- Discuss an overview of financial statement analysis using trends and comparisons [SLIDE 1] All financial statements are historical documents. They summarize what has happened during a particular period. However, most users of financial statements are concerned with what will happen in the future. For example, stockholders are concerned with future earnings and dividends, and creditors are concerned with the company's future ability to repay its debts. While financial statements are historical in nature, they can still provide users with valuable insights. These users rely on financial statement analysis, which involves examining trends in key financial data, comparing financial data across companies, and analyzing financial ratios to assess the financial health and future prospects of a company. The ultimate purpose of financial reporting is to enable managers, creditors, investors, and other interested parties to evaluate a company's financial performance. Users of financial statements therefore need to be familiar with the analytical tools and techniques used in performance measurement and the assumptions that underlie them. Financial statement analysis uses all the techniques available to show how important items in a company's financial statements relate to the company's financial objectives. Persons with a strong interest in measuring a company's financial performance fall into two groups:
  1. A company's top managers, who set and strive to achieve financial performance objectives; middle-level managers of business processes; and lower-level employees who own stock in the company
  2. Creditors and investors, as well as customers who have cooperative agreements with the company
The analysis of a company's financial information typically follows a three-pronged approach. First, trends within a company's own financial information are analyzed, such as sales and earnings from one year to the next, using two methods: trend analysis and common-size analysis. Second, financial measures are compared between competitors. Finally, financial ratios are compared to industry averages. Although financial statement analysis is a useful tool, it has two limitations that should be mentioned before proceeding any further. These two limitations involve:
  1. The comparability of financial data between companies
  2. The need to look beyond ratios
Let's look at the limitations in more detail. [SLIDE 2] Comparisons of one company with another can provide valuable clues about the financial health of an organization. Unfortunately, differences in accounting methods between companies sometimes make it difficult to compare their financial data. For example, if one company values its inventories by the LIFO method and another company by the average cost method, then direct comparisons of their financial data such as inventory valuations and cost of goods sold may be misleading. The analyst should keep in mind any lack of comparability. Even with this limitation in mind, comparisons of key financial ratios with other companies or with industry averages often suggest avenues that can provide useful insights. Ratios should not be viewed as an end, but rather as a starting point. They raise many questions and point to opportunities for further analysis, but they rarely answer any questions by themselves. In addition to ratios, the analyst should evaluate industry trends, technological changes, changes in consumer tastes, changes in broad economic factors, and changes within the company itself. [SLIDE 3] To gain insight into a company's financial performance, one must look beyond the individual numbers to the relationship between the numbers and their change from one period to another. The tools of financial analysis are: These tools are intended to show financial data relationships and changes. [SLIDE 4] Comparative financial statements provide financial information for the current year and the previous year. To gain insight into year-to-year changes, analysts use trend or horizontal analysis, in which changes from the previous year to the current year are computed in both dollar amounts and percentages. The percentage change relates the size of the change to the size of the dollar amounts involved. Horizontal/Trend Analysis shows the changes between years in both dollar and percentage form. As an example, in fiscal years 2005 and 2004, Starbucks had the operating income shown above of $703,870 in 2005 and $547,516 in 2004. While readers of the financial information can see that operating income increased from 2004 to 2005, the exact dollar amount of the change and the percent change is more helpful in evaluating the company's performance. The base year, noted in the equation, is always the first year to be considered in any set of data. For example, when comparing data for 2004 and 2005, 2004 is the base year. The dollar amount of change is calculated as follows: Amount of change = Current year amount – Base year amount $156,354=$703,870−$547,516 Most of us would consider $156,354 to be a huge amount, but the only way to gauge the true significance of this amount for Starbucks is to calculate the percent change from 2004 to 2005. The percent change is calculated as the current year amount minus the base year amount, divided by the base year amount. Percent change = (Current year amount – Base year amount) ÷ Base year amount 28.6% = ($703,870 − $547,516) ÷ $547,516 The calculation above shows operating income increased 28.6 percent from 2004 to 2005. This represents positive results for Starbucks. As we further analyze Starbucks' income statements presented on the slide, we see that net revenues increased by $1,075,053 thousand, or 20.3 percent, while gross margin increased by $661,281 thousand, or 21.3 percent. This indicates that cost of sales did not grow faster than net