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Chapter 6

Financial Statement

Objectives of Financial
Statement Analysis
Understand reported financial data
Better manage a business
Provide a base for rational decision
making (though the major focus of
separate analyses and types of decision
under consideration will vary)
Make a reasonable assessment of
future financial condition based on
present and past financial conditions and
on best available estimate of future
economic occurrences

Objectives of Financial
Statement Analysis
Why not accept prepared financial
statements at face value?
Prepared financial statements require
some analysis as first step toward
extracting information from presented
Decisions made on basis of financial
analysis are important and accepting
presented financial data at face value is
poor policy.

Ratio Analysis
Ratio analysis: financial ratios are used to
develop a set of statistics that reveal key
financial characteristics of a company
Ratios are compared with industry standards.

Some industry standards can be obtained through

commercial services (i.e. Dun and Bradstreet, Robert Morris
Associates) or through industry trade services.
Analysts may have to develop their own standards by
calculating average ratios for leading companies in same

Ratios are used to analyze the trend over

time for a particular company.

Track key ratios through previous one or two economic

recessions to determine companys financial strength
during periods of economic adversity

Ratio Analysis
Four major categories of key financial ratios:
1. Profitability: bottom-line ratios designed to
measure earning power and profitability record of
2. Liquidity: ratios designed to measure ability of
firm to meet its short-term liabilities as they come
3. Operating efficiency: measures of efficiency
with which corporate resources are employed to
earn profit
4. Capital structure (leverage): measures of
extent to which debt financing is employed by

Ratio Analysis
1. Profitability:
1. Return on sales (ROS)
2. Return on assets (ROA)
3. Return on equity (ROE)

Ratio Analysis
1. Profitability
1. Return on sales (ROS or net margin)
ROS = Earnings after tax
Net sales
Net sales: dollar volume of sales less any
returns, allowances, and cash discounts

Ratio Analysis
1. Profitability

Return on assets (ROA or return on

total assets (ROTA) or return on
investment (ROI)):
ROA = Earnings after tax
Total assets

Ratio Analysis
1. Profitability
3. Return on equity (ROE):

Measures owners invested capital

Earnings after tax

Stockholders equity:
by deducting

total liabilities and intangible assets from total assets

Excludes effect of any intangible assets (i.e. goodwill,


ROE of at least 15% is a reasonable objective to

provide adequate dividends and to fund future

Ratio Analysis
2. Liquidity:

Current ratio
Quick ratio
Average collection period
Days sales in inventory

Ratio Analysis
2. Liquidity
1. Current ratio:

Current ratio =

Current assets
Current liabilities

Current assets: cash, marketable securities,

accounts receivable, and inventories
Current liabilities: accounts payable, current
notes payable, and currently due portion of
any long-term debt

Ratio Analysis
2. Liquidity
2. Quick ratio (acid test):
Quick ratio =

Cash + Marketable securities + Accounts receivable

Current liabilities

For bankers and other lenders, ratio should

be at least 1 to 1.
Quick assets (current assets net of
inventories): assets that can be quickly
converted to cash

Ratio Analysis
2. Liquidity
3. Average collection period: measures
the speed with which receivables are
turned into cash

should not exceed net maturity indicated

by firms selling terms
by more than 10-15
days daily sales = 365 days

Average collection period = Accounts receivable

Average daily sales

Ratio Analysis
2. Liquidity
4. Days sales in inventory:

Days sales in inventory =
Average daily sales

Net sales used in numerator, which represents cost

of goods sold plus gross profit margin
Not a good measure of physical turnover
Provides important benchmark against which to
compare ratio of sales dollars to inventory stocks of
one business to that of another and how efficiently
management is using its inventory resources to
support sales

Ratio Analysis
3. Operating efficiency ratios:
measure the relationship between
annual sales and investments in
various classes of asset accounts
1. Cost of goods sold to inventory
2. Sales to total assets
3. Sales to working capital

Ratio Analysis
3. Operating efficiency ratios
1. Cost of goods sold to inventory:
provides estimate of physical turnover
Cost ofrates
sales to inventory = Cost of goods sold

Numerator measures how efficiently

inventory is being managed

Ratio Analysis
3. Operating efficiency ratios
2. Sales to total assets: measures
relationship between sales and assets
used to support those sales
Net sales
Sales to total assets =
Total assets

Often used to compare structure and

capital requirements of different industries

Ratio Analysis
3. Operating efficiency ratios
3. Sales to working capital:
Net sales
Sales to working capital =
Working capital


Working capital = Current assets current


Ratio Analysis
4. Capital structure (leverage) ratios

Leverage: extent to which firm employs debt

capital to finance its operations


The more debt employed by firm, the more highly

leveraged it is said to be.

