Limitations of Financial Statements Analytical Review

Question Description

what are some limitations of financial statements analysis? Meaning, what are some things which make financial statement analysis less reliable? Do some research on this and post your thoughts on what you find.

1 Chapter Twenty-One Analyzing Financial Statements After completing this chapter, you should be able to: 1 Explain the objectives of financial statement analysis. 2 Describe and use the following four analytical techniques: horizontal analysis, trend analysis, vertical analysis, and ratio analysis. 3 Explain the importance of comparisons and trends in financial statement analysis. 4 Prepare and interpret common-size financial statements. 5 Define and compute the various financial ratios discussed in the chapter. CONTEMPORARY INTERIORS TO GO NATIONAL Chicago, IL—Contemporary Interiors, a Chicago tradition in Scandinavian furniture and contemporary design, has announced a decision to go national. Although Contemporary Interiors has opened stores throughout the Midwest in recent years, the company has remained a regional business with the bulk of its sales in the greater Chicago area.

Yesterday, however, a company spokesman announced that Contemporary Interiors’ Board of Directors had decided the time was right to make the next move. Marc Janson, spokesman for the firm’s president and CEO, pointed to the strong economy and consumer confidence as being key to the decision. “Disposable income is up, and we’re seeing that in our business,” said Janson. “Even more important, though, is our company’s strong financial position. The analysts tell us that our financial statements look good. Our working capital, inventory turnover, return on assets, and so forth are all strong. This will be important, because in order to expand, the company’s going to have to raise capital.

And the bankers and potential investors are going to need to see those strong financial indicators. The board hasn’t decided yet how much of our new capital needs should be debt and how much should be in stock. I’m sure they’ll keep a close eye on the debt-equity ratio.” When asked where Contemporary Interiors’ next store would appear, Janson replied that New York, Atlanta, and San Francisco were all under consideration. 44 Chapter 21 Analyzing Financial Statements Financial statements provide the primary means for managers to communicate about the financial condition of their organization to outside parties. Managers, investors, lenders, financial analysts, and government agencies are among the users of financial statements. Substantial information is conveyed by financial statements about the financial strength and current performance of an enterprise.

Although financial statements are prepared primarily for users outside an organization, managers also find their organization’s financial statements useful in making decisions. As managers develop operating plans, they think about how those plans will affect the performance of the organization, as conveyed by the financial statements. In this chapter, we explore how to analyze financial statements to glean the most information about an organization. Overview of Financial Statements Overview of Financial Statements There are four primary financial statements: 1. 2. 3. 4. Balance sheet Income statement Retained earnings statement Statement of cash flows Exhibit 21–1 presents the basic structure of each of these statements and the relationships between them. The balance sheet presents an organization’s financial position at a point in time. It shows the balances in the organization’s assets, liabilities, and owners’ equity, as of the balance sheet date. The other three financial statements depicted in Exhibit 21–1 relate to a period of time. The income statement reports the income for the period between two balance sheet dates. The retained earnings statement shows how income and dividends for the period have changed the organization’s retained earnings. The statement of cash flows shows how cash was obtained during the period and how it was used. In this chapter, we will concentrate on analyzing the data conveyed by the balance sheet, the income statement, and the retained earnings statement. In the preceding chapter, we explored how the statement of cash flows is prepared and used. Objectives of Financial Statement Analysis Objectives of Financial Statement Analysis Financial statements are based on historical accounting information, which reflects the transactions and other events that have affected the firm.

Managers and other users of the firm’s financial statements are interested in the future. The objective of financial statement analysis is to use historical accounting data to help in predicting how the firm will fare in the future. The aspects of an organization’s future performance that are of most interest depend on the needs of the user. A manager in the firm would be interested in the company’s overall financial strength, its income and growth potential, and the financial effects of pending decisions. A potential lender, such as a bank loan officer, would be concerned primarily about the firm’s ability to pay back the loan. Potential investors would be interested not only in the company’s ability to repay its loan obligations, but also its future profit potential. Potential customers would want to assess the firm’s ability to carry out its operations effectively and meet delivery schedules. Thus, the needs of the analyst dictate the sort of financial statement analysis that is most appropriate.

