Chapter 14
ANALYSIS OF FINANCIAL
STATEMENTS
Chapter 14 Questions
Questions to be answered:
What are the major financial statements
provided by firms and what specific
information does each of them contain?
Why do we use financial ratios to examine the
performance of a firm, and why is it important
to examine performance relative to the
economy and to a firm’s industry?
Chapter 14 Questions
What are the major categories for financial
ratios and what questions are answered by
the ratios in these categories?
What specific ratios help determine a firm’s
internal liquidity, operating performance, risk
profile, growth potential, and external
liquidity?
How can the DuPont analysis help evaluate a
firm’s return on equity over time?
Chapter 14 Questions
What is “quality” balance sheet or income
statement?
Why is financial statement analysis done if
markets are efficient and forward-looking?
What major financial ratios help analysts in
the following areas: stock valuation,
estimating and evaluating systematic risk,
predicting the credit ratings on bonds, and
predicting bankruptcy?
Analyzing Financial
Statements
We will be considering asset valuation.
Financial asset values are a function of
two variables:
Discount rate ( the required rate of return)
 Expected future cash flows

Financial statement analysis can be
useful in estimating both of these
valuation inputs.
Major Financial
Statements
Corporate shareholder annual and
quarterly reports must include:
Balance sheet
 Income statement
 Statement of cash flows

Reports filed with Securities and
Exchange Commission (SEC)

10-K and 10-Q
Generally Accepted
Accounting Principles
GAAP are formulated by the Financial
Accounting Standards Board (FASB)
Provides some flexibility of accounting
principles



Can be good for firms in different situations
Can represent a challenge for analysis
Financial statements footnotes must disclose
which accounting principles are used by the firm
Balance Sheet
Shows resources (assets) of the firm
and how it has financed these
resources
Indicates current and fixed assets
available at a point in time
Financing is indicated by its mixture of
current liabilities, long-term liabilities,
and owners’ equity
Income Statement
Contains information on the profitability
of the firm during some period of time
Indicates the flow of sales, expenses,
and earnings during the time period
Statement of Cash
Flows
Integrates the information on the balance
sheet and income statement
Shows the effects on the firm’s cash flow of
income statement items and changes in
various items on the balance sheet
Three sections show cash flows from



Operating activities
Investing activities
Financing activities
Alternative Measures of
Cash Flow
Cash flow from operations


Traditional cash flow equals net income plus
depreciation expense and deferred taxes
Also adjust for changes in operating assets and
liabilities that use or provide cash
Free cash flow recognizes that some
investing and financing activities are critical to
ongoing success of the firm

Modifies cash flow from operations to reflect
necessary capital expenditures and projected
divestitures
Purpose of Financial
Statement Analysis
Evaluate management performance in
Profitability
 Efficiency
 Risk

Although financial statement information
is historical, it is used to project future
performance
Analysis of Financial
Ratios
Ratios can often be more informative
that raw numbers
Puts numbers in perspective with other
numbers
 Helps control for different sizes of firms

Ratios provide meaningful relationships
between individual values in the
financial statements
Importance of Relative
Financial Ratios
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:




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
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
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
Industry averages may not be representative
A firm may operate in several distinct
industries
Several approaches:


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
Determine whether it is progressing or
declining
Helpful for estimating future
performance
Consider trends as well as averages
over time
Six Categories of
Financial Ratios
1. Common size statements
2. Internal liquidity (solvency)
3. Operating performance
 Operating efficiency
 Operating profitability
4. Risk analysis
 Business risk
 Financial risk
 External liquidity risk
5. Growth analysis
Common Size
Statements
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
Evaluating Internal
Liquidity
Internal liquidity (solvency) ratios
indicate the ability to meet future shortterm financial obligations
Current Ratio examines current assets
and current liabilities
Current Assets
Current Ratio 
Current Liabilitie s
Evaluating Internal
Liquidity
Quick Ratio adjusts current assets by
removing less liquid assets
Cash  Marketable Securities  Receivable s
Quick Ratio 
Current Liabilitie s
Evaluating Internal
Liquidity
Cash ratio relates cash (ultimate liquid
asset) to current liabilities
Cash  Marketable Securities
Cash Ratio 
Current Liabilitie s
Evaluating Internal
Liquidity
Receivables turnover examines the
management of accounts receivable
Net Annual Sales
Receivable s Turnover 
Average Receivable s
Receivables turnover can be converted into an average
collection period
365
Average Receivable s Collection Period 
Annual Turnover
Evaluating Internal
Liquidity
Inventory turnover relates inventory to
sales or cost of goods sold (CGS)
Cost of Goods Sold
Inventory Turnover 
Average Inventory
Given the turnover values, you can compute the average
inventory processing time
365
Average Invetory Processing Period 
Annual Turnover
Evaluating Internal
Liquidity
Cash conversion cycle combines
information from the receivables
turnover, inventory turnover, and
accounts payable turnover
CCC = Receivables Collection Period
+ Inventory Processing Period
- Payables Payment Period
Evaluating Operating
Performance
Ratios that measure how well
management is operating a business

