Too tough to test
Qualitative analysis- just as important as quantitative
Step 1- Before you start the project….
Step 2: Students select two United States based publicly traded comparable companies using www.sec.gov.
Step 3: Students create common sized balance sheets and income statements for the selected companies and align them for comparability.
Step 4: Students select the three best ratios to best evaluate the companies
At this point during class, I review the various ratios and their categories (liquidity, solvency, profitability, and market prospects). I will show the students how to calculate all the ratios for my sample companies.
After all ratios that I am covering have been computed, I ask the class to determine which ratios are most meaningful and which requires critical thinking. Anyone can calculate a ratio; however, can the student decide which ratios are most relevant to a company?
For Home Depot and Lowe’s (the Step 3 company examples), the inventory turnover ratio is more important than the accounts receivable turnover. Why? Receivables are insignificant as an overall percentage to either company while inventory (beyond fixed assets) are the most significant balance sheet items for both Home Depot and Lowe’s.
If you are having the students craft a paper for the project, you can have them identify the three ratios (or however many you choose to evaluate) and then give details as to why the student chose each ratio (e.g. % of assets, revenue, etc.). While I am pretty flexible on grading, I do reduce the points given if the student did not put some thought into the ratios they selected.
You will be surprised as to what else will potentially come out of the discussion. While reviewing the acid-test ratio of a publicly traded company (which was less than .1), a student shared that her husband had done business with that company and had not been paid in over 150 days. The class quickly realized that just because a company is publicly traded does not mean that they will pay their obligations timely. Before doing business with anyone, a company needs to perform its due diligence prior to extending credit even to a publicly traded company.
Step 5: Students must compute the price to earnings ratio
I always have my students compute the Price to Earnings (“P/E”) ratio so that they gain perspective as to how companies are currently valued by investors. For instance, as of October 20, 2017, Amazon had a P/E ratio of 248.01...Amazon will need approximately 248 years to earn back its share price (at current earnings / price levels). This is longer than the United States has been independent. Also, some companies such as Tesla have no P/E ratio as these companies continue to operate at a loss.
Step 6: Students draft a paper and comment on their findings
I require my students to submit a paper that details, in their own words, why they selected the two companies. I’ve had some great responses from “I like to drink beer” to “I worked at that company and I hated it.” The students then craft a corporate summary (this can be pulled from the 10-K as long as they acknowledge the source) and include the ratio analysis from Steps 4 and 5. Lastly, the student makes a recommendation to buy or sell the stocks they have chosen based on their financial statement analysis.
One of my most awesome Irvine Valley College students, Edmond King, gave the prototype for a lifetime. This paper compares Under Armour to Nike.
Step 7: Extra credit opportunities
If a student does not complete the assignment or creates work that is not up to your standard, you may consider giving the student an opportunity to obtain additional points. I make it very clear to the student that if they ask me to make a custom assignment for them, they need to do the work. This generally stops the point fishing expedition.
At this point, you can make the project a true research vehicle. Goodwill, intangibles, stock compensation expense, fair value vs. historical cost of assets are all fertile ground for further investigation by the student. Here you will find a sample e-mail that I initially send to my student as well as a follow up e-mail if a student failed to complete the additional work.
Final thoughts - teaching financial statement analysis:
Some of my most gratifying moments as an accounting instructor have come as a result of assigning the paper. A parent was shocked to learn that his daughter (my student) knew what a 10-K was in a lower division managerial accounting course. Another student was able to have a conversation with a prospective employer about the real-life project that she had done while in class. While grading and creating these assignments will take a considerable amount of time, the practical education you are giving will give them an advantage as your students start their professional careers.
Thank you for reading this article. Stay tuned, because our next post will be the Part 3 of this series, which is accounting ethics. Please feel free to leave your comments below!