Introduction to Financial
Statement Analysis
P.V. Viswanath
Themes
 Financial Statements have to be modified and/or
understood appropriately to be useful to Financial
Analysts.


Accounting Value is not necessary Market Value – managers
need market values for decision-making.
Accounting Flows are not cashflows. Cashflows are relevant
for valuation.
 Financial Ratios can be used to gauge the financial
health of an institution.
 Financial Ratios can be used for strategic decisionmaking.
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Functions of Financial Statements
 They provide information to the owners and
creditors of the firm about the company’s current
status and past financial performance
 Financial statements provide a convenient way for
owners and creditors to set performance targets and
to impose restrictions on the managers of the firm.
 Financial statements provide convenient templates
for financial planning.
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The Balance Sheet
The balance sheet is a snapshot of the firm’s
assets and liabilities at a given point in time
Assets are listed in order of liquidity, i.e. ease
of conversion to cash without significant loss
of value
Liabilities are listed in order of time to
maturity
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Assets
 Assets are divided into current assets and long-term
assets. Current assets are:




Cash and marketable securities
Accounts receivable
Inventories
Other current assets, such as prepaid expenses
 Long-term assets include net property, plant and
equipment (net PP&E).

This consists of the original cost of PP&E reduced each
year by an amount called depreciation that is intended to
account for wear-and-tear and obsolescence.
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Assets
 When a firm acquires another firm, it will acquire a set of
assets that must be listed on its balance sheet. Often it will
pay more for these assets than their book value on the
acquired firm’s balance sheet.
 The difference is listed as goodwill.
 Trade-marks, patents and other such assets, along with
goodwill are called intangible assets.
 If their value decreases over time, they will be reduced by an
amortization charge.
 Amortization, like depreciation is not a cash expense.
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Liabilities
 Liabilities are divided into current and long-term liabilities.
 Liabilities that will be satisfied in one year are known as
current, and include:



Accounts payable,
Notes payable, short-term debt and all repayments of debt that will
occur within the year.
Items such as salary or taxes that are owed but have not yet been
paid.
 The difference between current assets and current liabilities
is known as (net) working capital.
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Long-term liabilities





