Understanding
Financial Statements
EIGHTH EDITION
Lyn M. Fraser
Aileen Ormiston
The Analysis of
Financial Statements
Ratios are tools and their value is limited when used
alone. The more tools used, the better the analysis.
For example, you can’t use the same golf club for every
shot and expect to be a good golfer. The more you
practice with each club, however, the better able you will
be to gauge which club to use on one shot. So to, we
need to be skilled with the financial tools we use.
- Diane Morrison
- CEO, R.E.C. Inc.
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The Analysis of
Financial Statements (cont.)
This chapter will develop tools and
techniques for the interpretation of
financial statement information
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Objectives of Analysis
Objectives will vary depending on the
perspective of the financial statement user
specific questions that are addressed
by the analysis
Remember--the identity of the user helps
define what information is needed
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Objectives of Analysis
(cont.)
Potential Financial Statement Users:
Creditors
Investors
Management
What types of questions do each of these
users seek answers to?
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Creditors
A creditor is ultimately concerned with
the ability of an existing or
prospective borrower to make
interest and principal payments on
borrowed funds
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Creditors
(cont.)
Questions raised in a credit analysis
should include:



What is the borrowing cause?
What is the firm’s capital structure?
What will be the source of debt
repayment?
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Investors
An investor attempts to arrive at an
estimation of a company’s future
earnings stream in order to attach a
value to the securities being
considered for purchase or liquidation
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Investors
(cont.)
The investment analyst poses questions as:




How has the firm performed/what are
future expectations?
How much risk is inherent in the
existing capital structure?
What are expected returns?
What is firm’s competitive position?
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Management
Management relates to all questions raised by:
Creditors
Investors
Employees
General public
Regulators
Financial press
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Management
(cont.)
Looks to financial statement data to
determine:


How well the firm has performed
and why?
What operating areas have
contributed to success and which
have not?
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Management
(cont.)
Looks to financial statement data to
determine:


What are strengths/weaknesses of
company’s financial position?
What changes should be
implemented to improve future
performance?
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Caution!!!



Keep in mind: Management PREPARES
financial statements
Analyst should be alert to potential for
management to influence reporting to
make data more “appealing”
May want to supplement analysis with
other sources of information apart from
the Annual Report prepared by
management
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Sources of Information
The analyst will want to consider
the following resources:
Proxy Statement
Auditor’s Report
MD&A
Supplementary schedules
Form 10-K and Form 10-Q
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Other Sources of Information

Computerized data bases




Info on industry norms/ratios
Info on particular companies/industries
Ever-expanding financial and
investment websites
Articles in popular/business press
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Tools and Techniques
These include:
Common-size financial statements
Financial ratios
Trend analysis
Structural analysis
Industry comparisons
Most important:
Common sense and judgment
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Common-Size
Financial Statements
Express each account on the
 balance sheet as a percentage of
total assets
 income statement as a percentage
of net sales
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Key Financial Ratios
Standardize financial data in terms of
mathematical relationships
expressed in the form of
Percentages
Times
Days
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Key Financial Ratios
(cont.)
Four Categories of key financial ratios:
1. Liquidity Ratios
Measure a firm’s ability to meet cash
needs as they arise
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Key Financial Ratios
(cont.)
Four Categories of key financial ratios:
2. Activity Ratios
Measure the liquidity of specific assets
and the efficiency of managing
assets
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Key Financial Ratios
(cont.)
Four Categories of key financial ratios:
3. Leverage Ratios
Measure the extent of a firm’s financing
with debt relative to equity and its
ability to cover interest and other
fixed charges
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Key Financial Ratios (cont.)
Four Categories of key financial ratios:
4. Profitability Ratios
Measure the overall performance of a
firm and its efficiency in managing
assets, liabilities and equity
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Cautions!
Ratios are valuable analytical tools and
serve as screening devices, BUT. . .

They do not provide answers in and
of themselves

They are not predictive
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Cautions!
(cont.)

