ASSESSING FINANCIAL

STATEMENTS ANALYSIS
TOPIC 3
 Sources and Uses
Sources
Cash inflow occurs when we sell something
Decrease in asset account
Accounts receivable, inventory, and net fixed assets
Increase in liability or equity account
Accounts payable, other current liabilities, RE and common stock
Uses
Cash outflow occurs when we buy something
Increase in asset account
Cash and other current assets
Decrease in liability or equity account
Notes payable and long-term debt
Standardized Financial Statements
Common-Size Balance Sheets
Compute all accounts as a percent of total assets
Common-Size Income Statements
Compute all line items as a percent of sales
Standardized statements make it easier to compare financial
information, particularly as the company grows
They are also useful for comparing companies of different
sizes, particularly within the same industry
CommonBase Year (Income statement & Balance Sheet)
Compute all items relative to a certain base year amount.
Standardized Financial Statements

WRMAS 4
 USES OF FINANCIAL RATIO
Internal (Firm)
Identify deficiencies in a firms
performance and take corrective
action.
Evaluate employee performance
and determine incentive
compensation.
Compare the financial performance
of different divisions within the
firm.
Prepare, at both firm and division
levels, financial projections.
Compare performance against other
firms (competitors) or industry
standards.
Evaluate the financial condition of a
major supplier.
WRMAS
External (Outside the Firm)
Lenders in deciding whether or
not to make a loan to a company.
Credit-rating agencies in
determining a firms credit
worthiness.
Investors (shareholders and
bondholders) in deciding whether
or not to invest in a company.
Major suppliers in deciding
whether or not to grant credit
terms to a company.
5
 Types of Analysis
Trend analysis
Compare the current ratios with ratios in previous year. It
covers some time period so the analyst can see the
achievement flow for the company in longer period.
Comparison analysis
Compare the companys ratios with ratios of other equivalent
companies. If there is industry ratios, it can be used as a guide
to evaluate the position of the company in the industry.
Benchmarking
Compare the companys financial position with other
competitors.

WRMAS 6
Analyzing Financial Performance: Ratio

1. Liquidity Ratio
2. Asset Management/Activity Ratio
3. Profitability Ratio
4. Leverage Ratio
5. Market Value Ratio

WRMAS 7
Analyzing Financial Performance: 5 Key
Questions
1. How liquid is the firm?
Liquidity ratios (or short-term insolvency)
2. Is management generating adequate operating profits on
the firms assets?
Asset management (or turnover ratio)
3. How is the firm financing its assets?
Financial leverage ratios (or long-term insolvency)
4. Is management providing a good return on the capital
provided by the shareholders?
Profitability ratios
5. Is the management team creating shareholder value?
Market value ratios

WRMAS 8
Balance Sheet (For Ratios)

WRMAS 9
Income Statement (For Ratios)

WRMAS 10
 LIQUIDITY RATIO
How liquid is the firm?
Liquidity shows the ability of the firm to pay it short term
debt in the time given. It indicates the ease with which non-
cash assets can be converted to cash to meet the financial
obligations.
Generally, bigger liquidity ratios, give a better position of the
firms liquidity.

WRMAS 11
Liquidity Ratio

WRMAS 12
Liquidity Ratio

WRMAS 13
 ASSET MANAGEMENT RATIO
Is management generating adequate operating profits on the
firms assets?
It uses to identify the efficiency and effectiveness of the firm
in managing its assets.
The firm should make basic decision about total investment in
account receivable, inventory and fixed assets.
The firm is responsible to use the assets efficiency and
effectively.

WRMAS 14
Asset Management Ratio

WRMAS 15
 Asset Management Ratio
Inventory Turnover shows how many times per year the inventory
will be sold and replaced.
How many times is inventory rolled over per year?
Cost of goods sold
Inventory turnover = = TIMES
Inventory
Davies Example?
The higher turnover means the firm in better position because it
shows the quick inventory movement. Inventory can be sold
quickly and replace back immediately.

