Financial Statement Analysis

Chapter 13
 Chapter Outline

 Applications to people within and

outside the firm
 Analyzing financial performance
 Financial ratios
 Vertical analysis
 Horizontal analysis
 Trend analysis
 Comparative analysis
APPLICATIONS TO PEOPLE WITHIN
& OUTSIDE THE FIRM
 Financial statement analysis identifies significant
trends or relationships among the items
contained in the financial statements.
 Internal users: Management can identify
activities that have contributed to the success of
the firm and identify problems.
 External users: Trends in financial performance
are indicators of the firm’s future. Investors and
lenders look to see if the trends are positive or
negative.
ANALYZING FINANCIAL PERFORMANCE
 Measuring financial performance begins with the
information provided directly on the financial
statements.
 Example, the income statement answers the question:
How much did the firm earn or lose from operations
during the period?
 Further information is acquired by comparing
amounts within the statements, across years, and
with industry averages.
 Several techniques for analyzing financial
performance are available.
 FINANCIAL RATIOS

 A financial ratio is the relationship of one

number on the financial statements to another
number.
 To evaluate any financial ratio, a comparison
should be made to one or more past years,
industry averages, and key competitors.
 Categories of financial ratios

 Liquidity Ratios - Measure firm’s ability to pay

short-term debts.
 Profitability Ratios - Measure firm’s ability to
earn a satisfactory net income.
 Long-Term Solvency Ratios - Measure firm’s
ability to pay long-term debt.
 Stock Performance Ratios - Measure firm’s
ability to attract investors.
 Liquidity Ratios

 Liquidity ratios indicate the firm’s ability to

obtain cash and thereby pay short-term
liabilities.
 These liquidity ratios will be discussed:
1. Current ratio
2. Acid-test ratio
3. Receivable turnover
4. Inventory turnover
 Current ratio

 The most frequently used liquidity ratio is the

current ratio.
 Current ratio shows the firm’s ability to pay its
current liabilities out of its current assets.
 Calculation:
Current Assets
Current Ratio =
Current Liabilities
 Current ratio
Example:
 Ford Motor’s current ratios: 1.12 in 20Y3

1.17 in 20Y2
 What is a good current ratio?
Ford’s competitor, General Motors, had a
slightly higher current ratio of 1.37 in 20Y3.
 A higher current ratio implies that a company
has adequate liquidity to carry out business
operations. For most industries, a current ratio
of 2.0 is satisfactory.
 Acid-test ratio (quick ratio)

 The acid-test ratio, also called quick ratio, is

calculated by dividing the most liquid current
assets (cash and marketable securities and
receivables) by current liabilities.
 Calculation:
Acid-Test Cash + Marketable Securities + Receivables
=
Ratio Current Liabilities
 Acid-test ratio (quick ratio)

Example:
 Ford’s acid-test ratios: 0.91 in 20Y3
0.99 in 20Y2
 Ford’s most liquid current assets are 0.91
times as much as its current liabilities. For
most industries, an acid-test ratio of 0.90 is
satisfactory.
 Receivable turnover
 The receivable turnover ratio shows how
many times the average amount in accounts
receivable is collected in a year.
 This ratio measures a company’s ability to
manage its accounts receivable and collect
cash from credit customers.
 Calculation:
Net Credit Sales
Receivable Turnover =
Average Accounts Receivable
 Receivable turnover

Example:
 Ford’s receivable turnover ratios: 11.12 in 20Y3
9.28 in 20Y2
 General Motors’ 20Y3 receivable turnover was
9.27. This suggests that Ford is more
effectively managing its credit policies.
 Inventory turnover

 Inventory turnover measures a company’s

ability to manage its inventory by computing
the number of times the average amount in
inventory is sold in a year.
 Calculation:

Cost of Goods Sold

Inventory Turnover =
Average Inventory
 Inventory turnover

The challenge of inventory management is

keeping exactly the right amount of inventory
on hand.
 Keeping too much inventory on hand leads to
high warehouse and storage costs.
 Keeping too small of an inventory may lead to
to shortages and dissatisfied customers.
 Inventory turnover
Example:
 Ford’s inventory turnover ratios: 13.64 in 20Y3
16.08 in 20Y2
 General Motors’ 20Y3 inventory turnover was
13.41.
 Slower turnover might indicate a buildup in
inventory due to an unexpected decline in
sales. Or, the increase in inventory might be
planned in anticipated of higher future sales .
 Cross-functional teamwork

The necessary data to compute liquidity ratios initially

comes from various departments, such as:
 Finance supplies information regarding
marketable securities for the acid-test ratio.
 Marketing provides credit sale information for
the receivables turnover ratio, plus inventory
amounts for the inventory turnover ratio.
 The accountant gathers the data and provides
financial statement analysis for management.
 Cross-functional benefits
Liquidity ratios help the departments within a company
monitor the effectiveness of their various functions:
 Current ratio and acid-test ratio help the
finance department know if the company’s
debt is manageable.
 This benefits decisions regarding future financing.
 The inventory turnover ratio helps production
know if inventory is under or over-stocked.
 Inventory turnover also assists marketing in
knowing if sales volume is adequate.
 Summary of liquidity ratios
Exhibit 13.2

1. Current ratio - Measures ability to pay

current liabilities out of current assets.
2. Acid-test ratio - Measures ability to quickly
pay current liabilities out of the most liquid
current assets.
3. Receivable turnover - Measure ability to
collect cash from accounts receivable.
4. Inventory turnover - Measure ability to
manage and sell inventory.
 Profitability Ratios

 Profitability ratios indicate a firm’s ability to

make a satisfactory profit.
 These profitability ratios will be discussed:
1. Earnings per share
2. Return on sales (profit margin)
3. Asset turnover
4. Return on assets
5. Return on equity
 Earnings per share
 The most frequently quoted profitability ratio
is earnings per share (EPS).
 EPS shows the firm’s earnings per common
share of stock.
 Calculation:

Net Income - Preferred Dividends

EPS =
Common Shares Outstanding
 Earnings per share
Example:
 Ford’s EPS ratios: 1.91 in 20Y3
0.27 in 20Y2
 You can look at Ford’s income statement to
know that the increase in EPS is due to an
increase in net income.
 EPS is the only financial ratio that must be
included on the income statement.
 Return on sales
(Profit margin)
 Return on sales, also called profit margin,
shows the proportion of net income created
from each dollar of net sales.
 Calculation:

Return on Sales Net Income

=
(Profit Margin) Net Sales
 Return on sales
(Profit margin)
Example:
 Ford’s profit margin: 2% in 20Y3

0.3% in 20Y2
 Again, Ford’s increase in net income
substantially increased its return on sales
(profit margin).
 General Motors’ 20Y3 profit margin was 1.4%.
 Asset turnover

 Asset turnover shows how efficiently assets

are able to generate sales.
 Calculation:
Net Sales
Asset Turnover =
Average Total Assets
 Asset turnover
Example:
 Ford’s asset turnover ratios: 0.58 in 20Y3

0.57 in 29Y2
 Ford marginally improved its asset turnover,
which means that the company produced
more sales revenue per dollar of assets.
 General Motors’ 20Y3 asset turnover was
0.417.
 Return on assets
 ROA indicates how efficiently a company uses
its assets to generate income for the owners
and creditors of the company.
 Calculation:
Net Income + Interest Expense - Tax Savings
Return on Assets =
Average Assets
 Net income is the return on the owner’s
investment. Interest expense is the return on
the creditor’s investment.
 Return on assets
Example:
 Ford’s return on assets: 0.026 in 20Y3

