Chapter 5 -- Introduction to
Financial Statement Analysis
FINANCIAL ACCOUNTING
AN INTRODUCTION TO CONCEPTS,
METHODS, AND USES
12th Edition
Clyde P. Stickney and Roman L. Weil
Learning Objectives
1. Understand the relation between the expected
return and risk of investment alternatives, and
the role financial statement analysis can play
in providing information about returns and
risk.
2. Understand the usefulness of the rate of
return on assets (ROA) as a measure of a
firm’s operating profitability independent of
financing and the insights gained by
disaggregating ROA into profit-margin and
assets-turnover components.
Learning Objectives
3. Understand the usefulness of the rate of
return on common shareholders’ equity
(ROCE) as a measure of profitability that
incorporates a firm’s particular mix of
financing and the insights gained by
disaggregating ROCE into profit-margin,
assets-turnover, and capital-structureleverage-ration components.
4. Understand the strengths and weaknesses of
earnings per common share as a measure of
profitability.
Learning Objectives
5. Understand the distinction between shortterm liquidity risk and long-term liquidity risk
and the financial statement rations used to
assess these two dimensions of risk.
6. Develop skills to interpret an analysis of
profitability and risk.
7. (Appendix) Develop skills to prepare pro
forma financial statements.
8. (Appendix) Understand the usefulness of pro
forma financial statements in the valuation
of a firm.
Chapter Outline
1. Objectives of financial statement analysis
2. Analysis of profitability
3. Analysis of risk
4. Limitations of ratio analysis
5. International perspective
Chapter Summary
Appendix 5.1: Pro Forma Financial Statements
Purpose of Financial Statement
Analysis


To understand the economics of a firm
and
To help forecast its future define
profitability and risk
– Profitability is an increase in wealth
– Risk is the probability that a
specific level of profitability will be
achieved.
Relationship between Financial
Statement Analysis and Investment
Decisions
Past
Present
Future
Financial Statement
Analysis
Profitability
Expected
Return
Risk (Short-term
and long-term
Liquidity)
Risk
Investment Decision
What is the Usefulness of Ratios?



Helps compare different firms, and
Helps compare the firm against its past
performance
Standards against which to compare ratios
1. The planned ratio for the period
2. The corresponding ratio from a prior period
3. The corresponding ratio for another firm in
the same industry
4. The average ratio for other firms in the
same industry
Analysis of Profitability

Profitability is subtle and complex
concept. Doing well may be measured
by different standards. Three
concepts of profitability are given by:
1. Return on assets
2. Return on common equity
3. Earnings per common share

Each of these are discussed in turn.
Return on Assets (ROA)

ROA presents profitability independent of the
source of financing
– Does not consider leverage
– Measure of how well the firm uses its assets to
generate income
Disaggregating ROA -- ROA can be defined as the
product of two other ratios
1. Profit margin ratio, and
2. Total assets turnover
Return on Assets (Cont.)


Notice that when these two ratios are
multiplied, Sales cancel out, giving the
definition of ROA
Thus ROA = (profit margin ratio)*(total sales
turnover)
Profitability Ratios (Figure 5.3)
Rate of return
Level 1 on assets
Profit
Level 2 margin
for ROA
Level 2
=
Rate of return to
creditors and
preferred shareholders
Total assets
turnover
ratio
Various
expense-tosales
percentages
Profit
margin for
ROCE
A.R. turnover,
inv. turnover,
plant asset
turnover
Rate of return on
+ common shareholders’
equity
Total assets
turnover
ratio
Various
expense-tosales
percentages
Leverage
ratio
A.R. turnover,
inv. turnover,
plant asset
turnover
Profit Margin Ratio



Profit margin ratio measures a firm's ability
to control its expenses relative to its sales.
We expect expenses to grow as sales grow,
but not as fast.
A high profit margin ratio is preferred to a
low one.
Total Assets Turnover



Total assets turnover measures a firm's ability
to generate sales from a given level of assets.
A large asset turnover is preferred to a low
one.
Total assets turnover is related to three similar
ratios
a. Accounts receivable turnover
b. Inventory turnover
c. Fixed asset turnover
Accounts Receivable Turnover


Measures how quickly a firm collects cash.
If A.R. turn over twice a year, then they
average one half of a year in collection.

