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Lecture 3
Analysis of Financial Statements

 Analysts are more concerned about future

performance.

 Why is analysis needed

 Various stakeholders in analysis

 Perceptions vs facts
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Analysis of Financial Statements

 Users of financial statements:

- Trade creditors.
- Suppliers of LT debt.
- Investors.
- Management
 Standards of Comparison:
- Past ratios.
- Projected Ratios.
- Competitor’s Ratios.
- Industry Ratios.
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Ratio Analysis

Liquidity Ratios
Will the firm be able to meet the current debt?

Current Ratio

Quick Ratio

Industry averages
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Ratio Analysis

Asset Management Ratios

How effectively firm is managing its assets?

Inventory TO Ratio

DSO

Fixed Assets TO Ratio

Total Assets TO Ratio

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Ratio Analysis
Debt Management Ratios
Extent to which form uses debt financing

 Financial Leverage
Implications:
- Stockholders maintain control without inc their own investment.
- Lesser capital by stockholders: greater risk borne by creditors.
- If earning on investment>interest paid then ROE is “leveraged”
Examples of a unleveraged and leveraged firm.
Under recession leveraged firm’s return falls sharply as it
needs to pay interest charge.
Leveraged firm’s returns are magnified when economy is
normal but is exposed to greater risk.
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Ratio Analysis

Debt Ratio

TIE Ratio

Creditors prefer lower debt ratio to provide

greater cushion while stockholders want
higher to magnify the ROE.
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Ratio Analysis

•Profitability Ratios

•Profit margin on sales

•ROA

•ROE

•Industry averages and comparison.

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Ratio Analysis

•Market Value/Investor Ratios

•P/E Ratio

•Market/BV Ratio
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Trend Analysis

•Common Size Analysis

- Income statement items are divided by sales and B&S
items are divided by total assets.
- Facilitates comparison over time and across companies.

•Percentage Change Analysis

- Growth rates calculated on the basis of last year for the
same items.
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Duo Pont Analysis

•Covers:
- Profitability
- Operating efficiency
- Leverage

•ROE is affected by Asset TO, Profit margin and

Leverage
•ROA = Profit margin * Asset TO
•Company financed only with equity: ROA=ROE as
the total assets would be the same as total equity.
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Duo Pont Analysis

•Equity Multiplier
•Leverage firms have higher equity multiplier.
•ROE= ROA * Equity multiplier
•ROE= Profit margin*Asset TO*Equity multiplier
•Different departments could use all 3 components
for the analysis.
•Duo Pont Chart and analysis
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Limitations of Ratio Analysis

•Companies with different divisions

•Benchmarking
•Inflation
•Seasonal Factors
•Window Dressing
•Different accounting practices
•Looking beyond numbers