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Financial Statement Analysis

1
FINANCE 101
MAMUNUR RASHID

Chapter Objectives
2

To discuss briefly about different financial

statements.

To analyze the financial statements using different
techniques like ratio analysis, common size
statement, DuPont Method.

To learn how to write a report on financial statement
analysis.

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Financial Statements
3

Financial statements are end result of company

performance.

Types of financial statements:

Balance Sheet
Income Statement
Cash flow Statement
Owners Equity Statement
Value Added Statement

Balance Sheet
4

Balance Sheet is

ABC Company

a financial
Balance Sheet
statement that
As on 31st December, 2005
represents
(Figures in Million Taka)
Assets, Liability Assets
Liability + Owners Equity
and Owners
100 Short term loan
Equity; where Cash + Marketable Securities
Asset items Inventory
220 Accounts payable
must be Accounts Receivables
180 Long term bank loan
balanced with
500 Total liabilities
Liability Total Current Assets
+Owners Fixed Assets
100 Total equity
Equity items. Total Assets
600 Total Share Holders + Equity

50
50
150
250
350
600

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Income Statement
5

Income Statement

is a financial
statement that
represents
income, expenses
and net profit or
loss for a certain
period of time.

ABC Company
Income Statement
For the year ended on 31st Dec, 2005
(Figures in Million Taka)

Sales

1000

Less: Cost of Goods Sold (COGS)

800

Gross Profit

200

Less: Operating Expenses

120

Earnings before Interest and Taxes

80

Less: Interest

20

Less: Tax

30

Net Income

30

Cash Flow Statement

6

Cash flow statement is a financial statement that represent the cash inflow, cash

outflow and net cash flow for a certain period of time.

Calculation steps:

Prepare the sources and uses statement

Allocate the source and uses items into Operating, Financial and Investing activities.

Rules for Sources and Uses:

Increase in asset items will decrease cash and vice versa.

Increase in liability items will increase cash and vice versa.

Depreciation is always a source of cash.

Net income is source but net loss is use of cash.

Cash Flow Statement: Allocating sources and uses into

Operating activities: Short term asset and liabilities, and income statement items.

Investing activities: Long run investment in fixed asset and financial assets.

Financing activities: Long run collection of fund and related activities.

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Example of Cash flow Statement

7
SOURCE AND USE STATEMENT

Cash and marketable securities

31/12/04

31/12/05

Source

40

15

25

Use

Cash Flow Statement

For the year ended on Dec 31, 2005
Cash flows from operating activities
Net income

54

Depreciation

50

Increase in accounts payable

15

Accounts receivables

160

180

20

Inventory

200

270

70

Increase in accruals

Gross plant and equipment

600

680

80

Increase in accounts receivables

(20)

Accounts payable

15

30

15

Increase in inventory

(70)

Accruals

55

60

Cash flows from long-term investment activity

Acquisition of fixed asset

Net cash flows from operating activity

34
(80)

Notes payable

35

40

Long-term bonds

255

300

45

Increase in notes payable

Common stock (25 M shares)

130

130

Increase in bonds

45

Net income

54

Dividend payment

(29)

Add: Depreciation

50

Net Cash flows from financing activity

Gross cash flow from operations

104

Dividend payment

29

Totals

Cash flows from Financing Activity

104
29
199

21

Net change in cash

(25)

Cash at the beginning

40

Cash at the end of the year

15

199

Owners Equity Statement

8

O/E Statement is

a financial
statement that
shows the
changes in
owners capital
position
generally in
terms of share
capital, retained
earnings,
reserves and
dividends.

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Value Added Statement

9

Valued Added

Statement is
the financial
statement that
represents the
contribution
of the
company to
the economy
or society.

Financial Statement Analysis - Objective

10

P

Performance analysis.

P

Problem identification.

P

Plan to solve the problem.

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How to Analyze Performance?

11

Ratio Analysis: Ratios are mathematical variables

showing the interrelationship between two or more

variables.

Common-size Statement

DuPont Method

Ratio Analysis
12

Advantages:

Easy to calculate.

Easy way to understand financial health of the company.

Through comparison, problems can be identified easily.

Disadvantages:

Difficult to interpret the results.

Window Dressing System might affect the result.

Ratios are affected by economic variables.

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Types of Ratios (Clockwise)

13
Liquidity Ratios

Asset
Management
Ratios

Market Ratios

Debt
Management/
Leverage
Ratios

Profitability
Ratios

Liquidity Ratio
14

Popular Ratios
Liquidity Ratio measures the
instant ability of the company
to pay short-term liabilities.
It shows the reserve of shortterm asset to pay for shortterm liabilities.

Current Ratio

Quick Ratio or Acid Test Ratio

Cash Ratio

Internal Measure

NWC to Total Asset Ratio

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Current Ratio
15

Current Ratio measures the reserve of current asset for paying current liability.

Current Ratio =

Current Assets
= 1 .5 x
Current Liabilitie s

Interpretation: Company has total current asset of $1.5 to pay for $1 of current
liabilities.
Decision
 Current Ratio; Reserve of Current Asset to pay for Current Liabilities.
 Current Ratio; Liquidity but the profitability.

Quick or Acid Test Ratio

16
Quick Ratio measures the reserve of quick asset for paying current liability. Inventory is the least liquid
current assets and its required to be converted to A/R and cash will be collected. So, inventory is
deducted to show the reserve of quick asset to pay for current liability.

Quick Ratio =

Current Assets - Inventory

= 1.0 x
Current Liabilities

Interpretation: Company has quick asset of $1 to pay for $1 of current

liabilities.
Decision
 Quick Ratio; Reserve of Quick Asset to pay for Current Liabilities.
 Quick Ratio; Liquidity but the profitability.

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Cash Ratio
17

Cash Ratio measures the reserve of quickest asset for paying current liability. It
measures the instant liquidity of the company.

Cash Ratio =

Cash + M/S
= .50 x
Current Liabilities

Interpretation: Company has quickest asset, (the most liquid asset) of $0.50 to
pay for $1 of current liabilities.
Decision
 Cash Ratio; ability to pay liabilities very instantly.
 Cash Ratio; Liquidity but the profitability.

Trade off between Liquidity vs. Profitability

18

Liquidity - company will run well in short term.

Suppliers will be happy but owners will be unhappy.
Liquidity - Profitability
Liquidity - Profitability
Which one to choose?

Liquidity owners will be happy but company wont be

able to collect raw materials and therefore cannot sustain
for long.
Make a Trade Off
Managers responsibility to choose a balance between
two options, so that both the suppliers and the owners
become happy. In fact the basic responsibility of any
manager is to manage the stakeholders.

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Asset Management Ratio

Asset Management Ratio measures, how efficiently
company assets were managed?
Asset management ratios are related to both liquidity
and profitability and therefore should be treated very
carefully.

Cash

Inventory
Cash Conversion
Cycle (CCC)

Popular Ratios

Inventory Turnover Ratio

Inventory Turnover Period

Receivables Turnover Ratio

Receivables Turnover Period

Payables Turnover Ratio

Payables Turnover Period

Cash Conversion Cycle

Fixed Asset Turnover Ratio

Total Asset Turnover Ratio

A/R

Inventory Turnover Ratio (ITOR)

20

ITOR shows, how many times inventory is converted to Account Receivables

(or Sales or Turnover) within a year.

ITOR

COGS
Inventory

= 4x

Interpretation: Company can sell total finished goods (inventory) 4 times every year.

Decision
 ITOR; efficiency in managing inventory.
 ITOR; the reserve of inventory and inventory holding cost.

10

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Inventory Turnover Period (ITOP)

21

ITOP shows, how many days it takes to convert inventory to Account

Receivables (or Sales or Turnover) each time.

ITOP

Inventory
COGS
360

= 90 days

Interpretation: It takes average 90 days to sell inventories for each time.

Decision
 ITOP; efficiency in managing inventory.

Receivables Turnover Ratio (RTOR)

22

RTOR shows, how many times receivables is converted to cash within a year. It
means, how many times A/R is collected to cash?

RTOR =

Annual Sales
= 6x
A/R

Interpretation: Company can collect sell on credit from customers 6 times every year.

Decision
 RTOR; efficiency in managing receivables.
 RTOR; faster is the collection of cash, liquidity and profitability will go up.

11

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Receivables Turnover Period (RTOP)

23

RTOP shows, how many days it takes to convert receivables to cash each time.
This is also called Average Collection Period or Days Sales Outstanding.

