Analysis of Financial Statements

Prof. Kwame Adom-Frimpong.

1
FINANCIAL STATEMENTS

 Profit and Loss Account

 Cash Flow Statement
 Balance Sheet
 Notes that form part of the accounts

2
 Common-size Income Statements

 A common-size Elvis Products International

income statement Common-size Income Statement

For the Year Ended Dec. 31, 1997 ($ 000's)
restates all expenses 1997% 1997 1996% 1996
Sales 100.00% 3900.00 100.00% 3500.00
as a percentage of Cost of Goods Sold 83.33% 3250.00 81.83% 2864.00

sales Gross Profit

Selling and G&A Expenses
16.67%
8.47%
650.00
330.30
18.17%
6.86%
636.00
240.00

 This allows the Fixed Expenses

Depreciation Expense
2.56%
0.51%
100.00
20.00
2.86%
0.54%
100.00
18.90
analyst to quickly EBIT 5.12% 199.70 7.92% 277.10
Interest Expense 1.95% 76.00 1.79% 62.50
and easily see which Earnings Before Taxes 3.17% 123.70 6.13% 214.60

expenses have Taxes @ 40%

Net Income
1.27%
1.90%
49.48
74.22
2.45%
3.68%
85.84
128.76
increased or
decreased relative to
sales
3
 Common-size Balance Sheets
Elvis Products International
Common-size Balance Sheet
As of Dec. 31, 1997 ($ 000's)
 A common-size Assets
Cash and Equivalents
1997%
3.03%
1997
50.00
1996%
3.92%
1996
57.60
balance sheet Accounts Receivable
Inventory
24.35%
50.76%
402.00 23.91%
838.00 48.69%
351.20
715.20
restates all assets Total Current Assets
Plant & Equipment
78.14% 1290.00 76.53% 1124.00
31.92% 527.00 33.43% 491.00
and liabilities as a Accumulated Depreciation
Net Fixed Assets
10.07% 166.20 9.95% 146.20
21.86% 360.80 23.47% 344.80
percentage of total Total Assets 100.00% 1650.80 100.00% 1468.80

assets Liabilities and Owner's Equity

Accounts Payable 10.61% 175.20 9.91% 145.60
Short-term Notes Payable 13.63% 225.00 13.62% 200.00
 This allows the Other Current Liabilities 8.48% 140.00 9.26% 136.00
Total Current Liabilities 32.72% 540.20 32.79% 481.60
analyst to quickly Long-term Debt 25.72% 424.61 22.02% 323.43
Total Liabilities 58.45% 964.81 54.81% 805.03
and easily see which Common Stock 27.87% 460.00 31.32% 460.00
Retained Earnings 13.69% 225.99 13.87% 203.77
accounts have Total Shareholder's Equity 41.55% 685.99 45.19% 663.77

increased or
Total Liabilities and Owner's Equity 100.00% 1650.80 100.00% 1468.80

decreased relative to
total assets 4
Financial Ratios

 Financial ratios are the analyst’s microscope; they

allow us to get a better view of the firm’s financial
health than just looking at the raw financial
statements
 Ratios are used by both internal and external analysts
• Internal uses
 planning
 evaluation of management

• External uses
 credit granting
 performance monitoring
 investment decisions

5
Categories of Financial Ratios

 Financial ratios are often divided into

categories based on the information that they
provide:
• Liquidity
• Efficiency
• Leverage
• Coverage
• Profitability
• Market valuation

6
Liquidity Ratios

 ‘Liquidity’ refers to the speed with which an

asset can be converted to cash
 Liquidity ratios describe the ability of a firm
to meet its current obligations
 There are three common liquidity ratios:
• The Current Ratio
• The Quick Ratio
• The Cash Ratio

7
 The Current Ratio

Current Assets
CR 
Current Liabilities
For EPI the current ratio in 1997 is:

1290
CR   2.39
540.20

8
 The Quick Ratio

Current Assets  Inventories

QR 
Current Liabilities

For EPI the quick ratio in 1997 is:

1290  838
QR   0.84
540.20

9
 The Cash Ratio

Cash
Cash Ratio 
Current Liabilities

For EPI the cash ratio in 1997 is:

50
Cash Ratio   0.09256
540.20

10
Efficiency Ratios

 The efficiency ratios (A.K.A. assets utilization

ratios) describe how well a firm is using its
investment in various asset classes:
• Inventory Turnover Ratio
• Accounts Receivable Turnover Ratio
• Average Collection Period
• Fixed Asset Turnover Ratio
• Total Asset Turnover Ratio

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 The Inventory Turnover Ratio

Cost of Goods Sold

Inventory Turnover 
Inventory

For EPI the inventory turnover ratio in 1997 is:

3250
Inventory Turnover   388
.
838

12
 The A/R Turnover Ratio

Annual Credit Sales

A / R Turnover 
Accounts Re ceivable

For EPI the accounts receivable turnover ratio in 1997 is:

3900
A / R Turnover   9.70
402

13
 The Average Collection Period

Accounts Re ceivable
Average Collection Period 
Annual Credit Sales 360

For EPI the average collection period in 1997 is:

402
Average Collection Period   37.11
3900 360

14
 The Fixed Asset Turnover Ratio

Sales
Fixed Asset Turnover 
Net Fixed Assets

For EPI the fixed asset turnover ratio in 1997 is:

3900
Fixed Asset Turnover   10.81
360.80

15
 The Total Asset Turnover Ratio

Sales
Total Asset Turnover 
Total Assets
For EPI the total asset turnover ratio in 1997 is:

3900
Total Asset Turnover   2.36
1650.80

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Leverage Ratios

 Leverage ratios describe the amount of debt

that the firm has used to finance its
investments in assets:
• Total Debt Ratio
• Long-term Debt Ratio
• Debt to Equity
• Long-term Debt to Equity

17
 The Total Debt Ratio

Total Liabilities
Total Debt Ratio 
Total Assets
For EPI the total debt ratio in 1997 is:

964.81
Total Debt Ratio   58.45%
1650.80

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 The Long-term Debt Ratio

Long termDebt
Long termDebt Ratio 
Total Assets
For EPI the long-term debt ratio in 1997 is:

424.61
Long termDebt Ratio   25.72%
1650.80

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 The Debt to Equity Ratio

Total Liabilities
Debt to Equity 
Total Equity
For EPI the debt to equity ratio in 1997 is:

964.81
Debt to Equity   141
.
685.99

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 The Long-term Debt to Equity Ratio

Long term Debt

LTD to Equity 
Total Equity

For EPI the long-term debt to equity ratio in 1997 is:

424.61
LTD to Equity   6190%
.
685.99

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Coverage Ratios

 Coverage ratios indicate the firm’s ability to

pay certain expenses:
• Times Interest Earned Ratio
• Cash Coverage Ratio

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 The Times Interest Earned Ratio
EBIT
TIE 
Interest Expense

For EPI the times interest earned ratio in 1997 is:

199.70
TIE   2.63
76

23
 The Cash Coverage Ratio

EBIT  Non cash Expenses

Cash Coverage Ratio 
Interest Expense

For EPI the cash coverage ratio in 1997 is:

199.70  20
Cash Coverage Ratio   2.89
76

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The Fixed Charge Coverage Ratio

EBIT + Lease Payments

Fixed Ch arg e Coverage =
SF Payments
Int. Exp.+LeasePayments +
(1- t )

 Note: SF Payments are Sinking Fund payments

which are not tax deductible. Therefore, we must
divide them by (1-t) to find out how much we need
before taxes to meet this after-tax expense. Also, you
must include preferred dividends in this number.

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Profitability Ratios

 Profitability ratios provide a measure of the

returns that a firm is generating:
• Gross Profit Margin
• Operating Profit Margin
• Net Profit Margin
• Return on Total Assets
• Return on Equity
• Return on Common Equity

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 The Gross Profit Margin

Gross Profit
GPM 
Sales

For EPI the gross profit margin in 1997 is:

650
GPM   16.67%
3900

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 The Operating Profit Margin

Net Operating Income

OPM 
Sales

For EPI the operating profit margin in 1997 is:

199.70
OPM   512%
.
3900

28
 The Net Profit Margin

Net Income
NPM 
Sales

For EPI the net profit margin in 1997 is:

74.22
NPM   190%
.
3900

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 The Return on Total Assets

Net Income
ROA 
Total Assets

For EPI the return on total assets in 1997 is:

74.22
ROA   4.50%
1650.80

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 The Return on Equity

Net Income
ROE 
Total Equity

For EPI the return on equity in 1997 is:

74.22
ROE   10.82%
685.99

31
 The Return on Common Equity

Net Income
ROCE 
Total Common Equity

For EPI the return on common equity in 1997 is:

74.22
ROCE   10.82%
685.99

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Market Valuation Ratios

 The market valuation ratios provide an

indication of the relative under- or over-
pricing of a firm’s stock:
• Price/Earnings Ratio
• Price/Book Ratio

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The Price/Earnings Ratio

Stock Pr ice
P/E
Earnings per Share

34
The Price/Book Ratio

Stock Price
P/B
Book Value per Share

35
Rules for Memorizing Ratios

 There can be an infinite number of financial

ratios, but knowing a few basic rules will help
you to memorize the formulas: The basic rule
is that the name tells you how to calculate the
ratio.
• Any ‘margin’ ratio is something divided by sales
• Any ‘turnover’ ratio is sales (or a variation of
sales) divided by something
• Any ‘return on’ ratio is net income (or a variation
of net income) divided by something
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Using Financial Ratios

 Calculating ratios is pointless unless you know how

to use them
 The most basic rule is: a single ratio provides very little
information and may be misleading
 With that in mind, there are at least 4 uses of ratios:
• Trend analysis (internal and external)
• Comparison to industry averages (internal and external)
• Setting and evaluating company goals (internal)
• Restrictive debt covenants (external)

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Trend Analysis of Ratios

 Trend analysis involves the

examination of ratios over
time EPI Current Ratio Trend

 The analyst tries to 2.40 x

2.39 x
determine if the ratio is 2.38 x

Curre nt Ratio
changing in a favorable, or
2.37 x
2.36 x

unfavorable, direction 2.35

2.34
x
x

The chart shows EPI’s

2.33 x
 2.32 x

current ratio for two years 2.31

2.30
x
x
(we really need more data) 1996 1997
Ye ar

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Comparing to Industry Averages
Industry
Ratio 1997 1997 1996
Liquidity Ratios
Current 2.70 x 2.39 x 2.33 x

Industry average ratios

Quick 1.00 x 0.84 x 0.85 x
 Efficie ncy Ratios

provide a benchmark
Inventory Turnover 7.00 x 3.88 x 4.00 x
A/R Turnover 10.70 x 9.70 x 9.97 x
Average Collection Period 33.64 37.11 36.12
for comparison Fixed Asset Turnover
Total Asset Turnover
11.20 x
2.60 x
10.81 x
2.36 x
10.15 x
2.38 x

 We assume that if a Total Debt Ratio

Le ve rage Ratios
50.00% 58.45% 54.81%

ratio is too far from the

Long-term Debt Ratio 20.00% 25.72% 22.02%
LTD to Total Capitalization 28.57% 38.23% 32.76%
Debt to Equity 1.00 x 1.41 x 1.21 x
average something is LTD to Equity 40.00%
Cove rage Ratios
61.90% 48.73%

wrong Times Interest Earned 2.50 x

Profitabilty Ratios
2.63 x 4.43 x

Industry ratios are

Gross Profit Margin 17.50% 16.67% 18.17%
 Operating Profit Margin 6.25% 5.12% 7.92%

available from Robert

Net Profit Margin 3.50% 1.90% 3.68%
Return on Total Assets 9.10% 4.50% 8.77%
Return on Equity 18.20% 10.82% 19.40%
Morris Associates and Payout Ratio
Othe r Ratios
70.06%
Standard & Poor’s Plowback (Retention) Ratio
Internal Growth Rate
29.94%
1.36%
Sustainable Growth Rate 3.35%
Capital Intensity Ratio 38.46% 42.33% 41.97%
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Company Goals and Debt Covenants

 Company goals are often stated in terms of

financial ratios
• For example, it is common for management to set
goals regarding the firm’s ROE
 Debt covenants often contain restrictions on
certain ratios
• For example, a borrower might be required to
maintain a debt to equity ratio of less than 1.0 and
a current ratio greater than 2.0

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