ANALYSIS OF

FINANCIAL
STATEMENTS
Principles of Managerial Finance
Gitman, Lawrence J._ Zutter, Chad J.
What are Financial Statements?

 Financial statements are formal records that provide a

summary of a company’s financial performance, position,
and cash flows over a specific period.

 They are essential tools for stakeholders, such as investors,

creditors, and management, to assess the company’s
financial health and make informed decisions.
THE FOUR KEY FINANCIAL STATEMENTS

 INCOME STATEMENT
 BALANCE SHEET
 STATEMENT OF STOCKHOLDERS’ EQUITY
 STATEMENT OF CASH FLOWS
THE FOUR KEY FINANCIAL
STATEMENTS ( Income Statement )

 Providea financial summary of the firm’s

operating results during a specific period.
BARTLETT COMPANY
INCOME STATEMENT
Balance Sheet

 Summary statement of the firm’s financial

position at a given point in time.
BARTLETT COMPANY
BALANCE SHEETS
Examples of Accounts in
Balance Sheet
 In Assets :  In Liabilities :
 CASH  ACCOUNTS PAYABLE
 ACCOUNTS RECEIVABLE  NOTES PAYABLE
 MARKETABLE SECURITIES  ACCRUALS
 INVENTORY  Long – Term debt
 Accumulated Depreciation
 Equipment
 Property
Statement of Retained Earnings

 Itis the abbreviated form of “Statement of

Stockholders‘ equity”

 Reconciles the net income earned during a given

year, and any cash dividends paid, with the change
in retained earnings between the start and the end of
that year.
BARTLETT COMPANY STATEMENT OF RETAINED EARNINGS
STATEMENT OF CASH FLOWS

 Providesa summary of the firm’s operating,

investment and financing cash flows and
reconciles them with changes in its cash and
marketable securities during the period.
BARTLETT COMPANY
STATEMENT OF CASH
FLOWS
NOTES TO THE FINANCIAL
STATEMENTS

• Explanatory notes are extra details in financial

statements that explain how the numbers were
calculated, the rules followed, and provide important
information about the company’s financial activities.
 Summary of the purposes of each of the four
major financial statements.

 The income statement shows profitability by detailing revenues and

expenses over a period
 The balance sheet provides a snapshot of the company’s financial
position by listing assets, liabilities, and equity at a specific date
 The statement of retained earnings explains changes in retained
earnings by outlining profits retained in the business after dividends,
and ;
 The statement of cash flows summarizes cash inflows and outflows
from operating, investing, and financing activities to assess liquidity
and cash management.
Why are the notes to the financial
statements important to professional
securities analysts?

 Becauseit helps the analysts accurately assess the

company’s financial health, risks, and long-term
performance and to avoid mistakes in making financial
statements that could possibly lead to a bigger problem.
USING FINANCIAL
RATIOS
WHAT IS RATIO?

 Inbusiness, a RATIO is a numerical

comparison between two related values. It
helps assess the relationship between different
financial or operational aspects of a company.
RATIO ANALYSIS

 Involves methods of calculating and interpreting financial ratios

to analyze and monitor the firm’s performance.

 INTERESTED PARTIES :
1. Current & Prospective Shareholders
2. Creditors
3. Firm‘s own Management
TYPES OF RATIO
COMPARISONS
CROSS – SECTIONAL ANALYSIS

 Comparison of different firms‘ financial ratios

at the same point of time; involves comparing
the firm’s ratios with those of other firms in its
industry or with industry averages.
Type of C.S.A : BENCHMARKING

 A type of cross – sectional analysis in which

the firm’s ratio values are compared with those
of a key competitors that it wishes to imitate.
TIME – SERIES ANALYSIS

 Evaluationof the firm’s financial performance over time

using financial ratio analysis.

 EXAMPLE : Amazon stock may have upward trends

around major sales events (ex. Prime Day or Black Friday),
giving stockholders an opportunity to plan their investment
strategy based on these recurring patterns.
COMBINED ANALYSIS

 The most useful way to do ratio analysis is by combining cross-

sectional and time – series analysis. This lets you see how a
company’s ratios change over time and compare them to the
overall industry trend.

