Chapter 3: Analysis of Financial

Statements
 Financial statements and reports- income statement,
balance sheet, statement of retained earnings,
statement of cashflow
 Accounting income vs cashflow
 Ratio analysis – liquidity ratios, asset management
ratios, debt management ratios, profitability ratios,
market value ratios
 Trend analysis
 Dupont analysis
 Comparative ratios
 Uses and limitations of ratio analysis
 Tax system – income tax (individual), capital gain
and corporate.
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 Financial Statements and Reports

 Annual report- A report issued annually by a corporation to its

stockholders, which contains basic financial statements, as well as
management’s opinion of the past year’s operations and the firm’s
future prospects.
 Financial statement – A set of statements is prepared at the
end of a certain accounting period of an enterprise for reporting
operating performance, financial position, liquidity position and equity
position to stakeholders for making their future important decisions is
known as financial statement.

 Types of financial statements:

1. Income statement – A statement summarizing the
firm’s revenues and expenses over an accounting period,
generally a year.

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 Financial Statements and Reports
2. Comprehensive income statement: Income is the sum of
net income and other items that must bypass the
income statement because they have not been realized,
including items like an unrealized holding gain or loss from
available for sale securities and foreign currency translation
gains or losses. These items are not part of net income, yet
are important enough to be included in comprehensive
income, giving the user a bigger, more comprehensive picture
of the organization as a whole. The statement shows all these
items is known as comprehensive income statement.

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 Financial Statements and Reports
3. Balance sheet – A statement shows a firm’s financial
position i.e. amount of assets, liabilities and owners’ equity at a
specific point of time.

4. Statement of retained earnings or Statement

of stockholders’ equity – A statement reporting the
change in retained earnings balance from the starting to the
ending of an accounting period as a result of operating
performance.

5. Cash flow statement – A statement reporting the

change in net cash position from the beginning to the ending of
an accounting period affected by firm’s operating, investing and
financing activities.

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Financial statement analysis:
It is defined as the process of identifying financial
strengths and weaknesses of the firm by properly
establishing relationship between the items of the
balance sheet and the profit and loss account. The
process of reviewing and evaluating a company’s
financial statements (such as the balance sheet or
profit and loss statement), thereby gaining an
understanding of the financial health of the company
and enabling more effective decision making.

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 Techniques of financial statement analysis:
1. Common-size or vertical analysis – The financial statement analysis in
which the total asset figure, total liability and equity figure and
revenues are considered as hundred percentage and the percentage of
all other individual item is determined with respect to that hundred
percentage is called common-size or vertical statement analysis.
2. Horizontal analysis – The financial statement analysis under which the
amount of current year with respect to base year is determined for all
individual items is called horizontal statement analysis. This analysis is
performed generally in case of consecutive two years financial
statements.

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3. Trend percentage analysis - The financial statement
analysis under which the percentage of all years of all
individual items are determined with respect to base year
in case of more than two consecutive years’ financial
statements is called trend percentage analysis.
4. Ratio analysis – The financial statement analysis in which
the numerical relationship between two financial figures
of a financial statement is determined is called ratio
analysis. In financial statement analysis, a number of
ratios are commonly used in assessing the financial
position and operating performance of the firm.
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5. Statement of changes in financial position (Cash flow
statement and funds flow statement) – The external
financial statement that shows where working capital,
cash flow and funds flow came from and how these
were used during the period is known as statement of
changes in financial position.

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 Ratio Analysis

 Financial ratio
A: Liquidity ratio- ratios that show the relationship of a
firm’s cash and other current assets to its current
liabilities. This includes (i) Current ratio (ii) Quick ratio

B: Asset management ratio- A set of ratios that measures

how effectively a firm is managing its assets. This
includes (i) Inventory turnover ratio (ii) Days sales
outstanding or average collection period (iii) Fixed
asset turnover (iv) Total asset turnover

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 Ratio Analysis

C: Debt management ratio - ratios that show the relationship of a

firm’s total debt, equity and total assets. This includes (i) Debt
ratio (ii) Debt-equity ratio (iii) Times interest earned ratio (iv)
Fixed charge coverage ratio

D: Profitability ratio- a group of ratios showing the effect of

liquidity, asset management and debt management on operating
results. This includes (i) Gross profit margin (ii) Operating profit
margin (iii) Net profit margin (iv) Return on total asset (v)
Return on common equity (vi) Operating expense ratio

E: Market value ratio – a set of ratios that relate the firm’s stock
price to its earnings and book value per share. Ratios under this
are (i) Price/earnings ratio (ii) Market value/book value ratio