Long-term debt is any loan or debt obligation with a maturity of more than one year.
Capital leases are long-term lease contracts that obligate the firm to make regular
payments in exchange for the use of an asset.
Deferred taxes are taxes that are owed but not yet paid. Firms keep two sets of books –
one for financial reporting and one for tax purposes. Deferred tax liabilities arise when
the firm’s financial (accounting) income exceeds its income for tax purposes. If a firm
depreciates assets faster for tax purposes than for reporting purposes, its tax paid will be
less than tax due according to reported income. Hence it will look as if the firm has not
paid taxes that it owes.
Over time, the discrepancy will disappear and the tax due will be “paid.” Hence deferred
tax is recorded as a liability.
For example, if reported depreciation is $200, while actual depreciation for tax purposes
is $300. Then if the tax rate is 20%, actual tax paid (based on the higher depreciation)
will be 20%(100) or $20 less. Hence this will create a tax liability, i.e. an obligation to
pay the IRS $20 in the future. However, in an subsequent period, if reported
depreciation is $300, while actual depreciation for tax purposes is $200; then the actual
tax paid (based on the lower depreciation of $200 will be 20%(100) or $20 more than the
tax required on the reported income. This will reduce the tax liability to zero.
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Deferred Tax Assets
 In principle, there could be deferred tax assets, as well.
 This occurs when taxable income is less than reported income; i.e. when
tax recorded as paid (based on reported income) is greater than the actual
tax paid (based on taxable income).
 For example, when a product is sold with a warranty, warranty expense
is estimated for the period the products are sold even though the actual
cost isn’t incurred until later periods.
 However, tax laws recognize a warranty expense only when the payment
is actually made.
 Hence if warranty claims are lower in earlier periods and higher in later
periods, the amounts deductible in later periods will produce tax benefits
that are recognized now as a deferred tax asset.
 The lower actual warranty payouts in earlier periods will generate higher
taxable income, but the reported higher warranty expense will make the
reported income lower and hence the reported required tax payment
lower. Hence the actual “excessively” high payment will generate a
deferred tax asset.
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Stockholder’s Equity
 The sum of current liabilities and long-term liabilities is total
liabilities. The difference between the firm’s assets and its
liabilities is Stockholders’ Equity or the book value of
equity.
 This number often does not provide us with an accurate
assessment of the firm’s equity because book values are
based on historical quantities and not on market values.
 The market price of a share times shares outstanding is
called market capitalization; this reflects what investors
expect the firms assets to produce in the future that can be
distributed to shareholders.
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Market Value vs. Book Value
Example
According to Generally Accepted Accounting Principles
(GAAP), your firm has equity worth $6 billion, debt worth
$4 billion, assets worth $10 billion. The market values your
firm’s 100 million shares at $75 per share and the debt at $4
billion.
Q: What is the market value of your assets?
A: Since (Assets=Liabilities + Equity), your assets must have a
market value of $11.5 billion.
In this example, the market value of debt is the same as the
book value of debt, but this need not always be true.
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Market Value vs. Book Value
Example
Book Value Balance Sheet
Assets = $10 bil
Debt = $4 bil
Equity = $6 bil
Market Value Balance Sheet
Assets = $11.5 bil
Debt = $4 bil
Equity = $7.5 bil
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
The Balance Sheet Identity
Current Liabilities
Payables
Short-term Debt
Current Assets
Cash & Securities
Receivables
Inventories
+
=
Fixed Assets
Tangible Assets
Intangible Assets
+
Long-term Liabilities
+
Shareholders’ Equity
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Pepsico Inc. Balance Sheet (in mil. $)
28- Dec- 02 29- Dec- 01 Liabilities
28- Dec- 02 29- Dec- 01
Assets
6,052
4,998
Current Assets
Current Liabilities
Cash And
Cash
1,638
683
Accounts Payable
5,490
3,484
Short T erm
Investment
207
966 Short/Current
562
354
Long
T erm Debt
Net
Other
Current
Receivable
2,531
2,142
Liabilities
1,160
Inventory
1,342
1,310 T otal Cu rren t L iab ilities
6,052
4,998
695
752 Long T erm Debt
2,187
2,651
Other
T otal
CuCurrent
rren t Assets
6,413
5,853 Other long-term liabilities
5,937
5,398
Assets
Long T erm
2,611
2,871 T
14,176
13,021
Investments
otal L iab
ilities
Property Plant and
Common
Stock
& Other Paid7,390
6,876 up Capital
30
69
Equipment
3,631
3,374 Retained Earnings
9,268
8,605
Goodwill
1,588
1,467 T otal S tockh old ers' E q u ity
9,298
8,674
Intangible Assets
1,841
1,254
Other Assets
21,695 T ot L iab s & S h areh old ers' E q u ity
21,695
T otal Assets
23,474
23,474
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Income Statement
The income statement is like a video of the
firm’s operations for a specified period of
time.
You report revenues first and then deduct any
expenses for the period.
Matching principle – GAAP requires the
income statement to show revenue when it
accrues and match the expenses required to
generate the revenue.
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Earnings Calculations
 Gross Profit

The difference between sales revenues and the costs incurred to make and sell
the products.
 Operating Expenses

Expenses in the ordinary course of running the business, but not directly
related to producing the goods; includes administrative expenses, marketing
expenses, R&D
 Earnings before Interest and Taxes (EBIT)

Includes other sources of income or expenses that arise from activities that
are not the central part of the business, e.g. investment income.
 Pretax Income and Net Income (NI)


From EBIT, we deduct interest paid and corporate taxes to determine Net
Income.
EPS = NI/Shares Outstanding
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Income Statement
Pepsico Inc. (in mil. $)
As of year ending
Dec 02
Dec 01
Revenue
25,112
26,935
Cost of Goods Sold
10,523
9,837
Gross Profit
14,589
17,098
SG&A Expense
8,523
11,608
Depreciation & Amortization
1,112
1,082
Operating Income
4,954
4,408
316
227
5046
4248
178
219
Income Before Taxes
4,868
4,029
Income Taxes
1,555
1,367
Nonoperating Income
EBIT
Interest
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Accounting vs Economic Measures of
Income
 The return to a stockholder of investing in a stock is simply
the rate of return on his investment:
Ending Priceof Share - BeginningPrice Cash Dividend
r
BeginningPriceof Share
 Accountants often measure corporate performance using the
return on equity (ROE):
Net Income
ROE 
Shareholders' Equity
 A big difference between the two is that the ROE does not
incorporate the impact on the share price of future expected
superior (or inferior) returns
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Ratio Analysis
 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
important.
 Keep in mind also the difference between flow
numbers (over a period of time) and stock numbers
(at a specific point in time).
 Ratios are used both internally and externally
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Categories of Financial Ratios
 Profitability ratios

