CH 03; FINANCIAL STATEMENT ANALYSIS INppt

Chapter 3:
Financial Statement and Ratio Analysis
Chapter

Businesses report information in the form of financial
statements issued on a periodic basis. GAAP requires the
following four financial statements.
 Balance Sheet - statement of financial position at a given point in time.
 Income Statement - revenues minus expenses for a given time period
ending at a specified date.
 Statement of Owner's Equity - also known as Statement of Retained
Earnings or Equity Statement.
 Statement of Cash Flows - summarizes sources and uses of cash;
indicates whether enough cash is available to carry on routine
operations.

Financial Statements
 The 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.

 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.

 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 8.3

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 and financing and operating
activities, but also ties together the income statement
and previous and current balance sheets .For a given
period, the cash flow statement provides the following
information:
Sources of cash
Uses of cash
Change in cash balance

CH 03; FINANCIAL STATEMENT ANALYSIS INppt

Operating cash flows include:
 Receipts from the sale of goods or services
 Receipts for the sale of loans, debt or equity instruments
in a trading portfolio
 Interest received on loans
 Dividends received on equity securities
 Payments to suppliers for goods and services
 Payments to employees or on behalf of employees
 buying Merchandise
 Depreciation
 Deferred tax
 Amortization (loss of intangible asset value over time)
 Any gains or losses associated with the sale of a non-
current asset, because associated cash flows do not
belong in the operating section.

Investing activities are
 Purchase or Sale of an asset (assets can be land,
building, equipment, marketable securities, etc.)
 Loans made to suppliers or received from customers
 Payments related to mergers and acquisitions
Financing activities
 Proceeds from issuing short-term or long-term debt
 Payments of dividends
 Payments for repurchase of company shares
 Repayment of debt principal, including capital leases
 For non-profit organizations, receipts of donor-restricted
cash that is limited to long-term purposes

Financial Performance analysis serves the
following purposes :
Analysis of financial statements is an attempt to assess the
efficiency and performance of an enterprise.
The analysis and interpretation of financial statements is very
essential to measure the efficiency, profitability, financial
soundness and future prospects of the business units.
- Measuring the profitability
- Indicating the trend of Achievements
- Assessing the growth potential of the business
- Comparative position in relation to other firms
- Assess overall financial strength
- Assess solvency of the firm

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.

Types of Ratio Comparisons
 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.
 Combined Analysis
 Combined analysis simply uses a combination
of both time-series analysis and cross-sectional analysis.

Types of Ratio Comparisons
Figure 8.1

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.

Ratio Analysis Example
 Using Daton Company Financial Statements
 Liquidity ratios
 Activity ratios
 Financial leverage ratio
 Market ratios
 Profitability ratios

Ratio Analysis
 Liquidity Ratios
 Current Ratio
Current ratio =
Total current assets
Total current liabilities
Current ratio =
$1,233,000
$620,000
= 1.97

 Liquidity Ratios
 Quick ratio
Ratio Analysis
Quick ratio =
Total current assets - Inventory
Total current liabilities
Quick ratio =
$1,233,000 - $289,000
$620,000
= 1.51

Ratio Analysis
 Activity Ratios
 Inventory Turnover
Inventory turnover =
Cost of goods sold
Inventory
Inventory turnover =
$2,088,000
$289,000
= 7.2

Ratio Analysis
 Activity Ratios
 Average collection period
ACP =
Accounts receivable
Net sales/360
ACP =
$503,000
$3,074,000/360
= 58.9 days

Ratio Analysis
 Activity Ratios
 Average payment period
APP =
Accounts payable
Annual purchases/360
APP =
$382,000
(.70 x $2,088,000)/360
= 94.1 days

 Activity Ratios
 Total asset turnover
Ratio Analysis
Total asset turnover =
Net sales
Total assets
Total asset turnover =
$3,074,000
$3,579,000
= .85

 Financial Leverage Ratio
 Debt ratio
Ratio Analysis
Debt ratio =
Total liabilities
Total assets
Debt ratio =
$1,643,000
$3,579,000
= 45.7%

