1. Chapter (3) Analysis Of Financial Statements
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2. Chapter Outline: Introduction to Financial Statements Analysis.
Sources of Information for Financial Statement Analysis.
Common-Sized Financial Statements
Ratio Analysis.
Trend Analysis.
The Du Pont Equation.
Comparative Ratios and Benchmarking.
Uses and Limitations of Ratio Analysis.
Looking Beyond The Numbers.
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3. Introduction to Financial Statements Analysis:
The objectives of financial statement analysis vary across different types of decision makers.
suppliers, long-term creditors, and investors.
But, investors, by necessity must be concerned with all aspects of a firm’s financial status.
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4. Sources of Information for Financial Statement Analysis:
Annual reports.
Investment advisory services.
Business periodicals.
On-line financial services.
EDGAR the SEC’s Web site.
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5. Common-Sized Financial Statements:
Common-sized financial statements: financial statements in which each item is expressed as a percentage of a major financial statement component.
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6. Common-Sized Financial Statements:
Common-sized financial statements can be used to:
Identify key structural changes in a company’s financial data over a period of time.
Compare the financial data of firms that vary significantly in size.
Compare a company’s financial data to industry norms.
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7. Ratio Analysis:
Ratio analysis: an analytical technique that typically involves a comparison of the relationship between two financial items.
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8. Objectives of Ratio Analysis:
Standardize financial information for comparisons
Evaluate current operations
Compare performance with past performance
Compare performance against other firms or industry standards
Study the efficiency of operations
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9. Ratio Analysis: Ratio analysis begins:
with the calculation of a set of financial ratios
designed to show the relative strengths and weaknesses of a company as compared to:
Other firms in the industry
Leadings firms in the industry
The previous year of the same firm
Ratio analysis helps to show whether the firm’s position has been improving or deteriorating
Ratio analysis can also help plan for the future
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10. Five Types of Financial Ratios:
Liquidity Ratios.
Asset Management Ratios (Activity Ratios).
Debt Management Ratios (Leverage Ratios).
Profitability Ratios.
Market Value Ratios.
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11. Liquidity Ratios:
A liquid asset is one that can be easily converted into cash at a fair market value
Liquidity question deals with this question
Will the firm be able to meet its current obligations?
Two measures of liquidity
Current Ratio
Quick/Acid Test Ratio
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12. Liquidity Ratios: Current ratio = Current assets / Current liabilities
Purpose: Measures a firm’s ability to pay its current liabilities from its current assets.
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13. Liquidity Ratios: Quick (Acid Test) Ratio =
Current assets - Inventories / Current liabilities
Purpose: Measures a firm’s ability to pay its current liabilities without relying on the sale of its inventory.
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14. Asset Management Ratios:
Asset management ratio measures how effectively the firm is managing/using its assets
Do we have too much investment in assets or too little investment in assets in view of current and projected sales levels?
What happens if the firm has
Too much investment in assets
Too little investment in assets
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15. Asset Management Ratios:
The Inventory Turnover Ratio.
The Days Sales Outstanding.
The Fixed Assets Turnover Ratio.
The Total Assets Turnover Ratio.
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16. Asset Management Ratios:
The Inventory Turnover Ratio=
Sales/ Inventory.
Purpose: Indicates the number of times that a firm sells its inventory each year.
Measures the efficiency of Inventory Management
A high ratio indicates that inventory does not remain in warehouses or on shelves, but rather turns over rapidly into sales
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17. Asset Management Ratios:
The Days Sales Outstanding (DSO)=
Accounts Receivables/(Sales/360).
Purpose: Indicates the length of time normally required to collect a receivable resulting from a credit sale.
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18. Asset Management Ratio:
Days Sales Outstanding (DSO)
To appraise the quality of accounts receivables
Average length of time that the firm must wait after making a sale before receiving cash from customers
Measures effectiveness of a firm credit policy
Indicates the level of investment needed in receivables to maintain firm’s sales level
What happens if this ratio is
Too high, or
Too low
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19. Asset Management Ratio:
The Fixed Assets Turnover Ratio=
Sales/ Net Fixed Assets.
Purpose: to measure how effectively the firm uses its plant and equipment to generate sales.
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20. Asset Management Ratios:
Fixed Assets Turnover Ratio
Measures efficiency of long-term capital investment
How much fixed assets are needed to achieve a particular level of sales?
