UNIVERSITY OF SOUTHERN MINDANAO

Analysis of Financial Statements

 Topic Outline

▪ Nature of Ratio analysis ▪ Potential misuse of ROE

▪ Liquidity ratios ▪ Using ratios to assess
performance
▪ Asset management ratios ▪ Comparison with industry
averages
▪ Debt management ratios ▪ Benchmarking
▪ Profitability ratios ▪ Trend analysis
▪ Market value ratios ▪ Uses and limitation of ratios
▪ The DuPont equation ▪ Looking beyond the
numbers and ratios
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 Intended Learning Outcomes
▪ Discuss the nature of financial analysis by ratios
▪ Compute various ratios needed for financial analysis and
discuss their implications
▪ Compute the ROE using the DuPONT equation and discuss its
implications and importance on improving the firm
▪ Discuss the potential misuse of ratio in analysis firms
▪ Use ratio to assess the firms performance and compare firms
▪ Discuss the uses and limitations of ratios
▪ Discuss the qualitative factors that should also be considered
in financial analysis ACC 323B Financial Management (SMVillaruz) 3
Ratio Analysis
• Ratios help in evaluating and analyzing the financial statements to
identify weaknesses that need to be strengthened to maximize the
stock price. Ratios are also used to make comparisons with other
companies or different industries.

ASSET DEBT
LIQUIDITY PROFITABILITY MARKET VALUE
MANAGEMENT MANAGEMENT
• Current Ratio • Inventory • Total Debt to • Operating • Price/Earnings
• Quick (or Acid) Turnover Ratio Total Assets Margin Ratio
Ratio • Days Sales • Times-Interest- • Profit Margin • Market/Book
Outstanding Earned (TIE) • Return on Total Ratio
• Fixed Assets Ratio Assets
Turnover • Basic Earning
• Total Assets Power (BEP)
Turnover Ratio
• Return on
Common Equity

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 Liquidity Ratios
▪ Ratios that show the relationship of a firm’s cash and other current
assets to its current liabilities.
❑Will the firm be able to pay off its debts as they come due and thus remain a
viable organization?
▪ Liquid Asset is an asset that can be converted to cash quickly without
having to reduce the asset’s price very much.

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 Asset Management Ratios
▪ A set of ratios that measure how effectively a firm is managing its
assets.
❑Does the amount of each type of asset seem reasonable, too high, or too low
in view of current and projected sales?

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 Debt Management Ratios
▪ A set of ratios that measure how effectively a firm is managing its
debts.
❑What is the right mix of debt and equity?

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 Profitability Ratios
▪ A group of ratios that show the combined effects of liquidity, asset
management, and debt on operating results.
▪ It reflects all of the financing policies and operating decisions.
❑Do sales prices exceed unit costs, and are sales high enough as reflected in PM,
ROE, and ROA?

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 Market Value Ratios
▪ Ratios that relate the firm’s stock price to its earnings and book value
per share.
❑The market value ratios are used in three primary ways:
1. by investors when they are deciding to buy or sell a stock,
2. by investment bankers when they are setting the share price for a new stock issue (an
IPO), and
3. by firms when they are deciding how much to offer for another firm in a potential
merger.
❑Do investors like what they see as reflected in P/E and M/B ratios?

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 The DuPont Equation
▪ A formula that shows that the rate of return on equity can be found as
the product of profit margin, total assets turnover, and the equity
multiplier. It shows the relationships among asset management, debt
management, and profitability ratios.

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 Problems with ROE

▪ ROE and shareholder wealth are correlated, but problems can

arise when ROE is the sole measure of performance.
▪ ROE does not consider risk.
▪ ROE does not consider the amount of capital invested.

▪ Given these problems, reliance on ROE may encourage

managers to make investments that do not benefit
shareholders. As a result, analysts have looked to develop
other performance measures, such as EVA.
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 Why Ratios are useful?
▪ Ratios standardize numbers and facilitate comparisons.
▪ Ratios are used to highlight weaknesses and strengths.
▪ Ratio comparisons should be made through time and with
competitors.
▪ Trend analysis - An analysis of a firm’s financial ratios over time;
used to estimate the likelihood of improvement or deterioration in
its financial condition.
▪ Industry analysis
▪ Benchmark (peer) analysis - The process of comparing a particular
company with a set of benchmark companies.

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 Potential Problems and Limitations of
Financial Ratio Analysis
▪ Comparison with industry averages is difficult for a conglomerate
firm that operates in many different divisions.
▪ Different operating and accounting practices can distort
comparisons.
▪ Sometimes it is hard to tell if a ratio is “good” or “bad.”
▪ Difficult to tell whether a company is, on balance, in a strong or
weak position.
▪ “Average” performance is not necessarily good, perhaps the firm
should aim higher.
▪ Seasonal factors can distort ratios.
▪ “Window dressing” techniques can make statements and ratios
look better than they actually are.
▪ Inflation has distorted many firms’ balance sheets, so analyses
must be interpreted with judgment.
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 Summary
• Ratios are grouped into five categories: liquidity, asset
management, debt management, profitability, and market value.
• Firm’s ratios are compared with averages for its industry and with
the leading firms in the industry (benchmarking), and these
comparisons are used to formulate policies that will lead to
improved performance.
• Firm’s ratios can be analyzed over time to see if financial situation
is getting better or worse (trend analysis)
• ROE is the single most important ratio over which management
has control.
• DuPont analysis can help identify problems areas that should be
strengthened.
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Summary of Ratios

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 References
• Brigham, Eugene and Houston, Joel (2009). Fundamentals of Financial Management (12th edition)

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