Financial Statement Analysis

Stockholders and stakeholders may differ in the information they want to gain when analyzing financial
statements.

The role of financial statement analysis is to use the information in a company’s financial statements,
along with other relevant information, to make economic decisions. Examples of such decisions include
whether to invest in the company’s securities or recommend them to investors and whether to extend
trade or bank credit to the company. Analysts use financial statement data to evaluate a company’s past
performance and current financial position in order to form opinions about the company’s ability to
earn profits and generate cash flow in the future.

Stockholders’ Perspective
Stockholders are primarily concerned with the value of their stock and with how much cash they can
expect to receive from dividends and capital appreciation over time. Therefore, stockholders want
financial statements to tell them how profitable the firm is, what the return on their investment is, and
how much cash is available for stockholders, both in total and on a per-share basis. Ultimately,
stockholders are interested in how much a share of stock is worth.

Creditors’ Perspective
The primary concern of creditors is whether and when they will receive the interest payments they are
entitled to and when they will be repaid the money they loaned to the fi rm. Thus, a firm’s creditors,
including long-term bondholders, closely monitor how much debt the firm is currently using, whether
the firm is generating enough cash to pay its day-to-day bills, and whether the firm will have sufficient
cash in the future to make interest and principal payments on long-term debt after satisfying obligations
that have a higher legal priority, such as paying employees’ wages. Of course, the firm’s ability to pay
interest and principal ultimately depends on cash flows and profitability; hence, creditors—like
stockholders and managers—are interested in those aspects of the firm’s financial performance.

Guidelines for Financial Statement Analysis

1. Make sure you understand which perspective you are adopting to conduct your analysis: stockholder
or creditor. The perspective will dictate the type of information you need for the analysis and may affect
the actions you take based on the results.
2. Always use audited financial statements if they are available. Third, use financial statements that
cover three to five years, or more, to conduct your analysis. This enables you to perform a trend
analysis, which involves looking at historical financial statements to see how various ratios are
increasing, decreasing, or staying constant over time.
3. Use financial statements that cover three to five years, or more, to conduct your analysis. This enables
you to perform a trend analysis, which involves looking at historical financial statements to see how
various ratios are increasing, decreasing, or staying constant over time.
A common-size financial statement is one in which each number is expressed as a percentage of some
base number, such as total assets or net revenues (net sales). For example, each number on a balance
sheet may be divided by total assets. Dividing numbers by a common base to form a ratio is called
scaling. Financial statements scaled in this manner are also called standardized financial statements.
Common-size financial statements make it easier to evaluate changes in a firm’s performance and
financial condition over time. They also allow you to make more meaningful comparisons between the
financial statements of two firms that are different in size.

Vertical Common-Size Statements

A vertical common-size income statement expresses each category of the income statement as a
percentage of revenue. The common-size format standardizes the income statement by eliminating the
effects of size. This allows for comparison of income statement items over time (time-series analysis)
and across firms (cross-sectional analysis).

Horizontal Common-Size Statements

A horizontal common-size statement , also called a variation analysis or trend analysis, compares key
financial statement values and relationships for the same company over a period of years. The increase
or decrease in each of the major accounts is shown as a percentage of the base-year amount and hence
is sometimes referred to as the base-year financials. As illustrated in below figure, such an analysis sets
the base year at a value of 100% and then shows subsequent years in relation to increases or decreases
over the base year.

Classification of financial ratio

Financial ratios can be segregated into different classifications by the type of information about the
company they provide.
Liquidity ratios. Liquidity here refers to the ability to pay short-term obligations as they come due.
Solvency ratios. Solvency ratios give the analyst information on the firm’s financial leverage and ability
to meet its longer-term obligations.
Profitability ratios. Profitability ratios provide information on how well the company generates
operating profits and net profits from its sales.
Activity ratios. This category includes several ratios also referred to asset utilization or turnover ratios
(e.g., inventory turnover, receivables turnover, and total assets turnover). They often give indications of
how well a firm utilizes various assets such as inventory and fixed assets.
Valuation ratios. Sales per share, earnings per share, and price to cash flow per share are examples of
ratios used in comparing the relative valuation of companies.

