How to Analyse Financial StatementsThere is a

How to Analyse Financial Statements

There is a great deal of
valuable information in
financial statements.

But we must know how to
extract and refine it.

The process is like a doctor
diagnosing a patient's health.

The process is similar, but
our tools of analysis are not
quite the same.

Our tools of analysis are
financial ratios.

Financial Statement Analysis

When an unconscious patient arrives at the emergency room of
the hospital, what does the doctor do?

Answer: check the vital signs, like pulse, blood pressure,
temperature, etc.

Similarly, when we analyse financial statements, we check the
vital signs of the organization.

What are these vital signs? They include:

Short-term Liquidity


Profitability on Revenue

Profitability on Investment

Long-Term Asset Turnover

Long-term Leverage

For more, see the next slide.

Financial Vital Signs

Short-term Liquidity


On Revenue

On Investment

Long-Term Asset Turnover

Long-term Leverage

Market Performance

DuPont Analysis

Benchmarks (Yardsticks)‏

Data Sources

Short-term Liquidity

Short-term Liquidity means being able to
meet the payroll and pay the bills.

Organizations unable to meet the payroll
and pay the bills will soon collapse.

That is why our first step in financial
statement analysis is to test short-term

If an organization cannot survive the short
term, there is no need to examine its long
term signs.

Short-term Liquidity

Companies with a strong cash flow from
operations have good short term liquidity.

The cash flow statement shows the source
and uses of cash flows in a company.

Companies with good credit have bank
loans available for unexpected needs.

Assets on the balance sheet can be converted
to cash in an emergency.

Short-term Liquidity continued

Cash Flow Ratios

Cash from Operations/Net Income: represents cash
yield from Net Income. Trend should be reasonably
stable from period to period and above 100%.

Cash from Operations/Cash Used for Investing:
represents the extent to which expansion can be
financed from internally-generated cash from
operations. Trend should be reasonably stable from
period to period. Rapidly expanding companies will
need more cash than will be available from
operations. Most companies have had ratios above
1 in recent years.

Short-term Liquidity

Service companies differ from
manufacturing companies in their source of

Manufacturing companies have significant
inventory but service companies don’t.

Most manufacturing companies sell on
credit and have significant accounts

Some service companies get paid in advance
or at time of provision of service.

Short-term Liquidity Manufacturing

Current Assets & Current Liabilities are items to be
received or paid in cash within a year.

As Current Assets turn into cash, the cash is used
to pay off Current Liabilities.

For short-term liquidity, Current Assets should be
greater than Current Liabilities.

We begin measuring short-term liquidity with the
Current Ratio.

Current Ratio = Current Assets/Current

Current Ratio should usually be > 1 for
satisfactory liquidity – except for companies that
generate ample cash.

Short-term Liquidity: continued

The Quick Ratio.

Quick Ratio = (Current Assets, excluding
Inventory)/Current Liabilities.

Inventory can lose value fast through spoilage,
shrinkage, evaporation, obsolescence & etc.

Inventory cannot be sold off fast in a crunch –
except at fire sale prices.

So Quick Ratio conservatively – but realistically -
expects no value from inventory in an emergency.

Quick Ratio: should be > 1 for health for
companies that don’t have strong cash flow.

Short-term Liquidity: continued

Accounts Receivable Turnover.

Receivables Turnover = Sales/Accounts Receivable.

Example: Annual Sales = $120,000, Average Receivables =

Receivables Turnover = $120,000/$30,000 = 4 times per year

Can express as Days' Receivables on hand:

365 days/Receivables Turnover

Example continued: 365/4 = 91 days.

Receivables Turnover should be consistent;

With the firm's credit terms.

From period to period

Receivables Turnover measures the organization's efficiency in
collecting accounts receivable.

The faster the turnover the better the efficiency.

Short-term Liquidity: continued

Inventory Turnover.

Inventory Turnover = (Cost of Sales)/Inventory.

Example: Annual Cost of Sales = $100,000, Average Inventory =

Inventory Turnover = $100,000/$15,000 = 6.7 times per year

Can be expressed as Days' Inventory on hand:

365 days/Inventory Turnover

Example continued: 365/6.67 = 54.7 days.

