Analysis of Financial Statements
(Revised November 2004)
The financial position of a firm is important to understand because it determines to a large
extent the availability of capital and the desirability of future investments in new plants and
Basic Financial Statements:
The two basic financial statements of a firm are the balance sheet and the income statement or
the statement of profit and loss. The balance sheet is a statement of the financial position of a
firm as of a specific point in time. The basic balance sheet equation is:
Assets = Liabilities + Net Worth.
The assets are generally listed on the left side of a balance sheet. Assets are listed in
decreasing order of liquidity, where liquidity refers to an assets capability for being converted to
cash. For example, cash the most liquid asset is generally listed at the top of the assets column
on a balance sheet. Other assets in order of decreasing liquidity would be marketable
securities, accounts receivable and inventories. These assets are listed under current assets in
Figure 1 because they are convertible to cash in less than one year. Other assets include
investments not convertible to cash within one year, plant and equipment, prepaid expenses
and deferred charges. Prepaid expenses might include prepaid insured premiums or rents
whereas deferred charges refer to expenses to be recovered over an extended business
period. An example of a deferred charge might be the cost to set up the organization which
might be recovered over the life of the firm.
The claims on the assets of a firm include the liabilities and the net worth. Liabilities are claims
of creditors and have precedence on rights to the assets before the owners. Net worth refers to
the portion of the assets of a firm, which are paid for by the owners. Liabilities are separated
into current and other liabilities. Current liabilities are those debts which are payable within one
year. Examples of current liabilities include accounts and notes payable within one year and
taxes and other expenses which have accrued and are payable within one year. Net Working
capital is defined as the current assets minus current liabilities.
The Owner's Equity or Net Worth is generally made up of preferred and common stock, capital
surplus and retained earnings. Capital surplus is the amount of money received from the sale of
stock in excess of the face value of the stock. Retained earnings are the accumulated net
operating income after taxes less the dividends paid to stockholders.
The Income Statement or Statement of Profit and Loss (Figure 2) shows the financial
performance of the firm over an interval of time. Net Sales are gross sales less returns. Gross
Profit is net sales less the cost of goods sold excluding certain cost such as selling, general and
administrative expenses and lease payments which cannot be directly attributed to the
acquisition or manufacture of the goods sold. Gross operating income is gross profit less the
above mentioned operating expenses which are not directly attributed to the cost of the goods
Manhan Manufacturing Company Balance Sheet as of:
Assets Dec. Dec.2004
Current Assets (X 1000) (X 1000)
Cash 5,500 7,500
Marketable Securities 5,000 3000
Accounts Receivable 17,000 20,000
Notes Receivable 2,500 3,700
Finished Goods 22,700 21,400
Other Inventory 7,700 8,000
Other Current Assets 9,400 8,300
Total Current Assets 69,800 71,900
Other Investments 5,000 4,000
Plant and Equipment 140,000 150,000
Less Depreciation (50,000) 90,000 (70,000) 80,000
Prepaid Expenses 1 1,500 2,000
Deferred Charges 2 3,000 2,500
Total Assets 169,300 160,400
Accounts payable 26,000 15,000
Notes payable (within 15,000 10,000
Accrued taxes & other 3,500 3,000
Total Current Liabilities 44,500 28,000
First Mortgage bonds 22,000 20,000
Debentures 8% 10,000 10,000
Total Liabilities 76,500 58,000
Owner's Equity (Net
Preferred stock 10,000 10,000
Common Stock 40,000 40,000
Capital surplus 4 10,000 10,000
Retained earnings 5 32,800 42,400
Total Owner's Equity 92,800 102,400
Total Claims on Assets 169,300 160,400
Figure 1 Manhan Corporation Balance Sheet
1 An example could be a prepaid insurance premium.
2 Deferred charges refer to expenses which are recovered over an extended period of the business operation. Ex.
cost to incorporate, legal fees.
3 Includes federal income taxes, FICA, etc.
4 Capital surplus = Amount received from sale of the stock less face value of stock.
5 Retained earnings = Net operating income after taxes less dividends.
Net operating income is gross operating income less the depreciation charge for the period
covered by the statement. Net income before taxes is net operating income less non operating
expenses such as interest on notes and secured loans. Net income after taxes is net income
before taxes less federal and state income taxes.
The Statement of Retained Earnings (Figure 3) indicates how the retained earnings changes
from one balance sheet to the next. The prior balance sheet retained earnings is adjusted by
adding net income after taxes from the income statement and subtracting dividends paid to
stockholders to obtain retained earnings for the new balance sheet. The retained earnings
represents the additional investment in the company by the owners in addition to the initial
investment made when their stock was purchased.
