University of Technology, Jamaica

Fundamentals of Finance (FOF) Unit 3: Financial Statements Analysis

Learning Objective #1: Using Ratio Analysis as the first step in the analysis of a ompany!s
Financial Statements
Ratio Analysis involves examining the relationship between pieces of information in the financial
statements for a given accounting period.
Ratios are useful because: (i) They summarize much data and put it in a usable format (ii) They facilitate
comparison across different firms and also of the same firm over different periods of time (iii) They are
used to highlight the strengths and weanesses of a company relative to its industry (iv) They can be
used as an early warning system! as a means of monitoring management and as a screening tool (v)
"rom an investor#s standpoint! predicting the future is the purpose of financial statement analysis. (vi)
"rom management#s standpoint! it is useful both as a way to anticipate future conditions! and also as a
starting point for planning actions that will influence the future course of events.
$ote that several ratios should be reviewed during an analysis. %hen one ratio deviates from the norm!
other related ratios should be studied to help determine the cause of the deviation.
%e will examine & categories of ratios. 'ifferent staeholder groups have different needs! and tend to
focus on different categories of ratios. (i) (uppliers and short)term lenders are most interested in
li*uidity ratios (ii) (tocholders and potential investors are most interested in profitability and maret
value ratios (iii) +ong)term debt holders are most interested in debt and asset management ratios (iv)
,anagers of the firm would be interested in all ratios because they are responsible for satisfying the
interests of all staeholder groups. (v) Analysts usually perform long)run trend analysis over a &)-. year
period looing for long)term stoc maximization.
Li"#i$ity Ratios
#rrent Ratio % #rrent Assets &#ic' (or Aci$) Ratio % (#rrent Assets * +nventory)
#rrent Liabilities #rrent Liabilities
ash Flo, Ratio % Operating ash Flo,
#rrent Liabilities
+i*uidity ratios refer to the firm#s ability to meet short)term obligations. They show the relationship of a
company#s cash and other current assets to its current liabilities. "irms with poor li*uidity are more
liely to fail and default on their debts. Therefore! a higher ratio is better! but one that is too high may
suggest inefficient use of resources and reduced returns.
/urrent Ratio (i) (hows how well the company can meet0cover its short)term obligations. (ii) 1rovides a
margin of safety in shrinage of non)cash current assets. (iii) 1rovides a reserve of li*uid funds against
uncertainties and shocs to cash flows. (ome of its limitations are: (i) 2t can easily become outdated as
short)term assets and liabilities are easily changed. (ii) /ompanies sometimes choose a 3year)end4 when
they are liely to have less short)term debt and more cash. (iii) 2t is not able to measure and predict the
pattern of future cash inflows and outflows. (iv) 2t is not able to measure the ade*uacy of future cash
inflows to outflows.
5uic or Acid Ratio: This is a more stringent test of a company#s li*uidity as it ignores inventory which
can tae some time to be converted to cash depending on the length of the company#s operating cycle.
/ash "low Ratio6 This ratio shows how well a company can cover its current liabilities from cash
generated from its operating activities.
Asset -anagement Ratios
.otal Asset .#rnover % Sales Fi/e$ Asset .#rnover % Sales
(Average) .otal Assets (Ave)Fi/e$ Assets

Acco#nts Receivable .#rnover % Sales or re$it Sales +nvent0 .#rnover % ost of 1oo$s Sol$
(Ave) Acc0 Rec0 +nventory
2ays sales in Receivables % Acco#nts Receivable
or Ave0 ollection 3erio$ Average sales per $ay
or 2ays Sales O#tstan$ing (2SO)
2ays sales in +nventory % +nventory
Average sales (or O1S) per $ay

Asset ,anagement Ratios show how efficiently the company uses its assets to generate sales
-
Total Assets Turnover Ratio (TAT) can be improved if the firm (i) increases sales6 (ii) 2mproves
efficiency in the use of assets6 (iii) 'isposes of or replaces some assets6 (iv)A combination of the above.
"ixed Asset Turnover: A high ratio may indicate that the company is efficient or it may be woring
close to capacity with older assets. 2t may thus prove difficult to generate further business without an
increase in invested capital. A low ratio may indicate an inefficient use of assets or resources.
