Financial Statement Analysis

Topics Covered
• Income statement
• Balance sheet
• Statement of cash flows
• Free cash flow
• Performance measures

Financial Statement Analysis

How?
• comparing a firm’s performance with that of
other firms in the same industry, and
• evaluating trends in the firm’s financial position
over time
Uses of financial statement analysis
• Managers use financial analysis to identify
situations needing attention
• Potential lenders use financial analysis to determine
whether a company is creditworthy
• Stockholders use financial analysis to help predict
future earnings, dividends, and free cash flow.
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 Determinants of Intrinsic Value:
Calculating FCF

Financial Statements
• Income Statement
A summary of a company’s revenues and expenses over a specified
period, ending with net income or loss for the period.
• Balance Sheet
A summary of a company’s financial position on a given date that
shows total assets = total liabilities + owners’ equity.
• Cash Flow Statement
Reports cash flows stemming from the operating, investing and
financing activities of a firm over the year.
• Statement of stockholders’ equity
Changes in stockholders’ equity during the accounting period

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 Computron Inc.
• Computron expanded operations in 2022.
Following slides show key information and
financial statements to evaluate the
expansions.
2022 2023
Stock price $50.00 $30.00
Shares outstanding (millions) 100 100
Common dividends (millions) $90 $84
Tax rate 25% 25%
Cost of capital (WACC) 10.00% 10.00%

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Income Statement (Millions of

Dollars)
2022 2023
Sales $ 5,500 $ 6,000
COGS 4,300 4,800
Deprec. 290 320
Other expenses 350 420
Tot. op. costs $ 4,940 $ 5,540
EBIT $ 560 $ 460
Int. expense 68 108
Pre-tax earnings $ 492 $ 352
Taxes (25%) 123 88
Net income $ 369 $ 264

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 What happened to sales and net
income?
• Sales increased by $500 million (9% growth).
• 59% increase in interest payments.
• Net income fell by $105 million.

Balance Sheet: Assets (Millions of

Dollars)
2022 2023
Cash $ 60 $ 50
S-T invest. 100 10
AR 400 520
Inventories 620 820
Total CA $ 1,180 $ 1,400
Gross FA $ 3,900 $ 4,820
Less: Depr. 1,000 1,320
Net FA $ 2,900 $ 3,500
Total assets $ 4,080 $ 4,900

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 Effect of Expansion on Assets
• Current assets and net fixed assets each grew
by about 20%, much more than sales grew.
• AR and inventory increased.
– Taking longer to collect
– Unsold products (or unused raw materials) in
warehouses
• Cash and short-term investments fell.

Balance Sheet: Liabilities & Equity

(Millions of Dollars)
2022 2023

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 What effect did the expansion have
on liabilities & equity?
• Debt increased to help finance the
expansion.
• The company didn’t issue any stock.

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Statement of Cash Flows for 2023:

Operating Activities (Millions of
Dollars)
Operating Activities
$
Net Income
264
Adjustments:
Depreciation 320
Change in AR (120)
(200
Change in inventories
)
Change in AP 100
Change in accruals
40
$
Net cash provided (used) by ops.
404
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 Statement of Cash Flows: Investing
Activities (Millions of Dollars)

Investing Activities
Cash used to acquire FA $ (920)
Change in S-T invest. 90
Net cash prov. (used) by inv. act. $ (830)

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Statement of Cash Flows: Financing

Activities (Millions of Dollars)

Financing Activities
Change in notes payable $ 200
Change in long-term debt 300
Payment of cash dividends (84)
Net cash provided (used) by fin. act. $ 416

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 Statement of Cash Flows: Summary
(Millions of Dollars)
Net cash provided (used) by ops. $ 404
Net cash prov. (used) by inv. act. (830)
Net cash prov. (used) by fin. act. 416
Net change in cash (10)
Cash at beginning of year 60
Cash at end of year $ 50

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What can you conclude from the

statement of cash flows?
• Positive net CF from operations:
– Dragged down by big net increase in working capital.
• Negative net CF from investing:
– Small increase due to selling ST investments
– Bigger decrease due to large FA expenditures.
• Positive net CF from financing:
– Big increase in borrowing.
• Even after borrowing, the cash account fell.

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 What is free cash flow (FCF)? Why is it
important?
• FCF is the amount of cash available from
operations for distribution to all investors
(including stockholders and debtholders) after
making the necessary investments to support
operations.
• A company’s value depends on the amount of
FCF it can generate.

