Chapter: 03

Financial Statements &

Analysis

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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.
Annual Report
◦ basic financial statements
● income statement
● balance sheet
● statement of retained earnings
● statement of cash flows

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 What is Financial Analysis?
It is an evaluation of both firm’s past financial performance & its
prospects for the future. A financial analyst use the ratios to make
two types of comparison:
1. Industry Comparison or cross section.
2. Trend Analysis or time series.

Three Types of Analysis:

2. Horizontal Analysis: To evaluate the trend in the accounts over the
years.
3. Vertical Analysis: A significant item on a financial statement is used
as a base value, & all the other items on the financial statement are
compared to it.
4. Ratio Analysis: To compare figures from different categories.
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Why are ratios useful?
Ratios standardize numbers and facilitate comparisons.
◦ Comparisons can be made intercompany, intra-company or with
industry average
◦ Or, Cross section or time series.
Ratios are used to highlight weaknesses and strengths.

Five Categories of Ratios:

1. Liquidity Ratios,
2. Activity/Turnover/Asset Management Ratios,
3. Debt/Leverage/Solvency Ratios,
4. Profitability Ratios, &
5. Market Ratios.
Five major categories of Ratios
Liquidity ratios: It measures the company’s ability to meet its maturing short-term debt obligations.
gives us an idea of the firm’s ability to pay off debts that are maturing within a year.

Asset management ratios: Measures the speed with which various accounts are converted into sales or
cash – inflows or outflows. which gives us an idea of how efficiently the firm is using it’s assets

Debt management ratios: which gives us an idea of how the firm has financed it’s assets as well as the
firm’s ability to repay it’s long-term debt as they become due.

Profitability ratios: which gives us an idea of how profitably the firm is operating and utilizing it’s
assets. An indication of good financial health & how effectively the firm is being managed is the
company’s ability to earn satisfactory profit & return on investment.

Market value: Relate a firm’s market value, as measured by its current share price, to certain accounting
values. which brings in the stock price and gives us an idea of what investors think about the firm and it’s
future prospects.
Scenario: **(Also see Bertlett company's statements from book
chapter)
Income statement

2003 2002
Sales 7,035,600 6,034,000
COGS 5,875,992 5,528,000
Other expenses 550,000 519,988
EBITDA 609,608 (13,988)
Depr. & Amort. 116,960 116,960
EBIT 492,648 (130,948)
Interest Exp. 70,008 136,012
EBT 422,640 (266,960)
Taxes 169,056 (106,784)
Net income 253,584 (160,176)
1) Liquidity Ratios
Will the firm be able to pay off its debts as they come due and thus
maintain a viable organization?
◦ If there are more liquid assets then they can.
◦ A liquid asset is the one that can be converted to cash quickly without having to
reduce the asset’s price very much.

Ratio analysis provides a quick and easy-to-use measure of liquidity.

Two most commonly used liquidity ratios are: current ratio, acid-test
ratio
1) Liquidity Ratio:
a) Current Ratio:
Indicates the extent to which current liabilities are covered by
liquid assets (current assets).

Calculate the forecasted current ratio for 2003 & 2002.

Current ratio = Current assets / Current

liabilities
= $2,680,112 / $1,144,800
= 2.34 times or, 2.34 : 1

2002 = ???
1) Liquidity Ratio:
b) Quick Ratio/Acid test Ratio:
Not all current assets are very liquid.
Quick ratio removes the least liquid assets like inventory, and prepaid expense
from the current asset and then divides the remainder by current liabilities.
Calculate the Quick ratio or, Acid Test for 2003 & 2002.

Quick ratio = (Current assets – Inventory- prep.exp)/

Current liabilities
= ($2,680,112 - 1,716,480)/
$1,144,800
= 0.84 times or, 0.84 : 1
2002 = ???
Comments on current & Quick ratio

2003 2002 2001 Ind.

Current
2.34x 1.17x 2.30x 2.70x
ratio
Quick 1.11x
0.84x 0.39x 0.30x
ratio

■ Expected to improve but still below the industry

average.
■ Liquidity position is weak.
 2) Activity Ratio/Asset Management
Ratio:
To purchase assets, capital is required and obtaining capital is expensive.
◦ Too many assets will lead to high cost of capital and it can lower the profit
◦ Too low asset will lead to losing out on profitable sales

a) Inventory turnover Ratio:

How many times a particular asset is “turned over” to sales during the period.

