Financial Statements &
Analysis
1

Annual Report
◦ a report issued annually by a corporation to its
stockholders.
◦ management’s opinion of the past year’s operations and
the firm’s future prospects.
2

Annual Report
◦ basic financial statements




income statement
balance sheet
statement of retained earnings
statement of cash flows
3

It is an evaluation of both firm’s past financial
performance & its prospects for the future. A
financial analyst use the ratios to make two
types of comparison:
1. Industry Comparison or cross section.
2. Trend Analysis or time series.
6
1.
2.
3.
Horizontal Analysis: To evaluate the trend in the
accounts over the years.
Vertical Analysis: A significant item on a financial
statement is used as a base value, & all the other
items on the financial statement are compared to
it.
Ratio Analysis: To compare figures from different
categories.
7





Present & prospective shareholders.
Creditors.
Firm’s own management.
Regulatory Bodies.
Others.
8

Ratios standardize numbers and facilitate
comparisons.
◦ Comparisons can be made intercompany, intracompany or with industry average
◦ Or, Cross section or time series.

Ratios are used to highlight weaknesses and
strengths.
1.
2.
3.
4.
5.
Liquidity Ratios,
Activity/Turnover/Asset Management
Ratios,
Debt/Leverage/Solvency Ratios,
Profitability Ratios, &
Market Ratios.
10

Liquidity ratios: It measures the company’s ability to meet its maturing short-term
debt obligations. gives us an idea of the firm’s ability to pay off debts that are
maturing within a year.

Asset management ratios: Measures the speed with which various accounts are
converted into sales or cash – inflows or outflows. which gives us an idea of how
efficiently the firm is using it’s assets

Debt management ratios: which gives us an idea of how the firm has financed it’s
assets as well as the firm’s ability to repay it’s long-term debt as they become due.

Profitability ratios: which gives us an idea of how profitably the firm is operating and
utilizing it’s assets. An indication of good financial health & how effectively the firm is
being managed is the company’s ability to earn satisfactory profit & return on
investment.

Market value: Relate a firm’s market value, as measured by its current share price, to
certain accounting values. which brings in the stock price and gives us an idea of what
investors think about the firm and it’s future prospects.
Cash
A/R
Inventories
Total CA
Gross FA
Less: Dep.
Net FA
Total Assets
2003
85,632
878,000
1,716,480
2,680,112
1,197,160
380,120
817,040
3,497,152
2002
7,282
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
Accts payable
Notes payable
Accruals
Total CL
Long-term debt
Common stock
Retained earnings
Total Equity
Total L & E
2003
436,800
300,000
408,000
1,144,800
400,000
1,721,176
231,176
1,952,352
3,497,152
2002
524,160
636,808
489,600
1,650,568
723,432
460,000
32,592
492,592
2,866,592
Sales
COGS
Other expenses
EBITDA
Depr. & Amort.
EBIT
Interest Exp.
EBT
Taxes
Net income
2003
7,035,600
5,875,992
550,000
609,608
116,960
492,648
70,008
422,640
169,056
253,584
2002
6,034,000
5,528,000
519,988
(13,988)
116,960
(130,948)
136,012
(266,960)
(106,784)
(160,176)
No. of shares
EPS
DPS
Stock price
2003
2002
250,000
$1.014
$0.220
$12.17
100,000
-$1.602
$0.110
$2.25

Will the firm be able to pay off its debts as they come
due and thus maintain a viable organization?
◦ If there are more liquid assets then they can.
◦ A liquid asset is the one that can be converted to cash quickly
without having to reduce the asset’s price very much.

Ratio analysis provides a quick and easy-to-use
measure of liquidity.

Two most commonly used liquidity ratios are: current
ratio, acid-test ratio
Current ratio
= Current assets / Current
liabilities
= $2,680,112 / $1,144,800
= 2.34 times or, 2.34 : 1
2002 = ???
Quick ratio = (Current assets – Inventoryprep.exp)/ Current liabilities
= ($2,680,112 - 1,716,480)/
$1,144,800
= 0.84 times or, 0.84 : 1
2002 = ???
Current
ratio
Quick
ratio


2003
2002
2001
Ind.
2.34x
1.17x
2.30x
2.70x
0.84x
0.39x
0.30x
1.11x
Expected to improve but still below the
industry average.
Liquidity position is weak.

