Financial Statement Analysis

Financial Statement
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Analysis

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Financial Policy and Planning

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Outline

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 Meaning of Financial Statements and Financial

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Statement Analysis

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 Significance of Financial Statements

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Types of Financial Statements

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

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 Income Statement

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 Balance Sheet
 Cash Flow Statement

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 Statement of Retained Earnings

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 Ratio Analysis including Du Pont Analysis
 Limitations of Financial Statement Analysis

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Focus

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 The focus will be on financial statement analysis and

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its use in corporate finance.

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 financial statement analysis from managerial

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perspective and not from an investor and/or

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creditor’s perspective.

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 How to use financial statement analysis to ensure

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that shareholder wealth is maximized and the stock
price continues to rise?

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Meaning of Financial
Statements

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 Financial statements are summaries of the

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operating, financing, and investment activities

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of a firm.

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 According to the Financial Accounting

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Standards Board (FASB), the financial

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statements of a firm should provide sufficient

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information that is useful to
 investors and

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 creditors

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 in making their investment and credit
decisions in an informed way.

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c o m
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 The financial statements are expected to be prepared in

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accordance with a set of standards known as generally

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accepted accounting principles (GAAP).

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 The financial statements of publicly traded firms must be

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audited at least annually by independent public

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accountants.

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 The auditors are expected to attest to the fact that these

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financial statements of a firm have been prepared in
accordance with GAAP.

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Significance of Financial

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Statements



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Wall Street analysts and other sophisticated investors prefer
such financial disclosure documents as 10-Ks, which contain

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more detailed information about the company

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 Financial statements summarize and provide an overview of

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events relating to the functioning of a firm.

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 Financial statement analysis helps identify

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 a firm’s strengths and
 weaknesses

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 so that management can take advantage of a firm’s
strengths and make plans to counter weaknesses of

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the firm.
 The strengths must be understood if they are to be used to
proper advantage and weaknesses must be recognized if
corrective action needs to be taken
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c o m
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 For example, are inventories adequate to support the projected

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level of sales?
Does the firm have too heavy an investment in account

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
receivable?

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 Does large account receivable reflect a lax collection policy?

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 To ensure efficient operations of a firm’s manufacturing facility,
does the firm have too much or too little invested in plant and

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equipment?

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 Financial statement analysis provides answers to all of these
questions.

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Types of Financial Statements and

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Reports

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The Income Statement
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 The Balance Sheet

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 The Statement of Retained

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Earnings

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 The Statement of Cash Flows

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The Income Statement

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 An income statement is a summary of the revenues and

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expenses of a business over a period of time, usually either

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one month, three months, or one year.

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 Summarizes the results of the firm’s operating and financing

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decisions during that time.

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 Operating decisions of the company apply to production and

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marketing such as sales/revenues, cost of goods sold,
administrative and general expenses (advertising, office

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salaries)
 Provides operating income/earnings before interest and

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taxes (EBIT)

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c o m
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 Results of financing decisions are reflected in the

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remainder of the income statement.

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 When interest expenses and taxes are subtracted

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from EBIT, the result is net income available to

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shareholders.

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 Net income does not necessarily equal actual cash

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flow from operations and financing.


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The Balance Sheet

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 A summary of the assets, liabilities, and equity of a business at a particular point in time, usually at the
end of the firm’s fiscal year.

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Assets = Liabilities + Equity

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(Resources of the (Obligations of (ownership left over

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business enterprise) the business) Residual)

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Fixed Assets Long-term Common stock outstanding

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(Plant, Machinery, Equipment (Notes, bonds, & Additional paid-in capital
Buildings) Capital Lease Retained Earnings

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Current Assets Obligation)
(Cash, Marketable Securities, Current Liabilities

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Account Receivable, Inventories) (Accounts Payable,
Wages and salaries,
Short-term loans

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Any portion of long-term
Indebtedness due in one-year)

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THE STATEMENT OF CASH

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FLOWS


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The statement is designed to show how the firm’s operations have

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affected its cash position and to help answer questions such as these:

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 Is the firm generating the cash needed to purchase additional fixed assets

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for growth?

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 Is the growth so rapid that external financing is required both to maintain

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operations and for investment in new fixed assets?

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 Does the firm have excess cash flows that can be used to repay debt or to

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invest in new products?

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RATIO ANALYSIS

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 Financial statements report both on a firm’s

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position at a point in time and on its operations

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over some past period.