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 Trend Analysis

Trend analysis - an analysis of a firm’s financial ratios over

time that is used to determine the improvement or
deterioration in its financial position.
Dupont chart – a chart designed to show the relationships
among return on investment, asset turnover, profit margin and
leverage.
Dupont equation – a formula that gives the rate of return on
assets by multiplying the profit margin by the total asset
turnover.
(i) ROA = NPM X TAT=(Net income/Sales ) X
(Sales/Total assets)
(ii) ROE = NPMXTAT X EM = (Net income/Sales ) X
(Sales/Total assets) X (Total assets/Common
equity)
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 Comparative ratios (Benchmarking)

Comparative ratio analysis - an analysis

based on a comparison of a firm’s ratios with
those of other firms in the same industry.

Window dressing techniques – techniques

employed by firms to make their financial
statements look better than they actually
are.

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Balance Sheet: Assets
20X2 20X1
Cash $ 15.0 $40.0
A/R 180.0 160.0
Inventories 270.0 200.0
Total CA $ 465.0 400.0
Gross FA 680.0 600.0
Less: Dep. (300.0) (250.0)
Net FA 380.0 350.0
Total Assets $845.0 $750.0
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 Balance sheet:
Liabilities and Equity
20X2 20X1
Accts payable $30.0 15.0
Notes payable 40.0 35.0
Accruals 60.0 55.0
Total Current Liabilities $130.0 $105.0
Long-term debt 300.0 255.0
Total Liabilities $430.0 $360.0
Common stock 130.0 130.0
Retained earnings 285.0 260.0
$415.0 $390.0
Total Equity
$845.0 750.0
Total Liabilities & Equity
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Income statement
20X2 20X1
Sales $1500.0 $1435.0
COGS (1,230.0) (1,176.7)
Other expenses (90.0) (85.5)
EBITDA 180.0 173.3
Depr. & Amort. (50.0) (40.0)
EBIT $130.0 133.3
Interest Exp. (40.0) (35.0)
EBT $90.0 $98.3
Taxes (40%) (36.0) (39.3)
Net income $ 54.0 $59.0
Common Dividends (29.0) (27.0)
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Other data
20X2 20X1
Shares outstanding 25 25
EPS $2.16 $2.36
DPS $1.16 $1.08
Stock price $23.00 $23.00

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Statement of Retained
Earnings (2012)
Balance of retained
earnings, 12/31/X1 $260
Add: Net income, 54
20X2 (29)
Less: Dividends paid
Balance of retained $285
earnings, 12/31/1X2
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How to make cash-flow
statement
 There are 3 parts in the statement.
1. Cash flow from operating activities
2. Cash flow from financing activities
3. Cash flow from investment activities

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Statement of Cash Flows (20X2)

OPERATING ACTIVITIES
Net income $54.0
Add back depreciation 50.0
Subtract (Uses of cash):
Increase in A/R (20.0)
Increase in inventories (70.0)
Add (Sources of cash):
Increase in A/P 15.0
Increase in accruals 5.0
Net cash provided by operations. $34.0
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 Statement of Cash Flows
(20X2) (Contd.)
a. Net cash provided by operation $34.0
b. Cash Flow from Investment (80.0)
c. FINANCING ACTIVITIES
Increase in notes payable 5.0
Increase in long-term debt 45.0
Payment of cash dividend (29.0)
Net cash from financing 21.0
NET CHANGE IN CASH (25.0)
Plus: Cash at beginning of year 40.0
Cash at end of year $15.0

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 Comment about the financial
condition from the CF statement
 The net change in cash flow is negative. This
indicates that during the year the firm has more
cash outflow than inflow. The cash position of
the firm has deteriorated compared to the last
year.
 Huge inventories piled up that consumed cash
as well as the accounting profit
 Increase in fixed assets consumed cash as well
 Long term debt issued to pay cash dividends

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 1. Liquidity Ratio
a. Current Ratio for 20X2

Current ratio = Current assets / Current

liabilities
= $465 / $130
= 3.6
Industry average: 4.1
Comment: poorer than the industry

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 Comments on current ratio
20X2 20X1 Ind.
Current
3.6 3.8 4.1
ratio
 The firm has a liquidity which is more than the
benchmark of 2. However, compared to the
industry average it is not enough. More importantly
it is getting worse from the previous year.

