Chapter 4

Analyzing Financial Statements

Learning Objectives
1. Explain the three perspectives frm !hich financial statements can be vie!e".
#. $escribe cmmn%size financial statements& explain !hy they are 'se"& an" be able
t prepare an" 'se them t analyze the histrical perfrmance f a firm.
(. $isc'ss h! financial ratis facilitate financial analysis& an" be able t cmp'te an"
'se them t analyze a firm)s perfrmance.
4. $escribe the $'*nt system f analysis an" be able t 'se it t eval'ate a firm)s
perfrmance an" i"entify crrective actins that may be necessary.
+. Explain !hat benchmar,s are& "escribe h! they are prepare"& an" "isc'ss !hy
they are imprtant in financial statement analysis.
-. ."entify the majr limitatins in 'sing financial statement analysis
.. Chapter O'tline
4.1 /ac,gr'n" fr Financial Statement Analysis
A. Stockholders Perspective
Shareholders focus centers on the value of the stock they hold.
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Their interest in the financial statement is to gauge the cash flows that the firm
will generate from operations,
This allows them to determine the firms profitability, their return for that
period, and the dividend they are likely to receive.
B. Managers Perspective
On one hand, managements interest in the firms financial statement is similar
to that of shareholders.
A good performance by the firm will keep the management in the firm, while
a poor performance can cost them their obs.
!n addition, management gets feedback on their investing, financing, and
working capital decisions by identifying trends in the various accounts that are
reported in the financial statements.
C. Creditors Perspective
"reditors or lenders are primarily concerned about getting their loans repaid
and receiving interest payments on time.
Their focus is on#
Amount of debt the firm has.
$irms ability to meet short%term obligations.
$irms ability to generate sufficient cash flows to meet all legal obligations
first and still have sufficient cash flows to meet debt repayment and
interest payments.
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D. Guidelines for Financial Statement Analsis
!dentify whose perspective you are using to analy'e a firm(management,
shareholder, or creditor.
)se only audited financial statements if possible.
*erform analysis over a three% to five%year period(tren" analysis.
"ompare the firms performance to its direct competitors(that is, firms that
are similar in si'e and offer similar products.
*erform a benchmar, analysis. This involves comparing it to one or more of
the most relevant competitors(American Air with +elta or )nited Airlines.
4.# Cmmn%Size Financial Statements
A common%si'ed balance is created by dividing each asset or liability by a base number
like total assets or sales. Such common%si'e or standardi'ed financial statements allow
one to compare firms that are different in si'e.
A. Common!Si"e Balance Sheets
,ach asset and liability item on the balance sheet is standardi'ed by dividing it
by ttal assets,
This results in these accounts being represented as percentages of total assets.
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B. Common!Si"e #ncome Statements
,ach income statement item is standardi'ed by dividing it by the dollar
amount of sales.
,ach income statement item is now indicated as a percentage of sales.
4.( Financial Statement Analysis
A. $vervie%
A ratio is computed by dividing one balance sheet or income statement item
by another.
A variety of ratios can be computed to focus on speciali'ed aspects of the
firms performance.
The choice of the scale determines the story that can be garnered from the
ratio.
+ifferent ratios can be calculated based on the type of firm being analy'ed or
the kind of analysis being performed.
.atios may be computed to measure li/uidity, efficiency, leverage,
profitability, or market%value performance.
B. &i'uidit (atios
0i/uidity ratios measure the ability of the firm to meet short%term obligations
with short%term assets without putting the firm in financial trouble.
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There are two commonly used ratios to measure li/uidity(current ratio and
/uick ratio.
C'rrent rati is calculated by dividing the current assets by current
liabilities.
!t tells how many dollars of current assets the firm has per dollar of current
liabilities.
The higher the number, the more li/uid the firm and the better its ability to
pay its short%term bills.
0'ic, rati or aci"%test rati is calculated by dividing the most li/uid of
current assets by current liabilities. !nventory that is not very li/uid is
subtracted from total current assets to determine the most li/uid assets.
!t tells us how many dollars of li/uid assets the firm has per dollar of
current liabilities.
The higher the number, the more li/uid the firm and the better its ability to
pay its short%term bills.
2uick ratios will tend to be much smaller than current ratios for
manufacturing firms or other industries that have a lot of inventory, while
service firms that tend not to carry too much inventory will see no significant
difference between the two.
C. )fficienc (atios
This set of ratios, sometimes called asset turnover ratios, measures the
efficiency with which a firms management uses the assets to generate sales.
