Chapter Two

Financial Statement Analysis

MBA Students
Arba Minch University
Department of Accounting and Finance
By:- Wondwossen Jerene (Ph.D)
4/18/2021 By Dr. Wondwossen J. @ AMU 1
 Outline
 Introduction
 Financial Analysis
 Methods of Financial Analysis
 Uses and Limitations of Ratio Analysis

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 Business Survival
There are two key factors for business survival:
 Profitability
 Solvency

 Profitability is important if the business is to

generate revenue (income) in excess of the
expenses incurred in operating that business.
 The solvency of a business is important because it
looks at the ability of the business in meeting its
financial obligations.

4/18/2021 By Dr. Wondwossen J. @ AMU 3

 Financial Statement Analysis
Purpose:
 To use financial statements to evaluate an organisation’s
◦ Financial performance
◦ Financial position
 To have a means of comparative analysis across time in
terms of:
◦ Intracompany basis (within the company itself)
◦ Intercompany basis (between companies)
◦ Industry Averages (against that particular industry’s
averages)
 To apply analytical tools and techniques to financial
statements to obtain useful information to aid decision
making.

4/18/2021 By Dr. Wondwossen J. @ AMU 4

 Financial Statement Analysis…
Financial statement analysis involves analysing the
information provided in the financial statements to:
◦ Provide information about the organisation’s:
 Past performance
 Present condition
 Future performance
◦ Assess the organisation’s:
 Earnings in terms of power, persistence,
quality and growth
 Solvency

4/18/2021 By Dr. Wondwossen J. @ AMU 5

 Financial statement analysis involves:
 (1) comparing a firm’s performance with
that of other firms in the same industry and

 (2) evaluating trends in the firm’s financial

position over time.

 Why do Managers needs Financial Analysis?

4/18/2021 By Dr. Wondwossen J. @ AMU 6

Managers use financial analysis to
identify situations needing attention;
Potential lenders use financial analysis
to determine whether a company is
creditworthy;
Stockholders use financial analysis to
help predict future earnings, dividends,
and free cash flow.

4/18/2021 By Dr. Wondwossen J. @ AMU 7

 Tools of Financial Statement Analysis:

The commonly used tools for financial

statement analysis are:
 Financial Ratio Analysis
 Comparative financial statements analysis:
◦ Horizontal analysis/Trend analysis
◦ Vertical analysis/Common size analysis/
Component Percentages

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 Horizontal analysis/Trend analysis
 Trend percentage
 Line-by-line item analysis
 Items are expressed as a percentage of a
base year
 This is a time series analysis
 For example, a line item could look at
increase in sales turnover over a period of
5 years to identify what the growth in sales
is over this period.

4/18/2021 By Dr. Wondwossen J. @ AMU 9

Horizontal Analysis

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 Vertical analysis/Common size analysis/
Component Percentages
 All items are expressed as a percentage of a
common base item within a financial
statement
 e.g. Financial Performance – sales is the base
 e.g. Financial Position – total assets is the base
 Important analysis for comparative purposes
◦ Over time and
◦ For different sized enterprises

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Common Size Analysis

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 Ratio Analysis
 When we perform a financial analysis, we
conduct the following steps:
 1. Gather data (Financial Statements)
 2. Examine the Statement of Cash Flows
 Cash flow from operating, investment,
financing activities
 3. Calculate and Examine the Return on
Invested Capital (ROIC)- overall
performance
 4. Begin Ratio Analysis
4/18/2021 By Dr. Wondwossen J. @ AMU 13
  Financial ratio analysis is the use of
relationships among financial statement
accounts to gauge the financial condition and
performance of a company.
 We can classify ratios based on the type of
information the ratio provides:

Activity Ratios Liquidity Ratios Solvency Ratios Profitability Ratios

Effectiveness in Ability to meet Ability to manage

putting its asset short-term, Ability to satisfy expenses to
investment to immediate debt obligations. produce profits
use. obligations. from sales.

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 Methods of Ratio Analysis
Methods of Financial Ratio Analysis includes:
 1. Liquidity Ratio Analysis
 2. Asset Management Ratio Analysis
 3. Debt Management Ratio Analysis
 4. Profitability Ratio Analysis
 5. Market Value Ratio Analysis
 6. The Du Pont Equation

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 1. LIQUIDITY RATIOS (LR)
 LR answers question that whether the
company will have trouble satisfying current
obligations/liabilities?
 We discuss two commonly used liquidity
ratios in this section.
 A. The Current Ratio
 B. The Quick, or Acid Test Ratio

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 The current ratio is calculated by dividing
current assets by current liabilities:

 Current assets normally include cash,

marketable securities, accounts receivable,
and inventories.
 Current liabilities consist of accounts payable,
short-term notes payable, current maturities
of long-term debt, accrued taxes, and other
accrued expenses.
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 MicroDrive has a lower current ratio than the
average for its industry.
 Is this good or bad?
 Sometimes the answer depends on who is asking
the question. Suppliers? Or Shareholders?
 For example, suppose a supplier is trying to
decide whether to extend credit to MicroDrive.
 In general, creditors like to see a high current
ratio.
 If a company is getting into financial difficulty, it
will begin paying its bills (accounts payable) more
slowly, borrowing from its bank, and so on, so its
current liabilities will be increasing.
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 If current liabilities are rising faster than
current assets then the current ratio will
fall, and this could spell trouble.
 Because the current ratio provides the best
single indicator, of the extent to which the
claims of short-term creditors are covered
by assets,
 that are expected to be converted to cash
fairly quickly,
 it is the most commonly used measure of
short-term solvency.
4/18/2021 By Dr. Wondwossen J. @ AMU 20
 The quick, or acid test, ratio is calculated
by deducting inventories from current assets
and then dividing the remainder by current
liabilities:

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 A liquid asset is one that trades in an active
market.
 Hence can be converted quickly to cash at the
going market price.
 Inventories are typically the least liquid of a
firm’s current assets;
 Hence they are the current assets on which
losses are most likely to occur in a bankruptcy.
 Therefore, a measure of the firm’s ability to pay
off short-term obligations without relying on
the sale of inventories is important.
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 2. ASSET MANAGEMENT RATIOS
 AMR measure how effectively a firm is managing
its assets.
 If a company has excessive investments in assets,
then its operating capital will be unduly high,
which will reduce its free cash flow and ultimately
its stock price.
 On the other hand, if a company does not have
enough assets then it will lose sales, which will
hurt profitability, free cash flow, and the stock
price.
 Therefore, it is important to have the right
amount invested in assets.
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MicroDrive Inc.: Income Statements for Years Ending
December 31 (Millions of Dollars, Except for Per Share Data)

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 2a) The Inventory Turnover Ratio
 The inventory turnover ratio is defined as
sales divided by inventories:

 As a rough approximation, each item of Micro

Drive’s inventory is sold out and restocked, or
―turned over,‖ 4.9 times per year.

4/18/2021 By Dr. Wondwossen J. @ AMU 25

 MicroDrive’s turnover of 4.9 is much lower
than the industry average of 9.0.
 This suggests that Micro Drive is holding too
much inventory.
 High levels of inventory add to net operating
working capital (NOWC), which reduces FCF,
which leads to lower stock prices.
 In addition, Micro Drive’s low inventory
turnover ratio makes us wonder whether the
firm is actually holding obsolete goods not
worth their stated value.

4/18/2021 By Dr. Wondwossen J. @ AMU 26

 2b) Evaluating Receivables:
The Days Sales Outstanding
 Days sales outstanding (DSO), also called the
―average collection period‖ (ACP)
 Thus, the DSO represents the average length
of time that the firm must wait after making a
sale before receiving cash, which is the average
collection period.

4/18/2021 By Dr. Wondwossen J. @ AMU 27

 MicroDrive’s sales terms call for payment within
30 days.
 The fact that 46 days of sales are outstanding
indicates that customers, on average, are not
paying their bills on time.
 As with inventory, high levels of accounts
receivable cause high levels of NOWC, which
hurts FCF and stock price.
 A customer who is paying late may well be in
financial trouble.
 Therefore, if the trend in DSO has been rising but
the credit policy has not been changed,
 steps should be taken to review credit standards
and to expedite the collection of accounts
receivable.
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 2C) Evaluating Fixed Assets:
The Fixed Assets Turnover Ratio
 The fixed assets turnover ratio measures how
effectively the firm uses its plant and
equipment.
 It is the ratio of sales to net fixed assets:

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 2d) Evaluating Total Assets:
The Total Assets Turnover Ratio

 MicroDrive’s ratio is somewhat below the industry

average, indicating that the company is not generating a
sufficient volume of business given its total asset
investment.
 Sales should be increased, some assets should be sold,
or a combination of these steps should be taken.
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 3. DEBT MANAGEMENT RATIOS
 The extent to which a firm uses debt financing, or
financial leverage, has three important
implications:
 (1) By raising funds through debt, stockholders
can maintain control of a firm without increasing
their investment.
 (2) If the firm earns more on investments
financed with borrowed funds than it pays in
interest,
 then its shareholders’ returns are magnified, or
―leveraged,‖ but their risks are also magnified.
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 (3) Creditors look to the equity, or owner-
supplied funds, to provide a margin of safety,
 so the higher the proportion of funding
supplied by stockholders, the less risk
creditors face.
 The following ratios examine leverage from a
creditor’s point of view.
 3a) Total Liabilities to Total Assets
 3b) Times-Interest-Earned Ratio
 3c) EBITDA Coverage Ratio

