Chapter (3) Analysis Of Financial
Statements
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Chapter Outline:
• Introduction to Financial Statements Analysis.
• Sources of Information for Financial Statement
Analysis.
• Common-Sized Financial Statements
• Ratio Analysis.
• Trend Analysis.
• The Du Pont Equation.
• Comparative Ratios and Benchmarking.
• Uses and Limitations of Ratio Analysis.
• Looking Beyond The Numbers.
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Introduction to Financial Statements
Analysis:
• The objectives of financial statement analysis
vary across different types of decision makers.
• suppliers, long-term creditors, and investors.
• But, investors, by necessity must be concerned
with all aspects of a firm’s financial status.
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Sources of Information for Financial
Statement Analysis:
• Annual reports.
• Investment advisory services.
• Business periodicals.
• On-line financial services.
• EDGAR . . . the SEC’s Web site.
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Common-Sized Financial Statements:
Common-sized financial statements: financial
statements in which each item is expressed as a
percentage of a major financial statement
component.
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Common-Sized Financial Statements:
Common-sized financial statements can be used
to:
• Identify key structural changes in a company’s
financial data over a period of time.
• Compare the financial data of firms that vary
significantly in size.
• Compare a company’s financial data to industry
norms.
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Ratio Analysis:
Ratio analysis: an analytical technique that
typically involves a comparison of the
relationship between two financial items.
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Objectives of Ratio Analysis:
• Standardize financial information for
comparisons
• Evaluate current operations
• Compare performance with past performance
• Compare performance against other firms or
industry standards
• Study the efficiency of operations
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Ratio Analysis:
• 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
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Five Types of Financial Ratios:
• Liquidity Ratios.
• Asset Management Ratios (Activity Ratios).
• Debt Management Ratios (Leverage Ratios).
• Profitability Ratios.
• Market Value Ratios.
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Liquidity Ratios:
• 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
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Liquidity Ratios:
• Current ratio =
Current assets / Current liabilities
Purpose: Measures a firm’s ability to pay its
current liabilities from its current assets.
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Liquidity Ratios:
• Quick (Acid Test) Ratio =
Current assets - Inventories / Current liabilities
Purpose: Measures a firm’s ability to pay its
current liabilities without relying on the sale of
its inventory.
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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
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Asset Management Ratios:
• The Inventory Turnover Ratio.
• The Days Sales Outstanding.
• The Fixed Assets Turnover Ratio.
• The Total Assets Turnover Ratio.
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Asset Management Ratios:
The Inventory Turnover Ratio=
Sales/ Inventory.
Purpose: Indicates the number of times that a
firm sells its inventory each year.
– 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
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Asset Management Ratios:
The Days Sales Outstanding (DSO)=
Accounts Receivables/(Sales/360).
Purpose: Indicates the length of time normally
required to collect a receivable resulting from a
credit sale.
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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
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Asset Management Ratio:
The Fixed Assets Turnover Ratio=
Sales/ Net Fixed Assets.
Purpose: to measure how effectively the firm
uses its plant and equipment to generate sales.
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Asset Management Ratios:
• Fixed Assets Turnover Ratio
– Measures efficiency of long-term capital investment
– How much fixed assets are needed to achieve a
particular level of sales?
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Asset Management Ratio:
Total Asset Turnover Ratio=
Sales/ Total Assets.
Purpose: Measure efficiency of total assets for
the company as a whole or for a division of the
firm.
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Debt Management Ratios (Leverage
Ratios):
• 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
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Debt Management Ratios:
• Total Debt to Total Assets.
• Times Interest Earned Ratio (Coverage Ratio)
• EBITDA Coverage Ratio.
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Debt Management Ratios:
Total Debt to Total Assets Ratio=
Total debts/Total assets.
Purpose: Measures a firm’s financial leverage.
– Measures percentage of assets being financed
through borrowings
– Too high a number means increased risk of
bankruptcy
– What percentage of total assets are being financed
through debts?
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Debt Management Ratios:
Times Earned Interest (TIE)=
EBIT/Interest Charges.
Purpose: Indicates the number of times that a firm’s
interest expense is covered by earnings.
– 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
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Debt Management Ratios:
EBITDA Coverage Ratio=
EBITDA+ Lease Payment/Interest + Principal
Payment + Lease Payment
Purpose: Indicates the number of times that a firm’s
interest expense is covered by EBITDA.
Useful for short term lenders like banks.
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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
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Profitability Ratios:
• Net Profit Margin on Sales.
• Basic Earning Power (BEP).
• Return on Assets (ROA).
• Return on Common Equity (ROE).
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Profitability Ratios:
Profit Margin on Sales=
Net Income/ Sales.
Purpose: Indicates the percentage of each sales dollar
that contributes to net income.
– Relates net income available to common
stockholders to sales
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Profitability Ratios:
Basic Earning Power=
EBIT/Total Assets.
Purpose: Indicate the ability of the firm’s assets to
generate operating income.
– Relates EBIT to Total Assets
– Useful for comparing firms with different tax
situations and different degrees of financial leverage
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Profitability Ratios:
Return on Assets (ROA)=
Net Income/ Total Assets.
Purpose: Measures the rate of return a firm realizes on
its investment in assets.
– Relates net income available to common
stockholders to total assets
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Profitability Ratios:
Return on Common Equity (ROE)=
Net Income/ Common Equity.
Purpose: Measures the rate of return on a firm’s
stockholders’ equity.
– Relates net income available to common
stockholders to common stockholders equity
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Market Value Ratios:
• A set of ratios that relates the firm’s stock price to its
earnings, cash flow, and book value per share.
• Focus on the stock price and compare it to earnings
and book value.
• These ratios give management an indication of what
investors think of the company’s past performance and
future prospects.
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Market Value Ratios:
• Price/Earnings Ratio (P/E Ratio).
• Price/ Cash Flow Ratio.
• Market/ Book Ratio (M/B Ratio).
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Market Value Ratios:
Price/Earnings Ratio (P/E Ratio)=
Market Price Per Share/Earnings Per Share
Purpose: Indicates the amount investors are
willing to pay for each $1 of a firm’s earnings.
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Market Value Ratios:
Price/ Cash Flow Ratio=
Market Price Per Share/Cash Flow Per Share
Cash Flow Per Share= Net Income +
Depreciation and Amortization/Common Share
Outstanding.
Purpose: Indicates the amount investors are
willing to pay for each $1 of a firm’s Cash
Flow.
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Market Value Ratios:
Market/ Book Ratio=
Market Price Per Share/ Book Value Per Share
Book Value Per Share=
Common Equity/ Share Outstanding
Purpose: Indicates the amount investors are
willing to pay for each $1 of a firm’s Book
Value ( the firm’s net assets value) .
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Trend Analysis:
• The study of percentage changes in financial
statement items over a period of time.
• Trend analysis provides a simple forecasting
method.
• Used to estimate the likelihood of improvement
or deterioration in its financial conditions.
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Trend Analysis:
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The DuPont Equation:
It is a formula which shows that the rate of return
on assets can be found as the product of the
profit margin times the total assets turnover.
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The DuPont Equation:
• Method to breakdown ROE into:
– ROA and Equity Multiplier
• ROA is further broken down as:
– Profit Margin and Asset Turnover
• Helps to identify sources of strength and weakness in
current performance
• Helps to focus attention on value drivers
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The DuPont Equation:
ROE
ROA
Profit Margin
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Equity Multiplier
Total Asset Turnover
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The DuPont Equation:
ROE
ROA
Profit Margin
Equity Multiplier
Total Asset Turnover
ROE  ROA  Equity Multiplier
Net Income
Total Assets


