Financial Statement

Analysis
Overview
● Ratios facilitate comparison of:
● One company over time
● One company versus other companies
● Ratios are used by:
● Managers to identify areas of weakness and strength
● Lenders to determine creditworthiness
● Stockholders to estimate future cash flows and risk

2
Ratio Analysis
● Ratio analysis consists of calculating
financial performance using five basic
types of ratios:

● Liquidity Ratios
● Asset Management Ratios
● Debt Management Ratios
● Profitability Ratios
● Market Value Ratios
3
Ratio Analysis
● Profitability ratio measure the firm’s use of its assets and
control of its expenses to generate an acceptable rate of
return.
● Liquidity ratio measure the availability of cash to pay debt.
● Asset Management ratio, also called efficiency ratios,
measure the effectiveness of a firm’s use of resources, or
assets.
● Debt, or leverage, ratios measure the firm’s ability to repay
long-term debt.
● Market ratio are concerned with shareholder audiences. They
measure the cost of issuing stock and the relationship
between return and the value of an investment in company’s
shares. 4
Liquidity Ratios (1> is good)
Liquidity ratios are measurements used
to examine the ability of an organization
to pay off its short-term obligations. ...
Examples of liquidity ratios are:

● Current Ratio CA
CR = CL
● Quick Ratio
QR = CA - Inv.
CL

5
Liquidity Ratio
● Current ratio: This ratio compares current
assets to current liabilities. Its main flaw is
that it includes inventory as a current asset. It
should be between 1-3% then it is good.
● Quick ratio: This is the same as the current
ratio, but excludes inventory. 1 means assets
= liabilities.

6
Balance Sheet
Income statement
Asset Management Ratios
• Asset management ratios measure how effectively a firm
is managing its assets.
• If a company has excessive investments in assets, then
its operating capital will be unduly high, which will reduce
its free cash flow and ultimately its stock price.
• On the other hand, if a company does not have enough
assets then it will lose sales, which will hurt profitability,
free cash flow, and the stock price.

• Inventory Turnover Ratio (higher ratio prefer means

company inventory is in demand)
• Days Sales Outstanding (DSO), Average Collection
Period (ACP)
• Fixed Asset Turnover Ratio (higher the ratio means
generating sales from assets) 9

• Total Asset Turnover Ratio (same as above)

 Asset Management Ratios
Sales
Inv. turnover = Inventories

DSO = Receivables = Receivable

Average sales per s
day Sales/365
Fixed assets =      Sales             
turnover Net fixed assets
Total Sales       
     
=
assets Total assets
turnover 10
Debt Management Ratios
● The extent to which a firm uses debt financing, or
financial leverage, has three important implications:
1. By raising funds through debt, stockholders can maintain
control of a firm without increasing their investment.
2. If the firm earns more on investments financed with
borrowed funds than it pays in interest, then its
shareholders’ returns are magnified, or “leveraged,” but
their risks are also magnified.
3. Creditors look to the equity, or owner-supplied funds, to
provide a margin of safety, so the higher the proportion
of funding supplied by stockholders, the less risk
creditors face.
11
Debt Management Ratios
● Debt Ratio (0.4 is good, 0.6 is poor)
● Times Interests Earned Ratio (greater than 2.5 is
considered as acceptable risk)
● EBITDA Coverage Ratio (below 10 is healthy)

12
Debt Management Ratios
Total liabilities
Debt ratio = Total assets
TIE =             EBIT        
Interest expense

EBITDA Coverage Ratio =

EBIT + Depr. & Amort. + Lease payments(28)
Interest + Lease + Loan pmt.20
expense pmt.
13
Profitability Ratios
Profitability is the net result of a number
policies and decisions. The ratios examined
thus far provide useful clues as to the
effectiveness of a firm’s operations, but the
profitability ratios go on to show the
combined effects of liquidity, asset
management, and debt on operating results.
● Profit Margin on Sales
● Basic Earning Power
● Return on Total Assets
● Return on Common Equity 14
Profit Margin (if 10 then they are average)
Net profit margin (PM):
NI(Net Income)
PM = Sales
Operating profit margin (OM):
EBIT
OM = Sale
s margin (GPM):
Gross profit
Sales − COGS
GPM = Sales
15
Basic Earning Power
EBIT
BEP =
Total assets

Return on Asset (Over 5% are generally considered good)

NI
ROA =
Total assets

Return on Equity(Over 14% are acceptable and below 10% is

poor)
NI
ROE =
Common Equity
16
Market Values Ratios
Market value ratios relate a firm’s stock price to its
earnings, cash flow, and book value per share. Market
value ratios are a way to measure the value of a
company’s stock relative to that of another company.

● Price/Earnings Ratio
● Price/Cash Flow Ratio
● Market/Book Value Ratio

P/E = Price per

share
EPS
17
ANALYTICAL APPROACHES
● Trend Analysis - To do a trend analysis, you examine a
ratio over time.
● Common Size Analysis - all income statement items are
divided by sales and all balance sheet items are divided
by total assets. Thus, a common size income statement
shows each item as a percentage of sales, and a
common size balance sheet shows each item as a
percentage of total assets.
● Percent Change Analysis - growth rates are calculated
for all income statement items and balance sheet
accounts relative to a base year.

18