TOPIC 2

Financial
Statements and
Analysis

1
 Learning Goals
1. Understand who uses financial ratios, and how.
2. Use ratios to analyze a firm’s liquidity and activity.
3. Discuss the relationship between debt and financial
leverage and the ratios used to analyze a firm’s debt.
4. Use ratios to analyze a firm’s profitability and market
value.
5. Use a summary of financial ratios and the DuPont
system of analysis to perform a complete ratio
analysis.
6. Understand limitations of financial ratio analysis

2
Four Key Financial Statements
 Income Statement
 Balance Sheet
 Statement of Retained Earnings
 Statement of Cash Flows

3
 Income Statement
 The income statement provides a financial
summary of a company’s operating
performance during a specified period.
 Although they are prepared annually for
reporting purposes, they are generally
computed monthly by management and
quarterly for tax purposes.

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Table 2.1 Bartlett Company Income Statements ($000)

5
 SALES Income Statement
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses (marketing,administrative,lease)

OPERATING INCOME (EBIT)

- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
NET INCOME (Earnings distributable to
common stockholders) 6
 SALES Income Statement
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
NET INCOME (Earnings distributable to
common stockholders) 7
 SALES Income Statement
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
NET INCOME (Earnings distributable to
common stockholders) 8
 Balance Sheet
 The balance sheet presents a summary of a
firm’s financial position at a given point in time.
 Assets indicate what the firm owns, equity
represents the owners’ investment, and
liabilities indicate what the firm has borrowed.

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Table 2.2 Bartlett Company Balance Sheets ($000)

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11
 Balance Sheet
Outstanding
Debt
Total Assets = +
Shareholders’
Equity

12
 Balance Sheet
Assets Liabilities (Debt) & Equity
Current Assets Current Liabilities
Cash Accounts Payable
Marketable Securities Accrued Expenses
Accounts Receivable Short-term notes
Inventories Long-Term Liabilities
Prepaid Expenses Long-term loans
Bonds
Fixed Assets
Mortgages
Machinery & Equipment
Equity
Buildings and Land
Preferred Stock
Other Assets Common Stock (Par
Investments & patents value)
Goodwill, Brand name Paid in Capital
Retained Earnings 13
 Assets
 Current Assets: assets that are relatively liquid, and
are expected to be converted to cash within a year.
 Cash, marketable securities, accounts receivable,
inventories, prepaid expenses.
 Fixed Assets: machinery and equipment, buildings,
and land.
Net book value (NBV) = Cost – Accumulated Depreciation
 Other Assets: any asset that is not a current asset or
fixed asset.
 Intangible assets, such as purchased goodwill, patents
and copyrights.
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 Financing
 Debt Capital: financing provided by a
creditor.
 Short-term debt:borrowed money that
must be repaid within the next 12 months.
 Accounts payable, other payables such as
interest or taxes payable, accrued expenses,
short-term notes.
 Long-term debt: loans from banks or other
sources that lend money for longer than 12
months, corporate bonds issued.
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 Financing
 Equity Capital: shareholders’ investment
in the firm.
 Preferred Stockholders: receive fixed
dividends, and have higher priority than
common stockholders in event of
liquidation of the firm.
 Common Stockholders: residual owners of
a business. They receive whatever is left
after creditors and preferred stockholders
are paid.
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Statement of Retained Earnings
 The statement of retained earnings reconciles
the net income earned and dividends paid
during the year, with the change in retained
earnings (retained earnings in current year
minus retained earnings in previous year).

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 Table 2.3 Bartlett Company Statement of Retained
Earnings ($000) for the Year Ended December 31, 2009

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 Statement of Cash Flows
 The statement of cash flows provides a
summary of the cash flows over the period of
concern, typically the year just ended.
 This statement not only provides insight into a
company’s investment, financing and
operating activities, but also ties together the
income statement and previous and current
balance sheets.

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Table 2.4 Bartlett Company Statement of Cash Flows
($000) for the Year Ended December 31, 2009

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 Using Financial Ratios:
Interested Parties
 Ratio analysis involves methods of calculating
and interpreting financial ratios to assess a
firm’s financial condition and performance.
Tools that help us determine the financial
health of a company.
 It is of interest to shareholders, creditors, and
the firm’s own management.