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 1. Liquidity Ratio
b. Quick ratio for 2014.
Current assets - inventories Quick ratio 20X2=
Current liabilities
=$195 / $130 =1.5x
Quick ratio20X1=1.9
Industry average=2.1
Comment: Although the ratio is better than
the norm of 1 but it is much lower than the
industry standard. The firm needs to improve
that.
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 1. Overall comments on liquidity
 Liquidity performances are poor. The firm needs
to increase its cash balance which has drastically
gone down in the current year. Another reason
for low liquidity is that the sales has increased
only around 4% in the current year which must
be responsible for poor cash balance and poor
accounts receivables. The cash flow finding of too
much inventory piled up must have reduced cash
balance as well as contributed to the poor
liquidity.

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2. Asset Management Ratio:
a. Inventory turnover
Inv. turnover = Sales / Inventories
= $1230 / $270
= 4.6x

20X2 20X1 Ind.

Inventory
4.6x 5.9x 7.4x
Turnover

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Comments on Inventory Turnover

 Unilate’s inventory is sold out and

restocked, or “turned over”, 4.6 times
per year, which is considerably lower
than the industry average of 7.4 times.
It might be holding excessive stock of
inventory which indeed is unproductive.
It might have old inventory piled up that
suggests poor inventory management.

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 2. Asset Management Ratio:
b. Days Sales Outstanding: DSO is the average
number of days required for collection of sales

DSO = Receivables / Average sales per day

= Receivables / (Sales/365)
= $180 / ($1,500/360)= 43.2 days

20X2 20X1 Ind.

DSO 43.2 40.7 32.0

Unilete collects sales too slowly compared to the

industry, and the collection performance is getting
worse day-by-day. it has a poor credit policy.
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2. Asset Management Ratio:
c. Fixed asset turnover ratio
d. Total asset turnover ratios
FA turnover = Sales / Net fixed assets
= $1,500 / $380 = 3.9x
Industry average= 4.0x
TA turnover = Sales / Total assets
= $1,500 / $845 = 1.8x
Industry average= 2.1x

20X2 20X1 Ind.

FA TO 3.9x 4.1x 4.0x
TA TO 1.8x 1.9x 2.0x 3-29
 Comment on Fixed Assets turnover
and total asset turnover ratio

 Compared to the industry, the fixed

assets turnover ratio is alright but the
total asset turnover ratio is weak. The
reason might be the poor inventory
management of the firm.

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 2. Overall comments on asset
management
 Poor performances in all the asset management
ratios are due to poor sales promotion.
Considering the DSO, the firm can not relax the
credit terms, so to reduce the sales price and/or
aggressive market campaign may be a good option
to promote sales. To improve the DSO, the firm
should be more punctual in its collection of credit
sales. Cash discount can be increased. The reason
for poor asset management ratio is the inefficient
inventory management. Abnormal increase in
inventory in the current year [35%] does not
match with sales promotion [4%].
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 3. Debt Management Ratio
a. Debt Ratio=Total Debt/Total Assets
b. Times interest earned=EBIT/Interest charges

20X2 20X1 Ind.

Debt Ratio 50.9% 48% 45%

Times interest
3.3 x 3.8x 6.5x
earned

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 Debt Management Ratio
 The debt ratio is significantly higher than
the industry. Compared to the previous year
it is increasing as well. This is alarming as
interest charges are compulsory obligation.
In future this may result in a constraint to
raise debt. It might be rationalized by an
increased EPS by means of high debt
financing.
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 Debt Management Ratio
 Times interest earned ratio is worse
than the industry, as well as, that of last
year. Unilete is covering its interest charges
by a low margin of safety. This affects the
potentiality of raising further debt in future.

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 3. Overall comments on Debt
management
 Poor debt ratio and TIE ratio indicate that
the firm is highly a levered one. This may
affect the cost of debt in future. The firm
has raised debt capital to pay dividend,
which is not a good sign. Whether the firm
was capable of utilizing the advantage of
debt financing depends on profitability.

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 4. Profitability Ratios
a. Profit Margin on Sales = Net income/sales
x
b. Total Asset Turnover= Sales /Total Asset Du Pont
= Equation
c. Return on Assets (ROA) = Net Income/Total
Assets
x
d. Financial Leverage = Total Assets/Common Equity
=
e. Return on Equity (ROE) = Net income (available to
common stockholders)/Common Equity
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 Profitability Ratios
201X2 20X1 Ind.

