CHAPTER F12
Financial Statement
Analysis
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Learning Objective 1:
Identify the three major
categories of users of
financial statement
analysis and describe the
objectives of each.
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Financial Statement Analysis
 Financial statement analysis is just what
you would think it is: analyzing the
information presented in a firm’s financial
statements.
 Two major techniques are trend analysis
and ratio analysis.
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Who Performs Financial
Statement Analysis?
 Financial statement analysis is routinely
performed by:
1) Creditors (short term and long term)
 2) Equity investors (current and
potential)
 3) Company management

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Objectives of Creditors
 Short-term creditors, both trade creditors
and lending institutions, are primarily
concerned with the firm’s ability to pay its
bills in a timely fashion.
 Long-term creditors are concerned with
the firm’s long-term ability to repay any
loan amounts (including bonds) as well as
the interest on that debt.
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Objectives of Equity Investors
 Investors are concerned with many things,
but probably the most important
consideration is the company’s ability to
generate income in the future.
 Profitable operations for the company
usually translate into dividends and stock
price appreciation for the investors.
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Objectives of Management
 Members of management have the
responsibility of leading the firm through the
day-to-day activities. The results of these
activities are reflected in the financial
statements.
 Thus, management has two main concerns
regarding financial statement analysis: 1) to
present the information in the most favorable
light, and 2) to monitor the overall
performance.
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Learning Objective 2:
Gather information to
evaluate the political climate
and general economic
conditions and describe the
ways in which each can
affect business.
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Gathering Background
Information - A First Step
 To properly analyze the firm’s financial
statements, it is necessary to understand
the environment in which the firm operates.
In particular:
 the general economic conditions or
expectations,
 the political events and political climate, and
 the industry outlook.
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General Economic
Conditions and Expectations
 Another factor to consider in predicting the
future financial performance of a company
would be the current condition of the
general economy and your expectations
about the future of the economy.
 Companies in certain industries would be
affected more than others when an
economic downturn (or upswing) occurs.
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Political Events and
Political Climate
 Additional external factors that will have an
influence on a company’s financial
performance are the political events and the
general political climate.
 Congressional actions often affect the
financial performance through changes in
the tax code, environmental actions, or
reductions in governmental spending.
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Industry Outlook
 A third external factor is the general outlook for
the industry in which the firm operates.
 For example, technology-based companies were
hot in the late 1990s but many failed by 2001,
while the increase in the federal defense budget
has increased steadily since 2001.
 Can you guess what industry will be the most
successful in 2017?
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Learning Objective 3:
Locate sources of
information about
specific industries.
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Sources of Industry
Information
 Library Sources:
 Standard and Poor’s Industry Survey
 Mergent Industry Review
 Value Line Industry Survey
 Business Press:
 Wall Street Journal
 Business Week
 Fortune
 Forbes
 Internet Sources: (Beware of the integrity of the
source.)
 Trade Associations
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Learning Objective 4:
Describe the purpose of trend
analysis and ratio analysis
and explain the three primary
characteristics it helps users
evaluate.
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Trend Analysis
 Trend analysis is a particular type of
financial statement analysis where key
financial figures are analyzed over time
to see if there is a pattern of change.
 Trend analysis can often be effectively
illustrated through the use of graphs or
charts.
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Ratio Analysis
 Ratio analysis is a particular type of
financial statement analysis where the
relationship between two or more items
from the financial statements is analyzed.
 A particular ratio might include information
from various sources, including information
not typically contained in the financial
statements, such as market price of a stock.
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Major Categories of
Ratio Analysis
Profitability ratios
Liquidity ratios
Solvency ratios
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Learning Objective 5:
Calculate financial ratios
designed to measure a
company’s profitability,
liquidity, and solvency.
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Measuring Profitability
 Profitability refers to the company’s ability to
generate income. Profitability ratios are
used to measure a firm’s past performance
and to aid in the prediction of future profits.
 Most business people agree that long-term
profits are more important than short-term
profits, yet most of the commonly used
ratios focus on short-term profitability.
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Measuring Profitability
Commonly used measures include:
 Return on assets ratio
 Profit margin before income tax
 Total asset turnover
 Profit margin after income tax
 Return on equity
 Return before taxes on equity
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Return on Assets Ratio
Net income before income taxes
Total assets
 One measure of return on investment.
This is a measurement of how
efficiently the company’s assets are
used to generate profits.
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Return on Assets Ratio
 The return on assets can be broken down
into two component parts:
 the profit margin before income tax, and
 the total asset turnover.
 This might be abbreviated as follows:
 ROA
= Margin X Turnover
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Profit Margin Before
Income Tax Ratio
Net income before taxes
Sales
 This ratio measures the income produced
as a percentage from each dollar of sales
revenue.
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Total Asset Turnover Ratio
Sales
Total assets
 An analysis of the amount of sales
(instead of income) generated through
the effective use of the investment in
assets.
