Analyze Financial Statements with Ratios & Trends

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Analysis of Financial
Statements
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Key Financial Statements
Balance sheet provides a snapshot of a firms
financial position at one point in time.
Income statement summarizes a firms revenues
and expenses over a given period of time.
Statement of stockholders equity shows how
much of the firms earnings were retained, rather
than paid out as dividends.
Statement of cash flows reports the impact of a
firms activities on cash flows over a given period of
time.
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Why Do We Analyze Financial
Statements?
A firms financial
statements can be
analyzed internally
(by employees,
managers) and
externally (by
bankers, investors,
customers, and other
interested parties).

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Statements?
An internal financial analysis might be done:
To evaluate the performance of employees and
determine their pay raises and bonuses.
To compare the financial performance of the firms
different divisions.
To prepare financial projections, such as those
associated with the launch of a new product.
To evaluate the firms financial performance in light
of its competitors and determine how the firm
might improve its operations.

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Statements?
An external financial analysis might be done by:
Banks and other lenders deciding whether to loan money to the
firm.
Suppliers who are considering whether to grant credit to the firm.
Credit-rating agencies trying to determine the firms
creditworthiness.
Professional analysts who work for investment companies
considering investing in the firm or advising others about
investing.
Individual investors deciding whether to invest in the firm.

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Methods of Analyzing Financial
Statements
Common Size
Statements
Trend Analysis
Financial Ratios
DuPont Method

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Statements

Common Size Statements

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Standardizing Financial Information
A common size financial statement is a
standardized version of a financial statement in
which all entries are presented in percentages.
A common size financial statement helps to
compare entries in a firms financial statements,
even if the firms are not of equal size.
Also called Vertical Analysis
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Standardizing Financial Information
(cont.)
How to prepare a common size financial
statement?
- For a common size income statement, divide
each entry in the income statement by the
companys sales.
- For a common size balance sheet, divide each
entry in the balance sheet by the firms total
assets.
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Common
Size
Income
Statement
(H. J.
Boswell,
Inc.)
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Common Size
Balance Sheet
(H. J. Boswell,
Inc.)
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Statements

Trend Analysis

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Trend Analysis
Trend Analysis shows changes in the amounts of
corresponding financial statement items over a
period of time. It is a useful tool to evaluate the
trend situations.
The statements for two or more periods are used in
horizontal analysis.
The changes are generally shown both in amounts
and percentage.
Also called Horizontal Analysis

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Two Methods of Trend Analysis
1. Simple base-year
2. Progressive base-year

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1. Simple Base-Year Horizontal Trend Analysis

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Using Financial Ratios:
2. Progressive Base-Year Horizontal Trend
Analysis

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Statements

Financial Ratios

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Financial Ratio Analysis
Financial ratios provide a method for standardizing
the financial information on the income statement
and balance sheet.

A ratio by itself may have no meaning. Hence, a
given ratio is compared to:
ratios from previous years; or
ratios of other firms in the same industry.
If the differences in the ratios are significant, more in-
depth analysis must be done.

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Using Financial Ratios:
Types of Ratio Comparisons
1. Trend or time-series analysis (Horizontal Analysis)
- used to evaluate a firms performance over time
2. Cross-sectional analysis (Peer group comparison)
Industry comparative analysis
- compare one firms financial performance to the industrys average performance
Benchmarking
- compare the firms ratio values to those of a key competitor or group of competitors
that it wishes to emulate
3. Combined analysis
- uses a combination of both time series analysis and cross-sectional analysis

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Using Financial Ratios
Question Category of Ratios Used
1. How liquid is the firm? Will it be able to pay
its bills as they become due?

Liquidity ratios
2. How did the firm finance its assets? Does it
have the ability to repay its long-term
debts? Does it have the right mix of debt
and equity?

Debt management or Capital structure ratios

3. How efficient has the firms management
been in utilizing it assets to generate
sales? Does it have the right amount of
assets to support sales?

