FINANCIAL STATEMENT

ANALYSIS
 LEARNING OBJECTIVES
• Understand how business activities are reported through financial
statements
• Know the nature and significance of the financial statements
• Define financial statement analysis
• Understand the basis FS analysis techniques
• Know the basics of profitability analysis
• Analyze a business firm’s short-term financial position, asset liquidity and
management, long-term financial position and profitability using financial
ratios
 FINANCIAL STATEMENTS

• Financial Statements are summaries of the

operating, financing, and investment activities of a
firm.
• According to the Financial Accounting Standards
Board (FASB), the financial statements of a firm
should provide sufficient information that is useful to
investors and creditors in making their investment
and credit decisions in an informed way.
 FINANCIAL STATEMENTS
• The financial statements are expected to be prepared in
accordance with a set of standards known as Generally
Accepted Accounting Principles (GAAP).
• The financial statements of publicly traded firms must be
audited at least annually by an independent public
accountants.
• The auditors are expected to attest to the fact that these
financial statements of a firm have been prepared with
accordance with GAAP.
 TYPES OF FINANCIAL STATEMENTS

• Statement of Financial Position or Balance Sheet

• Statement of Performance or Income Statement
• The Statement of Cash Flows
• Statement of Changes in Equity
• Notes to Financial Statements
 STATEMENT OF FINANCIAL POSITION
• A summary of the assets, liabilities, and equity of a business at a
particular point in time, usually the end of the firm’s fiscal year.

ASSETS = LIABILITY + EQUITY

Resources of the Obligations of Ownership left
business the business over residual

Current Assets Current Liabilities Common Stock Outstanding

- Cash, Receivables, - Payables, Short-term Additional Paid-in Capital
Inventories, Prepaid loans, Deferred Income Retained Earnings
Expenses Noncurrent Liabilities
Non-Assets - Notes, Bonds, Capital
- Plant, Machinery, Lease and Obligations
Equipment, Buildings
 INCOME STATEMENT
• An income statement is a summary of the revenues and
expenses of a business over a period of time, usually either
one month, three months or one year.
• Summarizes the results of the firm’s operating and financing
decisions during that time.
• Operating decisions of the company apply to production
and marketing such as sales/revenues, cost of goods sold
(COGS), administrative and general expenses (advertising,
office salaries).
 STATEMENT OF CASH FLOWS
• The statement of cash flow is designed to show how the
firm’s operations have affected its cash position and to help
answer questions such as these:
• Is the firm generating the cash needed to purchase
additional fixed assets for growth?
• Is the growth so rapid that the external financing is
required both to maintain operations and for investment
in new fixed assets?
• Does the firm have excess cash flows that can be used
to repay debt or to invest in new products?
 IMPORTANCE OF FINANCIAL
STATEMENTS
• Financial statements report both on firm’s position at a point
in time and on its operations over some past period.

• From management’s viewpoint, financial statement analysis

is useful both as a way to anticipate future conditions and
more important, as a starting point for planning actions that
will influence the future course of events or to show whether
a firm’s position has been improving or deteriorating over
time.
 FS ANALYSIS
TECHNIQUES
1. Horizontal or Comparative Analysis
2. Vertical or Ordinary-Size Analysis
3. Financial Ratio Analysis
 HORIZONTAL OR COMPARATIVE
ANALYSIS
1. Horizontal analysis presents the differences in absolute amount and in percentage between two compared
variables.

2. Such comparisons may be made between two time period such as in years, quarters, months, or between two
companies, between actual or budgeted data, and other bases of analyses. The difference could either be an
increase or decrease both in amounts or in percentage.

3. Percentage change is computed as follows:

• Percentage of change = amount of change / base

4. The base may be the last year’s data, budgeted data, average industry data, or chief competitor’s data.

5. The percentage of change is not computed if the denominator (or base) is zero or negative.

6. Getting the change in amount and percentage is not the end-in-view of the financial statement analysis. The
interpretation about those changes is of more relevance.
VERTICAL OR COMMON-SIZE ANALYSIS
1. It gets the proportional component of each of the variables in the financial
statements in relation to a chosen base (i.e 100%). As in horizontal analysis,
the financial statements are treated individually and each is analyzed
independent of the others.
2. The base in the statement of comprehensive income is the net sales; the
base in the statement of financial position is the total assets. In the
statement of cash flows, the base may be the total cash available for use.
3. By expressing the financial data in percentage using a particular base, the
size of different companies is brought to a ordinary expression
4. Size alone does not reflect the true merits of managerial performance. To
compare the financial data, they should be put in equal standing by
expressing financial figures into percentage and defining ordinary base
(100%)
 RATIO ANALYSIS

