Analysis of Financial Statements

After reading this chapter, students should be able to:

Explain why ratio analysis is usually the

analysis of a companys financial statements.

List the five groups of ratios, specify which ratios belong in

each group, and explain what information each group gives us about
the firms financial position.

State what trend analysis is, and why it is important.

Describe how the Du Pont chart is used, and how it may be modified
to include the effect of financial leverage.

Explain benchmarking and its purpose.

List several limitations of ratio analysis.

Identify some of the problems with ROE that can arise when firms
use it as a sole measure of performance.

Identify some of the qualitative factors that must be considered

when evaluating a companys financial performance.

first

step

in

the

Financial Statements and Reports

Annual Report: Yearly record of a publicly held company's
financial condition. It includes a description of the firm's
operations, as well as balance sheet, income statement, and cash
flow statement information. SEC rules require that it be
distributed to all shareholders. A more detailed version is called
a 10-K.
Income Statement (Statement of Operations, Profit and Loss
Statement): A statement showing the revenues, expenses, and income
(the difference between revenues and expenses) of a corporation
over some period of time.
Balance Sheet: Also called the statement of financial condition,
it is a summary of a company's assets, liabilities, and owners'
equity at a specific point in time.
Statement of Retained Earnings: A statement of all transactions
affecting the balance of a company's retained earnings account.

Accounting Income versus Cash Flow

Cash Flow From Operations:

A firm's net cash inflow resulting

directly from its regular operations calculated as the sum of net
income plus noncash expenses (mainly depreciation) that are
deducted in calculating net income.
Statement of Cash Flows: A statement reporting the impact of a
firms operating, investing, and financing activities on cash
flows over an accounting period.

Ratio Analysis
Ratio analysis of a firms financial statements is of interest to
shareholders, creditors, and the firms management. Stockholders are
interested in the firms current and future level of risk and return,
which directly affect the stock price. The firms creditors are
primarily interested in the short-term liquidity of the company and
in its ability to make interest and principal payments. Internal
management is concerned with all aspects of the firms financial
performance. Therefore, they attempt to produce financial ratios
that will be considered favorable to both owners and creditors.
Additionally, management uses ratios to monitor the firms
performance from period to period. Unexpected changes or variances
are identified to isolate developing problem areas.

Liquidity Ratios:

Ratios that measure a firm's ability to meet

its short-term financial obligations on time.

1. Current Ratio: Indicator of short-term debt-paying ability.

Determined by dividing current assets by current liabilities. The
higher the ratio, the more liquid the company.
2. Quick Ratio: A stricter indication of a company's financial
strength (or weakness). Calculated by taking current assets less
inventories, divided by current liabilities. This ratio provides
information regarding the firm's liquidity and ability to meet its
obligations. Also called the Acid Test ratio.

Asset Management Ratios:

Ratios that measure how effectively a

firm is managing its assets.

1. Inventory Turnover: The ratio of cost of goods sold to inventory,

which measures the speed at which inventory is produced and sold.
Low turnover is an unhealthy sign, indicating excess stocks and/or
poor sales.
2. Days Sales Outstanding (Average Collection Period): The ratio of
accounts receivables to average sales per day, or the total amount
of credit extended per dollar of daily sales.
2

3. Fixed Asset Turnover: The ratio of sales to net fixed assets.

Measures how effectively the firm uses its plant and equipment to
generate revenues.
4. Total Assets Turnover: Calculated by dividing sales by total
assets. Indicates the efficiency with which the firm uses its
assets to generate sales.

Debt Management Ratios:

The more debt a firm a firm uses in

relation to its total assets, the greater the firms financial
leverage. Financial leverage refers to the magnification of risk
and return introduced through the use of fixed-cost financing such
as debt (and preferred stock). The more fixed-cost debt, or
financial leverage, a firm uses, the greater will be its risk and
its expected return.

1. Debt Ratio: Total debt divided by total assets. The percentage

of funds provided by creditors.
2. Times Interest Earned: Earnings before interest and taxes, divided
by interest payments. Measures the firms ability to make
contractual interest payments (also called the Interest Coverage
Ratio).
3. Fixed-Charge Coverage Ratio: A measure of a firm's ability to
meet its fixed-charge obligations: the ratio of earnings before
interest and taxes plus long-term lease payments to interest
charges paid plus long-term lease payments plus sinking fund
payments/(1-tax rate). This is a stricter measure of the firms
ability to meet fixed financial obligations since it includes
lease and sinking fund payments (some analysts also include
preferred stock dividends in this ratio).

