FINANCIAL STATEMENT

ANALYSIS
 LEARNING OBJECTIVES
• Understand how business activities are reported through financial
statements
• Know the nature and significance of the financial statements
• Define financial statement analysis
• Understand the basis FS analysis techniques
• Know the basics of profitability analysis
• Analyze a business firm’s short-term financial position, asset liquidity and
management, long-term financial position and profitability using financial
ratios
 RATIO ANALYSIS

• Ratio Analysis is a systematic use of ratio to interpret

or assess the performance status of the firm.
• It is a widely used tool of financial analysis.
• The term ratio refers to numerical or quantitative
relationship between two items or variables.
• The basic objective of ratio analysis is to compare
the risk and return relationship of firms of different
sizes.
 RATIO ANALYSIS

• A financial ratio is a relationship between to

accounting figures.
• Ratios help to make qualitative judgment about the
firm’s financial performance.
• Ratio analysis helps in finding out the strengths and
weaknesses of a firm.
 RATIO ANALYSIS

• Ratio analysis can help plan for the future.

• The relationship in ratio can be expressed in:
• Percentage- ex. Net Profit are 25% of Sales
• Fraction- ex. Net Profit is one-fourth of Sales
• Proportion- ex. Relationship between net profit
and sales is 1:4
 TYPES OF RATIOS

• Liquidity Ratios
• Leverage Ratios
• Activity Ratios
• Profitability Ratios
• Market Value Ratios
 LIQUIDITY RATIOS

• Ability of the firm to satisfy its short term obligations

as they become due.
• A liquid asset is one that can be easily converted
into cash at a fair market value
• “Will the firm be able to meet its current
obligations?”
• In general, the greater the level of coverage of
liquid assets to short-term liabilities the better.
 LIQUIDITY RATIOS

• Liquidity ratios are a key part of fundamental

analysis since they help determine a company's
ability to service its debts. If a company fails to pay
its debts, it could face bankruptcy or restructuring
activity that could be detrimental to shareholder
value.
 LIQUIDITY RATIOS

• Three Measures of Liquidity:

• Current Ratio
• Quick or Acid Test Ratio
• Net Working Capital
 LIQUIDITY RATIOS
• Current Assets are assets which can be converted into cash
easily in one accounting period.
• Cash & cash equivalents
• Receivables
• Inventories
• Prepaid Expenses
• Current Liabilities are liabilities which have to be paid in one
accounting period.
• Accounts Payable
• Short-term loans
 CURRENT RATIO

Current Assets
Current Ratio =
Current Liabilities
• It is the relationship between the current assets and current
liabilities of a concern.
 CURRENT RATIO

• A current ratio of 1.0 or greater is an indication that

the company is well-positioned to cover its current
or short-term liabilities.

• A current ratio of less than 1.0 could be a sign of

trouble if the company runs into financial difficulty.
 LIMITATIONS OF CURRENT RATIO
• this is not the whole story on company liquidity
• understand the types of current assets the company has
and how quickly these can be converted into cash to meet
current liabilities
• The current ratio inherently assumes that the company
would or could liquidate all of most of its current assets and
convert them to cash to cover these liabilities
• Companies with a seemingly high current ratio may not be
safer than a company with a relatively low current ratio.
 QUICK RATIO
Current Assets- Inventories & Prepaid Expenses
Quick Ratio =
Current Liabilities
• Also known as acid test ratio
• liquidity ratio that further refines the current ratio by measuring
the level of the most liquid current assets available to cover
current liabilities.
• is more conservative than the current ratio because it excludes
inventory and other current assets, which generally are more
difficult to turn into cash.
• A higher quick ratio means a more liquid current position.
 QUICK RATIO
• The quick ratio is conceivably a better barometer of the
coverage provided by these assets for the company’s
current liabilities should company experience financial
difficulties.
• Inventory is generally considered to be less liquid than these
other current assets.
• A rule of thumb is that a quick ratio greater than 1.0 means
that a company is sufficiently able to meet its short-term
obligations.
 QUICK RATIO
• A low and/or decreasing quick ratio might be delivering
several messages about a company. It could be telling us
that the company’s balance sheet is over-leveraged. Or it
could be saying the company’s sales are decreasing, the
company is having a hard time collecting its account
receivables or perhaps the company is paying its bills too
quickly.
• A company with a high and/or increasing quick ratio is likely
experiencing revenue growth, collecting its accounts
receivable and turning them into cash quickly and likely
turning over its inventories quickly.
 QUICK RATIO
• Not a perfect indicator
• The elimination of inventories makes the quick ratio a
somewhat better barometer of a company’s ability to meet
its short-term obligations than the current ratio. But like the
current ratio, the acid-test ratio is still not a perfect gauge. It
is not realistic to assume that a company will liquidate all
current assets that comprise the quick ratio to cover short-
term debts since the company still needs a level of working
capital to remain a going concern.
 CASH RATIO

