Chapter 6:

Financial Statement and Analysis

 Introduction
Every corporation has many and varied uses for the
standardized records and reports of its financial
activities. Periodically, reports must be prepared for
regulators, creditors (lenders), owners, and
management. The guidelines used to prepare and
maintain financial records and reports are known as
generally accepted accounting principles (GAAP). These
accounting practices and procedures are authorized by
the accounting profession’s rule-setting body, the
International Accounting Standards Council (IASC).
 Objectives
After studying this module, you should be able to:
• Understand who uses financial ratios and how.
• Use ratios to analyze a firm’s liquidity and
• Use ratios to analyze a firm’s activity
• Discuss the relationship between debt and financial
leverage and the ratios used to analyze a firm’s
debt.
• Use ratios to analyze a firm’s profitability
• Use ratios to analyze a firm’s market value.
• Use the Dupont system of analysis.
 The Four Key Elements of
Financial Statements
The four key financial statements required by the SEC for reporting to
shareholders are;
.
(1) the income statement
(2) the balance sheet,
(3) the statement of retained earnings, and
(4) the statement of cash flows.
Lesson 1: Using Financial
Ratios
The information contained in the four basic
financial statements is of major significance to
various interested parties who regularly need
to have relative measures of the company’s
operating efficiency.

Ratio analysis involves methods of

calculating and interpreting financial ratios to
analyze and monitor the firm’s performance.
The basic inputs to ratio analysis are the firm’s
income statement and balance sheet.
 Interested Parties
Ratio analysis of a firm’s financial statements is of
interest to shareholders, creditors, and the firm’s own
management. Both present and prospective
.
shareholders are interested in the firm’s current and
future level of risk and return, which directly affect share
price. The firm’s creditors are interested primarily in the
short-term liquidity of the company and its ability to
make interest and principal payments.
 Interested Parties
A secondary concern of creditors is the firm’s
profitability; they want assurance that the business is
healthy. Management, like stockholders,
.
is concerned
with all aspects of the firm’s financial situation, and it
attempts to produce financial ratios that will be
considered favorable by both owners and creditors. In
addition, management uses ratios to monitor the firm’s
performance from period to period.
Types of Ratio
Comparisons
Types of Ratio Comparisons
A meaningful basis for comparison is needed
to answer such questions as “Is it too high or
too low?” and “Is it good or bad?”
Cross-sectional Analysis
- involves the comparison of different firms’
financial ratios at the same point in time.
Analysts are often interested in how well a firm
has performed in relation to other firms in its
industry. Frequently, a firm will compare its
ratio values to those of a key competitor or
group of competitors that it wishes to emulate.
This type of cross-sectional analysis, called
benchmarking, has become very popular.
 Time-series Analysis
-evaluates performance over time.
Comparison of current to past performance,
using ratios, enables analysts to assess the
firm’s progress. Developing trends can be
seen by using multiyear comparisons. As in
cross-sectional analysis, any significant year-
to-year changes may be symptomatic of a
major problem.
 Combined Analysis
-The most informative approach to ratio
analysis combines cross-sectional and time-
series analyses. A combined view makes it
possible to assess the trend in the behavior
of the ratio in relation to the trend for the
industry.
Caution about using Ratio Analysis
Ratios with large deviations from the norm only indicate symptoms
1
of a problem. Additional analysis is typically needed to isolate the
causes of the problem. The fundamental point is this: Ratio analysis
merely directs attention to potential areas of concern; it does not
provide conclusive evidence as to the existence of a problem.

A single ratio does not generally provide sufficient information from

2
which to judge the overall performance of the firm. Only when a
group of ratios is used can reasonable judgments be made. However,
if an analysis is concerned only with certain specific aspects of a
firm’s financial position, one or two ratios may be sufficient.
Caution about using Ratio Analysis
The ratios being compared should be calculated using financial
3
statements dated at the same point in time during the year. If
they are not, the effects of seasonality may produce erroneous
conclusions and decisions.