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 From management’s viewpoint, financial

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statement analysis is useful both as a way to

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 anticipate future conditions and

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 more important, as a starting point for planning

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actions
 that will influence the future course of events or

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 to show whether a firm’s position has been improving
or deteriorating over time.

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c o m
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 Ratio analysis begins

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 with the calculation of a set of financial ratios

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 designed to show the relative strengths and

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 weaknesses of a company as compared to

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 Other firms in the industry

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 Leadings firms in the industry

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 The previous year of the same firm

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 Ratio analysis helps to show whether the firm’s
position has been improving or deteriorating

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 Ratio analysis can also help plan for the future

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Types of Ratios

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 Liquidity Ratios

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Current Ratio
Quick Ratio/Acid Test Ratio

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 Asset Management Ratios

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Inventory Turnover Ratio
Days Sales Outstanding

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Fixed Assets Turnover Ratio

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Total Assets Turnover Ratio
 Debt Management Ratio

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Total Debt to Total Assets Ratio
Times Interest Covered Ratio

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 Profitability Ratios
Profit Margin on Sales

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Return on Assets
Return on Equity
Basic Earning Power Ratio

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Liquidity Ratio

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 A liquid asset is one that can be easily

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converted into cash at a fair market value

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 Liquidity question deals with this question

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 Will the firm be able to meet its current

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obligations?

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 Two measures of liquidity

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 Current Ratio

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 Quick/Acid Test Ratio

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Asset Management Ratios

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 Asset management ratio measures how effectively

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the firm is managing/using its assets

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 Do we have too much investment in assets or too

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little investment in assets in view of current and

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projected sales levels?

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 What happens if the firm has

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 Too much investment in assets

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 Too little investment in assets

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 Inventory Turnover Ratio

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 Measures the efficiency of Inventory Management

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 A high ratio indicates that inventory does not remain in

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warehouses or on shelves, but rather turns over rapidly

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into sales

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 Two cautions
Market prices for sales and inventories at cost

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

 Sales over the year and inventory at the end of the year

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Asset Management Ratio

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 Days Sales Outstanding (DSO)

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 To appraise the quality of accounts receivables

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 Average length of time that the firm must wait after making

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a sale before receiving cash from customers

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 Measures effectiveness of a firm credit policy

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 Indicates the level of investment needed in receivables to

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maintain firm’s sales level

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 What happens if this ratio is
 Too high, or

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 Too low

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 Fixed Assets Turnover Ratio

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 Measures efficiency of long-term capital

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investment

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 How effectively a firm is using its plant and

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machinery to generate sales?

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 How much fixed assets are needed to achieve a

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particular level of sales?

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 Cautions

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Asset Management Ratio

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 Total Asset Turnover Ratio

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 Measure efficiency of total assets for the company

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as a whole or for a division of the firm

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 Core competency

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Debt Management Ratio

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 Implications of use of borrowings

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 Creditors look to Stockholders’ equity as a safety

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margin

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 Interest on borrowings is a legal liability of the firm

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Interest is to be paid out of operating income

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

 Debt magnifies return and risk to common

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stockholders

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 Total Debt to Total Assets Ratio

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 Measures percentage of assets being financed

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through borrowings

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 Too high a number means increased risk of

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bankruptcy

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 Leverage

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 What percentage of total assets are being

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financed through equity?

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c o m
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 Times Earned Interest (TIE)

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 Measure the extent to which operating income

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can decline before the firm is unable to meet its

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annual interest costs

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 Failure to pay interest can result in legal action by

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creditors with possible bankruptcy for the firm


Profitability Ratios

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 Net result of a number of policies and

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decisions

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 Show the combined effect of liquidity, asset

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management, and debt management on

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operating results


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 Net Profit Margin on Sales

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 Relates net income available to common stockholders to sales
 Basic Earning Power

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 Relates EBIT to Total Assets

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 Useful for comparing firms with different tax situations and

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different degrees of financial leverage

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 Return on Assets (ROA)

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 Relates net income available to common stockholders to total
assets

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 Return on Common Equity (ROE)
 Relates net income available to common stockholders to

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common stockholders equity

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PROBLEMS IN FINANCIAL

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STATEMENT ANALYSIS
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Developing and Using Comparative Data

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 Distortion of Comparative Data

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

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Notes to Financial Statements

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 Interpretation of Results

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

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Differences in Accounting Treatment
 Window Dressing

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 Effects of Inflation

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Financial Statement Analysis

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