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 Using Financial Ratios:
Types of Ratio Comparison
 We can compare a company’s financial
ratios with its ratios in previous years (trend
or time-series analysis).
 We can compare a company’s financial
ratios with those of different firms (its
competitors or industry average) at the same
point in time (cross-sectional analysis).
 Combined analysis simply uses a combination
of both time series analysis and cross-sectional
analysis.
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 Industry comparative analysis: a specific type of
cross-sectional analysis used to compare one firm’s
financial performance to the industry’s average
performance. Industry average ratios are published by
organizations such as Dun & Bradstreet, Robert Morris
Association and S&P.
 Benchmarking: a type of cross-sectional analysis in
which a firm’s ratio values are compared with those of
a key competitor or group of companies that it wishes
to emulate.
 Segmentation: a type of cross-sectional analysis
applicable to a firm that have two or more different
business lines.
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Table 2.5 Industry Average Ratios for Selected Lines
of Business

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Figure 2.1 Combined Analysis

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 Using Financial Ratios:
Cautions for Doing Ratio Analysis
1. Ratios must be considered together; a single
ratio by itself means relatively little.
2. Financial statements that are being compared
should be dated at the same point in time.
3. Use audited financial statements when possible.
4. The financial data being compared should have
been developed in the same way.
5. Be wary of inflation distortions.
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 Financial Ratio Analysis

 Are our decisions

maximizing
shareholder
wealth?

27
We will want to answer
questions about the firm’s

 Liquidity
 Activity / Efficient use of Assets
 Leverage (financing)
 Profitability
 Market-based performance

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 5 Categories of Financial
Ratios
 Liquidity, Activity and Leverage ratios
primarily measure risks (both operating
and financing risks)
 Profitability ratios measure return
 Market ratios capture both risks and
return.

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 Example:
CyberDragon Corporation

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 CyberDragon’s Balance
Sheet ($000)
Assets: Liabilities & Equity:
Cash $2,540 Accounts payable 9,721
Marketable securities 1,800 Notes payable 8,500
Accounts receivable 18,320 Accrued taxes payable 3,200
Inventories 27,530 Other current liabilities 4,102
Total current assets 50,190 Total current liabilities 25,523
Plant and equipment 43,100 Long-term debt (bonds) 22,000
less accum deprec. 11,400 Total liabilities 47,523
Net plant & equip. 31,700 Common stock ($10 par) 13,000
Total assets 81,890 Paid in capital 10,000
Retained earnings 11,367
Total stockholders' equity 34,367
Total liabilities & equity 81,890

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 CyberDragon’s
Income Statement ($000)
Sales (all credit) $112,760
Cost of Goods Sold (85,300)
Gross Profit 27,460
Operating Expenses:
Selling (6,540)
General & Administrative (9,400)
Total Operating Expenses (15,940)
Earnings before interest and taxes (EBIT) 11,520
Interest charges:
Interest on bank notes: (850)
Interest on bonds: (2,310)
Total Interest charges (3,160)
Earnings before taxes (EBT) 8,360
Taxes (40%) (3,344)
Net Income 5,016

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 CyberDragon
Other Information ($000)

Dividends paid on common stock $2,800

Earnings retained in the firm $2,216
Number of shares of common stock issued and outstanding
1,300,000
Market price per share $20.00
Book value per share *** $26.44
Earnings per share *** $ 3.86
Dividends per share *** $ 2.15

33
 CyberDragon
Other Information ($000)
 Book Value per share = Common Stock Equity
Number of Shares
= $34,367,000 / 1,300,000
= $26.44
(Note: Total Stockholders’ Equity may include
Preferred Stock Equity. Thus, Common Stock Equity
= Total Stockholders’ Equity minus Preferred Stock
Equity)
(Note: Common Stock Equity = Total Assets minus
Total Liabilities minus Preferred Stock Equity)
34
 CyberDragon
Other Information ($000)

 Earnings per share (EPS)

= Earnings attributable to common stockholder
Number of Shares
= $5,016,000 / 1,300,000 = $3.86
 Dividends per share
= Dividends paid on common stocks
Number of Shares
= $2,800,000 / 1,300,000 = $2.15
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 1. Liquidity Ratios
 Do we have enough liquid assets
to meet approaching short-term
obligations?