0.018 in 20Y2
 General Motors’ 20Y3 ROA was 0.022.
 Companies strive to generate as high an ROA
as possible, thereby benefiting shareholders
and lenders.
 Return on equity
 ROE shows how much profit is earned for
each dollar invested by the common
shareholders.
 ROE is also called return on common shareholders’
equity.
 Calculation:
Net Income - Preferred Dividends
Return on Equity =
Average Common Stockholders' Equity
 Return on equity
Example:
 Ford’s return on equity: 0.252 in 20Y3

0.057 in 20Y2
 General Motors’ 20Y3 ROE was 0.106.
 Ford’s ROE increased substantially. This is a
result of positive leveraging, which occurs
when the return on borrowed money is higher
than the cost of borrowing.
 Return on equity

 Achieving an ROE higher than its ROA occurs

when a company borrows at one rate, such as
7%, and invests funds to yield a higher rate,
such as the firm’s 25.2% ROE.
 Cross-functional teamwork
Profitability ratios provide information that can
assist department managers to do their jobs
more effectively. For instance:
 Profitability ratios that show positive trends help the
finance department secure loans for the company.
 Good profitability ratios also help the production or
marketing department obtain suppliers since they are
indicators that the company is in good financial
condition and able to pay its bills.
 Summary of profitability ratios
1. Earnings per share (EPS) – Shows earnings per
common share of stock.
2. Return on sales (profit margin) – Shows the
proportion of net income created from each dollar
of net sales.
3. Asset turnover – Shows how efficiently assets are
able to generate sales.
4. Return on assets (ROA) - shows how efficiently a
firm uses its assets to generate income for owners
and creditors.
5. Return on equity (ROE) – Shows how much profit is
earned from each dollar invested by common
stockholders.
Exhibit 13.3
 Long-Term Solvency Ratios

 Long-term solvency ratios indicate the

business firm’s ability to meet its long-term
obligations.
 The two key long-term solvency ratios are:
1. Debt to assets ratio

2. Times interest earned ratio

 Debt to assets ratio

 The debt to assets ratio shows the proportion

of total assets financed by the business firm’s
creditors.
 It is a measure of the firm’s capital structure.
 The ratio is also referred to as the debt ratio.
 Calculation:
Total Liabilities
Debt to Assets Ratio =
Total Assets
 Debt to assets ratio

Example:
 Ford’s debt to assets ratio: 0.945 in 20Y3

0.961 in 20Y2
 This means Ford used debt to finance 94.5%
of its assets in 20Y3.
 General Motors’ 20Y3 debt to assets ratio was
94.1%.
 Times interest earned ratio
 Times interest earned ratio shows the ability
of the firm to make interest payments.
 Calculation:

Times Interest NI + Interest Exp. + Tax Exp.

=
Earned Ratio Interest Expense

 The higher the times-interest-earned ratio, the

easier the firm is able to pay its interest
expense.
 Times interest earned ratio

Example:
 Ford’s interest earned: 1.63 in 20Y3

1.08 in 20Y2
 General Motors’ 20Y3 times interest earned
was 1.15.
 Summary of
long-term solvency ratios
1. Debt to assets – Shows the proportion of
total assets financed by creditors.
2. Times interest earned – Shows the
proportion of assets financed by debt.

Exhibit 13.4
 Stock Performance Ratios
 Stock performance ratios help investors
evaluate the current and potential future
value of a firm’s stock.
 These stock performance ratios, which relate
to the stock’s market price, will be
discussed:
1. Price to earnings
2. Dividend yield
3. Book value per share
4. Market price to book value
 Price to earnings ratio
 The price to earnings (P/E) ratio indicates the
confidence of investors in a company.
 When investors anticipate that a company’s future
earnings will grow faster than average, they are
willing to pay a higher price relative to current
earnings, thus, resulting in a higher than average
P/E ratio.
 Calculation:
Price to Market Price per Share
=
Earnings Ratio Earnings per Share
 Price to earnings ratio
Example:
 Ford’s P/E ratio: 7.68 in 20Y3
59.22 in 20Y2
 Investors in Ford stock are currently willing to pay
7.68 times the earnings.
 The decrease in P/E ratio indicates that investors do
not believe earnings will sufficiently grow in future
years to merit a high P/E ratio of 59.22.
 General Motors’ 20Y3 P/E ratio was 8.07.
 Remember that Ford’s earnings per share greatly
increased in 20Y3 (from $0.27 per share to $1.91).
 Price to earnings ratio

