Financial Statement Analysis
 Financial Statement Analysis: Overall View
 Different tools. Ratios
 Quality of Financial Reporting
Financial Statement Analysis
Overall View
Step 1: Establish the objectives of the analysis
Step 2: Study the industry, market, firm (e.g., strategy), etc. BUSINESS ANALYSIS
Step 3: Develop knowledge of the firm’s accounting practices. ACCOUNTING ANALYSIS
Step 4: Financial statements analysis –COMMON-SIZE financial statements, RATIOS,…
Step 5: Summarize findings based on analysis
Understanding The Business
Individual
Company
Factors
Industry
Factors
No
Invest?
Economy-wide
Factors
Yes
Understanding a Company’s Strategy
I need to know the company’s policies on product
differentiation, pricing, and cost control to make my
financial analysis more meaningful.
Financial Statements
Our objective:
 To ensure that financial statements serve as a map, not a maze.
 The better one can read and understand the financial statements,
the more useful they are as a MAP to decision-making.
Adapted from Fraser and Ormiston, C) 2007 Prentice Hall, Inc.
Financial Statements
THREE TYPES OF FINANCIAL STATEMENT INFORMATION
Past
Performance
Present
Condition
Future
Performance
Income, sales
volume, cash flows,
return- oninvestments,
EPS.
Assets, debt,
inventory, various
ratios.
Sales and earnings
trends are good
indicators of future
performance.
The Annual Report
Different sections: significant volume of information!
Financial statements
Notes to the financial statements
Management’s Discussion and Analysis of Operations (MD&A section)
The auditor’s report
Five-year summary of key financial data
High and low stock prices
Material included at discretion of management (voluntary disclosures)
Adapted from Fraser and Ormiston, C) 2007 Prentice Hall, Inc.
MD&A Section
 The Management Discussion and Analysis (MD&A) section (also
called “Business Review” or “Financial Review” section) provides:
 an overview of the previous year operations and how the company
performed financially.
 the upcoming year by outlining future goals and approaches to new projects.
 The MD&A section is important for investors and analysts because it
provides information useful for the interpretation of the financial
statements; it provides relevant information about the company’s key
financial indicators and about the performance of the management.
Auditor’s Report
Unqualified
Qualified
Adverse opinion
Disclaimer of opinion
Auditor’s Report
Unqualified (what you want! “clean”)
▫ Statements present information in conformity with GAAP
▫ Unqualified opinion with explanatory language (emphasis of matter) is
warranted when there is
 a consistency departure due to a change in accounting principle
 uncertainty caused by future events such as contract disputes and lawsuits
 an event (or events) that the auditor wishes to describe because they may present business
risk and/or going-concern problems
Auditor’s Report
Qualified
▫ Reports other than an unqualified opinion due to various circumstances. Typically
use word “except for”
Adverse opinion (not what you want!)
▫ Financial statements have not been presented fairly in accordance with GAAP
Disclaimer of opinion is issued when
▫ auditor cannot evaluate the fairness of the statements and expresses no opinion
▫ there is material scope limitation of the audit
The Annual Report
Financial statements
Notes to the financial statements
Management’s Discussion and Analysis of operations (MD&A)
The auditor’s report
Five-year summary of key financial data
High and low stock prices
Material included at discretion of management
In the Annual report we can also find information about stock prices,
risks the company faces; and other voluntary disclosures (e.g.,
information about IT security)]
Databases – IE Library
 ORBIS DATABASE: financial data (financial statements;
ownership; etc.) of more than 450 million companies
worldwide. Available at IE Virtual Library
(https://library.ie.edu/).
 FACTIVA DATABASE (DOWN JONES FACTIVA): Database
of nearly 33,000 premium sources, including licensed
publications, influential websites, blogs, images and videos.
Available at IE Virtual Library (https://library.ie.edu/).
