CHAPTER 5

ESSENTIALS OF FINANCIAL
STATEMENT ANALYSIS

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Roadmap

 Two concepts
– Cross-sectional vs. Time-series
– Common-size vs. Trend Statement
 Profitability analysis
 Credit risk analysis
 Return on equity and financial leverage
analysis
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Basic Approaches

 A. Time-series analysis helps identify

financial trends over time for a single
company or business unit.

 B. Cross-sectional analysis helps identify

similarities and differences across companies
or business units at a single moment in time.

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Common size and trend
statements
 1. Common size income statements recast
each statement item as a percentage of sales
for that period.

 2. Trend statements recast each statement

item as a percentage of that item in a base
year.

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Profitability, Competition, and
Business Strategy
 A. Financial ratios are another
powerful tool that analysts use in
evaluating profit performance and
assessing credit risk.

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Profitability, Competition, and
Business Strategy
Most evaluations of profit
performance begin with the return on
assets (ROA) ratio.
ROA = NOPAT/Average Assets

 1. A company’s sustainable operating profits

are isolated by removing nonoperating or
nonrecurring items from reported earnings.

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 Profitability, Competition, and
Business Strategy

 2. After-tax interest expense is eliminated from the profit

calculation so that operating profitability comparisons over
time are not clouded by differences in financial structure.

 3. Adjustments to eliminate distortions to both earnings &

assets for items such as off-balance sheet operating leases.

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Profitability, Competition, and
Business Strategy
 A company can increase its ROA in
two different ways:

– 1. By increasing the operating profit

margin.

– 2. By increasing the intensity of asset

utilization.

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 Profitability, Competition, and
Business Strategy
 In other words, ROA can be thought of as:

 a. Oper. profit margin  asset turnover ,

or

 b. NOPAT/SALES X SALES/AVG. ASSETS

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 Credit Risk and Capital
Structure
A. Credit risk refers to the ability and
willingness of a borrower to pay its debt.
 1. Ability to repay debt is determined by capacity to
generate cash from operations, asset sales, or external
financial markets in excess of cash needs.

 2. Willingness to pay depends on which competing cash

need is viewed as the most pressing at the moment.

 3. The statement of cash flows is an important source of

information for analyzing a company’s credit risk. Financial
ratios are also useful for this purpose.

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Credit Risk and Capital
Structure
B. Credit risk analysis using financial
ratios typically involves an assessment of
liquidity and solvency.
 1. Liquidity refers to the company’s short-term ability to
generate cash for working capital needs and immediate
debt repayment needs.

 2. Solvency refers to the long-term ability to generate cash

internally or from external sources in order to satisfy plant
capacity needs, fuel growth, and repay debt when due.

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Credit Risk and Capital
Structure
Short-term liquidity:

 Current Ratio = CA/CL

reflects cash as well as amounts that will be

converted into cash in the normal
operating cycle.

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Credit Risk and Capital
Structure
Short-term liquidity:

Quick Ratio = (CA-INV)/CL

Inventory is eliminated, providing a more short-run

reflection of liquidity, since few businesses can
instantaneously convert their inventories into cash.

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Credit Risk and Capital
Structure
Short-term liquidity:

A/R Turnover = Net Sales / Avg. A/R

This ratio tells users the proportion of yearly

sales that the average receivables balance
represents. This ratio will be correspondingly
larger for firms with cash sales that are a
larger proportion of total sales.

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Credit Risk and Capital Structure
Short-term
liquidity:

 Days Receivable Out. = 365

A/R Turnover
This ratio tells users the average collection period
for accounts receivable. This should be
compared to the credit period allowed by the
company.

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Credit Risk and Capital Structure
Short-term
liquidity:

Inventory Turnover Ratio = COGS / AVG.INV.

This ratio tells users the proportion of sales that the

average inventory balance represents. A higher ratio
may indicate:
i. More efficient operations, or
ii. Adoption of a low-cost leadership strategy.

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Credit Risk and Capital Structure
Short-term
liquidity:

 Days Inventory Held = 365 Days

INV.
TURNOVER
This ratio tells users the average number of
days that inventory is held in storage.

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Credit Risk and Capital Structure
Short-term
liquidity:

 A/P Turnover = Inventory Purchases

Avg. A/P.

This ratio, and its counterpart that follows, helps

analysts understand the company’s pattern of
payment to suppliers.

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Credit Risk and Capital Structure
Short-term
liquidity:

Days A/P Outstanding = 365 days
A/P Turnover

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Credit Risk and Capital Structure
Short-term
liquidity:
 + days receivable outstanding
+ days inventory held
- days accounts payable outstanding
Difference
to get a measure of the mismatching of cash inflows and outflows. The
level of concern is negatively correlated with the level of operating
cash flow.

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Credit Risk and Capital Structure
Long-term
solvency:
1. Debt ratios provide information about
the amount of long-term debt in a
company’s financial structure.

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 Credit Risk and Capital Structure
Long-term
solvency:
 2. L-Term Debt to Assets = Long-Term
Debt Total
Assets

reflects the proportion of each asset dollar

financed with long-term debt.

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Credit Risk and Capital Structure
Long-term
solvency:
 3. L-T Debt to
Tangible Assets = L-T Debt
Total Tangible Assets

The adjustment to remove intangible assets is

intended to remove “soft” assets, i.e., those
that are difficult to value reliably.

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 Credit Risk and Capital Structure
Long-term
solvency:
 4. Interest Coverage = Operating Income
before taxes &Int. Exp Interest Expense

While debt ratios are useful for understanding the

financial structure of a company, they provide no
information about its ability to generate a stream of
inflows sufficient to make principal and interest
payments. The interest coverage ratio is commonly
used for this purpose.

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Credit Risk and Capital Structure
Long-term
solvency:
 5. Operating Cash
Flows to Total Liabilities = CFOPA
Avg. CL +L-T Debt

  This ratio shows the ability of a company to

generate cash flows from operations in order to
service both short-term and long-term borrowings.

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Return on Equity and
Financial Leverage
 A. Profitability and credit risk
both influence the return that
common shareholders earn on their
investment in the company.

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Return on Equity and
Financial Leverage
 B. Return on C/E (ROCE) =

NI available to Common Shareholders

Avg. Common SE

This ratio measures a company’s

performance in using capital provided by
shareholders to generate earnings.

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Return on Equity and Financial
Leverage
C. Components of ROCE:
1. ROCE = ROA  common earnings
leverage  financial structure leverage

or

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Return on Equity and Financial
Leverage
C. Components of ROCE:
 2. ROCE =
NOPAT X NI AVAIL. TO COMMON X AVG. ASSETS
AVG. ASSETS NOPAT AVG. COMMON SE
a. The common earnings leverage ratio shows the proportion of NOPAT that belongs to common shareholders.
b. The financial structure leverage ratio measures the degree to which the company uses common shareholders’ capital to finance assets.

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Roadmap

 Two concepts
– Cross-sectional vs. Time-series
– Common-size vs. Trend Statement
 Profitability analysis
 Credit risk analysis
 Return on equity and financial leverage
analysis
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