Financial Statements

Analysis

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 Learning objectives

 Identify the ways that firms obtain and use cash

as reported in the Cash Flow Statement.
 Calculate and interpret key financial ratios.
 Discuss the Du Pont identity as a method of
financial analysis.
 Understand the use of financial information for
comparative purposes.
 Outline the problems associated with using
financial ratios.
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 Sources and Uses of Cash
 Atthe most fundamental level, firms do
two things: generate cash and spend cash.
 Cash is generated by selling a product or
service, asset or security.
 Cash is spent by paying for materials and
labor to produce a product or service and
by purchasing assets.

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 Sources and Uses of Cash
 Activities that bring in cash are called
sources of cash.
 Activities that involve spending cash are
called uses (or applications) of cash.
 An increase in an asset account or a decrease
in a liability or equity account is a use of
cash.
A decrease in an asset account or an increase
in a liability or equity account is a source of
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cash.
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 Financial Ratio Analysis
A Financial ratios is an index that relates two
accounting numbers and is obtained by dividing
one number by the other.
 Used to compare and investigate relationships
between different pieces of financial
information, either over time or between
companies. Types of Comparisons: Internal
Comparisons and External Comparisons
 Ratios eliminate the size problem.
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 Ratio Analysis: Questions
to Consider for Each Ratio
 How is it computed?
 Whatis it intended to measure, and why
might we be interested?
 What is the unit of measurement?
 Whatmight a high or low value be telling
us? How might such values be
misleading?
 How could this measure be improved?
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 Categories of Financial
Ratios
Liquidity Ratios
Leverage ratios (Capital Structure
Ratios) or Solvency
Profitability ratios
Valuation ratios
Turnover Ratios
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 Liquidity Ratios
 Current Ratio
 Quick Ratio
 Profitbefore depreciation and amortization
to current liabilities (PDACL)
 Operating cash flow to current liabilities
(OCFCL)
 Cash balance to total liabilities (CBTL)
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 Liquidity Ratios
 Current Ratio: The ratio is mainly used to
give an idea of the company's ability to pay
back its short-term liabilities (debt and
payables) with its short-term assets (cash,
inventory, receivables).
Current assets
Current ratio 
Current liabilitie s

Example: in 2006 = 1250/640 = 1.15

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 Liquidity Ratios
 Quick Ratio: The quick ratio measures the
dollar amount of liquid assets available for
each dollar of current liabilities.
Cash in hand + Cash at Bank + Receivables +
Quick Ratio = Marketable Securities
Current Liabilities

= (current assets – inventory)/ Current liabilities

Example:
in 2006 quick ratio = 1.50
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 Liquidity Ratios
 Profit before depreciation and amortization
to current liabilities (PDACL): Measures
how many times company’s net operating
profit (before tax and interest) covers
current liabilities.
Profit before depreciation and amortization
PDACL 
Current Liabilitie s

6-11 Example: in 2006 PDACL = 0.40

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 Liquidity Ratios
 Operating cash flow to current liabilities
(OCFCL): Refers to the cash generated
from the operations of a company
(revenues less all operating expenses, plus
depreciation), in relation to short-term debt
obligations. .
Operating Cash Flow
OCFCL 
Current Liabilitie s

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Example: In 2006 PDACL = 0.40
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 Liquidity Ratios
 Cash balance to total liabilities (CBTL):
Refers to the company’s cash balance in
relation to its total liabilities.

Cash Balance
CBTL 
Total Liabilitie s
Example: In 2006 CBTL = 0.40

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 Leverage (Capital
Structure) Ratios
 Debt to equity ratio (DE ratio)
 Total liabilities to total tangible assets
(TLTAI)
 Interest cover ratio
 Net debt to equity ratio
 Equity multiplier

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 Leverage (Capital
Structure) Ratios
 Debt to equity ratio (DE ratio): It refers a
company’s capital structure and whether the
company is more reliant on borrowings (debt)
or shareholder capital (equity) to fund assets
and activities.
Total debt
Debt/equity ratio 
Total equity

 Example: Debt/Equity ratio = 1.14

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 Leverage (Capital
Structure) Ratios
 Total liabilities to total tangible assets
(TLTAI): This ratio provides the relationship
between a company’s liabilities and tangible
assets. Tangible assets are defined as
physical assets, such as property, cash,
inventory and receivables.
Total liabilities
TLTAI 
Total tangible assets

 Example: TLTAI = 1.60

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 Leverage (Capital
Structure) Ratios
 Interest cover ratio: measures company’s
ability to meet interest expenses on debt using
profits.
EBIT (Earnings before interest and taxes)
Interest cover ratio 
Interest

 Example: ICR = 3

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 Leverage (Capital
Structure) Ratios
 Equity multiplier: It is a measurement of a
company's financial leverage. It measures the
amount of a firm's assets that are financed
either through equity or debt.
Total assets
Equity multiplier 
Total equity

 Example: EM = 1.11

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 Profitability Ratios
 Earnings per share (EPS )
 Gross profit margin
 Net profit margin
 Return on assets (ROA )
 Return on equity (ROE )

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 Profitability Ratios
 Earnings per share (EPS): It shows the portion
of a company’s profit that is allocated to each
outstanding share of common stock. EPS figure is
very important for shareholders because the
payment of dividend and increase in the value of
stock in future largely depends on it. EPS is the most
widely quoted and relied figure by investors.
Net income
EPS 
Total outstanding shares
Example: EPS = $1.60
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 Profitability Ratios
 Gross profit margin: Gross profit margin tells
us what percentage of a company’s sales
revenue would remain after deducting the cost
of goods sold.
Sales  Cost of goods sold (direct cost)
Gross Profit Margin  X100
Sales

