FINANCIAL

STATEMENT
ANALYSIS
Lecture
Ratio Analysis
Riaz Hussain Ansari
Lecturer Department of Business Administration
University of Sahiwal
Learning Goals

1. Review the contents of the stockholders’ report and

the procedures for consolidating international
financial statements.
2. Understand who uses financial ratios, and how.
3. Use ratios to analyze a firm’s liquidity and activity.
4. Discuss the relationship between debt and financial
leverage and the ratios used to analyze a firm’s debt.

2-2
Learning Goals (cont.)

5. Use ratios to analyze a firm’s profitability and

market value.
6. Use a summary of financial ratios and the
DuPont system of analysis to perform a
complete ratio analysis.

2-3
The Four Key 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.

2-4
The Four Key Financial Statements

Table 2.1 Bartlett

Company Income
Statements ($000)

2-5
The Four Key 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.

2-6
The Four Key Financial
Statements
Table 2.2a Bartlett
Company Balance
Sheets ($000)

2-7
The Four Key
Financial Statements (cont.)

Table 2.2b Bartlett

Company Balance
Sheets ($000)

2-8
The Four Key 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 © 2009 Pearson Prentice Hall. All rights reserved.

2-9
The Four Key Financial
Statements
Table 2.3 Bartlett Company Statement of Retained Earnings
($000) for the Year Ended December 31, 2009

2-10
The Four Key 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, financing and operating
activities, but also ties together the income
statement and previous and current balance
sheets.

2-11
The Four Key Financial
Statements
Table 2.4 Bartlett
Company Statement of
Cash Flows ($000) for
the Year Ended
December 31, 2009

2-12
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.

2-13
Using Financial Ratios:
Types of Ratio Comparisons

• Trend or time-series analysis

• Cross-sectional analysis
* Industry comparative analysis
* Benchmarking
* Combined

2-14
Using Financial Ratios:
Types of Ratio Comparisons (cont.)

Table 2.5 Industry Average Ratios for Selected Lines of

Businessa

2-15
Using Financial Ratios:
Types of Ratio Comparisons (cont.)

Figure 2.1 Combined Analysis

2-16
Using Financial Ratios:
Cautions for Doing Ratio Analysis

1. Ratios must be considered together; a single ratio by

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

2-17
Ratio Analysis Example

• We will illustrate the use of financial ratios for

analyzing financial statements using the Bartlett
Company Income Statements and Balance
Sheets presented earlier in Tables 2.1 and 2.2.

2-18
Ratio Analysis

• Liquidity Ratios
– Current Ratio

Current ratio = total current assets

total current liabilities

Current ratio = $1,233,000 = 1.97

$620,000

2-19
Ratio Analysis (cont.)

• Liquidity Ratios
– Current Ratio
– Quick Ratio

Quick ratio = Total Current Assets - Inventory

total current liabilities

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

$620,000
2-20
Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
– Inventory Turnover

Inventory Turnover = Cost of Goods Sold

Inventory

Inventory Turnover = $2,088,000 = 7.2

$289,000
2-21
Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
– Average Age of Inventory

Average Age of Inventory = 365

Inventory Turnover

Inventory Turnover = 365 = 50.7 days

7.2
2-22
Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
– Average Collection Period

ACP = Accounts Receivable

Net Sales/365

ACP = $503,000 = 59.7 days

$3,074,000/365
2-23
Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
– Average Payment Period

APP = Accounts Payable

Annual Purchases/365

APP = $382,000 = 95.4 days

(.70 x $2,088,000)/365
2-24
Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
– Total Asset Turnover

Total Asset Turnover = Net Sales

Total Assets

Total Asset Turnover = $3,074,000 = .85

$3,597,000
2-25
Ratio Analysis (cont.)