Operating efficiency ratios


Examine how management uses its assets to
generate sales; considers the relationship
between various asset categories and sales
Operating profitability ratios

Examine how management is doing at
controlling costs so that a large proportion of
the sales dollar is converted into profit
Operating Efficiency
Ratios
Total asset turnover ratio indicates the
effectiveness of a firm’s use of its total
asset base to produce sales
Net Sales
Total Asset Turnover 
Average Total Net Assets
Operating Efficiency
Ratios
Net fixed asset turnover reflects
utilization of fixed assets
This number can look temporarily bad if
the firm has recently added greatly to its
capacity in anticipation of future sales
Net Sales
Fixed Asset Turnover 
Average Net Fixed Assets
Operating Profitability
Ratios
Operating
profitability ratios
measure


The rate of profit on
sales (profit margin)
The percentage
return on capital
Operating Profitability
Ratios
Gross profit margin measures the rate
of return after cost of goods sold
What proportion of the sales dollar is left
after cost of goods sold?

Is the firm buying inputs (inventory and
direct labor) at good prices?
Gross Profit
Gross Profit Margin 
Net Sales
Operating Profitability
Ratios
Operating profit margin measures the
rate of profit on sales after operating
expenses
Operating profit is sometimes called
Earnings before interest and taxes (EBIT)
 Operating income can be thought of as the
“bottom line” from operations
Operating Profit
Operating Profit Margin 
Net Sales

Operating Profitability
Ratios
Net profit margin relates net income to
sales

Shows the combined effect of operating
profitability and the firm’s financing
decisions (since net income is after interest
and tax payments)
Net Income
Net Profit Margin 
Net Sales
Common Size Income
Statement
Since Net Sales is in the denominator of
all of the three previous ratios, the
common size income statement gives
all of these ratios at once

It also allows us to focus on any categories
of expenses that are out of line with the
appropriate benchmark
Operating Profitability
Ratios
Return on total capital relates the firm’s
earnings to all capital invested in the
business
Net Income  Interest Expense
Return on Total Capital 
Average Total Capital
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
Return on owner’s equity (ROE) can be
computed for the based only on the
common shareholder’s equity

Deducts preferred dividends, which are a
priority claim on net income
Net Income - Preferred Dividend
Return on Owner' s Equity 
Average Common Equity
Operating Profitability
Ratios
The DuPont System divides ROE into
several ratios that collectively equal
ROE while individually providing insight
Net Income
Net Income
Net Sales
ROE 


Common Equity
Net Sales Common Equity
Sales
Sales
Total Assets


Equity Total Assets
Equity
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
Operating Profitability
Ratios
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
We begin with the operating profit margin
(EBIT divided by sales) and introduce
additional ratios to derive an ROE value
Operating Profitability
Ratios
EBIT
Sales
EBIT


Sales Total Assets Total Assets
This is the operating profit return on total
assets. To consider the negative effects of
financial leverage, we examine the effect of
interest expense as a percentage of total
assets
Operating Profitability
Ratios
EBIT
Sales
EBIT


Sales Total Assets Total Assets
EBIT
Interest Expense Net Before Tax


Total Assets
Total Assets
Total Assets
We consider the positive effect of financial
leverage with the financial leverage multiplier
Operating Profitability
Ratios
EBIT
Sales
EBIT


Sales Total Assets Total Assets
EBIT
Interest Expense Net Before Tax


Total Assets
Total Assets
Total Assets
Net Before Tax (NBT)
Total Assets
Net Before Tax (NBT)


Total Assets
Common Equity
Common Equity
This indicates the pretax return on equity. To arrive
at ROE we must consider the tax rate effect.
Operating Profitability
Ratios
EBIT
Sales
EBIT


Sales Total Assets Total Assets
EBIT
Interest Expense Net Before Tax


Total Assets
Total Assets
Total Assets
Net Before Tax (NBT)
Total Assets
Net Before Tax (NBT)


Total Assets
Common Equity
Common Equity
Net Before Tax 
Income Taxes 
Net Income
 100% 

Common Equity 
Net Before Tax  Common Equity
Operating Profitability
Ratios
In summary, we have the following five
components of return on equity (ROE):
1.
2.
3.
4.
5.
Operating profit margin
Total asset turnover
Interest expense rate
Financial leverage multiplier
Tax retention rate
Risk Analysis
Risk analysis examines the uncertainty of
income for the firm and for an investor
Total firm risks can be decomposed into two
basic sources:


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 (primarily through employing leverage).
External liquidity analysis considers another
aspect of risk from an investor’s perspective
Business Risk
Variability of the firm’s operating income
over time
Can be measured by calculating the
standard deviation of operating income
over time or the coefficient of variation
In addition to measuring business risk,
we want to explain its determining
factors.
Business Risk
Two primary determinants of business risk
Sales variability

The main determinant of earnings variability
Cost Variability and Operating leverage




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
Financial Risk
Interest payments are deducted before we
get to net income

These are fixed obligations
Similar to fixed production costs, these lead
to larger earnings during good times, and
lower earnings during a business decline

Fixed financing costs are called financial leverage
The use of debt financing increases financial
risk and possibility of default while increasing
profitability when sales are high
Financial Risk
Two sets of financial ratios help measure
financial risk


Balance sheet ratios
Earnings or cash flow available to pay fixed
financial charges
Acceptable levels of financial risk depend on
business risk

A firm with considerable business risk should likely
avoid lots of debt financing
Financial Risk
Proportion of debt (balance sheet) ratios
Long-term debt can be related to:

Equity (L-t D/Equity)


How much debt does the firm employ in relation to its use
of equity?
Total Capital [L-t D/(L-t D +Equity)]

How much debt does the firm employ in relation to all
long-term sources of funds?
Total debt can be related to:

Total Capital [Total Debt/(Ttl. Liab.–Non-int. Liab.)]

