1. ESSENTIALS of FINANCIAL STATEMENT ANALYSIS
FINANCIAL REPORTING & ANALYSIS BY
REVSINE – COLLINS – JOHNSON
2nd Edition
CHAPTER 5
ESSENTIALS of FINANCIAL STATEMENT ANALYSIS
Adopted from Slides Authored by
Brian Leventhal
University of Illinois at Chicago

2. I. Basic Approaches
A. Time-series analysis helps identify financial trends over time for a single company or business unit.

3. I. Basic Approaches
B. Cross-sectional analysis helps identify similarities and differences across companies or business units at a single moment in time.

4. I. Basic Approaches
In time-series analysis, the benchmark may be the change in performance or health each year.

5. I. Basic Approaches
In cross-sectional analysis, the benchmark may be the performance or health of a particular competitor or industry averages.

6. II. Quaker Oats Example  
B. Common size and trend statements provide a convenient way to organize financial statement information……… so that major financial components and changes are easily recognized.

7. II. Quaker Oats Example
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.

8. Comparative Income Statements
II. Quaker Oats Example
Comparative Income Statements
($ in millions)
Sales $4, $ $5, $5, $5,954.0
Cost of Goods Sold 2, , , , ,294.4 Gross Profit , , , , ,659.6
Selling, G&A Exp , , , , ,358.8
(Gains) losses on (2.3) , (113.4) (1,053.5)
divestitures,
restructurings and
asset impairment
Interest Expense
Other (revenues) exp
Pre-tax income (1,064.3) ,220.5
Income taxes (133.4)
Net Income (loss) (930.9)

9. Comparative Income Statements
II. Quaker Oats Example –Common Size % Sales
Comparative Income Statements
($ in millions)
Sales
Cost of Goods Sold Gross Profit
Selling, G&A Exp
(Gains) losses on – –17.7 divest.,restructurings & asset impairment
Interest Expense
Other (revenues) exp
Pre-tax income
Income taxes
Net Income (loss)

10. Comparative Income Statements
II. Quaker Oats Example –Trend(1995=100%)
Comparative Income Statements
($ in millions)
Sales
Cost of Goods Sold
Gross Profit
Selling, G&A Exp
(Gains) losses on divest.,restructurings & asset impairment
Interest Expense
Other (revenues) exp
Pre-tax income
Income taxes
Net Income (loss)

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

12. III. Profitability, Competition, & Business Strategy
B. Most evaluations of profit performance begin with the Return on Assets (ROA) ratio:
ROA = net operating profit after taxes
average assets

13. III. Profitability, Competition, & Business Strategy
B. Most evaluations of profit performance begin with the return on assets (ROA) ratio:
ROA = net operating profit after taxes
average assets
2. Analysts can isolate a company’s sustainable operating profits by removing nonoperating or nonrecurring items from reported earnings.

14. III. Profitability, Competition, & Business Strategy
B. Most evaluations of profit performance begin with the return on assets (ROA) ratio:
ROA = net operating profit after taxes
average assets
Give examples of two firms. One firm is all equity and the other firm is half equity and half debt. Asssum that total assets is equal to 100 in both firms, calculate the net income and net income before interest expense to make the point.
3. 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.

15. III. Profitability, Competition, & Business Strategy
B. Most evaluations of profit performance begin with the return on assets (ROA) ratio:
ROA = net operating profit after taxes
average assets
4. Adjustments to eliminate distortions to both earnings and assets for items such as the capital and operating lease, for example mentioned earlier should be done.

