Financial Analysis

St eps t o a Basic Com pany Financial Analysis

Financial Rat io Analysis ( Abridged)

Financial St at em ent s Analysis

St e ps t o a Ba sic Com pa n y Fin a n cia l An a lysis

By Professor Harvey B. Lerm ack
Philadelphia Universit y
Philadelphia, PA

Revised May 23, 2003

© 2003 Harvey B. Lerm ack

These are basic st eps you m ay use when evaluat ing com pany cases in m y graduat e
and undergraduat e business st rat egy and business policy courses.

Before you st art , you m ust underst and a couple of t hings.

· This is not meant to be an exhaustive list; there are other steps that can be
followed to get deeper into the meaning of the numbers.
· You cannot analyze the numbers in a vacuum. The numbers only provide
indicators to trigger further questions in your mind.
· I n order t o do a t horough j ob, you m ust underst and som et hing about
t he com pany’s business and st rat egies, and it s indust ry. Financial indicat ors
vary from indust ry t o indust ry; t he rat ios can only be int erpret ed when
com pared and cont rast ed wit h ot her com panies in t hat indust ry. For
exam ple, financial indicat ors are ( and should be) different am ong financial

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inst it ut ions, m anufact uring com panies, com panies t hat provide services, and
t echnology and com put er inform at ion and services com panies.
· Financial analysis is something of an art. Experienced managers, investors
and analysts develop a data bank of information over time, and after doing many
such analyses, that they bring to bear every time they review a company.

St e p 1 . Acquire t he com pany’s financial st at em ent s for several years. These m ay

be found in your assigned case st udy; in a recent annual report ; in t he com pany’s
10K filing on t he SEC’s EDGAR dat abase; or from ot her sources found at m y LI NKS
websit e. As a m inim um , get t he following st at em ent s, for at least 3 t o 5 years.
· Balance sheets
· Income statements
· Shareholders equity statements
· Cash flow statements
St e p 2 . Quickly scan all of t he st at em ent s t o look for large m ovem ent s in specific
it em s from one year t o t he next . For exam ple, did revenues have a big j um p, or a
big fall, from one part icular year t o t he next ? Did t ot al or fixed asset s grow or fall?
I f you find anyt hing t hat looks very suspicious, research t he inform at ion you have
about t he com pany t o find out why. For exam ple, did t he com pany purchase a new
division, or sell off part of it s operat ions, t hat year?
St e p 3 . Review t he not es accom panying t he financial st at em ent s for addit ional
inform at ion t hat m ay be significant t o your analysis.
St e p 4 . Exam ine t he balance sheet . Look for large changes in t he overall
com ponent s of t he com pany's asset s, liabilit ies or equit y. For exam ple, have fixed
asset s grown rapidly in one or t wo years, due t o acquisit ions or new facilit ies? Has
t he proport ion of debt grown rapidly, t o reflect a new financing st rat egy? I f you find
anyt hing t hat looks very suspicious, research t he inform at ion you have about t he
com pany t o find out why.

St e p 5 . Examine the income statement. Look for trends over time. Calculate and graph
the growth of the following entries over the past several years.
· Revenues (sales)
· Net income (profit, earnings)

Are t he revenues and profit s growing over t im e? Are t hey m oving in a sm oot h and
consist ent fashion, or errat ically up and down? I nvest ors value predict abilit y, and
prefer m ore consist ent m ovem ent s t o large swings.

For each of t he key expense com ponent s on t he incom e st at em ent , calculat e it as a

percent age of sales for each year. For exam ple, calculat e t he percent of cost of

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goods sold over sales, general and adm inist rat ive expenses over sales, and research
and developm ent over sales. Look for favorable or unfavorable t rends. For
exam ple, rising G&A expenses as a percent of sales could m ean lavish spending.
Also, det erm ine whet her t he spending t rends support t he com pany’s st rat egies. For
exam ple, increased em phasis on new product s and innovat ion will probably be
reflect ed by an increased proport ion of spending on research and developm ent .

Look for non- recurring or non- operat ing it em s. These are " unusual" expenses not
direct ly relat ed t o ongoing operat ions. However, som e com panies have such it em s
on alm ost an annual basis. How do t hese reflect on t he earnings qualit y?

I f you find anyt hing t hat looks very suspicious, research t he inform at ion you have
about t he com pany t o find out why.

St e p 6 . Exam ine t he shareholder's equit y st at em ent . Has t he com pany issued new
shares, or bought som e back? Has t he ret ained earnings account been growing or
shrinking? Why? Are t here signals about t he com pany's long- t erm st rat egy here?

I f you find anyt hing t hat looks very suspicious, research t he inform at ion you have
about t he com pany t o find out why.

St e p 7 . Exam ine t he cash flow st at em ent , which gives inform at ion about t he cash
inflows and out flows from operat ions, financing, and invest ing.

While t he incom e st at em ent provides inform at ion about bot h cash and non- cash
it em s, t he cash flow st at em ent at t em pt s t o reconst ruct t hat inform at ion t o m ake it
clear how cash is obt ained and used by t he business, since t hat is what invest ors
and credit ors really care about .

I f you find anyt hing t hat looks very suspicious, research t he inform at ion you have
about t he com pany t o find out why.

St e p 8 . Calculate financial ratios in each of the following categories, for each year. You
may use the formulas found in your textbook, or other materials you have from your finance
and accounting courses. A summary of some useful ratios appears at the end of this
document.
· Liquidity ratios
· Leverage (or debt) ratios
· Profitability ratios
· Efficiency ratios
· Value ratios

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Graph t he rat ios over t im e, t o find t he t rends in t he rat ios from year t o year. Are
t hey going up or down? I s t hat favorable or unfavorable? This should t rigger furt her
quest ions in your m ind, and help you t o look for t he underlying reasons.

St e p 9 . Obt ain dat a for t he com pany’s key com pet it ors, and dat a about t he
indust ry.

For com pet it or com panies, you can get t he dat a and calculat e t he rat ios in t he sam e
way you did for t he com pany being st udied. You can also get com pany and indust ry
rat ios from t he Quicken.com Evaluat or, Schwab St ock Evaluat or, or ot her locat ions
on m y LI NKS websit e.

Com pare t he rat ios for t he com pet it ors and t he indust ry t o t he com pany being
st udied. I s t he com pany favorable in com parison? Do you have enough inform at ion
t o det erm ine why or why not ? I f you don’t , you m ay need t o do furt her research.

St e p 1 0 . Review t he m arket dat a you have about t he com pany’s st ock price, and
t he price t o earnings ( P/ E) rat io.

