University of Technology, Jamaica

Financial Management (FIN3001)

Unit 2 – Financial Statement Analysis

Learning Objective: Using Ratio Analysis as the first step in the analysis of a Company’s Financial
Statements
Ratio Analysis involves examining the relationship between pieces of information in the financial
statements for a given accounting period.
Ratios are useful because: (i) They summarize much data and put it in a usable format (ii) They facilitate
comparison across different firms and also of the same firm over different periods of time (iii) They are
used to highlight the strengths and weaknesses of a company relative to its industry (iv) They can be used
as an early warning system, as a means of monitoring management and as a screening tool (v) From an
investor’s standpoint, predicting the future is the purpose of financial statement analysis. (vi) From
management’s standpoint, it is useful both as a way to anticipate future conditions, and also as a starting
point for planning actions that will influence the future course of events.
Note that several ratios should be reviewed during an analysis. When one ratio deviates from the norm,
other related ratios should be studied to help determine the cause of the deviation.
We will examine 5 categories of ratios. Different stakeholder groups have different needs, and tend to
focus on different categories of ratios. (i) Suppliers and short-term lenders are most interested in liquidity
ratios (ii) Stockholders and potential investors are most interested in profitability and market value ratios
(iii) Long-term debt holders are most interested in debt and asset management ratios (iv) Managers of the
firm would be interested in all ratios because they are responsible for satisfying the interests of all
stakeholder groups. (v) Analysts usually perform long-run trend analysis over a 5-10 year period looking
for long-term stock maximization.
Liquidity Ratios
Current Ratio = Current Assets Quick (or Acid) Ratio = (Current Assets – Inventory)
Current Liabilities Current Liabilities
Cash Flow Ratio = Operating Cash Flow
Current Liabilities
Liquidity ratios refer to the firm’s ability to meet short-term obligations. They show the relationship of a
company’s cash and other current assets to its current liabilities. Firms with poor liquidity are more likely
to fail and default on their debts. Therefore, a higher ratio is better, but one that is too high may suggest
inefficient use of resources and reduced returns.
Current Ratio (i) Shows how well the company can meet/cover its short-term obligations. (ii) Provides a
margin of safety in shrinkage of non-cash current assets. (iii) Provides a reserve of liquid funds against
uncertainties and shocks to cash flows. Some of its limitations are: (i) It can easily become outdated as
short-term assets and liabilities are easily changed. (ii) Companies sometimes choose a “year-end” when
they are likely to have less short-term debt and more cash. (iii) It is not able to measure and predict the
pattern of future cash inflows and outflows. (iv) It is not able to measure the adequacy of future cash
inflows to outflows.
Quick or Acid Ratio: This is a more stringent test of a company’s liquidity as it ignores inventory which
can take some time to be converted to cash depending on the length of the company’s operating cycle.
Cash Flow Ratio; This ratio shows how well a company can cover its current liabilities from cash
generated from its operating activities.
Asset Management Ratios
Total Asset Turnover = Sales Fixed Asset Turnover = Sales
(Average) Total Assets (Ave)Fixed Assets

Accounts Receivable Turnover = Sales or Credit Sales Invent. Turnover = Cost of Goods Sold
(Ave) Acc. Rec. Inventory

Asset Management Ratios show how efficiently the company uses its assets to generate sales
Total Assets Turnover Ratio (TAT) can be improved if the firm (i) increases sales; (ii) Improves
efficiency in the use of assets; (iii) Disposes of or replaces some assets; (iv)A combination of the above.

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Fixed Asset Turnover: A high ratio may indicate that the company is efficient or it may be working
close to capacity with older assets. It may thus prove difficult to generate further business without an
increase in invested capital. A low ratio may indicate an inefficient use of assets or resources.
Accounts Receivable Ratios: (i) A high turnover ratio indicates that the company is efficient in the
collection of its receivables. (ii) days sales outstanding (DSO) show the number of days it takes the
company to collect amounts outstanding. A low figure is desirable but may also indicate an unduly
restrictive credit policy. (iii) Remember that when one ratio deviates from the norm, other related
ratios should be studied to help determine the cause.
Inventory Ratios (i) Inventory turnover measures the average speed that inventories move through the
company i.e. – the number of times per year that the company fills up and then completely empties its
warehouses or stores. (i) A high ratio may be a sign of efficiency, high sales or that the company is
living from hand to mouth, providing little variety to customers and may sometimes be out of stock.
(ii)A low ratio may indicate that the company is holding too much stock or holding damaged or obsolete
stock. (iii) The days sales in inventory ratio shows the number of days it takes to sell inventory and is
useful in assessing purchasing and production policies.
Debt Management Ratios
Total Debt Ratio = Total Assets – Total Equity = Total Debt
Total Assets Total Assets
Debt to Equity Ratio = Total Debt
Total Equity
Equity Multiplier = Total Assets = 1 + Debt to equity ratio
Total Equity

