Financial Statement Analysis
Basic Approaches
¦Time-series analysis
¦Cross-sectional analysis
¦Benchmark comparison
Quality of Accounting Numbers
Irrespective of the approach
used the analyst must “get
behind the numbers.”
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Two Useful Tools
¦Common size statements
¦Trend statements
Return on Assets
ROA =
NOPAT
Average Assets
Adjustments to Reported Earnings
¦ Isolate sustainable operating profit
¦ Eliminate after-tax interest expense
¦ Correct distortions related to accounting
quality concerns
Factors Underlying ROA
Margin = NOPAT / Sales
Turnover = Sales / Average Assets
2
Factors Underlying ROA
NOPAT
Sales
X
ROA =
Sales
Average Assets
NOPAT
ROA =
Average Assets
Controlling ROA
A company may increase profitability
three ways:
• By increasing revenues
• By reducing expenses
• By reducing assets
¦Strategies
• Differentiation
• Low-cost leadership
Credit Risk
¦Liquidity
¦Solvency
3
Short-Term Liquidity
During an operating cycle a company must
generate sufficient cash to supply working
capital needs and also service debt.
Current Assets
Current Ratio =
Current Liabilities
Current Assets - Inventories
Quick Ratio =
Current Liabilities
Activity Ratios
¦Activity Ratios tell the analyst how
efficiently a company is using its
assets.
¦Activity ratios are especially valuable
when analyzed together.
Accounts Receivable Turnover
Net Credit Sales
Average Accounts Receivable
4
Days Receivable Outstanding
3 6 5 Days
Accounts Receivable Turnover
Inventory Turnover
Cost of Goods Sold
Average Inventory
Days Inventory Held
3 6 5 Days
Inventory Turnover
5
Accounts Payable Turnover
Inventory Purchases
Average Accounts Payable
Days Accounts Payable
Outstanding
3 6 5 Days
Accounts Payable Turnover
Long-Term Solvency
¦Debt ratios provide information
about the amount of long-term debt
in a company’s capital structure.
• Long-term debt to assets
• Long-term debt to tangible assets
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Long-Term Solvency
¦Analysts also want to know about the
ability of companies to generate
inflows sufficient to service their
debt.
• Interest coverage ratio
• Cash flow coverage ratio
• Operating cash flow to current liabilities
Return on Equity
¦ROCE measures a company’s
performance in using capital
provided by shareholders to
generate earnings.
Net Income Available
to Common Shareholders
ROCE =
Average Common Shareholders Equity
Return on Equity
¦ROCE can be broken down into three
components
• ROA
• Common earnings leverage
• Financial structure leverage
¦The latter two components measure
financial leverage---the use of debt to
increase a company’s earnings
performance.
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Financial Statement Analysis
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