Topic 2

Financial Statements
and Financial Analysis
Learning Goals

1. Review the basic financial statements.

2. Understand, differentiate and apply trend vs cross
sectional analysis
3. Understand and apply the different financial ratios:
– Liquidity ratios
– Activity ratios
– Financial Leverage ratios
– Profitability ratios
– DuPont

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Complete set of financial statements
(PAS 1)
• Statement of financial position
• Income statement
• Statement of comprehensive income
• Statement of changes in equity
• Statement of cash flows
• Notes, comprising a summary of significant
accounting policies and other explanatory notes

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Income
Statement

2-4
Statement of Financial Position

2-5
Statement of Financial Position (cont.)

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Statement of Cash Flows

2-7
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
– Used to evaluate a firm’s performance
over time

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Using Financial Ratios:
Types of Ratio Comparisons (cont.)
• Trend or time-series analysis

• Cross-sectional analysis
– Used to compare different firms at the same
point in time

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Using Financial Ratios:
Types of Ratio Comparisons (cont.)
• Trend or time-series analysis

• Cross-sectional analysis
– Industry comparative analysis
• Used to compare one firm’s financial performance
to the industry’s average performance

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Using Financial Ratios:
Types of Ratio Comparisons (cont.)
• Trend or time-series analysis

• Cross-sectional analysis
– Benchmarking
• A type of cross sectional analysis in which the
firm’s ratio values are compared to those of a key
competitor or group of competitors that it wishes
to emulate

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Using Financial Ratios:
Types of Ratio Comparisons (cont.)
• Trend or time-series analysis
• Cross-sectional analysis
• Combined Analysis
– Combined analysis simply uses a
combination of both time series analysis and
cross-sectional analysis

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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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Income
Statement

2-15
Statement of Financial Position

2-16
Statement of Financial Position (cont.)

2-17
Statement of Cash Flows

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Ratio Analysis

• Liquidity Ratios
– measure how well the firm can meet its
current (short-term) obligations when they
come due.

2-19
Ratio Analysis

• Liquidity Ratios
– Current Ratio

Current ratio = total current assets

total current liabilities

Current ratio = $1,223,000 = 1.97

$620,000

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Ratio Analysis (cont.)

• Liquidity Ratios
– Current Ratio
– Quick Ratio

Quick ratio = Total Current Assets - Inventory

total current liabilities

Quick ratio = $1,223,000 - $289,000 = 1.51

$620,000
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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
– used to measure the speed with which
various accounts are converted (or could be
converted) into cash or sales.

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Ratio Analysis (cont.)

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

Inventory Turnover = $2,088,000 = 7.1

$294,500
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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
– Average Age of Inventory
Average Age of Inventory = 365
Inventory Turnover

Ave. Age of Inventory= 365 = 51.4 days

7.1
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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
– Average Collection Period

ACP = Ave. Accounts Receivable

Net Sales/365

ACP = $434,000 = 51.5 days

$3,074,000/365
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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
– Average Payment Period

APP = Ave. Accounts Payable

Annual Purchases/365

APP = $326,000 = 81.4 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

Ave. Total Assets

Total Asset Turnover = $3,074,000 = .90

$3,433,500
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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Financial Leverage Ratios
– how much of the firm is financed with other
people’s money and the firm’s ability to meet
fixed charges.

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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
• Financial 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
• Financial Leverage Ratios
• Profitability Ratios
– measure a firm’s return with respect to sales,
assets, or equity (overall performance)

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Ratio Analysis (cont.)

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

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Ratio Analysis (cont.)

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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)

NPM = Earnings Available to Common Stockholders

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

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

Ave. Total Assets

ROA = $221,000/$3,433,500 = 6.4%

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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

Ave. Total Common Equity

ROE = $221,000/$1,687,000 = 13.1%

2-39
 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

*Assuming market price per share of common stock is $32.25.

2-40
 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
– BV/Share Ratio

BV/Share = Common Stock Equity

Number of Shares of Common Stock

BV/Share = $1,754,000/76,262 = $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

M/B Ratio = $32.25/$23.00 = 1.40

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Summarizing All Ratios

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Summarizing All Ratios (cont.)

2-45
Summarizing All Ratios (cont.)

2-46
Summarizing All Ratios (cont.)

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Summarizing All Ratios (cont.)

2-48
DuPont System of Analysis

• The DuPont system of analysis is used to disect

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: ROA and ROE
as shown in the equation below and in Figure 2.2 on the
following slide.

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DuPont System of Analysis

• 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:

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2-51
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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Using Financial Ratios:
Cautions for Doing Ratio Analysis
• Ratios must be considered together; a single
ratio by itself means relatively little.
• Financial statements that are being compared
should be dated at the same point in time.
• Use audited financial statements when possible.
• The financial data being compared should have
been developed in the same way.
• Be wary of inflation distortions.

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References

• Principles of Managerial Finance by Lawrence

J. Gitman (Brief Fourth Edition)

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