Key Concepts and Skills

Know how to standardize financial statements

for comparison purposes
Know how to compute and interpret important
financial ratios
Be able to compute and interpret the Du Pont
Identity
Understand the problems and pitfalls in
financial statement analysis

3-2
Overview
Financial statement analysis involves a study
of the relationships between income
statement and balance sheet accounts, how
these relationships change over time (trend
analysis), and how a particular company
compares with other companies in its
industry (comparative ratio analysis)
Basics of Analysis
Financial statement analysis applies
analytical tools to financial statements &
related data to determine the relative
strengths and weaknesses of a
company.
Purpose of analysis:
Financial statement analysis for internal users
is to provide strategic information to
improve company efficiency &
effectiveness in providing products & services
External users rely on financial statement
analysis to make better & more informed
decisions in pursuing their own goals
4
Financial analysis tools
1. Comparative Financial statements:
Statements are compared across
years.
2. Common-size statements: Recast
each statement item as a
percentage of a certain item.
3. Trend statements: Recast each
statement item in percentage of a
base year number.
4. Financial ratios.
5
1. Common size analysis (vertical analysis)
Useful in comparison of firms of
unequal size or with currency
differences
Common-Size Balance Sheets
Compute all accounts as a percent of
total assets
Common-Size Income Statements
Compute all line items as a percent of
sales
 Vertical Analysis (B/S)
Accounts 201 201 Accounts 2013 2012
3 2
Current % % S-T Debt % %
Assets
Cash 696 12.9 58 1.2 A/P 307 5.7 303 6.0
A/R 956 17.7 992 19.7 N/P 26 0.5 119 2.4
Inventory 301 5.6 361 7.2 Other CL 1662 30.8 1353 26.9
Other CA 303 5.6 264 5.2 Total CL 1995 37 1775 35.3
Total CA 2256 41.8 167 33.3
5
L-T Debt
Fixed L-T Debt 843 15.6 1091 21.7
Assets
Net Fixed 3138 58.2 335 66.7 Common 2556 47.6 2167 43
8 Stock
Asset 5394 100 503 100 Tot 5394 100 5033 100
Total 3 Liab&Equit
y
Vertical Analysis (Income Statement)
Accounts 2013 %
Revenues 5,000 100
Cost of Goods Sold (2,006) 40
Expenses (1,740) 34.8
Depreciation (116) 2.3
EBIT 1,138 22.8
Interest Expense (7) 0.0
Taxable Income 1,131 22.6
Taxes (442) 8.8
Net Income 689 13.8
 2. Horizantal Analysis (Trend Analysis)
Select a base year and then express
each item or account as a percent of
the base-year value of that item.
An alternative is “Combined
Common-Size and Base-Year
Analysis”.
B/S Horizantal Analysis (in 000’s)
Accounts 2013 2012 Diff %

Current Assets

Cash 696 58 638 1100

A/R 956 992 (36) -3.6
Inventory 301 361 (60) -16.6
Other CA 303 264 39 14.8

Total CA 2256 1675 581 34.7

Fixed Assets
Net Fixed 3138 3358 (220) -6.55
Asset Total 5394 5033 361 7.2
B/S Horizantal Analysis (in 000’s)
2013 2012 Diff %

S-T Debt
A/P 307 303 4 1.3
N/P 26 119 -93 -78
Other CL 1662 1353 309 22.8
Total CL 1995 1775 220 12.4

L-T Debt
L-T Debt 843 1091 (248) -22.7
Common Stock 2556 2167 389 18
Tot Liab&Equity 5394 5033 361 7.2
3. Ratio Analysis
A ratio expresses a mathematical relation
between two quantities. It can be
expressed as a percent, rate or proportion

Ratios are among the more widely used

tools of financial analysis because they
provide clues to & symptoms of
underlying conditions

A ratio can help you uncover conditions &

trends difficult to detect by inspecting
individual components making up the
ratio
3-12
Why are ratios useful?
Ratios standardize numbers and
facilitate comparisons.

Ratios are used to highlight

weaknesses and strengths.
Benchmarking:
Ratio comparisons
Ratios are not very helpful by
themselves; they need to be
compared to something

3-14
Basic Approaches
1. Time-series analysis : Identify
financial trends over time for a single
company. It is used to see how the firm’s
performance is changing over time.
2. Cross-sectional analysis (Peer group
analysis): Compare to similar companies
or within industries at a single moment
in time.

