This document discusses financial statement ratio analysis. It explains that ratio analysis evaluates relationships within financial statements to provide insights into a company's performance relative to peers and over time. Differences in ratios can be due to strategy, management effectiveness, accounting methods, or financial strategy. The DuPont formula breaks return on equity into net profit margin, asset turnover, and financial leverage. Various liquidity and solvency ratios are also discussed.

1. Financial Statement
and
Ratio Analysis
Rosario C. Garcia, DBA
Source: Harvard Business School
Serial No. 9-101-029

2. Financial Statement and Ratio Analysis
 process of evaluating relationships between
component parts of the firm’s financial statements
 develop insights into the financial performance of
companies
 provides a way to examine how a firm has
performed relative to its peers and relative to its own
historical performance.

3. Why a firm’s ratios are different from its
peers or its own historical performance?
 product and market strategy used
 effectiveness of management team at implementing its
strategy
 financial strategy used
 accounting methods used for reporting the same underlying
economic events
 We should have a clear understanding of how a firm’s accounting decisions
compare with those of its competitors, or with its own decisions in prior years.
 If there are important differences in accounting decisions, it may be necessary
to make adjustments to the affected firm’s financial statements to ensure that
ratio comparisons isolate differences in strategy or performance.

4. Classic Tools and Techniques Of Financial
Analysis
1. Horizontal Analysis
 involves the computation of peso amount changes and
percentage changes from the previous to the current year
2. Vertical Analysis
 involves the percentage changes to bring out the quantitative
relationships existing among different items to the total in a
single statement.
3. Ratio Analysis
 an important means of stating the relationship between two
numbers
 ratios reduce the data being compared to more meaningful
terms, and they bring out more clearly certain relationship that
may otherwise be overlooked.

5. Ratio Analysis:
DuPont Formula (F – I – O Method)
 Perspective: SHAREHOLDERS
 Goal of a firm: maximization of shareholders’
wealth
 Starting point:
 computation of RETURN ON EQUITY (ROE)
ROE = Net Income
Average Shareholders’ Equity

6. Return on Equity (ROE)
 indicates how profitably the firm has been able
to invest shareholder funds for the period
 Why firms generate high ROEs:
 they are in a superior industry
 they make more risky investments and so have to
provide investors with a higher return,
 they are able to execute their strategy more
effectively than their competitors.

7. DuPont Formula (F – I – O Method)
 helps us get a better understanding of reasons for differences in
ROEs across firms
 recognizes the three fundamental factors driving ROE:
 NET PROFIT MARGIN (reflecting how well the firm
manages its operations),
 ASSET TURNOVER (reflecting how efficiently it
uses its assets)
 FINANCIAL LEVERAGE (what kind of financing
strategy used)
ROE = Net Income = Net Income * Sales * Assets
Equity Sales Assets Equity
= Net Profit Margin * Asset Turnover * Financial Leverage
= Operating * Investing * Financing

8. OPERATING: Net Profit Margins
 otherwise known as return on sales
 reflect how well the firm manages its operations
 show the profitability of each dollar of sales.
 depend on a firm’s strategy and its industry.
 industries that rely heavily on volume (e.g. supermarkets), tend
to have low margins,
 industries that sell low volumes of specialty products ( e.g.
jewelry stores) tend to have high margins.
 firms with the strategy to be the low cost provider in their
industry have lower sales margins than firms with differentiated
strategies.
Net Profit Margin = Net Income
Sales

9. INVESTMENT EFFICIENCY:
Asset Turnover
 reflects how efficiently it uses its assets
 measures the multiple of sales generated per dollar of assets
 heavily affected by a company’s investment strategy and the
technology used to deliver its products or service.
 capital intensive industries that take advantage of economies of
scale (e.g. utilities) tend to have low turnover ratios, whereas
labor-intensive service industries tend to have high turnover.
Asset Turnover = Sales
Average Total Assets

10. INVESTMENT EFFICIENCY:
Asset Turnover
 Also affected by working capital management
 Working capital = receivables + inventory - payables.
 Firms that are able to collect promptly from their customers,
to hold relatively little inventory, or to get suppliers to finance
inventory are able to use less of their own funds or working
capital, increasing turnover.
 Several measures of working capital management include:
 Days receivable = 365 * (average receivables/sales)
 Days inventory = 365 * (average inventory/ cost of sales)
 Days payable = 365 * (average payable / cost of sales )
 Receivable turnover = sales / average receivables
 Inventory turnover = cost of sales / average inventory
 Payable Turnover = cost of sales / average payables

11. FINANCING STRATEGY:
Financial Leverage
 measures the multiple of assets to equity, therefore, the higher the leverage
multiple the higher the potential risk and reward.
 enables a firm to substantially increase its asset base relative to its equity base,
thus allowing it to increase ROE.
 A firm is successful at using leverage (positive leverage) if it earns a higher rate of
return on borrowed funds than the after-tax interest rate costs for borrowing the
money.
 However, leverage also creates risk for shareholders.
 Unlike equity financing where dividend declaration is at the discretion of the board, debt
financing has predefined interest payment terms and schedules must be met.
 A firm faces risk of financial distress if its fails to meet these commitments.
Financial Leverage = Average Total Assets
Average Shareholders’ Equity

12. FINANCING STRATEGY:
Financial Leverage
 The firm’s ability to meet its financial commitments
which requires calculation of short-term liquidity and
long term solvency ratios should also be analyzed
 Short-term liquidity Ratios
 try to explain whether the firm has the financial means to
pay on its current obligations defined as obligations
coming due within the year.
 Long-term solvency Ratios
 ability to meet interest payments, preferred
dividends, and other fixed charges.

13. FINANCING STRATEGY:
Financial Leverage
 Short-term Liquidity Ratios
 CURRENT RATIO
 Most common short-term liquidity ratio
 Current ratio = current assets
current liabilities
 compares all the current resources of the firm, cash, marketable
securities, accounts receivable, prepaid expenses, and inventory,
to all the current obligations of the firm.
 QUICK RATIO
 includes only the current assets that can be used immediately to
extinguish any current liabilities.
 Quick ratio = (cash + marketable securities + A/R)
current liabilities

14. FINANCING STRATEGY:
Financial Leverage
 Long-term solvency Ratios
 NET DEBT TO EQUITY RATIO
 Net Interest Bearing Debt to Equity = (interest bearing debt – cash)
Shareholders’ equity
 measures the degree to which a firm’s activities are supported by debt relative to
owner’s equity.
 Cash is typically considered as negative debt and therefore deducted from the
numerator in the ratio.
 INTEREST COVERAGE RATIO (Times Interest Earned)
 Interest Coverage Ratio = Profits before interest and taxes
Total Interest Charges
 This ratio assesses the current ability of a firm to meet its interest payments.
 It is a multiple that measures how many times interest charges the corporation has
earned on a pretax basis.
 Alternative method for calculating this ratio: cash flow coverage ratio
 uses a numerator of cash flows rather than earnings before taxes.
 The larger the coverage ratio, the greater the cushion the firm has to meet interest
obligations.

15. Summary
 financial ratios provide a useful way of enabling users of financial
statements to compare the performance of one firm with its
peers, or with its own historical performance
 Many different ratios are popular in practice.
 Successful ratio analysis requires a thorough understanding of
accounting differences between the firms compared, as well as a
deep understanding of their business differences.
 It is important to dig deeply to understand the causes for any
ratio differences generated through your analysis.