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ANALYSIS
Teaching Note – March 7, 2018
This Teaching Note supplements textbook Chapter 14.
The goal of financial statement analysis is to identify financial strengths and weaknesses.
Investors, employees, lenders, suppliers, and the firm’s own managers use financial statements
to evaluate past performance, and, as a basis for projecting future performance. A company’s
financial statements play a key role in financial analysis because they furnish the input data
from which financial ratios are computed. But, the financial statements alone are insufficient for
a comprehensive financial analysis. The quality of the firm’s products, an assessment of the
firm’s management, a review of the firm’s competition, and a determination of where the firm’s
products are located in their product life cycle are examples of important factors not revealed in
The income statement, balance sheet, and cash flow statement are the three financial statements
with which investors need to be familiar. We begin with the income statement.
(sales) and expenses (costs) a firm experiences during a specified time span called the
accounting period. The following equation concisely summarizes the income statement.
Nearly every company publishes annual Income Statements, and many also publish quarterly
financial statements. Table 1 contains three annual income statements for a hypothetical
electronics manufacturer, it shows that the National Electronics Corporation (NEC) earned an
1
Operating income can be used as a synonym for EBIT and for operating profit if the firm has
no non-operating income, which is common. If a firm has any non-operating income, defining
EBIT is slightly more complicated. A simple definition of EBIT that is undisputable is: EBIT =
Net income + all taxes paid + all interest paid.
Cost of goods sold (COGS on line I10 of Table 1) is what NEC spent on raw materials and
labor to produce its products. The COGS statement in Table 2 dissects COGS into smaller
Some firms’ Income Statements merely list COGS as the single line entry shown on line I10 of
Table 1 and omit the details shown in Table 2. In these cases the determination of COGS shown
in Table 2 is usually shown in a supporting financial statement that provides details omitted from
Table 3 is called a common-size income statement because the firm’s sales revenues are
treated as a common denominator for every other item in that income statement. In other words,
each year’s net sales revenue equals 100 percent and all other items in that accoun ting
period are stated as a percentage of net sales. Converting all income statement items to a
percent of sales facilitates comparing income statements from different years (called time-series
IC9 of the common-size income statement in Table 3 show that NEC’s production process spends
considerably more on raw materials than on labor. This might be because NEC’s managers
choose to buy components from sub-contractors rather than manufacture these “building blocks”
internally.
profit is a gross measure, not a net measure, of profitability because operating expenses have
not yet been deducted. Total operating expenses on line I21 of Table 1 and line IC21 of Table
3 equals the sum of assorted indirect costs like executive salaries, advertising expenses, pension
expenses, and other outlays that did not contribute directly to producing the firm’s products. A
company’s net operating income (NOI) on lines I22 and IC22 of Tables 1 and 3 is computed
by deducting all indirect costs from the firm’s gross profit. A corporation’s NOI is sometimes
A corporation’s income statement summarizes inflows and outflows that produce the firm’s sales
revenue. However, cash payments to pay off a maturing bond issue, for example, is not
included in a corporation’s income statement. Financial cashflows are summarized in the firm’s
cashflow statement, this financial statement is discussed later in this chapter. Financial
cashflows are not included in the corporation’s income statement because they are not incurred
directly in the production and sale of the company’s products. Unlike the income statement, a
accounting period in a firm’s life. In contrast, the balance sheet is like a still photo of a
company’s sources and uses of funds. Stated differently, the balance sheet lists the company’s
assets, liabilities and owners equity that existed at one instant in time. A firm may prepare a
balance sheet and income statement monthly, each quarter, or annually. Table 4 shows the
balance sheet for the National Electronics Corporation at the end of three of the corporation’s
The balance sheet in Table 4 may be converted into a common-sized balance sheet by dividing
each item in Table 4 by the value of the firm’s total assets to create Table 5. Converting all
items in a balance sheet to percentages facilitates comparing income statements from different
years and from different corporations. For instance, lines LC8 and EC5 in Table 5 indicate
that NEC borrows about 70 percent of the funds spent to buy assets, while the stockholders
undertake, this s u g g e s t s that NEC is managed aggressively and is more likely to get into
financial difficulties than companies with more equity and less debt.
show how cash changes in the Balance Sheet and cashflows from operations affect the
1. They provide information about a firm’s solvency, liquidity, and its ability to
handle specific cashflows.
