This document provides an overview of financial statement analysis and key financial ratios. It includes sample balance sheets, income statements, and cash flow statements for ABC Company for 2006 and 2007. Various common size statements and calculations of key financial ratios like liquidity, asset management, leverage, profitability and valuation ratios are presented for ABC Company. The document aims to describe the components of key financial statements and how to analyze them using ratios to evaluate a company's financial performance and condition.

1. Session 9: Financial Statement Analysis
Series 2: Equity Securities
Securities and Exchange Commission of Sri Lanka

2. These lecture notes have been prepared strictly for the use of
instructors and candidates in the Certificate in Capital
Markets only. The use of this material including photocopying
and distribution for any other purpose in any form is
prohibited.
© 2018, Securities and Exchange Commission of Sri Lanka

3. Learning Outcomes
Series 2: Equity Securities 3
1. Describe the components of the balance sheet, income statement and statement
of cash flows.
2. Prepare common size financial statements.
3. Analyze common size financial statements.
4. Describe, calculate and assess the financial performance and condition of a
firm using financial ratios (liquidity, asset management, leverage, profitability,
and valuation ratios).
5. Identify strengths and weaknesses of a company’s financial performance and
condition through a comparative ratio analysis.
6. Perform a DuPont analysis and interpret results.
7. Discuss financial shenanigans and their effects on financial ratios.
8. Describe financial and non-financial information provided in a company annual
report that are relevant to evaluating a company’s past and future performance.
9. Describe and analyze the information provided in a company’s quarterly report.

4. ABC Company
Balance Sheet as at December 31 (Rs. Mn.)
2006 2007
Assets
Cash 80 100
Marketable securities 20 30
Accounts Receivables 250 300
Inventory 500 580
Current Assets 850 1010
Net Property, Plant and Equipment 500 540
Balance Sheet
Total Assets 1,350 1,550
Liabilities
Short-term Debt
Accounts Payable
Accrued Expenses
Total Current Liabilities
100
200
70
240
50 40
350 350
Long-term Debt 400 500
Total Liabilities 750 850
Shareholders' Equity
Common stock (50 mn shares of Rs. 10 each) 500 500
Retained earnings 100 200
Total Shareholders' Equity 600 700
Total Liabilities and Equity 1350 1550
Series 2: Equity Securities 4

5. Income Statement
ABCCompany
IncomeStatementforYearsendingDecember31(Rs.Mn.)
2006 2007
Sales
CostofSales
4000 4800
2500 2950
GrossProfit 1500 1850
Selling,general andadministrative expenses 1200 1440
Depreciation 50 74
Earningbefore Interestandtaxes 250 336
InterestExpenses 75 90
Earnings before taxes 175 246
Taxes(35%) 61 86
NetIncome 114 160
Commondividends 54 60
RetainedEarnings 60 100
Note: 75% of the sales are credit sales.
Series 2: Equity Securities 5

6. Cash Flow Statement
ABC Company
Cash Flow Statement for Year ending December 31 (Rs. Mn.)
2007
Operating Activities
Net Income
Add: Noncash expenses
Depreciation
Changes in Working Capital
160
74
(Increase) decrease in Receivables (50)
(Increase) decrease in Inventory (80)
Increase (decrease) in Accounts Payables 40
Increase (decrease) in Accrued Expenses (10)
Cash Flows Provided from Operating Activities 134
Investing Activities
Increase in Marketable Securities (10)
Purchase of Property, Plant and Equipment (114)
Cash Flow from Investing Activities (124)
Financing Activities
Increase (decrease) in Short-term debt (30)
Increase (decrease) in Long-term Debt 100
Dividend payments (60)
Cash Flow from Financing Activities 10
Net Increase (Decrease) in Cash 20
Cash at the beginning of the year 80
Cash at the end of the year 100
Series 2: Equity Securities 6

7. ABC Company
Balance Sheet as at December 31 (Rs. Mn.)
2006 % of TA 2007 % of TA
Assets
Cash 80 5.9% 100 6.5%
Marketable securities 20 1.5% 30 1.9%
Accounts Receivables 250 18.5% 300 19.4%
Inventory 500 37.0% 580 37.4%
Current Assets 850 63.0% 1010 65.2%
Property, Plant and Equipment, Net 500 37.0% 540 34.8%
Total Assets 1,350 100.0% 1,550 100.0%
Liabilities
Short-term Debt 100 7.4% 70 4.5%
Accounts Payable 200 14.8% 240 15.5%
Accrued Expenses 50 3.7% 40 2.6%
Total Current Liabilities 350 25.9% 350 22.6%
Long-term Debt 400 29.6% 500 32.3%
Total Liabilities 750 55.6% 850 54.8%
Shareholders' Equity
Common stock 500 37.0% 500 32.3%
Retained earnings 100 7.4% 200 12.9%
Total Shareholders' Equity 600 44.4% 700 45.2%
Total Liabilities and Equity 1350 100.0% 1550 100.0%
Series 2: Equity Securities 7
Common Size Balance Sheet