Used to measure the firm’s return on its investments
 Liquidity ratios

Short-term solvency or how easily the firm can lay its hands on cash.
 Financial leverage ratios

Show long-term solvency; how heavily the firm is in debt.
 Efficiency or turnover ratios

Indicate how productively the firm is using its assets
 Market value ratios
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Computing Profitability Measures
 Gross Margin = Gross Profit/ Sales

14589/25112 = 58.10%
 (Net) Profit Margin = Net Income / Sales

3313/ 25112 = 0.1319 times or 13.19%
 Operating Margin = (Operating Income) / Sales

(4954) / 25112 = 0.1973 times or 19.73%
 Return on Assets (ROA) = (Net Income) / Av TA

(3313) / [(23474+21695)/2] = 0.1467 times or 14.67%
 Return on Equity (ROE) = Net Income / Average Equity

3313 / [(9298+8674)/2] = 0.3687 times or 36.87%
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Computing Liquidity Ratios
 Current Ratio = CA / CL

6413 /6052 = 1.06 times
 Quick Ratio = (CA – Inventory) / CL

(6413 – 1342) / 6052 = 0.838 times
 Cash Ratio = Cash / CL

1,638 / 6,052 = .276 times
 Net Working Capital to TA Ratio = NWC/TA

(6413-6052)/ 23474 = 0.154
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Computing Coverage Ratios
These are also measures of a firm’s short-term
solvency, similar to its liquidity ratios. Indirectly,
they also measure the riskiness of the firm’s debt
 Times Interest Earned = EBIT / Interest

(4868 + 178) / 178 = 28.35 times
 Cash Flow Coverage = (EBIT + Depreciation) /
Interest

(4868 + 178 + 1112) / 178 = 34.60 times
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Computing Inventory Ratios
 These are measures of how efficiently the firm uses its
inventory.
 Inventory Turnover = Cost of Goods Sold / Average
Inventory

10523 / [(1342+1310)/2] = 7.94 times
 Inventory Days = Days’ Sales in Inventory = 365 /
Inventory Turnover = Av Inv/(COGS/365)
This ratio gives investors an idea of how long it takes a company
to sell its inventory.
 365 / 7.94 = 45.99 days
 Note: When you have ratios with Income Statement numbers in
the numerator and Balance Sheet numbers in the denominator, use
average of year beginning and year end quantities.
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Computing Receivables Ratios
 These are measures of how efficiently the firm uses is
receivables policy.
 Receivables Turnover = Sales / Av Accounts
Receivable

25112 / [(2531+2142)/2] = 10.75 times
 Accounts Receivable Days = Average Collection Period
= Days’ Sales in Receivables = 365 / Receivables
Turnover = Accounts Receivables/ Av Daily Sales
 This measure is also known as “receivables in days.”

365 / 10.75 = 33.96 days
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Computing Total Asset Turnover
 These are measures of how efficiently the firm uses
its assets overall.
 Total Asset Turnover = Sales / Av Total Assets

25112 / [(23474+21695)/2] = 1.11 times
 Measure of asset use efficiency
 Not unusual for TAT < 1, especially if a firm has a
large amount of fixed assets.
 What is a reasonable value for TAT will depend on
the industry in question
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Computing Leverage Ratios for 2002
 Total Debt Ratio Debt-to-Capital Ratio = Total Debt / TA



Total debt, here, is usually interpreted to mean all debt-like
obligations, which is effectively total liabilities
14176 / 23,474 = .6039 times or 60.39%
The firm finances almost 60% of their assets with debt.
 Debt/Equity = Tot Debt / Tot Equity

