Analysis of Financial

Statement
This Chapter will cover:
1. Definition of Financial Statement & their
classification.
2. Analysis of financial statement through different
ratio analysis.
3. Identification of the strength & weaknesses of the
firm through ratio analysis and the interpretation
of the results.
Financial Statement Analysis 1
 Financial Statement Analysis—What & Why?

Financial statement analysis involves a

comparison of a firm’s performance with that of
other firms in the same line of business. This
analysis is used to
 Determine the firm’s current financial position
through identifying its current strengths and
weaknesses.
 Suggesting the required actions that might
pursue to take advantage of the strengths and
correct the weaknesses.
Financial Statement Analysis 2
Financial Statements and Reports
• Annual Report
– a report issued annually by a corporation to its
stockholders
– management’s opinion of the past year’s
operations and the firm’s future prospects
– basic financial statements
• income statement
• balance sheet
• statement of retained earnings
• statement of cash flows

Financial Statement Analysis 3

 Financial Statements and Reports
• Income Statement
– a statement summarizing the firm’s revenues
and expenses over an accounting period,
generally a quarter or a year
• Balance Sheet
– a statement of the firm’s financial position at a
specific point in time

Financial Statement Analysis 4

 Financial Statements and Reports
• Balance Sheet - points worth noting
1. Cash versus other assets
2. Liabilities versus stockholders equity
3. Breakdown of common equity account
• common stock
• paid in capital
• retained earnings
4. Accounting alternatives
• FIFO (first-in, first-out)
• LIFO (last-in, first-out)
• Accelerated or straight-line depreciation
• The time dimension
– balance sheet is at a point in time
Financial Statement Analysis 5
 Financial Statements and Reports
• Statement of Retained Earnings
– a statement reporting changes in the firm’s
retained earnings as a result of the income
generated and retained during the year
– the balance sheet figure for retained earnings is
the sum of the earnings retained for each year
the firm has been in business.
Unilate Textile: Statement of Retained Earnings for the Year Ending Dec 31, 2005

Balance of Retained Earnings, Dec 31 2004 $260

Add: 2005 net income 54
Less: 2005 dividends to stockholders (29)
Balance of retained earnings, Dec 31, 2005 $285
Financial Statement Analysis 6
 Financial Statements and Reports
• Accounting income versus cash flow
– cash flows
• the cash receipts and the cash disbursements, as opposed
to the revenues and expenses reported for computation of
net income, generated by a firm during some specified
period
– accounting profit
• a firm’s net income as reported on its income statement
– operating cash flows
• those cash flows that arise from normal operations
• the difference between cash collections and cash
expenses

Financial Statement Analysis 7

 Financial Statements and Reports
• Statement of cash flows
– a statement reporting the impact of a firm’s operating,
investing, and financing activities on cash flows over
an accounting period
– sources of cash
• increase in liability or equity account
• decrease in an asset account
– uses of cash
• decrease in a liability or equity account
• increase in an asset account

Financial Statement Analysis 8

Ratio Analysis
A. Liquidity ratios
– ratios that relates the firm’s cash and other
assets to its current liabilities
• Liquid asset
– an asset that can be easily converted into
cash without significant loss of its original
value

Financial Statement Analysis 9

Ratio Analysis
Current ratio
– indicates the extent to which current liabilities are
covered by assets expected to be converted into cash
in the near future
Current assets
Current ratio 
Current Liabilities
Quick (Acid test) ratio
– deducts inventories from current assets and divides the
remainder by current liabilities
– a variation of the current ratio
Current assets - Inventories
Quick ratio 
Current Liabilities
Financial Statement Analysis 10
B. Asset management ratios
– ratios that measure how effectively a firm is managing
its assets
• Inventory turnover ratio  Cost of Goods Sold
Inventories
It represents that how many times the company’s inventory is sold
out and restocked per year.

• Days sales outstanding (DSO)

Receivables Receivables
 
Average sales per day  Annual sales 
 360 

• This measure is alternatively called average collection period.

DSO represents the average length of time the firm have to wait
for receiving the payment against credit sales.

Financial Statement Analysis 11

• Fixed assets turnover ratio  Sales
Net fixed assets

It measures that how effectively the firm uses its

plant and equipment to help generate sales.

Sales
• Total assets turnover ratio 
Total assets
It measures the effectiveness of the firm to generate
sales through using the firm’s total assets.

Financial Statement Analysis 12

B. Debt management ratios
– analyze the company’s use of debt
• Financial leverage
– the use of debt financing
• Debt ratio  Total debt
Total assets
It measures the percentage of the firm’s assets financed by
creditors( borrowers).
EBIT
• Times-interest-earned (TIE) ratio 
Interest Charges
The TIE measures the extent to which earnings before
interest and taxes (EBIT), also called operating income,
can decline before the firm is unable to meet its annual
interest costs.
Financial Statement Analysis 13
C. Profitability ratios
– ratios showing the effect of liquidity, asset
management, and debt management on operating
results

Net income
• Net profit margin on sales 
Sales

It measures the firm’s ability to earn profit per

dollar of sales.

Financial Statement Analysis 14

• Return on total assets (ROA) Net income

Total assets

It provides a measures of the overall return on

investment earned by the firm
Net income available
• Return on common equity (ROE) 
to common stockholders
Common equity

It provides a measure regarding the rate of return

the firm earned by the common stockholders
investment.

Financial Statement Analysis 15

D. Market value ratios
– ratios that relate the firm’s stock price to its earnings and
book value per share
Net income available
to common stockholders
• Earnings per share (EPS) 
Number of common
shares outstanding

Market price per share

• Price/Earnings (P/E) ratio 
Earnings per share

The P/E ratio shows the dollar amount investors will

pay for $1 of current earnings.

Financial Statement Analysis 16

 Ratio Analysis
Common equity
• Book value per share 
Number of common
shares outstanding

Market price per share

• Market/Book (M/B) ratio 
Book value per share

Financial Statement Analysis 17

Ratio Analysis
• Trend analysis
– an analysis of a firm’s financial ratios over
time
– used to determine improvement or
deterioration in its
financial situation

Financial Statement Analysis 18

 Uses and Limitations of Ratio Analysis
1. Large firms operate divisions in different industries
– difficult to develop meaningful industry averages
2. If the goal is to be better than average, industry
averages are not the target
– focus on the industry leaders’ ratios
3. Inflation distorts balance sheets
– depreciation and inventory costs affect income
statements
– Ratio analysis for one firm over time or the comparative
analysis of firm may be wrongly interpreted with the
judgment.

Financial Statement Analysis 19

Uses and Limitations of Ratio Analysis
4. Seasonal factors distort ratios
– use monthly averages as base for inventory and
receivables instead of one particular month
5. Window dressing techniques
– make financial statements appear better than they
actually are
– borrowing “long-term” to be repaid quickly distorts
liquidity ratios
6. Different accounting practices
– distorts comparisons
– inventory valuation
– depreciation methods
Financial Statement Analysis 20
 Uses and Limitations of Ratio Analysis
7. Difficult to generalize about “good” or “bad” ratios
– high current ratio can indicate strong liquidity or
excessive cash
– high fixed assets turnover can indicate efficient use
or undercapitalized
8. Firm may have some “good” ratios and others that look
“bad”
– difficult to tell whether overall the company is strong
or weak
– statistical procedures can analyze the net effects of
a set of ratios
Financial Statement Analysis 21