Chapter 12: Financial Accounting Analysis and Interpretation

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Ever wish you had like an x -ray vision for businesses, you know, a way to really peek beneath the surface and see if a company is actually doing well beyond just, you know, their stock price or brand recognition.

Absolutely.

It's about going deeper, understanding the financial engine that drives these businesses.

And that's exactly what we're diving into today, financial statement analysis.

It's the toolkit that helps you unlock those aha moments where you start to see the story behind the numbers, whether it's Under Armour, Apple, or any company you're interested in.

This approach can give you a real edge in understanding how they're performing.

Right.

And I think a lot of people hear financial statement analysis and their eyes kind of glaze over.

But don't worry, our mission today is to break it down in a way that's clear and easy to understand.

No jargon, no intimidation, just a practical guide to the core techniques, using real world examples to show how these tools can be applied.

So think of this as your crash course in financial statement analysis.

We're going to cover the theories, the concepts, the research, and most importantly, the applications.

And we'll use specific companies like Under Armour and Apple as our case studies to really bring these concepts to life.

So first up, let's talk about horizontal analysis.

Now picture yourself looking at a spreadsheet, right, with rows of numbers representing different years.

And you're scanning across those rows, comparing how specific figures have changed over time.

That's the essence of horizontal analysis.

We're looking for trends, are revenues increasing, are expenses under control, is profitability growing?

And it allows you to see those changes in a quantifiable way.

Not just vague notions, but actual percentage increases or decreases that highlight the magnitude of those shifts.

Exactly.

So with Under Armour, for example, we've got their income statement data from 2014 to 2016.

And one of the things we can look at is their income from operations.

And that reveals a very interesting pattern.

In 2014, their income from operations was $354 million.

Then in 2015, it jumps to $409 million.

That's a pretty solid increase, around 15%.

Right.

But then, when we look at 2016, it only inches up to $417 .9 million, a mere 2 % growth.

So that raises a big question.

Why did that growth engine seem to slow down so dramatically?

Exactly.

And that's the power of horizontal analysis.

It reveals these shifts in momentum that might not be immediately apparent just from looking at the raw numbers.

And it prompts you to dig deeper.

Is it because costs are rising faster than revenue?

Is it increased competition?

Changes in consumer preferences?

These are the questions that any savvy investor or business owner would want to explore.

Now let's drill down a bit into Under Armour's revenue sources.

Between 2014 and 2016, their total net revenues saw a decent increase, about 21 .8%.

Sounds good on the surface.

But when we break it down by product category, things get more interesting.

Apparel, which I guess is a huge part of their business, only grew by 15 .3%.

Footwear, on the other hand, jumped by a whopping 49 .1%, suggesting strong demand in that segment.

And accessories grew by 17 .2%.

Then there's their connected fitness category, which includes things like their fitness tracking apps and devices.

That one saw the biggest percentage surge at 50 .6%.

Right.

So their expansion into the digital fitness space was clearly gaining traction.

But here's the key point.

That overall sales growth of 21 .8 % from 2014 to 2016 was notably lower than the 28 .5 % increase they'd achieved in just fiscal year 2015.

So even though certain areas were booming, the overall pace of expansion had cooled off.

And that's a critical insight that horizontal analysis helps us to uncover.

It's not just about whether numbers are going up or down, but also the rate at which they're changing.

Exactly.

Now horizontal analysis isn't just limited to the income statement.

We can also apply it to the balance sheet to see how a company's assets and liabilities are evolving over time.

What kind of things would we be looking for there?

Well, with Under Armour, for example, we see a significant jump in property and equipment net, between 2014 and 2016.

It increased by a substantial 49 .3%, or $265 .7 million.

That sounds like a lot of investment.

What would that typically indicate?

It often suggests that the company is putting money into its long -term infrastructure.

New warehouses, retail stores, technology upgrades, things like that.

So it's a signal that they're aiming for expansion and growth.

And of course, those investments usually need funding.

Where did that money come from for Under Armour?

Well, if we look at their long -term debt, net of current maturities, we see that it also rose significantly during that period.