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ROA Comparisons
 Compare the return on assets for the
following two firms:
A jewelry store with a 30% profit margin
and an asset turnover of .6, and a grocery
store with a 4% profit margin and an asset
turnover of 5.0:
 Jewelry: 30% X .6 = 18% ROA
 Grocery: 4% X 5.0 = 20% ROA
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Profit Margin After
Income Tax Ratio
Net income after taxes
Sales
 Use after-tax income instead of before-
tax. Some people argue that since taxes
are a normal expense, the effect of
income taxes should be included.
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Return on Equity Ratio
Net income after taxes
Equity
 This ratio measures the profitability on
the amount of investment by the
company owners rather than the total
investment in assets.
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Return Before Taxes
on Equity Ratio
Net income before taxes
Equity
 We are measuring the earnings generated
for the owners before considering the cost
of taxes.
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Measuring Liquidity
 Liquidity (in this context) refers to the
company’s ability to generate cash as
needed to pay its short-term obligations.
 Short-term creditors (current and
potential) are particularly concerned with
a company’s liquidity measures.
 Liquidity measures focus on the “liquidity
of the assets” available to the company.
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Measuring Liquidity
Commonly used measures include:
 Current ratio
 Quick ratio
 Receivables turnover
 Inventory turnover
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Current Ratio
Current assets
Current liabilities
 This ratio is a comparison of the level
of current assets available to pay the
current liabilities. This is a very widely
used ratio.
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Quick Ratio
Cash + Accounts & notes receivable
Current liabilities
 Also called the acid-test ratio, this is a
more stringent measure of liquidity. The
focus is placed on the “quick assets,” those
that can be quickly turned into cash.
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Receivables Turnover Ratio
Sales
Accounts receivable
 A measurement of how quickly a
company collects their accounts
receivable. The higher the turnover, the
more quickly the receivables are being
collected.
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Inventory Turnover Ratio
Cost of sales
Inventory
 A measurement of how many times total
merchandise inventory is purchased and
sold during an accounting period.
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Measuring Solvency
 Solvency refers to the ability to meet long-
term obligations resulting from debt.
 These measurements are similar to the
liquidity measures, except the focus is on all
assets and liabilities rather than the current
assets and liabilities.
 These measures are of interest to long-term
creditors, stockholders, and management.
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Measuring Solvency
Commonly used measures include:
 Debt ratio
 Debt to equity ratio
 Coverage ratio
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Debt Ratio
Total liabilities
Total assets
 Measures the percentage of a
company’s assets that is financed by
debt, rather than equity.
 Debt % + Equity % = 100%
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Debt to Equity Ratio
Total liabilities
Net worth
 Net worth is the same as owners’
equity; it is equal to Assets - Liabilities.
This ratio highlights the relationship
between creditors’ claims and owners’
claims to assets.
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Coverage Ratio
Earnings before interest and income taxes
Interest expense
 Also called the times interest earned ratio,
it is an indication of the company’s ability to
make interest payments. Lenders pay close
attention to this ratio.
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Learning Objective 7:
Evaluate a company’s
ratios using a comparison
to industry averages.
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Using the Ratios
 After calculating the ratios for a particular
company, you might want to do some or
all of the following:
Compare ratios to industry averages,
 Look for company trends,
 Consider the industry environment, and
 Draw conclusions

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Learning Objective 8:
Use ratio values from
consecutive time periods
to evaluate the
profitability, liquidity, and
solvency of a business.
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Using the Ratios
 After comparing the ratios for a company
to the industry, you should prepare a
trend analysis of the ratio numbers.
 Small changes in the ratios over time
may indicate improvement or danger
signs of decline in financial health.
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Ratio Trend Analysis
 What would the following ratio trend analysis
indicate to you about the financial condition of the
company?
 Profit after taxes ratio
 Current ratio
 Debt ratio
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2006
5.5%
2.0
42%
2007
5.7%
1.9
47%
2008
5.9%
1.7
56%
2009
6.3%
1.4
65%
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Learning Objective 6:
Explain the purpose of the
North American Industry
Classification System and
specify what an NAICS
code indicates.
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NAICS
 NAICS is a classification system instituted
by the federal government to gather useful
industrial data from tax returns and SEC
filings.
 Each industry has its own classification
numbers.
 The 452990 code represents discount
general merchandise stores with centralized
checkout.
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NAICS
 The NAICS information allows analysts to
compare companies that are as alike as
possible.
 Published ratios are grouped by NAICS
codes to facilitate meaningful comparison.
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Learning Objective 9:
State the limitations of
ratio analysis.
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Limitations of Ratio Analysis
 As informative as ratio analysis can be, it
also has some inherent limitations:
 1) Attempting to predict the future using past
results is problematic at best. Past results are
not always indicative of future performance.
 2) The financial statements used as the basis
of the ratios are based on the accounting
principle of historical cost.
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Limitations of Ratio Analysis
 3) Figures from the balance sheet used in the
calculation of the ratios are year-end values, which
may or may not be representative.
 4) Comparing the ratios of companies in different
industries is difficult because of industry
peculiarities.
 5) There are no hard-and-fast rules telling the
analyst what numbers to use to calculate the ratios.
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The End of Chapter 12
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