Chapter 3

Financial Statement
Analysis
To Thi Thanh Truc
Faculty of Finance and Banking
University of Economics and Law

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 Learning outcomes
After finishing this chapter you should be able to:
 Explain why financial statement analysis is important to the

firm and to outside suppliers of capital.

 Define, calculate, and categorize the major financial ratios

and understand what they can tell us about the firm.

 Use ratios to analyze a firm’s health and then recommend
reasonable alternative courses of action to improve the
health of the firm.
 Analyze a firm’s return on assets and return on equity using

a Du Pont approach.
 Explain the limitations of financial ratio analysis.

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Outline

 Introduction to financial analysis

 Common-size and index analysis
 Ratio Analysis
 Du Pont system
 Effects of improving ratios
 Limitations of ratio analysis
 Qualitative factors 3-3
 Introduction to financial
statement analysis

Financial statement analysis?

 The application of analytical tools and techniques to
financial statements and related data to drive
estimates and inferences useful.
 Financial statement analysis involves:
 Comparing the firm’s performance to that of other
firm in the same industry
 Evaluating trends in the firm’s finacial position
over time.

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 Introduction to financial
statement analysis
Will I
be paid?
Creditors
How
good is our
investment? How are we
performing?
Stockholders

Management
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 Analytical techniques

 Comparative financial statement

analysis: Year – to – Year change
analysis, Index – number trend Analysis.
 Common-Size Statements analysis
 Ratio Analysis

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 Financial statement analysis:
comparison
Company XYZ
1 intracompany basis
Year 1 Year 2

2 industry averages

3 intercompany basis
Co. A Co. C
Co. B
Co. ABC Co. XYZ
Co. D Co. E

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 Comparative financial
statement analysis
Reviewing consecutive financial
statements from period to period, involves a
review of changes in individual account balances
on a year-to-year or multiyear basis.

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 Comparative financial
statement analysis

Information revealed is trend:

direction, speed, and extent of
trend.

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Common-Size Statements
Analysis
An analysis of percentage financial
statements where all balance sheet
items are divided by total assets
and all income statement items are
divided by net sales or revenues

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 Percentage Change Analysis: Find
Percentage Change from First Year (2017)

Income St. 2017 2018 2019

Sales 0.0% 70.0% 105.0%
COGS 0.0% 73.9% 102.5%
Other exp. 0.0% 111.8% 80.3%
Depr. 0.0% 518.8% 534.9%
EBIT 0.0% -91.7% 140.4%
Int. Exp. 0.0% 181.6% 28.0%
EBT 0.0% -208.2% 188.3%
Taxes 0.0% -208.2% 188.3%
NI 0.0% -208.2% 188.3%
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Analysis of Percent Change
Income Statement
 We see that 2019 sales grew 105%
from 2017 and that NI grew 188%
from 2017.
 So the firm has become more
profitable.

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 Percentage Change Balance Sheets
Assets 2017 2018 2019
Cash 0.0% -19.1% 55.6%
ST Invest. 0.0% -58.8% 47.4%
AR 0.0% 80.0% 150.0%
Invent. 0.0% 80.0% 140.0%
Total CA 0.0% 73.2% 138.4%
Net FA 0.0% 172.6% 142.7%
TA 0.0% 96.5% 139.4%
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Liab. & Eq. 2017 2018 2019
AP 0.0% 122.5% 147.1%
Notes pay. 0.0% 260.0% 50.0%
Accruals 0.0% 109.5% 179.4%
Total CL 0.0% 175.9% 115.9%
LT Debt 0.0% 209.2% 54.6%
Total eq. 0.0% -16.0% 197.9%
Total L&E 0.0% 96.5% 139.4%
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Analysis of Percent Change:
Balance Sheets
 We see that total assets grew at a rate
of 139%, while sales grew at a rate of
only 105%. So asset utilization remains
a problem.

