1. Basic Finance Analysis of Financial Statements9
An introduction to financial institutions, investments & Management
Eleventh Edition

2. General Accounting Principles
Reliability
Understandability
Comparability

3. The Balance Sheet
Enumerates
Assets
Liabilities
Stockholders’ Equity

4. Assets
Current: cash and cash equivalents, accounts receivable, and inventory
Long-term: land, buildings, machinery, and equipment
Hidden assets
Goodwill and intangible assets

5. Liabilities Current Long-term debt Accounts Payable Accruals
Notes payable
Long-term debt

6. Equity Preferred stock Common stock Additional paid-in capital
Retained earnings
Book value
Book value per share

7. Income Statement Enumerates To determine Revenues Expenses
Income (earnings)
Earnings per share

8. Statement of Cash Flows
Enumerates
sources of funds (cash inflows)
uses of funds (cash outflows)
Determines change in the cash position
Emphasis on the firm’s ability to generate cash

9. Cash Inflows A decrease in an asset An increase in a liability
An increase in equity

10. Cash Outflows An increase in an asset A decrease in a liability
A decrease in equity

11. Limitations of Accounting Data
Nonmeasureable items are excluded
Aggregations
Possible biased estimates of data
Insufficient challenges by auditors

12. Depreciation Allocation of the cost of plant and equipment over time
Non-cash expense
Impact on taxes and cash flow

13. Depreciation Straight-line depreciation Accelerated depreciation
Equal allocation each year
Accelerated depreciation
Larger proportion during the early years

14. Modified Accelerated Cost Recovery System (MACRS)
Asset classified by years 3, 5, 7, 10, 15, 20 years
The half-year convention

15. Ratio Analysis
How do you evaluate a company?

16. Ratio Analysis What is Ratio Analysis

17. Ratio Analysis Analysis
Accounting data are often used to analyze a firm’s financial condition.
Creditors measure the safety of their loans
Investors how well managers are doing
Management identify weakness in the firm

18. Ratio Analysis 5 Groups Liquidity Activity or Asset Utilization
Profitability
Leverage
Coverage

19. Ratio Analysis 5 Groups Liquidity Ratio
Indicate the ability of the firm to meet its short-term obligation as they become due

20. Ratio Analysis 5 Groups Activity or Asset Utilization Ratio
Are concerned with the amount of assets a firm uses to support it sales.
More rapidly assets turn over, the fewer assets the firm needs to generate sales.
High turnover of inventory and accounts receivable also indicates how quickly the firm is able to convert these to current assets into cash.

21. Ratio Analysis 5 Groups Profitability Ratio
Are a measure of performance, they indicate what the firm earns on it sales, assets, and equity.

22. Ratio Analysis 5 Groups Leverage Ratio
Are concerned with the firm’s capital structure, or the extent to which debt is used to finance the firm’s assets.

23. Ratio Analysis 5 Groups Coverage Ratio
Indicate the extent to which the firm generates operating income to cover an expense.

24. Ratio Analysis Facilitates Comparisons
Time-series analysis: Analysis of a firm over a period of time
Cross-sectional analysis: Analysis of several firms in the same industry at a point in time

25. Liquidity Ratio What are liquidity Ratio’s

26. Liquidity Ratio
Liquidity is the ease with which assets may be converted into cash without loss.
Current Ratio
Quick Ratio (acid test)
Cash Ratio

27. Current Ratio What is the Current Ratio

28. Current Ratio
Current ratio: Ratio of current assets to current liabilities: Measure of liquidity
Ratio indicates how well the current liabilities, which must be paid in a year are covered.
Current assets / current liabilities
$2,945 ,021/ $2,062,846 = 1.43

29. Current Ratio
Desirable to have more current assets than current liabilities
Rule of thumb is 2:1
Determines if the firm has sufficient liquid assets to meet it bills.
Low current ratio is undesirable: it indicates financial weakness
High current ration may be undesirable: it may imply the firm is not using funds economically

30. Quick Ratio What is the Quick Ratio (acid test):

31. Quick Ratio
Quick Ratio (acid test): Current assets excluding inventory divided by current liability: Measures liquidity
Considers that not all current assets are equally liquid
Eliminates inventory, places a greater emphasis on cash, cash equivalents and accounts receivables

