Financial Statement Analysis Guided Tutorial (CH 2)

Dr. Kevin Bracker, Dr. Fang Lin and Jennifer Pursley

OBJECTIVE – The purpose of this handout is to walk you through the topic of
financial statement analysis.  This should be used as a supplement to the
online text chapter on Financial Statement Analysis.

LEARNING OBJECTIVES

After completing this tutorial, students should be able to

 Discuss the purpose and key issues associated with the income
statement, balance sheet, and statement of cash flows
 Identify the three components of the statement of cash flows and
interpret each of the three components
 Calculate and interpret key financial ratios
 Calculate and interpret a common size income statement and common
size balance sheet
 Discuss and apply the concept of trend analysis, including both its
strengths and weaknesses
 Discuss and apply the concept of comparative analysis, including both
its strengths and weaknesses
  Identify key users of financial statement analysis
 Identify potential strengths and weaknesses for a firm, given financial
statements for the firm and industry (or competitor)
 Discuss and interpret the many issues associated with financial
statement analysis (such as seasonality, context, etc.)

INTRODUCTION

One of tools that finance professionals have at their disposal for analyzing the
health and performance of corporations is financial statement analysis. 
Financial statement analysis can be used by a variety of people for different
purposes.  Some examples are presented below:

COMPANY (AND COMPETITOR) MANAGEMENT

Company (and competitor) management can use financial statement analysis

to identify the firm’s (or the firm’s competitor’s) strengths and weaknesses.
Knowing this information can improve management’s ability to make strategic
decisions that improve financial performance and the value of the firm.

STOCK INVESTORS

Stock investors (both current stockholders and potential stockholders) can use
financial statement analysis to evaluate the potential risks and rewards of
owning the stock, make forecasts of future performance, and help them
determine if the stock prices are overvalued, undervalued or fairly valued.

SHORT-TERM CREDITORS

Short-term creditors (such as suppliers and banks) can use financial statement
analysis to evaluate the ability of a firm to repay their loans before they extend
credit.

BOND INVESTORS

Bond investors (both current bondholders and potential bondholders) can use
financial statements to evaluate the ability of the firm to make all the
promised coupon payments and the maturity payment at the bond’s maturity.
This can help bond investors decide if the expected return that they anticipate
earning on the bond is sufficient to compensate them for the risk.

All of these parties place their emphasis on different aspects of financial

statements and use different tools to develop the information that helps them
with their decision process.

FINANCIAL STATEMENTS

There are three key financial statements that we will focus on in our coverage
of financial statement analysis – the income statement, the balance sheet, and
the statement of cash flows.  I have included information from these three
statements from the 2017 fiscal year for Wal-Mart (WMT) and Target (TGT)
with data pulled from Yahoo!Finance.  Financial Statements are reported
according to Generally Accepted Accounting Principles (GAAP).  The
advantage of a source like Yahoo!Finance is that they put the reports into a
standard format for easier comparison.  The disadvantage is that they do not
contain the full statements as reported in the annual reports along with the
footnotes.  In order to do a professional-quality financial statement analysis, it
is critical that you read through the annual and/or quarterly reports (10-K and
10-Q documents) so that you know not only what numbers are reported, but
the details behind those numbers.  This information will not be seen in
summary reports like presented in Yahoo!Finance or other common
repositories of financial statement information.

INCOME STATEMENT

The income statement is designed to provide information related to a

company’s revenues (sometimes called sales), expenses, and profits.

The income statement is presented on an “accrual” basis. This means that

revenues are recognized as they are earned and expenses are recognized as
they are incurred.  This is very different from a “cash” basis which looks at
when money is received or spent.  For example, consider a company that
manufactures and sells widgets.  When this company purchases a large piece
of equipment to manufacture their widgets, they will record the expense of the
equipment spread out over its lifetime (usually several years) instead of
recording it when the equipment is purchased.  Now, let’s assume that a
customer purchases 1000 widgets on credit and doesn’t have to pay until 3
months after the purchase.  The revenue is still recorded at the time of the
sale, even though no money was received.  Being aware of these accrual
concepts and their implications is very important from a finance perspective
because in finance we are focused on cash.  While accrual accounting does a
good job of capturing a firm’s performance, it can distort timing and have an
impact on valuation analysis due to the time value of money.

