Financial Statement Analysis

Financial statements are a structured representation of the financial position and financial performance of an
entity. The objective of financial statements is to provide information about the financial position, financial
performance and cash flows of an entity that is useful to a wide range of users in making economic decisions.
Financial statements also show the results of the managements stewardship of the resources entrusted to it.
(IFRS 1)
The Basic Financial Statements
The basic financial statements are composed of the following:
1. Statement of Financial Position also known as the balance sheet, this presents the value of the
companys assets, liabilities and equity as of a given point in time.
2. Statement of Comprehensive Income - a statement summarizing the firm's revenues and expenses over
an accounting period.
3. Statement of Changes in Owners Equity
4. Statement of Cash Flows - a statement reporting the impact of a firm's operating, investing and financing
cash flows over an accounting period.
5. Notes to the Financial Statements
Analysis Using Financial Ratios
Financial ratios are used to compare the risk and return of different firms in order to help equity investors and
creditors make intelligent investment and credit decisions, and also to help management to evaluate financial
performance and position compared to other relevant entities. The interests of financial statement users differ.
Short term bank and trade creditors are primarily interested in short-term liquidity. Longer-term creditors are
interested in long-term solvency. Equity investors are primarily interested in the long-term earning power of the
firm.
Ratios are hugely popular in financial statement analysis because it can be used to compare firms of different
sizes. Ratios can also provide a profile of a firm, its economic characteristics and comparative strategies, and
its unique operating, financial and investment characteristics. The process of standardization may, however,
be deceptive as it ignores differences among industries, the effect of varying capital structures, and differences
in accounting and reporting methods.
There are four broad ratio categories which measure the different aspects of risk and return relationships:
Activity / asset management ratios - evaluates revenue and output generated by the firm's assets.
Liquidity ratios - measures the adequacy of a firm's cash resources to meet its short-term cash obligations
Long-term debt and solvency / debt management ratios - examines the firm's capital structure, including
the mix of its financing sources and the ability of the firm to satisfy its longer-term debt and investment
obligations.
Profitability ratios - measures the income of the firm relative to its revenues and invested capital
These categories are interrelated rather than independent. Thus, financial analysis relies on the integrated use
of many ratios rather than a selected few.
There are also other variations of the traditional ratio analysis. Horizontal Analysis looks at how a particular
item changes from year to year and expresses the change in percentage form. It shows the trends in different
financial statement items. Vertical Analysis, on the other hand, is the conversion of all money amounts to
percentages with respect to a certain base. For the income statement, net sales is used as the common base.
For the balance sheet, total assets is used as the common base
Cautionary Notes on Ratio Analysis

Implicit in ratio analysis is the proportionality assumption that the economic relationship between numerator
and denominator does not depend on size. This ignores the existence of fixed costs. When there are fixed
costs, changes in total costs (and conversely, profits) are not proportional to change in sales.
Ratio analysis often lack appropriate benchmarks to indicate optimal levels. Often, industry ratios are
used, but it may have limited usefulness if the whole industry or majority of the firms in the industry is
performing poorly.
Because of seasonality, ratios may not reflect normal operating relationships. Timing issues can lead to
window-dressing.
Negative numbers in the financial statements may give misleading ratios.
The choice of accounting methods and estimates can greatly affect reported financial statement amounts.