RTOP =

Receivables
= 60 days
Annual Sales
360

Interpretation: It takes average 60 days to collect receivables for each time.

Decision
 RTOP; efficiency in collecting cash from clients.
 Company cannot pay before 60 days. So, company shout get into credit terms with
the suppliers for at least 60 days (with some days kept as precaution i.e. + 5 days).

Fixed Asset Turnover Ratio (FATOR)

24

FATOR shows, how much sales is generated by using per unit of fixed asset? It
measures the efficiency of fixed asset management.

FATOR =

Annual Sales
= 3x
Net Fixed Asset

Interpretation: Company generated $3.0 of sales by investing $1 in fixed asset.

Decision
 FATOR; efficiency in managing fixed asset.
 High FATOR shows that fixed assets were properly utilized.

12

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Total Asset Turnover Ratio (TATOR)

25

TATOR shows, how much sales is generated by using per unit of total asset? It
measures the efficiency of total investment management.

TATOR =

Annual Sales
= 1.2 x
Total Asset

Interpretation: Company generated $1.2 of sales from $1 of total investment.

Decision
 TATOR; efficiency in managing total investment.
 TATOR shows the integrated efficiency of production, marketing and finance
department.

Debt Management Ratio

26

Debt Management Ratio shows

company efficiency to manage
the outside/ borrowed fund.
This ratio measures the
percentage of fund from outside
sources both for short-term and
long-term.

Popular Ratios

Debt to Asset Ratio
(D/A Ratio)

Long-term Debt to
Asset Ratio

Times Interest Earned
(TIE) Ratio

13

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Debt to Asset Ratio (D/A Ratio)

27

Debt to Asset Ratio shows the percentage of fund collected from outside debt
sources in the capital structure.

D/A Ratio =

Total Debt
= 50.9%
Total Asset

Interpretation: Company financed 50.9% fund from outside debt sources.

Decision
 D/A; more fund collected from outside, less fund can be collected form issuance of share.
 High D/A ratio also exhibits high level of risk. Company with high D/A ratio, usually carries
high risk and tends to offer more premium with other financing modes.

Long-term Debt to Asset Ratio (Lt.D/A Ratio)

28
Long-term Debt to Asset Ratio shows the percentage of fund collected from long-term
outside debt sources in the capital structure.

Lt.D/A Ratio =

Total Long - term Debt

= 20%
Total Asset

Interpretation: Company financed 20% fund from long-term debt sources.

Decision
 Lt. D/A; more fund collected from long-term outside sources, less fund can be collected
form issuance of share and short-term sources.
 High Lt. D/A ratio exhibits an opportunity loss since the company is collecting less shortterm debt sources, therefore by not taking the chance of credit purchase or accruals, those
are much safer than long-term debt and equity.

14

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Times Interest Earned (TIE)

29
TIE Ratio measures the ability of paying fixed financing liability i.e. interest. How much
interest company can with current operating income, is the main theme of TIE Ratio.

TIE Ratio =

EBIT
= 3x
Interest

Interpretation: Company can pay interest twice with the current operating income available.

Decision
 TIE Ratio; ability to pay interest.
 Company with high TIE ratio can easily get loan. Because bank will check companys TIE
Ratio, whether the company is able to pay the interest in time or not.

Profitability Ratio
30

Popular Ratios

Profit Margin on Sales
Profit + Ability = Profitability
(PMOS)
This ratio measures the
Return on Asset (ROA)
ability to earn profit.
(also called ROI)

Return on Equity
(ROE)

15

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Profit Margin On Sales (PMOS)

31

PMOS ratio calculates the percentage profit earned on sales.

PMOS =

Net Income
= 3%
Sales

Interpretation: Company earned $3 on each $100 sales.

Decision
 PMOS; ability to earn profit
 Higher PMOS ratios shows the integrative profit management in the
company.

Return on Asset (ROA) or ROI

32

ROA ratio measures the percentage of income earned on total investment.

Sometimes also called Return on Investment.

ROA =

Net Income
= 1.5%
Total Asset

Interpretation: Company earned $1.5 for each $100 of total investment.

Decision
 ROA; profitability on marginal investment.

16

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Return on Equity (ROE)

33

ROE ratio measures the income earned on the fund provided by the owners.

