The Analysis of Financial

Statements

• The Use Of Financial Ratios

• Analyzing Liquidity
• Analyzing Activity
• Analyzing Debt
• Analyzing Profitability
• A Complete Ratio Analysis
1
 The Analysis of Financial
Statements
• THE USE OF FINANCIAL RATIOS
– Financial Ratio are used as a relative
measure that facilitates the evaluation of
efficiency or condition of a particular
aspect of a firm's operations and status
– Ratio Analysis involves methods of
calculating and interpreting financial
ratios in order to assess a firm's
performance and status 2
 Example

(1) (2) (1)/(2)

Year End Current Assets/Current Liab. Current Ratio
2017 $550,000 /$500,000 1.10
2018 $550,000 /$600,000 .92

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 Interested Parties

Three sets of parties are

interested in ratio analysis:
• Shareholders
• Creditors
• Management
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 Types of Ratio Comparisons

There are two types of ratio

comparisons that can be made:
• Cross-Sectional Analysis
• Time-Series Analysis
– Combined Analysis uses both types of
analysis to assess a firm's trends versus
its competitors or the industry
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 Words of Caution
Regarding Ratio Analysis
• A single ratio rarely tells enough to make a
sound judgment.
• Financial statements used in ratio analysis must
be from similar points in time.
• Audited financial statements are more reliable
than unaudited statements.
• The financial data used to compute ratios must
be developed in the same manner.
• Inflation can distort comparisons.
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 Groups of Financial Ratios

• Liquidity
• Activity
• Debt
• Profitability
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 Analyzing Liquidity

• Liquidity refers to the solvency of the

firm's overall financial position, i.e. a
"liquid firm" is one that can easily
meet its short-term obligations as they
come due.
• A second meaning includes the
concept of converting an asset into
cash with little or no loss in value.
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Copyright 1994, HarperCollins Publishers
 Three Important Liquidity Measures

Net Working Capital (NWC)

NWC = Current Assets - Current Liabilities

Current Ratio (CR)

Current Assets
CR =
Current Liabilities

Quick (Acid-Test) Ratio (QR)

Current Assets - Inventory
QR =
Current Liabilities
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Copyright 1994, HarperCollins Publishers
 Three Important Liquidity Measures

Net Working Capital (NWC):

A measure of both a company's efficiency and
its short-term financial health.

Current Ratio (CR):

A liquidity ratio that measures a company's
ability to pay short-term obligations.

Quick (Acid-Test) Ratio (QR):

A more conservative approach to current ratio. 10
 Analyzing Activity

• Activity is a more sophisticated

analysis of a firm's liquidity,
evaluating the speed with which
certain accounts are converted
into sales or cash; also
measures a firm's efficiency
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 Five Important Activity Measures
Cost of Goods Sold
IT =
Inventory Turnover (IT) Inventory

Accounts Receivable
Average Collection Period (ACP) in days ACP =
Annual Sales/360

Accounts Payable
Average Payment Period (APP) in days APP=
Annual Purchases/360
Sales
Fixed Asset Turnover (FAT) FAT =
Net Fixed Assets

Total Asset Turnover (TAT) Sales

TAT =
Total Assets 12
 Five Important Activity Measures
Inventory Turnover (IT):
A ratio showing how many times a company's inventory is sold and replaced over a
period.

Average Collection Period (ACP) in days:

The approximate amount of time in days that it takes for a business to
receive payments owed, in terms of receivables, from its customers and
clients.
Average Payment Period (APP) in days:
The measure shows investors how many times per period in days the company
pays its average payable amount.

Fixed Asset Turnover (FAT):

The amount of sales generated for every dollar's worth of fixed assets only. It is
calculated by dividing sales in dollars by assets in dollars.