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21. Asset Management Ratio:
Total Asset Turnover Ratio=
Sales/ Total Assets.
Purpose: Measure efficiency of total assets for the company as a whole or for a division of the firm.
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22. Debt Management Ratios (Leverage Ratios):
Implications of use of borrowings
Creditors look to Stockholders’ equity as a safety margin
Interest on borrowings is a legal liability of the firm
Interest is to be paid out of operating income
Debt magnifies return and risk to common stockholders
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23. Debt Management Ratios:
Total Debt to Total Assets.
Times Interest Earned Ratio (Coverage Ratio)
EBITDA Coverage Ratio.
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24. Debt Management Ratios:
Total Debt to Total Assets Ratio=
Total debts/Total assets.
Purpose: Measures a firm’s financial leverage.
Measures percentage of assets being financed through borrowings
Too high a number means increased risk of bankruptcy
What percentage of total assets are being financed through debts?
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25. Debt Management Ratios:
Times Earned Interest (TIE)=
EBIT/Interest Charges.
Purpose: Indicates the number of times that a firm’s interest expense is covered by earnings.
Measure the extent to which operating income can decline before the firm is unable to meet its annual interest costs
Failure to pay interest can result in legal action by creditors with possible bankruptcy for the firm
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26. Debt Management Ratios:
EBITDA Coverage Ratio=
EBITDA+ Lease Payment/Interest + Principal Payment + Lease Payment
Purpose: Indicates the number of times that a firm’s interest expense is covered by EBITDA.
Useful for short term lenders like banks.
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27. Profitability Ratios:
Net result of a number of policies and decisions
Show the combined effect of liquidity, asset management, and debt management on operating results
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28. Profitability Ratios:
Net Profit Margin on Sales.
Basic Earning Power (BEP).
Return on Assets (ROA).
Return on Common Equity (ROE).
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29. Profitability Ratios:
Profit Margin on Sales=
Net Income/ Sales.
Purpose: Indicates the percentage of each sales dollar that contributes to net income.
Relates net income available to common stockholders to sales
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30. Profitability Ratios:
Basic Earning Power=
EBIT/Total Assets.
Purpose: Indicate the ability of the firm’s assets to generate operating income.
Relates EBIT to Total Assets
Useful for comparing firms with different tax situations and different degrees of financial leverage
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31. Profitability Ratios:
Return on Assets (ROA)=
Net Income/ Total Assets.
Purpose: Measures the rate of return a firm realizes on its investment in assets.
Relates net income available to common stockholders to total assets
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32. Profitability Ratios:
Return on Common Equity (ROE)=
Net Income/ Common Equity.
Purpose: Measures the rate of return on a firm’s stockholders’ equity.
Relates net income available to common stockholders to common stockholders equity
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33. Market Value Ratios:
A set of ratios that relates the firm’s stock price to its earnings, cash flow, and book value per share.
Focus on the stock price and compare it to earnings and book value.
These ratios give management an indication of what investors think of the company’s past performance and future prospects.
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34. Market Value Ratios: Price/Earnings Ratio (P/E Ratio).
Price/ Cash Flow Ratio.
Market/ Book Ratio (M/B Ratio).
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35. Market Value Ratios: Price/Earnings Ratio (P/E Ratio)=
Market Price Per Share/Earnings Per Share
Purpose: Indicates the amount investors are willing to pay for each $1 of a firm’s earnings.
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36. Market Value Ratios: Price/ Cash Flow Ratio=
Market Price Per Share/Cash Flow Per Share
Cash Flow Per Share= Net Income + Depreciation and Amortization/Common Share Outstanding.
Purpose: Indicates the amount investors are willing to pay for each $1 of a firm’s Cash Flow.
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37. Market Value Ratios: Market/ Book Ratio=
Market Price Per Share/ Book Value Per Share
Book Value Per Share=
Common Equity/ Share Outstanding
Purpose: Indicates the amount investors are willing to pay for each $1 of a firm’s Book Value ( the firm’s net assets value) .
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38. Trend Analysis:
The study of percentage changes in financial statement items over a period of time.
Trend analysis provides a simple forecasting method.
Used to estimate the likelihood of improvement or deterioration in its financial conditions.
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39. Trend Analysis:
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40. The DuPont Equation:
It is a formula which shows that the rate of return on assets can be found as the product of the profit margin times the total assets turnover.
