Chapter
8
Financial
Statements
and Analysis
Introduction to Finance
Lawrence J. Gitman
Jeff Madura
Learning Goals
Review the contents of the stockholder’s report, and the
procedures for consolidating financial statements.
Understand who uses financial ratios and how.
Use ratios to analyze a firm’s liquidity and activity.
Discuss the relationship between debt and financial
leverage and the ratios used to analyze a firm’s debt.
Use ratios to analyze a firm’s profitability and its
market value.
Use the DuPont system of analysis to perform
a complete ratio analysis.
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The Stockholders’ Report
 The guidelines used to prepare and maintain financial
records and reports are known as generally accepted
accounting principles (GAAP).
 GAAP is authorized by the Financial Accounting
Standards Board (FASB).
 Public corporations with more than $5 million
in assets and more than 500 stockholders
are required by the SEC to provide their
stockholders with an annual stockholders’ report.
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Financial Statements
 The Income Statement
 The income statement provides a financial
summary of a company’s operating results
during a specified period.
 Although they are prepared annually for reporting
purposes, they are generally computed monthly
by management and quarterly for tax purposes.
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Financial Statements
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Table 8.1 (Panel 1)
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Financial Statements
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Table 8.1 (Panel 2)
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Financial Statements
 The Balance Sheet
 The balance sheet presents a summary of a firm’s
financial position at a given point in time.
 Assets indicate what the firm owns, equity represents
the owners’ investment, and liabilities indicate what
the firm has borrowed.
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Financial Statements
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Table 8.2 (Panel 1)
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Financial Statements
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Table 8.2 (Panel 2)
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Financial Statements
 Statement of Retained Earnings
 The statement of retained earnings reconciles
the net income earned and dividends paid during
the year with the change in retained earnings.
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Financial Statements
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Table 8.3
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Financial Statements
 Statement of Cash Flows
 The statement of cash flows provides a summary
of the cash flows over the period of concern,
typically the year just ended.
 This statement not only provides insight into a
company’s investment and financing and operating
activities, but also ties together the income
statement and previous and current balance sheets.
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Financial Statements
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Table 8.4
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Consolidating International
Financial Statements
 FASB 52 mandated that companies based in the United
States translate their foreign-currency denominated
assets and liabilities into dollars using the current rate
(translation) method.
 Under the translation method, companies translate
foreign-currency-denominated assets and liabilities
into dollars for consolidation with the parent company’s
financial statements.
 Income statement items are usually treated similarly,
although they can also be translated at the average
exchange rate during the period (year).
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Consolidating International
Financial Statements
 Equity accounts, on the other hand, are translated
into dollars by using the exchange rate that prevailed
when the parent’s equity investment was made
(the historical rate).
 Retained earnings are adjusted to reflect each year’s
operating profits (or losses), but do not consider any
profits or losses resulting from currency changes.
 Instead, translation gains and losses are accumulated
in an equity reserve account called the cumulative
translation adjustment.
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Consolidating International
Financial Statements
 Translation gains (losses) increase (decrease)
this account balance.
 However, the gains and losses are not “realized” until
the parent company sells or shuts down the subsidiary.
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Using Financial Ratios
 Interested Parties
 Ratio analysis involves methods of calculating
and interpreting financial ratios to assess a firm’s
financial condition and performance.
 It is of interest to shareholders, creditors,
and the firm’s own management.
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Types of Ratio Comparisons
 Trend or Time-Series Analysis
 Used to evaluate a firm’s performance over time.
 Cross-Sectional Analysis
 Used to compare different firms at the same point in time.
 Industry comparative analysis
• One specific type of cross sectional analysis. Used to compare
one firm’s financial performance to the industry’s average performance.
 Combined Analysis
 Combined analysis simply uses a combination
of both time-series analysis and cross-sectional analysis.
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Types of Ratio Comparisons
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Figure 8.1
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Cautions for Doing Ratio Analysis
 Ratios must be considered together;
a single ratio by itself means relatively little.
 Financial statements that are being compared
should be dated at the same point in time.
 Use audited financial statements when possible.
 The financial data being compared should have been
developed in the same way.
 Be wary of inflation distortions.
