Introduction to Financial Statement Analysis

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Introduction to Financial Statement Analysis

Learning Objectives

After studying this chapter, you should be able to:

1 Explain the purpose of financial statement analysis.

2 Understand the relationships between financial statement numbers and use ratios in analyzing and describing a company's performance.

3 Use common-size financial statements to perform comparison of financial statements across years and between companies.

4 Understand the DuPont framework and how return on equity can be decomposed into its profitability, efficiency, and leverage components.

5 Use cash flow information to evaluate cash flow ratios.

6 Understand the limitations of financial statement analysis.

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Setting the Stage

chapter 5

In 1987, IBM was the most valuable company in the world, worth an estimated $105.8 billion. By the end of 1992, IBM had an estimated value of $28.8 billion. This decline in value can be traced to a strategic error made by IBM in the early 1980s. Prior to 1981, IBM was the major player in the computer market and was the primary provider of computers for government, universities, and businesses. At this time, believe it or not, virtually no computers were available at an affordable price for individuals. Then, in 1981, IBM introduced its personal computer (IBM PC), and it quickly established the standard by which other PCs would be measured. However, IBM elected to leave the software development for PCs to other companies. Instead of developing its own disk operating system (DOS), IBM elected to use a DOS developed by a small company located in Seattle--MICROSOFT.1

Microsoft was founded in 1975 by Bill Gates and Paul Allen.2 When they founded Microsoft, Gates and Allen envisioned that computers would eventually find their way into everyday life (contrary to IBM's prediction in the 1950s when one IBM executive forecast the total worldwide demand for computers to be about five). While IBM's performance floundered in the mid- and late-1980s, Microsoft demonstrated an amazing ability to become a major player in practically every aspect of the computer software market--from operating systems to the Internet to networks to spreadsheets and word processors.

With Microsoft's many accomplishments comes the question: "Just how successful is the company?" The answer to that question depends on how you define "success." Measured in terms of number of employees, Microsoft has grown from just 32 employees in 1981 when IBM elected to use Microsoft's DOS to 50,500 as of the June 30, 2002, fiscal year. In terms of social impact, Microsoft and its employees donate millions of dollars each year to such charitable causes as Special Olympics, Boys and Girls Clubs, and the United Negro College Fund. Microsoft also supports elementary and

high schools throughout the country in their efforts to incorporate technology into the curriculum, and the company has established scholarship programs to encourage minorities and women to pursue careers in computer science and related technical fields. In addition, Bill Gates and his wife Melinda have started a foundation dedicated primarily to health and education. Thus far they have contributed several billion dollars to their foundation.

FYI:

In fact, many people are of the opinion that Microsoft has succeeded too well. Several of Microsoft's competitors allege that Microsoft is involved in monopolistic practices that stifle competition.

In terms of stock price, Microsoft's per-share stock price (adjusted for stock splits) has gone from $0.10 in 1986 to almost $26 in April of 2003 (see Exhibit 1). But as the graph illustrates, Microsoft's stock price is down from its historic high of over $58 per share in 1999. An analysis of Microsoft's financial statements reveals some of the reasons for the declining stock price. That is the topic of this chapter--an introduction to financial statement analysis. With some basic analysis tools (called ratios), we will be able to conduct some fundamental analysis of a company's financial statements. Our analysis will provide us with insights as to a company's performance and will help us identify areas of concern. Keep in mind that this is merely an introduction to financial statement analysis. There are entire textbooks devoted to the analysis of financial statements. Our objective here is to expose you to some of the basic tools to help you start to understand what financial statements can tell us about the operations of a business. To illustrate the analysis techniques introduced in this chapter, we will reference the financial statement of Microsoft included in Appendix A.

1 The decision to have another company develop the software for its personal computer was not IBM's only strategic error. At the same time, IBM decided to use another company's microprocessors--the "brains" of the computer. As a result, another successful company was born--INTEL. IBM lost the opportunity to dominate the software market as well as the computer chip market. By September 2003, Microsoft, Intel, and IBM had market values exceeding $317 billion, $187 billion, and $158 billion, respectively.

2 Everybody knows Bill Gates, but few people know about Paul Allen. Allen was Microsoft's head of research and new product development until 1983 when a serious illness caused him to leave the company. He now spends much of his time investing in technology companies and watching the Seattle Seahawks, a professional football team, and the Portland Trailblazers, a professional basketball team, both of which he owns.

204 Part 1 Financial Reporting and the Accounting Cycle

Exhibit 1: History of Microsoft's Stock Price per Share 60.00 50.00 40.00 30.00 20.00 10.00 0.00 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

The Need for Financial Statement Analysis

1 Explain the purpose of financial statement analysis.

financial statement analysis The examination of both the relationships among financial statement numbers and the trends in those numbers over time.

Consider the following questions related to financial statement information for MICROSOFT in 2002:

? Microsoft's net income in 2002 was $7.829 billion. That seems like a lot, but does it represent a large amount for a company the size of Microsoft?

? Total assets for Microsoft at the end of 2002 were $67.646 billion. Given the volume of business that Microsoft does, is this amount of assets too much, too little, or just right?

? By the end of 2002, Microsoft's liabilities totaled $15.466 billion. Is this level of debt too much for Microsoft?

