ANALYSIS OF

FINANCIAL
STATEMENT
Accounting and Finance
Choirunnisa Arifa
 Analysis of Financial Statement
• Ratio Analysis
• Liquidity ratios
• Asset management ratios
• Debt management ratios
• Profitability ratios
• Market value ratios
• Trend analysis
• The Dupont equation
 Why are ratios useful?
• Ratios standardize numbers and facilitate
comparisons.
• Ratios are used to highlight weaknesses
and strengths.
What are the five major categories of ratios,
and what questions do they answer?

• Liquidity: Can we make required payments?

• Asset management: right amount of assets vs. sales?
• Debt management: Right mix of debt and equity?
• Profitability: Do sales prices exceed unit costs, and are sales
high enough as reflected in PM, ROE, and ROA?
• Market value: Do investors like what they see as reflected
in P/E and M/B ratios?
 Liquidity Ratios
• The ratios help answer the question of:
Will the firm be able to pay off its debts as they
come due and thus remain a viable organization?
• The ratios Show the relationship of a firm’s cash and
other current assets to its current liabilities
• The most common ratios are:
• Current ratio
• Acid-test ratio
Current ratio

• Current assets include: cash, marketable securities, accounts

receivable, and inventories
• If a company is having financial difficulties, it begins to pay its
accounts payable more slowly and borrow more from its bank
• If current liabilities are rising faster than current assets, the
current ratio will fall; hence this is a sign of possible trouble
Acid-test ratio

• Inventories are the least liquid of a firm’s current

assets.
• If sales slow down, they might not be converted to
cash as quickly as expected.
• In the event of liquidation, inventories are the
assets on which losses are most likely to occur.
Asset Management Ratios
Analysis of Financial Statements
Asset Management Ratios
• The asset management ratios measure how
effectively the firm is managing its assets
• The ratios help answer the question of:
• Does the amount of each type of asset seem
reasonable, too high, or too low in view of current and
projected sales?
• The most common ratios are:
• Inventory turnover ratio
• Days sales outstanding
• Fixed assets turnover ratio
• Total assets turnover ratio
Inventory Turnover Ratio

• The asset management ratios measure how

effectively the firm is managing its assets
• The low level of ratio indicates that the firm is
holding too much inventory.
• Excess inventory is unproductive and represents an
investment with a low or zero rate of return
Days Sales Outstanding (DSO)

• The DSO, also called the average collection period,

calculates how many days’ sales are tied up in receivables
• The DSO represents the average length of time the firm
must wait after making a sale before receiving cash
• The high average DSO indicates that if some customers
are paying on time, quite a few must be paying very late
Fixed Assets Turnover Ratio

• The ratio measures how effectively the firm uses

its plant and equipment
• The interpretation for this ratio might be biased as
fixed assets are shown on the balance sheet at
their historical costs
Total Assets Turnover Ratio

• The ratio measures the turnover of all of the firm’s

assets
• The low level of this ratio might be caused by the
problem with the firm’s current assets
Debt Management Ratios
Analysis of Financial Statements
Debt Management Ratios
• The use of debt can “leverage up” a firm’s ROE if the firm
earns more on its assets than the interest rate it pays on debt
• The debt management ratios measure how effectively the
firm is managing its debts
• The firms with a high level of debt ratios typically have higher
expected return when the economy is normal, but lower
return and possibly bankruptcy if the economy goes into a
recession
• To examine the firm’s debt:
• Check the balance sheet to determine the proportion of total funds
represented by debt
• Review the income statement to see the extent to which interest is
covered by operating profits
Total Debt to Total Assets

• The ratio measures the percentage of funds provided by

creditors
• Creditors prefer low debt ratios because the lower the
ratio, the greater the cushion against creditors’ losses in
the event of liquidation
• Stockholders may want more leverage because it can
magnify the expected earnings
Times-Interest-Earned Ratio

