CHAPTER

CHAPTER 14
14
Analyzing Financial Statements:
A Managerial Perspective

Slide 14-2

Why
Why Managers
Managers Analyze
Analyze Financial
Financial
Statements
Statements
Managers analyze financial statements
for a variety of reasons including:
Control of operations
Assess the financial stability of vendors,
customers, and other business partners
Assess the appearance of the company
to investors and creditors

Slide 14-3

Learning objective 1: Explain why managers

analyze financial statements

Control
Control of
of Operations
Operations
Analysis of financial statements help
management gain insight into whether
their goals have been achieved
Assume successful implementation of
plan will be reflected in financial
information
- If financial information is inconsistent
with a successful implementation an
investigation will be launched

Slide 14-4

Learning objective 1: Explain why managers

analyze financial statements

Assessment
Assessment of
of Vendors,
Vendors,
Customers,
Customers, and
and Other
Other Partners
Partners
Management takes same approach to
review the financial stability of vendors,
customers, and other strategic partners
Analysis of financial statements used to
identify, qualify, and monitor potential
partners
- Important when developing
relationships to determine whether
vendor or customers business is viable
and will continue operations

Slide 14-5

Learning objective 1: Explain why managers

analyze financial statements

Assessment
Assessment of
of Vendors,
Vendors,
Customers,
Customers, and
and Other
Other Partners
Partners
Managers analyze financial statements
to assess whether:
Vendors are stable and will continue in
existence
Customers need to be able to pay
amounts owed on a timely basis
Potential partners are in financial
difficulty

Slide 14-6

Learning objective 1: Explain why managers

analyze financial statements

Assessment
Assessment of
of Appearance
Appearance to
to
Investors
Investors and
and Creditors
Creditors
Accrual income v. cash flows
- Describe the differences between net
income and cash flow from
operating activities to help readers
Managers need to analyze statements from
the perspective of investors and creditors
- Need to be prepared in order to answer
questions

Slide 14-7

Learning objective 1: Explain why managers

analyze financial statements

Why do managers analyze financial

statements?
a. To evaluate and control operations
b. To evaluate vendors and customers
c. To anticipate questions from
shareholders and creditors
d. All of the above

Answer: d
All of the above
Slide 14-8

Learning objective 1: Explain why managers

analyze financial statements

Horizontal
Horizontal and
and Vertical
Vertical Analyses
Analyses
Horizontal analysis
- Analysis of the dollar value and
percentage changes in financial
statement amounts across time

Vertical analysis
- Also called common size analysis
- Analysis of financial statement
amounts in comparison to a base
amount, e.g. total assets
Slide 14-9

Learning objective 2: Perform horizontal and vertical analyses of the

balance sheet and the income statement

Horizontal
Horizontal Analysis
Analysis
Horizontal analysis
Calculate amount of change for each
item on the balance sheet or income
statement
Calculate percent change
-Amount of change divided by old amount

Slide 14-10

Learning objective 2: Perform horizontal and vertical analyses of the

balance sheet and the income statement

Horizontal
Horizontal Analysis
Analysis

Slide 14-11

Learning objective 2: Perform horizontal and vertical

analyses of the balance sheet and the income statement

Horizontal
Horizontal Analysis
Analysis

Slide 14-12

Learning objective 2: Perform horizontal and vertical analyses of the

balance sheet and the income statement

Prepare a horizontal analysis of the

following condensed balance sheet

Slide 14-13

Learning objective 2: Perform horizontal and vertical analyses of the

balance sheet and the income statement

Vertical
Vertical Analysis
Analysis
Analysis of the balance sheet and
income statement in comparison to a
base amount
Divide each amount by the base
amount to calculate percentage
- For the balance sheet the base
amount is total assets
- For the income statement the base
amount is net sales

Slide 14-14

Learning objective 2: Perform horizontal and vertical analyses of the

balance sheet and the income statement

Vertical
Vertical Analysis
Analysis

Slide 14-15

Learning objective 2: Perform horizontal and vertical analyses of the

balance sheet and the income statement

Vertical
Vertical Analysis
Analysis

Slide 14-16

Learning objective 2: Perform horizontal and vertical analyses of the

balance sheet and the income statement

Horizontal analysis analyzes:

a. Comparable companies
b. Changes in expenses as a percentage of
sales
c. Changes in expenses as a percent of total
assets
d. Changes in balances from one year to
another
Answer: d
Changes in balances from one year to another

Slide 14-17

Learning objective 2: Perform horizontal and vertical analyses of the

balance sheet and the income statement

Prepare a vertical analysis of the

following condensed income statement

Slide 14-18

Learning objective 2: Perform horizontal and vertical analyses of the

balance sheet and the income statement

Prepare a vertical analysis of the

following condensed income statement

Slide 14-19

Learning objective 2: Perform horizontal and vertical analyses of the

balance sheet and the income statement

Earnings
Earnings Management
Management
Accounting numbers can be manipulated
to make performance appear stronger
Allegations of impropriety have been
leveled against:
Slide 14-20

