Analysis of

Financial
Statements
RHODILET B. VALDEZ, CPA
Financial • Financial statements aren’t “just accounting”; they
provide a wealth of information that can be used for
Statements: a wide variety of purposes by various users.
• Accounting data can be used to see why a company
A Recap is performing the way it is and where it is heading.
Analysis of • An analysis of its statements can highlight a
company’s strengths and shortcomings, and
Financial this information can be used by
management to improve the company’s
Statements performance and by others to predict future
results.
Financial analysis involves:
 Ratio Analysis and/or
Common-size Analysis
 Comparing the firm’s
performance to that of other
firms in the same industry
(Industry averaging/benchmarking)
 Evaluating trends in the
firm’s financial statements
over time. (Time-series Analysis)
 Ratio Analysis
• Ratio – relative values
correlating a firm’s income
statement and balance sheet
items.
• Ratio analysis involves methods
of calculating and interpreting
financial ratios to analyze and
monitor the firm’s performance.
• Ratios help evaluate financial
statements.
 It is better to understand
what they are designed to do
than to memorize names and
equations
 Financial Ratios:
Five Basic Categories
We can calculate many different
ratios, with different ones used to
examine different aspects of the
firm’s operations. They are as follows:
• Liquidity
• Asset Management (Activity)
• Debt Management
• Profitability
• Market Value
 Liquidity Ratios
• Liquidity ratios, which give an
idea of the firm’s ability to pay off
debts that are maturing within a
year.
Importance:
• Satisfactory liquidity ratios are
necessary if the firm is to
continue operating.
• A common precursor to financial
distress and bankruptcy is low or
declining liquidity; these ratios
can provide early signs of cash
flow problems and impending
business failure.
 Liquidity Ratio (cont’d)
• Liquidity test: Will the firm be
able to pay off its debts as they
come due and thus remain a
viable organization?
• A full liquidity analysis requires
a cash budget; however, by
relating cash and other current
assets to current liabilities, ratio
analysis provides a quick and
easy-to-use measure of
liquidity.
 CURRENT RATIO
CURRENT ASSETS  Current assets should be
CURRENT RATIO = convertible within a year.
CURRENT LIABILITIES
 Current assets typically include
cash, marketable securities,
accounts receivable, and
inventories.

LIQUID ASSETS  A liquid asset is an asset that

CURRENT RATIO = can be converted to cash
CURRENT LIABILITIES quickly without having to
reduce the asset’s price very
much.
 Current Ratio; Interpretation
• Generally, the higher the current ratio, the
more liquid the firm is.
• If current liabilities rise faster than current
assets, the current ratio will fall.
• WARNING: A high current ratio generally
indicates a very strong, safe liquid position
but it also might indicate that the firm has
too much cash, receivables, and
inventories, in which these assets are not
managed efficiently.
• The firm has too many old accounts
receivable that may turn into bad debts or
too much old inventory that will have to be
written off.
QUICK (ACID-TEST) RATIO
• The quick (acid-test) ratio is like the
current ratio except that it excludes
inventory, which is generally the
least liquid current asset.
• Therefore, the quick ratio, which
measures the ability to pay off short-
term obligations without relying on
the sale of inventories, is important.
Why is inventory the most
illiquid current asset?
• Many types of inventory cannot be
easily sold because they are partially
completed items, special-purpose
items, and the like. If sales slow down,
they might not be converted to cash as
quickly as expected.
• Inventory is typically sold on credit,
which means that it becomes an
account receivable before being
converted into cash.
• Inventories are the assets on which
losses are most likely to occur in the
event of liquidation.
 QUICK (ACID-TEST) RATIO
CURRENT ASSETS - INVENTORIES
QUICK (ACID-TEST) RATIO =
CURRENT LIABILITIES

