Analysis of Financial Statements
Financial Statements and Reports
 Income statement
 Balance sheet
 Statement of retained earnings
 Statement of cash flows
Ratio Analysis
Ratio Analysis—DuPont Approach
Uses and Limitations of Ratio Analysis
1
Analysis of Financial Statements
What financial statements do corporations publish,
and what information does each provide?
How do investors utilize financial statements?
What is ratio analysis and why are the results
important to both managers and investors?
What are some potential problems associated with
financial statement analysis?
What is the most important factor in financial
statement analysis?
2
Financial Statements and Reports
Financial reporting is used to disclose information
about the firm
Financial statements provided to




stockholders/creditors
SEC
IRS
Management
Annual report—includes
 a general discussion about the firm’s activities during
the past year and expectations in the near future
 financial statements of the firm for the most recent
years
3
Income Statement
Provides a summary of the revenues
recognized and the expenses incurred during
a particular operating period.
Matching principle—revenues are recognized
when sales occur (earned) and expenses are
realized when they are incurred.
Accrual accounting versus cash flows
4
Balance Sheet
Records the financial position of the firm at a
particular point in time by showing the
assets—that is, the investments—and the
liabilities and equity—that is, the financing—of
the firm.
Historical costs
5
Balance Sheet
Cash versus other assets—only cash
represents actual funds that can be invested
Liabilities versus stockholders’ equity—
liabilities represent debt, whereas equity
represents ownership
Preferred versus common stock—all
corporations have one type of stock called
common stock; some firms have equity called
preferred stock
6
Balance Sheet
Common equity accounts:
common stock = number of shares
outstanding times the par value of each share
paid-in capital = amount above the par value
for which common stock was issued
retained earnings = income the firm earned in
the past that was “retained” and reinvested in
assets
7
Statement of Retained Earnings
Shows the change in the retained
earnings and common equity accounts
since the last balance sheet was
constructed.
8
Statement of Cash Flows
Reports the effect of the firm’s
activities—operating, investing, and
financing—over some period on its cash
position
9
Statement of Cash Flows
Income versus cash flows—revenues and
expenses are recognized when incurred, not
when cash is received or paid
Non-cash items—some non-cash items appear on
the income statement, such as depreciation
Accounting profit—net income, or the “bottom
line” on the income statement; net income and
cash flows generally are highly correlated
Operating cash flows—cash flows generated from
the normal operating activities of the firm
10
Statement of Cash Flows
Simple rules to follow when constructing a statement
of cash flows:
Sources of Cash
 Liability Account
(e.g., borrow more)
 Equity Account
(e.g., issue stock)
 Asset Account
(e.g., sell inventory)
Uses of Cash
 Liability Account
(e.g., payoff loans)
 Equity Account
(e.g., pay a dividend)
 Asset Account
(e.g., purchase equipment)
11
Eagle, Inc. Income Statement
Sales
Variable operating costs
Fixed costs, excluding depreciation
Depreciation
EBIT = NOI
Interest
Earnings before taxes (EBT)
Taxes (40%)
Net income
Dividends
Addition to retained earnings
$80,000
(60,000)
(12,000)
( 2,000)
6,000
( 1,000)
5,000
( 2,000)
$ 3,000
2,000
1,000
12
Eagle, Inc. Balance Sheet
Current Previous
Year
Year
Cash & securities $ 2,000 $1,000 Accounts payable
Accounts receivable 6,000
5,000 Accruals
Inventory
7,000
8,000 Notes payable
Current assets
15,000 14,000 Current liabilities
Net fixed assets
10,000
9,000 Long-term debt
Total assets
$25,000 $23,000 Total liabilities
Common stock
Retained earnings
Owners’ equity
Total liabilities
& equity
Current Previous
Year
Year
$ 4,000 $ 2,000
5,000
4,000
1,000
2,000
10,000
8,000
6,000
7,000
16,000 15,000
6,000
6,000
3,000
2,000
9,000
8,000
$25,000 $23,000
13
Eagle, Inc. Balance Sheet—
Changes in Assets
Current
Year
Cash & securities
$ 2,000
Accounts receivable
6,000
Inventory
7,000
Current assets
15,000
Net fixed assets
10,000
Total assets
$25,000
Previous
Year
$ 1,000
5,000
8,000
14,000
9,000
