As the title implies, Understanding Financial Statements is about understanding and interpreting financial statements (i.e., the balance sheet, the income statement, and the statement of cash flows).
I found Understanding Financial Statements an informative book. And even though financial statements were not completely new to me, the book helped to clarify some things and I also learned a few new things. The writing style is dry and boring, and it took me a long time to finish it.
Financial Statements: An Overview
Financial statements are currently prepared according to generally accepted accounting principles (GAAP) that have been adopted in order to achieve a presentation of financial information that is understandable by users as well as relevant and reliable for decision making.
The two authorities primarily responsible for establishing GAAP in the United States are the SEC, a public-sector organization, and the Financial Accounting Standards Board (FASB), a private-sector organization.
The globalization of business activity has resulted in the need for a uniform set of accounting rules in all countries. Investors and creditors in international markets would benefit from financial statements that are consistent and comparable regardless of the firm's location. To address this need, the IASB, formerly the International Accounting Standards Committee, was formed in 1973. The eventual goal of the IASB is the adoption of uniform international accounting standards.
A corporate annual report contains four basic financial statements [...].
- The balance sheet or statement of financial position shows the financial position – assets, liabilities, and stockholders' equity – of the firm on a particular date, such as the end of a quarter or a year.
- The income or earnings statement presents the results of operations – revenues, expenses, net profit or loss, and net profit or loss per share – for the accounting period.
- The statement of stockholders' equity reconciles the beginning and ending balances of all accounts that appear in the stockholders' equity section of the balance sheet. [...]
- The statement of cash flows provides information about the cash inflows and outflows from operating, financing, and investing activities during an accounting period.
Immediately following the four financial statements is the section entitled Notes to the Financial Statements [...]. The notes are, in fact, an integral part of the statements and must be read in order to understand the presentation on the face of each financial statement. The first note to the financial statements provides a summary of the firm's accounting policies. If there have been changes in any accounting policies during the reporting period, these changes will be explained and the impact quantified in a financial statement note. Other notes to the financial statements present details about particular accounts [...].
Related to the financial statements and notes is the report of an independent or external auditor [...]. Management is responsible for the preparation of financial statements, including the notes, and the auditor's report attests to the fairness of the presentation.
An unqualified report [...] states that the financial statements present fairly, in all material respects, the financial position, the results of operations, and the cash flows for the accounting period, in conformity with GAAP. Some circumstances warrant reports other than an unqualified opinion and are called qualified reports. A departure from GAAP will result in a qualified opinion [...]. If the departure from GAAP affects numerous accounts and financial statement relationships, then an adverse opinion is rendered, which states that the financial statements have not been presented fairly in accordance with GAAP.
Many circumstances warrant an unqualified opinion with explanatory language such as: a consistency departure due to a change in accounting principle, uncertainty caused by future events such as contract disputes and lawsuits, or events that the auditor wishes to describe because they may present business risk and going-concern problems.
The Management Discussion and Analysis (MD&A) section, sometimes labeled "Financial Review", is of potential interest to the analyst because it contains information that cannot be found in the financial data. The content of this section includes coverage of any favorable or unfavorable trends and significant events or uncertainties in the areas of liquidity, capital resources, and results of operations.
The SEC requires companies to solicit shareholder votes in a document called the proxy statement, as many shareholders do not attend shareholder meetings. The proxy statement contains voting procedures and information, background information about the company's nominated directors, director compensation, executive compensation and any proposed changes in compensation plans, the audit committee report, and a breakdown of audit and nonaudit fees paid to the auditing firm. This information is important in assessing who manages the firm and how management is paid and potential conflict-of-interest issues.
GAAP-based financial statements are prepared according to the "accrual" rather than the "cash" basis of accounting. The accrual method means that the revenue is recognized in the accounting period when the sale is made rather than when the cash is received. The same principle applies to expense recognition; the expense associated with the product may occur before or after the cash is paid out.
The Balance Sheet
The balance sheet shows the financial condition or financial position of a company on a particular date. The statement is a summary of what the firm owns (assets) and what the firm owes to outsiders (liabilities) and to internal owners (stockholders' equity). By definition, the account balances on a balance sheet must balance; that is, the total of all assets must equal the sum of liabilities and stockholders' equity.
When a parent owns more than 50% of the voting stock of a subsidiary, the financial statements are combined for the companies even though they are separate legal entities. The statements are consolidated because the companies are in substance one company, given the proportion of control by the parent.
