CHAPTER 14
Financial Statement
Analysis
Income Statement
14.1 THE MAJOR FINANCIAL
STATEMENTS
Table 14.1 Consolidated Statement of
Income
Four broad classes:
– Cost of goods sold
– General and administrative expenses
– Interest expense
– Taxes on earnings
Common Sizing
Balance Sheet
Assets
– Current
– LongLong-term
Liability and stockholders’
stockholders’ equity
Common Sizing
Table 14.2 Consolidated Balance Sheet
Statement of Cash Flows
Table 14.3 Consolidated Statement of Cash
Flows
Recognizes only transactions in which
cash changes hands
Accounting Versus Economic Earnings
14.2 ACCOUNTING VERSUS
ECONOMIC EARNINGS
Accounting earnings
– Affected by several conventions regarding the
valuation of assets
Economic earnings
– Earnings above or below a trend line
Past Versus Future ROE
14.3 PROFITABILITY MEASURES
Data from recent past may provide
information regarding future performance
Analysts should always keep an eye on
the future
Expectations of future dividends and
earnings determine intrinsic value of stock
Financial Leverage and ROE
The relationship among ROE, ROA, and
leverage:
14.4 RATIO ANALYSIS

Debt 
ROE = (1 − Tax rate)  ROA + ( ROA − Interest rate)
Equity 

Decomposition of ROE
Ratio Analysis
Purpose of Ratio Analysis
Uses
– Trend analysis
– Comparative analysis
– Combination
Use by External Analysts
– Important information for investment
community
– Important for credit markets
Type of Financial Ratios
Profitability Ratios
Turnover or Asset Utilization Ratios
Liquidity Ratios
Leverage Ratios
Market Price Ratios
ROE =
Net Profit
x
Pretax Profit
(1)
Tax
Burden
x
x
Pretax Profit
EBIT
(2)
Interest
Burden
x
x
EBIT
Sales
(3)
x
x
Sales
Assets
(4)
x
x
Assets
Equity
(5)
x Margin x Turnover x Leverage
Profitability Ratios
Net Profit Margin %
Net Income
Sales
Operating Return on Assets %
Earnings Before Int. & Taxes
Total Assets
Profitability Ratios (cont.)
Return on Equity %
Net Income
Common Equity
Operating Margin After Depreciation %
Operating Profit
Sales
Activity or Management Efficiency
Ratios (cont.)
Average Collection Period
Accounts Receivable
Sales Per Day
Days to Sell Inventory
Inventory
Sales Per Day
Leverage Ratios
Times Interest Earned
Earnings Before Int. & Taxes
Interest Expense
Fixed Charge Coverage Ratios
Lease Payments
Principal Repayments
Preferred Dividends
Activity or Management Efficiency
Ratios
Inventory Turnover
Sales or Cost of Goods Sold
Inventory
Total Asset Turnover
Sales
Total Assets
Liquidity Ratios
Current Ratio
Current Assets
Current Liabilities
Quick Ratio
Current Assets - Inventory
Current Liabilities
Leverage Ratios (cont.)
Debt to Assets %
Long Term Debt
Assets
Debt to Equity %
Long Term Debt
Shareholders Equity
Market Price Ratios
Figure 14.1 DuPont Decomposition for
Hewlett-Packard
Price to Earnings
Market Price of Stock
Earnings
MarketMarket-toto-BookBook-Value
Market Price of Stock
Book Value Per Share
Economic Value Added
14.5 ECONOMIC VALUE ADDED
Approach to compare accounting
profitability with the cost of capital
Definition
– ROAROA-K (Capital Invested in the firm)
– K = opportunity cost for capital
Ties accounting to return by investors
Table 14.12 Economic Value Added, 2006
14.6 AN ILLUSTRATION OF FINANCIAL
STATEMENT ANALYSIS
Table 14.13 Key Financial Ratios of
Growth Industries Inc.
Table 14.14 Growth Industries
Statement of Cash Flows
Comparability Problems
14.7 COMPARABILITY
PROBLEMS
Quality of Earnings:
Areas of Accounting Choices
Allowance for bad debts
NonNon-recurring items
Earnings smoothing
Stock options
Revenue recognition
OffOff-balance sheet assets and liabilities
Inventory valuation
– LIFO and FIFO
Depreciation
Inflation and interest expense
International Accounting Conventions
Reserving practices
Depreciation
Intangibles
Figure 14.2 Adjusted Versus
Reported Price-Earnings Ratios
14.8 VALUE INVESTING: THE GRAHAM
TECHNIQUE
Benjamin Graham
Graham believed careful analysis of a
firm’
firm’s financial statements could turn up
bargain stocks
He developed many different rules for
determining the most important financial
ratios