1. Financial Statements and Analysis
Chapter 2
Financial Statements and Analysis

2. Learning Goals
Review the contents of the stockholders’ report and the procedures for consolidating international financial statements.
Understand who uses financial ratios, and how.
Use ratios to analyze a firm’s liquidity and activity.
Discuss the relationship between debt and financial leverage and the ratios used to analyze a firm’s debt.
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3. Learning Goals (cont.)
Use ratios to analyze a firm’s profitability and market value.
Use a summary of financial ratios and the DuPont system of analysis to perform a complete ratio analysis.
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4. The Stockholders’ Report
The guidelines used to prepare and maintain financial records and reports are known as generally accepted accounting principles (GAAP).
GAAP is authorized by the Financial Accounting Standards Board (FASB).
The Sarbanes-Oxley Act of 2002, passed to eliminate the many disclosure and conflict of interest problems of corporations, established the Public Company Accounting Oversight Board (PCAOB), which is a not-for-profit corporation that overseas auditors.
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5. The Stockholders’ Report (cont.)
The PCAOB is charged with protecting the interests of investors and furthering the public interest in the preparation of informative, fair, and independent audit reports.
Public corporations with more than $5 million in assets and more than 500 stockholders are required by the SEC to provide their stockholders with an annual stockholders report.
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6. The Four Key Financial Statements: The Income Statement
The income statement provides a financial summary of a company’s operating results during a specified period.
Although they are prepared annually for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes.
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7. The Four Key Financial Statements
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8. The Four Key Financial Statements: The Balance Sheet
The balance sheet presents a summary of a firm’s financial position at a given point in time.
Assets indicate what the firm owns, equity represents the owners’ investment, and liabilities indicate what the firm has borrowed.
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9. The Four Key Financial Statements
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10. The Four Key Financial Statements (cont.)
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11. The Four Key Financial Statements: Statement of Retained Earnings
The statement of retained earnings reconciles the net income earned and dividends paid during the year, with the change in retained earnings.
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12. The Four Key Financial Statements
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13. The Four Key Financial Statements: Statement of Cash Flows
The statement of cash flows provides a summary of the cash flows over the period of concern, typically the year just ended.
This statement not only provides insight into a company’s investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets.
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14. The Four Key Financial Statements
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15. Consolidating International Financial Statements
FASB 52 mandated that U.S. based companies translate their foreign-currency denominated assets and liabilities into dollars using the current rate (translation) method.
Under the translation method, companies translate all foreign-currency-denominated assets and liabilities into dollars at the exchange rate prevailing at the fiscal year ending date (the current rate).
Income statement items are usually treated similarly.
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16. Consolidating International Financial Statements (cont.)
Equity accounts, on the other hand, are translated into dollars by using the exchange rate that prevailed when the parent’s equity investment was made (the historical rate).
Retained earnings are adjusted to reflect each year’s operating profits (or losses).
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17. Using Financial Ratios: Interested Parties
Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firm’s financial condition and performance.
It is of interest to shareholders, creditors, and the firm’s own management.
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18. Using Financial Ratios: Types of Ratio Comparisons
Trend or time-series analysis
Used to evaluate a firm’s performance over time
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19. Using Financial Ratios: Types of Ratio Comparisons (cont.)
Trend or time-series analysis
Cross-sectional analysis
Used to compare different firms at the same point in time
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20. Using Financial Ratios: Types of Ratio Comparisons (cont.)
Trend or time-series analysis
Cross-sectional analysis
Industry comparative analysis
One specific type of cross sectional analysis. Used to compare one firm’s financial performance to the industry’s average performance
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21. Using Financial Ratios: Types of Ratio Comparisons (cont.)
Trend or time-series analysis
Cross-sectional analysis
Benchmarking
A type of cross sectional analysis in which the firm’s ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate
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22. Using Financial Ratios: Types of Ratio Comparisons (cont.)
Trend or time-series analysis
Cross-sectional analysis
Combined Analysis
Combined analysis simply uses a combination of both time series analysis and cross-sectional analysis
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23. Using Financial Ratios: Types of Ratio Comparisons (cont.)
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24. Using Financial Ratios: Types of Ratio Comparisons (cont.)
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25. Using Financial Ratios: Cautions for Doing Ratio Analysis
Ratios must be considered together; a single ratio by itself means relatively little.
Financial statements that are being compared should be dated at the same point in time.
Use audited financial statements when possible.
The financial data being compared should have been developed in the same way.
Be wary of inflation distortions.
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26. Ratio Analysis Example
We will illustrate the use of financial ratios for analyzing financial statements using the Bartlett Company Income Statements and Balance Sheets presented earlier in Tables 2.1 and 2.2.
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27. Ratio Analysis Liquidity Ratios Current Ratio
Current ratio = total current assets
total current liabilities
Current ratio = $1,233,000 = 1.97
$620,000
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28. Ratio Analysis (cont.) Liquidity Ratios Current Ratio Quick Ratio
Quick ratio = Total Current Assets - Inventory
total current liabilities
Quick ratio = $1,233,000 - $289,000 =
$620,000
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29. Ratio Analysis (cont.) Liquidity Ratios Activity Ratios
Inventory Turnover
Inventory Turnover = Cost of Goods Sold
Inventory
Inventory Turnover = $2,088,000 = 7.2
$289,000
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30. Ratio Analysis (cont.) Liquidity Ratios Activity Ratios
Average Age of Inventory
Average Age of Inventory =
Inventory Turnover
Inventory Turnover = = days
7.2
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31. Ratio Analysis (cont.) Liquidity Ratios Activity Ratios
Average Collection Period
ACP = Accounts Receivable
Net Sales/365
ACP = $503, = days
$3,074,000/365
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32. Ratio Analysis (cont.) Liquidity Ratios Activity Ratios
Average Payment Period
APP = Accounts Payable
Annual Purchases/365
APP = $382,000 = days (.70 x $2,088,000)/365
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33. Ratio Analysis (cont.) Liquidity Ratios Activity Ratios
Total Asset Turnover
Total Asset Turnover = Net Sales
Total Assets
Total Asset Turnover = $3,074,000 = .85
$3,597,000
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34. Ratio Analysis (cont.) Insert Table 2.6 here
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35. Debt Ratio = Total Liabilities/Total Assets
Ratio Analysis (cont.)
