Why Financial Statements

Are Analyzed
A Framework for Financial
Statement Analysis

In order for financial information to be

useful, it must be interpreted.

Chapter 11

Why Financial Statements

Are Analyzed
A comprehensive set of ratios allows
the user to make sense of all the
financial information reported in the
financial statements.

Users of Financial
Information
Users of financial information may be
current or future users.

Users of Financial
Information
Some of the users of financial
information are the following:

Investors
Managers
Customers
Potential suppliers
and creditors

Sources of Financial
Information
The major source of financial
information is a firm's annual report.

Government
regulators
Employee unions
Public interest and
community groups

The following are elements

of most annual reports:
Management discussion and analysis
Independent auditor's report
Primary financial statements
Secondary financial statements
Notes to the financial statements

Other Sources of
Information
Reports filed with regulatory agencies
(special, quarterly, and annual)
Business periodicals (magazines,
newspapers, newsletters)
Investment advisory services
(Standard & Poor, Moody's, etc.)

Basis of Comparison
When analyzing financial reports, one
of the first decisions is to identify the
basis of comparison.

Restatements May Be
Necessary
The statements may need to be
restated when significant unusual
events have occurred which would
distort comparisons.

Data may be compared with

the following:
The firm's own data from prior years
Data from another firm in the same
industry
Data from another firm in which the
analyst may invest
Industry averages
Benchmarks or targets

Restatements May Be
Necessary
Such events include, among others,
mergers or acquisitions, discontinued
operations, changes in accounting
principles, and extraordinary items.

More Comparability Is
Better
Comparability is enhanced when
firms' size, capital structure, and
product mix are similar.

A summary of the steps:

Review the financial statements, notes,
and audit opinion to identify any
unusual events or characteristics and
to become familiar with the nature of
the firms operation.

A summary of the steps:

Identify the purpose and objectives of
analysis.

A summary of the steps:

Determine whether any restatements
due to mergers, discontinued
operations, etc., are necessary to
enhance comparability of the firms
financial statements.

A summary of the steps:

Financial Statement Analysis

Ratios & Framework

Determine whether the firms size,

capital structure, and product mix are
sufficiently comparable (between
firms or time periods) to proceed with
the ratio calculations.

The analyst usually performs

horizontal and vertical analyses of the
financial statements.

Financial Statement Analysis

Ratios & Framework

Financial Statement Analysis

Ratios & Framework

Horizontal analysis focuses on

changes or growth, year to year, for
each major element on the income
statement and the balance sheet.

Vertical analysis examines the

percentage composition of the income
statement and the balance sheet: It
uses common-size financial statements
for this analysis.

Categories of Financial
Ratios
Ratios are usually grouped into broad
categories.

Liquidity Ratios
Liquidity ratios indicate the short-term
solvency of the firm.

Categories of Financial
Ratios
Four widely used major headings are
liquidity, profitability, capital
structure, and investor.

Liquidity Ratios
They also indicate how effectively the
firm is managing its working capital.

Liquidity Ratios

Liquidity Ratios

The following are commonly used

liquidity ratios:
Current ratio =

Current assets
Current liabilities

Liquidity Ratios

Quick ratio =
Cash + Cash equivalents + Accounts receivable
Current liabilities

Liquidity Ratios

The following are commonly used

liquidity ratios:
Average sales per day =

The following are commonly used

liquidity ratios:

Sales revenue
365

The following are commonly used

liquidity ratios:
Cost of goods sold per day =

Cost of goods sold

365

Liquidity Ratios
The following are commonly used
liquidity ratios:

Profitability Ratios
Profitability ratios measure how
profitable a firm is.

Number of days' sales in ending inventory =

Ending inventory
Cost of goods sold per day

Profitability Ratios
This is very important for investors
who want to invest in a firm which
can return their investment to them.

Profitability Ratios
The following are commonly used
profitability ratios:

Gross profit percentage =

Gross profit
Net sales revenue

Profitability Ratios
The following are commonly used
profitability ratios:
Operating income percentage =
Operating income +
Extraordinary losses - unusual gains
Sales revenue

Profitability Ratios
The following are commonly used
profitability ratios:
Return on assets =
Net income +
(Interest expense [1 - Tax rate])
Sales revenue

Profitability Ratios
The following are commonly used
profitability ratios:
Return on equity =

Net income
Average shareholders' equity

Profitability Ratios
The following are commonly used
profitability ratios:
Cash return on assets =
Cash flow from operating activities +
interest paid
Average total assets

Profitability Ratios
The following are commonly used
profitability ratios:

Capital Structure Ratios

Capital structure ratios help in
assessing a firm's strategies for
financing its assets.

