Chapter 2:

Financial Analysis

Corporate Finance for Executives

 Understanding the Financial
Statements

What are financial statements?

➢The summarized results of your business
financial transactions over a designated period.
➢They will show your financial performance and
positions.
But where does this information come from?
Understanding Financial Statements
Orders and Income Balance
Activities Statement Sheet Cash Flow

Cash Flow
Statement
Income Balance Sheet
shows the
Transactions Statement captures
cash effects of
occur records snapshot of
income
throughout financial assets &
statement
the period impact during liabilities at a
events and
the period point in time
balance sheet
changes

3
 Primary Financial Statements
►Primary financial statements answer basic
questions including:
►What is the company’s current financial status?
►What was the company’s operating results for
the period?
►How did the company obtain and use cash
during the period?
 Market vs Book Value
►The balance sheet provides the book value of
the assets, liabilities and equity
►Market value is the price at which the assets,
liabilities or equity can actually be bought or
sold
►Market value and book value are often very
different. Why?
►Which is more important to the decision-making
process?
 Meaning of Financial Analysis

➢ Financial statement analysis is a process of

evaluating relationships between component
parts of financial statements to obtain a better
understanding of the firm’s financial condition
and performance.
➢ Its objective is to identify the firm’s current
strengths and weaknesses and to suggest actions
that the firm might pursue to take advantage of
those strengths and correct any weaknesses.
 Steps in Financial Analysis

1. Set objectives of the analysis

Objective depends on the need of the user. For example:
➢ Shareholders are interested in the firm’s current and future level of
risk and return.
➢ Creditors are primarily concerned with the short term liquidity of the
firm and the firm’s profitability.
➢ Management uses financial analysis for planning and controlling
decisions.
2. Gather Relevant Data
➢ Financial statements for at least 3 to 5 years.
✓ Balance sheets
✓ Income statements
➢ Economic and industry data.
 Steps in Financial Analysis…

3. Select and apply appropriate tools and

techniques to gain a basic understanding of the firm’s
financial status and performance.
▪ Techniques in analyzing financial statements
include:
➢ Ratio analysis,
➢ Common size statements analysis /vertical analysis/
➢ Trend Analysis
4. Evaluation and interpretation
 Ratio Analysis

➢ It is a financial technique that involves dividing

various financial statement numbers into one
another.
➢ Ratios can be examined to determine trends and
reasons for changes in the financial statement
from month to month.
➢ Ratios are valuable tools, as they standardize
balance sheet and income statement numbers.
 Types/Forms of ratio
comparisons
➢ Cross-sectional analysis/Peer Group Analysis:
✓ involves comparison of different firm’s financial ratios at
the same point in time.
✓ A firm’s ratios may be compared to those of the industry
leader or to industry averages.
➢ Time series analysis (trend analysis)
✓ Evaluate a firm’s performance over time.
✓ Any significant year to year changes can be evaluated to assess
whether they are symptomatic of major problem.
➢ Combined analysis (Use Panel Data):
✓ the most informative approach that combines cross-
sectional and time-series analyses.
 Types of Financial Ratios

➢Liquidity ratios
➢Asset-management/Activity
ratios
➢Financial-leverage/Debt
Management ratios
➢Profitability ratios
➢Market-value ratios
We will use the following data to compute ratios in this
chapter