$23,000
Change Source
-1,000
X
(1,000)
3,000
Use
X
X
Sources
Cash or sales =Uses
of Cash
Fixed assets
if no of
purchases
$9,000
- $2,000 = $7,000
 Asset
Account
 Asset Account
Depreciation
= $2,000
Change in fixed assets = $10,000 - $7,000 = $3,000
14
Eagle, Inc. Balance Sheet—
Changes in Liabilities and Equity
Current Previous
Year
Year
Accounts payable
$ 4,000 $ 2,000
Accruals
5,000
4,000
Notes payable
1,000
2,000
Current liabilities
10,000
8,000
Long-term debt
6,000
7,000
Total liabilities
16,000 15,000
Common stock
6,000
6,000
Retained earnings
3,000
2,000
Owners’ equity
9,000
8,000
Total liabilities & equity $25,000 $23,000
Sources of Cash
 Liability/Equity Account
Change
2,000
1,000
(1,000)
Source
X
X
X
X
(1,000)
0
Use
--
--
--
Uses of Cash
 Liability/Equity Account
15
Eagle, Inc. Statement of Cash Flows
Cash Flows from Operations:
Cash Flows from Financing Activities:
Net income (NI)
$3,000
Adjustments to NI
Depreciation
2,000
 Inventory
1,000
 Accounts payable
2,000
 Accruals
1,000
 Accounts receivable (1,000)
Net CF from operations
$8,000
 Notes payable
 Long-term bonds
Dividend payment
Net CF from financing
Net Change in cash
Cash at beginning of year
Cash at end of year
(1,000)
(1,000)
(2,000)
$(4,000)
1,000
1,000
$2,000
Cash Flows from Long-Term Investing:
Acquisition of assets
(3,000)
16
Financial Statements:
Accounting Alternatives
In many instances, the same business
activity can be recorded using one of
several accepted accounting methods—
for example, LIFO versus FIFO for
inventory valuation.
17
Financial Statements:
Time Dimension
Balance sheet—a “snapshot” of where the
firm is at a specific point in time (stock
statement).
Income statement and statement of cash
flows—shows the results of the firm’s
activities over a period of time (flow
statement).
18
What Information Do Investors Use from
Financial Statements?
Net working capital (NWC)
= Current assets - Current liabilities
Operating cash flow (OCF)
= NOI (1-Tax rate) + Depreciation & amortization expense
Free cash flow (FCF)
= OCF – Investments
Economic Value Added (EVA)
= NOI (1 - T) - [(Invested capital) X (After-tax cost of funds)
19
Financial Statement (Ratio) Analysis
Used to evaluate how financial positions:
Change on a year-to-year basis for a
single firm.
Compare among firms, even if they
differ in size.
20
Ratio (Financial Statement) Analysis
Used by:
Managers inside the firm
Stockholders and creditors—existing
and potential—outside the firm
21
Ratio (Financial Statement) Analysis
General categories of analysis:
Liquidity
Asset management
Debt management
Profitability
Market value
22
Liquidity Ratios
Provide an indication of how well the firm can
meet its current obligations
Help measure the liquidity position of the firm
Too little, or too much liquidity could be
considered a “bad sign”
 too little liquidity—suggests the firm will have
problems paying its current obligations in the future
 too much liquidity—might suggest the firm is not
investing its funds wisely
23
Current ratio
Shows the relationship between current assets
and current liabilities; a higher value suggests
greater liquidity, and vice versa:
Current assets
Current ratio =
Current liabilitie s
24
Quick (Acid Test) Ratio
Similar to the current ratio, except the value of
inventories is subtracted from current assets (CA)
in the numerator; inventories represent the least
liquid of the current assets:
CA - Inventories
Quick, or acid- test, ratio =
CL
25
Asset Management Ratios
Provide an indication of how well the firm
manages its assets (efficiency)
Show how often the firm is “turning over” its
assets to generate funds
Generally, when assets are not turned over
quickly enough, it is because sales have slowed
or current assets, such as inventory and
receivables, are too high
If assets are turned over too quickly, it could
mean that the firm is not producing enough
26
Inventory Turnover
Shows how many times during a period—for
example, one year—the amount of average
inventory is turned over due to sales activities.
Cost of goods sold
Inventory turnover =
Inventorie s
27
Days Sales Outstanding (DSO)
Indicates the average time it takes customers to
pay for credit purchases—that is, the length of
time it takes the firm to collect for credit sales.
Receivable s
Days sales
=
outstanding (DSO) Average sales per day
=
Receivable s
 Annualsales 


