Analysis of Financial

Statements
Learning Objectives
❖ Discuss the objectives of financial
statement analysis for different types of
decision makers.
❖ Identify the key sources of information for
financial statement analysis.
❖ Prepare trend analyses of financial
statement data.
❖ Prepare common-sized financial
statements.
❖ Compute key financial ratios including
liquidity, leverage, activity, profitability,
and market strength ratios.
❖ Principals of financial analysis
 Financial Statement Analysis . . . Making
Informed Decisions
Decision makers must be capable of
analyzing financial data . . .

The objectives of financial statement analysis vary across

different types of decision makers . . .

managers, suppliers, long-term creditors, and investors.

 Sources of Information for Financial
Statement Analysis

❖ Annual reports
❖ Investment advisory
services
❖ Business periodicals
❖ On-line financial services
Annual Reports . . . Key Items of
Interest to Decision Makers

❖ Financial
statements and accompanying
footnotes
❖ Independent auditor’s report
 Investment Advisory
Services
❖ Value Line
❖ Standard & Poor’s
❖ Moody’s
❖ Dun & Bradstreet
❖ Robert Morris Associates
 Three Common Approaches to
Financial Statement Analysis

❖ Trend analysis (Horizontal Analysis)

❖ Common-sized financial statements
(Vertical Analysis)
❖ Ratio analysis
 Objective
1

Perform a Trend
(Horizontal) Analysis
of Financial Statements.
Trend Analysis (Horizontal
analysis)
❖ Trend analysis:
the study of percentage changes
in financial statement items over
a period of time.
❖ Trend analysis provides a simple
forecasting method.
❖ But . . . predictions yielded by trend
analysis are “soft.”
❖ For more reliability . . . try regression
analysis.
 Horizontal Analysis

Increase/(Decrease)
2xx2 2xx1 Amount Percent
Sales $41,500 $37,850 $3,650 9.6%
Expenses 40,000 36,900 3,100 8.4%
Net income 1,500 950 550 57.9%

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 Horizontal Analysis

2xx2 2xx1 Difference

Sales $41,500 $37,850 $3,650

$3,650 ÷ $37,850 = .0964, or 9.6%

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 Trend
Percentages...
…are computed by selecting a base year
whose amounts are set equal to 100%.
❖ The amounts of each following year are
expressed as a percentage of the base
amount.

Trend % = Any year $ ÷ Base year $

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 Trend
Percentages
Year 2xx2 2xx1 2xx0
Revenues $27,611 $24,215 $21,718
Cost of sales 15,318 14,709 13,049
Gross profit $12,293 $ 9,506 $ 8,669
2003 is the base year.

What are the trend percentages?

1
 Trend
Percentages

Year 2xx2 2xx1 2xx0

Revenues 127% 111% 100%
Cost of sales 117% 113% 100%
Gross profit 142% 110% 100%

These percentages were calculated by

dividing each item by the base year.

1
 Objective
2

Perform a Vertical Analysis

of Financial Statements.

1
 Vertical Analysis...

…compares each item in a financial

statement to a base number set to
100%.
❖ Every item on the financial statement is
then reported as a percentage of that
base.

1
 Vertical Analysis

2xx2 %
Revenues $38,303 100.0
Cost of sales 19,688 51.4
Gross profit $18,615 48.6
Total operating expenses 13,209 34.5
Operating income $ 5,406 14.1
Other income 2,187 5.7
Income before taxes $ 7,593 19.8
Income taxes 2,827 7.4
Net income $ 4,766 12.4
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 Vertical Analysis

Assets 2xx2 %
Current assets:
Cash $ 1,816 4.7
Receivables net 10,438 26.9
Inventories 6,151 15.9
Prepaid expenses 3,526 9.1
Total current assets $21,931 56.6
Plant and equipment, net 6,847 17.7
Other assets 9,997 25.7
Total assets $38,775 100.0
1
 Objective
2

Perform a Vertical Analysis

of Financial Statements

Which means:
Prepare common-sized
financial statements

1
 Vertical Analysis...

…compares each item in a financial

statement to a base number set to
100%.
❖ Every item on the financial statement is
then reported as a percentage of that
base.

2
 Vertical Analysis

2xx2 %
Revenues $38,303 100.0
Cost of sales 19,688 51.4
Gross profit $18,615 48.6
Total operating expenses 13,209 34.5
Operating income $ 5,406 14.1
Other income 2,187 5.7
Income before taxes $ 7,593 19.8
Income taxes 2,827 7.4
Net income $ 4,766 12.4
2
 Vertical Analysis

Assets 2xx2 %
Current assets:
Cash $ 1,816 4.7
Receivables net 10,438 26.9
Inventories 6,151 15.9
Prepaid expenses 3,526 9.1
Total current assets $21,931 56.6
Plant and equipment, net 6,847 17.7
Other assets 9,997 25.7
Total assets $38,775 100.0
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 Common-size
Statements
❖ On the income statement, each item is
expressed as a percentage of net sales.
❖ On the balance sheet, the common size is
the total on each side of the accounting
equation.

