Module 3
Analyzing and
Interpreting
Financial Statements
Common Questions that F/S
Analysis Can Help To Answer

Creditor

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Investor


Manager
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Can the company pay the interest and
principal on its debt? Does the company reply
too much on nonowner financing?
Does the company earn an acceptable return
on invested capital? Is the gross profit margin
growing or shrinking? Does the company
effectively use nonowner financing?
Are costs under control? Are the company’s
markets growing or shrinking? Do observed
changes reflect opportunities or threats? Is the
allocation of investment across different
assets too high or too low?
Ratio Analysis


Examining various income statement and
balance sheet components in relation to one
another facilitates financial statement analysis.
This type of examination is called ratio analysis.
This module focuses on the disaggregation of
Return Measures into
1.
2.
3.
4.
Level I – RNOA and LEV
Level II – Profit Margins and Turnover
Level III – GPM, SGA, ART, INVT, PAT, APT, WCT
As well as Liquidity and Solvency Measures
Profitability Analysis

Return on Assets (ROA):
ROA = Net Income / Average Assets

For example, if we invest $100 in a savings
account yielding $3 at year-end, the return on
assets is 3%.
Disaggregating Return on Assets
Profit Margin, Asset Turnover, and Return on
Assets for Selected Industries
Operating vs. Nonoperating


Operating expenses are the usual and
customary costs that a company incurs to
support its main business activities
Nonoperating expenses relate to the
company’s financing and investing activities
Transitory vs. Core


Transitory items are one-time events (e.g., not
likely to recur)
Core items are likely to recur (persist) and are,
therefore, more relevant for company valuation
Operating/Nonoperating vs.
Core/Transitory
Analysis Structure
Return on Equity

Return on equity (ROE) is computed as:
ROE = Net Income / Average Equity
Key Definitions
Level 1 Analysis – RNOA
and Leverage
Return on Net Operating Assets
(RNOA)
RNOA = NOPAT / Average NOA
where,
NOPAT is net operating profit after tax
NOA is net operating assets
Operating and Nonoperating
Assets/Liabilities
NOPAT


Net operating profit includes
Operating revenues less
Operating expenses (COGS, SG&A, Taxes)
Excluded are after-tax earnings from
investments returns and interest expenses.
Financial Leverage and Risk
LEV is the other component of ROE
 Is Debt a bad thing?
 Given that increases in financial
leverage increase ROE, why are all
companies not 100% debt financed?

Leverage and Income Variability
Level II Analysis – Margin and
Turnover
Margin vs. Turnover
Level 3 Analysis — Disaggregation of
Margin and Turnover
Gross Profit Margin


It allows a focus on average unit mark-ups
A high gross profit margin is preferred to a lower
one, which also implies that a company has
relatively more flexibility in product pricing.
Gross Profit Margin

Two main factors determine gross profit
margins:
1. Competition – as the level of competition
intensifies, more substitutes become available,
which limits a company’s ability to raise prices
and pass along price increases to customers.
2. Product mix – if the proportion of lower price,
higher volume products increases relative to
that of higher priced, lower volume products,
then gross profit dollars may stay the same,
but gross profit margin declines.
Operating Expense Margin


Operating expense ratios (percents) are used
to examine the proportion of sales consumed
by each major expense category.
Expense ratios are calculated as follows:
Operating expense percentage = Expense item/Net sales
Turnover


Turnover measures relate to the productivity of
company assets. Such measures seek to answer the
amount of capital required to generate a specific
sales volume.
As turnover increases, there is greater cash inflow
as cash outflow for assets to support the current
sales volume is reduced.
Accounts Receivable Turnover (ART)
Inventory Turnover (INVT)
Accounts Payable Turnover (APT)
Liquidity and Solvency Measures

Liquidity refers to cash: how much we have,
how much is expected, and how much can
be raised on short notice.

Solvency refers to the ability to meet
obligations; primarily obligations to
creditors, including lessors.
Current and Quick Ratio
Solvency Ratios
Flow Ratios
Limitations of Ratio analysis
Vertical and Horizontal Analysis
Vertical and Horizontal Analysis