It went up by 26 .7 % or $166 .3 million.

So they likely financed a good chunk of those new assets through borrowing, which, again, isn't necessarily bad, but it's something to keep an eye on.

Absolutely.

As an investor or someone analyzing the company, you'd want to assess whether those investments are generating sufficient returns to justify taking on that additional debt.

So through horizontal analysis, we've gotten a pretty good sense of Under Armour's growth trajectory, their investment strategies, and how they've been financing those investments.

It's a valuable starting point for understanding their overall financial health.

And what's great is that this isn't some complex, inaccessible process.

As the try it in Excel section of the source material highlights, you can actually pull this data yourself and perform these calculations to get a first -hand understanding of a company's trends.

Okay, so we've looked at how things change over time.

Now let's shift our focus to vertical analysis.

This is where we look at the proportions within a single year's financial statements.

Exactly.

Instead of comparing year to year, we're looking at the relative size of different line items within the same period, and then also how those proportions change over time.

It's also called common size analysis.

And the key here is to express each item as a percentage of a base figure.

So for the income statement, we typically use net revenues as our 100 % benchmark.

Right.

So every other item on the income statement, cost of goods sold, operating expenses, net income is shown as a percentage of those net revenues.

This tells you how much of each sales dollar is being allocated to different costs and ultimately to profit.

And for the balance sheet, the base figure is typically total assets.

So each asset, each liability, and each equity account is expressed as a percentage of those total assets.

Exactly.

And this is particularly useful for comparing companies of different sizes because it levels the playing field and helps you see how their financial structures differ.

The source material even provides a step -by -step guide on how to create these common size statements in Excel.

They emphasize the importance of freezing the denominator, which is a really handy tip for anyone who wants to try this out themselves.

Absolutely.

And one of the key benefits of vertical analysis is that it can reveal subtle shifts in a company's financials that might not be obvious just from looking at the absolute dollar amounts.

Right.

For example, you might notice that the cost of goods sold is gradually consuming a larger percentage of revenue each year, even though the absolute dollar amount of cost of goods sold might still be increasing.

That could indicate potential problems with rising input costs or a shrinking profit margin, even if overall sales are still growing.

It's like creating a pie chart of the income statement or the balance sheet for each year.

And then you can easily compare how those slices of the pie are changing over time.

Exactly.

So while horizontal analysis shows us the direction of change,

vertical analysis helps us understand the magnitude and relative impact of those changes within the overall financial picture.

Okay, we've covered horizontal analysis, vertical analysis.

Now let's get into the real meat of things, ratio analysis.

This is where we start to really distill the numbers into meaningful metrics that can help us make decisions.

Absolutely.

And we're going to use Apple as our prime example here, since they're such a widely followed company and their financial data is readily available.

And what's interesting is that the source points out that a lot of companies actually include some of these key ratios directly in their annual reports.

You can also find them on various financial websites.

So it really underscores how essential these ratios are for understanding a business.

They are.

Now while tools like the Excel template mentioned in the source can help you automate the calculation of these ratios, the real value comes from understanding what each ratio tells you and how to interpret those numbers in context.

Right.

So let's start with profitability ratios.

These are the ones that help us gauge how effectively a company is generating profits from its operations.

Right.

And there are several key ones to keep in mind.

First we have the gross profit percentage, which is calculated as net sales minus cost of goods sold divided by net sales.

So essentially it tells you what percentage of revenue is left over after covering the costs of producing the goods or services sold.

Exactly.

It gives you a sense of the profitability of their core product or service offerings.

Then we have the operating income percentage, which is income from operations divided by net sales.

This one takes into account operating expenses, things like salaries, rent, marketing costs.

So it gives you a picture of the profitability of the core business activities before factoring in interest and taxes.

Then there's the net profit margin, often called the rate of return on sales, which is net income divided by net sales.

This is the bottom line profitability, showing how much profit a company makes for every dollar of sales after all expenses are accounted for.

So for an investor, this is a key indicator of the overall profitability of the business.

Absolutely.

