Week 4
Financial
Statements
Analysis
Common Questions that F/S Analysis
Can Help To Answer
 Creditor
 Investor
 Manager
 Can the company pay the interest and
principal on its debt? Does the company
reply too much on non-owner financing?
 Does the company earn an acceptable
return on invested capital? Is the gross
profit margin growing or shrinking? Does
the company effectively use non-owner
financing?
 Are costs under control? Are the
company’s markets growing or
shrinking? Do observed changes reflect
opportunities or threats? Is the allocation
of investment across different assets too
high or too low?
General Categories of Questions
Solvency
Liquidity
Earnings Potential
What we work with
Financial Statements
Balance Sheet
Income Statement
Statement of Cash Flows
Other Parts of the 10K (Annual Report)
MD&A
Notes to the financial statements
Ratio Analysis
 Examining various income statement
and balance sheet components in
relation to one another facilitates
financial statement analysis. This type
of examination is called ratio analysis.
Garbage In
At this point we will assume the numbers
are worth using without adjustment
Generally this is not a good assumption for
a lot of analysis
Apples to apples
Persistent and transitory
Some Limitations of Ratio analysis
What is Good?
The company earned $2,000,000
Does that mean it had a good year?
Does management deserve a big bonus?
Would you, as a shareholder, be happy?
How about the lenders?
Financial Statement Analysis
Across time
Within industry
Within firm
Common size statements
Ratio analysis
Comparisons Within
the Financial Statements
Common-size financial statements
(vertical analysis)
Compare to a base amount
Ratio analysis
Profitability ratios – Earnings potential
Solvency and Liquidity ratios – Ability to pay
creditors
Asset Management Ratios (Turnover) Efficiency
Market ratios – Stock price versus accounting
Profitability Analysis
Return on Assets (ROA):
ROA = Net Income / Total Assets
For example, if we invest $100 in a
savings account yielding $3 at year-end,
the return on assets is 3%.
Disaggregating Return on Assets
Profit Margin, Asset Turnover, and Return on Assets for
Selected Industries
Gross Profit Margin
 It allows a focus on average unit mark-ups
 A high gross profit margin is preferred to a
lower one, which also implies that a
company has relatively more flexibility in
product pricing.
 Competition and product mix will affect it
Turnover
 Turnover measures relate to the productivity
of company assets. Such measures seek to
answer the amount of capital required to
generate a specific sales volume.
 As turnover increases, there is less need for
cash since cash outflow for assets to
support the current sales volume is reduced.
Turnover ratios
Total assets
Sales / Assets
Accounts receivable
Sales / A/R
Inventory
COGS / Inventory
Accounts Payable
COGS / A/P
Turnover ratios
To convert turnovers to a period number
divide into 365
Cash collection cycle
ROE Analysis Structure
Return on Equity
Return on equity (ROE) is computed as:
ROE = Net Income / Average Equity
Financial Leverage and Risk
LEV is the other component of
ROE
Is Debt a bad thing?
Given that increases in financial
leverage increase ROE, why are all
companies not 100% debt
financed?
Leverage and Income Variability
Liquidity and Solvency Measures
Liquidity refers to cash: how much we
have, how much is expected, and how
much can be raised on short notice.
Solvency refers to the ability to meet
obligations; primarily obligations to
creditors, including lessors.
Current Ratio
Current ratio is simply current assets
divided by current liabilities.
If we subtracted rather than divided we
would have working capital
A very rough gauge of the ability to service
short-term obligations.
What is a good number?
Quick Ratio
A refinement of the current ratio.
Rather then using all current assets in the
numerator, we limit it to cash, marketable
securities, and accounts receivable.
Why?
Solvency
Some combination of debt divided by
either total assets or stockholders’ equity
Long-term debt to assets
Long-term debt to shareholders’ equity
Total debt to assets
Total debt to shareholders’ equity
Times interest earned
EBIT divided by interest expense
Vertical and Horizontal Analysis
Vertical and Horizontal Analysis