Illustration: the income statement and balance sheet of Lucy

Company are given below. Calculate financial ratios for the
data provided
Lucy Company
Income Statements
2009 2008
Net sales $315,000 $259,000
Cost of goods sold -189,000 -154,000
General, selling, and administrative expenses
-54,000 -46,000
EBIT 72,000 59,000
Interest expense -4,000 -4,500
Income before taxes 68,000 54,500
Income tax expense (30%) -20,400 -16,350
Net income 47,600 38,150
 Example …
Lucy Company
Balance sheet
2009 2008
Cash $6,500 $11,500
Accounts receivable 51,000 49,000
Inventories 155,000 147,500
Total current assets 212,500 208,000
Plant and equipment (net) 187,500 177,000
Total assets 400,000 385,000
Accounts payable 60,000 81,500
Other current liab. 25,000 22,500
Total current liabilities 85,000 104,000
Bonds payable 100,000 100,000
Total liabilities 185,000 204,000
Common stock (1,000 shares) 150,000 150,000
Paid-In capital in excess of par 20,000 20,000
Retained earnings 45,000 11,000
Total stockholders’ equity 215,000 181,000
Total liabilities and stockholders’ equity 400,000 385,000
 1. Liquidity Ratios
➢ Liquidity refers to how quickly a firm can turn its
assets into cash.
➢ Liquidity ratios indicate the ability to meet short-
term obligations to creditors as they mature or
come due.
➢ Will the firm be able to pay off its debts as they
come due over the next year or so?
➢ Two commonly used liquidity ratios are:
✓ Current ratio
✓ Quick, or Acid Test, Ratio
 1.1. Current ratio

➢Too high current ratio indicates that:

➢too much capital is tied up in current assets
➢firm is not using its current borrowing capacity
➢Too low current ratio may suggest that a
firm may face difficulty in paying its short
term liabilities.
 1.2. Quick, or Acid Test Ratio
9

➢Focuses on quick assets to analyze liquidity.

➢Quick Assets: Current assets excluding
inventories and prepaid expenses are usually
assumed to be quick assets.
 2. Asset Management Ratios
➢ Also called activity or utilization ratios
➢ Measure how effectively the firm is managing its
assets.
➢ Indicate the extent to which assets are used to
support sales.
➢ include:-
✓ Inventory Turnover Ratio (ITO)
✓ Inventory Period (Average age of inventory)
✓ Days sales outstanding (DSO)
✓ Accounts Receivable Turnover
✓ The Fixed Assets Turnover Ratio
✓ The Total Assets Turnover Ratio
 2.1. Inventory Turnover Ratio (ITO)
➢ Indicates how quickly inventory is sold.
➢ It measures the efficiency of management in
managing inventories.
➢ The inventory turnover ratio is calculated as:
 2.1. Inventory turnover…
➢ An ITO significantly higher than the industry
average may indicate:
✓ Superior selling practice
✓ Improved liquidity and profitability,
✓ fewer cases of damaged or obsolete
inventory,
✓ use of just in time inventory
management.

2-
 2.1. Inventory turnover…
➢ Potential problems in higher ITO are:
✓lost sales due to insufficient level of inventory
✓firm’s policy of buying in small quantities & lost
quantity discount,
✓production interruptions because of lack of raw
materials.
➢ Potential problems in lower ITO are:
✓over investment in inventory
✓ inferior quality goods
✓stock of un-sellable or obsolete inventory
✓funds locked up in inventory and higher
inventory carrying costs
 2.2. Inventory Period

➢ also known as Days in Inventory.

➢ It measures the average number of days the
inventory is in warehouse before sale.

➢ The shorter the period, the higher the inventory

turnover and the better the performance is.
➢ The interpretation is the same to that of inventory
turnover ratio except this is in terms of days.
 2.3. Days sales outstanding (DSO)

➢ also called the “average collection period”

(ACP),
➢ the average length of time that the firm must
wait after making a credit sale before receiving
cash.
➢ DSO = 365/RTR
2.4. Accounts Receivable Turnover (ARTO)

➢Measures how many times on average

credit sales is made and collected in a
year.
➢It is calculated as:

➢ ARTO and DSO ratios are reciprocals of

each other.
 2.5. The Fixed Assets Turnover Ratio/FATO/

➢ Measures how effectively the firm uses its plant

and equipment.
➢ Unused or idle capacity is very costly and often
represents a major factor in a firm’s poor
operating performance.
➢ It is the ratio of sales to net fixed assets:
2.6. The Total Assets Turnover Ratio

➢ Measures the turnover of, the

entire firm’s assets.
➢ It is calculated by dividing net
sales by total assets:
 3. Debt Management Ratios

