Chapter 3

Financial Statements
and Analysis

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Financial Statements
and Analysis
 What financial statements do corporations
publish, and what information does each provide?
 How do investors utilize financial statements?
 What is ratio analysis and why are the results
important to both managers and investors?
 What are some potential problems associated
with financial statement analysis?
 What is the most important factor in financial
statement analysis?

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The Stockholders’ Report
 The guidelines used to prepare and maintain
financial records and reports are known as
generally accepted accounting principles
(GAAP).
 The Sarbanes-Oxley Act of 2002, passed to
eliminate the many disclosure and conflict of
interest problems of corporations, established the
Public Company Accounting Oversight Board
(PCAOB), which is a not-for-profit corporation
that overseas auditors.

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The Stockholders’ Report
 The PCAOB is charged with protecting the
interests of investors and furthering the
public interest in the preparation of
informative, fair, and independent audit
reports.
 Public corporations with more than $5
million in assets and more than 500
stockholders are required by the SEC to
provide their stockholders with an annual
stockholders report.

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The Four Key Financial Statements:
The Income Statement

 The income statement provides a financial

summary of a company’s operating results
during a specified period.
 Although they are prepared annually for
reporting purposes, they are generally
computed monthly by management and
quarterly for tax purposes.

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Bartlett Company Income Statements
($000)

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Notes
Sales revenue: The total dollar amount of sales
during the period
Gross profits: The amount remaining to satisfy
operating, financial and tax costs.
Operating profirs (EBIT): Profits earned from
producing and selling products. It doesn’t consider
financial and tax costs.
EPS: Earning available for common stock holders
divided by the number of shares of common stock
DPS: Dollar amount of cash distributed during the
period on behalf of each outstanding share of
common stock.
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The Four Key Financial Statements:
The Balance Sheet
 The balance sheet presents a summary of
a firm’s financial position at a given point
in time.
 Assets indicate what the firm owns, equity
represents the owners’ investment, and
liabilities indicate what the firm has
borrowed.

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Bartlett Company Balance Sheets
($000)

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Bartlett Company Balance Sheets
($000)

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The Four Key Financial Statements:
Statement of Retained Earnings
 The statement of retained earnings
reconciles the net income earned and
dividends paid during the year, with the
change in retained earnings.

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Bartlett Company Statement of Retained
Earnings ($000) for the Year Ended December
31, 2009

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The Four Key Financial Statements:
Statement of Cash Flows
 The statement of cash flows provides a
summary of the cash flows over the period
of concern, typically the year just ended.
 This statement not only provides insight
into a company’s investment, financing
and operating activities, but also ties
together the income statement and
previous and current balance sheets.

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Bartlett Company Statement of Cash Flows
($000) for the Year Ended December 31, 2009

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Using Financial Ratios:
Interested Parties
 Ratio analysis involves methods of
calculating and interpreting financial ratios
to assess a firm’s financial condition and
performance.
 It is of interest to shareholders, creditors,
and the firm’s own management.

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Using Financial Ratios:
Types of Ratio Comparisons
 Trend or time-series analysis
 Used to evaluate a firm’s performance over time
 Cross-sectional analysis
 Used to compare different firms at the same point in time
 Industry comparative analysis
 One specific type of cross sectional analysis. Used to compare one firm’s
financial performance to the industry’s average performance
 Benchmarking
 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
 Combined Analysis
 Combined analysis simply uses a combination of both time series
analysis and cross-sectional analysis

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Industry Average Ratios for Selected
Lines of Business

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Example
X company inventory turnover: 14.8
Industry average: 9.7

Significantly better than the average firm in the

industry. Turnover is 53% faster than industry
average.

High inventory turnover could also mean very low

levels of inventory. The consequence of low
inventory could be excessive stockouts (insufficient
inventory)
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Combined Analysis

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Using Financial Ratios:
Cautions for Doing Ratio Analysis
1. Ratios must be considered together; a single
ratio by itself means relatively little.
2. Financial statements that are being compared
should be dated at the same point in time.
3. Use audited financial statements when possible.
4. The financial data being compared should have
been developed in the same way.
5. Be wary of inflation distortions.

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Five Major Categories of Ratios

 Liquidity: is the firm able to meet its current

obligations (provide early signs of cash flow
problems and impending business failure)
 Activity (Asset management): is the firm
effectively managing its assets (measure the
speed with which various accounts are converted
into sales or cash)
 Debt management: does the firm have the right
mix of debt and equity
 Profitability: the combined effects of liquidity,
asset and debt management
 Market values: relates the firm’s stock price to its
earnings and the book value per share
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Ratio Analysis
 Liquidity Ratios
 Current Ratio
Current ratio = total current assets
total current liabilities