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4hile management can use these ratios to identify areas of inefficiency that
re/uire improvement, creditors can use some of these ratios to determine the
speed with which inventory can be converted to receivables, which can then
be converted to cash and help the firm to meet its debt obligations.
These efficiency ratios focus on inventory, receivables, and the use of fi5ed
and total assets.
.nventry t'rnver rati is calculated by dividing the cost of goods sold by
inventory.
6ear%end inventory can be used or, if a firm e5periences significant
changes in the inventory level during the year, the average inventory level
can be used.
!t measures how many times the inventory is turned over into saleable
products.
The more times a firm can turn over the inventory, the better.
Too high a turnover or too low a turnover could be a warning sign.
Another ratio that builds on the inventory turnover ratio is the "ays) sales in
inventry.
!t measures the number of days the firm takes to turn over the inventory.
The smaller the number, the faster the firm is turning over its inventory
and the more efficient it is.
Acc'nts receivables t'rnver rati measures how /uickly the firm collects
on its credit sales.
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The higher the fre/uency of turnover, the /uicker it is converting its credit
sales into cash flows.
Another measure of the firms efficiency in this regard is $ays Sales
O'tstan"ing.
!t measures in days the time the firm takes to convert its receivables into
cash.
The fewer the days it takes the firm to collect on its receivables, the more
efficient the firm is.
.ecogni'e, however, that an over'ealous credit department may turn off
the firms customers.
1tal asset t'rnver rati measures the level of sales a firm is able to
generate per dollar of total assets.
The higher the total asset turnover, the more efficiently management is
using total assets.
Fixe" asset t'rnver rati measures the level of sales a firm is able to
generate per dollar of fi5ed assets.
The higher the fi5ed asset turnover, the more efficiently management is
using its plant and e/uipment.
This ratio is more significant for e/uipment%intensive manufacturing
industry firms, while the total assets turnover ratio is more relevant for
service industry firms.
D. &everage (atios
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The ability of a firm and its owners to use their e/uity to generate borrowed
funds is reflected in the leverage ratios.
Financial leverage refers to the use of long%term debt in a firms capital
structure.
The use of debt increases shareholders returns thanks to the ta5 benefits
provided by the interest payments on debt.
Two sets of ratios can be used to analy'e leverage(debt ratios that /uantify
the use of debt in the capital structure and coverage ratios that measure the
ability of the firm to meet its debt obligations.
The first ratio, ttal "ebt rati, is calculated by dividing total debt by total
assets.
Total debt includes short%term and long%term debt.
The higher the amount of debt, the higher the firms leverage, and the
more risky it is.
The second leverage ratio is "ebt%t%e2'ity rati.
!t measures the amount of debt per dollar of e/uity.
The third leverage ratio is called the e2'ity m'ltiplier or leverage
m'ltiplier.
!t tells us the amount of assets that the firm has for every dollar of e/uity.
!t serves as the best measure of the firms ability to leverage shareholders
e/uity with borrowed funds.
Of the cverage ratis, the first one is times interest earne".
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!t measures the number of dollars in operating earnings the firm generates
per dollar of interest e5pense.
The higher the number, the greater the ability of the firm to meet its
interest obligations.
The second ratio is the cash cverage rati.
!t measures the amount of cash a firm has to meet its interest payments.
). Profita*ilit (atios
These ratios measure the financial performance of the firm.
3rss prfit margin measures the amount of gross profit generated per dollar
of net sales, while perating prfit margin measures the amount of operating
profit generated by the firm for each dollar of net sales. 4et prfit margin
measures the amount of net income after ta5es generated by the firm for each
dollar of net sales.
!n each case, the higher the ratio, the more profitable the firm.
4hile management and creditors are likely to focus on these profitability
measures, shareholders are likely to concentrate on two others.
1he ret'rn n assets 56OA7 ratio measures the amount of net income per
dollar of total assets.
A variation of this ratio, called the E/.1 ret'rn n assets, is a powerful
measure of return because it tells us how efficiently management utili'ed the
assets under their command, independent of financing decisions and ta5es.
This measures the amount of ,:!T per dollar of total assets.
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The ret'rn n e2'ity 56OE7 ratio measures the dollar amount of net income
per dollar of shareholder s e/uity.
$or a firm with no debt .OA < .O,= for firms with leverage .O, > .OA
?assuming that .OA is positive@.