Alternatively,
CASH + ACCOUNTS RECEIVABLE
QUICK (ACID-TEST) RATIO =
CURRENT LIABILITIES
 When to use?
• The quick ratio provides a better
measure of overall liquidity only
when a firm’s inventory cannot be
easily converted into cash.
• But if inventory is liquid, the
current ratio is a preferred
measure of overall liquidity.
 ASSET MANAGEMENT
RATIOS
• Asset management ratios, which
give an idea of how efficiently the
firm is using its assets.
• Good asset management ratios
are necessary for the firm to keep
its costs low and thus its net
income high.
• Asset Management test: Does
the amount of each type of asset
seem reasonable, too high, or too
low given current and projected
sales?
 TURNOVER RATIOS
• As the name implies, these ratios show how many times the
particular asset is “turned over” during the year:

SALES
TURNOVER =
ASSET

• A company must strike a balance between too many and too

few assets, and the asset management ratios will help it strike
this proper balance.
 TOTAL ASSET TURNOVER
• Total assets turnover is calculated by dividing the sales by total
assets. It measures how effectively the firm uses its total assets.
SALES
TOTAL ASSETS
=
TURNOVER
TOTAL ASSETS
 INVENTORY TURNOVER
SALES  However, inventory turnover is
INVENTORY calculated differently because
=
TURNOVER sales are stated at “market”
INVENTORY
prices, while inventories are
carried at cost.
COST OF GOODS
INVENTORY SOLD  If sales are used in the inventory
=
TURNOVER
INVENTORY calculation, the calculation
overstates the true inventory
turnover ratio.
 INVENTORY TURNOVER (cont’d)
COST OF GOODS The cost of goods sold
SOLD occurs OVER THE ENTIRE
INVENTORY
= YEAR
TURNOVER
The inventory figure is for
INVENTORY
ONE POINT IN TIME.

For this reason, using an AVERAGE INVENTORY measure might be better.

 SIMPLE AVERAGE – Sum of the monthly figures during the year divided
by 12.
 WEIGHTED AVERAGE – Sum of the weighted monthly average
 If monthly data are not available, the beginning and ending figures can be
added and then divided by 2.
Inventory Turnover; Interpretation
• As a rough approximation, inventory
turnover provides how many times
each item of inventory is sold and
restocked, or “turned over”.
• Resulting turnover is meaningful ONLY
when it is compared with that of other
firms in the same industry or to the
firm’s past turnover.
• Example: An inventory turnover of 20.0
would not be unusual for a grocery
store, whereas a common inventory
turnover for an aircraft manufacturer is
4.0.
 AVERAGE AGE OF
INVENTORY
• Inventory turnover can be
easily converted into an
average age of inventory or
the average number of day
sales in inventory.

AVERAGE AGE 365

OF =
INVENTORY INVENTORY
TURNOVER
DAY SALES OUTSTANDING
• Day Sales Outstanding (DSO), also
called average collection period.
• It indicates how many days’ sales
are tied up in receivables or the
average length of time the firm must
wait after making a sale before it
receives cash.
 DAYS SALES OUTSTANDING (DSO)
RECEIVABLES RECEIVABLES
DAY SALES
=
OUTSTANDING AVERAGE SALES
ANNUAL SALES/365
PER DAY

The formula as presented assumes, for simplicity, that all sales are made
on a credit basis.

RECEIVABLES
DAY SALES
=
OUTSTANDING AVERAGE CREDIT
SALES PER DAY
 Day Sales Outstanding;
Interpretation
• The DSO can be compared
with the industry average
and previous ratios.
• But the average collection
period is MORE
MEANINGFUL when
compared to the firm’s
credit terms.
Day Sales Outstanding; Interpretation
(cont’d)
 A high DSO may indicate a poorly
managed credit or collections
department, or both, which means some
customers are paying on time, but quite a
few must be paying very late.
 If the trend in the DSO is rising, but the
credit policy has not been changed, this
reinforces the credit manager to take
steps to collect receivables faster.
 ACCOUNTS RECEIVABLE TURNOVER
• Receivables turnover could also be used to evaluate receivables.
ACCOUNTS SALES
RECEIVABLE =
AVERAGE
TURNOVER
RECEIVABLES
• However, the DSO ratio is easier to interpret and judge.
 FIXED ASSET TURNOVER
• Fixed asset turnover is the ratio of sales to net fixed assets. It measures
how effectively the firm uses its plant and equipment.

