CHAPTER 4

FINANCIAL STATEMENT ANALYSIS

OUTLINE …..

FINANCIAL ANALYSIS
 Ratio Analysis
A. Liquidity ratios
B. Activity ratios
C. Leverage ratios
D. Profitability ratios
E. Market value ratios
Vertical Analysis
Horizontal Analysis

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 FINANCIAL ANALYSIS
Financial analysis is an evaluation of both a
firm’s past financial performance and its
prospects for the future.
Typically, it involves an analysis of the firm’s
financial statements and its flow of funds.
Financial statement analysis involves the
calculation of various ratios. It is used by such
interested parties such as :
 creditors,
 Investors, and
 managers to determine the firm’s financial position
relative to that of others.
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 Objectives of Analysis for Creditors
A creditor is ultimately concerned with the ability of an
existing or prospective borrower to make interest and
principal payments on borrowed funds.
Questions raised in a credit analysis should include:
 What is the borrowing cause?
 What is the firm’s capital structure?
 What will be the source of debt repayment?

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Objectives of Analysis for Investors
An investor attempts to arrive at an estimation of a
company’s future earnings stream in order to attach a
value to the securities being considered for purchase
or liquidation.
The investment analyst poses questions such as:
 What is the company’s performance record?
 What are the future expectations?
 How much risk is inherent in the existing capital
structure?
 What are expected returns?
 What is firm’s competitive position?

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Objectives for Analysis for Management
 Management relates to all questions raised by
creditors and investors.
 Management must also consider its employees, the
general public, regulators, and the financial press.
 Looks to financial statement data to determine
 How well has the firm performed and why?
 What operating areas have contributed to
success and which have not?
 What are strengths and weaknesses of the
company’s financial position?
 What changes should be implemented to
improve future performance?

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 FINANCIAL STATMENT ANALYSIS
The financial statements of an enterprise
present the summarized data of its assets,
liabilities, and equities in the balance sheet
and its revenue and expenses in the income
statement.
The financial statements are sources of data
for financial statement analysis
Balance Sheet
Income Statement
Statement of Retained Earnings
Statement of Cash Flows
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 Financial Analysis …
Various measuring instruments may be used to
evaluate the financial health of a business, including
Horizontal, Vertical, and Ratio analyses.
financial analyst uses the ratios to make two types of
comparisons:
(a) Industry Comparison:- The ratios of a firm are
compared with those of similar firms or with industry
averages or norms to determine how the company is
faring relative to its competitors.

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(b) Trend analysis:-A firm’s present ratio is
compared with its past and expected future
ratios to determine whether the company’s
financial condition is improving or deteriorating
over time.

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 RATIO ANALYSIS
 It is essential to compare figures from different
categories.
 Ratios are tools, and their value is limited when
used alone. The more tools used, the better the
analysis.
 So to, we need to be skilled with the financial tools
we use.
 There are many ratios that an analyst can use,
depending upon what the user considers to be
important relationships.

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 RATIO TYPES
Financial ratios can be classified into five
groups:
A. Liquidity ratios
B. Activity ratios
C. Leverage ratios
D. Profitability ratios
E. Market value ratios

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 A. Liquidity Ratios
Liquidity ratios measure a firm’s ability to
meet cash needs as they arise-ability of a firm
to meet near-term demands for cash
Should include analysis of selected financial ratios
and a comparison with industry averages
Analyzing corporate liquidity is especially important
to creditors.
 Liquidity ratios include:
 Current ratio
 Quick or acid-test ratio

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Current Ratio

Measures the ability of a firm to meet debt

requirements as they come due-Short-Term
Solvency.
Liquidity of short term solvency means ability of
the business to pay its short-term liabilities.

Current Assets
Current liabilities

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Example

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Example

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 CR=Current asset/current liabilities
=$1000/310=3.2, industry average is 4.2
Is the current ratio of Micro Drive good or bad? Sometimes the answer
depends on who is asking the question.
For example, suppose a supplier is trying to decide whether to extend
credit to Micro Drive.
In general, creditors like to see a high current ratio.
If a company is getting into financial difficulty, it will begin paying its bills
(accounts payable) more slowly, borrowing from its bank, and so on, so
its current liabilities will be increasing.
If current liabilities are rising faster than current assets then the current
ratio will fall, and this could spell trouble.
Because the current ratio provides the best single indicator of the
extent to which the claims of short-term creditors are covered by assets
that are expected to be converted to cash fairly quickly, it is the most
commonly used measure of short-term solvency.