Cash + Marketable Securities

Cash Ratio =
Current Liabilities
• The cash ratio is another measurement of a company’s
liquidity and their ability to meet their short-term obligations.
• shows the level of the firm’s cash and near-cash investments
relative to their current liabilities
 WORKING CAPITAL
Working Capital = Current Asset – Current Liabilities

• Indicates relative liquidity of asset

• working capital is the money available to meet your current, short-term
obligations
 LEVERAGE RATIOS
• Also known as solvency ratios.
• A leverage ratio is any one of several 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.
• The leverage ratio is important given that companies rely on
a mixture of equity and debt to finance their operations,
and knowing the amount of debt held by a company is
useful in evaluating whether it can pay its debts off as they
come due.
 LEVERAGE RATIOS
• Too much debt can be dangerous for a company and its
investors.
• Uncontrolled debt levels can lead to credit downgrades or
worse.
• Too few debt can also raise questions.
• A leverage ratio may also be used to measure a company's
mix of operating expenses to get an idea of how changes
in output will affect operating income.
 LEVERAGE RATIOS

• Four Measures of Leverage:

• Debt Ratio
• Equity Ratio
• Debt-Equity Ratio
• Interest Coverage Ratio
 DEBT RATIO
Total Liabilities
Debt Ratio =
Total Assets
• the ratio of total debt to total assets, expressed as a decimal or percentage.
• It can be interpreted as the proportion of a company’s assets that are
financed by debt.
• A figure of 0.5 or less is ideal. In other words, no more than half of the
company’s assets should be financed by debt.
 EQUITY RATIO
Total Equity
Equity Ratio
Total Assets

• the ratio of total equity to total assets, expressed as a decimal or

percentage.
• It can be interpreted as the proportion of a company’s assets that are
financed by equity.
• A figure of 0.5 or more is ideal. In other words, more than half of the
company’s assets should be financed by equity.
• Measures the proportion of all assets that are financed with capital/equity
 DEBT-EQUITY RATIO

• indicates how much capital a company is using to finance

its assets relative to the value of shareholders’ equity.
• A high debt/equity ratio generally means that a company
has been aggressive in financing its growth with debt.
• Aggressive leveraging practices are often associated with
high levels of risk. This may result in volatile earnings as a
result of the additional interest expense.
 INTEREST COVERAGE RATIO
Operating Income
Interest Coverage Ratio =
Interest Expense
• a debt ratio and profitability ratio used to determine how easily a
company can pay interest on its outstanding debt.
• Interest coverage ratio is also called “times interest earned.”
 INTEREST COVERAGE RATIO

• measures how many times over a company could pay its current
interest payment with its available earnings.
• The lower a company’s interest coverage ratio is, the more its
debt expenses burden the company.
• Moreover, an interest coverage ratio below 1 indicates the
company is not generating sufficient revenues to satisfy its interest
expenses.
 ACTIVITY RATIO
• Also called efficiency ratios
• Evaluates how well a company uses its assets and liabilities to
generate sales and maximize profits.
• Key efficiency ratios are the following:
• Receivable Turnover
• Average Collection Period
• Inventory Turnover
• Days Supply in Inventory
• Asset Turnover
• Payable Turnover
 RECEIVABLES TURNOVER
Net Credit Sales
Accounts Receivable Turnover =
Average Accounts Receivable

