FINANCIAL STATEMENT ANALYSIS: Evaluating a Firms Performance

Financial Statement Analysis

Financial Statements Analysis is the examination of firms past and current
financial to understand and explain its performance in terms liquidity, solvency,
asset management and profitability and obtain indicators about its future
performance.
Financial analysis will often focus on the analysis of income statement, balance
sheet, and cash flow statement including any additional information impacting
on the firms performance (notes to the financial statements).
Financial Statement Analysis answers questions like:
Can the firm meet its short-term obligations?
Is the firm managing its short-term assets efficiently?
How profitable is the firm?
How much financial risk is the firm placing on the returns of the shareholders?
Is the firm generating enough of a return to satisfy the expectations of the
shareholders?
How can we assess firms performance? In analyzing information from
financial statements, the following techniques are used:
Trend Analysis
Common Size Analysis
Cross-section analysis
Comparative

Trend Analysis
Trend analysis or time-series analysis is an analysis of a firms financial
information over time. It is used to obtain a judgment concerning the firms
financial situation. It involves the identification of patterns and outliers across
time for the same firm.
Trend analysis will, in most cases, reveal the direction of change in
performance along with the magnitude of change. Past trend often is a good
predictor of the future if all relevant variables remain constant or nearly
constant. In practice, however, this is seldom the case.
An analyst should use the results of trend analysis and adjust them in the light
of other available information, including the expected state of the economy
and industry.
Trend analysis (also known as horizontal analysis) is a financial analysis
technique that shows the behavior (patterns and outliers) of ratios or items
over a period of time.

It is a useful tool to evaluate the trend situations.

The financial statements for two or more periods are used in horizontal
analysis.
Common Size analysis
To evaluate the performance of a firm we need to make comparisons about the
firm over different points in time (trend analsys) and also to compare the firm
against its competitors in the market and the industry (cross sectional and
industry comparative analysis).
One common and useful way of doing this is to express all items expressed as
a percentage of a base:
Percentage of base = (Item/Base) x 100
By doing this we obtain a common size financial statements.
In common-size financial statements, all amounts are expressed as a
percentage of some base financial statement item.
A common-size balance sheet express all asset account balances as a percent
of total assets al all liabilities and equity accounts as a percentage of total
liabilities and equity.
A common size income statement express all revenue and expense accounts a
a percentage of gross revenues or sales. For the income statement all
components statement like cost of sales, gross profit, operating expenses,
income tax, and net income etc. are shown as a percentage of sales or gross
revenue.
Common size statements are helpful in analyzing performance by comparing
financial statements of a) a firm for two or more different periods, b) two or
more different companies in an industry, c) a firm with the industrys average.
Common size analysis is also a response to the need of comparing the financial
statements if a) the size of the firm changes over time, b) if the size of the firm
and the size of its competitors is different, and c) the currency of the financial
statements is different
Suppose firm A and firm B belong to same industry. A is a small company and B
is a large company. Company As sales and gross profit are $100,000 and
$30,000 respectively whereas company Bs sales and gross profit are
$1,000,000 and $300,000 respectively.
Ford, GM and Toyota are competitors, but they are different in size and also
Toyotas financial statements are denominated in yen, then we have size and
currency differences.
By common size analysis we standardize the financial statements and make
them comparable. To start making comparisons, we must first standardize the
financial statements.

Cross-section analysis
Cross-section analysis uses ratios to compare different firms at the same point
in time to identify relevant difference and helps the analyst to formulate
judgments about the firms performance.
Comparative analysis
Comparative analysis is used to compare a firms ratios against average ratios
in the industry the firm operates, or the ratios of the leading firm in the same
industry. This technique is also known as benchmarking.

RATIO ANALYSIS (FINANCIAL RATIOS)

A ratio expresses a relation between two quantities.
To be meaningful (useful in analysis), a ratio must capture an important
economic relation.
The trend of these ratios over time is analyzed to confirm whether they are
improving or deteriorating.
Ratios are also compared across different companies in the same sector to get
a comparison
Ratio analysis is a cornerstone of fundamental analysis.
For a specific ratio, most companies may have values that fall within a certain
range.
And a company whose ratio falls outside the range may be regarded as
warning of a potential improvement or deterioration in a companys financial
situation or performance, depending on the ratio.