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 3a) How the Firm is Financed:
Total Liabilities to Total Assets
 The ratio of total liabilities to total assets is
called the debt ratio, or sometimes the total
debt ratio.
 It measures the percentage of funds provided
by current liabilities and long-term debt:

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 Creditors prefer low debt ratios because the
lower the ratio, the greater the cushion
against creditors’ losses in the event of
liquidation.
 Stockholders, on the other hand, may want
more leverage because it magnifies their
return.
 MicroDrive’s debt ratio is 53.2% but its debt
ratio in the previous year was 47.6%,
 Which means that creditors are now supplying
more than half the total financing.
 In addition to an upward trend, the level of the
debt ratio is well above the industry average.
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 Creditors may be reluctant to lend the firm more
money because a high debt ratio is associated
with a greater risk of bankruptcy.
 Some sources report the debt-to-equity ratio,
defined as:

 The debt-to-equity ratio shows that MicroDrive

has $1.14 of debt for every dollar of equity,
 whereas the debt ratio shows that 53.2% of
MicroDrive’s financing is in the form of liabilities.
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 Sometimes it is useful to express debt ratios
in terms of market values.
 It is easy to calculate the market value of
equity, which is equal to the stock price
multiplied by the number of shares.
 MicroDrive’s market value of equity is $23(50)
= $1,150.

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 MicroDrive’s market debt ratio in the previous
year was 38.1%.
 The big increase was due to two major factors:
 Liabilities increased and the stock price fell.
 The stock price reflects a company’s prospects
for generating future cash flows,
 so a decline in stock price indicates a likely
decline in future cash flows.
 Thus, the market debt ratio reflects a source of
risk that is not captured by the conventional
book debt ratio.
4/18/2021 By Dr. Wondwossen J. @ AMU 37
 3b) Ability to Pay Interest:
Times-Interest-Earned Ratio
 The times-interest-earned (TIE) ratio, also
called the interest coverage ratio,
 Is determined by dividing earnings before
interest and taxes (EBIT in Table 3-1) by the
interest expense:

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 The TIE ratio measures the extent to which
operating income can decline before the firm
is unable to meet its annual interest costs.
 Failure to meet this obligation can bring legal
action by the firm’s creditors, possibly
resulting in bankruptcy.
 Note that earnings before interest and taxes,
rather than net income, is used in the
numerator.
 Because interest is paid with pre-tax dollars,
the firm’s ability to pay current interest is not
affected by taxes.
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 MicroDrive’s interest is covered 3.2 times.
 The industry average is 6, so MicroDrive is
covering its interest charges by a relatively low
margin of safety.
 Thus, the TIE ratio reinforces the conclusion
from our analysis of the debt ratio that
MicroDrive would face difficulties if it
attempted to borrow additional funds.

4/18/2021 By Dr. Wondwossen J. @ AMU 40

 3c) Ability to Service Debt:
EBITDA Coverage Ratio
 The TIE ratio is useful for assessing a company’s
ability to meet interest charges on its debt.
 But this ratio has two shortcomings:
 (1) Interest is not the only fixed financial charge
companies must also reduce debt on schedule,
and
 many firms lease assets and thus must make
lease payments.
 If they fail to repay debt or meet lease
payments, they can be forced into bankruptcy.
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 (2) EBIT does not represent all the cash flow
available to service debt,
 especially if a firm has high depreciation and/or
amortization charges.
 The EBITDA coverage ratio accounts for
these deficiencies:

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 Therefore, MicroDrive covered its fixed financial
charges by 3.0 times.
 However, if EBITDA declines then the coverage
will fall, and EBITDA certainly can decline.
 Moreover, MicroDrive’s ratio is well below the
industry average,
 So again the company seems to have a relatively
high level of debt.
 Therefore, banks and other relatively short-term
lenders focus on the EBITDA coverage ratio,
 Whereas long-term bondholders focus on the TIE
ratio.
4/18/2021 By Dr. Wondwossen J. @ AMU 43
 4. PROFITABILITY RATIOS

 Profitability is the net result of a number of

policies and decisions.
 The ratios examined thus far provide useful
clues as to the effectiveness of a firm’s
operations,
 but the profitability ratios go on to show the
combined effects of liquidity, asset
management, and debt on operating results.

