MODULE: FINANCIAL MANAGEMENT

ACADEMIC YEAR: 2021-2022

INSTRUCTOR: MSc. Ngo Nguyen Bao Tran
LESSON 3: Financial Statement Analysis (Part 1)

1. Financial Statements: (read powerpoint slides)

2. A Possible Framework for Analysis:

(Horne et al., 2008, p.134)

Analysis of the funds needs of the firm:
- The trend and seasonal component of a firm’s funds requirements:
+ How much funding will be required in the future?
+ What is the nature of these needs?
+ Is there a seasonal component to the needs?
- Analytical tools used to answer these questions include: sources and uses of funds
statements, statements of cash flow, and cash budgets
Analysis of the financial condition and profitability of the firm:
- The tools used to assess the financial condition and performance of the firm are
financial ratios
Analysis of the business risk of the firm:
- Business risk relates to the risk inherent in the operations of the firm, e.g.:
 + A machine tool company: is in highly volatile lines of business and/or may be
operating close to their break-even point.
+ A profitable electric utility: is in very stable lines of business and/or find themselves
operating far from their break-even point.
=> The analyst needs to estimate the degree of business risk of the firm being analysed
=> All three of these factors should be used in determining the financial needs of the firm:
The greater the funds requirements => the greater the total financing
- the nature of the needs for funds influences the type of financing that should be used:
+ If there is a seasonal component to the business => the type of financing that should
be used (company uses short-term financing/bank loans)
- firm’s level of business risk => the type of financing that should be used:
+ the greater the business risk => the less desirable debt financing.
Because equity financing is safer in that there is no contractual obligation to pay
interest and principal, as there is with debt => A firm with a high degree of business risk is
generally ill advised to take on considerable financial risk as well
- The financial condition and performance of the firm => the type of financing that
should be used:
+ The greater the firm’s liquidity => the stronger the overall financial condition
+ The greater the profitability of the firm > the more risky the type of financing that
can be incurred. That is, debt financing becomes more attractive with improvements in
liquidity, financial condition, and profitability.

2.1. Use of Financial Ratios:

- To evaluate a firm’s financial condition and performance, the financial analyst needs to
perform “checkups” on various aspects of a firm’s financial health
- To get a comparison that may prove more useful than the raw numbers by themselves
e.g.: suppose that a firm had a net profit figure this year of $1 million. That looks pretty
profitable. But what if the firm has $200 million invested in total assets? Dividing net profit by
total assets, we get $1M/$200M = 0.005, the firm’s return on total assets. The 0.005 figure
means that each dollar of assets invested in the firm earned a one-half percent return
2.1.1. Internal Comparisons:
- the analyst can compare a present ratio with past and expected future ratios for the
same company
  the analyst can study the composition of change and determine whether there has been
an improvement or deterioration in the firm’s financial condition and performance over time.
2.1.2. External Comparisons and Sources of Industry Ratios:
- the analyst can compare the ratios of one firm with those of similar firms or with
industry averages at the same point in time
 + gives insight into the relative financial condition and performance of the firm.
+ helps us identify any significant deviations from any applicable industry average (or
standard).
2.2. Types of Financial Ratios:

(Horne et al., 2008, p.138)

3. Balance Sheet Ratios:
3.1. Liquidity Ratios
- are used to measure a firm’s ability to meet short-term obligations.
 - compare short-term obligations with short-term (or current) resources available to
meet these obligations.
 much insight can be obtained into the present cash solvency of the firm and the firm’s
ability to remain solvent in the event of adversity
3.1.1. Current Ratio:
- shows a firm’s ability to cover its current liabilities with its current assets.
- Formula:
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
- the higher the current ratio, the greater the ability of the firm to pay its bills
- e.g.: For Aldine Manufacturing Company (Table 6.1, Horne et al., 2008, p.130), this
ratio for year-end 20X2 is:
$2,241,000
$823,000
= 2.72
 The company has the current ratio as 2.72 which means that the company has $2.72 of
current assets for every $1 of current liabilities
3.1.2. Acid-Test (or Quick) Ratio
- shows a firm’s ability to cover its current liabilities with its most liquid (quick) current
assets.
- Formula:
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔 − 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒊𝒆𝒔
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
- This ratio is the same as the current ratio except that it concentrates primarily on the
more liquid current assets – cash, marketable securities, and receivables – in relation to
current obligations.
- e.g.: For Aldine Manufacturing Company (Table 6.1, Horne et al., 2008, p.130), this
ratio for year-end 20X2 is:
$2,241,000−1,329,000
$823,000
= 1.11
 The company has the current ratio as 1.11 which means that the company has $1.11 of
cash and receivables for every $1 of current liabilities