A benchmark is useful for interpretation of the ratio ( If a firms return on

assets is .02 and the industry average is .08, the ratio becomes more useful for
interpretation purposes as ratios can provide an analyst with clues and
symptoms of underlying conditions or highlight areas that require further
investigation and inquiry)
Usefulness of insights obtained from ratios depends on their skillful
interpretation by the analyst
Ratios, like all other analysis tools, cannot predict the future.
Ratios are only comparable across companies in the same industry or sector,
since an acceptable ratio in one industry may be regarded as too high in
another. For example, companies in sectors such as banking have a high debtequity ratio, but a similar ratio for a technology company may be regarded as
unsustainably high.
Ratio analysis can identify and provide an early warning of a potential
improvement or deterioration in a firms financial situation or performance.
Analysts engage in extensive number-crunching of the financial data in a firms
financial reports searching for early warnings of improvement or deterioration.
Types of Ratios
Ratio analysis is used to evaluate various aspects of a companys operating
and financial performance such as its efficiency, liquidity, profitability and
solvency. It is common practice to group ratios as follows:
Liquidity ratios (Short-Term Solvency)
Asset-management ratios (Activity or Turnover)
Financial-leverage ratios (Long-Term Solvency)
Profitability ratios
Liquidity ratios refers to how quickly a firm can turn its assets into cash. A
firm, for example, that has only cash assets is completely liquid. On the
opposite extreme would be a firm whose only assets are real estate. Because
real estate sales can take months, or even years, and may even take a loss on
the transaction, the firm is illiquid.
Liquidity is important because of the changing business climate. A firm must be
able to pay its financial obligations when needed. If a firm cannot pay its
financial obligations, it will go bankrupt.
The less liquid the firm, the greater the risk of insolvency or default. Because
debt obligations are paid with cash, the firms cash flows ultimately determine
solvency.
Ability of a business to pay its short-term debts is frequently referred to as
short-term solvency position or liquidity position of the business.
A business with liquid assets to pay its current liabilities as they become due is
considered to have a strong liquidity position.

Asset management ratios are a set of ratios which measure how effectively
a firm is managing its assets. Assets are investments and the good
management of assets should be reflected in more sales.
Financial leverage ratios measure the use of debt for financing the firms
investments and operations. It is a measure of how compromised are the firm
s investments and cash flows to creditor or debtholders.
Profitability ratios measure the earning power of the firm to create value.
Du Pont Analysis is used to understand the relationships among return on
investment, asset turnover, the profit margin, and leverage.
Window dressing is a technique employed by firms to make their financial
statements look better than they really are.
Liquidity Ratios
A business with insufficient liquid assets is considered to have weak liquidity
position.
Liquidity ratios are used to know whether the business has liquid assets to
meet its current obligations.
Creditors hesitate to offer short-term loans to businesses with weak short-term
solvency position.
Current Ratio
Current Ratio = Current Assets / Current Liabilities
As current assets and liabilities are converted to cash over the following 12
months, the current ratio is a measure of short-term liquidity.
The current ratio is a measure of a companys ability to pay off its short-term
debt as it comes due.
The unit of measurement is either dollars or times.
How many dollars a firm has in current assets for every $1 in current liabilities,
or
How many times its currents assets cover its current liabilities.
We would expect to see a current ratio of at least 1.
A current ratio of less than 1 would mean that net working capital (current
assets less current liabilities) is negative.
The current ratio, like any ratio, is affected by various types of transactions.

