Analysis of Financial

Statements – Profitability and

Risk analysis
Profitability Analysis and Various measures of Income

• Net Income (fairly high persistent), Other comprehensive Income (Low persistent),
and Comprehensive Income

• The analysis of profitability includes, among other things, the analysis of various
financial ratios based on numbers from the financial statements. Ratios are not
metrics you must memorize but are useful tools that you may use to capture
information relevant to your particular task.
Complementary approaches to analyze Net Income
Per Share Analysis
Earnings per share- Basic EPS Vs Diluted EPS
 Criticisms of EPS
• It does not consider the amount of assets or capital required to generate a
particular level of earnings. Two firms with the same earnings and EPS are not
equally profitable if one firm requires twice the amount of assets or capital to
generate those earnings compared to the other firm.
• The change in EPS is an ambiguous measure of the change in profitability over
time because a change in shares outstanding over time can have a
disproportionate effect on the numerator and denominator. For example, a firm
could experience a decline in earnings during a year but report higher EPS than it
did the previous year if it repurchased a sufficient number of shares early in the
period.
• Despite these criticisms of EPS as a measure of profitability, it remains one of the
focal points earnings announcements, and analysts frequently use it in valuing
firms. The reason for its ubiquity is the direct comparability of a firm’s earnings
per share to its stock price per share.
 Common Size Analysis &
Percentage Change Analysis
Common-Size Analysis
• Converts financial statement line items into percentages of either total sales
(for line items on the income statement) or total assets (for those on the
balance sheet).

• Through the use of a common denominator, common-size analysis enables

you to compare financial statements across firms and across time for the
same firm. Common-size analysis is also a very helpful comparison tool when
evaluating financial statements reported using different currencies, or
financial statements of firms of different size.

• A primary benefit of these analyses is the assessment of whether recent

profitability and growth are persistent or transitory.
Percentage change Analysis:
• Percentage changes in individual line items, which also can be compared
across firms and across time. However, the focus is on the changes in
individual line items through time.
• One way to examine this further is to analyze the compound annual growth
rate (CAGR), which measures the average annual rate of growth between
two distant years.
• For example, for Clorox we can calculate the CAGR for sales between 2016
and 2020, a span of four years.
 Caution:
When you perform common-size or percentage change
analysis, be aware that percentages can change because
of changes in expenses independent of changes in sales
(for example, salaries, rent, or depreciation are fixed for
the period)
Alternative measures of
Profit
Alternative definitions of profits
1. Gross Profit= Revenue − Cost of Goods Sold (COGS)
(Used commonly in all industries but less significant in-service industry)

2. Operating Income or EBIT (Earnings Before Interest and Taxes) = Gross Profit − Operating Expenses
(Used commonly in all industries but very significant where financing structures significantly impact financial statements like private equity and
M&A)

3. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)= EBIT + Depreciation + Amortization
(Used in industries where capital expenditures significantly impact financial statements like telecom, energy, etc.)

4. EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization, and Rent)= EBITDA + Rent/Lease Expenses
(Used in industries like airlines and hospitality, where rent significantly impact financial statements)

5. NOPAT (Net Operating Profit After Taxes)= EBIT × (1 − Tax Rate

(Used commonly, shows profit from core operations after taxes but before financing costs.)

6. Adjusted EBITDA= EBITDA ± Adjustments

(Used commonly, adjustments may include one-time expenses, restructuring costs, or non-recurring items.)

But, not all companies report these profit matrix separately, thus analyst needs to calculate.
Non-GAAP Earnings (Pro-forma, adjusted, or street earning)
Managers often discuss specific computations of “earnings” that exclude certain
line items.

Managers of such firms argued that the key to assessing performance was the
level of and growth in revenues, which reflected first-mover advantages to gain
market share and growth in customers who would secure the firm’s profitability in
the future.
Rate of Return Analysis
Return on Assets (ROA):
• ROA measures a firm’s success in using assets to generate earnings independent of the financing of those assets.
 ROA Vs ROIC

• To compute ROIC (Return on invested capital), analysts subtract excess cash

and/or average non-interest-bearing liabilities (such as accounts payable and
accrued liabilities) from average total assets in the denominator of ROA, the
argument being that these items are sources of indirect financing.

• Both ROA and ROIC attempt to measure the profitability of a firm’s business.
However, ROA is explicitly intended to be a measure of profitability that is
independent of the way in which a firm finances its assets. ROIC allows one
financing decision to affect the calculation—financing through non-interest-
bearing liabilities.
Disaggregating ROA
• The assets turnover ratio indicates the firm’s ability to use assets to generate sales.
• The profit margin for ROA indicates the firm’s ability to use sales to generate profits.
• The product of the two ratios is ROA, indicating the firm’s ability to use assets to generate profitability.
Economic and Strategic Determinants of ROA
Trade-Offs between Profit Margin and Assets Turnover
Analysing Total Assets Turnover
Return on Common shareholders Equity (ROCE or ROE)
• ROCE is a more complete measure of firm performance because it incorporates the
results of a firm’s operating, investing, and financing decisions.

• Having computed ROE for Clorox of 128.0%, is this “good” or “bad” performance?
• A more direct benchmark against which to judge ROE is the return demanded by
common shareholders for a firm’s use of their capital. Because common shareholders
are the residual claimants of the firm, accountants do not treat the cost of common
shareholders’ equity capital as an expense when computing net income.
• A firm that generates ROCE less than the cost of common equity capital destroys
value for shareholders, whereas a firm that generates ROCE in excess of the cost of
capital creates value. ROCE measures the return to the common shareholders but
does not indicate whether this rate of return exceeds or falls short of the cost of
common equity capital.
Under what circumstances will ROCE exceed ROA? And Under what circumstances will
ROCE be less than ROA?
• It depends on how the use of financing from sources other than common
shareholders can harm or benefit common shareholders.
• ROCE will exceed ROA whenever ROA exceeds the cost of capital provided by
creditors, lessors and preferred shareholders.
Disaggregating ROCE

*This disaggregation of ROCE is also called as Dupont Analysis

Limitation of disaggregation of ROCE
Increasing leverage has potential benefits and risks. A
shortcoming of this standard disaggregation of ROCE is the
inability to directly gauge the extent to which a firm can
strategically increase leverage to increase returns to
common shareholders without offsetting profitability.
Analyst refer to this as financial flexibility. To gauge a firm’s
financial flexibility, it is helpful to disaggregate ROCE into
the operating and financing components of ROCE.
Alternative disaggregation of
ROCE & Financial Flexibility
leverage is captured by the total financial obligations divided by common equity, like the standard debt-to-equity ratio, except
that preferred equity and noncontrolling interests are included as financial obligations. Spread is the difference between
operating ROA and the net borrowing rate, which is the combined effective rate of interest and preferred dividends. Put simply,
the greater the positive spread between the firm’s operating ROA and the net borrowing rate, the more beneficial incremental
borrowing will be for the firm’s common equity shareholders.
Here, noncontrolling
interests and preferred
equity are treated as
financing obligations
because the focus is
from a common equity
holder’s point of view.
Risk Analysis
Risk Analysis

Specific types of risk

1. Short-term liquidity risk
2. Long-term solvency risk
3. Credit risk
4. Bankruptcy risk
Disclosures Regarding Risk and Risk Management
Analyzing Short-Term Liquidity Risk
• Short-term liquidity is the firm’s ability to
satisfy near-term payment obligations to
suppliers, employees, and creditors for
short-term borrowings, the current
portion of long-term debt, and other
short-term liabilities. Thus, the analysis of
short-term liquidity risk requires an
understanding of the operating cycle of a
firm.
1. Current ratio
2. Quick ratio
3. Operating cash flow to current liabilities
ratio
4. Accounts receivable turnover
5. Inventory turnover
6. Accounts payable turnover
Thank You