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Now consider the current ratio from the perspective of a
shareholder.
 A high current ratio could mean that the company has a lot of
money tied up in non productive assets, such as excess cash or
marketable securities.
Or perhaps the high current ratio is due to large inventory
holdings, which might well become obsolete before they can be
sold.
Thus, shareholders might not want a high current ratio.

An industry average is not a magic number that all firms should
strive to maintain-in fact, some very well-managed firms will be
above the average, while other good firms will be below it.
However, if a firm’s ratios are far remote from the averages for its
industry, this is a red flag, and analysts should be concerned
about why the variance occurs.

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 Current assets - Inventory
Quick or Acid-Test Ratio Current liabilities

Measures ability to meet short-term cash needs more rigorously

by eliminating inventory
It is more conservative than the current ratio.
Quick; or acid test ratio for Micro Drive
=385/310= 1.2, industry average is 2.1
A liquid asset is one that trades in an active market and hence
can be converted quickly to cash at the going market price.
Inventories are typically the least liquid of a firm’s current assets;
hence they are the current assets on which losses are most likely
to occur in a bankruptcy.
Therefore, a measure of the firm’s ability to pay off short-term
obligations without relying on the sale of inventories is important.

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 B. Activity (Asset management) Ratios
Asset management ratios measure how effectively a firm is
managing its assets.
If a company has excessive investments in assets, then its operating
capital will be unduly high, which will reduce its free cash flow and
ultimately its stock price.
On the other hand, if a company does not have enough assets
then it will lose sales, which will hurt profitability, free cash flow, and
the stock price.
Therefore, it is important to have the right amount invested in
assets.
Activity ratios include
i. Inventory Turnover
ii. Average Collection Period
iii. Fixed Asset turnover
iv. Total Asset turnover

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 i. Inventory Turnover
Measures firm’s efficiency in managing its inventory.
It measures how fast the inventory is turned over to produce the
years sales.
Inventory turnover ratio = Sales/Inventories
=$3,000/$615 = 4.9, Industry average = 9.0
As a rough approximation, each item of Micro Drive’s inventory is
sold out and restocked, or “turned over,” 4.9 times per year,
much lower than the industry average.
This suggests that Micro Drive is holding too much inventory.
High levels of inventory add to net operating working capital
(NOWC), which reduces FCF, which leads to lower stock prices.
In addition, Micro Drive’s low inventory turnover ratio makes us
wonder whether the firm is actually holding obsolete goods not
worth their stated value.

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Inventory turnover
Note that sales occur over the entire year, whereas
the inventory figure is measured at a single point in
time.
For this reason, it is better to use an average inventory
measure.
If the firm’s business is highly seasonal, or if there has
been a strong upward or downward sales trend
during the year, then it is especially useful to make
some such adjustment.

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 ii. Average Collection Period
Also called Accounts Receivable Turnover or Days Sales Outstanding.
Shows the average length of time that a firm must wait after making a sale, but
before receiving cash.
Measures efficiency of firm’s collection and credit policies.
DSO = Receivables / (Annual sales /365)
=375 /(3000/365)
= 45.6 days = 46 days
Micro Drive has 46 DSO, well above the 36-day industry average
Micro Drive’s sales terms call for payment within 30 days.
The fact that 46 days of sales are outstanding indicates that customers, on
average, are not paying their bills on time.
As with inventory, high levels of accounts receivable cause high levels of
NOWC, which hurts FCF and stock price.
A customer who is paying late may well be in financial trouble, in which
case Micro Drive may have a hard time ever collecting the receivable.
Therefore, if the trend in DSO has been rising but the credit policy has not
been changed, steps should be taken to review credit standards and to
expedite the collection of accounts receivable.

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 Net sales
iii. Fixed Asset Turnover Net property, plant, equipment

Assesses how effectively a firm uses its plant and

equipment to generate sales.
=$3,000/$1,000 = 3.0; Industry average = 3.0
Micro Drive’s ratio of 3.0 is equal to the industry average, indicating
that the firm is using its fixed assets about as intensively as are other
firms in its industry.
Therefore, Micro Drive seems to have about the right amount of fixed
assets in relation to other firms.
A potential problem can exist when interpreting the fixed assets
turnover ratio.
Recall from accounting that fixed assets reflect the historical costs of
the assets.
Inflation has caused the current value of many assets that were
purchased in the past to be seriously understated.
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Therefore, if we were comparing an old firm that
had acquired many of its fixed assets years ago at
low prices with a new company that had acquired
its fixed assets only recently, we would probably
find that the old firm had the higher fixed assets
turnover ratio.
However, this would be more reflective of the
difficulty accountants have in dealing with inflation
than of any inefficiency on the part of the new firm.
You should be alert to this potential problem when
evaluating the Fixed Assets Turnover ratio.

