FINANCIAL STATEMENT ANALYSIS

Understanding the financial statements of a firm is critical since it is often the

only source of information with which we must make investment decisions; i.e.,
whether or not to loan the company money or invest some equity. There is a rationale
behind the construction of the financial statements that helps us to interpret the
information that is contained within them.
Income Statements:
Revenues
Less !ost of "oods #old $anufacturing
"ross %rofit
Less #alaries
&dvertising
Rent #elling ' &dministrative
(epreciation
Utilities
)perating *ncome
Less *nterest +,pense -inance
Ta,able *ncome
Less Ta,es "overnment .Ta, accounting/
0et *ncome
The income statement is broken down by functional area. This allows us to more
accurately determine where our strengths or weaknesses lie.
Balance Sheets
&s with the income statement, the balance sheet is constructed in a very
methodical manner. )n the &sset side, the assets are listed in order from the most
liquid to the least liquid. #imilarly, on the Liability ' +quity side, the accounts are listed
in order from the most immediately due to the least.
!ash &ccounts %ayable
$arketable #ecurities 1ages %ayable
&ccounts Receivable 2ank 0ote %ayable
*nventory !urrent %ortion of L3T (ebt
%repaid +,penses
Total !urrent &ssets Total !urrent Liabilities
%lant ' +quipment Long3Term (ebt
.&ccumulated (epr./ !ommon #tock
0et %lant ' +quip. Retained +arnings
Total &ssets Total Liabilities ' +quity
Statement of Cash Flows
-rom a financial perspective, the #tatement of !ash -lows is the most important
financial statement because it integrates the *ncome #tatement and 2alance sheet
while ad4usting the accounting figures based upon accrual accounting into actual cash
flow.
-rom )perations
0et *ncome
%lus (epreciation
%lus &morti5ation
)perating !ash -low
%lus !hanges in 0on3!ash !urrent &ssets
%lus !hanges in )perations3related !urrent Liabilities
Total -rom )perations
-rom *nvesting &ctivities
!hanges *n "ross -i,ed &ssets
%lus !hanges in )ther 0on3!urrent &ssets
Total -rom *nvesting &ctivities
-rom -inancing &ctivities
!hanges in 0on3)perations3related current liabilities
%lus !hanges in Long3Term (ebt
%lus !hanges in )ther !apital &ccounts
.e,cept Retained +arnings/
Less (ividends %aid
Total -rom -inancing &ctivities
Total !hange in !ash
%lus 2eginning !ash 2alance
+nding !ash 2alance
COMMON SIZE INCOME STATEMENTS
&ll *tems +,pressed as a %ercentage of Revenues.
COMMON SIZE BALANCE SHEETS
&ll &ccounts +,pressed as a %ercentage of Total &ssets.
1hat6s the purpose of calculating !ommon3#i5ed statements7 .!omparison
purposes./
FINANCIAL RATIOS
The financial statements are often the only information upon which to base an
investment decision .as an equityholder or a lender/, so it is imperative that we be able
to determine what economic information the statements contain. -inancial Ratios are
used as tools to help us squee5e as much information as possible from the financial
statements. *t must be kept in mind, however, that a financial ratio is only one number
divided by another and only yields a number. The ratio takes on meaning when
compared with other firms or industry averages .a static analysis/ or when compared
with previous periods for trends to see if a firm6s position is improving or deteriorating
.a dynamic analysis/. The ratios must also be taken together as a group 8 if a ratio
appears to be 9higher: than it normally is, it can be due to the numerator being large
)R the denominator being small. 2y looking at other ratios we can determine which is
the case.
Liquidity Ratios
Liquidity ratios are designed to measure the e,tent to which our short3term, or
liquid, assets e,ist to cover our short3term obligations. 1hile most ratios have
definitions that vary .and, hence, one must be certain that the appropriate definition is
being used for comparison purposes/, the definition of the !urrent Ratio is standard
Current Ratio =
Total Current Assets
Total Current Liabilities
The current ratio is looking at those assets that are e,pected to be converted into cash
with one year, relative to those liabilities that come due within a year. & more stringent
measure is the ;uick .or &cid Test/ Ratio. This ratio recogni5es that some current
assets are more liquid than others. 1hile the book defines the quick ratio6s numerator
as being the !urrent &ssets less *nventories, the general definition used in practice
e,cludes other current assets that are not liquid in nature, such as prepaid e,penses.
