The Analysis of
Financial Statements
Ratios are tools and their value is limited when used
alone. The more tools used, the better the analysis.
For example, you can’t use the same golf club for every
shot and expect to be a good golfer. The more you
practice with each club, however, the better able you will
be to gauge which club to use on one shot. So to, we
need to be skilled with the financial tools we use.
- Diane Morrison
- CEO, R.E.C. Inc.
(C) 2007 Prentice Hall, Inc.
5-1
Objectives of Analysis
Objectives will vary depending on the
perspective of the financial statement user
specific questions that are addressed
by the analysis
Remember--the identity of the user helps
define what information is needed
(C) 2007 Prentice Hall, Inc.
5-2
Creditors
A creditor is ultimately concerned with
the ability of an existing or
prospective borrower to make
interest and principal payments on
borrowed funds
(C) 2007 Prentice Hall, Inc.
5-3
Investors
An investor attempts to arrive at an
estimation of a company’s future
earnings stream in order to attach a
value to the securities being
considered for purchase or liquidation
(C) 2007 Prentice Hall, Inc.
5-4
Tools and Techniques
These include:
Common-size financial statements
Financial ratios
Trend analysis
Industry comparisons
Most important:
Common sense and judgment
(C) 2007 Prentice Hall, Inc.
5-5
Common-Size
Financial Statements
Express each account on the
 balance sheet as a percentage of
total assets
 income statement as a percentage
of net sales
(C) 2007 Prentice Hall, Inc.
5-6
Key Financial Ratios
Standardize financial data in terms of
mathematical relationships
expressed in the form of
Percentages
Times
Days
(C) 2007 Prentice Hall, Inc.
5-7
Key Financial Ratios





(cont.)
Liquidity (Short-term liquidity)
Activity
Leverage (Long-term solvency)
Profitability
Market
(C) 2007 Prentice Hall, Inc.
5-8
Liquidity Ratios:
Short-Term Solvency
Current Ratio
Measures ability to meet short-term
cash needs
Current assets
Current liabilities
(C) 2007 Prentice Hall, Inc.
5-9
Liquidity Ratios:
Short-Term Solvency
(cont.)
Quick or Acid-Test Ratio
Measures ability to meet short-term cash needs
more rigorously by eliminating inventory
(Cash+short-term investments + A/R)
current liabilities
Current assets - Inventory
Current liabilities
(C) 2007 Prentice Hall, Inc.
5-10
Liquidity Ratios:
Short-Term Solvency
(cont.)
Cash Flow Liquidity Ratio
Focuses on ability of the firm to
generate operating cash flows as a
source of liquidity
Cash + Marketable securities + CFO *
Current liabilities
*Cash flow from operating activities
(C) 2007 Prentice Hall, Inc.
5-11
Liquidity Ratios
Short term liquidity
Current Ratio
Quick Ratio
Cash Flow Liquidity
(C) 2007 Prentice Hall, Inc.
2007
1,13
0,48
0,76
2006
1,18
0,52
0,57
2005
1,43
0,68
1,21
2004
2,04
0,86
1,61
2003
1,65
0,40
0,92
5-12
Activity Ratios: Asset Liquidity,
Asset Management Efficiency
Accounts Receivable Turnover
Another measure of efficiency of firm’s
collection and credit policies
Credit sales, net
Average trade receivable s, net
365
receivable turnover
(C) 2007 Prentice Hall, Inc.
5-13
Activity Ratios: Asset Liquidity,
Asset Management Efficiency (cont.)
Inventory Turnover
Another measure of firm’s efficiency in
managing its inventory
Cost of goods sold
average inventorie s
365
inventory turnover
(C) 2007 Prentice Hall, Inc.
5-14
Activity Ratios: Asset Liquidity,
Asset Management Efficiency (cont.)
Payables Turnover
Another way to gain insight into a firm’s
pattern of payment to suppliers
COGS   in inventorie s
Average trade payables
365
payable turnover
(C) 2007 Prentice Hall, Inc.
5-15
Cash Conversion Cycle or
Net Trade Cycle
The normal cycle of a firm that consists of:



Buying or manufacturing inventory,
with some purchases on credit
Selling inventory, with some sales
on credit
Collecting the cash
(C) 2007 Prentice Hall, Inc.
5-16
Cash Conversion Cycle or
Net Trade Cycle (cont.)
Helps the analyst understand why cash
flow generation has improved or
deteriorated by analyzing:
Key balance sheet accounts that affect
cash flow from operating activities
 Accounts Receivable
 Inventory
 Accounts Payable
(C) 2007 Prentice Hall, Inc.
5-17
Cash Conversion Cycle or
Net Trade Cycle (cont.)
Calculated as follows:
Average collection period
Plus
Days inventory held
Minus
Days payable outstanding
Equals
Cash conversion or net trade cycle
(C) 2007 Prentice Hall, Inc.
5-18
Activity Ratios: Asset Liquidity,
Asset Management Efficiency (cont.)
Fixed Asset Turnover
Assesses effectiveness in generating sales
from investments in fixed assets
Net sales
Net property, plant, equipment
(Average)
(C) 2007 Prentice Hall, Inc.
5-19
Activity Ratios: Asset Liquidity,
Asset Management Efficiency (cont.)
Total Asset Turnover
Assesses effectiveness in generating sales
from investments in all assets
Net sales
Total assets
(Average)
(C) 2007 Prentice Hall, Inc.
5-20
Activity Ratios- Summary
Receivable Turnover
Inventory Turnover
Payable Turnover
Fixed Asset Turnover
Total Asset Turnover
Net Sales/Average Trade Receivables
COGS/Average Inventories
Purchases/Average Trade Payables
Net Sales/Average PP&E
Net Sales/Average Total Assets
Average collection period
Average days in inventory
Avergae payment period
365/receivable turnover
365/inverntory turnover
365/payable turnover
Net Trade Period
collection period +
days in inventory -
(C) 2007 Prentice Hall, Inc.
5-21
Activity Ratios- Summary
Activity Ratios
Receivable Turnover
Inventory Turnover
Payable Turnover
PPE Turnover
Asset Turnover
2007
10,62
4,84
17,75
1,13
0,71
2006
10,67
4,98
14,21
0,96
0,60
2005
11,40
6,08
13,90
0,91
0,58
2004
15,55
6,57
25,24
0,98
0,63
Collection Period
Days in inventory
Payment period
34,37
75,48
20,57
34,21
73,33
25,68
32,00
59,99
26,26
23,47
55,52
14,46
Cash cycle
89,29
81,86
65,74
64,54
(C) 2007 Prentice Hall, Inc.
5-22
Leverage Ratios:
Debt Financing and Coverage
Debt Ratio
Considers the proportion of all assets
that are financed with debt
Total liabilities
Total assets
(C) 2007 Prentice Hall, Inc.
5-23
Leverage Ratios:
Debt Financing and Coverage
(cont.)
Long-term Debt to Total Capitalization
Reveals the extent to which long-term
debt is used for the firm’s
permanent financing (both longterm debt and equity)
Long–term debt
Long-term debt + Stockholders’ equity
(C) 2007 Prentice Hall, Inc.
5-24
Leverage Ratios:
Debt Financing and Coverage
(cont.)
Debt to Equity
Measures the riskiness of the firm’s
capital structure in terms of the
relationship between the funds
supplied by creditors (debt) and
investors (equity)
Total liabilities
Stockholders’ equity
(C) 2007 Prentice Hall, Inc.
5-25
Leverage Ratios:
Debt Financing and Coverage
(cont.)
Times Interest Earned
Indicates how well operating earnings
cover fixed interest expenses
Operating profit
Interest expense
(C) 2007 Prentice Hall, Inc.
5-26
Leverage Ratios:
Debt Financing and Coverage
(cont.)
Cash Interest Coverage
Measures how many times interest
payments can be covered by cash
flow from operations before interest
and taxes
CFO + interest paid + taxes paid
Interest paid
(C) 2007 Prentice Hall, Inc.
5-27
Leverage Ratios:
Debt Financing and Coverage
(cont.)
Fixed Charge Coverage
Broader measure of how well operating
earnings cover fixed charges
Operating profit + Rent expense
Interest expense + Rent expense
*Rent expense = operating lease payments
(C) 2007 Prentice Hall, Inc.
5-28
Leverage Ratios:
Debt Financing and Coverage
(cont.)
Cash Flow Adequacy
Measures firm’s ability to cover capital
expenditures, long-term debt
payments and dividends each year
Cash flow from operating activities
Capital expenditures + debt repayments
+ dividends paid
(C) 2007 Prentice Hall, Inc.
5-29
Leverage Ratios: Debt Financing and
Coverage Summary
Solvency Ratios
Debt Ratio
LT Debt to Capital
Debt to equity
Times interest earned
Cash interest coverage
Long-term Liquidity
Debt ratio
L/T Debt to Capitalization
debt to equity
Times interest earned
(C) 2007 Prentice Hall, Inc.
Total liabilities/Total assets
Total liabilities/Total equity
Oper. Income/Interest expense
CFO + interest paid + tax paid)/Interest paid
2007
0,43
0,28
0,86
4,79
2006
0,43
0,29
0,83
3,84
2005
0,38
0,26
0,67
11,57
2004
0,29
0,19
0,43
8,63
5-30
Profitability Ratios:
Overall Efficiency and Performance
Gross Profit Margin
Measures ability to translate sales into
profit after consideration of cost of
products sold
Gross profit
Net sales
(C) 2007 Prentice Hall, Inc.
5-31
Profitability Ratios:
Overall Efficiency and Performance (cont.)
Operating Profit Margin
Measures ability to translate sales into
profit after consideration of
operating expenses
Operating profit
Net sales
(C) 2007 Prentice Hall, Inc.
5-32
Profitability Ratios:
Overall Efficiency and Performance (cont.)
Net Profit Margin
Measures ability to translate sales into
profit after consideration of all
expenses and revenues, including
interest, taxes and nonoperating
items
Net earnings
Net sales
(C) 2007 Prentice Hall, Inc.
5-33
Profitability Ratios:
Overall Efficiency and Performance (cont.)
Cash Flow Margin
Measures ability to translate sales into
cash (with which to pay bills!)
Cash flow from operating activities
Net sales
(C) 2007 Prentice Hall, Inc.
5-34
Profitability Ratios:
Overall Efficiency and Performance (cont.)
Return on Equity (ROE)
Measures rate of return on stockholders’
investment
Net earnings
Stockholders’ equity
(Average)
(C) 2007 Prentice Hall, Inc.
5-35
Profitability Ratios:
Overall Efficiency and Performance (cont.)
Return on Total Assets (ROA) or Return
on Investment (ROI)
Measures overall efficiency of firm in
managing investment in assets and
generating profits
(C) 2007 Prentice Hall, Inc.
Net earnings
Total assets
(Average)
5-36
Relating the Ratios
—The Du Pont System
Is helpful to complete the evaluation of a
firm by considering the interrelationship
among the individual ratios
The Du Pont System helps the analyst see
how the firm’s decisions and activities over
the course of an accounting period interact
to produce an overall return to the firm’s
shareholders, the return on equity
(C) 2007 Prentice Hall, Inc.
5-37
Relating the Ratios
—The Du Pont System
(cont.)
The summary ratios used are the following:
(1)
Net profit margin
(2)
Total asset turnover
Net income
Net sales
Net sales
X
Total assets
(3)
Return on investment
(4)
Financial leverage
Net income
Total assets
Total assets
(C) 2007 Prentice Hall, Inc.
(3)
Return on investment
Net income
=
Total assets
(5)
Return on equity
Net income
X Stockholder equity = Stockholder equity
5-38
Profitability Ratios:
Overall Efficiency and Performance (cont.)
Cash Return on Assets