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What are the five uses of FCF?

1. Pay interest on debt.
2. Pay back principal on debt.
3. Pay dividends.
4. Buy back stock.
5. Buy nonoperating assets (e.g., marketable
securities, investments in other companies,
etc.)

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 Calculating Free Cash Flow in 5 Easy
Steps

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Net Operating Profit after Taxes

(NOPAT)
NOPAT=EBIT 1 − Taxrate

NOPAT23 = $460 1 − 0.25

= $345.

NOPAT22 = $420.

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 What are operating current assets?
• Operating current assets are the CA needed to
support operations.
– Op CA include: cash, inventory, receivables.
– Op CA exclude: short-term investments, because
these are not a part of operations.

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What are operating current liabilities?

• Operating current liabilities are the CL
resulting as a normal part of operations.
– Op CL include: accounts payable and accruals.
– Op CL exclude: notes payable, because this is a
source of financing, not a part of operations.

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 Net Operating Working Capital
(NOWC)
NOWC = Operating CA − Operating CL

NOWC23 = $50 + $520 + 820 − $400 + $240

= $750.
NOWC22 = $580.

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Total net operating capital

(also called operating capital)
• Operating Capital= NOWC + Net fixed assets.
• Operating Capital 2023:
OpCap23 = $750 + $3,500
= $4,250.

• Operating Capital 2022:

OpCap22 = $3,480.

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 Free Cash Flow (FCF) for 2023

FCF =NOPAT - Net investment in operating

capital FCF = $345 − ($4, 250 − $3, 480)
= $345 − $770
= −$425.
How do you suppose investors reacted?

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Uses of FCF

After-tax interest payment $81

Reduction (increase) in debt −$500
Payment of dividends $84
Repurchase (Issue) stock $0
Purch. (Sale) of ST
−$90
investments
Total uses of FCF −$425

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 Return on Invested Capital (ROIC)

NOPAT
ROIC =
Total operating capital
$345
ROIC23 = = 8.1%.
$4,250
ROIC22 = 12.1%.

ROIC fell due to a decline in operating

profitability and an increase in the operating
capital required to generate a dollar of sales.

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The firm’s cost of capital is 10%. Did

the growth add value?
• No. The ROIC of 8.1% is less than the WACC of
10%. Investors did not get the return they
require.
• Note: High growth usually causes negative FCF
(due to investment in capital), but that’s ok if
ROIC > WACC.

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 Economic Value Added (EVA)
• WACC is weighted average cost of capital
• EVA = NOPAT − (WACC)(Capital)

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Economic Value Added

(WACC 10% for both years)
EVA = NOPAT− (WACC)(Capital)
EVA23 = $345 − 0.1 ($4,250)
= $345 − $425
= −$80.
EVA22 = $420 − 0.10 ($3,480)
= $420 − $348
= $72.

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 Market Value Added (MVA) (1 of 2)
MVA = Market Value of the Firm
− Book Value of the Firm

Mkt Value = (# shares)(Price)

+ Mkt Val of Debt

Book Value = Total common equity + Debt

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Market Value Added (MVA) (2 of 2)

• If the market value of debt is close to the book
value of debt, then MVA is:

MVA = Market value of equity

− book value of equity

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 2023 MVA (Assume market value of debt book value of
debt.)
• Market Value of Equity 2023:
– (100)($30.00) = $3,000.
• Book Value of Equity 2023:
– $2,910.
• MVA23 = $3,000 − $2,910 = $90.
• MVA22 =$5,000 − $2,730 = $2,270.

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Ratio Analysis
Topics covered
• Ratio analysis
– Ratios (profitability, asset management, liquidity,
debt management, market value)
– Common size statements
– Percent change statement
• DuPont equation
• Limitations of ratio analysis

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 Why Financial Ratios?
• Ratios facilitate comparison of:
– One company over time
– One company versus other companies

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Income Statement
2023 2024E
Sales $6,000 $6,600
COGS except
4,800 5,210
depr.
Depr. 320 370
Other expense 420 400
EBIT $ 460 $ 620
Int. expense 108 100
EBT $ 352 $ 520
Taxes (40%) 88 130
Net income $ 264 $ 390

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 Balance Sheets: Assets
2023 2024E
Cash $ 50 $ 60
S-T invest. 10 50
AR 520 530
Inventories 820 660
Total CA $1,400 $1,300
Net FA 3,500 3,700
Total
$4,900 $5,000
assets

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Balance Sheets: Liabilities & Equity