Assessment of overall debt load, including short-term
Financial Risk
Earnings or Cash Flow Ratios
Relate operating income (EBIT) to fixed
payments required from debt obligations
 Higher ratio means lower risk

Financial Risk
Interest Coverage or Times Interest
Earned Ratio
Measures the number of times Interest
payments are “covered” by EBIT
Interest Coverage = EBIT/Interest Expense

May also want to calculated coverage
ratios that reflect other fixed charges

Lease obligations (Fixed charge coverage)
Financial Risk
Cash flow ratios


Fixed financing costs such as interest payments
must be paid in cash, so these ratios use cash
flow rather than EBIT to assess the ability to meet
these obligations
Relate the flow of cash available from operations
to:



Interest expense
Total fixed charges
The face value of outstanding debt
External Liquidity Risk
Market Liquidity is the ability to buy or
sell an asset quickly with little price
change from a prior transaction
assuming no new information
External market liquidity is a source of
risk to investors
External Liquidity Risk
The most important factor of external
market liquidity is the dollar value of
shares traded
This can be estimated from the total
market value of outstanding securities
 It will be affected by the number of security
owners


Numerous buyers and sellers provide liquidity
Analysis of Growth
Potential
Want to determine sustainable growth
potential

Important to both creditors and owners
Creditors interested in ability to pay future
obligations
 For owners, the value of a firm depends on its
future growth in earnings, cash flow, and
dividends

Determinants of Growth
Sustainable Growth Model

Suggests that the sustainable growth rate is a
function of two variables:



What is the rate of return on equity (which gives the
maximum possible growth)?
How much of that growth is put to work through earnings
retention (rather than being paid out in dividends)?
g = ROE x Retention rate


The retention rate is one minus the firm’s dividend payout
ratio
Anything that impacts ROE would also be a determinant
of future growth
Determinants of Growth
ROE (recall the DuPont equation) is a
function of
Net profit margin
 Total asset turnover
 Financial leverage (total assets/equity)

Analysis of Non-U.S.
Financial Statements
Statement formats will be different
Differences in accounting principles
Ratio analysis will reflect local
accounting practices
The Quality of Financial
Statements
“Quality financial statements” reflect
reality rather than use accounting tricks
or one-time adjustments to make things
look better than they are
The Quality of Financial
Statements
High-quality balance sheets typically
have
Conservative use of debt
 Assets with market value greater than book
 No liabilities off the balance sheet

The Quality of Financial
Statements
High-quality income statements

Reflect repeatable earnings


Gains from nonrecurring items should be
ignored when examining earnings
High-quality earnings result from the use of
conservative accounting principles that do
not overstate revenues or understate costs
The Value of Financial
Statement Analysis
Financial statements, by their nature, are
backward-looking
An efficient market will have already
incorporated these past results into security
prices, so why analyze the statements?


Analysis provides knowledge of a firm’s operating
and financial structure
This aids in estimating future returns
Uses of Financial Ratios
Stock valuation
Identification of corporate variables
affecting a stock’s systematic risk (beta)
Assigning credit quality ratings on
bonds
Predicting insolvency (bankruptcy) of
firms
Financial Ratios and
Stock Valuation Models
Stock valuation often considers discounted
cash flow analysis


Estimate cash flows
Estimate an appropriate discount rate

A number of financial ratios can be useful in arriving at
estimates for each of these inputs
Price ratio analysis for a stock

Sometimes we estimate the value of a stock
through various price ratios such as P/E

Would need to estimate variables such as expected
growth rate of earnings and dividends
Financial Ratios and
Systematic Risk
A firm’s systematic risk (as measured by
beta) is related to a number of financial
statement variables
Financial Ratios and
Bond Ratings
Changes in bond ratings are linked to
changes in various financial statement
variables

Predicting such changes in ratings before
they occur can increase the return on a
bond or stock portfolio
Financial Ratios and
Insolvency (Bankruptcy)
Certainly, analysts and investors are
concerned with the possibility of
bankruptcy
A number of variables have a rather strong
relationship to the bankruptcy experience
of firms in the past
 Can use financial statement analysis to
identify firms where insolvency is a likely
outcomes

Limitations of Financial
Ratios
Always consider relative financial ratios
Accounting treatments may vary among firms,
especially among non-U.S. firms
Firms may have have divisions operating in
different industries making it difficult to derive
industry ratios
Are the results consistent?
Ratios outside an industry range may be
cause for concern