1. Financial Statement Analysis

2. Financial statement analysis helps users make better decisions.
Purpose of Analysis
Financial statement analysis helps users make better decisions.
Managers
Officers
Internal Auditors
Shareholders
Lenders
Customers
Financial analysis is used by many people within an organization, such as managers who use it to plan and control operations. External users of financial information, such as shareholders, lenders, and customers are interested in the results of comprehensive financial analysis, too, as they want to learn as much as possible about the financial health of the company.
Internal Users
External Users

3. Purpose of Analysis
Many different financial measures are used to analyze financial statements and rank the performance of competing investment opportunities, including growth in sales, return to stockholders, profit margins, and return on equity. These are just four possible measures considered and evaluated by investors and creditors. More will be covered throughout this chapter.

4. Outcomes Describe meaning and usage of financial statement analysis
3 Types of Analysis
5 Types of Financial Ratios

5. Ratio Analysis Why? numbers versus ratios EX : COMPANY AA BB
NET INCOME
$ 1,000,000
$ 10,000
TOTAL ASSETS
$ 5,000,000
$ 20,000
NI / TA
0.20 = 20%
0.50 = 50%

6. Ratio Analysis Types of ratio analysis Industry Comparative You
Industry average
NI / TA
28 %
22 %
To compare with the average of the companies in the same industry
(your performance is higher or lower than the mean?)

7. Ratio Analysis Types of ratio analysis Trend or time series YEAR 2001
2002
2003
NI / TA
22 %
23 %
25 %
To compare with yourself along the period of time
(your performance is improving or getting worse?)

8. Ratio Analysis Types of ratio analysis Cross-sectional COMPANY You C1
NI / TA
28 %
19 %
22 %
36 %
To compare with your main competitors
(your performance is better or worse than them?)

9. Types of Financial Ratios
Liquidity
Asset Management (Efficiency)
Debt Management (Financial Leverage)
Profitability
Market Value

10. 1. Liquidity Ratios
= Ability to pay current obligations (S-T debts; A/P, N/P)
By using current sources of cash (Current Assets)
Current ratio = CA ÷ CL
Example
You
Co1
Co2
Current ratio
1.20
1.00
0.70
Analysis
Good
Normal
Bad
Quick or acid-test ratio = (CA - Inventories) ÷ CL
Inventories are the least liquid current assets so exclude it out

11. 2. Asset Management Ratios
= Measure how efficient the assets can turn into sales
$$$ $$$
$$$$
(Investment)
$ 1,000,000
(Sales)
$ 3,000,000
Meaning: investing $1 can generate sales $3

12. 2. Asset Management Ratios
Inventory Turnover = COGS ÷ Inventory
Receivables Turnover = S ÷ A/R
Average collection period (ACP) = A/R x 365 ÷ S
Example: A/R = $100, Sales = $3,650
ACP = A/R x ÷ S
ACP = $100 x 365 days ÷ $3,650
ACP = 10 days
10 days
Meaning:
Make sales today
Collect cash from customer

13. Inventory Turnover Rate
Cost of Goods Sold
Average Inventory
Inventory
Turnover =
= times
$140,000
($10,000 + $12,000) ÷ 2
Inventory
Turnover =
This ratio measures the number
of times merchandise inventory
is sold and replaced during the year.
Part I
Like receivables turnover we can also calculate the inventory turnover. Inventory turnover is calculated by dividing cost of goods sold for the period by the average inventory.
Part II
At Babson Builders inventory turnover is times. So, inventory is turned-over about 13 times per year.
Part III
The inventory turnover ratio measures the number of times inventory is sold and replaced during the year. Higher inventory turnover helps protect a company from obsolete inventory items.

14. Average Days Sales In Inventory
Average Sale Period =
365 Days
Inventory Turnover
= days
Average Sale Period =
365 Days
12.73 Times
Part I
We can also calculate the average day's sales in inventory by dividing inventory turnover into 365 days.
Part II
At Babson the average days sales in inventory is days. Inventory is sold completely in about 29 days, or less than one month.
This ratio measures how many days, on average, it takes to sell the inventory.

15. Accounts Receivable Turnover Rate
Net Sales
Average Accounts Receivable
Accounts Receivable
Turnover =
= times
$500,000
($17,000 + $20,000) ÷ 2
Accounts Receivable
Turnover =
Part I
We calculate accounts receivable turnover by dividing our net credit sales, or sales on account, by average accounts receivable. This is yet another example of a ratio that contains and income measure in the numerator and a balance sheet measure in the denominator. Remember, in this type of ratio we always use an average amount in the denominator.
Part II
At Babson accounts receivable turnover is times. This means that on average accounts receivable turnover completely about 27 times per year.
Part III
This ratio helps us get a feel for the number of times per year a company can convert its accounts receivable into cash. For any company, the higher the turnover, the faster the cash collection on accounts receivable.
This ratio measures how many times a company converts its receivables into cash each year.