To purchase assets capital is required and
obtaining capital is expensive.
◦ Too many assets will lead to high cost of capital and it can
lower the profit
◦ Too low asset will lead to losing out on profitable sales

Asset Management Ratios help us determine a
reasonable asset cost in view of current and
projected sales.

Any “turnover” ratio means Sales is divided by
some asset.
◦ How many times a particular asset is “turned over” to
sales during the period.


Inventory turnover = Sales/ Inventory
Sales occur over entire period, whereas
inventory figure is for one point in time
◦ It is better to use an average inventory measure.
Inv. turnover
Inventory
Turnover
= Sales / Inventories
= $7,035600 / $1,716,480
= 4.10x
2003
2002
2001
Ind.
4.1x
???
4.8x
6.1x



Inventory turnover is below industry average.
The company might have old inventory, or its
control might be poor.
No improvement is currently forecasted.
Measures the efficiency of Fixed Assets.
FA turnover = Sales / Net fixed assets
= $7,036 / $817 = 8.61x

When comparing with a newer company
problem arises as the same asset costs
differently.
c) Total asset turnover ratio:
TA turnover= Sales / Total assets
= $7,036 / $3,497 = 2.01x


2003
2002
2001
Ind.
FA TO
8.6x
???
10.0x
7.0x
TA TO
2.0x
???
2.3x
2.6x
FA turnover projected to exceed the industry average.
TA turnover below the industry average. Caused by excessive
currents assets (A/R and Inv).
DSO or ACP = Receivables / Annual sales/365
= $8,78,000 / 7,035,600/365
= 46 days
e) Average payment period:
Average payment period
= Payables / Annual purchases/365
= $ 1,144,800/ $5,875,992/365
= 71 days

An indication of good financial health & how effectively the
firm is being managed is the company’s ability to earn
satisfactory profit & return on investment. The ratios are:
a) Gross Profit Margin= Gross profit/ Sales
b) Operating Profit Margin= Operating profit or EBIT/ Sales
c) Net Profit Margin = Net Income After Tax / Net Sales.
d) BEP = EBIT/Total Assets
e) Return on Assets (ROA) = Net Income After Tax / Total
Assets.
or, ROA = NetProfit Margin X Total Asset Turnover
f) Return on Equity (ROE) = Net Income After Tax /
Stockholders Equity.
or, ROE = ROA X Equity Multiplier.
## equity multiplier = total assets / stockholders equity
g) EPS= Earnings avl. For common stockholders or N.I/ number
of share of common stock outstanding
27
Net Profit margin
= Net income / Sales
= $253.6 / $7,036 = 3.6%
PM

2003
3.6%
2002
???
2001
2.6%
Ind.
3.5%
Profit margin was very bad in 2002, but is projected to
exceed the industry average in 2003.


The ability of the firm’s assets to generate operating income
BEP = EBIT/Total Assets
Shows the raw earning power of the firm’s assets
before the influence of taxes and debt.
How much of the total assets contribute to the net
income?
ROA= Net income / Total assets
= $253.6 / $3,497 = 7.3%
Return on equity:


Measures the rate of return on common
stockholder’s investment
Stockholders expect to earn a return on their money
and this ratio tells how well they are doing.
ROE = Net income / Total common equity
= $253.6 / $1,952 = 13.0%
ROA
ROE




2003
7.3%
13.0%
2002
-5.6%
-32.5%
2001
6.0%
13.3%
Ind.
9.1%
18.2%
Both ratios rebounded from the previous year, but are still below the
industry average. More improvement is needed.
Lower ROA ratio means either high operating cost or high interest
expense.
Wide variations in ROE illustrate the effect that leverage can have
on profitability.
Higher debt can lead to higher ROE

ROE and shareholder wealth are correlated,
but problems can arise when ROE is the sole
measure of performance.
◦ ROE does not consider risk.
◦ ROE does not consider the amount of capital
invested.
◦ Might encourage managers to make investment
decisions that do not benefit shareholders.

