1. Analysis of Financial Statements
Chapter 3
Analysis of Financial Statements

2. Copyright © 2014 by Nelson Education Ltd.

3. Ratio Analysis
Individual numbers in a firm’s financial statements do not mean much if looked at independently.
Ratios are calculated to reveal relationships between different numbers and to extract important information.
Ratios also remove the size factor between different firms and make comparison of them meaningful ($5 million of net income for $50 million vs. $100 million of sales).
Copyright © 2014 by Nelson Education Ltd.

4. Financial Statements and Reports
The Income Statement
The income statement provides a financial summary of a company’s operating results during a specified period.
Although they are prepared annually for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes.

5. Penny Ltd. Income Statement
Sales €80,000
Variable operating costs (60,000)
Fixed costs, excluding depreciation (12,000)
Depreciation ( 2,000)
EBIT = NOI 6,000
Interest ( 1,000)
Earnings before taxes (EBT) 5,000
Taxes (40%) ( 2,000)
Net income € 3,000
Dividends 2,000
Addition to retained earnings 1,000

6. Financial Statements and Reports
The Balance Sheet
The balance sheet presents a summary of a firm’s financial position at a given point in time.
Assets indicate what the firm owns, equity represents the owners’ investment, and liabilities indicate what the firm has borrowed.

7. Penny Ltd. Balance Sheet
Current Current
Year Year
Cash & securities € 2,000 Accounts payable € 4,000
Accounts receivable 6,000 Accruals 5,000
Inventory 7,000 Notes payable 1,000
Current assets 15,000 Current liabilities 10,000
Net fixed assets 10, Long-term debt 6,000
Total assets €25,000 Total liabilities 16,000
Common stock 6,000
Retained earnings 3,000
Owners’ equity 9,000
Total liabilities
& equity €25,000

8. Penny Ltd. Balance Sheet—Changes in Assets
Current Previous
Year Year Change
Cash & securities € 2,000 €1,000
Accounts receivable 6,000 5,000
Inventory 7, ,000
Current assets 15,000 14,000
Net fixed assets 10, ,000
Total assets €25,000 €23,000
Source Use
1,000
(1,000) X
Fixed assets if no purchases or sales = €9,000 - €2,000 = €7,000
Depreciation = €2,000
Change in fixed assets = €10,000 - €7,000 = €3,000
Sources of Cash Uses of Cash
 Asset Account  Asset Account

9. Penny Ltd. Balance Sheet—Changes in Liabilities and Equity
Current Previous
Year Year
Accounts payable € 4,000 € 2,000
Accruals 5,000 4,000
Notes payable 1, ,000
Current liabilities 10,000 8,000
Long-term debt 6, ,000
Total liabilities 16,000 15,000
Common stock 6,000 6,000
Retained earnings 3, ,000
Owners’ equity 9,000 8,000
Total liabilities & equity €25,000 €23,000
Change
2,000
(1,000)
1,000
Source Use X
Sources of Cash Uses of Cash
 Liability/Equity Account  Liability/Equity Account

10. Financial Statements and Reports
Statement of Cash Flows
The statement of cash flows provides a summary of the cash flows over the period of concern, typically the year just ended.
This statement not only provides insight into a company’s investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets.

11. Penny Ltd. Statement of Cash Flows
Cash Flows from Operations:
Net income (NI) €3,000
Adjustments to NI
Depreciation 2,000
 Inventory 1,000
 Accounts payable 2,000
 Accruals 1,000
 Accounts receivable (1,000)
Net CF from operations €8,000
Cash Flows from Long-Term Investing:
Acquisition of assets (3,000)
Cash Flows from Financing Activities:
 Notes payable (1,000)
 Long-term bonds (1,000)
Dividend payment (2,000)
Net CF from financing €(4,000)
Net Change in cash 1,000
Cash at beginning of year 1,000
Cash at end of year €2,000

12. Notes to the Financial Statements
Notes to the financial statements provide detailed information on the accounting policies, procedures, calculations, and transactions underlying various entries in the financial statements.
Common issues include revenue recognition, income taxes, breakdowns of fixed asset accounts, debt and lease terms, and contingencies.

13. Financial Statements: Time Dimension
Balance sheet—a “snapshot” of where the firm is at a specific point in time (stock statement).
Income statement and statement of cash flows—shows the results of the firm’s activities over a period of time (flow statement).

14. Ratio (Financial Statement) Analysis
General categories of analysis:
Liquidity
Asset management
Debt management
Profitability
Market value

15. Liquidity Ratios
Provide an indication of how well the firm can meet its current obligations
Help measure the liquidity position of the firm
Too little, or too much liquidity could be considered a “bad sign”
too little liquidity—suggests the firm will have problems paying its current obligations in the future
too much liquidity—might suggest the firm is not investing its funds wisely

16. Liquidity Ratios Current ratio = total current assets
total current liabilities
Quick ratio = Total Current Assets - Inventory
total current liabilities

17. Asset Management Ratios
Provide an indication of how well the firm manages its assets (efficiency)
Show how often the firm is “turning over” its assets to generate funds
Generally, when assets are not turned over quickly enough, it is because sales have slowed or current assets, such as inventory and receivables, are too high
If assets are turned over too quickly, it could mean that the firm is not producing enough

18. Asset Management Ratios
Inventory Turnover = Cost of Goods Sold
Inventory
DSO =Days Sales Outstanding = Receivables
Average sales per day
Fixed assets turnover ratio = Sales
Net fixed assets
Total Asset Turnover = Sales
Total Assets

19. Debt Management Ratios
Indicate how the firm’s financial position is affected by the amount of debt it has
financial leverage refers to the use of debt
leverage helps to magnify returns, on both the positive and the negative sides, because debt represents a fixed obligation

20. Debt Management Ratios
Debt Ratio = Total Liabilities/Total Assets
Times Interest Earned = EBIT/Interest charges
Fixed charge coverage ratio = EBIT + Lease Pymts
Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}

21. EBITDA Coverage (EC) Ratio
= = 3.0x
EBITDA + Lease payments
Interest Lease
expense pmt.
Loan pmt.
($ $100) + $28
$88 + $28 + $20
Copyright © 2014 by Nelson Education Ltd.