LO 1 Explain the objectives of financial statement analysis. LO 2 Describe and use the following four analytical techniques: horizontal analysis, trend analysis, vertical analysis, and ratio analysis. Analytical Techniques Used Four analytical tools are in widespread use in analyzing financial statements: 1. 2. Horizontal analysis Trend analysis Chapter 21 45 Analyzing Financial Statements Exhibit 21–1 BALANCE SHEET 12/31/x0 BALANCE SHEET 12/31/x1 Liabilities Assets  Overview of Financial Statements Liabilities  Assets Owner’s Equity   Owner’s Equity Time 12/31/x0 12/31/x1                     INCOME STATEMENT For the Year Ended 12/31/x1 Revenues  Expenses  Gains  Losses Income RETAINED EARNINGS STATEMENT For the Year Ended 12/31/x1 Retained earnings on 12/31/x0  Income  Dividends Retained earnings on 12/31/x1 STATEMENT OF CASH FLOWS For the Year Ended 12/31/x1 Cash inflows during 20×1  Cash outflows during 20×1 Change in cash during 20×1           These three state ments refer to a  period of time, the  year 20×1. They help  reconcile the  account balances on  the balance sheets  as of 12/31/x0 and  12/31/x1.            3. Vertical analysis 4. Ratio analysis Each of these techniques is defined, discussed, and illustrated in the following sections of the chapter.

Importance of Comparisons and Trends No single measure of a company’s financial condition or performance can LO 3 Explain the importance of comtell us much. The single most important point to remember about financial parisons and trends in financial statement analysis is that every financial measure should be compared statement analysis. across time and across other companies to be meaningful. For example, an airline’s profit for the current year should be compared with the same company’s profit for several previous years. Moreover, the company’s profit should be compared with the profit reported by other airlines of similar size and operational 46 Chapter 21 Analyzing Financial Statements characteristics. Comparing key financial data with industry norms also adds meaning to the reported profit for the company being analyzed. To reemphasize the point, every financial measure discussed in this chapter should be compared with other analogous measures to be meaningful. Sources of Data Published financial statements provide the primary source of data about any organization’s financial condition and performance. A company’s annual report, quarterly reports, and financial news releases provide a wealth of information about the firm.

Other sources of financial information also are available, both for individual companies and for entire industries. The Securities and Exchange Commission requires that every publicly held company file a detailed financial report with the commission annually. These reports are available to the public. The financial press, such as The Wall Street Journal, Barron’s, Business Week, Fortune, Forbes, and various industry trade publications, provides in-depth coverage of specific companies and industries. Other important sources of financial data include financial advisory services, such as Dun & Bradstreet, Moody’s Investors Service, Dow Jones, Standard & Poor’s, and Robert Morris Associates. A wealth of financial information is also available on the Internet. Doing a good job of financial statement analysis is not a trivial task. It requires a solid knowledge of accounting, familiarity with the analytical techniques to be discussed in this chapter, and substantial research using data from a variety of sources. Comparative Financial Statements Comparative Financial Statements To illustrate each of the techniques used in analyzing financial statements, we will focus on a retail business. Contemporary Interiors, Inc., headquartered in Chicago, operates a chain of furniture stores in the Midwest.

The company specializes in contemporary furniture, much of it imported from the Scandinavian countries. The firm also sells handcrafted furnishings, such as ceramic lamps and handwoven wall hangings. Contemporary Interiors’ balance sheets for December 31, 20×0 and 20×1, are displayed in Exhibit 21–2. The company’s income statements and retained earnings statements for 20×0 and 20×1 are presented in Exhibit 21–3. Horizontal Analysis Exhibits 21–2 and 21–3 display comparative financial statements, which show the company’s financial results for two successive years. These statements highlight the change in each financial item between 20×0 and 20×1. For example, Exhibit 21–2 shows that Contemporary Interiors’ cash balance increased by $100,000 between December 31, 20×0, and December 31, 20×1. Notice that the changes highlighted in Exhibits 21–2 and 21–3 are shown in both dollar and percentage form. Thus, Contemporary Interiors’ $100,000 increase in cash represents an increase of 14.3 percent of the December 31, 20×0, amount (14.3%  $100,000  $700,000).

