Purpose of understanding financial analysis

 Explain what we can learn by analyzing a firm’s financial statements.

 Use common size financial statements as a tool of financial analysis.
 Calculate and use a comprehensive set of financial ratios to evaluate a company’s performance.
 Select an appropriate benchmark for use in performing a financial ratio analysis.
 describe the limitations of financial ratio analysis.

Financial Ratio serves as a comparative tools:

 Measure company's Performance overtime

 Compare it with its competitors
 Compare its Performance to various standards of Performance

Note:

 Financial ratios provide a second method for standardizing the financial information on the
income statement and balance sheet.

 A ratio by itself may have no meaning. Hence, a given ratio is generally compared to: (a) ratios
from previous years; or (b) ratios of other firms in the same industry.

LIQUIDITY RATIOS

Current Ratio

measure the company's ability to pay its currently maturing obligations on a time basis. It shows
the degree of protection provided by a company's Currents Assets to its Current Liabilities.

CR = CA /CL

Quick Ratio

variation of more stringent liquidity

QR = (CA – Inventory) / CL
 Cash Ratio

measure of liquidity to solely based on cash-equivalent items only

Cash Ratio = (Cash + Mktble Secs) / CL

ACTIVITY RATIOS

Receivable Ratio

 Average Collection Period measures the number of days it takes the firm to collects its
receivables.
Average Collection Accounts Receivable Accounts Receivable
 
Period Annual Credit Sales/365 days Daily Credit Sales

 Accounts Receivable Turnover Ratio measures how many times AR are “rolled over” during
a year.
Annual Credit Sales
Accounts Receivable Turnover 
Accounts Receivable

Inventory Turnover Ratio

measures how many times the company turns over its inventory during the year. Shorter
inventory cycles lead to greater liquidity because the items in inventory are converted to cash
more quickly. Inventory turnover ratio is important as it has implications for cash flows and
profitability of a firm. Changes in inventory turnover ratio will impact the firm’s investment in
inventory.

Cost of Goods Sold

Inventory Turnover 
Inventories

CAPITAL STRUCTURE RATIOS

refers to the way a firm finances its assets using a combination of debt and equity. Capital structure
ratios address the important question: How has the firm financed the purchase of its assets? To
address this issue, we use two types of capital structure ratios: the debt ratio, and the times interest
earned ratio.

Debt ratio measures the proportion of the firm’s assets that were financed using current plus
long-term liabilities.
 Total Liabilities
Debt Ratio 
Total Assets

Times Interest Earned Ratio measures the ability of the firm to service its debt or repay the
interest on debt. Times interest earned ratio is an important ratio for firms that use debt financing.
It measures the firm’s ability to service its debt. The ratio requires comparing net operating
income or EBIT with Interest expense. Both items are found on the income statement.

Times Interest Net Operating Income or EBIT


Earned Interest Expense

Asset Management Efficiency Ratios

Asset management efficiency ratios measure a firm’s effectiveness in utilizing its assets to generate
sales. These ratios are commonly referred to as turnover ratios as they reflect the number of times a
particular asset account balance turns over during the year.

Total Asset Turnover Ratio & Fixed Asset Turnover Ratio: represents the amount of sales
generated per dollar invested in the firm’s total and or Fixed assets.

Profitability Ratio

Two fundamental determinants of firm’s profitability and returns on investments are the following:

1. Cost Control – How well has the firm controlled its costs relative to each dollar of firm sales? The
firm must investigate the cost of goods sold and operating expenses to see if there are
opportunities to reduce costs. For example, the firm must investigate if it can reduce the size of
its inventories.

2. Efficiency of asset utilization – How effective is the firm in using the assets to generate sales?

• Gross Profit margin shows how well the firm’s management controls its expenses to generate
profits; whilst
• Operating Profit Margin measures how much profit is generated from each dollar of sales after
accounting for both costs of goods sold and operating expenses. It also indicates how well the firm
is managing its income statement.

• Net Profit Margin measures how much income is generated from each dollar of sales after adjusting
for all expenses (including income taxes).

Profitability Ratios = Related Margin / Sales

 Operating Return on Assets ratio is the summary measure of operating profitability. It takes into
account both management’s success in controlling expenses and its efficient use of assets.
Operating Return Net Operating Income or EBIT

on Assets (OROA) Total Assets

= Total Asset Turnover × Operating Profit Margin

Decomposing :

 Return on Equity (ROE) ratio measures the accounting return on the common stockholders’
investment. Is the Firm Providing a Reasonable Return on the Owner?
Return on Net Income

Equity Common Equity

DuPont method analyzes the firm’s ROE by decomposing it into three parts.
ROE = Profitability × Efficiency × Equity Multiplier
Equity multiplier captures the effect of the firm’s use of debt financing on its return
on equity. The equity multiplier increases in value as the firm uses more debt.
Decomposing:

ROE = Profitability × Efficiency × Equity Multiplier

 Equity multiplier captures the effect of the firm’s use of debt financing on its
return on equity. The equity multiplier increases in value as the firm uses more
debt.
Return on Equity
 Profitability  Efficiency 
Equity Multiplier
Net Profit Total Asset Equity
  
Margin Turnover Multiplier
Net Income Sales 1
  
Sales Total Assets 1  Debt Ratio

Selecting a Performance Benchmark

There are two types of benchmarks that are commonly used to analyze a firm’s financial performance
by means of its financial statements:

• Trend Analysis – compares a firm’s financial statements over time (time-series comparisons).

• Peer Group Comparisons – compares the subject firm’s financial statements with “peer” firms. A
peer firm is simply one that the analyst believes will provide a relevant benchmark for the analysis
at hand. Peer groups often consist of firms from the same industry. Industry average financial
ratios can be obtained from a number of financial databases (such as Compustat) and internet
sources (such as yahoo finance and google finance).

Limitations of Ratio Analysis

1. Picking an industry benchmark can sometimes be difficult.

2. Published peer-group or industry averages are not always representative of the firm being
analyzed.

3. An industry average is not necessarily a desirable target or norm.

4. Accounting practices differ widely among firms.

5. Many firms experience seasonal changes in their operations.

6. Financial ratios offer simply clues that can suggest the need for further investigation.

7. The results of financial analysis are no better than the quality of the financial statements.