Introduction to Financial Statement Analysis

1 Learning Objectives5chapterIntroduction to FinancialStatement Analysis1 Explain the purposeof Financial the rela-tionships between finan-cial Statement numbersand use ratios in analyz-ing and describing a com-pany s common-size fi-nancial statements to per-form comparison offinancial statements acrossyears and between theDuPont framework andhow return on equity canbe decomposed into itsprofitability, efficiency,and leverage cash flow infor-mation to evaluate cashflow the limita-tions of Financial studying this chapter, youshould be able to: 2003 Getty 11/13/03 7:39 PM Page 202In 1987, IBMwas the most valuable company in theworld, worth an estimated $ billion. By the endof 1992, IBM had an estimated value of $ decline in value can be traced to a strategic errormade by IBM in the early 1980s.

2 Prior to 1981, IBM wasthe major player in the computer market and was theprimary provider of computers for government, univer-sities, and businesses. At this time, believe it or not,virtually no computers were available at an affordableprice for individuals. Then, in 1981, IBM introduced itspersonal computer (IBM PC), and it quickly establishedthe standard by which other PCs would be , IBM elected to leave the software develop-ment for PCs to other companies. Instead of develop-ing its own disk operating system (DOS), IBM electedto use a DOS developed by a small company located inSeattle was founded in 1975 by Bill Gates andPaul they founded Microsoft, Gates andAllen envisioned that computers would eventually findtheir way into everyday life (contrary to IBM s predic-tion in the 1950s when one IBM executive forecast thetotal worldwide demand for computers to be about five).

3 While IBM s performance floundered in the mid- andlate-1980s, Microsoft demonstrated an amazing abilityto become a major player in practically every aspect ofthe computer software market from operating systemsto the Internet to networks to spreadsheets and Microsoft s many accomplishments comes thequestion: Just how successful is the company? Theanswer to that question depends on how you define success. Measured in terms of number of employees,Microsoft has grown from just 32 employees in 1981when IBM elected to use Microsoft s DOS to 50,500 asof the June 30, 2002, fiscal year. In terms of social im-pact, Microsoft and its employees donate millions ofdollars each year to such charitable causes as SpecialOlympics, Boys and Girls Clubs, and the United NegroCollege Fund.

4 Microsoft also supports elementary andhigh schools throughout the country in their efforts toincorporate technology into the curriculum, and thecompany has established scholarship programs to en-courage minorities and women to pursue careers in com-puter science and related technical fields. In addition,Bill Gates and his wife Melinda have started a founda-tion dedicated primarily to health and education. Thusfar they have contributed several billion dollars to terms of stock price, Microsoft s per-share stockprice (adjusted for stock splits) has gone from $ in1986 to almost $26 in April of 2003 (see Exhibit 1). Butas the graph illustrates, Microsoft s stock price is downfrom its historic high of over $58 per share in 1999.

5 Ananalysis of Microsoft s Financial statements reveals someof the reasons for the declining stock price. That is thetopic of this chapter an Introduction to Financial state-ment Analysis . With some basic Analysis tools (called ra-tios), we will be able to conduct some fundamentalanalysis of a company s Financial statements. Our analy-sis will provide us with insights as to a company s per-formance and will help us identify areas of concern. Keepin mind that this is merely an Introduction to financialstatement Analysis . There are entire textbooks devotedto the Analysis of Financial statements. Our objectivehere is to expose you to some of the basic tools to helpyou start to understand what Financial statements cantell us about the operations of a business.

6 To illustratethe Analysis techniques introduced in this chapter, wewill reference the Financial Statement of Microsoft in-cluded in Appendix 5 Setting the Stage1 The decision to have another company develop the software for its personal computer was not IBM s only strate-gic error. At the same time, IBM decided to use another company s microprocessors the brains of the com-puter. As a result, another successful company was born INTEL. IBM lost the opportunity to dominate thesoftware market as well as the computer chip market. By September 2003, Microsoft, Intel, and IBM had mar-ket values exceeding $317 billion, $187 billion, and $158 billion, Everybody knows Bill Gates, but few people know about Paul Allen.

7 Allen was Microsoft s head of researchand new product development until 1983 when a serious illness caused him to leave the company. He nowspends much of his time investing in technology companies and watching the Seattle Seahawks, a professionalfootball team, and the Portland Trailblazers, a professional basketball team, both of which he :In fact, many people are of the opinion thatMicrosoft has succeeded too well. Several ofMicrosoft s competitors allege that Microsoftis involved in monopolistic practices thatstifle 11/13/03 7:39 PM Page 203204 Part 1 Financial Reporting and the accounting CycleExhibit 1:History of Microsoft s Stock Price per Need for Financial Statement AnalysisConsider the following questions related to Financial Statement information for MICROSOFTin 2002: Microsoft s net income in 2002 was $ billion.

8 That seems like a lot, but does it rep-resent a large amount for a company the size of Microsoft? Total assets for Microsoft at the end of 2002 were $ billion. Given the volume ofbusiness that Microsoft does, is this amount of assets too much, too little, or just right? By the end of 2002, Microsoft s liabilities totaled $ billion. Is this level of debt toomuch for Microsoft?The important point to recognize is that just having the Financial Statement numbers is notenough to answer the questions that Financial Statement users want answered. Without furtheranalysis, the raw numbers themselves don t tell much of a Statement analysisinvolves the examination of both the relationships amongfinancial Statement numbers and the trends in those numbers over time.

9 One purpose of fi-nancial Statement Analysis is to use the past performance of a company to predict how it willdo in the future. Another purpose is to evaluate the performance of a company with an eyetoward identifying problem areas. In sum, Financial Statement Analysis is both diagnosis identifying where a firm has problems and prognosis predicting how a firm will performin the the purposeof Financial Statement analy-sisThe examination of boththe relationships among fi-nancial Statement numbersand the trends in those num-bers over 11/13/03 7:39 PM Page 204 Relationships between Financial Statement amounts are called Financial ratios. Net in-come divided by sales, for example, is a Financial ratio called return on sales, which tells youhow many pennies of profit a company makes on each dollar of sales.

10 The return on sales forMicrosoft is , meaning that Microsoft makes 28 cents worth of profit forevery dollar of product sold. There are hundreds of different Financial ratios, eachshedding light on a different aspect of the health of a 2 illustrates how Financial Statement Analysis fits into the decisioncycle of a company s management. Notice that the preparation of the financialstatements is just the starting point of the process. After the statements areprepared, they are analyzed using techniques akin to those to be introduced inthis chapter. Analysis of the summary information in the Financial statementsusually doesn t provide detailed answers to management s questions, but it doesidentify areas in which further data should be gathered.