Chapter 3:

Analysis of Financial
statements

Financial management

Will I
be paid?

How Creditors
good is our
investment?
How are we
performing?
Stockholders

Managers
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 Financial statement Analysis
Financial statement analysis is the application of analysis tools
to financial statements and related data to derive estimates
and inferences useful in business analysis.

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Analysis tools
1. Comparative financial statement analysis

2. Common-size financial statement analysis

3. Ratio analysis

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 1. Comparative financial statement analysis

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1. Comparative financial statement analysis

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 2. Common-size financial statement analysis

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3. Ratio Analysis
• Ratio analysis is among the most popular and widely used
tools of financial analysis.
• A ratio expresses a mathematical relation between two
quantities.
• While computation of a ratio is a simple arithmetic
operation, its interpretation is more complex.
• To be meaningful, a ratio must refer to an economically
important relation.
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 Industry comparative analysis & Benchmarking
• Industry comparative analysis: compare one firm’s financial
performance to the industry’s average performance

• Benchmarking: compare one firm’s financial performance to

the performance of industry leader or key competitor

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5 categories of Ratios
1. Liquidity ratios: the firm’s ability to pay off debts that are maturing
within a year.
2. Asset management ratios: how efficiently the firm is using its assets.
3. Debt management ratios: how the firm has financed its assets as well
as the firm’s ability to repay its debt.
4. Profitability ratios: how profitably the firm is operating and utilizing
its assets.
5. Market value ratios: what investors think about the firm and its
future prospects.
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 Contents
1. Liquidity Ratios 5. Market Value Ratios

2. Asset Management Ratios 6. The DuPont Equation

3. Debt Management Ratios 7. Limitations of Ratios

4. Profitability Ratios

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Balance sheet

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 Balance sheet

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Income statement

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 Income statement

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1. Liquidity Ratios
2. Asset Management Ratios
3.Debt Management Ratios
4. Profitability Ratios
5. Market Value Ratios
6. The DuPont Equation
7. Limitations of Ratios

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 1. Liquidity Ratios
Ratios that show the relationship of a firm’s cash and other current assets
to its current liabilities.

Two of the most commonly used liquidity ratios:

• Current Ratio

• Quick (Acid Test) Ratio

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Current Ratio
This ratio is calculated by dividing current assets by current liabilities.

→ The extent to which current liabilities are covered by those assets

expected to be converted to cash in the near future.

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 Quick (Acid Test) Ratio
This ratio is calculated by deducting inventories from current assets and
then dividing the remainder by current liabilities.

→ The firm’s ability to pay off short-term obligations without relying on

the sale of inventories

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1. Liquidity Ratios

2. Asset Management Ratios

3.Debt Management Ratios
4. Profitability Ratios
5. Market Value Ratios
6. The DuPont Equation
7. Limitations of Ratios

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 2. Asset Management Ratios
A set of ratios that measure how effectively a firm is managing its assets.

• Inventory Turnover Ratio

• Days Sales Outstanding (DSO) Ratio

• Fixed Assets Turnover Ratio

• Total Assets Turnover Ratio

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Inventory Turnover Ratio

This ratio is calculated by dividing sales by inventories.

→ How many times inventory is turned over during the year.

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 Days Sales Outstanding (DSO) Ratio
This ratio is calculated by dividing accounts receivable by average sales
per day.

→ The average length of time the firm must wait after making a sale
before it receives cash.

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Fixed Assets Turnover Ratio

The ratio of sales to net fixed assets.

→ How effectively the firm uses its PPE.

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 Total Assets Turnover Ratio
This ratio is calculated by dividing sales by total assets.

→ How effectively the firm uses its total assets.

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1. Liquidity Ratios
2. Asset Management Ratios

3.Debt Management Ratios

4. Profitability Ratios
5. Market Value Ratios
6. The DuPont Equation
7. Limitations of Ratios

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 3.Debt Management Ratios
A set of ratios that measure how effectively a firm manages its debt:

• Total debt to total capital

• Times-interest-earned ratio

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Total debt to total capital

The ratio of total debt to total capital measures the percentage of the
firm’s capital provided by debtholders.