Quality of income =
Cash flow from operating activities
Net income

Capital Structure Ratios

Capital structure indicates the relative
amounts of debt and equity capital.

Capital Structure Ratios

Percentage composition analysis is
the starting point for any analysis of
capital structure.

Capital Structure Ratios

Percentage composition analysis
describes the relative amounts of
capital obtained from each major
source of financing.

Capital Structure Ratios

Percentage composition analysis is the
starting point for any analysis of
capital structure.
Percentage composition =

Current liabilities
Total liabilities +
Shareholders equity

Capital Structure Ratios

Current liabilities, long-term debt,
deferred taxes and other similar
liabilities, and shareholders' equity all
will be divided by the total of total
liabilities and shareholders' equity.

Capital Structure Ratios

Percentage composition analysis is the
starting point for any analysis of
capital structure.
Percentage composition =

Long term debt

Total liabilities +
Shareholders equity

Capital Structure Ratios

Percentage composition analysis is the
starting point for any analysis of
capital structure.
Deferred taxes +
Other similar liabilities
Percentage composition =
Total liabilities +
Shareholders equity

Capital Structure Ratios

The following capital structure ratios
are also computed:
Financial leverage =

Total liabilities
Total assets

Capital Structure Ratios

Percentage composition analysis is the
starting point for any analysis of
capital structure.
Percentage composition =

Shareholders' equity
Total liabilities +
Shareholders equity

Capital Structure Ratios

The following capital structure ratios
are also computed:
Times interest earned =
Earnings before interest and Taxes
Interest expense

Investor Ratios
Investor ratios all relate to an external
dimension of ownership interest.
Most indicate how a firm is
performing with regard to the market
value of its shares.

Investor Ratios
The following are commonly used
investor ratios:
Market to book value =

Market price per share

Book value per share

Investor Ratios
The following are commonly used
investor ratios:
Earnings per share =

Net income
Weighted average number
of shares outstanding

Investor Ratios
The following are commonly used
investor ratios:
Price to earnings =

Market price per share

Earnings per share

Financial Statement
Analysis Framework
The financial statement analysis
framework includes the following
steps.

Financial Statement
Analysis Framework
Review the financial statements, notes
and audit opinion.

Financial Statement
Analysis Framework
Identify the purpose and objectives of
the analysis.

Financial Statement
Analysis Framework
Determine whether restatements are
necessary to enhance the
comparability of the statements.

Financial Statement
Analysis Framework
Determine whether the firm's size,
capital structure, and product mix are
appropriate to proceed with the ratio
calculations.

Financial Statement
Analysis Framework
Calculate the basic liquidity ratios.

Financial Statement
Analysis Framework
Conduct horizontal and vertical
analyses of each financial statement,
with special emphasis on the income
statement.

Financial Statement
Analysis Framework
Calculate profitability ratios based on
net income and on cash flow from
operating activities. Evaluate trends.

Financial Statement
Analysis Framework
Evaluate the firm's capital structure
with special emphasis on trends in the
percentage composition ratios.

Financial Statement
Analysis Framework
Examine any inconsistencies in the
ratio results, review notes, and
recalculate the ratios.

Financial Statement
Analysis Framework
Examine the firm's market
performance using the investor ratios.

Limitations of Financial
Statement Analyses
Financial statement analysis is limited
due to several items.

Limitations of Financial
Statement Analyses
GAAP presents some limits.

Limitations of Financial
Statement Analyses
Many major factors affecting
profitability and survival of the firm
are not included in the financial
statements.

Limitations of Financial
Statement Analyses
GAAP presents some limits.
Managers often have the ability to
select favorable accounting methods.

Limitations of Financial
Statement Analyses
Many major factors affecting
profitability and survival of the firm
are not included in the financial
statements.
A perfect example is human resources.

Limitations of Financial
Statement Analyses
Many major factors affecting
profitability and survival of the firm
are not included in the financial
statements.

Limitations of Financial
Statement Analyses
"Real" events are often hard to
distinguish from the effects of
alternative accounting methods or
principles.

While employees are often a firm's most

important asset, a value for employees
does not appear on the balance sheet.

Limitations of Financial
Statement Analyses
Financial statement analysis relies on
past numbers, and the past may not be
a reliable indication of the future.

A Framework for Financial

Statement Analysis
End of Chapter 11