Accounts Receivable Ratios: (i) A high turnover ratio indicates that the company is efficient in the
collection of its receivables. (ii) days sales outstanding ('(7) show the number of days it taes the
company to collect amounts outstanding. A low figure is desirable but may also indicate an unduly
restrictive credit policy. (iii) Remember that when one ratio deviates from the norm! other related
ratios should be studied to help determine the cause.
2nventory Ratios (i) 2nventory turnover measures the average speed that inventories move through the
company i.e. 8 the number of times per year that the company fills up and then completely empties its
warehouses or stores. (i) A high ratio may be a sign of efficiency! high sales or that the company is
living from hand to mouth! providing little variety to customers and may sometimes be out of stoc.
(ii)A low ratio may indicate that the company is holding too much stoc or holding damaged or obsolete
stoc. (iii) The days sales in inventory ratio shows the number of days it taes to sell inventory and is
useful in assessing purchasing and production policies.
2ebt -anagement Ratios
.otal 2ebt Ratio % .otal Assets * .otal 4"#ity % .otal 2ebt
.otal Assets .otal Assets
2ebt to 4"#ity Ratio % .otal 2ebt
.otal 4"#ity
4"#ity -#ltiplier % .otal Assets % 1 5 2ebt to e"#ity ratio .+4 % 46+.7+nterest
.otal 4"#ity
Fi/e$ harges overage % 46+.7 (+nt0 4/p0 5 Lease payts0)
ash overage % (46+. 5 2epreciation)7+nterest
'ebt management ratios show how well the company manages or uses debt. /ompanies use borrowed
funds to increase the returns to company owners. 9y raising funds through debt! the firm avoids diluting
stocholder ownership. To have a positive leverage! the company must be able to earn a greater return
on the assets the borrowed money is invested in! than the interest cost. 2f the rate of return on assets is
less than the rate of interest on the borrowed money! the interest must be paid! and it will come from the
owners of share capital.
+ong)term creditors are most interested in debt management ratios. %hat do they loo for: (i) A margin
of safety provided by e*uity capital. ;igher e*uity levels indicate lower ris for creditors (ii) /reditors
loo at the firm#s past payment history and at the level of income being generated to determine if it can
cover repayment of loans with interest (T2<! "ixed /harges /overage = /ash /overage) (iii)The debt
ratio is used to determine creditworthiness (iv) The expected return on investment should be higher than
the interest rate on loan.
Total 'ebt Ratio: shows how the firm is financed 8i.e. 8 the percentage of the firm that is financed by
borrowed funds. %hen business is good or normal! firms with relatively high debt ratios have higher
expected returns! however! when business is poor! they are exposed to ris of loss. The ris of
banruptcy is further increased and there is less cushion against creditors loss in the event of li*uidation.
/reditors may be reluctant to lend more. 2t may be costly to raise additional debt capital without first
raising more e*uity capital
3rofitability Ratios
1ross 3rofit -argin % Reven#es * ost of 1oo$s Sol$
8et Sales
3rofit -argin on Sales % 8et +ncome after .a/ Ret#rn on .otal Assets (ROA) % 8+A.
or 8et 3rofit Ratio 8et Sales (Ave) .otal
Assets
% 3rofit -argin 9 Asset .#rnover
Ret#rn on ommon 4"#ity (RO4) % 8et +ncome after .a/
(Average) .otal 4"#ity
% Ret#rn on Assets 9 4"#ity -#ltiplier
Ret#rn on apital 4mploye$ % 8et +ncome after .a/
(RO4) .otal apital
6asic 4arning 3o,er Ratio % 4arnings before +nterest : .a/
(643) .otal Assets
>
46+.2A overage Ratio % 46+.2A 5 Lease payments
+nterest 5 3rincipal 5 Lease
1rofitability relates to a company#s ability to earn a satisfactory income. 1rofitability is closely lined to
its li*uidity because earnings ultimately produce cash flow. All financial statements are pertinent to
profitability analysis. 1rofitability ratios show the combined effects of li*uidity! asset management and
debt on operating results.