• Ratio Analysis is a systematic use of ratio to interpret

or assess the performance status of the firm.
• It is a widely used tool of financial analysis.
• The term ratio refers to numerical or quantitative
relationship between two items or variables.
• The basic objective of ratio analysis is to compare
the risk and return relationship of firms of different
sizes.
 RATIO ANALYSIS

• A financial ratio is a relationship between to

accounting figures.
• Ratios help to make qualitative judgment about the
firm’s financial performance.
• Ratio analysis helps in finding out the strengths and
weaknesses of a firm.
 RATIO ANALYSIS

• Ratio analysis can help plan for the future.

• The relationship in ratio can be expressed in:
• Percentage- ex. Net Profit are 25% of Sales
• Fraction- ex. Net Profit is one-fourth of Sales
• Proportion- ex. Relationship between net profit
and sales is 1:4
 TYPES OF RATIOS

• Liquidity Ratios
• Leverage Ratios
• Activity Ratios
• Profitability Ratios
• Market Value Ratios
 LIQUIDITY RATIOS

• Ability of the firm to satisfy its short term obligations

as they become due.
• A liquid asset is one that can be easily converted
into cash at a fair market value
• “Will the firm be able to meet its current
obligations?”
• In general, the greater the level of coverage of
liquid assets to short-term liabilities the better.
 LIQUIDITY RATIOS

• Liquidity ratios are a key part of fundamental

analysis since they help determine a company's
ability to service its debts. If a company fails to pay
its debts, it could face bankruptcy or restructuring
activity that could be detrimental to shareholder
value.
 LIQUIDITY RATIOS

• Three Measures of Liquidity:

• Current Ratio
• Quick or Acid Test Ratio
• Net Working Capital
 LIQUIDITY RATIOS
• Current Assets are assets which can be converted into cash
easily in one accounting period.
• Cash & cash equivalents
• Receivables
• Inventories
• Prepaid Expenses
• Current Liabilities are liabilities which have to be paid in one
accounting period.
• Accounts Payable
• Short-term loans
 CURRENT RATIO

Current Assets
Current Ratio =
Current Liabilities
• It is the relationship between the current assets and current
liabilities of a concern.
 CURRENT RATIO

• A current ratio of 1.0 or greater is an indication that

the company is well-positioned to cover its current
or short-term liabilities.

• A current ratio of less than 1.0 could be a sign of

trouble if the company runs into financial difficulty.
 LIMITATIONS OF CURRENT RATIO
• this is not the whole story on company liquidity
• understand the types of current assets the company has
and how quickly these can be converted into cash to meet
current liabilities
• The current ratio inherently assumes that the company
would or could liquidate all of most of its current assets and
convert them to cash to cover these liabilities
• Companies with a seemingly high current ratio may not be
safer than a company with a relatively low current ratio.
 QUICK RATIO
Current Assets- Inventories & Prepaid Expenses
Quick Ratio =
Current Liabilities
• Also known as acid test ratio
• liquidity ratio that further refines the current ratio by measuring
the level of the most liquid current assets available to cover
current liabilities.
• is more conservative than the current ratio because it excludes
inventory and other current assets, which generally are more
difficult to turn into cash.
• A higher quick ratio means a more liquid current position.
 QUICK RATIO
• The quick ratio is conceivably a better barometer of the
coverage provided by these assets for the company’s
current liabilities should company experience financial
difficulties.
• Inventory is generally considered to be less liquid than these
other current assets.
• A rule of thumb is that a quick ratio greater than 1.0 means
that a company is sufficiently able to meet its short-term
obligations.
 QUICK RATIO
• A low and/or decreasing quick ratio might be delivering
several messages about a company. It could be telling us
that the company’s balance sheet is over-leveraged. Or it
could be saying the company’s sales are decreasing, the
company is having a hard time collecting its account
receivables or perhaps the company is paying its bills too
quickly.
• A company with a high and/or increasing quick ratio is likely
experiencing revenue growth, collecting its accounts
receivable and turning them into cash quickly and likely
turning over its inventories quickly.
 QUICK RATIO
• Not a perfect indicator
• The elimination of inventories makes the quick ratio a
somewhat better barometer of a company’s ability to meet
its short-term obligations than the current ratio. But like the
current ratio, the acid-test ratio is still not a perfect gauge. It
is not realistic to assume that a company will liquidate all
current assets that comprise the quick ratio to cover short-
term debts since the company still needs a level of working
capital to remain a going concern.
 CASH RATIO

