FINANCIAL STATEMENT

ANALYSIS
Ratio and DuPont Analysis
 FINANCIAL STATEMENTS

• Financial Statements are summaries of the

operating, financing, and investment activities of a
firm.
• According to the Financial Accounting Standards
Board (FASB), the financial statements of a firm
should provide sufficient information that is useful to
investors and creditors in making their investment
and credit decisions in an informed way.
 FINANCIAL STATEMENTS
• The financial statements are expected to be prepared in
accordance with a set of standards known as Generally
Accepted Accounting Principles (GAAP).
• The financial statements of publicly traded firms must be
audited at least annually by an independent public
accountants.
• The auditors are expected to attest to the fact that these
financial statements of a firm have been prepared with
accordance with GAAP.
 TYPES OF FINANCIAL STATEMENTS

• Income Statement
• Statement of Financial Position or Balance Sheet
• The Statement of Cash Flows
 INCOME STATEMENT
• An income statement is a summary of the revenues and
expenses of a business over a period of time, usually either
one month, three months or one year.
• Summarizes the results of the firm’s operating and financing
decisions during that time.
• Operating decisions of the company apply to production
and marketing such as sales/revenues, cost of goods sold
(COGS), administrative and general expenses (advertising,
office salaries).
 BALANCE SHEET
• A summary of the assets, liabilities, and equity of a business at a
particular point in time, usually the end of the firm’s fiscal year.

ASSETS = LIABILITY + EQUITY

Resources of the Obligations of Ownership left
business the business over residual

Current Assets Current Liabilities Common Stock Outstanding

- Cash, Receivables,
Inventories, Prepaid
Expenses
Fixed Assets
- Plant, Machinery,
Equipment, Buildings
- Payables, Short-term Additional Paid-in Capital
loans, Deferred Income Retained Earnings
Noncurrent Liabilities
- Notes, Bonds, Capital
Lease and Obligations
 STATEMENT OF CASH FLOWS
• The statement of cash flow is designed to show how the
firm’s operations have affected its cash position and to help
answer questions such as these:
• Is the firm generating the cash needed to purchase
additional fixed assets for growth?
• Is the growth so rapid that the external financing is
required both to maintain operations and for investment
in new fixed assets?
• Does the firm have excess cash flows that can be used
to repay debt or to invest in new products?
 IMPORTANCE OF FINANCIAL
STATEMENTS
• Financial statements report both on firm’s position at a point
in time and on its operations over some past period.

• From management’s viewpoint, financial statement analysis

is useful both as a way to anticipate future conditions and
more important, as a starting point for planning actions that
will influence the future course of events or to show whether
a firm’s position has been improving or deteriorating over
time.
 RATIO ANALYSIS

• Ratio Analysis is a systematic use of ratio to interpret

or assess the performance status of the firm.
• It is a widely used tool of financial analysis.
• The term ratio refers to numerical or quantitative
relationship between two items or variables.
• The basic objective of ratio analysis is to compare
the risk and return relationship of firms of different
sizes.
 RATIO ANALYSIS

• A financial ratio is a relationship between to

accounting figures.
• Ratios help to make qualitative judgment about the
firm’s financial performance.
• Ratio analysis helps in finding out the strengths and
weaknesses of a firm.
 RATIO ANALYSIS

• Ratio analysis can help plan for the future.

• The relationship in ratio can be expressed in:
• Percentage- ex. Net Profit are 25% of Sales
• Fraction- ex. Net Profit is one-fourth of Sales
• Proportion- ex. Relationship between net profit
and sales is 1:4
 TYPES OF RATIOS

• Liquidity Ratios
• Leverage Ratios
• Activity Ratios
• Profitability Ratios
 LIQUIDITY RATIOS

• Ability of the firm to satisfy its short term obligations

as they become due.
• A liquid asset is one that can be easily converted
into cash at a fair market value
• “Will the firm be able to meet its current
obligations?”
• In general, the greater the level of coverage of
liquid assets to short-term liabilities the better.
 LIQUIDITY RATIOS