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What is CyberDragon’s Current
Ratio?
current assets
current liabilities
50,190
25,523 = 1.97
If the average current ratio for the
industry is 2.4, is this good or not?
37
What is the firm’s Acid Test
Ratio?
current assets - inventories
current liabilities
50,190 - 27,530 = .89
25,523
Suppose the industry average is .92.
What does this tell us?
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 Generally, it is satisfactory if current ratio is above
one and acid test ratio is slightly above one.
 It is important that current and acid test ratios kept to
an appropriate level, given the nature of the firm’s
business activities. A retailer, where debtors are few
and inventory turnover is rapid, should be safer on a
low current ratio than a manufacturer whose
customers take long credit terms and where there is
a lengthy production process.
 A large and well known company can by its
reputation and market power easily access to
overdraft facility and more favourable terms of credit,
could again maintain a low liquidity ratio (easy to
raise short term financing to meet obligations).
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 Consequences of too low liquidity ratios are:
1) late payments to trade creditors, resulting
loss of cash discounts for prompt payment
and creditors withhold further supplies
2) essential maintenance and replacement of
fixed assets are frequently postponed,
resulting in rising operating expenses
3) new investment projects are delayed,
which may reduce future growth rate of the
firm

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 If the current ratio and acid test ratio are too
high, anxiety over cash flows are removed, but
equally undesirable consequences are:
1) idle cash is tied up unproductively, without
investing in potential profitable projects, which
could affect future growth of the firm
2) unnecessarily large inventories, resulting in
high storage and other carrying costs, and
potential loss in market value of inventories that
become obsolete
3) a valuable discipline on credit control will
be lost, resulting in unwise amount and
length of credit being advanced to customers
(potential for bad debts increase)
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2. Operating Efficiency Ratios
 Measure how efficiently the
firm’s assets generate operating
profits.

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What is the firm’s Operating Income
Return on Investment (OIROI)?

operating income
total assets
11,520 = 14.07%
81,890
•Slightly below the industry average of 15%.
•The OIROI reflects product pricing and the
firm’s ability to keep costs down.
43
What is their Operating
Profit Margin?
operating income
sales

11,520 = 10.22%
112,760
•This is below the industry average of 12%.
44
 What is their Total Asset
Turnover?
sales
total assets
112,760 = 1.38 times
81,890
The industry average is 1.82 times.
The firm needs to figure out how to squeeze more
sales dollars out of its assets.
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 Note: OIROI is actually operating profit margin
times total asset turnover
 A reduction in operating profit margin could still
lead to higher OIROI. A firm may want to reduce
selling price in order to achieve higher sales volume,
especially if that business line is in nature very price
competitive. When sales volume increases, given no
new investment in fixed assets, total asset turnover
ratio will increase. If the effects of sales volume
increase is larger than selling price decrease (elastic
demand), OIROI could increase.
 If demand is inelastic, the increase in total asset
turnover will be lower than the decrease in operating
profit margin, hence OIROI could decrease.
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 What is the firm’s Accounts
Receivable Turnover?
credit sales
accounts receivable
112,760 = 6.16 times
18,320
CyberDragon turns their A/R over 6.16
times per year. The industry average
is 8.2 times. Is this efficient? sales
(Note: if not stated, assume credit sales = total) 47
What is the firm’s Inventory
Turnover?
cost of goods sold
inventory
85,300
27,530 = 3.10 times
CyberDragon turns their inventory
over 3.1 times per year.
The industry average is 3.9 times. Is
this efficient? 48
Low inventory turnover:
The firm may have too much inventories,
which is expensive because:
1) Inventories take up costly warehouse
space.
2) Some inventories may become
spoiled or obsolete.
3) Higher risk of stock pilferage.

