Financial

Statements
and Analysis
 Learning Goals

Review the contents of the stockholder’s report, and the

procedures for consolidating financial statements.
Explain who uses financial ratios and how.
Use ratios to analyze a firm’s liquidity and activity.
Discuss the relationship between debt and financial
leverage and the ratios used to analyze a firm’s debt.
Use ratios to analyze a firm’s profitability and its
market value.
Use the DuPont system of analysis to perform
a complete ratio analysis.
Copyright © 2001 Addison-Wesley 8-1
 Financial Statements

 The Income Statement

 The income statement provides a financial
summary of a company’s operating results
during a specified period.
 Although they are prepared annually for reporting
purposes, they are generally computed monthly
by management and quarterly for tax purposes.

Copyright © 2001 Addison-Wesley 8-2

 Financial Statements

Copyright © 2001 Addison-Wesley Table 8.1 (Panel 1) 8-3

 Financial Statements

Copyright © 2001 Addison-Wesley Table 8.1 (Panel 2) 8-4

 Financial Statements

 The Balance Sheet

 The balance sheet presents a summary of a firm’s
financial position at a given point in time.
 Assets indicate what the firm owns, equity represents
the owners’ investment, and liabilities indicate what
the firm has borrowed.

Copyright © 2001 Addison-Wesley 8-5

 Financial Statements

Copyright © 2001 Addison-Wesley Table 8.2 (Panel 1) 8-6

 Financial Statements

Copyright © 2001 Addison-Wesley Table 8.2 (Panel 2) 8-7

 Financial Statements

 Statement of Retained Earnings

 The statement of retained earnings reconciles
the net income earned and dividends paid during
the year with the change in retained earnings.

Copyright © 2001 Addison-Wesley 8-8

 Financial Statements

Copyright © 2001 Addison-Wesley Table 8.3 8-9

 Financial Statements

 Statement of Cash Flows

 The statement of cash flows provides a summary
of the cash flows over the period of concern,
typically the year just ended.
 This statement not only provides insight into a
company’s investment and financing and operating
activities, but also ties together the income
statement and previous and current balance sheets.

Copyright © 2001 Addison-Wesley 8-10

 Financial Statements

Copyright © 2001 Addison-Wesley Table 8.4 8-11

 Using Financial Ratios

 Interested Parties
 Ratio analysis involves methods of calculating
and interpreting financial ratios to assess a firm’s
financial condition and performance.
 It is of interest to shareholders, creditors,
and the firm’s own management.

Copyright © 2001 Addison-Wesley 8-12

 Types of Ratio Comparisons

 Trend or Time-Series Analysis

 Used to evaluate a firm’s performance over time.
 Cross-Sectional Analysis
 Used to compare different firms at the same point in time.
 Industry comparative analysis
• One specific type of cross sectional analysis. Used to compare
one firm’s financial performance to the industry’s average performance.

 Combined Analysis
 Combined analysis simply uses a combination
of both time-series analysis and cross-sectional analysis.

Copyright © 2001 Addison-Wesley 8-13

 Types of Ratio Comparisons

Copyright © 2001 Addison-Wesley Figure 8.1 8-14

 Cautions for Doing Ratio Analysis

 Ratios must be considered together;

a single ratio by itself means relatively little.
 Financial statements that are being compared
should be dated at the same point in time.
 Use audited financial statements when possible.
 The financial data being compared should have been
developed in the same way.
 Be wary of inflation distortions.

Copyright © 2001 Addison-Wesley 8-15

 Ratio Analysis Example

 Using Daton Company Financial Statements

 Liquidity ratios
 Activity ratios
 Financial leverage ratio
 Leverage ratios
 Profitability ratios

