Financial Statements

Just as a doctor takes a look at a patient’s X-rays or CAT-scan when

diagnosing health problems, a manager or analyst can take a look at
a firm’s primary financial statements--i. e., the income statement
and the balance sheet--when trying to gauge the status or
performance of a firm.
● Income statement ➔ periodic recording of the
sources of revenue and
expenses of a firm
● Balance sheet ➔ provides a point-in-time
snapshot of the firm’s
assets, liabilities, and
owners’ equity.
Financial Statement Analysis
●Financial Statement Analysis is the process of
understanding the fundamentals of the company by
reviewing its financial statements namely the Income
Statement, Balance Sheet and Cash Flows.
 Financial Analysis
● Financial analysis is a process of selecting,
evaluating, and interpreting financial data, along with
other pertinent information, in order to formulate an
assessment of a company’s present and future financial
condition and performance.
Financi
Market al
Data Disclos
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Financial Analysis
Types of Financial Statement
analysis
● Horizontal Analysis
● Vertical Analysis
●Trend Analysis
● Ratio Analysis
Example – Horizontal Analysis
Horizontal
Analysis
Example – Vertical
Analysis
Oper Company Vertical
analysis
Income Statement
For Year Ended December 31, 20X8
20X8 %
Net sales $ 12,250 100.0%
Cost of Goods Sold 6,050 49.4%
Gross Profit from Sales $ 6,200 50.6%
Operating Expense:
Selling $ 2,700 22.0%
General & Administrative 1,050 8.6%
Total Operating Expenses $ 3,750 30.6%
Operating Income $ 2,450 20.0%
Interest Expense 225 1.8%
Income before Taxes $ 2,225 18.2%
Income Taxes 890 7.3%
Net Income $ 1,335 10.9%
Vertical Income Statement
Oper Company
Common Size Comparative Income Statement
For Year Ended December 31, 20X8 and 20X7
20X8 2007
Net sales 100.0% 100.0%
Cost of Goods Sold 49.4% 47.7%
Gross Profit from Sales 50.6% 52.3%
Operating Expense:
Selling 22.0% 21.6%
General & Administrative 8.6% 10.8%
Total Operating Expenses 30.6% 32.4%
Operating Income 20.0% 19.9%
Interest Expense 1.8% 2.5%
Income before Taxes 18.2% 17.4%
Income Taxes 7.3% 6.9%
Net Income 10.9% 10.5%
Financial Ratios

●Financial ratios are relationships between different accounts from

financial statements—usually the income statement and the balance
sheet—that serve as performance indicators

●Because they are relative values, financial ratios allow for meaningful
comparisons across time, between competitors, and with industry
averages.
Classification of Ratios
Common size Income Statement
 Comparative Common Size Balance
Sheet
 Financial Ratios

● Financial ratios are relationships between different

accounts from financial statements—usually the
income statement and the balance sheet—that serve as
performance indicators

● Because they are relative values, financial ratios allow

for meaningful comparisons across time, between
competitors, and with industry averages.
 Financial Ratios (continued)

● Five key areas of a firm’s performance can be analyzed by using

financial ratios:
1. Liquidity ratios: Can the company meet its obligations over the short
term?
2. Solvency ratios (also known as financial leverage ratios): Can the
company meet its obligations over the long term?
3. Asset management ratios: How efficiently is the company managing
its assets to generate sales?
4. Profitability ratios: How well has the company performed overall?
5. Market value ratios: How does the market (investors) view the
company’s financial prospects?
Can also conduct a Du Pont analysis, which involves a breakdown
of the return on equity into its three components of profit margin,
turnover, and leverage.
 Short-Term Solvency: Liquidity Ratios

● Measure a company’s ability to cover its short-term debt

obligations in a timely manner
● Three key liquidity ratios include the current ratio, the quick
ratio, and the cash ratio:
Short-Term Solvency: Liquidity Ratios

Liquidity Ratios 2016 for Cogswell Cola and Spacely Spritzers

Liquidity Ratios Cogswell Cola Spacely Spritzers

The liquidity ratios indicate that overall, Cogswell has better liquidity and
short-term solvency than Spacely, but higher investment in current assets
also means that lower yields are being realized since current assets are
typically low-yielding.
So we need to look at the other areas and interrelated effects of the firm’s
various accounting items.
Long-Term Solvency: Financial Leverage Ratios

● Measure a company’s ability to meet its long-term debt

obligations based on its overall debt level and earnings
capacity.
● Failure to meet its interest obligation could put a firm
into bankruptcy.
Long-Term Solvency: Financial Leverage Ratios
Long-Term Solvency: Financial Leverage Ratios
Financial Leverage Ratios for 2016 for Cogswell Cola and Spacely Spritzers

Financial Leverage Ratios Cogswell Cola Spacely

Cogswell Cola has relatively less debt and a significantly greater

ability to cover its interest obligations by using either its EBIT
(times interest earned ratio) or its net cash flow (cash coverage
ratio) than Spacely Spritzers.