Cendant
Computer Associates
Enron
Kroger
Lucent
Sunbeam
Waste Management
Learning objective 3: Discuss earnings management and the importance of
comparing net income to cash flow from operations

Earnings
Earnings Management
Management
Why do managers manipulate earnings?
- Managers often are evaluated and
rewarded based on the level of earnings
- Managers can benefit from inflated stock
prices
A red flag for earnings management is a
substantial difference between reported
earnings and operating cash flow
- Fictitious sales will not produce cash
- Understated expenses need to be paid

Slide 14-21

Learning objective 3: Discuss earnings management and the importance of

comparing net income to cash flow from operations

Cash
Cash Flow
Flow versus
versus Earnings
Earnings

Slide 14-22

Learning objective 3: Discuss earnings management and the importance of

comparing net income to cash flow from operations

Other
Other Sources
Sources of
of Financial
Financial
Performance
Performance
Management discussion and analysis
Management provides financial statement
users with explanations of financial
results

Credit reports
Number of firms (e.g. Dun & Bradstreet)
provides information on a companys
credit history

Slide 14-23

Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain
insight into a companys current and future financial performance

Other
Other Sources
Sources of
of Financial
Financial
Performance
Performance
News articles
Includes announcements regarding major
company changes which may indicate
problems
Many on-line services are available in
which to conduct a search of news articles:
- Lexis-Nexis provides information for a
fee
- Yahoo! Finance provides free information
- Search the internet using ticker symbol

Slide 14-24

Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain
insight into a companys current and future financial performance

Management
Management Discussion
Discussion &
&
Analysis
Analysis (MD&A)
(MD&A) Example
Example

Slide 14-25

Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain
insight into a companys current and future financial performance

In connection with a companys annual report,

MD&A stands for:
a. Management discussion and analysis
b. More depreciation and amortization
c. Monthly depreciation and
amortization
d. Monthly discounts and advertising
Answer: a
Management discussion and analysis

Slide 14-26

Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain
insight into a companys current and future financial performance

Ratio
Ratio Analysis
Analysis
Profitability ratios
- Reveals a companys ability to generate
profits
Turnover ratios
- Reveals the companys efficiency with
regard to the use of its assets
Debt-related ratios
- Reveals a companys ability to re-pay its
obligations
Slide 14-27

Learning objective 5: Calculate and

interpret profitability ratios

Profitability
Profitability Ratios
Ratios

Slide 14-28

Learning objective 5: Calculate and

interpret profitability ratios

Profitability
Profitability Ratio
Ratio Formulas
Formulas

Slide 14-29

Learning objective 5: Calculate and

interpret profitability ratios

Turnover
Turnover Ratios
Ratios

Slide 14-30

Learning objective 6: Calculate and

interpret turnover ratios

Turnover
Turnover Ratio
Ratio Formulas
Formulas

Slide 14-31

Learning objective 6: Calculate and

interpret turnover ratios

The efficient use of assets is indicated by:

a.
b.
c.
d.

Turnover ratios
Debt-related ratios
The ratio of debt to equity
The ratio of current assets to current
liabilities

Answer: a
Turnover ratios
Slide 14-32

Learning objective 6: Calculate and

interpret turnover ratios

Debt-Related
Debt-Related Ratios
Ratios

Slide 14-33

Learning objective 7: Calculate and

interpret debt-related ratios

Debt-Related
Debt-Related Ratios
Ratios

Slide 14-34

Learning objective 7: Calculate and

interpret debt-related ratios

Too
Too Much
Much Debt
Debt

Slide 14-35

Learning objective 7: Calculate and

interpret debt-related ratios

The ratio times interest earned can be used to

evaluate:
a. The amount of debt versus equity financing
b. The extent to which interest income exceeds
interest expense
c. The extent to which interest expense exceeds
interest income
d. The likelihood that a company will be able to
make required interest payments

Answer: d
The likelihood that a company will be able to make
required interest payments
Slide 14-36

Learning objective 7: Calculate and

interpret debt-related ratios

Ratio
Ratio
Too
Too High
High or
or Low?
Low?

Slide 14-37

Learning objective 7: Calculate and

interpret debt-related ratios

Comparative
Comparative Ratio
Ratio Data
Data

Slide 14-38

Learning objective 7: Calculate and

interpret debt-related ratios

Strategic
Strategic Partners
Partners

Slide 14-39

Learning objective 7: Calculate and

interpret debt-related ratios

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Slide 14-40