Liquidity Ratios
Activity Ratios
Financial Leverage Ratios
Debt Ratio
Debt Ratio = Total Liabilities/Total Assets
Debt Ratio = $1,643,000/$3,597,000 = 45.7%
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36. Ratio Analysis (cont.) Liquidity Ratios Activity Ratios
Leverage Ratios
Times Interest Earned Ratio
Times Interest Earned = EBIT/Interest
Times Interest Earned = $418,000/$93,000 = 4.5
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37. Ratio Analysis (cont.) Liquidity Ratios Activity Ratios
Leverage Ratios
Fixed-Payment coverage Ratio (FPCR)
FPCR = EBIT + Lease Payments
Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}
FPCR = $418,000 + $35,000 = 1.9
$93,000 + $35,000 + {($71,000 + $10,000) x [1/(1-.29)]}
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38. Ratio Analysis (cont.) Liquidity Ratios Activity Ratios
Leverage Ratios
Profitability Ratios
Common-Size Income Statements
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39. Ratio Analysis (cont.)
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40. GPM = Gross Profit/Net Sales
Ratio Analysis (cont.)
Liquidity Ratios
Activity Ratios
Leverage Ratios
Profitability Ratios
Gross Profit Margin
GPM = Gross Profit/Net Sales
GPM = $986,000/$3,074,000 = 32.1%
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41. Ratio Analysis (cont.) Liquidity Ratios Activity Ratios
Leverage Ratios
Profitability Ratios
Operating Profit Margin (OPM)
OPM = EBIT/Net Sales
OPM = $418,000/$3,074,000 = 13.6%
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42. NPM = Earnings Available to Common Stockholders Sales
Ratio Analysis (cont.)
Liquidity Ratios
Activity Ratios
Leverage Ratios
Profitability Ratios
Net Profit Margin (NPM)
NPM = Earnings Available to Common Stockholders Sales
NPM = $221,000/$3,074,000 = 7.2%
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43. Ratio Analysis (cont.) Liquidity Ratios Activity Ratios
Leverage Ratios
Profitability Ratios
Earnings Per Share (EPS)
EPS = Earnings Available to Common Stockholders Number of Shares Outstanding
EPS = $221,000/76,262 = $2.90
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44. ROA = Earnings Available to Common Stockholders Total Assets
Ratio Analysis (cont.)
Liquidity Ratios
Activity Ratios
Leverage Ratios
Profitability Ratios
Return on Total Assets (ROA)
ROA = Earnings Available to Common Stockholders Total Assets
ROA = $221,000/$3,597,000 = 6.1%
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45. ROE = Earnings Available to Common Stockholders Total Equity
Ratio Analysis (cont.)
Liquidity Ratios
Activity Ratios
Leverage Ratios
Profitability Ratios
Return on Equity (ROE)
ROE = Earnings Available to Common Stockholders Total Equity
ROE = $221,000/$1,754,000 = 12.6%
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46. Ratio Analysis (cont.)
Liquidity Ratios
Activity Ratios
Leverage Ratios
Profitability Ratios
Market Ratios
Price Earnings (P/E) Ratio
P/E = Market Price Per Share of Common Stock Earnings Per Share
P/E = $32.25/$2.90 = 11.1
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47. Ratio Analysis (cont.)
Liquidity Ratios
Activity Ratios
Leverage Ratios
Profitability Ratios
Market Ratios
Market/Book (M/B) Ratio
BV/Share = Common Stock Equity Number of Shares of Common Stock
BV/Share = $1,754,000/72,262 = $23.00
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48. Ratio Analysis (cont.)
Liquidity Ratios
Activity Ratios
Leverage Ratios
Profitability Ratios
Market Ratios
Market/Book (M/B) Ratio
M/B Ratio = Market Price/Share of Common Stock Book Value/Share of Common Stock
M/B Ratio = $32.25/$ = 1.40
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49. Summarizing All Ratios
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50. Summarizing All Ratios (cont.)
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51. Summarizing All Ratios (cont.)
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52. Summarizing All Ratios (cont.)
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53. DuPont System of Analysis
The DuPont system of analysis is used to dissect the firm’s financial statements and to assess its financial condition.
It merges the income statement and balance sheet into two summary measures of profitability: ROA and ROE as shown in the equation below and in Figure 2.2 on the following slide.
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54. DuPont System of Analysis (cont.)
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55. Modified DuPont Formula
The Modified DuPont Formula relates the firm’s ROA to its ROE using the financial leverage multiplier (FLM), which is the ratio of total assets to common stock equity:
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56. Modified DuPont Formula (cont.)
Use of the FLM to convert ROA into ROE reflects the impact of financial leverage on the owner’s return.
Substituting the values for Bartlett Company’s ROA of 6.1 percent calculated earlier, and Bartlett’s FLM of 2.06 ($3,597,000 total assets ÷ $1,754,000 common stock equity) into the Modified DuPont formula yields:
ROE = 6.1% X 2.06 = 12.6%
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