Now, another important profitability ratio is the return on total assets, or ROA, which is calculated as net income divided by average total assets.

This one tells us how effectively a company is using all of its assets, both current and long term, to generate profits.

So it's a good measure of how well they're managing their resources.

And what's fascinating about ROA is that we can break it down further using the DuPont analysis.

This framework tells us that ROA is essentially the product of two components,

the net profit margin, which we just discussed, and the asset turnover, which we'll get into shortly.

So a company can improve its return on assets either by making more profit on each sale, which is reflected in the net profit margin.

Or by using its assets more efficiently to generate more sales, which is where the asset turnover comes in.

Makes sense.

Now, we also have the return on common stockholders' equity, or ROE, which is calculated as net income minus preferred dividends divided by average common stockholders' equity.

This one focuses specifically on the return generated for the company's common shareholders on their investment in the business.

So it's a key metric for those who are considering buying or holding the company's stock.

And just like with ROA, we can expand on the ROE using the DuPont analysis.

It shows that ROE is essentially net profit margin times asset turnover times the leverage ratio, also known as the equity multiplier.

So it highlights how profitability, asset efficiency, and the use of debt financing all interact to determine the ultimate return on equity for shareholders.

Precisely.

It's a very insightful way to understand the different levers that can impact shareholder returns.

So we've covered profitability ratios.

Now let's talk about efficiency.

What ratios help us understand how well a company is utilizing its assets to generate sales and manage its working capital?

These are often called turnover ratios, and the key one here is the inventory turnover, which is calculated as cost of goods sold divided by average inventory.

So this tells us how many times, on average, a company sells and replenishes its inventory during a specific period, usually a year.

Right.

A high inventory turnover generally suggests strong sales and efficient inventory management, meaning they're not tying up too much cash and inventory that's just sitting around.

But too high of a turnover could mean they're not keeping enough inventory on hand, which could lead to stock outs and lost sales.

Conversely, a low turnover might signal slow -moving or obsolete inventory.

Exactly.

It's a balancing act.

And then we have the accounts receivable turnover, which is net credit sales divided by average accounts receivable.

This one tells us how quickly a company is collecting the money it's owed by its customers who bought on credit.

A faster turnover here generally means they have more efficient collection practices and a lower risk of bad debts.

And from the accounts receivable turnover, we can calculate the day's sales outstanding, or DSO, which tells us the average number of days it takes to collect those receivables.

The source notes that Apple, for example, has had a DSO that fluctuated between 19 and 31 days, which is quite efficient.

They contrast this with Alphabet, which had a DSO of 52 days in 2016.

So Apple is clearly collecting payments from its customers much more quickly than Alphabet.

Now we also need to look at how a company manages its payables, right?

Yes.

The accounts payable turnover, which is calculated as cost of goods sold divided by average accounts payable, tells us how many times a company pays off its suppliers during a year.

And just like with receivables, we can convert this into days with the day's payable outstanding, or DPO.

Right.

DPO tells us the average number of days a company takes to pay its own suppliers.

Now all of these turnover ratios come together in the concept of the cash conversion cycle.

Ah yes, the cash conversion cycle.

This is a really important one.

Can you break it down for us?

It essentially measures the time it takes for a company to convert its investments in inventory and other resources into cash flow from sales.

So it's a measure of how efficiently they're managing their working capital.

Exactly.

And it's calculated as days inventory outstanding,

or DIO, plus days sales outstanding,

or DSO, minus days payable outstanding, or DPO.

The source highlights that Apple actually has a negative cash conversion cycle, which sounds kind of strange.

What does that actually mean?

It's a very advantageous position to be in.

A negative cash conversion cycle means they're able to sell their inventory and collect cash from customers before they even have to pay their own suppliers.

So they've got this constant inflow of cash that they can use for other purposes,

like investing in research and development, or returning capital to shareholders.

Exactly.

And this really speaks to their strong brand and the high demand for their products.

They have a lot of leverage in their relationships with both customers and suppliers.

Now Apple's competitor, Alphabet, had a positive cash conversion cycle in 2016 according to the source.

