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2.9 Other Issues
Public firms in the US follow generally accepted accounting principles (GAAP) that go a long way toward standardizing accounting procedures. Yet, firms still have substantial leeway in the way they account for book values and report earnings that may lead to major differences in the financial statements of otherwise similar firms. Some of the more important reasons these statements may differ include:
• Firms may differ in how they account for intangible assets such as patents, copyrights, and trademarks. Including these intangible assets on the balance sheet provides a better estimate of the accounting value of the firm as an ongoing concern. On the other hand, excluding such assets may provide a more conservative estimate of the firm’s accounting value in measuring its liquidation value.
3 The market value of options can be estimated using option-pricing models. The most common model is the Black–Scholes option-pricing model. The formula for this model can be obtained from most standard investments textbooks. However, experts are currently debating whether the cost of these options should be recognized as an expense on a firm’s income statement. Some argue that these stock options represent a financing cost that is borne by the existing shareholders, and thus should not be reported as an expense on the income statement. The eventual exercise of these options will dilute the ownership of current stockholders and reduce the value of their ownership claim by allowing new shareholders to possibly purchase new shares at exercise prices below market value in the future.
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• Firms may not include all of their liabilities on their balance sheet such as some lease obligations, warrants sold to investors or issued to employees, and other off-balance sheet financings.
Furthermore, analysts also differ in the way they interpret a firm’s financial performance from these financial statements. Some analysts, for example, exclude profits and losses from extraordinary or nonrecurring events when determining a firm’s net income, while others include them.
International Comparisons
Differences in international accounting standards can greatly complicate the analysis and comparison of firms from different countries. For example, while accounting standards in the US are more stringent than in many countries, firms in the US may use one set of accounts for financial reporting purposes and another set of accounts for tax purposes. This would not be allowed in most other countries. Accounting standards differ in terms of the degree of flexibility and rigidity. German firms, for example, have much greater flexibility to hide money in reserve accounts.
The desire of some firms to list their stocks on major stock exchanges such as the New York Stock Exchange (NYSE) has led to greater uniformity in accounting standards among firms from different countries. NYSE regulations require all firms to conform to US GAAP accounting standards. When Daimler-Benz AG decided to list on the NYSE, the revision of its financial statements to conform to US accounting standards turned its modest profit in 1993 using German accounting standards to a loss of nearly $600 million.
Negotiations are ongoing among countries to adopt a uniform set of accounting rules.
The International Accounting Standards Board (IASB) working together with the Inter- national Organization of Securities Commissions (IOSCO) has garnered wide support for adopting congruous accounting rules. The continuing integration of the world’s capital markets has produced considerable momentum for adopting a set of uniform international accounting standards.
Financial Reforms
With all of the national attention given to various financial scandals such as Enron dur- ing late 2001, many expect the accounting profession to enact some important reforms.
At the top of the list are changes in the ways firms can keep debt off their balance sheets through off-balance sheet financing methods. Other needed reforms include creat- ing a firewall between the auditing and consulting services that many of the large ac- counting firms provide to the same firm or even instituting term limits for auditing of a particular firm. Whether these efforts will lead to any major reforms in the financial reporting process for firms is uncertain. Financial analysts and managers who are respon- sible for interpreting financial statements need to keep abreast of these and other potential reforms.
4 We are not recommending or promoting these two sites over the many others that exist.
E-sources of Financial Information
For years, investors trekked to libraries to view a company’s financial statements or to collect other financial information. The Internet age has now dramatically altered how we can access financial information. The Securities and Exchange Commission (SEC) has devel- oped an Internet-based database (www.sec.gov/edgar.shtml) where it posts the Form 10-K and quarterly 10-Q filings made by firms. Most companies now have their own websites that contain a wealth of financial information including complete financial statements in their 10-K and 10-Q filings, press releases, stock price charts and other financial news. Other websites, including MoneyCentral (moneycentral.msn.com) and Bloomberg4 (www.bloomberg.com), provide detailed historical information including financial statements, earnings estimates, analysts’ ratings, stock price quotes and charts, and other useful information. An increasing level of financial services is becoming available online. For example, Lowes, a major com- petitor to Home Depot, allows investors to purchase shares of its common stock online from the company web page (www.lowes.com).