❖ What are they used for?

2
 Common-sized financial
statements can be used to . .
.
Common-size statements are used to compare one company to other
companies, and to the industry average – for benchmarking.

. . . identify key structural changes in a company’s

financial data over a period of time.
. . . more easily compare the financial data of firms
that vary significantly in size.
. . . compare a company’s financial data to industry
norms.

2
 Objective
3

Understand Benchmarking

2
 Benchmarking
Percent of Net Sales
Lucent
12,4%
Technologies MCI
10,8%
7,4% 8,0%

43,0%
51,4%

28,8%
38,2%

■ Cost of goods sold ■ Operating

expenses
■ Income tax ■ Net income 2
Objective
4

Using Ratios

2
Ratio Analysis

Ratio analysis: an analytical technique that

typically involves a comparison of the
relationship between two financial items.

Ratio analysis can be applied .

..
cross-sectionally, or
longitudinally.

2
 Why are ratios
useful?
❖ Ratios standardize numbers and
facilitate comparisons.
❖ Ratios are used to highlight
weaknesses and strengths.

2
 Five Types of Financial
Ratios

❖ Liquidity
❖ Activity Efficiency Ratios
❖ Leverage - Measuring ability to pay short-term and
long-term debt
❖ Profitability - Measuring profitability
❖ Market Strength - Analyzing stock as an investment

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Palisades Furniture Example

Net sales (Year 2xx2) $858,000

Cost of goods sold 513,000
Gross profit $345,000
Total operating expenses 244,000
Operating income (EBIT) $101,000
Interest revenue 4,000
Interest expense (24,000)
Income before taxes (EBT) $ 81,000
Income taxes 33,000
Net income $ 48,000
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Palisades Furniture Example

Assets 2xx2 2xx1

Current assets:
Cash $ 29,000 $ 32,000
Receivables net 114,000 85,000
Inventories 113,000 111,000
Prepaid expenses 6,000 8,000
Total current assets $262,000 $236,000
Long-term investments 18,000 9,000
Plant and equipment, net 507,000 399,000
Total assets $787,000 $644,000
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 Palisades Furniture Example

Liabilities 2xx2 2xx1

Current liabilities:
Notes payable $ 42,000 $ 27,000
Accounts payable 73,000 68,000
Accrued liabilities 27,000 31,000
Total current liabilities $142,000 $126,000
Long-term debt 289,000 198,000
Total liabilities $431,000 $324,000

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 Palisades Furniture Example

Stockholders’ Equity 2xx2 2xx1

Common stock, no par $186,000 $186,000
Retained earnings 170,000 134,000
Total stockholders’ equity $356,000 $320,000

Total liabilities and

stockholders’ equity $787,000 $644,000

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Liquidity Ratios
1. Current Ratio
The current ratio measures
the company’s ability to pay
current liabilities with current assets.

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 Measuring Ability to
Pay Current Liabilities

❖ Palisades’ current ratio:

❖ 2xx1: $236,000 ÷ $126,000 = 1.87
❖ 2xx2: $262,000 ÷ $142,000 = 1.85
❖ The industry average is 1.50.
❖ The current ratio decreased slightly
during 2xx2.

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Liquidity Ratios
2. The acid-test ratio (Quick ratio)

The acid-test ratio shows the company’s

ability to pay all current liabilities
if they come due immediately
(without relying on the sale of its inventory)

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 Measuring Ability to
Pay Current Liabilities

❖ Palisades’ Quick Ratio :

❖ 2xx1: ($32,000 + $85,000) ÷ $126,000
= .93
❖ 2xx2: ($29,000 + $114,000) ÷
$142,000 = 1.01
❖ The industry average is .40.
❖ The company’s acid-test ratio improved
considerably during 20x5.

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 Liquidity Ratios
3. Cash ratio

The Cash ratio shows the company’s

ability to pay all current liabilities
if they come due immediately

3
 Measuring Ability to
Pay Current Liabilities

❖ Palisades’ cash ratio:

❖ 2xx1: $32,000 ÷ $126,000 = .25
❖ 2xx2: $29,000 ÷ $142,000 = .20
❖ The industry average is .20.
❖ The company’s cash ratio decreased
slightly during 2xx2.