?ross 1rofit ,argin(?1,): (i) A high ?1, might indicate that the company is efficient or that its
prices are high. (ii) A low ?1, could indicate that sales are too low or costs or too high! or both.
$et 1rofit ,argin ($1,): A low $1, may indicate that: (i) /osts are too high (ii) 7perations may be
inefficient (iii) The company may be heavily in debt! leading to high interest charges
Return on Assets (R7A): This ratio can be derived from multiplying the net profit margin by the asset
turnover. The profit margin measures the profitability of the company relative to sales! while the asset
turnover ratio measures the effectiveness of the company in generating sales from assets.
Return on /apital <mployed (R7/<):(i) is an indicator of the company#s overall profitability. (ii) 2t
relates profits with all methods of financing! (iii) /onveys return on invested capital from different
financing perspectives. (iii) is sometimes used in evaluating managerial effectiveness as management is
responsible for all company activities. (iv) depends on the sill! resourcefulness! ingenuity and
motivation of management.
9asic <arning 1ower Ratio (9<1): measures the raw earning power of the firm#s assets. 2t is useful for
comparing companies with different financing structures and tax rates.
Return on <*uity (R7<)
This ratio can also be derived by multiplying R7A by the <*uity ,ultiplier. This shows that R7< is
affected by profit margins! asset use efficiency and financial leverage.
-ar'et ;al#e Ratios
4arnings per Share % 8et +ncome for common sharehol$ers
.otal # of common shares o#tstan$ing
3rice74arnings (374) Ratio % -ar'et 3rice per Share
4arnings per Share
-ar'et to 6oo' ;al#e % -ar'et 3rice per Share
6oo' ;al#e per Share
-ar'et to ash Flo, % -ar'et 3rice per Share
ash Flo, per Share
6oo' ;al#e per share % .otal ommon 4"#ity
.otal # of common shares
,aret @alue Ratios relate the company#s stoc price to the internal performance of the company. They
give an indication of how investors feel about the company#s future prospects based on its past
performance. ;igh ratios indicate good prospects and is expected if all other ratios are good. (toc
prices are expected to be high if all ratios are good.
The 10< ratio shows how much investors are willing to pay per dollar of reported profits. A high 10<
ratio may indicate that the maret expects an increase in earnings in the future. 10< ratio is usually
higher for firms with strong growth prospects. A low 10< ratio usually indicates poorer growth prospects
or higher ris or both. "irms that earn high returns on their assets! usually have share prices well in
excess of their boo values.
Learning Objective #<: Using .ren$ Analysis to compare financial statements
Trend Analysis is the evaluation of consecutive financial statements or ratios over time. 2t shows the
direction! speed and extent of any trends in the company#s performance. Trend Analysis is also nown
as =ori>ontal Analysis because it loos at information horizontally across time. 2t shows the year)to)
year changes in ratios and reveals whether the firm#s condition is improving or deteriorating over time.
Learning Objective #3: 3erform a comparative analysis of financial statements
/omparative Analysis sees to brea down each item in the financial statements to enable better
comparison. 2t is also nown as ;ertical Analysis or ommon?si>e Analysis! because it breas down
all figures into percentages. /omparative or vertical analysis shows the relationship of each item to a
specified base! which is the -..A figure. <very other item on the financial statement is then reported as
a percentage of that base. 7n a common)size income statement (profit = loss account)! each item is
expressed as a percentage of net sales 8 which is shown as -..A. 7n a common)size balance sheet! each
item is expressed as a percentage of total assets 8 which is shown as -..A.
B
2n using comparative analysis! companies should be adCusted for impact of size before maing
comparisons.
6enchmar'ing is the practice of comparing a company to other companies both inside and outside its
own industry. /ommon)size statements are also used to compare a company to other companies in
benchmaring.
Learning Objective #@: Limitations of #sing financial statement analysis in $ecision ma'ing
$o single ratio or one)year figure is sufficient to provide an assessment of a company#s performance.