Current ratio = $1,233,000 = 1.97

$620,000
The higher the current ratio, the more liquid the firms is
considered to be. Generally, current ratio>2 is good but
depends on the industry.
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Ratio Analysis
 Liquidity Ratios
 Current Ratio
 Quick Ratio (Acid-test ratio): similar to current
ratio but excludes inventory, which is generally the least
liquid current asset.
Quick ratio = Total Current Assets - Inventory
total current liabilities

Quick ratio = $1,233,000 - $289,000 = 1.51

$620,000
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Quick ratio
We exclude the inventory because:
1-many types of inventory cannot be easily sold because they
are partially completed items, special purpose items.
2- Inventory is usually sold on credit. (it becomes accounts
receivable before cash)

**Quick ratio>1 is recommended, depends on the industry.

Quick ratio provides a better measure of liquidity when a
firm’s inventory cannot be easily converted into cash.
If inventory is liquid, current ratio is preferred measure of
liquidity.

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Ratio Analysis
 Activity Ratios
 Inventory Turnover: measures the firm’s
inventory’s activity (liquidity)

Inventory Turnover = Cost of Goods Sold

Inventory

Inventory Turnover = $2,088,000 = 7.2

$289,000
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Ratio Analysis
 Activity Ratios
 Average Age of Inventory

Average Age of Inventory = 365

Inventory Turnover

Inventory Turnover = 365 = 50.7 days

7.2

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Ratio Analysis
 Activity Ratios
 Average Collection Period: is useful in
evaluating credit and collection policies.

ACP = Accounts Receivable

Net Sales/365

ACP = $503,000 = 59.7 days

$3,074,000/365
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Ratio Analysis
 Activity Ratios
 Average Payment Period: prospective lenders and suppliers of
trade credits are most interested in the average payment
period because it provides insight to the firm’s bill paying
patterns.
APP = Accounts Payable
Annual Purchases/365

APP = $382,000 = 95.4 days

(.70 x $2,088,000)/365
Assumption in this example: company’s purchases equals 70% of
its cost of goods sold.
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Difficulty: Annual purchases is not available
in published financial statements.
Purchases are estimated as a given
percentage of cost of goods sold.

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Ratio Analysis
 Activity Ratios
 Total Asset Turnover : the efficiency with which the firm uses
its assets to generate sales.
(the higher the firm’s total asset turnover, the more efficiently its
assets have been used).

Total Asset Turnover = Net Sales

Total Assets

Total Asset Turnover = $3,074,000 = .85

$3,597,000

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 The more debt a firm has, the greater its
risk of being unable to meet its
obligations. Shareholders, lenders are
concerned about the firm’s indebtedness.
 FINANCIAL LEVERAGE: magnification of
risk and return introduced through the use
of fixed-cost financing.

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Financial Leverage example
 I currently have 10,000. I see a
cryptocurrency I want to invest. I borrow
another 10,000 from Aisha.
 So, I invest a total of 20,000 in
cryptocurrency.
 If crypto earns 10%----$2000 will be my
profit. If I didn’t borrow, I would invest
only 10,000 and make $1000 profit only.
 If crypto loses 10%-----$2000 will be my
loss. If I didn’t borrow, I would invest only
10,000 and lose only $1000. 32
Example
 Patty considers establishing a new
business. Initial investment is $50,000,
$20,000 in current assets and $30,000 in
fixed assets.
 Invest $50,000 without borrowing
 Invest $25,000 and borrow $25,000 with 12%
interest
 Regardless of the financing alternative,
she expects sales=$30,000, costs and
operating expenses=$18,000 and
tax=40% 33
Financial Statements Associated with
Patty’s Alternatives

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Ratio Analysis
 Financial Leverage Ratios
 Debt Ratio: the higher this ratio, the greater
the amount of other people’s money being
used to generate profit.
Debt Ratio = Total Liabilities/Total Assets
Debt Ratio = $1,643,000/$3,597,000 = 45.7%
 The higher this ratio, the greater the firm’s
degree of indebtedness and the more financial
leverage it has.

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Ratio Analysis
 Financial Leverage Ratios
 Times Interest Earned Ratio (Interest
coverage ratio)-measures the firm’s
ability to make contractual payments.
Times Interest Earned = EBIT/Interest

Times Interest Earned = $418,000/$93,000 = 4.5

 The higher this ratio, the better able the
firm is to fulfill its interest obligations.
 TIE>3 close to 5 is suggested.
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Ratio Analysis
 Financial Leverage Ratios
 Fixed-Payment coverage Ratio (FPCR) : the firm’s ability to
meet all fixed-payment obligations, such as loan interest and
principal, lease payments and preferred stock dividends.

FPCR = EBIT + Lease Payments________________

Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}

FPCR = $418,000 + $35,000 = 1.9
$93,000 + $35,000 + {($71,000 + $10,000) x [1/(1-.29)]}
 Both TIE and FPCR measure risk. The greater the ratio, the
lower the risk. Both higher TIE and FPCR are preferred, but too
high a ratio (above industry norms) may result in
unnecessarily low risk and return.