32. Quick Ratio (Current assets - inventory) / current liabilities

33. Cash Ratio What is the Cash Ratio

34. Cash Ratio (Cash and Cash equivalents) / current liabilities
($373,145) / $ 2,062,846 = 0.18

35. Interpretations
Current ratio: the firm’s current assets are 1.43 times its current liabilities
Quick ratio: the firm’s more liquid current assets are 0.83 its current liabilities
Cash ratio: the firm’s cash position are .18 its current liabilities

36. Activity Ratios What are Activity Ratios

37. Activity Ratios
Activity ratios indicate how rapidly the firm is turning its assets (inventory & accounts receivable) into cash.
Inventory turnover
Receivable turnover
More rapidly the firm turns over its inventory & receivables more rapidly it acquires cash.

38. Activity Ratios
High turnover indicates that the firm is rapidly receiving cash & is more able to pay it liabilities as they come due.
Does not imply that the firm is maximizing profits
Why?

39. Inventory Turnover What is Inventory Turnover Ratio
nventoryturnover.asp?lgl=no-infinite

40. Inventory Turnover
Inventory turnover: speed with which inventory is sold
Sales / average inventory
Sales/(20x1+20x0/2)
$10,148/($1,237,613+$1,378,216)/2
$10,148 / $1,308 = 7.8

41. Inventory Turnover 2nd Equation Cost of Goods Sold / avg inventory
COGS/(20x1+20x0/2)
$6,564 / $1,308 = 5.02

42. Inventory Turnover Difference Sales / average inventory
$10,148 / $1,308 = 7.8
Cost of Goods Sold / avg inventory
$6,564 / $1,308 = 5.02

43. Inventory Turnover What is Days Sales of Inventory Ratio
gl=no-infinite

44. Inventory Turnover Days in a year/Inventory Turnover Equation 1
$10,148 / $1,308 = 7.8
365/7.8 = 47 Days
Equation 2
$6,564 / $1,308 = 5.02
365/5.02 = 73 Days

45. Receivables Turnover What is the Receivable Turnover Ratio
ceivableturnoverratio.asp?lgl=no-infinite

46. Receivables Turnover
Receivable turnover: Speed at which accounts receivable are collected
Sales / accounts receivable
$10,148 / $1,172 = 8.7 a year
365/8.7 = 42 Days

47. Days Sales Outstanding (Average Collection Period)
What is the Days Sales Outstanding Ratio
gl=no-infinite

48. Days Sales Outstanding (Average Collection Period)
Days sales outstanding (average collection period): Number of days required on the average to collect an account receivable
Accounts receivable / sales per day
Sales / 365 = Sales per day
$1,172 / 27,803 = 42 Days

49. Interpretations
Inventory turnover: inventory turns over (is sold) every 47 days.
Receivables turnover and days sales outstanding: receivables are collected in 42 days (i.e., are outstanding for 42 days)

50. Fixed Asset Turnover What is the Fixed Asset Turnover Ratio
d-asset-turnover.asp?lgl=no-infinite

51. Fixed Asset Turnover
Fixed asset turnover: Ratio of sales to fixed assets; measure of fixed assets necessary to generate sales.
This ratio specifically measures how able a company is to generate net sales from fixed- asset investments.
Sales / fixed assets (land, plant ect)- Dep
$10,148 / $1,978 = 5.1

52. Total Asset Turnover What is the Total Asset Turnover Ratio
tturnover.asp?lgl=no-infinite

53. Total Asset Turnover
Total asset turnover: Ratio of sales to total assets; measure of total assets required to generate sales
Sales / total assets
$10,148 / $9,664 = 1.05

54. Interpretations
Fixed asset turnover: every $1 in fixed assets generates $5.1 in sales
Total asset turnover: every $1 in assets generates $1.05 in sales

55. Profitability Ratio What is a Profitability Ratio

56. Profitability Ratio
Profitability Ratio: measure of performance that indicate what the firm is earning on its sales or assets or equity.
Operating profit margin
Net profit margin
Gross profit margin
Return on total assets
Return on equity
Basic earning power

57. Operating Profit Margin
What is the Operating Profit Margin Ratio

58. Operating Profit Margin
Operating Profit Margin Ratio: Ratio of operating income to sales; percentage earned on sales before deducting interest expense and taxes.
Earnings before interest & taxes (EBIT)/ Sales
$1,572 / $10,148 = 15.5%

