Essentials of Financial
Statement Analysis
Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 5
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Learning objectives
1. How cause of change analysis and common-size and trend statements
illuminate financial statement patterns and shed light on business
activities.
2. How competitive forces and business strategies affect firms’ financial
statements.
3. How return on assets (ROA) is used to evaluate profitability.
4. How return on equity (ROCE) can be used to assess the effect of
financial leverage on profitability.
5. How short-term liquidity risk and long-term solvency risk are assessed.
6. How to use the Statement of Cash Flows to assess credit and risk.
7. How to interpret the results of an analysis of profitability and risk.
8. How to prepare and analyze business segment disclosures.
5-2
Financial statement analysis:
Tools and approaches
Tools:
Approaches used with each tool:
Common size statements
Trend statements
Financial ratios
(e.g., ROA and ROCE)
1. Time-series analysis: the same firm
over time (e.g., Wal-Mart in 2012 and
2010)
2. Cross-sectional analysis: different
firms at a single point in time (e.g.,
Wal-Mart and Target in 2012).
3. Benchmark comparison: using
industry norms or predetermined
standards.
5-3
Evaluating accounting “quality”
 Analysts use financial statement information to “get behind the
numbers”.
 However, financial statements do not always provide a complete
and faithful picture of a company’s activities and condition.
5-4
How the financial accounting “filter”
sometimes works
GAAP puts capital leases
on the balance sheet, but
operating leases are “offbalance-sheet”.
Managers have some
discretion over estimates
such as “bad debt
expense”.
Managers have some
discretion over the timing
of business transactions
such as when to buy
advertising.
Managers can choose
any of several different
inventory accounting
methods.
5-5
Whole Foods Market:
Comparative Income Statement
5-6
Whole Foods Market:
Simple Financial Model Representation of
Net Income
5-7
Whole Foods Market:
Cause-of-Change Analysis
5-8
Whole Foods Market:
Common-Size Statements
5-9
Whole Foods Market:
Trend Statements
5-10
Whole Foods Market:
Store Analysis
5-11
Whole Foods Market:
Comparative Balance Sheet
5-12
Whole Foods Market:
Comparative Balance Sheet
5-13
Whole Foods Market:
Common-Size Analysis of Assets
5-14
Whole Foods Market:
Trend Analysis of Assets
5-15
Whole Foods Market:
Common-Size Analysis of Liabilities and Shareholders’ Equity
5-16
Whole Foods Market:
Trend Analysis of Liabilities and Shareholders’ Equity
5-17
Whole Foods Market:
Comparative Cash Flow Statements
5-18
Whole Foods Market:
Common-Size and Trend Analysis of Selected Cash Flow
Items
5-19
Financial ratios and profitability
analysis
Operating profit margin
EBI
Sales
Return on assets
ROA=
EBI
Average assets
X
Asset turnover
Sales
Average assets
Analysts do not always use the reported earnings, sales and asset figures. Instead, they
often consider three types of adjustments to the reported numbers:
1. Remove non-operating and nonrecurring items to isolate sustainable operating profits.
2. Eliminate after-tax interest expense to avoid financial structure distortions.
3. Eliminate any accounting quality distortions (e.g., off-balance operating leases).
5-20
How can ROA be increased?
There are just two ways:
1. Increase the operating profit margin, or
2. Increase the intensity of asset utilization (turnover rate).
Asset turnover
ROA =
EBI
Average assets
EBI
Sales
Sales
Average assets
Operating profit margin
5-21
ROA and competitive advantage:
Grocery industry

Competition works to drive down
ROA toward the competitive floor.

Companies that consistently earn an
ROA above the floor are said to
have a competitive advantage.

However, a high ROA attracts more
competition which can lead to an
erosion of profitability and
advantage.

Both Harris Teeter Supermarkets
(HTSI) and Safeway, Inc. (SWY)
both earned about the average
industry return of 4.6% but Harris did
it with higher margins and lower
turnover than Safeway

Differences in business strategies
give rise to economic differences
that are reflected in differences in
operating margin, asset utilization,
and profitability (ROA).
Average ROA
is 4.6%
Different points on the
curve have different
combinations of margin
and turnover
5-22
Profitability and financial leverage

Good earnings year: ROCE is higher for HiDebt because leverage increased the return
to shareholders due to the after-tax interest payment of only 6% (10% x (1-40%)

Neutral earnings year: Leverage neither helps nor harms shareholders

Bad earnings year: After-tax interest charges wipe out earnings, and ROCE is
0% for HiDebt
5-23
Components of ROCE
Return on assets (ROA)
EBI
Average assets
Return on common
equity (ROCE)
X
Common earnings leverage
Net income available to
common shareholders
Net income available to
common shareholders
Average common
shareholders’ equity
EBI
X
Financial structure leverage
Average assets
Average common
shareholders’ equity
5-24
Financial statement analysis and
accounting quality
 Financial ratios, common-size statements, and trend statements
are extremely powerful tools.
 But they can be no better than the data from which they are
constructed.
 Be on the lookout for accounting distortions when using these
tools. Examples include:
Nonrecurring
gains and losses
Differences in
accounting methods
Differences in
accounting estimates
GAAP implementation
differences
Historical
cost convention
5-25
Liquidity, Solvency, and Credit
Analysis: Overview
 Credit risk refers to the risk of nonpayment by the borrower.
 The lender risks losing interest payments and loan principal.
 A borrower’s ability to repay debt is driven by its capacity to
generate cash from operations, asset sales, or external financial
markets.
 A company’s willingness to repay debt depends on which of the
competing cash needs management believes is most pressing at
the moment.
5-26
Liquidity, Solvency, and Credit
Analysis: Balancing cash sources and needs
Figure 5.4
5-27
Liquidity Analysis:
Short-term liquidity ratios
Current ratio =
Liquidity
ratios
Quick ratio =
Current assets
Current liabilities
Cash + Marketable securities + Receivables
Current liabilities
Short-term
liquidity
Accounts receivable turnover =
Activity
ratios
Inventory turnover =
Net credit sales
Average accounts receivable
Cost of goods sold
Average inventory
Accounts payable turnover =
Inventory purchases
Average accounts payable
5-28
Liquidity Analysis:
Comparison of Operating and cash conversion
cycle
5-29
Liquidity Analysis:
Credit Risk Analysis: Short-Term Liquidity
5-30
Liquidity Analysis:
Long-term solvency
Long-term debt to assets =
Long-term debt
Total assets
Debt ratios
Long-term debt to tangible assets =
Long-term debt
Total tangible assets
Long-term
solvency
Interest coverage =
Operating incomes before taxes and interest
Interest expense
Coverage
ratios
Operating cash flow
to total liabilities =
Cash flow from continuing operations
Average current liabilities + long-term debt
5-31
Credit risk:
Financial ratios and default risk

A firm defaults when it fails to make
principal or interest payments.

Lenders can then:




Adjust the loan payment schedule.
Increase the interest rate and require
loan collateral.
Seek to have the firm declared
insolvent.
Financial ratios play two roles in
credit analysis:


They help quantify the borrower’s
credit risk before the loan is granted.
Once granted, they serve as an early
warning device for increased credit
risk.
Default Rates among public companies
by S&P credit rating: 1981-2008
5-32
Default frequency:
Probability of default within five years
among public companies: 1980-1999
5-33
Summary
 Financial ratios, common-size statements and trend statements
are powerful tools.
 However:



There is no single “correct” way to compute financial ratios.
Financial ratios don’t provide the answers, but they can help you ask
the right questions.
Watch out for accounting distortions that can complicate your
interpretation of financial ratios and other comparisons.
5-34