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Bartlett Company Common-Size
Income Statements

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Ratio Analysis
 Profitability Ratios
 Gross Profit Margin: measures the percentage
of each sales dollar remaining after the firm
has paid for its goods.
GPM = Gross Profit/Net Sales
GPM = $986,000/$3,074,000 = 32.1%
 The higher this ratio, the better (the lower the
relative cost of merchandise sold)

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Ratio Analysis

 Profitability Ratios
 Operating Profit Margin (OPM): measures the
percentage of each sales dollar remaining after
all costs and expenses other than interest, tax,
preferred stock dividends are deducted.
OPM = EBIT/Net Sales
OPM = $418,000/$3,074,000 = 13.6%
 High Operating Profit Margin is preferred.

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Ratio Analysis

 Profitability Ratios
 Net Profit Margin (NPM): measures the % of each sales dollar
remaining after all costs and expenses, including interest, tax,
preferred stock dividends have been deducted.

NPM = Earnings Available to Common Stockholders

Sales

NPM = $221,000/$3,074,000 = 7.2%

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Ratio Analysis

 Profitability Ratios
 Earnings Per Share (EPS): measures the number of dollars
earned during the period on behalf of each outstanding share
pf common stock.

EPS = Earnings Available to Common Stockholders

Number of Shares Outstanding

EPS = $221,000/76,262 = $2.90

DPS: the $ amount of cash actually distributed to each shareholder.

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 Ratio Analysis
 Profitability Ratios
 Return on Total Assets (ROA): measures the
overall effectiveness of management in
generating profits with its available assets.

ROA = Earnings Available to Common Stockholders

Total Assets

ROA = $221,000/$3,597,000 = 6.1%

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 Ratio Analysis
 Profitability Ratios
 Return on Equity (ROE): measures the return
earned on the common stockholder’s
investment in the firm.

ROE = Earnings Available to Common Stockholders

Total Equity

ROE = $221,000/$1,754,000 = 12.6%

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Ratio Analysis
 Market Ratios
 Price Earnings (P/E) Ratio: used to assess the
owners’ appraisal of share value. It measures
the amount that investors are willing to pay for
each dollar of a firm’s earnings.
P/E = Market Price Per Share of Common Stock
Earnings Per Share

P/E = $32.25/$2.90 = 11.1

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 Ratio Analysis
 Market Ratios
 Market/Book (M/B) Ratio: provides an
assessment of how investors view the firm’s
performance.

BV/Share = Common Stock Equity

Number of Shares of Common Stock

BV/Share = $1,754,000/72,262 = $23.00

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 Ratio Analysis

 Market Ratios
 Market/Book (M/B) Ratio

M/B Ratio = Market Price/Share of Common Stock

Book Value/Share of Common Stock

M/B Ratio = $32.25/$23.00 = 1.40

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Summarizing All Ratios

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Summarizing All Ratios (cont.)

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DuPont System of Analysis
 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:

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DuPont System of Analysis

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DuPont System of Analysis

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Modified DuPont Formula
 Use of the FLM to convert ROA into ROE
reflects the impact of financial leverage on
the owner’s return.
 Substituting the values for Bartlett
Company’s ROA of 6.1 percent calculated
earlier, and Bartlett’s FLM of 2.06
($3,597,000 total assets ÷ $1,754,000
common stock equity) into the Modified
DuPont formula yields:
ROE = 6.1% X 2.06 = 12.6%

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Notes on DuPont Formula
 The advantage of the DuPont system :
allows the firm to break its return on
equity into a profit on sales component
(net profit margin) and efficiency of asset
use component (total asset turnover) and
use of financial leverage component
(financial leverage multiplier).

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Potential Problems and Limitations of
Financial Ratio Analysis
 Comparison with industry averages is difficult if
the firm operates many different divisions
 Inflation distorts balance sheets
 Seasonal factors can distort ratios
 “Window dressing” can make ratios look better.
 Different operating and accounting practices
distort comparisons
 Sometimes hard to tell if a ratio is “good” or
“bad”
 Difficult to tell whether company is, on balance,
in strong or weak position

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Review
 Review the contents of the stockholders’ report and the
procedures for consolidating international financial
statements.
 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.

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Review
 Understand who uses financial ratios and how.
 Ratio analysis enables stockholders, lenders, and the firm’s
managers to evaluate the firm’s financial performance. It can be
performed on a cross-sectional or a time-series basis.
Benchmarking is a popular type of cross-sectional analysis. Users
of ratios should understand the cautions that apply to their use.
 Use 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. 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.
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Review
 Discuss the relationship between debt and financial
leverage and the ratios used 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 the debt ratio. The ability to pay fixed charges
can be measured by times interest earned and fixed-payment
coverage ratios.
 Use 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.
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Review
 Use a summary of financial ratios and the DuPont system
of analysis to perform a complete ratio 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.

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