Analysis of Financial
Statements
1
Overview of Financial Analysis
• First order of business is to SPECIFY
THE OBJECTIVES OF THE ANALYSIS
• Remember -- the identity of the user
helps define what information is
needed
Potential Financial Statement
Users:
•
•
•
•
Creditors
Investors
Managers
Employees
• What types of questions do each of these
users seek answers to?
Creditors
• Why does the firm want/need to
borrow funds?
• What is the firm’s capital structure?
How leveraged are they?
• How will they pay it back? What
kind of cash flows are being
generated by operations?
Investors
• How has the firm performed/what are
future expectations?
• How much RISK is inherent in the
capital structure?
• What are expected returns from the
firm?
• What is firm’s competitive position?
Managers
• Need all info creditors and investors need
PLUS:
• What operating areas have contributed to
success and which have not?
• What are strengths/weaknesses of
company’s financial position?
• What changes are indicated to improve
future performance?
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
Where to look for data...
•
•
•
•
Financial statements (and notes)
Annual Report
10K and 10Q reports filed with SEC
Computerized data bases
• Info on industry norms/ratios
• Info on particular companies/industries/mutual
funds
• Websites
Basic Tools
• Common size financial
statements
• Financial ratios
• Trend analysis
• Industry comparisons
Common Sizing
Firm A
Firm B
Sales
2531456.24
4561234.87
COGS
784564.54
1556456.24
1746891.70
3004778.63
Gr. Profit
Common Sizing
Firm A
Sales
COGS
Gr. Profit
Firm B
2,531,456
4,561,234
784,564
1,556,456
1,746,891
3,004,778
Common Sizing
Firm A
Sales
COGS
Gr. Profit
Firm B
2,531,456
100%
4,561,234
100%
784,564
31%
1,556,456
34%
1,746,891
69%
3,004,778
66%
Common Size Statements
• Common size income statement
• expresses each income statement
category as a percentage of sales
• Common size balance sheet
• expresses each item on balance sheet as
a percentage of total assets or equities
Ratio Analysis
Four Categories of Ratios
•
•
•
•
Profitability
Liquidity
Debt Utilization
Asset Utilization ratios
14
Ratio Analysis
Profitability Ratios
• Measure the overall effectiveness of
the firm’s management.
15
Ratio Analysis
Profitability Ratios
Gross Profit Margin =
Gross Profit
Sales
How effective is the firm at generating
revenue in excess of its cost of goods
sold?
16
Balance Sheet
Excalibur Corporation
Cash
$175
Accounts Receivable 430
Inventories
625
Current Assets
$1,230
Plant & Equipment $2,500
Less:Acc. Depr.
(1,200)
Net Fixed Assets
$1,300
Total Assets
$2,530
Income Statement
Excalibur Corporation
Sales
$1,450
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
Net Operating Income
$330
Interest Expense
60
Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Common Dividends Paid
100
Addition to Retained Earnings $62
Gross
Profit
Margin
=
Accounts Payable
$115
S-T Notes Payable
115
Current Liabilities
$230
Bonds
$600
Owner’s Equity
Common Stock
$300
Capital in Excess of Par 600
Retained Earnings
800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity
$2,530
Gross Profit
Sales
Gross Profit Margin =
$575
$1,450
= 39.7%
17
Ratio Analysis
Profitability Ratios
Operating Profit Margin =
Operating Income
Sales
How effective is the firm in keeping costs
of production low?
18
Balance Sheet
Excalibur Corporation
Cash
$175
Accounts Receivable 430
Inventories
625
Current Assets
$1,230
Plant & Equipment $2,500
Less:Acc. Depr.
(1,200)
Net Fixed Assets
$1,300
Total Assets
$2,530
Income Statement
Excalibur Corporation
Sales
$1,450
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
Operating Income
$330
Interest Expense
60
Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Common Dividends Paid
100
Addition to Retained Earnings $62
Accounts Payable
$115
S-T Notes Payable
115
Current Liabilities
$230
Long-term Debt
$600
Owner’s Equity
Common Stock
$300
Capital in Excess of Par 600
Retained Earnings
800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity
$2,530
Operating
Operating Income
Profit
=
Sales
Margin
Oper. Profit Margin =
$330
$1,450
= 22.8%
19
Ratio Analysis
Profitability Ratios
Note: Net Income equals Earnings Available to CS
when there is no preferred stock.
Profit Margin or
Return on Sales =
Net Income
Sales
How much net profit is being generated
from each dollar of sales?
