CHAPTER 6

FINANCIAL STATEMENT ANALYSIS

The Faculty of Finance

University of Economics, The University of Danang
 Reading
• Chapter 2&3, Fundamentals of Corporate
Finance; Stephen A. Ross, Randolph W.
Westerfield, Bradford D. Jordan; McGraw-Hill
(2010).
 Chapter Outline
• Objective of FSA
• Financial Statements (Balance Sheet,
Income Statement, Cash Flow Statement)
• Ratio Analysis
• Dupont Analysis
Objective of FSA

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 Objective of FSA
Financial analysis is a
process of selecting, Market Data
Financial
Disclosures
evaluating, and interpreting
financial data, along with other
pertinent information, in order Economic
Data
to formulate an assessment of
a company’s present and
future financial condition and
Financial Analysis
performance.

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 Objective of FSA
• Internal uses:
– performance evaluation
– planning for the future

• External uses:
– evaluation by outside parties (ex. Government -
Taxation, Debtholders – Credit decisions)
– making investment decisions
– evaluation of main competitors
– identifying potential takeover targets
Financial Statements

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 Balance Sheet
• The balance sheet is a snapshot of the firm’s
assets and liabilities at a given point in time
• Assets are listed in order of decreasing liquidity
– Ease of conversion to cash
– Without significant loss of value
• Balance Sheet Identity
– Assets = Liabilities + Stockholders’ Equity

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 The Statement of Financial
Position

Figure 6.1: The Statement of Financial Statement.

Left side: Total value of Assets. Right side: Total value of Liabilities and Shareholders’ Equity
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 Market Value 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?

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 Income Statement
• The income statement is more like a video of the firm’s
operations for a specified period of time.
• You generally report revenues first and then deduct any
expenses for the period
• Matching principle – to first determine revenues and then
match those revenues with the costs associated with
producing them. So, if we manufacture a product and then
sell it on credit, the revenue is realized at the time of sale.
The production and other costs associated with the sale of
that product will likewise be recognized at that time. Once
again, the actual cash outflows may have occurred at
some different time
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 Income Statement (cont’ed)
• Revenues less Expenses = Net Income
• Earnings Per Share is reported on face of IS
• Also called the Statement of Earnings
• Comparative financial statements enable users to
analyze performance over multiple periods and identify
significant trends.
• Consolidated financial statements combine the
financial results of a “parent company” with its
subsidiaries.

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Income Statement (cont’ed)
• Income reported on income statement is based
on Accrual Accounting, all revenues earned in
the year & all expenses incurred in that year
(NOT on the cash generated or cash paid during
accounting period)

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 Statement of Cash Flows
* Cash
• Cash is generated by selling a product or service,
asset or security.
• Cash is spent by paying for materials and labour to
produce a product or service and by purchasing
assets.
• Recall:
Cash flow from assets = Cash flow to debt holders
+ Cash flow to shareholders
 Cash Flow
• Sources of cash are those activities that
bring in cash.
• Uses of cash are those activities that
involve spending cash.
• The firm’s statement of cash flows is the
firm’s financial statement that summarises
its sources and uses of cash over a
specified period.
 Statement of Cash Flows
• A statement that summarizes the sources and
uses of cash.
• Changes are divided into three main categories:
– Operating activities-includes net profit and
changes in most current accounts
– Investment activities-includes changes in fixed
assets
– Financing activities-includes changes in notes
payable, long-term debt and equity accounts
as well as dividends.
 Statement of Cash Flows
• Operating activities
+ Net profit
+ Depreciation
+ Any decrease in current assets (except cash)
+ Increase in accounts payable
– Any increase in current assets (except cash)
– Decrease in accounts payable
• Investment activities
+ Ending fixed assets
– Beginning fixed assets
+ Depreciation
• Financing activities
– Decrease in notes payable
+ Increase in notes payable
– Decrease in long-term debt
+ Increase in long-term debt
+ Increase in ordinary shares
– Dividends paid
Cash Flow Summary – Table 6.3