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41. The DuPont Equation: Method to breakdown ROE into:
ROA and Equity Multiplier
ROA is further broken down as:
Profit Margin and Asset Turnover
Helps to identify sources of strength and weakness in current performance
Helps to focus attention on value drivers
DuPont Chart and Equation - Tie the Ratios Together
Shows how profit margin, asset turnover ratio, and equity multiplier determine ROE
Shows how expense control (profit margin), efficient use of assets in production (asset turnover) and capital structure (equity multiplier) affect return on equity.
Ties together all aspects of firm - production and financing.
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42. The DuPont Equation:
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43. The DuPont Equation:
Notice that using more debt (and less equity) to finance assets raises the Equity Multiplier. This has two effects for stockholders.
The Equity Multiplier acts as a lever to magnify the effects of ROA on returns for stockholders. If ROA is positive, ROE is a larger positive value, but if ROA is negative ROE is a larger negative.
Raising the s magnifying effect also raises the risk for stockholders.
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44. The DuPont Equation:
Return on Assets is affected by two areas of operations. The Profit Margin measures the degree to which the firm controls expenses. Since expenses comprise the difference between Sales and Net Income, lowering the expenses taken out of each dollar of sales raises the Profit Margin.
At the same time, Return on Assets can be raised by producing sales by using fewer assets. Asset Turnover measures the dollar of sales produced with each dollar invested in assets. This is often thought of as sales volume.
Different industries achieve ROA in different ways. Some have low profit margins but high volume, e.g. grocery stores. Others have lower volume but are able to maintain higher profit margins, e.g. car dealerships.
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45. The DuPont Equation:
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46. Comparative Ratios and Benchmarking:
Benchmarking is the process of comparing a particular company with a group of a “benchmark” companies.
It is to compare the firm’s ratios with those of a smaller set of leading companies in the same industry.
Knowing the absolute level of a single entry on the income statement or balance sheet doesn’t provide sufficient information to evaluate performance. Ratios help by focusing on relationships among entries on the financial statements.
The ratios in the DuPont system show the connection between the firm’s operations, its capital structure and the returns for investors.
Because a firm’s size affects financial statement values, it’s hard to evaluate performance using absolute levels. By controlling for differences in size to make comparisons ratios facilitate the evaluation of a firm’s performance.
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47. Uses and Limitations of Ratio Analysis:
Comparison with industry averages is difficult if the firm operates many different divisions.
“Average” performance not necessarily good.
Seasonal factors can distort ratios.
“Window dressing” techniques can make statements and ratios look better.
Different operating and accounting practices distort comparisons.
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48. Uses and Limitations of Ratio Analysis:
Sometimes hard to tell if a ratio is “good” or “bad.”
Difficult to tell whether company is, on balance, in strong or weak position.
A firm’s industry category is often difficult to identify
Published industry averages are only guidelines
Sometimes difficult to interpret deviations in ratios.
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49. Uses and Limitations of Ratio Analysis:
Relative size is ignored (e.g., both large & small firms can be compared)
It is assumed that all numbers used are correct (consider both possible errors and earnings management)
If the numbers are not reliable, ratios are not particularly useful
Effects of Inflation
Limitations
1.      Large firms operate different divisions in different industries
a. Difficult to develop meaningful industry averages
b. More useful for small, narrowly focused firms
2.      Firms want to be better than average
a. Attaining average performance not necessarily good
b. Best to focus on industry leaders’ ratios
3.      Inflation may have distorted balance sheets
a. Must consider effects when comparing over time
4.      Seasonal factors distort ratio analysis
a. Use monthly averages for season items such as inventory
5.      Window dressing can make financial statements look better
6.      Different accounting practices can distort comparisons
a. Inventory valuation, depreciation methods
7.      Difficult to generalize whether a ratio is “good” or “bad”
a. High current ratio – strong liquidity or too much cash (nonearning)
8.      Ratios can give “mixed” view of company
a. Analyze net effects of a set of ratios
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50. Looking Beyond The Numbers:
Good financial analysis involves more than just calculating numbers.
There are Qualitative factors to be considered when evaluating a company’s future financial performance.
These important and basic skills are necessary when making business decisions, when evaluating performance, and when forecasting likely future developments.
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51. Looking Beyond The Numbers:
Are the firm’s revenues tied to One key customer, product, or supplier?
What percentage of the firm’s business is generated overseas?
Competition.
Future prospects.
Legal and regulatory environment.
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52. End of Chapter 3
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