20
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Income Statement
Total Liabilities and
Excalibur Corporation
Owners Equity
$2,530
Sales
$1,450
Cost of Goods Sold
Gross Profit
Operating Expenses
Depreciation
Operating Income
Interest Expense
Income Before Taxes
Taxes (40%)
Net Income
Common Dividends Paid
Addition to Retained Earnings
875
$575
45
200
$330
60
$270
108
$162
100
$62
Net
Profit
Margin
=
Profit Margin =
Net Income
Sales
$162
$1,450
= 11.2%
21
Ratio Analysis
Profitability Ratios
Return on Assets =
Net Income
Total Assets
How effectively is the firm generating net
income from its assets ?
22
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Total Liabilities and
Income Statement
Owners Equity
$2,530
Excalibur Corporation
Sales
$1,450
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Net Income
Return on
Depreciation
200
=
Operating Income
$330
Total Assets
Assets
Interest Expense
60
Income Before Taxes
$270
Taxes (40)
108
$162 = 6.4%
Net Income%
$162
ROA = $2,530
Common Dividends Paid
100
Addition to Retained Earnings $62
23
Ratio Analysis
Profitability Ratios
Return on Common Equity =
Net Income
Equity
How well is the firm generating return to
its equity providers?
24
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Income Statement
Total Liabilities and
Excalibur Corporation
Owners Equity
$2,530
Sales
$1,450
Cost of Goods Sold
Gross Profit
Operating Expenses
Depreciation
Operating Income
Interest Expense
Income Before Taxes
Taxes (40%)
Net Income
Common Dividends Paid
Addition to Retained Earnings
875
$575
45
200
$330
60
$270
108
$162
100
$62
Return on Equity =
ROE =
$162
$1,700
Net Income
Equity
= 9.53%
25
Ratio Analysis
Liquidity Ratios
• Measure the ability of the firm to
meet its short-term financial obligations.
Current Assets
Current Ratio =
Current Liabilities
Are there sufficient current assets to pay off
current liabilities? What is the cushion of
safety?
26
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity
$2,530
Current Ratio =
Current Assets
Current Liabilities
Current Ratio = $1,230 = 5.35x
$230
27
Ratio Analysis
Liquidity Ratios
• Measure the ability of the firm to meet
its short-term financial obligations.
Quick Ratio =
Current Assets - Inventory
Current Liabilities
What happens to the firm’s ability to repay current
liabilities after what is usually the least liquid of the
current assets is subtracted?
28
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity
$2,530
Quick Ratio =
Current Assets - Inventory
Current Liabilities
Acid-Test Ratio =
$1,230 -$625
= 2.63x
$230
29
Ratio Analysis
Debt Utilization Ratios
• Measure the relative size of the firm’s
debt load and the firm’s ability to pay
off the debt.
30
Ratio Analysis
Debt Ratios
Debt Ratio =
Total Debt
Total Assets
What proportion of the firm’s assets is
financed with debt?
31
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Income Statement
Total Liabilities and
Excalibur Corporation
Owners Equity
$2,530
Sales
$1,450
Cost of Goods Sold
Gross Profit
Operating Expenses
Depreciation
Operating Income
Interest Expense
Income Before Taxes
Taxes (40%)
Net Income
Common Dividends Paid
Addition to Retained Earnings
875
$575
45
200
$330
60
$270
108
$162
100
$62
Debt Ratio =
Total Debt
Total Assets
Debt Ratio = $230 + $600 = 33%
$2,530
32
Ratio Analysis
Debt Ratios
Times Interest Earned Ratio =
Operating Income
Interest Expense
What is the firm’s ability to repay interest
payments from its operating income?
33
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Income Statement
Excalibur Corporation
Total Liabilities and
Sales
$1,450
Owners Equity
$2,530
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
Times
Operating Income
Operating Income
$330
Interest
=
Interest Expense
60
Interest Expense
Earned
Ratio
Income Before Taxes
$270
Taxes (40%)
108
$330
Net Income
$162
TIE Ratio =
= 5.50x
Common Dividends Paid
100
$60
Addition to Retained Earnings $62
34
Ratio Analysis
Asset Management Ratios
• Help assess how effectively the firm is using
assets to generate sales.
35
Ratio Analysis
Asset Utililzation Ratios
Average Collection Period =
Accounts Receivable
Avg. Daily Cr. Sales
How long does it take for the firm on
average to collect its credit sales from
customers?
36
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Bonds
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Income Statement
Total Liabilities and
Excalibur Corporation
Owners Equity
$2,530
Sales
$1,450
Additional Info:
We assume all
sales are credit
sales.