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 Net sales
iv. Total Asset Turnover
Total assets

Assesses effectiveness in generating sales from

investments in all assets.
Total asset turnover =$3,000/$2,000 = 1.5; Industry average = 1.8
Micro Drive’s ratio is somewhat below the industry
average, indicating that the company is not
generating a sufficient volume of business given its
total asset investment.
Sales should be increased, some assets should be sold,
or a combination of these steps should be taken.

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C. DEBT MANAGEMENT/ Financial Leverage Ratios

Leverage ratios measure the extent of a firm’s financing with

debt relative to equity and its ability to cover interest and other
fixed charge.
The extent to which a firm uses debt financing, or financial
leverage, has three important implications:
By raising funds through debt, stockholders can maintain control of a
firm without increasing their investment.
If the firm earns more on investments financed with borrowed funds than
it pays in interest, then its shareholders’ returns are magnified, or
“leveraged,” but their risks are also magnified.
 Creditors look to the equity, or owner-supplied funds, to provide a
margin of safety, so the higher the proportion of funding supplied by
stockholders, the less risk creditors face.
Common Leverage ratios include:
Debt ratio
Times interest earned
Fixed charge coverage

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 Total liabilities
i. Debt Ratio
Total assets

The ratio of total liabilities to total assets is called the debt

ratio, or sometimes the total debt ratio.
Considers the proportion of all assets that are financed with
debt.
It measures the percentage of funds provided by current
liabilities and long-term debt:
Debt ratio = Total liabilities/Total assets
=$310 + $754
$2,000
= 53.2%; Industry average = 40.0%

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Creditors prefer low debt ratios because the lower the
ratio, the greater the cushion against creditors’ losses
in the event of liquidation.
Stockholders, on the other hand, may want more
leverage because it magnifies their return.
Micro Drive’s debt ratio is 53.2% but its debt ratio in the
previous year was 47.6%, which means that creditors
are now supplying more than half the total financing.
In addition to an upward trend, the level of the debt
ratio is well above the industry average.
Creditors may be reluctant to lend the firm more
money because a high debt ratio is associated with a
greater risk of bankruptcy.

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Some sources report the debt-to-equity ratio,
defined as:
Debt-to-equity ratio =Total liabilities/(Total assets − Total liabilities)
= $310 +$754 / ($2,000 − ($310 + $754)
= 1.14; Industry average = 0.67

The debt-to-equity ratio and the debt ratio contain

the same information but present that information
slightly differently.
The debt-to-equity ratio shows that Micro Drive has
$1.14 of debt for every dollar of equity, whereas the
debt ratio shows that 53.2% of Micro Drive’s
financing is in the form of liabilities.

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 ii. Times Interest Earned (TIE)
Earning Before Interest and Tax (EBIT)
Interest expense
Indicates how well operating earnings cover fixed
interest expenses, also called the interest coverage
ratio.
Times-interest-earned (TIE) ratio for Micro Drive
=$283.8/$88 =3.2 times, Industry average = 6.0
The TIE ratio measures the extent to which operating
income can decline before the firm is unable to meet
its annual interest costs.
Failure to meet this obligation can bring legal action
by the firm’s creditors, possibly resulting in bankruptcy.

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 Times Interest Earned ratio
Note that Earnings Before Interest and Taxes (EBIT),
rather than Net Income, is used in the numerator.
Because interest is paid with pre-tax dollars, the firm’s
ability to pay current interest is not affected by taxes.
Micro Drive’s interest is covered 3.2 times.
The industry average is 6, so Micro Drive is covering its
interest charges by a relatively low margin of safety.
Thus, the TIE ratio reinforces the conclusion from our
analysis of the debt ratio that Micro Drive would face
difficulties if it attempted to borrow additional funds.

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 iii. Fixed Charge or EBITDA Coverage ratio