The idea behind e,cluding inventories is twofold first, inventories are generally illiquid
and can only be converted into cash by selling at steep discounts. #econdly, most
companies sell inventories on credit, so they become an account receivable which must
then be collected. 2y e,cluding inventories, the quick ratio is therefore recogni5ing the
fact that they are one step further removed from becoming cash than other current
assets.
Quick (Acid Test ) Ratio =
Monetary Current Assets
Total Current Liabilities
FINANCIAL LEVERAGE
The ne,t set of financial ratios is designed to e,amine the e,tent to which a
company utili5es debt in the financing of its assets. The use of debt is referred to as
financial leverage. -irst, let6s look at the effect of financial leverage on a firm.
!onsider a company that has three different possible debt financing strategies, ranging
from no debt to <=> debt. &lso, let6s assume that the interest rate on any debt
employed is ?=> and that the firm has a ta, rate of @=>.
*nterest Rate A ?=>
Ta, Rate A @=>
? B C
AAA AAA AAA
(+2T = D== <==
+;U*TE ?,=== D== ?==
33333333 33333333 33333333
T)T&L &##+T# ?,=== ?,=== ?,===
#ince the effect of financing doesn6t appear until we go below the )perating *ncome
.+2*T/ line, we can 4ump straight down to the operating income to analy5e the effect of
financial leverage. &ssume that the +2*T is F?@= for the firm; then, the calculation of
0et *ncome, and the rate of return that the 0et *ncome represents on the equity
invested, are as follows
+2*T ?@= ?@= ?@=
3 *0T = .D=/ .<=/
33333333 33333333 33333333
T&G. *0!. ?@= <= D=
3 T&G .DH/ .CH/ .B=/
33333333 33333333 33333333
0+T *0!)$+ I@ D@ C=
R)+ A I.@> ?=.I> C=.=>
0otice that the Return on +quity is magnified by the use of debt, and that the more the
debt that is employed, the greater the magnification. The profits of the firm can be
greatly magnified through the use of debt.
Leverage, however, is a two3edged sword. 0ot only are profits magnified, but
also losses. !onsider the same firm when +2*T is only FH=
? B C
AAA AAA AAA
(+2T = D== <==
+;U*TE ?,=== D== ?==
33333333 33333333 33333333
T)T&L &##+T# ?,=== ?,=== ?,===
+2*T H= H= H=
3 *0T = .D=/ .<=/
33333333 33333333 33333333
T&G. *0!. H= ?= .C=/
3 T&G .B@/ .@/ ?B
33333333 33333333 33333333
0+T *0!)$+ CH H .?I/
R)+ A C.H> ?.B> 3?I.=>
0ow the use of debt results in lower profitability. -inancial leverage magnifies both
profits and losses 8 in other words, it magnifies the risk of the company. -inancial
leverage will be looked at in more detail later. -or now, a basic understanding of the
effect of leverage is sufficient; but let6s look at some of the ratios designed to measure
the e,tent to which a company utili5es debt, and 4ust how well it can manage its debt.
Leverae !So"ve#$y% Ratios
The (ebt3to3&ssets Ratio looks at how much of a company6s assets are financed
with debt; i.e., other people6s money.
Debt / Asset Ratio =
Total Debt
Total Assets
& variation on the (ebt3to3&sset Ratio that is more commonly used in practice is
the (ebt3to3+quity Ratio which simply e,presses the debt as a percentage of equity
rather than total assets. The two measures are equivalent as indicated by the second
part of the equation
D/A - 1
D/A
=
Net ort!
s Liabilitie Total
= Ratio y Debt/"#uit
#ometimes it is desirable to break down the use of debt into short3term and long3term
debt. 1hich type of debt do you think is more risky for the company to utili5e7 .To
answer this, ask yourself whether you would prefer to buy a house using a one3year
note that would have to be refinanced in twelve months, or a C=3year mortgage./
Current Liabs$ to Net ort! =
Total Current Liabilities
Net ort!
