Chapter 2
Financial
Statements
and Analysis
Learning Goals
1. Review the contents of the stockholders’ report
and the procedures for consolidating
international financial statements.
2. Understand who uses financial ratios,
and how.
3. Use ratios to analyze a firm’s liquidity
and activity.
4. Discuss the relationship between debt and
financial leverage and the ratios used to
analyze a firm’s debt.
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Learning Goals (cont.)
5. Use ratios to analyze a firm’s profitability
and market value.
6. Use a summary of financial ratios and
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).
• The Sarbanes-Oxley Act of 2002, passed to eliminate
the many disclosure and conflict of interest problems of
corporations, established the Public Company
Accounting Oversight Board (PCAOB), which is a notfor-profit corporation that overseas auditors.
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The Stockholders’ Report (cont.)
• The PCAOB is charged with protecting the
interests of investors and furthering the public
interest in the preparation of informative, fair,
and independent audit reports.
• 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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The Four Key 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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The Four Key
Financial
Statements
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The Four Key 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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The Four Key Financial Statements
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The Four Key
Financial Statements (cont.)
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The Four Key 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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The Four Key Financial Statements
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The Four Key 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, financing
and operating activities, but also ties
together the income statement and
previous and current balance sheets.
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The Four Key Financial Statements
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Consolidating International
Financial Statements
• FASB 52 mandated that U.S. based companies translate
their foreign-currency denominated assets
and liabilities into dollars using the current rate
(translation) method.
• Under the translation method, companies translate all
foreign-currency-denominated assets and liabilities into
dollars at the exchange rate prevailing at the fiscal year
ending date (the current rate).
• Income statement items are usually treated similarly.
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Consolidating International
Financial Statements (cont.)
• 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).
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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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Using Financial Ratios:
Types of Ratio Comparisons
• Trend or time-series analysis
– Used to evaluate a firm’s performance
over time
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Using Financial Ratios:
Types of Ratio Comparisons (cont.)
• Trend or time-series analysis
• Cross-sectional analysis
– Used to compare different firms at the same
point in time
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Using Financial Ratios:
Types of Ratio Comparisons (cont.)
• Trend or time-series analysis
• Cross-sectional analysis
– Industry comparative analysis
• One specific type of cross sectional analysis.
Used to compare one firm’s financial performance
to the industry’s average performance
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Using Financial Ratios:
Types of Ratio Comparisons (cont.)
• Trend or time-series analysis
• Cross-sectional analysis
– Benchmarking
• A type of cross sectional analysis in which the
firm’s ratio values are compared to those of a key
competitor or group of competitors that it wishes
to emulate
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Using Financial Ratios:
Types of Ratio Comparisons (cont.)
• Trend or time-series analysis
• Cross-sectional analysis
• Combined Analysis
– Combined analysis simply uses a
combination of both time series analysis and
cross-sectional analysis
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Using Financial Ratios:
Types of Ratio Comparisons (cont.)
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Using Financial Ratios:
Types of Ratio Comparisons (cont.)
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Using Financial Ratios:
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
• We will illustrate the use of financial ratios
for analyzing financial statements using
the Bartlett Company Income Statements
and Balance Sheets presented earlier in
Tables 2.1 and 2.2.
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Ratio Analysis
• Liquidity Ratios
– Current Ratio
Current ratio
=
total current assets
total current liabilities
Current ratio
=
$1,223,000 = 1.97
$620,000
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Ratio Analysis (cont.)
• Liquidity Ratios
– Current Ratio
– Quick Ratio
Quick ratio
= Total Current Assets - Inventory
Total Current Liabilities
Quick ratio
= $1,223,000 - $289,000 = 1.51
$620,000
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Ratio Analysis (cont.)
• Liquidity Ratios
• Activity Ratios
– Inventory Turnover
Inventory Turnover = Cost of Goods Sold
Inventory
Inventory Turnover = $2,088,000 = 7.2
$289,000
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Ratio Analysis (cont.)
• Liquidity Ratios
• Activity Ratios
– Average Age of Inventory
Average Age of Inventory =
365
Inventory Turnover
Inventory Turnover =
365 = 50.7 days
7.2
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Ratio Analysis (cont.)
• Liquidity Ratios
• Activity Ratios
– Average Collection Period
ACP = Accounts Receivable
(Net Sales/365)
ACP =
$503,000
= 59.7 days
($3,074,000/365)
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Ratio Analysis (cont.)
• Liquidity Ratios
• Activity Ratios
– Average Payment Period
APP =
Accounts Payable
(Annual Purchases/365)
APP =
$382,000
= 95.4 days
(0.70 x $2,088,000)/365
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Given
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Ratio Analysis (cont.)
• Liquidity Ratios
• Activity Ratios
– Total Asset Turnover
Total Asset Turnover
=
Net Sales
Total Assets
Total Asset Turnover
= $3,074,000 = 0.85
$3,597,000
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Ratio Analysis (cont.)