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 4a) Net Profit Margin
 The net profit margin, which is also called the
profit margin on sales, is calculated by dividing net
income by sales.
 It gives the profit per dollar of sales:

 why is this below the average? Is it due to

inefficient operations, high interest expenses, or
both?
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 Instead of just comparing net income to sales,
many analysts also break the income
statement into smaller parts to identify the
sources of a low net profit margin.
 For example, the operating profit margin is
defined as:

 The operating profit margin identifies how a

company is performing with respect to its
operations before the impact of interest
expenses is considered.
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 Some analysts drill even deeper by breaking
operating costs into their components.
 For example, the gross profit margin is
defined as:

 The gross profit margin identifies the gross

profit per dollar of sales before any other
expenses are deducted.

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 4b) Basic Earning Power (BEP) Ratio
 The basic earning power (BEP) ratio is
calculated by dividing earnings before interest
and taxes (EBIT) by total assets:

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 This ratio shows the raw earning power of the
firm’s assets before the influence of taxes and
leverage,
 And it is useful for comparing firms with
different tax situations and different degrees of
financial leverage.
 Because of its low turnover ratios and low
profit margin on sales,
 MicroDrive is not getting as high a return on
its assets as is the average company in its
industry.

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 4c) Return on Total Assets
 The ratio of net income to total assets
measures the return on total assets (ROA)
after interest and taxes.
 This ratio is also called the return on assets
and is defined as follows:

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 MicroDrive’s 5.7% return is well below the
9% average for the industry.
 This low return is due to
 (1) the company’s low basic earning power
and
 (2) high interest costs resulting from its
above-average use of debt;
 Both of these factors cause MicroDrive’s
net income to be relatively low.

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 4d) Return on Common Equity
 The ratio of net income to common equity
measures the return on common equity
(ROE):

 Stockholders invest to earn a return on their

money, and this ratio tells how well they are
doing in an accounting sense.
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 5. TYING THE RATIOS TOGETHER:
THE DU PONT EQUATION
 In ratio analysis, it is sometimes easy to miss
the forest for all the trees.
 The Du Pont equation provides a framework
that ties together a firm’s profitability, asset
efficiency, and use of debt.
 The return on assets (ROA) can be expressed
as the profit margin multiplied by the total
assets turnover ratio:

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 For MicroDrive, the ROA is:

 MicroDrive made 3.8%, or 3.8 cents, on each

dollar of sales, and its assets were turned over 1.5
times during the year.
 Therefore, the company earned a return of 5.7%
on its assets.
 To find the return on equity (ROE), multiply the
ROA by the equity multiplier, which is the ratio of
assets to common equity:

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 Firms that have a lot of leverage (i.e., a lot of
liabilities or preferred stock) have a high
equity multiplier
 because the assets are financed with a
relatively smaller amount of equity.
 Therefore, the return on equity (ROE)
depends on the ROA and the use of leverage:

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 Combining Equations 3-1 and 3-3 gives the
extended, or modified, Du Pont equation,
 which shows how the profit margin, the total
assets turnover ratio, and the equity multiplier
combine to determine the ROE:

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 The insights provided by the Du Pont model are
valuable,
 And the model can be used for ―quick and dirty‖
estimates of the impact that operating changes
have on returns.
 For example, holding all else equal, if MicroDrive
can implement lean production techniques and
increase to 1.8 its ratio of sales to total assets,
 Then its ROE will improve to
(3.8%)(1.8)(2.23) = 15.25%.
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 USES AND LIMITATIONS OF RATIO
ANALYSIS
 Ratio analysis provides useful information
concerning a company’s operations and
financial condition,
 But it has limitations that necessitate care and
judgment.
 Some potential problems include the following.

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 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. To set goals for high-level performance, it is
best to benchmark on the industry leaders’
ratios rather than the industry average ratios.
 3. Inflation may have badly distorted firms’
balance sheets—reported values are often
substantially different from ―true‖ values.
 4. Seasonal factors can also distort a ratio
analysis.
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 5. Firms can employ ―window dressing‖
techniques to make their financial
statements look stronger.
 6. Companies’ choices of different
accounting practices can distort
comparisons.
 For example, choices of different inventory
valuation and depreciation methods affect
financial statements.

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 LOOKING BEYOND THE NUMBERS
 Sound financial analysis involves more than just
calculating and comparing ratios qualitative
factors must be considered.
 Here are some questions suggested by the
American Association of Individual Investors
(AAII).
 1. To what extent are the company’s revenues tied
to one key customer or to one key product?
 To what extent does the company rely on a single
supplier?
 Reliance on single customers, products, or
suppliers increases risk.
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 2. What percentage of the company’s business
is generated overseas?
 Companies with a large percentage of
overseas business are exposed to risk of
currency exchange volatility and political
instability.
 3. What are the probable actions of current
competitors and the likelihood of additional
new competitors?

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 4. Do the company’s future prospects depend
critically on the success of products currently
in the pipeline or on existing products?
 5. How does the legal and regulatory
environment affect the company?

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