Basics of Financial Management 3rd edition Bacon et. al Copley Publishing Group CHAPTER THREE 3-1 ©2005 All rights reservedSlides by Hassan Moussawi, Ph.D., M.B.A. FINANCIAL STATEMENT ANALYSIS

Financial Statements Analysis  The two fundamental corporate financial statements are: 1.Balance Sheet (assets, liabilities, and stockholders’ equity on a given date) 2.Income Statement (revenues, expenses, taxes and profits during a particular period of time)  The analysis of these two statements combined with the analysis of other financial data is called financial statements analysis.

Balance Sheet

Income Statement

Uses of Ratio Analysis The four major interest groups of the company are: 1.Short-term creditors (the ability of the company to meet its short term obligation) 2.Long-term creditors (the company will be able to make its interest and principal payment when they come due) 3.Managers (measure the firm’s performance from period to period) 4.Stockholders (value maximization of their stock)

Inflation  Inflation can distort some financial data, manager should explore the impact of inflation on ratios  Examples of distortion are: 1. Accounting for Inventory” FIFO method LIFO method 2. Depreciation

Financial Analysis Different types of ratio are important for two reason:  No single ratio provides us with sufficient information  Ratios means different things to different people

Financial Analysis, continued … Five categories of financial ratios: 1.Liquidity ratios: firm's ability to pay short-term debts 2.Leverage ratios: firm's ability to serve long-term debts 3.Activity ratios: to judge how well resources are used 4.Profitability ratios: to determine management's performance 5.Common stock, market value, or investment ratios: to determine the value of the firm's stock and its growth potential

Ratio Definitions and Values

Ratio Definitions and Values, continued …

DuPont System The DuPont system I an important technique for examining the relationship among factors affecting the rate of return on equity. ROA {Return on Assets (Investment)} = Profit Margin (PM) x Asset Turnover (AT) = Profit Margin (PM) x Asset Turnover (AT) = (Net Income After Tax / Sales ) X ( Sales / Total Asset) = (Net Income After Tax / Sales ) X ( Sales / Total Asset) ROE (Return on Equity) = Return on Assets / Equity Ratio = Return on Assets / Equity Ratio ═ (Profit Margin x Asset Turnover) / (1 - Debt Ratio) ═ (Profit Margin x Asset Turnover) / (1 - Debt Ratio) Where; Debt Ratio = Total Debt / Total Asset = D / TA

Common-size (Percentage) Financial Statements It is important for the financial manager to compare changes on the financial statements that take place from period to period. Common-size Financial Statements are: 1.Balance sheet: $ amount of each item divided by total assets 2.Income statement: $ amount of each item divided by net sales

Common-Size Balance Sheet

Common-Size Income Statement

Comparative Ratio Analysis (1) Historical standards: getting better, worse, or about the same (2) Industry standards: industry average ratios

Comparing to The Industry

Comparing to The Industry, continued …

Limitations of Ratios Analysis 1.Distortion of comparative data 2.Varied product lines 3.Differences in accounting methods 4.Window dressing 5.Other limitations