Inv. turnover = Sales / Inventories

= $7,035600 / $1,716,480
= 4.10x
Comments on
Inventory Turnover
2003 2002 2001 Ind.
Inventory
4.1x ??? 4.8x 6.1x
Turnover
Inventory turnover is below industry average.
The company might have old inventory, or its control
might be poor.
No improvement is currently forecasted.
 2) Activity Ratio:
b) Fixed asset turnover ratio:
Measures the efficiency of Fixed Assets.
FA turnover= Sales / Net fixed assets
= $7,036 / $817 = 8.61x
When comparing with a newer company problem arises as the
same asset costs differently.

c) Total asset turnover ratio:

TA turnover = Sales / Total assets
= $7,036 / $3,497 = 2.01x
 Evaluating the FA turnover and TA
turnover ratios
2003 2002 2001 Ind.
FA TO 8.6x ??? 10.0x 7.0x
TA TO 2.0x ??? 2.3x 2.6x

■ FA turnover projected to exceed the industry average.

■ TA turnover below the industry average. Caused by excessive
currents assets (A/R and Inv).
2) Activity Ratio:
d) the Average Collection period or days sales
outstanding
ACP or DSO= Receivables / Annual sales/365
= $8,78,000 / 7,035,600/365
= 46 days
e) Average payment period:
Average payment period
= Payables / Annual purchases/365
= $ 1,144,800/ $5,875,992/365
= 71 days
3) Profitability Ratios
An indication of good financial health & how effectively the firm is being
managed is the company’s ability to earn satisfactory profit & return on
investment. The ratios are:
a) Gross Profit Margin= Gross profit/ Sales
b) Operating Profit Margin= Operating profit or EBIT/ Sales
c) Net Profit Margin = Net Income After Tax / Net Sales.
d) BEP = EBIT/Total Assets
e) Return on Assets (ROA) = Net Income After Tax / Total Assets.
or, ROA = NetProfit Margin X Total Asset Turnover
f) Return on Equity(ROE)=Net Inc. After Tax/Stockholders Equity**.
** Total common stockholders equity=c.s+r.e+p.in.cap
or, ROE = ROA X Equity Multiplier.
** *equity multiplier = total assets / stockholders equity
g) EPS= Earnings avl. For common stockholders or N.I/ number of share of common
stock outstanding*
*number of share of common stock outstanding=total C.S/Par value

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 3) Profitability Ratios:
c) Net Profit margin
Net Profit margin= Net income / Sales
= $253.6 / $7,036 = 3.6%
Appraising profitability with the profit margin
2003 2002 2001 Ind.
PM 3.6% ??? 2.6% 3.5%

■ Profit margin was very bad in 2002, but is projected to exceed

the industry average in 2003.
d)Basic Earning Power (BEP) Ratio
■ The ability of the firm’s assets to generate operating income(EBIT)
■ BEP = EBIT/Total Assets
Shows the raw earning power of the firm’s assets before the
influence of taxes and debt.
3) Profitability Ratios:
e)Return on assets (ROA):
How much of the total assets contribute to the net income?
ROA = Net income / Total assets
= $253.6 / $3,497 = 7.3%
f) Return on equity (ROE):
Measures the rate of return on common stockholder’s investment
Stockholders expect to earn a return on their money and this ratio
tells how well they are doing.
ROE = Net income / Total common equity*
= $253.6 / $1,952 = 13.0%
* Total common equity=c.s+r.e+p.in.cap
 Appraising profitability with the return on
assets and return on equity

2003 2002 2001 Ind.

ROA 7.3% -5.6% 6.0% 9.1%
ROE 13.0% -32.5% 13.3% 18.2%
■ Both ratios rebounded from the previous year, but are still below the
industry average. More improvement is needed.
■ Lower ROA ratio means either high operating cost or high interest
expense.
■ Wide variations in ROE illustrate the effect that leverage can have
on profitability.
■ Higher debt can lead to higher ROE
Problems with ROE
ROE and shareholder wealth are correlated, but
problems can arise when ROE is the sole measure of
performance.
◦ ROE does not consider risk.
◦ ROE does not consider the amount of capital invested.
◦ Might encourage managers to make investment decisions
that do not benefit shareholders.
ROE focuses only on return. A better measure is one
that considers both risk and return.
4) Debt Management Ratios

■ Use of debt increases a firm’s ROE if the firm

earns more on it’s assets than the interest rate it
pays on the debt. This is called “leverage”.
■ However, debt exposes the firm to more risk
than if it financed only with equity.
■ Debt Management Ratios show how efficiently
firm manages it’s debts.
 4) Debt Ratios:
a) Debt ratio= Total debt / Total assets
= ($1,145 + $400) / $3,497 = 44.2%
Creditors are not willing to lend capital when debt ratio is too high.
b) TIE = EBIT / Interest expense
= $492.6 / $70 = 7.0x
Firm’s ability to meet its annual interest payments.
c) Fixed-payment Coverage: measures firms ability to meet fixed
payment obligations.
 5) Market Ratios
Market Value depends on investor’s expectation and demand.

If liquidity, asset management, debt management, and profitability ratios all look
good and if investors think these ratios will continue to look good in the future, then
the market value will be high.