• The TIE ratio measures the extent to which

operating income can decline before the firm is
unable to meet its annual interest costs
• The low level of TIE ratio indicates that the firm is
covering its interest charges by a relatively low
margin of safety
Profitability Ratios
Analysis of Financial Statements
Operating Margin

• This ratio measures operating income per dollar

sales
• The low level of this ratio indicates that the firm’s
operating costs are too high, and vice versa
Profit Margin

• This ratio measures net income per dollar sales

• Low profit margin can be caused by the high
operating costs or the heavy use of debt
Return on total assets

• This ratio measures the profitability of the firm’s total

assets
• Low return on total assets can result from a
conscious decision to use a great deal of debt, hence
high interest expenses will cause lower net income
Basic Earning Power (BEP) Ratio

• This ratio indicates the ability of the firm’s assets to

generate operating income
• This ratio shows the raw earning power of the
firm’s assets before the influence of taxes and debt
Return on Common Equity (ROE)

• The ROE is the most important, or bottom line,

accounting ratio
• This ratio measures the rate of return on common
shareholders’ investment
Market Value Ratios
Analysis of Financial Statements
Market Value Ratios
• Although ROE is the best accounting measure of
performance, the investors need to take a concern about
financial leverage
• If a high ROE is achieved by using a great deal of debt, the
stock price might be lower than if the firm had been using
less debt, as financial leverage increases the firm’s risk
• To address the above situation, the users of financial
statement can have a look on a set of market value ratios,
which relate the stock price to earning and book value price
• If all ratios look good and investors expect these ratios will
continue to look good in the future, the market value ratios
will be high
Market Value Ratios
• The market value ratios are used in three primary
ways:
• By investors – when they are deciding to buy or sell a
stock
• By investment bankers – when they are setting the
share price for a new stock issue
• By firms – when they are deciding how much to offer
for another firm in a potential merger
• The most important ratios are:
• Price/Earning (P/E) ratio
• Market/Book (M/B) ratio
Price/Earning (P/E) Ratio

• The P/E ratio shows how much investors are willing

to pay per dollar of reported profit.
• The P/E ratios are relatively high for firms with strong
growth and little risk, but low for slowly growing and
risky firms.
Market/Book (M/B) Ratio
Market/Book (M/B) Ratio

• The M/B ratio shows the ratio of a stock’s market

price to its book value.
• Companies that are well regarded by investors –
which means low risk and high growth – have high
M/B ratio.
• Supposedly, M/B ratio exceeds 1.0, which means
that investors are willing to pay more for stocks
than the accounting book value of the stocks.
Trend Analysis
Analysis of Financial Statements
Trend analysis
• Analyzes a firm’s financial ratios over time
• Can be used to estimate the likelihood of
improvement or deterioration in financial
condition.
The Du Pont Equation
Analysis of Financial Statements
The Du Pont Equation
• The equation that shows that the rate of return on equity
can be found as the product of profit margin, total assets
turnover, and the equity multiplier
• The du pont equation shows the relationship among asset
management, debt management and profitability ratios
• Therefore, the du pont equation can be used to help
identify ways to improve a firm’s performance
The Du Pont Equation
Benchmarking
Analysis of Financial Statements
Benchmarking
• The process of comparing a particular company with a set
of benchmark companies
 Potential problems and limitations of
financial ratio analysis
• Comparison with industry averages is difficult for a
conglomerate firm that operates in many different divisions.
• “Average” performance is not necessarily good, perhaps the
firm should aim higher.
• Seasonal factors can distort ratios.
• “Window dressing” techniques can make statements and
ratios look better.
More issues regarding ratios:
• Different operating and accounting practices can
distort comparisons.
• Sometimes it is hard to tell if a ratio is “good” or
“bad”.
• Difficult to tell whether a company is, on balance, in
strong or weak position.
Qualitative factors to be considered when evaluating a
company’s future financial performance

• Are the firm’s revenues tied to 1 key customer,

product, or supplier?
• What percentage of the firm’s business is generated
overseas?
• Competition
• Future prospects
• Legal and regulatory environment