Chapter 6

Chapter 6
Financial Statement Analysis
Objectives of Financial Statement
Understand reported financial data
Better manage a business
Provide a base for rational decision making
(though the major focus of separate analyses
and types of decision under consideration will
Make a reasonable assessment of future
financial condition based on present and past
financial conditions and on best available
estimate of future economic occurrences
Objectives of Financial Statement
• Why not accept prepared financial statements
at face value?
– Prepared financial statements require some
analysis as first step toward extracting information
from presented data.
– Decisions made on basis of financial analysis are
important and accepting presented financial data
at face value is poor policy.
Ratio Analysis
• Ratio analysis: financial ratios are used to
develop a set of statistics that reveal key financial
characteristics of a company
– Ratios are compared with industry standards.
Some industry standards can be obtained through commercial
services (i.e. Dun and Bradstreet, Robert Morris Associates) or
through industry trade services.
Analysts may have to develop their own standards by calculating
average ratios for leading companies in same industry.
– Ratios are used to analyze the trend over time
for a particular company.
Track key ratios through previous one or two economic
recessions to determine company’s financial strength during
periods of economic adversity
Ratio Analysis
• Four major categories of key financial ratios:
1. Profitability: “bottom-line” ratios designed to
measure earning power and profitability record of
2. Liquidity: ratios designed to measure ability of firm
to meet its short-term liabilities as they come due
3. Operating efficiency: measures of efficiency with
which corporate resources are employed to earn
4. Capital structure (leverage): measures of extent to
which debt financing is employed by company
Ratio Analysis
1. Profitability:
1. Return on sales (ROS)
2. Return on assets (ROA)
3. Return on equity (ROE)
Ratio Analysis
1. Profitability
1. Return on sales (ROS or net margin)
ROS = Earnings after tax
Net sales
• Net sales: dollar volume of sales less any returns,
allowances, and cash discounts
Ratio Analysis
1. Profitability
2. Return on assets (ROA or return on total assets
(ROTA) or return on investment (ROI)):
Earnings after tax
Total assets
Ratio Analysis
1. Profitability
3. Return on equity (ROE):
Measures owner’s invested capital
Stockholder’s equity: determined by deducting total
liabilities and intangible assets from total assets
Earnings after tax
Stockholder’s equity
Excludes effect of any intangible assets (i.e. goodwill,
ROE of at least 15% is a reasonable objective to provide
adequate dividends and to fund future growth.
Ratio Analysis
2. Liquidity:
Current ratio
Quick ratio
Average collection period
Days sales in inventory
Ratio Analysis
2. Liquidity
1. Current ratio:
Current ratio =
Current assets
Current liabilities
Current assets: cash, marketable securities, accounts
receivable, and inventories
Current liabilities: accounts payable, current notes
payable, and currently due portion of any long-term
Ratio Analysis
2. Liquidity
2. Quick ratio (“acid test”):
Quick ratio =
Cash + Marketable securities + Accounts receivable
Current liabilities
For bankers and other lenders, ratio should be at least
1 to 1.
Quick assets (current assets net of inventories): assets
that can be quickly converted to cash
Ratio Analysis
2. Liquidity
3. Average collection period: measures the speed
with which receivables are turned into cash
should not exceed net maturity indicated by firm’s
selling terms by more than 10-15 days
Average daily sales = Net sales
365 days
Average collection period = Accounts receivable
Average daily sales
Ratio Analysis
2. Liquidity
4. Days sales in inventory:
Days sales in inventory =
Average daily sales
Net sales used in numerator, which represents cost of goods
sold plus gross profit margin
Not a good measure of physical turnover
Provides important benchmark against which to compare
ratio of sales dollars to inventory stocks of one business to
that of another and how efficiently management is using its
inventory resources to support sales
Ratio Analysis
3. Operating efficiency ratios: measure the
relationship between annual sales and
investments in various classes of asset
1. Cost of goods sold to inventory
2. Sales to total assets
3. Sales to working capital
Ratio Analysis
3. Operating efficiency ratios
1. Cost of goods sold to inventory: provides
estimate of physical turnover rates
Cost of sales to inventory = Cost of goods sold
Numerator measures how efficiently inventory is
being managed
Ratio Analysis
3. Operating efficiency ratios
2. Sales to total assets: measures relationship
between sales and assets used to support those
Net sales
Sales to total assets =
Total assets
Often used to compare structure and capital
requirements of different industries
Ratio Analysis
3. Operating efficiency ratios
3. Sales to working capital:
Net sales
Sales to working capital =
Working capital
Working capital = Current assets – current liabilities
Ratio Analysis
4. Capital structure (leverage) ratios
Leverage: extent to which firm employs debt capital to
finance its operations
The more debt employed by firm, the more highly leveraged it is
said to be.
