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Limitations of financial statement analysis

Comparing financial data across companies

• Differences in accounting methods between companies sometimes make it difficult to

compare their financial data. For example:
• If one company values its inventory using the LIFO method and another uses the average
cost method, then direct comparisons of financial data such as inventory valuations and
cost of goods sold may be misleading.
• Even with this limitation in mind, comparing financial ratios with other companies or
industry averages can provide useful insights.

Looking beyond ratios

Ratios should not be viewed as an end, but rather as a starting point. They raise many questions
and point to opportunities for further analysis, but they rarely answer questions by themselves.
In addition to ratios, other sources of data should also be considered such as industry trends,
technological changes, changes in consumer tastes, and changes in broad economic factors.

Statements in comparative and common-size form

An item on a balance sheet or income statement has little meaning by itself. The meaning of the
number can be enhanced by drawing comparisons.

1. Peso/Dollar and percentage changes on statements (horizontal analysis).

2. Common-size statements (vertical analysis)
3. Peso/Dollar and percentage changes on statements

Horizontal analysis (also known as trend analysis) involves analyzing financial data over time.

• Quantifying dollar changes over time serves to highlight the changes that are the most
important economically.
• Quantifying percentage changes over time serves to highlight the changes that are the
most unusual.
• Horizontal analysis can be even more useful when data from a number of years are used
to compute trend percentages. To compute a trend percentage, a base year is selected and
the data for all years are stated in terms of a percentage of that base year.
Common-size statements

• Vertical analysis focuses on the relations among financial statement items at a given
point in time. A common-size financial statement is a vertical analysis in which each
financial statement item is expressed as a percentage.

• In balance sheets, all items are usually expressed as a percentage of total assets.
• In income statements, all items are usually expressed as a percentage of sales.

Liquidity Ratios

The data and ratios that managers use to assess liquidity include working capital, the current
ratio, and the acid-test (quick) ratio. These ratios are quick measures of a firm’s ability to provide
sufficient cash to conduct business over the next few months. The cash budget provides the best
assessment of a firm’s liquidity position

Working capital = Current Assets – Current Liabilities

The excess of current assets over current liabilities is known as working capital. Working capital
is not free. It must be financed with long-term debt and equity. Therefore, managers often seek to
minimize working capital. A large and growing working capital balance may not be a good sign.
For example, it could be the result of unwarranted growth in inventories.

Current ratio = Current Assets

Current Liabilities

It measures a company’s short-term debt paying ability. It measures the ability of a firm to pay
its current liabilities. However, it must be interpreted with care. For example, a declining ratio
may be a sign of deteriorating financial condition, or it might result from eliminating obsolete
inventories or other stagnant current assets.

Acid-test (quick) ratio = Current Assets – Inventories

Current Liabilities

It is a more rigorous measure of short-term debt paying ability because it only includes cash,
marketable securities, accounts receivable, and current notes receivable. It measures a company’s
ability to meet its obligations without having to liquidate its inventory.
Asset management

Managers compute a variety of ratios for asset management purposes. These ratios indicate how
much a firm has invested in a particular type of asset or group of assets relative to the revenue
the asset is producing. This indicates how efficient the firm is in allocating its resources.

Accounts receivable turnover = Net Credit Sales

Average trade receivables

It measures how quickly credit sales are converted to cash.

Average collection period = Accounts Receivable or 365

Annual credit sales/365 days Receivables Turnover

It measures how many days, on average, it takes to collect an account receivable. It should be
interpreted relative to the credit terms offered to customers.

Inventory turnover = Cost of Sales

Average Inventory

The inventory turnover is computed as shown. It measures how many times a company’s
inventory has been sold and replaced during the year. It should increase for companies that adopt
just-in-time methods. It should be interpreted relative to a company’s industry. For example,
grocery stores turn their inventory over quickly, whereas jewelry stores tend to turn their
inventory over slowly. If a company’s inventory turnover is less than its industry average, it
either has excessive inventory or the wrong sorts of inventory.

Average Sale Period = 365

Inventory Turnover

A related measure is called the average sale period. It measures the number of days being taken,
on average, to sell the entire inventory one time.

Operating cycle

The operating cycle is calculated as shown.

It measures the elapsed time from when inventory is received from suppliers to when cash is
received from customers.
Fixed Asset Turnover Ratio = Sales
Net Fixed Assets

This ratio indicates the extent to which a firm is using existing property, plant and equipment to
generate sales. This ratio should be used primarily for year-to year comparison within the same
company, rather than for intercompany comparisons.

Total asset turnover = Sales

Total Assets

The total asset turnover is calculated as shown. It measures how efficiently a company’s assets
are being used to generate sales. This ratio expands beyond current assets to include noncurrent

Debt management Ratios/Financial Leverage Management Ratios

Managers compute a variety of ratios for debt management purposes. These ratios measure the
degree to which a company is employing financial leverage and as such are of interest to
creditors and owners. Both short-term and long-term creditors are concerned with the amount of
leverage a company employs because it indicates the company’s risk exposure in meeting debt
service charges like principal and interest repayment. Owners are interested in financial leverage
because it influences the rate of return they can expect to realize on their investment and the
degree of risk involved.

Times interest earned ratio = Earnings before interest and taxes (EBIT)
(interest coverage ratio) Interest charges

It is the most common measure of a company’s ability to protect its long-term creditors.
It is based on earnings before interest and income taxes because that is the amount of earnings
that is available for making interest payments. A ratio of less than 1 is inadequate.

Debt Ratio = Total Debt

Total Assets

This ratio measures the proportion of a firm’s total assets that is financed with creditors’ funds.
This is stated in terms of percentage.