Debt ratio
Long-term debt to total assets
Debt equity ratio
Times interest earned ratio

Ratio Anaylsis
4. Capital structure ratios
1. Debt ratio: measures relationship
between total assets and amount of
debt used to finance those assets
Debt ratio =

Total debt
Total assets

Ratio Analysis
4. Capital structure ratios
2. Long-term debt to total assets:
measures percentage of total assets
that is financed by long-term debt
Long-term debt
Long-term debt/Total assets ratio =
Total assets

Ratio Analysis
4. Capital structure ratios
3. Debt equity ratio: measures
relationship between capital supplied
by lenders (debt) and capital supplied
by owners (equity)
Debt equity ratio =

Total debt

Ratio Analysis
4. Capital structure ratios
4. Times interest earned ratio:

Computed as ratio of earnings before

interest and taxes (EBIT) to interest

EBIT = Earnings after tax + Interest expense +

Income tax Earnings before interest and taxes

Times interest earned =

Interest expense

Ratio Analysis
Interrelationships Among Ratios
Firms profitability, liquidity
position, operating efficiency, and
leverage position are all

Ratio Analysis
DuPont system of analysis: relates
return on investment to firms profit margin
and asset turnover

Net income
Total assets

Net income

Total assets

ROA results from interaction of firms profit margin (net

income/sales) and asset turnover (sales/total assets)
ROA = margin x turnover
ROA is an overall performance measure of profitability
(profit margin) and its operating efficiency (total asset

Ratio Analysis
Relationships among ROE, ROA and
leverage position
Net income
Stockholders equity

Net income X

Total assets

The higher the firms leverage (ratio of total assets to

stockholders equity), the higher will be its ROE
relative to ROA.
Equity multiplier: measure of leverage used to show
that use of debt (leverage) is reflected in an increasing
ratio of assets to equity because use of debt allows
firm to add assets without increasing equity

Ratio Analysis
Computation and display of a set of ratios
for a given company in a given year is of
limited usefulness by itself.

Ratios must be compared to

performance in other years and
to appropriate standards for
companies of approximately
equal asset size in similar

Common-Size Statements
Common-size financial
statement: expresses all accounts
on balance sheet and income
statement as a percentage of some
key figure

Common-Size Statements
Common-size balance sheet
Analyzes internal structure and
allocation of firms financial resources
Asset side shows how investments in various
financial resources are distributed among asset
Liabilities and equities side shows percentage
distribution of financing provided by current
liabilities, long-term debt, and equity capital

Common-Size Statement
Common-size income statement
Shows proportion of sales or revenue
dollar absorbed by various cost and
expense items

Sequence of Analysis
Main objective of analysis determines
relative degree of emphasis to place
on each area of analysis (profitability,
liquidity, operating efficiency, or
capital structure)
But one logical framework can be
employed to systematically
explore financial health of

Sequence of Analysis
1. Specify clearly objectives of analysis
and develop set of key questions
that should be answered to attain
this objective
2. Prepare data (i.e. key ratios and
common-size statements) necessary
to work toward specified goals

Sequence of Analysis
3. Analyze and interpret numerical
information developed in prepared
First examine information provided by
ratio analysis in order to develop overall
feel for potential problem areas
Then use preliminary questions and
opinions developed during analysis of
ratio data to focus on information
contained in common-size statements

Sequence of Analysis
4. Form conclusions based on data and
answer questions posed in Step 1
Present specific recommendations,
backed up by available data, along with
brief summary of major points
developed previously
Begin written report with summary of
conclusions developed in this final

Case Study
Technosystems, Inc.
Technosystems: 3-year-old, privately
owned company engaged in wholesale
distribution of plumbing, heating, and air
President: John Diamond

