Analyzing Financial Data and
Ratios
Mr. Michael Wong
Lecturer, PolyU HKCC
Value of Financial Statement
Analysis
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Financial statements, by their nature, are backwardlooking
So why analyze the statements?
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Analysis provides knowledge of a firm’s operating and
financial structure
This aids in estimating future returns
Major Financial Statements
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Corporate annual reports must include:
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Statement of Financial Position
Income statement
Statement of cash flows
Enough for analysis?
Purpose of Financial Statement
Analysis

Evaluate management performance in
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Profitability
Efficiency
Risk
Although financial statement information is
historical, it is used to project future
performance
Five Categories of Financial Ratios
1.
2.
3.
Common size statements
Internal liquidity (solvency)
Operating performance
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4.
Risk analysis
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5.
Operating profitability
Operating efficiency
Business risk
Financial risk
Growth analysis
Common Size Statements
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Normalize balance sheets and income statement
items to allow easier comparison of different size
firms
A common size balance sheet expresses accounts as
a percentage of total assets
A common size income statement expresses all items
as a percentage of sales
Consolidated
Statement of
Income
Consolidated
Statement of
Financial
Position
Evaluating Internal Liquidity

Internal liquidity (solvency) ratios indicate the
ability to meet future short-term financial
obligations
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Current Ratio
Quick Ratio
Cash Ratio
Evaluating Operating Performance

Ratios that measure how well management is
operating a business

Operating profitability ratios

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Examine how management is doing at controlling
costs so that a large proportion of the sales dollar is
converted into profit
Operating efficiency ratios

Examine how management uses its assets to generate
sales; considers the relationship between various asset
categories and sales
Operating Profitability Ratios

Operating profitability
ratios measure
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Gross profit margin
Operating profit margin
Net profit margin
Return on owner’s
equity (ROE)
Operating Efficiency Ratios

How effectiveness of a firm’s use of its total
asset base to produce sales
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Total asset turnover
Non-current asset turnover
Operating cycle
Cash conversion cycle
Operating Cycle & Cash Conversion Cycle
Raw material
purchased
Finished goods sold
Cash
received
Order
Stock
Placed Arrives
Inventory period
Accounts receivable period
Time
Accounts payable period
Firm receives invoice
Cash paid for materials
Operating cycle
Cash
conversion
cycle
Operating Profitability Ratios

Return on owner’s equity (ROE) indicates the
rate of return earned on the capital provided
by the stockholders after paying for all other
capital used
Net Income
Return on Total Equity 
Average Total Equity
Operating Profitability Ratios
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The DuPont System divides ROE into several
ratios that collectively equal ROE while
individually providing insight
An extended DuPont System provides
additional insights into the effect of financial
leverage on the firm and pinpoints the effect
of income taxes on ROE
Operating Profitability Ratios
Net Income

Common Equity
Net Income
Sales
Total Assets



Sales
Total Assets Common Equity
=
Profit
Margin
Total Asset
x Turnover
Financial
x Leverage
Risk Analysis
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Risk analysis examines the uncertainty of income for
the firm and for an investor
Total firm risks can be decomposed into two basic
sources:
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Business risk: The uncertainty in a firm’s operating
income, highly influenced by industry factors
Financial risk: The added uncertainty in a firm’s net
income resulting from a firm’s financing decisions
Business Risk
Variability of the firm’s operating income over time
Two primary determinants of business risk
 Sales variability
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The main determinant of earnings variability
Cost Variability and Operating leverage
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Production has fixed and variable costs
Greater fixed production costs cause greater profit
volatility with changes in sales
Fixed costs represent operating leverage
Greater operating leverage is good when sales are high
and increasing, but bad when sales fall
Effect of operating leverage

More operating leverage leads to more business
risk, for then a small sales decline causes a big
profit decline.
Rev.
Rev.
$
TC
$
} Profit
TC
FC
FC
QBE

Sales
QBE
Sales
What happens if variable costs change?
Financial Risk

Interest payments are deducted before we get
to net income
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Similar to fixed production costs, these lead to
larger earnings during good times, and lower
earnings during a business decline
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These are fixed obligations
Fixed financing costs are called financial leverage
The use of debt financing increases financial
risk and possibility of default
Financial Risk
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Two sets of financial ratios help measure
financial risk
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Balance sheet ratios
Earnings or cash flow available to pay fixed
financial charges
Acceptable levels of financial risk depend on
business risk
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A firm with considerable business risk should
likely avoid lots of debt financing
Financial Risk
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Balance Sheet Ratios
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Total debt ratio
Debt-equity ratio
Equity multiplier
Earnings or cash flow available to pay fixed
financial charges
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Times interest earned ratio
Cash coverage ratio
Potential Growth Analysis
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Important to both creditors and owners

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ability to pay future obligations
Ability to pay dividends
g = ROE x Retention rate
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The retention rate is one minus the firm’s dividend
payout ratio
Anything that impacts ROE would also be a
determinant of future growth
Importance of Relative Financial
Ratios
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In order to make sense of a ratio, we must compare it
with some appropriate benchmark or benchmarks
Examine a firm’s performance relative to:
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The aggregate economy
Its industry or industries
Its major competitors within the industry
Its own past performance (time-series analysis)
Comparing to the Aggregate
Economy
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Most firms are influenced by economic
expansions and contractions in the business
cycle
Analysis helps you estimate the future
performance of the firm during subsequent
business cycles
Comparing to the Industry Norms
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Most popular comparison
Industries affect the firms within them differently,
but the relationship is always significant
The industry effect is strongest for industries with
homogenous products
Can also examine the industry’s performance relative
to aggregate economic activity
Comparing to the Firm’s Major
Competitors
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Industry averages may not be representative
A firm may operate in several distinct industries
Several approaches:
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Select a subset of competitors for the comparison group
Construct a composite industry average from the different
industries in which the firm operates
Comparing to the Firm’s Own Past
Performance
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Determine whether it is progressing or
declining
Helpful for estimating future performance
Consider trends as well as averages over time
Other than financial statements
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Corporate Profile
Chairman’s Statement
Management Discussion and Analysis
Notes to Financial Statements
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Segment information
Noncurrent assets component
Any commitments, etc.
Government & Industry Statistics
Your Observation
Is financial performance everything?
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Financial performance may lead
management’s emphasis on short-run
financial performance
Need to have some measures that translate an
organisation’s mission and strategy into a
comprehensive set of performance measures.
Other perspectives
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1
2
3
4
Four key perspectives:
Financial
Customer
Internal business processes
Learning and growth
Other perspectives
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Because the non-financial and operational indicators
measure fundamental changes that a company is
making.
The financial benefits of these fundamental changes
may not be captured in short-run earnings.
Strong improvements in non-financial measures
signal the prospect of creating economic value in the
future.
Q&A
Summary of Ratio analysis