2023 2024E
Accts. payable $ 400 $ 330
Notes payable 250 100
Accruals 240 270
Total CL $ 890 $ 700
Long-term debt 1,100 1,100
Total
liabilities $1,990 $1,800
Common stock 1,000 1,000
Ret. earnings 1,910 2,200
Total equity $2,910 $3,200
Total L&E $4,900 $5,000

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 Other Data
2023 2024E
EPS $2.64 $3.90
DPS $0.84 $1.00
Book value per
share $29.10 $32.00
Dividends $84 $100
Number of shares 100 100
Year-end stock
price $30.00 $49.00
Lease payments $20 $20
Tax rate 25% 25%

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Profitability Ratios
• What is the company’s rate of return on sales?
– Profit margin
– Operating profit margin
• What is the company’s rate of return on
assets?
– Basic earning power
– Return on assets
– Return on equity

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 Profit Margin

Net profit margin (PM):

NI $390
PM = = = 5.9%.
Sales $6, 600

2022 2023 2024E Ind.

Profit Margin 6.7% 4.4% 5.9% 7.2%

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Operating Profit Margin

Operating profit margin:

EBIT $620
PM = = = 9.4%.
Sales $6, 600

2022 2023 2024E Ind.

Operating Profit
10.2% 7.7% 9.4% 10.4%
Margin

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 Basic Earning Power (BEP)

EBIT
BEP =
Total assets
$620
= = 12.4%.
$5,000

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Basic Earning Power vs. Industry

Average
• BEP removes effect of taxes and financial
leverage. Useful for comparison.
• Projected to be below average.
• Room for improvement.
2022 2023 2024E Ind.
Basic Earning
13.7% 9.4% 12.4% 15.6%
Power

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 Return on Assets (ROA) and Return on
Equity (ROE) (1 of 2)

NI
ROA =
Total assets
$390
= = 7.8%.
$5,000

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Return on Assets (ROA) and Return on

Equity (ROE) (2 of 2)

NI
ROE =
Common Equity
$390
= = 12.2%.
$3, 200

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 ROA and ROE vs. Industry Averages

2022 2023 2024E Industry

ROA 9.0% 5.4% 7.8% 10.8%
ROE 13.5% 9.1% 12.2% 15.4%

• Both below industry average but improving.

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Effects of Debt on ROA and ROE

• ROA is lowered by debt--interest expense
lowers net income, which also lowers ROA.
• However, the use of debt lowers equity, and if
equity is lowered more than net income, ROE
would increase.

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 Asset Management Ratios

• How efficiently does the firm use its assets?

• How much does the firm have tied up in
assets for each dollar of sales?

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Inventory Turnover Ratio vs.

Industry Average

COGS
Inv. Turnover =
Inventories
$5, 210 + $370
= = 8.5
$660
2022 2023 2024E Ind.
Inventory
7.4 6.2 8.5 9.0
turnover

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 Comments on Inventory Turnover
• Inventory turnover:
– Improved from previous year
– Below industry average

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DSO: average number of days from

sale until cash received.
Receivables
DSO =
Average sales per day
Receivables $530
= =
Sales 365 $6,600 365
= 29.3 days.

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 Appraisal of DSO

• Higher than 2022, worse than industry.

2022 2023 2024E Ind.

Days Sales
26.5 31.6 29.3 28.0
Outstanding

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Fixed Assets and Total Assets

Turnover Ratios
(1 of 2)
Sales
Fixed assets turnover =
Net fixed assets
$6,600
= = 1.8
$3,700
Sales
Total assets turnover =
Total assets
$6,600
= = 1.320.
$5,000

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 Fixed Assets and Total Assets
Turnover Ratios
(2 of 2)
• Better than previous year.
• Not up to industry average. Caused by high
fixed assets relative to sales.
2022 2023 2024E Ind.
Fixed Asset
1.9 1.7 1.8 3.0
Turnover
Total Asset
1.348 1.224 1.320 1.5
Turnover

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Liquidity Ratios
• Can the company meet its short-term
obligations using the resources it currently has
on hand?

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 Forecasted Current and Quick Ratios

CA $1, 200
CR = = = 1.9.
CL $700

CA − Inv.
QR =
CL
$1, 200 − $660
= = 0.9.
$700

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Comments on Current and Quick

Ratios
2022 2023 2024E Ind.
Current 2.1 1.6 1.9 2.5
Quick 1.0 0.7 0.9 1.9

• Expected to improve but still below the

industry average.
• Liquidity position is weak.

