Financial Statement Analysis

How to “Interpret” & “Analyze”

Financial Statements
Evaluating Financial Performance

 This section provides a clear and concise overview of

specific financial ratios used to measure financial
performance.

 Performance areas covered include liquidity, asset

management, profitability, leverage, market value ratios,
and comparative analysis.

 The objective of this section is to provide the user with

methodologies that can be useful in measuring and
monitoring financial performance.

2
Why Ratio Analysis ?

 You must measure what you expect to manage and accomplish.

 Without measurement, you have no reference to work with, and
thus, you tend to operate in the dark.
 One way of establishing references and managing the financial
affairs of an organization is to use financial ratios.
 Ratios are simply relationships between two financial balances
or financial calculations.
 These relationships establish our references so we can
understand how well we are performing financially.
 Ratios also extend our traditional way of measuring financial
performance; i.e. relying on financial statements.
 By applying ratios to a set of financial statements, we can better
understand financial performance.
3
The Use of Financial Ratios
 Ratio analysis is used to compare a company's
performance and status with that of another
company or itself over time.
 The basic inputs to ratio analysis is items from
Income statement and Balance Sheet
 What’s important in ratio analysis is the
interpretation,
interpretation rather than the calculation itself.

4
We should Consider the following
 A single ratio does not generally provide sufficient
information from which to judge the overall
performance of the firm. A group of ratios should be
used
 The financial statements being compared should be
dated at the same point in time during the year. To
avoid the effect of seasonality.
 Use audited financial statements.
 Compare financial statements with similar accounting
treatments.
5
 Types of Ratio Comparison
 Cross Sectional
 The comparison of different Companies’ financial

ratios at the same point in time; involves comparing the

company’s ratios to those of an industry leader or to
the industry average.
 Times series
 Evaluation of the company’s financial performance

over time utilizing financial ratio analysis

 Combined analysis

6
Dollar and Percentage Changes
Dollar Change:

Dollar Analysis Period Base Period

Change = Amount – Amount

:Percentage Change

%
Percent Base Period
Change = Dollar Change
÷ Amount
Dollar and Percentage Changes
Let’s
Let’s look
look at
at the
the asset
asset section
section of
of Clover,
Clover,
Inc.
Inc. comparative
comparative balance
balance sheet
sheet and
and
income
income statement
statement for
for 2007
2007 and
and 2006.
2006.
Compute
Compute the the dollar
dollar change
change and
and the
the
percentage
percentage change
change for
for cash.
cash.
 Clover, Inc.
Comparative Balance Sheets
December 31,
Dollar Percent
2007 2006 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 ? ?
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $ 155,000 $ 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700
* Percent rounded to one decimal point.
 Clover, Inc.
Comparative Balance Sheets
December 31,
Dollar Percent
2007 2006 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) ?
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $ 155,000
))11,500 ($$==164,700
11,500($ $23,500
$23,500 –– $12,000
$12,000
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700
* Percent rounded to one decimal point.
 Clover, Inc.
Comparative Balance Sheets
December 31,
Dollar Percent
2007 2006 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) -48.9%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
48.94%
48.94% == 100%
100% ×× ))$23,500
$23,500 ÷÷ $11,500
$11,500((
Total current assets $ 155,000 $ 164,700
Property and equipment:
Land 40,000 40,000 Complete
Complete thethe
Buildings and equipment, net 120,000 85,000 analysis
analysis for
for the
the
..other
other assets
assets
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700
* Percent rounded to one decimal point.
 Clover, Inc.
Comparative Balance Sheets
December 31,
Dollar Percent
2007 2006 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) -48.9%
Accounts receivable, net 60,000 40,000 20,000 50.0%
Inventory 80,000 100,000 (20,000) -20.0%
Prepaid expenses 3,000 1,200 1,800 150.0%
Total current assets $ 155,000 $ 164,700 (9,700) -5.9%
Property and equipment:
Land 40,000 40,000 - 0.0%
Buildings and equipment, net 120,000 85,000 35,000 41.2%
Total property and equipment $ 160,000 $ 125,000 35,000 28.0%
Total assets $ 315,000 $ 289,700 $ 25,300 8.7%
* Percent rounded to one decimal point.
Trend Percentages

