Chapter 3
Introduction
to Financial
Statement
Analysis
The Need for Financial
Statement Analysis
Financial Statement Analysis
Financial statement analysis involves
the examination of
– the relationships among financial
statement numbers
– the trends in those numbers over time
Relationships between financial
statement amounts are called financial
ratios
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Financial Statement Analysis
• Past performance is used to predict
future performance of a company
– Prognosis
• Problem areas can be identified
– Analysis
• Not in isolation
– Intra-company comparison
– Intra-industry comparison
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Financial Statement
Analysis
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Widely Used
Financial Ratios
Debt Ratio
Represents the proportion of borrowed
funds used to acquire the company’s
assets
Total Liabilities
Debt Ratio =
Total Assets
Debt ratios should be around 50%,
but may vary by industry
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Current Ratio
Measures the ability to repay debt in the
short run
Current Assets
Current Ratio =
Current Liabilities
Historically, less than 2:1 indicative of
liquidity concerns
Now, frequently less than 1:1
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Return on Sales
Shows the profit percentage for each
dollar of sales
Net Income
Return on Sales =
Sales
Evaluate by comparison with other
industry members
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Asset Turnover
Gives an overall measure of company
efficiency
Sales
Asset Turnover =
Total Assets
The higher the turnover ratio, the
more efficient the company is at
using its assets to generate sales
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Return on Equity
The overall measure of performance of a
company
Net Income
Return on Equity =
Stockholders' Equity
Good companies generally have a
return on equity between 15 and 25
percent
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Price-Earnings Ratio
Shows the number of dollars an investor
must pay to “buy” the future rights to
each dollar of current earnings
Market Value of Shares
PE Ratio =
Net Income
PE ratios typically range between 5
and 30
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Common-Size
Financial Statements
Common-Size Financial Statements
• Show all amounts for a given year as a
percentage of sales
• They should be included in the initial
stages of any comprehensive financial
statement analysis
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DuPont Framework
DuPont Framework
• Provides a systematic approach to
identifying factors causing ROE to
deviate from normal
• Provides a framework for
computation of financial ratios
for a more detailed analysis of
a company’s strengths and
weaknesses
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DuPont ROE Analysis
Return
=
on Equity
Profitability
 Efficiency 
Leverage
Return ofROE
Asset
Assets to Equity
Analysis
=
Using
on Sales
Turnover
Ratio
Net Income
Sales
Assets
the= DuPont
Framework


Sales
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Assets
Equity
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DuPont ROE Analysis
Return
=
on Equity
=
Profitability
Return
on Sales
 Efficiency 

Net Income
=

Sales
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Asset
Turnover
Sales
Assets
Leverage
 Assets to Equity
Ratio

Assets
Equity
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DuPont ROE Analysis
Return
=
on Equity
=
Profitability
Return
on Sales
 Efficiency 

Net Income
=

Sales
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Asset
Turnover
Sales
Assets
Leverage
 Assets to Equity
Ratio

Assets
Equity
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DuPont ROE Analysis
A preliminary DuPont analysis may
indicate a need to compute more ratios
in any of the three ROE components:
– Profitability ratios
– Efficiency ratios
– Leverage ratios
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Profitability Ratios
When the return on sales indicates a
problem with the profit per dollar of
sales, the common-size income
statement can pinpoint which expenses
are causing the problem
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Efficiency Ratios
Average Collection Period
– Shows the average number of days that
elapse between sales and cash
collections
– The average collection period should
vary with credit terms
Average Receivables
Average Collection Period =
Average Daily Sales
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Efficiency Ratios
Number of Days’ Sales in Inventories
– The number of days a business can
continue to sell products without receiving
any replacement inventory
Number of
Days' Sales in =
Inventory
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Average Inventory
Average Daily
Cost of Goods Sold
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Efficiency Ratios
Fixed Asset Turnover
– The number of dollars in sales
generated by each dollar of fixed assets
Fixed Asset =
Turnover
Sales
Average Fixed Assets
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Margin versus Turnover
Profitability and efficiency comprise
the first two-thirds of the DuPont
analysis of ROE
These combine to form return on assets
Net Income
Return on Assets =
Total Assets
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Margin versus Turnover
• Margin
– The profitability of each dollar in sales
• Turnover
– The degree to which assets are used to
generate sales (efficiency)
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Leverage Ratios
Leverage is borrowing that allows a
company to purchase more assets than
its stockholders are able to provide
through their investment
– More assets can be purchased
– More sales can be generated
– Net income should increase
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Leverage Ratios
Debt Ratio
– The percentage of funds that a company
acquires through borrowing
Total Liabilities
Debt Ratio =
Total Assets
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Leverage Ratios
Debt-to-Equity Ratio
– The number of dollars of borrowing for
each dollar of equity investment
Debt-to-Equity = Total Liabilities
Ratio
Total Equity
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Leverage Ratios
Times Interest Earned
– The number of times a company can
make its interest payments
Net Income before
Times
Interest and Taxes
Interest =
Interest Expense
Earned
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Cash Flow Ratios
Cash Flow Ratios
Useful when net income does not
portray the economic performance of a
company:
– Large noncash expenses
– Rapid growth
– Window dressing in reported earnings
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Cash Flow Ratios
Cash Flow to Net Income
– Reflects the extent to which accrual
accounting assumptions and
adjustments have been included in
computing net income
Cash Flow to = Cash from Operations
Net Income
Net Income
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Cash Flow Ratios
Cash Flow Adequacy
– Indicates whether a business is
generating enough cash from operations
to pay for plant and equipment
Cash From Operations
Cash Flow =
Adequacy
Fixed Asset Additions and
Acquisition Expenditures
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Cash Flow Ratios
Cash Times Interest Earned
– Provides an indicator of interest-paying
ability
Cash From Operations
Before Interest and Taxes
Cash Times
=
Interest Earned
Cash Paid for Interest
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Potential Pitfalls
Potential Pitfalls
• Financial statements do not contain
all information
• Lack of comparability
– Expenses reported in different
categories
– Conglomerates comprised diverse
companies
– Differences in accounting practices
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Potential Pitfalls
• One monumental flaw may not
present itself from ratio analysis
• Historical analysis should be
balanced against current data from
different sources
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In Summary ...
• Financial statement analysis is both diagnostic and
prognostic
• Ratios describe relationships between two financial
numbers
• Common-size financial statements are percentage-based
• The DuPont framework decomposes Return on Equity
into its three components
• Cash flows are traditionally overlooked but provide
valuable information
• Analyze comparable information
• Do not ignore non-financial information
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