Financial Statement Analysis
As we discussed in the previous chapter, financial statements are the primary
source of financial data about a company. It is difficult to do much meaningful analysis
from the raw financial statements however. Converting the financial statements to cash
flow provides useful information. Converting financial statement numbers into ratios
also provides a useful way of looking at the data.
STATEMENT OF CASH FLOWS
In the last chapter we learned how to convert the financial statements into a
‘computation’ of cash flows. One of the financial statements prepared by accountants is
the statement of cash flows. The statement of cash flows provides virtually the same
information as the computation we have already learned. The primary differences
between the two are format, and the statement prepared by the accountants shows the
changes in the components of working capital, while the computation we prepared
indicates the change in working capital in total.
STANDARDIZED FINANCIAL STATEMENTS
We cannot conclude much from the raw financial statement data. It would be
helpful to have a benchmark or basis for comparison. The usual basis of comparison is
similar companies in the industry (see below), or historical data of the same company.
However, because of differences of size direct comparison is not very useful. Size
differences are solved by creating ‘common-size’ or standardized financial statements.
• Standardized balance sheet - a common-size balance sheet presents all balance
sheet account amounts as a percentage of total assets.
• Standardized income statement - a common-size income statement presents all
account balances as a percentage of sales.
• Common-base financial statements - a different way to standardize financial
statements is to divide all account balances by the corresponding account’s balance in a
base year. The result indicates the growth rate of each account, or the trend in each
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Ratio analysis is a very useful tool for analyzing the financial aspects of a
company. In fact, the common-size financial statements discussed previously already
contain many of the ratios which are specifically examined in ratio analysis. Before
computing the ratios, we should recognize several important points:
• What are we trying to measure or analyze? (performance? liquidity?)
• Who is the user?
- management: management will be interested in all ratios, though will
emphasize some over others
• What goes into a particular ratio? In general, book value which represents
• What is the unit of measurement? Percent of a $, days, turnover?
• What is a ‘good’ or ‘bad’ ratio?
Finally, ratio analysis is a means to an end, not an end in itself. That is, ratio analysis
may present more questions than it answers. Why is a particular ratio high or low? Is it
transitory, or continuing?
There are five major groups of ratios. These are:
1. Short-term solvency or liquidity ratios
2. Long-term solvency or financial leverage ratios
3. Asset management or turnover ratios
4. Profitability ratios
5. Market ratios.
Note that who the user is will dictate which particular group of ratios is most important.
Many of the ratios are defined differently, not only by accounting and finance textbooks,
but sometimes between different finance textbooks. Comparability is most important.
• Short-term solvency or liquidity ratios - indicate ability of corporation to meet
its short-term obligations. These are primarily of interest to suppliers and other short-
term creditors. See Table 3.8 for definitions of these ratios.
• Long-term solvency or financial leverage ratios - indicate degree of debt
financing by a company, as well as ability to meet long-term obligations. These are
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primarily of interest to bondholders, and may be of interest to shareholders. See Table
3.8 for definitions of these ratios.
• Asset Utilization or Turnover ratios - indicate intensity and efficiency of asset
use. Also called asset management ratios. Of particular interest to management and
financial analysts. Total asset turnover may be too broad oftentimes to be useful. The
components would be important.
• Profitability ratios - indicate combined use of both assets and debt. These are
primarily of interest to management and analysts/shareholders. See Table 3.8 for
definitions of these ratios. Net margin is sometimes too broad, and can mask underlying
problems. (Net margin is tainted by the use of debt. See DuPont later.) I would include
the following ratios:
Gross margin = gross profit ÷ sales
Operating margin = operating profit ÷ sales
These two ratios are not ‘tainted’ by the financing decisions or tax situation of the
company and get at the underlying profitability of the company.
• Market ratios - these ratios incorporate both financial statement information and
market-based information. These reflect market perceptions of company performance
and market expectations of the future. (Recall that accounting numbers reflect the past,
while market numbers reflect expectations about the future.) See Table 3.8 for
definitions of these ratios.
DuPont analysis is useful for determining the components of ROE. That is, what
Net Income = Net income x Sales x Assets
Equity Sales Assets Equity
ROE = Net x Asset x Equity
Margin Turnover Multiplier
Profitability = operating x asset x financial
efficiency efficiency leverage
Companies may have similar ROE’s for very different reasons. Consider a very
operationally efficient company with no debt and an average operationally efficient
company with moderate to significant debt.
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Other Caveats about ratio analysis
• Inflation can have a distortionary effect on ratios. As an example, consider the
effect of inflation on total asset turnover for a capital intensive company.
• Timing problems. Most ratios are calculated using the year-end financial
statements. If the year-end numbers are not ‘representative’ of the whole year, then
neither are the financial ratios. For example, a very large credit sale at year-end could
inflate accounts receivable and create a high ‘days sales outstanding’ ratio, implying a
slower collection period. Similarly distortions occur with accounts payable and
inventory. Companies with seasonal operations are particularly prone to this problem.
Finally, different accounting methods can distort ratios. One way to solve this problem is
to use average asset balances. Whether or not to solve the problem depends on what you
are doing with the ratios and what you are comparing them to.
• Comparability. Financial statements cannot be examined in a vacuum. There
must be some benchmark for comparison, whether that benchmark is historical data or
industry data. Comparability should be the guiding principle in determining how to do
financial ratio analysis and how to interpret the results.
PEER GROUP ANALYSIS
As stated previously, raw financial statements or financial ratios in isolation are of
limited value. They are most useful when they can be compared to historical data or
industry data. Comparison with industry data is sometimes called ‘peer group analysis.’
The first step is to identify the appropriate peer group or industry. Conceptually, this
means selecting a group for comparison which has the same type of assets contained in
the ‘circle’ in our picture of the firm. Practically, these means selecting companies
having the same SIC code. SIC code means Standard Industrial Classification code, and
these codes are four digit codes established by the US government for statistical reporting
purposes by companies. Table 3.9 in your text contains examples for the first two digits
of the SIC codes. There are many sources of industry data available in the library and on
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