FINANCIAL

MANAGEMENT
PREPARED BY: MS. IDA RAMOS

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 CHAPTER 6:
ANALYSIS OF FINANCIAL
STATEMENTS

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 Objectives:
1. Identifying the different financial ratios
2. Determine which financial ratio should be used on
specific decision problems
3. Differentiate each financial ratios
4. Preparing a Horizontal Analysis or Trend Analysis
5. Preparing a Vertical Analysis or Common Size
Trend Analysis
6. Differentiate Horizontal and Vertical Analysis

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Financial Statement Analysis
Involves:
● comparing a firm’s performance with that of other firms
in the same industry
● evaluating trends in the firm’s financial position over
time

Financial analysis is used to determine whether a company

is creditworthy, and stockholders use financial analysis to
help predict future earnings, dividends, and free cash flow.

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Financial Ratio
INDUSTRY AVERAGES - are commonly used as benchmarks
or tools to assist businesses in making comparisons that aid in
determining their position within the industry and evaluating
their financial performance.

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Financial Statement Analysis
Steps:

1. Gather Data
○ Financial Statements
2. Examine the Statement of Cash Flows
○ We always look to the statement of cash flows first!
○ Operating Activities downward trends or negative net cash flow
indicates problems
○ Investing Activities shows whether the company has made a big
acquisition
○ Financing Activities reveals whether the company is raising capital
from investors or returning it to them

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Financial Statement Analysis
Steps:

3. Calculate and Examine the Return on Invested

Capital and Free Cash Flow
○ Calculate Net Operating Profit After Taxes (NOPAT) and Total Net
Operating Capital (TNOC)
○ Calculate:
✓ Operating Profitability (OP)
✓ Capital Requirement Ratio (CPR)
✓ Return on Invested Capital (ROIC)
✓ Free Cash Flow (FCF)

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Financial Statement Analysis
Steps:

3. Calculate and Examine the Return on Invested

Capital and Free Cash Flow
○ Calculate:
✓ Operating Profitability (OP)
✓ Capital Requirement Ratio (CPR)
✓ Return on Invested Capital (ROIC)
● provides a vital measure of a firm’s overall performance
● If the ROIC is greater than the company’s WACC, then
the company usually is adding value. Otherwise, the
company is in trouble.
✓ Free Cash Flow (FCF)
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Financial Statement Analysis
Steps:

3. Calculate and Examine the Return on Invested

Capital and Free Cash Flow
○ Examine:
➢ Increase in Capital Requirement + Decrease in Operating
Profitability meant the business is not generating enough
sales from operating capital = Decline in ROIC

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Financial Statement Analysis
Steps:

4. Begin Ratio Analysis

Financial ratios are designed to extract important information

that might not be obvious simply from examining a firm’s
financial statements.
● Liquidity Ratio
● Asset Management Ratio
● Debt Management Ratio
● Profitability Ratio
● Market Value Ratio
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Financial Ratio
LIQUIDITY RATIO - measure of the ability of a company to
pay off its maturing liabilities or determine how quickly a
company can convert the assets and use them for meeting
the dues that arise. The higher the ratio, the easier is the
ability to clear the debts and avoid defaulting on payments.
● Current Ratio
● Quick Ratio

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Financial Ratio
LIQUIDITY RATIO
● Current Ratio - provides the best single indicator of the
extent to which the claims of short-term creditors are
covered by assets that are expected to be converted to
cash fairly quickly, it is the most commonly used measure
of short-term solvency

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Financial Ratio
LIQUIDITY RATIO
● Current Ratio
○ Current Asset normally include cash, marketable securities,
accounts receivable, and inventories
○ Current Liabilities consist of accounts payable, short-term notes
payable, current maturities of long-term debt, accrued taxes, and
other accrued expenses

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Financial Ratio
LIQUIDITY RATIO
● Current Ratio

In assessing Current Ratio, we compare computed ratio to industry

average. In general, creditors like to see a high current ratio. If
current liabilities are rising faster than current assets, then the current
ratio will fall, and this could spell trouble. However, shareholders
might not want a high current ratio because it could mean that the
company has a lot of money tied up in non-productive assets (excess
cash and marketable securities) or perhaps it is due to large inventory
holdings, which might become obsolete before they can be sold.
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Financial Ratio
LIQUIDITY RATIO
● Quick Ratio - aka Acid Test Ratio is a measure of the
firm’s ability to pay off short-term obligations without
relying on the sale of inventories.