16. III. Profitability, Competition, & Business Strategy
C. A company can increase its ROA in two different ways:
ROA = net operating profit after taxes
average assets
By increasing the operating profit margin.
By increasing the intensity of asset utilization.
In other words, ROA can be thought of as:
Operating profit margin  asset turnover

17. III. Profitability, Competition, & Business Strategy
C. A company can increase its ROA in two different ways:
ROA = net operating profit after taxes
average assets
Operating profit margin  asset turnover
Net operating profit after taxes(NOPAT)
Sales 
S a l e s
Average Assets

18. III. Profitability, Competition, & Business Strategy
D. ROA and competitive advantage:
Operating profit margin  asset turnover
Net operating profit after taxes(NOPAT)
Sales
S a l e s
Average Assets 
5. There are only two strategies for achieving superior performance in any business:
a. One strategy is product and service differentiation in order to focus customer attention on “unique” product or service attributes to gain customer loyalty and attractive profit margins.

19. III. Profitability, Competition, & Business Strategy
D. ROA and competitive advantage:
Operating profit margin  asset turnover
Net operating profit after taxes(NOPAT)
Sales
S a l e s
Average Assets 
5. There are only two strategies for achieving superior performance in any business:
b. Low-cost leadership focuses customer attention on product pricing. The goal is to under price the competition, achieve highest sales volumes, and still make a profit on each sale.

20. III. Profitability, Competition, & Business Strategy
D. ROA and competitive advantage:
Operating profit margin  asset turnover
Net operating profit after taxes(NOPAT)
Sales
S a l e s
Average Assets 
5. There are only two strategies for achieving superior performance in any business:
c. Few companies actually pursue one strategy to the exclusion of the other Rather, they try to develop brand loyalty while controlling cost.

21. IV. Credit Risk & Capital Structure
A. Credit risk refers to the ability and willingness of a borrower to pay its debt.

22. IV. Credit Risk & 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.

23. IV. Credit Risk & Capital Structure
A. Credit risk refers to the ability and willingness of a borrower to pay its debt.
2. Willingness to pay depends on which competing cash need is viewed as the most pressing at the moment.

24. IV. Credit Risk & Capital Structure
A. Credit risk refers to the ability and willingness of a borrower to pay its debt.
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.

25. IV. Credit Risk & 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.

26. IV. Credit Risk & Capital Structure
B. Credit risk analysis using financial ratios typically involves an assessment of liquidity and solvency.
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.

27. IV. Credit Risk & Capital Structure
C. Short-term liquidity:
Current = Current Assets
Ratio Current Liabilities
1. Reflects cash & other current assets that will be converted into cash in the normal operating cycle.

28. IV. Credit Risk & Capital Structure
C. Short-term liquidity:
Quick = Cash+ Receivables+Marketable Securities
Ratio Current Liabilities
2. Inventory is not included, providing a more short-run reflection of liquidity, since few businesses can instantaneously convert their inventories into cash.

29. IV. Credit Risk & Capital Structure
3. Activity ratios tell users how efficiently the company is using its assets by highlighting causes for cash flow mismatches.
A/R Turnover = N e t S a l e s
Average 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.

30. IV. Credit Risk & Capital Structure
3. Activity ratios tell users how efficiently the company is using its assets by highlighting causes for cash flow mismatches.
Days Receivables’ = D a y s
Outstanding 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.

31. IV. Credit Risk & Capital Structure
3. Activity ratios tell users how efficiently the company is using its assets by highlighting causes for cash flow mismatches.
Inventory Turnover =Cost of Goods Sold
Ratio Average Inventory
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.

32. IV. Credit Risk & Capital Structure
3. Activity ratios tell users how efficiently the company is using its assets by highlighting causes for cash flow mismatches.
Days Inventory = D a y s
Held Inventory Turnover
d. This ratio tells users the average number of days that inventory is held in storage.

33. IV. Credit Risk & Capital Structure
3. Activity ratios tell users how efficiently the company is using its assets by highlighting causes for cash flow mismatches.
Accounts Payable =Inventory Purchases
Turnover Average A/P
e. This ratio, and its counterpart that follows, helps analysts understand the company’s pattern of payment to suppliers.