"inancial analysis may indicate that something is wrong! but it may not identify the specific problem or
show how to correct it. 2n using financial statement analysis a single ratio may serve more than one
purpose! eg indicating profitability0performance as well as flexibility0adaptability (i) Dse ratios in
conCuction with other supporting ratios and within the context of the industry! remembering the impact
of inflation and size. 2nflation can distort a firm#s balance sheet and profits. (ii) (easonal factors can
distort ratios (iii) (ometimes comparing a company with an industry average can be misleading if the
company operates in more than one industry. (iv) 2nterpreting the results of your analysis re*uires a
sound understanding of the company! the industry and the general economic environment. (v) 'ifferent
accounting practices can distort comparisons.
Learning Objective #A: onsi$ering "#alitative factors in the analysis of financial statements
(ome other factors to be considered in analyzing a company: (i) Are the company#s revenues tied to -
ey customer: (ii) To what extent are the company#s revenues tied to - ey product: (iii) To what extent
does the company rely on a single supplier: (iv) %hat percentage of the company#s business is
generated overseas: (v) +evel of competition to which the company is exposed (vi) "uture prospects for
growth and expansion (vii) +egal and regulatory environment
&#antitative +nformation So#rces: "inancial (tatements! 2ndustry (tatistics! <conomic 2ndicators!
Regulatory "ilings! Trade Reports
&#alitative +nformation So#rces: ,anagement discussion and analysis! /hairman#s and /<7#s letter.
Annual Report! ,ission (tatement! /ompany web sites! "inancial 1ress! /ompany 1ress Releases
Financial Statements 1ublic firms are re*uired to publish several different financial statements which
together give a picture of the firm#s operations and financial condition. %e shall examine two of the
most important ones! namely the 2ncome (tatement which gives a summary of the firm#s revenues and
expenses over an accounting period (eg a year or a *uarter) and the 9alance (heet
The income statement reports on operations over a period of time! usually a *uarter or a year. 2t starts
with a topline figure or revenue from operations! followed by a series of deductions! and ending in the
bottom line or net income. $ote that taxes are deducted after most costs are met! as they are regarded as
business expenses payable from operating revenue. $et income remains after all expenses are paid! and
belongs to the firm#s common shareholders.
The balance sheet reports the firm#s state of affairs at a particular point in time. 2t lists the firm#s assets
on one side (in order of li*uidity)! and the claims against those assets. /laims are of two inds6 liabilities
(money the firm owes)! and stocholder#s e*uity (their ownership stae). /laims are listed in the order
in which they must be paid. Thus accounts payable! a liability usually due in B. days or less! is at the
top! while at the bottom is stocholders e*uity which never needs to be 3paid off4. 7f the assets!
although all are stated in E! only 3cash4 is actual money.
F
+8O-4 S.A.4-48. (3 : L)
<BBC (D) <BBA (D)
(ales G!.B&!H.. H!.BF!...
/ost of goods sold (/.7.?.() &!IG&.JJ> &!&>I!...
7ther <xpenses &&.!... &-J!JII
<arnings before 2nterest = Taxes (<92T'A) H.J!H.I (-B!JII)
'epreciation = Amortization --H!JH. --H!JH.
<arnings before 2nterest = Taxes (<92T) FJ>!HFI (-B.!JFI)
2nterest G.!..I -BH!.->
<arnings before Taxes (<9T) F>>!HF. (>HH!JH.)
Taxes -HJ!.&H (-.H!GIF)
$et 2ncome ($2) >&B!&IF (-H.!-GH)
6ALA84 S=44.
Assets
/ash I&!HB> G!>I>
Accounts Receivable (debtors! AR) IGI!... HB>!-H.
2nventory -!G-H!FI. -!>IG!BH.
Total Current Assets >!HI.!--> -!J>H!I.>
"ixed Assets I-G!.F. JBJ!GJ.
Total Assets B!FJG!-&> >!IHH!&J>
Liabilities : 4"#ity
Accounts 1ayable FBH!I.. &>F!-H.
$otes 1ayable B..!... HBH!I.I
Accruals F.I!... FIJ!H..
Total Current Liabilities -!-FF!I.. -!H&.!&HI
+ong Term 'ebt F..!... G>B!...