Broader measure of how well operating earnings cover

Fixed Charges by including lease payments and Sinking
fund obligations.
The TIE ratio is useful for assessing a company’s ability to
meet interest charges on its debt, but this ratio has two
shortcomings:
1. Interest is not the only fixed financial charge-companies must
also reduce debt on schedule, and many firms lease assets
and thus must make lease payments.
 If they fail to repay debt or meet lease payments, they can be forced
into bankruptcy.
2. EBIT does not represent all the cash flow available to service debt,
especially if a firm has high depreciation and/or amortization
charges.
The EBITDA coverage ratio accounts for these deficiencies.
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 EBITDA coverage ratio for Micro Drive = $383.8 + $28
$88 + $20 + $28
= $411.8
$136
= 3.0 times, Industry average = 4.3
Micro Drive had $383.8 million of earnings before interest, taxes,
depreciation, and amortization (EBITDA).
 Also, lease payments of $28 million were deducted while calculating
EBITDA.
That $28 million was available to meet financial charges; hence
it must be added back, bringing the total available to cover fixed financial
charges to $411.8 million.
Fixed financial charges consisted of $88 million of interest, $20 million of
sinking fund payments, and $28 million for lease payments, for a total of
$136 million.
 Therefore, Micro Drive covered its Fixed Financial Charges by 3.0 times.
However, if EBITDA declines then the coverage will fall.
Moreover, Micro Drive’s ratio is well below the industry average, so again
the company seems to have a relatively high level of debt.
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The EBITDA coverage ratio is most useful for relatively
short-term lenders such as banks, which rarely make
loans (except real estate-backed loans) for longer
than about 5 years.
Over a relatively short period, depreciation-
generated funds can be used to service debt.
Over a longer time, those funds must be reinvested to
maintain the plant and equipment or else the
company cannot remain in business.
Therefore, banks and other relatively short-term
lenders focus on the EBITDA coverage ratio, whereas
long-term bondholders focus on the TIE ratio.

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 D. PROFITABILITY RATIOS
Profitability ratios measure the overall performance of
a firm and its efficiency in managing assets, liabilities,
and equity.
Profitability is the net result of a number of policies and
decisions.
The ratios examined thus far provide useful clues as to
the effectiveness of a firm’s operations, but the
Profitability ratios go on to show the combined effects
of liquidity, asset management, and debt on operating
results.
Profitability ratios include
 Net Profit Margin (PM)
 Basic Earnings Power (BEP)
 Return on total Assets (ROA) or Return on Investment (ROI)
 Return on Equity (ROE) Yidersal35D (PhD)
i. Net Profit Margin: %age of income from a birr amount of sale.
The net profit margin, which is also called the profit margin on sales.
Net profit margin =Net income available to common stockholders/Sales
=$113.5/$3,000 = 3.8%; Industry average = 5.0%
Micro Drive’s net profit margin is below the industry average of 5%, but why
is this so?
Is it due to inefficient operations, high interest expenses, or both?
Instead of just comparing net income to sales, many analysts also break
the income statement into smaller parts to identify the sources of a low net
profit margin.
For example, the operating profit margin is defined as
Operating Profit Margin = EBIT/sales
The operating profit margin identifies how a company is performing with
respect to its operations before the impact of interest expenses is
considered.
Some analysts drill even deeper by breaking operating costs into their
components.
For example, the gross profit margin is defined as
Gross profit margin = (Sales − Cost of goods sold)/ Sales
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 ii. Basic Earnings Power (BEP)
Basic earning power (BEP) ratio = EBIT/ Total assets
=$283.8/$2,000 =14.2%; Industry average= 17.2%
This ratio shows the raw earning power of the firm’s
assets before the influence of taxes and leverage, and it
is useful for comparing firms with different tax situations
and different degrees of financial leverage.
Because of its low turnover ratios and low profit margin
on sales, Micro Drive is not getting as high a return on its
assets as is the average company in its industry.

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 iii. Return on Total Assets (ROA)
The ratio of net income to total assets measures the
return on total assets (ROA) after interest and taxes.
This ratio is also called the return on asset.
Return on total assets (ROA) = Net income available to
common stockholders/Total assets
=$113.5/ $2,000 = 5.7%; Industry Average = 9.0%
Micro Drive’s 5.7% return is well below the 9% average
for the industry.
This low return is due to
1. the company’s low Basic Earning Power and
2. high interest costs resulting from its above-average use of debt;
 both of these factors cause Micro Drive’s net income to be
relatively low.

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 iv. Return on Equity (ROE)
Measures rate of return on stockholders’ investment
The ratio of net income to common equity
ROE = Net income available to common stockholders/Common equity
=$113.5/$896 = 12.7%; Industry average =15.0%
Stockholders invest to earn a return on their money,
and this ratio tells how well they are doing in an
accounting sense.
Micro Drive’s 12.7% return is below the 15% industry
average, but not as far below as its return on total
assets.
This somewhat better result is due to the company’s
greater use of debt.