Ratios should be used with other
elements of financial analysis

There are no “rules of thumb” that
apply to the interpretation of ratios
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Cautions!
(cont.)
Keeping this in mind, let’s take a look at
some of the ratios. . . .
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Liquidity Ratios:
Short-Term Solvency
Current Ratio
Measures ability to meet short-term
cash needs
Current assets
Current liabilities
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Liquidity Ratios:
Short-Term Solvency
(cont.)
Quick or Acid-Test Ratio
Measures ability to meet short-term cash
needs more rigorously by
eliminating inventory
Current assets - Inventory
Current liabilities
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Liquidity Ratios:
Short-Term Solvency
(cont.)
Cash Flow Liquidity Ratio
Focuses on ability of the firm to
generate operating cash flows as a
source of liquidity
Cash + Marketable securities + CFO *
Current liabilities
*Cash flow from operating activities
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Liquidity Ratios:
Short-Term Solvency
(cont.)
Average Collection Period
Helps gauge liquidity of accounts
receivable (ability to collect cash
from customers) and may help
provide information about a
company’s credit policies
Net accounts receivable
Average daily sales
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Liquidity Ratios:
Short-Term Solvency
(cont.)
Days Inventory Held
Measures the efficiency of the firm in
managing its inventory
Inventory
Average daily cost of sales
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Liquidity Ratios:
Short-Term Solvency
(cont.)
Days Inventory Held: Example of ratio
comparisons for two companies in the
Electronic Computers industry*
Current Yr.
5 days
Prior Year
5 days
2 Yrs. Prior
4 days
Current Yr.
23 days
Prior Year
22 days
2 Yrs. Prior
15 days
*Data from SEC website, www.sec.gov
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Liquidity Ratios:
Short-Term Solvency
(cont.)
Days Payable Outstanding
Offers insight into a firm’s pattern of
payments to suppliers
Accounts payable
Average daily cost of sales
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Cash Conversion Cycle or
Net Trade Cycle
The normal cycle of a firm that consists of:



Buying or manufacturing inventory,
with some purchases on credit
Selling inventory, with some sales
on credit
Collecting the cash
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Cash Conversion Cycle or
Net Trade Cycle (cont.)
Helps the analyst understand why cash
flow generation has improved or
deteriorated by analyzing:
Key balance sheet accounts that affect
cash flow from operating activities
 Accounts Receivable
 Inventory
 Accounts Payable
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Cash Conversion Cycle or
Net Trade Cycle (cont.)
Calculated as follows:
Average collection period
Plus
Days inventory held
Minus
Days payable outstanding
Equals
Cash conversion or net trade cycle
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Activity Ratios: Asset Liquidity,
Asset Management Efficiency
Accounts Receivable Turnover
Another measure of efficiency of firm’s
collection and credit policies
Net sales
Net accounts receivable
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Activity Ratios: Asset Liquidity,
Asset Management Efficiency (cont.)
Inventory Turnover
Another measure of firm’s efficiency in
managing its inventory
Cost of goods sold
Inventory
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Activity Ratios: Asset Liquidity,
Asset Management Efficiency (cont.)
Payables Turnover
Another way to gain insight into a firm’s
pattern of payment to suppliers
Cost of goods sold
Accounts payable
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Activity Ratios: Asset Liquidity,
Asset Management Efficiency (cont.)
Fixed Asset Turnover
Assesses effectiveness in generating sales
from investments in fixed assets
Net sales
Net property, plant, equipment
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Activity Ratios: Asset Liquidity,
Asset Management Efficiency (cont.)
Total Asset Turnover
Assesses effectiveness in generating sales
from investments in all assets
Net sales
Total assets
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Leverage Ratios:
Debt Financing and Coverage
Debt Ratio
Considers the proportion of all assets
that are financed with debt
Total liabilities
Total assets
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Leverage Ratios:
Debt Financing and Coverage
(cont.)
Debt Ratio: Example of ratio comparisons for
two companies in the Grain Mills industry*
Current Yr.
62.31%
Prior Year
69.93%
Current Yr.
Prior Year
79.08%
85.77%
*Data from SEC website, www.sec.gov
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Leverage Ratios:
Debt Financing and Coverage
(cont.)
Long-term Debt to Total Capitalization
Reveals the extent to which long-term
debt is used for the firm’s
permanent financing (both longterm debt and equity)
Long–term debt
Long-term debt + Stockholders’ equity
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Leverage Ratios:
Debt Financing and Coverage
(cont.)
Debt to Equity
Measures the riskiness of the firm’s
capital structure in terms of the
relationship between the funds
supplied by creditors (debt) and
investors (equity)
Total liabilities
Stockholders’ equity
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Leverage Ratios:
Debt Financing and Coverage
(cont.)
Times Interest Earned
Indicates how well operating earnings
cover fixed interest expenses
Operating profit
Interest expense
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Leverage Ratios:
Debt Financing and Coverage
(cont.)
Cash Interest Coverage
Measures how many times interest
payments can be covered by cash
flow from operations before interest
and taxes
CFO + interest paid + taxes paid
Interest paid
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Leverage Ratios:
Debt Financing and Coverage
(cont.)
Fixed Charge Coverage
Broader measure of how well operating
earnings cover fixed charges
Operating profit + Rent expense
Interest expense + Rent expense
*Rent expense = operating lease payments
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Leverage Ratios:
Debt Financing and Coverage
(cont.)
Cash Flow Adequacy
Measures firm’s ability to cover capital
expenditures, long-term debt
payments and dividends each year
Cash flow from operating activities
Capital expenditures + debt repayments
+ dividends paid
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Profitability Ratios:
Overall Efficiency and Performance
Gross Profit Margin
Measures ability to translate sales into
profit after consideration of cost of
products sold
Gross profit
Net sales
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Profitability Ratios:
Overall Efficiency and Performance (cont.)
Operating Profit Margin
Measures ability to translate sales into
profit after consideration of
operating expenses
Operating profit
Net sales
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Profitability Ratios:
Overall Efficiency and Performance (cont.)
Net Profit Margin
Measures ability to translate sales into
profit after consideration of all
expenses and revenues, including
interest, taxes and nonoperating
items
Net earnings
Net sales
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Profitability Ratios:
Overall Efficiency and Performance (cont.)
Cash Flow Margin
Measures ability to translate sales into
cash (with which to pay bills!)
Cash flow from operating activities
Net sales
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Profitability Ratios:
Overall Efficiency and Performance (cont.)
Return on Total Assets (ROA) or Return
on Investment (ROI)
Measures overall efficiency of firm in
managing investment in assets and
generating profits
Net earnings
Total assets
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Profitability Ratios:
Overall Efficiency and Performance (cont.)
Return on Equity (ROE)
Measures rate of return on stockholders’
investment
Net earnings
Stockholders’ equity
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Profitability Ratios:
Overall Efficiency and Performance (cont.)
Cash Return on Assets


