Financial Statements &

Ratio Analysis

Business Studies Department, BUKC

Business Studies Department, BUKC
 Financial Statement Information
Used extensively by internal users
• Management at various levels
Performance evaluation
Competitive analysis
Investment decisions
Valuation of targets
• Current and future employees
Is this firm going to meet its payroll and will the stock options be
worth anything?

Business Studies Department, BUKC

 Financial Statement Information
Used primarily by external users
1. Financial intermediaries (analysts)
Stock recommendations
2. Lenders
Loan decisions
Monitoring
3. Investment bankers
Valuation for M&A and IPO
Top management performance evaluation

Business Studies Department, BUKC

 Financial Statement Analysis
Financial statement analysis and business analysis
applications
– Focus is more than a mechanical analysis of financial
statements.
– Draw heavily on your understanding of finance,
economics, marketing, and strategy.
• Combine that understanding with financial statement
information to diagnose problems and come up with
solutions/recommendations

Business Studies Department, BUKC

 Examples of Internal Uses of Statement Analysis

• Plan -- Focus on assessing the current financial

position and evaluating potential firm
opportunities.
• Control -- Focus on return on investment for
various assets and asset efficiency.
• Understand -- Focus on understanding how
suppliers of funds analyze the firm.

Business Studies Department, BUKC

 Primary Types of Financial Statements
Balance Sheet
 A summary of a firm’s financial position on a given
date that shows total assets = total liabilities +
owners’ equity.
Income Statement
• A summary of a firm’s revenues and expenses over
a specified period, ending with net income or loss
for the period.

Business Studies Department, BUKC

Business Studies Department, BUKC
 Balance sheet analysis
• Cash versus other assets.
• Working capital. Current assets are often called working capital
because these assets “turn over”; that is, they are used and then
replaced throughout the year.
• Net working capital
• Other sources of funds.
• Depreciation
• Market values versus book values
• Time dimension

Business Studies Department, BUKC

Basket Wonders’ Balance Sheet (Asset
Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2018a

Cash and C.E. $ 90 a. How the firm stands on a

Acct. Rec.c 394 specific date.
Inventories 696 b. What BW owned.
Prepaid Exp d 5 Accumc. Amounts owed by
Tax Prepay 10 customers.
d. Future expense items
Current Assetse $1,195 Fixed already paid.
Assets (@Cost)f 1030 Less: Acc. e. Cash/likely convertible to
Depr. g (329) Net Fix. cash within 1 year.
Assets $ 701 Investment, LT f. Original amount paid.
50 Other Assets, LT g. Acc. deductions for wear
223 Total Assets b
$2,169 and tear.
Basket Wonders’ Balance Sheet
(Liability Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2018

Notes Payable $ 290 Acct. a. Note, Assets = Liabilities +

Payablec 94 Equity.
Accrued Taxes d 16 Other b. What BW owed and
Accrued Liab. d 100 ownership position.
Current Liab. e $ 500 Long- c. Owed to suppliers for goods
Term Debt f 530 and services.
Shareholders’ Equity Com. d. Unpaid wages, salaries, etc.
Stock ($1 par) g 200 Add Pd e. Debts payable < 1 year.
in Capital g 729 Retained f. Debts payable > 1 year.
Earnings h 210 Total g. Original investment.
Equity $1,139 h. Earnings reinvested.
Total Liab/Equitya,b $2,169
Basket Wonders’ Income Statement
Basket Wonders Statement of Earnings (in thousands) for Year Ending December
31, 2018a

Net Sales $ 2,211 Cost of a. Measures profitability over a

Goods Sold b 1,599 Gross time period.
Profit $ 612 SG&A Expenses c b. Received, or receivable, from
402 EBITd customers.
$ 210 Interest Expensee c. Sales comm., adv., officers’
59 EBT f $ 151 salaries, etc.
Income Taxes 60 d. Operating income.
EATg $ 91 Cash e. Cost of borrowed funds.
Dividends 38 f. Taxable income.
Increase in RE $ 53 g. Amount earned for
shareholders.
 Other relevant financial statements
• STATEMENT OF CASH FLOWS: A report that shows how things that
affect the balance sheet and income statement affect the firm’s cash flows.
• Statement of Stockholders’ Equity: A statement that shows by how much a
firm’s equity changed during the year and why this change occurred.

Business Studies Department, BUKC

 Income Taxes
Individuals and corporations pay out a significant
portion of their income as taxes, so taxes are important
in both personal and corporate decisions.

Business Studies Department, BUKC

Figure 3:
Fundamentals of financial Management by
Van Horne.
 Liquidity ratios
• Liquidity ratios measure a company's ability to pay debt obligations
and its margin of safety.
1. Current Ratio= CA/CL
2. Quick, or Acid Test Ratio=(CA-Inventories)/CL
3. Cash Ratio (Cash/Current Liabilities)
4. Working Capital Management= CA-CL

Business Studies Department, BUKC

 Asset Management Ratios
• Asset management ratios measure how effectively a firm is managing its assets.
1. Inventory turnover ratio = Sales/ Inventory or COGS/ Inventory
2. Days sales in inventory = Inventories *365/ COGS or 365 days/Inventory turnover
3. Receivables turnover ratio = Sales/ Accounts Receivables
4. Days sales in receivables = Receivable *365/ Total credit sales or
5. 365 days/Receivables turnover
6. Fixed Assets Turnover Ratio = Sales/ Net Fixed Assets
7. Total Assets Turnover Ratio = Sales/ Total Assets

Business Studies Department, BUKC

 Debt Management Ratios
The extent to which a firm uses debt financing, or financial leverage, has three important
implications:

1. By raising funds through debt, stockholders can maintain control of a firm without increasing
their investment.

2. If the firm earns more on investments financed with borrowed funds than it pays in interest,
then its shareholders’ returns are magnified, or “leveraged,” but their risks are also
magnified.

3. Creditors look to the equity, or owner-supplied funds, to provide a margin of safety, so the
higher the proportion of funding supplied by stockholders, the less risk creditors face. C

Business Studies Department, BUKC

 Debt Management Ratios
1. Debt Ratio = Total Debt / Total Assets
2. Debt Equity Ratio = Total Debt / Total Equity
3. Equity Multiplier = Total Assets / Total Equity
4. Long-term Debt Ratio= Long term Debt / (Long term Debt+ Total
Equity)
5. Times-Interest-Earned Ratio = EBIT/Interest Expense
6. Cash Coverage Ratio = (EBIT + Depreciation ) / Interest Expense

Business Studies Department, BUKC

 Equity Multiplier – Special Case
• Equity Multiplier = Total Assets/Common Equity

Business Studies Department, BUKC

 Practice Problems
• Word Problems:
3-1 , 3-2, 3-7, 3-9.

Business Studies Department, BUKC

 Reference
• Chapter 3 from Financial management theory and practice by
Brigham and Ehrhardt (13th Edition).

Business Studies Department, BUKC