1. Financial Statement Analysis
Dr Gourav Vallabh
XLRI Jamshedpur
Dr Gourav Vallabh

2. FINANCIAL STATEMENT ANALYSIS
The way to compare companies of different sizes is to use standard measures
Financial ratios are standard measures that enable analysts to compare companies of different sizes
Dr Gourav Vallabh

3. FINANCIAL STATEMENT ANALYSIS
The objectives of financial statement analysis are to help investors
Predict their expected returns (see the previous graph)
Assess the risks associated with those returns
Dr Gourav Vallabh

4. USING RATIOS TO MAKE BUSINESS DECISIONS
A ratio expresses the relationship of one number to another
The ratios used to make business decisions may be classified as follows:
Ratios that measure the company’s ability to pay current liabilities
Ratios that measure the company’s ability to sell inventory and collect receivables
Dr Gourav Vallabh

5. USING RATIOS TO MAKE BUSINESS DECISIONS
Ratios that measure the company’s ability to pay long-term debt
Ratios that measure the company’s profitability
Ratios used to analyze the company’s stock as an investment
Dr Gourav Vallabh

6. MEASURING A COMPANY’S ABILITY TO PAY CURRENT LIABILITIES
Working capital is defined as follows:
Working capital = Current assets - Current liabilities
Dr Gourav Vallabh

7. MEASURING A COMPANY’S ABILITY TO PAY CURRENT LIABILITIES
Working capital is widely used to measure a business’s ability to meet its short-term obligations with its current assets
The larger the working capital, the better able is the business to pay its debts
Dr Gourav Vallabh

8. CURRENT RATIO The current ratio
Is current assets divided by current liabilities
Measures the ability of the company to pay current liabilities with current assets
The following slides give the comparative income statement and balance sheet of Palisades Furniture, Inc.
Dr Gourav Vallabh

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11. The current ratio of Palisades Furniture, Inc
The current ratio of Palisades Furniture, Inc., at December 31, 20X3 and 20X2, follow, along with the average for the retail furniture industry:
Palisades’ Current Ratio
Formula
20X3
20X2
Current assets
$262,000
$236,000
Current ratio = =
1.85 =
1.87
Current liabilities
$142,000
$126,000
In most industries a
current ratio of 2.0 is
considered good
Industry Average = 1.70
In general, a higher current ratio indicates a stronger financial position
Dr Gourav Vallabh

12. ACID TEST RATIO The acid-test (or quick) ratio
Indicates whether the entity could pay all its current liabilities if they came due immediately
Is computed by dividing cash, short-term investments, and net current receivables (accounts and notes receivable, net of allowances) by current liabilities
Dr Gourav Vallabh

13. Palisades Furniture’s acid-test ratios for 20X3 and 20X2 are:
Palisades’ Acid-Test Ratio
Formula
20X3
20X2
Cash + short-term investments + net current receivables
Acid-Test ratio =
$29,000 + $0 + $114,000
$32,000 + $0 + $85,000 =
1.01 =
0.93
Current liabilities
$142,000
$126,000
An acid-test ratio of 0.90
to 1.00 is acceptable in
most industries
Industry Average = 0.40
Dr Gourav Vallabh

14. MEASURING ABILITY TO SELL INVENTORY AND COLLECT RECEIVABLES
Three ratios are presented that measure the company’s ability to sell inventory and collect receivables
Inventory turnover
Accounts receivable turnover
Days’ sales in receivables
Dr Gourav Vallabh

15. INVENTORY TURNOVER Inventory turnover is
A measure of the number of times a company sells its average level of inventory during a year
Computed by dividing the cost of goods sold by the average inventory for the period
Dr Gourav Vallabh

16. INVENTORY TURNOVER
A high rate of turnover indicates relative ease in selling inventory; a low turnover indicates difficulty in selling
In general, companies prefer a high inventory turnover
Inventory turnover varies widely with the nature of the business
Dr Gourav Vallabh

17. Palisades’ Inventory Turnover
Palisades Furniture’s inventory turnover for 20X3 is:
Palisades’ Inventory Turnover
Formula
Cost of goods sold
$513,000
Inventory turnover = =
4.58
Average inventory
$112,000
Industry Average = 3.00
Palisades Furniture’s turnover of 4.58 times a year is high for its industry, which has an average turnover of 3.00
Dr Gourav Vallabh

18. ACCOUNTS RECEIVABLE TURNOVER
Measures a company’s ability to collect cash from credit customers
Is computed by dividing net sales by average net accounts receivable
The resulting ratio indicates how many times during the year the average level of receivables was turned into cash
Dr Gourav Vallabh

19. ACCOUNTS RECEIVABLE TURNOVER
In general, the higher the ratio, the more successfully the business collects cash and the better off its operations
A receivable turnover that is too high may indicate that credit is too tight, causing the loss of sales to good customers
Dr Gourav Vallabh

