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

2. The Four Key Financial Statements

3. 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.

4. The Four Key Financial Statements

5. The Four Key Financial Statements (cont.)

6. The Four Key Financial Statements
The statement of retained earnings reconciles the net income earned and dividends paid during the year, with the change in retained earnings.

7. 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.

8. The Four Key Financial Statements

9. 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.

10. Using Financial Ratios: Types of Ratio Comparisons (cont.)
Trend or time-series analysis
Used to evaluate a firm’s performance over time
Cross-sectional analysis
Used to compare different firms at the same point in time
Industry comparative analysis
One specific type of cross sectional analysis. Used to compare one firm’s financial performance to the industry’s average performance

11. Using Financial Ratios: Types of Ratio Comparisons (cont.)
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
Combined Analysis
Combined analysis simply uses a combination of both time series analysis and cross-sectional analysis

12. Using Financial Ratios: Types of Ratio Comparisons (cont.)

13. Using Financial Ratios: Types of Ratio Comparisons (cont.)

14. 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.

15. Ratio Analysis Current ratio = total current assets
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.
Liquidity Ratios
Current Ratio
Current ratio = total current assets
total current liabilities
Current ratio = $1,233,000 = 1.97
$620,000

16. 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

17. Ratio Analysis (cont.) Activity Ratios Inventory Turnover
Inventory Turnover = Cost of Goods Sold
Inventory
Inventory Turnover = $2,088, = 7.2
$289,000
Average Age of Inventory
Average Age of Inventory =
Inventory Turnover
Inventory Turnover = = days
7.2

18. Ratio Analysis (cont.) Average Payment Period
Average Collection Period
ACP = Accounts Receivable
Net Sales/365
ACP = $503, = days
$3,074,000/365
Average Payment Period
APP = Accounts Payable
Annual Purchases/365
APP = $382,000 = days
(.70 x $2,088,000)/365

19. 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

20. Ratio Analysis (cont.)
Insert Table 2.6 here

21. Ratio Analysis (cont.) Times Interest Earned Ratio Debt Ratio
Financial Leverage Ratios
Debt Ratio
Debt Ratio = Total Liabilities/Total Assets
Debt Ratio = $1,643,000/$3,597,000 = 45.7%
45% of assets is financed by debt.
Times Interest Earned Ratio
Times Interest Earned = EBIT/Interest
Times Interest Earned = $418,000/$93,000 = 4.5
The firm can generate 4.5 times operating income to cover its interest expenses. The higher the ratio, the better .Lower ratio shows a higher default risk for the firm.

22. Ratio Analysis (cont.) Liquidity Ratios Activity Ratios
Leverage Ratios
Profitability Ratios
Common-Size Income Statements

23. Ratio Analysis (cont.)

24. GPM = Gross Profit/Net Sales
Ratio Analysis (cont.)
Profitability Ratios
Gross Profit Margin
GPM = Gross Profit/Net Sales
GPM = $986,000/$3,074,000 = 32.1%
Operating Profit Margin (OPM)
OPM = EBIT/Net Sales
OPM = $418,000/$3,074,000 = 13.6%

25. NPM = Earnings Available to Common Stockholders Sales
Ratio Analysis (cont.)
Profitability Ratios
Net Profit Margin (NPM)
NPM = Earnings Available to Common Stockholders Sales
NPM = $221,000/$3,074,000 = 7.2%
Earnings Per Share (EPS)
EPS = Earnings Available to Common Stockholders Number of Shares Outstanding
EPS = $221,000/76,262 = $2.90

26. Ratio Analysis (cont.) Return on Equity (ROE) Profitability Ratios
Return on Total Assets (ROA)
ROA = Earnings Available to Common Stockholders Total Assets
ROA = $221,000/$3,597,000 = 6.1%
Return on Equity (ROE)
ROE = Earnings Available to Common Stockholders Total Equity
ROE = $221,000/$1,754,000 = 12.6%

27. Ratio Analysis (cont.) 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
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

28. Ratio Analysis (cont.) 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
Market Ratios are used to assess whether a firm’s stock is over/undervalued. A very high (low) Market Ratio might be a sign of an overvalued (undervalued) stock. Undervalued stocks are ideal candidates to buy whereas overvalued stocks are ideal for selling.

29. Summarizing All Ratios

30. Summarizing All Ratios (cont.)

31. Summarizing All Ratios (cont.)

32. 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.

33. DuPont System of Analysis (cont.)

34. 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:

35. 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%