Financial

Statements and
Analysis
Learning Goals

1. Review the contents of the stockholders’ report and

the procedures for consolidating international
financial statements.
2. Understand who uses financial ratios, and how.
3. Use ratios to analyze a firm’s liquidity and activity.
4. Discuss the relationship between debt and financial
leverage and the ratios used to analyze a firm’s debt.

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Learning Goals (cont.)

5. Use ratios to analyze a firm’s profitability and

market value.
6. Use a summary of financial ratios and
the DuPont system of analysis to perform
a complete ratio analysis.

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Why This Matters?

ACCOUNTING You need to understand the stockholders’ report and

preparation of the four key financial statements; how firms consolidate
international financial statements; and how to calculate and interpret
financial ratios for decision making.

INFORMATION SYSTEMS You need to understand what data are

included in the firm’s financial statements to design systems that will
supply such data to those who prepare the statements and to those in
the firm who use the data for ratio calculations.

MANAGEMENT You need to understand what parties are interested in

the stockholders’ report and why; how the financial statements will be
analyzed by those both inside and outside the firm to assess various
aspects of performance; the caution that should be exercised in using
financial ratio analysis; and how the financial statements affect the
Cont…..

MARKETING You need to understand the effects your decisions will

have on the financial statements, particularly the income statement and
the statement of cash flows, and how analysis of ratios, especially
those involving sales figures, will affect the firm’s decisions about levels
of inventory, credit policies, and pricing decisions.

OPERATIONS You need to understand how the costs of operations are

reflected in the firm’s financial statements and how analysis of ratios,
particularly those involving assets, cost of goods sold, or inventory,
may affect requests for new equipment or facilities.

IN YOUR PERSONAL LIFE routine step in personal financial

planning is to prepare and analyze personal financial statements, so that
you can monitor progress toward your financial goals. Also, you need to
understand and analyze corporate financial statements to build and
The Stockholder’s Report

Annual report that publicly owned corporations must provide to

stockholders; it summarizes and documents the firm’s financial activities
during the past year.

• letter to stockholders
• Four key financial statement
The Four Key Financial Statements:
The Income Statement

• The income statement provides a financial

summary of a company’s operating results
during a specified period.
• Although they are prepared annually for
reporting purposes, they are generally
computed monthly by management and
quarterly for tax purposes.

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The Four Key Financial Statements

Table 2.1 Bartlett

Company Income
Statements ($000)

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The Four Key Financial Statements:
The Balance Sheet

• The balance sheet presents a summary of a

firm’s financial position at a given point in time.
• Assets indicate what the firm owns, equity
represents the owners’ investment, and
liabilities indicate what the firm has borrowed.

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The Four Key Financial Statements

Table 2.2a
Bartlett Company
Balance Sheets
($000)

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The Four Key
Financial Statements (cont.)

Table 2.2b
Bartlett Company
Balance Sheets
($000)

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The Four Key Financial Statements:
Statement of Retained Earnings

• The statement of retained earnings reconciles

the net income earned and dividends paid
during the year, with the change in retained
earnings.

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The Four Key Financial Statements

Table 2.3 Bartlett Company Statement of Retained Earnings

($000) for the Year Ended December 31, 2009

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The Four Key Financial Statements:
Statement of Cash Flows

• The statement of cash flows provides a

summary of the cash flows over the period
of concern, typically the year just ended.
• This statement not only provides insight into a
company’s investment, financing and
operating activities, but also ties together the
income statement and previous and current
balance sheets.

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The Four Key Financial Statements

Table 2.4 Bartlett

Company Statement of
Cash Flows ($000) for
the Year Ended
December 31, 2009

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Using Financial Ratios:
Interested Parties

• Ratio analysis involves methods of

calculating and interpreting financial ratios to
assess a firm’s financial condition and
performance.
• It is of interest to shareholders, creditors, and
the firm’s own management.

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Using Financial Ratios:
Types of Ratio Comparisons

• Trend or time-series analysis

• Cross-sectional analysis
* Industry comparative analysis
* Benchmarking
* Combined

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Using Financial Ratios:
Types of Ratio Comparisons (cont.)

Table 2.5 Industry Average Ratios for Selected Lines of

Businessa
ght © 2009 Pearson Prentice

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Using Financial Ratios:
Types of Ratio Comparisons (cont.)

Figure 2.1 Combined Analysis

© 2009 Pearson Prentice

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Using Financial Ratios: Cautions for Doing
Ratio Analysis

1. Ratios must be considered together; a single ratio by

itself means relatively little.
2. Financial statements that are being compared should
be dated at the same point in time.
3. Use audited financial statements when possible.
4. The financial data being compared should have been
developed in the same way.
5. Be wary of inflation distortions.

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Ratio Analysis Example

• We will illustrate the use of financial ratios for

analyzing financial statements using the
Bartlett Company Income Statements and
Balance Sheets presented earlier in Tables 2.1
and 2.2.

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Ratio Analysis

• Liquidity Ratios
– Current Ratio

Current
= total current
ratio
assets total current

Current = liabilities
$1,233,000 = 1.97
ratio
$620,000

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Ratio Analysis (cont.)