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 Common Size Balance Sheets:
Divide all items by Total Assets
Assets 2017 2018 2019 Ind.
Cash 0.6% 0.3% 0.4% 0.3%
ST Invest. 3.3% 0.7% 2.0% 0.3%
AR 23.9% 21.9% 25.0% 22.4%
Invent. 48.7% 44.6% 48.8% 41.2%
Total CA 76.5% 67.4% 76.2% 64.1%
Net FA 23.5% 32.6% 23.8% 35.9%
TA 100.0% 100.0% 100.0% 100.0%
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 Divide all items by
Total Liabilities & Equity
2017 2018 2019 Ind.
AP 9.9% 11.2% 10.2% 11.9%
Notes pay. 13.6% 24.9% 8.5% 2.4%
Accruals 9.3% 9.9% 10.8% 9.5%
Total CL 32.8% 46.0% 29.6% 23.7%
LT Debt 22.0% 34.6% 14.2% 26.3%
Total eq. 45.2% 19.3% 56.2% 50.0%
Total L&E 100.0% 100.0% 100.0% 100.0%
3-17
 Analysis of Common Size Balance
Sheets
 The firm has higher proportion of
inventory and current assets than
Industry.
 The firm now has more equity (which
means LESS debt) than Industry.
 The firm has more short-term debt than
industry, but less long-term debt than
industry.

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 Common Size Income Statement:
Divide all items by Sales
2017 2018 2019 Ind.
Sales 100.0% 100.0% 100.0% 100.0%
COGS 83.4% 85.4% 82.4% 84.5%
Other exp. 9.9% 12.3% 8.7% 4.4%
Depr. 0.6% 2.0% 1.7% 4.0%
EBIT 6.1% 0.3% 7.1% 7.1%
Int. Exp. 1.8% 3.0% 1.1% 1.1%
EBT 4.3% -2.7% 6.0% 5.9%
Taxes 1.7% -1.1% 2.4% 2.4%
NI 2.6% -1.6% 3.6% 3.6%
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Analysis of Common Size
Income Statements
 The firm has lower COGS (86.7) than
industry (84.5), but higher other
expenses. Result is that the firm has
similar EBIT (7.1) as industry.

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Ratio analysis
A ratio expresses a mathematic relation
between two quantities (two accounts on
financial statements).
A ratio must refer to an economically
important relation.

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Why are ratios useful?
 Ratios standardize numbers and
facilitate comparisons.
 Ratios are used to highlight
weaknesses and strengths.
 Ratio comparisons should be made
through time and with competitors
 Trend analysis
 Peer (or Industry) analysis

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 What are the five major categories of
ratios, and what questions do they
answer?
Give us an idea of:
 Liquidity: the firm’s ability to pay off debts that are maturing
within a year?
 Asset management: how efficiently the firm is using its
assets, whether the firm has a right amount of assets vs.
sales.
 Debt management: how the firm has financed its assets as
well as the firm’s ability to repay its long-term debt. Whether
the firm has a right mix of debt and equity.
 Profitability: How profitably the firm is operating and utilizing
its assets.
 Market value: what investors think about the firm and its
future prospects. 3-23
Balance Sheet: Assets
2019E 2018
Cash 85,632 7,282
A/R 878,000 632,160
Inventories 1,716,480 1,287,360
Total CA 2,680,112 1,926,802
Gross FA 1,197,160 1,202,950
Less: Dep. 380,120 263,160
Net FA 817,040 939,790
Total Assets 3,497,152 2,866,592
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Balance sheet:
Liabilities and Equity
2019E 2018
Accts payable 436,800 524,160
Notes payable 300,000 636,808
Accruals 408,000 489,600
Total CL 1,144,800 1,650,568
Long-term debt 400,000 723,432
Common stock 1,721,176 460,000
Retained earnings 231,176 32,592
Total Equity 1,952,352 492,592
Total L & E 3,497,152 2,866,592
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Income statement
2019E 2018
Sales 7,035,600 6,034,000
COGS 5,875,992 5,528,000
Other expenses 550,000 519,988
EBITDA 609,608 (13,988)
Depr. & Amort. 116,960 116,960
EBIT 492,648 (130,948)
Interest Exp. 70,008 136,012
EBT 422,640 (266,960)
Taxes 169,056 (106,784)
Net income 253,584 (160,176)
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Other data
2019E 2018
No. of shares 250,000 100,000
EPS $1.014 -$1.602
DPS $0.220 $0.110
Stock price $12.17 $2.25
Lease pmts $40,000 $40,000

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 Calculate D’Leon’s forecasted current
ratio and quick ratio for 2019.