Debt ratio
Long-term debt to total assets
Debt equity ratio
Times interest earned ratio
Ratio Anaylsis
4. Capital structure ratios
1. Debt ratio: measures relationship between total
assets and amount of debt used to finance those
Debt ratio =
Total debt
Total assets
Ratio Analysis
4. Capital structure ratios
2. Long-term debt to total assets: measures
percentage of total assets that is financed by
long-term debt
Long-term debt
Long-term debt/Total assets ratio =
Total assets
Ratio Analysis
4. Capital structure ratios
3. Debt equity ratio: measures relationship
between capital supplied by lenders (debt) and
capital supplied by owners (equity)
Debt equity ratio =
Total debt
Ratio Analysis
4. Capital structure ratios
4. Times interest earned ratio:
Computed as ratio of earnings before interest and
taxes (EBIT) to interest expense
EBIT = Earnings after tax + Interest expense + Income tax
Times interest earned =
Earnings before interest and taxes
Interest expense
Ratio Analysis
• Interrelationships Among Ratios
– Firm’s profitability, liquidity position, operating
efficiency, and leverage position are all
Ratio Analysis
• DuPont system of analysis: relates return on
investment to firm’s profit margin and asset
Net income
Total assets
Net income
Total assets
– ROA results from interaction of firm’s profit margin (net
income/sales) and asset turnover (sales/total assets)
– ROA = margin x turnover
– ROA is an overall performance measure of profitability
(profit margin) and its operating efficiency (total asset
Ratio Analysis
• Relationships among ROE, ROA and leverage
Net income
Stockholder’s equity
Net income X
Total assets
– The higher the firm’s leverage (ratio of total assets to
stockholders’ equity), the higher will be its ROE relative to ROA.
– Equity multiplier: measure of leverage used to show that use of
debt (leverage) is reflected in an increasing ratio of assets to
equity because use of debt allows firm to add assets without
increasing equity
Ratio Analysis
• Computation and display of a set of ratios for a given
company in a given year is of limited usefulness by
• Ratios must be compared to performance in
other years and to appropriate standards for
companies of approximately equal asset size
in similar industries.
Common-Size Statements
• Common-size financial statement: expresses
all accounts on balance sheet and income
statement as a percentage of some key figure
Common-Size Statements
• Common-size balance sheet
– Analyzes internal structure and allocation of firm’s
financial resources
– Asset side shows how investments in various financial
resources are distributed among asset accounts
– Liabilities and equities side shows percentage distribution
of financing provided by current liabilities, long-term debt,
and equity capital
Common-Size Statement
• Common-size income statement
– Shows proportion of sales or revenue dollar
absorbed by various cost and expense items
Sequence of Analysis
• Main objective of analysis determines
relative degree of emphasis to place on each
area of analysis (profitability, liquidity,
operating efficiency, or capital structure)
• But one logical framework can be employed
to systematically explore financial health of
Sequence of Analysis
1. Specify clearly objectives of analysis and
develop set of key questions that should be
answered to attain this objective
2. Prepare data (i.e. key ratios and common-size
statements) necessary to work toward
specified goals
Sequence of Analysis
3. Analyze and interpret numerical information
developed in prepared data
– First examine information provided by ratio
analysis in order to develop overall feel for
potential problem areas
– Then use preliminary questions and opinions
developed during analysis of ratio data to focus
on information contained in common-size
Sequence of Analysis
4. Form conclusions based on data and answer
questions posed in Step 1
– Present specific recommendations, backed up by
available data, along with brief summary of
major points developed previously
– Begin written report with summary of
conclusions developed in this final phase
Case Study – Technosystems, Inc.
• Technosystems: 3-year-old, privately owned
company engaged in wholesale distribution of
plumbing, heating, and air conditioning
– President: John Diamond
• Walker Equipment Company: company
specializing in sale and leasing of heavy
construction equipment
– President: David Walker
– CPA: Carla Gilberti
Case Study – Technosystems, Inc.