The income statement captures a firm’s performance OVER time. This means

that all transactions during the period are treated equally regardless of when
they occur within the period.  For instance, if I am preparing an annual
income statement, sales made at the start of the year are no different than
sales made at the end of the year.  All transactions related to revenues and
expenses are a part of the income statement as long as they occurred in the
period.

BALANCE SHEET

The balance sheet is designed to capture information about a firm’s assets,

liabilities, and equity at a point in time.

 Assets represent things the firm has. These can be long-term assets
(such as property, plant, and equipment) or current assets (such as cash,
accounts receivable, and inventory).
 Liabilities represent what the firm owes and can also be long-term (such
as bonds the firm has issued) or short-term (such as short-term loans,
accounts payable, or accruals).
 Owners’ equity represents what belongs to the shareholders. This is
often broken down into what was originally contributed when the firm
issued the shares and retained earnings (profits that have not been paid
out in dividends – note that retained earnings are an accounting tool
and do not represent cash that the company is holding).

A fundamental relationship in the balance sheet is the following formula 

Assets = Liabilities + Owners’ Equity. Firms finance their assets through debt
(liabilities) or equity.  Everything that the firm has (its assets) minus its debt
obligations (liabilities) belongs to the stockholders (equity).

The Balance Sheet tends to understate the true value of the firm’s assets (and,
in turn, the equity). The reason for this understatement comes from a couple
of sources:
Assets are reported on the balance sheet at historical cost minus
accumulated depreciation. This may be different than the market value of
the asset.

Some assets (such as land) tend to appreciate in value over time.

Some assets do not depreciate on an economic basis as fast as they do on an

accounting basis.

Some assets are more valuable in their cash-flow generating capability as they
are employed by the firm then what the firm paid for them.

Intangible Assets are not recorded on the balance sheet unless they
are purchased (such as in an acquisition). Intangible assets are things like
brand name, copyrights, patents, etc.  They have important economic value in
that they help firms generate cash flows, however they typically are not
purchased and therefore are hard to value from an accounting standpoint. 
(Note – Both Pepsi and Coca-Cola have Goodwill and Other Intangible Assets
on their Balance Sheets.  These are primarily derived from purchases of many
smaller companies over their corporate lives and are not capturing the FULL
value of the intangible assets these companies possess.)

For many companies, their brand name and reputation are among their most
valuable assets. Consider a company like Nike.  People pay more for their
products partially due to the brand name.  Coke sells for more than generic
cola because people identify with the name brand.

Patents and copyrights can be valuable due to the pricing power that they
provide, however, the value of these will vary significantly based on the
specific patent and copyright. Some may be worth millions and others may be
virtually worthless.

Some activities that are treated as expenses (such as marketing, research and
development, employee training, etc.) can create intangible assets.

The Balance Sheet reflects a POINT IN TIME. It represents the firm’s

assets, liabilities, and equity on a specific date.  If a firm makes its payroll
payment one day before the balance sheet is prepared, the cash account may
appear low.  If it is ready to make the payroll payment one day after the
balance sheet is prepared, the cash account may appear high.  Several items on
the balance sheet (mainly current assets and current liabilities) will vary
significantly throughout the year, so the seasonality factor in balance sheets
will be high.  Also, if a firm borrows a large sum of money one week after the
fiscal year starts and pays it back one week before the fiscal year ends, this
transaction will not have any direct impact on the annual balance sheet.

THE STATEMENT OF CASH FLOWS

The Statement of Cash Flows is designed to present the firm’s income on a

cash basis and to show where cash flows came from and went to during the
period.

The Statement of Cash Flows has three main components – Cash Flows from
Operating Activities, Cash Flows from Investing Activities, and Cash Flows
from Financing Activities.

Cash Flows from Operating Activities

CF from Operating Activities measures the firm’s operating income on a cash

flow basis.

Starts with net income and then adjusts to remove accrual-based impacts.