2. They supply facts that can be used to evaluate the company’s assets, liabilities,
and equity.
3. They reveal data about cash inflows and outflows not found in the Balance Sheet
and Income Statement.
4. They furnish insights about the amount, timing, and probability of future cashflows.
The Cashflow Statement is a standard periodic financial statement that should accompany the
Balance Sheet and Income Statement. It eliminates some hypothetical cashflows that
accompany certain accounting conventions. For example, depreciation reduces the book values
of assets with usage or with the passage of time. Cashflows from depreciation come from
income tax reductions, not from earnings. The cashflows from depreciating assets (line C3) are
A Cashflow Statement breaks down a company’s cash inflows and outflows into three categories:
operating, investing, and financing activities. Table 6 contains three annual Cashflow Statements
for NEC.
4 FINANCIAL RATIOS
This section shows how data from financial statements are used to compute financial ratios.
Solvency ratios, or liquidity ratios, measure a firm’s ability to meet its short-term financial
obligations. For example, if a firm’s Current Ratio equals two or better, and, if its Quick Ratio
equals one or more, the firm is probably solvent. The high solvency ratio values in Table 7 indicate
that NEC is holding more cash each year. Being insolvent should be avoided because it
would embarrass the firm and reduce the firm’s future credit worthiness. But, cash is a non-
earning asset and, therefore, carrying excessive cash is also undesirable. Perhaps NEC is
hoarding cash, for example, to finance the acquisition of new assets. If so, these p l a n n e d
statements. Or, NEC’s management might prefer to keep its strategic plans secret. A financial
analyst should be curious and investigate to discover the reason for NEC’s rapidly growing cash
holdings.
Most of the following financial ratios have descriptive names that provide guidance about how
financial statements.
4B Turnover Ratios
Turnover ratios are also called efficiency ratios or activity ratios, they measure particular
business activities within a firm. The idea underlying all turnover ratios is that inactive assets
may be non-earning assets. Once non-earning assets have been pinpointed, actions can be taken
If a liquor distiller had an inventory turnover of two times per year, the company must be
producing the product so hastily that it might be unfit or unsafe. Alternatively, if the firm is in the
fresh vegetable business, inventory that is (12 months divided by 2 turns equals) six months old is
garbage. An electronics industry average inventory turnover would make an appropriate yardstick
for interpreting NEC's inventory turnover.*
Footnote *: An entire book on financial statement analysis would delve deeper than this chapter’s
review. For example, an in-depth inventory analysis might break total inventory down into raw
materials inventory, finished goods inventory, other components that might be appropriate, and,
each different type of inventory could be analyzed separately.
4C Coverage Ratios
Coverage ratios measure the extent to which a firm's earnings are able to cover interest
expense and repay debt. The values of NEC’s Times-Interest-Earned ratios and Cashflow to
Long-Term-Debt ratios in Table 9 indicate that NEC is easily able to pay the interest on its
debts.
Three quantities from a firm’s Income and Expense Statement can be combined to determine its
∙ EBIT: As mentioned above, a firm's normal operating income (NOI) before taxes is
sometimes called its earnings before interest and taxes (EBIT). Using the item numbers in
Depreciation and Amortization: Depreciation is a business expense that accounts for fair
wear and tear on plant and equipment. Amortization is similar business expense that allows
Even though no cash outlays actually occur, generally accepted accounting principles (GAAP)
stipulate that any deductions for depreciation or amortization expense be deducted in the
d e d u c t i o n s that reduce the firm’s taxable income. These tax savings generate cash flows
that can be either spent or saved. NEC's depreciation and amortization may be found in lines
I14 and I17 of Table 1. Similar deductions may be found in lines C3 and C4 of Table 6.
4E Leverage Ratios
Leverage ratios measure the extent to which a firm has been financed by creditors. Borrowing
increases what is called financial risk, default risk, credit risk, or bankruptcy risk. NEC
uses a substantial amount of borrowed funds, as evidenced by the values in Table 10. But,
NEC employs a slightly smaller proportion of debt than some other electronic firms.