Leverage must be analyzed as a combination of debt level and

coverage. If a firm is heavily leveraged but has good interest
coverage, it is using the interest deductibility feature of taxes to
its benefit. Having a high leverage with low coverage could put
the firm into a risk of bankruptcy.
Benefits of Debt
● Financial leverage (Financial gearing) is the
ability that owners have to use other people’s
money at fixed rates to make higher rates of
return than would have been possible by using
all of their own money. It represents one of the
main benefits of taking on debt.
● Firms that take on debt as part of their capital
structure are therefore known as leveraged or
geared firms while those that do not are
known as unlevered or ungeared firms.
Earnings per Share as a Measure of the
Benefits of Borrowing

One way to measure the benefits of gearing is to

compare the EPS of firms with different capital
structures under good and bad economic
conditions.
EPS as a Measure of the Benefits of
Borrowing
● Assuming a cost of debt of 10% for all firms and identical EBIT
(earnings before interest and tax) ($2000), EPS is calculated below:
Earnings per Share of Firms with Different Funding Structures

● If the firm’s EBIT covers its interest cost, higher leverage benefits the
stockholders with a higher EPS.
EPS as a Measure of the Benefits of
Borrowing (cont)
However, if the firm’s EBIT does not cover its interest
cost, the reverse is true:

So gearing is a two-edged sword; benefiting firms in

good times and hurting them in bad times.
 Asset Management Ratios

● Measure how efficiently a firm is using its assets to generate revenues or how
much cash is being tied up in other assets such as receivables and inventory.
● Equations given below can be used to calculate 5 key asset management
ratios:
Asset Management Ratios
Asset Management Ratios 2016 for Cogswell Cola and Spacely Spritzers

While Cogswell is more efficient at managing its

inventory, Spacely seems to be doing a better job of
collecting its receivables and utilizing its total assets in
generating revenues
 Profitability Ratios

• Profitability ratios measure a firm’s effectiveness in

turning sales or assets into profits.
• Equations given below can be used to calculate 3 key
profitability ratios:
Profitability Ratios (continued)
Profitability Ratios 2016 for Cogswell Cola and Spacely Spritzers

As far as profitability is concerned, Cogswell is

outperforming Spacely by about 3%.
 Market Value Ratios
Used to gauge how attractive or reasonable a firm’s
current price is relative to its earnings, growth rate, and
book value:
Market Value Ratios (continued)

• Potential investors and analysts often use these ratios as part of their
valuation analysis.
• Typically, if a firm has a high price-to-earnings and a high market-to-
book value ratio, it is an indication that investors have a good
perception about the firm’s performance.
• However, if these ratios are very high, it could also mean that a firm is
overvalued.
• With the price/earnings-to-growth ratio (PEG ratio), the lower it is,
the more of a bargain it seems to be trading at, vis-à-vis its growth
expectation.
 Market Value Ratios (continued)
Ratio Cogswell Cola Spacely Spritzers

P/E 15.41 13.01

PEG 1.28 0.86
P/B 5.49 4.17

The ratios seem to indicate that investors in both firms have

good expectations about the firms’ performance and are
therefore paying fairly high prices relative to their earnings
book values.
 Du Pont analysis

Involves breaking down ROE into three components of the firm:

1) operating efficiency, as measured by the profit margin (net
income/sales)
2) asset management efficiency, as measured by asset turnover
(sales/total assets)
3) financial leverage, as measured by the equity multiplier (total
assets/total equity)

Equation 14.19 shows that if we multiply a firm’s net profit margin by

its total asset turnover ratio and its equity multiplier, we will get its
return on equity:
 Du Pont analysis (continued)

• Cogswell has better operational efficiency, i.e., it is better able to move sales
dollars into income, but Spritzer is more efficient at utilizing its assets, and
since it uses more debt, it is able to get more of its earnings to its shareholders.
• Although the ratios we have studied here are not the only ones that can be used
to assess a firm’s performance, they are the most popular ones.
• It is important to look at the overall picture of the firm in all 5 areas and
accordingly reach conclusions or make recommendations for changes.
 External Uses of Financial Statements and Industry
Averages
Financial statements of publicly traded companies
and industry averages of key items provide the raw
material for analysts and investors to make
investment recommendations and decisions.
Industry Ratios - India
FMCG PE ratios
ROCE
FMCG ROE
DE Ratio
Cola Wars

Key Financial Ratios and Accounts for PepsiCo and Coca-Cola (through
third quarter 2022)
Cola Wars

Some Key Ratios and Accounts for PepsiCo and Coca-Cola

(Five-Year Period)
Ratio Company 2012 2013 2014 2015
2016
Cola Wars (continued)

● One of the first things we notice in looking over the five years of data is
how similar many of the ratios are from year to year, showing
remarkable consistency for these two companies.
● We also can see that the gross margin of Coca-Cola is consistently
higher than that of PepsiCo.
● The debt-to-equity ratio of both firms is mostly falling over the five-
year period.
● We can also see that ROE has been very good for both companies,
although slightly better for PepsiCo.
● Finally, PepsiCo has very strong and growing earnings per share over
this period, outperforming Coca-Cola’s EPS, but PepsiCo is also more
expensive (higher current price per share).
Industry ratios:
Financial Ratios: Industry Averages

• Industry ratios are often used as benchmarks for financial ratio

analysis of individual firms.
• There can be significant differences in various key areas across
industries, so comparing company ratios with industry averages can
be useful and informative.