Chapter 4 Analysis of Financial Statements

4-1 Ratio Analysis

We divide the ratios into five categories:
1. Liquidity - measures the ability to meet short-term obligations
2. Asset Management - measures the ability to contain the growth of assets, and the ability to
effectively utilize assets
3. Debt Management - measures the use of financial leverage (debt) and its impact
4. Profitability - measures the profitability of various segments of a company
5. Market value ratios, which bring in the stock price and give us an idea of what investors think about
the firm and its future prospects.

Examines firms management of various facets of the companys business through its financial
statements.
Scales balance sheet and income statement information for easy comparison across time or to other
companies.

Two Common Approach
Trend Analysis - looks at changes in one companys ratios over time.
Benchmarking: Comparison or Industry Analysis - compares companys ratios against a similar
company or against industry-wide ratios.

4-2 Liquidity Ratios

Higher current ratio, higher liquidity company has.
Inventories are typically the least liquid of a firms current assets.

Window Dressing Why a current ratio > 1 is preferred.
Window dressing techniques: Techniques employed by firms to make their financial statements look better
than they really are.
If current ratio is 2=2/1, new current ratio is (2+1)/(1+1)=1.5 decreases
If current ratio is 0.5=1/2, new current ratio is (1+1)/(2+1)=0.67 increases

4-3 Asset Management Ratios



4-4 Debt Management Ratios


4-5 Profitability Ratios

s e i t i l i b a i l current
assets current
= ratio Current
s e i t i l i b a i l current
inventory assets- current
= ratio Quick
inventory
sales
= turnover Inventory
Sales/365 Annual
s Receivalbe
= g(DSO) Outstandin Sales Days
assets fixed Net
Sales
= Turnover Asset Fixed
assets total
sales
= over asset turn Total
assets total
s e i t i l i b a i l (debt) total
= assets to Debt
charges Interest
EBIT
= earned interest - Times
sales
income Net
= sales on margin rofit P
assets Total
income Net
= assets on total Return

Profit Margin x Total Asset Turnover=Return on total assets

4-6 Breaking Down ROE: DuPont Equation
ROE (NI/Eq) = Return on Assets (NI/TA) x Equity Multiplier (TA/Eq)
ROE = Profit Margin on Sales (NI/S) x Total Asset Turnover (S/TA) x TA/Eq
Profit margin is a measure of the firms operating efficiency how well does it control costs
Total asset turnover is a measure of the firms asset use efficiency how well does it manage
its assets
Equity multiplier is a measure of the firms financial leverage

assets Total
EBIT
= Power(BEP) Earning Basic
equity rs' Stockholde
income Net
= equity common on Return