Review Chapter 3 Analysis of Financial Statements

The primary purpose of this chapter was to discuss techniques used by investors and

managers to analyze financial statements.

A. Ratio Analysis

Financial statements report both on a firm’s position at a point in time and on its

operations over some past period. From an investor’s standpoint, predicting the future

is what financial statement analysis is all about, while from management’s standpoint,

financial statement analysis is useful both to help anticipate future conditions and,

more important, as a starting point for planning actions that will improve the firm’s

future performance.

B. Liquidity Ratios

Liquid Asset is an asset that can be converted to cash quickly without having to

reduce the asset’s price very much.

Liquidity Ratios is ratios that show the relationship of a firm’s cash and other current

assets to its current liabilities.

Two commonly used liquidity ratios

1. Ability to Meet Short -Term Obligations : The Current Ratio

The Current Ratio is calculated by dividing current assets by current liabilities. It

indicates the extent to which current liabilities are covered by those assets expected to

be converted to cash in the near future.

2. Quick, or Acid Test, Ratio

Quick (Acid Test) is calculated by deducting inventories from current assets and

dividing the remainder by current liabilities.

C. Asset Management Ratios

Asset Management Ratios is a set of ratios that measure how effectively a firm is

managing its assets.

1. Evaluating Inventories : The Inventory Turnover Ratio

Inventory Turnover Ratio is calculated by dividing sales by inventories.

2. Evaluating Receivables : The Days Sales Outstanding

Days Sales Outstanding (DSO) is calculated by dividing accounts receivable by

average sales per day; indicates the average length of time the firm must wait after

making a sale before it receives cash.

3. Evaluating Fixed Assets : The Fixed Assets Turnover Ratio

The fixed assets turnover ratio measures how effectively the firm uses its plant and

equipment. Fixed Assets Turnover Ratio is The ratio of sales to net fixed assets.

4. Evaluating Total Assets : The Total Assets Turnover Ratio

Total Assets Turnover Ratio is calculated by dividing sales by total assets.

D. Debt Management Ratios

Financial Leverage show the extent to which a firm uses debt financing.

1. How The Firm Is Financed: Total Debt to Total Assets

The ratio of total debt to total assets, generally called the debt ratio.

2. Ability to Pay Interest : Times -Interest -Earned Ratio

Times-Interest-Earned (TIE) Ratio is the ratio of earnings before interest and taxes

(EBIT) to interest charges; a measure of the firm’s ability to meet its annual interest

payments.

3. Ability to Service Debt : EBITDA Coverage Ratio

EBITDA Coverage Ratio is a ratio whose numerator includes all cash flows available

to meet fixed financial charges and whose denominator includes all fixed financial

charges.
E. Profitability Ratios

Profitability Ratios is a group of ratios that show the combined effects of liquidity,

asset management, and debt on operating results.

1. Profit Margin on Sales

Profit Margin on Sales measures net income per dollar of sales; it is calculated by

dividing net income by sales.

2. Basic Earning Power (BEP)

Basic Earning Power (BEP) Ratio indicates the ability of the firm’s assets to generate

operating income; calculated by dividing EBIT by total assets.

3. Return on Total Assets

Return on Total Assets (ROA) is the ratio of net income to total assets.

4. Return on Common Equity

Return on Common Equity (ROE) is the ratio of net income to common equity;

measures the rate of return on common stockholders’ investment.

F. Market Value Ratios

Market Value Ratios is a set of ratios that relate the firm’s stock price to its earnings,

cash flow, and book value per share.

1. Price /Earnings Ratio

Price/Earnings (P/E) Ratio is the ratio of the price per share to earnings per share;

shows the dollar amount investors will pay for $1 of current earnings.

2. Price /Cash Flow Ratio

Price/Cash Flow Ratio is the ratio of price per share divided by cash flow per share;

shows the dollar amount investors will pay for $1 of cash flow.

3. Market /Book Ratio

Market/Book (M/B) Ratio is the ratio of a stock’s market price to its book value.
G. Trend Analysis

Trend Analysis is an analysis of a firm’s financial ratios over time; used to estimate

the likelihood of improvement or deterioration in its financial condition.

H. Tying The Ratios Together: The Du Pont Chart and Equation

Du Pont Chart is a chart designed to show the relationships among return on

investment, asset turnover, profit margin, and leverage. Du Pont Equation is a formula

which shows that the rate of return on assets can be found as the product of the profit

margin times the total assets turnover.

I. Comparative Ratios and “Benchmarking”

Benchmarking is the process of comparing a particular company with a group of

“benchmark” companies.

J. Uses and Limitations of Ratio Analysis

Ratio analysis is used by three main groups: (1) managers, who employ ratios to help

analyze, control, and thus improve their firms’ operations; (2) credit analysts,

including bank loan officers and bond rating analysts, who analyze ratios to help

ascertain a company’s ability to pay its debts; and (3) stock analysts, who are

interested in a company’s efficiency, risk, and growth prospects.

Though that while ratio analysis can provide useful information concerning a

company’s operations and financial condition, it does have limitations that necessitate

care and judgment. Some potential problems are listed below:

1. Many large firms operate different divisions in different industries, and for such

companies it is difficult to develop a meaningful set of industry averages.

2. Most firms want to be better than average, so merely attaining average performance

is not necessarily good.

3. Inflation may have badly distorted firms’ balance sheets — recorded values are

often substantially different from “true” values. Further, since in-flation affects both

depreciation charges and inventory costs, profits are also affected.

4. Seasonal factors can also distort a ratio analysis.

5. Firms can employ “window dressing” techniques to make their financial statements

look stronger.

6. Different accounting practices can distort comparisons.

7. It is difficult to generalize about whether a particular ratio is “good” or “bad.”

8. A firm may have some ratios that look “good” and others that look “bad,” making it

difficult to tell whether the company is, on balance, strong or weak.

K. Problems With ROE

Despite its widespread use and the fact that ROE and shareholder wealth are often

highly correlated, some problems can arise when firms use ROE as the sole measure

of performance. First, ROE does not consider risk. Second, ROE does not consider

the amount of invested capital.

L. Looking Beyond The Numbers

Sound financial analysis involves more than just calculating numbers —good analysis

requires that certain qualitative factors be considered when evaluating a company.

These factors, as summarized by the American Association of Individual Investors

(AAII), include the following:

1. Are the company’s revenues tied to one key customer?

2. To what extent are the company’s revenues tied to one key product?

3. To what extent does the company rely on a single supplier?

4. What percentage of the company’s business is generated overseas?

5. Competition.
6. Future prospects.

7. Legal and regulatory environment.