Measures firm’s ability to generate cash
from the utilization of its assets
Useful comparison to ROA
Cash flow from operating activities
Total assets
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Market Ratios
Four market ratios of particular interest
to the investor are
1.
2.
3.
4.
Earnings per common share
Price-to-earnings
Dividend payout
Dividend yield
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Market Ratios
(cont.)
Earnings per Common Share
Provides the investor with a common
denominator to gauge investment
returns
Net earnings
Average shares outstanding
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Market Ratios
(cont.)
Price-to-Earnings
Relates earnings per common share to the
market price at which the stock trades,
expressing the “multiple” that the stock
market places on a firm’s earnings
Market price of common stock
Earnings per share
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Market Ratios
(cont.)
Dividend Payout
Determined by the formula cash
dividends per share divided by
earnings per share
Dividends per share
Earnings per share
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Market Ratios
(cont.)
Dividend Yield
Shows the relationship between cash
dividends and market price
Dividends per share
Market price of common stock
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Analyzing the Data
Now that some of the “tools” of financial
analysis have been illustrated,
where does one go from here?
Taking a general approach to financial
statement analysis, one might
proceed as follows. . .
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Five Steps of a Financial
Statement Analysis
Step 1
Establish objectives of the analysis



Who are you and why are you interested
in this company?
What questions would you like to have
answered?
What info is vital to the decision at hand?
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Five Steps of a Financial
Statement Analysis (cont.)
Step 2
Study the industry in which the firm
operates and relate industry climate
to current and projected economic
developments
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Five Steps of a Financial
Statement Analysis (cont.)
Step 3
Develop knowledge of the firm and
the quality of management
 How well does this firm appear to be run?
 Are they taking advantage of
opportunities?

Are they innovative, forward-looking, etc?
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Five Steps of a Financial
Statement Analysis (cont.)
Step 4
Evaluate financial statements–tools include:
 Common-size financial statements
 Key financial ratios
 Trend analysis
 Structural analysis
 Comparison with industry competitors
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Five Steps of a Financial
Statement Analysis (cont.)
Step 4
Evaluate financial statements–areas include:
 Short-term liquidity
 Operating efficiency
 Capital structure and long-term solvency
 Profitability
 Market ratios
 Segmental analysis (when relevant)
 Quality of financial reporting
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Five Steps of a Financial
Statement Analysis (cont.)
Step 5
Summarize findings based on analysis

Reach conclusions about the firm
relevant to your established
objectives
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Relating the Ratios
—The Du Pont System
Is helpful to complete the evaluation of
a firm by considering the
interrelationship among the
individual ratios
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Relating the Ratios
—The Du Pont System
(cont.)
The Du Pont System helps the analyst
see how the firm’s decisions and
activities over the course of an
accounting period interact to
produce an overall return to the
firm’s shareholders, the return on
equity
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Relating the Ratios
—The Du Pont System
(cont.)
The summary ratios used are the following:
(1)
Net profit margin
(2)
Total asset turnover
Net income
Net sales
Net sales
X
Total assets
(3)
Return on investment
(4)
Financial leverage
Net income
Total assets
Total assets
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Return on investment
Net income
=
Total assets
(5)
Return on equity
Net income
X Stockholder equity = Stockholder equity
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What we have accomplished
Turned Maze
Statement of Cash Flows
Balance Sheet
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MD&A
Income Statement
Notes
Auditor’s Report
Statement of Shareholders’ Equity
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Financial Statements
An Overview
into Map
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