Current ratio = Current assets / Current liabilities

= $2,680 / $1,145
= 2.34x
Quick ratio = (CA – Inventories) / CL
= ($2,680 – $1,716) / $1,145
= 0.84x

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Comments on liquidity ratios
2019E 2018 2017 Ind.
Current Ratio 2.34x 1.20x 2.30x 2.70x
Quick Ratio 0.84x 0.39x 0.85x 1.00x

 Expected to improve but still below the

industry average.
 Liquidity position is weak.

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What is the inventory turnover
vs. the industry average?
Inv. turnover = Sales / Inventories
= $7,036 / $1,716
= 4.10x

2019E 2018 2017 Ind.

Inventory
4.1x 4.70x 4.8x 6.1x
Turnover

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Comments on
Inventory Turnover
 Inventory turnover is below industry
average.
 D’Leon might have old inventory, or
its control might be poor.
 No improvement is currently
forecasted.

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DSO is the average number of days after
making a sale before receiving cash.

DSO = Receivables / Avg sales per day

= Receivables / (Annual sales/365)
= $878 / ($7,036/365)
= 45.6 days

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Appraisal of DSO
2019E 2018 2017 Ind.
DSO 45.6 38.2 37.4 32.0

 D’Leon collects on sales too slowly,

and is getting worse.
 D’Leon has a poor credit policy.

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Fixed assets and total assets turnover
ratios vs. the industry average

FA turnover = Sales / Net fixed assets

= $7,036 / $817 = 8.61x

TA turnover = Sales / Total assets

= $7,036 / $3,497 = 2.01x

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Evaluating the FA turnover and
TA turnover ratios
2019E 2018 2017 Ind.
FA TO 8.6x 6.4x 10.0x 7.0x
TA TO 2.0x 2.1x 2.3x 2.6x

 FA turnover projected to exceed the industry

average.
 TA turnover below the industry average.
Caused by excessive current assets (A/R and
Inv).
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 Calculate the debt ratio, times-interest-
earned, and EBITDA coverage ratios.

Debt ratio = Total debt / Total assets

= ($1,145 + $400) / $3,497
= 44.2%

TIE = EBIT / Interest expense

= $492.6 / $70 = 7.0x

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 Calculate the debt ratio, TIE, and
EBITDA coverage ratios.

EBITDA (EBITDA + Lease pmts)

=
coverage Int exp + Lease pmts + Principal pmts

$609.6 + $40
=
$70 + $40 + $0
= 5.9x

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 How do the debt management ratios
compare with industry averages?
2019E 2018 2017 Ind.
D/A 44.2% 82.8% 54.8% 50.0%
TIE 7.0x -1.0x 4.3x 6.2x
EBITDA
5.9x 0.1x 3.0x 8.0x
coverage

 D/A and TIE are better than the industry

average, but EBITDA coverage still trails the
industry.
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 Profitability ratios: Profit margin

Profit margin = Net income / Sales

= $253.6 / $7,036 = 3.6%

Operating Margin = EBIT / Sales

= $492.6 / $3,497 = 14.1%

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Profitability ratios:
Basic earning power (BEP)

BEP = EBIT / Total assets

= $492.6 / $3,497 = 14.1%

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 Appraising profitability with the profit
margin and basic earning power
2019E 2018 2017 Ind.
PM 3.6% -2.7% 2.6% 3.5%
BEP 14.1% -4.6% 13.0% 19.1%

 Profit margin was very bad in 2018, but is projected to

exceed the industry average in 2019. Looking good.
 BEP removes the effects of taxes and financial leverage
and is useful for comparison.
 BEP is projected to improve, yet still below the industry
average. There is room for improvement.
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Profitability ratios:
Return on assets and Return on equity

