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A. KEH
FINANCIAL STATEMENT ANALYSIS

Introduction:
Financial Statements are basically the information an outsider can derive from the company. To be able to assess the
different aspects of the enterprise (such as asset management, profitability and performance), a financial statement analysis
can be made.
Financial Statements
Balance Sheet
Income Statement
Cash Flow Statement

Analysis
Solvency and Stability
Profitability
Liquidity

Measurement
Capital adequacy to meet long-term obligations
Performance and growth potential
Availability of cash and other near cash assets to meet
maturing short term obligations

Financial Statement Analysis interprets financial statement data and presents in summary form to simplify users analysis.
Uses and Purposes of Financial Performance Analysis:
1.
2.
3.
4.
5.
6.

To set goals and targets

To compare the firms performance to others
To measure financial strength for granting purposes
To spot trends, weaknesses and potential problem areas
To evaluate alternative courses of action
To understand interactions that financial changes have on a firms financial position.

Types of Financial Statement Analysis

1.

Horizontal Analysis or Comparative Statements data from two time periods are compared or a comparison
between actual and budgets or two versions of budgets.

2.

Trend Percentage Analysis base year comparisons are made over a series of periods and expressed in % forms
with the earliest year as base year.

3.

Common-size Statements or Vertical Analysis also known as Percentage Composition Statement; all
statement values are expressed as a percentage of a base number which is set equal to 100%.
Income Statement NET Sales = 100%
Balance Sheet Assets = 100%
Most useful information derived from vertical analysis are:
Gross Profit Rate = Gross Profit / Sales
CGS Ratio
= CGS / Sales
Net Income%
= Net Income / Sales
Debt Ratio
Equity Ratio

4.

= Debt / Assets
= Equity / Assets

Ratio Analysis defined as selecting one variable as the numerator and another variable as the denominator which
can be expressed as a %, a ratio or merely a number.

Risks and Returns

Financial Performance Analysis can be classified into two interrelated areas: (CAL-GEM):
RISKS
Capital Adequacy
Asset Quality
Liquidity

RETURNS
Growth
Earnings
Market Performance

Risk areas measure the financial safety of the firm.

Returns areas measure the financial success of the firm.
Business Risk risk associated with projections of a firms future returns on assets or returns on equity if the firm uses
no debt.

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Financial Risk additional risk placed on the common stockholders as a result of the firms decision to use debt.

Liquidity
What liquid assets are available or accessible to meet demands for cash from expected and unexpected sources?

1. Current Ratio =
Measure:
2.

Current Assets
Current Liabilities
Ability to meet maturing short term obligations

Quick Ratio/ Acid Test Ratio =

(Cash + Marketable Securities + Receivables)
Current Liabilities
Measure:
ratio

3.

Ability to meet maturing short-term obligations and more stringent measure compared to current

Cash Ratio
(Cash + Marketable Securities)
Current Liabilities
Measure:
Ability to meet maturing short-term obligations for companies with problematic inventory and
receivable levels.

4.

Net Working Capital

Current Assets Current Liabilities
Measure:

5.

Liquidity level of the company in absolute amounts

Off-balance sheet financing liquidity sources such as lines of credit and borrowing agreements
Measure:

Availability of other sources of funds to meet maturing obligations.

Capital Adequacy/ Solvency

How much capital is necessary to protect creditors and shareholders against losses? and How little capital is
necessary to allow shareholders to enjoy maximum favorable returns on equity and dividends?
1.

Debt to Equity Ratio

Total Debt
Equity
Measure:

2.

Indicates how much of the debt is matched by investment by owners.

Debt Ratio
Debt
------Total Assets
Measure:

3.

Capital Multiplier =

Measure:
4.

Level of debt as matched to the assets owned by the company

Total Assets
---------------Total Equity

Indicates how much total investment can be financed from owner-provided equity

Times Interest Earned (TIE)

Earnings before Interest and Taxes
Interest Expense
Measure:
Ability of the company to pay-off interest charges from operating income; measure of credit
worthiness of the company

5.

Book Value per Share

Total SHE Liquidation Value of Preferred Stocks Preferred Dividends in Arrears
Common Shares Outstanding
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Measure:
6.

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Indicates the worth of each share of common stock based on historical cost.

Dividend Payout Percentage

Dividends
Earnings
Measure:

Level of earnings that is declared and distributed as dividends to stockholders

Asset Quality
Are assets used efficiently?
1.

Accounts Receivable Turnover

SALES
Ave. Accounts Receivable
Measure:

2.