Cash + Marketable Securities

Cash Ratio =
Current Liabilities
• The cash ratio is another measurement of a company’s
liquidity and their ability to meet their short-term obligations.
• shows the level of the firm’s cash and near-cash investments
relative to their current liabilities
 WORKING CAPITAL
Working Capital = Current Asset – Current Liabilities

• Indicates relative liquidity of asset

• working capital is the money available to meet your current, short-term
obligations
 LEVERAGE RATIOS
• Also known as solvency ratios.
• A leverage ratio is any one of several financial
measurements that look at how much capital comes in the
form of debt (loans), or assesses the ability of a company to
meet its financial obligations.
• The leverage ratio is important given that companies rely on
a mixture of equity and debt to finance their operations,
and knowing the amount of debt held by a company is
useful in evaluating whether it can pay its debts off as they
come due.
 LEVERAGE RATIOS
• Too much debt can be dangerous for a company and its
investors.
• Uncontrolled debt levels can lead to credit downgrades or
worse.
• Too few debt can also raise questions.
• A leverage ratio may also be used to measure a company's
mix of operating expenses to get an idea of how changes
in output will affect operating income.
 LEVERAGE RATIOS

• Three Measures of Leverage:

• Debt Ratio
• Debt-Equity Ratio
• Interest Coverage Ratio
 DEBT RATIO
Total Liabilities
Debt Ratio =
Total Assets
• the ratio of total debt to total assets, expressed as a decimal or percentage.
• It can be interpreted as the proportion of a company’s assets that are
financed by debt.
• A figure of 0.5 or less is ideal. In other words, no more than half of the
company’s assets should be financed by debt.
•
 DEBT-EQUITY RATIO
Total Liabilities
Debt- Equity Ratio =
Total Equity
• indicates how much debt a company is using to finance its
assets relative to the value of shareholders’ equity.
• A high debt/equity ratio generally means that a company
has been aggressive in financing its growth with debt.
• Aggressive leveraging practices are often associated with
high levels of risk. This may result in volatile earnings as a
result of the additional interest expense.
 INTEREST COVERAGE RATIO
Operating Income
Interest Coverage Ratio =
Interest Expense
• a debt ratio and profitability ratio used to determine how easily a
company can pay interest on its outstanding debt.
• Interest coverage ratio is also called “times interest earned.”
 INTEREST COVERAGE RATIO

• measures how many times over a company could pay its current
interest payment with its available earnings.
• The lower a company’s interest coverage ratio is, the more its
debt expenses burden the company.
• Moreover, an interest coverage ratio below 1 indicates the
company is not generating sufficient revenues to satisfy its interest
expenses.
 ACTIVITY RATIO
• Also called efficiency ratios
• Evaluates how well a company uses its assets and liabilities
to generate sales and maximize profits.
• Key efficiency ratios are the following:
• asset turnover ratio
• Receivables turnover
• inventory turnover
• days' sales in inventory.
 ASSET TURNOVER RATIO
Sales
Asset Turnover =
Average Total Assets

• measures the value of a company’s sales or revenues

generated relative to the value of its assets.
• The Asset Turnover ratio can often be used as an indicator
of the efficiency with which a company is deploying its
assets in generating revenue.
 RECEIVABLES TURNOVER
Net Credit Sales
Accounts Receivable Turnover =
Average Accounts Receivable

• Receivable turnover ratio is also often called accounts

receivable turnover, the accounts receivable turnover ratio,
or the debtor’s turnover ratio.
• Accounting measure used to quantify a firm's effectiveness
in extending credit and in collecting debts on that credit.
• The receivables turnover ratio is an activity ratio measuring
how efficiently a firm uses its assets.
 RECEIVABLES TURNOVER
• A high receivables turnover ratio can imply a variety of
things about a company:
• The company operates on a cash basis
• The company’s collection of accounts receivable is
efficient
• A low receivables turnover ratio can imply a variety of things
about a company:
• the company may have poor collecting processes
• a bad credit policy or none at all
• the company has a high amount of cash receivables for
collection from its various debtors
 INVENTORY TURNOVER
Sales
Inventory Turnover =
Average Inventory
COGS
Inventory Turnover =
Average Inventory