59. Operating Profit Margin
What is the Net Profit Margin Ratio

60. Net Profit Margin
Net Profit Margin Ratio: Ratio of earnings after interest and taxes to sales; percentage earned on sales.
Typically expressed as a percentage, net profit margins show how much of each dollar collected by a company as revenue translates into profit.
Earnings after interest & taxes / sales
$923 / $10,148 = 9.1%

61. Gross Profit Margin What is the Gross Profit Margin Ratio

62. Gross Profit Margin
Gross profit margin is a financial metric used to assess a company's financial health and business model by revealing the proportion of money left over from revenues after accounting for the cost of goods sold (COGS).
Gross profit margin, is also known as gross margin.

63. Gross Profit Margin
Gross Profit Margin Ratio: Ratio of revenues minus cost of goods sold to sales; percentage earnings on sales before considering operating expenses, interest and taxes.
(revenues - cost of goods sold) / sales
$3,584 / $10,148 = 35.3%

64. Interpretation
Gross profit margin: the firm earns $0.353 on every $1 in sales after deducting the cost of the goods sold.
Operating profit margin: the firm earns $ on every $1 in sales after deducting operating expenses.
Net profit margin: the firm earns $0.091 on every $1 in sales after deducting operating expenses, financing costs and taxes.

65. Return on Assets What is the Return on Total Asset Ratio

66. Return on Total Assets
Return on Total Asset: Ratio of earnings to total assets; percentage earned on assets.
The ratio is considered to be an indicator of how effectively a company is using its assets to generate earnings before contractual obligations must be paid.
Earnings after Interest & Taxes/ Total Assets
$923 / $9,664 = 9.6%

67. Return on Equity What is the Return on Equity Ratio

68. Return on Equity
Return on Equity: Ratio of earnings to owners’ equity; percentage earned on equity.
Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.
Earnings after interest & taxes / equity
$923 / $1,220 = 75.7%

69. Basic Earning Power
Basic Earning Power: Ratio of operating income to total assets; measure of the firm’s ability to generate income before considering interest and taxes.
EBIT / total assets
$1,572 / $9,664 = 16.3%

70. Interpretations
Return on assets: the firm earns $0.096 on every $1.00 of assets.
Return on equity: the firm earns $0.757 on every $1.00 of equity (stock).
Basic earning power: the firm earns $0.163 on every $1.00 of assets before considering sources of financing.

71. Leverage Ratio What is a Leverage Ratio

72. Leverage Ratio Leverage Ratio
Companies rely on a mixture of owners' equity and debt to finance their operations. A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt (loans), or assesses the ability of a company to meet financial obligations.
Debt/Net Worth Ratio
Debt Ratio

73. Leverage Ratio
Leverage Ratio give you an indication of financial Risk.
High leverage ratios are considered riskier, to creditors why
How about investors and why

74. Debt Ratio What is the Debt/Net Worth Ratio

75. Debt to Equity Ratio
Debt / Net Worth Equity: Ratio of debt to equity; debt divided by equity.
Debt/Equity Ratio is a debt ratio used to measure a company's financial leverage.
The D/E ratio indicates how much debt a company is using to finance its assets relative to the amount of value represented in shareholders’ equity.
D/E Ratio = Debt/Equity
$8,434 / $1,219 = 6.91

76. Debt Ratio What is the Debt Ratio

77. Debt Ratio
Debt Ratio: Total debt divided by total assets; proportion of assets financed by debt; a measure of financial leverage.
It can be interpreted as the proportion of a company’s assets that are financed by debt.
Debt ratio = Debt/Total Assets
$8,434 / $9,664= 87.3%

78. Interpretations
Debt ratio: debt finances 87.3 percent of the firm’s assets
Debt to equity ratio: debt is 6.9 times the firm’s equity.

79. DuPont System of Analysis
Combines
Net profit margin
Turnover
Leverage
Helps identify source of weakness

80. DuPont System of Analysis

81. Times-interest-earned
Earnings before interest and taxes / interest
$1,572 / $340 = 4.6
Interpretation: operating earnings is 4.6 times interest expense

82. Ratio Comparisons Ratios of firms within an industry
tend to have similar numerical values
differences in numerical values are reasons for further analysis

83. Possible Problems with Ratio Comparisons
Readily available data from internet sources may differ
Differences in time periods covered
Differences in ratio definitions used for calculations