Trend
Trend analysis
analysis is
is used
used to
to reveal
reveal patterns
patterns in
in
..data
data covering
covering successive
successive periods
periods

Trend Analysis Period Amount

Percentages =
Base Period Amount
× 100%
 Trend Percentages
Berry Products
Income Information
,For the Years Ended December 31
Item 2007 2006 2005 2004 2003
Revenues $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000

Item 2007 2006 2005 2004 2003

Revenues 145% 129% 116% 105% 100%
Cost of sales
is
is the
the base
150% base period
period
132%
so
so 2003
118% 2003
104% 100%
Gross profit its
its amounts
135% 124% will
amounts will equal
equal 108%
112% 100%
(290,000  275,000)  ..100%
100% 100%
= 105%
(198,000  190,000)  100% = 104%
(92,000  85,000)  100% = 108%
 Component Percentages
Examine the relative size of each item in the financial
statements by computing component
(or common-sized) percentages.

Component Analysis Amount

Percentage = × 100%
Base Amount

Financial
Financial Statement
Statement Base
Base Amount
Amount
Balance
Balance Sheet
Sheet Total
Total Assets
Assets
Income
Income Statement
Statement Revenues
Revenues
 Clover, inc.
Comparative Balance Sheets
December 31,
Complete the common-size analysis for the other Common-size
assets. Percents*
2007 2006 2007 2006
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
3.8%
3.8% == 100%
100% ×× ))$315,000
$315,000 ÷÷ $12,000
$12,000((
Total current assets $ 155,000 $ 164,700
Property and equipment:
Land 8.1% == 100%
8.1%40,000100% ×× ))$289,700
40,000 ÷÷ $23,500
$289,700 $23,500((
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
 Clover, Inc.
Comparative Balance Sheets
December 31,
Common-size
Percents*
2007 2006 2007 2006
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000 19.0% 13.8%
Inventory 80,000 100,000 25.4% 34.6%
Prepaid expenses 3,000 1,200 1.0% 0.4%
Total current assets $ 155,000 $ 164,700 49.2% 56.9%
Property and equipment:
Land 40,000 40,000 12.7% 13.8%
Buildings and equipment, net 120,000 85,000 38.1% 29.3%
Total property and equipment $ 160,000 $ 125,000 50.8% 43.1%
Total assets $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
 Clover, Inc.
Comparative Balance Sheets
December 31,
Common-size
Percents*
2007 2006 2007 2006
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 21.3% 15.2%
Notes payable 3,000 6,000 1.0% 2.1%
Total current liabilities $ 70,000 $ 50,000 22.3% 17.3%
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 23.8% 27.6%
Total liabilities $ 145,000 $ 130,000 46.1% 44.9%
Shareholders' equity:
Preferred stock 20,000 20,000 6.3% 6.9%
Common stock 60,000 60,000 19.0% 20.7%
Additional paid-in capital 10,000 10,000 3.2% 3.5%
Total paid-in capital $ 90,000 $ 90,000 28.5% 31.1%
Retained earnings 80,000 69,700 25.4% 24.0%
Total shareholders' equity $ 170,000 $ 159,700 53.9% 55.1%
Total liabilities and shareholders' equity $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
 Clover, Inc.
Comparative Income Statements
For the Years Ended December 31,
Common-size
Percents*
2007 2006 2007 2006
Revenues $ 520,000 $ 480,000 100.0% 100.0%
Costs and expenses:
Cost of sales 360,000 315,000 69.2% 65.6%
Selling and admin. 128,600 126,000 24.7% 26.3%
Interest expense 6,400 7,000 1.2% 1.5%
Income before taxes $ 25,000 $ 32,000 4.8% 6.7%
Income taxes (30%) 7,500 9,600 1.4% 2.0%
Net income $ 17,500 $ 22,400 3.4% 4.7%
Net income per share $ 0.79 $ 1.01
Avg. # common shares 22,200 22,200
* Rounded to first decimal point.
Common Size Analysis (Income Statement)
Commom Size (Vertical) Horizontal Analysis
Item Description 2003 2004 2003 2004 2003 2004
Total Sales 500 550 100% 100% 100% 110%
Less: Cost of Goods Sold 350 360 70% 65% 100% 103%
Gross Profit 150 190 30% 35% 100% 127%
Less: Selling, General & Administrative Expenses 70 75 14% 14% 100% 107%
Less: Depreciation 8 10 2% 2% 100% 125%
Operating Profit 72 105 14% 19% 100% 146%
Add: Interest Income 10 11 2% 2% 100% 110%
Add: Investment Income - - 0% 0%
Add: Other Sundry Income 10 15 2% 3% 100% 150%
Less: Other Sundry expense 15 20 3% 4% 100% 133%
Earnings Before Interest & Tax (EBIT) 77 111 15% 20% 100% 144%
Less: Interest Expenses 40 38 8% 7% 100% 95%
Earnings Before Tax (EBT) 37 73 7% 13% 100% 197%
Less: Tax 8 15 2% 3% 100% 188%
Net Profit After Taxes 29 58 6% 11% 100% 200%
20
Common Size Analysis (Balance Sheet)
Commom Size (Vertical) Horizontal Analysis
As s e ts 2003 2004 2003 2004 2003 2004
Cash 100 110 10% 11% 100% 110%
Accounts Receivables 150 165 16% 16% 100% 110%
Inventory 200 210 21% 21% 100% 105%
Total Curre nt As s e ts 450 485 47% 48% 100% 108%
Land 50 50 5% 5% 100% 100%
Buildings 120 125 13% 12% 100% 104%
Machinery 300 320 31% 32% 100% 107%
Other Fixed Assets 90 95 9% 9% 100% 106%
(Accumulated Depreciation) 55 65 6% 6% 100% 118%
Ne t Fixe d As se ts 505 525 53% 52% 100% 104%
TOTAL ASSETS 955 1,010 100% 100% 100% 106%
Liabilitie s & Equity 2003 2004 2003 2004 2003 2004
Short Term Debt 95 120 10% 12% 100% 126%
Accounts Payable 120 130 13% 13% 100% 108%
Accrued Expenses 60 65 6% 6% 100% 108%
Total Curre nt Liabilitie s 275 315 29% 31% 100% 115%
Long Term Debt 250 225 26% 22% 100% 90%
Total Liabilite s 525 540 55% 53% 100% 103%
Common Stock 200 200 21% 20% 100% 100%
Reserves 150 165 16% 16% 100% 110%
Retained Earnings 80 105 8% 10% 100% 131%
Total Equity 430 470 45% 47% 100% 109%
Total Liabilitie s & Equity 955 1,010 100% 100% 100% 106%
21
Main Groups of Financial Ratios
 Analyzing Liquidity
 Analyzing Activity (Asset Management)
 Analyzing Debt
 Analyzing Profitability