A common-size balance sheet expresses each item on the balance sheet as a percentage of total assets. Common-size statements facilitate the internal or structural analysis of a firm.
Current assets include cash or those assets expected to be converted into cash within one year or one operating cycle, whichever is longer. The operating cycle is the time required to purchase or manufacture inventory, sell the product, and collect the cash. [...] The designation "current" refers essentially to those assets that are continually used up and replenished in the ongoing operations of the business. The term working capital or net working capital is used to designate the amount by which current assets exceed current liabilities (current assets less current liabilities).
Marketable securities (also referred to as short-term investments) are cash substitutes, cash that is not needed immediately in the business and is temporarily invested to earn a return. These investments are in instruments with short-term maturities (less than one year) to minimize the risk of interest rate fluctuations. They must be relatively riskless securities and highly liquid so that funds can be readily withdrawn as needed.
Accounts receivable are customer balances outstanding on credit sales and are reported on the balance sheet at their net realizable value, that is, the actual amount of the account less an allowance for doubtful accounts. Management must estimate – based on such factors as past experience, knowledge of customer quality, the state of the economy, the firm's collection policies – the dollar amount of accounts they expect will be uncollectible during an accounting period. Actual losses are written off against the allowance account, which is adjusted at the end of each accounting period.
There should be a consistent relationship between the rate of change or growth rates in sales, accounts receivable, and the allowance for doubtful accounts. If the amounts are changing at significantly different rates or in different directions – for example, if sales and accounts receivable are increasing, but the allowance account is decreasing or is increasing at a much smaller rate – the analyst should be alert to the potential for manipulation using the allowance account. Of course, there could be a plausible reason for such a change.
Inventories are items held for sale or used in the manufacture of products that will be sold. A retail company [...] lists only one type of inventory on the balance sheet: merchandise inventories purchased for resale to the public. A manufacturing firm, in contrast, would carry three different types of inventories: raw materials or supplies, work-in-process, and finished goods.
The method chosen by a company to account for inventory determines the value of inventory on the balance sheet and the amount of expense recognized for cost of goods sold on the income statement.
Inventory valuation is based on an assumption regarding the flow of goods and has nothing whatever to do with the actual order in which products are sold.
The three cost flow assumptions most frequently used by U.S. companies are FIFO (first in, first out), LIFO (last in, first out), and average cost. As the terms imply, the FIFO method assumes the first units purchased are the first units sold during an accounting period; LIFO assumes that the items bought last are sold first; and the average cost method uses an average purchase price to determine the cost of products sold.
Certain expenses, such as insurance, rent, property taxes, and utilities, are sometimes paid in advance. They are included in current assets if they will expire within one year or one operating cycle, whichever is longer. Generally, prepayments are not material to the balance sheet as a whole.
[Property, Plant, and Equipment] encompasses a company's fixed assets (also called tangible, long-lived, and capital assets) – those assets not used up in the ebb and flow of annual business operations. These assets produce economic benefits for more than one year, and they are considered "tangible" because they have a physical substance.
Fixed assets other than land (which has a theoretically unlimited life span) are "depreciated" over the period of time they benefit the firm. The process of depreciation is a method of allocating the cost of long-lived assets. The original cost, less any estimated residual value at the end of the asset's life, is spread over the expected life of the asset. Cost is also considered to encompass any expenditures made to ready the asset for operating use. On any balance sheet date, property, plant, and equipment is shown at book value, which is the difference between original cost and any accumulated depreciation to date.
[...] management must choose a method of depreciation: The straight-line method allocates an equal amount of expense to each year of the depreciation period, whereas an accelerated method apportions larger amounts of expense to the earlier years of the asset's depreciable life and lesser amounts to the later years.
The choices and estimates relating to the depreciation of equipment affect the amounts shown on the financial statements relating to the asset. The fixed asset account on the balance sheet is shown at historical cost less accumulated depreciation, and the annual depreciation expense is deducted on the income statement to determine net income.
Additional categories of noncurrent assets frequently encountered [...] are long-term investments and intangible assets, such as goodwill recognized in business combinations, patents, trademarks, copyrights, brand names, and franchises. Of the intangible assets, goodwill is the most important for analytical purposes because of its potential materiality on the balance sheet of firms heavily involved in acquisitions activity.