Missing and Hard-to-Find Information
Not available in the financial statements:
 Employee relations with management
 Morale/efficiency of employees
 Reputation/public perceptions of the firm
 Effectiveness of management team/provisions for succession
 Potential exposure to regulatory changes
 …
QUALITIES THAT IMPACT OPERATING SUCCESS BUT ARE
DIFFICULT TO QUANTIFY
Adapted from Fraser and Ormiston, C) 2007 Prentice Hall, Inc.
Non-Financial Disclosures
 Investors, capital markets participants, and regulators are
increasingly interesting in non-financial information. As a response,
more and more companies provide non-financial data about factors
like organizational culture, company's environmental impact or
company’s diversity.
 Non-financial information is mainly around three areas:
environmental component, social component, and governance
component.
 Different types of reports: sustainability reports; integrated reports
Financial Statement
Analysis
 Time-Series Analysis
 Common-Size Financial
Statements (vertical analysis
or components percentage)
 Financial Ratios
Source: https://www.ontariosciencecentre.ca/CafeSci/Toronto/
Financial Statement Analysis
Financial statement analysis is based
on comparisons.
Intracompany Basis
Intercompany Basis
Industry Average
Tools & Techniques
These include:
Horizontal (Trend; Time-Series) Analysis
Vertical Analysis (Common-Size Analysis)
Ratio Analysis
Most important:
Common sense and judgment!!!
Time-Series Analysis
 Comparing across time or “time-series analysis”: information is compared over
time. For example, the percentage of change in comparable store sales, using
data taken from the MD&A section of The Home Depot’s recent annual report
Source: Libby et al. (2026)
Vertical Analysis
 Express each item on a particular financial statement as a
percentage of a single base amount
 I/S components as % of NET SALES.
 B/S components, as a % of TOTAL ASSETS.
Example – Income Statement
Source: Libby et al. (2026)
Example – Income Statement
 It is always useful to use graphs to analyze the financial data. For example, we can
see below the key income percentages for Home Depot and its competitor Lowe’s:
Source: Libby et al. (2026)
Financial Ratios
 Standardize financial data in terms of mathematical relationships
expressed in the form of percentages, times, days
 Objectives will vary depending on the:
▫ Perspective of the financial statement user
▫ Specific questions that are addressed by the analysis
 The identity of the user helps define what information is needed
(e.g., creditors, investors, management, etc.)
Financial Ratios
Cautions!
Ratios are valuable analytical tools and serve as screening devices,
BUT. . .
 No one ratio provides the whole story, and that the standards for each ratio are different
for every industry
 They are not predictive
 Ratios should be used with other elements of financial analysis
 There are no “rules of thumb” that apply to the interpretation of ratios
Keeping this in mind, let’s take a look at some ratios
The Pyramid of Profits
Profitability = Primary measure of the overall success of a
company.
Return on Equity
 Starting point for a systematic analysis of a firm’s performance
 Return from the shareholders’ perspective: how well
managers are employing the funds invested by the firm’s
shareholders to generate returns
Return on Equity
=
Net Income
Average Stockholders’ Equity
Return on Assets
 Economic return; from an operational perspective
 How much profit a company is able to generate for each euro
of assets invested
ROA =
Net Income *
Total Assets
* Or EBIT
What is behind ROA?
Return On Sales (Profit Margin)
Indicator of Profitability
Asset Turnover
Indicator of Efficiency
Gross Profit Margin
 The gross profit margin (also referred to as the gross profit percentage)
reflects gross profit as a percent of sales.
 If not shown separately on a company’s income statement, gross profit
is computed by subtracting cost of sales from net sales.
Gross Profit Margin =
Gross Profit
Net Sales Revenue
Net Profit Margin
 The net profit margin reflects NET INCOME as a percent of sales
Net Profit Margin =
Net Income
Net Sales Revenue
Earnings Per Share (EPS)
 The earnings per share ratio is a measure of return on investment that is
based on the number of common shares outstanding.
 This is probably the most popular financial ratio and the only ratio
required by GAAP/IFRS.