F. Market!+alue #ndicators
The ratios that follow tell us how the market views the companys li/uidity,
efficiency, leverage, and profitability.
1he earnings per share 5E*S7 ratio measures the income after ta5es
generated by the firm for each share outstanding.
The price%earnings 5*8E7 ratio ties the firms earnings per share to price per
share.
The *A, ratio reflects investors e5pectations that the firms earnings will
grow in the future.
4.4 1he $'*nt System9 A $iagnstic 1l
A. An $vervie%
The +u*ont system is a set of related ratios that links the balance sheet and
the income statement.
!t is used as a diagnostic tool to evaluate a firms financial health.
:oth management and shareholders can use this tool to understand the factors
that drive a firms .O,.
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!t is based on two e/uations that relate a firms .OA and .O,.
B. ,he ($A )'uation
.eturn on assets, which is Cet income A Total assets, can be broken down into
two components(profit margin and total assets turnover ratio. See ,/uation
1.&1.
The net profit margin measures managements ability to generate sales and
efficiently manage the firms operating e5penses= overall, this is a measure of
operating efficiency.
Total asset turnover looks at how efficiently management uses the assets under
its command(that is, how much output can be generated with a given asset
base. Thus, asset turnover is a measure of asset use efficiency.
The .OA e/uation says that if management wants to increase the firms .OA,
it can increase the profit margin, asset turnover, or both.
:y the same token, management can e5amine a poor .OA and determine
whether operating efficiency is the problem or asset use efficiency problem.
C. ,he ($) )'uation
This e/uation is simply a restatement of ,/uation 11.9. .eorgani'ation of the
terms allows .O, to be restated as a product of the .OA and the e/uity
multiplier.
.O, is determined by the firms .OA and its use of leverage.
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A firm with a small .OA can magnify it by using a higher leverage to get a
higher .O,.
D. ,he DuPont )'uation
Substituting the .OA into the .O, e/uations gives us the +u*ont e/uation as
shown in ,/uations 1.&- and 1.&1.
The +u*ont e/uation shows that a firms .O, is determined by three factors#
?1@ net profit margin, which measures the firms operating efficiency, ?&@ total
asset turnover, which measures the firms asset use efficiency, and ?-@ the
e/uity multiplier, which measures the firms financial leverage.
Analy'ing a firms financial performance will allow one to identify where the
inefficiencies are and where the strengths are.
!f operational efficiency is the area of weakness, then it calls for a closer look
at the firms income statement items.
!f asset turnover or leverage is the problem area, then the focus shifts to the
balance sheet.
). ($) as a Goal
The issue of whether ma5imi'ing .O, is e/uivalent to ma5imi'ing
shareholders wealth is something to be discussed.
Those who do not agree that they are the same identify three key weaknesses.
The first weakness with .O, is that it is based on after%ta5 earnings, not
cash flows.
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Ce5t, .O, does not consider risk.
Third, .O, ignores the si'e of the initial investment as well as future cash
flows.
Those who believe that they are consistent propose that#
.O, allows management to break down the performance and identify
areas of strengths and weaknesses.
.O, is highly correlated with shareholder wealth ma5imi'ation.
4.+ Selecting a /enchmar,
A ratio analysis becomes relevant only if it can be compared against a
benchmark.
$inancial managers can create a benchmark for comparison in three ways#
through trend analysis, industry average analysis, and peer group analysis.
A. ,rend Analsis
This benchmark is based on a firms historical performance.
!t allows management to e5amine each ratio over time and determine whether
the trend is good or bad for the firm.
B. #ndustr Analsis
!ndustry analysis is another way of developing a benchmark.
$irms in the same industry are grouped by si'e, sales, and product lines to
establish benchmark ratios.
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One way of identifying industry groups is the Stan"ar" .n"'strial
Classificatin 5S.C7 System.
C. Peer Group Analsis
!nstead of selecting an entire industry, management may choose to identify a
set of firms that are similar in si'e or sales, or who compete in the same
market.
The average ratios of this peer group would then be used as the benchmark.
+epending on the industry, peer groups can be as small as three or four firms.
4.-. :sing Financial 6atis
0imitations of ratio analysis include the following#
!t depends on accounting data based on historical costs.
There is no theoretical backing in making udgments based on financial
statement and ratio analysis.
4hen doing industry or peer group analysis, you are often confronted with
large, diversified firms that do not fit into any one S!" code.
Trend analysis could be distorted by financial statements affected by inflation.
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