This document outlines what constitutes Financial Analysis to study a company's Balance Sheet, Profit and Loss accounts, Cash Flow Statements. It also provides guidance to do Ratio Analysis.

1. Financial Statement
c o m
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Analysis
e
tr e
Financial Policy and Planning
R I s
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2. Outline
c o m
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 Meaning of Financial Statements and Financial
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Statement Analysis
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 Significance of Financial Statements
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Types of Financial Statements
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
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 Income Statement
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 Balance Sheet
 Cash Flow Statement
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 Statement of Retained Earnings
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 Ratio Analysis including Du Pont Analysis
 Limitations of Financial Statement Analysis
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3. Focus
c o m
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 The focus will be on financial statement analysis and
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its use in corporate finance.
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 financial statement analysis from managerial
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perspective and not from an investor and/or
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creditor’s perspective.
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 How to use financial statement analysis to ensure
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that shareholder wealth is maximized and the stock
price continues to rise?
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4. Meaning of Financial
Statements
c o m
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 Financial statements are summaries of the
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operating, financing, and investment activities
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of a firm.
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 According to the Financial Accounting
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Standards Board (FASB), the financial
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statements of a firm should provide sufficient
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information that is useful to
 investors and
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 creditors
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 in making their investment and credit
decisions in an informed way.
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5. c o m
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 The financial statements are expected to be prepared in
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accordance with a set of standards known as generally
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accepted accounting principles (GAAP).
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 The financial statements of publicly traded firms must be
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audited at least annually by independent public
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accountants.
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 The auditors are expected to attest to the fact that these
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financial statements of a firm have been prepared in
accordance with GAAP.
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6. m
Significance of Financial
c o
Statements

e t .
Wall Street analysts and other sophisticated investors prefer
such financial disclosure documents as 10-Ks, which contain
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more detailed information about the company
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 Financial statements summarize and provide an overview of
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events relating to the functioning of a firm.
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 Financial statement analysis helps identify
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 a firm’s strengths and
 weaknesses
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 so that management can take advantage of a firm’s
strengths and make plans to counter weaknesses of
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the firm.
 The strengths must be understood if they are to be used to
proper advantage and weaknesses must be recognized if
corrective action needs to be taken
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7. c o m
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 For example, are inventories adequate to support the projected
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level of sales?
Does the firm have too heavy an investment in account
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
receivable?
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 Does large account receivable reflect a lax collection policy?
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 To ensure efficient operations of a firm’s manufacturing facility,
does the firm have too much or too little invested in plant and
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equipment?
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 Financial statement analysis provides answers to all of these
questions.
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8. m
Types of Financial Statements and
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Reports

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The Income Statement
c
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 The Balance Sheet
r e
 The Statement of Retained
s t
Earnings
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 The Statement of Cash Flows
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9. The Income Statement
c o m
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 An income statement is a summary of the revenues and
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expenses of a business over a period of time, usually either
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one month, three months, or one year.
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 Summarizes the results of the firm’s operating and financing
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decisions during that time.
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 Operating decisions of the company apply to production and
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marketing such as sales/revenues, cost of goods sold,
administrative and general expenses (advertising, office
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salaries)
 Provides operating income/earnings before interest and
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taxes (EBIT)
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10. c o m
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 Results of financing decisions are reflected in the
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remainder of the income statement.
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 When interest expenses and taxes are subtracted
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from EBIT, the result is net income available to
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shareholders.
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 Net income does not necessarily equal actual cash
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flow from operations and financing.
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11. m
The Balance Sheet
. c o
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 A summary of the assets, liabilities, and equity of a business at a particular point in time, usually at the
end of the firm’s fiscal year.
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Assets = Liabilities + Equity
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(Resources of the (Obligations of (ownership left over
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business enterprise) the business) Residual)
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Fixed Assets Long-term Common stock outstanding
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(Plant, Machinery, Equipment (Notes, bonds, & Additional paid-in capital
Buildings) Capital Lease Retained Earnings
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Current Assets Obligation)
(Cash, Marketable Securities, Current Liabilities
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Account Receivable, Inventories) (Accounts Payable,
Wages and salaries,
Short-term loans
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Any portion of long-term
Indebtedness due in one-year)
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12. m
THE STATEMENT OF CASH
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FLOWS

