Financial statement analysis

Financial statement analysis

Financial Statement
Analysis helps both
internal and external
users by providing
them with better
information about key
factors of the business.
The balance sheet
 The balance sheet

• The balance sheet is a snapshot of the

firm’s assets and liabilities at a given point
in time.
• Assets are listed in order of decreasing
liquidity.
– Ease of conversion to cash without significant
loss of value
• Balance Sheet Identity
Assets = Liabilities + Stockholders’ Equity
The balance sheet
The income statement
 The income statement

•The income statement is more like a video of the

firm’s operations for a specified period of time.

•You generally report revenues first and then deduct

any expenses for the period.

•Matching principle – GAAP says to recognize

revenue when it is fully earned and match expenses
required to generate revenue to the period of
recognition.
 Ratio analysis

•Ratios allow for better comparison through time or

between companies.

•As we look at each ratio, ask yourself what the ratio

is trying to measure and why that information is
important.

•Ratios are used both internally and externally.

 Types of financial ratios

•Short-term solvency or liquidity ratios

•Long-term solvency or financial leverage ratios

•Asset utilization or turnover ratios

•Profitability ratios

•Market value ratios

 Sample balance sheet

Cash 680,623 A/P 318,301

A/R 1,051,438 N/P 4,613
Inventory 300,459 Other CL 1,645,748
Other CA 415,310 Total CL 1,968,662
Total CA 2,447,830 LT Debt 909,814
Net FA 3,415,159 S/E 2,984,513
Total Assets 5,862,989 Total Liab. & Equity 5,862,989
 Sample income statement
Sale (Revenues) 5,250,538
- Cost of Goods Sold (2,046,645)
- Gross profit 3,203,893
Operating Expenses
Salaries (1,005,500)
Other operating expenses (899,056)
Depreciation & Amortization (124,647)
Operating profit / EBIT 1,174,690
- Interest Expense (5,785)
Taxable Income 1,168,905
- Taxes (412,495)
Net Income 756,410
EPS (193,000 shares outstanding) 3.92
Dividends per share 1.20
Computing ratios
 Computing liquidity ratios

•Current Ratio shows a firm’s ability to cover its

current liabilities with its current assets.
•Current Ratio
= CA / CL
= 2,447,830 / 1,968,662
= 1.24 times
•Strength: Higher
 Computing liquidity ratios

•Quick Ratio shows a firm’s ability to meet current

liabilities with its most liquid assets.
•It is also known as the acid-test ratio.

•Quick Ratio
= (CA – Inventory) / CL
= (2,447,830 – 300,459) / 1,968,662
= 1.09 times
•Strength: Higher
 Computing leverage ratios
•Total Debt (or debt-to-total assets) Ratio shows the
percentage of the firm’s assets that are supported by
debt financing.

•Total Debt Ratio

= (TA – TE) / TA
= (5,862,989 – 2,984,513) / 5,862,989
= .491 times or 49.1%

•The firm finances slightly over 49% of their assets with

debt.

•Strength: Lower
 Computing leverage ratios
•Debt-to-Equity ratio shows the extent to which the
firm is financed by debt.

•Debt/Equity
= TD / TE
= (5,862,989 – 2,984,513) / 2,984,513
= 0.964 times

•Strength: Lower
 Computing leverage ratios
•Times Interest Earned is a measure of the firm’s
ability to meet its annual interest payments.
•Times Interest Earned/Interest Coverage Ratio
= EBIT / Interest
= 1,174,690 / 5,785
= 203 times
•Strength = Higher
 Computing turnover ratios

•Receivables Turnover signifies a firm’s

effectiveness in extending credit as well as
collecting debts.
•Receivables Turnover
= Sales / Accounts Receivable
= 5,250,538 / 1,051,438
= 4.99 times
•Strength: Higher
 Computing turnover ratios

•Days Sales in Receivables (or days sales

outstanding/DSO) indicates the average time
in days that receivables are outstanding.
•Days Sales in Receivables
= 365 / Receivables Turnover
= 365 / 4.99
= 73 days
•Strength: Lower
 Computing turnover ratios

•Total Asset Turnover (or asset turnover) is

a measure of how well assets are being used
to produce revenue.
•Total Asset Turnover
= Sales / Total Assets
= 5,250,538 / 5,862,989
= 0.896 times
•Strength: Higher
 Computing profitability measures

•Gross Profit Margin measures gross profit

per dollar of sales.

•Gross Profit Margin

= Gross profit / Sales
= 3,203,893 / 5,250,538
= 0.6102 times or 61.02%
•Strength: Higher
 Computing profitability measures

•Net Profit Margin (or net margin) measures

net income per dollar of sales.

•Net Profit Margin

= Net Income / Sales
= 756,410 / 5,250,538
= 0.1441 times or 14.41%
•Strength: Higher
 Computing profitability measures

•Return on Assets (ROA) is an indicator of

how profitable a firm is relative to its total
assets.
•Return on Assets (ROA)
= Net Income / Total Assets
= 756,410 / 5,862,989
= .1290 times or 12.90%
•Strength: Higher
 Computing profitability measures

•Return on Equity (ROE) measures a firm’s

profitability by revealing how much profit it
generates with the money shareholders have
invested.