Manhan Manufacturing Company Income Statement
(For Year Ended Dec. 31, 2004)
Net sales 300,000
Cost of goods sold 188,000
Gross profit 112,000
Less operating expenses
General & admin. 20,000
Lease payments 14,000 49,000
Gross operating income 63,000
Less depreciation 20,000
Net operating income 43,000
Less other expenses
Interest in notes payable 3,000
Interest on first mortgage 1,400
Interest on debentures 800 5,200
Net Income before income taxes 37,800
Federal income tax 18,144
Net income after income taxes 19,656
Figure 2 Manhan Corporation Income Statement
Manhan Manufacturing Company Statement of Retained Earnings
(For Year Ended Dec. 31, 2004)
Balance of retained earning 1/1/04 32,800
Add: Net income 2004 19,656 52,456
Less: Dividends to stockholders 10,056
Balance of retained earnings 12/31/04 42,400
Figure 3 Manhan Corporation Statement of Retained Earnings
Ratio Analysis of Financial Statements:
The four types of ratios are: liquidity ratios, leverage ratios, activity ratios V and profitability
ratios. Liquidity ratios are most important when accessing a firm ability to meet its' short term
debts. A creditor considering making a short term loan to a firm would be most interested in the
firm's liquidity ratios.
Leverage ratios measure the extent which a firm's assets are financed by creditors as
compared with owners. High leverage ratios generally mean high risk for creditors. Activity
ratios measure the firm’s ability to effectively manage its resources, such as inventory, and
fixed assets. Profitability ratios measure the firm's ability to achieve returns on sales and
investment. Activity and profitability ratios are most important when measuring the firm's long
term financial position.
Table 1 presents the ratio, its calculation formula, and the application of the formula to the 2004
Manhan Corporation data presented in its balance sheet and income statement. In order to
gage the financial condition of the Manhan Corporation the analyst must compare the ratios
obtained with industry averages for its industry. In order to obtain a picture of the firm’s
progress over the past several years, it is often helpful to plot key ratios for the corporation and
the industry average on the same time scaled graph as shown in Figure 4.
Comparative ratios for major corporations and industry groups may be obtained from a wide
variety of sources. Perhaps the most complete source is compiled by Dun & Bradstreet, Inc.
Other sources of comparative ratios include Robert Morris Associate; the National Association
of Bank Loan Officers; the Quarterly Financial Report for Manufacturing Corporations published
jointly by the Federal Trade Commission (FTC) and the Securities and Exchange Commission
(SEC); Forbes, Annual Report on American Industry, vital facts and ratios for 500 largest
corporations, published annually in the January issue; Fortune, Fortune 500 annual report on
costs and ratios, June issue and Standards and Poor's Industry Surveys for all major industries,
includes ratios for each major company in each major industry.
Table 1 Manhan Corporation Financial Ratios
Ratio Formula Manhan Corp. 04
I Liquidity Ratios
1. Current Ratio Current Assets / Current Liabilities 71,900 / 28,000 =
2. Quick or acid test Current Assets-inventory / Current 42,500 / 28,000 =
II Leverage Ratios
3. Debt to total Total liabilities / Total Assets 58,000 / 160,400 =
4. Times interest Gross operating income* / Interest 63,000 / 5,200 =
earned charges* 12.12
III Activity Ratios
5. Inventory turnover Net sales* / Inventory 300,000 / 29,400 =
6. Fixed assets Net sales* / Fixed assets 300,000 / 80,000 =
7. Total assets Net sales* / Total assets 300,000 / 160,400 =
8. Average collection Receivables / Sales per day* 23,700 / 822 = 28.8
IV Profitability Ratios
9. Return on Total Net income after taxes* / Total assets 19,656 / 160,400 =
10. Profit margin Net income after taxes* / Net Sales* 19,656 / 300,000 =
on sales 6.6%
11. Return on Net Net income after taxes* / Net Worth 19,656 / 102,400 =
Worth or Return on 19.2%
* This comes from the income statement
Figure 4 Comparison over time of Manhan Corporation ratios with industry averages.
A funds flow chart is presented in Figure 5. The chart depicts the impact of various costs, sales,
and assets on total return on investment. The cost data appearing under each rectangular
block of Figure 5 was taken from Figures 1 and 2.
Manhan Corporation Funds Flow chart Cash & Marketable
+ Accounts & Notes
Net Sales 23700
═ 300000 Capital ═ +
Turn Over ÷ Inventories
1.87 Total ═ + 63600 29400
160400 Assets * Cost of Goods Sold
Return on ═
x 96800 188000
12.25 Net Sales +
* Selling Expenses
Net income ═ - 300000
after Taxes 15000
Net income as ═ ═
19656 Cost of + * General & Admin.
a % of sales ÷ operation
+ * Other Operating
* This comes from the income statement. Depreciation,
+ Interest & Taxes
Figure 5 Manhan Corporation Funds flow chart
Exercise: Select a company of interest and perform a financial analysis of that company by
obtaining data from one of the sources mentioned in this section.
1. Forbes Magazine, “Annual Report on American Industry”, Presents vital facts and ratios for 500 largest
corporations, January of each year
2. Forbes Magazine, “Annual Report - Fortune 500", Costs and ratios for 500 corporations, June
3. Foulke, Roy A., "Practical Financial Statement Analyses," N.Y. - McGraw-Hill,
4. "Standard and Poor's Basic Industry Surveys for Major Industries," includes financial ratios for each major
company in each major industry.
5. "Quarterly Financial Report for Manufacturing Corporations," issued jointly by the Federal Trade Commission,
Washington, U.S. Govt. Printing Office.
6. Johnson, Arnold W., "The Interpretation of Financial Statements," Financial
Analyst Journal, Nov. - Dec., 1968, pp. 75-84.