Understanding
Financial Statements
Seventh EDITION
Lyn M. Fraser
Aileen Ormiston
Insert
BOOK COVER
The Analysis of
Financial Statements
This chapter will develop tools and
techniques for the interpretation of
financial information
Chapter 5
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Objectives of Analysis
First order of business is to
Specify the objectives of the analysis
Focus on WHO is the financial statement user
Remember--the identity of the user helps
define what information is needed
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Objectives of Analysis
Continued
Potential Financial Statement Users:
Creditors
Investors
Management
What types of questions do each of these
users seek answers to?
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Creditors
A creditor is ultimately concerned with
the ability of an existing or
prospective borrower to make
interest and principal payments on
borrowed funds
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Creditors
Continued
Questions raised in a credit analysis
should include:



What is the borrowing cause?
What is the firm’s capital structure?
What will be the source of debt
repayment?
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Investors
The ultimate objective is to determine
whether the investment is sound
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Investors
Continued
The investment analyst poses questions as:




How has the firm performed/what are
future expectations?
How much risk is inherent in the
existing capital structure?
What are expected returns?
What is firm’s competitive position?
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Management
Management relates to all questions raised by:
Creditors
Investors
Employees
General public
Regulators
Financial press
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Management
Continued
Looks to Financial Statement Data
to Determine:


How well the firm has performed
and why?
What operating areas have
contributed to success and which
have not?
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Management
Continued
Looks to Financial Statement Data
to Determine:


What are strengths/weaknesses of
company’s financial position?
What changes are indicated to
improve future performance?
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Caution!!!



Keep in mind: management PREPARES
financial statements
Analyst should be alert to potential for
management to influence reporting to
make data more “appealing”
May want to supplement analysis with
information apart from Annual Report
prepared by management
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Sources of Information
The analyst will want to consider
the following resources:
Proxy Statement
MD&A
Supplementary schedules
Form 10-K and Form 10-Q
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Other Sources of Information

Computerized data bases




Info on industry norms/ratios
Info on particular
companies/industries/ mutual funds
Articles in popular/business press
Ever-expanding websites
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Tools and Techniques
These include:
Common-size financial statements
Financial ratios
Trend analysis
Structural analysis
Most important:
Common sense and judgment
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Common-Size
Financial Statements
Express each account on the balance
sheet as a percentage of total
assets and each account on the
income statement as a percentage
of net sales
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Key Financial Ratios
Standardize financial data in terms of
mathematical relationships expressed
in the form of percentages or times
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Key Financial Ratios
Continued
Four Categories of ratios:
1. Liquidity Ratio
Measures a firm’s ability to meet cash
needs as they arise
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Four Categories of Ratios
Continued
2. Activity Ratio
Measures the liquidity of specific assets
and the efficiency of managing
assets
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Four Categories of Ratios
Continued
3. Leverage Ratio
Measures the extent of a firm’s financing
with debt relative to equity and its
ability to cover interest and other
fixed charges
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Four Categories of Ratios
Continued
4. Profitability Ratio
Measures the overall performance of a
firm and its efficiency in managing
assets, liabilities and equity
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Caution!
Ratios are valuable, BUT. . .
They do not provide answers in and of
themselves and are not predictive
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More Cautions!