For a healthy company, we want to see this be positive and growing over time.
If a company cannot earn positive cash flows from its operating activities, it
will not be able to stay operational over time.  Also, companies strive for
growth.  If it is not positive and growing over time, we want to see (A) a
reasonable explanation and (B) a plan for moving towards a positive and
growing cash flow from operating activities.

Often, young firms lose money during their first few years. If the firm has
negative CF from operating activities due to it being young, it is important that
we see the values moving towards a positive level.  We also want to make sure
the firm has enough capital and/or access to additional capital to stay alive
until it starts generating positive cash flows from operating activities.

Sometimes when there are industry problems or the economy enters a

recession, many normally healthy companies will see a decline in (or even
negative) CF from operating activities. If this happens, we want to make sure
that it is a short-term issue and is correctable.

Cash Flows from Investing Activities

CF from Investing Activities looks at cash outflows associated with purchasing
new property, plant and equipment (PPE) along with other long-term
investments. Also, cash inflows from selling existing PPE and other LT
investments will fall in this category.

Cash Flows from Investing Activities will typically be negative for almost every
company. In order to grow over time, companies need to spend on long-term
assets which causes the cash outflows in this category to outweigh cash inflows
in most cases.  However, if CF from Investing Activities is growing more
negative over time without seeing CF from operating activities also increasing
at the same rate or better, this is likely a problem.

Cash Flows from Financing Activities

CF from Financing Activities looks at cash outflows from repaying existing

debt, buying back shares of stock, and paying dividends along with cash
inflows from issuing new debt or issuing new shares of stock.

CF from Financing Activities often tells us more about where a company is in

its life cycle than it does about the company’s health (although negative cash
flows from financing activities are preferred to positive values, all else equal).

Young firms will typically have positive CFs from Financing Activities as they
are spending more on LT investments than they are bringing in from
operations. This difference must be financed by borrowing or issuing new
equity.

Rapidly growing firms will typically have positive CFs from Financing
Activities as they are spending significant amounts on Property, Plant, and
Equipment and other LT Investments to support the growth. Often, not all of
this growth can be financed from operating CFs and must come from
financing.

Older, established firms will typically have negative CFs from Financing
Activities as they are generating significant CFs from Operating Activities and
can use the excess cash to pay off existing debt, buy back existing shares of
stock, or pay dividends.

Financial Statements for Walmart & Target from Appendix B

FINANCIAL RATIOS

In addition to this handout, the chapter includes a list of key financial ratios
along with their formulas.  Also see Explanation of Ratios in Appendix B for
explanations and interpretations of these ratios.  Note that the ratios covered
in this class are a subset of financial ratios and not an inclusive list.  Financial
ratios are a tool that allows us to use information from the Income Statement
and Balance Sheet to look at specific issues associated with a company’s
financial health.  Using the Wal-Mart and Target financial statements, we have
prepared ratios for their fiscal years 2017 through 2020.  We would encourage
you to calculate at least one year of these ratios for practice).  Here are the
results of all the ratio calculations:

Financial Statements for Walmart & Target from Appendix B

When conducting analysis of Wal-Mart, having the financial ratios for Target
is critical for comparative analysis (ideally you would use the industry
averages, however in this situation Target makes a nice comparison as they are
a similar competitor).  Also, we have included four years of data so that we can
do some trend analysis.  Be sure to read the online text for more discussion on
trend analysis and comparative analysis.  Both trend and comparative analysis
are essential for providing some of the context necessary for financial
statement analysis.  Note that we say “some” of the context, as it is also
important to really understand the specific companies under analysis, their
strategies, and the overall economy to get the most out of looking at ratios and
common size statements.
COMMON SIZE STATEMENTS

Common Size Statements are designed to present each line item in the income
statement as a percentage of total revenues and each line item in the balance
sheet as a percentage of total assets.  This makes it easier to compare changes
from year to year and from one company to the industry.  For instance, below
you will find common size income statements and common size balance sheets
for Wal-Mart and Target.  Be sure you understand how these statements are
generated.