Try t o research and underst and t he m ovem ent s in t he st ock price and P/ E over
t im e. Det erm ine in your own m ind whet her t he st ock m arket is react ing favorably t o
t he com pany’s result s and it s st rat egies for doing business in t he fut ure.

Review t he evaluat ions of st ock m arket analyst s. These m ay be found at any

brokerage sit e, or from various locat ions on m y LI NKS websit e.

St e p 1 1 . Review t he dividend payout . Graph t he payout over several years.

Det erm ine whet her t he com pany’s dividend policies are support ing t heir st rat egies.
For exam ple, if t he com pany is at t em pt ing t o grow, are t hey ret aining and
reinvest ing t heir earnings rat her t han dist ribut ing t hem t o invest ors t hrough
dividends? Based on your research int o t he indust ry, are you convinced t hat t he
com pany has sufficient opport unit ies for profit able reinvest m ent and growt h, or
should t hey be dist ribut ing m ore t o t he owners in t he form of dividends? Viewed
anot her way, can you learn anyt hing about t heir long- t erm st rat egies from t he way
t hey pay dividends?

St e p 1 2 . Review all of the data that you have generated. You will probably find that there
is a mix of positive and negative results. Answer the following question:

“ Based on everyt hing I know about t his com pany and it s st rat egies, t he
indust ry and t he com pet it ors, and t he ext ernal fact ors t hat will influence
t he com pany in t he fut ure, do I t hink t his com pany is wort h invest ing in
for t he long t erm ?”

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© 2003 Harvey B. Lerm ack

Fin a n cia l Ra t io An a lysis ( Abr idge d)

Adapt ed from " Financial St at em ent s Analysis,"
Court esy of Professor Philip Russel
Philadelphia Universit y
Philadelphia, PA

A popular way t o analyze t he financial st at em ent s is by com put ing rat ios. A rat io is a
relat ionship bet ween t wo num bers, e.g. rat io of A: B = 1.5: 1 = = > A is 1.5 t im es B.
A rat io by it self m ay have no m eaning. Hence, a given rat io is com pared t o:

Rat ios from previous years for int ernal t rends

Rat ios of ot her firm s in t he sam e indust ry for ext ernal t rends.

Rat io analysis is a diagnost ic t ool t hat helps t o ident ify problem areas and
opport unit ies wit hin a com pany. , we will discuss how t o m easure and int erpret
som e key rat ios.

The m ost frequent ly used rat ios by Financial Analyst s provide insight s int o a firm 's

Liquidit y
Degree of financial leverage or debt
Profit abilit y
Efficiency
Value

A. An a lyzin g Liqu idit y

Liquid asset s are t hose t hat can be convert ed int o cash quickly. The short - t erm
liquidit y rat ios show t he firm ’s abilit y t o m eet it s short - t erm obligat ions. Thus a
higher rat io ( # 1 and # 2) would indicat e a great er liquidit y and lower risk for short -
t erm lenders. The Rules of Thum b for accept able values are: Current Rat io ( 2: 1) ,
Quick Rat io ( 1: 1) .

While high liquidit y m eans t hat t he com pany will not default on it s short - t erm
obligat ions, one should keep in m ind t hat by ret aining asset s as cash, valuable
invest m ent opport unit ies m ay be lost . Obviously, cash by it self does not generat e
any ret urn. Only if it is invest ed will we get fut ure ret urn.

1 . Cu r r e n t Ra t io = Tot al Current Asset s / Tot al Current Liabilit ies

2 . Qu ick Ra t io = ( Tot al Current Asset s - I nvent ories) / Tot al

Current Liabilit ies

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I n t he quick rat io, we subt ract invent ories from t ot al current asset s,
since t hey are t he least liquid am ong t he current asset s

B. An a lyzin g D e bt

Debt rat ios show t he ext ent t o which a firm is relying on debt t o finance it s
invest m ent s and operat ions, and how well it can m anage t he debt obligat ion, i.e.
repaym ent of principal and periodic int erest . I f t he com pany is unable t o pay it s
debt , it will be forced int o bankrupt cy. On t he posit ive side, use of debt is beneficial
as it provides t ax benefit s t o t he firm , and allows it t o exploit business opport unit ies
and grow.

Not e t hat t ot al debt includes short - t erm debt ( bank advances + t he current port ion
of long- t erm debt ) and long- t erm debt ( bonds, leases, not es payable) .

1 . Le ve r a ge Ra t ios

1 a. D e bt t o Equ it y Ra t io = Tot al Debt / Tot al Equit y

This shows t he firm ’s degree of leverage, or it s reliance on ext ernal debt

for financing.

1 b. D e bt t o Asse t s Ra t io = Tot al Debt / Tot al asset s

Som e analyst s prefer t o use t his rat io, which also shows t he com pany’s
reliance on ext ernal sources for financing it s asset s.

I n general, wit h eit her of t he above rat ios, t he lower t he rat io, t he m ore
conservat ive ( and probably safer) t he com pany is. However, if a
com pany is not using debt , it m ay be foregoing invest m ent and growt h
opport unit ies. This is a quest ion t hat can be answered only by furt her
com pany and indust ry research.

A frequent ly cit ed rule of t hum b for m anufact uring and ot her non-
financial indust ries is t hat com panies not finance m ore t han 50% of t heir
capit al t hrough ext ernal debt .

2 . I n t e r e st Cove r a ge ( or Tim e s I n t e r e st Ea r n e d) Ra t io = Earnings

Before I nt erest and Taxes / Annual I nt erest Expense

This shows t he firm ’s abilit y t o cover fixed int erest charges ( on bot h
short - t erm and long- t erm debt ) wit h current earnings. The m argin of
safet y t hat is accept able varies wit hin and across indust ries, and also

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depends on t he earnings hist ory of a firm ( especially t he consist ency of

earnings from period t o period and year t o year) .

3 . Ca sh Flow Cove r a ge = Net Cash Flow / Annual I nt erest Expense

N e t ca sh flow = Net I ncom e + / - non- cash it em s ( e.g. - equit y incom e +

m inorit y int erest in earnings of subsidiary + deferred incom e t axes +
depreciat ion + deplet ion + am ort izat ion expenses)

Since depreciat ion is usually t he largest non- cash it em in m ost

com panies, analyst s oft en approxim at e Net cash flow as being
equivalent t o Net I ncom e + Depreciat ion.

Cash flow is a “ crit ical variable” in assessing a com pany. I f a com pany
is showing st rong profit s but has poor cash flow, you should invest igat e
furt her before passing a favorable opinion on t he com pany. nalyst s
prefer rat io # 3 t o rat io # 2.