• a ratio showing how many times a company has sold and

replaced inventory during a period.
• Low turnover implies weak sales and, excess inventory.
• A high ratio implies either strong sales or large discounts.
 DAYS’ SALES IN INVENTORY
Sales
Days' Sales of Inventory = ( ) 365 days
Average Total Assets
• Days sales of inventory, or days inventory, is one part of
the cash conversion cycle, which represents the process of
turning raw materials into cash.
• Days sales of inventory (DSI) is one measure of the
effectiveness of inventory management. By calculating the
number of days that a company holds onto inventory
before selling, this efficiency ratio measures the average
length of time that a company’s cash is tied up in
inventory.
 PROFITABILITY RATIO
• These ratios show how well a company can generate profits
from its operations.
• Key efficiency ratios are the following:
• Profit margins
• Return on Assets (ROA)
• Return on Equity (ROE)
 PROFIT MARGIN RATIO
Net Income
Profit Margin =
Sales

• Profit margin is a profitability ratios calculated as net income

divided by revenue, or net profits divided by sales.
• Profit margins are expressed as a percentage and, in effect,
measure how much out of every dollar of sales a company
actually keeps in earnings.
 PROFIT MARGIN RATIO
• Different kinds of profit margins:
• gross profit margin
• operating margin (or operating profit margin)
• Pre-tax profit margin
• net margin (or net profit margin)
 RETURN ON ASSET
Net Income
Return on Asset =
Total Assets
• Return on assets (ROA) is an indicator of how profitable a
company is relative to its total assets.
• ROA gives a manager, investor, or analyst an idea as to
how efficient a company's management is at using its assets
to generate earnings.
 RETURN ON ASSET

• When using ROA as a comparative measure, it is best to

compare it against a company's previous ROA numbers or
against a similar company's ROA.
• ROA is most useful for comparing companies in the same
industry, as different industries use assets differently.
 RETURN ON EQUITY
Net Income
Return on Equity =
Total Equity

• Return on equity (ROE) is the amount of net income returned

as a percentage of shareholders' equity.
• Return on equity (also known as "return on net worth"
[RONW]) measures a corporation's profitability by revealing
how much profit a company generates with the money
shareholders have invested.
 RETURN ON EQUITY
• ROE is useful in comparing the profitability of a company to
that of other firms in the same industry.
• It illustrates how effective the company is at turning the cash
put into the business into greater gains and growth for the
company and investors.
• The higher the return on equity, the more efficient the
company's operations are making use of those funds.
 DuPont ANALYSIS
• DuPont analysis is a fundamental performance
measurement framework popularized by the DuPont
Corporation and is also referred to as the "DuPont identity."
• DuPont analysis is a useful technique used to decompose
the different drivers of the return on equity (ROE).
• Decomposition of ROE allows investors to focus their
research on the distinct company performance indicators
otherwise cursory evaluation.
 DuPont ANALYSIS
• DuPont analysis breaks ROE into its constituent components
to determine which of these components is most responsible
for changes in ROE.
• Net Margin
• Asset Turnover Ratio
• Equity Multiplier
 DuPont ANALYSIS
• Net Margin
• Expressed as a percentage of the total revenue, net margin is
the revenue that remains after subtracting all operating
expenses, taxes, interest and preferred stock dividends from a
company's total revenue.
• Asset Turnover Ratio
• This ratio is an efficiency measurement used to determine how
effectively a company uses its assets to generate revenue.
The formula for calculating asset turnover ratio is total revenue
divided by total assets. As a general rule, the higher the
resulting number, the better the company is performing.
 DuPont ANALYSIS
• Equity Multiplier
• This ratio measures financial leverage. By comparing total
assets to total stockholders' equity, the equity multiplier
indicates whether a company finances the purchase of assets
primarily through debt or equity.
• The higher the equity multiplier, the more leveraged the
company, or the more debt it has in relation to its total assets.
 DuPont ANALYSIS

ROE = Net Profit Margin x Return on Asset x Financial Leverage

Net Profit Sales Assets

ROE = x x
Sales Assets Equity
Net Profit
ROE =
Equity

ROA = Net Profit Margin x Return on Asset

Net Profit Sales

ROA = x
Sales Assets
Net Profit
ROA =
Assets