 By doing both, you can better understand how the company is

performing compared to others in the industry.
Summary

 Cross-sectional analysis compares a company’s performance

with other companies at the same point in time.
 Time-series analysis looks at a company’s performance over
a period of time to spot trends.
 Benchmarking is comparing a company’s performance
against the best in the industry to set goals and improve.
 EXAMPLES

 Cross-sectional analysis: A company like Coca-Cola might compare

its profitability ratio (e.g., profit margin) with that of Pepsi in the same
year to see how well it performed relative to its competitor.
 Time-series analysis: Apple could track its revenue growth over the
past five years to see how sales have changed year by year. This
helps them identify trends like steady growth or seasonal spikes.
 Benchmarking: A company like Nike might benchmark its customer
service performance against industry leaders like Amazon, using
Amazon’s practices as a standard to improve its own service quality.
CAUTIONS ABOUT USING RATIO
ANALYSIS
1. Ratio that reveal large deviations from the norm merely indicate
the possibility of a problem. Additional analysis is typically needed to
determine whether there is a problem and to isolate the causes of
the problem.

2. The single ratio does not generally provide sufficient information

from which to judge the overall performance of the firm. However, if
an analysis is concerned only with the specific aspects of a firm’s
financial position, one or two ratios may suffice.
3. The ratios being compared should be calculated using
financial statements dated at the same point in time during the
year. If they are not, the effects of seasonality may product
erroneous conclusions and decisions

4. It is preferable to use audited financial statements for ratio

analysis. If they have not been audited, the data in them may
not reflect the firm’s true financial condition.
5. The financial data being compared should have been developed in the same
way. The use of differing accounting treatments especially relative to inventory
and depreciation can distort the result of ratio comparisons, regardless of
whether cross – sectional or time – series analysis is used.

6. Results can be distorted by inflation, which can cause the book values of
inventory and depreciable assets to differ greatly from their replacement
values. Inventory costs and depreciation write – offs can differ from their true
values, thereby distorting profits. Without adjustment, inflation tends to cause
older assets to appear more efficient and profitable than newer assets. Clearly,
in using ratios, you must be careful when comparing older with new assets or
comparing an asset to itself over a long period of time.
In financial ratio analysis, how do the viewpoints
held by the firm’s present and prospective
shareholders, creditors, and management differ?

 Current shareholders want to see strong returns on their investment.

 Prospective shareholders look for future growth and profits.
 Creditors focus on the company’s ability to repay loans while;
 Management is concerned with overall performance and efficiency to keep the
business running smoothly.

Each group has different priorities, but all are interested in the company’s financial
health.
Why is it preferable to compare ratios
calculated using financial statements that are
dated at the same point in time during the
year?
 It is preferable to compare ratios from financial statements at
the same time of year because companies can have seasonal
changes in sales, expenses, or operations. Comparing at the
same point ensures you get a fair and accurate comparison.
LIQUIDITY
RATIOS
WHAT IS LIQUIDITY?

A firm’s ability to satisfy its SHORT – TERM

obligations as they come due.
 CURRENT RATIO
 A measure of liquidity calculated by dividing the firm’s current
assets by its current liabilities
 It measures the firm’s ability to meet it’s short term obligations.

 Current Ratio = CURRENT ASSETS ÷ CURRENT LIABILITIES

Answers below 1.00 = BAD
Answers above 1.00 = GOOD
If 1.00 = not bad, stable but there’s no safety net if
something unexpected happens
QUICK (Acid – Test) RATIO

 Similar to the current ratio except that it excludes inventory,

which is the least liquid current asset.
 Inventory is the least liquid current asset because it takes time to sell.
Unlike cash or receivables, inventory needs to be sold and possibly
converted into cash, which can take longer. It’s not immediately ready to
use for payments.
QUICK (Acid – Test) RATIO

 BELOW 1.00 = BAD

 ABOVE 1.00 = GOOD
Under what circumstances would the current ratio
be the preferred measure of overall firm liquidity?
Under what circumstances would the quick ratio be
preferred?