C. An a lyzin g Pr ofit a bilit y

Profit abilit y is a relat ive t erm . I t is hard t o say what percent age of profit s represent s
a profit able firm , as profit s depend on such fact ors as t he posit ion of t he com pany
and it s product s on t he com pet it ive life cycle ( for exam ple profit s will be lower in t he
init ial years when invest m ent is high) , on com pet it ive condit ions in t he indust ry, and
on borrowing cost s.

For decision- m aking, we are concerned only wit h t he present value of expect ed
fut ure profit s. Past or current profit s are im port ant only as t hey help us t o ident ify
likely fut ure profit s, by ident ifying hist orical and forecast ed t rends of profit s and
sales.

We want t o know whet her profit s are generally on t he rise; whet her sales st able or
rising; how t he profit s com pare t o t he indust ry average; whet her t he m arket share
of t he com pany is rising, st able or falling; and ot her t hings t hat indicat e t he likely
fut ure profit abilit y of t he firm .

1 . N e t Pr ofit M a r gin = Profit aft er t axes / Sales

2 . Re t u r n on Asse t s ( ROA) = Profit aft er t axes / Tot al Asset s

3 . Re t u r n on Equ it y ( ROE) = Profit aft er t axes / Shareholders’

Equit y ( book value)

4 . Ea r n in gs pe r Com m on sh a r e ( EPS) = ( Profit s aft er t axes -

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Preferred Dividend) / ( # of com m on shares out st anding)

5 . Pa you t Ra t io = Cash Dividends / Net I ncom e

Not e: The t erm s profit s, earnings and net incom e are oft en used
int erchangeably in financial st at em ent s. Be sure t o review t he
st at em ent s t o underst and t heir com ponent s.

D . An a lyzin g Efficie n cy

These rat ios reflect how well t he firm ’s asset s are being m anaged.

The invent ory rat ios shows how fast t he invent ory is being produced and sold.

1 . I n ve n t or y Tu r n ove r = Cost of Goods Sold / Average I nvent ory

This rat io shows how quickly t he invent ory is being t urned over ( or
sold) t o generat e sales. A higher rat io im plies t he firm is m ore efficient
in m anaging invent ories by m inim izing t he invest m ent in invent ories.
Thus a rat io of 12 would m ean t hat t he invent ory t urns over 12 t im es, or
t he average invent ory is sold in a m ont h.

2 . Tot a l Asse t s Tu r n ove r = Sales / Average Tot al Asset s

This rat io shows how m uch sales t he firm is generat ing for every
dollar of invest m ent in asset s. The higher t he rat io, t he bet t er t he
firm is perform ing.

3 . Accou n t s Re ce iva ble Tu r n ove r = Annual Credit Sales /

Average Receivables

4 . Ave r a ge Colle ct ion pe r iod = Average Account s Receivable /

( Tot al Sales / 365)

Rat ios # 3 and # 4 show t he firm ’s efficiency in collect ing cash from
it s credit sales. While a low rat io is good, it could also m ean t hat t he
firm is being very st rict in it s credit policy, which m ay not at t ract
cust om ers.

5 . D a ys in I n ve n t or y = Days in a year / I nvent ory t urnover

Rat io # 5 is referred t o as t he “ shelf- life” i.e. how quickly t he

m anufact ured product is sold off t he shelf. Thus # 5 and # 1 are
relat ed.

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E. Va lu e Ra t ios

Value rat ios show t he “ em bedded value” in st ocks, and are used by invest ors as a
screening device before m aking invest m ent s.

For exam ple, a high P/ E rat io m ay be regarded by som e as being a sign of “ over
pricing” . When t he m arket s are bullish ( opt im ist ic) or if invest or sent im ent is
opt im ist ic about a part icular st ock, t he P/ E rat io will t end t o be high. For exam ple, in
t he lat e 1990s I nt ernet st ocks t ended t o have ext rem ely high P/ E rat ios, despit e
t heir lack of profit s, reflect ing invest ors' opt im ism about t he fut ure prospect s of
t hese com panies. Of course, t he burst of t he bubble showed t hat such confidence
was m isplaced.

On t he ot her hand, a low P/ E rat io m ay show t hat t he com pany has a poor t rack
record. On t he ot her hand, it m ay sim ply be priced t oo low based on it s pot ent ial
earnings. Furt her invest igat ion is required t o det erm ine whet her t he com pany would
t hen provide a good invest m ent opport unit y.

1 . Pr ice To Ea r n in gs Ra t io ( P/ E) = Current Market Price Per

Share / Aft er- t ax Earnings Per Share

2 . D ivide n d Yie ld = Annual Dividends Per Share / Current Market

Price Per Share

F. Use s a n d Lim it a t ion s of Ra t io a n a lysis

Use s

1. To evaluat e perform ance, com pared t o previous years and t o com pet it ors and t he
indust ry

2. To set benchm arks or st andards for perform ance

3. To highlight areas t hat need t o be im proved, or areas t hat offer t he m ost

prom ising fut ure pot ent ial

4. To enable ext ernal part ies, such as invest ors or lenders, t o assess t he
credit wort hiness and profit abilit y of t he firm

Lim it a t ion s

1. There is considerable subj ect ivit y involved, as t here is no “ correct ” num ber for

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t he various rat ios. Furt her, it is hard t o reach a definit e conclusion when som e of
t he rat ios are favorable and som e are unfavorable.

2. Rat ios m ay not be st rict ly com parable for different firm s due t o a variet y of
fact ors such as different account ing pract ices or different fiscal year periods.
Furt herm ore, if a firm is engaged in diverse product lines, it m ay be difficult t o
ident ify t he indust ry cat egory t o which t he firm belongs. Also, j ust because a
specific rat io is bet t er t han t he average does not necessarily m ean t hat t he com pany
is doing well; it is quit e possible rest of t he indust ry is doing very poorly.

3. Rat ios are based on financial st at em ent s t hat reflect t he past and not t he
fut ure. Unless t he rat ios are st able, it m ay be difficult t o m ake reasonable
proj ect ions about fut ure t rends. Furt herm ore, financial st at em ent s such as t he
balance sheet indicat e t he pict ure at “ one point ” in t im e, and t hus m ay not be
represent at ive of longer periods.

4. Financial st at em ent s provide an assessm ent of t he cost s and not value. For
exam ple, fixed asset s are usually shown on t he balance sheet as t he cost of t he
asset s less t heir accum ulat ed depreciat ion, which m ay not reflect t he act ual current
m arket value of t hose asset s.

5. Financial st at em ent s do not include all it em s. For exam ple, it is hard t o put a
value on hum an capit al ( such as m anagem ent expert ise) . And recent account ing
scandals have brought light t o t he ext ent of financing t hat m ay occur off t he balance
sheet .