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Ratio Analysis
• Financial ratios are relationships
determined from a firm’s financial
information.
• Used to compare and investigate
relationships between different pieces of
financial information, either over time or
between companies.
• Ratios eliminate the size problem.
 Categories of Financial Ratios
• Liquidity-measures the firm’s short-term
solvency.
• Capital structure-measures the firm’s ability to
meet long-run obligations (financial leverage).
• Asset management (turnover)-measures the
efficiency of asset usage to generate sales.
• Profitability-measures the firm’s ability to
control expenses.
• Market value-per-share ratios.
 Liquidity Ratios

Current assets
Current ratio 
Current liabilities

Current assets  Inventory

Quick ratio 
Current liabilities
 Capital Structure Ratios

Total assets  Total equity

Total debt ratio 
Total assets
Total debt
Debt/equity ratio 
Total equity
Total assets
Equity multiplier 
Total equity
EBIT
Net interest cover 
Interest  finance charges
Interest - bearing debt
Debt to gross cash flow 
Net profit after tax  depreciation  amortisation
 Turnover Ratios
Cost of goods sold
Inventory turnover =
Inventory

365 days
Days' sales in inventory =
Inventory turnover

Sales
Receivables turnover =
Accounts receivable
Turnover Ratios (cont’ed)
365 days
Days' sales in receivables 
Receivables turnover

Sales
Fixed asset turnover 
Non - current assets

Sales
Total asset turnover 
Total assets
 Profitability Ratios
Net income
Profit margin 
Sales

Net income
Return on assets (ROA)   100%
Total assets

EBIT
Return on investment   100%
Total assets

Net income
Return on equity (ROE)   100%
Total equity
 Market Value Ratios

Price per share

Price/earning ratio 
Earnings per share

Market val ue per share

Market - to - book ratio 
Book value per share
 The Du Pont Identity
• Breaks ROE into three parts:
– operating efficiency
– asset use efficiency
– financial leverage

Net income Sales Assets

ROE   
Sales Assets Equity

 Profit margin  Total asset turnover  Equity multiplier

 ROA  Equity multiplier

 The DuPont Formulas
• The DuPont formula uses the
Return on Equity
relationship among financial
statement accounts to decompose a
return into components.
• Three-factor DuPont for the return Net Profit Total Asset Financial
on equity: Margin Turnover Leverage
– Total asset turnover
– Financial leverage
– Net profit margin Operating Profit
• Five-factor DuPont for the return on Margin
equity:
– Total asset turnover
– Financial leverage
Effect of Nonoperating
– Operating profit margin
Items
– Effect of nonoperating items
– Tax effect

Tax
Effect
Five-Component DuPont Model
Example: The DuPont Formula
Suppose that an analyst has noticed that the return on equity of
the D Company has declined from FY2012 to FY2013. Using
the DuPont formula, explain the source of this decline.

(millions) 2013 2012

Revenues $1,000 $900
Earnings before interest and taxes $400 $380
Interest expense $30 $30
Taxes $100 $90

Total assets $2,000 $2,000

Shareholders’ equity $1,250 $1,000
 2013 2012
Return on equity 0.20 0.22
Return on assets 0.13 0.11

Financial leverage 1.60 2.00

Total asset turnover 0.50 0.45
Net profit margin 0.25 0.24
Operating profit margin 0.40 0.42

Effect of nonoperating items 0.83 0.82

Tax effect 0.76 0.71
Benchmarks for Comparison
• Ratios are most useful when compared to
a benchmark.
• Time-trend analysis-examine how a
particular ratio(s) has performed
historically.
• Peer group analysis-using similar firms
(competitors) for comparison of results.
Problems with Ratio Analysis
• No underlying theory to identify correct
ratios to use or appropriate benchmarks.
• Benchmarking is difficult for diversified
firms.
• Firms may use different accounting
procedures.
• Firms may have different recording periods.
• One-off events can severely affect financial
performance.
 Ethics Issues
• Why is manipulation of financial
statements not only unethical and illegal,
but also bad for stockholders?

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