Comparative financial statements and change data enable managers and financial analysts to do horizontal analysis, which is an analysis of the year-to-year change in each financial statement item. The purpose of horizontal analysis is to determine how each item changed, why it changed, and whether the change is favorable or unfavorable. This is a tall order, and it requires substantial additional information. Suppose, for example, that a business periodical recently published a story about a growing demand for Danish furniture. A glance at Contemporary Interiors’ comparative balance LO 2 Describe and use the following four analytical techniques: horizontal analysis, trend analysis, vertical analysis, and ratio analysis. Comparative financial statements show the company’s financial results for two successive years and highlight changes.

Horizontal analysis is an analysis of the year-toyear change in each financial statement item. Chapter 21 Exhibit 21–2 Contemporary Interiors, Inc. Comparative Balance Sheets December 31, 20×1 and 20×0 (in thousands) Comparative Balance Sheets Year Assets Current assets: Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Marketable securities . . . . . . . . . . . . . . . . . . . . . . Accounts receivable, net . . . . . . . . . . . . . . . . . . . . Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . Increase or (Decrease) 20×0 Amount 700 300 11,000 17,000 300 $ 100 150 1,000 3,000 (50) 14.3 50.0 9.1 17.6 (16.7) $ 33,500 $ 29,300 $4,200 14.3 Long-term investments . . . . . . . . . . . . . . . . . . . . . . . $ $ 550 $ (50) (9.1) Property, furnishings, and equipment: Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Buildings, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equipment and furnishings, net . . . . . . . . . . . . . . . $ 6,000 55,000 25,000 $ 6,000 52,000 23,000 $ –0– 3,000 2,000 –0– 5.8 8.7 Total property, furnishings, and equipment . . . . . $ 86,000 $ 81,000 $5,000 6.2 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000 $110,850 $9,150 8.3 Liabilities and Stockholders’ Equity Current liabilities: Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,500 2,200 3,000 $ 7,050 2,100 3,200 $ 450 100 (200) 6.4 4.8 (6.3) Total current liabilities . . . . . . . . . . . . . . . . . . . . Long-term liabilities: Bonds payable ($1,000 face value; 10%) . . . . . . . . $ 12,700 $ 12,350 $ 350 2.8 37,300 35,700 1,600 4.5 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000 $ 48,050 $1,950 4.1 Stockholders’ equity: Preferred stock ($100 par value; 8%) . . . . . . . . . . . Common stock ($10 par value)* . . . . . . . . . . . . . . . Additional paid-in capital . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000 25,000 4,000 35,000 $ 6,000 24,000 3,800 29,000 $ –0– 1,000 200 6,000 –0– 4.2 5.3 20.7 Total stockholders’ equity . . . . . . . . . . . . . . . . . $ 70,000 $ 62,800 $7,200 11.5 Total liabilities and stockholders’ equity . . . . . . . . . . . $120,000 $110,850 $9,150 8.3 Total current assets . . . . . . . . . . . . . . . . . . . . . . 20×1 $ 800 450 12,000 20,000 250 500 47 Analyzing Financial Statements $ Percentage *100,000 shares of common stock were issued on January 1, 20×1. Since these shares were outstanding during the entire year, the weighted-average number of shares outstanding in 20×1 was 2,500,000 shares. sheet reveals that its cash, accounts receivable, and inventory have all increased during 20×1. These changes are consistent with expanded operations in response to increased demand for the company’s goods. The comparative income statement helps to confirm this supposition, since sales and cost of goods sold increased from 20×0 to 20×1. Thus the analyst’s job is like putting together a jigsaw puzzle.