Total Liabilities -!&FF!I.. >!BGB!&HI
/ommon (toc -!G>-!-GH FH.!...
Retained <arnings >B-!-GH B>!&J>
Total Stockholders Equity -!J&>!B&> FJ>!&J>
Total Liabilities & Equity B!FJG!-&> >!IHH!&J>
&
U8+. 3: .U.OR+AL &U4S.+O8S
-. 7ver the past year ,' Ryngaert = /o has realized an increase in its current ratio and a drop in
its total assets turnover ratio.. ;owever the company#s sales! *uic! and fixed assets turnover
ratios have been constant. %hat explains these changes: (B.-)
>. 2f a firm#s R7< is low and management wants to improve it! explain how using more debt might
help (B.H)
B. 9aer 9rothers has a '(7 of F. days. The company#s annual sales are EG.B,. what is its level
of accounts receivable: (Assume a year of BH& days) (B.-)
F. ?raser Trucing has E->9 in assets and its tax rate is F.A. The firm#s basic earning power ratio
is -&A and its return on assets (R7A) &A. %hat is ?raser#s T2< ratio: (B.&)
&. The ;.R 1icett /orp has E&..!... of debt outstanding and it pays an annual average interest
rate of -.A. Annual sales are E>,! its tax rate is B.A! and its net profit margin is &A. 2ts ban
will refuse to renew its loan! a move which would banrupt the firm! if it does not maintain a
T2< ratio of at least &. %hat is its present T2< ratio: (B.I)
H. ,idwest 1acaging#s R7< last year was only BA! but management has developed plans to
improve it. The new plans call for a total debt ratio of H.A! which will result in interest charges
of EB..!...0year. ,anagement proCects an <92T of E-, on sales of E-., and expects a total
asset turnover of >... The tax rate is expected to be BFA. 2f the changes are made! what will be
the firm#s new R7<: (B.-.)
G. ;arriett 2ndustries has EG.&9 in total assets. 2ts basic earning power ratio is -.A and its T2< ratio
is >.&. ;arriett#s depreciation and amortization expenses total E-.>&9. 2t has EGG&, in lease
payments and E&.., must go towards principal payments on its loans and long term debt. %hat
is ;arriett#s <92T'A coverage ratio: (B.-F)
I. A<2 incorporated has E&9 in assets and its tax rate is F.A.2ts basic earning power ratio is -.A
and its R7A is &A. %hat is A<2#s times interest earned (T2<) ratio: (B.-&)
J. ?iven the following information! calculate the maret price of the firm#s stoc: (tocholder#s
e*uity K EB.G&9! 10< ratio K B.&! common stoc outstanding K &.,! and maret to boo ratio K
-.J. (B.-H)
-.. ;arrelson 2nc. currently has EG&.!... in accounts receivable. 2ts days sales outstanding ('(7) is
&& days. 2t wants to reduce its '(7 to the industry average of B& days by pressuring customers to
pay on time. The /hief "inancial 7fficer (/"7) estimates that average sales will fall by -&A if
the policy is adopted. Assuming the firms achieves the '(7 of B& days and suffers the -&A sales
decline! what will be the new level of accounts receivable: Assume - year KBH& days (B.-G)
--. <bersoll ,anufacturing /o. has EH, in sales. 2ts R7< is ->A and total assets turnover is B.>
times. <bersoll is &.A e*uity financed. %hat is its net income: (B.-J)
->. /omplete the following balance sheet using the given information: 'ebt ratio K&.A. Total assets
turnover K -.&! current ratio K-.I! '(7 K BH.& days! gross profit margin on sales L(sales 8 cost of
goods sold)0salesM K >&A! 2nventory turnover ratio K &. (B.>-)
ASS4.S (E) L+A6+L+.+4S : 4&U+.E (E)
/ash Accounts 1ayable
Accounts Receivable +ong Term 'ebt H.!...
2nventories /ommon (toc
"ixed Assets NNNNNNNNNN Retained <arnings JG!&..
.otal Assets B..!... .otal Liabilities : 4"#ity OOO..
Sales ost of 1oo$s Sol$
H