Chapters 2

Financial Statement Analysis

ectives
and purposes of financial analysis
and the tools for financial analysis
mon size financial statements
parative financial statements
d analysis
analysis
e and interpret key measures of operating efficiency, leverage, liquidity, profitab
value.
ow profitability depends on the efficient use of assets and on profits as a fraction
 Financial Statements
on
cial reports providing information about financial performance & financial position
in information useful to make investment/credit decisions

al (yearly) versus interim (covering less than a year e.g., quarterly)

lidated, unconsolidated versus combined

accounting = revenues and expenses are booked when they are incurred, rega
ey are actually received or paid.
 Financial Statements …
nents of basic financial statements/annual report
ment of comprehensive income .
t tells you whether a company is making a profit or
t indicates how much profit or loss a company generates over a period o
ment of financial position .
t gives a snapshot of the company’s financial situation.
t tells you how efficiently the company is utilizing its assets and how wel
managing its liabilities in pursuit of profit.
ment of changes in owners’ equity
ancial Statements …
ment of cash flows .
Tells where the company’s cash comes from and where it goes.
• i.e the flow of cash in, through, and out of the company.
t tells you whether a company is turning profits into cash.
s to financial statements
are a required, integral part of a company's external financial statements
are used to explain the assumptions used to prepare the numbers in the
tatements as well as the accounting policies adopted by the company.
report
poses of financial analysis
al analysis refers to an assessment of the viability, stability, and profitability of a
iness or project.
mary purpose of financial analysis is
determine how a business is performing in specific areas, such as:
o Efficient utilization of assets,
o Managing liquidity,
o Managing debt,
o managing cash flow, and
o collecting accounts receivable in a timely fashion
al investors or firms that are interested in investing in businesses use financial a
ues in evaluating target companies' financial information.
ancial statement analysis
statements, by themselves, tells you quite a bit:
much profit the company made, where it spend its money, how large its
….and so on.
do you interpret all the numbers these statements provide?
e company’s profit small or large?
e level of debt healthy or not?
why we employ the financial analysis tools.
ancial statement analysis…
tion
ering and examining financial data to evaluate health of a firm
iquidity – ability to meet current financial obligations
financial flexibility – ability to exploit business opportunities
solvency – confidence that the entity will survive/sustain doing business
profitability/earning power – ability to earn return on investment
efficiency – ability to efficiently utilize economic resources/assets
market value – firm’s value relative to the market
d as bases for investment/credit decisions, firm valuation and regulation
ers of financial statement analysis
nders (trade creditors) – interested to determine ability of a firm to pay its debts
areholders/investors – concerned with present and future profitability of a firm
mployees – concerned with financial status of their employer/firm
gulatory agencies – concerned with financial health and performance of a firm/in
nagement – interested in every aspect of financial analysis/a firm
es of financial statement analysis
tal – analysis
tionships between elements of financial statements over multiple periods
nges] in elements of financial statements over multiple periods
– analysis
onships between elements of financial statements within a give period
hniques of financial statement analysis
tio analysis
establishing meaningful relationship between two/more elements of financial statements
mparative analysis
comparing elements of financial statements over multiple periods
mmon-size analysis
expressing each item on statement of financial position as a % of total assets
expressing each item on statement of financial performance as a % of sales
hniques of financial statement analysis …
d analysis
analyzing financial ratios over time to estimate likelihood of improvement or deterioration
h flow analysis
analyzing inflows and outflows of actual cash (cash and cash equivalents)
summarizing operating, investment and financing cash flows
shows short-term position of a firm
d flow analysis
analyzing changes in working capital
shows long-term position of a firm
io analysis
n
des a means of digging deeper into the information contained in the financial statements.
lishing relationship among elements of FS to evaluate performance by comparing ratios of
ver several years (a time-series comparison/trend/horizontal analysis)
that of other firms in the industry (cross-sectional comparison)
some absolute benchmark/industry norms assessing relationship among elements of financial reports
th its planned/budgeted amounts
mmon types of ratios
mple Income statement
uidity ratios
finition, purpose and implications
relationship between current assets and current liabilities
measures ability of a firm to meet its current financial obligations
ower ratios imply liquidity problems while higher ratios may imply inefficiency in using ass
see activity ratio)
uidity ratios…
and formula
ent ratio
rime measure of how solvent a company is.
o popular with lenders……called banker’s ratio.
igher the ratio, the better financial condition a company is in.