The analyst first gathers all the puzzle pieces (financial data) and then tries to fit them together to create a meaningful picture (the firm’s financial condition and performance). 48 Chapter 21 Analyzing Financial Statements Exhibit 21–3 Contemporary Interiors, Inc. Comparative Income and Retained Earnings Statements For the Years Ended December 31, 20×1 and 20×0 (in thousands) Comparative Income and Retained Earnings Statements Year Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating expenses: Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . Administrative expenses . . . . . . . . . . . . . . . . . . . . Increase or (Decrease) 20×1 $87,000 60,930 20×0 $82,000 56,350 Amount $5,000 4,580 Percentage 6.1 8.1 $26,070 $25,650 $ 420 1.6 $ 5,000 2,000 $ 4,600 2,100 $ 400 (100) 8.7 (4.8) Total operating expenses . . . . . . . . . . . . . . . . . . $ 7,000 $ 6,700 $ 300 4.5 Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,070 4,030 $18,950 3,890 $ 120 140 .6 3.6 Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . Income-tax expense . . . . . . . . . . . . . . . . . . . . . . . . . $15,040 3,760 $15,060 3,800 $ (20) (40) (.1) (1.1) Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,280 $11,260 $ 20 –0– .2 Dividends on preferred stock . . . . . . . . . . . . . . . . . . . 480 480 Net income available to common stockholders . . . . . . Dividends on common stock . . . . . . . . . . . . . . . . . . . $10,800 4,800 $10,780 4,600 $ 20 200 –0– .2 4.3 Net income added to retained earnings . . . . . . . . . . . . Retained earnings, January 1 . . . . . . . . . . . . . . . . . . . $ 6,000 29,000 $ 6,180 22,820 $ (180) 6,180 (2.9) 27.1 Retained earnings, December 31 . . . . . . . . . . . . . . . . $35,000 $29,000 $6,000 20.7 Trend Analysis The comparative financial statements in Exhibits 21–2 and 21–3 allow a comparison of only two years’ data.

When the comparison is extended to three or more years, the technique is called trend analysis. Trends can be shown in both dollar and percentage form by designating the first year in the sequence as the base year. Then the amounts in subsequent years are shown as a percentage of the base-year amount. Exhibit 21–4 displays a trend analysis of Contemporary Interiors’ sales and net income data over a six-year period. Contemporary Interiors’ sales and net income both have risen steadily over the sixyear period. However, the growth in sales has been greater than the growth in net income. The increase in income between year 5 and year 6 is quite small, despite a large increase in sales. The relationship between the trend in sales and the trend in net income could be cause for concern.

Why has Contemporary Interiors’ management been unable to convert a relatively larger growth in sales into an equally large growth in net income? While the trend analysis does not answer this question, it does serve an attention-directing role for the analyst. An alert financial analyst will delve more deeply into this issue and try to come up with an explanation. LO 2 Describe and use the following four analytical techniques: horizontal analysis, trend analysis, vertical analysis, and ratio analysis. Trend analysis is a comparison of three or more years’ data. Vertical analysis concentrates on the relationships between various financial items on a financial statement. Vertical Analysis LO 2 Describe and use the following four analytical techniques: horizontal analysis, trend analysis, vertical analysis, and ratio analysis.

Horizontal and trend analyses focus on the relationships between the amounts of each financial item across time. In contrast, vertical analysis concentrates on the relationships between various financial items on a particular financial statement. To show these relationships, each item on the Chapter 21 49 Analyzing Financial Statements Exhibit 21–4 Year 6 Year 5 Year 4 Year 3 Year 2 Year 1 A. Trend Analysis in Dollars (Measured in Thousands) Sales . . . . . . . . . . . . . . $87,000 Net income . . . . . . . . . . 11,280 $82,000 11,260 $78,000 11,000 $74,800 10,500 $73,000 10,200 $72,000 9,900 Year 5 Year 4 Year 3 Year 2 Year 1 108 111 104 106 101 103 100 100 Year 6 B. Trend Analysis in Percentages Sales . . . . . . . . . . . . . . 121* Net income . . . . . . . . . . 114 *121%  $87,000  $72,000 †114%  $82,000  $72,000 114† 114 Trend Analysis: Contemporary Interiors, Inc. statement is expressed as a percentage of a base item that also appears on the statement. On the balance sheet, each item is expressed as a percentage of total assets. On the income statement, each item is stated as a percentage of sales.

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