360
28
Fixed Assets Turnover
Indicates how efficiently the firm uses its fixed
assets (excludes current assets) to produce
revenues
Sales
Fixed assets turnover ratio =
Net fixed assets
29
Total Assets Turnover
Similar to the fixed assets turnover, except the
value of total assets (includes current assets) is
used.
Sales
Total assets turnover ratio =
Total assets
30
Debt Management Ratios
Indicate how the firm’s financial position is
affected by the amount of debt it has
financial leverage refers to the use of debt
leverage helps to magnify returns, on both
the positive and the negative sides, because
debt represents a fixed obligation
31
Debt Ratio
Indicates the capital structure of the firm;
measures the percent debt used by the firm for
the purposes of financing assets.
Total debt Total liabilitie s
Debt ratio =
=
Total assets
Total assets
32
Times-Interest-Earned (TIE) Ratio
Indicates whether the firm generates sufficient
operating income (not cash) to meet its
interest obligations each year.
EBIT
Times- interest-earned ratio =
Interest charges
Operating income
=
Interest charges
33
Fixed Charge Coverage Ratio
Like the times-interest-earned ratio, except all
fixed payments related to financing are
included.
EBIT  Lease payments
Fixed charge

coverage ratio  Interest   Lease  Sinking fund payments
 charges    payments  
1 tax rate

 



Funds available to cover financing obligation s

Fixed financing obligation s
34
Profitability ratios
Indicate how the firm’s management of its
liquidity position, assets, and debt has
affected normal operating activities.
35
Net Profit Margin
Shows what percent of sales revenues is left
after expenses related to operations and the
effects of financing and taxes.
Net income
Net profit margin =
Sales
36
Return on Total Assets (ROA)
Measures the return on investment earned by
the firm; ROA represents a return on all
invested funds (both debt and equity).
Net income
Return on total assets (ROA) =
Total assets
37
Return on Equity (ROE)
Similar to ROA, ROE is a measure of the return
on the original funds provided by common
stockholders (equity only).
Re turn on  Income available to common stockholders
Equity (ROE)
Common equity
Net income  Preferred dividends

Common equity
38
Market Value Ratios
Measures that consider the value of the firm’s
stock in the financial markets—that is, how
well investors perceive that the firm is
creating value.
39
Price/Earnings (P/E) Ratio
Indicates how much investors pay for each
dollar of income generated by the firm.
Market price per share
Price/earn ings ratio =
Earnings per share
Earnings Per Income available to common stockholde rs
=
Share (EPS)
Number of common shares outstandin g
40
Market/Book Value Ratio
Indicates the relationship between the selling
price of the common stock and its book
value.
Market value per share
Market / book value 
Book value per share


Market value per share
Common equity
Number of common shares outstanding

41
Trend and Comparative Analyses
Ratios should be evaluated
At a point in time in comparison to a norm,
such as an industry average, to determine
the firm’s current financial position
(comparative analysis).
Over time to determine whether the firm’s
current financial position is improving or
deteriorating (trend analysis).
42
Du Pont Equation/Method
Shows the relationship between the return
on investment (ROA) and both the total
assets turnover and the net profit margin so
as to give more detail where weaknesses or
strengths exist.
For example, if ROA is relatively low, it
might be due to a low profit margin, a slow
turnover of assets, or both.
43
Du Pont Equation
ROA  Net profit margin x Total assets turnover

Net income
Sales

Net income
Total assets
x
Sales
Total assets
44
Uses and Limitations of Ratio Analysis
Classifying a very large, multidivisional firm into a
single industry often is difficult.
Using a single norm, or “target,” ratio for
comparisons might be misleading.
Values on balance sheets are historical costs, so
ratios might not portray a “true” picture.
Seasonality in operations might cause ratios to
differ significantly at different times of the year.
45
Uses and Limitations of Ratio Analysis
Sometimes firms try to make financial statements
look better by using “window dressing” techniques.
If firms use different accounting methods,
comparisons between firms can be difficult.
Do not make general conclusions about the firm’s
financial position by examining only one or a few
ratios; ratio analysis should be comprehensive.
The most important part of ratio analysis is the
judgment used when interpreting the results, not
the computation of the ratios.
46
Analysis of Financial Statements
What financial statements do corporations
publish?
 Balance sheet, income statement, statement of
cash flows, and statement of retained earnings
How do investors utilize financial statements?
 Debt holders estimate future cash flows to
determine whether the debt contracts will be
honored
 Stockholders estimate future cash flows to
determine the value of the firm’s common stock.
47
Analysis of Financial Statements
What is ratio analysis and why are the results
important to both managers and investors?
 Ratio analysis is used to evaluate a firm’s current
financial position and, based on the results, to forecast
the firm’s future financial position.
What are some potential problems associated
with financial statement analysis?
 Seasonality, alternative accounting methods, and
historical costs are a few factors that make evaluation
of financial statements difficult.
48
Analysis of Financial Statements
What is the most important factor in financial
statement analysis?
 To form general impressions about a firm’s financial
position, judgment must be used when interpreting
financial ratios
49