Ratios should be used with other
elements of financial analysis

There are no “rules of thumb” that
apply to interpretation of ratios
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More Cautions!
Continued
Keeping this in mind, let’s take a look at
some of the ratios. . . .
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Liquidity Ratios:
Short-Term Solvency
Current Ratio
Measures ability to meet short-term
cash needs
Current assets
Current liabilitie s
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Liquidity Ratios:
Short-Term Solvency
Continued
Quick or Acid-Test Ratio
Measures ability to meet short-term cash
needs more rigorously
Current assets - Inventory
Current liabilitie s
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Liquidity Ratios:
Short-Term Solvency
Continued
Cash Flow Liquidity Ratio
Focuses on ability of the firm to
generate operating cash flows as a
source of liquidity
Cash  Marketable securities  CFO *
Current liabilitie s
*Cash flow from operating activities
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Liquidity Ratios:
Short-Term Solvency
Continued
Average Collection Period
Helps gauge liquidity of accounts
receivable (ability to collect cash
from customers)
Accounts receivable
Average daily sales
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Liquidity Ratios:
Short-Term Solvency
Continued
Days Inventory Held
Is the average number of days it takes
to sell inventory to customers
Inventory
Average daily cost of sales
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Liquidity Ratios:
Short-Term Solvency
Continued
Days Payable Outstanding
Is the average number of days it takes
to pay accounts payables in cash
Accounts payable
Average daily cost of sales
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Net Trade Cycle
Is the normal cycle of a firm that
consists of:



Buying or manufacturing inventory,
with some purchases on credit
Selling inventory, with some sales
on credit
Collecting the cash
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Net Trade Cycle
Continued
Average collection period
Plus
Days inventory held
Minus
Days payable outstanding
Equals
Net trade cycle
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Activity Ratios: Assets Liquidity,
Asset Management Efficiency
Accounts Receivable Turnover
Another measure of efficiency of firm’s
collection and credit policies
Net sales
Accounts receivable
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Activity Ratios: Assets Liquidity,
Asset Management Efficiency Con’t
Inventory Turnover
Measures efficiency of inventory
management
Cost of goods sold
Inventory
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Activity Ratios: Assets Liquidity,
Asset Management Efficiency Con’t
Payables Turnover
Another measure of efficiency of
inventory management
Cost of goods sold
Accounts payable
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Activity Ratios: Assets Liquidity,
Asset Management Efficiency Con’t
Fixed Asset Turnover
Assesses effectiveness in generating
sales from investment in fixed assets
Net sales
Net property, plant, equipment
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Activity Ratios: Assets Liquidity,
Asset Management Efficiency Con’t
Total Asset Turnover
Assesses effectiveness in generating sales
from investment in total assets
Net sales
Total assets
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Leverage Ratios:
Debt Financing and Coverage
Debt Ratio
Measures the extent of firm’s financing
with debt
Total liabilitie s
Total assets
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Leverage Ratios:
Debt Financing and Coverage
Con’t.
Long-term Debt to Total Capitalization
Measures the extent of firm’s financing
with long-term debt
Long - term debt
Long - term debt  Stockholde rs' equity
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Leverage Ratios:
Debt Financing and Coverage
Con’t
Debt to Equity
Measures the extent of firm’s financing
with debt
Total liabilitie s
Stockholde rs' equity
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Leverage Ratios:
Debt Financing and Coverage
Con’t
Times Interest Earned
Indicates how well operating earnings
cover fixed interest charges
Operating profit
Interest expense
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Leverage Ratios:
Debt Financing and Coverage
Con’t
Cash Interest Coverage
Measures how many times interest
payments can be covered by cash
flow from operations before interest
and taxes
CFO  interest paid  taxes paid
Interest paid
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Leverage Ratios:
Debt Financing and Coverage
Con’t
Fixed Charge Coverage
Broader measure of how well operating
earnings cover fixed charges
Operating profit  Rent expense
Interest expense  Rent expense
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Leverage Ratios:
Debt Financing and Coverage
Con’t
Cash Flow Adequacy
Measures firm’s ability to cover capital
expenditures, long-term debt
payments and dividends each year
Cash flow from operating activities
Capital expenditur es  debt repayments
 dividends paid
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Profitability Ratios:
Overall Efficiency and Performance
Gross Profit Margin
Measures profit generated after
consideration of cost of products sold
Gross profit
Net sales
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Profitability Ratios:
Overall Efficiency and Performance Con’t.
Operating Profit Margin
Measures profit generated after
consideration of operating expenses
Operating profit
Net sales
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Profitability Ratios:
Overall Efficiency and Performance Con’t.
Net Profit Margin
Measures profit generated after
consideration of all expenses and
revenues
Net earnings
Net sales
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Profitability Ratios:
Overall Efficiency and Performance Con’t.
Cash Flow Margin
Measures ability to translate sales into
cash (with which to pay bills!)
Cash flow from operating activities
Net sales
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Profitability Ratios:
Overall Efficiency and Performance Con’t.
Return on Total Assets (ROA) or Return
on Investment (ROI)
Measures overall efficiency of firm in
managing investment in assets and
generating profits
Net earnings
Total assets
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Profitability Ratios:
Overall Efficiency and Performance Con’t.
Return on Equity (ROE)
Measures rate of return on stockholders’
investment
Net earnings
Stockholde rs equity
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Profitability Ratios:
Overall Efficiency and Performance Con’t.
Cash Return on Assets
 Useful comparison to return on

