Analysis of Financial Statements

The purpose of analyzing financial statements of a company is to find the strengths and
weaknesses of that company and use them to predict the future performance of the company. Part
of this analysis include comparing a firm’s performance with its other competitors’ or industry’s
performance and using the information to improve the future performance of the firm. The
analysis also include evaluating the firm’s financial position trend over time and using the
information to predict their future earnings, cashflow, and dividends.
There are problems involved in comparing companies of different sizes. However, calculating
and comparing financial ratios is a way of avoiding those problems. Financial ratios are used to
compare and investigate the relationships between different pieces of financial information (Ross
et al., 2016). There are five categories of financial ratios:
First is, Short-term Solvency or Liquidity Ratios:
These type of ratios checks if a firm can pay its bills over a short run without stress. These ratios
focus on current assets and current liabilities.
One of the ratios is Current Ratio (a short-term solvency). The formula for current ratio is
Current Assets ⁒ Current Liabilities. The unit of measurement is dollar or times. The current
ratio of less than 1 expresses a negative net working capital. The current ratio greater than 1
means the company is safe.
The other ratio is Quick Ratio. Quick ratio deals with the ability to pay off short-term without
liquidating inventory. The formula for quick ratio is Current Assets - Inventory ⁒ Current
liabilities.
Second is, Long-term Solvency or Financial Leverage Ratios
These ratios evaluate a firm’s long-run ability to meet its obligations.
Total Debt Ratio: accounts for all debts to all creditors. The formula for total debt ratio is Total
Assets – Total Equity ⁒ Total Assets.
Other Variations of total debt ratio include:
Debt-Equity ratio = Total Debt ⁒ Total Equity and
Equity Multiplier = Total Assets ⁒ Total Equity.
Times Interest Earned (TIE): measures the ability of a firm to meet its interest obligations. TIE
is also often called the Interest Coverage Ratio. The formula for TIE = EBIT ⁒ Interest
Cash Coverage Ratio : includes the non-cash items. The formula for Cash Coverage Ratio =
(EBIT + Depreciation) ⁒ Interest
Third is, Asset Management or Turnover Ratios
These ratios check the level of efficiency at which a company manages its assets to generate
sales.
Inventory Turnover Ratio: expresses how often goods are sold out and restocked and how fast a
firm sells the goods. The formula for Inventory Turnover = Cost of goods sold ⁒ Inventory.
Day’s sales in inventory = 365 days ⁒ Inventory Turnover.
As long as a firm is not running out of stock and forgoing sales, the higher the ratio, the more
efficiently inventory is being managed (Ross et al., 2016).
Receivables Turnover Ratio: measures how fast a firm collect sales. The formula for
Receivables Turnover = Sales ⁒ Accounts Receivable.
Days’ sales in receivables = 365 days ⁒ Receivables Turnover. Days’ sales in receivable is also
known as Average Collection Period (ACP) (Ross et al., 2016). The faster a firm collects on
sales, the better.
Fixed Assets and Total Assets Turnover Ratios: measures how effectively a firm uses its assets.
The formula for Fixed Assets Turnover = Sales ⁒ Net Fixed Assets. Total Assets Turnover
= Sales ⁒ Total Asset.
Fourth is, Profitability Ratios
These ratios check the effectiveness of a firm’s operation.
Profit Margin = Net Income ⁒ Sales (Profit per dollar of sales).
Return on Assets (ROA) is a measure of profit per dollar of assets (Ross et al., 2016). The
formula is Net Income ⁒ Total Assets.
Return on Equity (ROE) measures how the stockholders did during the year. It is also known as
return on net worth (Ross et al., 2016). The formula for ROE = Net Income ⁒ Total Equity.
Fifth is, Market Value Ratios
These ratios examine how investors like the company.
Price-Earnings Ratio: measures how much the investors are willing to pay per dollar profits or
earnings. The formula for Price-Earnings Ratio = Price Per Share ⁒ Earnings Per Share. Earning
Per Share = Net Income ⁒ Number of Shares.
Market to Book Ratio: compares the market value of a firm’s investment to their cost.
Market to Book Ratio = Market Value Per Share ⁒ Book Value Per Share. Book Value Per Share
= Total Equity ⁒ Number of Shares Outstanding.
If the value is less than 1, it means the firm has not been successful to create value for its
stockholders.
Du Pont Analysis
The Du Pont analysis is about expense control, asset utilization, and debt utilization. The Du
Pont system shows how the factors of profit margin, total asset turnover, and equity multiplier
combine to determine Return on Equity (ROE). Therefore, the formula for the Du Pont System is
Profit Margin x Total Asset Turnover x Equity Multiplier = ROE or ROA x Equity Multiplier =
ROE.
Problems and Limitations of Financial Ratio Analysis
When comparing with industry averages, financial ratio analysis is difficult if the firm has many
different divisions. Seasonal factors and window dressing techniques can make the statements
and ratios look better than they are. Sometimes, there is difficulty in interpreting if a ratio value
is good or bad. It is difficult to tell if a company is in a strong or weak financial situation because
the different ratios give different signals.
External Financing and Growth
When there is no growth, there is no need of financing because there is surplus – added ratioed
earnings. As the growth rate increases, there will be need of external financing as internal
financing will not be enough.
Internal Growth Rate: is the rate the firm can maintain with internal financing only (retained
earnings only).
External Financing Needed (EFN) = New Investment – Retained Earnings = (Growth Rate x
Assets – Addition to Retained Earnings)
When EFN = 0, Internal Growth Rate = Addition to Retained Earnings ⁒ Assets
The Sustainable Growth Rate deals with “how much the firm can grow by using internally
generated funds and issuing debt to maintain a constant debt to equity ratio – without additional
equity issues” (Park, 2021, p. 14).
References
Park, D. (2021). W2 lecture [Word doc].
Ross, S. A., Westerfield, R. W., Jaffe, J., & Jordan, B. D. (2016). Corporate Finance. (11th ed.).
McGraw-Hill Education