 Leverage Ratios
 Times interest earned ratio
Ratio Analysis
Times interest earned =
EBIT
Interest Expense
Times interest earned =
$418,000
$93,000
= 4.5

 Leverage Ratios
 Fixed-payment coverage ratio (FPCR)
Ratio Analysis
FPCR =
EBIT + Lease pymts
Interest + Lease pymts + {(Princ pymts + PSD) x [1/(1 - t)]}
FPCR =
$418,000 + $35,000
$93,000 + $35,000 + {($71,000 + $10,000) x [1/(1 - .29)]}
= 1.9

 Profitability Ratios
 Gross profit margin
Ratio Analysis
GPM =
Gross profit
Net sales
GPM =
$986,000
$3,074,000
= 32.1%

 Operating profit margin
Ratio Analysis
OPM =
EBIT
Net sales
OPM =
$418,000
$3,074,000
= 13.6%

 Net profit margin
Ratio Analysis
NPM =
Net profits after taxes
Net sales
NPM =
$231,000
$3,074,000
= 7.5%

 Return on total assets (ROA)
Ratio Analysis
ROA =
Net profits after taxes or EACS
Total assets
ROA =
$231,000
$3,597,000
= 6.4%

 Return on equity (ROE)
Ratio Analysis
ROE =
Net profits after taxes or EACS
Stockholders’ equity
ROE =
$231,000
$1,954,000
= 11.8%

 Earnings per share (EPS)
Ratio Analysis
EPS =
Earnings available to common stockholder
Number of shares outstanding
EPS =
$221,000
76,262
= $2.90

 Market Ratios
 Price earnings (P/E) ratio
Ratio Analysis
P/E =
Market price per share of common stock
Earnings per share
P/E =
$32.25
$2.90
= 11.1

 Market Ratios
 Market/book (M/B) ratio
Ratio Analysis
M/B =
Market price per share of common stock
Book value per share of common stock
M/B =
$32.25
$23.00
= 1.40

Summarizing All Ratios
Table 8.7 (Panel 2)

 Common-size income statements
Ratio Analysis

DuPont System of Analysis
 The DuPont system 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 Figure 8.2 on the following slide.
 The top portion focuses on the income statement,
and the bottom focuses on the balance sheet.
 The advantage of the DuPont system is that it allows
you to break ROE into a profit-on-sales component,
an efficiency-of-asset-use component, and a use-of-
leverage component.

DuPont Analysis
A method of performance measurement that was started by the
DuPont Corporation in the 1920s. With this method, assets are
measured at their gross book value rather than at net book value in
order to produce a higher return on equity (ROE). It is also known
as "DuPont identity".
DuPont analysis tells us that ROE is affected by three things:
- Operating efficiency, which is measured by profit margin
- Asset use efficiency, which is measured by total asset turnover
- Financial leverage, which is measured by the equity multiplier
ROE = Profit Margin (Profit/Sales) * Total Asset Turnover
(Sales/Assets) * Equity Multiplier (Assets/Equity)

DuPont Analysis
 Utilizing all three ratios, the DuPont Analysis provides deeper
insight into the health of the organization versus the simple
ROE calculation (annual earnings/ shareholder's equity).
 For instance, if a company's return on equity increases
because of an improved net profit margin (net income/sales)
or due to increased asset turnover (sales/assets), this is a
very positive sign. But, if the assets to equity result is the
reason for the increase, the company could very well be over
leveraged (too much debt), which puts the company in a more
risky situation.
 While the DuPont Analysis is a good starting point when
analyzing the creditworthiness of an organization, the result is
not meaningful unless compared to an industry benchmark. If
such a benchmark is not available, you should at least do a
trend analysis of the same company's return on equity over 3
or more years.

Figure 8.2

Figure 8.2 (Panel 1)

Figure 8.2 (Panel 2)

CH 03; FINANCIAL STATEMENT ANALYSIS INppt

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