PROFESSIONAL HUT

Financial Statement Analysis

A Practical Approach
 Outline
 Meaning of Financial Statements and Financial
Statement Analysis
 Significance of Financial Statements
 Types of Financial Statements
 Income Statement
 Balance Sheet
 Cash Flow Statement
 Statement of Retained Earnings
 Ratio Analysis including Du Pont Analysis
 Limitations of Financial Statement Analysis
 Focus
 The focus will be on financial statement
analysis and its use in corporate finance.
 financial statement analysis from managerial
perspective and not from an investor and/or
creditor’s perspective.
 How to use financial statement analysis to
ensure that shareholder wealth is maximized
and the stock price continues to rise?
MEANING OF FINANCIAL STATEMENTS
 Financial statements are summaries of the operating,
financing, and investment activities of a firm.
 According to the Financial Accounting Standards Board (FASB),
the financial statements of a firm should provide sufficient
information that is useful to
 investors and
 creditors
 in making their investment and credit decisions in an
informed way.
 For example, are inventories adequate to support the
projected level of sales?
 Does the firm have too heavy an investment in account
receivable?
 Does large account receivable reflect a lax collection policy?
 To ensure efficient operations of a firm’s manufacturing
facility, does the firm have too much or too little invested in
plant and equipment?
 Financial statement analysis provides answers to all of these
questions.
Types of Financial Statements and Reports
 The Income Statement
 The Balance Sheet
 The Statement of Retained
Earnings
 The Statement of Cash Flows
 The Income Statement

 An income statement is a summary of the revenues and

expenses of a business over a period of time, usually either one
month, three months, or one year.
 Summarizes the results of the firm’s operating and financing
decisions during that time.
 Operating decisions of the company apply to production and
marketing such as sales/revenues, cost of goods sold,
administrative and general expenses (advertising, office salaries)
 Provides operating income/earnings before interest and taxes
(EBIT)
 Results of financing decisions are reflected in the
remainder of the income statement.
 When interest expenses and taxes are subtracted
from EBIT, the result is net income available to
shareholders.
 Net income does not necessarily equal actual cash
flow from operations and financing.
 The Balance Sheet

 A summary of the assets, liabilities, and equity of a business at a particular point in time, usually
at the end of the firm’s fiscal year.

Assets = Liabilities + Equity

(Resources of the (Obligations of (ownership left over
business enterprise) the business) Residual)

Fixed Assets Long-term Common stock outstanding

(Plant, Machinery, Equipment (Notes, bonds, & Additional paid-in capital
Buildings) Capital Lease Retained Earnings
Current Assets Obligation)
(Cash, Marketable Securities, Current Liabilities
Account Receivable, Inventories) (Accounts Payable,
Wages and salaries,
Short-term loans
Any portion of long-term
Indebtedness due in one-year)
THE STATEMENT OF CASH FLOWS
 The statement is designed to show how the firm’s operations have
affected its cash position and to help answer questions such as
these:

 Is the firm generating the cash needed to purchase additional

fixed assets for growth?
 Is the growth so rapid that external financing is required both to
maintain operations and for investment in new fixed assets?

 Does the firm have excess cash flows that can be used to repay
debt or to invest in new products?
RATIO ANALYSIS

 Financial statements report both on a firm’s position at a

point in time and on its operations over some past period.
 From management’s viewpoint, financial statement analysis
is useful both as a way to
 anticipate future conditions and
 more important, as a starting point for planning actions
 that will influence the future course of events or
 to show whether a firm’s position has been improving or
deteriorating over time.
 Ratio analysis begins
 with the calculation of a set of financial ratios
 designed to show the relative strengths and
 weaknesses of a company as compared to
 Other firms in the industry
 Leadings firms in the industry
 The previous year of the same firm
 Ratio analysis helps to show whether the firm’s position has
been improving or deteriorating
 Ratio analysis can also help plan for the future
Types of Ratios

 Liquidity Ratios
Current Ratio
Quick Ratio/Acid Test Ratio
 Asset Management Ratios
Inventory Turnover Ratio
Days Sales Outstanding
Fixed Assets Turnover Ratio
Total Assets Turnover Ratio
 Debt Management Ratio
Total Debt to Total Assets Ratio
Times Interest Covered Ratio
 Profitability Ratios
Profit Margin on Sales
Return on Assets
Return on Equity
Basic Earning Power Ratio
Liquidity Ratio
 A liquid asset is one that can be easily converted
into cash at a fair market value
 Liquidity question deals with this question
 Will the firm be able to meet its current
obligations?
 Two measures of liquidity
 Current Ratio
 Quick/Acid Test Ratio
Asset Management Ratios
 Asset management ratio measures how
effectively the firm is managing/using its assets
 Do we have too much investment in assets or too
little investment in assets in view of current and
projected sales levels?
 What happens if the firm has
 Too much investment in assets
 Too little investment in assets
Asset Management Ratios
 Inventory Turnover Ratio
 Measures the efficiency of Inventory
Management
 A high ratio indicates that inventory does not
remain in warehouses or on shelves, but rather
turns over rapidly into sales
 Two cautions
 Market prices for sales and inventories at cost
 Sales over the year and inventory at the end of
the year
Asset Management Ratio
 Days Sales Outstanding (DSO)
 To appraise the quality of accounts receivables
 Average length of time that the firm must wait
after making a sale before receiving cash from
customers
 Measures effectiveness of a firm credit policy
 Indicates the level of investment needed in
receivables to maintain firm’s sales level
 What happens if this ratio is
 Too high, or
 Too low
Asset Management Ratios
 Fixed Assets Turnover Ratio
 Measures efficiency of long-term capital
investment
 How effectively a firm is using its plant
and machinery to generate sales?
 How much fixed assets are needed to
achieve a particular level of sales?
 Cautions
Asset Management Ratio
 Total Asset Turnover Ratio
 Measure efficiency of total assets for the
company as a whole or for a division of the
firm
 Core competency
Debt Management Ratio
 Implications of use of borrowings
 Creditors look to Stockholders’ equity as a safety
margin
 Interest on borrowings is a legal liability of the firm
 Interest is to be paid out of operating income
 Debt magnifies return and risk to common
stockholders
 Total Debt to Total Assets Ratio
 Measures percentage of assets being financed
through borrowings
 Too high a number means increased risk of
bankruptcy
 Leverage
 What percentage of total assets are being
financed through equity?
 Times Earned Interest (TIE)
 Measure the extent to which operating
income can decline before the firm is
unable to meet its annual interest costs
 Failure to pay interest can result in legal
action by creditors with possible
bankruptcy for the firm
Profitability Ratios
 Net result of a number of policies and decisions
 Show the combined effect of liquidity, asset
management, and debt management on
operating results
 Net Profit Margin on Sales
 Relates net income available to common stockholders to sales
 Basic Earning Power
 Relates EBIT to Total Assets
 Useful for comparing firms with different tax situations and different
degrees of financial leverage
 Return on Assets (ROA)
 Relates net income available to common stockholders to total assets
 Return on Common Equity (ROE)
 Relates net income available to common stockholders to common
stockholders equity
 PROBLEMS IN FINANCIAL STATEMENT
ANALYSIS
 Developing and Using Comparative Data
 Distortion of Comparative Data
 Notes to Financial Statements
 Interpretation of Results
 Differences in Accounting Treatment
 Window Dressing
 Effects of Inflation