6. Account ing st andards and pract ices vary am ong count ries, and t hus ham per
m eaningful global com parisons.

Fin a n cia l St a t e m e n t s An a lysis

By Professor Philip Russel

Philadelphia Universit y
Philadelphia, PA

August , 2004

This out line discusses how t he m yriad of inform at ion present ed in t he financial
st at em ent s is used t o facilit at e decision m aking by t he m anagers, invest ors,
regulat ors, com pet it ors, banks, and ot her int erest ed groups. The analysis is
perform ed chiefly by sum m arizing t he financial st at em ent inform at ion int o rat ios.
The out line will assist you in get t ing a general underst anding of t he financial
st at em ent s and ident ifying som e of t he key rat ios.

CONTENTS

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1. I nt roduct ion

2. Annual Reports and Financial Statements

3. What you Need to Know About Financial Statements?

4. Financial Ratio Analysis

5. Uses and Limitations of Ratio Analysis

1 . I n t r odu ct ion

Financial st at em ent analysis involves analyzing t he firm ’s financial st at em ent s t o

ext ract inform at ion t hat can facilit at e decision- m aking. For exam ple, an analysis of
t he financial st at em ent can reveal whet her t he firm will be able t o m eet it s long- t erm
debt com m it m ent , whet her t he firm is financially dist ressed, whet her t he com pany is
using it s physical asset s efficient ly, whet her t he firm has an opt im al financing m ix,
whet her t he firm is generat ing adequat e ret urn for it s shareholders, whet her t he firm
can sust ain it s com pet it ive advant age et c; While t he inform at ion used is hist orical,
t he int ent is clearly t o arrive at recom m endat ions and forecast s for t he fut ure rat her
t han provide a “ pict ure of t he past ” .

The perform ance of a firm can be assessed by com put ing key rat ios and analyzing:
( a) How is t he firm perform ing relat ive t o t he indust ry? ( b) How is t he firm
perform ing relat ive t o t he leading firm s in t heir indust ry? ( c) How does t he current
year perform ance com pare t o t he previous year( s) ? ( d) What are t he variables
driving t he key rat ios? ( e) What are t he linkages am ong t he rat ios? ( f) What do t he
rat ios reveal about t he fut ure prospect s of t he firm for various st akeholders such as
shareholders, bondholders, em ployees, cust om ers et c.? Merely present ing a series of
graphs and figures will be a fut ile exercise. We need t o put t he inform at ion in a
proper cont ext by clearly ident ifying t he purpose of our analysis and ident ifying t he
key dat a driving our analysis.

Financial analysis is perform ed by bot h int ernal m anagem ent and ext ernal groups.
Firm s would perform such an analysis in order t o evaluat e t heir overall current
perform ance, ident ify problem / opport unit y areas, develop budget s and im plem ent
st rat egies for t he fut ure. Ext ernal groups ( such as invest ors, regulat ors, lenders,
suppliers, cust om ers) also perform financial analysis in deciding whet her t o invest in
a part icular firm , whet her t o ext end credit et c. There are several rat ing agencies
( such as Moody’s, St andard & Poors) t hat rout inely perform financial analysis of
firm s in order t o arrive at a com posit e rat ing.

2. Annual Reports and Financial Statements

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The annual report s of com panies t ypically cont ain: ( a) CEO/ President ’s let t er t o
shareholders ( b) Financial st at em ent s ( c) Ot her inform at ion

( a) CEO/ President ’s let t er sum m arizing t he operat ions of last year, explanat ions for
good/ bad perform ance, and a discussion on t he goals for t he im m ediat e and long-
t erm fut ure. I t will be a good idea t o review t he let t er t o shareholders of som e
prom inent com panies. Warren Buffet of Berkshire Hat haway is fam ous for writ ing
t he m ost insight ful let t ers.

( b) Four Financial St at em ent s

The financial st at em ent s ( t ypically published every quart er and annually) are
prepared according t o GAAP and audit ed by “ independent audit ors” . However, as t he
recent corporat e scandals have revealed, t here are definit ely t oo m any gaps/
loopholes in how t he GAAP is im plem ent ed! ! . Nonet heless, financial st at em ent s are
an invaluable source of inform at ion.

B1. Ba la n ce Sh e e t ( also known as t he St at em ent of Financial Posit ion) : This

provides t he value of firm ’s asset s ( what t he firm owns) , liabilit ies ( what t he firm
owes t o out siders) and equit y ( what t he inside shareholders or owners own) on a
part icular dat e. The value of asset s will equal t he value of liabilit ies plus owner’s
equit y ( or A = L + E) . I t em s in t he balance sheet are list ed based on conservat ive
principle i.e. if est im at ing or in doubt of t he act ual value, t he value of asset s is not
be overst at ed and t he value of liabilit ies is not be underst at ed.

What do we see in the balance sheet? Asset s: Current asset s ( ex. cash, m arket able
securit ies, account s receivable, invent ory, prepaid expenses) t hat are m ore liquid
t han t he long- t erm / fixed asset s ( ex. equipm ent , land) , asset s t hat are int angible and
yet valuable ( ex. goodwill, pat ent s, deferred charges) . Liabilit ies could include
current liabilit ies ( ex. bank advances, incom e t ax payable, account s payable, accrued
expenses) , deferred incom e t axes ( difference bet ween t he t ax report ed on t he
incom e st at em ent and t ax report ed on t he t ax ret urn) , Minorit y int erest in subsidiary
com panies ( represent ing out side ownership in subsidiary com panies) , long- t erm debt
( ex. Bonds, capit al leases) . Shareholder’s Equit y includes Share capit al ( par or st at ed
value of shares received at t he t im e of original issue) , Paid- in- capit al ( when shares
are sold for m ore t han t he par or st at ed value) , ret ained earnings/ deficit
( undist ribut ed earnings) , foreign currency t ranslat ion adj ust m ent ( fluct uat ion in t he
value of asset s of foreign subsidiaries due t o changes in exchange rat es) . Equit y is
also expressed as “ residual int erest ” ( E= A- L) . I f E is negat ive, t he firm is t echnically
bankrupt .

Net wort h or Book Value refers t o what is available t o com m on shareholders and is
given by:

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Tot al Asset s – Tot al Liabilit ies – Preferred St ock = Net Wort h

Net wort h divided by num ber of com m on shares out st anding will give us t he
book value per share. The m arket value is equal t o t he price per share t im es t he
num ber of shares out st anding ( also referred t o as t he m arket capit alizat ion of a
com pany) . We can est im at e t he int rinsic value of st ock by using discount ed cash
flow m odels.

