Chapter 2

FINANCIAL STATEMENT ANALYSIS

BY:

AGNES M. SEIFNEZHAD, CPA

FINANCIAL MANAGEMENT PROFESSOR
 OBJECTIVES OF
FINANCIAL STATEMENT ANALYSIS

 The objective of financial statements analysis is to

determine the extent of a firm’s success in
attaining in financial goals, namely:
a) To earn maximum profit

b) To maintain solvency

c) To attain stability
 MAJOR FINANCIAL STATEMENT USERS

 Creditors – lend money to a company on either a short-

term or a long-term basis. Short-term creditors include
trade creditors and lending institutions. Long-term
creditors include lending institutions and corporate
bondholders.

 Equity investors – those who purchase an ownership

interest in a company. They are after the dividends.

 Management – analyzes the company’s financial

statements with a view toward favorably impressing
external parties.
 EXTERNAL FACTORS THAT AFFECT
FINANCIAL INFORMATION

 General economic environment

Business periodicals are good sources for
information about anticipated changes in economic
conditions.

 Political event
-an action that has already taken place, while the
political climate is a situation that can lead t an
action. Example: Actions taken by the Congress or
the President on government regulation, income
taxes, health care, etc.
 EXTERNAL FACTORS THAT AFFECT
FINANCIAL INFORMATION

 Industry outlook
-defines both the opportunities the company may
seize and the challenges it must face. Government
regulation and deregulation and technological
changes are examples of items that can directly
impact an industry.
PROFITABILITY, LIQUIDITY & SOLVENCY

 Profitability is the ease with which a company

generates income.
 Liquidity is the ease with which an item, such as an
asset, can be converted to cash. It is the ability to
generate sufficient cash to meet its short-term
obligations.
 Solvency is a company’s ability to meet the
obligations created by its long-term debt.
 I. Liquidity Ratios

Give us an idea of the firm’s

ability to pay off debts that are
maturing within a year or within
the next operating cycle.
I. Analysis of Liquidity or Short-Term Solvency

Current ratio

2011 2010

Current ratio is the primary test of

solvency to meet current obligations from
current assets.
I. Analysis of Liquidity or Short-Term Solvency

Current ratio

2011 2010

13,730.50

Current ratio is the primary test of

solvency to meet current obligations from
current assets.
I. Analysis of Liquidity or Short-Term Solvency

Quick or Acid test ratio

2011 2010

Acid-test (quick) ratio is a more severe

test of immediate solvency; test of ability
to meet demands from current assets.
I. Analysis of Liquidity or Short-Term Solvency

Quick or Acid test ratio

2011 2010

13,730.50
Acid-test (quick) ratio is a more severe
test of immediate solvency; test of ability
to meet demands from current assets.
I. Analysis of Liquidity or Short-Term Solvency

Cash-Flow Liquidity Ratio

2011 2010

Cash flow liquidity ratio measures short-tem

liquidity by considering as cash resources
(numerator) cash plus cash equivalents plus
cash flow from operating activities.
 I. Analysis of Liquidity or Short-Term Solvency

Cash-Flow Liquidity Ratio

2011 2010

13,730.50
Cash flow liquidity ratio measures short-tem
liquidity by considering as cash resources
(numerator) cash plus cash equivalents plus
cash flow from operating activities.
II. Asset Management Ratios

Give us the idea of how

efficiently the firm is using its
assets.
Good asset management ratios
are necessary for the firm to
keep its costs low and thus, its
net income high.
II. Analysis of Asset Liquidity and Asset
Management Efficiency

Accounts Receivable Turnover

2011 2010

Accounts receivable turnover measures

the velocity of collection of trade
accounts; tests the efficiency of collection.
 II. Analysis of Asset Liquidity and Asset
Management Efficiency

Accounts Receivable Turnover

2011 2010


Accounts receivable turnover measures

the velocity of collection of trade
accounts; tests the efficiency of collection.
II. Analysis of Asset Liquidity and Asset
Management Efficiency

Average Collection Period

2011 2010

Average collection period evaluates the

liquidity of accounts receivable and the
firm’s credit policies.
 II. Analysis of Asset Liquidity and Asset
Management Efficiency

