Analysis of Financial Statements
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Financial analysis is designed to determine the
relative strengths and weaknesses of a
company
 Investors need this information to estimate
both future cash flows from the company and
the riskiness of those cash flows
 Information is provided by analysis both to
evaluate a company’s past performance and
to map future plans
Overview
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Financial statement analysis involves a
study of the relationships between
income statement and balance sheet
accounts, how these relationships
change over time (trend analysis), and
how a particular company compares with
other companies in its industry
(comparative ratio analysis)
Financial Statements
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Are used to help predict the company’s
future earnings and dividends
Financial Ratios
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Financial ratios are designed to show
relationships between financial
statement accounts
Liquidity Ratios
Are used to measure a firm’s ability to
meet its current obligations as they come
due
 Current Ratio
 Quick, or Acid Test, Ratio

Current Ratio
Measures the extent to which the claims
of short-term creditors are covered by
short-term assets
 It is determined by dividing current
assets by current liabilities

Quick, or Acid Test, Ratio
Is calculated by deducting inventory from
current assets and then dividing the
remainder by current liabilities
 Inventory is excluded because it may be
difficult to liquidate it at full book value

Asset Management Ratios
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Measure how effectively a firm is managing its
assets and whether or not the level of those
assets is properly related to the level of
operations as measured by sales
Inventory Turnover Ratio
Days Sales Outstanding (DSO)
Fixed Assets Turnover Ratio
Total Assets Turnover Ratio
Inventory Turnover Ratio
Is defined as sales divided by inventory
 It is often necessary to use the average
inventory figure rather than the year-end
figure, especially if a firm’s business is
highly seasonal

Days Sales Outstanding (DSO)
Is used to appraise accounts receivable,
and it is calculated by dividing average
daily sales into accounts receivable to
find the number of days’ sales tied up in
receivables
 DSO represents the average length of
time that a company must wait after
making a sale before receiving cash

Fixed Assets Turnover Ratio
Is the ratio of sales to net fixed assets
 It measures how effectively the firm uses
its plant and equipment

Total Assets Turnover Ratio
Is calculated by dividing sales by total
assets
 It measures the utilization of all the firm’s
assets
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Debt Management Ratios
Measure the extent to which the firm is
using debt financing, or financial
leverage, and the degree of safety
afforded to creditors
 Debt Ratio
 Times-Interest-Earned (TIE) Ratio
 Fixed Charge Coverage Ratio
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Debt Ratio
Or ratio of total debt to total assets,
measures the proportion of funds
provided by creditors
 The lower the ratio, the greater the
protection afforded creditors in the event
of liquidation

Times-Interest-Earned (TIE)
Is determined by dividing earnings
before interest and taxes (EBIT) by the
interest charges
 The TIE measures the extent to which
operating income can decline before the
company is unable to meet its annual
interest costs

Fixed Charge Coverage Ratio

Is similar to the TIE ratio, but it is more
inclusive because it recognizes that
many companies lease assets and incur
long-term obligations under lease
contracts and sinking funds.
Review
Financial Analysis
 Financial Statements
 Financial Ratios
 Liquidity Ratios
 Asset Management Ratios
 Debt Management Ratios
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Time to Answer a Few Questions