14,176 / 9,298 = 1.5246 times
These numbers can also be computed for long-term debt (i.e.
long-term liabilities):
 Long Term Debt Ratio = LT Debt/ Total Assets = (2,187 +
5,937)/ 23,474 = 0.3461
 Long Term Debt/Equity = (2,187 + 5,937)/9,298 = 0.87375
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Computing Market Value Measures
 Market Price (end of 2002) = $42.22 per share
 Shares outstanding = 1753 million
 P/E Ratio = Price per share / Earnings per share

42.22 / 1.89 = 22.34 times
 Market-to-book ratio = mkt value per share / book value per share

42.22 / (9298 / 1753) = 7.96 times
 Enterprise Value


The value of the underlying business assets – computed as Mkt Value of
Equity + Debt – Cash = 42.22(1,753) + 14,176 - 1,638 = 86,549.66m.
This can be interpreted as the cost to take over the entire business.
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Payout and Retention Ratios
 Dividend payout ratio = Cash dividends / Net
income


Cash dividend equals common dividend + preferred divs
1041 / 3313 = .3142 or 31.42%
 Plowback ratio = Retention ratio = 1 – payout ratio

1 – 0.3142 = 0.6858 = 68.58%
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Benchmarking
 Ratios are not very helpful by themselves; they need
to be compared to something
 Time-Trend Analysis


Used to see how the firm’s performance is changing
through time
Internal and external uses
 Peer Group Analysis


Compare to similar companies or within industries
SIC and NAICS codes
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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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Statement of Cashflows
 A firm’s cashflows can be quite different from its
net income. For example:


The income statement does not recognize capital
expenditures as expenses in the year that the capital
goods are paid for. Those expenses are spread over time
as a deduction for depreciation.
The income statement recognizes revenues and expenses
when sales are made, even though the money may not
have been collected (revenues) or paid out (expenses).
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The Statement of Cashflows
 The statement of cashflows shows the firm’s cash
inflows and outflows from



Operations
Investments and
Financing
 The form of this statement is determined by
accounting standards.
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Statement of Cash Flows:
Operating Activities
 Operating activities are earnings-related
activities. Generally these relate to Income Statement
activities, and items included in working
capital. Included are:







Sales and expenses necessary to obtain sales
Related operating activities, such as extending credit to
customers
investing in inventories
obtaining credit from suppliers
payment of taxes
insurance payments
Other activities that don't easily fit into the other two
categories, such as settlements in lawsuits.
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Statement of Cash Flows:
Investing and Financing Activities
 Investing activities relate to the acquisition
and disposal of noncash assets: assets which
are expected to generate income for the
company over a period of time. These include
lending funds and collecting on these loans.
 Financing activities relate to the contribution,
withdrawing and servicing of funds to support
business activities.
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Pepsico Inc. (in mil. $)
Statement of Cash Flows 2002
3 ,3 13
N e t Inc o m e
O pe ra t ing A c t iv it ie s , C a s h F lo ws P ro v ide d B y o r Us e d In
1,112
Depreciatio n
A djustments To Net Inco me
-390
Changes In A cco unts Receivables
-260
Changes In Liabilities
704
Changes In Invento ries
-53
Changes In Other Operating A ctivities
201
T o t a l C a s h F lo w F ro m O pe ra t ing A c t iv it ie s
4 ,6 2 7
Inv e s t ing A c t iv it ie s , C a s h F lo ws P ro v ide d B y o r Us e d In
-1,437
Capital Expenditures
Investments
757
Other Cashflo ws fro m Investing A ctivities
153
T o t a l C a s h F lo ws F ro m Inv e s t ing A c t iv it ie s
-527
F ina nc ing A c t iv it ie s , C a s h F lo ws P ro v ide d B y o r Us e d In
-1,041
Dividends P aid
-1,734
Sale P urchase o f Sto ck
-404
Net B o rro wings
T o t a l C a s h F lo ws F ro m F ina nc ing A c t iv it ie s
Effect Of Exchange Rate Changes
C ha nge In C a s h a nd C a s h E quiv a le nt s
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$ 955
36
Notes to Financial Statements
 The Notes to the Financial Statements are
frequently very useful in assessing the financial
health of the firm. They often contain:

An explanation of accounting methods used




Straight-line versus accelerated depreciation
LIFO vs FIFO
Restatement of results from prior years using the new standards
Greater details regarding certain assets and liabilities