investment
Indicates firm’s ability to generate cash
from utilizing its assets
Cash flow from operating activities
Total assets
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Analyzing the Data
Now that some of the “tools” of financial
analysis have been illustrated,
where does one go from here?
Taking a general approach to financial
statement analysis, one might
proceed as follows. . .
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Five Steps of a
Financial Statement Analysis
Step 1
Establish objectives of the analysis



Who are you and why are you interested
in this company?
What questions would you like to have
answered?
What info is vital to the decision at hand?
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Five Steps of a
Financial Statement Analysis
Con’t.
Step 2
Study the industry in which the firm
operates and relate industry climate
to current and projected economic
developments
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Five Steps of a
Financial Statement Analysis
Con’t
Step 3
Develop knowledge of firm and
quality of management
 How well does this firm seem to be run?
 Are they taking advantage of

opportunities?
Are they innovative, forward-looking,
etc?
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Five Steps of a
Financial Statement Analysis
Con’t
Step 4
Evaluate financial statements

Tools: Common-size financial
statements, key financial ratios,
trend analysis, structural analysis,
and comparison with industry
competitors
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Five Steps of a
Financial Statement Analysis
Con’t
Step 4 Continued
Evaluate financial statements

Major Areas: Short term liquidity,
operating efficiency capital structure
and long-term solvency, profitability,
market ratios, and segmental
analysis (when relevant)
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Five Steps of a
Financial Statement Analysis
Con’t
Step 5
Summarize findings

Reach conclusions about the firm
relevant to your established
objectives
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Relating the Ratios
—The Du Pont System
It is helpful to complete the evaluation
of a firm by considering the
interrelationship among the
individual ratios
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Relating the Ratios
—The Du Pont System
Continued
The Du Pont System helps the analyst
see how the firm’s decisions and
activities over the course of an
accounting period interact to
produce an overall return to the
firm’s shareholders, the return on
equity
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Relating the Ratios
—The Du Pont System
Continued
The summary ratios are:
(1)
Net profit margin
Net income

Sales
(3)
Return on investment
Net income

Assets
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Total asset turnover
(3)
Return on investment
Sales
Assets
Net income
Assets

(4)
Financial leverage
Assets
Equity
(5)
Return on equity

Net income
Equity
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Four Market Ratios
1.
2.
3.
4.
Earnings per common share
Price-to-earnings
Dividend payout
Dividend yield
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Market Ratios
Continued
Earnings per Common Share
Provides the investor with a common
denominator to gauge investment
returns
Net earnings
Average shares outstandin g
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Market Ratios
Continued
Price-to-Earnings
Relates earnings per common share to the
market price at which the stock trades,
expressing the “multiple” that the stock
market places on a firm’s earnings
Market price of common stock
Earnings per share
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Market Ratios
Continued
Dividend Payout
This ratio is determined by the formula
cash dividends per share divided by
earnings per share
Dividends per share
Earnings per share
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Market Ratios
Continued
Dividend Yield
Shows that relationship between cash
dividends and market price
Dividends per share
Market price of common stock
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What we have accomplished
Turned Maze
Statement of Cash Flows
Balance Sheet
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MD&A
Income Statement
Notes
Auditor’s Report
Statement of Shareholders’ Equity
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Financial Statements
An Overview
into Map
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