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 Debt Management Ratios
• Does the company have too much debt?
• Can the company’s earnings meet its debt
servicing requirements?

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Leverage Ratios: Debt Ratio

Total debt
Debt ratio =
Total assets
$100 + $1,100
= = 24.0%.
$5,000

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 Leverage Ratios: Debt-to-Equity Ratio

Total debt
Debt-equity =
Equity
$100 + $1,100
= = 37.5%.
$3, 200

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Leverage Ratios: Liabilities-to-Assets

Ratio

Total liabilities
Liabilities TA ratio =
Total assets
$1,800
=
$5,000
= 36.0%.

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 Leverage Ratios: Equity Multiplier
Equity multiplier = Total Assets
Common Equity
= $5,000
$3,200 = 1.5625

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Times Interest Earned Ratio

EBIT
TIE =
Int. expense
$620
= = 6.2
$100

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 EBITDA Coverage (EC)

EBIT + Depr. &Amort. + Lease payments

Interest expense + Lease pmt. + Loan pmt.
$620 + $370 + $20
= = 8.4
$100 + $20 + $0

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Debt Management Ratios vs.

Industry Averages
2022 2023 2024E Industry
Debt Ratio 20.8% 27.6% 24.0% 15.0%
Debt-to-equity 0.31 0.46 0.38 0.22
Liabilities-to-assets 33.1% 40.6% 36.0% 32.0%
Equity Multiplier 1.49 1.68 1.56 1.47
Times Interest Earned 8.2 4.3 6.2 13.0
EBITDA Coverage Ratio 9.9 6.3 8.4 17.2

• Improved, but more debt than industry

• More risk than industry

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 Market Value Ratios
• Market value ratios incorporate the:
– High current levels of earnings and cash flow
increase market value ratios
– High expected growth in earnings and cash flow
increases market value ratios
– High risk of expected growth in earnings and cash
flow decreases market value ratios

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Calculate and appraise the

Price/Earnings (P/E) ratio.
Price per share (P) = $49.00
Earnings per share (EPS) = $3.90

P/E = P/E = $49.00/$3.90 = 16.8

• P/E: How much investors will pay for $1 of

earnings. Higher is better.

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 Calculate and appraise the M/B ratio.
BVPS = Equity/ # Shares
= $3,200/100 = $32.00.
M/B = P/BVPS
M/B = $49.00/$32.00 = 1.53
• M/B: How much paid for $1 of book value.
Higher is better.

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Comparison with Industry Averages

2022 2023 2024E Ind.

Price-to Earnings 13.6 11.4 12.6 16.8
Market-to-Book 1.8 1.0 1.5 2.7

• The P/E ratio and the M/B ratio indicate that

the market doesn’t value the company as
highly as it does the average firm in industry.

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 Common Size Balance Sheets: Divide
all items by Total Assets
Assets 2022 2023 2024E Ind.
Cash 1.5% 1.0% 1.2% 1.5%
ST Inv. 2.5% 0.2% 1.0% 7.6%
AR 9.8% 10.6% 10.6% 13.2%
Invent. 15.2% 16.7% 13.2% 17.8%
Total CA 28.9% 28.6% 26.0% 40.0%
Net FA 71.1% 71.4% 74.0% 60.0%
TA 100.0% 100.0% 100.0% 100.0%

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Divide all items by Total Liabilities &

Equity
Liab. & Eq. 2022 2023 2024E Ind.
AP 7.4% 8.2% 6.6% 6.8%
Notes pay. 1.2% 5.1% 2.0% 3.0%
Accruals 4.9% 4.9% 5.4% 10.2%
Total CL 13.5% 18.2% 14.0% 20.0%
LT Debt 19.6% 22.4% 22.0% 12.0%
Total Liab. 33.1% 40.6% 36.0% 32.0%
Total eq. 66.9% 59.4% 64.0% 68.0%
Total L&E 100.0% 100.0% 100.0% 100.0%

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 Analysis of Common Size Balance
Sheets
• Computron has higher proportion of net fixed
assets than the industry.
• Computron’s total debt is 24% (the combined
percentages of notes payable and long-term
bonds) of its assets, which is higher than the
industry’s combined debt percentage.