Financial Statements for Walmart & Target from Appendix B

When you look at these statements, you can quickly see two important pieces
of information.  First, Wal-Mart has seen their cost of sales increase over the
first three years and then decrease in the last year (albeit only slightly) which
indicates that Wal-Mart is taking steps to manage their costs.  The second
item is that Target’s cost of sales is much lower than Wal-Mart’s each year. 
These comparisons are much easier to see on a percentage basis than they
would be when just looking at the dollar values in the original financial
statements.  As a potential investor (or management), the next step would be
to try to understand what is driving this.  Is Wal-Mart doing a better job of
negotiating terms with suppliers?  Is there ordering and distribution system
resulting in more efficient inventory management?  Are they able to raise
prices slightly?  Is Target more efficient than Wal-Mart with respect to
inventory costs or are they able to charge higher prices?  Remember that
financial statement analysis doesn’t really identify and fix specific problems. 
Instead, it is a starting point that tells us where there MIGHT be a problem. 
Once we dig deeper we can then identify if there is a problem and how we
might go about trying to address it.  We will come back to these specific
concerns with cost of sales in a little bit.

One issue that you will often find when developing common size statements
for comparative analysis is that most companies follow slightly different
formats for their income statements and balance sheets.  In order to create
common size statements for comparative analysis, there are two approaches. 
One is to obtain financial statements from a source such
as finance.yahoo.com (as I did for this handout) which standardize all financial
statements into a standard format.  Alternatively, you can obtain the financial
statements from each firm’s annual report and make your own judgments as
to how to form them into a standard format.  While the first approach is
easier, if you are doing a formal financial statement analysis, it is essential that
you do read through the financial statements in their annual report rather
than just pull up the statements from a source like Yahoo!Finance.  The reason
for this is that the annual report will explain all the accounting issues
associated with the numbers so that you can better understand the story
behind the numbers.

ANALYSIS USING FINANCIAL RATIOS AND COMMON SIZE

STATEMENTS

Conducting financial statement analysis using ratios and common size

statements is as much of an art form as it is a science.  These tools provide us
with a quick way to skim the surface and identify areas that need to be
explored in further detail.  Contrary to popular opinion, the ratios and
common size statements are the STARTING points for identifying
strength/weaknesses, not the ENDING points.  They help raise red flags over
stuff that needs further investigation and identify POTENTIAL strengths and
weaknesses.  There are many reasons why something that appears to be a
weakness may not really be a problem for the firm or something that appears
to be a strength be more illusion than real competitive advantage.  As has been
stated a few times previously, it is critical that you understand the story
behind the numbers (the context) in order to adequately use them.

A QUICK EXAMPLE OF RATIO/COMMON SIZE ANALYSIS FOR

WAL-MART

Let’s look at Wal-Mart and do a quick glance for potential strengths and
weaknesses using ratios and common size statements.

POTENTIAL WEAKNESSES

Selling, General and Administrative Costs

Over the four-year time frame, Wal-Mart has seen their SGA costs decrease
from 21.3% of sales to 20.8% of sales. While this is not a huge movement, keep
in mind these lower costs directly impact the final margin.  As Wal-Mart’s net
profit margin was 2.4% or more each of the last two years, it is easy to see that
this decline in SGA expenses is having a noticeable impact on the bottom line. 
Also, while Wal-Mart had more than a 150-basis-point (100 basis points = 1%)
disadvantage in SGA relative to one of their larger rivals (Target) at the start of
the analysis period, it was able to close the gap in the following years. This is
another indication that SGA costs are a concern for Wal-Mart.  Now, the key is
to figure out why these costs are declining.  Is it a sign of efficiency or is Wal-
Mart intentionally decreasing spending in this area but lose other advantages?

Accounts Payable

We want to be careful calling this a “weakness” as having higher accounts

payable could be a sign that we are struggling to repay our inventory
purchases or it could be a strategy to improve our cash flow (by hanging onto
our cash a little longer).  However, the fact remains that the accounts payable
as a percent of assets has been increasing over the last few years.  It would be
worthwhile for analysts to get a good understanding of why.

Profitability Ratios
As mentioned earlier, Wal-Mart has seen its SGA expenses decline as a
percentage of sales.  This in turn has had a positive impact on their
profitability ratios.  The net profit margin (which we can see as both a ratio or
in the common size statements) has improved (albeit in a volatile way) over
the four-year window.  Their return on assets and return on equity have also
increased over this time-period.  While we know the key reason for the
increase in profitability (lower SGA expenses) it is not clear whether the trend
can continue.  That said, awareness of the issue can be useful to
management/investors.