Less time is preferred to more.

A high turnover is preferred to a low one.
Accounts
Receivable
Turnover
Sales
=
Ave. Accts. Rec.
Inventory Turnover




Indicates how fast firms sell merchandise.
If inventory turn over twice a year, then they
average one half of a year in inventory.
Holding inventory is costly because the funds
invested in inventory could be used elsewhere.
A high turnover is preferred to a low one.
Inventory
Turnover
Cost of Goods Sold
=
Ave. Inventory
Fixed Asset Turnover




Measures the relation between investment in longterm or fixed assets (such as property, plant,
equipment) and sales.
Efficient use of fixed assets would be associated
with high sales.
If fixed assets turn over every four years, then
each dollar invested in fixed assets is generating a
quarter of a dollar in sales per year.
A high turnover is preferred to a low one.
Return on Common Equity


The numerator measures return as net income
reduced by any payments to preferred shareholders as
these dividends are not available to the common
shareholder and have not been deducted from net
income.
The denominator is the average amount contributed by
common shareholders which includes
– Common stock at par,
– Additional paid in capital, and
– Retained earnings.
Relation between ROA and ROCE
(Cont.)



ROCE is the residual return which goes to the
common shareholders. Since it may be low in
poor years but high in good years, it has a risk,
that is, the residual return is not known.
Debt is characterized by a definite schedule of
payments, so there is little risk to the debt
holders.
Preferred stock is like debt, the dividends are
specified. However, debtors must be paid
before preferred shareholders and if the
money runs out, then they aren't paid.
Relationship between ROA and
ROCE (Cont.)

ROA can be divided into
– Return to creditors or debtors
– Return to preferred shareholders, and
– Return to common shareholders (ROCE)

Because the return to debtors and preferred
shareholders are fixed, in good years when the
firm has high returns, there is a lot of profit
left over for the common shareholders; in poor
years when returns are low, there is little or
maybe no profit left over.
Relation between ROA and ROCE
(Cont.)


Thus, if ROCE and ROA were both linear, then
ROCE would have a greater slope than ROA,
that is, it is more highly levered.
A prudent firm will borrow funds only when the
return on those marginal funds exceed the cost
of borrowing giving a net positive return to the
common shareholder.
Relationship between ROA and
ROCE (Cont.)

ROCE can be disaggregated into
three related ratios
1. Profit margin ratio
2. Total assets turnover
3. Leverage ratio
Relationship between ROA and
ROCE (Cont.)


The first two have been previously defined.
Leverage ratio indicates the relative proportion
of capital provided by common shareholders as
distinct from that provided by creditors
(debtors) or preferred shareholders.
Relationship between ROA and
ROCE (Cont.)



A high leverage ratio means that the firm has
a lot of assets at its command, but that the
shareholders have less of their own
investments at risk.
This is good in good years because the
common shareholders capture all profits over
what is needed to service the debt.
This bad in poor years because the debt has
to be serviced whether or not the common
shareholders make a profit.
Earnings/Share of Common Stock



This ratio is the profit that goes to each
share of common stock.
It would be simply the net income less
preferred dividends divided by the number of
common shares.
However, the number of common shares is
complicated by certain securities that may
become (converted to) a common share.
How to account for these is a complex issue.
Earnings/Share of Common Stock

For example, if there are 100 common
shares but 50 preferred shares that could
convert to 50 common shares, do you
divide earnings by 100 or 150? The
answer depends on how likely it is that
the convertible securities will convert.
Earnings Per Share (EPS) (Cont.)