22
 Analyzing Liquidity
 The liquidity of a business firm is measured by
its ability to satisfy its short-term obligations as
they come due.
 Current Ratio

 Quick (Acid-Test) Ratio

 Cash Ratio.

 Net Working Capital

23
Analyzing Liquidity: Current Ratio
 It is a measure of liquidity calculated by dividing the
firm’s current assets by its current liabilities

Current Ratio = Current Assets / Current Liabilities

24
Analyzing Liquidity: Quick (Acid-test) Ratio
 It is similar to the current ratio; except it excludes the
inventory; which is generally the least liquid current
asset.

Quick Ratio = (Current assets – Inventory) /

Current Liabilities

25
Analyzing Liquidity: Net Working Capital
 A measure of liquidity calculated by subtracting current
liabilities from current assets

Net Working Capital = Current Assets – Current

Liabilities
 It is only useful for internal control inside the company,

not for comparison with other companies

26
 Liquidity Measures
 Note that for all three liquidity measures; the higher the
value, the more liquid the firm is typically considered to
be.
 However this low risk sacrifices profitability
 Current assets are less profitable/productive than

fixed assets
 Current liabilities are a less expensive financing

source than long term funding

27
 Asset Management
 Activity ratios are used to measure the speed in which
various accounts are converted into sales or cash.
 Inventory Turnover

 Average Collection Period

 Average Payment Period

 Fixed Asset Turnover

 Total Assets Turnover

28
Asset Management: Inventory Turnover
 It measures the activity or liquidity of a firm’s inventory
Inventory Turnover = COGS / Inventory

 Inventory Days on Hand

 It is the average length of time inventory is held by the

firm
Inventory Days on Hand = 365 / Inventory Turnover

29
Asset Management: Average Collection
Period
 It is the average amount of time needed to collect
accounts receivable

Accounts Receivable Turnover =

Sales / Accounts Receivable

Average Collection Period (Days Sales Outstanding)

