Financial Statement
Analysis
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Standardized Financial
Statements
• Common-Size Balance Sheets
– Compute all accounts as a percent of total assets
• Common-Size Income Statements
– Compute all line items as a percent of sales
• Standardized statements make it easier to compare
financial information, particularly as the company
grows
• They are also useful for comparing companies of
different sizes, particularly within the same industry
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• Prufrock corporation balance sheet
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•Prufrock corporation common size balance
sheet
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Common-Size Balance Sheet
• Notice that total change has to be zero because
the beginning and ending numbers must add up
to 100 percent.
• Also notice that the statement is relatively easy to
read and compare (for example: CA increased
from 19.1 to 19.7%, CL decreased from 15.7 to
12.7%)
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• Prufrock corporation income statement
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•Prufrock common- income statement
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Common-Size Income
Statements
• Common-Size Income Statement tells us what
happens to each dollar in sales (for example: we
pay taxes $.061 of each $1 in sales)
• Notice that the percentages are useful in
comparisons, such as cost control.
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Common-Base Year Financial
Statements
•
•
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Common-Base Year Financial Statements
(Trend Analysis): Select a base year and then
express each item or account as a percent of
the base-year value of that item. This is useful
for picking up trends through time.
Combined Common-Size and
Base
• Combined Common-Size and Base (Year
Analysis):
Express each item in base year as a percent of
either total assets or sales. Then, compare each
subsequent year’s common-size percent to the
base-year percent (abstracts from the growth in
assets and sales).
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Summary of Standardized
Financial Statements
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Financial Statement Analysis
• Another way of avoiding the problem involved in
comparing of different sizes is to calculate and
compare financial ratios.
• Ratio analysis is a quick and easy way of
analyzing a firm’s financial statements.
• Financial ratio itself is not meaningful without
comparing it to a benchmark. Benchmarks can
be a rival firm’s financial ratio or an industry
average.
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Financial Statement Analysis
Ratio analysis
– Financial ratios: Relationships determined from a
firms financial information and used for
comparison purposes.
– Ratios also allow for better comparison through
time or between companies.
– As we look at each ratio, ask yourself what the
ratio is trying to measure and why is that
information is important.
– Ratios are used both internally and externally.
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Categories of Financial Ratios
1.
Short-term solvency, or liquidity, ratios: The ability to
pay bills in the short-run.
2.
Long-term solvency, or financial leverage, ratios: The
ability to meet long-term obligations.
3.
Asset management, or turnover, ratios: Efficiency of
asset use.
4.
Profitability ratios: Efficiency of operations and how that
translates to the “bottom line”.
5.
Market value of ratios: How the market values the firm
relative to the book values.
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1.
Liquidity Ratios
– Provide information about the firm’s liquidity.
– It is also called liquidity measures and primary
concern is the ability of the firm to pay it’s bills over
the short run without undue stress.
– It focus on current asset and current liability.
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1. Liquidity Ratios
– This ratio is interesting to short term creditors.
– This ratio is important to firms because they deal with
banks and other short term lenders.
– A disadvantage: current assets and current liabilities
can and do change fairly so that today’s amount may
not be a reliable guide to the future.
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1.
Liquidity Ratios
A) Current ratio: measures short term liquidity.
Current Ratio = current assets / current liabilities
708/540= 1.31 times
• It mean that the company has 1.31 in CA for every 1$ in
CL.
• The higher this ratio the better but sometimes it means inefficiency
in using cash and other short tem assets
– Standard: 2:1
– The unit of measurement is either dollar or times
– Any current ratio less than 1 means negative networking
capital
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1.
Liquidity Ratios
B) The quick ratio: is quite a bit lower than the
current ratio
• Quick Ratio = (current assets – inventory) /
current liabilities
(708 – 422) / 540 = .53 times
– Standard 1:1
• Because inventory i the least liquid CA, so
it omit inventory from CA, it mean that the
company has .53 in CA except the
inventory for every 1$ in CL.