• Receivable turnover ratio is also often called accounts

receivable turnover, the accounts receivable turnover ratio,
or the debtor’s turnover ratio.
• Accounting measure used to quantify a firm's effectiveness
in extending credit and in collecting debts on that credit.
• The receivables turnover ratio is an activity ratio measuring
how efficiently a firm uses its assets.
 RECEIVABLES TURNOVER
• A high receivables turnover ratio can imply a variety of
things about a company:
• The company operates on a cash basis
• The company’s collection of accounts receivable is
efficient
• A low receivables turnover ratio can imply a variety of things
about a company:
• the company may have poor collecting processes
• a bad credit policy or none at all
• the company has a high amount of cash receivables for
collection from its various debtors
AVERAGE COLLECTION PERIOD
 INVENTORY TURNOVER

Cost of Goods Sold

Inventory Turnover =
Average Inventory

• a ratio showing how many times a company has sold and

replaced inventory during a period.
• Low turnover implies weak sales and, excess inventory.
• A high ratio implies either strong sales or large discounts.
 DAYS’ SALES IN INVENTORY
360 days
Inventory Turnover =
Inventory turnover

• Days sales of inventory (DSI) is one measure of the

effectiveness of inventory management. By calculating the
number of days that a company holds onto inventory
before selling, this efficiency ratio measures the average
length of time that a company’s cash is tied up in
inventory.
 ASSET TURNOVER RATIO
Sales
Asset Turnover =
Average Total Assets

• measures the value of a company’s sales or revenues

generated relative to the value of its assets.
• The Asset Turnover ratio can often be used as an indicator
of the efficiency with which a company is deploying its
assets in generating revenue.
 PAYABLE TURNOVER

Purchases
Payable Turnover =
Average Accounts Payable

• Measure efficiency of the company in meeting trade payable.

 PROFITABILITY RATIO
• These ratios show how well a company can generate profits
from its operations.
• Key efficiency ratios are the following:
• Profit margins
• Return on Assets (ROA)
• Return on Equity (ROE)
 PROFIT MARGIN RATIO
Net Income
Profit Margin =
Sales

• Profit margin is a profitability ratios calculated as net income

divided by revenue, or net profits divided by sales.
• Profit margins are expressed as a percentage and, in effect,
measure how much out of every dollar of sales a company
actually keeps in earnings.
 PROFIT MARGIN RATIO
• Different kinds of profit margins:
• gross profit margin
• operating margin (or operating profit margin)
• Pre-tax profit margin
• net margin (or net profit margin)
 RETURN ON ASSET
Return on Investment on Net Income
Assets Average Total Assets
• Return on assets (ROA) is an indicator of how profitable a
company is relative to its total assets.
• ROA gives a manager, investor, or analyst an idea as to
how efficient a company's management is at using its assets
to generate earnings.
 RETURN ON ASSET

• When using ROA as a comparative measure, it is best to

compare it against a company's previous ROA numbers or
against a similar company's ROA.
• ROA is most useful for comparing companies in the same
industry, as different industries use assets differently.
 RETURN ON EQUITY

Net Income
Return on Equity
Average Stockholder's Equity
• Return on equity (ROE) is the amount of net income returned
as a percentage of shareholders' equity.
• Return on equity (also known as "return on net worth"
[RONW]) measures a corporation's profitability by revealing
how much profit a company generates with the money
shareholders have invested.
 RETURN ON EQUITY
• ROE is useful in comparing the profitability of a company to
that of other firms in the same industry.
• It illustrates how effective the company is at turning the cash
put into the business into greater gains and growth for the
company and investors.
• The higher the return on equity, the more efficient the
company's operations are making use of those funds.
MARKET VALUE RATIO
MARKET VALUE RATIO
 DuPont ANALYSIS
• DuPont analysis is a fundamental performance
measurement framework popularized by the DuPont
Corporation and is also referred to as the "DuPont identity."
• DuPont analysis is a useful technique used to decompose
the different drivers of the return on equity (ROE).
• Decomposition of ROE allows investors to focus their
research on the distinct company performance indicators
otherwise cursory evaluation.
 DuPont ANALYSIS
• DuPont analysis breaks ROE into its constituent components
to determine which of these components is most responsible
for changes in ROE.
• Net Margin
• Asset Turnover Ratio
• Equity Multiplier
QUESTIONS?