As with other ratios, what is considered a good

or bad P/E ratio varies from industry to
industry.
P/E ratios larger than 50 are common among
high tech firms such as Google, while P/E
ratios ranging from 6 to 10 are prevalent
among utility companies.
 Dividend yield

 The dividend yield indicates the proportion of

a stock’s market price that the company pays
to an investor in the form of dividends.
 Calculation:
Dividends per Share of Stock
Dividend Yield =
Market Price per Share
 Dividend yield

Example:
 Ford’s dividend yield: 2.7% in 20Y3

2.5% in 20Y2
 Dividend yield decreased because the market
price per share increased from $14.64 to
$16.00, while the dividend remained constant
at $0.40 per share.
 General Motors’ 20Y3 dividend yield was 5%.
 Dividend yield
 Many older, established companies pay
substantial dividends each year.
 Auto companies typically pay dividends ranging
from 2% to 6%.
 Technology companies such as Ebay, Yahoo,
and Google, which emphasize company
growth, typically pay little or no dividends.
 Of course, dividend yield is only one aspect of
a stock’s return on investment; the change in
the stock’s market price is the other aspect.
 Book value per share

 Book value per share shows the recorded

accounting amount per share.
 Calculation:

Book Value per Common Stockholders' Equity

=
Share Common Shares Outstanding

 Common stockholders’ equity is total stockholders’

equity less preferred stockholders’ equity.
 Book value per share

Example:
 Ford’s book value per share: $8.77
$6.36
 The increase is due to a large increase in
common stockholders’ equity and a small
decrease in common shares outstanding.
 General Motors’ 20Y3 book value per share
was $49.06.
 Book value per share

Comparing book values per share of different

companies is not meaningful for investment
analysis unless the book value is compared to
the stock’s market price.
Thus, many financial analysts use the ratio of
market price to book value in their investment
analysis.
 Market price to book value

 Market price to book value is the ratio of what

investors are willing to pay compared to the
recorded accounting amount per share of
stock.
 Calculation:

Market Price to Market Price per Share

=
Book Value Book Value per Share
 Market price to book value
 Investors who prefer stocks with low
market to book ratios are referred to as
“value” investors.
 Investors who prefer stocks with high
market to book ratios are referred to as
“growth” investors.
 Growth investors choose companies whose
earnings are expected to increase
significantly each year.
 Market price to book value

Example:
 Ford’s market price to book value: 1.67 in 20Y3
2.52 in 20Y2
 The decrease in market price to book value
makes the stock more attractive to value
investors.
 General Motors’ 20Y3 market price to book
value was 0.82.
 Summary of stock
performance ratios
 Price to earnings (P/E) – Indicates the confidence of
investors in a company.
 Dividend yield – Indicates the proportion of a stock’s
market price that the company pays to an investor in
the form of dividends.
 Book value per share – Shows the recorded
accounting amount per share.
 Market price to book value – The ratio of what
investors are willing to pay compared to the
recorded accounting amount per share of stock.
 How GAAP affects ratios
 You will recall that GAAP sometimes allows for more
than one method to account for an item.
Consequently, calculation of financial ratios may yield
different results, depending on which accounting
method is used.
 For example, the type of depreciation method affects
amounts on the financial statements. If depreciation
expense is reduced, then net income is increased. As
a result, most of the profitability ratios will be
enhanced.
 Ethics and financial ratios

People may be tempted to change accounting

methods for the purpose of manipulating
financial ratios - this is wrong.
Furthermore, investors, lenders, and financial
analysts would eventually see through such
deception. This, in turn, would lead to lower
trust that would hurt the company.
 VERTICAL ANALYSIS
Exhibit 13.6