Average Collection Period

2011 2010


Average collection period evaluates the

liquidity of accounts receivable and the
firm’s credit policies.
II. Analysis of Asset Liquidity and Asset
Management Efficiency

Inventory Turnover

2011 2010

Inventory turnover measures the

efficiency of the firm in managing and
selling inventory.
 II. Analysis of Asset Liquidity and Asset
Management Efficiency

Inventory Turnover

2011 2010


Inventory turnover measures the

efficiency of the firm in managing and
selling inventory.
II. Analysis of Asset Liquidity and Asset
Management Efficiency

Average Sale Period

2011 2010

Average sale period measures average

number of days to sell or consume the
average inventory.
II. Analysis of Asset Liquidity and Asset
Management Efficiency

Average Sale Period

2011 2010


Average sale period measures average

number of days to sell or consume the
average inventory.
 II. Analysis of Asset Liquidity and Asset
Management Efficiency

Fixed Asset Turnover

2011 2010

Fixed asset turnover measures the

effectiveness in generating sales from
investments in fixed assets particularly for
a capital-intensive firm.
 II. Analysis of Asset Liquidity and Asset
Management Efficiency

Fixed Asset Turnover

2011 2010


Fixed asset turnover measures the

effectiveness in generating sales from
investments in fixed assets particularly for
a capital-intensive firm.
II. Analysis of Asset Liquidity and Asset
Management Efficiency

Total Asset Turnover

2011 2010

Total asset turnover measures the

efficiency of management to generate
sales and thus earn more profit for the
firm.
 II. Analysis of Asset Liquidity and Asset
Management Efficiency

Total Asset Turnover

2011 2010


Total asset turnover measures the

efficiency of management to generate
sales and thus earn more profit for the
firm.
III. Debt Management Ratios

Tell us how the firm has

financed its assets as well as the
firm’s ability to repay its long-
term.
III. Analysis of Leverage: Debt Financing and Coverage

Debt ratio

2011 2010

Debt ratio measures the proportion of all

assets that are financed with debt.
III. Analysis of Leverage: Debt Financing and Coverage

Debt ratio

2011 2010


Debt ratio measures the proportion of all

assets that are financed with debt.
III. Analysis of Leverage: Debt Financing and Coverage

Times Interest Earned

2011 2010

Times interest earned ratio measures the

ability of a firm’s operations to provide
protection to long-term creditors.
III. Analysis of Leverage: Debt Financing and Coverage

Times Interest Earned

2011 2010


Times interest earned ratio measures the

ability of a firm’s operations to provide
protection to long-term creditors.
III. Analysis of Leverage: Debt Financing and Coverage

Fixed Charge Coverage

2011 2010

Fixed charge coverage measures the firm’s

coverage capability to cover not only interest
payments but also the fixed payment associated
with leasing which must be met annually.
III. Analysis of Leverage: Debt Financing and Coverage

Fixed Charge Coverage

2011 2010

Fixed charge coverage measures the firm’s

coverage capability to cover not only interest
payments but also the fixed payment associated
with leasing which must be met annually.
 IV. Profitability

Give us an idea of how

profitability the firm is
operating and utilizing its
assets.
IV. Operating Efficiency and Profitability

Gross Profit Margin

2011 2010

Gross profit margin shows the relationship

between sales and the cost of products sold,
measures the ability of a company both to
control costs and inventories or manufacturing
of products and to pass along price increases
IV. Operating Efficiency and Profitability

Gross Profit Margin

2011 2010


Gross profit margin shows the relationship

between sales and the cost of products sold,
measures the ability of a company both to
control costs and inventories or manufacturing
of products and to pass along price increases
IV. Operating Efficiency and Profitability

Operating Profit Margin

2011 2010

Operating profit margin is a measure of

overall operating efficiency and incorporates
all of the expenses associated with ordinary
or normal business activities.
IV. Operating Efficiency and Profitability

Operating Profit Margin

2011 2010


Operating profit margin is a measure of

overall operating efficiency and incorporates
all of the expenses associated with ordinary
or normal business activities.
IV. Operating Efficiency and Profitability

Net Profit Margin

2011 2010

Net profit margin measures profitability after

considering all revenues and expenses, including
interest, taxes and non-operating items such as
extraordinary items, cumulative effect of accounting
changes, etc.
IV. Operating Efficiency and Profitability