Measures firm’s ability to generate cash
from the utilization of its assets
Useful comparison to ROA
Cash flow from operating activities
Total assets
(Average)
(C) 2007 Prentice Hall, Inc.
5-39
Profitability Ratios-Summary
Profitability Ratios
Gross Margin
Operating Margin
Net Profit Margin
Return on Assets
Return on Equity
Cash Return on Assets
(C) 2007 Prentice Hall, Inc.
Gross profit/Sales revenue
Operating Income/Sales revenue
Net Income/Sales Revenue
Net income/Average total assets
Net income/Average total equity
CFO/Average total assets
5-40
Profitability Ratios-Summary
Profitability
Gross margin %
Operating Margin
Net Profit Margin
ROA =
ROE =
Cash Return on Assets
(C) 2007 Prentice Hall, Inc.
2007
27,36%
15,18%
7,91%
5,60%
10,99%
14,15%
2006
27,14%
10,99%
5,45%
3,25%
5,99%
7,63%
2005
27,80%
15,78%
9,98%
5,76%
9,37%
16,58%
2004
30,83%
18,61%
12,61%
7,94%
11,96%
5-41
Market Ratios
Four market ratios of particular interest
to the investor are
1.
2.
3.
4.
Earnings per common share
Price-to-earnings
Dividend payout
Dividend yield
(C) 2007 Prentice Hall, Inc.
5-42
Market Ratios
(cont.)
Earnings per Common Share
Provides the investor with a common
denominator to gauge investment
returns
Net earnings
Average shares outstanding
(C) 2007 Prentice Hall, Inc.
5-43
Market Ratios
(cont.)
Price-to-Earnings
Relates earnings per common share to the
market price at which the stock trades,
expressing the “multiple” that the stock
market places on a firm’s earnings
Market price of common stock
Earnings per share
(C) 2007 Prentice Hall, Inc.
5-44
Market Ratios
(cont.)
Dividend Payout
Determined by the formula cash
dividends per share divided by
earnings per share
Dividends per share
Earnings per share
(C) 2007 Prentice Hall, Inc.
5-45
Market Ratios
(cont.)
Dividend Yield
Shows the relationship between cash
dividends and market price
Dividends per share
Market price of common stock
(C) 2007 Prentice Hall, Inc.
5-46
Market Ratios
Market Ratios
Price earnings ratio
price to book value
(C) 2007 Prentice Hall, Inc.
2007
12,73
1,35
2006
46,67
1,34
2005
16,93
1,49
2004
11,16
1,28
5-47
Financial Analysis
 Credit Analysis
 Equity Analysis
Creditors