4F Profitability Ratios
Profitability ratios measure the productivity of money invested in a firm. NEC is a profitable
firm. The trend in its profit margins is upward, while the trend in its return on assets and
return on equity is slightly downward. As mentioned above, the lack of growth in all of
NEC’s profit ratios might be attributed to its increasingly large holdings of liquid assets that are
non-earning assets. If NEC’s managers plan to acquire a competitor, for example, that planned
acquisition could explain NEC’s large accumulation of liquid assets. Clever financial analysts
and shrewd investors will try to discover and anticipate such developments before they become
public information.
NEC’s net profit margins of 15% would be far too low for an upscale retail establishments like
Tiffany’s Jewelry Store in New York City or Harrods Department Store in London (where Her
Majesty shops). These luxurious stores have expensive displays and polished clerks. In
contrast, most U.S. supermarket chains have low net profit margins of one to two percent,
because they operate low cost mass merchandising operations. Different industries have
different profit margins.
Balance sheet data can be used to derive per share common stock measurements used by security
analysts. More specifically, the number of shares of common stock outstanding in line E1 of
Table 4 is used to compute several of the per share financial ratios in Table 12. For example,
NEC’s book value per share in line P2 of Table 12 is computed by dividing NEC’s shareholder’s
equity from line E5 of Table 4 by the number of common stock shares outstanding in line P1 of
earnings (net income) from line I26 of Table 1 by the number of common stock shares
outstanding. And, NECs cash dividends per share (P4 in Table 12) are determined by dividing the
corporation’s total cash dividend payment from line C16 of Table 6 by the number of common
The DuPont Corporation is credited with developing an insightful way to analyze a firm’s return on
equity (ROE). ROE (Eqn.R4 from Table 11) can be decomposed into the equity turnover ratio
(Eqn.T5 from Table 8) and the net profit margin (Eqn.R2 from Table 11), as shown in Eqn.(1).
The algebra below reveals that the equity turnover ratio can be derived from two component ratios.
Equity turnover Eqn.(2) can be substituted into ROE Eqn.(1) to obtain Eqn.(3). Table 13 shows
Eqn.(3) computed with three years of NEC’s financial statement data. The numerical analysis in
Table 13 shows that NEC’s declining ROE ratios result from declining asset turnover that occurs
while the firm’s financial leverage remains constant and its net profit margin creeps up slightly.
Essentially, NEC’s ROE is declining because it accumulated more assets than it needs; this finding
is supported by its declining return on assets (ROA) ratio - - see ratio R3 in Table 11.
Analysis of growth. The rate of price appreciation in a corporation's common stock depends on
several factors. If we simplify things by ignoring external borrowing, any corporate growth that
occurs must be financed from the firm’s retained earnings. First, the retention ratio (RR) measures
the fraction of a company’s net income that is retained and invested internally.
Second, the growth rate also depends on the return on equity (ROE), as shown in Eqn.(4).
Further Analysis of Growth. Substituting the three-part ROE ratio of Eqn.(3) into growth rate,
If a company borrowed significant amounts, Eqns.(4) and (5) must be supplemented to include
borrowing.
6 INTERPRETION
Analyzing Different Types of Risk. In addition to the factors shown in Eqn.(5), a firm’s growth
rate is related to its riskiness. If all other factors remain unchanged, when a firm becomes riskier the
𝐴 𝑓𝑖𝑟𝑚′ 𝑠 𝐵𝑎𝑛𝑘𝑠 𝑎𝑛𝑑 𝑜𝑡ℎ𝑒𝑟 𝑖𝑛𝑣𝑒𝑠𝑡𝑜𝑟𝑠 𝑆𝑡𝑜𝑐𝑘 𝑎𝑛𝑑 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒𝑠 𝑑𝑟𝑜𝑝
( 𝑟𝑖𝑠𝑘𝑖𝑛𝑒𝑠𝑠 ) → (𝑟𝑒𝑞𝑢𝑖𝑟𝑒 ℎ𝑖𝑔ℎ𝑒𝑟 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑠) → (𝑤ℎ𝑒𝑛 𝑡ℎ𝑒 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑓𝑖𝑟𝑚′ 𝑠) (6)
𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠 𝑡𝑜 𝑚𝑎𝑘𝑒 𝑟𝑖𝑠𝑘𝑖𝑒𝑟 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑟𝑖𝑠𝑒𝑠.