• The current ratio is preferred when inventory can be quickly sold,

such as in retail, and you want a broad look at all current assets.

• The quick ratio is preferred when you need a stricter view of

liquidity, focusing only on easily liquid assets like cash and
receivables, especially if inventory is harder to sell or takes longer
to turn over.
ACTIVITY
RATIOS
ACTIVITY RATIO

 Activity ratios measure how efficiently a company uses its

assets to generate sales or revenue. They show how well
the business is managing things like inventory or
receivables to keep operations running smoothly.
INVENTORY TURNOVER

 Measures the activity, liquidity, of a firm’s inventory.

 Inventory Turnover = Cost of good sold ÷ Inventory

 AVERAGE AGE OF INVENTORY

 Average number of days’ sales in inventory.
 (365 ÷ Answer in I.T)
AVERAGE COLLECTION PERIOD
 The average amount of time needed to collect accounts
receivable.
AVERAGE PAYMENT PERIOD
 The average amount of time needed to pay accounts payable.
TOTAL ASSET TURNOVER
 Indicates the efficiency with which the firm uses its assets to
generate sales.
To assess the firm’s average collection period
and average payment period ratios, what
additional information is needed, and why?
• To assess the average collection period, you need credit sales and
average accounts receivable.

• For the average payment period, you need credit purchases and
average accounts payable.

• This information helps calculate how long the firm takes to collect
payments from customers and how long it takes to pay its suppliers.
DEBT
RATIOS
 The debt ratio measures a company's financial risk by
showing the percentage of its assets financed by debt.

• Debt can finance a business because companies often borrow money

(debt) to fund their operations, growth, or investment needs.

• This allows them to use borrowed funds to acquire assets, such as

equipment or inventory, or cover expenses without immediately using their
own cash. The business repays the debt over time, typically with interest.

• So, a portion of the company's assets is financed through loans or credit

rather than from the owners' equity or cash reserves.
 In general, the more debt a firm uses in relation to its
total assets, the greater its financial leverage

 Financial Leverage – the magnification of risk and

return through the use of fixed – cost financing, such
as debt and preferred stock.

• It means a company takes on more risk by borrowing money or using preferred

stock, because it has to pay back the loan or give dividends no matter what. If
the company makes a lot of profit, the returns to the owners can be bigger. But if
the company doesn't do well, it still has to pay, making it riskier.
DEBT OF INDEBTEDNESS
 Measures the amount of debt relative to other significant
balance sheet amounts.

• It shows how much debt a company has compared to

things like its assets or equity. This helps understand if
the company relies heavily on borrowing money to fund
its operations or if it uses its own resources.
ABILITY TO SERVICE DEBTS
 Theability of a firm to make the payments required
on a scheduled basis over the life of a debt.

COVERAGE RATIOS
 Ratiosthat measure the firm’s ability to pay certain
fixed charges.
DEBT RATIO
 Measures the proportion of total assets financed by the firm’s
creditors. The higher this ratio, the greater the amount of other
people’s money being used to generate profits.
 DEBT – TO – EQUITY RATIO
 Measures the relative proportion of total liabilities and
common stock equity used to finance the firm’s total assets.

The debt-to-equity ratio shows how much a company is borrowing (debt)

compared to the money invested by its owners (equity). A higher ratio
means the company is using more borrowed money than its own to fund
the business, which can increase risk.
TIME INTEREST EARNED RATIO
 Measure the firm’s ability to make contractual interest
payments ; sometimes called the interest coverage ratio.

The time interest earned ratio shows how easily a company can
pay its interest on debt. A higher ratio means the company makes
enough money to cover its interest payments comfortably.
FIXED – PAYMENT COVERAGE
RATIO
 Measures the firm’s ability to meet all fixed – payment obligations.
FIXED – PAYMENT COVERAGE
RATIO

 The fixed payment coverage ratio measures how well a company

can pay its fixed financial obligations, like interest and lease
payments, using its earnings. A higher ratio means the company
is in a better position to meet its fixed payment obligations.
What is financial leverage?