 Vertical analysis shows the proportional

relationships of the items in a financial
statement.
 Common-size statements result from vertical
analysis and show percentages of a total
figure that is set at 100 percent, such as net
sales on the income statement.
 Vertical analysis can reveal if one item is out-
of-balance with the rest.
 Vertical analysis

Ford’s Common-Size Income Statement

20Y3* 20Y2*
Net Sales 100.0 % 100.0 %
Costs and Expenses
Cost of Goods Sold 79.1 75.6
Interest Expense 4.1 4.5
Other Costs and Expenses 13.9 15.0
Earnings Before Taxes 2.8 % 0.8 %
Tax Expense (Benefit) 0.5 0.1
Discontinued Op. & Other Adjustments 0.2 0.4
Net Income 2.0 % 0.3 %

*Note: Due to rounding, additions and subtractions do not always total precisely.
 Vertical analysis
Ford’s Common-Size Balance Sheet
20Y3* 20Y2*
Assets
Cash 8.0 % 7.8 %
Marketable Securities 3.2 3.5
Accounts Receivable 5.2 5.3
Inventory 3.7 3.1
Total Current Assets 20.1 19.6
Long-Term Assets 79.9 80.4
Total Assets 100.0 % 100.0 %
Liabilities & Stockholders' Equity
Current Liabilities 18.0 16.7
Other Liabilities 76.5 79.4
Total Liabilities 94.5 96.1
Total Stockholders' Equity 5.5 3.9
Total Liabilities & Stockholders' Equity 100.0 % 100.0 %
 HORIZONTAL ANALYSIS

 Horizontal analysis shows the percentage

changes in financial statement items from one
year to the next.
 Calculation:

Amount of change
Percentage change = 100 x
Base period amount

 The base period in any set of data is the first time

period being studied.
 Horizontal analysis
Exhibit 13.8

Ford’s comparative income statements with horizontal

analysis:
Increase (Decrease)
($ millions) 20Y3 20Y2 Amount Percentage
Net Sales 171,652 164,338 7,314 4.5
Costs and Expenses
Cost of Goods Sold 135,856 129,685 6,171 4.8
Interest Expense 7,071 7,643 (572) (7.5)
Other Costs and Expenses 23,872 25,671 (1,799) (7.0)
Earnings Before Taxes 4,853 1,339 3,514 262.4
Tax Expense (Benefit) 937 123 814 661.8
Discontinued Op. & Other Adjustments 429 721 (292) (40.5)
Net Income 3,487 495 2,992 604.4
 TREND ANALYSIS

 Analysis of financial statements from several

years will provide a more complete
understanding of the current situation and
future outlook of a business firm.
 Typically, the best predictor of future performance
is past performance.
 Trend analysis shows percentage changes of
key financial statement items for several time
periods.
 Trend analysis
Ford’s total revenues for three years:
Total Revenue
200
171
162 164
160

120
$ billions

80

40

0
20Y1 20Y2 20Y3
Year
Exhibit 13.10
 Trend analysis
Ford’s net income for three years:
Net Income
4 3.48

2
$ billions

1 0.49

-1
-0.98
-2
2002 2003 2004
Exh.
Year
13.10
 COMPARATIVE ANALYSIS

 To gain a better understanding of one

company’s financial performance, it is helpful
to compare the company to a competitor or to
industry averages.
 Comparing ratios of a company to industry
averages is also beneficial.
 Comparative analysis
Exhibit 13.14

Comparison of Ford to Industry Averages of Major Auto

Manufacturers:
Industry
Ford Average

Profit Margin (Return on Sales) = 0.020 0.019

Return on Equity = 0.252 0.091
Price to Earnings = 7.683 22.500
Dividend Yield = 0.027 0.011
Market Price to Book Value = 1.670 1.700