Total Assets Common Equity
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The DuPont Equation:
ROE
ROA
Profit Margin
Equity Multiplier
Total Asset Turnover
ROA  Profit Margin  Total Asset Turnover
Net Income
Sales


Sales
Total Assets
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The DuPont Equation:
ROE
ROA
Profit Margin
Equity Multiplier
Total Asset Turnover
ROE  Profit Margin  Total Asset Turnover  Equity Multiplier
Net Income
Sales
Total Assets



Sales
Total Assets Common Equity
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Comparative Ratios and
Benchmarking:
• Benchmarking is the process of comparing a
particular company with a group of a
“benchmark” companies.
• It is to compare the firm’s ratios with those of a
smaller set of leading companies in the same
industry.
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Uses and Limitations of Ratio
Analysis:
• Comparison with industry averages is difficult
if the firm operates many different divisions.
• “Average” performance not necessarily good.
• Seasonal factors can distort ratios.
• “Window dressing” techniques can make
statements and ratios look better.
• Different operating and accounting practices
distort comparisons.
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Uses and Limitations of Ratio
Analysis:
• Sometimes hard to tell if a ratio is “good” or
“bad.”
• Difficult to tell whether company is, on
balance, in strong or weak position.
• A firm’s industry category is often difficult to
identify
• Published industry averages are only guidelines
• Sometimes difficult to interpret deviations in
ratios.
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Uses and Limitations of Ratio
Analysis:
• Relative size is ignored (e.g., both large &
small firms can be compared)
• It is assumed that all numbers used are correct
(consider both possible errors and earnings
management)
• If the numbers are not reliable, ratios are not
particularly useful
• Effects of Inflation
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Looking Beyond The Numbers:
• Good financial analysis involves more than just
calculating numbers.
• There are Qualitative factors to be considered when
evaluating a company’s future financial performance.
• These important and basic skills are necessary when
making business decisions, when evaluating
performance, and when forecasting likely future
developments.
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Looking Beyond The Numbers:
• Are the firm’s revenues tied to One key
customer, product, or supplier?
• What percentage of the firm’s business is
generated overseas?
• Competition.
• Future prospects.
• Legal and regulatory environment.
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End of Chapter 3
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