Financial Statement and Ratio Analysis
Introduction:
The annual stockholders’ report, which publicly owned corporations must
provide to stockholders, documents the firm’s financial activities of the past
year. It includes the letter to stockholders and various subjective and factual
information. It also contains four key financial statements: the income
statement, the balance sheet, the statement of stockholders’ equity (or its
abbreviated form, the statement of retained earnings), and the statement of
cash flows. Notes describing the technical aspects of the financial statements
follow. Financial statements of companies that have operations whose cash
flows are denominated in one or more foreign currencies must be translated
into dollars in accordance with FASB Standard No. 52.
Interested Parties:
Ratio analysis involves methods of calculating and interpreting
financial ratios to analyze and monitor the firm’s financial performance.
• Current and prospective shareholders are interested in the firm’s current
and future level of risk and return, which directly affect share price.
• Creditors are interested in the short-term liquidity of the company and
its ability to make interest and principal payments.
• Management is concerned with all aspects of the firm’s financial
situation, and it attempts to produce financial ratios that will be
considered favorable by both owners and creditors.
Types of Ratio Comparisons
• Cross-sectional analysis is the comparison of different firms’ financial
ratios at the same point in time; involves comparing the firm’s ratios to
those of other firms in its industry or to industry averages
• Benchmarking is a type of cross-sectional analysis in which the firm’s
ratio values are compared to those of a key competitor or group of
competitors that it wishes to emulate.
• Time-series analysis is the evaluation of the firm’s financial performance
over time using financial ratio analysis.
1
• Comparison of current to past performance, using ratios, enables
analysts to assess the firm’s progress.
• Developing trends can be seen by using multiyear comparisons.
• The most informative approach to ratio analysis combines cross-
sectional and time-series analyses.
Cautions about Using Ratio Analysis
• Ratios that reveal large deviations from the norm merely indicate the
possibility of a problem.
• A single ratio does not generally provide sufficient information from
which to judge the overall performance of the firm.
• The ratios being compared should be calculated using financial
statements dated at the same point in time during the year.
• It is preferable to use audited financial statements.
• The financial data being compared should have been developed in the
same way.
• Results can be distorted by inflation.
Types of Ratios:
Ratios to analyze a firm’s liquidity and activity.
• Liquidity, or the ability of the firm to pay its bills as they come due, can
be measured by the current ratio and the quick (acid-test) ratio.
• NB: Large enterprises generally have well established relationships with
banks that can provide lines of credit and other short-term loan products
in the event that the firm has a need for liquidity. Smaller firms may not
have the same access to credit, and therefore they tend to operate with
more liquidity.
• Activity ratios measure the speed with which accounts are converted into
sales or cash—inflows or outflows. The activity of inventory can be
measured by its turnover, that of accounts receivable by the average
collection period and that of accounts payable by the average payment
period. Total asset turnover measures the efficiency with which the firm
uses its assets to generate sales.
Ratios to analyze a firm’s debt.
• The more debt a firm uses, the greater its financial leverage, which
magnifies both risk and return. A common measure of indebtedness is
2
the debt ratio. The ability to pay fixed charges can be measured by times
interest earned and fixed-payment coverage ratios.
Ratios to analyze a firm’s profitability and its market value.
• The common-size income statement, which shows all items as a
percentage of sales, can be used to determine gross profit margin,
operating profit margin, and net profit margin. Other measures of
profitability include earnings per share, return on total assets, and return
on common equity. Market ratios include the price/earnings
ratio and the market/book ratio.
DuPont System of Analysis
A summary of all ratios can be used to perform a complete ratio analysis using
cross-sectional and time-series analysis. The DuPont system of analysis is a
diagnostic tool used to find the key areas responsible for the firm’s financial
performance. It enables the firm to break the return on common equity into
three components: profit on sales, efficiency of asset use, and use of financial
leverage.
• The DuPont system of analysis is used to dissect the firm’s financial
statements and to assess its financial condition.
• It merges the income statement and balance sheet into two summary
measures of profitability.
• The Modified DuPont Formula relates the firm’s ROA to its ROE using the
financial leverage multiplier (FLM), which is the ratio of total assets to
common stock equity:
• ROA and ROE as shown in the series of equations as shown below.
• The DuPont system first brings together the net profit margin, which
measures the firm’s profitability on sales, with its total asset turnover,
which indicates how efficiently the firm has used its assets to generate
sales.
ROA = Net profit margin Total asset turnover
• Substituting the appropriate formulas into the equation and simplifying
results in the formula given earlier
3
Modified DuPont Formula
• The modified DuPont Formula relates the firm’s return on total assets to
its return on common equity. The latter is calculated by multiplying the
return on total assets (ROA) by the financial leverage multiplier (FLM),
which is the ratio of total assets to common stock equity:
ROE = ROA FLM
• Substituting the appropriate formulas into the equation and simplifying
results in the formula given earlier