For example, suppose the firm borrows over the long term to raise money. The
short-run effect would be an increase in cash from the issue proceeds and an
increase in long-term debt. Current liabilities are not affected, but the current
ratio will rise.
Quick (or Acid-Test) Ratio
Quick, or acid-test, ratio is computed just like the current ratio, except
inventory is omitted
Quick ratio eliminates inventories since they are among the least liquid of the
current asset as they must first be converted to sales.
Inventory is relatively illiquid compared to cash and is often the least liquid
current asset.
Quality and value of the inventory is always a potential issue (some of the
inventory may be damaged, obsolete)
Quick ratio = Current assets Inventory/Current liabilities
Q.: Using cash to buy inventory does not affect the current ratio, but it reduces
the quick ratio. Why?
Walmart and Manpower, Inc., had current ratios of .89 and 1.12, respectively.
However, Manpower carries no inventory, whereas Walmarts current assets are
virtually all inventory.
As a result, Walmarts quick ratio was only .27, and Manpowers was 1.12, the
same as its current ratio.
Cash Ratio
A very short-term creditor might be interested in the cash ratio
Cash Ratio = Cash / Current Liabilities
Asset-Management or Activity Ratios
Also referred to activity or utilization ratios
Asset-management ratios indicate the extent or intensity to which assets are
used to generate sales.
What they are intended to describe is how efficiently, or intensively, a firm uses
its assets to generate sales.
The specific ratios we discuss can all be interpreted as measures of turnover.
Inventory Turnover

The inventory-turnover ratio is computed by dividing the cost of goods sold by

the year-end inventory.
Inventory Turnover = Cost of Goods Sold (COGS) / Inventory
It measures how many times during the year a firm is turning over its inventory.
It measure how efficiently the amount of inventory is managed (avoid running
out of products or avoiding the unnecessary accumulation)
The higher this ratio is, the more efficiently the firm is managing its inventory.
The turnover ratio indicates whether the inventory is consistent to the volume
of sales when compared against industry or when tracked over time for a
specific company.
Too low inventory turnover could be related to holding obsolete inventory.
Too high an inventory turnover could lead to lack of inventory and lost sales.
As the use of year end data may distort the comparison of ratios over time,
analysts use the average inventory (beginning inventory balance plus ending
inventory balance divided by two) to calculate inventory turnovers.

Days Sales in Inventory

DaysSales in Inventory is the average number of days inventory is in the
firm before it is sold to customers
DaysSales in Inventory is a ratio derived from the Inventory Turnover
Days sales in inventory =

365 days / Inventory Turnover

If a firm knows that its inventory is turn over x times during the year
(inventory turnover), it can immediately find out how long it takes to turn it
over on average.
Receivables Turnover
The receivables turnover is defined as
Receivables Turnover = Sales / Accounts Receivables
Receivables turnover tells us how many times during a year a firm collect the
credit given to its customers and provide credit again.
Days Sales in Receivables (Average Collection Period)
It reports the number of days it takes, on average, to collect credit sales.

It is the Receivables Turnover converted into days.

Days sales in receivables = 365 / Receivables Turnover
The average collection period measures the days of financing that a company
extends to its customers.
A shorter average collection period is usually preferred to a longer one.

Asset Turnover Ratio

Asset-turnover ratio is computed by dividing net sales by the companys total
assets.
Assets Turnover Ratio = Sales / Assets
It indicates how efficiently the firm is utilizing its assets to produce revenues or
sales.
It is a measure of the dollars of sales generated by $1 of the firms
assets.
The size of the ratio is by characteristics of the industry within which the firm
operates.
Capital-intensive electric utilities might have asset turnover ratios as low as
0.33, indicating that they require $3 of investment in assets in order to produce
$1 in revenues.
In contrast, retail food chains with asset turnovers as high as 10 would require
a $0.10 investment in assets to produce $1 in sales.
A typical manufacturing firm has an asset turnover of about 1.5.

Financial-Leverage Ratios
Financial-leverage ratios indicate the extent to which debt funds are used to
finance the firms assets or investments and also the firms long-term ability to
meet its obligations (the firms financial leverage)
Debt to Assets:
Debt-to-Assets ratio is computed by dividing the total debt or total liabilities of
the firm by the total assets.

Debt to Assets = Liabilities / Assets

Debt to Assets = (Assets Equity) / Assets
Debt to Assets = ( (1 Equity / Assets)
This ratio shows the portion of the total assets financed by debtholders.

Debt-to-equity ratio:
Debt-to-equity ratio = Debt/Equity
Debt-to-equity ratio shows a firms total debt in relation to the total dollar
amount owners have invested in the firm.
It shows the amount of debt per dollar of equity.
The higher the ratio, the lower the solvency.
A comparison to the industry provides an insight of the solvency risk.

