Chapter 6

Van Horne and Wachowicz

Fundamentals of Financial Management (11/e)

Financial Statement Analysis

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Financial Statement Analysis

 Financial statements (or financial reports) are formal

records of the financial activities of a business,
person, or other entity. Financial statements provide
an overview of a business or person's financial
condition in both short and long term.
 All the relevant financial information of a business
enterprise, presented in a structured manner and in
a form easy to understand, are called the financial
statements. There are four basic financial
statements:
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Financial Statement Analysis
 Balance sheet: also referred to as statement of financial position
or condition, reports on a company's assets, liabilities, and net
equity as of a given point in time.
 Income statement: also referred to as Profit and Loss statement
(or a "P&L"), reports on a company's income, expenses, and profits
over a period of time. Profit & Loss account provide information
on the operation of the enterprise. These include sale and the
various expenses incurred during the processing state.
 Statement of retained earnings: explains the changes in a
company's retained earnings over the reporting period.
 Statement of cash flows: reports on a company's cash flow
activities, particularly its operating, investing and financing
activities.
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Balance Sheet

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Income Statement

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Financial Statement Analysis

 Financial statement analysis refers to an

assessment of the viability, stability and
profitability of a business, sub-business or project.
 It is performed to prepare reports using ratios
that make use of information taken from financial
statements and other reports. These reports are
usually presented to top management as one of
their bases in making business decisions.

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Goals of financial statement analysis

 Profitability - its ability to earn income and sustain growth in both

short-term and long-term. A company's degree of profitability is
usually based on the income statement, which reports on the
company's results of operations;
 Solvency - its ability to pay its obligation to creditors and other
third parties in the long-term;
 Liquidity - its ability to maintain positive cash flow, while satisfying
immediate obligations;
 Stability- the firm's ability to remain in business in the long run,
without having to sustain significant losses in the conduct of its
business. Assessing a company's stability requires the use of both
the income statement and the balance sheet, as well as other
financial and non-financial indicators.
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Methods of financial statement
Analysis
 Past Performance - Across historical time periods
for the same firm (the last 5 years for example),
 Future Performance - Using historical figures and
certain mathematical and statistical techniques,
including present and future values, This
extrapolation method is the main source of errors in
financial analysis as past statistics can be poor
predictors of future prospects.
 Comparative Performance - Comparison between
similar firms.
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Framework for Financial Analysis

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Framework for Financial Analysis

 The tools used to assess the financial condition and performance of

the firm is financial ratios. In finance, a financial ratio or accounting
ratio is a ratio of two selected numerical values taken from an
enterprise's financial statements.
 There are many standard ratios used to try to evaluate the overall
financial condition of a corporation or other organization.
 Financial ratios may be used by managers within a firm, by current
and potential shareholders (owners) of a firm, and by a firm's
creditors.
 Security analysts use financial ratios to compare the strengths and
weaknesses in various companies.
 If shares in a company are traded in a financial market, the market
price of the shares is used in certain financial ratios.
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Types of Ratios

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Balance Sheet Ratios

 Liquidity Ratios:
 Liquidity is the ability of an asset to be
converted into cash without a significant
price concession.
 Liquidity ratios are used to measure a firm’s
ability to meet short-term obligations. They
compare short-term liabilities to short-term
(current) resources available to meet these
obligations.
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Current Ratio

 Current ratio shows a firm’s ability to cover its

current liabilities with its current assets
 The higher the current ratio, the greater the ability
of the firm to pay its liabilities
 Standard current ratio is 2:1

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Acid Test Ratio

 This ratio concentrates on more liquid assets

 It excludes less liquid inventory
 This ratio provides a more penetrating
measure of liquidity
 Standard is 1:1

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Balance Sheet Ratios
 Financial Leverage or Debt Ratios:
 Leverage or leveraging refers to the use of debt to supplement
investment or the degree to which an investor or business is
utilizing borrowed money. Financial leverage takes the form of a
loan or other borrowings (debt), the proceeds of which are
invested with the intent to earn a greater rate of return than the
cost of interest.
 Companies that are highly leveraged may be at risk of bankruptcy if
they are unable to make payments on their debt; they may also be
unable to find new lenders in the future.
 Financial leverage is not always bad, however; it can increase the
shareholders' return on their investment and often there are tax
advantages associated with borrowing.
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Debt-to-Equity Ratio