Why is Cost of Sales the numerator, rather than Sales?

Sales are shown at selling price. Inventory is shown at cost.

To make numerator and denominator consistent, both should be at

Inventory Turnover measures the efficiency of inventory management.

Toyota and other Japanese firms using "just in time" inventory
showed the importance of speeding up inventory turnover.

A note of caution

Both the Current Ratio and the Quick Ratio can
be too high as well as too low.

When companies get into financial difficulty,
customer may stop paying bills – perhaps from
dissatisfaction with products

Inventory may include products that are no
longer able to be sold.

So a if the Current Ratio or Quick Ratio
increases dramatically, we should look to see
what is happening to inventory and receivables

Short-term Liquidity continued

Accounts Payable Turnover.

Payables Turnover = Cost of Sales/Accounts Payable.

Example: Annual Cost of Sales = $100,000, Average Payables =

Payables Turnover = $100,000/$20,000 = 5 times per year

Can be expressed as Days' Payables on hand:

365 days/Payables Turnover

Example continued: 365/5 = 73 days.

Why is Cost of Sales the numerator, rather than Sales?

Sales are at selling price. Payables are at cost, being amounts owed
to suppliers.

For consistency, both numerator and denominator should be at

Payables Turnover measures how promptly suppliers are
being paid – and whether cash discounts are being taken,
or lost.

Summary: Short-term Liquidity

Ratios measuring Short-term Liquidity:

Cash Flow Ratios

Current Ratio

Quick Ratio

Receivables Turnover & Days' Receivables

Inventory Turnover & Days' Inventory

Payables Turnover & Days' Payables


Profitability is the most important factor in long term
corporate survival

Profits or Net Income are “the bottom line.”

On the income statement net income is the bottom line.

Businesses are formed and exist to generate returns
(profits or net income) for the owners.

Charities exist for people who want to give their money
to help others.

Good companies look to the long term to create value for

As we will see later in the course, long term value is
created when customers, employees and communities
all benefit.


Profitability is measured in two different ways:

Profitability in Relation to Investment

Return on Equity ROE: Net Income/Equity. Shows profit
in relation to owner equity capital invested. Often the
first ratio to be considered. Some consider this
the most important ratio.

Return on Assets ROA: Net Income / Total Assets shows
what can be earned from the total of what is used in the

Raw Earning Power: EBIT/(LT Debt + Equity). Shows
earning power on total long-term capital invested,
regardless of type of financing.


Profitability is measured in two different ways:

Profitability on Revenue

Profit Margin = Net Income/Sales or Net Income /
Revenue - Useful, and gives indication of pricing strategy

Gross profit ratio: Gross Profit/Sales

SG & A ratio: SG & A Expenses/Sales

EBIT ratio: EBIT/Sales – indication of cash flow

Asset Turnover

Total Asset Turnover (TATO):

Total Asset Turnover = Total Revenue/Total

Measures capital intensity.

Capital intensity affects total amount of capital

The faster the turnover of Total Assets, the lower
the total amount of capital that needs to be
invested in Total Assets.

Long-Term Leverage

Long-Term Leverage measures long-run risk.

Times Interest Earned (Interest Coverage):

Ratio of EBIT to Interest Expense.

Shows how much profit "cushion" there is to cover
interest payments.

Times Interest earned using Depreciation and

Ratio of EBITDA to Interest expense

Depreciation and Amortization are “non cash
charges” and available to provide cash to pay interest.

Long-Term Leverage

Long-Term Leverage measures long-run risk.

Debt to Equity Ratios:

Ratio of Long-Term Debt /LT Debt + Equity

Used in Weighted Average Cost of Capital work

Ratio of Debt / Total Assets

Ratio of Debt / Equity

Equity Multiplier: Total Assets / Equity

Used in DuPont Formula

More debt adds more risk, because debt repayment
must be made, whether times are good or bad.

More leverage makes the good times better, and the
bad times worse.

Stock Market Ratios

Market-based ratios reflect the investor view.

Price-Earnings Ratio P/E= Market Price per
Share/Earnings per Share.

Shows how much the market is paying per dollar of
current earnings.

