Financial Statement and

Ratio Analysis

Rosario C. Garcia, DBA

Source: Harvard Business School Serial No. 9-101-029

Financial Statement and Ratio Analysis

process of evaluating relationships between component parts of the firm’s financial statements

develop insights into the financial performance of companies

provides a way to examine how a firm has performed relative to its peers and relative to its own historical performance.

Why a firm’s ratios are different from its peers or its own historical performance?

product and market strategy used

effectiveness of management team at implementing its strategy

financial strategy used

accounting methods used for reporting the same underlying economic events

We should have a clear understanding of how a firm’s accounting decisions compare with those of its competitors, or with its own decisions in prior years.

If there are important differences in accounting decisions, it may be necessary to make adjustments to the affected firm’s financial statements to ensure that ratio comparisons isolate differences in strategy or performance.

Classic Tools and Techniques Of Financial Analysis

1. Horizontal Analysis involves the computation of peso amount changes and

percentage changes from the previous to the current year

2. Vertical Analysis involves the percentage changes to bring out the quantitative

relationships existing among different items to the total in a single statement.

3. Ratio Analysis an important means of stating the relationship between two

numbers ratios reduce the data being compared to more meaningful

terms, and they bring out more clearly certain relationship that may otherwise be overlooked.

Ratio Analysis: DuPont Formula (F – I – O Method)

Perspective: SHAREHOLDERS Goal of a firm: maximization of shareholders’

wealth

Starting point: computation of RETURN ON EQUITY (ROE)

ROE = Net Income Average Shareholders’ Equity

Return on Equity (ROE)

indicates how profitably the firm has been able to invest shareholder funds for the period

Why firms generate high ROEs: they are in a superior industry they make more risky investments and so have to

provide investors with a higher return, they are able to execute their strategy more

effectively than their competitors.

DuPont Formula (F – I – O Method)

helps us get a better understanding of reasons for differences in ROEs across firms

recognizes the three fundamental factors driving ROE: NET PROFIT MARGIN (reflecting how well the firm

manages its operations), ASSET TURNOVER (reflecting how efficiently it

uses its assets) FINANCIAL LEVERAGE (what kind of financing

strategy used)

ROE = Net Income = Net Income * Sales * Assets Equity Sales Assets Equity = Net Profit Margin * Asset Turnover * Financial Leverage

= Operating * Investing * Financing

OPERATING: Net Profit Margins

otherwise known as return on sales

reflect how well the firm manages its operations

show the profitability of each dollar of sales.

depend on a firm’s strategy and its industry. industries that rely heavily on volume (e.g. supermarkets), tend

to have low margins, industries that sell low volumes of specialty products ( e.g.

jewelry stores) tend to have high margins. firms with the strategy to be the low cost provider in their

industry have lower sales margins than firms with differentiated strategies.

Net Profit Margin = Net IncomeSales

INVESTMENT EFFICIENCY: Asset Turnover

reflects how efficiently it uses its assets

measures the multiple of sales generated per dollar of assets

heavily affected by a company’s investment strategy and the technology used to deliver its products or service. capital intensive industries that take advantage of economies of

scale (e.g. utilities) tend to have low turnover ratios, whereas labor-intensive service industries tend to have high turnover.

Asset Turnover = Sales Average Total Assets

INVESTMENT EFFICIENCY: Asset Turnover

Also affected by working capital management

Working capital = receivables + inventory - payables.

Firms that are able to collect promptly from their customers, to hold relatively little inventory, or to get suppliers to finance inventory are able to use less of their own funds or working capital, increasing turnover.

Several measures of working capital management include: Days receivable = 365 * (average receivables/sales) Days inventory = 365 * (average inventory/ cost of sales) Days payable = 365 * (average payable / cost of sales ) Receivable turnover = sales / average receivables Inventory turnover = cost of sales / average inventory Payable Turnover = cost of sales / average payables

FINANCING STRATEGY: Financial Leverage

measures the multiple of assets to equity, therefore, the higher the leverage multiple the higher the potential risk and reward.

enables a firm to substantially increase its asset base relative to its equity base, thus allowing it to increase ROE.

A firm is successful at using leverage (positive leverage) if it earns a higher rate of return on borrowed funds than the after-tax interest rate costs for borrowing the money.

However, leverage also creates risk for shareholders. Unlike equity financing where dividend declaration is at the discretion of the board, debt

financing has predefined interest payment terms and schedules must be met. A firm faces risk of financial distress if its fails to meet these commitments.

Financial Leverage = Average Total Assets Average Shareholders’ Equity

FINANCING STRATEGY: Financial Leverage

The firm’s ability to meet its financial commitments which requires calculation of short-term liquidity and long term solvency ratios should also be analyzed

Short-term liquidity Ratios try to explain whether the firm has the financial means to

pay on its current obligations defined as obligations coming due within the year.

Long-term solvency Ratios ability to meet interest payments, preferred

dividends, and other fixed charges.

FINANCING STRATEGY: Financial Leverage

Short-term Liquidity Ratios

CURRENT RATIO Most common short-term liquidity ratio Current ratio = current assets

current liabilities compares all the current resources of the firm, cash, marketable

securities, accounts receivable, prepaid expenses, and inventory, to all the current obligations of the firm.

QUICK RATIO includes only the current assets that can be used immediately to

extinguish any current liabilities. Quick ratio = (cash + marketable securities + A/R)

current liabilities

FINANCING STRATEGY: Financial Leverage

Long-term solvency Ratios

NET DEBT TO EQUITY RATIO Net Interest Bearing Debt to Equity = (interest bearing debt – cash) Shareholders’ equity measures the degree to which a firm’s activities are supported by debt relative to

owner’s equity. Cash is typically considered as negative debt and therefore deducted from the

numerator in the ratio.

INTEREST COVERAGE RATIO (Times Interest Earned) Interest Coverage Ratio = Profits before interest and taxes

Total Interest Charges This ratio assesses the current ability of a firm to meet its interest payments. It is a multiple that measures how many times interest charges the corporation has

earned on a pretax basis. Alternative method for calculating this ratio: cash flow coverage ratio

uses a numerator of cash flows rather than earnings before taxes. The larger the coverage ratio, the greater the cushion the firm has to meet interest

obligations.

Summary financial ratios provide a useful way of enabling users of financial

statements to compare the performance of one firm with its peers, or with its own historical performance

Many different ratios are popular in practice. Successful ratio analysis requires a thorough understanding of

accounting differences between the firms compared, as well as a deep understanding of their business differences.

It is important to dig deeply to understand the causes for any ratio differences generated through your analysis.