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 E. MARKET VALUE RATIOS
 Market value ratios are a way to measure the value
of a company’s stock relative to that of another
company.
Market value ratios relate a firm’s stock price to its
 Earnings,
 Cash Flow, and
 Book Value per share.
Includes
 Price/Earnings (P/E) Ratio:
 Price/Cash Flow Ratio
 Market/Book Ratio

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 i. Price Per Earnings(P/E) Ratio
 Shows how much investors are willing to pay per birr of
reported profit (Current earnings).
Relates earnings per common share to the market price at
which the stock trades, expressing the “multiple” that the
stock market places on a firm’s earnings
Micro Drive’s stock sells for $23, with an earnings per share (EPS) of
$2.27.
P/E ratio = Price per share/ Earnings per share
= $23.00/ $2.27 = 10.1; Industry average = 12.5
P/E ratios are higher for firms with strong growth prospects, other
things held constant, but they are lower for riskier firms.
Because Micro Drive’s P/E ratio is below the average, this suggests
that the company is regarded as being somewhat riskier than most,
as having poorer growth prospects, or both.

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 ii. Price/Cash Flow Ratio
 Stock prices depend on a company’s ability to
generate cash flows.
 Consequently, investors often look at the price/cash
flow ratio, where cash flow is defined as net income
plus depreciation and amortization:
Price/cash flow ratio = Price per share/ Cash flow per share
=$23.00/$4.27 = 5.4; Industry average = 6.8
 Micro Drive’s price/cash flow ratio is also below the
industry average, once again suggesting that its
growth prospects are below average, its risk is above
average, or both.

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iii. Market Per Book value(M/B) Ratio
 Shows how much investors are willing to pay for Book
value of a firm.
 The ratio of a stock’s market price to its book value
gives another indication of how investors regard the
company.
 Companies with relatively high rates of return on
equity generally sell at higher multiples of book value
than those with low returns.
Book value per share = Common Equity/Shares Outstanding
=$896/50 = $17.92
Divide the market price by the book value to get a
market/book (M/B) ratio of 1.3 times:
Market/book ratio (M/B) = Market price per share/Book value per share
= $23.00/ $17.92 = 1.3; Industry average =
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Investors are willing to pay relatively little for a dollar of Micro
Drive’s book value.
The average company in the S&P 500 had a market/book ratio of
about 2.50 in early 2009.
Since M/B ratios typically exceed 1.0, this means that investors
are willing to pay more for stocks than their accounting book
values.
The book value is a record of the past, showing the cumulative
amount that stockholders have invested, either directly by
purchasing newly issued shares or indirectly through retaining
earnings.
In contrast, the market price is forward-looking, incorporating
investors’ expectations of future cash flows.
For example, in early 2009 Alaska Air had a market/book ratio of
only 0.81, reflecting the airline industry’s problems, whereas
Apple’s market/book ratio was 3.45, indicating that investors
expected Apple’s past successes to continue.
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USES AND LIMITATION OF RATIOS
A. Strengths:
(a) Easier to understand than absolute measures.
(b) Easier to look at changes over time.
(c) Puts performance into context.
(d) Can be used as targets.
(e) Summarise results.
B. USES
Used for decision making by
 Managers
 Creditors
 Stockholders

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C. Limitations
1. it is difficult to develop meaningful industry average
for multi-industry firms.
2.Most firms want to be better than averages.
3.Inflation may distort firm’s balance sheets.
4.Seasonal factors can distort ratio analysis.
5.Firms can employ “window dressing” technique.
6.Different accounting practices can distort comparison.
7.it is difficult to generalize whether a particular ratio is
good or bad.
8.A firm may have some good ratios and another bad
ratios making difficult to tell whether a company is
good or bad in balance.

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 LOOKING BEYOND THE NUMBERS
Sound Financial Analysis involves more than just calculating and
comparing ratios-Qualitative Factors analysts must consider.
To what extent are the company’s revenues tied to one key customer
or to one key product? To what extent does the company rely on a
single supplier? Reliance on single customers, products, or suppliers
increases risk.
What percentage of the company’s business is generated overseas?
Companies with a large percentage of overseas business are exposed
to risk of currency exchange volatility and political instability.
What are the probable actions of current competitors and the
likelihood of additional new competitors?
Do the company’s future prospects depend critically on the success of
products currently in the pipeline or on existing products?
How does the legal and regulatory environment affect the company?

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Common size, Index and Trend Analyses

Are used to have a good insight of trends of financial

statement items or ratios.
Are useful for comparing firms with different sizes.
A. Common Size Analysis
Expresses each item in the balance sheet as a
percentage of total net assets and each item in the
income statement as a percentage of total net sales.
• Eg. Comparative financial statements.

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B. Index (percentage change) Analysis
 items in the financial statement are expressed as an
index relative to the base year.
All items of the base year are assigned a 100% index.
All items in the subsequent to the base year valued
relative to the base year items.
◦ Eg. Indexed financial statements.

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CHAPTER END

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