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Efficiency Ratios

❖ The efficiency ratios describe how well a

firm is using its investment in various
asset classes:
• Accounts Receivable Turnover Ratio
• Average Collection Period
• Inventory Turnover Ratio
• Fixed Asset Turnover Ratio
• Total Asset Turnover Ratio

4
The A/R Turnover Ratio

4
 Measuring Ability to
Collect Receivables

❖ Palisades’ accounts receivable turnover:

❖ 2xx2: $858,000 ÷ $99,500 = 8.62 times
❖ The industry average is 51 times.
❖ Palisades’ receivable turnover is much
lower than the industry average.
❖ The company is a home-town store that
sells to local people who tend to pay
their bills over a lengthy period of time.

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The Average Collection
Period

4
 Measuring Ability to
Collect Receivables

❖ Palisades’ days’ sales in Accounts

Receivable for 2xx2:
❖ One day’s sales:
❖ $858,000 ÷ 360 = $2,383
❖ Days’ sales in Accounts Receivable:
❖ $99,500 ÷ $2,383 = 42 days
❖ The industry average is 7 days.

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The Inventory Turnover Ratio

4
 Measuring Ability to
Sell Inventory

❖ Palisades’ inventory turnover:

❖ 2xx2: $513,000 ÷ $112,000 = 4.58
❖ The industry average is 3.4.
❖ A high number indicates an ability to
quickly sell inventory.

4
The Fixed Asset Turnover
Ratio

Fixed Asset Turnover =

= 858 / 507 = 1.69

4
The Total Asset Turnover
Ratio

Total Asset Turnover =

= 858 / 787 = 1.09
4
Leverage Ratios

❖ Leverage ratios describe the amount of

debt that the firm has used to finance
its investments in assets:
• Total Debt Ratio
• Long-term Debt Ratio
• Debt to Equity
• Long-term Debt to Equity
• Times Interest Earned Ratio

5
The Total Debt Ratio

5
 Measuring Ability to
Pay Debt

❖ Palisades’ debt ratio:

❖ 2xx1: $324,000 ÷ $644,000 = 0.50
❖ 2xx2: $431,000 ÷ $787,000 = 0.55
❖ The industry average is 0.64.
❖ Palisades Furniture expanded
operations during 20x5 by financing
through borrowing.

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The Long-term Debt Ratio

Long Term Debt = 289 / 787 = 0.367

5
The Debt to Equity Ratio

Debt to Equity = 431 / 356 = 1,21

5
The Long-term Debt to Equity
Ratio

LTD to Equity = 289 / 356 = 0,81

5
 The Times Interest Earned
Ratio
Indicates the firm’s ability to pay Interest expenses

5
 Measuring Ability to
Pay Debt

❖ Palisades’ times-interest-earned ratio:

❖ 2xx1: $ 57,000 ÷ $14,000 = 4.07
❖ 2xx2: $101,000 ÷ $24,000 = 4.21
❖ The industry average is 2.80.
❖ The company’s times-interest-earned
ratio increased in 2xx2.
❖ This is a favorable sign.

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Profitability Ratios

❖ Profitability ratios provide a measure of

the returns that a firm is generating:
• Gross Profit Margin
• Operating Profit Margin
• Net Profit Margin (Return on Sales)
• Return on Total Assets
• Return on Equity
• Return on Common Equity

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The Gross Profit Margin

GPM = 345 / 858 = 0,40

5
 The Operating Profit
Margin

EBIT
OPM = = 101 / 858 = 0,12
Sales

6
The Net Profit
Margin
(Return on Sales)

6
 Measuring Profitability

❖ Palisades’ rate of Return on Sales:

❖ 2xx1: $26,000 ÷ $803,000 = 0.032
❖ 2xx2: $48,000 ÷ $858,000 = 0.056
❖ The industry average is 0.008.
❖ The increase is significant in itself and
also because it is much better than the
industry average.

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The Return on Total Assets

6
 Measuring Profitability

❖ Palisades’ rate of return on total assets

for 2xx2:
❖ $48,000 ÷ $787,000 = 0.061
❖ The industry average is 0.078.
❖ How does Palisades compare to the
industry?

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The Return on Equity

6
 Measuring Profitability

❖ Palisades’ rate of return on equity for

2xx2:
❖ $48,000 ÷ $356,000 = 0.135
❖ The industry average is 0.121.
❖ Why is this ratio larger than the return
on total assets 0.061?
❖ Because Palisades uses leverage.