In contrast to the increasing risk in Eqn.(6), if all other factors are held constant, reducing risk leads
to a lower interest rates, a reduced cost of capital for the borrower, and that causes higher market
prices for the borrower’s stock and bonds. Because of the inverse relationship between risk and
security prices, wealth-maximizing investors need to assess the riskiness of their investments. To
supplement the information from financial ratios, risk can also be measured in terms of the
variability of dollar sales, variability of unit sales, variability of units produced, variability of net
income, or by the variability of other metrics. The coefficient of variation is a useful tool for
of profit, or other variables can be analyzed with the coefficient of variation (CV).
dividing it by the average value of X. The CV that results is an index number that measures
variability relative to the average value. Like all index numbers, the CV is dimensionless because it
is not measured in dollars, percentages, pounds, miles, or any other standard unit of measure. Not
having a size dimension is a quality that facilitates comparing the riskiness of different things, for
example, the riskiness of IBM’s huge net income and the riskiness of the much smaller net income
Different Risk Measures: Business firms are exposed to different types of risk. A firm’s business
risk is determined by the volatility of its operating income. Purchasing power risk comes from
inflation. Foreign exchange risk arises when foreign exchange rates fluctuate. The financial risks
a firm undertakes can be measured with the coverage ratios and the leverage ratios from Tables 9
and 10. Financial ratios and CV variations can be compared with other statistics to analyze risk.
Cross-Sectional Analysis. Financial analysts routinely use two different approaches to interpreting
financial statements. First, competing firms are compared. A firm's financial ratios can be compared
to other firm's ratios or industry average ratios. Making different cross-sectional comparisons can
reveal strengths and/or weaknesses in one firm relative to competing firms. Standard & Poors,
Moodys, Fitch, Value Line, Yahoo.com, Bloomberg, and other financial information providers
Time-Series Analysis. The second approach to interpreting financial statements focuses on a firm's
own ratios from previous years. Time-series analysis of financial data from a single firm can
highlight trends or changes. Many of the tables in this chapter provide three year examples of time-
series financial data for NEC to help the financial analyst discover trends and relationships.
through time.
7A Inflationary Distortions
Inflation distorts financial statements and financial ratios. For example, if several consecutive years
of financial statements from a single corporation are compared, the comparison can be clouded by
inflating prices. Inflation can be a particular problem with the balance sheet, where some fixed
assets are reported at their historical cost. Historical costs can become irrelevant and even
misleading after a few years of inflation. Furthermore, some generally accepted accounting
procedures (GAAP) mandate depreciating a fixed asset while its market value might actually be
appreciating. In countries that with serious inflation problems, accountants and financial analysts
find it necessary to make explicit inflation-adjustments to make a firm’s financial statements from
The generally accepted accounting principles (GAAP) used to define a firm's income are not always
defined in extremely narrow and precise terms. Whether the firm's accountants use straight-line or
accelerated depreciation, LIFO or FIFO or some other inventory valuation technique, and whether
sales are recognized as occurring when the order is signed by the customer or when the customer
Subsidiary corporations must be accounted for on the balance sheet of the parent corporation. For
instance, the Coca-Cola Company (NYSE ticker symbol KO) is a parent company that owns (i) the
well-known red and white Coca-Cola trademark and (ii) the secret recipes for the syrups used to
manufacture its soft drinks. (iii) A KO division named the Bottling Investment Group (BIG) owns
billions of dollars’ worth of interests in bottling subsidiaries like Coca-Cola Enterprises (NYSE
ticker symbol CCE) and other bottling subsidiaries around the globe. KO exercises more than a
modest ownership control in these bottling subsidiaries. Some financial analysts argue that KO
should fully disclose all information about all the bottling affiliates over which it exercises
significant controls in its consolidated balance sheet. Such a consolidation would increase KO's
total assets, reduce its return on assets (ROA) and reveal debts of the subsidiaries that were
previously out-of-sight. KO has not violated any generally accepted accounting principles or done
anything illegal. But, some accountants argue that KO’s consolidated balance sheet is unethical
because it reports KO’s subsidiary interests in bottling companies with less than total transparency.