 It shows the extent to which the firm is financed by debt

 It tells the contribution of creditors for each unit of money
being provided by the shareholders (owners)
 Lower the ratio better for creditors because higher cushion
 Sometimes preferred stocks are included as debt rather
than as equity
 Low ratio may attract more creditors

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Debt-to-Total Assets Ratio

 It shows the percentage of firm’s assets

supported by debt financing
 Higher ratio means higher financial risks
 Lower ratio means lower financial risks

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Long Term Debt to Total Capitalization
Ratio

 Total capitalization represents all long-term debt

and shareholders’ equity. So, it is the total long-term
debt and all types of equity of a company that
constitutes its capital structure.
 It tells us the relative importance of ling-term debt to
the capital structure (long-term financing) of the firm

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Balance Sheet Ratios
 Companies can finance their operations through either debt or
equity. The debt-to-capital ratio gives users an idea of a
company's financial structure, or how it is financing its
operations, along with some insight into its financial strength.
The higher the debt-to-capital ratio, the more debt the
company has compared to its equity. This tells investors
whether a company is more prone to using debt financing or
equity financing. A company with high debt-to-capital ratios,
compared to a general or industry average, may show weak
financial strength because the cost of these debts may weigh
on the company and increase its default risk.

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Income Statement and
Income Statement / Balance Sheet Ratios

 Ratios takes data from income statement and

balance sheet.

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Coverage Ratios

 Coverage ratios are designed to relate the financial charges to its ability
to service, or cover, them.
 It indicates a firm’s ability to cover interest charges, and thus avoid
bankruptcy.
 Higher the ratio, greater is the ability of the firm to cover interest
charges.
 A combination of debt ratios with coverage ratios may give deeper
insight about the ability of a firm to avoid debt related risks or financial
risks.
 A cash flow analysis is also necessary.

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Activity Ratios

 Activity ratios, also known as efficiency or

turnover ratios, measure how effectively the
firm is using its assets.

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Receivables

 Provides insight into the quality of the firm’s receivables and

how successful the firm is in its collections.
 This ratio tells us the number of times account receivables have
been turned over during the year.
 If sales are seasonal, use year end receivables data not correct.
Use average of month end receivables data.
 In growth case, use average of beginning and end of year
receivables data.
 Analyze quality of receivables and its liquidity.

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Receivable in Days

 It shows average collection period or state of

liquidity of receivables.
 Receivable turnover in days should be reasonable
according to standard of the industry.

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Ageing Accounts Receivables

 The process of classifying accounts

receivables by their age outstanding as of a
given date.
 The analysis is based of the term of accounts
receivables (2/10, net 30).

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Payables
 Firm may analysis its ability to pay suppliers
and its potential as credit customers.

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Analysis of aging of accounts payables

 If purchase data not available cost of goods

sold may be used
 Compare payables accounts with terms of
credit
 Beginning Inventory + Purchase – COGS =
Ending Inventory
 Purchase = COGS + Ending Inventory –
Beginning Inventory

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Inventory

 How effectively the firm is managing inventory. It tells how

many times inventory is turned over to receivables through
sales during the year
 Consider seasonality and growth situations.
 Higher inventory turnover indicates higher efficiency. Higher
inventory turnover may increase stockout risk. Stockout is not
having enough inventory items in inventory to fill an order.
 IT ratio may be calculated separately for different categories
of products

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Inventory

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Operating Cycle versus Cash Cycle

 Operating Cycle – The length of time from the commitment

of cash for purchases until the collection of receivables
resulting from the sale of goods or services.
 Operating Cycle = Inventory turnover in days (ITD) +
Receivable turnover in days (RTD)
 Cash Cycle – The length of time from the actual outlay of cash
for purchases until the collection of receivables resulting from
the sale of goods and services.
 Cash Cycle = Operating Cycle (ITD + RTD) – Payable
turnover in days (PTD)
 Short operating cycle needs less resource

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Profitability Ratios

 Profitability ratios relate profits to sales and

investment.

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Profitability in relation to sales

 Gross Profit Margin= (Net Sales-Cost of

Goods Sold)/(Net Sales)

 Net Profit Margin=(Net Profit after

taxes)/(Net Sales)

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Profitability in relation to Investment

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ROI and Du Pont Approach

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Du Pont Approach

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Trend Analysis

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Common Size and Index Analysis

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