Net Profit Margin

2011 2010


Net profit margin measures profitability after

considering all revenues and expenses, including
interest, taxes and non-operating items such as
extraordinary items, cumulative effect of accounting
changes, etc.
IV. Operating Efficiency and Profitability

Cash Flow Margin

2011 2010

Cash flow margin measures the ability of

the firm to translate sales to cash to enable it
to service debt, pay dividends or invest in
new capital assets.
IV. Operating Efficiency and Profitability

Cash Flow Margin

2011 2010


Cash flow margin measures the ability of

the firm to translate sales to cash to enable it
to service debt, pay dividends or invest in
new capital assets.
IV. Operating Efficiency and Profitability

Return on Investment on Assets (ROA)

or…. Net Profit Margin x Total Asset Turnover

2011 2010

Return on Investment on Assets

measures overall efficiency of the firm in
managing assets and generating profits.
 IV. Operating Efficiency and Profitability

Return on Investment on Assets (ROA)

or…. Net Profit Margin x Total Asset Turnover

2011 2010


Return on Investment on Assets

measures overall efficiency of the firm in
managing assets and generating profits.
IV. Operating Efficiency and Profitability

Return on Equity (ROE)

Return on Assets x Financial Leverage or Equity Multiplier

2011 2010

Return on equity measures the rate of

return on resources provided by owners.
IV. Operating Efficiency and Profitability

Return on Equity (ROE)

Return on Assets x Financial Leverage or Equity Multiplier

2011 2010

Return on equity measures the rate of

return on resources provided by owners.
IV. Operating Efficiency and Profitability

Financial Leverage Index (FLI)

2011 2010

If the FLI is greater than 1 indicating the return on

equity exceeds return on assets, the firm is using debt
effectively. If FLI is less than 1, the financial leverage is
negative which means that the firm is not using debt
successfully.
IV. Operating Efficiency and Profitability

Financial Leverage Index (FLI)

2011 2010

If the FLI is greater than 1 indicating the return on

equity exceeds return on assets, the firm is using debt
effectively. If FLI is less than 1, the financial leverage is
negative which means that the firm is not using debt
successfully.
 IV. Operating Efficiency and Profitability

Other Ratios used to Measure Returns to Investors

a) Earnings per share (EPS)

Formula
:

2011 2010

Earnings per share is the peso return on each

ordinary shares. It shows the ability to pay
dividends.
 IV. Operating Efficiency and Profitability

Other Ratios used to Measure Returns to Investors

a) Earnings per share (EPS)

Formula
:

2011 2010

Earnings per share is the peso return on each

ordinary shares. It shows the ability to pay
dividends.
 IV. Operating Efficiency and Profitability

Other Ratios used to Measure Returns to Investors

b) Price Earnings Ratio (P/E)

Formula
:

2011 2010

P/E ratio relates earnings per ordinary share to the

market price at which the stock trades, expressing the
“multiple” which the stock market places on a firm’s
earnings.
 IV. Operating Efficiency and Profitability

Other Ratios used to Measure Returns to Investors

b) Price Earnings Ratio (P/E)

Formula
:

2011 2010

P/E ratio relates earnings per ordinary share to the

market price at which the stock trades, expressing the
“multiple” which the stock market places on a firm’s
earnings.
 IV. Operating Efficiency and Profitability

Other Ratios used to Measure Returns to Investors

c) Dividend payout ratio

Formula
:

2011 2010

Dividend payout ratio shows percentage of

earnings paid to shareholders.
 IV. Operating Efficiency and Profitability

Other Ratios used to Measure Returns to Investors

c) Dividend payout ratio

Formula
:

2011 2010

Dividend payout ratio shows percentage of

earnings paid to shareholders.
 IV. Operating Efficiency and Profitability

Other Ratios used to Measure Returns to Investors

d) Dividend yield

Formula
:

2011 2010

Dividend yield shows the rate earned by

shareholders from dividends relative to current
price of stock.
 IV. Operating Efficiency and Profitability

Other Ratios used to Measure Returns to Investors

d) Dividend yield

Formula
:

2011 2010

Dividend yield shows the rate earned by

shareholders from dividends relative to current
price of stock.
END OF CHAPTER 2