• Liquidity ratios are a key part of fundamental

analysis since they help determine a company's
ability to service its debts. If a company fails to pay
its debts, it could face bankruptcy or restructuring
activity that could be detrimental to shareholder
value.
 LIQUIDITY RATIOS

• Three Measures of Liquidity:

• Current Ratio
• Quick or Acid Test Ratio
• Cash Ratio
 LIQUIDITY RATIOS
• Current Assets are assets which can be converted into cash
easily in one accounting period.
• Cash & cash equivalents
• Receivables
• Inventories
• Prepaid Expenses
• Current Liabilities are liabilities which have to be paid in one
accounting period.
• Accounts Payable
• Short-term loans
 CURRENT RATIO

Current Assets
Current Ratio =
Current Liabilities
• It is the relationship between the current assets and current
liabilities of a concern.
 CURRENT RATIO

• A current ratio of 1.0 or greater is an indication that

the company is well-positioned to cover its current
or short-term liabilities.

• A current ratio of less than 1.0 could be a sign of

trouble if the company runs into financial difficulty.
 LIMITATIONS OF CURRENT RATIO
• this is not the whole story on company liquidity
• understand the types of current assets the company has
and how quickly these can be converted into cash to meet
current liabilities
• The current ratio inherently assumes that the company
would or could liquidate all of most of its current assets and
convert them to cash to cover these liabilities
• Companies with a seemingly high current ratio may not be
safer than a company with a relatively low current ratio.
 QUICK RATIO
Current Assets- Inventories & Prepaid Expenses
Quick Ratio =
Current Liabilities
• Also known as acid test ratio
• liquidity ratio that further refines the current ratio by measuring
the level of the most liquid current assets available to cover
current liabilities.
• is more conservative than the current ratio because it excludes
inventory and other current assets, which generally are more
difficult to turn into cash.
• A higher quick ratio means a more liquid current position.
 QUICK RATIO
• The quick ratio is conceivably a better barometer of the
coverage provided by these assets for the company’s
current liabilities should company experience financial
difficulties.
• Inventory is generally considered to be less liquid than these
other current assets.
• A rule of thumb is that a quick ratio greater than 1.0 means
that a company is sufficiently able to meet its short-term
obligations.
 QUICK RATIO
• A low and/or decreasing quick ratio might be delivering
several messages about a company. It could be telling us
that the company’s balance sheet is over-leveraged. Or it
could be saying the company’s sales are decreasing, the
company is having a hard time collecting its account
receivables or perhaps the company is paying its bills too
quickly.
• A company with a high and/or increasing quick ratio is likely
experiencing revenue growth, collecting its accounts
receivable and turning them into cash quickly and likely
turning over its inventories quickly.
 QUICK RATIO
• Not a perfect indicator
• The elimination of inventories makes the quick ratio a
somewhat better barometer of a company’s ability to meet
its short-term obligations than the current ratio. But like the
current ratio, the acid-test ratio is still not a perfect gauge. It
is not realistic to assume that a company will liquidate all
current assets that comprise the quick ratio to cover short-
term debts since the company still needs a level of working
capital to remain a going concern.
 CASH RATIO

Cash + Marketable Securities

Cash Ratio =
Current Liabilities
• The cash ratio is another measurement of a company’s
liquidity and their ability to meet their short-term obligations.
• shows the level of the firm’s cash and near-cash investments
relative to their current liabilities
 CASH RATIO
• This ratio tells creditors and analysts the value of current
assets that could quickly be turned into cash, and what
percentage of the company’s current liabilities these cash
and near-cash assets could cover.
• Seldom used in financial reporting or by analysts in the
fundamental analysis of a company.
 LEVERAGE RATIOS
• Also known as solvency ratios.
• A leverage ratio is any one of several financial
measurements that look at how much capital comes in the
form of debt (loans), or assesses the ability of a company to
meet its financial obligations.
• The leverage ratio is important given that companies rely on
a mixture of equity and debt to finance their operations,
and knowing the amount of debt held by a company is
useful in evaluating whether it can pay its debts off as they
come due.
 LEVERAGE RATIOS
• Too much debt can be dangerous for a company and its
investors.
• Uncontrolled debt levels can lead to credit downgrades or
worse.
• Too few debt can also raise questions.
• A leverage ratio may also be used to measure a company's
mix of operating expenses to get an idea of how changes
in output will affect operating income.
 LEVERAGE RATIOS

