ANALYSIS OF FINANCIAL STATEMENTS

MODULE 1 CHAPTER 4
Analysis of Financial Statements

I. Ratio Analysis
II. Dupont Equation
III. Limitations of Ratios
IV. Qualitative Factors

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Ratio Analysis

Uses of Ratios

● Standardize numbers and facilitate comparisons

● Highlight weaknesses and strengths
● Compare through time and competitors
○ Industry Analysis
○ Benchmark (Peer) Analysis
○ Trend Analysis

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Ratio Analysis

Five Categories

1. Liquidity Ratios
2. Asset Management Ratios
3. Debt Management Ratios
4. Profitability Ratios
5. Market Value Ratios

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Ratio Analysis

Liquidity Ratios

- give us an idea of the firm’s ability to pay off debts that are maturing
within a year

Generally, high Current Ratio (CR) → very strong, safe liquidity position

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Ratio Analysis

Liquidity Ratios

- give us an idea of the firm’s ability to pay off debts that are maturing
within a year

Current Asset (CA) - Invty > Current Liabilities (CL) → can still pay off CL

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Ratio Analysis

Asset Management Ratios

- measure how effectively the firm is managing its assets

Assets Results

Too many Too high cost of capital

→ Depressed Profits
Too low Lost Profitable Sales

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Ratio Analysis

Asset Management Ratios

Invty Turnover Ratio (ITO) < Industry Average → Too much Invty

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Ratio Analysis

Asset Management Ratios

Assume: payment within 30 days as part of the example’s company credit policy

DSO > Company Credit Policy → Customers are not paying on time

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Ratio Analysis

Asset Management Ratios

Fixed Asset Turnover Ratio (FATO) is slightly above Industry Average (Avg)

→ uses Fixed Assets as intensively as other firms in the industry

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Ratio Analysis

Asset Management Ratios

Total Asset Turnover Ratio (TATO) is somewhat below the Industry Avg

→ not generating enough sales given its Total Assets (TA)

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Ratio Analysis

Debt Management Ratios

- set of ratios that measure how effectively a firm manages its debt.

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Ratio Analysis

Debt Management Ratios

Creditors’ Preference

↓ Debt Ratio (DR or D/A) → ↑ Cushion against Creditors’ Losses in the event of Liquidation
Stockholders’ Preference

↑ Debt Ratio (DR) → ↑ Expected Earnings

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Ratio Analysis

Debt Management Ratios

Failure to Pay Interest → Legal Action & Bankruptcy

TIE < Industry Avg → Covers Interest Charges by relatively low margin of safety

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Ratio Analysis

Debt Management Ratios

Debt-to-Equity (D/E) & Debt-to-Asset (D/A or DR)

EBITDA Coverage

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Ratio Analysis

Profitability Ratios

- A group of ratios that show the combined effects of liquidity, asset

management, and debt on operating results.

Operating (Op) Margin < Industry Avg More debt → Relatively Low Net Profit Margin

→ Op Costs are too high

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Ratio Analysis

Profitability Ratios

↑ ROA → Better ↓ Turnover Ratios → ↓ BEP

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Ratio Analysis

Profitability Ratios

Negative EVA → Shareholders earned less

Most Important Accounting Ratio

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Ratio Analysis

Profitability Ratios

Rate of Return on Total Investor Capital

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Ratio Analysis

Market Value Ratios

- Ratios that relate the firm’s stock price to its earnings and Book Value
(BV) per share
1. Investors: when buying/selling a stock
2. Investment Bankers: when setting the share price for a new stock issue
3. Firms: when deciding how much to offer for another firm’s potential
merger

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Ratio Analysis

Market Value Ratios

P/E < Industry Avg High M/B → low risk & high growth

→ relatively risky / has poor growth prospects

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Ratio Analysis

Trend Analysis

- Analysis of a firm’s financial

ratios over time

Benchmarking
- Comparing a company with the
top firms in an industry

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Dupont Equation

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Limitations of Ratios

1. Difficult to compare for multidivisional firms

2. Distorted firms’ balance sheets caused by inflation, seasonal factors and
different account practices
3. Difficult to generalize whether a ratio is good or bad
4. Difficult to tell whether a company is on balance, strong or weak position

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Qualitative Factors

1. Revenues’ dependency with One Key Customer, Product and Supplier

2. Percentage of Overseas Business
3. Competitive Environment
4. Future Prospects
5. Legal & Regulatory Environment

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