Beta = a measure of common equity risk versus the entire
common equity market (which has Beta = 1.0)

Used in WACC work later in course

Market: Book Ratio.

Total Market Value of Equity/Book Value of Equity.

This is the ultimate measure of management success.

It shows how much the management has increased
the market value of the stock above the amount
invested by stockholders.

DuPont Analysis

So far, we have looked at ratios individually.

But DuPont Analysis is a way to see the
combined effect of the major ratios.

This is very important for business strategy.

The following slides explain how and why.

The DuPont Formula

Profit Margin x Total Asset Turnover x Equity
Multiplier = Return on Equity

NI = Net Income.

SA = Sales or Revenue

TA = Total assets

EQ = Total Equity (at book value)‏



These 4 ratios encompass the elements of strategy

Pricing can be low and that requires that asset
turnover is high. ‏

DuPont Analysis for Business Strategy

Long-term strategy goal: maintain strong

DuPont analysis tells us exactly how to do

Optimize one or more of the following:

NI/SA = profit on sales

SA/TA = total asset turnover (capital intensity)‏

TA/EQ = leverage

Profit on Sales

Ways to optimize profit on sales include:

Differentiate products to raise margins.

Revive and promote old products (Jell-O)‏

Promote the most profitable products.

Prune the least profitable products.

Cut costs of production.

Improve efficiency of operations


Total Asset Turnover

Ways to optimize total asset turnover are:

Adopt "just-in-time" inventory

Sell off obsolete inventory

Improve receivables collection efficiency

Sell and lease back property & plant

Slow down paying of accounts payable

Cut back on executive jets, corporate yachts

Seek out less capital intensive methods of

Relocate operations to less expensive locations



Increase leverage, within safe limits:

Repurchase outstanding stock

Increase debt financing

Repurchase stock & issue more debt

Repurchase common stock & issue more
preferred stock


In order to be meaningful, financial ratios
need to be compared with benchmark ratios.

Possible Benchmarks:

Same company, in earlier period

Competitor company, in same period

Group of competitor companies, in same period

An industry benchmark, such as The North
American Industry Classification System

NAICS provides standard classifications for
industries, for example, see the next slide

Example of NAICS

NAICS code 2002

Includes NAICS Title: 21 Mining

211111 Crude Petroleum and Natural Gas Extraction

211112 Natural Gas Liquid Extraction

212111 Bituminous Coal and Lignite Surface Mining

212112 Bituminous Coal Underground Mining

212113 Anthracite Mining

These 6-digit codes describe standard industry classifications.
For more, see

Sources of Industry Data

Most sources of industry data require purchase of a

However, the UMUC Library offers access to
several industry databases, such as Dun &
Bradstreet (D&B)

Sources that offer limited industry data free are:

Yahoo Finance

MSN Money

Industry Data

One caution is that some companies operate in several
different industries.

For example, General Electric Company (GE) is a
diversified industrial corporation engaged in developing,
manufacturing and marketing a wide variety of products for
the generation, transmission, distribution, control and
utilization of electricity. On June 23, 2005, GE announced
reorganization of its 11 businesses into six industry-focused
businesses effective July 5, 2005. The six businesses are GE
Infrastructure, GE Industrial, GE Commercial Financial
Services, GE NBC Universal, GE Healthcare and GE
Consumer Finance.

It is difficult to find industry benchmarks for conglomerates
like GE. Benchmarks are easier for companies in one

Financial Ratio Calculation

Financial ratios have a numerator and a

These numerators and denominators are
items from the Balance Sheet or the Income

Example: Current Ratio = Current
Assets/Current Liabilities.

Continued on next slide ...

Financial Ratio Calculation

Balance Sheets show financial position as of one
specific date.

But one specific date cannot represent an entire
accounting period – such as a year.

Therefore it is better to average beginning and
ending balance sheet amounts

In practice, for stable companies, we can
accomplish our learning goals without needing to
calculate these averages.

Please use Excel for all calculations

Please show calculations step by step.


Use financial ratios to

Short-term solvency


Long-term solvency

Use DuPont Analysis

Devise strategy

Implement strategy.


Industry comparisons

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