Chapter 3
Financial Statements and Ratio Analysis
Sinha Marzuka Sultana
Lecturer
Department of Finance and Banking, FBS, BUP
Chapter Outline
• Four Key Financial Statements
• Using Financial Ratios
• Ratio Analysis
• DuPont System of Analysis
Four Key Financial Statements
Four Key Financial Statements
1. 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.
Four Key Financial Statements
1. Income Statement
Table 2.1 Bartlett Company
Income Statements ($000)
Four Key Financial Statements
2. 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.
Four Key Financial Statements
2. Balance Sheet
Table 2.2 Bartlett Company
Balance Sheet ($000)
Four Key Financial Statements
3. Statement of Retained Earnings
• The statement of retained earnings reconciles the net income
earned and dividends paid during the year, with the change in
retained earnings.
Table 2.3 Bartlett Company Statement of Retained Earnings ($000) for
the Year Ended December 31, 2009
Four Key Financial Statements
4. 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.
Four Key Financial Statements
4. Statement of Cash Flows
Table 2.4 Bartlett Company
Statement of Cash Flows ($000)
for the Year Ended December
31, 2009
Using Financial Ratios
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.
Using Financial Ratios
Types of Ratio Comparisons
1. Time-series analysis: Evaluates the firm’s performance
over time
2. Cross-sectional analysis: Comparison of different firms’
financial ratios at the same point in time; involves
comparing the firm’s ratios with those of other firms in its
industry or with industry averages.
Benchmarking: A type of cross-sectional analysis in which the
firm’s ratio values are compared with those of a key competitor
or with a group of competitors that it wishes to emulate.
Using Financial Ratios
Types of Ratio Comparisons
3. Combined Analysis: The most informative approach to
ratio analysis combines cross-sectional and time-series
analyses.
A combined view makes it possible to assess the trend in
the behavior of the ratio in relation to the trend for the
industry.
Using Financial Ratios
Types of Ratio Comparisons
Table 2.5 Industry Average Ratios for Selected Lines of Businessa
Using Financial Ratios
Types of Ratio Comparisons
Figure 2.1 Combined Analysis
Using Financial Ratios
Cautions for Doing Ratio Analysis
1. Ratios must be considered together; a single ratio by
itself means relatively little.
2. Financial statements that are being compared should
be dated at the same point in time.
3. Use audited financial statements when possible.
4. The financial data being compared should have been
developed in the same way.
5. Be wary of inflation distortions.
Ratio Analysis
Ratio Analysis: Liquidity Ratios
Liquidity • Measure the ability to pay short-term obligations as
they come due
Ratios
• “Liquid” assets can easily “flow/move” or be
converted into cash to pay bills
• Firms have to balance the need for safety that liquidity
provides against the low returns that liquid assets
generate for investors.
• How much liquidity a firm needs depends on
a variety of factors, including the firm’s size,
its access to short-term financing sources
like bank credit lines, and the volatility of its
business.
Ratio Analysis: Liquidity Ratios
• A higher current ratio indicates
a greater degree of liquidity.
• Quick ratio is similar to current
ratio but excludes inventory
from current assets
• Inventory is least liquid current
asset Cash ratio
• Many types of inventory cannot
be easily sold as they are
partially completed items
• Inventory is typically sold on
credit (it becomes an accounts
receivable before becoming
cash)
• Inventory is hard sell when
Ratio Analysis: Activity Ratios
Activity Speed with which various accounts are converted
Ratios into sales or cash, or inflows or outflows;
Efficiency of operations
Speed can be measured as:
• Time Period: How long it takes to do something
• Turnover: How many times something can be done in a
given time period
Ratio Analysis: Activity Ratios
• Inventory turnover commonly
measures the activity, or
liquidity, of a firm’s inventory.
• Inventory turnover can be
easily converted into an
average age of inventory if we
divide 365 by it.
• The average collection period,
or average age of accounts
receivable, is useful in
evaluating credit and collection
policies.
Ratio Analysis: Solvency or Debt Ratios
Solvency
Ratios
Level of debt and ability to repay debt;
Amount of debt in comparison to assets and equity;
Amount of interest in comparison to earnings
Debt position indicates amount of other
people’s money used to generate profits;
Profit financial leverage magnifies risk & return
Equity
Debt
Ratio Analysis: Solvency or Debt Ratios
• Debt ratio measures the proportion of total assets financed by the
firm’s creditors.
• Times interest earned ratio measures the firm’s ability to make
contractual interest payments; sometimes called the interest
coverage ratio.
• Fixed-payment coverage ratio: Measures the firm’s ability to meet all
fixed-payment obligations.
Ratio Analysis: Profitability Ratios
Profitability
Ratios Evaluate the firm’s profits with respect to a given
level of sales, a certain level of assets, or the
owners’ investment
Useful tool: Common-size income statement
Each item on this statement is expressed as a percentage of
sales. Especially useful when comparing performance
across years because it is easy to see if certain categories of
expenses are trending up or down as a percentage of the total
volume of business
Ratio Analysis: Profitability Ratios
Table 2.7
Bartlett Company
Common-Size Income
Statements
Ratio Analysis: Profitability Ratios
• Gross profit margin: Measures
the percentage of each sales
dollar remaining after the firm
has paid for its goods.
• Operating profit margin:
Measures the percentage of
each sales dollar remaining
after all costs and expenses
other than interest, taxes, and
preferred stock dividends are
deducted; the “pure profits”
earned on each sales dollar.
• Net profit margin: Measures the
percentage of each sales dollar
remaining after all costs and
expenses, including interest,
taxes, and preferred stock
dividends, have been deducted.
Ratio Analysis: Profitability Ratios
• Earnings per share (EPS):
Represents the number of
dollars earned during the period
on behalf of each outstanding
share of common stock.
• Return on total assets (ROA):
Measures the overall
effectiveness of management in
generating profits with its
available assets; also called the
return on investment (ROI).
• Return on equity (ROE):
Measures the return earned on
the common stockholders’
investment in the firm.
Ratio Analysis: Market Ratios
Relate the firm’s market value (current share price) to
Market certain accounting values (e.g. earnings, book value)
Ratios
Insight into how investors in the marketplace believe
that the firm is doing in terms of risk and return.
They tend to reflect, on a relative basis, the common
stockholders’ assessment of all aspects of the firm’s
past and expected future performance.
Ratio Analysis: Profitability Ratios
• Price/Earnings (P/E) ratio: Measures the amount that investors are
willing to pay for each dollar of a firm’s earnings; the higher the P/E
ratio, the greater the investor confidence.
• Market/Book (M/B) ratio: Provides an assessment of how investors view
the firm’s performance. Firms expected to earn high returns relative to
their risk typically sell at higher M/B multiples.
Ratio Analysis: Formulae
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.
• 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:
• ROA and ROE as shown in the series of equations on the following
slide and in Figure 2.2 on the following slide.
DuPont System of Analysis
DuPont System of Analysis (cont.)
Figure 2.2 DuPont
System of Analysis
2-34
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%
2-35
Mathematical Problems
Problem 1
Problem 2
Problem 3
Problem 4
Problem 5