3. Benchmark comparison: measures a

company’s performance against some
predetermined standard.

15
Categories of Financial Ratios
Short-term solvency or liquidity
ratios
Asset management or efficiency or
turnover ratios
Long-term solvency or financial
leverage ratios
Profitability ratios
Market value ratios
 Alpha Co.
Balance sheet
December 31, 2005
Assets
Current assets
Cash 360
Marketable security 70
Accounts receivable 500
Inventories 290
Total current assets 1220
Fixed assets 4670
Less: accumulated depreciation 2290
Net fixed assets 2380
Total assets 3600
 Liabilities and stockholders equity

Current liabilities
Accounts payable 380
Notes payable 80
Accruals 160
Total current liabilities
620

Long term debts

1020
Total liabilities
1,640

Stockholders equity
Preferred stock 200
Common stock 620
Retained earnings 1140
Total stockholders equity
1,960
Total liabilities and stockholders equity
3600
 Alpha Co
Income statement
For the year ended on Dec. 31, 2005
Sales 3200
Less: sales returns 130
Net sales 3070
Less: cost of goods sold 2090
Gross profit 980
Less: operating expenses 570
Operating profits 410
Less: interest expense 90
Net profit before taxes 320
Less: taxes 90
Net Profit after taxes 230
1. Liquidity Ratios
Liquidity refers to the availability of
resources to meet short term cash
requirements & the analysis of liquidity is
aimed at a company’s funding requirements
Efficiency refers to how productive a
company is in using its assets & is usually
measured relative to how much revenue is
generated from a certain level of assets

20
1. Liquidity Ratios
Liquidity: Nearness to cash
Are used to measure a firm’s ability to meet
its current obligations as they come due
Liqudity ratioa are
- Current ratio
- Quick ration
- Cash ratio
Current Ratio
Measure of short-term financial health
Consider composition of current assets

Rule of thumb
2:1
Acid-Test (Quick) Ratio
Stricter test of ability to pay debts
Excludes inventories and prepaid
assets
Quick Assets
Current Liabilities
Current ratio = Current assets / Current liabilities
= 1220 / 620
= 1.97x
Assume the industry average is 1.8
Commonly acceptable is 2.00
Quick ratio = (CA – Inventories) / CL
= (1220 – 290) / 620
930/620
=1.50x
Assume the industry average is 1.6
Acceptable ratio =1
Comments on liquidity ratios
2005 2004 Ind.
Current
1.97x 2.30x 2.70x
Ratio
Quick Ratio 1.50x 0.85x 1.60x

 Expected to improve but still below the

industry average.
 Liquidity position is weak.
2. Asset Management Ratios(Activity Ratio)
Measure how efficiently a firm is
managing its assets and whether or not the
level of those assets is properly related to
the level of operations as measured by sales
Inventory mgt ratios
A/R ratios
Fixed Assets Turnover Ratios
Total Assets Turnover Ratios
Average payment period
1. Inventory Management
Ratios
a) Average Age of Inventory (Inventory Holding Period)

365 Days x Ave. Inventory

CGS

365x 290/2090 =50.65 days

Represents the average # of days

inventory is on hand before it’s sold
Evaluate the average age of inventory vs.
the industry average.

2005 2004 Ind.

Average
50.65 60
Age of 76 days
days days
Inventory
Comments on average age of inventory
The age of inventory is below the
industry average.
The company has better
inventory management, or its
control might be better.
b) Inventory Turnover Ratio
Cost of Goods Sold
Average Inventory
Or
365 days
Average Age of Inventory
Represents the number of times per
period inventory is turned over (i.e.,
sold).
Evaluate the inventory turnover vs. the
industry average.
Inv. turnover = CGS / Inventories
= 2090 / 290
= 7.2times

2005 2004 Ind.

Inventory
7.2x 6.8x 6.1x
Turnover
i. A/R Management Ratios
a) Average Collection Period or Days Sales
Outstanding
365 days x Average A/R
Net Credit sales

Represents the average # of days the firm

after making sales before collecting cash
 Average Collection Period

365 Days x500

= 59.4 days
3070
If this company’s credit terms are net 30, what
would this tell you about the efficiency of the
collection process?
 Appraisal of ACP
2005 2004 Ind.

ACP 59.4 57.4 44.3

 The Co. collects on sales too slowly,

and is getting worse.
 The Co. has a poor credit policy.
 Average Collection Period
Too low  Too high

Credit policies Credit department

too stringent; not operating
may be losing effectively;
sales possible quality
problems
iii. Fixed Asset Turnover

It measures how efficiently the firm uses its

plant and equipment
Efficient use of fixed assets would be
associated with high sales.
A high turnover is preferred to a low one.
FA turnover = Sales / Net fixed assets
= $3070 / 2380 = 1.29x

2005 2004 Ind.

FA TO 1.29x 10.0x 7.0x

 FA turnover is low in year 2005 than the

industry average.
 iv. Total Assets Turnover
 Total assets turnover measures a firm's
ability to generate sales from a given level
of assets.
 A large asset turnover is preferred to a low
one.
 Total assets turnover is related to three
similar ratios
a. Age of receivable
b. Inventory turnover
c. Fixed asset turnover
TATO = Sales / Total assets
= 3070 / 3600
= 0.85x

2006E 2005 2004 Ind.

TA TO 2.0x 0.85x 2.3x 2.6x

 TA turnover below the industry average. Caused by

excessive currents assets (A/R and Inv).
V. Average Payment Period
365 days x Average A/P
Net Credit Purchases

365 X 380/1463 =94.81 days

Represents the average # of days the firm

to pay for its accounts payable.
3. Debt Management Ratios
Measure the extent to which the firm is using
debt financing, or financial leverage, and the
degree of safety afforded to creditors
More important to creditors
They are of two type:
a) Leverage ratios: measure degree
indebtedness
b) Coverage ratios: measure earning
capacity of the firm relating to its
obligations
Solvency Analysis
Ability to stay in business over the long-term

Times
Debt-to- Interest
Equity Earned
Debt Ratio
Ratio

Fixed Charge
Equity
Coverage
Multiplier
Ratio
i) Leverage Ratios
How much debt does the firm have? That’s the
question answered by the leverage ratios
Examples are the debt ratio and debt to equity
ratio
Some debt is, without a doubt, good, but too
much can be disastrous
Especially be on the lookout for companies with a
high proportion of fixed costs (high operating
leverage) and with lots of debt. Airlines are a
good example
a) Debt Ratio
measures the proportion of funds provided by
creditors
The lower the ratio, the greater the
protection afforded to creditors in the event
of liquidation
Debt ratio = Total debt / Total assets
= 1640 / 3600
= 45.6%

2005 2004 Ind.

DR 45.6% 62.8% 40.0%

b) Debt-to-Equity Ratio
How much have

Total Liabilities creditors

contributed

Total Stockholders’ Equity

compared to
owners?
b)Debt-to-Equity Ratio

Total Liabilities
Total Stockholders’ Equity
1640/1960= 0.84
c) Equity Multiplier
Total Assets
Total stockholders Equity

= 3600/1960 = 1.84
ii. Coverage Ratios
a) Times Interest Earned Ratio (TIE)
TIE =Earnings before interest& Taxes =410/90 =4.56x
Interest expense
 Measures the ability of the firm to cover
interest obligations using earnings
 The greater the coverage the better
 TIE = EBIT / Interest expense
2005
= $492.6 / $70 2004
= 7.0x Ind.

TIE 4.56x 4.3x 9.2x

b) Fixed Charge Coverage Ratio
FCCR (EBIT + Lease pmts)
=
Int.+ Lease + (Principal pmts + PD)/1-
T)

410 + 35
=
90+ 35+ 71+10
= 1-0.4
= 1.71x
4. Profitability Ratios
Show the combined effect of liquidity,
asset management, and debt
management on operating results
3 elements of the profitability analysis:
Analysing on sales : trading margin and
the control of costs
Analysing the return on assets

Assessing the return on equity

© Mary Low
i. Profitability of sales
a) Gross profit margin (the mark up on sales)
 Gross Profit % = Gross Profit * 100
Net Sales
980/3070 =0.3192 =31.92%
The industry average =30%
 Measures the margin the firm gets from
sales before deducting operating expenses.
 It is a function of negotiating power and
volume of purchase.
Analysis:

Questions to Ask Reason

Calculate the Gross Profit Margin The higher the gross profit margin, the more
money is available to cover the operating costs of
the company

Has the gross profit margin changed over time? This can show the impact of price changes or
changes in the cost of inventory.

Understand the industry Certain industries may have tighter margins, such
as technology retail.

How does the company’s turnover compare with The turnover should be close to industry averages,
the industry? if not, the analyst needs to know why

53
b) Profit margin
Reflects a company’s ability to earn net
profit from sales
It is a function of cost control strategy

Net Profit % = Net Profit after tax *

100%
Net Sales
Profitability ratios: Profit Margin

Net Profit margin = Net income / Sales

= 230 / 3070
= 0.07
=7.5%
Comment on profit margin ratios

2005 2004 Ind.

NPM 7.5% 2.6% 3.5%

 Net Profit margin was very good in 2005.

ii. Return on Assets
It measures the return brought to
Investors (both creditors and owners).
ROA = Net income / Total assets
Or
ROA = Profit Margin x Total Asset
Turnover
ROA = Net income / Total assets
= 230 / 3600
= 0.064
= 6.4%

2005 2004 Ind.

ROA 6.4% 6.0% 4.8%

 The ratio shows improvement, and it is

above the industry average.
iii. Return on Equity (ROE)
Measures the return brought to the shareholders

ROE = Net
Income
Stockholders’
equity
= 230/1960
= 11.73%
Du Pont formula:
ROE = Profit Margin x TATO x Equity
Multiplier
= ROA/1-DR
 ROE = Net income / Total common equity
= 230/1960 =11.73%

2005 2004 Ind.

ROE 11.73% 13.3% 13%

 The ratio has decreased in 2003 as compared

to 2004 and below the industry average in this
year.
A moment of Exercise…..
A company has $200 billion of sales and $10
billion of net income. Its total assets are $100
billion, financed half by debt and half by
common equity.
a)What is its profit margin?
b)What is its ROA?
c)What is its ROE?
d)If the firm used less leverage: Would ROA
increase? (yes); Would ROE increase? (No)
V. Market Value Ratios
These ratios are used as indicators of the future
return & risk of a company as perceived by the
stock’s buyers & sellers
Market value ratios 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.
a. Earning per share
EPS = earning available to common stock
no. of common shares outstanding
= net income – preferred dividend
no. of common shares outstanding
= 230-10
80
= 2.75
Industry average = 2.6
 b. Price Earnings Ratio
The price/earnings (P/E) ratio shows how
much investors are willing to pay per dollar of
reported profits.
Alphas common stock was selling at
Birr32.25
P/E = Price / Earnings per share
= 32.25 / 2.75
= 11.73

Industry average =12.50

 c. Market/Book ratio
 Measures the value created by the mgt to shareholders.

M/B = Market price per share

Book value per share
Book value per share = common equity
shares outstanding
= 620/80
=7.75

M/B= 32.25 / 7.75 = 4.16

2005 2004 Ind.

P/E 11.73x 9.7x 12.5x
M/B 4.16x 1.3x 5x
A moment of Exercise…..
A company has $6 billion of net income, $2
billion of depreciation and amortization, $80
billion of common equity, and 1 billion shares
of stock. If its stock price is $96 per share:
a) What is its price/earnings ratio?
b) Its market/book ratio?
 Potential problems and limitations of
financial ratio analysis
Comparison with industry averages is difficult
for a conglomerate firm that operates in many
different divisions.
“Average” performance is not necessarily good,
perhaps the firm should aim higher.
Seasonal factors can distort ratios.
“Window dressing” techniques can make
statements and ratios look better.
More issues regarding ratios
Different operating and accounting practices
can distort comparisons.
Sometimes it is hard to tell if a ratio is “good”
or “bad”.
It is assumed that all numbers used are correct.
If numbers are not reliable, ratios are not
particularly useful.
 Qualitative factors to be considered when
evaluating a company’s future financial
performance
Are the firm’s revenues tied to one key
customer, product, or supplier?
What percentage of the firm’s business is
generated overseas? (Risk of exchange rate
volatility and political instability)
What are the probable actions by current
competitors and the likelihood of additional new
competitors?
Future prospects
Legal and regulatory environment
End of Chapter II