Table 2.6 Financial Statements Associated with Patty’s Alternatives

2-26
Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Financial Leverage Ratios
– Debt Ratio

Debt Ratio = Total Liabilities/Total Assets

Debt Ratio = $1,643,000/$3,597,000 = 45.7%

2-27
Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
– Times Interest Earned Ratio

Times Interest Earned = EBIT/Interest

Times Interest Earned = $418,000/$93,000 = 4.5

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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
– Fixed-Payment coverage Ratio (FPCR)
FPCR = EBIT + Lease Payments________________

Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}

FPCR = $418,000 + $35,000 = 1.9
$93,000 + $35,000 + {($71,000 + $10,000) x [1/(1-.29)]}

2-29
Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
– Common-Size Income Statements

2-30
Ratio Analysis (cont.)

Table 2.7
Bartlett Company
Common-Size
Income
Statements

2-31
Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
– Gross Profit Margin

GPM = Gross Profit/Net Sales

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

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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
– Operating Profit Margin (OPM)

OPM = EBIT/Net Sales

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

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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
– Net Profit Margin (NPM)

NPM = Earnings Available to Common Stockholders

Sales
NPM = $221,000/$3,074,000 = 7.2%
Copyright © 2009 Pearson Prentice Hall. All rights reserved.
2-34
Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
– Earnings Per Share (EPS)

EPS = Earnings Available to Common Stockholders

Number of Shares Outstanding

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

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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
– Return on Total Assets (ROA)

ROA = Earnings Available to Common Stockholders

Total Assets

ROA = $221,000/$3,597,000 = 6.1%

2-36
Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
– Return on Equity (ROE)

ROE = Earnings Available to Common Stockholders

Total Equity

ROE = $221,000/$1,754,000 = 12.6%

2-37
Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
• Market Ratios
– Price Earnings (P/E) Ratio

P/E = Market Price Per Share of Common Stock

Earnings Per Share

P/E = $32.25/$2.90 = 11.1

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Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
• Market Ratios
– Market/Book (M/B) Ratio

BV/Share = Common Stock Equity

Number of Shares of Common Stock

BV/Share = $1,754,000/72,262 = $23.00

2-39
Ratio Analysis (cont.)

• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios
• Market Ratios
– Market/Book (M/B) Ratio

M/B Ratio = Market Price/Share of Common Stock

Book Value/Share of Common Stock

M/B Ratio = $32.25/$23.00 = 1.40

2-40
Summarizing All Ratios
Table 2.8 Summary of Bartlett Company Ratios (2007–
2009, Including 2009 Industry Averages)

2-41
Summarizing All Ratios (cont.)
Table 2.8 Summary of Bartlett Company Ratios (2007–
2009, Including 2009 Industry Averages)

2-42
DuPont System of Analysis

• The DuPont system of analysis 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.
• The Modified DuPont Formula relates the firm’s ROA to its ROE
using the financial leverage multiplier (FLM), which is the ratio of
total assets to common stock equity:
• ROA and ROE as shown in the series of equations on the following
slide and in Figure 2.2 on the following slide.

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DuPont System of Analysis

2-44
DuPont System of Analysis (cont.)

Figure 2.2 DuPont

System of Analysis

2-45
Modified DuPont Formula (cont.)

• Use of the FLM to convert ROA into ROE reflects the

impact of financial leverage on the owner’s return.
• Substituting the values for Bartlett Company’s ROA of
6.1 percent calculated earlier, and Bartlett’s FLM of
2.06 ($3,597,000 total assets ÷ $1,754,000 common
stock equity) into the Modified DuPont formula yields:

ROE = 6.1% X 2.06 = 12.6%

2-46
 REFERENCE

For further reading see the book

Managerial Fiance by Lawrance J Gitman
Financial Management by Brigham
Financial Management by Van, Horne
Corporate Finance by J.Ross Stephen
 QUESTIONS

• In case of any query contact me at: riazhussain

@uosahiwal.edu.pk
• You can also ask questions via Google Classroom
Thank you