• Liquidity Ratios
– Current Ratio
– Quick Ratio

Quick
= Total Current Assets -
ratio
Inventory total current
opyright © 2009 =
Quick ratio Pearson Prentice- $289,000 = 1.51
$1,233,000
liabilities
$620,000
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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
– Inventory Turnover
Inventory Turnover = Cost of Goods Sold
Inventory

yright © 2009
Inventory Pearson Prentice
Turnover = $2,088,000 = 7.2

$289,000
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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
– Average Age of Inventory
Average Age of Inventory = 365
Inventory
Turnover
Inventory Turnover =
365 = 50.7
days 7.2
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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
– Average Collection Period

ACP =
Accounts
Receivable Net
ht © 2009
ACP = Pearson Prentice = 59.7 days
$503,000
Sales/365
$3,074,000/365
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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
– Average Payment Period

APP = Accounts
Payable Annual
APP = Purchases/365
$382,000 = 95.4
days (.70 x $2,088,000)/365
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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
– Total Asset Turnover

Total Asset Turnover

= Net
Sales Total
yright ©
Total 2009 Turnover
Asset Pearson Prentice
= $3,074,000 = .85
Assets
$3,597,000
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Ratio Analysis (cont.)

Table 2.6 Financial Statements Associated with Patty’s

Alternatives
009 Pearson Prentice

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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Financial Leverage Ratios
– Debt Ratio
Debt Ratio = Total Liabilities/Total Assets

Debt Ratio = $1,643,000/$3,597,000 = 45.7%

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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
– Times Interest Earned Ratio
Times Interest Earned = EBIT/Interest

Times Interest Earned = $418,000/$93,000 = 4.5

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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
– Fixed-Payment coverage Ratio (FPCR)
FPCR = EBIT + Lease Payments

Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}

Copyright © 2009 Pearson Prentice

FPCR = $418,000 + $35,000 = 1.9
$93,000 + $35,000 + {($71,000 + $10,000) x [1/(1-.29)]}
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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
– Common-Size Income Statements

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Ratio Analysis (cont.)

earson Prentice
Table 2.7
Bartlett Company
Common-Size
Income
Statements

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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
– Gross Profit Margin
GPM = Gross Profit/Net Sales

GPM = $986,000/$3,074,000 = 32.1%

.
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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
– Operating Profit Margin (OPM)
OPM = EBIT/Net Sales

OPM = $418,000/$3,074,000 = 13.6%

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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
Net Profit Margin
–
NPM = Earnings Available to Common Stockholders
(NPM)
Sales

NPM = $221,000/$3,074,000 = 7.2%

.
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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
–Earnings Per
Share (EPS) =
EPS Earnings Available to Common
Stockholders Number of Shares
Outstanding
Copyright © 2009 Pearson Prentice
EPS = $221,000/76,262 = $2.90
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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
–Return on Total
Assets
ROA (ROA)
= Earnings Available to Common Stockholders
Total Assets

Copyright © 2009 Pearson Prentice

ROA = $221,000/$3,597,000 = 6.1%
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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
Return on Equity
–
(ROE)
ROE = Earnings Available to Common Stockholders
Total Equity

ROE = $221,000/$1,754,000 = 12.6%

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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
• Market Ratios
– Price Earnings (P/E) Ratio

P/E = Market Price Per Share of Common Stock

Earnings Per Share
P/E = $32.25/$2.90 = 11.1
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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
• Market Ratios
– Market/Book (M/B) Ratio

BV/Share = Common Stock Equity

Number of Shares of Common Stock

BV/Share = $1,754,000/72,262 = $23.00

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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
• Market Ratios
– Market/Book (M/B) Ratio

M/B Ratio = Market Price/Share of Common

Stock Book Value/Share of Common
Stock

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Summarizing All Ratios
Table 2.8 Summary of Bartlett Company
Ratios (2007–2009, Including 2009 Industry
Averages)

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Summarizing All Ratios (cont.)
Table 2.8 Summary of Bartlett Company Ratios
(2007–2009, Including 2009 Industry Averages)
yright © 2009 Pearson Prentice

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DuPont System of Analysis

• The DuPont system of analysis is used to dissect the firm’s

financial statements and to assess its financial condition.
• It merges the income statement and balance sheet into two summary
measures of profitability.
• The Modified DuPont Formula relates the firm’s ROA to its ROE
using the financial leverage multiplier (FLM), which is the ratio of
total assets to common stock equity:
• ROA and ROE as shown in the series of equations on the following
slide and in Figure 2.2 on the following slide.

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DuPont System of Analysis

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DuPont System of Analysis (cont.)

son Prentice
Figure 2.2
DuPont System of
Analysis

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Modified DuPont Formula (cont.)

• Use of the FLM to convert ROA into ROE reflects the

impact of financial leverage on the owner’s return.
• Substituting the values for Bartlett Company’s ROA
of
6.1 percent calculated earlier, and Bartlett’s FLM of
2.06 ($3,597,000 total assets ÷ $1,754,000 common
stock equity) into the Modified DuPont formula yields:

ROE = 6.1% X 2.06 = 12.6%

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