49
 Overtrading: a situation where a firm experiences
liquidity problem due to its trading beyond capital
resources available to it. Usually has low liquidity
ratios (current ratio and acid test ratio) and abnormally
high turnover ratios (A/R turnover ratio, inventory
turnover ratio and total asset turnover ratio).
 Overcapitalization: a situation where a firm has
excess capital, under-utilized probably due to lack of
attractive investment opportunities. Usually has high
liquidity ratios (current ratio and acid test ratio) and
abnormally low turnover ratios (A/R turnover ratio,
inventory turnover ratio and total asset turnover ratio).

50
What is the firm’s Average
Collection Period?
accounts receivable  365
credit sales
18,320 365
112,760 = 59.3 days
If the industry average is 47 days, what
does this tell us?
51
What is the firm’s Average
Inventory Holding Period?
inventory  365
COGS
27,530 365
85,300 = 117.80 days
If the industry average is 93.59 days,
what does this tell us?
52
 Activity Ratios:
Working Capital Management
 Average Collection Period (also known as Receivables
Conversion Period)
= Accounts Receivable  365
Credit Sales
 Average Inventory Holding Period (also known as Inventory
Conversion Period)
= Inventory  365
COGS
 Average Creditors Payment Period (also known as Payables
Conversion Period)
= Accounts Payable  365
Purchases

53
 Activity Ratios:
Working Capital Management
 Cash conversion cycle (CCC) is the time duration in which
a firm is able to convert its resources into cash. It is
actually the total time period required to first convert resources
into inventories, then inventories into finished goods, then
goods into sales, and then sales into cash. In other words, it
can be defined as the time taken to collect cash from sales
after making payments for resources acquired by the firm.
Here the resources may include raw material, labour, power
and fuel, etc.
 CCC = Average Collection Period
add Average Inventory Holding Period
minus Average Payment Period
54
 Generally, the lower the CCC the better. It
indicates that the firm can convert resources
into cash faster and the firm manages its
working capital more efficiently.
 However, one must be careful to investigate
the reason behind the decrease in CCC. If the
decrease in CCC is because of increasing
average payment period to creditors, it is not a
good signal. Trade creditors may not want to
supply goods to the company in the future.

55
What is the firm’s Fixed
Asset Turnover?
sales
fixed assets
112,760
31,700 = 3.56 times
If the industry average is 4.6 times, what
does this tell us about CyberDragon?
56
 3. Leverage Ratios
(financing decisions)
 Measure the impact of using debt
capital to finance assets.
 Firms use debt to lever up (increase)
returns on common equity.

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 Firms with more real assets (land and
buildings) are able to finance more of their
assets with debt.
 Amount of debt a firm uses depend on
1) income record
2) amount of assets available as collateral

58
How does Leverage work?
 Suppose we have an all equity-
financed firm worth $100,000. Its
earnings this year totalling $15,000.

15,000
ROE = = 15%
100,000

59
How does Leverage work?
 Suppose the same $100,000 firm is
financed with half equity, and half 8%
debt (bonds). Earnings are still $15,000.

ROE = 15,000 - 4,000 = 22%

50,000

60
What is CyberDragon’s Debt
Ratio?
total debt
total assets
47,523 = 58%
81,890
If the industry average is 47%, what
does this tell us?
Can leverage make the firm more profitable?
Can leverage make the firm riskier? 61
Gearing Ratio (Debt-to-Equity
Ratio)
Long-term liabilities
Common Stock Equity
The higher the gearing level, the higher the financial
risk.
High leverage or debt-to-equity ratio is acceptable if
the firm can still cover its interest payments.

62
What is the firm’s Times
Interest Earned Ratio?
operating income
interest expense
11,520
3,160 = 3.65 times
The industry average is 6.7 times. This
is further evidence that the firm uses
more debt financing than average.
63
 Times interest earned ratio (also known as interest
coverage ratio) reflects the ability of operating income
(EBIT) to cover interest expenses.
 Although generally high leverage (financed by more
debt) will increase financial risk, financing with debt
could help to reduce the firm’s cost of capital because
cost of debt capital is usually lower than cost of raising
funds through new issuance of equity shares. Cost of
debt capital is lower due to tax deductibility of interest
payments and low risk premium.
 Thus, a firm should be financed by more debt capital
until the point where it can still comfortably cover its
interest payments. Therefore, usually analyse these
two ratios together.