EPS does not consider the amount of assets or
capital required to generate earnings.
EPS is of limited use in comparing two firms.
For investment purposes, the price to earnings (P/E
ratio) ratio is sometimes used.
This is the return to the purchaser of a share.
– P/E = (market price of a share of stock)/(EPS)
– A low P/E is preferred to a high P/E.
Analysis of Risk

Factors that affect risk of a firm
– Economy-wide factors such as inflation
– Industry-wide factors such as competition
– Firm-specific factors such as potential for a labor
strike

Questions or issues
a. Can the firm pay short-term obligations like
workers' wages? That is, what are measures of
short term risk?
b. Can the firm pay long-term obligations like debt?
That is, what are long-term measures of risk?
Measures of Short-Term Risk

Measures of short-term liquidity risk

Current ratio
– = (current assets)/(current liabilities)
– Measure of ability of the firm to pay short-term
liabilities on time

Quick ratio
– = (current highly liquid assets)/(current liabilities)
– Current highly liquid assets are assets that are
quickly and easily converted into cash
– This includes bank accounts but not inventories
Measures of Short-Term Risk
(Cont.)

Cash flow from operations to current liabilities ratio
– = (cash flow from operations)/(current liabilities)
– Measures the ability of the firm to pay current
liabilities without borrowing or additional
investments.

Working capital turnover ratios
– Working capital is a broad definition of cash that
includes cash and other assets that are highly liquid
such as marketable securities.
– Ratios that use working capital show the short-term
liquidity of the firm including near-cash assets.
Measures of Long-Term Risk

Debt-to-equity ratio
– = (total liabilities)/(total equities)
– total equities = total liab. + shareholders’ equity
– Percentage of total financing provided by debtors or
creditors.
– A firm is said to be highly leveraged when this ratio
is large.

Cash from operations to total liabilities ratio
– Measures the ability of the firm to pay all liabilities
from cash without new debt or additional
investment.
Measures of Long-Term Risk
(Cont.)

Interest coverage ratio=
(Earnings before interest and income tax)
(interest expense)



Number of times interest is covered by income
Indicates the relative protection that operating
profitability provides to debtors
Some analysts use cash flows instead of
income
Limitations of Ratio Analysis
1. Ratios based on financial data share the same
problems of financial data (such as timeliness).
2. Changes in many ratios correlate with other ratios so
a direct interpretation of a change in a ratio is not
always apparent.
3. Comparing ratios over time is complicated by the
fact that economic conditions may change also.
4. Comparing ratios between two firms is complicated
by the fact that the firms may have different
economic environments or production technologies
even though they produce the same product.
An International Perspective



The format and terminology of financial
statements in different countries often differ
making it difficult to find comparable numbers
Economic, political and cultural factors affect
the way ratios are interpreted
Foreign accounting principles may be subtly
and substantially different from U.S. GAAP
Chapter Summary



This chapter presents ratios that allow for the
comparison of a firm's performance overtime,
against competitors and against industry
averages.
The concept of risk is introduced and
presented as an integral part of financial
statement analysis.
Specific ratios are discussed and some
limitations of ratio analysis are presented.
Appendix 5.1 -- Pro Forma
Financial Statements

Pro forma refers to a projection of what the
financial statements might look like if certain
future conditions prevail. Of course, a pro
forma statement is only as good as the
forecast of the future conditions.
Appendix 5.1 -- Pro Forma
Financial Statements
In order to prepare a set of pro forma statements:
1. Project operating revenues
2. Project operating expenses given the level of
revenues
3. Project assets required to support the revenues
4. Project financing for the additional assets
5. Project the cost of the financing
6. Project the cash flow statement based on
assumptions about the timing of revenues and
payments on debt and for expenses.
Rapid Review – Name that Ratio
1. (Net Income – Preferred Dividends) /
(Weighted Average Commons Shares
Outstanding)
2. (Earnings before Interest and Income Tax)
/ (Interest Expense)
3. (Current Assets) / Current Liabilities)
4. (Market Price of a Share of Stock) /
(Earnings Per Share)