34. IV. Credit Risk & Capital Structure
3. Activity ratios tell users how efficiently the company is using its assets by highlighting causes for cash flow mismatches.
Days A/P = D a y s
Outstanding A/P Turnover
Show on average how long the company takes to payoff Accounts Payable.

35. IV. Credit Risk & Capital Structure
3. Activity ratios tell users how efficiently the company is using its assets by highlighting causes for cash flow mismatches
Cash Inflow Vs Cash Outflow Mismatching
Days Receivable Outstanding+ Days Inventory Held
- Days A/P Outstanding
The level of concern is negatively correlated with the level of operating cash flow.

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

37. IV. Credit Risk & Capital Structure
D. Long-term solvency:
Long-Term Debt = Long-Term Debt
to Total Assets Total Assets
2. Reflects the proportion of each asset dollar financed with long-term debt.

38. IV. Credit Risk & Capital Structure
D. Long-term solvency:
Long-Term Debt = Long-Term Debt
to Tangible Assets Total Tangible Assets
3. The adjustment to remove intangible assets is intended to remove “soft” assets,
i.e., those that are difficult to value reliably.

39. IV. Credit Risk & Capital Structure
D. Long-term solvency:
Interest =Operating Income before taxes & Interest
Coverage Interest Expense
Ability to generate a stream of inflows sufficient to make principal and interest payments.
The interest coverage ratio is commonly used for this purpose.

40. IV. Credit Risk & Capital Structure
D. Long-term solvency:
Operating
Cash Flows = Cash Flow from continuing operations
to Total Avg. C/L + Long-Term Debt
Liabilities
5. The ability of a company to generate cash flows from operations in order to service both short-term and long-term borrowings.

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

42. V. Return on Equity & Financial Leverage
Net Income Available to
Return on common shareholders
Common Equity = Average Common (ROCE) Shareholders’ Equity
B. Measures a company’s performance in using capital provided by shareholders to generate earnings.

43. V. Return on Equity & Financial Leverage
C. Components of ROCE:
Net Income Available to
Return on common shareholders
Common Equity = Average Common
(ROCE) Shareholders’ Equity
ROCE = ROA x Common earning lev. x Fin. structure lev.
NOPAT
AVG. Assets
NI avail to CS
AVG Common SE x
a. The common earnings leverage ratio shows the proportion of NOPAT that belongs to common shareholders.

44. V. Return on Equity & Financial Leverage
C. Components of ROCE:
Net Income Available to
Return on common shareholders
Common Equity = Average Common
(ROCE) Shareholders’ Equity
ROCE = ROA x Common earning lev. x Fin. structure lev.
NOPAT
AVG. Assets
NI avail to CS
AVG Common SE x
b. The financial structure leverage ratio measures the degree to which the company uses common shareholders’ capital to finance assets.

45. VI. Earnings, Cash Earnings, or EBITDA?
A. There are several measures of earnings that may be used in press releases.

46. VI. Earnings, Cash Earnings, or EBITDA?
A. There are several measures of earnings that may be used in press releases.
1. GAAP earnings are those reported to the SEC using GAAP.

47. VI. Earnings, Cash Earnings, or EBITDA?
A. There are several measures of earnings that may be used in press releases.
2. EBITDA is earnings before interest, taxes, depreciation, and amortization.

48. VI. Earnings, Cash Earnings, or EBITDA?
A. There are several measures of earnings that may be used in press releases.
3. Cash earnings is generally defined as earnings before goodwill amortization.
Pro forma earnings is a variant that excludes a variety of costs that are routinely included in GAAP earnings.
One popular operationalization is net income before goodwill amortization and one-time costs such as merger integration costs.

49. VI. Earnings, Cash Earnings, or EBITDA?
A. There are several measures of earnings that may be used in press releases.
3. Cash earnings is generally defined as earnings before goodwill amortization.
b. Standard definitions for these benchmarks do not currently exist.

50. VI. Earnings, Cash Earnings, or EBITDA?
B. Analysts must be wary and look behind the numbers to see what is really going on!