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Financial Ratio
LIQUIDITY RATIO
● Quick Ratio
○ Liquid Asset is one that trades in an active market, so it can be
converted quickly to cash at the going market price or current
assets on which losses are most likely to occur in a bankruptcy

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Financial Ratio
LIQUIDITY RATIO
● Quick Ratio

In assessing Quick Ratio, a computation that is lower

than 1.0 meant that inventories would have to be
liquidated in order to pay off current liabilities should the
need arise.

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Financial Ratio
ASSET MANAGEMENT RATIO- aka Efficiency Ratios, measure
how effectively a firm is managing its assets.

If a company has excessive investments in assets, then its

operating capital is unduly high, which reduces its free cash flow
and ultimately its stock price.

If a company does not have enough assets, then it may lose sales,
which would hurt profitability, free cash flow, and the stock price.

Therefore, it is important to have the right amount invested in

assets.

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Financial Ratio
ASSET MANAGEMENT RATIO
● Total Assets Turnover Ratio
● Fixed Assets Turnover Ratio
● Days Sales Outstanding
● Inventory Turnover Ratio

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Financial Ratio
ASSET MANAGEMENT RATIO
● Total Assets Turnover Ratio - measures the dollars in
sales that are generated for each dollar that is tied up in
assets

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Financial Ratio
ASSET MANAGEMENT RATIO
● Total Assets Turnover Ratio

In assessing Total Asset Turnover Ratio, we compare our

TAT Ratio to the industry average. If TAT Ratio is below
industry average it means that the company is not
generating as much business (relative to its peers) given its
total asset investment or that assets are used insufficiently.
The following ratios can be used to identify the specific
asset classes that are causing this problem.

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Financial Ratio
ASSET MANAGEMENT RATIO
● Fixed Assets Turnover Ratio - measures how effectively
the firm uses its plant and equipment. It is the ratio of sales
to net fixed assets

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Financial Ratio
ASSET MANAGEMENT RATIO
● Fixed Assets Turnover Ratio

In assessing Fixed Assets Turnover Ratio, we compare our

FAT Ratio to the industry average. If FAT Ratio is below
industry average it indicates that the firm is not using its
fixed assets as intensively as are other firms in its industry.

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Financial Ratio
ASSET MANAGEMENT RATIO
● Fixed Assets Turnover Ratio

*Note: Inflation can cause problems when interpreting the

FAT ratio because FA are reported using the historical costs
of the assets instead of current replacement costs that may
be higher due to inflation. Therefore, a mature firm with fixed
assets acquired years ago might well have a higher fixed
assets turnover ratio than a younger company with newer
fixed assets that are reported at inflated prices relative to the
historical prices of the older assets.
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Financial Ratio
ASSET MANAGEMENT RATIO
● Days Sales Outstanding - aka Average Collection Period
(ACP), is used to appraise accounts receivable; DSO
represents the average length of time that the firm must
wait after making a sale before receiving cash, which is the
average collection period.

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Financial Ratio
ASSET MANAGEMENT RATIO
● Days Sales Outstanding

In assessing DSO, every business has a ‘call for payment’

term. If DSO is longer than the call for payment term, this
indicates that customers, on average, are not paying their
bills on time. If the trend in DSO has been rising
unexpectedly, steps should be taken to review credit
standards and to expedite the collection of accounts
receivable. High levels of of AR causes high NOWC which
hurts FCF and stock prices.
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Financial Ratio
ASSET MANAGEMENT RATIO
● Inventory Turnover Ratio - shows how effectively
inventory is managed by comparing cost of goods sold with
average inventory for a period or measures how many
times average inventory is “turned” or sold during a period.

