chapter 02 l. j. gitman chapter 02 l. j. gitman analysisof financial statements

CHAPTER 02 CHAPTER 02 L. J. Gitman L. J. Gitman

ANALYSIS ANALYSIS

OFOF

FINANCIAL FINANCIAL STATEMENTSSTATEMENTS

What is Financial Statements?What is Financial Statements?

• A structured financial representation of the A structured financial representation of the financial position of and the transactions financial position of and the transactions undertaken by an enterprise/firm.undertaken by an enterprise/firm.

• A complete set of financial statements includes:A complete set of financial statements includes: a) Income statements:a) Income statements: which presents the which presents the

revenues and expenses and resulting net revenues and expenses and resulting net income or net loss for a specific period of time.income or net loss for a specific period of time.

For example:

ABC CorporationABC CorporationIncome StatementIncome Statement

for the Year Ended December 31, 2008for the Year Ended December 31, 2008

Sales Revenue- Cost of Goods Sold= Gross ProfitsSales Revenue- Cost of Goods Sold= Gross Profits

Gross Pro.- Operating Exp.= Operating Profit (EBIT)Gross Pro.- Operating Exp.= Operating Profit (EBIT)

Operating Pro.- Int. Exp.= Net Profit b4 Taxes (EBT)Operating Pro.- Int. Exp.= Net Profit b4 Taxes (EBT)

Net Pro. b4 Taxes- Taxes= Net Profit after TaxesNet Pro. b4 Taxes- Taxes= Net Profit after Taxes

Net Pro. after Taxes- Preferred Stocks= Earnings Net Pro. after Taxes- Preferred Stocks= Earnings Available to Common Stock holdersAvailable to Common Stock holders

Earning Per Share (EPS)= Earning Per Share (EPS)=

Dividend Per Share (DPS)= Dividend Per Share (DPS)=

goutstandin stockscommon of No.

common toavailable Earnings

goutstandin stockscommon of No.

rsstockholdecommon topaid Dividends


b) Balance Sheet:b) Balance Sheet: A balance sheet reports A balance sheet reports the assets, liabilities, and owners equity at the assets, liabilities, and owners equity at a specific date. Estimates the firm’s worth a specific date. Estimates the firm’s worth on a given date; built in the accounting on a given date; built in the accounting equation:equation:

Assets = Liabilities + Owner’s EquityAssets = Liabilities + Owner’s Equity

c) An owner’s Equity Statement:c) An owner’s Equity Statement: Summarizes the changes in owner’s Summarizes the changes in owner’s equity for a specific period of time. equity for a specific period of time.

ABC CompanyABC CompanyBalance SheetBalance Sheet

as of Dec. 31, 2008as of Dec. 31, 2008

Assets = Liabilities + Stockholder’s EquityAssets = Liabilities + Stockholder’s Equity

Assets = Current Assets + Net Fixed AssetsAssets = Current Assets + Net Fixed Assets

C/A = Cash + Marketable Securities + Accounts C/A = Cash + Marketable Securities + Accounts Receivable + Inventories Receivable + Inventories

Net Fixed Assets = Gross Fixed Assets – Net Fixed Assets = Gross Fixed Assets – Accumulated DepreciationAccumulated Depreciation

Gross F/A = Land & Buildings + Machinery & Gross F/A = Land & Buildings + Machinery & Equipments + Furniture + VehiclesEquipments + Furniture + Vehicles

ABC CompanyABC CompanyBalance SheetBalance Sheet

as of Dec. 31, 2006as of Dec. 31, 2006

Liabilities = Current Liabilities + Long term DebtLiabilities = Current Liabilities + Long term Debt

C/L = Accounts payable + Notes payable + C/L = Accounts payable + Notes payable + Accruals Accruals

Stockholders’ Equity = Preferred Stocks + Stockholders’ Equity = Preferred Stocks + Common Stocks + Paid-in Capital in Access of Common Stocks + Paid-in Capital in Access of Par on Common Stock + Retained EarningsPar on Common Stock + Retained Earnings


d) Cash Flow Statement:d) Cash Flow Statement: Summarizes Summarizes information about the cash inflows information about the cash inflows (receipts) and outflows (payments) for a (receipts) and outflows (payments) for a specific period of time. (Shows the specific period of time. (Shows the changes in the firm’s working capital over changes in the firm’s working capital over a period of time by listing the sources of a period of time by listing the sources of funds and usesfunds and uses of these funds)of these funds)

e) Accounting Policies and Explanatory e) Accounting Policies and Explanatory Notes.Notes.

