1. Analysis of Financial Statements
Chapter 11
Analysis of Financial Statements

2. Financial Statements and Reports
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.

3. Penny Ltd. Income Statement
Sales €80,000
Variable operating costs (60,000)
Fixed costs, excluding depreciation (12,000)
Depreciation ( 2,000)
EBIT = NOI 6,000
Interest ( 1,000)
Earnings before taxes (EBT) 5,000
Taxes (40%) ( 2,000)
Net income € 3,000
Dividends 2,000
Addition to retained earnings 1,000

4. Financial Statements and Reports
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.

5. Penny Ltd. Balance Sheet
Current Current
Year Year
Cash & securities € 2,000 Accounts payable € 4,000
Accounts receivable 6,000 Accruals 5,000
Inventory 7,000 Notes payable 1,000
Current assets 15,000 Current liabilities 10,000
Net fixed assets 10, Long-term debt 6,000
Total assets €25,000 Total liabilities 16,000
Common stock 6,000
Retained earnings 3,000
Owners’ equity 9,000
Total liabilities
& equity €25,000

6. Penny Ltd. Balance Sheet—Changes in Assets
Current Previous
Year Year Change
Cash & securities € 2,000 €1,000
Accounts receivable 6,000 5,000
Inventory 7, ,000
Current assets 15,000 14,000
Net fixed assets 10, ,000
Total assets €25,000 €23,000
Source Use
1,000
(1,000) X
Fixed assets if no purchases or sales = €9,000 - €2,000 = €7,000
Depreciation = €2,000
Change in fixed assets = €10,000 - €7,000 = €3,000
Sources of Cash Uses of Cash
 Asset Account  Asset Account

7. Penny Ltd. Balance Sheet—Changes in Liabilities and Equity
Current Previous
Year Year
Accounts payable € 4,000 € 2,000
Accruals 5,000 4,000
Notes payable 1, ,000
Current liabilities 10,000 8,000
Long-term debt 6, ,000
Total liabilities 16,000 15,000
Common stock 6,000 6,000
Retained earnings 3, ,000
Owners’ equity 9,000 8,000
Total liabilities & equity €25,000 €23,000
Change
2,000
(1,000)
1,000
Source Use X
Sources of Cash Uses of Cash
 Liability/Equity Account  Liability/Equity Account

8. Financial Statements and Reports
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.

9. Penny Ltd. Statement of Cash Flows
Cash Flows from Operations:
Net income (NI) €3,000
Adjustments to NI
Depreciation 2,000
 Inventory 1,000
 Accounts payable 2,000
 Accruals 1,000
 Accounts receivable (1,000)
Net CF from operations €8,000
Cash Flows from Long-Term Investing:
Acquisition of assets (3,000)
Cash Flows from Financing Activities:
 Notes payable (1,000)
 Long-term bonds (1,000)
Dividend payment (2,000)
Net CF from financing €(4,000)
Net Change in cash 1,000
Cash at beginning of year 1,000
Cash at end of year €2,000

10. Notes to the Financial Statements
Notes to the financial statements provide detailed information on the accounting policies, procedures, calculations, and transactions underlying various entries in the financial statements.
Common issues include revenue recognition, income taxes, breakdowns of fixed asset accounts, debt and lease terms, and contingencies.

11. Financial Statements: Time Dimension
Balance sheet—a “snapshot” of where the firm is at a specific point in time (stock statement).
Income statement and statement of cash flows—shows the results of the firm’s activities over a period of time (flow statement).

12. Ratio (Financial Statement) Analysis
General categories of analysis:
Liquidity
Asset management
Debt management
Profitability
Market value

13. Liquidity Ratios
Provide an indication of how well the firm can meet its current obligations
Help measure the liquidity position of the firm
Too little, or too much liquidity could be considered a “bad sign”
too little liquidity—suggests the firm will have problems paying its current obligations in the future
too much liquidity—might suggest the firm is not investing its funds wisely

14. Liquidity Ratios Current ratio = total current assets
total current liabilities
Quick ratio = Total Current Assets - Inventory
total current liabilities

15. Asset Management Ratios
Provide an indication of how well the firm manages its assets (efficiency)
Show how often the firm is “turning over” its assets to generate funds
Generally, when assets are not turned over quickly enough, it is because sales have slowed or current assets, such as inventory and receivables, are too high
If assets are turned over too quickly, it could mean that the firm is not producing enough

16. Asset Management Ratios
Inventory Turnover = Cost of Goods Sold
Inventory
DSO =Days Sales Outstanding = Receivables
Average sales per day
Fixed assets turnover ratio = Sales
Net fixed assets
Total Asset Turnover = Sales
Total Assets

17. Debt Management Ratios
Indicate how the firm’s financial position is affected by the amount of debt it has
financial leverage refers to the use of debt
leverage helps to magnify returns, on both the positive and the negative sides, because debt represents a fixed obligation

18. Debt Management Ratios
Debt Ratio = Total Liabilities/Total Assets
Times Interest Earned = EBIT/Interest charges
Fixed charge coverage ratio = EBIT + Lease Pymts
Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}

19. Profitability ratios
Indicate how the firm’s management of its liquidity position, assets, and debt has affected normal operating activities.

20. Profitability Ratios Profit Margin on Sales = Net Income/ Sales
Return on Total Assets = Net Income/ Total Assets
Return on Common Equity = Net Income available to common stockholders / Common equity

21. Market Value Ratios
Measures that consider the value of the firm’s stock in the financial markets—that is, how well investors perceive that the firm is creating value.

22. Market Value Ratios
P/E = Market Price Per Share of Common Stock Earnings Per Share
M/B = Market Price Per Share of Common Stock Book Value Per Share of Common Stock

23. Trend and Comparative Analyses
Ratios should be evaluated
At a point in time in comparison to a norm, such as an industry average, to determine the firm’s current financial position (comparative analysis).
Over time to determine whether the firm’s current financial position is improving or deteriorating (trend analysis).

24. Types of Ratio Comparisons
Using Financial Ratios
Types of Ratio Comparisons