ROE focuses only on return. A better
measure is one that considers both risk and
return.
4) Debt Management Ratios



Use of debt increases a firm’s ROE if the firm
earns more on it’s assets than the interest rate it
pays on the debt. This is called “leverage”.
However, debt exposes the firm to more risk
than if it financed only with equity.
Debt Management Ratios show how efficiently
firm manages it’s debts.
a) Debt ratio= Total debt / Total assets
= ($1,145 + $400) / $3,497 = 44.2%
Creditors are not willing to lend capital when debt ratio is
too high.
b) TIE
= EBIT / Interest expense
= $492.6 / $70 = 7.0x
Firm’s ability to meet its annual interest payments.
c) Fixed-payment Coverage: measures firms ability to
meet fixed payment obligations.

2003
2002
2001
Ind.
D/A
44.2%
???
54.8%
50.0%
TIE
7.0x
???
4.3x
6.2x
What can we tell about D/A and TIE by comparing with the industry
average?

Market Value depends on investor’s expectation and
demand.

If liquidity, asset management, debt management, and
profitability ratios all look good and if investors think
these ratios will continue to look good in the future, then
the market value will be high.

Market value ratios relate the firm’s stock price (market
value) to it’s earnings and book value per share.

Market value ratios are used in three primary ways
1. By investors when they are deciding to buy or sell a
stock.
2. By investment bankers when they are setting the share
price for a new stock issue (IPO).
3. By firms when they are deciding how much to offer for
another firm in a potential merger.
P/E
ratio shows how much investors are
willing to pay per dollar of reported
profit from each share.
P/E
= Mkt price per share/ Earnings per share
= $12.17 / $1.014 = 12.0x
M/B ratio is another indicator of how investors regard the
company.
M/B = Mkt price per share / Book value per share
= $12.17 / ($1,952 / 250) = 1.56x
P/E
M/B
2003
12.0x
1.56x
2002
-1.4x
0.5x
2001
9.7x
1.3x
Ind.
14.2x
2.4x
P/E: How much investors are willing to pay
for $1 of earnings.
 M/B: How much investors are willing to pay
for $1 of book value equity.
 For each ratio, the higher the number, the
better.
 Lower P/E ratio means perceived risk is high
but it also means the market price correctly
reflects the stock’s earning ability.
 Higher M/B ratio means share is overvalued
and investors expectations is very high.

**Also see formula table from book pg-72-73
Also can be expressed as:
ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)
Or, ROE= ROA*FLM
 Focuses on:
◦ Expense control: (PM)
◦ Asset utilization: (TATO)
◦ Debt utilization: Eq. Mult. or FLM
(financial leverage multiplier)

Shows how these factors combine to determine
ROE.

DuPont analysis is an expression which breaks ROE
(Return On Equity) into three parts. This analysis
enables the analyst to understand the source of superior
(or inferior) return by comparison with companies in
similar industries (or between industries).
Dupont Formula
 ROA= Profit margin)*(T.Asset turnover)
ROE=(Profit margin)*(T.Asset turnover)*(Equity
multiplier)

#Profit Margin = Net Income After Tax / Net Sales.
#Total Asset Turnover = Sales / Total Assets.
# equity multiplier or FLM= total assets / stockholders
equity
 Modified Dupont formula: ROE= ROA*FLM
44
ROE = (Profit margin) x (TA turnover) x (Equity multiplier)
=
3.6%
x
2
x
1.8
=
13.0%
2001
2002
2003
Ind.
PM
2.6%
-2.7%
3.6%
3.5%
TA TO
2.3
2.1
2.0
2.6
EM
2.2
5.8
1.8
2.0
ROE
13.3%
-32.5%
13.0%
18.2%


Analyzes a firm’s
financial ratios over
time
Can be used to
estimate the
likelihood of
improvement or
deterioration in
financial condition.






Comparison with industry averages is difficult
for a conglomerate firm that operates in many
different divisions.
“Average” performance is not necessarily good,
perhaps the firm should aim higher.
Seasonal factors can distort ratios.
Different operating and accounting practices can
distort comparisons. Example: LIFO, FIFO.
Sometimes it is hard to tell if a ratio is “good” or
“bad”.
Difficult to tell whether a company is, on
balance, in strong or weak position.





Are the firm’s revenues tied to 1 key customer,
product, or supplier?
What percentage of the firm’s business is
generated overseas?
Competition
Future prospects
Legal and regulatory environment