Goodwill arises when one company acquires another company (in a business combination accounted for as a purchase) for a price in excess of the fair market value of the net identifiable assets (identifiable assets less liabilities assumed) acquired. This excess price is recorded on the books of the acquiring company as goodwill. Goodwill must be evaluated annually to determine whether there has been a loss of value. If there is no loss of value, goodwill remains on the balance sheet at the recorded cost indefinitely. If it is determined that the book value or carrying value of goodwill exceeds the fair value, the excess book value must be written off as an impairment expense.
Liabilities represent claims against assets, and current liabilities are those that must be satisfied in one year or one operating cycle, whichever is longer. Current liabilities include accounts and notes payable, the current portion of long-term debt, accrued liabilities, unearned revenue, and deferred taxes.
Accounts payable are short-term obligations that arise from credit extended by suppliers for the purchase of goods and services.
Notes payable are short-term obligations in the form of promissory notes to suppliers or financial institutions.
When a firm has bonds, mortgages, or other forms of long-term debt outstanding, the portion of the principal that will be repaid during the upcoming year is classified as a current liability.
Accrued liabilities result from the recognition of an expense in the accounting records prior to the actual payment of cash. Thus, they are liabilities because there will be an eventual cash outflow to satisfy the obligations.
Reserve accounts are often set up for the purpose of estimating obligations for items such as warranty costs, sales returns, or restructuring charges, and are recorded as accrued liabilities.
Companies that are paid in advance for services or products record a liability on the receipt of cash. The liability account is referred to as unearned revenue or deferred credits. The amounts in this account will be transferred to a revenue account when the service is performed or the product delivered as required by the matching concept of accounting.
Deferred taxes are the result of temporary differences in the recognition of revenue and expense for taxable income relative to reported income.
Most large companies use one set of rules for calculating income tax expense, paid to the IRS, and another set for figuring income reported in the financial statements. The objective is to take advantage of all available tax deferrals to reduce actual tax payments, while showing the highest possible amount of reported net income. There are many areas in which firms are permitted to use different procedures for tax and reporting purposes. Most firms use an accelerated method of depreciation [...] to figure taxable income and the straight-line method for reporting purposes.
Obligations with maturities beyond one year are designated on the balance sheet as noncurrent liabilities. This category can include bonded indebtedness, long-term notes payable, mortgages, obligations under leases, pension liabilities, and long-term warranties.
The ownership interests in the company are represented in the final section of the balance sheet, stockholders' equity or shareholders' equity. Ownership equity is the residual interest in assets that remains after deducting liabilities.
The retained earnings account is the sum of every dollar a company has earned since its inception, less any payments made to shareholders in the form of cash or stock dividends. Retained earnings do not represent a pile of unused cash stashed away in corporate vaults; retained earnings are funds a company has elected to reinvest in the operations of the business rather than pay out to stockholders in dividends.
Income Statement and Statement of Stockholders' Equity
The income statement, also called the statement of earnings, presents revenues, expenses, net income, and earnings per share for an accounting period, generally a year or a quarter. [...] The statement of stockholders' equity is an important link between the balance sheet and the income statement. This statement documents the changes in the balance sheet equity accounts from one accounting period to the next. Companies may choose to report the information on the statement of stockholders' equity in a supplementary schedule or in a note to the financial statements rather than preparing a formal financial statement.
Data are presented in corporate income statements for three years to facilitate comparison and to provide evidence regarding trends of revenues, expenses, and net earnings.
Total sales revenue for each year of the three-year period is shown net of returns and allowances. A sales return is a cancellation of a sale, and a sales allowance is a deduction from the original sales invoice price.
If a company's sales are increasing (or decreasing), it is important to determine whether the change is a result of price, volume, or a combination of both. [...] The reasons for sales growth (or decline) are covered in a firm's Management Discussion and Analysis section of the annual or 10-K report [...].
The first expense deduction from sales is the cost to the seller of products or services sold to customers. This expense is called cost of goods sold or cost of sales. The amount of cost of goods sold for any accounting period [...] will be affected by the cost flow assumption used to value inventory.
The relationship between cost of goods sold and net sales – called the cost of goods sold percentage – is an important one for profit determination because cost of goods sold is the largest expense item for many firms.
The difference between net sales and cost of goods sold is called gross profit or gross margin. [...] Gross profit, expressed as a percentage of net sales, is the gross profit margin.
Selling and administrative expenses are expenses relating to the sale of products or services and to the management of the business. They include salaries, rent, insurance, utilities, supplies, and sometimes depreciation and advertising expense.