8. Common Size Income Statement
Series 2: Equity Securities 8
ABC Company
Income Statement for Years ending December 31 (Rs. Mn.)
2006 %of Sales 2007 %of Sales
Sales 4000 100% 4800 100.0%
Cost of Sales 2500 62.5% 2950 61.5%
Gross Profit 1500 37.5% 1850 38.5%
Selling, general and administrative expenses 1200 30.0% 1440 30.0%
Depreciation 50 1.3% 74 1.5%
Earning before Interest and taxes 250 6.3% 336 7.0%
Interest Expenses 75 1.9% 90 1.9%
Earnings before taxes 175 4.4% 246 5.1%
Taxes (35%) 61 1.5% 86 1.8%
Net Income 114 2.8% 160 3.3%
Common dividends 54 1.4% 60 1.3%
Retained Earnings 60 1.5% 100 2.1%

9. Types of Financial Ratios
Series 2: Equity Securities 9
 Liquidity ratios
 Asset management ratios
 Leverage ratios
 Profitability ratios
 Valuation ratios

10. Liquidity Ratios
Series 2: Equity Securities 10
 Liquidity ratios assess the firm’s ability to meet its
short-term obligations
 Key liquidity ratios
 Current ratio
 Quick ratio
 Cash ratio

11. Current Ratio
 Current Ratio
Indicates the extent to which current liabilities can
be paid off through current assets.
Current Liabilities
Series 2: Equity Securities 11
Current Assets
Current Ratio 

12. Quick Ratio
 Quick Ratio (Acid Test)
• Removes from current assets less liquid current
assets (inventory, pre-paid expenses) that cannot
be converted into cash quickly.
• Indicates the extent to which current liabilities can
be paid off through liquid current assets (cash,
marketable securities and receivables).
Quick Ratio 
Current Assets-Inventory
Current Liabilities
Series 2: Equity Securities 12

13. Cash Ratio
Series 2: Equity Securities 13
 Cash Ratio
• Uses only very liquid current assets (cash and cash
equivalents).
• Indicates the extent to which current liabilities can be
paid of through very liquid assets.

14. Asset Management Ratios
Series 2: Equity Securities 14
 Asset management or efficiency ratios indicate the
efficiency of the use of its in generating sales.
 Key ratios
 Average collection period
 Inventory turnover
 Cash conversion cycle
 Fixed assets turnover
 Total assets turnover

15. Average Collection Period
Series 2: Equity Securities 15
 Average Collection Period (Days Sales Outstanding)
• Indicates the average length of time (# of days) the firm
must wait after making a sale before it receives cash.
• Shows the average number of days accounts receivables
remain outstanding.
• Used to evaluate the credit policy;
• High ACP indicates a liberal policy
• Low ACP indicates a stringent policy
Receiva
Average CollectionPeriod 

16. Inventory Turnover
 Inventory Turnover
• Indicates whether inventory levels are reasonable in
relation to cost of goods sold.
• Low turnover may indicate excessive, obsolete, or
slow-moving inventory.
• High turnover may indicate inadequate inventory and
shortages.
Average Inventory
Series 2: Equity Securities 16
Inventory Turnover 
Cost of Goods Sold
• Average inventory = (Beg Inventory + Ending
Inventory)/2

17. Inventory Processing Days
Series 2: Equity Securities 17
 Inventory Processing Days
Indicates the average number of days the cash is
tied up in inventory.