Profitability Ratios:

Show the effect of liquidity, asset

management, and debt management on operating results. They focus
on the profitability of the firm. Profit margins measure
performance with relation to sales. Rate of return ratios measure
performance relative to some measure of size of the investment.

1. Net Profit Margin on Sales: The ratio of earnings available to

common stockholders to net sales. Measures the percentage of each
sales dollar remaining after all costs and expenses, including
interest and taxes, have been deducted.
2. Return on Total Assets (ROA): The ratio of net income to total
assets. Measures the firms overall effectiveness in generating
profits with its available assets.
3. Return on Common Equity ROE): The ratio of net income to common
equity. Measures the return earned on the owners (common
stockholders) investment in the firm.

 Market Value Ratios:

Relate the firms stock price to its

earnings and book value.

1. Price/Earnings (P/E) Ratio: Shows the "multiple" of earnings at

which a stock sells. Determined by dividing current stock price by
current earnings per share (adjusted for stock splits). Earnings
per share for the P/E ratio are determined by dividing earnings
for past 12 months (four quarters) by the number of common shares
outstanding. Higher "multiple" means investors have higher
expectations for future growth, and have bid up the stock's price.
2. Market/Book Ratio: The ratio of a stocks market price to its
book value. An indication of how investors regard the company. A
stocks book value is the ratio of stockholder equity to the
number of common shares outstanding. Book value per share should
not be thought of as an indicator of economic worth, since it
reflects accounting valuation (and not necessarily market
valuation).

The DuPont System of Analysis

The DuPont system of analysis merges the income statement and balance
sheet into two summary measures of profitability: Return on Total
Assets (ROA) and Return on Equity (ROE).

ROA

The DuPont Equation

= Net Profit Margin on Sales x Total Assets Turnover
ROA = Net Income/Sales x Sales/Total Assets

Extended DuPont Equation

ROE = Net Profit Margin x Total Assets Turnover x Equity Multiplier
ROE = N.I./Sales x Sales/Total Assets x Total Assets/Common Equity
Note: Debt Ratio = Total Debt/Total Assets
= [1 - (1/Equity Multiplier)]
Note:

Equity Multiplier = 1/[1-(Total Debt/Total Assets)]

Types of Ratio Comparisons

Trend Analysis: Also termed time-series analysis. Evaluation of the
firms financial performance over time to help determine or predict
the improvement or deterioration in its financial situation.

Comparative Analysis: Also termed cross-sectional analysis.

Involves comparing the firms ratios to those of other firms in the
same industry or to industry averages. Benchmarking is a type of
cross-sectional analysis in which the firms ratios are compared to
those of a key competitor or group of competitors, primarily to
identify areas for improvement.

Uses and Limitations of Ratio Analysis

1. Difficult to develop a meaningful set of industry average ratios
for comparative purposes due to the fact that most large firms
operate a number of divisions in different industries.
2. Striving for average performance is not a target for most firms.
3. Inflation can distort firms balance sheets. Assets are carried
at their historical cost.
4. Seasonal factors can distort a ratio analysis. Average account
figures should be used for all ratios when possible to alleviate
this problem.
5. Management sometimes employ window dressing techniques to
artificially present better ratios.
6. Different accounting practices can distort comparisons.
7. Difficult to generalize about whether a particular ratio is good
or bad.
8. Even with a comprehensive ratio analysis, it is difficult to tell
whether the company is, on balance, strong or weak. The most
important and difficult input to a successful ratio analysis is
the judgement used when interpreting the results to reach an
overall conclusion about the firms financial position.
RATIO ANALYSIS

CURRENT
QUICK
0.4
INVENTORY TURNOVER
DAYS SALES OUTSTANDING
FIXED ASSETS TURNOVER
TOTAL ASSETS TURNOVER
DEBT RATIO
TIE
EBITDA COVERAGE
PROFIT MARGIN
BASIC EARNING POWER
ROA
ROE
PRICE/EARNINGS
PRICE/CASH FLOW
MARKET/BOOK
BOOK VALUE PER SHARE

2002E

2001
1.2
0.8
4.7
38.2
6.4
2.1
82.8%
-1.0
0.1
-2.7%
-4.6%
-5.6%
-32.5%
-1.4
-5.2
0.5
$4.93

2000
2.3
1.0
4.8
37.4
10.0
2.3
54.8%
4.3
3.0
2.6%
13.0%
6.0%
13.3%
9.7
8.0
1.3
$6.64

INDUSTRY
AVERAGE
2.7
6.1
32.0
7.0
2.6
50.0%
6.2
8.0
3.5%
19.1%
9.1%
18.2%
14.2
11.0
2.4
n.a.