20. Palisades’ Accounts Receivable Turnover
Palisades’ Furniture’s accounts receivable turnover ratio for 20X3 is computed as follows:
Palisades’ Accounts Receivable Turnover
Formula
Accounts receivable = turnover
Net credit sales
$858,000 =
8.62
Average net accounts receivable
$99,000
Industry Average = 31.3
Palisades’ receivable turnover of 8.62 is much lower than the industry average, possibly because larger stores sell their receivables
Dr Gourav Vallabh

21. DAYS’ SALES IN RECEIVABLES
The days’-sales-in-receivables ratio tells
How many days’ sales remain in Accounts Receivable
Is computed by a two-step process
First, divide net sales by 365 days to figure the average sales amount for one day
Second, divide this average day’s sales amount into the average net accounts receivable
Dr Gourav Vallabh

22. Palisades’ Days’ Sales in Accounts Receivable
Formula
Net sales
$858,000
1. One day’s sales = =
$2,351
365 days
365 days
Average net accounts receivable
Days’ sales in average accounts = receivable 2.
$99,500 =
42 days
One days’ sales
$2,351
Industry Average = 2 days
The day’s sales in receivables for Palisades is higher (worse) than the industry average because the company collects its own receivables
Dr Gourav Vallabh

23. MEASURING A COMPANY’S ABILITY TO PAY LONG-TERM DEBT
Two indicators of a business’s ability to pay long-term liabilities are the
Debt ratio
Times-interest-earned ratio
Dr Gourav Vallabh

24. DEBT RATIO
The debt ratio tells the proportion of the company’s assets that it has financed with debt
The higher the debt ratio, the higher the strain of paying interest each year and the principal amount at maturity
The lower the ratio, the lower the business’s future obligations
Dr Gourav Vallabh

25. Calculation of the debt ratios for Palisades Furniture at the end of 20X3 and 20X2 is as follows:
Palisades’ Debt Ratio
Formula
20X3
20X2
Total liabilities
$431,000
$324,000
Debt ratio = =
0.55 =
0.50
Total assets
$787,000
$644,000
The average debt ratio
for most companies
ranges from
Industry Average = 0.64
The company’s debt ratio indicates a fairly low-risk debt compared to the retail furniture industry average
Dr Gourav Vallabh

26. MEASURING A COMPANY’S PROFITABILITY
There are four rate-of-return measurements that help evaluate a company’s profitability:
Rate of return on net sales
Rate of return on total assets
Rate of return on common stockholders’ equity
Earnings per share of common stock
Dr Gourav Vallabh

27. RATE OF RETURN ON NET SALES
The rate of return on net sales shows the percentage of each sales dollar earned as net income
The higher the rate of return, the more net sales dollars are providing income to the business and the fewer net sales dollars are absorbed by expenses
Dr Gourav Vallabh

28. Palisades’ Rate of Return on Sales
The rate-of-return-on-sales ratios for Palisades Furniture are calculated as follows:
Palisades’ Rate of Return on Sales
Formula
20X3
20X2
Rate of return on sales
Net income
$48,000
$26,000 = =
0.056 =
0.032
Net Sales
$858,000
$803,000
Industry Average = 0.008
The increase in Palisades Furniture’s return on sales identifies the company as more successful than the average furniture store
Dr Gourav Vallabh

29. RATE OF RETURN ON COMMON STOCKHOLDERS’ EQUITY
Rate of return on stockholders’ equity (return on equity)
Shows the relationship between net income and common stockholders’ investment in the company
Is calculated by dividing net income available to common stockholders by the average stockholders’ equity during the year
Dr Gourav Vallabh

30. Palisades’ 20X3 Rate of Return on Common Stockholders’ Equity
The rate of return on common stockholders’ equity for Palisades Furniture is calculated as follows:
Palisades’ 20X3 Rate of Return on Common Stockholders’ Equity
Formula
Rate of return on common stockholders’ equity
Net income
Preferred Dividends -
$48,000 - $0
0.142 = =
Average common stockholders’ equity
$338,000
Industry Average = 0.121
Dr Gourav Vallabh

31. RATE OF RETURN ON COMMON STOCKHOLDERS’ EQUITY
Palisades’ return on equity (0.142) is higher than its return on assets (0.101).
This difference results from borrowing at one rate (8%) and investing the funds to earn a higher rate (14.2%)
This practice is called trading on the equity or using financial leverage
Dr Gourav Vallabh

32. LIMITATIONS OF FINANCIAL ANALYSIS
Ratios have their limitations
Financial analysis may indicate that something is wrong, but it may not identify the specific problem or show how to correct it
Managers must evaluate data on all ratios in the light of other information about the company
Dr Gourav Vallabh

33. LIMITATIONS OF FINANCIAL ANALYSIS
Ratios should be analyzed over a period of years
Any one year, or even any two years, may not be representative of the company’s performance over the long term
Dr Gourav Vallabh