18. Payables Payment Period
 Payables Payment Period
• Indicates the average number of days the firm is able
to take before making payments to creditors.
• Payables turnover shows the COGS relative to
payables
Average Trade Payables
Cost of Goods Sold
Payables Turnover 
Payables Turnover
Series 2: Equity Securities 18
365
Payables Payment Period 

19. Cash Conversion Cycle
Series 2: Equity Securities 19
 Cash Conversion Cycle
Average number of days it takes for inventory to be
converted into cash.
Cash Conversion Cycle = Inventory Processing Days
+ Receivables Collection Period
- Payables Payment Period

20. Fixed Assets Turnover Ratio
 Fixed Assets Turnover Ratio (FAT)
• Measures the efficiency of the use of fixed assets in
generating sales.
• Low Turnover may indicate excessive fixed assets.
• High turnover may indicate inadequate/low fixed assets
or outdated/depreciated fixed assets.
Sales
Series 2: Equity Securities 20
Fixed Assets Turnover 

21. Total Asset Turnover Ratio
Average Total Assets
Series 2: Equity Securities 21
Sales
Total Asset Turnover 
 Total Assets Turnover Ratio (TAT)
Measures the efficiency of the use of total assets in
generating sales.

22. Leverage Ratios
Series 2: Equity Securities 22
 Measure two key aspects of the use of debt financing or the
financial leverage
 Degree of financial leverage (How much debt does the
firm use?)
 Debt service (Can the firm service debt obligations?)
 Key ratios
 Debt ratio
 Deb-Equity ratio
 Interest Cover

23. Debt Ratio
 Debt Ratio
• Indicates the proportion of assets financed through
debt.
• Higher ratio indicates higher leverage and lower debt
capacity.
• Total debt = short-term debt + long-term debt
Total Assets
Series 2: Equity Securities 23
Debt Ratio 
Total Debt

24. Debt-Equity Ratio
Total Equity
Series 2: Equity Securities 24
Debt -Equity Ratio 
Long Term Debt
 Debt-Equity Ratio (D/E)
• Indicates the proportion of long term debt in relation
to total equity.
• Higher debt-equity ratio indicates greater financial
risk.
• Total equity = common + preferred

25. Interest Coverage
Interest Charges
Series 2: Equity Securities 25
EBIT
Interest Coverage 
 Interest Coverage (Times-Interest Earned) Ratio
• The number of times Interest payments are covered
by EBIT.
• Measures the ability of firm’s current operating
earnings (EBIT) to meet current interest obligations.

26. Profitability Ratios
Series 2: Equity Securities 26
 Profitability or performance ratios assess the firm’s
ability to earn profits on sales, assets, and equity.
 Key ratios
 Gross profit margin
 Operating profit margin
 Net profit margin
 Return on assets
 Return on equity

27. Profitability Ratios
Sales
Series 2: Equity Securities 27
Gross Profit Margin 
Sales - COGS
 Gross Profit Margin (GPM)
 Shows the firm’s profit margin after deducting costs
of goods sold but before deducting operating
expenses, interest expenses and taxes.
 Indicates the ability to
• control production costs (material, labor and
overhead)
• get better prices from suppliers
• control the price of goods sold

28. Operating Profit Margin
Sales
Series 2: Equity Securities 28
Operating ProfitMargin 
EBIT
 Operating Profit Margin (OPM)
 Shows the firm’s profit margin after deducting costs
of goods sold and operating expenses but before
interest expenses and taxes.
 Measures the operating profit (earnings before
interest and taxes or EBIT) as a percent of sales.

29. Net Profit Margin
Sales
Series 2: Equity Securities 29
Net Profit Margin 
Net Income
 Net Profit Margin (NPM)
 Shows the firm’s profit margin after all the costs and
expenses
 Need to deduct dividends to preferred shareholders, if
any.
 Shows the “bottom line” available for distribution to
common shareholders as a percent of sales.

30. Return on Assets
ROA 
Net Income  Interest Expenses
Average Total Assets
Series 2: Equity Securities 30
 Return on Assets (ROA)
 Measures the return earned on total assets employed in
the business.
 Also called return on total capital

31. Return on Equity
 Return on Equity (ROE)
Measures the return earned on capital provided by the
common stockholders after providing for all other
sources of capital (debt and preferred) used in the
business.
ROE 
Net Income - Preferred Dividend
Average Common Equity
Series 2: Equity Securities 31

32. Valuation Ratios
Series 2: Equity Securities 32
 Indicate the market valuation of the stock in terms of
some measure of company fundamentals
 Key ratios
 Price / Earnings Ratio
 Price / Book value ratio
 Price / Cash flow ratio
 Dividend yield

33. Price/Earnings Ratio
 Price/ Earnings Ratio (P/E)
 Indicates the price of a share in terms of earnings.
 Shows the rupee amount an investor has to pay for
each rupee of earnings.
P/E 
Market Price Per
E
Series 2: Equity Securities 33

