CHAPTER 3

Analysis of Financial Statements

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Financial statement analysis involves
(1) comparing a firm’s performance with that of other firms in the same industry and
(2) evaluating trends in the firm’s financial position over time.

Managers use financial analysis to identify situations needing attention, potential lenders
use financial analysis to determine whether a company is creditworthy, and
stockholders use financial analysis to help predict future earnings, dividends, and free
cash flow.

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 Intrinsic Value,Free Cash Flow,
and Financial Statements

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 Financial Analysis
When we perform a financial analysis, we conduct the following steps.

1. Gather Data

2. Examine the Statement of Cash Flows

3. Calculate and Examine the Return on Invested Capital and Free Cash Flow

4. Begin Ratio Analysis

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 Examine the Statement of Cash Flows
• Some financial analysis can be done with virtually no calculations.

• For example, we always look to the statement of cash flows first, particularly the net cash provided by operating activities.
Downward trends or negative net cash flow from operations almost always indicates problems.

• The statement of cash flows section on investing activities shows whether the company has made a big acquisition, especially
when compared with prior years’ net cash flows from investing activities.

• A quick look at the section on financing activities also reveals whether a company is issuing debt or buying back stock; in other
words, is the company raising capital from investors or returning it to them?

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Calculate and Examine the Return on Invested
Capital and Free Cash Flow

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Calculate and Examine the Return on Invested
Capital and Free Cash Flow

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 Begin Ratio Analysis
• Financial ratios are designed to extract important information that might not be obvious simply from examining a firm’s financial
statements. For example, suppose Firm A owes $5 million in debt while Firm B owes $50 million. Which company is in a
stronger financial position?

• It is impossible to answer this question without first standardizing each firm’s debt relative to total assets and earnings. Such
standardized comparisons are provided through ratio analysis.

• We will calculate the 2019 financial ratios for MicroDrive Inc. using data from the balance sheets and income statements given
in Figure 3-1; dollar amounts are in millions. Recall from Chapter 2 that MicroDrive reports only net plant, property, and
equipment (PP&E) on its balance sheets instead of separately reporting cumulative depreciation and cumulative PP&E.

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 Profitability Ratio
• Profitability ratios go on to show the combined effects of liquidity, asset management, and debt on operating and financial
results.

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 Net Profit Margin

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 Figure 3-1 MicroDrive Inc.: Balance Sheets and Income Statements for
Years Ending December 31 (Millions of Dollars, Except for Per Share Data)

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 Net Profit Margin

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 Net Profit Margin

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 Net Profit Margin

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Basic Earning Power (BEP ) Ratio

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 Return on Total Assets

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 Return on Common Equity

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 Asset Management Ratio

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Evaluating Total Assets: The Total Assets
Turnover Ratio

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Evaluating Fixed Assets: The Fixed Assets Turnover Ratio

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Evaluating Receivable: The Days Sales Outstanding

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Evaluating Inventory : The Inventory Turnover Ratio

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 Liquidity Ratios

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 The Current Ratio

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 The Quick Ratio

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 Debt Management Ratio

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How the Firm is Financed: Leverage Ratios

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How the Firm is Financed: Leverage Ratios

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How the Firm is Financed: Leverage Ratios

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How the Firm is Financed: Leverage Ratios

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How the Firm is Financed: Leverage Ratios

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Ability to Pay Interest: Times Interest-Earned Ratio

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Ability to Service Debt: EBITDA Coverage Ratio

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Ability to Service Dent: EBITDA Coverage Ratio

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 Market Value Ratios

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 Price/Earnings Ratio

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Price/Free Cash Flow (P/FCF) Ratio

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 Market/Book Ratio

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 Market/Book Ratio

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 Market/Book Ratio

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Table 3-1 MicroDrive Inc.: Summary of Selected
Financial Ratios (Millions of Dollars)

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Comparative Ratios and Benchmarking

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Uses and Limitations of Ratio Analysis

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 Looking Beyond the Numbers

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