Financial Analysis and Management

Ratios and common-sized financial statements are used to measure the

performance and financial position of a company. However, ratios in of
themselves are not useful. They are only useful when used relative to some
other benchmarkusually past internal results (time-series analysis) or
compared to other companies (cross-sectional analysis).
Common-size financial statements and financial ratios remove the effect of
size, allowing comparisons of a company with peer companies (crosssectional analysis) and comparison of a companys results over time (trend or
time-series analysis).
Common-sized financial statements essentially converts every line item in
the statement to a financial ratio relative to the base value. The base value
used in the vertical common-sized income statement and statement of cash
flows is usually revenue. The base value used in the vertical common-sized
balance sheet is total assets. The base value used in horizontal statements is
the original value of that line item.
The following categories are not mutually exclusive; some ratios are useful in
measuring multiple aspects of the business. Types of ratios:
o Activity ratios measure the efficiency of a companys operations, such
as collection of receivables or management of inventory. Major activity
ratios include inventory turnover, days of inventory on hand,
receivables turnover, days of sales outstanding, payables turnover,
number of days of payables, working capital turnover, fixed asset
turnover, and total asset turnover.
o Liquidity ratios measure the ability of a company to meet short-term
obligations. Major liquidity ratios include the current ratio, quick ratio,
cash ratio, and defensive interval ratio.
o Solvency ratios measure the ability of a company to meet long-term
obligations. Major solvency ratios include debt ratios (including the
debt-to-assets ratio, debt-to-capital ratio, debt-to-equity ratio, and
financial leverage ratio) and coverage ratios (including interest
coverage and fixed charge coverage).
o Profitability ratios measure the ability of a company to generate profits
from revenue and assets. Major profitability ratios include return on
sales ratios (including gross profit margin, operating profit margin,
pretax margin, and net profit margin) and return on investment ratios
(including operating ROA, ROA, return on total capital, ROE, and return
on common equity).
o Valuation ratios express the relation between the market value of a
company or its equity (for example, price per share) and some
fundamental financial metric (for example, earnings per share).
DuPont Formula. There are three major ways to state it, with the extended
DuPont formula (5 step) being the most illustrative. The first is too simple
because it does not explain why ROE increased or decreased. For example, a
higher profit margin or asset turnover ratio has a positive and sustainable
effect on ROE, but taking on more financial leverage makes returns riskier.

The five-step equation shows that increases in leverage don't always indicate
an increase in ROE. If the company has a high borrowing cost, its interest
expenses on more debt could mute the positive effects of the leverage.
o ROE = NI/Sales
o ROE = (NI/Sales x Sales/Assets)x(Assets/Equity) = (net profit margin x
asset TO) x DFL = ROA x DFL
o ROE = [(EBIT / sales) * (sales / assets) (interest expense / assets)] *
(assets / equity) * (1 tax rate) = [(operating profit margin) * (asset
turnover) (interest expense rate)] * (equity multiplier) * (tax retention
rate)
o ROE = Tax burdenInterest burdenEBIT marginTotal asset
turnoverLeverage =
Most ratios should be near the industry averagetoo high or too low is
generally not a good sign. However, interpreting ratios requires some
judgement and multiple ratios should be examined to get the complete
picture. Also, each industry may focus on different ratios and may have its
own specialized ratios.
Before computing ratios or common-sized financial statements, always adjust
the financial statements to eliminate the effects of different accounting
methods (e.g., LIFO vs FIFO) and non-recurring items and currencies. This is
especially important for cross-sectional analysis as a companys financial
statements should already present adjusted historical statements if there
were any changes in accounting method.
When a ratio uses an income or cash flow statement with a balance sheet
item, it is usually best practice to use the average value of the balance sheet
item over the period used in the income or cash flow statement. If data is
available, it is even more accurate to use more data points in the calculation
of the average, such as beginning, midpoint and ending values. Databases
usually only use the beginning and ending values.
A company must disclose separate information about any operating segment
which meets certain quantitative criterianamely, the segment constitutes
10 percent or more of the combined operating segments revenue, assets, or
profit. It is often useful to compute ratios for a specific segment.