FINANCIAL STATEMENT

ANALYSIS

THE NEED FOR FINANCIAL

STATEMENT ANALYSIS
Financial statement analysis
involves the examination of both
the relationships among financial
statement numbers and the trends
in those numbers over time
Relationships between financial
statement amounts are called
financial ratios
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THE NEED FOR FINANCIAL

STATEMENT ANALYSIS
Past performance is used to
predict future performance of a
company
Problem areas can be identified

Structure of Ratio Analysis

From broadest to more specific
levels.
Compared to ratios for other time
periods (i.e., longitudinal or trend
analysis).
Best to choose which ratios are most
relevant for your company.
Not defined by GAAP.

Categorizing Ratios

Liquidity or Solvency
Leverage: Structural & Coverage
Efficiency or Turnover
Profitability and Return
Market Based and Others

Liquidity Ratios

current assets
Current ratio =
current liabilities

Liquidity Ratios
cash + marketable securities + receivables
Quick ratio =
current liabilities

cash + marketable securities

Cash ratio =
current liabilities

cash + marketable securities + receivables

Interval measure =
average daily expenditures from operations

Leverage Ratios
long term debt
Long term debt ratio =
long term debt + equity

long term debt + value of leases

Debt equity ratio =
equity

T o ta l d e b t ra tio

to ta l lia b ilitie s
to ta l a s s e ts
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Leverage Ratios
EBIT+ dep + Non Cash Charges
Int Coverage=
interest
EBIT + dep + Non Cash Charges
FCCR =
Int + LP + P/(1 - T)
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Efficiency Ratios
Asset turnover ratio

Sales
=
Average total assets

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Efficiency Ratios
cost of goods sold
Inventory turnover ratio =
average inventory

average inventory
Days' sales in inventory =
cost of goods sold / 365

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Efficiency Ratios
Sales or Credit Sales
Debtors turnover ratio =
average debtors
Average

Collection

Period

average debtors
=
sales /365

average debtors
Average Collection Period =
average daily sales

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Profitability Ratios
GP or NP
Gross or Net profit margin =
sales

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Return on Equity ROE)

R e tu rn o n e q u ity

e a rn in g s a v a ila b le fo r c o m m o n s to c k
a v e ra g e e q u ity

Net income Shareholders equity

Reflects what company has earned on
funds invested by shareholders.
Of interest to current and prospective
shareholders.
Important indicator of shareholder value
creation.

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Return on Assets (ROA)

EBIT - tax
Return on assets =
average total assets
EBIT (1 - Tax Rate)
Return on assets =
average total assets

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Return on Assets (ROA)

[Net income + Interest x (1 Tax rate)] Total
assets
Reflects how well management is using its
resources.
Some analysts ignore interest adjustment.
Used to measure divisional performance
when manager has significant influence on
assets, but not financing.
Sometimes calculated only using tangible
assets.

Return on Invested
Capital (ROIC)
[Net income + Interest x (1 Tax rate)]
(Long-term liabilities + Shareholders equity)
Denominator also called invested capital.
Invested capital (i.e., permanent capital) is funds
entrusted to the firm for relatively long time.
Invested capital is also equal to working capital
plus noncurrent assets.
Used to measure divisional performance when
managers have significant influence on
financing and operations.

Other Ratios
dividends
Payout ratio =
earnings

earnings - dividends
Plowback ratio =
earnings
= 1 - payout ratio

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Market Value Ratios

stock price
PE Ratio =
earnings per share

dividend per share

Dividend yield =
stock price

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Price/Earnings (PE) ratio

Market price per share Net income
per share.
Widely used measure of overall
performance.
Market price not controlled by
company.
Best measure of how investors judge
companys future performance.
Commonly compared to other
companies in same industry.
Can reflect differing expectations of
growth among industries.

Market Value Ratios

stock price
Market to book ratio =
book value per share

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DUPONT FRAMEWORK
Provides a framework for
computation of financial ratios for
a more detailed analysis of a
companys strengths and
weaknesses

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The DuPont System

A breakdown of ROE and ROA into
component ratios
EBIT - taxes
ROA =
assets
EBIT - tax - interest
ROE =
equity
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The DuPont System

sales
EBIT - taxes
ROA =
x
assets
sales

asset
turnover

profit
margin

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The DuPont System

assets
sales
EBIT - taxes EBIT - taxes - interest
ROE =
x
x
x
equity
assets
sales
EBIT - taxes

leverage asset
ratio turnover

profit
margin

debt
burden

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ANALYSIS OF ROE USING

THE DUPONT FRAMEWORK
ROE = Profitability x Efficiency x Leverage
= Return on Sales x Asset turnover x Assets-to-Equity Ratio

= Net Income x

Sales

Sales
Assets

Assets
Equity
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ANALYSIS OF ROE USING

THE DUPONT FRAMEWORK
A preliminary DuPont analysis may
indicate a need to compute more
ratios in any of the three ROE
components:
Profitability ratios
Efficiency ratios
Leverage ratios
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CASH FLOW RATIOS

Are useful when net income does not
portray the economic performance of a
company
Such situations happen when
There are large noncash expenses
There is rapid growth
Accrual accounting assumptions may be
stretched to provide window dressing in
reported earnings
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CASH FLOW RATIOS

Cash Flow Adequacy
Indicates whether a business is generating
enough cash from operations to pay for
plant and equipment

Cash Flow
Cash
From
Operations
Adequacy =
Fixed Assets Additions and
Acquisition Expenditures
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CASH FLOW RATIOS

Cash Times Interest Earned
Provides an indicator of interestpaying ability

Cash From Operations

Cash Times
Before
Interest
and
Taxes
Interest Earned = Cash Paid for Interest
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Difficulties in Making
Comparisons
Need to find proper basis for comparison.
Increase in some ratios will usually be good
(e.g., profit margin).
But some ratios may need to fall within a quality
range (e.g., current ratio).

May need to adjust for:

Changes in conditions.
Changes in price levels.
Differences in book values among companies.
Differences in GAAP usage, definitions among
companies.
Hidden short-run changes.
Conditions in past that have changed.

Possible Bases for

Comparison
Experience.
Subjective standards of competent
analyst/manager.
A feel for what is right or reasonable.

Budgets.
Target developed within the company.
Factors to consider:
Was budget carefully constructed?
Are budget conditions still prevailing?
Outside analysts do not have complete
access to information.

Possible Bases for

Comparison
Historical standards.
Prior periods results adjusted for
changes in accounting methods.
Potential problem: Does prior results
provide an acceptable standard?

External benchmarks.
Highly regarded competitor.
Best business unit within company.
Industry average.

Use vs. Abuse of

Comparisons
Primarily provides questions to be
answered (rarely provides definitive
answers).
Cannot view a ratio or group of ratios in
isolation (e.g., a favorable increase in
one ratio may be caused by an
unfavorable increase in others).
Ratio comparisons assume all other
things are equal (normally does not
exist).

POTENTIAL PITFALLS
Financial statements do not
contain all information
Sometimes financial statement
numbers are not comparable
Expenses reported in different
categories
Companies in unrelated industries
Differences in accounting practices
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POTENTIAL PITFALLS

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One monumental flaw may not

present itself from ratio analysis
Historical analysis should be
balanced against current data from
different sources

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COMMON-SIZE FINANCIAL
STATEMENTS
Common-size financial statements
show all amounts for a given year
as a percentage of Sales (Income
Statement) or Total Assets (Balance
Sheet)
They should be included in the
initial stages of any comprehensive
financial statement analysis
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