Debt-to-equity ratio = Total debt

Total equity

This ratio is stated in terms of percentage. It indicates the relative proportions of debt and equity
on a company’s balance sheet.
Creditors and stockholders have different views when defining the optimal debt-to-equity ratio.
Stockholders like a lot of debt if the company’s rate of return on its assets exceeds the rate of
return paid to creditors. Creditors prefer less debt and more equity because equity represents a
buffer of protection. In practice, debt-to-equity ratios from 0.0 to 3.0 are common.

Fixed Charge = EBIT + Lease payments

Coverage Ratio Interest + Lease Payments + Preferred Dividends before tax + Before tax Sinking Fund
Earnings After Taxes = Earnings before taxes – Taxes
= Earnings before taxes – Earnings before taxes x T
= Earnings before tax (1 – T)

Earnings before Taxes = Earnings after taxes / 1 - T

This ratio measures the number of times a firm is able to cover fixed charges, which includes (in
addition to interest payments) preferred dividends and payments required under long-term lease
contracts. In calculating the fixed charge coverage ratio, an analyst must consider each of the
firm’s obligations on a before tax basis. After tax payments must be adjusted by dividing the
amount by (1 – T).

The equity multiplier = Total Assets

Stockholders’ Equity

It indicates the portion of a company’s assets that are funded by equity.

It focuses on average amounts maintained throughout the year rather than amounts at one point
in time.

Profitability Ratios

Gross margin percentage = Sales – Cost of Sales

Gross Profit Margin Ratio Sales

It measures the relative profitability of a firm’s sales after deducting the cost of sales. It should
be more stable for retailing companies than for other companies because the cost of goods sold in
retailing companies excludes fixed costs. It reveals how effectively the firm’s management is
making decisions regarding pricing and control of production costs.

Net profit margin percentage = Earnings after taxes


Operating Profit Margin Ratio = EBIT

EBIT DA Margin = Earnings before interest, taxes, depreciation and amortization

This ratio measures how profitable a company’s sales are after all expenses including taxes and
interest are deducted. In addition to cost of goods sold, it also looks at how selling and
administrative expenses, interest expense, and income tax expense influence performance.
Return on total assets (Investment) = Earnings after Taxes (EAT)
Total Assets

This ratio measures a firm’s net income in relation to the total asset investment. Adding interest
expense back to net income enables the return on assets to be compared for companies with
different amounts of debt or over time for a single company that has changed its mix of debt and

Return on equity = Earnings after Taxes (EAT)

Stockholders’ Equity

Dupont Formula = Net Profit Margin x Total asset turnover x Equity Multiplier

Dupont = Earnings after taxes x Sales x Total Assets

Formula Sales Total Assets Stockholder’s Equity

This measure indicates how well the company used the owners’ investments to earn net income.
The return on equity can also be computed using the DuPont formula.

Earnings per share = Earnings after Taxes – Preferred Dividends

Average commons stockholders’ Equity

Earnings per share is computed as shown.

The average number of common shares outstanding is computed by adding the shares
outstanding at the beginning of the year to the shares outstanding at the end of the year and
dividing by two. Managers analyze this ratio because earnings form the basis for dividend
payments and future increases in the value of shares of stock.

Financial leverage

Financial leverage results from the difference between the rate of return the company earns on
investments in its own assets and the rate of return that the company must pay its creditors.
Positive financial leverage exists if the rate of return on the company’s assets exceeds the rate of
return the company pays its creditors. In this case, having some debt in a company’s capital
structure can benefit shareholders. Negative financial leverage exists if the rate of return on the
company’s assets is less than the rate of return the company pays its creditors. In this case, the
common stockholder suffers by having debt in the capital structure.

Market performance Ratios

The market based ratios for a firm should parallel the accounting ratios of that firm. For
example, if the accounting ratios of a firm suggest that the firm has more risk than the average
firm in the industry and haw lower profit prospects , this information should be reflected in a
lower market price of that firm’s stock.

Price-earnings ratio = Market Price per share

Current Earnings per share

This ratio tells us how much investors (market) is willing to pay per peso of earnings of the firm.
In general, the lower the firm’s risk, the higher its P/E ratio should be. A higher price-earnings
ratio means that investors are willing to pay a premium for a company’s stock because of its
optimistic future growth prospects.

Market Price to Book Value = Market Price per share

(P/BV Ratio) Book value per share

EV-EBITDA Multiple = Enterprise Value

Earnings before interest, taxes, depreciation and amortization

Enterprise value is calculated as the sum of the market value of the common stock plus the
market value of debt (book value of debt). This ratio represents the aggregate measure of value
that tells us the overall worth of the company per peso of earnings (cash flow) available to all
capital holders.

Dividend Policy Ratios

These ratios provide insights regarding a firm’s dividend policies and its future growth prospects.

Dividend payout ratio = Dividends per share

Earnings per share

This ratio indicates the percentage of a firm’s earnings that are paid out as dividends to its
common stockholders. Investors who seek market price growth would like this ratio to be small,
whereas investors who seek dividends prefer it to be large.

Dividend yield ratio = Expected dividend per share

Stock Price

This ratio measures the investor’s rate of return (in the form of cash dividends only) when
buying common stock at the current market price.

Book value per share

It measures the amount that would be distributed to holders of each share of common stock if all
assets were sold at their balance sheet carrying amounts and if all creditors were paid off. This
measure is based entirely on historical cost. The market price reflects expectations about future
earnings and dividends, whereas the book value per share is based on historical cost