11/13/2010

Financial Statement
Analysis

Copyright © 2007 Prentice-Hall. All rights reserved 1

Purpose
• To make informed decisions about a
company
• Generally based on comparative
financial data
– From one year to the next
– With another company
– With the industry

Copyright © 2007 Prentice-Hall. All rights reserved 2

Red Flags
• Earnings problems
• Decreased cash flow
• Too much debt
• Inability to collect receivables
• Inventory buildup
• Strange movement of sales,
inventory, and receivables

Copyright © 2007 Prentice-Hall. All rights reserved 3

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Financial Statement Analysis

Three basic tools are used in financial

statement analysis :
1. Horizontal analysis
2. Vertical analysis
3. Ratio analysis

Horizontal Analysis

• Is a technique for evaluating a

series of financial statement data
over a period of time.
• Purpose is to determine whether an
increase or decrease has taken
place.
• The increase or decrease can be
expressed as either an amount or a
percentage. 5

Horizontal Analysis- Balance Sheet

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Horizontal Analysis –
Income Statement

Vertical Analysis

• Is a technique for evaluating financial

statement data that expresses each item in
a financial statement as a percent of a
base amount.
• Total assets is the base amount in vertical
analysis of a balance sheet.
• Net sales is the base amount in vertical
analysis of an income statement.
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Vertical Analysis - Balance Sheet

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Common--Size Statements
Common
• Reports only percentages
• Useful when benchmarking a
company against industry averages
or key competitors

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intercompany comparison by
common-size statements

financial ratio analysis

Can provide clues to underlying conditions
that may not be apparent from an
inspection of the individual components.

Single ratio by itself is not very meaningful.

May includes categories
– Liquidity
– Profitability
– Asset utilization
– Debt utilization
– Stock performance

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liquidity ratios
• To measure the firm’s ability to
pay off short-term obligations
WHO CARES?
Short-term creditors such as
bankers and suppliers
• Ratios
– Working capital
– Current ratio
– Quick [acid test] ratio

profitability ratios
• To measure the ability of the firm
to earn an adequate return on
sales, total assets, and invested
capital
• Ratios
– Profit margin
– Return on assets [investment]
– Return on equity
– Return on share basis

Profitability
• Rate of return on net sales (profit
margin)– percentage of each sales
dollar that is earned as net income

Net income
Net sales

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Profitability
• Rate of return on total assets – how
successful the business is in using
assets to earn a profit

Net income + Interest expense

*Average total assets

*Average total assets =

(Beginning assets + Ending assets) / 2
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return on asset
ROA
Income
Profit margin =
Sales
Sales
Asset Turnover =
Total Assets
Income
Return on Asset=
Total Assets
Income Sales
= X
Sales Total Assets
= Profit margin X Asset turnover

Profitability
• Rate of return on common
stockholders’ equity - how much
income is earned for every $1
invested by the common stockholder

Net income – Preferred dividends

*Average common stockholders’ equity
*Average common stockholders’ equity =
(Beginning + Ending common stockholders; equity) / 2
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return on equity
ROE

Income
Return on equity =
Stockholders’equity

ROA
=
(1-Debt/Assets)

asset utilization ratios

• To measure the firm’s ability to

effectively employ its resources
• Ratios
– Receivable turnover
– Average collection period (days’ sales
in receivables)
– Inventory turnover
– Fixed asset turnover
– Total asset turnover

receivable turnover
• Is a measure of how effectively a firm is
using credit extended to customers

Sales [credit]
Receivable turnover = (times)
Receivables

Accounts receivable
Average collection period = (Days)
Average daily credit sales

365
= (Days)
Receivable turnover

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inventory turnover
• Indicates how well the firm has
used inventory to generate the
goods and services that are sold
Cost of goods sold
Inventory turnover = (times)
Inventory

Inventory
Days’s sales in inventory = (days)
Average COGS per day
365
= (days)
Inventory turnover

operating cycle

• The time takes for the firm to get cash

back from its investment in inventory
and A/R
• The longer the operating cycle, the
more current assets are needed
(relative to current liabilities)

Number of days Number of days

Operating cycle = +
of inventory of credit

asset turnover
• Total asset turnover
Sales
Total asset turnover =
Total asset
• Fixed asset turnover
Sales
Fixed asset turnover =
Fixed asset

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debt utilization ratios

• To evaluate the overall debt position of

the firm in light of its asset base and
earning power
• To assess how much financial risk the
firm has taken on
• Ratios
– Debt to total assets
– Interest coverage ratio (times-interest-
earned ratio)

Total debt
Total asset turnover = (times)
Total asset

EBIT
Interest coverage ratio = (times)
Interest expense

du pont analysis
EBIT

÷ Profit Margin
Return on
Sales x Assets

÷ Asset turnover
Return on assets Return on
Total Assets =
(1 - Debt/Assets) Equity

Total Debt

Financing
÷ plan

Total Assets

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practices
• Financial statement analysis
illustration
• S14-3, S14-7

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Stock Investments
• Price/earnings ratio – the market
price of $1 of earnings

Market price per share

EPS

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Stock Investments
• Dividend yield – percentage of a
stock’s market value that is returned
annually as dividends

Dividend per share

Market price per share

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Economic Value Added

(EVA®)
• Measures whether a business’s
operations have increased its
stockholder wealth

Net income + Interest expense – Capital charge

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Economic Value Added

(EVA®)
• Capital charge – amount
stockholders and lenders charge a
company for the use of their money

Notes Bonds Stockholders’ Cost of

+ + x
payable payable Equity capital

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Economic Value Added

(EVA®)
• Positive EVA® - increase in
stockholder wealth

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financial analysis
limitations

• Horizontal, vertical, and ratio analysis

are frequently used in making
significant business decisions
• One should be aware of the limitations
of these tools and the financial
statements
– Estimations
– Quality of earnings
– Differences in accounting methods

estimations
• Financial statements are based on
estimates.
– allowance for uncollectible accounts
– depreciation
– costs of warranties
– contingent losses
• To the extent that these estimates are
inaccurate, the financial ratios and
percentages are also inaccurate.

quality of earnings
• A company that has a high quality
of earnings provides full and
transparent information that will
not confuse or mislead users of the
financial statements

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alternative accounting methods

• One company may use the FIFO method,

while another company in the same
industry may use LIFO
• If the inventory is significant for both
companies, it is unlikely that their current
ratios are comparable
• In addition to differences in inventory
costing methods, differences also exist in
reporting such items as depreciation,
depletion, and amortization

teamwork

• Article “Cracking the code of income

statement”
• Discuss
– What do we have to be aware of when
analyzing the income statement?
– What does the term “Pro Forma” mean?
– How can we analyze the information from
an income statement (combining with other
statements)?
– What indicators can be derived from
analyzing the income statement of the
company? And their meanings?

teamwork
• Article “the power of ratios – learning
what the numbers are really telling you”
• Discuss
– How do you understand the term “Bill-and-
hold”
– How can financial ratios be used in
analysis?
– Which ratios are important to the business?
How can managers influence these ratios to
make them favorable?

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