 Financial Statement Analysis

o Gaining an understanding of an organization’s financial situation by reviewing its

financial reports
 Basis of Financial Statement Analysis
o Characteristics
 Liquidity
 Profitability
 Solvency
o Tools of Analysis
 Horizontal
 Vertical
 Ratio
o Comparison Bases
 Intracompany
 Industry Averages
 Intercompany
 Horizontal Analysis
o Trend analysis
o A technique for evaluating a series of financial statement data over a period of time
o Purpose – determine the increase pr decrease that has taken place
o Balance sheet, income statement, statement of RE
 Step 1: compute the dollar amount of change from earlier period to later period.
 Step 2: divide peso amount of change by the earlier period amount.
 Earlier period = base period
 Trend percentages
o Form of horizontal analysis
o Trends = shows the direction a business is taking
o Computed by selecting a base year
 Base year amounts = 100%
 Trend % = (any year peso amount)/(base year peso amount)
 Vertical Analysus
o Common-size analysis
o Relations among FS accounts at a given point in time
o Balance sheet and income statement
 IS - % of net sales
 BS - % of total assets
 Ratio Analysis
o Evaluating the relationships between the key components of FS
o Few require the amount of the company’s closing market price
o Some require knowledge of the no. of shares outstanding
 5 major categories of ratios and the questions they answer
o Liquidity – can the company meet its short-term obligations using the resources it
currently has on hand?
 o Asset management – right amount of assets vs sales?
o Debt mgt. – right mix of debt & equity?
o Profitability – do sale prices exceed unit costs, and are sales high enough as reflected in
PM, ROE and PRA
o Market performance – do investors like what they see as reflected in P/E and M/B
ratios?
 Liquidity Ratio
o Working capital – ability to meet short-term obligations w/ current assets
 Current Assets – current liabilities
o Current ratio – ability to pay current liabilities with current assets
 CA/CL
o Acid test ratio (quick ratio) – immediate liquidity
 Quick assets – cash, short-term investment, net current receivables
 QA/CL
 Asset Management
o Inventory turnover – how many times a year company sells its average inventory
 COGS/Average Inventory
 Average Inventory = (BI + EI)/2
o Average Sale Period – efficiency ratio, measures ave. no. of days the company holds its
inventory before selling it
 No. of days funds are tied up in inventory
 365 days/Inventory turnover
o AR Turnover – no. of times, on average, company collects receivables during the period
 Net credit sales/Average AR
 Ave. AR = (Beg. Receivables + End receivables)/2
o Average Collection Period – ave. no of days required to collect an account
 365 days/AR Turnover
o Operating cycle – elapsed time from when inventory is received from suppliers to when
cash is received from customers
 Average sale period + Average collection period
o Total Asset Turnover – how efficient a company’s assets are being used to generate
sales
 Sales/Ave. total assets
 Debt Management Ratio
o Times Interest Earned Ratio
 Earnings before interest and income taxes/Interest expense
o Debt-to-equity ratio – indicates the relative proportions of debt and equity at one point
in time on a company’s balance sheet
 If it increases, a company is increasing its financial leverage
 Total liabilities/Total stockholders’ equity
o Equity Multiplier – portion of the company’s assets funded by equity
 Average total assets/Average stockholder’s equity
 Profitability Ratio – income or operating success of a company for a given period of time
o Gross Margin Ratio - % of each peso of sales that results in gross margin
  Gross margin/Net sales
o Net profit Margin Ratio - % of each peso sales that results in net income
 Net income/Net sales
o Return on Total Assets – measure of operating performance
 Net income + [Interest expense x (1-tax rate)]/Average total assets
o Return on Equity – profits relative to the book value of stockholder’s equity
 Net income/Ave. total stockholders’ equity
o DuPont System of Analysis
 ROE = Net profit margin percentage x total asset turnover x equity multiplier
 Net profit margin % = Net income/sales
 Total asset turnover = sales/ave. total assets
 Equity multiplier = ave. total assets/ave. stockholders’ equity
 Market Performance
o Earnings per share of common stock – measure of net income earned on each share of
common stock
 (net income – preferred dividends)/ave. no. of common shares outstanding
o Price Earnings Ratio – relationship between a stock’s market price and its earnings per
share
 Market price per share/earnings per share
o Dividend Payout - % of earnings distributed in the form of cash dividends
 Dividend per share/Net income
o Dividend yield
 Rate of return (form of cash dividends only) that would be earned by an investor
who buys common stock at the current price
 Dividend per share/Market price per share
o Book value per share – rate of return (form of cash dividends only) that would be
earned by an investor who buys common stock at the current market price
 (total stockholders’ equity – preferred equity)/no. of common shares
outstanding
 Red Flags in FS Analysis
o Movement of sales, inventory and receivables
o Earnings problems
o Decreased cash flow
o Too much debt
o Inability to collect receivables
o Inventory buildup
 Using Financial Ratios: Cautions about using ratio analysis
o Ratios that reveal large deviations from the norm merely indicate the possibility of a
problem.
o Single ratio – does not generally provide sufficient information from which to judge the
overall performance of the firm
o Ratios being compared – calculated using FS dated at same point in time during the year
o Preferable to use audited financial statements
o Financial data being compared should have been developed in the same way.
o Results – distorted by inflation