It is preferable to use audited financial statements for ratio

4 analysis. If the statements have not been audited, the data
contained in them may not reflect the firm’s true financial
condition.
Caution about using Ratio Analysis
The financial data being compared should have been
5
developed in the same way. The use of differing accounting
treatments—especially relative to inventory and depreciation
—can distort the results of ratio analysis, regardless of
whether cross-sectional or time-series analysis is used.

Results can be distorted by inflation, which can cause the

6
book values of inventory and depreciable assets to differ
greatly from their true (replacement) values.
Categories of Financial
Ratios
Financial ratios can be divided for
convenience into five basic categories:
liquidity, activity, debt, profitability, and
market ratios. Liquidity, activity, and debt
ratios primarily measure risk. Profitability
ratios measure return. Market ratios
capture both risk and return.
Lesson 2: Liquidity Ratios

LIQUIDITY RATIOS – determine a company’s

ability to cover – short term obligations and
cash flows.

LIQUIDITY – refers to the solvency of the firm’s

overall financial position—the ease with which
it can pay its bills.
Two Basic Measures of Liquidity
1. CURRENT RATIO
2. QUICK (Acid-test) RATIO
 Two Basic Measures of Liquidity
1. CURRENT RATIO - one of the most commonly cited financial
ratios, measures the firm’s ability to meet its short-term
obligations. It is expressed as follows:

Current Ratio= Current Assets

Current Liabilities
 Two Basic Measures of Liquidity
2. Quick (Acid-Test) Ratio - is similar to the current ratio except
that it excludes inventory, which is generally the least liquid current
asset. The generally low liquidity of inventory results from two
primary factors:
(1) many types of inventory cannot be easily sold because they are
partially completed items, special-purpose items, and the like; and

(2) inventory is typically sold on credit, which means that it becomes an

account receivable before being converted into cash.
 Two Basic Measures of Liquidity
2. Quick (Acid-Test) Ratio
The quick ratio is calculated as follows:

Quick Ratio = Current Assets – Inventory –Prepaid Expenses

Current Liabilities
 Lesson 3: Activity Ratios

Activity ratios measure the speed with which various accounts are
converted into sales or cash-inflows or outflows. A number of
ratios are available for measuring the activity of the most
important current accounts, which include inventory, accounts
receivable, and accounts payable. The efficiency with which total
assets are used can also be assessed.
 Inventory Turnover
-commonly measures the activity, or liquidity, of a firm’s
inventory. It is calculated as follows:

Inventory turnover = Cost of goods sold

Inventory
 Average Collection
Period
-the average collection period, or average age of accounts receivable, is
useful in evaluating credit and collection policies. It is arrived at by dividing
the average daily sales into the accounts receivable balance:

Average collection period = Accounts receivable

Average sales per day

= Accounts receivable
Annual sales
365
 Total Asset Turnover
-the total asset turnover indicates the efficiency with which the firm
uses its assets to generate sales. Total asset turnover is calculated as follows:

Total asset turnover = Sales

Total Assets
Lesson 4: Debt Ratios
Debt ratios are essential financial metrics used to assess a
firm's financial leverage and risk. They help determine how
much a company relies on borrowed money to generate
profits. Financial analysts, lenders, investors, and
management all use debt ratios to evaluate a firm's ability to
meet its financial obligations.

