Chapter 3: Financial Statements and Ratio Analysis

The stockholders’ report is an annual report that publicly owned corporations must
provide to stockholders; it summarizes and documents the firm’s financial activities during
the past year. It begins with a letter to the stockholders from the firm’s chief executive officer
or chairman of the board. The letter to stockholders is the primary communication from
management; it describes the events that are considered to have had the greatest effect on the
firm during the year.
The four key financial statements required by the SEC for reporting to shareholders are:
1. Income Statement, which provides a financial summary of the firm’s operating results
during a specified period. It will also include the earnings per share (EPS); the number
of dollars earned during the period on behalf of each outstanding share of common
stock, and dividend per share (DPS); the dollar amount of cash distributed during the
period on behalf of each outstanding share of common stock.
2. Balance Sheet, which presents a summary statement of the firm’s financial position at
a given point in time.
3. Statement of Stockholders’ Equity, which shows all equity account transactions that
occurred during a given year.
4. Statement of Cash Flows, which provides a summary of the firm’s operating,
investing, and financing cash flows and reconciles them with changes in its cash and
marketable securities during the period.
Ratio analysis involves methods of calculating and interpreting financial ratios to
analyze and monitor the firm’s performance which is of interest to shareholders, creditors and
the firm’s own management. The inputs to ratio analysis are the firm’s income statement and
balance sheet.
Types of ratio comparisons:
 Cross-Sectional Analysis, which is the comparison of different firms’ financial ratios at
the same point in time; it involves comparing the firm’s ratios with those of other firms
in its industry or with industry averages.
 Time-Series Analysis, which is the evaluation of the firm’s financial performance over
time using financial ratio analysis.
  Combined Analysis, which combines cross-sectional and time-series analyses; this
makes it possible to assess the trend in the behaviour of the ratio in relation to the trend
for the industry.
Liquidity Ratios
The liquidity is a firm’s ability to satisfy its short-term obligations as they come due.
The two basic measures of liquidity are the current ratio and the quick (acid-test) ratio. The
current ratio is a measure of liquidity calculated by dividing the firm’s current assets by its
current liabilities (Formula: Current Ratio = Current Assets ÷ Current Liabilities). The quick
(acid-test) ratio is a measure of liquidity calculated by dividing the firm’s current assets

Current assets−Inventory
minus inventory by its current liabilities (Formula: ).
Current liabilities
Activity Ratios is a measure of speed with which various accounts are converted into
sales or cash, or inflows or outflows. A number of ratios are available for measuring the
activity of the most important current accounts, which are inventory, accounts receivable, and
accounts payable. Inventory turnover measures the activity or liquidity of a firm’s inventory
(Formula: Inventory turnover = Cost of goods sold ÷ Inventory). The average collection
period is the average amount of time needed to collect accounts receivables (Formula:

Accounts receivable
). The average payment period is the average amount of time needed to
Average sales per day

Accounts payable
pay accounts payable (Formula: ). Total asset turnover indicates
Average purchases per day
the efficiency with which the firm uses its assets to generate sales (Formula: Total asset
turnover = Sales ÷ Total assets).
Debt Ratios
The debt position of a firm indicates the amount of other people’s money being used to
generate profits. The more debt a firm has, the greater its risk of being unable to meet its
contractual debt payments. The more debt a firm uses in relation to its total assets, the greater
it financial leverage (the magnification of risk and return through the use of fixed-cost
financing, such ash debt and preferred stock). Debt ratio measures the proportion of total
assets financed by the firm’s creditors (Formula: Debt ratio = Total liabilities ÷ Total assets).
The debt-to-equity ratio measures the relative proportion of total liabilities and common
stock equity used to finance the firm’s total assets (Formula: Debt-to-equity ratio = Total
liabilities ÷ Common stock equity). The times interest earned ratio measures the firm’s
ability to make contractual interest payments (Formula: Times interest earned ratio =
Earnings before interest and taxes ÷ Interest).