t . c
The statement is designed to show how the firm’s operations have
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affected its cash position and to help answer questions such as these:
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 Is the firm generating the cash needed to purchase additional fixed assets
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for growth?
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 Is the growth so rapid that external financing is required both to maintain
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operations and for investment in new fixed assets?
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 Does the firm have excess cash flows that can be used to repay debt or to
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invest in new products?
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13. m
RATIO ANALYSIS
. c o
t
 Financial statements report both on a firm’s
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position at a point in time and on its operations
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over some past period.
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 From management’s viewpoint, financial
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statement analysis is useful both as a way to
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 anticipate future conditions and
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 more important, as a starting point for planning
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actions
 that will influence the future course of events or
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 to show whether a firm’s position has been improving
or deteriorating over time.
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14. c o m
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 Ratio analysis begins
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 with the calculation of a set of financial ratios
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 designed to show the relative strengths and
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 weaknesses of a company as compared to
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 Other firms in the industry
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 Leadings firms in the industry
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 The previous year of the same firm
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 Ratio analysis helps to show whether the firm’s
position has been improving or deteriorating
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 Ratio analysis can also help plan for the future
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15. m
Types of Ratios
. c o
t
 Liquidity Ratios
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Current Ratio
Quick Ratio/Acid Test Ratio
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 Asset Management Ratios
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Inventory Turnover Ratio
Days Sales Outstanding
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Fixed Assets Turnover Ratio
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Total Assets Turnover Ratio
 Debt Management Ratio
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Total Debt to Total Assets Ratio
Times Interest Covered Ratio
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 Profitability Ratios
Profit Margin on Sales
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Return on Assets
Return on Equity
Basic Earning Power Ratio
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16. Liquidity Ratio
c o m
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 A liquid asset is one that can be easily
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converted into cash at a fair market value
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 Liquidity question deals with this question
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 Will the firm be able to meet its current
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obligations?
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 Two measures of liquidity
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 Current Ratio
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 Quick/Acid Test Ratio
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17. Asset Management Ratios
c o m
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 Asset management ratio measures how effectively
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the firm is managing/using its assets
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 Do we have too much investment in assets or too
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little investment in assets in view of current and
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projected sales levels?
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 What happens if the firm has
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 Too much investment in assets
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 Too little investment in assets
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18. Asset Management Ratios
c o m
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 Inventory Turnover Ratio
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 Measures the efficiency of Inventory Management
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 A high ratio indicates that inventory does not remain in
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warehouses or on shelves, but rather turns over rapidly
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into sales
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 Two cautions
Market prices for sales and inventories at cost
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
 Sales over the year and inventory at the end of the year
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19. Asset Management Ratio
c o m
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 Days Sales Outstanding (DSO)
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 To appraise the quality of accounts receivables
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 Average length of time that the firm must wait after making
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a sale before receiving cash from customers
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 Measures effectiveness of a firm credit policy
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 Indicates the level of investment needed in receivables to
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maintain firm’s sales level
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 What happens if this ratio is
 Too high, or
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 Too low
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20. Asset Management Ratios
c o m
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 Fixed Assets Turnover Ratio
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 Measures efficiency of long-term capital
r e
investment
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 How effectively a firm is using its plant and
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machinery to generate sales?
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 How much fixed assets are needed to achieve a
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particular level of sales?
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 Cautions
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21. Asset Management Ratio
c o m
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 Total Asset Turnover Ratio
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 Measure efficiency of total assets for the company
r e
as a whole or for a division of the firm
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 Core competency
R I s
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22. Debt Management Ratio
c o m
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 Implications of use of borrowings
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 Creditors look to Stockholders’ equity as a safety
r e
margin
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 Interest on borrowings is a legal liability of the firm
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Interest is to be paid out of operating income
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
 Debt magnifies return and risk to common
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stockholders
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23. c o m
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 Total Debt to Total Assets Ratio
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 Measures percentage of assets being financed
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through borrowings
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 Too high a number means increased risk of
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bankruptcy
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 Leverage
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 What percentage of total assets are being
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financed through equity?
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24. c o m
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 Times Earned Interest (TIE)
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 Measure the extent to which operating income
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can decline before the firm is unable to meet its
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annual interest costs
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 Failure to pay interest can result in legal action by
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creditors with possible bankruptcy for the firm
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25. Profitability Ratios
c o m
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 Net result of a number of policies and
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decisions
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 Show the combined effect of liquidity, asset
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management, and debt management on
I s
operating results
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26. c o m
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 Net Profit Margin on Sales
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 Relates net income available to common stockholders to sales
 Basic Earning Power
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 Relates EBIT to Total Assets
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 Useful for comparing firms with different tax situations and
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different degrees of financial leverage
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 Return on Assets (ROA)
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 Relates net income available to common stockholders to total
assets
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 Return on Common Equity (ROE)
 Relates net income available to common stockholders to
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common stockholders equity
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27. m
PROBLEMS IN FINANCIAL
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STATEMENT ANALYSIS

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Developing and Using Comparative Data
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 Distortion of Comparative Data
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
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Notes to Financial Statements
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 Interpretation of Results
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
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Differences in Accounting Treatment
 Window Dressing
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 Effects of Inflation
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