34. Price/Book Value Ratio
 Price / Book Value Ratio (P/BV)
 Indicates the price of a share in terms of the book
value of equity.
 Shows the rupee amount an investor has to pay for
each rupee of book value.
P/BV 
Market Price Per Share
Book Value Per Share
Series 2: Equity Securities 34

35. Price/Cash Flow Ratio
 Price / Cash Flow Ratio (P/CF)
 Indicates the price of a share in terms of the cash flow
per share.
 Shows the rupee amount an investor has to pay for
each rupee of cash flow generated.
 Cash flow = Net Income + Depreciation &
Amortization.
P/CF 
Market Price Per Share
Cash Flow Per Share
Series 2: Equity Securities 35

36. Dividend Yield
Mar
Series 2: Equity Securities 36
Dividend Per Share
DY 
 Dividend Yield (DY)
 Indicates ability to generate dividend income as a
percent of the investment.
 Key valuation measure for investors seeking income.

37. DuPont Analysis
Average Total Assets
Series 2: Equity Securities 37
x
Sales Average Total Assets Average Common Equity
ROE 
Net Income
x
Sales
 ROE = Net Profit Margin x Total Asset Turnover x Equity
Multiplier
 Net Profit Margin indicates the profitability and expense
control.
 Assets Turnover shows the efficiency of utilization of
assets in generating sales.
 Equity Multiplier (financial leverage) shows the use of
debt to finance assets.

38. Ratios for ABC Company
Series 2: Equity Securities 38
Liquidity
CurrentRatio 2.9
QuickRatio 1.2
CashRatio 0.4
AssetManagement
AverageCollection Period(Days) 30
InventoryTurnover 5.5
AverageInventoryProcessingPeriod (Days) 67
Payables TurnoverRatio 13
Payables PaymentPeriod(Days) 27
CashConversionCycle(Days) 70
FixedAssetTurnover 9.2
TotalAssetTurnover 3.31
Leverage
DebtRatio(%) 54.8
Debt-EquityRatio(%) 71.4
Interest Coverage 3.7

39. Profitability
Gross Profit Margin (%) 38.5
Operating Profit Margin (%) 7.0
Net Profit Margin (%) 3.33
ROA (%) 17.2
ROE (%) 24.6
Valuation
EPS (Rs) 3.20
Price (Rs) 38.5
P/E 12.0
BV (Rs) 14.0
P/BV 2.8
Cash Flow Per Share (Rs) 4.7
P/CF 8.23
DPS (Rs) 1.20
Dividend Yield (%) 3.1
Dupont Analysis
Net Profit Margin (%) 3.33
Total Asset Turnover 3.31
Equity Multiplier 2.23
ROE - DuPont (%) 24.6
Series 2: Equity Securities 39
Ratios for ABC Company

40. Beware of Financial Shenanigans*
Series 2: Equity Securities 40
 Financial shenanigans (actions that intentionally distort
financial performance and financial condition)
 Recording revenue too soon or of questionable quality
Ex: Recording revenue when future services remain to be
provided
Recording revenue before shipment of goods
Selling to an affiliated party
 Recording bogus revenue
Ex: Selling products where the customer has no obligation
to purchase them; customer can return them
 Boosting income with one-time gains
Ex: Booting profits by selling assets
*Financial Shenanigans, Howard Schilit, 2nd Ed., McGraw Hill, 2002

41. Beware of Financial Shenanigans*
Series 2: Equity Securities 41
 Shifting current expenses to a later or earlier period
Ex: Capitalizing normal operating costs
Shifting current expenses to an earlier period
Amortizing costs too slowly
Failing write down or write off impaired assets
 Failing to record or improperly reducing liabilities
Ex: Failing to record expenses and related liabilities when
future obligations remain
 Shifting current revenue to a later period
Ex: Creating reserves (deferred revenue) and releasing
them into income in a later period

42.  Shifting future expenses to the current period as a special
charge
Ex: Improperly inflating amount included in a special
charge such as restructuring costs (big bath accounting)
Series 2: Equity Securities 42
Beware of Financial Shenanigans

43.  A firm’s financial ratios need to be compared with a proper
benchmark
 Selection of a proper benchmark is very critical. Benchmarks
may include
 Closest competitor
 Peers (a set of firms that best match in terms of business and
size)
 Industry (firms in the industry)
 Differences in accounting practices may make it difficult to
compare among different companies, and adjustment may
have to be made to make them comparable.
Series 2: Equity Securities 43
Comparative Analysis