•Return on Equity (ROE)

= Net Income / Total Equity
= 756,410 / 2,984,513
= 0.2534 times or 25.34%

•Strength: Higher
 Computing market value measures
•Market Price = $91.54 per share
•Shares outstanding = 193,000
•Price-Earnings Ratio (also known as the multiple)
shows the dollar amount investors will pay for $1 of
cash flow.

•PE Ratio
= Price per share / Earnings per share
= 91.54 / 3.92
= 23.35 times
•Strength: Higher
 Computing market value measures

•Market Price = $91.54 per share

•Shares outstanding = 193,000
•Market-to-book ratio (also known as the price-equity ratio) is
used to compare a stock’s market value to its book value

•Market-to-book ratio
= market value per share / book value per share
= market value per share / (Equity / shares outstanding)
= 91.54 / (2,984,513 / 193,000)
= 5.92 times

•Strength: Higher
Calculating financial ratios
 Types of financial ratios
•Short-term solvency or liquidity ratios: measure the
firm’s abilities to meet its maturing short-term obligations.

•Long-term solvency or financial leverage ratios:

measure the extent to which the firm has been financed by debt.

•Asset utilization or turnover ratios: show how

effectively the firm is using its resources.

•Profitability ratios: measure management’s overall

effectiveness in generating profits.

•Market value ratios: measure the firm’s relationship to the

broader stock market.
 Why evaluate financial statements?

•Internal uses
– Performance evaluation – compensation and comparison
between divisions
– Planning for the future – guide in estimating future cash
flows

•External uses
– Creditors
– Suppliers
– Customers
– Stockholders / Investors
 Benchmarking
•Ratios are not very helpful by themselves; they
need to be compared to something

•Time-Trend Analysis
– Used to see how the firm’s performance is changing
through time
– Internal and external uses

•Peer Group Analysis

– Compare to similar companies or within industries
 Real-world example

• Go to the Google Finance webpage (

http://www.google.com/finance).

• Enter Coca Cola’s ticker symbol: KO.

• Click on “Financials” in the left-hand panel.
 Real-world example

• Click on “Summary” in the left-hand

panel to go back to the main page.

• Scroll down to see how related

companies are doing.
•Scroll down a little bit and check the “Key
stats and ratios” blurb on the right-hand side.
 Real-world example #3
Ratios 2008 2009 2010 2012
Current ratio 2.2 2.8 2.6 2.3
Quick ratio 1.3 1.6 1.3 1.0
Total debt ratio 30.6 28.9 33.2 25.7
TIE ratio 195.4 318.4 395.8 269.7
Inv. Turnover 4.1 4.4 5.2 5.7
Rec. Turnover 6.4 6.1 7.0 7.5
T.A. Turnover 0.926 0.878 0.868 0.835
Profit margin 22.0 24.7 27.7 23.1
ROA 20.4 21.7 24.0 19.3
ROE 29.4 30.6 36.0 26.0
Market-to-book 3.83 6.37 5.92 8.41
 Real-world example #3

Ratios Firm Industry

Current ratio 3.2 2.8
TIE ratio 269.7 20.8
T.A. Turnover 0.86 0.82
Profit margin 26.1 11.1
ROA 19.3 7.2
ROE 28.9 14.1
Market-to-book 8.41 6.04
PE ratio 36.3 67.3
 Real-world example #3
Ratios Firm Industry What it means
Current ratio 3.2 2.8 Above average liquidity
TIE ratio 269.7 20.8 High coverage
T.A. Turnover 0.86 0.82 Above average efficiency
Profit margin 26.1 11.1 High profitability
ROA 19.3 7.2 High ROA
ROE 28.9 14.1 High ROE
Market-to-book 8.41 6.04 High market-to-book
PE ratio 36.3 67.3 Below average PE
 Real-world example #4

Particulars 2003 2004 2005 2006 2007 2008

Current ratio (times) 1.20 1.20 1.00 1.00 1.00 1.13

Quick ratio (times) 0.50 0.50 0.60 0.60 0.60 0.66

Return on equity (%) 12.70 10.40 12.40 15.80 24.60 48.80

Inventory turnover
(times) 2.30 2.40 3.00 3.30 3.60 3.20

P/E ratio (times) 12.70 17.00 10.00 7.40 9.50 7.80

 Real-world example #4

Current ratio

1.25
1.20
1.15
1.10
1.05
1.00
0.95
0.90
2003 2004 2005 2006 2007 2008
 Real-world example #4

Quick ratio

0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
2003 2004 2005 2006 2007 2008
 Real-world example #4

ROE

60.00

50.00

40.00

30.00

20.00

10.00

0.00
2003 2004 2005 2006 2007 2008
 Real-world example #4

Inve ntory turnove r

4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
2003 2004 2005 2006 2007 2008
 Real-world example #4

P/E ratio

20.00

15.00

10.00

5.00

0.00
2003 2004 2005 2006 2007 2008
Real-world example #4
Real-world example #4
 Potential problems and limitations

•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.
•“Window dressing” techniques can make
statements and ratios look better.
 Potential problems and limitations

•Different operating and accounting practices can

distort comparisons.
•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.
 Qualitative factors

•Are the firm’s revenues tied to 1 key customer,

product, or supplier?
•What percentage of the firm’s business is generated
overseas?
•Competition
•Future prospects
•Legal and regulatory environment