Net Income

Wal-Mart has seen their net income decline by more than 30% in FY2018 with
a dramatic rebound in FY2019 and FY2020. While part of the volatility can be
explained by the COVID-19 pandemic, this is still something that should draw
the attention of both management and current/potential stockholders.

POTENTIAL STRENGTHS

Days Sales Outstanding

If we look at Wal-Mart’s DSO ratio, we can see a couple of things.  First, the
ratio itself is quite low as it takes them less than 5 days on average to collect
their credit sales. Second, it also has declined over the past few years.

Inventory Turnover

Wal-Mart has seen their inventory turnover ratio increase slowly over each of
the past four years.  Importantly, it is also significantly higher than one of
their primary competitors (Target).  This indicates that Wal-Mart does a good
job of moving through their inventory and not building up excess inventory. 
Maintaining a high inventory turnover ratio helps avoid spoilage costs and
frees up financing costs as the firm has less time with “dead” money invested
in inventory that is either sitting on store shelves or in the warehouse.

Fixed and Total Asset Turnover

While there is a slight downtrend in the asset turnover ratios, the real
advantage is seen in comparison to Target.  Wal-Mart does a much better job
of generating sales from its investment into assets.  One thing that should be
noted is that some of this could be tied to strategy.  Remember that Wal-Mart
had a notably higher cost of sales than Target did.  One explanation for this is
that Wal-Mart is pursuing a lower-margin, higher-turnover strategy while
Target is pursuing a higher-margin, lower-turnover strategy.  This is not an
argument that one strategy is better than another, but instead is a way for the
two firms to create a little differentiation in their markets.

Cash Flow from Operating Activities

While Wal-Mart’s net income has declined noticeably over the past two years,
their cash flow from operating activities has increased rather significantly over
the past three years. Given some of our issues with net income, this may be
more relevant.  On the other hand, it may be a little misleading.  For example,
over the past year, Wal-Mart has seen their inventory drop by a little over a
billion dollars and their liabilities increase by about $5.5 billion.  Are those
sustainable changes?  Probably not.  This may lessen the importance of the
increase in cash flow from operating activities over the past year and without
those changes, we could be looking at a net decline over the past two years.

OTHER

From the cash flow from financing activities portion of the statement of cash
flows, we can see that both firms have been active in buying back shares of
their own stock over the past few years. This is not a strength or weakness, but
a way to return cash to shareholders (in that these firms use buybacks as a
partial substitute to paying higher cash dividends).

Similarly, both companies have been engaged in retiring their debt over the
past few years, although Wal-Mart had a big net increase in debt in FY 2018.
The fact that cash flow from operating activities has been significantly higher
than the outlays these firms have allocated to cash flow from investing
activities, they have had significant ability to pay dividends, buy back shares of
stock, and pay back portions of their long-term debt.

OTHER ISSUES WITH FINANCIAL STATEMENT ANALYSIS

SEASONALITY

When dealing with quarterly financial statements, we must be aware that

many firms face seasonal patterns that can cause the numbers to behave
strangely. Be careful to compare quarter one of this year with quarter one of
last year instead of the previous quarter when you have significant seasonality.

Quarterly income statements, quarterly balance sheets, and annual balance

sheets all have seasonality. When calculating ratios using inputs from any of
these statements, we must be aware of seasonality.

While firms in the same industry will often have similar seasonal patterns, it is
important to watch the fiscal year. A fiscal year is different from the calendar
year and some firms end their fiscal year at the end of December while others
end their fiscal year at the end of January or March.  If firms have different
fiscal years, their ratios and common size statements may not be comparable.

ACCOUNTING DIFFERENCES

While all firms use GAAP, there is a lot of flexibility in applying GAAP.
Different depreciation approaches, inventory methods, etc. can cause two
firms with similar levels of business activity appear to have different levels of
profitability.  The better you understand financial accounting, the better you
will be able to dig into a company’s financial statements and understand
exactly how comparable the ratios are across firms.