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Common Size Income Statement:

Divide all items by Sales
2022 2023 2024E Ind.
Sales
100.0% 100.0% 100.0% 100.0%
COGS 78.2% 80.0% 78.9% 69.0%
Depr. 5.3% 5.3% 5.6% 3.3%
Other exp. 6.4% 7.0% 6.1% 17.3%
EBIT 10.2% 7.7% 9.4% 10.4%
Int. Exp. 1.2% 1.8% 1.5% 0.8%
Pre-tax earn. 8.9% 5.9% 7.9% 9.6%
Taxes (25%) 2.2% 1.5% 2.0% 2.4%
NI 6.7% 4.4% 5.9% 7.2%

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 Analysis of Common Size Income
Statements
• Computron’s profit margin is less than the
industry ratio
– Computron has lower Other Costs.
– But… it has much higher costs of goods sold

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Percentage Change Analysis:

Cumulative Change from First Year
(2022)
Income St. 2022 2023 2024E
Sales 0.0% 9.1% 20.0%
COGS 0.0% 11.6% 21.2%
Depr. 0.0% 10.3% 27.6%
Other exp. 0.0% 20.0% 14.3%
EBIT 0.0% -17.9% 10.7%
Int. Exp. 0.0% 58.8% 47.1%
EBT 0.0% -28.5% 5.7%
Taxes 0.0% -28.5% 5.7%
NI 0.0% -28.5% 5.7%

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 Analysis of Percent Change Income
Statement
• For 2023:
– Sales grew by 9% in 2023.
– Net income fell by 28.5%!
• For 2024 projections:
– Cumulative sales growth is 20%.
– Cumulative net income growth is 5.7%
• Improvement, but more work is needed

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Cumulative Percentage Change:

Assets
Assets 2022 2023 2024E
Cash 0.0% -16.7% 0.0%
ST Invest. 0.0% -90.0% -50.0%
AR 0.0% 30.0% 32.5%
Invent. 0.0% 32.3% 6.5%
Total CA 0.0% 18.6% 10.2%
Net FA 0.0% 20.7% 27.6%
TA 0.0% 20.1% 22.5%

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 Cumulative Percentage Change:
Liabilities & Equity
Liab. & 2022 2023 2024E
Eq.
AP 0.0% 33.3% 10.0%
Notes pay. 0.0% 400.0% 100.0%
Accruals 0.0% 20.0% 35.0%
Total CL 0.0% 61.8% 27.3%
LT Debt 0.0% 37.5% 37.5%
Total eq. 0.0% 6.6% 17.2%
Total L&E 0.0% 20.1% 22.5%

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Analysis of Percent Change Balance

Sheets: 2023
• Assets grew by 20.1% even though net income
fell.
• Much of the asset growth was in accounts
receivable and inventories.
– Not collecting on credit sales
– Unsold product is piling up.
• Growth was funded with big increase in debt.

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 Analysis of Percent Change Balance
Sheets: Projections Compared with
2023
• Small cumulative increase in 2024E total assets
(22.5%) compared with 2023 change in total
assets (20.1%)
– But big reduction in cumulative inventory growth
(6.5% in 2024E vs. 32.3% in 2023)
• Big drop in cumulative notes payable growth in
2024E relative to notes payable growth in 2023.

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Explain the Extended DuPont

Equation
• The DuPont equation focuses on:
– Expense control (Profit margin, PM)
– Asset utilization (Total asset turnover,TAT)
– Debt utilization (Equity multiplier, EM)
• It shows how these factors combine to
determine the return on equity (ROE).

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 The Simple Version of the DuPont
Equation
Net income
ROE =
Equity
Net income Total assets
= 
Total assets Equity
ROE = ROA  EM

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The Extended DuPont Equation

Net income Total assets

ROE = 
Total assets Equity

Net income Sales Total assets

ROE =  
Sales Total assets Equity

ROE = Profit margin  Total asset turnover  Equity multiplier

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 ROE: (Profit margin)(TA turnover)(EM)

ROE2022 = (6.7%)(1.348)(1.495) = 13.5%

ROE2023 = (4.4%)(1.224)(1.684) = 9.1%

ROE2024E = (5.9%)(1.320)(1.563) = 12.2%

ROEInd = (7.2%)(1.5)(1.47) = 15.9%

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Potential Problems and Limitations of

Ratio Analysis
• Comparison with industry averages is difficult if
the firm operates many different divisions.
• Seasonal factors can distort ratios.
• Window dressing techniques can make
statements and ratios look better.
• Different accounting and operating practices can
distort comparisons.
• Financial ratios do not tell full story: ratios must
be evaluated together, not individually; ratios
must be related to the industry average or some
other criteria.
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