A Framework for Financial

Statement Analysis

Chapter 11
Why Financial Statements
Are Analyzed
• In order for financial information to be
useful, it must be interpreted.
Why Financial Statements
Are Analyzed
• A comprehensive set of ratios allows
the user to make sense of all the
financial information reported in the
financial statements.
Users of Financial
Information
• Users of financial information may be
current or future users.
Users of Financial
Information
• Some of the users of financial
information are the following:

– Investors – Government
– Managers regulators
– Customers – Employee unions
– Potential suppliers – Public interest and
and creditors community groups
Sources of Financial
Information
• The major source of financial
information is a firm's annual report.
The following are elements
of most annual reports:
• Management discussion and analysis
• Independent auditor's report
• Primary financial statements
• Secondary financial statements
• Notes to the financial statements
Other Sources of
Information
• Reports filed with regulatory agencies
(special, quarterly, and annual)
• Business periodicals (magazines,
newspapers, newsletters)
• Investment advisory services
(Standard & Poor, Moody's, etc.)
Basis of Comparison
• When analyzing financial reports, one
of the first decisions is to identify the
basis of comparison.
Data may be compared with
the following:
• The firm's own data from prior years
• Data from another firm in the same
industry
• Data from another firm in which the
analyst may invest
• Industry averages
• Benchmarks or targets
Restatements May Be
Necessary
• The statements may need to be
restated when significant unusual
events have occurred which would
distort comparisons.
Restatements May Be
Necessary
• Such events include, among others,
mergers or acquisitions, discontinued
operations, changes in accounting
principles, and extraordinary items.
More Comparability Is
Better
• Comparability is enhanced when
firms' size, capital structure, and
product mix are similar.
A summary of the steps:
• Identify the purpose and objectives of
analysis.
A summary of the steps:
• Review the financial statements, notes,
and audit opinion to identify any
unusual events or characteristics and
to become familiar with the nature of
the firm’s operation.
A summary of the steps:
• Determine whether any restatements
due to mergers, discontinued
operations, etc., are necessary to
enhance comparability of the firm’s
financial statements.
A summary of the steps:
• Determine whether the firm’s size,
capital structure, and product mix are
sufficiently comparable (between
firms or time periods) to proceed with
the ratio calculations.
Financial Statement Analysis
Ratios & Framework
• The analyst usually performs
horizontal and vertical analyses of the
financial statements.
Financial Statement Analysis
Ratios & Framework
• Horizontal analysis focuses on
changes or growth, year to year, for
each major element on the income
statement and the balance sheet.
Financial Statement Analysis
Ratios & Framework
• Vertical analysis examines the
percentage composition of the income
statement and the balance sheet: It
uses common-size financial statements
for this analysis.
Categories of Financial
Ratios
• Ratios are usually grouped into broad
categories.
Categories of Financial
Ratios
• Four widely used major headings are
liquidity, profitability, capital
structure, and investor.
Liquidity Ratios
• Liquidity ratios indicate the short-
term solvency of the firm.
Liquidity Ratios
• They also indicate how effectively the
firm is managing its working capital.
Liquidity Ratios
• The following are commonly used
liquidity ratios:

Current assets
Current ratio =
Current liabilities
Liquidity Ratios
• The following are commonly used
liquidity ratios:

Quick ratio =
Cash + Cash equivalents + Accounts receivable
Current liabilities
Liquidity Ratios
• The following are commonly used
liquidity ratios:

Sales revenue
Average sales per day =
365
Liquidity Ratios
• The following are commonly used
liquidity ratios:

Cost of goods sold

Cost of goods sold per day =
365
Liquidity Ratios
• The following are commonly used
liquidity ratios:

Number of days' sales in ending inventory =

Ending inventory
Cost of goods sold per day
Profitability Ratios
• Profitability ratios measure how
profitable a firm is.
Profitability Ratios
• This is very important for investors
who want to invest in a firm which
can return their investment to them.
Profitability Ratios
• The following are commonly used
profitability ratios:

Gross profit
Gross profit percentage =
Net sales revenue
Profitability Ratios
• The following are commonly used
profitability ratios:

Operating income percentage =

Operating income +
Extraordinary losses - unusual gains
Sales revenue
Profitability Ratios
• The following are commonly used
profitability ratios:

Net income
Return on equity =
Average shareholders' equity
Profitability Ratios
• The following are commonly used
profitability ratios:

Return on assets =
Net income +
(Interest expense  [1 - Tax rate])
Sales revenue
Profitability Ratios
• The following are commonly used
profitability ratios:

Cash return on assets =

Cash flow from operating activities +
interest paid
Average total assets
Profitability Ratios
• The following are commonly used
profitability ratios:

Quality of income =
Cash flow from operating activities
Net income
Capital Structure Ratios
• Capital structure ratios help in
assessing a firm's strategies for
financing its assets.
Capital Structure Ratios
• Capital structure indicates the relative
amounts of debt and equity capital.
Capital Structure Ratios
• Percentage composition analysis is
the starting point for any analysis of
capital structure.
Capital Structure Ratios
• Percentage composition analysis
describes the relative amounts of
capital obtained from each major
source of financing.
Capital Structure Ratios
• Current liabilities, long-term debt,
deferred taxes and other similar
liabilities, and shareholders' equity all
will be divided by the total of total
liabilities and shareholders' equity.
Capital Structure Ratios
• Percentage composition analysis is the
starting point for any analysis of
capital structure.

Current liabilities
Percentage composition =
Total liabilities +
Shareholders equity
Capital Structure Ratios
• Percentage composition analysis is the
starting point for any analysis of
capital structure.

Long term debt

Percentage composition =
Total liabilities +
Shareholders equity
Capital Structure Ratios
• Percentage composition analysis is the
starting point for any analysis of
capital structure.

Deferred taxes +
Other similar liabilities
Percentage composition =
Total liabilities +
Shareholders equity
Capital Structure Ratios
• Percentage composition analysis is the
starting point for any analysis of
capital structure.

Shareholders' equity
Percentage composition =
Total liabilities +
Shareholders equity
Capital Structure Ratios
• The following capital structure ratios
are also computed:

Total liabilities
Financial leverage =
Total assets
Capital Structure Ratios
• The following capital structure ratios
are also computed:

Times interest earned =

Earnings before interest and Taxes
Interest expense
Investor Ratios
• Investor ratios all relate to an external
dimension of ownership interest.
• Most indicate how a firm is
performing with regard to the market
value of its shares.
Investor Ratios
• The following are commonly used
investor ratios:

Net income
Earnings per share =
Weighted average number
of shares outstanding
Investor Ratios
• The following are commonly used
investor ratios:

Market price per share

Market to book value =
Book value per share
Investor Ratios
• The following are commonly used
investor ratios:

Market price per share

Price to earnings =
Earnings per share
Financial Statement
Analysis Framework
• The financial statement analysis
framework includes the following
steps.
Financial Statement
Analysis Framework
• Identify the purpose and objectives of
the analysis.
Financial Statement
Analysis Framework
• Review the financial statements, notes
and audit opinion.
Financial Statement
Analysis Framework
• Determine whether restatements are
necessary to enhance the
comparability of the statements.
Financial Statement
Analysis Framework
• Determine whether the firm's size,
capital structure, and product mix are
appropriate to proceed with the ratio
calculations.
Financial Statement
Analysis Framework
• Conduct horizontal and vertical
analyses of each financial statement,
with special emphasis on the income
statement.
Financial Statement
Analysis Framework
• Calculate the basic liquidity ratios.
Financial Statement
Analysis Framework
• Calculate profitability ratios based on
net income and on cash flow from
operating activities. Evaluate trends.
Financial Statement
Analysis Framework
• Evaluate the firm's capital structure
with special emphasis on trends in the
percentage composition ratios.
Financial Statement
Analysis Framework
• Examine the firm's market
performance using the investor ratios.
Financial Statement
Analysis Framework
• Examine any inconsistencies in the
ratio results, review notes, and
recalculate the ratios.
Limitations of Financial
Statement Analyses
• Financial statement analysis is limited
due to several items.
Limitations of Financial
Statement Analyses
• GAAP presents some limits.
Limitations of Financial
Statement Analyses
• GAAP presents some limits.
• Managers often have the ability to
select favorable accounting methods.
Limitations of Financial
Statement Analyses
• Many major factors affecting
profitability and survival of the firm
are not included in the financial
statements.
Limitations of Financial
Statement Analyses
• Many major factors affecting
profitability and survival of the firm
are not included in the financial
statements.
– A perfect example is human resources.
Limitations of Financial
Statement Analyses
• Many major factors affecting
profitability and survival of the firm
are not included in the financial
statements.
– While employees are often a firm's most
important asset, a value for employees
does not appear on the balance sheet.
Limitations of Financial
Statement Analyses
• "Real" events are often hard to
distinguish from the effects of
alternative accounting methods or
principles.
Limitations of Financial
Statement Analyses
• Financial statement analysis relies on
past numbers, and the past may not be
a reliable indication of the future.
A Framework for Financial
Statement Analysis

End of Chapter 11