• Three Measures of Leverage:

• Debt Ratio
• Debt-Equity Ratio
• Interest Coverage Ratio
 DEBT RATIO
Total Liabilities
Debt Ratio =
Total Assets
• the ratio of total debt to total assets, expressed as a decimal or percentage.
• It can be interpreted as the proportion of a company’s assets that are
financed by debt.
• A figure of 0.5 or less is ideal. In other words, no more than half of the
company’s assets should be financed by debt.
•
 DEBT-EQUITY RATIO
Total Liabilities
Debt- Equity Ratio =
Total Equity
• indicates how much debt a company is using to finance its
assets relative to the value of shareholders’ equity.
• A high debt/equity ratio generally means that a company
has been aggressive in financing its growth with debt.
• Aggressive leveraging practices are often associated with
high levels of risk. This may result in volatile earnings as a
result of the additional interest expense.
 INTEREST COVERAGE RATIO
Operating Income
Interest Coverage Ratio =
Interest Expense
• a debt ratio and profitability ratio used to determine how easily a
company can pay interest on its outstanding debt.
• Interest coverage ratio is also called “times interest earned.”
 INTEREST COVERAGE RATIO

• measures how many times over a company could pay its current
interest payment with its available earnings.
• The lower a company’s interest coverage ratio is, the more its
debt expenses burden the company.
• Moreover, an interest coverage ratio below 1 indicates the
company is not generating sufficient revenues to satisfy its interest
expenses.
 ACTIVITY RATIO
• Also called efficiency ratios
• Evaluates how well a company uses its assets and liabilities
to generate sales and maximize profits.
• Key efficiency ratios are the following:
• asset turnover ratio
• Receivables turnover
• inventory turnover
• days' sales in inventory.
 ASSET TURNOVER RATIO
Sales
Asset Turnover =
Average Total Assets

• measures the value of a company’s sales or revenues

generated relative to the value of its assets.
• The Asset Turnover ratio can often be used as an indicator
of the efficiency with which a company is deploying its
assets in generating revenue.
 RECEIVABLES TURNOVER
Net Credit Sales
Accounts Receivable Turnover =
Average Accounts Receivable

• Receivable turnover ratio is also often called accounts

receivable turnover, the accounts receivable turnover ratio,
or the debtor’s turnover ratio.
• Accounting measure used to quantify a firm's effectiveness
in extending credit and in collecting debts on that credit.
• The receivables turnover ratio is an activity ratio measuring
how efficiently a firm uses its assets.
 RECEIVABLES TURNOVER
• A high receivables turnover ratio can imply a variety of
things about a company:
• The company operates on a cash basis
• The company’s collection of accounts receivable is
efficient
• A low receivables turnover ratio can imply a variety of things
about a company:
• the company may have poor collecting processes
• a bad credit policy or none at all
• the company has a high amount of cash receivables for
collection from its various debtors
 INVENTORY TURNOVER
Sales
Inventory Turnover =
Average Inventory
COGS
Inventory Turnover =
Average Inventory