revenues. In fact, cost of sales increased only 18.9 percent compared with the 20.3 percent increase in net revenues. Starbucks' total operating expenses increased by $504,927 thousand, or 19.8 percent, also not as fast as the 20.3 percent increase in net revenues. As a result, operating income increased by $156,354 thousand, or 28.6 percent, and net income increased by $105,494 thousand, or 27.1 percent. The primary reason for the increases in operating income and net income is that total cost of sales and operating expenses increased at a slower rate (18.9 and 19.8 percent, respectively) than net revenues (20.3 percent). The percentage changes reveal that Starbucks' management has the ability to control its costs while growing the revenue, resulting in faster growth in operating income. [SLIDE 5] As we examine the balance sheet changes for Starbucks, it is important to consider the dollar amount of the change as well as the percentage change in each component. For example, the percentage increase in prepaid expenses and other current assets (32.4 percent) is slightly greater than the increase in inventories (29.3 percent). However, the dollar increase in inventories is more than five times the dollar increase in prepaid expenses and other current assets ($123,636 thousand versus $23,082 thousand). Thus, even though the percentage changes differ by only 3.1 percent, inventories require much more investment. Starbucks' balance sheets for this period show an increase in total assets of $127,524 thousand, or 3.8 percent. This reflects an increase of property, plant, and equipment, net, of $290,603 thousand, or 18.7 percent, while short-term investments decreased by $374,729 thousand, or 73.8 percent. Starbucks is redeploying its assets for growth. In addition, shareholders' equity decreased by $379,577 thousand, or 15.4 percent. Starbucks' equity declined despite an increase in retained earnings because, based on footnotes provided, the company repurchased its common stock during the period. Let's look at the example using Trend analysis. [SLIDE 6] Trend analysis is a variation of horizontal analysis. With this tool, the analyst calculates percentage changes for several successive years instead of for just two years. Because of its long-term view, trend analysis can highlight basic changes in the nature of a business. Many companies present a summary of key data for five or more years in their annual reports. On the slide, we are viewing a trend analysis of Starbucks' five-year summary of net revenues and operating income. Trend analysis uses an index number to show changes in related items over time. For an index number, the base year is set at 100 percent. Other years are measured in relation to that amount. For example, the 2005 index for Starbucks' net revenues is figured as follows (dollar amounts are in thousands): Index = 100 * (Index year amount / Base year amount) = 100 * ($6,369,300 / $2,648,980 = 240.4% The trend analysis in the slide shows that Starbucks' net revenues increased over the five-year period, as did operating income. Overall, revenue grew 240.4 percent, while operating income grew 278.8 percent. The percentage changes reveal that Starbucks' management has the ability to control its costs while growing the revenue, resulting in faster growth in operating income. Let's look at the example using Common-size analysis. [SLIDE 7] Common-size, also known as vertical analysis, shows how the different components of a financial statement relate to a total figure in the statement. The analyst sets the total figure at 100 percent and computes each component's percentage of that total. (On the balance sheet, the figure would be total assets or total liabilities and stockholders' equity, and on the income statement, it would be net revenues or net sales.) The resulting financial statement, which is expressed entirely in percentages, is called a common-size statement . Common-size balance sheets and common-size income statements for our example, Starbucks Corporation, are shown in financial statement form on the slide. Vertical analysis and common-size statements are useful in comparing the importance of specific components in the operation of a business and in identifying important changes in the components from one year to the next. The main conclusions to be drawn from our analysis of Starbucks are that the company's assets consist largely of current assets and property, plant, and equipment; that the company finances assets primarily through equity and current liabilities; and that it has few long-term liabilities. Looking at the common-size balance sheets, you can see that the composition of Starbucks' assets shifted from property, plant, and equipment to current assets. You can also see that the relationship of liabilities and equity shifted slightly from stockholders' equity to current liabilities. The common-size income statements show that Starbucks reduced its operating expenses from 2004 to 2005 by 0.3 percent of revenues (48.3% to 48.0%). In other words, operating expenses did not grow as fast as revenues. Common-size statements are often used to make comparisons between companies. They allow an analyst to compare the operating and financing characteristics of two companies of different size in the same industry. For example, the analyst might want to compare Starbucks with other specialty retailers in terms of percentage of total assets financed by debt or in terms of operating expenses as a percentage of net revenues. Common-size statements would show those and other relationships. These statements can also be used to compare the characteristics of companies that report in different currencies. Now that we have a general overview of financial statement analysis, let's look at financial ratios and how they can further assist with analysis.