Total Asset Turnover (TAT):

The amount of sales generated for every dollar's worth of assets. It is calculated by
dividing sales in dollars by assets in dollars.
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 Analyzing Debt
• Debt is a true "double-edged" sword as it
allows for the generation of profits with the
use of other people's (creditors) money, but
creates claims on earnings with a higher
priority than those of the firm's owners.
• Financial Leverage is a term used to
describe the magnification of risk and return
resulting from the use of fixed-cost financing
such as debt and preferred stock.
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 Measures of Debt

• There are Two General

Types of Debt Measures
–Degree of Indebtedness
–Ability to Service Debts

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 Four Important Debt
Measures
Total Liabilities
Debt Ratio DR=
Total Assets
(DR)
Long-Term Debt
Debt-Equity Ratio DER=
Stockholders’ Equity
(DER)
Earnings Before Interest
& Taxes (EBIT)
TIE=
Times Interest Earned Interest
Ratio (TIE) Earnings Before Interest &
Taxes + Lease Payments
FPC=
Interest + Lease Payments
Fixed Payment Coverage Ratio +{(Principal Payments +
Preferred Stock Dividends)
(FPC) X [1 / (1 -T)]} 16
 Four Important Debt Measures
Debt Ratio (DR):
A ratio that indicates what proportion of debt a company has relative to its
assets. The measure gives an idea to the leverage of the company along
with the potential risks the company faces in terms of its debt-load.

Debt-Equity Ratio (DER):

A measure of a company's financial leverage calculated by dividing its total
liabilities by stockholders' equity. It indicates what proportion of equity and
debt the company is using to finance its assets.

Times Interest Earned Ratio (TIE):

It is used to measure a company's ability to meet its debt obligations.

Fixed Payment Coverage Ratio (FPC):

It is used to measure a company's ability to meet its fixed debt obligations.
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 Analyzing Profitability

– Profitability Measures the firm's ability to

operate efficiently and are of concern to
owners, creditors, and management

– A Common-Size Income Statement, which

expresses each income statement item
as a percentage of sales, allows for easy
evaluation of the firm’s profitability relative
to sales.
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 Seven Basic Profitability
Measures
Gross Profit Margin
Gross Profits
(GPM) GPM=
Sales

Operating Profit Margin OPM =

Operating Profits (EBIT)

(OPM) Sales
Net Profit After Taxes
Net Profit Margin (NPM) NPM= Sales
Net Profit After Taxes
Return on Total Assets ROA= Total Assets
(ROA) Net Profit After Taxes
ROE=
Stockholders’ Equity
Return On Equity (ROE) Earnings Available for
Common Stockholder’s
EPS =
Earnings Per Share Number of Shares of Common
Stock Outstanding
(EPS)
Market Price Per Share of
Common Stock
Price/Earnings (P/E) P/E =
Earnings Per Share
Ratio 19
 Seven Basic Profitability Measures
Gross Profit Margin (GPM):
it used to assess a firm's financial health by revealing the proportion of money left
over from revenues

Operating Profit Margin (OPM):

A ratio used to measure a company's pricing strategy and operating efficiency.
Net Profit Margin (NPM):
It measures how much out of every dollar of sales a company actually earns after
paying taxes.
Return on Total Assets (ROA):
The ratio is considered an indicator of how effectively a company is using its assets
to generate earnings before contractual obligations must be paid.
Return On Equity (ROE):
A measure of a corporation's profitability that reveals how much profit a company
generates with the money shareholders have invested.

Earnings Per Share (EPS):

The portion of a company's profit allocated to each outstanding share of common
stock.
Price/Earnings (P/E) Ratio:
A valuation ratio of a company's current share price compared to its per-
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share earnings.
 A Complete Ratio Analysis

• DuPont System of Analysis

– DuPont System of Analysis is an
integrative approach used to dissect a
firm's financial statements and assess its
financial condition
– It ties together the income statement and
balance sheet to determine two summary
measures of profitability, namely ROA and
ROE 21
 DuPont System of Analysis

• The firm's return is broken into three

components:
–A profitability measure (net profit margin)
–An efficiency measure(total asset turnover)
–A leverage measure (financial leverage
multiplier)

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 Summarizing All Ratios

• An approach that views all aspects of

the firm's activities to isolate key
areas of concern
• Comparisons are made to industry
standards (cross-sectional analysis)
• Comparisons to the firm itself over
time are also made (time-series
analysis)
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