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Financial Ratio
ASSET MANAGEMENT RATIO
● Inventory Turnover Ratio

In assessing Inventory Turnover Ratio, we compare it to

industry average. If Inventory turnover ratio is lower than
industry average, it means that the business have high
level of inventory. High levels of inventory add to net
operating working capital (NOWC), which reduces FCF,
which leads to lower stock prices.

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Financial Ratio
DEBT MANAGEMENT RATIO - The extent to which a firm
uses debt financing is called financial leverage. Here are three
important implications:

1. Stockholders can control a firm with smaller investments of

their own equity if they finance part of the firm with debt
2. If the firm’s assets generate a higher pre-tax return than
the interest rate on debt, then the shareholders’ returns are
magnified, or “leveraged.” Conversely, shareholders’ losses
are also magnified if assets generate a pre-tax return less
than the interest rate.
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Financial Ratio
DEBT MANAGEMENT RATIO - The extent to which a firm
uses debt financing is called financial leverage. Here are three
important implications:

3. If a company has high leverage, even a small decline in

performance might cause the firm’s value to fall below the
amount it owes to creditors

Therefore, a creditor’s position becomes riskier as leverage

increases.

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Financial Ratio
DEBT MANAGEMENT RATIO
➔ Leverage Ratios
➔ Times-Interest-Earned Ratio
➔ EBITDA Coverage Ratio

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Financial Ratio
DEBT MANAGEMENT RATIO
➔ Leverage Ratios - financial measurements that look at
how much capital comes in the form of debt (loans) or
assesses the ability of a company to meet its financial
obligations.
◆ Debt-to-Asset Ratio (Debt Ratio)
◆ Debt-to-Equity Ratio
◆ Market Debt Ratio
◆ Liabilities-to-Asset Ratio

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Financial Ratio
DEBT MANAGEMENT RATIO
➔ Leverage Ratios
◆ Debt-to-Asset Ratio (Debt Ratio) - represents the
proportion of a company’s assets that are financed by
debt. High Debt Ratio meant that the business may
have difficulty in paying its maturing debts.

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Financial Ratio
DEBT MANAGEMENT RATIO
➔ Leverage Ratios
◆ Debt-to-Equity Ratio - shows the amount of debt for
every dollar of equity. High Debt-to-Equity ratio means
the business is heavily financed by that rather than
equity.

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Financial Ratio
DEBT MANAGEMENT RATIO
➔ Leverage Ratios
◆ Market Debt Ratio

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Financial Ratio
DEBT MANAGEMENT RATIO
➔ Leverage Ratios
◆ Market Debt Ratio - measures the level of debt of a
company relative to the current market value of the
company and is potentially a better measure of
solvency because market values are more relevant
than book values. Market debt ratio reflects a source
of risk that is not captured by the conventional debt
ratio, the fall of stock prices.

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Financial Ratio
DEBT MANAGEMENT RATIO
➔ Leverage Ratios
◆ Market Debt Ratio

Increase in MDR meant that debt increased and the

stock price fell, The stock price reflects a company’s
prospects for generating future cash flows, so a
decline in stock price indicates a likely decline in future
cash flows.

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Financial Ratio
DEBT MANAGEMENT RATIO
➔ Leverage Ratios
◆ Liabilities-to-Asset Ratio - shows the extent to
which a firm’s assets are not supported by equity.
Comparing to the industry average, if ratio is higher
meaning business has more leverage than peers.

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Financial Ratio
DEBT MANAGEMENT RATIO
➔ Times-Interest-Earned Ratio - aka interest coverage ratio
measures the extent to which operating income can decline
before the firm is unable to meet its annual interest costs.