The cost of assets other than land that will benefit a business enterprise for more than a year is allocated over the asset's service life rather than expensed in the year of purchase. Land is an exception to the rule because land is considered to have an unlimited useful life. The cost allocation procedure is determined by the nature of the long-lived asset. Depreciation is used to allocate the cost of tangible fixed assets such as buildings, machinery, equipment, furniture and fixtures, and motor vehicles. Amortization is the process applied to capital leases, leasehold improvements, and the cost expiration of intangible assets such as patents, copyrights, trademarks, and franchises. The cost of acquiring and developing natural resources – oil and gas, other minerals, and standing timber – is allocated through depletion.
Operating profit (also called EBIT or earnings before interest and taxes) [...] measures the overall performance of the company's operations: sales revenue less the expenses associated with generating sales. The figure for operating profit provides a basis for assessing the success of a company apart from its financing and investing activities and separate from tax considerations.
[Other Income (Expense)] includes revenues and costs other than from operations, such as dividend and interest income, interest expense, gains (losses) from investments, equity earnings (losses), and gains (losses) from the sale of fixed assets.
An additional issue that users sometimes encounter in attempting to evaluate financial statement data is the method – cost or equity – employed to account for investments in the voting stock of other companies. [...] Accounting rules permit two different methods to account for stock investments of less than 50%. The equity method allows the investor proportionate recognition of the investee's net income, irrespective of the payment or nonpayment of cash dividends; under the cost method, the investor recognizes investment income only to the extent of any cash dividends received.
Use of the equity method somewhat distorts earnings in the sense that income is recognized even though no cash may ever be received.
Discontinued operations occur when a firm sells or discontinues a clearly distinguishable portion of its business. The results of continuing operations are shown separately from the operating results of the discontinued portion of the business. Any gain or loss on the disposal is also disclosed separately.
Extraordinary gains and losses are items that meet two criteria: unusual in nature and not expected to recur in the foreseeable future, considering the firm's operating environment.
Net earnings, or "the bottom line", represents the firm's profit after consideration of all revenue and expense reported during the accounting period.
Earnings per common share is the net earnings available to common stockholders for the period divided by the average number of common stock shares outstanding.
Companies with complex capital structures – which means existence of convertible securities (such as bonds convertible into common stock), stock options, and warrants – must calculate two amounts for earnings per share: basic and diluted. If convertible securities were converted into common stock and/or the options and warrants were exercised, there would be more shares outstanding for every dollar earned, and the potential for dilution is accounted for by the dual presentation.
Currently, there are four items that may comprise a company's other comprehensive income: foreign currency translation effects, unrealized gains and losses, additional pension liabilities, and cash flow hedges.
The statement of stockholders' equity details the transactions that affect the balance sheet equity accounts during an accounting period.
Statement of Cash Flows
The statement of cash flows [...] provides information about cash inflows and outflows during an accounting period. On the statement, cash flows are segregated by operating activities, investing activities, and financing activities.
The statement of cash flows is prepared in exactly that way: by calculating the changes in all of the balance sheet accounts, including cash; then listing the changes in all of the accounts except cash as inflows or outflows; and categorizing the flows by operating, financing, or investing activities. The inflows less the outflows balance to and explain the change in cash.
Cash includes cash and highly liquid short-term marketable securities, also called cash equivalents. [...] Some companies will separate marketable securities into two accounts: (1) cash and cash equivalents and (2) short-term investments. When this occurs, the short-term investments are classified as investing activities.
Operating activities include delivering or producing goods for sale and providing services and the cash effects of transactions and other events that enter into the determination of income.
Investing activities include (1) acquiring and selling or otherwise disposing of (a) securities that are not cash equivalents and (b) productive assets that are expected to benefit the firm for long periods of time and (2) lending money and collecting on loans.
Financing activities include borrowing from creditors and repaying the principal and obtaining resources from owners and providing them with a return on the investment.
Depreciation and amortization are added back to net income because they reflect the recognition of a noncash expense. Remember that depreciation represents a cost allocation, not an outflow of cash. The acquisition of the capital asset was recognized as an investing cash outflow [...] in the statement of cash flows for the period in which the asset was acquired. [...] Amortization is similar to depreciation – an expense that enters into the determination of net income but that does not require an outflow of cash.
The ongoing operation of any business depends on its success in generating cash from operations. It is cash that a firm needs to satisfy creditors and investors. Temporary shortfalls of cash can be satisfied by borrowing or other means, such as selling long-lived assets, but ultimately a company must generate cash.