SALES
FIXED ASSETS
=
TURNOVER
NET FIXED ASSETS
(Historical costs – depreciation)
 CAVEAT ON FIXED
ASSET TURNOVER
• POTENTIAL PROBLEMS may arise
when interpreting the fixed assets
turnover ratio:
• If we compare an old firm whose fixed
assets have been depreciated with a
new company with similar operations
that acquired its fixed assets only
recently, the old firm will probably
have a higher fixed assets turnover
ratio.
• However, this would be more
reflective of the age of the assets than
of inefficiency on the part of the new
firm.
Debt Management
Ratios
• Debt management ratios,
which give an idea of how
the firm has financed its
assets and its ability to
repay its long-term debt.
• Debt management ratios
indicate how risky the firm
is and how much of its
operating income must be
paid to its bondholders
rather than stockholders.
Debt Management Ratios
(Cont’d)
• The debt position of a firm indicates
the amount of other people’s money
being used to generate profits.
• Degree of indebtedness measures the
amount of debt relative to other
significant balance sheet amounts.
• Ability to service debts is the ability of a firm
to make the payments required on a
scheduled basis over the life of the
debt. These are measured through
coverage ratios.
 TOTAL DEBT TO TOTAL CAPITAL
 Debt-to-capital (D/C) ratio is a financial ratio used to assess the company’s
capital structure and its ability to meet its debt obligations.
 The ratio reveals how much debt a company is using to finance its assets and
operations.

TOTAL DEBT TOTAL DEBT

TOTAL DEBT TO
=
TOTAL CAPITAL TOTAL DEBT + TOTAL
TOTAL CAPITAL
EQUITY

 Debt is interest-bearing liabilities. It includes both short-term and long-

term interest-bearing liabilities.
 Capital is defined as investor-supplied funds (externally financed)
Debt to Capital Ratio;
Interpretation
 DEBT TO EQUITY RATIO
• Debt-to-equity (D/E) ratio measures a company’s financial risk by comparing
its total debt obligations to its total shareholder equity, indicating the
proportion of financing from debt versus equity.

TOTAL DEBT
DEBT TO EQUITY RATIO =
TOTAL EQUITY
 DEBT RATIO
• Debt ratio measures the proportion of total assets financed by the firm’s
creditors.

TOTAL LIABILITIES
DEBT (LIABILITY) RATIO =
TOTAL ASSETS

Contradicting,
TOTAL DEBT
DEBT RATIO =
TOTAL ASSETS
 TIMES INTEREST EARNED RATIO
• It is a measure of the firm’s ability to meet its annual interest payments or
measures the extent to which operating income can decline before the firm is
unable to meet its annual interest costs.

OPERATING INCOME (EBIT)

TIMES INTEREST EARNED
=
RATIO
INTEREST CHARGES

• Note that earnings before interest and taxes, rather than net income, is used
as the numerator because interest is deducted from operating income and
not net income.
• Failure to pay interest will bring legal action by the firm’s creditors and
probably result in bankruptcy.
 EBITDA COVERAGE
EBITDA + LEASE PAYMENTS
EBITDA COVERAGE RATIO =
INTEREST + PRINCIPAL PAYMENTS + LEASE PAYMENTS

• This ratio is more complete than the times-interest-earned ratio because it

recognizes that depreciation and amortization expenses are non-cash
expenses and thus are available to service debt.
• In addition, lease payments and principal repayments on debt are fixed
charges.