• Financial leverage is the use of borrowed money (debt) to increase

the potential return on investment. It means a company uses loans or
other forms of debt to fund its operations or investments, hoping to
earn more from those investments than it pays in interest on the debt.
If successful, this can lead to higher profits, but it also increases risk
because the company must repay the borrowed money regardless of
its financial performance.
What is financial leverage?

 Financial leverage is like borrowing money to invest in something

with the hope of making a profit. For example, if you borrow money
from a friend to buy and sell bicycles, you can buy more bikes than
you could with just your own money. If you sell the bikes for a profit,
you can pay back your friend and keep the extra money. However,
if you can’t sell the bikes for enough money, you still have to repay
your friend, which makes it riskier. So, using borrowed money can
help you make more money, but it also increases your financial risk.
In summary, what ratio measures the firm’s
degree of indebtedness? What ratios assess
the firm’s ability to service debts?
• The debt ratio measures how much a company owes compared to its
assets, showing its level of indebtedness. To assess how well a company
can pay its debts, you can look at the interest coverage ratio, which
compares earnings to interest expenses, and the fixed payment
coverage ratio, which looks at how easily the company can cover all its
fixed payments, like interest and lease payments, with its earnings.
PROFITABILITY
RATIOS
 A profitability ratio measures how much profit a company
makes relative to its revenue, assets, or equity. It helps assess
the company's ability to generate earnings and is useful for
comparing performance over time or against other companies.

 A useful tool for evaluating profitability in relation to sales is the

common – size income statement.
COMMON – SIZE INCOME
STATEMENT

 An income statement which each item is

expressed as a percentage of sales.
GROSS PROFIT MARGIN
 Gross profit margin shows how much money a company keeps from its
sales after covering the cost of making the product.
 A higher margin means the company is making more profit from each sale.
OPERATING PROFIT MARGIN
 Operating profit margin shows how much profit a company makes
from its core business activities after covering operating costs, like
rent and salaries, but before paying interest and taxes.
 A higher margin means the company is more efficient at making
profit from its operations.
NET PROFIT MARGIN
 Net profit margin shows how much profit a company keeps from its
total sales after all expenses, including operating costs, interest,
and taxes, are paid.
 A higher net profit margin means the company is keeping more of
its sales as profit.
EARNINGS PER SHARE (EPS)
 Earnings per share (EPS) is a measure of how much profit a
company makes for each share of its stock.
 A higher EPS means the company is making more money per
share, which is good for investors.
RETURN ON TOTAL ASSETS
 Return on Total Assets (ROA) or also called return on investment (ROI)
shows how efficiently a company uses its assets to generate profit.
 A higher ROA means the company is better at using its assets to make
money.
RETURN ON EQUITY (ROE)
 Return on Equity (ROE) shows how much profit a company
makes with the money invested by its shareholders.
 A higher ROE means the company is using its investors'
money more effectively to generate profits.
What three ratios of profitability are found in
common–size income statement?

• In a common-size income statement, you’ll find the

gross profit margin, which shows how much of the
sales revenue is left after covering the cost of goods
sold.
• There’s also the operating profit margin, which tells
you what percentage of sales is left after paying for
operating expenses.
• Finally, the net profit margin shows how much of the
sales revenue is kept as profit after all expenses,
including taxes and interest, are paid.
What would explain a firm’s having a high
gross profit margin and a low net profit
margin?

• A company might have a high gross profit margin but a

low net profit margin if it spends a lot on things like
rent, salaries, or debt payments. Even though it
makes good money from its sales after paying for the
products, these extra costs lower the profit it keeps in
the end.
Which measure of profitability is probably of
greatest interest to the investing public?
Why?

• Investors are most interested in earnings per share

(EPS) because it tells them how much profit the
company makes for each share they own. It helps
them see if the company is making good money and if
their investment is growing.
MARKET
RATIOS
 Market ratios help investors understand how the stock
market values a company. They compare things like the
company’s stock price to its earnings or book value. These
ratios give an idea of whether the company’s stock is priced
fairly, too high, or too low based on its financial performance.
What is BOOK VALUE?
 Book value is essentially what a company is worth based
on its financial statements. It's calculated by taking the total
value of everything the company owns (assets) and
subtracting what it owes (liabilities).