Cost of Goods Sold
Gross Profit
Operating Expenses
Depreciation
Operating Income
Interest Expense
Income Before Taxes
Taxes (40%)
Net Income
Common Dividends Paid
Addition to Retained Earnings
875
$575
45
200
$330
60
$270
108
$162
100
$62
Average
Collection =
Period
ACP =
Accounts Receivable
Avg. Daily Sales
$430
$1,450/365
= 108.24 days
Days in a
year
37
Ratio Analysis
Asset Management Ratios
Inventory Turnover Ratio =
Sales
Inventory
Is inventory efficiently translating into
sales for the firm?
38
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Income Statement
Total Liabilities and
Excalibur Corporation
Owners Equity
$2,530
Sales
$1,450
Cost of Goods Sold
Gross Profit
Operating Expenses
Depreciation
Operating Income
Interest Expense
Income Before Taxes
Taxes (40%)
Net Income
Common Dividends Paid
Addition to Retained Earnings
875
$575
45
200
$330
60
$270
108
$162
100
$62
Inventory
Turnover =
Ratio
Inventory Turnover =
Sales
Inventory
$1450
$625
= 2.3x
39
Ratio Analysis
Asset Management Ratios
Sales
Fixed Asset Turnover Ratio = Net Fixed Assets
How effective is the firm in using its fixed
assets to help generate sales?
40
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Income Statement
Total Liabilities and
Excalibur Corporation
Owners Equity
$2,530
Sales
$1,450
Cost of Goods Sold
Gross Profit
Operating Expenses
Depreciation
Operating Income
Interest Expense
Income Before Taxes
Taxes (40%)
Net Income
Common Dividends Paid
Addition to Retained Earnings
875
$575
45
200
$330
60
$270
108
$162
100
$62
Fixed Asset
Turnover
Ratio
=
Sales
Net Fixed Assets
Fixed Asset Turnover =
$1,450
= 1.12x
$1,300
41
Ratio Analysis
Asset Management Ratios
Total Asset Turnover Ratio =
Sales
Total Assets
How effective is the firm in using its
overall assets to generate sales?
42
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175
Accounts Receivable 430
Inventories
625
Current Assets
$1,230
Plant & Equipment $2,500
Less:Acc. Depr.
(1,200)
Net Fixed Assets
$1,300
Total Assets
$2,530
Income Statement
Excalibur Corporation
Sales
$1,450
Cost of Goods Sold
875
Gross Profit
$575
Operating Expenses
45
Depreciation
200
Operating Income
$330
Interest Expense
60
Income Before Taxes
$270
Taxes (40%)
108
Net Income
$162
Common Dividends Paid
100
Addition to Retained Earnings $62
Accounts Payable
$115
S-T Notes Payable
115
Current Liabilities
$230
Long-term Debt
$600
Owner’s Equity
Common Stock
$300
Capital in Excess of Par 600
Retained Earnings
800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity
$2,530
Total Asset
Turnover =
Ratio
Total Asset Turnover =
Sales
Total Assets
$1,450
$2,530
= 0.57x
43
Ratio Analysis
Market Value Ratios
Price to Earnings Ratio =
Price per Share
Earnings per Share
How much are investors willing to pay per
dollar of earnings of the firm?
(Indicator of investor’s attitudes toward
future prospects of the firm and of the
firm’s risk.)
44
Balance Sheet
Excalibur Corporation
Assets
Liabilities
Cash
$175 Accounts Payable
$115
Accounts Receivable 430 S-T Notes Payable
115
Inventories
625 Current Liabilities
$230
Current Assets
$1,230 Long-term Debt
$600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr.
(1,200) Common Stock
$300
Net Fixed Assets
$1,300 Capital in Excess of Par 600
Total Assets
$2,530 Retained Earnings
800
Total Owners’ Equity $1,700
Income Statement
Total Liabilities and
Excalibur Corporation
Owners Equity
$2,530
Sales
$1,450
Additional Info:
100 shares
$20.00 per
share
Cost of Goods Sold
Gross Profit
Operating Expenses
Depreciation
Operating Income
Interest Expense
Income Before Taxes
Taxes (40%)
Net Income
Common Dividends Paid
Addition to Retained Earnings
875
$575
45
200
$330
60
$270
108
$162
100
$62
P/E
=
Ratio
P/E ratio =
Price/Share
EPS
$20.00
= 12.35x
$162/100
45
Ratio
Industry Excalibur
Profitability
Gross Profit Margin
Operating Profit Margin
Net Profit Margin
Return on Assets
Return on Equity
38%
20%
12%
9.0%
13.4%
39.7%
22.8%
11.2%
6.4%
9.5%
46
Ratio
Industry Excalibur
Profitability
Gross Profit Margin
Operating Profit Margin
Net Profit Margin
Return on Assets
Return on Equity
38%
20%
12%
9.0%
13.4%
39.7%
22.8%
11.2%
6.4%
9.5%
Excalibur is good at keeping operating
costs down, but not as good at total
costs. ROA and ROE are low mainly
due to productivity problems.