Activity Ratios
Operating Activity Ratios:
Inventory Turnover = CGS / Average Inventory
Average No. of Days Inventory in Stock = 365 / Inventory Turnover
Receivables Turnover = Net Credit Sales / Average Trade Receivables
Average No. of Days Receivables Outstanding (aka Days Sales Outstanding) = 365 / Receivables Turnover
Payables Turnover = Purchases / Average Accounts Payable
Average No. of Days Payables Outstanding = 365 / Payables Turnover
Investment Activity Ratios:
Fixed Asset Turnover = Sales / Average Fixed Assets
Total Asset Turnover = Sales / Average Total Assets
Liquidity Ratios
Current Ratio = Current Assets / Current Liabilities
Quick Ratio = Quick Assets / Current Liabilities
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
Operating Cycle = Days to sell inventory + Days to convert receivables to cash
Cash Cycle = Operating Cycle - Days Payables Outstanding
Defensive Interval = 365 x (Quick Assets / Projected Expenditures)
Solvency Ratios
Debt to Assets = Total Debt / Total Assets
Debt to Total Capital = Total Debt / Total Capital
Debt to Equity = Total Debt / Total Equity
Times Interest Earned = EBIT / Interest Expense
Profitability Ratios
Gross Margin = Gross Profit / Sales
Operating Margin = Operating Income / Sales
Net Profit Margin or Return on Sales = Net Income / Sales
Return on Assets (ROA) = EBIT / Average Total Assets
Return on Equity (ROE) = Net Income / Average Stockholder's Equity
Return on Common Equity (ROCE) = (Net Income - Preferred Dividends) / Average Common Equity
Disaggregating Ratios Using the Du Pont Analysis
The Du Pont Analysis shows the interrelation of the different aspects of risk and return analysis with respect to
the ROE measure.
ROE = Income / Equity
ROE = (Income / Assets) x (Assets / Equity)

ROE = (Income/Sales) x (Sales/Assets) x (Assets/Equity)

ROE = Profitability x Activity x Financial Leverage
Economic Characteristics and Strategies
Ratios are not randomly distributed among companies: management strategy, industry characteristics and
product life cycle are all reflected in the firm's ratios.

A high turnover + low margin firm sells large volumes at low prices. To be successful, this firm must
carefully control costs.
The low turnover + high margin firm competes on the basis of attributes rather than price. Cost control is
not that important. Rather, the key issue is quality.
At the introduction stage, firms have high short-term activity but low liquidity ratios. Debt tends to be high.
Profitability tends to be low.
At the growth stage, profits grow, but cash from operations lags. Investment in capacity also rises,
decreasing long-term activity ratios. Profits and ROA remain low. Debt ratios remain high.
At maturity, ratios would finally stabilize and look favorable for the firm.
During the decline stage, ROA would reach its peak. Cash flows from investment would be positive.
Profitability would start to decline.

Exercises:
1. Which of the following statements is false?
a. Ratios are used to show relationships and comparisons between different items in the company's
financial statement
b. Changes and trends across time are typically drawn out through horizontal analysis
c. A typical output when performing vertical analysis is the common-size financial statement
d. There is a general disagreement in the standard formula used for financial ratios
For questions 2 - 4, refer to the following 5-year income statement for a domestic fast food company. Figures
are in thousands.
2005
2004
2003
2002
2001
Sales
14,200
13,000
8,700
7,000
5,000
Cost of Goods Sold
11,000
10,000
6,700
4,200
2,900
Gross Profit
3,200
3,000
2,000
2,800
2,100
Operating Expenses including
Depreciation and Amortization
2,300
1,700
1,100
1,900
1,400
Earnings Before Interest and
Taxes
900
1,300
900
900
700
Interest Income (Expenses)
30
(5)
(400)
(20)
100
Earnings Before Income Tax
930
1,295
500
880
800
Income Tax
Net Income / Profit
930
1,295
500
880
800
2. What is the appropriate base in performing a vertical analysis for this income statement?
a. Sales
b. Net Income
c. Year 2001 figures
d. Year 2005 figures
3. Which of the following statements is true?
a. For the past five years, sales has grown at a faster rate than cost of goods sold
b. The net profit margin has consistently gone down every year for the past five years
c. During 2003, cost of goods sold as a proportion of sales grew while operating expense as a proportion
of sales went down
d. Vertical analysis must be performed to see how much sales grew over the last five years