Equity multiplier = Total assets/Total equity

It is the investment in assets per dollar of equity.
Equity multiplier = Total assets/Total equity
Equity multiplier = (Liabilities + Equity )/Equity
Equity multiplier = 1 + Liabilities/Equity
Equity multiplier = 1+ Debt-to- Equity Ratio
Equity multiplier = 1+ (Debt/Assets) / (Equity
/Assets)
A large value of the equity multiplier imply a greater use of leverage by the
firm. Why?
Equity multiplier is a ratio used to analyze a company's debt and equity financing
strategy. A higher ratio means that more assets were funding by debt than by equity.
In other words, investors funded fewer assets than by creditors.

When a firm's assets are primarily funded by debt, the firm is considered to be highly
leveraged and more risky for investors and creditors. This also means that current
investors actually own less of the company assets than current creditors.
Lower multiplier ratios are always considered more conservative and more favorable
than higher ratios because companies with lower ratios are less dependent on debt
financing and don't have high debt servicing costs.
The multiplier ratio is also used in the DuPont analysis to illustrate how leverage
affects a firm's return on equity. Higher multiplier ratios tend to deliver higher returns
on equity according to the DuPont analysis.
Example: Tom's Telephone Company works with the utility companies in the area to
maintain telephone lines and other telephone cables. Tom is looking to bring his
company public in the next two years and wants to make sure his equity multiplier
ratio is favorable. According to Tom's financial statements, he has $1,000,000 of total
assets and $900,000 of total equity. Tom's equity multiplier is calculated as assets
divided by equity. As you can see, Tom has a ratio of 1.11. This means that Tom's debt
levels are extremely low. Only 10 percent of his assets are financed by debt.
Conversely, investors finance 90 percent of his assets. This makes Tom's company
very conservative as far as creditors are concerned. Tom's return on equity will be
negatively affected by his low ratio, however.

Times Interest Earned (TIE)

It is calculated by dividing the firms operating income or earnings before
interest and taxes
(EBIT) by the annual interest expense.
Times interest earned ratio = EBIT / Interest
TIE measures how well a company has its interest obligations covered, and it is
often called the Interest Coverage ratio.
The interest coverage figure indicates the extent to which the operating
income or EBIT level could decline before the ability to pay interest obligations
is weakened.
Suppose a firms interest coverage ratio is 3.0. This would mean that its
operating income could drop to 1/3 of its current level, and interest payments
still could be met.
The highest the ratio, the better

Cash Coverage
A problem with the TIE ratio is that it is based on EBIT, which is not really a
measure of cash available to pay interest. The reason is that depreciation and
amortization, noncash expenses, have been deducted out.
Cash Coverage Ratio = EBITDA / Interest

EBITDA = Earnings Before Interest Taxes Depreciation and Amortization

TIE is not really a measure of cash available to pay interest. The reason is that
noncash expenses as depreciation have been deducted out to get EBIT
Cash coverage ratio = EBITDA / Interest
The highest the ratio, the better

Profitability Ratios
Profitability ratios indicate the firms ability to generate returns on its sales,
assets, and equity.
Two basic profit margin ratios are important to the financial manager, the
operating profit margin and the net profit margin.
Operating profit margin
The operating profit margin is calculated on the firms earnings before interest
and taxes divided by net sales.
Operating profit margin = EBIT / Sales
This ratio indicates the firms ability generate to generate profits from its
assets (investments).
Notice that this ratio focuses on the firms operating performance and ignores
how the firm is financed and taxed.
The higher the ratio, the better.
Margins are very different for different industries. Grocery stores have a low
profit margin, generally around 2 percent. In contrast, the profit margin for the
pharmaceutical industry is about 13 percent.

Net Profit Margin

It measure how many dollar in profits after taxes is generating a firm for every
dollar in sales.
The higher the ratio, the better.
The size of the ratio is by characteristics of the industry within which the firm
operates and the firms strategy.

Return on Assets Return on assets (ROA)

ROA is a measure of how much profits a firm can generate per dollar of
investment in assets.
Return on Assets = Net Income / Assets

Return on equity (ROE)

The return on equity measures the return that shareholders earned on their
equity invested in the firm.
The return on equity is measured as the firms net income divided by
stockholders
equity.
Return on Equity = Net Income / Equity

Du Pont Analysis
Du Pont analysis is the breaking down return on total equity and assets and to
find out the inlfuence financial leverage on the firms profitability.
Breaking down the ROE:
ROE = Net Income / Equity
ROE = (Net Income / Equity) x (Assets / Assets)
ROE = (Net Income / Assets) x ( Assets/Equity)
We that Net Income / Assets is ROA. We can express ROA as:
ROA = (Net Income/Sales) x (Sales / Asset) = Profit Margin x Assets Turnover
Equity / Assets = Equity Multiplier = (1 + Debt to Equity Ratio)
DuPont identity tells us that ROE is affected by three things:
1. Operating efficiency (as measured by profit margin).
2. Asset use efficiency (as measured by total asset turnover).
3. Financial leverage (as measured by the equity multiplier).
Weakness in either operating or asset use efficiency (or both) will show up in a
diminished
return on assets, which will translate into a lower ROE.

Considering the DuPont identity, it appears that the ROE could be leveraged up
by increasing the amount of debt in the firm. However, notice that increasing
debt also increases interest expense, which reduces profit margins, which acts
to reduce ROE.
So, ROE could go up or down, depending.
More important, the use of debt financing has a number of other effects, and
the amount of leverage a firm uses is governed by its capital structure policy.
Benefits and Issues of Ratio Analysis
Benefit of Ratio Analysis
It simplifies the financial statements.
It helps in comparing companies of different size with each other.
It helps in trend analysis which involves comparing a single company over a
period.
It highlights important information in simple form quickly. A user can judge a
company by just looking at few numbers instead of reading the whole financial
statements.
Issues of Ratios Analysis
Ratios deal mainly in numbers they dont address issues like product quality,
customer service, employee morale and so on (though those factors play an
important role in financial performance).
Ratios are most useful when they are used to compare performance over a long
period of time or against comparable businesses and an industry this
information is not always available
Ratios largely look at the past, not the future. However, investment analysts
will make assumptions about future performance using ratios. All of the
information used in ratio analysis is derived from actual historical results and
that does not mean that the same results will carry forward into the future.
It can be dangerous to conduct a ratio analysis comparison between two firms
that are pursuing different strategies. For example, one company may be
following a low-cost strategy, and so is willing to accept a lower gross margin in
exchange for more market share. Conversely, a company in the same industry
is focusing on a high customer service strategy where its prices are higher and
gross margins are higher, but it will never attain the revenue levels of the first
company.
Ratios from the balance sheet refer to the last day of the reporting period and
do not necessarily represent what happen during the whole reporting period. If
in the last day of the reporting period there was an unusual peak in the account
balance, this can impact the outcome of the ratio analysis. Also seasonal

factors can also distort ratio analysis. Understand how this seasonal factors
affect a business can reduce the chance of misinterpretation. For example, a
retailer's inventory may be high in the summer in preparation for the back-toschool season. As a result, the company's accounts payable will be high and its
ROA low.
Financial information can be massaged in several ways to make the figures
used for ratios more attractive. For example, many businesses delay payments
to trade creditors at the end of the financial year to make the cash balance
higher than normal and the creditor days figure higher too.
Financial accounting information is affected by estimates and assumptions.
Accounting standards allow different accounting policies, which impairs
comparability and hence ratio analysis is less useful in such situations.
Many large firms operate different divisions in different industries. For these
companies it is difficult to find a meaningful set of industry-average ratios.
Different accounting practices can distort comparisons even within the same
company (leasing versus buying equipment, LIFO versus FIFO, etc.)
It is difficult to generalize about whether a ratio is good or not. A high cash
ratio in a historically classified growth company may be interpreted as a good
sign, but could also be seen as a sign that the company is no longer a growth
company and should command lower valuations. Also, a company may have
some good and some bad ratios, making it difficult to tell if it's a good or weak
company.
As long as you are aware of these challenges and interpret with judgement,
ratio analysis is still useful. Ratio analysis conducted in a mechanical,
unthinking manner is dangerous. If used smartly ratio analysis can provide
insightful information.