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Financial Statement Analysis Transcript
Speakers: Host, Paul Kimmel, PhD, CPA
HOST: Why should someone learn the basics of financial statement analysis?
PAUL KIMMEL: Well, let me give you a few examples from Wall Street Journal headlines that I think really highlight why students need to be familiar with some basic financial statement analysis concepts. For example, one Wall Street Journal headline, if you take a look, says “U.S. Small-Cap Shares Look Pricey.”
Well what does it mean? How do – how does an analyst know whether something is pricey or not pricey? What does that mean? You have to have some reference in order to understand whether or not something is pricey or not.
Another example, Amazon which is frequently in the financial press because people are constantly speculating whether or not Amazon’s, you know, priced fairly or too high or too low, and the headline said “Amazon’s Valuation is Hard to Justify.” Well, again, in order to justify the price, you need to understand the basics of, you know, how is the price determined? How does an analyst look at that?
Another great headline in the Wall Street Journal was that “Facebook Shows There is a Sucker Born Every Minute,” okay? Well again that – when Facebook initially issued its sharers, that there were an awful lot of people that were surprised at the change in the stock price after it was issued.
Then lastly “For Bubble 2.0, Try Security Analysis 1.0.” And that article really brought home the idea of why people need to understand the basics of security analysis.
HOST: What financial attributes do we typically measure?
PAUL KIMMEL: We emphasize three main attributes, the first being liquidity. Liquidity is the ability to meet your short – pay your short-term obligations. The second attribute we look at is solvency. Solvency relates to your ability to meet your long-term obligations and to survive in the long-term. And lastly we look at profitability and profitability is simply measuring how well the company performed during a period of time. How did they make their money and how much money did they make?
HOST: Can you discuss some examples of ratios used by managers in this course?
PAUL KIMMEL: Let me give you three examples; one example from each of the types, the first being liquidity ratio. And the most commonly referred to liquidity ratio is the current ratio. In fact, many times you will see the requirement for the current ratio within a debt covenant. The current ratio is simply current assets divided by current liabilities.
The one thing that is very important for students to understand is that you want to have an intuitive understanding of these ratios. And so if you think about it, there really isn’t anything more intuitive than the current ratio. That if you’re paying your bills, your short-term bills, you’re going to pay those bills using current assets, and the obligations are measured by current liabilities. And so if you divide current assets by your current liabilities, you’re getting an indication of your ability to meet your short-term needs.
For solvency which is your ability to pay your long-term obligations and survive in the long-term, a measure that we refer to frequently in the book is the debt to assets ratio. You are dividing your total debt by your total assets. What that indicates is how much of your assets were financed using debt financing versus equity financing. The more heavily you’re relying on debt financing, the riskier your company is, and therefore the lower your solvency.
Lastly, one of the most common profitability ratios is the return on assets ratio. The return on assets ratio is net income divided by total assets. Again, this is a very intuitive measure because if I tell you that I made a million dollars this year, well, you don’t really know whether that million dollars is a good number or a bad number until you know, well, how many assets did you need to use in order to generate that million dollars? So if I divide my net income by my total assets, I get a very good, very intuitive measure of how efficient and effective I am in terms of generating income.
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