FINANCIAL ANALYSIS

o Financial analysis is the process of evaluating financial and other information for decision-
making.
Overview of Financial Analysis
o SPECIFY THE OBJECTIVES OF THE ANALYSIS
o Focus on who is the financial statement user
o The identity of the user helps define what information is needed
Steps of a F/S Analysis
1. Establish objectives of the analysis
2. Study the industry and relate industry climate to current and projected economic developments -
o a growth industry?
o a dying industry?
o a changing industry?
o Develop knowledge of firm and quality of management
o Evaluate financial statements using basic tools
o Summarize findings
o Reach conclusions relevant to established objectives
Potential Financial Statement Users:
o Creditors
o Investors
o Managers
o Who else?
o What types of questions do each of these users seek answers to?
Data sources
o Financial statements (and notes)
o Auditors report
o Supplementary schedules
o 10K and 10Q reports filed with SEC
o Computerized data bases
o Info on industry norms/ratios
o Info on particular companies/industries/mutual funds
o Articles in popular/business press
o Websites
Tools for analysis
o Common size financial statements
o Financial ratios
o Trend analysis
o Structural analysis
o Industry comparisons
o Common sense and judgment
Financial Ratio Categories
o Liquidity Ratios
measure a firms ability to meet cash needs as they arise
o Activity Ratios
measure the liquidity of specific assets and the efficiency of managing assets
o Leverage Ratios
measure the extent of a firms financing with debt relative to equity and its ability to cover
interest and other fixed charges
o Profitability Ratios
measure the overall performance of a firm and its efficiency in managing assets, liabilities and
equity
Caution!
o Ratios are valuable, BUT..
o They do not provide answers of themselves and are not predictive
o They should be used with other elements of financial analysis
o There are no rules of thumb that apply to interpretation of ratios
Profitability Ratios
o Gross Profit Margin
Gross Profit/Net Sales
o Operating Profit Margin
Operating Profit/Net Sales
o Net Profit Margin
Net Earnings/Net Sales
o All measure firms ability to translate sales peso into profits
o Return on Investment (or Return on Assets)
Net Earnings/Total Assets
o Return on Equity
Net Earnings/Stockholders Equity
o Both measure overall efficiency of firm in managing investment in assets and generating return to
stockholders
o Cash Flow Margin
o Cash Flow from Operating Activities /Net Sales
o Measures ability to translate sales into cash (with which to pay bills)
o Cash Return on Assets
o Cash Flow from Operating Activities /Total Assets
o Useful comparison to return on investment
o Indicates firms ability to generate cash from utilizing its assets
Return on Investment
o Return on Investment (ROI)
ROI= NET OPERATING INCOME/ AVERAGE OPERATING ASSETS
o Net operating income
o Income before interest and taxes
o Operating assets
o Assets held for operating purposes ONLY
o i.e. cash, accounts receivable, inventory, plant and equipment
Liquidity Ratios
o Current Ratio
Current Assets/Current Liabilities
Measures ability to meet short-term cash needs
o Quick or Acid Test Ratio
Current Assets-Inventory/Current Liabilities
Measure ability to meet short-term cash needs more rigorously
o Cash Flow Liquidity Ratio
Cash +Marketable Securities +Cash Flow from Operating Activities/Current Liabilities
Focuses on ability of the firm to generate operating cash flows as a source of liquidity
Activity Ratios
o Average Collection Period
Accounts Receivable/Average Daily Sales
Helps gauge liquidity of accounts receivable (ability to collect cash from customers)
o Accounts Receivable Turnover
Net Sales/Accounts Receivable
Another measure of efficiency of firms collection and credit policies
o Inventory Turnover
Cost of Goods Sold/Inventory
Measures efficiency of inventory management
o Fixed Asset and Total Asset Turnover
Net Sales/Net PP&E (Fixed Asset T/O)
Net Sales/Total Assets (Total Asset T/O)
Both assess effectiveness in generating sales from investment in assets
Leverage: Debt Ratios
o Debt Ratio
Total Liabilities/Total Assets
o Long-Term Debt to Total Capitalization
Long-term Debt/Long-term Debt + Stockholders Equity
o Debt to Equity Ratio
Total Liabilities/Stockholders Equity
o All three measure extent of firms financing with debt
Leverage: Coverage Ratios
o Proportion and amount of debt in capital structure is important to analyst
o Tradeoff between risk and return
o Use of debt involves risk -- commitment to fixed charges
o Fixed charges must be COVERED -- following are some ratios to assess coverage
o Times Interest Earned
Operating Profit/Interest Expense
Indicates how well operating earnings cover fixed interest charges
o Fixed Charge Coverage
Operating Profit + Lease Payments/Interest Expense + Lease Payments
Broader measure of how well operating earnings cover fixed charges
o Cash Flow Adequacy
Cash Flow from Operating Activities/ Average Annual Long-Term Debt Maturities
Measures firms ability to cover long-term debt maturities each year
Rationale is that over the long-run operating cash flows must be adequate to cover investing activities
financed with debt

Other Ratios
o Earnings per Common Share
Net Earnings/Average Common Shares Outstanding
Indicates return on a per share basis
o Price to Earnings
Market Price of Common Stock/Earnings per Common Share
Expresses a multiple the stock market places on earnings
o Dividend Payout
Dividends per Share/Earnings per Share
Shows percentage of earnings paid out to stockholders
o Dividend Yield
Dividends per Share/Market Price of Common Share
Shows rate earned by shareholders from dividends relative to current stock price