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 The Return on Common
Equity

48
ROCE = = 0,26
186

6
 The Du Pont system
Net Income Sales
ROA = * = NPM * Total Asset Turnover
Total Assets Sales

ROA = 0,056*1,09 = 0,061

Net Income Total Assets Total Assets

ROE = * = ROA *
Equity Total Assets Equity

Total Assets
ROE = NPM * Total Asset Turnover *
Equity
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 Market Valuation
Ratios
❖ The market valuation ratios provide an
indication of the relative under- or over-
pricing of a firm’s stock:
• Price/Earnings Ratio
• Price/Book Ratio

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The Price/Earnings
Ratio

7
 Analyzing Stock as an
Investment
❖ Price/earning ratio is the ratio of market
price per share to earnings per share.
❖ 2xx1: $35 ÷ $2.60 = 13.5
❖ 2xx2: $60 ÷ $4.80 = 12.5
❖ Given Palisades Furniture’s 2xx2 P/E
ratio of 12.5, we would say that the
company’s stock is selling at 12.5 times
earnings.

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The Price/Book
Ratio

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 Analyzing Stock as an
Investment
❖ Book value per share of Palisades’
common stock:
❖ 2xx1: ($320,000 – $0) ÷ 10,000 =
$32.00
❖ 2xx2: ($356,000 – $0) ÷ 10,000 =
$35.60
❖ Book value bears no relationship to
market value.

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 Rules for Memorizing
Ratios
❖ There can be an infinite number of financial ratios, but
knowing a few basic rules will help you to memorize
the formulas: The basic rule is that the name tells you
how to calculate the ratio.
• Any ‘margin’ ratio is something divided by sales
• Any ‘turnover’ ratio is sales (or a variation of sales) divided
by something
• Any ‘return on’ ratio is net income (or a variation of net
income) divided by something

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 Using Financial
Ratios
❖ Calculating ratios is pointless unless you know how
to use them
❖ The most basic rule is: a single ratio provides very
little information and may be misleading
❖ With that in mind, there are at least 4 uses of ratios:
• Trend analysis (internal and external)
• Comparison to industry averages (internal and external)
• Setting and evaluating company goals (internal)
• Restrictive debt covenants (external)

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 Trend Analysis of
Ratios
❖ Trend analysis involves
the examination of
EPI Current Ratio Trend
ratios over time
❖ The analyst tries to 2.40
2.39
x
x
determine if the ratio is 2.38 x

Curre nt Ratio
2.37 x
changing in a favorable, 2.36 x
2.35 x
or unfavorable, 2.34 x

direction 2.33
2.32
x
x
2.31 x
❖ The chart shows EPI’s 2.30 x

current ratio for two 1996 1997

Year
years (we really need
more data)

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 Comparing to Industry
Averages Industry
Ratio 1997 1997 1996
Liquidity Ratios
Current 2.70 x 2.39 x 2.33 x
Quick 1.00 x 0.84 x 0.85 x
❖ Industry average ratios Efficiency Ratios

provide a benchmark for Inventory Turnover

A/R Turnover
7.00 x
10.70 x
3.88 x
9.70 x
4.00 x
9.97 x
comparison Average Collection Period
Fixed Asset Turnover
33.64
11.20 x
37.11
10.81 x
36.12
10.15 x
Total Asset Turnover 2.60 x 2.36 x 2.38 x
❖ We assume that if a ratio Leverage Ratios

is too far from the Total Debt Ratio

Long-term Debt Ratio
50.00%
20.00%
58.45%
25.72%
54.81%
22.02%
average something is LTD to Total Capitalization
Debt to Equity
28.57%
1.00 x
38.23%
1.41 x
32.76%
1.21 x
wrong LTD to Equity 40.00%
Coverage Ratios
61.90% 48.73%

❖ Industry ratios are Times Interest Earned 2.50 x

Profitabilty Ratios
2.63 x 4.43 x

available from Robert Gross Profit Margin

Operating Profit Margin
17.50%
6.25%
16.67% 18.17%
5.12% 7.92%
Morris Associates and Net Profit Margin
Return on Total Assets
3.50%
9.10%
1.90% 3.68%
4.50% 8.77%
Standard & Poor’s Return on Equity 18.20% 10.82% 19.40%
Other Ratios
Payout Ratio 70.06%
Plowback (Retention) Ratio 29.94%
Internal Growth Rate 1.36%
Sustainable Growth Rate 3.35%
Capital Intensity Ratio 38.46% 42.33% 41.97%
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Company Goals and Debt
Covenants
❖ Company goals are often stated in
terms of financial ratios
• For example, it is common for management
to set goals regarding the firm’s ROE
❖ Debt covenants often contain
restrictions on certain ratios
• For example, a borrower might be required
to maintain a debt to equity ratio of less
than 1.0 and a current ratio greater than 2.0