The purchase of one company by another can create problems when their financial statements are
consolidated. An intangible asset called "goodwill" often appears on the consolidated balance sheet
of the acquiring firm to reflect the difference between the purchase price and the book value of a
subsidiary. Since it is intangible, the true value of goodwill is difficult to assess. For example, in
August 2011 Google purchased Motorola for $12.5 billion. Then, Google sold Motorola for $2.9
billion to Lenovo in 2014. But, Google retained several billion of dollars’ worth of Motorola’s
patents. As a result of these transactions, Google’s accountants reported billions of dollars’ worth of
Google’s balance sheet would be amortized away as the Motorola patents expired and became
worthless. Such vague explanations force security analysts to do forensic accounting work.
During the peak of sub-prime mortgage crisis, 2007-2008, many commercial banks owned stocks,
bonds, real estate, and other assets that collapsed in value. If banks carried these assets on their
financial statements at the assets’ historical costs, the banks were able to meet the legal reserve
requirements that banking laws and the government’s bank examiners required. But, if these banks
carried the assets on their financial statements at their much lower fair (market determined)
values, the banks would have been bankrupt. Citibank, J. P. Morgan Chase, Merrill Lynch,
Goldman Sachs, and some other large banks provide examples of the banks that were determined to
be too big to fail. As a result, after the sub-prime mortgage crisis, a number of large banks were
under great pressure from the nation’s bank regulators to retain most of their earnings internally to
replenish their capital and avoid bankruptcy. Some of these troubled banks asked their bank
examiners if they could switch from fair value accounting to historic book value accounting rather
than endure the costly process of replenishing their capital accounts to meet the reserve
requirements that were based on fair (market) value accounting procedures. In the final analysis, the
bank examiners compromised and required the troubled banks use fair value accounting for many
categories of assets but also permitted some asset categories to be valued at their historical costs.
7F Corporate Fraud
Enron Corporation was a Houston, Texas energy-trading company and public utility that became
embroiled in one of the biggest accounting frauds in U.S. history. Enron’s common stock reached a
high of $90 per share in mid-2000, before it plummeted to $0.30 when the fraud was uncovered in
October 2001. Most of Enron’s employees were surprised to read in the newspapers that their
for bankruptcy in December 2001. The resulting scandals shocked investors and regulators and
made them more aware that some large and respected companies might not be publishing truthful
financial statements. Some of Enron’s high ranking executives went to jail for years. To protect
investors from corporate fraud in the future, and to improve investors’ confidence, Congress
enacted a corporate ethics law called the Sarbanes-Oxley Act of 2002. While the Enron case is
worse than most other cases of fraud, it is not as rare as we might like.2 Companies that generate
their earnings through shadowy financial accounting are said to have low quality earnings.
richness of the information contained in many financial statements while understanding the
limitations of that information. Financial analysis can reduce the analyst’s uncertainty and give the
analyst the confidence needed to make good buy and sell recommendations.
Skeptics sometimes ask if financial statement data are able to explain changes in the price of a
common stock. The answer is yes, thousands of professional security analysts earn their livings by,
in part, studying financial statements. When a corporation announces its latest earnings per share to
the public, if the earnings rise (fall), stock prices usually rise (fall) too. Financial research also
shows that increases in a corporation’s size, riskiness, and financial leverage tend to reduce the
price of its stock. Conversely, researchers report that increases in a firm’s earnings and its growth
rate cause increased stock price. As long as no inside information is used, a clever financial analyst
2
For an empirical study over 2,000 cases of “cooking the books” see Simi Kedia, Kevon Koh,
Shicaram Rajgopal, “Evidence on Contagion in Earnings Management,” Accounting Review,
November 2015.
REFERENCES
Leopold A. Bernstein and John J. Wild, Analysis of Financial Statements, Fifth Edition, McGraw-
Stephen H. Penman, Financial Statement Analysis and Security Valuation, Fifth Edition, Richard D.