What is the borrowing cause?
What is the firm’s capital structure?
What will be the source of debt
repayment?
(C) 2007 Prentice Hall, Inc.
5-49
Credit Rating
 Business Risk
 Industry characteristics
 Company position
 Management
 Financial Risk






Financial characteristics
Financial Policy
Profitability
Capital Structure
Cash Flow Protection
Financial flexibility
(C) 2007 Prentice Hall, Inc.
5-50
Standard & Poor’s rating
method
1.
2.
3.
4.
5.
6.
7.
8.
EBIT interest coverage
EBITDA interest coverage
Funds from operations/Total debt %
Free operating cash flow/Total debt %
Return on capital %
Operating income/Sales
Long-term debt/Capital
Total debt/Capital
(C) 2007 Prentice Hall, Inc.
5-51
Standard and Poors
Corporate Ratings
(C) 2007 Prentice Hall, Inc.
5-52
Financial distress
The deterioration in a company’s
financial condition such that its
ability to repay debt is impaired
(C) 2007 Prentice Hall, Inc.
5-53
Prediction of financial distress
Univariate models

Beaver (1966) relied on






Cash flow to total debt
Net income to total assets
Total debt to total assets
Working capital to total assets
Current ratio
No-credit (defensive) interval
(C) 2007 Prentice Hall, Inc.
5-54
Prediction of financial distress
Multivariate models