Right.

So that means they had cash tied up in inventory and receivables for a longer period.

And this helps to explain why Apple is able to hold such substantial amounts of short -term marketable securities, because they have this consistent stream of cash coming in.

Okay.

So we've covered profitability and efficiency.

Now let's move on to solvency.

What ratios help us assess a company's ability to meet its long -term financial obligations?

Solvency ratios are all about gauging a company's long -term financial health.

And the key one here is the debt ratio, which is calculated as total liabilities divided by total assets.

So it shows you what proportion of a company's assets are financed by debt.

Exactly.

A higher debt ratio generally means they're more reliant on borrowing, which can increase financial risk if things go south.

And we also have the equity multiplier, which we touched on earlier with the DuPont analysis.

Remind us how that relates to solvency.

The equity multiplier, also called the leverage ratio, shows how many dollars of assets are supported by each dollar of shareholders' equity.

So a higher equity multiplier indicates that the company is using more debt to finance its assets, which can amplify both gains and losses.

The source points out that Apple had a higher equity multiplier than Alphabet, meaning they were using more borrowed capital in their capital structure.

Again, that's not inherently good or bad, but it's a different financial strategy with different implications.

Okay.

Last but not least, let's talk about stock valuation ratios.

These are the ones that are particularly relevant for those looking at a company as a potential investment.

These ratios help investors assess whether a stock is attractively priced relative to its earnings, dividends, and other fundamental factors.

One of the most widely used valuation ratios is the price earnings ratio, or P -E ratio.

This is calculated as the market price per share of common stock divided by earnings per share.

So it basically shows you how much investors are willing to pay for each dollar of the company's earnings.

A higher P -E ratio often indicates that investors have high expectations for future earnings growth or that the stock is considered overvalued relative to its current earnings.

And then we have the dividend yield, which is calculated as dividends per share of common stock divided by the market price per share of common stock.

This one is particularly relevant for income -seeking investors.

It shows you the percentage return you can expect to receive in the form of dividends relative to the current stock price.

The source actually mentions an interesting anecdote about Apple and their decision to start paying dividends in 2012.

Apparently, shareholder pressure played a big role in that decision.

It did.

They had accumulated this massive cash hoard and their stock price had been soaring.

So shareholders were essentially saying, hey, we want some of that value back.

And they even came up with a clever strategy to avoid paying potentially high taxes on repatriating their foreign earnings.

Instead of bringing that money back to the U .S., they opted to borrow money to fund those dividend payments.

Which makes sense from a tax perspective.

Interest payments on debt are often deductible while dividend payments are not.

The source also mentions Apple's stock split in 2014, which doesn't change the underlying value of the company, but it does make the stock more accessible to individual investors.

Right.

It increases the number of shares outstanding and proportionally lowers the per share price.

All right.

So ratio analysis gives us this incredibly powerful toolkit for dissecting a company's financials and understanding its investment appeal.

But it's important to remember that these are just tools.

They have their limitations.

Absolutely.

As the source points out, a single ratio is like a temperature reading.

It might indicate that something's off, but it doesn't tell you the underlying cause.

They use this great analogy of a physician and a thermometer.

A fever might be a symptom of various illnesses.

You need more information to make a diagnosis.

Exactly.

And similarly, you can't just look at one ratio in isolation.

You need to analyze trends over several years, consider the industry context, compare against competitors and take into account various external factors.

Now all of this brings us to the concept of earnings quality.

What exactly does that mean?

Earnings quality essentially refers to how accurately a company's reported earnings reflect its true economic performance and whether those earnings are sustainable over the long term.

So are they playing accounting games to make their numbers look better?

Or are their earnings based on solid fundamental business performance?

Precisely.

And the source highlights a few key characteristics of high quality earnings.

One is conservative revenue and expense recognition.

So recognizing revenue when it's actually earned and expenses when they're incurred, not manipulating those numbers to inflate profits.

Right.

They give the example of OCZ Technology Group, which manipulated its revenue recognition practices and ended up overstating its revenues, misleading investors.

