FINANCIAL STATEMENTS

ANALYSIS – A SUMMARY
CRUZ, TALION AND TIMBANG
CA51012 Financial Management
UST Alfredo M. Velayo College of Accountancy
University of Santo Tomas
 1. LEARNING OBJECTIVES
• Recognize that ratio analysis provides a meaningful
comparison of a company to its industry.
• Explain what ratios are used for and what they measure.
• Recall that the DuPont system of analysis identifies the true
sources of return on assets and return to stockholders.
• Detail what trend analysis shows.
• Explain why reported income must be further evaluated.
 2. RATIO ANALYSIS
Financial ratios.
• Used to weigh and evaluate operating performance of firm.
• Measured in relation to other values.
• Compares performance record against similar firms in
industry.
• Additional evaluation of company management, physical
facilities, and other factors is needed.
• Financial data reported by S&P, Moody’s, etc.
 2A. RATIO ANALYSIS – CLASSIFICATION
SYSTEM
A. PROFITABILITY RATIOS
1. Profit margin
2. Return on assets (investment)
3. Return on equity
 2B. RATIO ANALYSIS – CLASSIFICATION
SYSTEM
B. ASSET UTILIZATION RATIOS
4. Receivable turnover
5. Average collection period
6. Inventory turnover
7. Fixed asset turnover
8. Total asset turnover
 2C. RATIO ANALYSIS – CLASSIFICATION
SYSTEM
C. LIQUIDITY RATIOS
9. Current ratio
10. Quick ratio
D. DEBT UTILIZATION RATIOS
11. Debt to total assets
12. Times interest earned
13. Fixed charge coverage
 2D. RATIO ANALYSIS – CLASSIFICATION
SYSTEM
A. PROFITABILITY RATIOS – CATEGORY A
Measures firm’s ability to earn adequate returns
Sales
Total assets
Invested capital
 2E. RATIO ANALYSIS – CLASSIFICATION
SYSTEM
B. ASSETS UTILIZATION RATIOS – CATEGORY B
Measures speed at which firm turnover
Accounts receivable
Inventory
Long-term assets
 2F. RATIO ANALYSIS – CLASSIFICATION
SYSTEM
C. LIQUIDITY RATIOS – CATEGORY C
Emphasize firm’s ability to pay off short-term obligations
as they come due

D. DEBT UTILIZATION RATIOS – CAGTEGORY D

Estimate overall debt position of the firm
Evaluate in light of asset base, earning power
 2G. RATIO ANALYSIS – CLASSIFICATION
Users of financial statements haveSYSTEM
differing degrees of importance in categories of
ratios.
Potential investors and security analysts.
• Primary considerations—profitability ratios.
• Secondary considerations—liquidity and debt utilization.
For banker or trade creditor.
• Primary consideration—liquidity ratios.
For long-term creditors (bondholder).
• Primary consideration—debt utilization ratios (debt to total assets) and
profitability ratios.
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3. FINANCIAL STATEMENT FOR RATIO ANALYSIS
 3A. THE ANALYSIS – PROFITABILITY RATIOS

Saxton Company Industry Average

Net income $200, 000
1. Profit margin   5% 6.7%
Sales $4, 000, 000

2. Return on assets (investments) 

Net income $200, 000
a.  12.5% 10%
Total assets $1, 600,111
Net income Sales
b.  5%  2.5  12.5% 6.7% 1.5  10%
Sales Total assets
3. Return on equity 
Net income $200, 000
a.  20% 15%
Stockholders' equity $1, 000, 000
Return on assets (investments) 0.125 0.10
b.  20%  15%
(1  Debt/Assets) 1  0.375 1  0.33

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 3B. THE ANALYSIS – DuPont SYSTEM OF
ANALYSIS
Satisfactory return on assets can be derived through.
• High profit margin.
• Rapid asset turnover (generating more sales per dollar of
assets).
• Combination of both
Return on assets (investment)
= Profit margin × Asset turnover
 3C. THE ANALYSIS – DuPont SYSTEM OF
ANALYSIS
Satisfactory return on equity can be derived through.
• High return on total assets.
• Generous utilization of debt.
• Combination of both

Return on assets investment 

Return on equity 
1 – Debt/Assets 
3D. DuPont ANALYSIS
 3E. THE ANALYSIS – ASSET UTILIZATION RATIOS

• Relate balance sheet (assets) to income statement (sales).