47
Summary of Excalibur Corporation Ratios
Ratio
Industry
Excalibur
Liquidity
Current Ratio
Quick Ratio
5.00x
3.00x
5.35x
2.63x
48
Summary of Excalibur Corporation Ratios
Ratio
Industry
Excalibur
Liquidity
Current Ratio
Quick Ratio
5.00x
3.00x
5.35x
2.63x
Looking at the current ratio it appears
that Excalibur is more liquid than the
industry.... however when looking at
Acid Test (a better measure) they are
not as liquid indicating that inventory
levels are probably too high.
49
Ratio
Industry Excalibur
Debt
Debt Ratio
Times Interest Earned
35%
7.00x
33%
5.50x
50
Ratio
Industry Excalibur
Debt
Debt Ratio
Times Interest Earned
35%
7.00x
33%
5.50x
While the debt ratio is close to the industry
average, Excalibur is not able to cover
interest payments as easily as the industry.
This indicates Excalibur may have too much
debt relative to what they can realistically
afford.
51
Ratio
Industry Excalibur
Asset Management
Avg. Collection Period
Inventory Turnover
Fixed Asset Turnover
Total Asset Turnover
90 days
3.00x
1.00x
0.75x
108 days
2.32x
1.12x
.57x
52
Ratio
Industry Excalibur
Asset Management
Avg. Collection Period
Inventory Turnover
Fixed Asset Turnover
Total Asset Turnover
90 days
3.00x
1.00x
0.75x
108 days
2.32x
1.12x
.57x
Collection policies need examining, as Excalibur is
slower than average at collecting receivables.
Inventories are being sold more slowly than the
industry average, again indicating inventories that
are too high. Excalibur is very efficient at converting
Fixed Assets to Sales (fixed assets are productive).
However, overall assets are not productive
indicating Current Assets (e.g. inventories) are not
as productive as for the industry.
53
Ratio
Market Value
PE Ratio
Industry Excalibur
18.0
12.35
54
Ratio
Market Value
PE Ratio
Industry Excalibur
18.0
12.35
Excalibur’s Investors are not willing to
pay as much per dollar of earnings or
per dollar of book value as they are for
shares in other firms in the industry.
This signals that they consider the firm’s
prospects to be worse than the average.
However, the firm is still selling for more
than its accounting book value.
55
Relationships Among Ratios:
The Du Pont System
• Ratio Analysis generally involves
an examination of related ratios.
• Comparison of these relationships
over time helps to identify the
company’s strengths and
weaknesses.
56
Relationships Among Ratios:
The Du Pont System
The Du Pont Equation
Return
=
on
Assets
Net
Profit x
Margin
Net Inc.
Assets
= Net Inc. x
Sales
Total
Asset
Turnover
Sales
Assets
57
Relationships Among Ratios:
The Du Pont System
Return
=
on
Equity
Net
Profit x
Margin
Net Inc.
=
Equity
Net Inc.
Sales
Total
x
Asset
Turnover
x
Sales
Assets
Equity
Multiplier
x
Equity
Assets
58
DuPont Equation: TGT vs. Walmart
Target
Net Profit Asset
Margin
Turnover
4.0%
1.45
Wal-Mart 3.6%
2.40
Which would you prefer?
DuPont Equation: TGT vs. Walmart
Jan. 2005 Net Profit Asset
ROA
Margin
Turnover
Target
4.0%
1.45
5.8%
Wal-Mart 3.6%
2.40
8.6%
DuPont Equation: TGT vs. Walmart
Jan. 2005 Net Profit Asset
Equity
ROE
Margin
Turnover Multiplier
Target
4.0%
1.45
2.5
15%
Wal-Mart 3.6%
2.40
2.4
21%
What is Target’s debt ratio?
How much debt would Target need for ROE=21%
• The DuPont approach is nice because it
divides the firm into three tasks
• expense management (measured by the profit
margin)
• asset management (measured by asset
turnover)
• debt management (measured by the equity
multiplier)
DuPont Example
Profit M.
Ass.Turn.
ROA
Eq. Mult.
ROE
Wal-Mart
Sears
4%
3
?
2
?
6%
1.5
?
1
?
What is the top overall ratio?
Ratio Exercise
Inv turn.
5
Debt to net
worth
.50
G. P.
Margin
Acid test
TA
turnover
Cash
______ Acc Pay
_____
Acc Rec.
14,795
Inv.
______ Stock
25,000
Plant Eq.
______ Ret Earn.
35,000
Total
Assets
Tot. Liab
______ & Eq.
_______
Sales
____
______
.30
1.2
2
COGS