Concept Check 2.9
1 What are some of the differences in international accounting standards and the US GAAP?
2 What are some important financial reforms that will likely be adopted in the near future?
Summary
This chapter discussed how to interpret financial statements issued by firms. The major points are as follows.
1 Interpreting the information provided in a firm’s financial statements is an import- ant task to the many stakeholders including the firm’s lenders, equity investors, suppliers, customers, employees, and executive management.
2 The financial statements issued by a firm include its income statement, balance sheet, statement of cash flows, and statement of retained earnings.
3 An income statement summarizes the total revenues earned and the total expenses incurred to generate these revenues during a particular time period. The bottom line of an income statement is the firm’s net income (earnings).
4 A balance sheet reports a firm’s assets, liabilities and stockholders’ equity as of a given date, usually at the end of a reporting period. The balance sheet is constructed according to the basic accounting identity: assets = liabilities + stockholders’ equity.
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5 A statement of cash flows reports changes in the cash position for a firm over a specified period of time. The statement is divided into three main sections including operating cash flows, investing cash flows, and financing cash flows.
6 A statement of retained earnings provides information on the composition of the stockholders’ equity accounts for a firm and the amounts of any stock or cash dividends issued during the period.
7 The net income reported by a firm for a particular time period will differ from the actual net cash flow generated by the firm during that period due to the accrual accounting process, depreciation, and taxes. Although financial analysts pay close attention to both net income and net cash flow, more attention should be given to the net cash flow.
8 The items reported on a balance sheet are typically reported at their book values, which are based on historical cost. Analysts need to understand that these historical values may differ substantially from their current market values. This is especially true for real estate and for stockholders’ equity.
9 Common-size statements provide a basis for interpreting trends and comparing firms of different size. A vertical common-size balance sheet is constructed by dividing all items for a given year by the total assets for that year. A vertical common- size income statement is constructed by dividing all items for a given year by the net sales for that year.
FURTHERREADING
Bernstein, Leopold A. and John J. Wild. Financial Statement Analysis: Theory, Application, and Inter- pretation, 6th edn, Irwin McGraw-Hill, 1998.
Brigham, Eugene F. and Michael C. Ehrhardt. Financial Management: Theory and Practice, 11th edn, Thomson, 2005.
Fraser, Lyn M. and Aileen Ormiston. Understanding Financial Statements, Prentice-Hall, 2001.
Schilit, Howard. Financial Shenanigans, 2nd edn, McGraw-Hill, 2002.
White, Gerald I., Ashwinpaul C. Sondhi, and Dov Fried. The Analysis and Use of Financial Statements, 3rd edn, Wiley, 2003.
Chapter 3
Interpreting Financial Ratios
Financial ratios are used to compare the risk and return of different firms in order to help equity investors and creditors make intelligent investment and credit decisions. Such decisions require both an evaluation of performance over time for a particular investment and a comparison among all firms within a single industry at a specific point in time. (Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried, The Analysis and Use of Financial Statements, 3rd edn, Wiley, 2003, p. 111.)
Overview
In this chapter we show how lenders, investors, analysts, and managers can use information from a firm’s balance sheet, income statement, and statement of cash flows to calculate financial ratios that provide useful insights into particular aspects of a firm’s performance. These ratios allow the firm’s stakeholders to better understand its liquidity and long-term debt paying ability, efficiency in employing its various assets, profitability, and how the market is valuing the firm relative to key financial variables. We show how to calculate and interpret various ratios related to each of the above areas using the financial statement information from Home Depot, Inc. We compare the performance of Home Depot to that of its closest competitor, Lowe’s Companies, Inc. We discuss several uses and limitations of financial ratio analysis.
Learning Objectives
After completing this chapter, you should be able to:
• calculate and interpret commonly used ratios;
• understand how to use financial ratios to assess the liquidity, solvency, efficiency, and profitability of a firm;
• understand how financial ratios can be used to estimate the likelihood of bank- ruptcy for a firm that uses debt financing;
• conduct a DuPont analysis to decompose a firm’s return on equity into other ratio subcomponents;
• discuss the uses and limitations of financial ratio analysis.
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