The important point to recognize is that just having the financial statement numbers is not enough to answer the questions that financial statement users want answered. Without further analysis, the raw numbers themselves don't tell much of a story.

Financial statement analysis involves the examination of both the relationships among financial statement numbers and the trends in those numbers over time. One purpose of financial statement analysis is to use the past performance of a company to predict how it will do in the future. Another purpose is to evaluate the performance of a company with an eye toward identifying problem areas. In sum, financial statement analysis is both diagnosis-- identifying where a firm has problems--and prognosis--predicting how a firm will perform in the future.

Introduction to Financial Statement Analysis Chapter 5 205

financial ratios Relationships

Relationships between financial statement amounts are called financial ratios. Net in-

between financial statement amounts.

come divided by sales, for example, is a financial ratio called return on sales, which tells you how many pennies of profit a company makes on each dollar of sales. The return on sales for

Microsoft is 27.6%, meaning that Microsoft makes 28 cents' worth of profit for

FYI:

Financial information is almost always compared to what was reported in the previous year. For example, when Microsoft publicly announced on April 15, 2003, that its quarterly revenues were $7.84 billion, the press release also stated that this amount represented an 8% increase over the same period in the prior year.

every dollar of product sold. There are hundreds of different financial ratios, each shedding light on a different aspect of the health of a company.

Exhibit 2 illustrates how financial statement analysis fits into the decision cycle of a company's management. Notice that the preparation of the financial statements is just the starting point of the process. After the statements are prepared, they are analyzed using techniques akin to those to be introduced in this chapter. Analysis of the summary information in the financial statements usually doesn't provide detailed answers to management's questions, but it does identify areas in which further data should be gathered. Decisions are then made and implemented, and the accounting system captures the results of these deci-

sions so that a new set of financial statements can be prepared. The process then

repeats itself.

FYI:

For external users of financial statements, such as investors and creditors,

Financial statement analysis often points to areas in which additional data must be gathered, including details of significant transactions, market share information, competitors' plans, and customer demand forecasts.

financial statement analysis plays the same role in the decision-making process. Whereas management uses the analysis to help in making operating, investing, and financing decisions, investors and creditors analyze financial statements to decide whether to invest in, or loan money to, a company.

In analyzing a company's financial statements, merely computing a list of financial ratios is not enough. Most pieces of information are meaningful only

when they can be compared with some benchmark. For example, knowing that

Microsoft's return on sales in 2002 was 27.6% tells you a little, but you can evaluate the ratio

value much better if you know that Microsoft's return on sales was 29.0% and 41.0% in 2001

and 2000, respectively. In short, the usefulness of financial ratios is greatly enhanced when they

are compared with past values and with values for other firms in the same industry.

T O S U M M A R I Z E : Financial statement analysis

is used to predict a company's future profitability and cash flows from its past performance and to evaluate the performance of a company with an eye toward identifying prob-

lem areas. The informativeness of financial ratios is greatly enhanced when they are compared with past values and with values for other firms in the same industry.

Exhibit 2: The Need for Financial Statement Analysis

Prepare Financial statements

Analyze Financial statements

Gather Additional information

Make Decisions ? Operating ? Investing ? Financing

Implement Decisions and

Observe Results

b u s i n e s s environment

Market Efficiency: Can Financial Statement Analysis Help You Win in the Stock Market? An efficient market is one in which information is reflected rapidly in prices. For example, if the real estate market in a city is efficient, then news of an impending layoff at a major employer in the city should result quickly in lower housing prices because of an anticipated decrease in demand. The major stock exchanges in the United States often are considered to be efficient markets in the sense that information about specific

companies or about the economy in general is reflected almost immediately in stock prices. One implication of market efficiency is that because current stock prices reflect all available information, future movements in stock prices should be unpredictable.

It seems clear that capital markets in the United States are efficient in a general sense, but accumulated evidence suggests the existence of a number of puzzling "anomalies" in the form of predictability in the pattern of stock returns. For example, prices tend to continue to drift upward for weeks or months after favorable earnings news is released. In addition, prices continue to climb for at least a year after a stock split is announced.

Widely Used Financial Ratios

2 Understand the relationships between financial statement numbers and use ratios in analyzing and describing a company's performance.

debt ratio A measure of leverage, computed by dividing total liabilities by total assets.

Before diving into a comprehensive treatment of financial ratio analysis, we'll first get our feet wet with the most widely used ratios. Familiarity with financial ratios will allow you to hold your own in most casual business conversations and will enable you to understand most ratios used in the popular business press. Data from Microsoft's 2002 financial statements will be used to illustrate the ratio calculations. The data are displayed in Exhibit 3.

Debt Ratio

Comparing the amount of liabilities with the amount of assets indicates the extent to which a company has borrowed money to leverage the owners' investments and increase the size of the company. One frequently used measure of leverage is the debt ratio, computed as total liabilities divided by total assets. An intuitive interpretation of the debt ratio is that it represents the proportion of borrowed funds used to acquire the company's assets. For Microsoft, the debt ratio is computed as shown on the following page.

Exhibit 3: Selected Financial Data for Microsoft for 2002

Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stockholders' equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Market value of shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

*All numbers are in millions of dollars.

$ 48,576* 67,646 12,744 15,466 52,180 28,365 7,829

293,137

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