 Example: Gross profit margin = 50%

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 Profitability Ratios
 Net profit margin: Net profit margin
meanwhile indicates what percentage of a
company’s sales revenue would remain after
all costs have been taken into account.
Net Income
Net Profit Margin  X100
Sales

 Example: Net profit margin = 20%

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 Profitability Ratios
 Basic Earning Power: measure that calculates
the earning power of a business before the effect of
the business’ income tax and its financial leverage

EBIT
Average Total Assets

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 Profitability Ratios
 Return on assets (ROA): It is a measurement
of management performance. ROA tells the
investor how well a company uses its assets
to generate income. A higher ROA denotes a
higher level of management performance.
Net Income
Return on assets (ROA)   100
Average Total Assets

 Example: ROA = 13.3%

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 Profitability Ratios
 Return on equity (ROE): It is another
measurement of management performance.
ROE tells the investor how well a company
has used the capital from its shareholders to
generate profits. A higher ROE denotes a
higher level of management performance.
Net Income
Return on equity (ROE)  100 %
Average Total Equity

 Example:
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 Turnover Ratios
Inventory turnover
Fixed asset turnover
Total asset turnover
Day’s sales in inventory
Receivables turnover
Day’s sales in receivable
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 Turnover Ratios

Inventory turnover: It is a measure

of the number of times inventory is
sold or used in a time period such as
a year Cost of goods sold
Inventory turnover 
Average Inventory

 Example: Inventory turnover = 0.29 times

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 Turnover Ratios

Fixed asset turnover: It measures

how successfully a company is
utilizing its fixed assets in generating
revenue.
Net revenue
Fixed asset turnover 
Average Fixed Assets

 Example: Fixed asset turnover = $6.44

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 Turnover Ratios
Total asset turnover: It measures a
company's ability to generate sales from its
assets by comparing net sales with average
total assets. In other words, this ratio shows
how efficiently a company can use its assets
to generate sales.
Net Sales
Total Asset Turnover 
Average Total Assets
Example: Total Assets Turnover = 0.33
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 Turnover Ratios
Day’s sales in inventory: It measures
the number of days it will take a company to
sell all of its inventory. In other words, the days
sales in inventory ratio shows how many days
a company's current stock of inventory will
last. Ending Inventory
Days' sales in inventory  365 days X365
.
Cost of goods
Inventory sold
Turnover
Example: Day’s sales inventory = 122 days
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 Turnover Ratios
Receivables turnover: It measures how
many times a business can turn its accounts
receivable into cash during a period. In other
words, the accounts receivable turnover ratio
measures how many times a business can
collect its average accounts receivable during
the year. Net Credit Sales
Receivable s turnover 
Average AccountsReceivable

 Example: Receivable Turnover: 3.33

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 Turnover Ratios
Day’s sales in receivable: It measures
the number of days it takes a company to
collect cash from its credit sales. In other
words, it shows how well a company can
collect cash from its customers.
Accounts365
Receivable
days X365
.
Days' sales in receivables 
Receivables Turnover
Net credit sales

 Example: Days’ sales in receivables = 31

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 Turnover Ratios
Payables turnover: It measures how
trade payables remain unpaid. In other words,
it measures the time which elapses from the
purchase of materials up to the payment of
accounts payable arising from such purchase

Payables Turnover = Net credit purchase .

Average Trade Payables

 Example: Receivable Turnover: 3.33

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 Turnover Ratios

Ave. Age of Trade Payables:

Ave. Age of Trade = 365 days .

Payables Payables Turnover

 Example: Ave Age of Trade Payables = 3 days

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 Turnover Ratios

Cash Conversion Cycle

= Day’s sales in receivable + Day’s
sales in inventory – Day’s sales in trade
payables

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 The Du Pont Identity
 Breaks ROE into three parts:
 operating efficiency (as measured by Net profit margin)
 asset use efficiency (as measured by total asset turnover)
 financial leverage (as measured by the equity multiplier)

Net profit (income) Sales Total assets

ROE   
Sales Total assets Total equity

 Net profit margin  Total asset turnover  Equity multiplier

 ROA  Equity multiplier

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 Example: The Du Pont Identity
Sales are $7 000, net profit is $250,
total assets are $3 500 and equity is
$1 900.
Net profit Sales Assets
ROE   
Sales Assets Equity

250 7000 3500

  
7000 3500 1900

 3.57%  2.00  1.84  13.14%

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 Why Evaluate Financial
Statements?
 Internal uses:
 performance evaluation
 planning for the future

 External uses:
 evaluation by outside parties
 evaluation of main competitors
 identifying potential takeover targets
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 Benchmarks for Comparison
 Ratios are most useful when compared
to a benchmark.
 Time-trend analysis—examine how a
particular ratio(s) has performed
historically.
 Peer group analysis—using similar
firms (competitors) for comparison of
results.
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 Problems with Financial
Statement Analysis
 No underlying theory to identify correct
ratios to use or appropriate benchmarks.
 Benchmarking is difficult for diversified
firms.
 Firms
may use different accounting
procedures.
 Firms may have different recording periods.
 One-off
events can severely affect financial
performance.
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 Summary and Conclusions
 Activities that bring in cash are called ‘sources of cash’, and
activities that involve spending cash are called ‘uses of cash’.
 A Cash Flow Statement summarises sources and uses of
cash over a specified period.
 Financial ratios are grouped together into five main
categories: Liquidity, Capital Structure, Valuation,
Profitability, and Turnover.
 Ratios are most useful when compared to a benchmark (e.g.
time-trend and peer group analysis).
 Problems can arise in using financial statements.

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