22. Profitability ratios
Indicate how the firm’s management of its liquidity position, assets, and debt has affected normal operating activities.

23. Profitability Ratios Profit Margin on Sales = Net Income/ Sales
Return on Total Assets = Net Income/ Total Assets
Return on Common Equity = Net Income available to common stockholders / Common equity
Basic Earning Power = EBIT / Total assets

24. Market Value Ratios
Measures that consider the value of the firm’s stock in the financial markets—that is, how well investors perceive that the firm is creating value.

25. Market Value Ratios
P/E = Market Price Per Share of Common Stock Earnings Per Share
CF per share =NI + Depr. / Shares out.
P/CF = Price per share / Cash flow per share
M/B = Market Price Per Share of Common Stock Book Value Per Share of Common Stock

26. Common Size Balance Sheets: Divide All Items By Total Assets
2017
2016
Ind.
Cash
0.5%
0.9%
1.0%
ST inv.
0.0%
3.9%
2.2% AR
18.8%
17.8%
Invent.
30.8%
24.7%
19.8%
Total CA
50.0%
48.2%
40.8%
Net FA
51.8%
59.2% TA
100.0%

27. Divide All Items By Total Liabilities and Equity
Assets
2017
2016
Ind. AP
3.0%
1.8%
Notes pay.
5.5%
3.6%
4.4%
Accruals
7.0%
7.7%
Total CL
15.5%
13.1%
9.8%
LT bonds
37.7%
34.5%
30.2%
Total liabilities
53.2%
47.6%
40.0%
Pref. stock
2.0%
2.4%
0.0%
Total com. eq.
44.8%
50.0%
60.0%
Total L&E
100.0%

28. Analysis of Common Size Balance Sheets
The company has a higher proportion of inventory and current assets than industry.
The company has less equity (which means more debt) than industry.
The company now has zero short-term debt but more long-term debt than industry.

29. Common Size Income Statement: Divide All Items By Sales
2017
2016
Ind.
Net sales
100.0%
Op. costs
87.2%
87.6%
EBITDA
12.8%
12.4%
Depr.
3.3%
3.2%
2.8%
EBIT
9.5%
9.2%
9.6%
Int. exp.
2.9%
2.1%
1.3%
EBT
6.5%
7.1%
8.3%
Taxes
2.6%
NI before pref. div.
3.9%
4.3%
5.0%
Pref. dividends
0.1%
0.0%
NI (profit margin)
3.8%
4.1%

30. Analysis of Common Size Income Statements
The company has similar operating cost (87.2) as industry (87.6), but slightly higher depreciation and amortization. The result is that the company has similar EBIT. However, the high interest expense lowers the EBT (6.5) compared to industry (8.3).

31. Income Statement Percentage Change Analysis: % Change from Base Year
Net sales
5.3%
Operating costs
4.8%
EBITDA
8.7%
Depr. & amortization
11.1%
EBIT
7.9%
Int. exp.
46.7%
EBT
(3.5%)
NI before pref. dividends
Preferred dividends
0.0% NI
(3.7%)

32. Analysis of Percent Change Income Statement
We see that 2017 sales grew 5.3% from 2016, and that NI fell 3.7% from So the company has become less profitable.
The analysis reveals whether the firm’s condition has been improving or deteriorating over time.
Similar analysis can be performed on the balance sheet. The extreme growth in inventories (48.2%) should be of great concern.

33. Tying the Ratios Together: The DuPont Equation
The DuPont equation focuses on:
expense control (PM)
asset utilization (TATO)
debt utilization (EM)
It shows how these factors combine to determine the ROE.
It also provides a “quick and dirty” estimate of the impact of operating changes on returns.

34. ( )( )( ) = ROE The DuPont Equation x CE Profit margin TA turnover
Equity
multiplier NI
Sales CE x
= ROE

35. The DuPont Equation (cont’d)NI
Sales TA CE x
= ROE
2013: 3.8% x 1.5 x = 12.7%
Alternatively,
ROE = ROA × equity multiplier
= 5.7% x ($2,000/$896) = 12.7%

36. Comparative Ratios and Benchmarking
Ratio analysis involves comparing a firm’s ratios with industry average figures.
Managers can also use a technique called “benchmarking” – comparing the firm’s ratios with those of a smaller set of leading companies in its industry.
Comparative ratios are available from various sources including FP informart.

37. Uses and Limitations of Ratio Analysis
Comparison with industry averages is difficult if the firm operates many different divisions.
“Average” performance is not necessarily good.
Seasonal factors can distort ratios.
“Window dressing” techniques can make statements and ratios look better.

38. Uses and Limitations (cont’d)
Different accounting and operating practices can distort comparisons.
Sometimes it is difficult to tell if a ratio value is “good” or “bad.”
Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition.