analysis -Analysis is to interpret certain information for decision purpose -Financial analysis involves analyzing financial statements prepared in accordance with generally accepted accounting principles to ascertain information concerning the magnitude, timing, and riskness of future cash flows Different purpose of financial analysis -The firm itself and outside providers of capital---creditors and investors---all undertake financial analysis. The type of analysis varies according to the specific interests of the party involved -Trade creditors (suppliers) are interested in the liquidity of a firm -The claims of bondholders (bankers or other creditors) are more interested in the cash-flow ability of the firm to service debt over a long period of time -Investors in a company's common stock are principally concerned with present and expected future earnings as well as with the stability of these earnings about a trend line -Management also employ financial analysis for the purpose of internal control and to better provide what capital suppliers seek in financial condition 2. Financial statements -See page 128-129 balance sheet and income statement -The probable defect of financial statements analysis: window ...
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