Asset management efficiency ratios
4. How profitable has the firm been in
operating and utilizing its assets? Do
sales prices exceed unit costs? Are sales
high enough?

Profitability ratios

5. What do investors think about the firm and
its future prospects? Do investors like
what they see?

Market value ratios

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Financial Ratios

Liquidity Ratios

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Liquidity Ratios
The liquidity of an asset refers to the speed with which the
asset can be converted into cash without loss of value.
The liquidity of a firm as a whole is its ability to
regularly convert its current assets into cash so that it
can pay its bills on time.
This is a function of both the liquidity of the firms
current assets and the size of the bills it must pay

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Liquidity Ratios
We can analyze a firms liquidity from two
perspectives:
Overall liquidity is analyzed by comparing the
firms current assets to the firms current
liabilities.
Liquidity of specific assets is analyzed by
examining the timeliness in which the firms
primary liquid assets accounts receivable and
inventories are converted into cash.

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Liquidity Ratios: Current Ratio
The overall liquidity of a firm is analyzed by
computing the net working capital, current
ratio, acid-test ratio, and cash ratio.
Net Working Capital the difference
between the firms current assets and current
liabilities
= Current Assets Current Liabilities
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Liquidity Ratios: Current Ratio
Current Ratio: Current Ratio compares a
firms current (liquid) assets to its current
(short-term) liabilities.

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Liquidity Ratios: Quick or Acid-
Test Ratio
The Acid-Test (Quick) Ratio excludes the
inventory from current assets as inventory
may not always be very liquid.

*Quick Assets = Cash + Cash Equivalents + Accounts Receivable
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Liquidity Ratios: Cash Ratio
The cash ratio is
an indicator of a
company's liquidity
that further refines
both the current
ratio and the quick
ratio by measuring
the amount of cash
and cash
equivalents to cover
current liabilities.

Cash + Cash Equivalents
Cash Ratio = ------------------------------------
Current Liabilities
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Liquidity Ratios:
Individual Asset Categories
We can also measure the liquidity of the firm
by examining the liquidity of individual
current asset accounts, including accounts
receivable and inventories.
We can assess the liquidity of the firm by
measuring how long it takes the firm to
convert its accounts receivable and
inventories into cash.
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Liquidity Ratios: Accounts
Receivable
Average Collection Period (Days Sales
Outstanding) measures the number of days
it takes the firm to collect its receivables.

OR
365 days Accounts Receivable Turnover
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Receivable Turnover Ratio
Accounts Receivable Turnover Ratio
measures how many times accounts
receivable are rolled over during a year.

365 days Average Collection Period
OR
When computing a ratio that uses data from both the income statement and the balance sheet,
it is better to use the average balance of the data coming from the balance sheet if available.
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Payable
Average Payment Period measures the number of
days a company takes to pay off credit purchases.
Accounts Payable
Average Payment Period = ---------------------------------------------
(Total Annual Credit Purchases 365)
Average Daily Purchases
= 365 Accounts Payable Turnover

OR
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Payable

Annual Credit Purchases
Accounts Payable Turnover = ---------------------------------------
Accounts Payable
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Liquidity Ratios:
Inventory Turnover Ratio
Inventory turnover ratio measures how
many times the company turns over its
inventory during the year. Shorter inventory
cycles lead to greater liquidity since the items
in inventory are converted to cash more
quickly.
Note: Some books use Sales instead of Cost of Goods Sold.
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Liquidity Ratios:
Days Sales in Inventory
We can express the inventory turnover ratio
in terms of the number of days the inventory
sits unsold on the firms shelves (average
age of inventory).
365
Days Sales = ------------------------------------
in Inventory Inventory Turnover Ratio

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Liquidity Ratios: Interval Ratio
The interval measure is used to measure the burn rate or how
fast you "burn" through current assets in your business.