Market value ratios relate the firm’s stock price (market value) to it’s earnings and
book value per share.
Market value ratios are used in three primary ways
1. By investors when they are deciding to buy or sell a stock.
2. By investment bankers when they are setting the share price for a
new stock issue (IPO).
3. By firms when they are deciding how much to offer for another firm
in a potential merger.
 5) Market Ratios:
a) Price/Earnings (P/E Ratio):
P/E ratio shows how much investors are willing to pay per dollar of reported profit
from each share.
P/E= Mkt price per share/ Earnings per share
= $12.17 / $1.014 = 12.0x
b) Market/Book ratio:
M/B ratio is another indicator of how investors regard the company.
M/B = Mkt price per share / Book value per share**
= $12.17 / ($1,952/ 250) = 1.56x
** Book value per share= total com.st. equity/no of shares

2003 2002 2001 Ind.

P/E 12.0x -1.4x 9.7x 14.2x
M/B 1.56x 0.5x 1.3x 2.4x
Analyzing the market value ratios
P/E: How much investors are willing to pay for $1 of earnings per
share.
M/B: How much investors are willing to pay for $1 of book value of
share.
For each ratio, the higher the number, the better.
Lower P/E ratio means perceived risk is high but it also means the
market price correctly reflects the stock’s earning ability.
Higher M/B ratio means share is overvalued and investors
expectations is very high.
The Du Pont system
Also can be expressed as:
ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)
Or, ROE= ROA*FLM
Focuses on:
◦Expense control: (PM)
◦Asset utilization: (TATO)
◦Debt utilization: Eq. Mult. or FLM (financial
leverage multiplier)
Shows how these factors combine to determine ROE.
DuPont Analysis
DuPont analysis is an expression which breaks ROE (Return On
Equity) into three parts. This analysis enables the analyst to
understand the source of superior (or inferior) return by comparison
with companies in similar industries (or between industries).
Dupont Formula
ROA= Profit margin)*(T.Asset turnover)
ROE=(Profit margin)*(T.Asset turnover)*(Equity
multiplier)
#Profit Margin = Net Income After Tax / Net Sales.
#Total Asset Turnover = Sales / Total Assets.
# equity multiplier or FLM= total assets / stockholders equity
Modified Dupont formula: ROE= ROA*FLM

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 Extended DuPont equation:
Breaking down Return on equity
ROE = (Profit margin) x (TA turnover) x (Equity multiplier)
= 3.6% x 2 x 1.8
= 13.0%

PM TA TO EM ROE
2001 2.6% 2.3 2.2 13.3%
2002 -2.7% 2.1 5.8 -32.5%
2003 3.6% 2.0 1.8 13.0%
Ind. 3.5% 2.6 2.0 18.2%
Potential problems and limitations of
financial ratio analysis
Comparison with industry averages is difficult for a
conglomerate firm that operates in many different
divisions.
“Average” performance is not necessarily good, perhaps
the firm should aim higher.
Seasonal factors can distort ratios.
Different operating and accounting practices can distort
comparisons. Example: LIFO, FIFO.
Sometimes it is hard to tell if a ratio is “good” or “bad”.
Difficult to tell whether a company is, on balance, in strong
or weak position.
**Also see formula table from book chapter end
**Also see formula table from book chapter end
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Formulas
Current Ratio = Current Asset/Current Liabilities
Quick Ratio = (Current Asset – Inventories)/Current Liabilities
Inventory Turnover ratio = Sales/Inventories or, COGS/Inventory
Avg. Collection Period= Receivables/Average sales per day
Fixed Asset Turnover = Sales/Net Fixed Asset
Total Asset Turnover = Sales/Total Assets
Debt Ratio = Total debt/Total Assets
Time-Interest-Earned = EBIT/Interest Expense
Operating Margin = EBIT/Sales
Profit Margin = Net Income/Sales
Basic Earning Power (BEP) = EBIT/Total Assets
Return on Total Assets = Net Income/Total Assets
Return on Common Equity = Net Income/Common Equity
EPS= Earnings avl. For common stockholders or N.I/ number of share of common stock outstanding
Price/Earnings Ratio = Mkt. Price Per Share/Earnings Per Share
Market/Book Ratio = Market price per share/Book value per share

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 List of ratios
1. Liquidity Ratios: 4. Debt Management Ratios:
i. Current ratio i. Debt ratio
ii. Quick ratio ii. Times Interest Earned(TIE)
2. Asset Management Ratios:
5. Market Ratios:
i. Inventory turnover i. Price/Earnings Ratio(P/E)
ii. Receivable turnover/Avg. Collection period ii. Market to Book Ratio (M/B)
iii. Avg. Payment period
iv. Total Asset turnover
v. Fixed Asset turnover
3. Profitability Ratios:
i. Gross Profit Margin= Gross profit/ Sales
ii. Operating Profit Margin
iii. Net Profit Margin
iv. Basic Earnings Power (BEP)
v. Return on Assets (ROA)
vi. Return on Equity (ROE)
vii. Earnings Per Share (EPS)
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