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Financial Ratio
DEBT MANAGEMENT RATIO
➔ Times-Interest-Earned Ratio - the number of times the
business can cover its interest, must be above 1, the point
at which EBIT isn’t sufficient to pay interest. If below
industry average it means business has enough EBIT to
pay interest expenses but has a relatively low margin of
safety compared to its peers. Thus, the TIE ratio reinforces
the conclusion from our analysis of the debt ratio.

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Financial Ratio
DEBT MANAGEMENT RATIO
➔ EBITDA Coverage Ratio - is most useful for relatively
short-term lenders such as banks, which rarely make loans
(except real estate-backed loans) for longer than about 5
years.

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Financial Ratio
PROFITABILITY RATIO - show the combined effects of liquidity,
asset management, and debt on operating results. Profitability is the
net result of a number of policies and decisions.
● Profit Margins
○ Net Profit Margin
○ Operating Profit Margin
○ Gross Profit Margin
● Basic Earning Power (BEP) Ratio
● Return on Total Assets
● Return on Equity
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Financial Ratio
PROFITABILITY RATIO

Net Profit Margin aka Profit Margin on Sales or Profit Margin,

measures how much net income or profit is generated as a
percentage of revenue. Typically expressed as a percentage
but can also be represented in decimal form.

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Financial Ratio
PROFITABILITY RATIO

Operating Profit Margin identifies how a company is

performing with respect to its operations before the impact of
interest expenses is considered.

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Financial Ratio
PROFITABILITY RATIO

Gross Profit Margin identifies the gross profit per dollar of

sales before any other expenses are deducted.

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Financial Ratio
PROFITABILITY RATIO

Basic Earning Power (BEP) Ratio shows the earning power

of the firm’s assets before the influence of taxes and leverage,
and it is useful for comparing firms with different tax situations
and different degrees of financial leverage.

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Financial Ratio
PROFITABILITY RATIO

Return on Total Assets an indicator of how effectively a

company is using its assets to generate earnings. Low ROTA
compared to industry average is due to (1) the company’s low
basic earning power, and (2) high interest costs resulting from
its above-average use of debt.

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Financial Ratio
PROFITABILITY RATIO

Return on Common Equity provides investors with insight

into how efficiently a company (or more specifically, its
management team) is handling the money that shareholders
have contributed to it. It measures the profitability of a
corporation in relation to stockholders’ equity. The higher the
ROE, the more efficient a company's management is at
generating income and growth from its equity financing.

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Financial Ratio
PROFITABILITY RATIO

Return on Common Equity In a situation when ROE is

negative because of negative shareholder equity, the higher
the negative ROE, the better. This is so because it would
mean profits are that much higher, indicating possible long-
term financial viability for the company.

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Financial Ratio
MARKET VALUE RATIO - relate a firm’s stock price to its
earnings, cash flow, and book value per share. Market value
ratios are a way to measure the value of a company’s stock
relative to that of another company.
● Price/Earnings Ratio
● Price/Cash Flow Ratio
● Market/Book Ratio
○ Book value per share - Market book ratio
○ Market cap - Market book ratio

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Financial Ratio
MARKET VALUE RATIO

Price/Earnings Ratio shows how much investors are willing to

pay per dollar of reported profits. Price/earnings ratios are
higher for firms with strong growth prospects, other things held
constant, but they are lower for riskier firms. When compared to
industry average, if lower, the company is regarded as being
somewhat riskier than most or as having poorer growth
prospects, or both.

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Financial Ratio
MARKET VALUE RATIO

Price/Earnings Ratio

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Financial Ratio
MARKET VALUE RATIO

Price/Cash Flow Ratio measures the value of a stock’s price

relative to its operating cash flow per share. P/CF is especially
useful for valuing stocks that have positive cash flow but are not
profitable because of large non-cash charges. A low P/CF
multiple may imply that a stock is undervalued in the market.
Below the industry average suggests that its growth prospects
are below average, its risk is above average, or both.