EPS =
Net Income
Weighted Average Number of Shares
Outstanding
 The DILUTED EPS ratio computes the EPS if all convertible securities
(e.g., convertible bonds; stock options) were realized
Quality of Income Ratio
 Compare NET INCOME and cash flow from operations
 A ratio higher than 1 indicates high-quality income because each
dollar of income is supported by one or more dollars of cash flows
Quality of Income =
Cash Flow from Operating Activities
Net Income
ROE Profit Driver Analysis
Equity
ROE
=
Net Income
Total Assets
×
Net Income
=
ROA
×
Total Assets
Equity
Financial
Leverage
How many Euros of assets the firm is able to deploy for each euro invested by
its shareholders; proportion of assets acquired with funds supplied by owners.
ROE & ROA
Legend:
ROE = Return on Equity
ROA = Return on Assets
Int. Exp. = Interest Expense
SE = Stockholders’ Equity
T. Liab. = Total Liabilities
k = Cost of Debt
ROE & ROA
K = cost of debt (interest rate)
If ROA > k = positive leverage effect (ROE > ROA)
If ROA < k = negative leverage effect (ROE < ROA)
The Pyramid of Ratios
The Pyramid of Profits
EPS
(basic & diluted)
Inventory Turnover Ratio
Receivables Turnover Ratio
Payables Turnover Ratio
Assets Turnover Ratios
Total asset turnover ratio =
Net Sales Revenue
Average Total Assets
It captures how well a company uses
its assets to generate revenue.
Fixed asset turnover ratio =
Net Sales Revenue
Average Net Fixed Assets
This ratio measures a company’s
ability to generate sales given an
investment in fixed assets.
Receivable turnover ratio =
Net Credit Sales
Average Net Receivables
This ratio measures how quickly a
company collects its accounts
receivable
Inventory turnover ratio =
Cost of Goods Sold
Average Inventory
This ratio measures how quickly the
company sells its inventory.
Also, ratios of the “number of days…”
Assets Turnover Ratios
Also, ratios of the “number of days…”
The receivable turnover ratio often is converted to reflect
the number of days, on average, it takes a company to
collect its receivables.
Average Days to Collect Receivables =
Days in a Year (365)
Receivables Turnover Ratio
The inventory turnover ratio often is converted to reflect
the number of days, on average, it takes a company to
sell its inventory.
Average Days to Sell Inventory =
Days in a Year (365)
Inventory Turnover Ratio
días
0
30
60
Days’
Inventory
90
120
Days’ Receivable
Bill – To
be paid in
60 days
Supplier
Inventory
Cash
Bill – to pay to
the supplier in
120 days
Days’ Payable
+ Days’ Payable
120
- Days’ Inventory 30
- Days’ Receivable 60
= WC needs
+ 30
No problem!
días
0
30
60
Days’
Inventory
90
120
Days’ Receivable
Bill Client
To be paid
60 days
Supplier
Inventory
Cash
Bill Supplier
To be paid 60
days
Days’ Payable
+ Days’ Payable
60
- Days’ Inventory 30
- Days’ Receivable 60
= WC needs - 30
How do we
finance
this?
Liquidity Ratios
Liquidity refers to a company’s ability to meet its currently maturing debts. Tests of
liquidity focus on the relationship between current assets and current liabilities.
*
*Acid-Test Ratio
Cash + S/T Investments + A/R (Net)
Current Liabilities
The Pyramid of Ratios
WC needs
Days’
Receivable
Days’
Payable
Tests of Solvency
Tests of solvency measure a company’s ability to meet its longterm obligations.
Debt-To-Assets Ratio
Debt-to-Equity Ratio
Times Interest Earned/Interest Coverage
Cash Coverage
Capital Acquisition Ratio (CAPEX ratio)
Debt-to-Assets Ratio
Debt-to-Assets Ratio =
Total Liabilities
Total Assets
Percentage of total assets that creditors provide = company’s degree of leverage
It also measures the company’s ability to withstand losses without
impairing the interest of creditors
Debt-to-Equity Ratio
Debt-to-Equity Ratio =
Total Liabilities
Stockholders’ Equity
This ratio measures the amount of liabilities that exists
for each $1 invested by the owners.