All asset s ( except Land) lose t heir value over t im e and t his is account ed for
t hrough depreciat ion ( for fixed asset s) , deplet ion ( for nat ural resources) and
am ort izat ion ( for int angible asset s/ deferred charges) .

Lim it at ions of Balance Sheet : The balance sheet records t he values of asset s and
liabilit ies in t erm s of t heir original cost . This is especially m isleading for fixed asset s
( t hat could have significant ly changed in value) . Also, it is difficult t o value int angible
asset s. Current asset s are less t roublesom e, part ly because of t heir short - t erm
nat ure ( invent ories and m arket able securit ies are list ed at lower of t heir cost or
m arket values) . Liabilit ies are also not biased ( since t hey are generally cont ract ual,
and m arket values will be equal t o t heir book values; For exam ple, if t he com pany
has t aken a loan, t he dollar am ount of loan obligat ion does not change wit h t im e) .
Also, an analyst should pay close at t ent ion t o “ off- balance sheet it em s” .

B2. I n com e St a t e m e n t ( also known as The st at em ent of earnings or profit & loss
st at em ent or t he st at em ent of operat ions) : The incom e st at em ent provides
inform at ion on t he various revenue and expense it em s during a cert ain period. Thus
t his st at em ent shows t he t ot al incom e generat ed in a cert ain period. I t em s in t he
incom e st at em ent are based on accrual principle i.e. t ransact ions ( such as sales) are
recognized when t hey occur and not when act ual cash is received. Furt herm ore, t he
expenses are m at ched t o when t he revenue is recognized and not when t he act ual
paym ent is m ade. The above principle m akes it obvious t hat t here could be wide
discrepancy bet ween a firm ’s revenue and act ual cash flow.

There are several form s of incom e st at em ent . An exam ple of a generic form is as
follows:

Sales Revenue

- Cost of Good Sold

= Gross Profit

- Selling and Adm inist rat ive expenses

- Depreciat ion

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= Earnings Before I nt erest and Taxes ( EBI T)

- int erest expenses ( on bank loans and bonds)

+ int erest incom e

= Earnings before Taxes ( EBT)

- t axes ( current and deferred)

= Earnings aft er Taxes ( EAT)

+ incom e from subsidiaries ( equit y incom e)

+ / - Gains/ Losses from discont inued operat ions

+ / - Gain/ loss on ext raordinary it em s

= Net Earnings

- Preferred St ock Dividends

= Earnings available for com m on shareholders

Limitations of Income Statement : I n finance, t he focus is on “ valuat ion” t hat requires

knowledge of expect ed cash flows rat her t han hist orical earnings. Not e net incom e
does not equal t he act ual cash flow. This is because t he incom e st at em ent report s
revenue/ expenses when t hey are earned/ accrued and not when act ual cash is
received. Furt her, several it em s are subj ect ively det erm ined ( ex. depreciat ion) .
Also, depreciat ion is based on hist orical cost of t he asset . Thus, during periods of
inflat ion, depreciat ion expense will be underst at ed as it is based on hist orical cost
while t he revenues reflect t he current m arket price.... such non- synchronizat ion
leads t o inflat ed earnings. Furt herm ore, a t radit ional incom e st at em ent only records
t ransact ions and not “ opport unit ies” . As Block, Hirt , and Short ( 1998, pp. 34) not e,
“ The econom ist defines incom e as t he change in real wort h t hat occurs bet ween t he
beginning and t he end of a specified t im e period. To t he econom ist , an increase in
t he value of a firm ’s land as a result of a new airport being built on an adj acent
propert y is an increase in t he real wort h of t he firm . I t , t herefore, represent s
incom e. The account ant does not ordinarily em ploy such a broad definit ion of
incom e” .

B3. St a t e m e n t of Re t a in e d Ea r n in gs ( also known as t he St at em ent of changes in

shareholder’s equit y, st at em ent of shareholders’ invest m ent or st at em ent of changes

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in shareholders’ equit y) : I t shows t he balance in ret ained earnings aft er m aking

adj ust m ent s for current profit s and current dividend. I t also shows inform at ion on
t reasury st ock, any new shares issued, t he im pact of exercised opt ions, preferred
st ock det ails and addit ional paid- in- capit al.

B4. Cash Flow Statement: It shows how the company obtained cash and for what purpose they
were used. Thus cash balance at the end =

Cash in t he beginning

+ Net Cash flow from operat ing ( incom e st at em ent cash it em s)

+ Net Cash flow from financing ( ex. proceeds from sale of bonds, repaym ent
of loan, paym ent of dividends)

+ Net Cash flow from invest ing act ivit ies ( ex. Sale/ purchase of asset ) .

( c) Ot her inform at ion in t he annual report

1. Not es t o financial st at em ent s[ 1]

2. The Audit or’s report

3. What You Need to Know About Financial Statements

( Reference: Prent ice Hall Publishers; Aut hors: Unknown, 2003)

As t he Enron fiasco has brought t o light , t here is plent y wrong wit h t he way financial
result s are report ed. Congressional com m it t ees will det erm ine how m uch of Enron’s
t roubles were due t o crim inal act ivit y, and how m uch due t o poor j udgm ent and
loopholes. But " m anaging result s" is an old gam e on Wall St reet . The pros know how
t o read bet ween t he lines t o ident ify shaky financials. They read t he foot not es t o t he
financial st at em ent s carefully for clues t hat will t ell t hem how aggressively t he
com pany is pushing t o use legal, but m isleading GAAP, rules t o t heir lim it .

So here is a list of t hings t o look for in financial st at em ent s t hat will t ell you as m uch
or m ore about t he com pany t han t he act ual report ed result s.

First , Wall St reet is not your friend. Making m oney in a st ock m arket t hat is t rading
flat is a zero sum gam e. For you t o profit , som eone else m ust lose. Be skept ical and
very careful where you get your invest m ent advice. Quest ion t he m ot ives of so-
called expert s. As of yet , t here are no rules ensuring t hat t hey disclose t heir conflict s
of int erest .

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Proform a Earnings Announcem ent s - Many companies now issue Proforma Earnings
Statements that exclude certain expense items as being "extraordinary". It is now a normal part of
business for many firms, particularly tech firms. The trouble is that there are no standards for
reporting Proforma Statements, leaving the door open to manipulating earnings and misleading
investors. Outgoing SEC Chief Economist Lynn Turner says pro forma earnings are effectively "EBS"
earnings--"Everything but the Bad Stuff." A study that compares the unaudited Proforma
Earnings Statements to the NASDAQ 100 companies with the audited statements they filed with
the SEC shows a huge $101billion difference for the first three quarters of 2001.