= 365 / A/R Turnover

30
Asset Management: Average payment
Period
 It is the average amount of time needed to pay accounts
payable

Accounts Payable Turnover =

COGS / Accounts Payable

Average Payment Period = 365 / A/P Turnover

31
Asset Management: Fixed Assets Turnover
 It measures the efficiency with which the firm has been
using its fixed or earning, assets to generate sales

Fixed Assets Turnover = Sales / Net Fixed Assets

32
Asset Management: Total Assets Turnover
 It indicates the efficiency with which the firm uses all its
assets to generate sales

Total Assets Turnover = Sales / Total Assets

33
 Analyzing Debt
 The debt position of a firm indicates the amount of other
people’s money being used in attempting to generate
profits.
 Generally, the more debt a firm uses in relation to its
total assets, the greater its financial leverage.

34
Analyzing Debt: Debt Ratio
 It measures the proportion of total assets financed by the
firm’s creditors

Debt Ratio = Total Liabilities / Total Assets

35
Analyzing Debt: Debt-Equity ratio
 It measures the ratio of long-term debt to stockholder’s
equity

Debt-Equity Ratio = Long-Term Debt/Equity

36
 Analyzing Debt: Times Interest Earned

 It measures the firm’s ability to make contractual interest

payments

Times Interest Earned= Earnings Before Tax / Interest Expense

37
 Analyzing Profitability

 Gross Profit Margin

 Operating Profit Margin
 Net Profit Margin
 Return on Assets
 Return on Equity
 Earning Per Share (EPS)
 Price/Earnings Ratio (P/E ratio)

38
 Gross Profit Margin
 It measures the percentage of each sales dollar
remaining after the firm paid for its goods

Gross Profit Margin = (Sales-COGS) / Sales

39
 Operating Profit Margin
 It measures the percentage of profit earned on each sales
dollar before interest and taxes

Operating Profit Margin= Operating Profit / Sales

40
 Net Profit Margin
 It measures the percentage of each sales dollar
remaining after all expenses, including taxes, have been
deducted

Net Profit Margin= Net Profit after Taxes / Sales

41
 Return on Total Assets
 It measures the overall effectiveness of management in
generating profits with its available assets.

Return on Total Assets=Net Profit after Tax/

Total Assets

42
 Return on Assets (ROA)
 It measures the efficiency with which a company allocates
and manages its resources.
 there are tow determinants for controlling REA :

Net Income Net income sales

ROA = -------------- = ---------------- X -------------
Assets sales assets

ROA = Profit margin X assets turnover

 Return on Equity
 It measures the return earned on the owners’ (both preferred
and common stockholders’) investment n the firm

Return on Equity = Net Profit after Tax / Stockholder’s Equity

44
Return on Equity
 There are three determinants for controlling REO :

 Profit Margin.

 Asset Turnover.

 Financial Leverage.

45
 Return on Equity
 It measures the return earned on the owners’ (both preferred
and common stockholders’) investment n the firm
Return on Equity = Net income/ Stockholder’s Equity
Net income Sales Assets
ROE = __________ X ___________ X __________________
sales Assets (Shareholder's equity)

ROE = Profits Margin X Assets Turnover X Financial Leverage

Is ROE a reliable Financial Yardstick?

 The Timing Problem.

 The Risk Problem.
 The value problem.
The timing Problem
 Because ROE necessarily includes only one year’s
earning, it fails to capture the full impact of multiperiod
decision.
The risk Problem
 ROE say nothing about what risks a company has taken
to generate it.
The value Problem
 The market value of equity is more significant to
shareholders because it measures the current, realizable
worth of the share, while book value is only history.
 Earnings per Share
 It represents the number of dollars earned on behalf of each
outstanding share of common stock.

EPS=Earnings Available for Common Stockholders /

Number of Shares of Common Stocks Outstanding

51
 Price/Earnings Ratio
 It reflects the amount investors are willing to pay for each
dollar of the firms earnings; the higher the P/E ratio, the
greater the investor confidence in the firm

P/E Ratio=Market Price per Share of Common Stocks/

Earnings Per Share

52
Questions & Answers