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1.
Liquidity Ratios
C) Cash Ratio = cash / current liabilities
98 / 540 = .18 times
– Normally a very short term creditor interested
in this ratio. This company carries a low cash
balance, although the cash ratio has
increased substantially from the previous year
(.03 in 2002).
– This may be an indication that they are
aggressively investing in assets that will
provide higher
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1. Liquidity Ratios
D) NWC to TA = (current assets – current liabilities) /
total assets
(708-540) / 3588 = 4.7%
– As NWC is viewed as the amount of short term
liquidity we use this ratio, a relatively low value
indicate a low levels of liquidity.
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1. Liquidity Ratios
E) Interval Measure = current assets / average
daily operating costs
708 / (1344/365) = 192 days
– It give an indicator for how long could the
company business keep running in case of
strike.
– Note that average daily operating costs
generally exclude depreciation expense since
it is not a cash expense and interest since it
is not an operating expense
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2. financial leverage
A) Total debt ratio = (total assets – total equity) /
total assets
(3588-2591) / 3588 = .28 times
– Standard 1:1
– It accounts the % of (all debt of all maturities to all
creditors) to the assets, it mean that the company has a
.28$ in debt for every 1$ in assets.
– .28 in debt and (1-.28= .72 ) in equity
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2. financial leverage
B) debt/equity ratio = (total assets – total equity) /
total equity
(3588-2591) / 2591 = .38 times
Or = Total Debt / Total Equity = .28/.72 = .38
equity multiplier = 1 + debt/equity ratio
1 + .38 = 1.38 times
Or = total assets / total equity = 3588/2591 = 1.38
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2. financial leverage
C) Times Interest Earned = EBIT / Interest
691/141 = 4.9 times
– It measure how well a company has its interest obligations
covered ( also called interest coverage ratio) Even though the
company is financed with over 64% debt, they have a
substantial amount of operating income available to cover the
required interest payments.
D) Cash Coverage = (EBIT + Depreciation) / Interest
(691+276) / 141 = 6.9 times
– It measure company cash flow available to meet financial
obligations (we add depreciation because it’s non cash
expenses)
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3.
•
•
Asset management ratios
Measures under this ratio are called asset
management or utilization ratio
It measure the efficiency a firm use its asset to
generate sales
A. Inventory Turnover = Cost of Goods Sold /
Inventory
1344 / 422 = 3.2 times
– As long as we are not running out of stock and
thereby forgoing sales, the higher ratio is, the more
efficiently we are managing inventory.
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3.
•
Asset management ratios
Inventory turnover can be computed using either ending
inventory or average inventory when you have both
beginning and ending figures. It is important to be
consistent with whatever benchmark you are using to
analyze the company’s strengths or weaknesses.

Days’ Sales in Inventory = 365 / Inventory Turnover
365 / 3.2 = 114 days
– This mean that inventory sits 114 days on
average before it sold.
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3.
Asset management ratios
B. Receivables Turnover = Sales / Accounts Receivable
2311/188 = 12.3 times
– The company collect its outstanding credit accounts
and reloaded the money 12.3 times during the year.
 Days’ Sales in Receivables = 365 / Receivables Turnover
365 / 12.3 = 30 days
– This ratio may also be called “average collection
period” or “days’ sales outstanding.”
– It mean that the company collects on its credit sales
in 30 days on average
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3.
Asset management ratios
C. NWC Turnover = Sales / NWC
2311 / (708-540) = 13.8 times
 It measure how much work we get out of our working
capital, the higher value is preferred.
D. Fixed Asset Turnover = Sales / net fixed assets
2311/3588 = .80 times
For every $1 in fixed assets, company generate $.80 in
sales.
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3.
Asset management ratios
E. Total Asset Turnover = Sales / Total Assets
2311/3588 = .8 times
– For every $1 in assets, company generate $.8 in
sales
– It is not unusual for TAT < 1, especially if a firm has a
large amount of fixed assets
– Having a TAT of less than one is not a problem for
most firms.