 In simple terms, it’s like saying if a company sold all its stuff
and paid off all its debts, the book value would be the
amount of money left over for the owners or shareholders.
PRICE / EARNINGS (P/E) RATIO
 The price/earnings (P/E) ratio is a way to see how much investors
are willing to pay for each dollar of a company’s earnings.

 A high P/E ratio might suggest that investors expect future

growth, while a low P/E ratio might indicate that the stock is
undervalued or the company is facing challenges.
MARKET / BOOK (M/B) RATIO

 The market/book ratio compares a company’s current stock price

(its market value) to its book value (the value of its assets minus
liabilities as reported on its financial statements). This ratio helps
investors understand how the stock is valued relative to the
company’s actual worth.

 A high market/book ratio suggests that investors believe the

company will grow and is worth more than its assets on paper,
while a low ratio may indicate the stock is undervalued.
CALCULATE FIRM’S M/B RATIO
 1. Find the book value per share of common stock
• it's the amount of money each shareholder would get if
the company sold all its assets and settled all its debts.
CALCULATE THE FIRM’S M/B RATIO
 2. After calculating book value per share of common stock,
proceed to m/b ratio
How do the price / earnings (P/E) ratio and
the market / book (M/B) ratio provide a feel
for the firm’s return and risk?

• These ratios help investors gauge market

expectations and perceived risk levels, giving a
sense of whether the firm is seen as a solid
investment opportunity or a risky bet.
TWO POPULAR APPROACHES TO A
COMPLETE RATIO ANALYSIS
 1. SUMMARIZING ALL RATIOS
This approach tends to view all aspects of the firm’s financial
activities to isolate key areas of responsibility.

 2. DuPont System of Analysis

This approach acts as a search technique aimed at finding the key
areas responsible for the firm financial condition.
SUMMARIZING ALL RATIOS
(Bartlett Company Ratios)
DuPont Formula
 When you multiply the net profit margin by the total asset turnover, you
get the Return on Assets (ROA). This tells you how well a company is
using its assets to generate profit.

 In simple terms, the DuPont formula for ROA explains that a company's
ability to generate profit from its assets can be improved by either
increasing the profit it makes on each sale (net profit margin) or by
using its assets more effectively to generate more sales (total asset
turnover).

 A value below 5% is commonly viewed as low, especially when

compared to industry averages and competitors.
Modified DuPont Formula
FINANCIAL LEVERAGE MULTIPLIER
 FLM shows how much of the company’s assets are financed by debt
(borrowed money) compared to equity (owners’ money).

 FLM = TOTAL ASSETS / TOTAL EQUITY

 A higher FLM means more borrowing, which can be risky, while a lower
FLM means less borrowing.
Difference of DuPont Formula and
Modified DuPont Formula

 the DuPont formula focuses on profitability and

efficiency in generating sales ;

 while the modified DuPont formula includes the effect

of financial leverage, providing a fuller picture of how
both operations and financing impact ROE.
Financial ratio analysis is often divided into five areas :
liquidity, activity, debt, profitability, and market ratios.
Differentiate each of those areas of analysis from the
others. Which is the greatest concern to creditors?
• Liquidity Ratios: These show if a company can pay its short-term bills, like rent or
salaries, using current assets like cash.
• Activity Ratios: These measure how efficiently a company uses its assets, like how
quickly it sells inventory or collects money from customers.
• Debt Ratios: These indicate how much of a company’s assets are financed by
borrowing versus owner investment. It shows the level of financial risk.
• Profitability Ratios: These reveal how well a company generates profit from its sales or
operations.
• Market Ratios: These assess a company’s stock performance, like the price investors
are willing to pay for its earnings or book value.
• Creditors are most concerned with liquidity and debt ratios because they want to
ensure the company can pay back its loans and manage its debt responsibly.
“An investment in knowledge pays
the best interest”

- Benjamin Franklin