A Guide to Earnings and Financial Reporting Quality
While financial statement users cannot readily determine premature revenue recognition policy, they can look for certain clues in the financial statement information. An important place to start is the firm's revenue recognition policy, which is discussed in financial statement notes, to determine whether any changes have been made to the policy and if so, to evaluate the reason for the change and its impact. Analyzing the relationship among sales, accounts receivable, and inventory can signal "red flags" if these accounts are not moving in comparable patterns. Fourth-quarter spikes in revenue may also indicate premature revenue recognition for companies that do not typically experience high seasonal fourth-quarter sales.
Another tactic to boost revenues is to record sales at the gross rather than the net price. "Gross" refers to the total amount that the final customer pays for an item. "Net" refers to the gross amount less the cost of the sale, which equals the fee that is paid to the reseller of the item. Some companies act as an agent between the customer and seller of a product or service. Agents receive the "net" amount for their role.
There should be a consistent relationship [...] between the rate of change in sales, accounts receivable, and the allowance for doubtful accounts. If the amounts are changing at different rates or in different directions [...] the analyst should be alert to the potential for manipulation through the allowance account. Of course, there could also be a plausible reason for such a change.
[...] the allowance for doubtful accounts is a type of reserve account and can be manipulated by under- or overestimating bad debt expenses. Underestimating bad debt expense will boost net income. On the other hand, by overestimating the allowance account, firms can set themselves up for a later correction that will ultimately boost net income.
If a company's sales are increasing (or decreasing), it is important to determine whether the change is a result of price, volume, or a combination of both factors. Are sales growing because the firm is increasing prices or because more units are being sold, or both? It would seem that, in general, higher-quality earnings would be the product of both volume and price increases (during inflation). The firm would want to sell more units and keep prices increasing at least in line with the growth rate of general inflation.
A company can increase earnings by reducing variable operating expenses in a number of areas such as the repair and maintenance of capital assets, research and development, and advertising and marketing. If such discretionary expenses are reduced primarily to benefit the current year's reported earnings, the long-run impact on the firm's operating profit may be detrimental and thus the quality lowered. The analyst should review the trends of these discretionary expenses and compare them with the firm's volume of activity and level of capital investment.
When a company sells a capital asset, such as property or equipment, the gain or loss is included in net income for the period. The sale of a major asset is sometimes made to increase earnings and/or to generate needed cash during a period when the firm is performing poorly. Such transactions are not part of the normal operations of the firm and should be excluded from net income when considering the future operating potential of the company.
Some companies have created their own operating profit numbers and tried to convince users that these figures are the ones to focus on instead of the GAAP-based amounts. These "company created" numbers go by a variety of names such as core earnings, pro forma earnings, or EBITDA. EBITDA, for example, refers to operating earnings before interest, tax, depreciation, and amortization expenses are deducted. Those who support focusing on EBITDA argue that depreciation and amortization charges are not cash items and should be ignored. In essence, they are asking that users ignore the fact that companies make long-term investments. Depreciation and amortization expenses are the allocation of an original cash amount spent for items such as equipment.
The Analysis of Financial Statements
When analyzing a company it is also important to review the annual reports of suppliers, customers, and competitors of that company. The bankruptcy of a supplier could affect the firm's supply of raw materials, whereas the bankruptcy of a customer could negatively impact the collection of accounts receivable and future sales. Knowing how one company compares financially to its competitors and understanding other factors such as innovation and customer service provided by the competition allows for a better analysis to predict the future prospects of the firm.
Although extremely valuable as analytical tools, financial ratios also have limitations. They can serve as screening devices, indicate areas of potential strength or weakness, and reveal matters that need further investigation. But financial ratios do not provide answers in and of themselves, and they are not predictive. Financial ratios should be used with caution and common sense, and they should be used in combination with other elements of financial analysis.
[...] there are no "rules of thumb" that apply to the interpretation of financial ratios. Each situation should be evaluated within the context of the particular firm, industry, and economic environment.
The current ratio is a commonly used measure of short-run solvency, the ability of a firm to meet its debt requirements as they come due. Current liabilities are used as the denominator of the ratio because they are considered to represent the most urgent debts, requiring retirement within one year or one operating cycle. The available cash resources to satisfy these obligations must come primarily from cash or the conversion to cash of other current assets.
A firm could have a relatively high current ratio but not be able to meet demands for cash because the accounts receivable are of inferior quality or the inventory is salable only at discounted prices. It is necessary to use other measures of liquidity, including cash flow from operations and other financial ratios that rate the liquidity of specific assets, to supplement the current ratio.