Frequent Rest ruct uring Charges and Writ e- Downs - As businesses adjust their internal
structure, they incur costs for shutting down one activity and starting another. In a small company,
charges for these activities would occur infrequently, but in a large company, they will be routine.
If charges and write downs for restructurings occur regularly, the company may be classifying
normal business expenses as extraordinary to create the illusion that the core business is more
profitable than it really is.

Reserve reversals - Companies generally establish reserves to cover the costs of restructuring.
Reserves allow management to "store profits" for later use if the reserves are unusually large. At a
later time, they can reverse the reserve for the amount that was not spent and it flows directly to
the bottom line.

Pension Funds - are great sources of earnings manipulation. Boost earnings by under funding
them or by overestimating the investment return of the fund so that current payments will be
lower and profits higher. If the fund does particularly well, pull the excess back into the income
statement to boost profits.

Foot not es t o Financial St at em ent s - St at em ent s can m islead and evade but t hey
m ust com e clean in t he foot not es or face crim inal charges. That ’s why t he pros look
here first . You will learn about risk exposure, debt t hat changes charact er under
cert ain condit ions, t he use of aggressive account ing pract ices and all sort s of ot her
det ails t hat m anagem ent would like t o avoid t elling you.

Sales/ Non- Sales - Look at t he revenue and receivable num bers over several years.
I s t he rat io of receivables t o sales increasing? I f yes, t hen t he com pany is shipping
goods fast er t han cust om ers are paying for t hem . Are deferred revenues dropping?
I f so, t he com pany is living off last year’s sales. I n t he current slowdown, cust om ers
look t o change sales t erm s t o use t he supplier’s m oney as m uch as possible by
acknowledging t he sale as lat e as possible.

Ca sh Flow is Kin g - The pros know t hat it is t oo easy t o m anipulat e earnings

num bers. So t hey focus on cash flow as being a m ore reliable indicat or of
perform ance because t he cash is eit her t here or it isn’t . One expert , t hinks a
com parison of cash flow vs. non- cash revenue could have been an early t ip of t o

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Enron invest ors.

Goodwill - Companies account for the premium over book value that they pay for an acquired
company as goodwill. Under the older accounting rules, companies could write down the payment
for goodwill with a charge against earnings spread out over decades. First Call estimates that,
because of the goodwill accounting change, analyst forecasts for 2002 are about three percentage
points too high. As companies restate prior year earnings to account for the change, earnings will
shrink.

Em ployee St ock Opt ions - 78% of companies with sales over $10 billion compensate
management with stock options. Yet accounting rules do not require the issuing of the option to
be accounted for with an expense. In the wake of Enron, this controversial and questionable rule
may be changed. If so, one expert estimates that many large tech companies may see an annual
reduction in earnings of 1/3.

4 . Fin a n cia l Ra t io An a lysis

A popular way t o analyze t he financial st at em ent s is by com put ing rat ios. A rat io is
a relat ionship bet ween t wo num bers, e.g. rat io of A: B = 30: 10= = > A is 3 t im es B.
A rat io by it self m ay have no m eaning. Hence, a given rat io is com pared t o ( a)
rat ios from previous years - int ernal t rends, or ( b) rat ios of ot her firm s in t he sam e
indust ry - ext ernal t rends. Rat ios are m ore of a diagnost ic t ool t hat helps us t o
ident ify problem areas and opport unit ies wit hin a com pany. I n t his sect ion, we will
discuss how t o m easure and int erpret som e key rat ios. Obviously, since rat io is
sim ply a com parison of t wo variables, t he possibilit ies for num ber of rat ios are
endless! There is no “ one” way of classifying various rat ios so you m ay find different
groupings depending on what t ext or art icle you read. Also, t here are no specific
rules on what is an “ ideal or accept able” num ber for a rat io, alt hough t here are som e
rules of t hum b.

The key rat ios t hat are det erm ined by t he financial analyst s provide insight s on ( a)
liquidit y ( b) degree of financial leverage or debt ( c) profit abilit y ( d) efficiency and ( e)
value.

A. Analyzing Liquidity

Liquid asset s are t hose asset s t hat can be convert ed int o cash quickly. The short -
t erm liquidit y rat ios show t he firm ’s abilit y t o m eet short - t erm obligat ions. Thus a
higher rat io ( # 1 and # 2) would indicat e a great er liquidit y and lower risk for short -
t erm lenders. The Rule of Thum b ( for accept able values) : Current Rat io ( 2: 1) , Quick
Rat io ( 1: 1) While high liquidit y m eans t hat t he com pany will not default on it s short -
t erm obligat ions, not e t hat by ret aining asset s as cash, valuable invest m ent
opport unit ies m ight be lost . Obviously, Cash by it self does not generat e any
ret urn ... only if it is invest ed will we get fut ure ret urn. I n quick rat io, we subt ract

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t he invent ories from t ot al current asset s since t hey are t he least liquid ( am ong t he
current asset s) .

1. Current Rat io = Tot al Current Asset s/ Tot al Current Liabilit ies

2. Quick or Acid- t est Rat io = Tot al Current Asset s - I nvent ories / Tot al
Current Liabilit ies

B. Analyzing Debt

These rat ios show t he ext ent t o which a firm is relying on debt t o finance it s
invest m ent s/ operat ions and how well it can m anage t he debt obligat ion ( i.e.
repaym ent of principal and periodic int erest ) . Obviously, if t he com pany is unable t o
repay it s debt or m ake t im ely paym ent s of int erest , it will be forced int o bankrupt cy.
On t he posit ive side, use of debt is beneficial as it provides valuable t ax benefit s t o
t he firm . Not e t ot al debt should include bot h short - t erm debt ( bank advances +
current port ion of long- t erm debt ) and long- t erm debt ( such as bonds, leases, and
not es payable) . Som e t ext s m ay include only long- t erm debt . Again, what you use
will depend on what your quest ion is.

1. Leverage Ratios

1a Asset - Equit y Rat io or Leverage Rat io= Asset s/ Shareholder’s Equit y

This shows firm ’s reliance on ext ernal debt for financing ( or t he degree of
leverage) . Any num ber above 100% shows t hat t he com pany relies on ext ernal debt
for financing som e of it s asset s. I f t he num ber equals 100% , it im plies t hat t he
asset s are fully financed by t he shareholders.

Som e analyst s t end t o use t he Debt rat io ( given by t ot al Debt / t ot al asset s) or Debt /
Equit y rat io ( given by t ot al long- t erm debt / equit y) . These rat ios also show
com pany’s reliance on ext ernal sources for financing it s asset s. Rat io 1d shows what
proport ion of t he t ot al long- t erm capit al com es from debt .