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Financial Ratio
MARKET VALUE RATIO

Price/Cash Flow Ratio

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Financial Ratio
MARKET VALUE RATIO

Market/Book Ratio used to evaluate a company’s current

market value relative to its book value. It determines the market
value of a company relative to its actual worth. Investors and
analysts use this comparison ratio to differentiate between the
true value of a publicly-traded company and investor
speculation. If the market value of a company is trading higher
than its book value per share, it is considered to be overvalued.
If the book value is higher than the market value, analysts
consider the company to be undervalued.
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Financial Ratio
MARKET VALUE RATIO

Market/Book Ratio when lower compared to industry average

means that investors are willing to pay relatively little for a dollar
of company’s book value.

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Financial Ratio
MARKET VALUE RATIO

Market/Book Ratio
● Book Value Per Share

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Financial Ratio
MARKET VALUE RATIO

Market/Book Ratio
● Market Capitalization (Cap)

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Trend Analysis, Common Size Analysis, and Percentage Change Analysis

❏ Trend Analysis is a technique used in technical analysis

that attempts to predict future stock price movements
based on recently observed trend data. Trend analysis
uses historical data, such as price movements and trade
volume, to forecast the long-term direction of market
sentiment.

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Trend Analysis, Common Size Analysis,
and Percentage Change Analysis

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Trend Analysis, Common Size Analysis, and Percentage Change Analysis

❏ Common Size Analysis displays line items as a

percentage of one selected or common figure. Creating
common size financial statements makes it easier to
analyze a company over time and compare it with its
peers. Using common size financial statements helps
investors spot trends that a raw financial statement may
not uncover.

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Trend Analysis, Common Size Analysis,
and Percentage Change Analysis

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Trend Analysis, Common Size Analysis,
and Percentage Change Analysis

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Trend Analysis, Common Size Analysis, and Percentage Change Analysis

❏ Percentage Change Analysis shows how two items

changed as a percentage from one period to another
period. Used on a balance sheet, a percent change
analysis shows how a balance sheet account changes
from year to year, or quarter to quarter.

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Trend Analysis, Common Size Analysis,
and Percentage Change Analysis

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Tying the Ratios Together: The DuPont Equation

DuPont Equation resulting percentage indicates how

efficiently a company is converting stockholder investments
into profits.

The DuPont equation uses two ratios we covered previously,

the profit margin and the total asset turnover ratio, as
measures of profitability and asset efficiency, but it uses a
new measure of financial leverage, the equity multiplier.

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Tying the Ratios Together: The DuPont Equation

Equity Multiplier

Extended DuPont Equation

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Tying the Ratios Together: The DuPont Equation

*when the focus just on asset profitability and financial

leverage

Firms that have a lot of financial leverage (i.e., a lot of liabilities or

preferred stock) have a high equity multiplier because the assets are
financed with a relatively smaller amount of equity.
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Comparative Ratios and Benchmarking

Comparative ratio analysis is a method companies use to

assess financial performance. Though the ratios use
accounting information, they can provide a deeper meaning to
the company’s profitability, asset use, leverage, and other
business activities. Benchmarking is typically the most common
purpose for this type of analysis.

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Comparative Ratios and Benchmarking

Benchmarking is an analysis where a company compares its

performance against other businesses. Financial benchmarking
involves running a financial analysis and making a comparison
of the results in order to assess a company's overall
competitiveness, efficiency and productivity.

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Uses and Limitations of Ratio Analysis

Some potential problems include the following:

1. Some businesses have different divisions in different

industries, and for such companies it is difficult to develop
a meaningful set of industry averages. Therefore, industry
averages are more meaningful for small companies.
2. To set goals for high-level performance, it is best to
benchmark on the industry leaders’ ratios rather than the
industry average ratios.

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Uses and Limitations of Ratio Analysis

Some potential problems include the following:

3. Inflation may badly distort firms’ balance sheets—reported

values are often substantially different from “true” values.
4. Seasonal effects can distort a ratio analysis.
5. Firms can employ window dressing techniques to make
their financial statements look stronger.
6. Companies’ choices of different accounting practices can
distort comparisons.

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 END OF CHAPTER :)

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