Just as in accounting where changes in current liabilities are included as a part
of operating cash flows .since accounts payable and accruals such as wages payable
arise from operations/, sometimes only the long3term portions of debt are considered.
This is because oftentimes a company is viable in the long3run but faces short3term
liquidity problems .consider when the (emocrats and Republicans shut down the
federal government for a few days in ?<<K/. The capitali5ation ratio looks at the long3
term debt financing that a company uses
Ca%itali&ation Ratio =
Lon'- ter( Debt
Lon'- ter( Ca%ital
1hile short3term solvency is obviously important, the long3term aspects are relevant for
long3term debtLinvestment considerations.
1hile the preceding measures of the e,tent to which a company uses debt to
finance its assets are important, what is probably of more concern is the ability of the
company to service its debt. The following ratios look at the ability of the company to
make debt service payments to its creditors. The most common of these, particularly
when only the financial statements are available, is the Times *nterest +arned ratio
Ti(es )nterest "arned =
"*)T
)nterest "+%ense
$ore important to many lenders is the ability of the company to not only make interest
payments, but also to repay the principal of the loan. The (ebt #ervice !overage Ratio
considers both interest and principal payments that are required. 0ote that the
principal portion is 9grossed up: to account for ta, considerations. 1hy7
Debt ,er-ice Co-era'e =
"*)T
)nt$ "+%$ .
/rinci%al /y(t$
1- t
-inally, it is common for lenders .such as banks/ to look more toward the cash flow
coverage of debt payments that a company can make. -or this reason, the )perating
*ncome .+2*T/ has the non3cash charges of (epreciation and &morti5ation added back
.4ust like they are in the )perating !ash -low section of the #tatement of !ash -lows/.
Cas! Co-era'e =
"*)T . De%reciation 0 A(orti&ation
)nterest "+%ense
=
"*)TDA
)nterest "+%ense
Asset Ma#ae&e#t !'ti"i(atio#% Ratios
&sset utili5ation ratios are designed to give insight into how effectively a
company is managing its assets. -or many firms, inventories are its largest category of
assets. 1hy is it bad to have too much inventory7 1hy is it bad to have too little7
)ne way to look at the amount of assets that a firm holds in relation to its level of sales
is the inventory turnover ratio
)n-entory Turno-er =
Cost 12 3oods ,old
)n-entory
The inventory turnover ratio can, alternatively, be stated as the &verage &ge of
*nventory; i.e., how long on average does an inventory item sit in the warehouse
before it is sold
A-era'e A'e o2 )n-entory =
)n-entory
C13,/ 456
The second ma4or category, at least of current assets, for most firms is the amount of
money that is tied3up in &ccounts Receivable. The &verage !ollection %eriod .or (ays6
#ales )utstanding/ tells you how long, on average, it takes for a firm to collect the
money due on a sale made on credit
A-era'e Collection /eriod (Days7 ,ales 1utstandin') =
Accounts Recei-able
,ales / 456
The final ma4or category of assets, particularly manufacturing firms, is that of
%roperty, %lant ' +quipment, or -i,ed &ssets. The -i,ed &sset Turnover ratio looks at
the amount of productive equipment that a firm has relative to the amount of sales that
it is generating. *n one sense, this could be interpreted as a measure of the amount of
capacity utili5ation that a firm has. 1hat problems do you see with this measure7
8i+ed Asset Turno-er =
,ales
Net 8i+ed Assets
& final measure looks at all of the firm6s investment in assets relative to its sales
level. This is the Total &sset Turnover ratio
Total Asset Turno-er =
,ales
Total Assets
)ro*ita+i"ity Ratios
)ne of the best measures for evaluating management lies in their ability to
control costs. Thus, profit margins are an important means of assessing this ability
3ross /ro2it Mar'in =
3ross /ro2it
,ales
1%eratin' /ro2it Mar'in =
1%eratin' )nco(e
,ales
Net /ro2it Mar'in =
Net )nco(e
,ales
&nother important factor has to do with the amount of profit being made relative
to the investment in assets that support the operations and sales. 0ote that this ratio
can be decomposed into the 0et %rofit $argin and the Total &sset Turnover. This has
two important implications -irst, it illustrates that there are two ways to make money 8
have a high profit margin and a low turnover rate, or a low profit margin and a high
turnover rate. #econdly, it provides us a means by which to determine where problems,
or strengths, reside. *f the net R)& is low, is it because we are not controlling costs .in
which case, is it in production, selling and administrative, or financing costs/, or is it
because we have too many assets relative to sales .such as too much inventory, too
long a collection period, too many unutili5ed fi,ed assets/. This approach to locating
the source.s/ of the problems is known as the (u%ont method of analysis. Eour
te,tbook gives you an e,ample of its implementation.