Walker Equipment Company: company

specializing in sale and leasing of heavy
construction equipment
President: David Walker
CPA: Carla Gilberti

Case Study
Technosystems, Inc.
David and Carla had no interest in
operating a new company, but they agree
to become equal partners in financing
Technosystems if John would start up and
manage it.
Technosystems was originally financed
with a $100,000 loan from David and
Carla, payable in ten annual installments
of $10,000 plus 14% interest on declining

Case Study
Technosystems, Inc.
Key Financial Ratios - See exhibit 6.3
Technosystems is undercapitalized
Debt ratio is extremely high
Total debt is equal to almost 80% of total
assets, compared with industry standard of
Long-term debt is equal to nearly 30% of total
assets, almost double industry standard of 15%
Debt is private debt loaned to company by two
of its partners

Case Study
Technosystems, Inc.
Key Financial Ratios - See exhibit 6.3
Profitability ratios
Overall level and trend of earnings looks
ROS is just below industry average of 3.5%,
and shows rapidly increasing trend
ROA is increasing rapidly and above industry
ROE is extremely high due mainly to high
debt position and low equity relative to debt

Case Study
Key Financial Ratios - See exhibit 6.3
Profitability ratios (continued)
ROA has improved as result of improvement in both ROS
ratio and asset turn over ratio:
ROA = (Profit margin) x (Asset turnover)
ROA (2008)= (3.34%) x (4.5) = 15.0%
ROA (2007) = (2.10%) x (3.6) = 7.5%
High rate of ROE of 68.1% is result of high debt position:
ROE = (ROA) x (Total assets/Equity)
ROE = (15.03%) x ($284,100/$62,700) = (15.03%) x
(4.53) = 68.1%
The higher this ratio, the more debt used

Case Study
Technosystems, Inc.
Key Financial Ratios - See exhibit 6.3
Liquidity ratios
Current ratio is below industry average
Quick ratio is approximately equal to industry
Average collection period is well below
industry average (indicates that company is
doing excellent job of collecting its receivables)
Inventory control (below-average days sales
in inventory number) is excellent

Case Study
Technosystems, Inc
Key Financial Ratios - See exhibit 6.3
Operating efficiency ratios
Inventory turnover (cost of sales to
inventory ratio), sales to total assets,
and sales to working capital ratios are
all above industry averages

Case Study
Technosystems, Inc.

Common-Size Analysis
Common-size balance sheet (see exhibit 6.4)
Fixed assets as percentage of total assets have
increased since 2001
Increase in retained earnings account and hence
total equity as percent of total assets
Sharp decrease in percentage of total assets financed
by current liabilities and long-term debt
Within working capital accounts, there is steady
decrease in total current assets as percent of total

Case Study
Technosystems, Inc.
Common-Size Analysis
Common-size income statement (see
exhibit 6.5)
From 2006 to 2008, steady improvements:
Gross profit margin has increased from 18.9% to
Pre-tax margin has increased from 0.1% to 5.6%
After-tax margin has increased from 0.1% to 3.3%

Total expenses as percent of sales have

remained relatively steady and only increased
from 18.9% to 19.8%

Case Study
Technosystems, Inc.
Technosystems Conclusions
Profitability is excellent and improving.
Liquidity position is strong and improving.
Technosystems carries a heavy debt load.
Liquidation is unlikely since lenders are two of
the founders
Repayment of loans is likely since operating
efficiency ratios reflect sound management
and profitability is growing

Financial Analysis, Financial

Fraud and Financial Stress
Enron and Worldcom were two of the largest
corporate bankruptcies related to allegations
of widespread fraud, cover-ups, and criminal
behavior by senior executives of these
corporations and their auditors.
Massive fraud on this scale are now exception
due to increased public scrutiny, but there are
new risks and problems due to combination of
excessive leverage, bad real estate deals,
under-provisioning for loan, insurance or
derivative losses and/or bad management

Financial Analysis, Financial

Fraud and Financial Stress
New regulations will likely prohibit:
Leverage ratios greater than 30 to 1
Ability of homeowners to borrow all or more
than all of value of equity in their homes
Unregulated writing of credit default swaps
without appropriate insurance reserves
(accounting for concentration of risk)