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CHAPTER 5:
FSA TECHNIQUES

 Common‐size analysis

 Ratio analysis

 Dupont analysis

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 Common-size statements normalize balance sheets and income

statements and allow the analyst to more easily compare performance
across firms and for a single firm over time.

 Vertical analysis compares each amount with a base amount selected

from the same year.

 A vertical common-size balance sheet expresses all balance sheet items as a

percentage of total assets.

 A vertical common-size income statement expresses all income statement items as

a percentage of sales.

 Horizontal analysis compares each amount with a base amount for a

selected base year. 5

East West
Cash $2,300 $1,500
Account receivable 3,700 1,100
Inventory 5,500 900
Current assets 11,500 3,500
Plant and equipment 32,500 11,750
Goodwill 1,750 0
Total assets $45,750 $15,250

Current liabilities $10,100 $1,000

Long-term debt 26,500 5,100
Total liabilities 36,600 6,100
Equity 9,150 9,150
Total liabilities & equity $45,750 $15,250
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East West
Cash 5% 10%
Account receivable 8% 7%
Inventory 12% 6%
Current assets 25% 23%
Plant and equipment 71% 77%
Goodwill 4% 0%
Total assets 100% 100%

Current liabilities 22% 7%

Long-term debt 58% 33%
Total liabilities 80% 40%
Equity 20% 60%
Total liabilities & equity 100% 100%
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North Co. South Co.

Revenue $75,000,000 $3,500,000

Cost of goods sold 52,500,000 700,000

Gross profit $22,500,000 $2,800,000

Administrative expense 11,250,000 525,000

Research expense 3,750,000 700,000

Operating profit $7,500,000 1,575,000

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North Co. South Co.

Revenue 100% 100%

Cost of goods sold 70% 20%

Gross profit 30% 80%

Administrative expense 15% 15%

Research expense 5% 20%

Operating profit 10% 45%

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 Ratios are useful tools for expressing relationships among data

that can be used for internal comparisons across firms. They are
often most useful in identifying questions that need to be
answered, rather than answering question directly.

 Ratios can be used to do the following:

 Project future earnings and cash flow.
 Evaluate a firm’s flexibility.
 Assess management’s performance.
 Evaluate changes in the firm and industry over time.

 Compare the firm with industry competitors.

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 Financial ratios are not useful when viewed in isolation.

 Comparisons with other companies are made more difficult by

different accounting treatments.

 It is difficult to find comparable industry ratios when analyzing

companies that operate in multiple industries.

 Conclusions cannot be made by calculating a single ratio. All

ratios must be viewed relative to one another.

 Determining the target or comparison value for a ratio is difficult,

requiring some range of acceptable values.

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1. Liquidity ratios refers to the ability to pay short-term obligations as

they come due.
2. Leverage ratios (solvency ratios) give the analyst information on
the firm’s financial leverage and ability to meet its longer-term
obligation.
3. Activity ratios refer to asset utilization or turnover ratios.
4. Profitability ratios provide information on how well the company
generates operating profits and net profits from its sales.
5. Market ratios are used in comparing the relative valuation of
companies.
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• The higher current ratio, the more likely it is that the

company will be able to pay its short-term bills.

• A current ratio of less than 1 means that the company has negative

working capital and is probably facing a liquidity crisis.

• Working capital = Current assets – current liabilities

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• The higher quick ratio, the more likely it is that the company will be

able to pay its short-term bills.

• Marketable securities are short-term debt instruments, typically

liquid and of good credit quality.

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• The higher cash ratio, the more likely it is that the company
will be able to pay its short-term bills.

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 Cash conversion cycle is the length of time it takes to turn

the firm’s cash investment in inventory back into cash.
𝐶𝐶𝐶 = 𝑑𝑎𝑦𝑠 𝑠𝑎𝑙𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
+ 𝑑𝑎𝑦𝑠 𝑜𝑓 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑜𝑛 ℎ𝑎𝑛𝑑
− 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑜𝑓 𝑝𝑎𝑦𝑎𝑏𝑙𝑒

 High cash conversion cycles are considered undesirable.

A CCC that is too high implies that the company has an
excessive amount of capital investment in the sale
process.
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 Increases and decreases in this ratio suggest a greater

or lesser reliance on debt as a source of financing.

 Total debt = Long-term debt + interest bearing short-

term debt.

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 Capital equals all short-term and long-term debt plus

preferred stock and equity.

 Increases and decreases in this ratio suggest a greater

or lesser reliance on debt as a source of financing.

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 Average means the average of the values at the

beginning and at the end of the period.

 Greater use of debt financing increases financial

leverage.

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 The lower this ratio, the more likely it is that the firm will

have difficulty meeting its debt payments.

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Ratio Formulation

Receivables turnover Annual sales/average receivables

Payables turnover Purchases/ average trade payables

Inventory turnover Cost of good sold/average

inventory

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Days of sales outstanding 365/receivable turnover

Number of days payables 365/payables turnover ratio

Days of inventory on hand 365/inventory turnover

Total asset turnover Revenue/ average total assets

Fixed asset turnover Revenue/average net fixed assets

Working capital turnover Revenue/average working capital

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Price/EPS

Price/Book value

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P/E:
P/E = Price/EPS

 If a company has a higher PE in comparison with its peers, it is

expected to have an optimistic prospect in the future. A company
who has a high PE ratio should be eventually deserving of
market’s expectation by its rapid growth in operating profit. If it
fails to meet the market’s expectation, its stock price will fall.

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P/B show the relationship between stock price and book

value per share

P/B = Stock price/Book value per share

BVPS =Equity/number of share outstanding

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 Original approach
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑅𝑂𝐸 =
𝑒𝑞𝑢𝑖𝑡𝑦

= × ×

Net profit margin Leverage ratio

Assets turnover

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Extended Dupont Analysis

𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝐸𝐵𝑇 𝐸𝐵𝐼𝑇 𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠

𝑅𝑂𝐸 = × × × ×
𝐸𝐵𝑇 𝐸𝐵𝐼𝑇 𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦

Tax burden Interest burden

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