64
 4. Profitability Ratios

How well are the firm’s managers maximizing

shareholders’ wealth? Are owners (ordinary
shareholders) and other investors receiving an
adequate return on their investment?
65
 What is CyberDragon’s
Return on Equity (ROE)?
net income
common equity
5,016
34,367 = 14.6%
The industry average is 17.54%.
Is this what we would expect, given
the firm’s leverage? 66
 Profit Margins and Rates of
Return
 Gross Profit Margin
= (Sales – COGS) / Sales  100%
 Operating Profit Margin
= Operating Income / Sales  100%
 Net Profit Margin
= Net Income / Sales  100%
 Return on Asset (ROA)
= Net Income / Total Assets  100%
Note: Net Income also known as Profit attributable to
common or ordinary stockholders
67
 Other things being equal, the higher the gross profit
margins the better. However, it must be noted that a firm,
within its limit, can manipulate its profit margins by setting
its pricing policy.
 A reduction in operating profit margins should be taken
seriously as it could be due to following reasons: (a) rising
COGS which are not passed on to customers; (b) careless
stock control which leads to pilferage or obsolescence; (c)
reduction in selling price due to competition in the product
market; (d) rising marketing or administrative expenses.
 Common-Size Income Statements: Calculate each
component of expenses as a percentage of sales, and
compare it to previous years or industry average. This
could help to isolate the type of costs that the firm needs to
control.

68
 Table 2.7
Bartlett Company Common-Size Income Statements

69
 5. Market Ratios
 Price/Earnings (P/E) ratio
= Market price per share
Earnings per share
P/E ratio measures the amount that investors are
willing to pay for each dollar of the firm’s earnings.
The higher the P/E ratio, the higher the degree of
confidence that the investors have in the firm’s future
prospects.
However, P/E ratio that is too high could signal that
ordinary shares of the company are overvalued in the
stock market.

70
 5. Market Ratios
 Market/Book (M/B) ratio
= Market price per share
Book value per share
M/B ratio relates the market value of the
firm’s shares to their strict accounting book
value (historical value). Usually, book value is
viewed as the minimum value of a firm.
Therefore, firms that perform well (earn
higher return relative to their risks) tend to
have higher M/B ratio. If M/B is less than one,
it is usually a buy signal for investors.
71
 5. Market Ratios
 Dividend yield
= Dividends per share  100%
Market price per share
 Earnings yield
= Earnings per share  100%
Market price per share
Both these ratios measure rate of return to
shareholders, based on current market value of
shares they owned. Easier for shareholders to
compare with rate of returns from other
alternative investments.

72
 The DuPont Model

Brings together:

 Profitability (net profit margin)

 Efficiency (total asset turnover)
 Leverage (earnings multiplier or known
as financial leverage multiplier)

73
 The DuPont Model
 The DuPont system of analysis is used to dissect the
firm’s financial statements and to assess its financial
condition.
 It merges the income statement and balance sheet into two
summary measures of profitability.
 The Modified DuPont Formula relates the firm’s ROA to
its ROE using the financial leverage multiplier (FLM) ,
which is the ratio of total assets to common stock equity
 Use of the FLM to convert ROA into ROE reflects the
impact of financial leverage on the ordinary
shareholder’s return.