Saxton Company Industry Average

4. Receivables turnover 
Sales (credit) $4, 000, 000
 11.4 10 times
Receivables $350, 000
5. Average collection period 
Accounts receivable $350, 000
 32 36 days
Average daily credit sales $11,111
6. Inventory turnover 
Sales $4, 000, 000
 10.8 7 times
Inventory $370, 000

• *This ratio may also be computed by using “cost of goods sold”

in the numerator

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3F. Return on Equity: Walmart versus. Target Using the DuPont Method
of Analysis

B C D = (1 − C) 1 − (A × B)/D
A Asset A × B Return Debt/ Debt/ Return
Name Profit Margin Turnover on Assets Assets Assets on Equity

Walmart Stores
3.83% 1.62 6.21% 65.12% 34.88% 17.80%
Inc.

Target 4.58% 1.29 5.90% 73.71% 26.30% 22.43%

Data: October 31,

2020

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3G.THE ANALYSIS – ASSET UTILIZATION
RATIOS
Saxton Company Industry Average
7. Fixed asset turnover 
Sales $4, 000, 000
5 5.4 times
Fixed assets $800, 000
8. Total asset turnover 
Sales $4, 000, 000
 2.5 1.5 times
Total assets $1, 600, 000

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3H. THE ANALYSIS – LIQUIDITY RATIOS
• These ratios determine if the firm can meet each
maturing obligation as it comes due.

Saxton Company Industry Average

9. Current ratio 
Current assets $800, 000
 2.67 2.1 times
Current liabilities $300, 000
10. Quick ratio 
Current assets  Inventory $430, 000
 1.43 1.1 times
Current liabilities $300, 000

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3I. THE ANALYSIS – DEBT UTILIZATION
RATIOS
• Measures the prudence of the debt management policies
of the firm.

Saxton Company Industry Average

11. Debt to total assets 
Total debt $600, 000
 37.5% 33%
Total assets $1, 600, 000
12. Times interest earned 
Income before interest and taxes $550, 000
 11 7 times
Interest $50, 000
13. Fixed charge coverage 
Income before fixed charges and taxes $600, 000
6 5.5 times
Fixed charges $100, 000

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3J. THE ANALYSIS – DEBT UTILIZATION RATIOS
• Fixed charge coverage measures the firm’s ability to
meet all fixed obligations rather than interest payments
alone.

Income before interest and taxes $550,000

Lease payments 50,000
Income before fixed charges and taxes $600,000

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3J. THE ANALYSIS – RATIO ANALYSIS
Saxton Industry Company Average Conclusion
A. Profitability
1. Profit margin 5.0% 6.7% Below average
2. Return on assets 12.5% 10.0% Above average due to high turnover
3. Return on equity 20.0% 15.0% Good, due to Ratios 2 and 11
B. Asset Utilization
4. Receivables turnover 11.4 10.0 Good
5. Average collection period 32.0 36.0 Good
6. Inventory turnover 10.8 7.0 Good
7. Fixed asset turnover 5.0 5.4 Below average
8. Total asset turnover 2.5 1.5 Good
C. Liquidity
9. Current ratio 2.67 2.1 Good
10. Quick ratio 1.43 1.1 Good
D. Debt Utilization
11. Debt to total assets 37.5% 33.0% Slightly more debt
12. Times interest earned 11.0 7.0 Good
13. Fixed charge coverage 6.0 5.5 Good

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 3K. TREND ANALYSIS
Over course of business cycle, sales and profitability
expand and contract.
• Ratio analysis for any one year does not reflect accurate
picture of the firm.

Trend analysis reflects performance over a number of

years.
• Without industry comparisons, may not reflect a
complete picture.
• Gives picture of performance over number of years
against industry averages.

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3L. TREND ANALYSIS

• Access the text alternative for slide images.