Total current assets – prepaid expenses

urrent ratio = CR=?
Total current liabilities
uidity ratios…
k/acid test
Measures the ratio of a company’s assets that can be quickly liquidated a
o pay debts.
alled acid-test ratio because it measure’s a company’s ability to deal ins
ith its liabilities
bility to pay obligations without relying on sales of inventories
Total current
o excludes inventory assetsthey
because – prepaid expenses
are least liquid – inventories
ick ratio = QR
Total current liabilities – unearned revenues
sh ratio
ivity ratios
finition, purpose and implications
also called asset management ratios
measures efficiency of a firm in using and managing its resources to generate maximum po
ncome
higher ratios imply efficiency while lower ratios imply inefficiency
ivity ratios …
pes and formula
accounts receivable/debtors turnover ratio (efficiency)
 number of times accounts receivable are generated and collected
 higher ratio imply efficiency in managing receivable (e.g., strict credit follow-up) and/or strict credi
adversely affecting sales

Net credit sales

Accounts receivable turnover ratio =
Average accounts receivable

ARToR=?
ivity ratios …
eivable collection period/Days receivables
number of days it takes to covert accounts receivable into cash
How long it actually takes a company to collect what it’s owed?

365
Accounts receivable collection period =
Accounts receivable turnover r

ARCP= ?
ivity ratios …
nventory turnover (efficiency)
 number of times inventory is sold/consumed
 higher ratio implies efficiency in managing inventories, lost sales opportunities due to inadequate inventory caus
production problems/poor sales forecasting/weak coordination between sales and production activities within a fi
 lower/declining ratio suggests a firm has continued to build up inventory, weakening demand or may be carrying
outdated/obsolete inventory

Cost of goods sold

Inventory turnover ratio = IToR=?
Average inventory
ivity ratios …
tory period/Days inventory
sures how long it takes a company to sell the average amount of inventory on hand during
od of time.
longer it takes to sell inventory, the more the company’s cash gets tied up and the greater
ihood that the inventory will not be sold at full-value.

365
ntory period = IP=? days
Inventory turnover ratio
ivity ratios …
counts payable/creditors turnover
number of times accounts payable are generated and paid
lower ratio is better given that the firm timely pays its bills and satisfies its financial obligations to its

Credit inventory purchases

Accounts payable turnover ratio =
Average accounts payable

APToR=?
ivity ratios …
orking capital turnover ratio
measures how effective a firm is at generating sales for every dollar of working capital put to use

WCR=?
ivity ratios …
ts payable payment period
s you how many days it takes to pay its suppliers

number of days it takes to settle accounts payable

The more days it takes, the longer a company has the cash to work with
ger payment period is preferred because accounts payable are cheaper source of funds

365
Accounts payable payment period =
Accounts payable turnover rati

APPP=? days
ivity ratios …
set turnover ratio
ates management’s effectiveness in using net fixed assets to generate sale
assets refer to property, plant and equipment

Net sales
set turnover
Fixed assetsratio
turnover ratio =
ws how efficiently a company uses its assets
FAToR=
Average net fixed assets

Net sales
Total assets turnover ratio = TAToR=
Average total assets
vency ratios
ion, purpose and implications
called debt management/leverage ratio
age = use of debt in financial structure
ratio tell you how, and how extensively, a company uses debt.
cates the relative mix of debt and equity financing
asures long-term debt paying ability & financial viability of a firm
eases potential reward to shareholders and potential for financial distress and business failure
vency ratios …
nd formula
bt ratio
ates percentage of total assets financed by debt
ts financial flexibility (i.e., operating/investing/financing decision)

bt-equity ratio
DR=?

Total liabilities
Debt-equity ratio = D-ER=?
Total equity
vency ratios …
erest coverage ratio/Times interest earned
sures a company’s margin of safety

How many times over the company can make its interest payments
ates ability of a firm to make contractual interest payments

uity multiplier
sures how much of a firm’s assets are financed through stockholders' equity

Total assets EM=?