74
 The DuPont Model
ROE
= Net Profit  Total Asset  Financial Leverage
Margin Turnover Multiplier
= Net Income  Sales  Total Asset
Sales Total Asset Common Equity

75
 The DuPont Model
Net Profit Total Asset Debt
ROE = Margin x Turnover / (1- Ratio )
Net Income Sales Total Debt
= Sales x Total Assets /(1- Total Assets )

= 5,016
112,760 x 112,760
81,890 / (1 - 47,523
81,890 )
= 14.6%
76
 The DuPont Model
 1 ÷ (1 – Debt Ratio) is sometimes called the
Financial Leverage Multiplier (FLM) or Equity
Multiplier, which is calculated as Total Asset divided
by Common Equity.
 Can ROE improve when both net profit margin and
total asset turnover deteriorate? Yes, if Equity
Multiplier rises, where the firm reduces the use of
equity or increases the use of debt in its capital
structure significantly. By using more debt than
equity, the firm enjoys cheaper cost of financing.
77
 SUMMARY
Ratios CyberDragon Industry

Liquidity Current Ratio 1.97 2.4

Quick Ratio 0.89 0.92

Ave Colln Pd 59.3 d 47 d

Operating OIROI 14.07% 15%

Efficiency Profit Margin 10.22% 12%
Total Assets T/O 1.38X 1.82X
AC Rec T/O 6.16X 8.2X

Inventory T/O 3.1X 3.9X

Fixed Assets T/O 3.56X 4.6X

78
 SUMMARY
Ratios CyberDragon Industry

Leverage Debt Ratio 58% 47%

Times Interest 3.65X 6.7X

Earned

Profitability ROE 14.6% 17.54%

DuPont Model

79
Limitations of Financial Ratio
Analysis
 Accounting policies/ treatments differ among firms.
This may distort cross-sectional ratio analysis between
two similar firms. Examples: depreciation method
(straight line, reducing balance, unit of production),
stock valuation method (FIFO, LIFO, AVCO), treatment
of purchased goodwill, treatment of development cost
etc. Affect all ratios that use ‘profit’ figure in the
calculation. Furthermore, some firms may have chosen
to revalue some of their fixed assets whereas other
firms have not do so. This may affect ratios that use
balance sheet items like ‘reserves’ and ‘total assets’ in
the formula.
80
 Ratios comparison may be distorted by inflation.
Most countries financial reporting standards
mandated the use of historical cost accounting. Book
values of inventories and depreciable assets may
differ greatly from their true replacement values.
Inflation tends to cause older firms (with older
assets) to appear more efficient and more profitable
than younger firms (with newer assets). Due to HCA,
older asset values are more ‘understated’ compared
to its current replacement cost and therefore
‘overstate’ ratios such as total asset turnover
and OIROI. Besides distorting cross-sectional ratio
analysis, inflation also distorts time-series ratio
analysis of a firm’s ratios over time.

81
 Many firms experience seasonality in their operations.
Balance sheet items and their corresponding ratios vary
with time of the year when the statements are prepared.
Balance Sheet shows the company’s financial position at
one point of time (last day of accounting period), whereas
P&L shows the company’s financial performance
throughout the accounting period. Using closing figures of
balance sheet items in the ratios computation may not be
accurate. For example, toy manufacturer that has
financial year ended 31st December might have much
lower inventory than toy manufacturer that has financial
year ended 30th June. Cross-sectional analysis between
competitors in the same industry that have different
financial year-ends might not be accurate if the industry
has seasonality in sales.

82
 Difficult to identify the industry category to which
a firm should belong to, especially if the firm
engages in multiple lines of businesses. For such
firm, it is difficult to find a competitor firm that
involves in similar multiple lines of businesses for
cross-sectional analysis. Segmentation technique is
used. Can use segmentation analysis.
 Comparing to industry average means
benchmarking to the ‘average’ firm and not the ‘stars’
and leaders of the industry.
 Window dressing and off-balance sheet financing
can be done near the year-end to manipulate the
closing balance sheet figures and hence distort
results of corresponding ratios.

83
 Non-financial information must be considered in
order to have a complete and more accurate picture
of the performance and prospects of a company.
Examples: (1) general industry and economic data –
Is the country’s economy in recession or booming?
Which stage of life cycle is the product/ industry in?
(2) Recent developments of the company’s markets
at home and abroad, (3) any recent acquisition or
disposal of a subsidiary? (4) Inherent goodwill of the
company due to advancement in technology, skilful
workforce, good atmosphere at the place of work,
highly calibre and experienced management, good
reputations with suppliers and customers and so on.

84