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 Times-interest-earned ratio
The ratio of earnings before interest and taxes (EBIT) to interest charges

→ The firm’s ability to meet its annual interest payments.

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1. Liquidity Ratios
2. Asset Management Ratios
3.Debt Management Ratios

4. Profitability Ratios
5. Market Value Ratios
6. The DuPont Equation
7. Limitations of Ratios

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 4. Profitability Ratios
A group of ratios that show the combined effects of liquidity, asset
management, and debt on operating results:
• Operating Margin
• Profit Margin
• Return on Total Assets (ROA)
• Return on Common Equity (ROE)
• Return on Invested Capital (ROIC)
• Basic Earning Power (BEP) Ratio

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Operating Margin
This ratio is calculated by dividing operating income by sales.

→ operating income, or EBIT, per dollar of sales

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 Profit Margin
This ratio is calculated by dividing net income by sales.

→ net income per dollar of sales

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Return on Total Assets (ROA)

The ratio of net income to total assets

→ The rate of return on the firm’s assets.

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 Return on Common Equity (ROE)
The ratio of net income to common equity

→ The rate of return on common stockholders’ investment.

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Return on Invested Capital (ROIC)

The ratio of after-tax operating income to total invested capital

→ The total return that the company has provided for its investors.

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 Basic Earning Power (BEP) Ratio
This ratio is calculated by dividing EBIT by total assets.

→ The ability of the firm’s assets to generate operating income

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1. Liquidity Ratios
2. Asset Management Ratios
3.Debt Management Ratios
4. Profitability Ratios

5. Market Value Ratios

6. The DuPont Equation
7. Limitations of Ratios

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 5. Market Value Ratios
Ratios that relate the firm’s stock price to its earnings and book value per
share:
• Price/Earnings (P/E) Ratio
• Market/Book (M/B) Ratio
• Enterprise Value/EBITDA (EV/EBITDA) Ratio

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Price/Earnings (P/E) Ratio

The ratio of the price per share to earnings per share

→ The dollar amount investors will pay for $1 of current earnings.

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 Market/Book (M/B) Ratio
The ratio of a stock’s market price to its book value.

In which:

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Enterprise Value/EBITDA (EV/EBITDA) Ratio

The ratio of a firm’s enterprise value relative to its EBITDA.

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 1. Liquidity Ratios
2. Asset Management Ratios
3.Debt Management Ratios
4. Profitability Ratios
5. Market Value Ratios

6. The DuPont Equation

7. Limitations of Ratios

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6. The DuPont Equation

A formula that shows that the rate of return on equity can be found as
the product of profit margin, total assets turnover, and the equity
multiplier.
→ The relationships among profitability, asset management, and debt
management ratios.

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 6. The DuPont Equation

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6. The DuPont Equation

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 6. The DuPont Equation
Ways to improve ROE

• Marketing: raise sales prices / introduce new products with higher

margins

• Accounting: cut costs

• Credit: speed up collections → reduce accounts receivable → increase

total assets turnover

• Financial: analyze the effects of alternative debt policies

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1. Liquidity Ratios
2. Asset Management Ratios
3.Debt Management Ratios
4. Profitability Ratios
5. Market Value Ratios
6. The DuPont Equation

7. Limitations of Ratios

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 7. Limitations of Ratios
1. Many firms have divisions that operate in different industries →
difficult to develop a meaningful set of industry averages.

2. Most firms want to be better than average, so merely attaining

average performance is not necessarily good.

3. Inflation has distorted many firms’ balance sheets → book values are
often different from market values.

4. Seasonal factors can also distort a ratio analysis.

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7. Limitations of Ratios
5. Firms can employ “window dressing” techniques to improve their
financial statements.

6. Different accounting practices can distort comparisons.

7. It is difficult to generalize about whether a particular ratio is “good” or

“bad.”

8. Firms often have some ratios that look “good” and others that look
“bad,” → difficult to tell whether the company is strong or weak.

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