(54/1500) (59/1435)
Profit Margin 4.7%
3.6% 4.1%
(1500/845) (1435/750)
Asset Turnover 2
1.77x 1.9x
(54/845) (59/750)
ROA 9.5%
6.4% 7.87%
Financial (845/415) (750/390)
1.8
Leverage 2.04 1.92
(54/415)
ROE 15.1% 17.2%
13.0%
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 5. Market value ratio
 a. Price/ Earnings Ratio =Market price
per share/EPS
EPS=Net income available to common
stockholders/No. of common shares
outstanding. So, EPS=$54/25=$2.16

20X2 20X1 Industry

$23/$2.16=10.6x $23/$2.36=9.7x 13.0x
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 5. Market value ratio (Contd.)
 Comment: P/E ratio is higher for firms with
high growth potentials and low for riskier
firms. We do not know the growth potential
of the firms but we know investors
considers the firm more risky perhaps due
to high leverage than industry average.
However, the ratio of the firms is increasing
to suggest more trust of the investors.

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 5. Market value ratio (Contd.)
 b. Market/Book value ratio
 Book value=Common equity/No. of shares outstanding
=$415/25=$16.60
 M/B value ratio=Market price per share/Book value per
share=$23/$16.6 =1.4x
 Previous year: BV=$390/25=15.6
 Previous year M/B=$23/$15.6=1.7x
 Industry average=2.0x
20X2 20X1 Industry
1.4 x 1.7x 2.0
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 5. Market value ratio (Contd.)
 Comment: The market value per share is 1.4
times the book value per share of the firm in
the current year. This is remarkably lower than
the industry average of 2 times. In the
previous year the same ratio was 1.7 times for
the firm. It demonstrates that not only the
firm performs poorer than the industry but also
the trust of investors in the firm goes down.

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Problem # 01: Given, cash Tk.95000, bank balance Tk.540000,
merchandise inventory Tk.128000, prepaid rent Tk.50000, marketable
securities Tk.150000, short-term notes receivable Tk.60000, accounts
receivable Tk.155000, stationery Tk.20000, plant & equipment Tk.490000,
land & building Tk.580000, computer & accessories Tk.200000, furniture
Tk.180000, long-term notes receivable Tk.210000, short-term notes
payable Tk.50000, accrued wages Tk.30000, unearned revenue (advance
receipt) Tk.100000, interest payable Tk.75000, tax payable Tk.55000,
long-term notes payable Tk.110000, bonds payable Tk.300000, debenture
Tk.150000, accounts payable Tk.65000, cost of goods sold Tk.1700000,
sales Tk.2900000 (80% on credit), operating expense Tk.350000, interest
expense Tk.80000, dividend declared Tk.120000, market price per share
Tk.280 and number of shares outstanding 20000. Calculate the
following ratios based on given information:

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a. Current ratio b. Quick asset or Acid test ratio c. Inventory
turnover d. Accounts receivable turnover e. Average collection
period f. Gross profit margin g. Operating profit margin
h. Net profit margin i. Operating expense ratio j. Return on
assets k. Return on equity l. Total assets turnover m. Fixed asset
turnover n. Debt ratio o. Debt-equity ratio p. Earnings per share
q. Dividend per share r. Dividend payout ratio s. Retention ratio
t. Book value per share u. Market value to Book value ratio v.
Price-earnings ratio w. Asset utilization ratio x. Dividend
yield y. Equity multiplier z. Times interest earned

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2. Given, Inventory Tk.250000, prepaid rent Tk.100000, marketable securities
Tk.120000, Short-term notes receivable Tk.60000, accounts receivable Tk.125000,
outstanding revenue Tk.70000, stationery Tk.40000, plant & equipment Tk.400000, land
& building Tk.500000, computer & accessories Tk.200000, furniture Tk.180000,
accounts payable Tk.50000, accrued wages Tk.60000, unearned revenue Tk.100000,
interest payable Tk.75000, tax payable Tk.55000, long-term note payable Tk.110000,
long-term bank loan Tk.200000, bonds payable Tk.300000, debenture Tk.150000, cost of
goods sold Tk.780000, credit sales Tk.1200000, operating expense Tk.200000, interest
expense Tk.50000, net income Tk.170000.Calculate the following ratios based on given
information:
a) Current ratio b) Inventory turnover c) Accounts receivable turnover d) Debt ratio e)
Operating expense ratio f) Days sales outstanding g) Gross margin h) Net margin i)
Return on asset j) Return on equity k) Equity multiplier l) Asset utilization ratio

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 H.W.
Questions: 2-1, 2-2, 2-3, 2-4,2-5 & 2-9.
Problems: 2-8, 2-13, 2-14.

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