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3M. TREND ANALYSIS

• Access the text alternative for slide images.

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 3N. IMPACT OF INFLATION ON FINANCIAL ANALYSIS
Major problem of inflation.
• Revenue stated in current dollars.
• Plant, equipment, or inventory may have been purchased at lower price
levels.
• Profits may be more function of increasing prices than satisfactory
performance.
Financial reports are distorted by not considering inflation.
• Affecting financial analysis.

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Table 3-4 Stein Corporation Income Statement for 2020
• STEIN CORPORATION
• Net Income for 2020

Sales $220 (100 units at $2)

Cost of goods sold 100 (100 units at $1)
Gross profit $100
Selling and administrative expense 20 (10% of sales)
Depreciation 10
Operating profit $ 70
Taxes (24%) 17
After tax income $ 53

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Table 3-5 Stein Corporation Income Statement for 2021
• STEIN CORPORATION
• Net Income for 2021

Sales $220 (100 units at 2021 price of $2.20)

Cost of goods sold 100 (100 units at $1.00)
Gross profit $120
Selling and administrative expense 22 (10% of sales)
Depreciation 10
Operating profit $ 88
Taxes (24%) 21
After tax income $ 67

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Table 3-6 Comparison of Replacement Cost Accounting and Historical Cost
Accounting
10 Chemical 8 Drug
Companies Companies
Replacement Historical Replacement Historical
Cost Cost Cost Cost
Increase in assets 28.4% – 15.4% –
Decrease in net income
before taxes 45.8% – 19.3% –
Return on assets 2.8% 6.2% 8.3% 11.4%
Return on equity 4.9% 13.5% 12.8% 19.5%
Debt-to-assets ratio 34.3% 43.8% 30.3% 35.2%
Interest coverage ratio
(times interest earned) 7.1 times 8.4 times 15.4 times 16.7 times

• Jeff Garnett and Geoffrey A. Hirt, “Replacement Cost

Data: A Study of the Chemical and Drug Industry for
Years 1976 through 1978.”
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 An Illustration
Replacement cost—reduces income but increases
assets.
• Increase in assets lowers debt-to-assets ratio.
• Decreased debt-to-assets ratio indicates decrease
in financial leverage of firm.
• Declining income results in decreased ability to
cover interest costs.

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 Disinflation Effect
Disinflation—situation of declining inflationary pressures.
• Will not impair purchasing power of dollar.
• Reduction in investors’ expectation of returns on financial assets.
• Financial assets such as stocks and bonds have potential to do
well.
• Tangible (real) assets like precious metals will fall.

Deflation.
• Actual declining of prices affecting everybody from
bankruptcies and declining profits.

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 Other Elements of Distortion in Reported Income
• Effect of changing prices.
• Reporting of revenues.
• Treatment of nonrecurring items.
• Tax write-off policies.

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 Table 3-7 Income Statements
• INCOME STATEMENTS
• For the Year 2018
Conservative Firm High Reported Income
A Firm B
Sales $4,000,000 $4,200,000
Cost of goods sold 3,000,000 2,700,000
Gross profit $1,000,000 $1,500,000
Selling and administrative expense 450,000 450,000
Operating profit $ 550,000 $1,050,000
Interest expense 50,000 50,000
Net income before taxes $ 500.000 $1,000,000
Taxes (30%) 150.000 300,000
Net income transferred to retained earnings $ 350,000 $ 700,000

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 Explanation of Discrepancies 1

Sales.
• Conservative firms may defer revenue recognition of the sale
until each payment is received.
• Other firms may attempt to recognize a fully effected sale as
early as possible.

Cost of goods sold.

• Use of different accounting principles.
• Company A uses LIFO versus Company B using FIFO.
• Varying treatment of R&D costs, etc.

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 Explanation of Discrepancies 2

Extraordinary gains/losses.
• Including extraordinary events in computing current income
versus leaving them out.

Net income.
• Use of different methods of financial reporting.
• Such as inclusion vs. exclusion of extraordinary gains and/or
losses.
• Each item must be examined in financial statements, rather than
accepting bottom-line figures.

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THE END!!!
MODULE 02