PROFESSIONAL HUT
Financial Statement Analysis
A Practical Approach
Outline
Meaning of Financial Statements and Financial
Statement Analysis
Significance of Financial Statements
Types of Financial Statements
Income Statement
Balance Sheet
Cash Flow Statement
Statement of Retained Earnings
Ratio Analysis including Du Pont Analysis
Limitations of Financial Statement Analysis
Focus
The focus will be on financial statement
analysis and its use in corporate finance.
financial statement analysis from managerial
perspective and not from an investor and/or
creditor’s perspective.
How to use financial statement analysis to
ensure that shareholder wealth is maximized
and the stock price continues to rise?
MEANING OF FINANCIAL STATEMENTS
Financial statements are summaries of the operating,
financing, and investment activities of a firm.
According to the Financial Accounting Standards Board (FASB),
the financial statements of a firm should provide sufficient
information that is useful to
investors and
creditors
in making their investment and credit decisions in an
informed way.
For example, are inventories adequate to support the
projected level of sales?
Does the firm have too heavy an investment in account
receivable?
Does large account receivable reflect a lax collection policy?
To ensure efficient operations of a firm’s manufacturing
facility, does the firm have too much or too little invested in
plant and equipment?
Financial statement analysis provides answers to all of these
questions.
Types of Financial Statements and Reports
The Income Statement
The Balance Sheet
The Statement of Retained
Earnings
The Statement of Cash Flows
The Income Statement
An income statement is a summary of the revenues and
expenses of a business over a period of time, usually either one
month, three months, or one year.
Summarizes the results of the firm’s operating and financing
decisions during that time.
Operating decisions of the company apply to production and
marketing such as sales/revenues, cost of goods sold,
administrative and general expenses (advertising, office salaries)
Provides operating income/earnings before interest and taxes
(EBIT)
Results of financing decisions are reflected in the
remainder of the income statement.
When interest expenses and taxes are subtracted
from EBIT, the result is net income available to
shareholders.
Net income does not necessarily equal actual cash
flow from operations and financing.
The Balance Sheet
A summary of the assets, liabilities, and equity of a business at a particular point in time, usually
at the end of the firm’s fiscal year.
Assets = Liabilities + Equity
(Resources of the (Obligations of (ownership left over
business enterprise) the business) Residual)
Fixed Assets Long-term Common stock outstanding
(Plant, Machinery, Equipment (Notes, bonds, & Additional paid-in capital
Buildings) Capital Lease Retained Earnings
Current Assets Obligation)
(Cash, Marketable Securities, Current Liabilities
Account Receivable, Inventories) (Accounts Payable,
Wages and salaries,
Short-term loans
Any portion of long-term
Indebtedness due in one-year)
THE STATEMENT OF CASH FLOWS
The statement is designed to show how the firm’s operations have
affected its cash position and to help answer questions such as
these:
Is the firm generating the cash needed to purchase additional
fixed assets for growth?
Is the growth so rapid that external financing is required both to
maintain operations and for investment in new fixed assets?
Does the firm have excess cash flows that can be used to repay
debt or to invest in new products?
RATIO ANALYSIS
Financial statements report both on a firm’s position at a
point in time and on its operations over some past period.
From management’s viewpoint, financial statement analysis
is useful both as a way to
anticipate future conditions and
more important, as a starting point for planning actions
that will influence the future course of events or
to show whether a firm’s position has been improving or
deteriorating over time.
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
Types of Ratios
Liquidity Ratios
Current Ratio
Quick Ratio/Acid Test Ratio
Asset Management Ratios
Inventory Turnover Ratio
Days Sales Outstanding
Fixed Assets Turnover Ratio
Total Assets Turnover Ratio
Debt Management Ratio
Total Debt to Total Assets Ratio
Times Interest Covered Ratio
Profitability Ratios
Profit Margin on Sales
Return on Assets
Return on Equity
Basic Earning Power Ratio
Liquidity Ratio
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
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
Asset Management Ratios
Inventory Turnover Ratio
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
Two cautions
Market prices for sales and inventories at cost
Sales over the year and inventory at the end of
the year
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
Asset Management Ratios
Fixed Assets Turnover Ratio
Measures efficiency of long-term capital
investment
How effectively a firm is using its plant
and machinery to generate sales?
How much fixed assets are needed to
achieve a particular level of sales?
Cautions
Asset Management Ratio
Total Asset Turnover Ratio
Measure efficiency of total assets for the
company as a whole or for a division of the
firm
Core competency
Debt Management Ratio
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
Total Debt to Total Assets Ratio
Measures percentage of assets being financed
through borrowings
Too high a number means increased risk of
bankruptcy
Leverage
What percentage of total assets are being
financed through equity?
Times Earned Interest (TIE)
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
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
Net Profit Margin on Sales
Relates net income available to common stockholders to sales
Basic Earning Power
Relates EBIT to Total Assets
Useful for comparing firms with different tax situations and different
degrees of financial leverage
Return on Assets (ROA)
Relates net income available to common stockholders to total assets
Return on Common Equity (ROE)
Relates net income available to common stockholders to common
stockholders equity
PROBLEMS IN FINANCIAL STATEMENT
ANALYSIS
Developing and Using Comparative Data
Distortion of Comparative Data
Notes to Financial Statements
Interpretation of Results
Differences in Accounting Treatment
Window Dressing
Effects of Inflation