Liquidity/Solvency Ratios
Liquidity is a relative measure of the proximity to cash of the assets and liabilities of the company and is
an indication of company’s ability to meet its short-term obligations. Since most of the liabilities of a
company (except unearned revenue) are paid in cash, a good measure of this ability is how rapidly a
company could convert its other assets into cash, if the need arises.
Solvency is the degree to which the current assets of an organization exceed the current liabilities of the
organization. Solvency describes the ability of an organization to meet its long-term fixed expenses and
to meet long-term expansion and growth. Organizations can calculate the net liquid balance (NLB) as a
measure of solvency by adding cash and cash equivalents to short-term investments, then subtracting
notes payable.

Liquidity ratios measure the firm’s ability to satisfy its short-term obligations as they come due. Liquidity
ratios include the current ratio, the quick ratio, and the cash ratio.
Current Ratio
The current ratio measures the degree to which current assets cover current liabilities. A higher ratio
indicates greater ability to pay current liabilities with current assets, thus greater liquidity.
The quick ratio , or acid-test ratio, examines liquidity from a more immediate aspect than does the
current ratio by eliminating inventory from current assets. The quick ratio removes inventory because it
turns over at a slower rate than receivables or cash and assumes that the company will be able to sell
the items to a customer and collect cash. Although there are a few different ways to compute the quick
(acidtest) ratio (by making adjustments to the numerator), the formula listed next is the one that is used
on the CMA exam.
The cash ratio analyzes liquidity in a more conservative manner than the quick ratio, by looking at a
company’s immediate liquidity. The cash ratio compares only cash and marketable securities to current
liabilities, eliminating receivables and inventory from the asset portion. When using this formula, cash
and cash equivalents are used for the term cash in the numerator.
The cash flow ratio measures a firm’s ability to meet its debt obligations with cash generated in the
normal course of business.
Higher ratios of operating cash flow to liabilities indicate a higher likelihood that the firm will be able to
meet its obligations with cash generated from normal business operations. This ratio measures the
ability of the company to meet its short-term obligations based on cash generated in the normal course
of business. A deteriorating cash flow ratio, over time, indicates impending liquidity problems.

Analysts must understand the limitations of balance sheet ratio analysis:

 Comparisons with peer firms are limited by differences in accounting standards and estimates.
 Lack of homogeneity as many firms operate in different industries.
 Interpretation of ratios requires significant judgment.
 Balance sheet data are only measured at a single point in time.
Degree of Total Leverage
The combination of business and financial risk, called the degree of total leverage (DTL), is the product
of operating and financial leverage.
Financial Leverage Ratio
On the CMA exam, the fi nancial leverage ratio is computed as:

A higher ratio implies that the assets of the company are financed primarily through debt. A financial
leverage ratio of 2.0 reflects that the liabilities of the company are equal to the equity. A ratio of greater
than 2.0 implies that liabilities are larger than equity; a ratio of less than 2.0 implies higher equity than
the liabilities of the company.

Financial leverage has a magnifying effect on earnings. When the earnings are positive, a marginal
percentage change in revenue translates to a greater percentage change on earnings per share or on
return on equity measures. Correspondingly, however, as debt represents fixed costs, leverage also has
a magnifying effect on losses. If the financial leverage ratio, for example, is 3.0 and the company
experiences a loss, it will experience a greater percentage loss in net income than the percentage
decline in revenue. An increase in the financial leverage ratio, therefore, represents not only increased
opportunity for leveraging returns but also an increased risk of magnifying any losses and of the
company’s inability to meet long-term debt. In summary, the potential loss or profit being magnified
belongs to the stockholder. So if a firm is profitable, the benefit realized from a high net income with a
high financial leverage ratio goes to stockholders.

If fixed assets to stockholders’ equity ratio is more than 1, it means that stockholders’ equity is less than
the fixed assets and the company is using debts to finance a portion of fixed assets. If the ratio is less
than 1, it means that stockholders’ equity is more than the fixed assets and the stockholders’ equity is
financing not only the fixed assets but also a part of the working capital. Different industries have
different norms. Generally a ratio of 0.60 to 0.70 (or 60% to 70%, if expressed in percentage), is
considered satisfactory for most of industrial undertakings.

