Analysis of

Financial
Statements
 Financial Statements And Reports
 Annual Report: A report issued annually by a corporation to
its stockholders. It contains basic financial statements, as
well as management’s opinion of the past year’s operations
and the firm’s future prospects.

The four basic statements contained in the annual report are :

 Income Statement: A statement summarizing the firm’s
revenues and expenses over an accounting period,
generally a quarter or a year.
Example: Table 3-1

 Balance Sheet: A statement of the firm’s financial position

at a specific point in time.
Example: Table 3-2
 Cont…..
 Common Stockholders’ Equity (Net Worth): The capital
supplied by common stockholders- capital stock, paid-in
capital, retained earnings and occasionally certain
reserves.

 Retained Earnings: That portion of the firm’s earnings

that has been saved rather than paid out as dividends.

 Statement of Retained Earnings: A statement reporting

the change in the firm’s retained earnings as a result of
the income generated and retained during the year. The
balance sheet figure for retained earnings is the sum of
the earnings retained for each year the firm has been in
business.
Example: Table 3-3
 Accounting Income Vs. Cash Flow
 Cash flow: The cash receipts and the cash disbursements, as
opposed to the revenues and expenses reported for the
consumption of net income, generated by a firm during some
specified period.

 Accounting Profit: A firm’s net income as reported on its

income statement.

 Operating cash Flow: Those cash flows that arise from

normal operations; the difference between cash collections
and cash expenses.
 Statement of Cash Flows
 Statement of Cash Flows: A statement reporting the impact of
a firm’s operating, investing, and financing activities on cash
flows over an accounting period.
Example: Table 3-4, 3-5
 This statement is designed to show how the firm’s operations
have affected its cash position by examining the investment
(uses of cash) and financing decisions (sources of cash) of the
firm.
 The information contained in the statement of cash flows is
useful both for financial managers and investors, so the
statement of cash flows is an important part of an annual
report.
 Ratio Analysis
 Liquidity Ratio: Ratios that show the relationship of a
firm’s cash and other current assets to its current
liabilities.

 Liquidity ratio measure a firms “liquid position” deals

with the question of how well the firm is able to meet its
current obligations.

 Liquid Asset: An asset that can be easily converted into

cash without significant loss of its original value.
 Short term or current assets are more easily converted
to cash (more liquid) than long term asset.
 Cont…..
 Two commonly used liquidity ratios are discussed as follows:
1. Current Ratio: This ratio is calculated by current liabilities. It
indicates the extent to which current liabilities are covered by
assets expected to be converted into cash in the near future.
Current asset
Current Ratio = ----------------------------
Current liabilities
• Current assets include cash, marketable securities, accounts
receivables and inventories.
• Current liabilities consists of accounts payable, short-term
notes payable, current maturities of long-term debt, accrued
income taxes and other accrued expenses (principally wages).
 Cont…..

2. Quick (Acid Test) Ratio: This ratio is calculated by

deducting inventories from current assets and
dividing the reminder by current liabilities. The
quick ratio is a variation of the current ratio.

Current Assets - Inventories

Quick/ Acid Test Ratio= ----------------------------------
Current Liabilities
 Cont…..
 Asset Management Ratio: A set of ratios that measures
how effectively a firm is managing its assets.

 The asset management ratios, measures how

effectively the firm is managing its assets.

 Production is affected by the capacity of assets, if

assets are too low, profitable sales might be lost
because the firm is unable to manufacture enough
products.
 Cont…..
1. Inventory Turnover Ratio: The ratio is calculated by dividing
cost of goods sold by inventories.
Cost of
goods sold
Inventory Turnover Ratio= --------------------------
Inventories

2. Days Sales Outstanding (DSO): The ratio is calculated by

dividing accounts receivable by average sales per day;
indicates the average length of time it takes the firm to collect
for credit sales.
Receivables Receivables
DSO= -------------------------------- = ------------------------
Average sales per day (Annual sales/360)
 Cont…..
3. Fixed Assets Turnover Ratio: The ratio of sales to net fixed
assets.
Sales
Fixed Asset Turnover Ratio= -----------------------
Net Fixed
Asset

4. Total Assets Turnover Ratio: The ratio calculated by

dividing sales by total assets.
Sales
Total Assets Turnover Ratio= -----------------------
Total Assets
 Cont…..
 Debt Management Ratio:
1. Debt Ratio: The ratio of total debt to total assets. It is a measure of
the percentage of the funds provided by creditors.
Total Debt
Debt Ratio = -----------------
Total assets

2. Times-Interest-Earned (TIE) Ratio: The TIE ratio is computed by

dividing earnings before interest and taxes (EBIT) by interest
charges; it measures the ability of the firm to meet its annual
interest Payment
EBIT

Times Interest Earned (TIE) Ratio=---------------------

Interest charges
 Cont…..

3. Fixed Charge Coverage Ratio: The ratio expands the TIE ratio
to include the firm’s annual long-term lease payments and
sinking fund payments.

EBIT + Lease Payment

Fixed Charge Coverage Ratio= -----------------------------------
Interest charges +Lease
payment + {Sinking fund
payments/ (1- Tax rate)}
 Cont…..
 Profitability Ratio: A group of ratios showing the effect of
liquidity, asset management, and debt management on
operating results.

 Profitability ratio shows the combined effects of liquidity,

asset management, and debt management on operating
results.

1. Net Profit Margin on Sales: This ratio measures net income

per dollar of sales; it is calculated by dividing net income by
sales.

Net Income

Net profit margin on sales= ----------------------

Sales
 Cont…..
2. Return on Total Asset (ROA): The ratio of net income to
total assets; it provides an idea of the overall return on
investment earned by the firm.
Net Income
ROA = -------------------
Total assets
3. Return on Common Equity (ROE): The ratio of net income
to common equity; it measures the rate of return on
common stockholders’ investment.
Net income available to common stockholder
ROE= ----------------------------------------------------
Common Equity
 Cont…..
 Market value Ratios: A set of ratios that relate the firm’s
stock price to its earnings and book value per share.

1. Price/ Earnings (P/E) Ratio: The ratio of the price per share
to earnings per share; it shows the dollar amount
investors will pay for $1 of current earnings.

Market Price Per Share

Price/ Earnings (P/E) Ratio= ---------------------------------
Earning per share (EPS)
• EPS= Net income available to common stockholders/
Number of common shares outstanding
 Cont…..

2. Market/ Book (M/B) Ratio: The ratio of a stock’s market

price to its book value.

Market Price per share

Market/Book Ratio= ---------------------------------
Book value Per Share

• Book value Per share= Common Equity / No. of

common shares outstanding
Summary of Ratio Analysis: The DuPont Chart
 Dupont Chart: A chart designed to show the relationship
among return on investment, asset turnover, the profit
margin, and leverage.

 Dupont Chart equation: A formula that gives the rate of

return on assets by multiplying the profit margin by the total
assets turnover.

ROA= Net profit margin X Total assets turnover

Net income Sales

= ------------------------ X ------------------------
Sale Total assets