Module 3

Analyzing and
Interpreting
Financial
Statements

Common Questions that F/S

Analysis Can Help To
Answer

Can the company pay the interest and

Creditor

Investor

Manage
r

principal on its debt? Does the company

reply too much on nonowner financing?
Does the company earn an acceptable
return on invested capital? Is the gross
profit margin growing or shrinking?
Does the company effectively use
nonowner financing?
Are costs under control? Are the
companys markets growing or
shrinking? Do observed changes reflect
opportunities or threats? Is the
allocation of investment across different
assets too high or too low?

Ratio Analysis

Examining various income statement and

balance sheet components in relation to
one another facilitates financial statement
analysis. This type of examination is called
ratio analysis.
This module focuses on the disaggregation
of Return Measures into
1.
2.
3.
4.

Level I RNOA and LEV

Level II Profit Margins and Turnover
Level III GPM, SGA, ART, INVT, PAT, APT, WCT
As well as Liquidity and Solvency Measures

Analysis Structure

Return on Equity

Return on equity (ROE) is computed as:

Equity

ROE = Net Income / Average

Key Definitions

Observed Medians of
Variables

Level 1 Analysis RNOA

and Leverage

Return on Net Operating

Assets
(RNOA)
RNOA = NOPAT / Average NOA
where,
NOPAT is net operating profit after tax
NOA is net operating assets

Operating and
Nonoperating
Assets/Liabilities

Simplified Operating and

Nonoperating Balance
Sheet

NOPAT

Net operating profit includes

Operating revenues less
Operating expenses (COGS, SG&A,
Taxes)

Excluded are after-tax earnings

from investments returns and
interest expenses.

Operating/Nonoperating vs.
Core/Transitory

Financial Leverage and

Risk
LEV is the other component of ROE
Given that increases in financial leverage
increase ROE, why are all companies not 100%
debt financed?
The answer is because debt is risky. This
increased risk increases the expected return
that investors require to provide capital to the
firm.
Higher financial leverage also results in a
higher interest rate on the companys debt.
Standard & Poors and Moodys Investor
Services ratings partly determine the debts
interest ratewith lower quality ratings
yielding higher interest rates and vice-versa.
So, all else equal, higher financial leverage
lowers a companys debt rating and increases
the interest rate it must pay.

Leverage and Income

Variability

Level II Analysis Margin

and Turnover

Margin vs. Turnover

NOPAT Margin

Turnover of NOA

Level 3 Analysis Disaggregation of

Margin and Turnover

Gross Profit Margin

It allows a focus on average unit mark-ups

A high gross profit margin is preferred to
a lower one, which also implies that a
company has relatively more flexibility in
product pricing.

Gross Profit Margin

Two main factors determine gross profit

margins:
1. Competition as the level of competition
intensifies, more substitutes become
available, which limits a companys
ability to raise prices and pass along
price increases to customers.
2. Product mix if the proportion of lower
price, higher volume products increases
relative to that of higher priced, lower
volume products, then gross profit
dollars may stay the same, but gross
profit margin declines.

Operating Expense
Margin

Operating expense ratios (percents) are

used to examine the proportion of sales
consumed by each major expense
category.
Expense ratios are calculated as follows:
Operating expense percentage = Expense item/Net
sales

Turnover

Turnover measures relate to the

productivity of company assets. Such
measures seek to answer the amount of
capital required to generate a specific
sales volume.
Turnover ratios are calculated as follows:
Turnover = Sales volume/Average Assets
As turnover increases, there is greater
cash inflow as cash outflow for assets to
support the current sales volume is
reduced.

Accounts Receivable
Turnover (ART)

Inventory Turnover (INVT)

L-T Operating Asset

Turnover (LTOAT)

Accounts Payable Turnover

(APT)

Net Operating Working

Capital Turnover (WOCT)

Liquidity and Solvency

Measures

Liquidity refers to cash: how

much we have, how much is
expected, and how much can be
raised on short notice.

Solvency refers to the ability to

meet obligations; primarily
obligations to creditors,
including lessors.

Cash Operating Cycle

Average Cash (Operating) Cycle the period of time from cash to

inventories to receivables to cash.

Current and Quick Ratio

Solvency Ratios

Flow Ratios

Bankruptcy Prediction

Limitations of Ratio
analysis

Vertical and Horizontal

Analysis

Vertical and Horizontal

Analysis

Derivation of ROE
Disaggregation