1b Tot al Debt rat io = Tot al Debt / Tot al asset s

1c. Debt - Equit y Rat io = Tot al Debt / Equit y

1d. Long- t erm Debt t o capit al = Debt / Debt + Equit y

For a lender, m ore im port ant t han t he degree of leverage is t he firm ’s abilit y t o
service t he debt and t his is capt ured in t he following t wo rat ios.

2. I nt erest Coverage Rat io = EBI T/ Annual I nt erest Expense

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This shows t he firm ’s abilit y t o cover fixed int erest charges ( on bot h short -
t erm and long- t erm debt ) . The m argin of safet y t hat is accept able will vary wit hin
and across indust ries, and will also depend on t he earnings hist ory of a firm .

3. Cash Flow Coverage = Net Cash flow/Interest Expense

Net Cash flow is equal t o Net I ncom e + / - non- cash it em s ( - equit y incom e +
m inorit y int erest in earnings of subsidiary + deferred incom e t axes + depreciat ion +
deplet ion + am ort izat ion expenses) . Since depreciat ion is t he biggest dollar t erm ,
oft ent im es analyst s would approxim at e Net cash flow as being equivalent t o EBI T +
depreciat ion.

Cash flow is a “ crit ical variable” in assessing a com pany. I f a com pany is showing
st rong profit s but has poor cash flow, you should invest igat e furt her before passing a
favorable opinion on t he com pany. Financial analyst s prefer using rat io # 3 t o rat io
# 2, alt hough rat io # 2 is m ore widely report ed.

C. Analyzing Sales and Profitability

Profit abilit y is a relat ive t erm . I t is hard t o say “ what % of profit s” represent s a
profit able firm as t he profit s will depend on t he product life cycle ( for exam ple profit s
will be lower in t he init ial years) , com pet it ive condit ions in t he m arket , borrowing
cost s, expense m anagem ent et c. Profit s can also be analyzed using t he fram ework
of CVP ( cost - volum e- prices) . Analyst s will be int erest ed in t he ( hist orical and
forecast ed) “ t rend” of sales/ expenses/ profit s … are t he profit s generally on t he rise,
are t he sales st able or rising, how do t he profit s com pare t o t he indust ry average, is
t he m arket share of t he com pany rising/ st able/ falling? Are t he expenses rising,
st able or falling? The set of rat ios here include som e of t he t radit ional earnings
based perform ance m easures such as ROS, ROA, ROI , and ROE. For a bet t er
underst anding of growt h rat es, it will be useful t o know t he “ real growt h rat e” as
opposed t o “ nom inal growt h rat e” . For exam ple, it is quit e possible t hat t he sales
growt h rat e figures are im pressive due t o inflat ion ( rat her t han an increase in t he
num ber of it em s sold) . This is part icularly useful if we are dealing wit h high inflat ion
period or conduct ing an ext ending t im e series analysis.

1. Sales Growt h Rat e = { ( Current year sales – last year sales) / last
year sales} * 100

2. Expense analysis = Various expenses / Sales

3. Gross Margin/ Sales = Gross Profit / Tot al Sales

4. Operat ing Profit / Sales = Operat ing Profit / Net Sales

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5. EBI T/ Sales = EBI T/ Net Sales

6. Return on Sales (ROS) or net profit ratio = Net Income/Net Sales

7. Ret urn on I nvest m ent ( ROI ) = Net I ncom e/ Tot al Asset s

8. Return on Assets (ROA) = Net Income/Total Assets

9. Return on Equity (ROE) = EAT/ Shareholders’ Equit y

10. Payout rat io = Cash Dividends/ Net I ncom e

11. Ret ent ion rat io = Ret ained Earnings/ Net I ncom e

12. Sust ainable growt h rat e ( SGR) = ROE * Ret ent ion Rat io

I t is useful t o disaggregat e t he ROE figure int o t hree elem ent s as follows t o get a
bet t er insight

ROE = { Net I ncom e/ Sales} * { Sales/ Asset s} * ( Asset s/ Equit y)

The above form ulat ion clearly shows t hat if m anagem ent wishes t o im prove t heir
ROE, t hey need t o im prove profit abilit y, efficient ly use t he asset s, and opt im ize t he
use of debt in t heir capit al st ruct ure. Thus t wo com panies wit h sim ilar profit abilit y
m ay have different ROEs depending on t heir degree of financial leverage. I f we
com bine t his wit h rat io # 10, we can see t hat a firm ’s growt h rat e will depend on all
of t hese fact ors plus t heir divided policy. Thus it covers t he t hree m ain financial
decisions in any corporat ion: invest m ent decision, operat ing decision and financing
decision.

SGR shows how m uch t he com pany will grow in t he fut ure if som e of t he key rat ios
rem ain t he sam e as in previous years. I t is useful t o disaggregat e t he sust ainable
growt h rat e as follows.

SGR = f( Profit abilit y, Asset Efficiency, Leverage, Dividend policy)

= Ret urn on Sales * Asset t urnover rat io * Leverage * Ret ent ion rat io

= ( Net incom e/ sales) * ( sales/ asset s) * ( asset s/ equit y) * ( RE/ net incom e)

D . An a lyzin g Efficie n cy

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These rat ios reflect how well t he firm ’s asset s are being m anaged. The invent ory
rat ios show how fast t he invent ory is being produced and sold. Rat io # 1 shows how
quickly t he invent ory is being t urned over ( or sold) t o generat e sales ... higher rat io
im plies t he firm is m ore efficient in m anaging invent ories by m inim izing t he
invest m ent in invent ories. Thus a rat io of 12 would m ean t hat t he invent ory t urns
over 12 t im es or t he average invent ory is sold in a m ont h. Obviously, t his rat io
should be higher for WAWA ( selling perishable goods) relat ive t o a VW car dealer.
Som e t ext s prefer t o use “ ending invent ory” rat her t han “ average invent ory” . High
rat io by it self does not m ean high level of efficiency as high rat io could also m ean
short ages. Ensure t hat t here has been no change in invent ory report ing policy ( LI FO,
FI FO) during t he analysis period. Rat io # 2 is referred t o as t he “ shelf- life” i.e. how
m any days t he invent ory was held in t he shelf. Rat io # 3 shows how m uch sales t he
firm is generat ing for every dollar of invest m ent in asset s … nat urally, higher t he
bet t er. However, not e t hat t his rat io is biased ( as asset s are list ed at hist orical cost s
while sales are based on current prices) . Rat ios # 4 and # 5 show t he firm ’s
efficiency in collect ing from credit sales. While a low rat io is good it could also m ean
t hat t he firm is being very st rict in it s credit policy, which m ay drive away som e
cust om ers. Rat ios # 6 and 7 focus on efficiency in m aking paym ent s. Com bining
invent ories, account s receivable and account s payable we get rat io # 8, which shows
t he financing period t o fund working capit al needs. Longer t he period, great er t he
short - t erm liquidit y risk.