Rate (speed) and efficiency of collection of outstanding accounts

Days Sales in Receivables (Average Collection Period)

360
ARTO
Measure:

3.

Average credit terms extended to customers

Inventory Turnover
Cost of SALES
Ave. Inventory
Measure:

4.

Level of inventory movement

Days Sales in Inventory (Average Inventory Period)

360
ITO
Measure:

5.

Fixed Asset Turnover

Measure:

6.

Average days inventory is kept in company premises

SALES
Average Fixed Assets
Level of usage of fixed assets in generating sales

Asset Turnover
SALES
Average Assets
Measure:

7.

Level of usage of assets in generating sales

Payables Turnover
Purchases
Average Accounts Payable

Measure:
8.

Indicates the liquidity of the firms payables

Days Payables Outstanding

360
Payables Turnover
Measure:

Indicates how the firm handles obligations of its suppliers.

Earnings
Is net income adequate to satisfy investors dividend and rate of return expectations and to support growth?
1.

Return on Sales
Net Income
Sales
Measure:

Amount of Net income generated from Sales

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2.

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Return on Assets
Net Income
Average Assets
Measure:

3.

Amount of Net Income generated from use of Assets

Return on Equity
Net Income
Average Stockholders Equity
Measure:

4.

Amount of Net Income generated from Investment by Owners

Earnings per Share (Return per share)

Net Income
Outstanding Shares
Measure:

5.

Income earned by each share of outstanding common stock

Gross Margin and Operating Expenses Percentage

Gross Margin
Sales
Measure:

Operating Expenses
Sales

Portion of sales attributed to Gross Margin and Operating Expenses

Market Performance
How do financial markets evaluate the financial condition of the firm?
1.

Price Earnings Ratio

Price per share
Earnings Per Share
Measure:
Markets willingness to pay for every peso earning of the company; determines the markets
confidence level towards the companys growth potential

2.

Dividend Yield
Dividend
Market Value
Measure:
Markets willingness to pay for every peso dividend distributed to its shareholders; determines the
markets confidence level towards the companys profitability and ability to declare future dividends
Exercise: (refer to Heart Sales Company and Acidic Inc.)
LEVERAGE

In physics, leverage implies the use of a lever (simple tool) to raise a heavy object with a small amount of force. In politics,
people have leverage if they can accomplish a great deal with their influence by simply making a phone call. We apply this
concept of leverage in business as well taking into account a small increase in sales will generate a large effect on income
(operating leverage). Similarly, a small increase in debt utilization can generate an improved ROE result. (financial leverage)
A. Operating Leverage

- used to measure the effect of change in sales to change in net income.

Change in EBIT
Degree of Operating Leverage = % Change in EBIT
EBIT
----------------------= ----------------------% Change in Sales
Change in Qty.
Quantity
Where:

EBIT = Sales Variable Cost Fixed Cost

Measure:

The effects on EBIT for each % change in the level of sales

Note: The above formula does not completely deviate from the original formula derived in the discussion of Break-even
Analysis which is CM / Net Income (also known as EBIT or Operating Income).

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Derivation:
(
Qty X CM/unit) FC
(Qty X CM/unit) FC

Qty
Qty

(
Qty X CM/unit) 0
(Qty X CM/unit) FC

Qty
Qty

Qty X CM/unit
(Qty X CM/unit) FC

Qty
Qty

Qty X CM/unit
(Qty X CM/unit) FC

CM
NI (Earnings Before Interest and Taxes)

B. Financial Leverage - use of borrowed funds and fixed income securities (debt and preferred stock) to enhance the
rate of return to equity owners.
Degree of Financial Leverage =
=

Measure:

% Change in EPS
% Change in EBIT
EBIT
---------------------EBIT Interest Preferred Dividends (before taxes)

The effects on EPS on changes in EBIT

Illustration of Financial Leverage Concept

Financial Leverage = Return on Common Stockholders Equity less Return on Total Assets