Altman Z-score





(Current assets – current liabilities)/total assets
(weight-1,2)
Retained earnings/Total assets (weight-1,4)
EBIT/Total assets (weight-3,3)
Preferred and common stock market value/Book
value of liabilities (weight-0,6)
Sales/Total assets (weight-1,0)
(C) 2007 Prentice Hall, Inc.
5-55
Altman Z-score



Z> 2,99  Not in financial distress
Z< 1,81  In financial stress
2,99>Z>1,81 Uncertain
(C) 2007 Prentice Hall, Inc.
5-56
Altman Z score Anadolu Cam
Altman Z-score
Ratio 1
Ratio 2
Ratio 3
Ratio 4
Ratio 5
Altman Z-score
(C) 2007 Prentice Hall, Inc.
2006
0,04
0,11
0,04
1,60
0,55
1,85
A. Cam
2005
2004
0,08
0,14
0,12
0,10
0,07
0,12
2,27
2,97
0,51
0,61
2,36
3,08
5-57
Additional considerations

Mezzanine items


Could be debt or equity
Off-balance-sheet liabilities



Operating leases
Contingent liabilities
Environmental liabilities
(C) 2007 Prentice Hall, Inc.
5-58
Equity Analysis
 Buy-side
 Work for an institutional investors (mutual fund)
 Make internal recommendations regarding the
purchase of equity securities
 Might review reports of sell-side analysts
 Sell-side
 Work for brokerage firms
 Issue reports for retail and institutional
customers
(C) 2007 Prentice Hall, Inc.
5-59
Valuation

Current value V0 is a function of

Present value of next year’s cash flow,


Required rate of return, r
Expected constant growth rate, g
CF1
V0
(C) 2007 Prentice Hall, Inc.
CF1

rg
5-60
Equity Analysis
Provides information regarding
1. The future cash flow generating
ability of the firm
2. The growth (or lack thereof) of those
cash flows
3. The risk of those cash flows, and
4. The risk-free rate commanded by the
market
(C) 2007 Prentice Hall, Inc.
5-61
Top-Down Analysis

Begin at highest (economy) level




Allocation between domestic and
international equities
Market sectors
Industries (within a sector)
End with evaluation of specific
companies
(C) 2007 Prentice Hall, Inc.
5-62
Bottom-Up Analysis

Begin with individual companies


Screen large data bases for
attractive characteristics


Look for key strengths
Compustat, Bloomberg, Baseline
Search for a combination of
characteristics
(C) 2007 Prentice Hall, Inc.
5-63
Five Steps of a Financial
Statement Analysis
Step 1
Establish objectives of the analysis



Who are you and why are you interested
in this company?
What questions would you like to have
answered?
What info is vital to the decision at hand?
(C) 2007 Prentice Hall, Inc.
5-64
Five Steps of a Financial
Statement Analysis (cont.)
Step 2
Study the industry in which the firm
operates and relate industry climate
to current and projected economic
developments
(C) 2007 Prentice Hall, Inc.
5-65
Five Steps of a Financial
Statement Analysis (cont.)
Step 3
Develop knowledge of the firm and
the quality of management
 How well does this firm appear to be run?
 Are they taking advantage of
opportunities?

Are they innovative, forward-looking, etc?
(C) 2007 Prentice Hall, Inc.
5-66
Five Steps of a Financial
Statement Analysis (cont.)
Step 4
Evaluate financial statements–tools include:
 Common-size financial statements
 Key financial ratios
 Trend analysis
 Comparison with industry competitors
(C) 2007 Prentice Hall, Inc.
5-67
Five Steps of a Financial
Statement Analysis (cont.)
Step 4
Evaluate financial statements–areas include:
 Short-term liquidity
 Operating efficiency
 Capital structure and long-term solvency
 Profitability
 Market ratios
 Segmental analysis (when relevant)
(C) 2007 Prentice Hall, Inc.
5-68
Five Steps of a Financial
Statement Analysis (cont.)
Step 5
Summarize findings based on analysis

Reach conclusions about the firm
relevant to your established
objectives
(C) 2007 Prentice Hall, Inc.
5-69
Financial Statements
An Overview
Map
(C) 2007 Prentice Hall, Inc.
5-70