Summary of Aldine’s Liquidity (So Far). Comparisons of Aldine’s current and acid-test
ratios with medians for the industry are favorable. However, these ratios don’t tell us
whether accounts receivable and/or inventory might actually be too high. If they are, this
should affect our initial favorable impression of the firm’s liquidity. Thus we need to go
behind the ratios and examine the size, composition, and quality of these two important
current assets.
3.2. Financial Leverage (Debt) Ratios
- Ratios that show the extent to which the firm is financed by debt
3.2.1. Debt-to-Equity Ratio
- a measure of the degree to which a company is financing its operations through debt
versus wholly-owned funds
- Creditors would generally like this ratio to be low.
- The ratio of debt to equity will vary according to the nature of the business and the
variability of cash flows.
e.g.: An electric utility, with very stable cash flows, will usually have a higher debt-to-
equity ratio than will a machine tool company, whose cash flows are far less stable
- The lower the ratio, the higher the level of the firm’s financing that is being provided
by shareholders, and the larger the creditor cushion (margin of protection) in the event of
shrinking asset values or outright losses.
- A comparison of the debt-to-equity ratio for a given company with those of similar
firms gives us a general indication of the creditworthiness and financial risk of the firm.
- Formula:
𝑻𝒐𝒕𝒂𝒍 𝑫𝒆𝒃𝒕𝒔
𝑶𝒘𝒏𝒆𝒓 𝑬𝒒𝒖𝒊𝒕𝒚
- e.g.: For Aldine Manufacturing Company (Table 6.1, Horne et al., 2008, p.130), this
ratio for year-end 20X2 is:
$1,454,000
$1,796,000
= 0.81
debt - to - equity
 The company has the current ratio as 0.81 which means that creditors are providing 81
cents of financing for each $1 being provided by shareholders.
3.2.2. Debt-to-Total Assets Ratio
- showing the percentage of the firm’s assets that is supported by debt financing
- the higher the debt-to-total-assets ratio, the greater the financial risk; the lower this
ratio, the lower the financial risk
- Formula:
 𝑻𝒐𝒕𝒂𝒍 𝑫𝒆𝒃𝒕𝒔
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔
- e.g.: For Aldine Manufacturing Company (Table 6.1, Horne et al., 2008, p.130), this
ratio for year-end 20X2 is:
$1,454,000
$3,250,000
= 0.45
debt-to assets
 The company has the current ratio as 0.45 which means that 45% of the firm’s assets
are financed with debt and the remaining 55% of the financing comes from
shareholders’ equity
3.2.3. Long-term-debt-to-total-capitalization ratio
- the relative importance of long-term debt to the capital structure (long-term financing)
of the firm
- Note: the total capitalization represents all long-term debt and shareholders’ equity
- Formula:
𝑳𝒐𝒏𝒈 − 𝒕𝒆𝒓𝒎 𝑫𝒆𝒃𝒕𝒔
𝑻𝒐𝒕𝒂𝒍 𝑪𝒂𝒑𝒊𝒕𝒂𝒍𝒊𝒛𝒂𝒕𝒊𝒐𝒏
- e.g.: For Aldine Manufacturing Company (Table 6.1, Horne et al., 2008, p.130), this
ratio for year-end 20X2 is:
$631,000
$2,427,000
= 0.26
 The company has the current ratio as 0.26 which means that 26% of the firm’s total
capitalization are financed with long-term debt