➢ Debt management ratios are used to

measure:
1. Degree of indebtedness - measures the extent
to which a firm finances itself with debt- we us
B/Sheet
2. Ability to service (pay) debts: measures the
ability of the firm to generate a level of income
sufficient to meet its obligations (fixed charges) –
we use I/Statement
3.1. Measures of Degree of indebtedness

a. Debt Ratio (DR)

➢ The ratio of total liabilities to total assets.

b. Total-debt-to-equity ratio (DE)

➢ It shows a firm’s total debt in relation to the total dollar amount
owners have invested in the firm.
 3.2. Coverage ratios

➢ Measure a firm’s ability to meet (cover) fixed charge

obligations such as interest on loans, lease payments,
preferred dividend and repayment of the installment of
loans.

a. Times-Interest-Earned Ratio
➢ measures a firm’s ability to pay interest on its
debts using operating profits.
 3.2. Coverage ratios …

b) Fixed Charge Coverage Ratio

➢measures a firm’s ability to pay all fixed
charges using operating profits.
 4. Profitability Ratios

➢ Measure a firm’s ability to

generate returns on its sales,
assets, and equity.
➢ Show the combined effects of
liquidity, asset management, and
debt on operating results.
 4.1. Measures of Profitability in terms
of Sales

a. Net Profit Margin /profit margin/

► shows after tax profits per dollar of sales.
 4.1. Measures of Profitability in terms
of Sales…
b) Gross profit margin
➢Measures the trading effectiveness and basic
profit earning potential of a firm.
➢It identifies the gross profit per dollar of sales
before any other expenses are deducted.
 4.2. Measures of Profitability in terms of
investment in total Assets
Return on Investment/ROI/
► Measure of profit per dollar of assets invested.
► It relates earnings to assets invested

➢ Return on assets=Profit Margin X Total Asset Turnover

 4.3. Measures of Profitability in terms of owners’
investment

Return on Equity (ROE)

➢ ROE measures the return the firm is earning on the
equity funds invested by its shareholders—the firm’s
owners
➢ It is the true bottom-line measure of
performance
 Dupont Analysis

➢ This says that management has only three levers for controlling ROE;
✓the earnings pressed out of each dollar of sales,
or the profit margin;
✓the sales generated from each birr of assets
employed, or the asset turnover; and
✓the amount of equity used to finance the assets,
or the equity multiplier.
 4.4. Earnings per share (EPS)

➢ Earning per share represents the number of dollars

earned on common stock.
➢ It shows the earnings available to the owners of
common stock.
➢ it specifically reveals how much money the company is
earning for every share.

EPS= $47,600/1,000 = $47.60 per share

 5. Market Value Ratios

➢ Relate a firm’s stock price to its earnings and

book values.
➢ indicate the willingness of investors to value a
firm in the marketplace relative to financial
statement values.
➢ A firm’s profitability, risk, quality of
management, and many other factors are
reflected in its stock prices.
➢ Market value ratios include:-
✓ Price/Earnings Ratio
✓ Market/Book Ratio
✓ Tobin Q ratio
✓ Dividend payout
 5.1. Price/Earnings Ratio

➢ Shows how much investors are willing to pay per dollar

of reported profits.
➢ Is higher for firms with strong growth prospects, other
things held constant, but it will be lower for riskier
firms.
➢ Assume the price per share is $250 for Lucy Company :
 5.2. Market/Book Ratio

➢ It gives another indication of how investors regard

the company.
➢ Companies with relatively high rates of return on
equity generally sell at higher multiples of book
value
 5.3. Tobin Q ratio
►
 5.4. Dividend Payout

➢ Shows the percentage of earnings paid to

shareholders.
➢ It expresses the cash dividend paid per share
(DPS) as a percentage of EPS
 Limitations of Financial Ratios
►Historical information
►Inflation effects
►Changes in Accounting Policy
►Manipulation of financial Statements
►Seasonal factors
THANK YOU for your Attention!
End of the chapter.

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