WRMAS 16
Asset Management Ratio

WRMAS 17
 PROFITABILITY RATIO
Are the firms managers generating adequate profit to the
companys ?
It measure a firms effectiveness in turning sales or assets into
profits.

WRMAS 18
Profitability Ratio

WRMAS 19
 Profitability Ratio
Return on Equity (ROE) determines the efficiency of the firm to
generate income for its shareholder. It is a profitability
measurement to equity investment in the firm.
Are the Firms Managers Providing a Good Return on the Capital
Provided by the Shareholders?
Net income
Return on equity = = %
Total equity
Davies Example?

Higher of this ratios is better because it shows the firm is able to

produce higher profit to its owners.

WRMAS 20
 LEVERAGE RATIO
Does the firm finance its assets by debt or equity or
both?
Leverage ratio shows the ability of the firm to fulfill its
responsibility or obligation to their creditors.
This ratio determines the effectiveness of management
in using and managing capital.
There are two major types of debt management ratios:
1. Ratios that measure the amount of debt
2. Ratios that indicate the ability of the firm to service
its debt

WRMAS 21
Leverage Ratio

WRMAS 22
 Leverage Ratio
Equity Multiplier -measures the dollars of assets on the balance
sheet for every dollar of equity financing
Total assets
EM = = 1 + D/E ratio
Total equity
Davies Example?
The lower of this ratio is better because it means a company
is using less debt to fund its assets
Long-term debt ratio -shows the relative importance of long-
term debt to the long-term financing of the firm. Total
Total long-term debt Capitalization
L-Term Debt =
Total L-T debt + Total Equity
The lower of this ratio is better because is thought to be less
risky as they have less liabilities and more equity.
WRMAS 23
 Leverage Ratio
Times Interest Earned (TIE) measures how many times the firm
has profit to pay interest expenses. Indicates a firms ability to
cover interest charges.
TIE = Operating profit (EBIT)
Interest expense = TIMES
Davies Example?
The higher of this ratio is better because it shows the firm is
able to pay the interest expenses.

Cash Coverage- measures the number of dollars of operating

cash available to meet each dollar of interest and other fixed
charges
EBIT + Depreciation
CC =
Interest

WRMAS 24
 MARKET VALUE RATIO
Are the firms managers creating shareholder value?
Ratios relate an observable market value, the stock price, to
book values obtained from the firm's financial statements.
Used to gauge how attractive or reasonable a firms current
price is relative to its earnings, growth rate, and book value:
Earning Per Share represents the portion of a firm's earnings,
that is allocated to each share of common stock.
Net income
Earning Per Share= = $
No. of Share outstanding
Davies Example?

The higher the earnings per share, the higher each share should
be worth.
WRMAS 25
Market Value Ratio

WRMAS 26
 DuPont Analysis
DuPont analysis is a decomposition model.
The Basic DuPont equation

=

=
The ROA depends on the firms profit margin (which is an
indicator of expense control) and total asset turnover, an
indicator of how efficiently the firm manages its assets.
The full DuPont formula looks at the decomposition of ROE:

27
LIMITATIONS OF FINANCIAL RATIO ANALYSIS
Ratios can provide meaningful comparisons of companies in
similar industries. Also, keep in mind that ratio analysis does not
tell the entire story. Why?
1) Many large firms operate in multiple lines of business. It is
difficult to find a meaningful set of industry-average ratios.
2) Seasonal factors can also distort ratio analysis.
3) Industry average is only estimation and guidelines. Industry
average is not necessarily a desirable target and required
ratio. It only illustrates the firm position in industry.
4) A company may have some good and some bad ratios,
making it difficult to tell if it's a good or weak company.
5) Different accounting method among the firm results different
calculation of ratios. For example, in calculating inventory and
depreciation.
WRMAS 28