ROE =

Net Income
= 5%
Total Equity

Interpretation: Company earned $1.5 for each $100 of total equity.

Decision
 ROE; profitability on owners fund, therefore, potential investors will be
attracted to invest in this company.

Market/Book Ratio (M/B Ratio)

34

Market/Book ratio
measures the value of
the company in the stock
market in terms of
market share. It
represents the value of
the company to the
owners.

Popular Ratios

Earning Per Share (EPS)

Dividend Per Share (DPS)

Price Earning Ratio (P/E
Ratio)

Market/Book Ratio (M/B
Ratio)

17

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EPS
35

EPS returns the earning for each share.

EPS =

Net Income
= $10
No. of Shares Outstanding

Interpretation: Company earned $10 for each share of the investors.

Decision
 EPS; profitability for existing shares, therefore, secondary market activity
will increase. Market value will increase as well.

DPS
36

DPS returns the actual dividend earning for each share.

DPS =

Dividend
= $5
No. of Common Shares Outstandin g

Interpretation: Company has given $5 as dividend per share to the shareholders.

Decision
 DPS; profitability for existing shares.
 Earning oriented investors will be attracted to purchase the share.
Secondary market activity will go up and the market as well.

18

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P/E Ratio
37

P/E Ratio measures the willingness of investors to purchase the share.

P/E Ratio =

MPS
= 2x
EPS

Interpretation: Investors are willing to spend $2 for each dollar of earning for the company share.

Decision
 P/E; investors willingness to purchase the share.
 It measures growth opportunity of the company. Investors will pay more if
the growth opportunity is high.

M/B Ratio
38

M/B ratio measures the comparative market and book value for the company.

M/B Ratio =

MPS
= 2x
Book Value per share

Interpretation: Company market value (image in the market) is 2 times higher than the
value in the book (balance sheet).
Decision
 M/B Ratio; market image of the company.
 Higher M/B might be successful to generate more investment opportunities for the
company when the market becomes clear about its image and activity.

19

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Du Pont Analysis
39

Du Pont is a multinational diversified company. It identified

an analysis method for judging its financial performance.

After the name of the company, therefore the name of the
analysis is Du Pont Analysis.

Du Pont analysis is the decomposition of financial variables

into smaller parts so that the problem can be easily

identified.

Du Pont Method
40

ROE

Sales Costs - I T

Current Asset +
Fixed Asset

Net Income
Total Equity

Total Asset over

Total Equity =
Equity Multiplier

Net Income Total Asset

x
Total Asset Total Equity

Total Equity = Share

capital, R/E, Other
reserves

Decompose ROE:
1. Sales, 2. Cost, 3. Interest expense, 4. Tax expense, 5. Current Assets, 6. Fixed assets,
7. Share capital, 8. Retained earnings, 9. Other reserves etc.

20

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Common Size Statement

41

How to Prepare:
Common-size Balance Sheet: Divide all the BALANCE SHEET items with Total Asset.
Common-size Income Statement: Divide all the INCOME STATEMENT items with Sales.

Result: Percentage result of all the Balance Sheet and Income Statement items having
Total Asset and Sales 100%.
Implication: Percentage result is always easy to understand and interpret.
Performance can be compared variable wise, company wise and year wise.

Example: Income (Common Size) Statement

ABC COMPANY INCOME STATEMENT (COMMON SIZE)
2001

2002

Sales

1000

100.0%

1200

100.00%

COGS

800

80.0%

900

75.00%

Gross Profit

200

20.0%

300

25.00%

Operating Expense

130

13.0%

180

15.00%

EBIT

70

7.0%

120

10.00%

Interest

15

1.5%

35

2.92%

EBT

55

5.5%

85

7.08%

Tax

22

2.2%

34

2.83%

Net Income

33

3.3%

51

4.25%

21

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Trend Analysis
43

Forecasting is the first responsibility of financial managers.

Trend analysis helps in forecasting the financial variables for

future, which eventually helps in decision making.

We can use a software which will give a trend forecast i.e.
Ms. Excel or SPSS.

You need historical time series information of the target
variable. You need to identify the dependent and
independent variables.

Trend Analysis using Microsoft Excel

44

22

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Trend Graph
45

Sales $

Trend Line

Year

23