Times Interest Earned
Times Interest Earned* =
Net Income
+
Interest Expense**
+ Income Tax Expense**
Interest Expense
**Since interest expense is deducted before computing taxes and net income,
we add both interest expense and income tax expense back to net income for
the numerator of this ratio.
It measures the ability of a company to meet its periodic interest payments = a margin
of protection for creditors.
* Also called Interest Coverage Ratio
Cash Coverage
Cash Coverage =
Cash Flow from Operating Activities Before Interest and Taxes Paid
Interest Paid
It compares the cash generated from operations to the cash
obligations of the company.
Capital Acquisition Ratio (CAPEX ratio)
Capital Acquisition Ratio
=
Cash Flow from Operating Activities
Cash Paid for Property, Plant and Equipment
It measures the degree to which a company is able to finance purchase of
PPE with cash provided by operating activities. A high ratio indicates less
need for outside financing when purchasing PPE. When the ratio is below
one, it implies that the company must have financed its purchases via other
means, such as borrowing, selling equity or selling other assets.
Market Tests
Ratios that relate the current market price of a share of stock to an
indicator of the return that might accrue to the investor.
Price/Earnings Ratio
Dividend Yield Ratio
Price/Earnings (P/E) Ratio
P/E Ratio
=
Current Market Price Per Share
Earnings Per Share
This ratio measures the relationship between the current
market price of the stock and its earnings per share.
Dividend Yield Ratio
Dividend Yield =
Dividends Per Share
Market Price Per Share
Investors are interested in the amount of income that they will receive in the form
of dividends. This ratio is often used to compare the dividend-paying
performance of different investment alternatives.
Pay-Out Ratio
It measures the percentage of earnings distributed as cash dividends.
Pay-Out Ratio
=
Cash Dividends Declared on Ordinary Shares
Net Income
Ratios: Potential Problems
 There is no underlying theory, so there is no way to know which ratios are most
relevant
 Benchmarking is difficult for diversified firms!
 Globalization and international competition makes comparison more difficult because of
differences in accounting regulations.
 “Average” performance, not necessarily good. Hard to tell if a ratio is “good” or “bad”…
 Different accounting rules and procedures (e.g., IFRS vs. US GAAP; FIFO vs. LIFO)
 Seasonal effects; extraordinary events…
QUALITY OF FINANCIAL INFORMATION
Quality of Financial Reporting
 Management has considerable discretion within GAAP
 Potential exists to “manipulate” the profit/loss reported
 Ideally, financial statements should: a) Reflect an accurate picture of
a company’s financial condition and performance; and b) Information
should be useful both to assess the past and predict the future
 Quality of income ratio introduced before (comparison of OCF and
NET INCOME)
Quality of Income: Some Red Flags
 BALANCE SHEET






Low liquidity, especially negative working capital;
Relationship of inventories and receivables to sales (esp. relative growth and changes);
Excessive use of operating leases and other off-balance-sheet items;
Warranties, commitments, contingencies and other that may understate true liabilities;
Long-term debt levels (especially if it is growing);
Excessive and growing treasury stock levels…
 INCOME STATEMENT




Trends in revenues, gross margin, operating margin, etc.;
Operating expense issues, including SG&A, R&D spending, special charges, etc.;
Effective tax rates and other tax issues;
Non-recurring charges—these should be rare…
 CASH FLOW STATEMENT
 CFO trends, especially related to net income (quality of income ratio);
 Relationships of CFO, CFI & CFF and comparisons to cash balances…
 STOCK PRICES AND OTHER MARKET ANALYSIS
Summarizing…
Step 1: Establish the objectives of the analysis
Step 2: Study the industry, market, firm (e.g., strategy), etc. BUSINESS ANALYSIS
Step 3: Develop knowledge of the firm’s accounting practices… ACCOUNTING ANALYSIS
Step 4: Financial statements analysis –Vertical Analysis. Horizontal Analysis. Ratios.
Step 5: Summarize findings based on analysis