• a ratio showing how many times a company has sold and

replaced inventory during a period.
• Low turnover implies weak sales and, excess inventory.
• A high ratio implies either strong sales or large discounts.
 DAYS’ SALES IN INVENTORY
Sales
Days' Sales of Inventory = ( ) 365 days
Average Total Assets
• Days sales of inventory, or days inventory, is one part of
the cash conversion cycle, which represents the process of
turning raw materials into cash.
• Days sales of inventory (DSI) is one measure of the
effectiveness of inventory management. By calculating the
number of days that a company holds onto inventory
before selling, this efficiency ratio measures the average
length of time that a company’s cash is tied up in
inventory.
 PROFITABILITY RATIO
• These ratios show how well a company can generate profits
from its operations.
• Key efficiency ratios are the following:
• Profit margins
• Return on Assets (ROA)
• Return on Equity (ROE)
 PROFIT MARGIN RATIO
Net Income
Profit Margin =
Sales

• Profit margin is a profitability ratios calculated as net income

divided by revenue, or net profits divided by sales.
• Profit margins are expressed as a percentage and, in effect,
measure how much out of every dollar of sales a company
actually keeps in earnings.
 PROFIT MARGIN RATIO
• Different kinds of profit margins:
• gross profit margin
• operating margin (or operating profit margin)
• Pre-tax profit margin
• net margin (or net profit margin)
 RETURN ON ASSET
Net Income
Return on Asset =
Total Assets
• Return on assets (ROA) is an indicator of how profitable a
company is relative to its total assets.
• ROA gives a manager, investor, or analyst an idea as to
how efficient a company's management is at using its assets
to generate earnings.
 RETURN ON ASSET

• When using ROA as a comparative measure, it is best to

compare it against a company's previous ROA numbers or
against a similar company's ROA.
• ROA is most useful for comparing companies in the same
industry, as different industries use assets differently.
 RETURN ON EQUITY
Net Income
Return on Equity =
Total Equity

• Return on equity (ROE) is the amount of net income returned

as a percentage of shareholders' equity.
• Return on equity (also known as "return on net worth"
[RONW]) measures a corporation's profitability by revealing
how much profit a company generates with the money
shareholders have invested.
 RETURN ON EQUITY
• ROE is useful in comparing the profitability of a company to
that of other firms in the same industry.
• It illustrates how effective the company is at turning the cash
put into the business into greater gains and growth for the
company and investors.
• The higher the return on equity, the more efficient the
company's operations are making use of those funds.
 DuPont ANALYSIS
• DuPont analysis is a fundamental performance
measurement framework popularized by the DuPont
Corporation and is also referred to as the "DuPont identity."
• DuPont analysis is a useful technique used to decompose
the different drivers of the return on equity (ROE).
• Decomposition of ROE allows investors to focus their
research on the distinct company performance indicators
otherwise cursory evaluation.
 DuPont ANALYSIS
• DuPont analysis breaks ROE into its constituent components
to determine which of these components is most responsible
for changes in ROE.
• Net Margin
• Asset Turnover Ratio
• Equity Multiplier
 DuPont ANALYSIS
• Net Margin
• Expressed as a percentage of the total revenue, net margin is
the revenue that remains after subtracting all operating
expenses, taxes, interest and preferred stock dividends from a
company's total revenue.
• Asset Turnover Ratio
• This ratio is an efficiency measurement used to determine how
effectively a company uses its assets to generate revenue.
The formula for calculating asset turnover ratio is total revenue
divided by total assets. As a general rule, the higher the
resulting number, the better the company is performing.
 DuPont ANALYSIS
• Equity Multiplier
• This ratio measures financial leverage. By comparing total
assets to total stockholders' equity, the equity multiplier
indicates whether a company finances the purchase of assets
primarily through debt or equity.
• The higher the equity multiplier, the more leveraged the
company, or the more debt it has in relation to its total assets.
 DuPont ANALYSIS

ROE = Net Profit Margin x Return on Asset x Financial Leverage

Net Profit Sales Assets

ROE = x x
Sales Assets Equity
Net Profit
ROE =
Equity

ROA = Net Profit Margin x Return on Asset

Net Profit Sales

ROA = x
Sales Assets
Net Profit
ROA =
Assets