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Ratio Analysis Example
 Using Daton Company Financial Statements
 Liquidity ratios
 Activity ratios
 Financial leverage ratio
 Leverage ratios
 Profitability ratios
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Ratio Analysis
 Liquidity Ratios
 Current Ratio
Current ratio =
Current ratio =
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Total current assets
Total current liabilities
$1,233,000
$620,000
= 1.97
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Ratio Analysis
 Liquidity Ratios
 Quick ratio
Quick ratio =
Total current assets - Inventory
Total current liabilities
$1,233,000 - $289,000
Quick ratio =
$620,000
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= 1.51
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Ratio Analysis
 Activity Ratios
 Inventory Turnover
Inventory turnover =
Inventory turnover =
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Cost of goods sold
Inventory
$2,088,000
$289,000
= 7.2
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Ratio Analysis
 Activity Ratios
 Average collection period
ACP =
Accounts receivable
Net sales/360
$503,000
ACP =
= 58.9 days
$3,074,000/360
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Ratio Analysis
 Activity Ratios
 Average payment period
APP =
Accounts payable
Annual purchases/360
$382,000
ACP =
= 94.1 days
(.70 x $2,088,000)/360
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Ratio Analysis
 Activity Ratios
 Total asset turnover
Total asset turnover =
Total asset turnover =
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Net sales
Total assets
$3,074,000
$3,579,000
= .85
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Ratio Analysis
 Financial Leverage Ratio
 Debt ratio
Total liabilities
Debt ratio =
Total assets
Debt ratio =
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$1,643,000
$3,579,000
= 45.7%
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Ratio Analysis
 Leverage Ratios
 Times interest earned ratio
Times interest earned =
Times interest earned =
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EBIT
Interest
$418,000
$93,000
= 4.5
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Ratio Analysis
 Leverage Ratios
 Fixed-payment coverage ratio (FPCR)
FPCR =
FPCR =
EBIT + Lease pymts
Interest + Lease pymts + {(Princ pymts + PSD) x [1/(1 - t)]}
$418,000 + $35,000
$93,000 + $35,000 + {($71,000 + $10,000) x [1/(1 - .29)]}
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= 1.9
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Ratio Analysis
 Profitability Ratios
 Common-size
income statements
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Table 8.6
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Ratio Analysis
 Profitability Ratios
 Gross profit margin
GPM =
GPM =
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Gross profit
Net sales
$986,000
$3,074,000
= 32.1%
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Ratio Analysis
 Profitability Ratios
 Operating profit margin
OPM =
OPM =
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EBIT
Net sales
$418,000
$3,074,000
= 13.6%
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Ratio Analysis
 Profitability Ratios
 Net profit margin
Net profits after taxes
NPM =
Net sales
NPM =
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$231,000
$3,074,000
= 7.5%
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Ratio Analysis
 Profitability Ratios
 Return on total assets (ROA)
Net profits after taxes
ROA =
Total assets
ROA =
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$231,000
$3,597,000
= 6.4%
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Ratio Analysis
 Profitability Ratios
 Return on equity (ROE)
Net profits after taxes
ROE =
Stockholders’ equity
ROE =
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$231,000
$1,954,000
= 11.8%
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Ratio Analysis
 Profitability Ratios
 Earnings per share (EPS)
Earnings available to common stockholder
EPS =
Number of shares outstanding
EPS =
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$221,000
76,262
= $2.90
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Ratio Analysis
 Profitability Ratios
 Price earnings (P/E) ratio
P/E =
Market price per share of common stock
Earnings per share
P/E =
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$32.25
$2.90
= 11.1
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Ratio Analysis
 Profitability Ratios
 Market/book (M/B) ratio
M/B =
Market price per share of common stock
Book value per share of common stock
M/B =
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$32.25
$23.00
= 1.40
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Summarizing All Ratios
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Table 8.7 (Panel 1)
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Summarizing All Ratios
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Table 8.7 (Panel 2)
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DuPont System of Analysis
 The DuPont system is used to dissect the firm’s financial
statements and to assess its financial condition.
 It merges the income statement and balance sheet
into two summary measures of profitability: ROA
and ROE as shown in Figure 8.2 on the following slide.
 The top portion focuses on the income statement,
and the bottom focuses on the balance sheet.
 The advantage of the DuPont system is that it allows
you to break ROE into a profit-on-sales component,
an efficiency-of-asset-use component, and a use-ofleverage component.
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DuPont System of Analysis
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Figure 8.2
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DuPont System of Analysis
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Figure 8.2 (Panel 1)
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DuPont System of Analysis
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Figure 8.2 (Panel 2)
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Chapter
Introduction to Finance
8
End of Chapter
Lawrence J. Gitman
Jeff Madura