1. I nvent ory Turnover = Cost of Goods Sold/ Average I nvent ory

2. Days in I nvent ory = ( Average I nvent ory/ Cost of Sales) * 365

3. Asset s t urnover = Net Sales/ Tot al Asset s

4. Receivables Turnover = Credit Sales/ Account s Receivables

5. Average Collect ion period = ( Account s Receivable/ Net Sales) * 365

6. Account s Payable t urnover = Purchases/ Account s Payable

7. Days AP out st anding = ( Account s Payable/ Cost of Sales) * 365

8. Financing Period = Average Collect ion period + days in invent ory – days
AP out st anding

E. An a lyzin g Va lu e

Earnings per share ( EPS) is widely report ed alt hough it is now less closely followed
( aft er academ ic t heory insight s int o t he drawback of EPS and im port ance of cash
flow based m easures) . SEC requires t hat t he com pany report bot h basic and dilut ed

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EPS. Basic EPS uses t he act ual num ber of shares current ly out st anding in t he m arket
while dilut ed EPS uses current ly out st anding shares + all pot ent ial shares ( due t o
convert ibilit y of debt or preferred st ock as well as exercise of st ock opt ions, right s
and warrant s) . Dividend yield, while widely report ed, m ay not cont ain m uch useful
inform at ion by it self ( especially when com paring across firm s) since dividend policies
vary across firm s. Furt herm ore, price appreciat ion ( as opposed t o dividends) is t he
m ore im port ant source of yield for shareholders.

Value rat ios such as PE rat io show t he “ em bedded value” in st ocks and are used by
t he invest ors as a screening device before m aking t heir invest m ent . For exam ple, a
high P/ E rat io m ay be regarded by som e as being a sign of “ over pricing” . When t he
m arket s are bullish or if t he invest or sent im ent is opt im ist ic about a part icular st ock,
t he P/ E rat io will t end t o be high indicat ing t hat invest ors are willing t o pay a high
price for com pany’s earnings. For exam ple, in lat e 1990s int ernet st ocks had
ext rem ely high P/ E rat ios ( despit e t heir lack of earnings) reflect ing invest or’s
opt im ism about t he fut ure prospect s of t hese com panies. Of course, t he burst of t he
bubble showed t hat such confidence was m isplaced. PS rat io can be com bined wit h
PE rat io t o analyze a com pany. Rat io # 7 is useful for valuing com panies such as
int ernet services or cable services t hat rely prim arily on m em bers t o generat e
incom e. Thus an assessm ent of m em bers ( t ot al m em bers, current and fut ure
expect ed growt h rat e, and average spending by m em ber) can provide useful
guideline in valuing such com panies ( especially when planning acquisit ions) .

1. Earnings per Com m on share ( EPS) = ( Net Earnings - Preferred Dividend)

# of shares out st anding

2. Earnings Yield = 1/ EPS

3. Cash flow per Share ( CPS) = Net Cash Flows/ # of shares

out st anding

4. Dividend Yield = Annual Dividend / Current Market price

5. Price- earning Rat io ( PE) = Market Price per share / EPS

6. Price- Sales Rat io ( PS) = Market price per share/ Sales per share

7. Mem bership Value = # of m em bers * value per m em ber

8. Free CF per share = ( Net Cash flow from Operat ions – Capit al
Expendit ure) / # of shares

9. Tot al Shareholder Ret urn ( TSR) = ( Ending Price + Dividend – Beginning

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Price) / Beginning Price

10. EVA = EAT – Cost of Financing ( t hat is, Net Capit al Asset s Em ployed *
WACC)

5 Uses and Limitations of Ratio analysis

Uses

1. To evaluat e perform ance ( com pared t o previous years & peers) ;

2. To set benchm arks or st andards for perform ance;

3. To highlight areas t hat need t o be im proved or highlight areas t hat offer

t he m ost prom ising fut ure pot ent ial;

4. To enable ext ernal part ies ( such as invest ors/ lenders) in assessing t he
credit wort hiness/ profit abilit y of t he firm .

Lim it a t ion s

1. There is considerable subj ect ivit y involved as t here is no t heory as t o what

should be t he “ right ” num ber for t he various rat ios. Furt her, it is hard t o reach
a definit e conclusion when som e of t he rat ios are favorable and som e are
unfavorable.

2. Rat ios m ay not be st rict ly com parable for different firm s due t o a variet y of
fact ors such as different account ing pract ices, different fiscal year.
Furt herm ore, if a firm is engaged in diverse product lines it is difficult t o
ident ify t he indust ry cat egory t o which t he firm belongs. Also, j ust because a
specific rat io is bet t er t han t he average does not necessarily m ean t hat t he
com pany is doing well ( it is quit e possible rest of t he indust ry is doing very
poorly)

3. Rat ios are based on financial st at em ent s t hat reflect t he past and not t he
fut ure. Unless t he rat ios are st able, one cannot m ake reasonable proj ect ions
about t he fut ure t rend.

4. Financial st at em ent s provide an assessm ent of t he cost s and not value.

For exam ple, t he m arket value of it em s m ay be very different from t he cost
figure given in t he balance sheet .

5. Financial st at em ent s do not include all it em s. For exam ple, it is hard t o

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put a value on hum an capit al ( such as m anagem ent expert ise) .

6. Account ing st andards and pract ices vary across count ries and t hus ham per
m eaningful global com parisons.

7. Managem ent decision m aking is a dynam ic process in a const ant ly

changing environm ent while rat io analysis is a st at ic analysis based on
hist orical dat a.

8. The linkage am ong various rat ios is not readily obvious.

Le a r n by D oin g: Review t he websit e of any publicly t raded com pany and

review t he annual report and see if you can underst and t he various it em s on
t he financial st at em ent s. Next , com put e t he various rat ios based on t his
out line and int erpret t hem .
Som e good sources of inform at ion on financial st at em ent s

o On reading annual report : ht t p: / / www.ibm .com / invest or/ financialguide/

gs/ gs3b.pht m l

o On reading financial st at em ent s: ht t p: / / www.ibm .com / invest or/

financialguide/

o Our library also has som e excellent links t o dat abases: ht t p: / / www.
philau.edu/ library/

[ 1] Som e of t he it em s com m only found in t he not es are: An explanat ion of t he

account ing m et hods used for depreciat ion, off- balance sheet it em s ( such as
derivat ive cont ract s) , det ails on leases, im pact of divest it ure and acquisit ion on t he
financial st at em ent s.

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