A calculation used to measure the approximate number of days
a company could operate simply on the current assets it
currently has on hand.
costs operating daily Average
assets Current
measure Interval
An interval measure is a financial ratio used to determine the length of
time a firm can continue everyday business with using current assets in
the event of a halt of inflow.
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The Operating Cycle (OC) is the time between
ordering materials and collecting cash from
receivables.
The Cash Conversion Cycle (CCC) is the time
between when a firm pays its suppliers for inventory
(cash outflow for payables) and collecting cash from
the sale of the finished product (cash inflow from
collections).
Cash Conversion Cycle
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Cash Conversion Cycle
Both the OC and CCC may be computed as
shown below.
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Timeline for IBMs Cash
Conversion Cycle
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Can a Firm Have Too Much
Liquidity?
A high investment in liquid assets will enable
the firm to repay its current liabilities in a
timely manner.

However, an excessive investment in liquid
assets can prove to be costly as liquid assets
(such as cash) generate minimal return.
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Financial Ratios

Capital Structure or
Debt Management
Ratios

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Capital Structure/Debt
Management Ratios
Capital structure ratios address the question:
How has the firm financed the purchase of
its assets?
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Management Ratios
Debt ratio (or Debt-to-Asset Ratio) measures
the proportion of the firms assets that are
financed by borrowing or debt financing.

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Management Ratios
The debt-to-equity (D/E) ratio is also used in
financial analysis. It indicates to what extent
owners equity can cushion creditors claims
in the event of liquidation.

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Management Ratios
The debt-to-asset (D/A) and debt-to-equity
(D/E) ratios are simply transformations of
each other:
D/E = D/A (1 D/A)
and
D/A = D/E (1 + D/E)
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Management Ratios
The equity multiple (EM) measures how many
pesos of assets a firm supports with each peso of
capital.
If a firm is totally financed by equity, the equity
multiplier will equal 1.00, while the larger the
number, the more highly leveraged is the firm.
EM = Total Assets or 1 + Total Debt
Total Equity Total Equity
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Management Ratios
Times Interest Earned Ratio measures the
ability of the firm to service its debt or repay
the interest on debt.

We use EBIT or operating income as interest
expense is paid before a firm pays its taxes.
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Management Ratios
The EBITDA Coverage Ratio is more complete
than the TIE ratio because it recognizes that
depreciation and amortization are not cash
charges and thus are available to service debt
and that lease payments and principal
payments on debt are fixed charges.
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Management Ratios

EBITDA + Lease payments
EBITDA =
Coverage Interest + Principal Payments
+ Lease Payments
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Management Ratios
The Cash Coverage Ratio is useful for
determining the amount available to pay for
interest. The ratio should be substantially
greater than 1:1.

Cash Coverage Ratio = EBITDA
Interest Expense
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Financial Ratios

Asset Management
Efficiency Ratios

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Asset Management Efficiency
Ratios
Asset management efficiency ratios
measure a firms effectiveness in utilizing its
assets to generate sales.
They are commonly referred to as turnover
ratios as they reflect the number of times a
particular asset account balance turns over
during a year.
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Ratios
Total Asset Turnover Ratio represents the
amount of sales generated per peso invested
in firms assets.
Sales
Total Asset Turnover = -------------------
Total Assets

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Ratios
Fixed asset turnover ratio measures firms
efficiency in utilizing its fixed assets (such as
property, plant and equipment).
Sales
Fixed Asset = -------------------------------------
Turnover Net Plant & Equipment

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Ratios
We could similarly compute the turnover ratio for
other assets.

We had earlier computed the receivables
turnover and inventory turnover, which measured
firm effectiveness in managing its investments in
accounts receivables and inventories.
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Financial Ratios

Profitability Ratios

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Profitability ratios address a very fundamental
question:
Has the firm earned adequate returns on its
investments?
We answer this question by analyzing the firms
profit margin, which predicts the ability of the
firm to control its expenses, and the firms rate of
return on investments.
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Profitability Ratios (cont.)
Two fundamental determinants of firms profitability
and returns on investments are:
Cost Control
Is the firm controlling costs and earning reasonable profit
margin?
Efficiency of asset utilization
Is the firm efficiently utilizing the assets to generate
sales?
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Gross profit margin shows how well the firms
management controls its expenses to generate
profits.