• David and Carla had no interest in operating a
new company, but they agree to become
equal partners in financing Technosystems if
John would start up and manage it.
• Technosystems was originally financed with a
$100,000 loan from David and Carla, payable
in ten annual installments of $10,000 plus 14%
interest on declining balance.
Case Study – Technosystems, Inc.
Key Financial Ratios - See exhibit 6.3
• Technosystems is undercapitalized
• Debt ratio is extremely high
– Total debt is equal to almost 80% of total assets, compared
with industry standard of 50%
– Long-term debt is equal to nearly 30% of total assets,
almost double industry standard of 15%
– Debt is private debt loaned to company by two of its
Case Study – Technosystems, Inc.
Key Financial Ratios - See exhibit 6.3
• Profitability ratios
– Overall level and trend of earnings looks positive
– ROS is just below industry average of 3.5%, and
shows rapidly increasing trend
– ROA is increasing rapidly and above industry
– ROE is extremely high due mainly to high debt
position and low equity relative to debt
Case Study – Technosystems, Inc.
Key Financial Ratios - See exhibit 6.3
• Profitability ratios (continued)
– ROA has improved as result of improvement in both ROS
ratio and asset turn over ratio:
• ROA = (Profit margin) x (Asset turnover)
• ROA (2008)= (3.34%) x (4.5) = 15.0%
• ROA (2007) = (2.10%) x (3.6) = 7.5%
– High rate of ROE of 68.1% is result of high debt position:
• ROE = (ROA) x (Total assets/Equity)
• ROE = (15.03%) x ($284,100/$62,700) = (15.03%) x
(4.53) = 68.1%
• The higher this ratio, the more debt used
Case Study – Technosystems, Inc.
Key Financial Ratios - See exhibit 6.3
• Liquidity ratios
– Current ratio is below industry average
– Quick ratio is approximately equal to industry
– Average collection period is well below industry
average (indicates that company is doing excellent
job of collecting its receivables)
– Inventory control (below-average days sales in
inventory number) is excellent
Case Study – Technosystems, Inc
Key Financial Ratios - See exhibit 6.3
• Operating efficiency ratios
– Inventory turnover (cost of sales to inventory
ratio), sales to total assets, and sales to working
capital ratios are all above industry averages
Case Study – Technosystems, Inc.
Common-Size Analysis
• Common-size balance sheet (see exhibit 6.4)
– Fixed assets as percentage of total assets have
increased since 2001
– Increase in retained earnings account and hence
total equity as percent of total assets
– Sharp decrease in percentage of total assets
financed by current liabilities and long-term debt
– Within working capital accounts, there is steady
decrease in total current assets as percent of total
Case Study – Technosystems, Inc.
Common-Size Analysis
• Common-size income statement (see exhibit 6.5)
– From 2006 to 2008, steady improvements:
• Gross profit margin has increased from 18.9% to 25.4%
• Pre-tax margin has increased from 0.1% to 5.6%
• After-tax margin has increased from 0.1% to 3.3%
– Total expenses as percent of sales have remained
relatively steady and only increased from 18.9% to
Case Study – Technosystems, Inc.
Technosystems Conclusions
• Profitability is excellent and improving.
• Liquidity position is strong and improving.
• Technosystems carries a heavy debt load.
– Liquidation is unlikely since lenders are two of the
– Repayment of loans is likely since operating
efficiency ratios reflect sound management and
profitability is growing
Financial Analysis, Financial Fraud
and Financial Stress
• Enron and Worldcom were two of the largest
corporate bankruptcies related to allegations of
widespread fraud, cover-ups, and criminal behavior
by senior executives of these corporations and their
• Massive fraud on this scale are now exception due to
increased public scrutiny, but there are new risks and
problems due to combination of excessive leverage,
bad real estate deals, under-provisioning for loan,
insurance or derivative losses and/or bad
Financial Analysis, Financial Fraud
and Financial Stress
• New regulations will likely prohibit:
– Leverage ratios greater than 30 to 1
– Ability of homeowners to borrow all or more than all
of value of equity in their homes
– Unregulated writing of credit default swaps without
appropriate insurance reserves (accounting for
concentration of risk)

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