Copyright © 2001 Addison-Wesley 8-16

 Ratio Analysis

 Liquidity Ratios
 Current Ratio

Total current assets

Current ratio =
Total current liabilities

$1,233,000
Current ratio = = 1.97
$620,000

Copyright © 2001 Addison-Wesley 8-17

 Ratio Analysis

 Liquidity Ratios
 Quick ratio

Total current assets - Inventory

Quick ratio =
Total current liabilities

$1,233,000 - $289,000
Quick ratio = = 1.51
$620,000

Copyright © 2001 Addison-Wesley 8-18

 Ratio Analysis

 Asset Management / Activity Ratios

 Inventory Turnover

Cost of goods sold

Inventory turnover =
Inventory

$2,088,000
Inventory turnover = = 7.2
$289,000

Copyright © 2001 Addison-Wesley 8-19

 Ratio Analysis

 Asset Management / Activity Ratios

 Average collection period

Accounts receivable
ACP =
Net sales/360

$503,000
ACP = = 58.9 days
$3,074,000/360

Copyright © 2001 Addison-Wesley 8-20

 Ratio Analysis

 Asset Management / Activity Ratios

 Average payment period

Accounts payable
APP =
Annual purchases/360

$382,000
APP = = 94.1 days
(.70 x $2,088,000)/360

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 Ratio Analysis

 Asset Management / Activity Ratios

 Total asset turnover

Net sales
Total asset turnover =
Total assets

$3,074,000
Total asset turnover = = .85
$3,579,000

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 Ratio Analysis

 Financial Leverage Ratio

 Debt ratio

Total liabilities
Debt ratio =
Total assets

$1,643,000
Debt ratio = = 45.7%
$3,579,000

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 Ratio Analysis

 Leverage Ratios
 Times interest earned ratio

EBIT
Times interest earned =
Interest

$418,000
Times interest earned = = 4.5
$93,000

Copyright © 2001 Addison-Wesley 8-24

 Ratio Analysis

 Profitability Ratios
 Common-size
income statements

Copyright © 2001 Addison-Wesley Table 8.6 8-25

 Ratio Analysis

 Profitability Ratios
 Gross profit margin

Gross profit
GPM =
Net sales

$986,000
GPM = = 32.1%
$3,074,000

Copyright © 2001 Addison-Wesley 8-26

 Ratio Analysis

 Profitability Ratios
 Operating profit margin

EBIT
OPM =
Net sales

$418,000
OPM = = 13.6%
$3,074,000

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 Ratio Analysis

 Profitability Ratios
 Net profit margin

Net profits after taxes

NPM =
Net sales

$231,000
NPM = = 7.5%
$3,074,000

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 Ratio Analysis

 Profitability Ratios
 Return on total assets (ROA)

Net profits after taxes

ROA =
Total assets

$231,000
ROA = = 6.4%
$3,597,000

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 Ratio Analysis

 Profitability Ratios
 Return on equity (ROE)

Net profits after taxes

ROE =
Stockholders’ equity

$231,000
ROE = = 11.8%
$1,954,000

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 Ratio Analysis

 Profitability Ratios
 Earnings per share (EPS)

Earnings available to common stockholder

EPS =
Number of shares outstanding

$221,000
EPS = = $2.90
76,262

Copyright © 2001 Addison-Wesley 8-31

 Ratio Analysis

 Profitability Ratios
 Price earnings (P/E) ratio

Market price per share of common stock

P/E =
Earnings per share

$32.25
P/E = = 11.1
$2.90

Copyright © 2001 Addison-Wesley 8-32

 Ratio Analysis

 Profitability Ratios
 Market/book (M/B) ratio

Market price per share of common stock

M/B =
Book value per share of common stock

$32.25
M/B = = 1.40
$23.00

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 Summarizing All Ratios

Copyright © 2001 Addison-Wesley Table 8.7 (Panel 1) 8-34

 Summarizing All Ratios

Copyright © 2001 Addison-Wesley Table 8.7 (Panel 2) 8-35

 DuPont System of Analysis

 The DuPont system is used to dissect the firm’s financial

statements and to assess its financial condition.
 It merges the income statement and balance sheet
into two summary measures of profitability: ROA
and ROE as shown in Figure 8.2 on the following slide.
 The top portion focuses on the income statement,
and the bottom focuses on the balance sheet.
 The advantage of the DuPont system is that it allows
you to break ROE into a profit-on-sales component,
an efficiency-of-asset-use component, and a use-of-
leverage component.
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 DuPont System of Analysis

Copyright © 2001 Addison-Wesley Figure 8.2 8-37

 DuPont System of Analysis

Copyright © 2001 Addison-Wesley Figure 8.2 (Panel 1) 8-38

 DuPont System of Analysis

Copyright © 2001 Addison-Wesley Figure 8.2 (Panel 2) 8-39