Conditions and expiration dates of long- and short-term debt,
leases, etc.
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Notes to Financial Statements

Information regarding the equity structure of the firm


Documentation of changes in operations


Conditions attached to the ownership of shares; these can be
particularly useful to assess the firm’s vulnerability to takeovers.
Acquisitions and Divestitures and their impact
Off-balance sheet items

Forward contracts, swaps, options and other derivative contracts,
which do not appear in the balance sheet, but which can affect a
firm greatly. A lot of Enron’s problems had to do with such offbalance sheet items.
P.V. Viswanath
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Determinants of Growth




Profit margin – operating efficiency
Total asset turnover – asset use efficiency
Financial leverage – choice of optimal debt ratio
Dividend policy – choice of how much to pay to
shareholders versus reinvesting in the firm
P.V. Viswanath
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The Du Pont Identity
 ROA = NI/ TA


ROA = (NI/ Sales)*(Sales / TA)
ROA = (Net Profit Margin)*(Asset Turnover)
 ROE = NI / TE


ROE = (NI/Sales)*(Sales/TA)*(TA/TE)
= Net Profit Margin*Asset Turnover*Equity Multiplier
 Net Profit margin is a measure of the firm’s operating efficiency – how well it
controls costs
 Total asset turnover is a measure of the firm’s asset use efficiency – how well
it manages its assets
 Equity multiplier is a measure of the firm’s financial leverage.
 A firm could have a high volume/low margin strategy, which would be
reflected in high asset turnover but low profit margins or the reverse.
 The firm’s marketing (e.g. branding) and other strategies have to be
commensurate.
 Note: ROA is sometimes defined as (NI + Int expense)/TA
P.V. Viswanath
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Determinants of Earnings Growth Rate
 Earnings in any period depends on the investment base, as well as
the rate of return that the firm earns on that investment base:
 Et+1 = (TotEquityt)ROE
= (TEt-1 + DTEt)(ROE), where DTEt is the increment in total
equity in period t over and above that in period t-1.
= (TEt-1)ROE + (DTEt)(ROE)
= Et + (DTEt)(ROE);
 Hence Et+1 - Et = (DTEt)(ROE)
 Dividing both sides by Et , we get gt = (DTEt/Et)(ROE) (= Retention
ratio)xROE, if there is no new equity issue).
 We have assumed that ROE does not change, i.e. that the debtequity ratio will be kept constant, as we can see from the DuPont
identity.
 Hence for this formula to be exactly correct, debt must be increased
and equity decreased in such a way as to keep the debt ratio
constant, assuming that the assets side of the business maintains a
constant profitability. This is the assumption.
P.V. Viswanath
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Sustainable Growth
 The sustainable growth rate tells us how fast the equity of the firm can
grow, without increasing financial leverage and without any additional
outside equity.
 We have already seen that gt = (DTEt/Et)(ROE)
 If only internal funds are used, then DTEt is simply retained earnings.
 Hence, sustainable growth rate (of earnings) = retention ratio x ROE


0.6858 x 0.3687 = 0.2528 or 25.28%
If the firm can continue to earn 36.87% on its equity and can plow back 68.58%
of earnings into operations, its earnings and equity should both grow at 25.28%
p.a.
 As discussed above, ROE is assumed to be constant, i.e. that the debt-equity
ratio will be kept constant, which means that debt will have to be increased
in proportion to the increase in equity due to the retention of earnings.
 However, if the firm will not have access to new debt financing, the
business can only grow at a lower rate, which is called the internal growth
rate.
P.V. Viswanath
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Internal Growth Rate
The rate at which the business as a whole, i.e. the total assets of the firm can
grow without additional external financing is called the internal growth rate.
Internal
retainedearnings

growth rate
totalassets

Internal
retainedearnings net income
equity
x
x
net income
equity
totalassets
Sustainable
equity

x
 RetentionRatio x ROA
growth rate Growth Rate total assets


0.2169 x (9298+8674) /(23474+21695) = 0.2528 x 0.3979 = 0.1006 or
10.06%
This differs from the sustainable growth rate in that there is no
presumption that additional debt can be obtained.
P.V. Viswanath
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