The quick or acid-test ratio is a more rigorous test of short-run solvency than the current ratio because the numerator eliminates inventory, considered the least liquid current asset and the most likely source of losses.
Another approach to measuring short-term solvency is the cash flow liquidity ratio, which considers cash flow from operating activities [...]. The cash flow liquidity ratio uses in the numerator, as an approximation of cash resources, cash and marketable securities, which are truly liquid current assets, and cash flow from operating activities, which represents the amount of cash generated from the firm's operations, such as the ability to sell inventory and collect the cash.
The average collection period of accounts receivable is the average number of days required to convert receivables into cash. The ratio is calculated as the relationship between net accounts receivable (net of the allowance for doubtful accounts) and average daily sales (sales/365 days).
The days inventory held is the average number of days it takes to sell inventory to customers. This ratio measures the efficiency of the firm in managing its inventory. Generally, a low number of days inventory held is a sign of efficient management; the faster inventory sells, the fewer funds tied up in inventory. On the other hand, too low a number could indicate understocking and lost orders, a decrease in prices, a shortage of materials, or more sales than planned. A high number of days inventory held could be the result of carrying too much inventory or stocking inventory that is obsolete, slow-moving, or inferior; however, there may be legitimate reasons to stockpile inventory, such as increased demand, expansion and opening of new retail stores, or an expected strike.
The days payable outstanding is the average number of days it takes to pay payables in cash. This ratio offers insight into a firm's pattern of payments to suppliers. Delaying payment of payables as long as possible, but still making payment by the due date, is desirable.
The cash conversion cycle or net trade cycle is the normal operating cycle of a firm that consists of buying or manufacturing inventory, with some purchases on credit and the creation of accounts payable; selling inventory, with some sales on credit and the creation of accounts receivable; and collecting the cash. The cash conversion cycle measures this process in number of days [...].
The fixed asset turnover and total asset turnover ratios are two approaches to assessing management's effectiveness in generating sales from investments in assets. [...] Generally, the higher these ratios, the smaller is the investment required to generate sales and thus the more profitable is the firm.
The amount and proportion of debt in a company's capital structure is extremely important to the financial analyst because of the trade-off between risk and return. Use of debt involves risk because debt carries a fixed commitment in the form of interest charges and principal repayment. Failure to satisfy the fixed charges associated with debt will ultimately result in bankruptcy. A lesser risk is that a firm with too much debt has difficulty obtaining additional debt financing when needed or finds that credit is available only at extremely high rates of interest.
The debt-to-equity ratio measures the riskiness of the firm's capital structure in terms of the relationship between the funds supplied by creditors (debt) and investors (equity). The higher the proportion of debt, the greater is the degree of risk because creditors must be satisfied before owners in the event of bankruptcy.
Gross profit margin, operating profit margin, and net profit margin represent the firm's ability to translate sales dollars into profits at different stages of measurement. The gross profit margin, which shows the relationship between sales and the cost of products sold, measures the ability of a company both to control costs of inventories or manufacturing of products and to pass along price increases through sales to customers. The operating profit margin, a measure of overall operating efficiency, incorporates all of the expenses associated with ordinary business activities. The net profit margin measures profitability after consideration of all revenue and expense, including interest, taxes, and nonoperating items.
Return on investment and return on equity are two ratios that measure the overall efficiency of the firm in managing its total investment in assets and in generating return to shareholders. Return on investment or return on assets indicates the amount of profit earned relative to the level of investment in total assets. Return on equity measures the return to common shareholders; this ratio is also calculated as return on common equity if a firm has preferred stock outstanding.
[...] a thorough analysis of the company, its environment, and its financial information offers a much better gauge of the future prospects of the company than looking exclusively at earnings per share and price-to-earnings ratios. These two ratios are based on an earnings number that can be misleading at times given the many accounting choices and techniques used to calculate it.
Earnings per common share is net income for the period divided by the weighted average number of common shares outstanding.
The price-to-earnings ratio (P/E ratio) relates earnings per common share to the market price at which the stock trades, expressing the "multiple" that the stock market places on a firm's earnings.
The dividend payout ratio is determined by the formula cash dividends per share divided by earnings per share.
The dividend yield shows the relationship between cash dividends and market price.
An individual company does not operate in a vacuum. Economic developments and the actions of competitors affect the ability of any business enterprise to perform successfully. It is therefore necessary to preface the analysis of a firm's financial statements with an evaluation of the environment in which the firm conducts business.