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Operating Profit Margin measures how much profit
is generated from each peso of sales after
accounting for both costs of goods sold and
operating expenses. It thus also indicates how well
the firm is managing its income statement.
Operating Net Operating Income or EBIT
Profit = ----------------------------------------------------
Margin Sales

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Net Profit Margin measures how much income is
generated from each peso of sales after
adjusting for all expenses (including income
taxes).

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Return on Assets ratio is a measure of net profit
per peso of asset.
Net Income
Return on Assets = -----------------------
Total Assets

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Basic Earning Power (BEP) is useful for
comparing firms in different tax situations and
with different degrees of financial leverage.
Also called Operating Return on Assets (OROA)

EBIT
Basic Earning Power = ---------------------------
Total Assets
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Profitability Ratios (cont.)
Decomposing the OROA ratio: We can use the
following equation to decompose the OROA ratio
that allows us to analyze the firms ability to control
costs and utilize its investments in assets efficiently.

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Return on Common Equity ratio measures the
accounting return on the common stockholders
investment.

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Financial Ratios

Market Value Ratios

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Market Value Ratios
Market value ratios address the question, how
are the firms shares valued in the stock
market?
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Market Value Ratios (cont.)
Price-Earnings (PE) Ratio indicates how much
investors are currently willing to pay for every
peso of reported earnings.

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Market Value Ratios
Market-to-Book Ratio measures the relationship
between the market value and the accumulated
investment in the firms equity.

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Market Value Ratios
Book Value per Share calculates the per share
value of a company based on its equity available
to common shareholders

Total equity Book value of preferred stock
----
Total number of common shares outstanding
Book Value per Common Share =
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Market Value Ratios
The dividend yield shows how much a
company pays out in dividends each year
relative to its share price.
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Statements

The DuPont Model

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DuPont System of Analysis
The DuPont system of analysis is used to dissect
the firms financial statements to assess its
financial condition.
The system uses three financial ratios to express
the ROA and ROE: Profit Margin Ratio, Asset
Turnover Ratio, and Equity Multiplier.

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Using the DuPont Method for
Decomposing the ROE ratio
DuPont method analyzes the firms ROE by decomposing it
into three parts: profitability, efficiency and an equity
multiplier.

ROE = Profitability Efficiency Equity Multiplier

Equity multiplier captures the effect of the firms use of debt
financing on its return on equity. The equity multiplier
increases in value as the firm uses more debt.

Equity multiplier = Total Assets Total Equity
or = 1 (1 D/A)
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The DuPont System
) (TA/Equity (Sales/TA) (NI/Sales) ROE
multiplier
Equity

turnover
assets Total

margin
Profit
ROE

Focuses on expense control, asset utilization,
and debt utilization.
ROE = Profitability Efficiency Equity Multiplier
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Using the
DuPont
Method for
Decomposing
the ROE ratio
(cont.)
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Other ratios
Earnings per share (EPS)
Net Working Capital to Total Assets
Net Working Capital Turnover
Capital Intensity Ratio
Dividend Payout Ratio

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The Limitations of Ratio Analysis
1. Picking an industry benchmark can sometimes be
difficult.
2. Published peer-group or industry averages are not
always representative of the firm being analyzed.
3. An industry average is not necessarily a desirable
target or norm.
4. Accounting practices differ widely among firms.

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The Limitations of Ratio Analysis
4. Many firms experience seasonal changes in their
operations.
5. Financial ratios offer only clues. We need to analyze
the numbers in order to fully understand the ratios.
6. The results of financial analysis are dependent on the
quality of the financial statements.
8. Window dressing techniques can make statements
and ratios look better.

Analyze Financial Statements with Ratios & Trends

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