Insert Table 2.6 here
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Ratio Analysis (cont.)
• Liquidity Ratios
• Activity Ratios
• Financial Leverage Ratios
– Debt Ratio
Debt Ratio = Total Liabilities/Total Assets
Debt Ratio = $1,643,000/$3,597,000 = 45.7%
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Ratio Analysis (cont.)
• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
– Times Interest Earned Ratio
Times Interest Earned = EBIT/Interest
Times Interest Earned = $418,000/$93,000 = 4.5
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Ratio Analysis (cont.)
• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
– Fixed-Payment coverage Ratio (FPCR)
FPCR =
EBIT + Lease Payments
Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}
FPCR =
$418,000 + $35,000
= 1.9
$93,000 + $35,000 + {($71,000 + $10,000) x [1/(1-0.29)]}
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Given
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Ratio Analysis (cont.)
• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
– Common-Size Income Statements
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Ratio Analysis (cont.)
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Ratio Analysis (cont.)
•
•
•
•
Liquidity Ratios
Activity Ratios
Leverage Ratios
Profitability Ratios
– Gross Profit Margin
GPM = Gross Profit/Net Sales
GPM = $986,000/$3,074,000 = 32.1%
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Ratio Analysis (cont.)
•
•
•
•
Liquidity Ratios
Activity Ratios
Leverage Ratios
Profitability Ratios
– Operating Profit Margin (OPM)
OPM = EBIT/Net Sales
OPM = $418,000/$3,074,000 = 13.6%
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Ratio Analysis (cont.)
•
•
•
•
Liquidity Ratios
Activity Ratios
Leverage Ratios
Profitability Ratios
– Net Profit Margin (NPM)
NPM = Earnings Available to Common Stockholders
Sales
NPM = $221,000/$3,074,000 = 7.2%
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Ratio Analysis (cont.)
•
•
•
•
Liquidity Ratios
Activity Ratios
Leverage Ratios
Profitability Ratios
– Earnings Per Share (EPS)
EPS = Earnings Available to Common Stockholders
Number of Shares Outstanding
EPS = $221,000 / 76,262 = $2.90
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Ratio Analysis (cont.)
•
•
•
•
Liquidity Ratios
Activity Ratios
Leverage Ratios
Profitability Ratios
– Return on Total Assets (ROA)
ROA = Earnings Available to Common Stockholders
Total Assets
ROA = $221,000 / $3,597,000 = 6.1%
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Ratio Analysis (cont.)
•
•
•
•
Liquidity Ratios
Activity Ratios
Leverage Ratios
Profitability Ratios
– Return on Equity (ROE)
ROE = Earnings Available to Common Stockholders
Common Equity
ROE = $221,000 / $1,754,000 = 12.6%
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Ratio Analysis (cont.)
•
•
•
•
•
Liquidity Ratios
Activity Ratios
Leverage Ratios
Profitability Ratios
Market Ratios
– Price Earnings (P/E) Ratio
P/E = Market Price Per Share of Common Stock
Earnings Per Share
P/E = $32.25/$2.90 = 11.1
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Ratio Analysis (cont.)
•
•
•
•
•
Liquidity Ratios
Activity Ratios
Leverage Ratios
Profitability Ratios
Market Ratios
– Market/Book (M/B) Ratio
BV per Share = Common Stock Equity
Number of Shares of Common Stock
BV per Share = $1,754,000 / 76,262 = $23.00
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Ratio Analysis (cont.)
•
•
•
•
•
Liquidity Ratios
Activity Ratios
Leverage Ratios
Profitability Ratios
Market Ratios
– Market/Book (M/B) Ratio
M/B Ratio = Market Price per Share of Common Stock
Book Value per Share of Common Stock
M/B Ratio = $32.25 / $23.00 = 1.40
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Summarizing All Ratios
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Summarizing All Ratios (cont.)
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Summarizing All Ratios (cont.)
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Summarizing All Ratios (cont.)
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DuPont System of Analysis
• The DuPont system of analysis 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 the equation below and in Figure 2.2 on the
following slide.
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DuPont System
of Analysis (cont.)
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Modified DuPont Formula
• The Modified DuPont Formula relates the firm’s
ROA to its ROE using the financial leverage
multiplier (FLM), which is the ratio of total assets
to common stock equity:
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Modified DuPont Formula (cont.)
• Use of the FLM to convert ROA into ROE
reflects the impact of financial leverage on the
owner’s return.
• Substituting the values for Bartlett Company’s
ROA of 6.1 percent calculated earlier, and
Bartlett’s FLM of 2.06 ($3,597,000 total assets ÷
$1,754,000 common stock equity) into the
Modified DuPont formula yields:
ROE = 6.1% X 2.06 = 12.6%
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