TIE = EBIT/Interest

Debt management ratios show how well the company manages or uses debt. Companies use borrowed
funds to increase the returns to company owners. By raising funds through debt, the firm avoids diluting
stockholder ownership. To have a positive leverage, the company must be able to earn a greater return on
the assets the borrowed money is invested in, than the interest cost. If the rate of return on assets is less
than the rate of interest on the borrowed money, the interest must be paid, and it will come from the owners
of share capital.
Long-term creditors are most interested in debt management ratios. What do they look for? (i) A margin
of safety provided by equity capital. Higher equity levels indicate lower risk for creditors (ii) Creditors
look at the firm’s past payment history and at the level of income being generated to determine if it can
cover repayment of loans with interest (TIE, Fixed Charges Coverage & Cash Coverage) (iii)The debt
ratio is used to determine creditworthiness (iv) The expected return on investment should be higher than
the interest rate on loan.
Total Debt Ratio: shows how the firm is financed –i.e. – the percentage of the firm that is financed by
borrowed funds. When business is good or normal, firms with relatively high debt ratios have higher
expected returns, however, when business is poor, they are exposed to risk of loss. The risk of bankruptcy
is further increased and there is less cushion against creditors loss in the event of liquidation. Creditors
may be reluctant to lend more. It may be costly to raise additional debt capital without first raising more
equity capital
Profitability Ratios
Gross Profit Margin = Revenues – Cost of Goods Sold
Net Sales
Profit Margin on Sales = Net Income after Tax Return on Assets (ROA) = NIAT
Net Sales Total Assets
= Profit Margin x Asset Turnover
Return on Common Equity (ROE) = Net Income after Tax
(Average) Total Equity
= Return on Assets x Equity Multiplier

Basic Earning Power Ratio = Earnings before Interest & Tax

(BEP) Total Assets

Profitability relates to a company’s ability to earn a satisfactory income. Profitability is closely linked to
its liquidity because earnings ultimately produce cash flow. All financial statements are pertinent to

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profitability analysis. Profitability ratios show the combined effects of liquidity, asset management and
debt on operating results.

Gross Profit Margin(GPM): (i) A high GPM might indicate that the company is efficient or that its prices
are high. (ii) A low GPM could indicate that sales are too low or costs or too high, or both.
Net Profit Margin (NPM): A low NPM may indicate that: (i) Costs are too high (ii) Operations may be
inefficient (iii) The company may be heavily in debt, leading to high interest charges
Return on Assets (ROA): This ratio can be derived from multiplying the net profit margin by the asset
turnover. The profit margin measures the profitability of the company relative to sales, while the asset
turnover ratio measures the effectiveness of the company in generating sales from assets.
Return on Capital Employed (ROCE):(i) is an indicator of the company’s overall profitability. (ii) It relates
profits with all methods of financing, (iii) Conveys return on invested capital from different financing
perspectives. (iii) is sometimes used in evaluating managerial effectiveness as management is responsible
for all company activities. (iv) depends on the skill, resourcefulness, ingenuity and motivation of
management.
Basic Earning Power Ratio (BEP): measures the raw earning power of the firm’s assets. It is useful for
comparing companies with different financing structures and tax rates.
Return on Equity (ROE)
This ratio can also be derived by multiplying ROA by the Equity Multiplier. This shows that ROE is
affected by profit margins, asset use efficiency and financial leverage.
Market Value Ratios
Earnings per Share = Net Income for common shareholders
Total # of common shares outstanding
Price/Earnings (P/E) Ratio = Market Price per Share
Earnings per Share
Market to Book Value = Market Price per Share
Book Value per Share
Book Value per share = Total Common Equity
Total # of common shares
Market Value Ratios relate the company’s stock price to the internal performance of the company. They
give an indication of how investors feel about the company’s future prospects based on its past
performance. High ratios indicate good prospects and is expected if all other ratios are good. Stock prices
are expected to be high if all ratios are good.
The P/E ratio shows how much investors are willing to pay per dollar of reported profits. A high P/E ratio
may indicate that the market expects an increase in earnings in the future. P/E ratio is usually higher for
firms with strong growth prospects. A low P/E ratio usually indicates poorer growth prospects or higher
risk or both. Firms that earn high returns on their assets, usually have share prices well in excess of their
book values.
Benchmarking is the practice of comparing a company to other companies both inside and outside its
own industry. Common-size statements are also used to compare a company to other companies in
benchmarking.
Learning Objective #2: Limitations of using financial statement analysis in decision making
No single ratio or one-year figure is sufficient to provide an assessment of a company’s performance.
Financial analysis may indicate that something is wrong, but it may not identify the specific problem or
show how to correct it. In using financial statement analysis a single ratio may serve more than one
purpose, eg indicating profitability/performance as well as flexibility/adaptability (i) Use ratios in
conjunction with other supporting ratios and within the context of the industry, remembering the impact
of inflation and size. Inflation can distort a firm’s balance sheet and profits. (ii) Seasonal factors can
distort ratios (iii) Sometimes comparing a company with an industry average can be misleading if the
company operates in more than one industry. (iv) Interpreting the results of your analysis requires a
sound understanding of the company, the industry and the general economic environment. (v) Different
accounting practices can distort comparisons.
Learning Objective #3: Considering qualitative factors in the analysis of financial statements
Some other factors to be considered in analyzing a company: (i) Are the company’s revenues tied to 1
key customer? (ii) To what extent are the company’s revenues tied to 1 key product? (iii) To what extent
does the company rely on a single supplier? (iv) What percentage of the company’s business is
generated overseas? (v) Level of competition to which the company is exposed (vi) Future prospects for
growth and expansion (vii) Legal and regulatory environment.
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