– Fixed assets are expensive and are meant to provide
sales over a long period of time. This is why the
matching principle indicates that they should be
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depreciated instead of immediately expensed.
3.
Asset management ratios
F. Payable turn over
• Shows how much time the company needs to
pay its bills
• = cost of good sold / account payable
Days in payable = 365/account payable
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4.
Computing Profitability Measures
A. Profit Margin = Net Income / Sales
363 / 2311 = 15.7%
– The company generate around 16 cents in profit for
every dollar in sales, the higher percentage is
preferred Profit margin.
–
It tells how much the firm earns for every dollar in
sales.
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4.
Computing Profitability Measures
B. Return on Assets (ROA) = Net Income /
Total Assets
363 / 3588 = 10.12%
– Measure of profit per dollar of assets. The
company generate around 10 cents in profit for
every dollar of assets.
– ROA is sometimes referred to as ROI (return on
investment).
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4. Computing Profitability Measures
C. Return on Equity (ROE) = Net Income / Total
Equity
363/2591 = 14%
– For every dollar in equity, the company generate 14
cents in profit.
– ROE will always be higher than ROA as long as the
firm has debt. The greater the leverage the larger
the difference will be. ROE is often used as a
measure of how well management is attaining the
goal of owner wealth maximization.
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5. Computing Market Value Measures
• Market Price
= $88 per share
• Shares outstanding = 33 million
A. Earnings per share = net income / shares
outstanding
363/33 = $11
B. Dividends per Share or DPS = Dividends/
shares outstanding
121/33 = $3.6
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5.
Computing Market Value Measures
C. Price-earnings ratio (PE) = Price per share /
Earnings per share
88/11 = 8 times
– The company shares sell for eight times earning,
or have PE multiple of 8.
– It measure how much investors are willing to pay
per dollar of current earnings.
– Higher PEs often take to mean the firm has
significant prospectus for future growth
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5.
Computing Market Value Measures
D. Price-Sales Ratio = Price per share / Sales per
share
88/(2311/33) = 1.26
E. Market-to-book ratio = market value per share /
book value per share
88 / (2591/33) = 1.12 times
– It compares the market value of firm’s investment to
their cost.
– A value less than 1 could mean that the firm has not
been successful overall in creating value for its
stockholders.
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5.
Computing Market Value Measures
• Tobin’s Q = Market value of firm’s assets /
Replacement cost of firm’s assets
= Market value of firm’s debt and equity /
Replacement cost of firm’s assets
– It focuses on what the firm is worth today relative to
what it would cost to replace it today.
– High ratio tend to be those with attractive investment
opportunities or significant competitive advantages.
– But it is difficult to estimate the replacement cost
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• Standardized Financial Statements
• Common-Size Balance Sheets
– Compute all accounts as a percent of total
assets.
• Common-Size Income Statements
– Compute all line items as a percent of sales
• Standardized statements make it easier to
compare financial information, particularly as the
company grows.
• They are also useful for comparing companies of
different sizes, particularly within the same
industry.
38
Common-Size Balance Sheet
39
• Common-Size Balance Sheet
• Notice that total change has to be zero because
the beginning and ending numbers must add up
to 100 percent.
• Also notice that the statement is relatively easy to
read and compare (for example: CA increased
from 19.1 to 19.7%, CL decreased from 15.7 to
12.7%)
40
• Common-Size Income Statements
41
• Common-Size Income Statements
• Common-Size Income Statement tells us what
happens to each dollar in sales (for example: we
pay taxes $.061 of each $1 in sales)
• Notice that the percentages are useful in
comparisons, such as cost control.
42
• problem of Financial Ratio Analysis
Seasonal factors can distort ratios.
Window dressing” techniques can make
statements and ratios look better.
Different operating and accounting practices
distort comparisons
Sometimes hard to tell if a ratio is “good” or “bad.”
Difficult to tell whether company is, on balance, in
strong or weak position
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