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Positive Financial leverage means that rate earned on borrowed assets exceeds the rate paid for the privilege of borrowing.
Also means that we made good use of the borrowed funds and earned profits from its use. (ROE > Interest Rate)
In the illustration above, it is assumed to have a positive financial leverage. With the use of debt (8%), ROE will improve
since current ROE is 12% (12% return > 8% debt).
Negative Financial Leverage means that the rate earned on borrowed assets is less than the borrowing rate. Simply put,
the returns supposedly generated from borrowings did not cover for the interest charges of the borrowing. (ROE < Interest
Rate)
EFFECT OF DEBT ON RATE OF RETURN
no
debt
P12,000
0
P12,000
P100,000
12%

net income before interest

interest expense
net income (before tax)
owner's equity
Rate of return

12%
debt
P12,000
4,800
P 7,200
P60,000
12%

10%
debt
P12,000
4,000
P 8,000
P60,000
13.33%

14%
debt
P12,000
5,600
P 6,400
P60,000
10.67%

*Assume a loan of P40,000

C. Degree of Total Leverage - measures the combined effect of both Operating Leverage and Financial Leverage

Degree of Total Leverage

% change in EPS OR CM
% change in Sales
EBT

(DOL)*(DFL)

Note: An increase in Operating leverage can result in lower need for Financial leverage.
Illustration:
Fufu Soft Drinks Inc. sells 500,000 bottles of softdrinks a year. Each bottle produced has a variable cost of P2.50 and sells for
P4.50. Fixed operating costs are P500,000. The company has current interest charges of P60,000 and preferred dividends of
P24,000. The corporate tax rate is 40%.
Required:
a.

Degree of Operating Leverage

b.

Degree of Financial Leverage

c.

Degree of Total Leverage

Altman Z-Score
The Z-score model is a quantitative model developed in 1968 by Edward Altman to predict bankruptcy (financial distress) of
a business, using a blend of the traditional financial ratios and a statistical method known as multiple discriminant analysis.
The Z-score is known to be about 90% accurate in forecasting business failure on year into the future and about 80%
accurate in forecasting it two years into the future.
Formula:
Z=

1.2
+1.4
+0.6
+0.999
+3.3

x
x
x
x
x

(Working Capital / Total Assets)

(Retained Earnings / Total Assets)
(Market Value of Equity / Book Value of Debt)
(Sales / Total Assets)
(EBIT/ Total Assets)

Z Score
Less than 1.8
Greater than 1.81 but less than 2.99
Greater than 3.0

Probability of Failure
Very High
Not Sure
Unlikely

Caveats in Using Financial Performance Analysis

1. No consistently valid rules of thumb exist.
2. No one ratio can tell a story.

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3.
4.
5.
6.
7.

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Industry averages are just that averages

Ratios must be defined uniformly and consistently,
More ratios do not necessarily make a better analysis.
Off-balance sheet events and factors impact the interpretation of financial ratios.
The goal of financial performance analysis is to diagnose the firms financial health.

Du Pont Chart
SALES
Minus
COST OF SALES
3

NET PROFIT
AFTER TAXES

Minus

OPERATING
EXPENSES

Net Profit
Margin

DIVIDED BY

MINUS

SALES

INTEREST
EXPENSES

Return
on Assets

MINUS

TAXES
SALES

CURRENT ASSETS

Total Asset
Turnover

DIVIDED BY

PLUS
NET FIXED ASSETS

TOTAL ASSETS
MULTIPLIED BY

CURRENT
LIABILITIES
3

Total L + C =
Total Assets

Total Liabilities

PLUS

Return
On
Equity

pl us

Divided by

CAPITAL
LONG TERM DEBT

CAPITAL

FINANCIAL
LEVERAGE
MULTIPLIER

Du Pont Chart - a chart designed to show the relationships among return on investment, asset turnover, the profit margin
and leverage
Du Pont Equation a formula that gives the rate of return on assets by multiplying the profit margin by the total assets
turnover.
Key Formulae developed from the Du Pont Chart
Profit Margin
X
Total Assets Turnover

ROA =
=

Net Income
Sales

Sales
Total Assets

ROA

Capital Multiplier

Net Income
Total Assets

Total assets
Total SHE

Net Income
Sales

Sales
Total Assets

Net Income %

Asset Turnover

ROE =

Note:

Asset
Asset

Total Assets
Total SHE
X

Total Debt
Asset

Total Equity
Asset

Debt Ratio

Equity Ratio

Capital Multiplier

Illustration:
1.

A fire has destroyed many of the financial records of Sons and Co. You are assigned to put together a financial
report. You have ground the return on equity to be 12% and the debt ratio was 0.40. What was the return on assets?

2.

Debra and Co. has a debt ratio of 0.50, a total assets turnover of 0.25 and a profit margin of 10%. The president is
unhappy with the current return on equity and he thinks it could be doubled. This could be accomplished by
increasing the profit margin to 14% and by increasing debt utilization. Total assets turnover will not change. What
new debt ratio along with the 14% profit margin is required to double the return on equity?

/keh

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