And on the expense side, there's the infamous case of WorldCom, which improperly classified billions of dollars of expenses to boost its profits artificially.

Those are extreme examples, but they illustrate the importance of looking beyond the headline numbers and really scrutinizing how those numbers are derived.

The source also mentions the importance of a high and ideally improving gross profit percentage coupled with stable or declining operating expenses as a percentage of sales.

That's a good sign that the company's core business is becoming more profitable and efficient.

And it suggests that their earnings are likely driven by genuine operational improvements, not accounting tricks.

Finally, it's crucial to distinguish between earnings from ongoing operations versus discontinued operations.

You want to make sure that you're evaluating the profitability of the core business that the company intends to continue operating.

One -time gains or losses from selling off a division, for example, can distort the overall picture.

Now, beyond those key aspects, the source also emphasizes the importance of making sure that a company actually owns the assets it claims to own, that all liabilities are properly recognized, that assets and liabilities are valued appropriately, and that revenues and expenses are recorded in the correct periods.

All of these contribute to the overall quality and reliability of a company's financial statements.

And the source also points out some potential red flags to watch out for, such as a persistent pattern of decreasing income or net losses.

While that might be normal for startups or companies in highly cyclical industries, it can be a warning sign for established businesses in more stable sectors.

Exactly.

It might signal underlying problems that need to be investigated.

Now, shifting gears a bit, let's talk about efficient markets.

How does that concept tie into all of this financial statement analysis we've been discussing?

So the efficient markets theory basically says that stock prices already reflect all publicly available information about a company.

Right.

The idea is that in a market where information flows freely and investors are rational,

any news or data about a company, including its financial statements, will quickly be incorporated into its stock price.

So you can't really trick the market by manipulating accounting figures to make your company look more profitable than it actually is.

Exactly.

The source gives the example of changing depreciation methods.

If a company switches to a method that makes their earnings per share look better, but doesn't actually change the underlying cash flows of the business,

the market is likely to see right through that.

Sophisticated investors and analysts will understand that it's just an accounting maneuver, not a real improvement in performance.

And in an efficient market, the stock price won't be significantly impacted by that kind of cosmetic change.

So it really emphasizes the importance of focusing on the fundamentals of the business, not just the accounting numbers.

Now, the source material includes this really handy decision guidelines feature that summarizes many of the key financial ratios we've discussed.

It's a great quick reference guide for understanding what each ratio measures and what it can tell you about a company's financial health.

And it also briefly touches on the concept of benchmarking, which involves comparing a company's ratios and performance against industry averages or its competitors.

That's a really useful way to see how a company stacks up relative to its peers and identify areas of strength or weakness.

And finally, the chapter wraps up with a glossary of key accounting terms, which is a great resource for solidifying your understanding of the language of financial analysis.

Building a strong vocabulary is essential for anyone who wants to become fluent in this field.

So to bring it all together, in this deep dive, we've explored the core principles of financial statement analysis.

We've seen how horizontal analysis helps us identify trends over time, how vertical analysis using common size statements reveals the internal structure of a company's financials, and how a wide array of financial ratios can give us deep insights into profitability, efficiency,

solvency, and stock valuation.

We used Under Armour to illustrate how to analyze trends and Apple to showcase the power of ratio analysis.

And we also discussed the limitations of these tools, the concept of earnings quality, and the idea of efficient markets.

The goal is to give you the knowledge and confidence to go beyond the headlines and really understand the financial engine that drives businesses.

So as a final thought, I'd encourage you to pick a company whose products you use regularly and apply some of these techniques to their financial statements.

Maybe calculate a few key ratios or create a simple common size income statement.

See what insights you can uncover by looking at their numbers through this new lens.

And think about how those insights might inform your decisions, not just as a potential investor, but also as a consumer or even as someone considering working for a particular company.

This deep dive is just the beginning.

There's so much more to explore.

And hopefully we've sparked your curiosity to dig deeper and continue learning.

Thanks for joining us on this journey into the fascinating world of financial statement analysis.