16. Number of Days to Collect Receivables
Average Collection Period =
365 Days
Accounts Receivable Turnover
= days
Average Collection Period =
365 Days
27.03 Times
This ratio measures, on average, how many days it takes to collect an account receivable.
Part I
Another way to look at receivable turnover is to calculate the average collection period in days. To do this we divide the accounts receivable turnover into 365 days.
Part II
At Babson Builders the average collection period on accounts receivable is 13.5 days. If Norton offers a two-ten, net thirty cash discount, we can see that most of the customers pay off the receivable balance close to the 10 day discount period.
Part III
This ratio measures how many days, on average, it takes for the company to collect its accounts receivable. If the collection period becomes long, management will want to develop a plan to speed the collection of receivables.

17. 2. Asset Management Ratios
Fixed Asset Turnover = Sales ÷ Fixed Assets
Total Asset Turnover = Sales ÷ Total Assets
Example
You
Co1
Co2
Sales
$ 3 m
$ 1 m
$ 1.4 m
Total Assets
$ 1 m
$ 1 m
$ 2 m
TATO
3.00
1.00
0.70
Analysis
Good
Normal
Bad

18. 3. Debt Management Ratios
= How much the firm has borrowed to make an investment
= Ability of a firm to meet total debt obligations (S-T & L-T)
Debt ratio = TL ÷ TA
Total Debt to Equity ratio = TL ÷ TE
Brown Co.
Green Co. TL TA TL TA TA
$100,000 TL
$ 80,000 TA
$100,000 TL
$ 20,000 =
80 % =
20 % TE
$ 80,000 TL TE TL TE = 4x =
0.25x TE
$ 20,000

19. 4. Profitability Ratios Gross Profit Margin
= Ability to earn profit generated from sales
= Ability to control costs, expenses
Gross Profit Margin
= Gross Profit / Sales
How many %profit left after paying cost of goods sold
Higher  good control of cost of goods sold
Lower  cost of goods sold are too high

20. 4. Profitability Ratios (cont.)
Operating Profit Margin
= EBIT / Sales
How many %profit left after paying cost of goods sold and operating expense
Higher  good control of both CGS and operating exp
Lower  CGS and operating expense are too high

21. 4. Profitability Ratios (cont.)
Net Profit Margin (NPM) = NI to CS ÷ S
Ex :
Co. 1
Co. 2
Sales
100,000
100,000
- expenses
- 40,000
- 60,000
NI to CS
60,000
40,000
NPM
60 %
40 %

22. 4. Profitability Ratios (cont.)
Return on Assets (ROA) = NI to CS ÷ TA
= How much is the profit from $ 1 total investment
Example :
Brown Co: TA = $100,000 NICS = $10,000
ROA =
10%
Green Co : TA = $100,000 NICS = $20,000
ROA =
20%
Return on Equity (ROE) = NI to CS ÷ CE
= How much is the profit from $ 1 owners’ investment
CE = Investment from Common Shareholders
= CS par + Paid in + RE

23. 5. Market Value Ratios
= How much the investors value the firm in the market
= Tell you what investors think about the firm’s future
Price to earnings ratio (P/E) = Market price per share
Earnings per share
**Earnings per share = NI to CS ÷ # of Common Shares
= How much the investors are willing to pay for each $ 1 of earnings per share (EPS)

24. 5. Market Value Ratios (cont.)
Dividend Yield (DY) = DPS
Market price per share
Dividend per share (DPS) = Dividends to CS
# of Common Shares

25. Dividend Yield
Dividend
Yield Ratio
Dividends Per Share
Market Price Per Share =
Babson Builders pays an annual dividend of $1.50 per share of capital stock. The market price of the company’s capital stock was $15.25 at the end of 2007.
Dividend
Yield Ratio
$1.50
$15.25 =
= 9.84%
Part I
To determine the dividend yield we divide the dividends per share by the closing market price per share of the company’s common stock.
Part II
At Babson the dividend yield is 9.84%. If we purchase the stock today for $15.25 per share and receive an annual dividend of $1.50, we will earn a return of 9.84% on our investment.
Once again, if you are an investor who required current income you will want to look for common shares with a high dividend yield. If you are willing to accept a less current income with a possibility of growth in the market price per share, you may look at companies with a lower dividend yield.
This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.