DEBT - represents the amount of other people’s money a firm uses to

generate profits. Long-term debt is a primary concern because it
commits the firm to a stream of fixed payments. A firm with a higher
proportion of debt in its total assets has greater financial leverage.
 Financial Leverage
- magnifies both risk and return, meaning firms with more fixed-cost financing
(debt and preferred stock) may experience higher gains but also face higher
financial risks.
Example:
Patty Akers is incorporating her business and needs $50,000 in initial capital. She has two
financing options:
1. No-Debt Plan – She invests the full $50,000 without borrowing.
2. Debt Plan – She invests $25,000 and borrows $25,000 at 12% annual interest.
In both plans, she expects the business to generate $30,000 in sales and incur $18,000 in
operating expenses. The earnings will be taxed at 40%.
Projected Outcomes:
• Under the No-Debt Plan, she earns $7,200 after tax, a 14.4% return on
investment (ROI).
• Under the Debt Plan, she earns $5,400 after tax, but because she only
invested $25,000, her ROI is 21.6%.
• The Debt Plan offers a higher return but also carries greater risk due to the
required annual $3,000 interest payment.

This example illustrates that higher financial leverage increases both potential
returns and risks.
 Two Types of Debts Measure
.

Measures of the Measures of

Degree of the Ability to
Indebtedness Service Debts
-these assess the -these evaluate the
amount of debt relative firm’s ability to make
to key balance sheet scheduled debt
figures. payments.
 Debt Ratios
The debt ratio measures the proportion of total assets financed by
the firm’s creditors. The higher this ratio, the greater the amount of
other people’s money being used to generate profits.
The ratio is calculated as follows:

Debt ratio = Total liabilities

Total assets
Example (Bartlett Company - 2006):

1,643,000 = 0.457 or 45.7%

3,597,000

Bartlett Company finances nearly half (45.7%) of its

assets with debt. A higher debt ratio means greater
financial leverage but also greater risk.
 Time Interested Ratio
-The Times Interest Earned (TIE) Ratio, also called the Interest Coverage
Ratio, measures a firm’s ability to pay interest on its debt:

Times interest earned ratio = Earnings before interest and taxes

Interest
Example (Bartlett Company - 2006):

Times Interest Earned Ratio = $418,000 = 4.5

$93,000

A TIE ratio of 4.5 means the company’s earnings can

cover its interest obligations 4.5 times over. A ratio of at
least 3.0 to 5.0 is generally considered safe. Bartlett
Company’s EBIT( Earnings Before Interest Taxes) could
decrease by 78% and still cover its interest obligations.
 Fixed Payment Coverage
Ratio
The fixed-payment coverage ratio measures the firm’s ability to meet
all fixed payment obligations, such as loan interest and principal, lease
payments, and preferred stock dividends. As is true of the times
interest earned ratio, the higher this value, the better. The formula for
the fixed-payment coverage ratio is

FPCR = Earnings before interest and taxes + Lease payments

Interest + Lease Payments +{(Principal Payments + Preferred Stock
dividends) x [1/(1-T)]}
Example (Bartlett Company - 2006):

FPCR = $418,000+ $35,000

$93,000 + $35,000+{($71,000 + $10,000) x [1/(1-0.29)]}

= $453,000 = 1.9
$242,000
A ratio of 1.9 means that earnings are nearly twice the fixed obligations,
indicating that the company can comfortably meet its debt payments. A
higher ratio indicates lower risk, while a lower ratio suggests higher risk
and a greater chance of financial distress.
Lesson 5: Profitability Ratio
There are many measures of profitability. As a group,
these measures enable the analyst to evaluate the firm’s
profits with respect to a given level of sales, a certain level
of assets, or the owners’ investment. Without profits, a firm
could not attract outside capital. Owners, creditors, and
management pay close attention to boosting profits
because of the great importance placed on earnings in the
marketplace.
 Common-size Income
Statements
A popular tool for evaluating profitability in relation to sales is the
common-size income statement. Each item on this statement is
expressed as a percentage of sales. Common-size income statements
are especially useful in comparing performance across years. Three
frequently cited ratios of profitability that can be read directly from
the common-size income statement are (1) the gross profit margin,
(2) the operating profit margin, and (3) the net profit margin.
 Gross Profit Margin
The gross profit margin measures the percentage of each sales dollar
remaining after the firm has paid for its goods. The higher the gross profit
margin, the better (that is, the lower the relative cost of merchandise sold).
The gross profit margin is calculated as follows:

Gross Profit Margin = Sales – Cost of Goods Sold = Gross Profits

Sales Sales
 Operating Profit Margin
The operating profit margin measures the percentage of each sales dollar
remaining after all costs and expenses other than interest, taxes, and
preferred stock dividends are deducted. It represents the “pure profits”
earned on each sales dollar. Operating profits are “pure” because they
measure only the profits earned on operations and ignore interest, taxes,
and preferred stock dividends. A high operating profit margin is preferred.
 Operating Profit Margin
The operating profit margin is calculated as follows:

Operating Profit Margin = Operating Profits

Sales
 Net Profit Margin
The net profit margin measures the percentage of each sales dollar
remaining after all costs and expenses, including interest, taxes, and
preferred stock dividends, have been deducted. The higher the firm’s net
profit margin, the better. The net profit margin is calculated as follows:

Net Profit Margin = Earnings available for common stockholders

Sales
 Return on Total Assets (ROA)
The return on total assets (ROA), often called the return on investment
(ROI), measures the overall effectiveness of management in generating
profits with its available assets. The higher the firm’s return on total assets,
the better. The return on total assets is calculated as follows:

Return on Total Assets = Earnings available for common stockholders

Total Assets
 Return on Common Equity
(RCE)
The return on common equity (ROE) measures the return
earned on the common stockholders’ investment in the
firm. Generally, the higher this return, the better off are the
owners. Return on common equity is calculated as follows:

Return on Common Equity = Earnings available for common stockholders

Common stock equity
 Lesson 6: Market Ratios
Market ratios relate the firm’s market value, as
measured by its current share price, to certain
accounting values. These ratios give insight into how
well investors in the marketplace feel the firm is doing
in terms of risk and return. They tend to reflect, on a
relative basis, the common stockholders’ assessment
of all aspects of the firm’s past and expected future
performance.
 Price/ Market/
Earnings Book (M/B)
(P/E) Ratio
Ratio
 Price/Earnings (P/E) Ratio
-is commonly used to assess the owners’ appraisal of share value. The
P/E ratio measures the amount that investors are willing to pay for
each dollar of a firm’s earnings. The level of the price/earnings ratio
indicates the degree of confidence that investors have in the firm’s
future performance. The higher the P/E ratio, the greater is investor
confidence. The P/E ratio is calculated as follows:

Price / Earnings (P / E) Ratio = Market price per share of common stock

Earnings per share
 Market/ Book (M/B) Ratio
The market/book (M/B) ratio provides an assessment
of how investors view the firm’s performance. It relates
the market value of the firm’s shares to their book—strict
accounting—value.
 Market/ Book (M/B) Ratio

Book value per share = Common stock equity of common stock

Numbers of shares of common stock outstanding

Market/book (M/B) ratio = Market price per share of common stock

Book value per share of common stock

 Lesson 7: DuPont System of
Analysis
DuPont System of Analysis The DuPont system of analysis is used to dissect
the firm’s financial statements and to assess its financial condition. It merges
the income statement and balance sheet into two summary measures of
profitability: return on total assets (ROA) and return on common equity (ROE).

The DuPont system first brings together the net profit margin, which
measures the firm’s profitability on sales, with its total asset turnover, which
indicates how efficiently the firm has used its assets to generate sales. DuPont
Formula: ROA = Net Profit Margin x Total Asset Turnover Modified DuPont
DuPont Formula:
ROA = Net Profit Margin x Total Asset Turnover

Modified DuPont Formula:

ROE = ROA x Financial Leverage Multiplier (FLM)

 The advantage of the DuPont system is
that it allows the firm to break its return on equity into a
profit-on-sales component (net profit margin), an
efficiency-ofasset-use component (total asset turnover),
and a use-of-financial-leverage component (financial
leverage multiplier).
Thank you for
listening