FINANCIAL STATEMENT

ANALYSIS
A Valuation Approach

by
Leonard Soffer and Robin Soffer
 Financial Statement Analysis
Where We Are Going

We will learn how to use financial

statements to construct ratios for
analyzing a firm

Chapter 5

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 Second Phase
of Security Analysis
Business Analysis

GAAP
Financial Financial Statement Forecast
Statements Analysis Assumptions

Valuation

Time Historical Periods Valuation Date Forecast Periods

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 Analysis Occurs when
Ratios are compared to
 Other firms or across time

Ratios are used to

 Investigate questions about the

company

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 Common Ratios

 Operating Ratios
 Credit Ratios
 Investment Ratios

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 Operating Ratios

Help analyze business profitability

and cash flow

Most useful for valuation analyses

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 Operating Ratios Continued

Revenue growth rate

Gross margin percentage
Operating margin percentage
Effective income tax rate
Days receivables outstanding
Days payables outstanding
Inventory turnover
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 Operating Ratios
Revenue Growth Rate

Measures expansion or
contraction of the business

Current year revenues - Prior year revenues

Prior year revenues

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 Operating Ratios
Gross Margin Percentage
Represents the amount per dollar of
revenues available to pay other costs
after the costs of the products sold have

been met
Gross margin
Revenues

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 Operating Ratios
Operating Margin Percentage

Shows profit from operating the business

before any taxes and financing costs

Operating income
Revenues

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 Operating Ratios
Effective Income Tax Rate

Compared to earnings before income

taxes rather than to revenues

Income taxes
Earnings before income taxes

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 Operating Ratios
Capital Components
Days Receivables Outstanding
Measures how well the company is
collecting its receivables

Average accounts receivable balance

Revenues / 365

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 Operating Ratios
Capital Components
Days Payables Outstanding
Too low a ratio indicates a company not
using available trade credit to its benefit

Too high a ratio indicates a problem in

making payments

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 Operating Ratios
Capital Components Continued

Days Payables Outstanding

Average accounts payable balance

Cost of sales / 365

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 Operating Ratios
Capital Components Continued

Inventory Turnover

Cost of sales
Average inventory balance

Higher turnover suggests greater efficiency

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 Credit Ratios

Measure a firm's ability to repay obligations

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 Credit Ratios
Current Ratio

Current assets
Current liabilitie s

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 Credit Ratios Continued
Quick Ratio

Cash and short - term investment s

Current liabilitie s

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 Credit Ratios Continued
Debt to Capital Ratio

Debt
Debt  Minority interest  Equity

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 Credit Ratios Continued
Interest Coverage Ratio

Earnings before interest and taxes

Interest expense

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 Investment Ratios

 Measure a firm's total performance

 Are used along with the operating ratios

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 Investment Ratios Continued
Price-to-Earnings Ratio

Stock price
Diluted earnings per share

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 Investment Ratios Continued
Market-to-Book Ratio

Stock price
Book value per share

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 Investment Ratios Continued
Return on Capital

Net income plus aftertax interest expense

Average total capital

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 Investment Ratios Continued
Return on Common Equity

Net income
Average common equity

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 Ratio Analysis

Is more meaningful when compared to

benchmarks such as trend analyses
and cross-sectional analyses

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 Trend Analysis

Looks at changes in ratios over time

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 Cross-sectional Analyses

Compare ratios across companies

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 Cautions about Using Ratios
Consider the effects of
 Accounting Methods

 Estimates

 Disclosure Levels

 Nonrecurring Items

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 More Cautions
about Using Ratios
 Industry Differences
 Business Environment Changes
 Adjustments may be needed to financial
data before preparing ratios
 Understand the definitions of ratios
used in our analysis

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 Summary
We have learned:

 Why ratios are used

 Common ratios
 Ratio analysis
 Cautions

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