Equity multiplier =
Total equity
fitability ratios
sures a company’s level of profitability by expressing sales and profits as a percentage of v
s.
sure earning power of a firm
sure how efficiently a firm uses its assets and manages its operations
sure management’s ability to control expenses in relation to sales
ombined effects of liquidity, asset management, and debt management on operating resul
ct a firm’s operating performance, riskiness, and leverage
fitability ratios …
es and formula
gross profit margin
measures gross profit earned from each birr/dollar sales
shows relationship between sales and cost of sales
percentage of each birr/dollar sales remaining after covering cost of sales

Gross profit
Gross profit margin = GPM=?
Net sales
fitability ratios …
perating profit margin
a way to measure how sales translate into bottom-line profit.
asures income earned from operating activities of a firm
ome left after covering all costs and expenses excluding non-operating income and expenses (e.g., inte
ns, losses, etc.)

Income from operations

Operating profit margin = OPM=?
Net sales
fitability ratios …
turn on assets (ROA)/return on investment (ROI)
vides quantitative description of how well a company has invested in its assets
asures income earned per each birr/dollar asset
ws net profit generated from each dollar invested in total assets
duct of ability to generate net income per each dollar sale and effective use of total assets to generate

Net income
Return on asset = =?
Average total assets
fitability ratios …
turn on equity (ROE)
accounting measure of maximization of wealth of shareholders
ws the return on the portion of the company’s financing that is provided by shareholders
duct of how profitability a firm employs its assets and the extent of which the assets are financed throu
reholders' equity

Net income
Return on equity = =?
Average total assets
fitability ratios …
Earnings per share (EPS)
shows profitability of a firm relative to its outstanding shares

Net income
Earnings per share = =?
Weighted average outstanding shares
e DuPont system
own of ROA and ROE into component ratios.
agement efficiency in generating income from total assets
ncial leverage – use of equity to finance assets
profit margin – profit generated as a percentage of revenue/sales
assets turnover ratio – measures effective use of assets to generate revenue/sales
e DuPont system…
rket value ratios
finition, purpose and implications
provide information on value of a firm relative to market
assumes a publicly traded stock
es and formula
price-earnings ratio
indicates how much investors are willing to pay per dollar of earnings for shares of the fir
indicates how the market perceives firm’s growth/profit opportunity

Market price per share

Price-earnings ratio = =?
Earnings per share (EPS)
rket value ratios …
market-to-book value ratio
Ratio of market value of equity to book value of equity.
measures how much value a firm has created for its shareholders.

Market value of shares

Market-to-book value ratio = =?
Book value of shares
rket value ratios …
dividend yield/dividend-price ratio
shows how much a firm pays out in dividends each year relative to its share price

dividend payout ratio

Dividend per share
shows percentage of a firm’s per share earnings paid out as cash dividends
Dividend yield = =?
Market price per share

Dividend per share

Dividend payout ratio = =?
Earnings per share
Problems with financial
statement analysis
 lack of meaningful industry average – e.g., firms
operating different divisions in different industries
 use of industry average ratios as benchmarks –
setting goals for high-level performance needs
benchmarking on industry leaders’ ratios
 inflation – ratio analysis for one firm over time or
a comparative analysis of firms of different ages
can be distorted by inflation
 seasonal factors – can distort a ratio analysis
making comparison difficult
 uses of different accounting practices – can distort
comparisons
Problems with financial
statement analysis …
 employing “window dressing” techniques – to
make financial statements look stronger
 e.g., a company
 takes out a 2-year Birr10,000,000 loan towards end
of its fiscal year (Dec 25)
 total current asset before loan = Birr100,000,000
 total current liabilities before loan = Birr58,000,000
 compute current ratio before and after taking the
loan
 if the company pays the loan back in January, then
the transaction was strictly window dressing
Solutions to problems of
financial statement
analysis
 Qualitative factors
 Revenues per key customers/key product
 Supplies of goods/services per key supplier
 Reliance on single customers, products, or suppliers increases risk

 Percentage of the company’s overseas business

 Exposure to risk of currency exchange volatility and political
instability
 Probable actions of current competitors and likelihood of
additional new competitors
 Do prospects of the firm depend critically on the success
of products currently in the pipeline or on existing
products?
 How does the legal and regulatory environment affect the
company?
End of chapter

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