4. Compared to 2004 figures,

a. cost of goods sold for 2005 as a percentage of sales has remained constant at around 77%
b. the operating profit margin for 2005 has increased
c. operating expense as a percentage of sales for 2005 has decreased
d. statements a, b and c are true
For questions 5 - 12, refer to the following set of financial statements (in millions) of PPC Company:
Balance Sheet
2005
2004
Cash and cash equivalents
13,200
7,800
Short-term investments
700
100
Accounts receivable
4,500
5,700
Inventory
10,100
7,400
Other current assets
100
300
Total Current Assets
28,600
21,300
PPE
23,600
21,500
Intangible assets
300
200
Other assets
400
600
Total Assets

52,900

43,600

Accounts payable
Accrued expenses
Total Current Liabilities
Noncurrent liabilities
Total Liabilities
Stockholder's Equity

26,800
5,300
32,100
1,700
33,800
19,100

13,300
5,700
19,000
6,100
25,100
18,500

Total Liabilities and Stockholder's Equity

52,900

43,600

2005
61,800
54,500
7,300
2,500
4,800
2,300
2,500
(400)
2,100
2,100

2004
59,000
50,000
9,000
2,600
6,400
2,100
4,300
300
4,600
4,600

Income Statement
Sales
Cost of Goods Sold
Gross Profit
Operating Expenses
EBITDA
Depreciation and Amortization
EBIT
Interest Income / (Expense)
Earnings Before Income Tax
Income Tax
Net Profit

All sales were made on credit. PPC uses a end-of-year figures and a 360-day year in making its calculations.
5. What is the current ratio of PPC for 2004 and 2005, respectively?
a. 0.72 and 0.57
b. 1.03 and 0.77
c. 1.12 and 0.60

d. 1.12 and 0.89

6. If the industry average current ratio for 2005 is 1.03 and assuming that most companies are fairly
represented by the industry average,
a. we may imply that PPC is more liquid than most companies in the industry
b. we may imply that PPC is less liquid than most companies in the industry
c. we may imply that PPC's liquidity is just about the same as most companies in the industry
d. we may imply that PPC has enough current assets to satisfy the payment of its current liabilities
7. What is the quick ratio for PPC for 2004 and 2005, respectively?
a. 1.03 and 0.89
b. 0.42 and 0.43
c. 0.72 and 0.57
d. 0.77 and 0.43
8. If the industry asset turnover for 2004 and 2005 is 1.02 and 0.98 and assuming that most companies are
fairly represented by the industry average,
a. we may imply that PPC's assets were broadly more productive in both years
b. we may imply that PPC's assets were broadly more productive in 2004 but less productive in 2005
c. we may imply that PPC's assets were broadly less productive in 2004 but more productive in 2005
d. we may imply that PPC's assets were broadly less productive in both years
9. If the average industry leverage ratio is 0.74 and assuming that most companies are fairly represented by
the industry average,
a. we may imply that PPC is more leveraged than most companies in the industry
b. we may imply that PPC is less leveraged than most companies in the industry
c. we may imply that PPC's leverage roughly approximates the industry average
d. we need more information to determine PPC's leverage compared to the industry
10. With respect to PPC's operational efficiency,
a. both accounts receivable turnover and inventory turnover improved in 2005
b. accounts receivable turnover deteriorated while inventory turnover improved in 2005
c. accounts receivable turnover improved while inventory turnover deteriorated in 2005
d. both accounts receivable turnover and inventory turnover deteriorated in 2005
11. If PPC's credit terms is 30 days,
a. we may imply that on the average, PPC collected past the due date in both 2004 and 2005
b. we may imply that on the average, PPC collected past the due date during 2004 but was able to
improve its collection efficiency by 2005
c. we may imply that on the average, PPC collected on time during 2004 but was unable to sustain it and
collected past the due date during 2005
d. we may imply that on the average, PPC collected on time in both 2004 and 2005
12. Using the Du Pont Model, which of the following is not a reason for the deterioration of PPC's ROE in
2005?
a. decrease in profitability
b. decrease in turnover
c. decrease in leverage
d. deterioration of Return on Assets
Assignment: Comprehensive Problem 4-24, Brigham and Houston pages 116 117.