Financial Statement Analysis

Financial Statements according to GAAP
Income Statement (Statement of Operations)
– Shows profitability for a period of time
– A summary statement of revenues, expenses, gains, and
– Must follow GAAP (financial accounting standards)
– Subject to much judgment by management and CPAs
– Traditionally, bottom-line earnings from income statements
represented primary stock price drivers
– Currently, the move is on in the accounting profession to
distinguish appropriately between earnings and “quality”
The Balance Sheet (Financial Position)
Determines Solvency Position of an organization on a
given date
– Assets (Resources): Future economic value owned or
controlled by the organization
• Current:--Cash and near cash assets
• Non-current—Relatively permanent assets used to generate
– Liabilities (Debts): Future claims by outsiders on assets of
the organization
• Current—Due in the near future
• Long-term—Due at least one year from the balance sheet date
– Stockholders’ Equity—Owners’ claim to organization
Statement of Cash Flows
Summarizes cash inflows and (outflows) for a
period of time
– Includes all cash inflows (outflows) regardless of
source or use
– Categories of cash flows
• Operating Activities: Shows cash flows from operating
income (from income statement)
• Investing Activities: Shows cash flows to investments and
from sales of investments
• Financing Activities: Shows cash flows from borrowing
and sales of original equity issues and subsequent pay
back of loans, equity re-acquisitions, and dividends
Sources of Financial Analysis Tools
Finance and Accounting Texts
Dess-Lumpkin Text pp 98-117
Stickney-Brown Text (5th Ed)
Handout Link in your tentative schedule (Best Source)
– Uses averages instead of end-of-year figures where
appropriate and cost of goods sold instead of sales in
inventory turnover calculations
– Emphasizes DuPont Model for R.O.I. calculations
– More cash flow analyses included
Financial Statement Analysis
Profitability Analysis
– Return on Investment (ROI)
• Return / Average Investment
– DuPont Model
• Return / Sales X Sales / Average Investment
• Sales Margin X Asset Turnover
– Return on Equity (ROE)
• Return / Average Stockholders’ Equity
– Others: PE Ratio; Dividend Yield; Dividend Payout
– Also be sure to compare your company stock price
trend with some of the major price indices.
Why We Use Averages in Denominators
Assume Total Assets at Beginning of Year = $500
– At July 1, we acquire $500 in new plant assets
– Net income (return on investment) for year is $50
If we use asset value at end of year
– ROI = .05 ($50/ $1,000)
If we use average asset value
– ROI = .067 ($50/ ($500 + 1,000)/2
Use of average assets gives a more accurate
annual return on your investment (The $50 was
earned during the last six months of the year)
Advantage of Using DuPont Model
Identifies cause of change in ROI from year to year
Uses the product of two intermediate calculations for
sales margin (efficiency measure) and asset turnover
(effective utilization of assets to generate revenue)
Assume the following information as an example
Year 01: Net Income-$50; Average Assets-$800; Sales-$1,000
Year 02: Net Income-$50; Average Assets-$1,000; Sales-$2,000
Calculation of ROI Both Methods
Year 01
Year 02
Regular $50/$800 = .0625
$50/$1,000= .05
50/1,000 * 1,000/800
.05 * 1.25 =
50/2,000 * 2000/1000
.025 * 2 =
Liquidity Analysis
Working Capital
– Working Capital =$Current Assets –$ Current Liabilities
– Current Ratio = Current Assets / Current Liabilities
– Acid Test Ratio = Cash, Temporary Investments and Receivables
/ Current Liabilities
Cash and Equivalents
Cash Flow Adequacy
Debt Coverage (Debt Payback)
Operations Index
Others include Reinvestment ratio, cash flow to sales, and cash
flow return on average assets
Activity and Efficiency Measures
Property-Plant-Equipment Turnover
Inventory Turnover (Day’s sales in inventory)
Accounts Receivable Turnover (Days sales in
accounts receivable)
Financial Leverage Analysis
Debt Ratio
Debt to Equity Ratio
Times Interest Earned
Times Interest Covered by Cash Flow from Operating
Wisely used outside capital injections greatly improve
owners’ return on equity
Unwise use of outside capital adds burdensome fixed costs
and contribute to increased risk of the organization
Solvency Evaluation (Short-range and Long-range)
Changes in Company Value (Owner’s net worth)
Earnings and Quality of Earnings Trend
Management Efficiency
Utilization and Control of Organization Resources
Cash Generation Efficiency of Organization
Risk Assessment