Ratio Analysis on Debt/Liabilities

Analysts can examine capital structure by comparing debt to assets (asset-based analysis) or to equity
(equity-based analysis). Various stakeholders evaluate capital structure ratios (also known as leverage
ratios ) in different ways. For example, creditors or potential creditors wish to see low debt ratios,
whereas stockholders and managers seek optimal debt levels, using as much debt in a firm’s capital
structure as can be managed effectively. Optimal debt ratios vary by industry. Firms in noncyclical
industries, for example, tend to have higher debt ratios than those in cyclical industries. When
performing cross-sectional analysis, therefore, one should compare only firms in the same industries.
The three primary ratios used to measure leverage are debt to total assets ratio, debt to equity ratio,
and times interest earned (interest coverage) ratio.

Total Debt to Total Capital Ratio

The total debt to total capital ratio measures the proportion of debt compared to the total capital of a
corporation. The total debt to total capital ratio is a measurement of the financial leverage of a
corporation.
Companies can finance their operations through either debt or equity. This ratio provides an
understanding of how a company is financing its operations and provides insights into the financial
strength of the company. The higher the ratio, the higher the debt being used to finance the operations
of the company. Comparing this ratio to that of the industry, a higher ratio typically means financial
weakness, weighing financially on the company, and increasing the default risk.

Debt to Equity Ratio

The debt to equity ratio also measures the firm’s ability to pay long-term debt and how well long-term
creditors are protected. It measures the relationship of debt to equity when financing asset purchases.
For example, a debt to equity ratio of 2 indicates that a firm historically has paid two parts debt to one
part equity when financing asset purchases. The lower the ratio, the less reliant the company is on debt.

The debt to equity ratio can be compared to previous years’ records for the same company. It can as
well be compared to competitors’ and industry averages. A higher ratio indicates that the firm is highly
leveraged, and there is a higher risk of bankruptcy.

Long-Term Debt to Equity Ratio

The long-term debt to equity ratio compares long-term debt only to shareholders’ equity.

A company with a low long-term debt to equity ratio has the ability to raise debt capital if it is needed.
Its fixed financing costs are lower because there are lower interest payments; however, the firm’s return
on capital probably will be lower because it is not using debt to its full capacity.

Debt to Total Assets Ratio

The debt to total assets ratio measures the proportion of assets financed through debt.

This ratio shows the percentage of assets financed by creditors and indicates how well creditors are
protected in case the company becomes insolvent. A lower debt to total assets ratio indicates a better
position for creditors, because the company has enough assets to cover long-term debt obligations. A
higher ratio, which indicates that creditors are not well protected, may make it more difficult and
expensive for the company to issue additional debt securities. An unusually low debt to total assets ratio
is also problematic, because debt may be a cheap source of capital to finance growth. However, very
successful companies—for example, Microsoft —do not have much debt either, primarily because they
generate much cash from their operation.

If the ratio is sufficiently high, the firm should be able to meet its interest obligations. When combined
with the debt ratio, the times interest earned ratio gives an analyst a strong indication of a firm’s ability
to manage debt effectively—or, in other words, to remain solvent. The combination of a high debt ratio
and low times interest earned ratio (when compared to industry averages) is a signal of poor solvency.
If, however, a firm has a slightly higher debt ratio along with a higher times interest earned ratio, an
analyst should have less worry. Again, debt is a cheap form of capital, and a firm should seek an optimal
level of debt, even if the industry average is less.
Capital Structure and Risk

Increases in debt create higher fixed costs for interest and principal payments. Considering the ratios of
capital structure, it results in a higher debt to equity ratio and, therefore, a less favorable position for
long-term debt-paying ability. Decreases in equity, as a result of redemption of stock or losses from
operations, also would result in a higher debt to equity ratio and higher risk for the company’s ability to
pay long-term debt. Increases in equity, such as those from profits, without corresponding increases in
debt would lower the debt to equity ratio, increasing the company’s position for long-term debt-paying
ability.
Capital structure of a firm is related to the “risk” of the firm, particularly bankruptcy risk. An increase in
the amount of debt worsens the capital structure, increasing the possibility of bankruptcy. This is
because higher debt means higher interest payments and payment of the principal, requiring a higher
amount of cash flows to meet these obligations. Any strain on the cash flow is more dangerous for firms
with higher debt because they still have to meet the debt payments. Failure to do so could result in
bankruptcy. This higher bankruptcy risk faced by the firm translates into higher interest rates charged by
its creditors. This is referred to as the “cost of capital” for the firm. Management tries to reduce the cost
of capital to increase the financial leverage of the firm. Thus, management takes much care to manage
the capital structure and its disclosure because of the direct impact it has on the cost of capital and thus
on the profitability of the fi rm.