ROA = Net income / Total assets

= $253.6 / $3,497 = 7.3%
ROE = Net income / Total common equity
= $253.6 / $1,952 = 13.0%
ROIC = EBIT(1-T)/ (Debt + Equity)

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Appraising profitability with the return
on assets and return on equity
2019E 2018 2017 Ind.
ROA 7.3% -5.6% 6.0% 9.1%
ROE 13.0% -32.5% 13.3% 18.2%

 Both ratios rebounded from the previous

year, but are still below the industry
average. More improvement is needed.
 Wide variations in ROE illustrate the effect
that leverage can have on profitability.
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Effects of debt on ROA and ROE
 ROA is lowered by debt--interest
lowers NI, which also lowers ROA =
NI/Assets.
 But use of debt also lowers equity,
hence debt could raise ROE =
NI/Equity.

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 Problems with ROE
 ROE and shareholder wealth are correlated,
but problems can arise when ROE is the sole
measure of performance.
 ROE does not consider risk.
 ROE does not consider the amount of capital
invested.
 Might encourage managers to make investment
decisions that do not benefit shareholders.
 ROE focuses only on return and a better
measure would consider risk and return.
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 Calculate the Price/Earnings, Price/Cash
flow, and Market/Book ratios.

P/E = Price / Earnings per share

= $12.17 / $1.014 = 12.0x

P/CF = Price / Cash flow per share

= $12.17 / [($253.6+$117.0) ÷ 250]
= 8.21x

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Calculate the Price/Earnings, Price/Cash
flow, and Market/Book ratios.

M/B = Market price / Book value per share

= $12.17 / ($1,952 / 250) = 1.56x

2019E 2018 2017 Ind.

P/E 12.0x -1.4x 9.7x 14.2x
P/CF 8.21x -5.2x 8.0x 11.0x
M/B 1.56x 0.5x 1.3x 2.4x

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Analyzing the market value ratios
 P/E: How much investors are willing to pay
for $1 of earnings.
 P/CF: How much investors are willing to pay
for $1 of cash flow.
 M/B: How much investors are willing to pay
for $1 of book value equity.
 For each ratio, the higher the number, the
better.
 P/E and M/B are high if ROE is high and risk
is low.
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 The Du Pont system
Profit Total assets Equity
ROE  margin  turnover 
multiplier
ROE  (NI/Sales)  (Sales/TA)  (TA/Equity)

 Focuses on expense control (PM), asset

utilization (TA TO), and debt utilization
(Equity multiplier.)

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Extended DuPont equation:
Breaking down Return On Equity

ROE = (NI / Sales) x (Sales/TA) x (TA/Equity)

= 3.6% x 2 x 1.8
= 13.0%
PM TA TO EM ROE
2017 2.6% 2.3 2.2 13.3%
2018 -2.7% 2.1 5.8 -32.5%
2019E 3.6% 2.0 1.8 13.0%
Ind. 3.5% 2.6 2.0 18.2%

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An example:
The effects of improving ratios
A/R $ 878 Debt $1,545
Other CA 1,802 Equity 1,952
Net FA 817 _____
TA $3,497 Total L&E $3,497

Sales / day = $7,035,600 / 365 = $19,275.62

How would reducing the firm’s DSO to 32

days affect the company?
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Reducing accounts receivable and
the days sales outstanding
 Reducing A/R will have no effect on
sales
Old A/R = $19,275.62 x 45.6 = $878,000
New A/R = $19,275.62 x 32.0 = $616,820
Cash freed up: $261,180

Initially shows up as addition to cash.

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Effect of reducing receivables on
balance sheet and stock price
Added cash $ 261 Debt $1,545
A/R 617 Equity 1,952
Other CA 1,802
Net FA 817 ______
Total Assets $3,497 Total L&E $3,497

What could be done with the new cash?

How might stock price and risk be affected?

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Potential uses of freed up cash
 Repurchase stock
 Expand business
 Reduce debt
 All these actions would likely improve
the stock price.

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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.
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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”.
 Difficult to tell whether a company is,
on balance, in strong or weak position.

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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?
 Competition
 Future prospects
 Legal and regulatory environment

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