INDUSTRY DIFFERENCES ARE NOT ALWAYS CLEAR

While Wal-Mart and Target have a lot of overlap in their primary business
activities, they also have some differences. Be careful when comparing firms
that the difference in the ratio or common size statement is not caused by non-
comparable differences.  This is where a thorough understanding of the
company comes in.  We discussed above how the differences in cost of sales
and turnover ratios could be related as much to strategy differences as they are
to differences in the underlying performance.  The best way to find out about
this is read each company’s annual/quarterly reports (10-K and 10-Q), listen
to conference calls made during quarterly earnings announcements, and pay
attention to all aspects of the companies.  Good financial statement analysis
involves a lot of digging and attention to detail, not just number crunching.
When dealing with large, dominant firms, it is difficult to compare them to
industries because they may dominate the industry and/or operate in many
different industries. This is why it may be better to compare Wal-Mart to
Target rather than industry averages.  If I compare Wal-Mart to the industry
average, those numbers are going to be heavily influenced by Wal-Mart’s
numbers as Wal-Mart makes up a large portion of the industry.

NUMBERS CAN BE DIFFICULT TO INTERPRET

Consider the low current ratios for Wal-Mart (and Target as well). They
appear to be struggling to meet their liquidity demands when looking at the
current ratio.  However, one of the reasons for a low current ratio is that they
have high inventory turnovers and they know that they will quickly be able to
generate the cash necessary to pay off their current liabilities.  Another issue is
that they are a very profitable company with predictable cash flows, so they
don’t need much of a cash “cushion” to keep them safe from downturns.  This
allows them to move more cash into long-term assets which earn a higher
return or to return that cash to investors through dividends and stock
buybacks.  What appears to be a liquidity problem, is likely more of a strategic
decision to keep current assets low and invest more capital into long-term
assets which can be more productive.

REAR VIEW MIRROR

Finance focuses on future expectations and financial statements describe past

performance. This does not mean that financial statement analysis is
meaningless.  It is hard to understand where you are going if you don’t know
where you have been.  Financial statement analysis can help us see potential
problems as they are developing so we can correct them (if we are
management) or avoid them (if we are investors).   However, we must be
aware that things can change quickly in the business world.  What was a
strength six months ago when the financial statements were prepared may
very well be a weakness today.  Always be digging for new, updated
information to avoid being blindsided by major, unexpected changes when
new financial statements are released.

Companies change management and corporate strategies. New competitors

enter the industry or existing competitors leave the industry.  Technology and
legal aspects change.  Economic conditions change.  All of these things can
make it hard to use past financial statements to make forecasts about the
future.  Again, it doesn’t mean that we ignore financial statement analysis. 
Instead it means we must be aware of the limitations and recognize that the
numbers are a part of the story and not the story itself.

CONTEXT IS CRITICAL

Any financial ratio without the proper context is close to meaningless. Think
of the following analogy.  Imagine you go into a doctor for a health checkup. 
One important piece of information for the doctor is your weight.  However, if
the doctor were to see a chart of “Patient X” and find out that the patient is 150
pounds, that information by itself is not very valuable.  Is the patient a 6’6”
30-year old male or a 4’2” 12-year old female?  Did the patient weight 135
pounds, 150 pounds, or 200 pounds 6-months ago?  All of the vital
information that the doctor collects (temperature, allergies, symptoms, blood
pressure, etc.) are used together to help diagnose the health of the patient. 
Any one of these pieces of information without context is not very useful by
itself.  Financial ratios are very similar.

RATIOS AND COMMON SIZE STATEMENTS

ARE INITIAL DIAGNOSTIC TOOLS

Similar to the item above regarding context, a medical analogy is helpful.

When you go into a doctor with a set of symptoms, the doctor gathers
information on you and your symptoms to get an idea of what MIGHT be
wrong.  Then, unless it is something common, the initial diagnosis is used as
the basis for further testing and examination to find out what is really wrong. 
Ratios and common size statements are similar.  They can be used to raise
“red flags”, but we want to be careful to remember that they identify areas that
need further investigation more than they clearly identify strengths and
weaknesses.