Net Return on Assets =
Net )nco(e
Total Assets
= Net /ro2it Mar'in 9 Total Asset Turno-er
=
Net )nco(e
,ales
9
,ales
Total Assets
-inally, equity investors are concerned with the rate of return that is being
generated on their investment in the company.
Return on "#uity =
Net )nco(e
Net ort!
=
Net R1A
1- D/ A
= Net R1A 9
Total Assets
Total "#uity
Mar,et Ratios
The last group of ratios is designed to look at market3related measures of
performance
"arnin's %er ,!are (*asic) =
Net )nco(e
Total No$ o2 ,!ares 1utstandin'
"arnin's %er ,!are (8ully Diluted) =
Net )nco(e
Total /ossible ,!ares 1utstandin'
/rice / "arnin's Ratio =
Market /rice / s!are
"arnin's %er ,!are
or
/
"
=
Di-$ / "arn$
k - '
,
A#ot-er Liquidity Measure
)ne problem with the !urrent and ;uick Ratios as measures of liquidity is the
fact that they are predicated upon the liquidation of the current assets of the firm in
order to satisfy the short3term liabilities. "enerally, however, one is not interested in
liquidating a firm in order to cover its short3term obligations .e,cept in e,treme cases/.
-or this reason, the cash cycle is often looked at in order to see the e,tent to which the
ongoing operations of the firm cover short3term requirements .primarily in the area of
accruals and payables/. *n order to calculate the cash cycle, we need to look at a
measure of the short3term liability encompassed by the trade credit that our supplier
provide to us
A-era'e A'e o2 /ayables =
Accounts /ayable
C13,/ 456
The cash cycle looks at how long a company has money tied3up in its
operations. $oney is invested in inventories, which sit in the warehouse for a certain
period of time and then are sold on credit which takes so3long to collect; but this length
of time .known as the operating cycle/ is reduced by the fact that our suppliers do not
require immediate payment for the inventories that we purchase.
Cas! Cycle = A-era'e A'e o2 )n-entory . A-era'e Collection /eriod - A-era'e A'e o2 /ayables
1hile a short cash cycle is considered to be an efficient use of money, what are
the dangers of having
?/ & low average age of inventory
B/ & short average collection period
C/ & long average payables period
The firm6s cash cycle is looking at how long, and hence, how much, cash is tied up.
(ecreasing the cash cycle decreases the amount of cash investment is required. &s
will be seen when working capital is addressed, cash can be free3up by accelerating
inflows .shortening the average collection period/ or delaying outflows .stretching out
the average payables period/ as well as by liquidating assets such as inventory .and
increasing inventory turnover which is the same as decreasing the average age of
inventory/.
I#dustry Averaes
*ndustry averages are often used for comparison purposes. The two most
popular sources of industry averages are R$&6s Annual Statement Studies and (un '
2radstreet6s Key Business Ratios. R$& is an association of banks that pool loan data
and (un ' 2radstreet is the well3known credit rating agency. *ndustry averages can
also be obtained from #tandard ' %oor6s and $oody6s, the two premier bond rating
agencies.