Objectives of Financial Objectives of Financial StatementsStatements

To provide information about the To provide information about the financial position, performance and financial position, performance and cash flows of an enterprise that is cash flows of an enterprise that is useful to a wide range of users in useful to a wide range of users in making economic decisions;making economic decisions;

To shows the results of To shows the results of management’s stewardship of the management’s stewardship of the resources entrusted to it.resources entrusted to it.

Analysis TechniquesAnalysis Techniques

The basic techniques to extract The basic techniques to extract information from financial statements information from financial statements are:are:

Examination of comparative Examination of comparative financial statements;financial statements;

Ratio Analysis.Ratio Analysis.

Analysis TechniquesAnalysis Techniques

Both techniques are based on:Both techniques are based on:Comparison of performance of Comparison of performance of

period with another period: time period with another period: time series analysis, orseries analysis, or

Comparison of performance of Comparison of performance of one business with that of similar one business with that of similar business, in either current or past business, in either current or past period: cross-sectional analysis.period: cross-sectional analysis.

Examination of Comparative Examination of Comparative Financial StatementsFinancial Statements

Comparative financial statements are side Comparative financial statements are side by side presentations of consecutive by side presentations of consecutive financial statements of the same type financial statements of the same type (balance sheets, income statements, and (balance sheets, income statements, and so forth).so forth).

They permit period-to-period comparisons They permit period-to-period comparisons of important accounts and account group.of important accounts and account group.

Thus they help statement users to identify Thus they help statement users to identify the causes of changes in a business’ the causes of changes in a business’ future profitability and financial position.future profitability and financial position.

Ratio AnalysisRatio Analysis

Ratio is the relationship between two or more Ratio is the relationship between two or more aspects of a particular data.aspects of a particular data.

In financial analysis, a ratio is used as a In financial analysis, a ratio is used as a benchmark for evaluating the financial benchmark for evaluating the financial position and performance of a firm.position and performance of a firm.

Ratio analysis is an examination of financial Ratio analysis is an examination of financial statements conducted by preparing and statements conducted by preparing and evaluating a series of ratios.evaluating a series of ratios.

Ratio AnalysisRatio Analysis

• Interested Parties:Interested Parties:Management should be the most Management should be the most

interested parties.interested parties.Both present and prospective Both present and prospective

shareholders are interested.shareholders are interested.The firm’s creditors are also interested.The firm’s creditors are also interested.Government and regulatory bodies. Government and regulatory bodies.

Types of Ratio:Types of Ratio:

Four types of ratios are used in analyzing the Four types of ratios are used in analyzing the financial position of a company:financial position of a company:

1.1. Liquidity ratiosLiquidity ratios indicate the company’s capacity indicate the company’s capacity to meet short-run obligations.to meet short-run obligations.

2.2. Activity ratiosActivity ratios indicate how effectively the indicate how effectively the company is using its assets.company is using its assets.

3.3. Leverage ratiosLeverage ratios indicate the company’s indicate the company’s capacity to meet its long term and short term capacity to meet its long term and short term debt obligations.debt obligations.

4.4. Profitability ratiosProfitability ratios indicate the net returns on indicate the net returns on sales and assets.sales and assets.

Ratio Analysis: Analyzing Ratio Analysis: Analyzing LiquidityLiquidity

• Liquidity Ratios-Liquidity Ratios- Tell whether or not the business will be Tell whether or not the business will be able to meet its maturing obligations as they come due.able to meet its maturing obligations as they come due.

1.1. Current RatioCurrent Ratio- Measures solvency by showing the firm’s - Measures solvency by showing the firm’s ability to pay current liabilities out of current assets. Suppose ability to pay current liabilities out of current assets. Suppose Industry Average Current Ratio = 1.50Industry Average Current Ratio = 1.50

CR =CR =

Example: 2-11Example: 2-11

sLiabilitieCurrent

AssetsCurrent


• Interpretation:Interpretation: The higher the ratio, more liquid the firm is. The higher the ratio, more liquid the firm is.

As a norm a CR of 2 is cited as As a norm a CR of 2 is cited as acceptable. The company’s current ratio is acceptable. The company’s current ratio is above the industry average by a significant above the industry average by a significant amount and equal as standard. The amount and equal as standard. The company should have no problem meeting company should have no problem meeting short-term debts as they come due.short-term debts as they come due.


2. 2. Quick Ratio-Quick Ratio- Shows the extent to which the Shows the extent to which the firm’s most liquid assets cover its current firm’s most liquid assets cover its current liabilities.liabilities.

Quick Ratio = Quick Ratio =

Suppose Industry Average Quick Ratio = .80Suppose Industry Average Quick Ratio = .80

The quick ratio of this company is satisfactory The quick ratio of this company is satisfactory as compare with industry average. Standard as compare with industry average. Standard recommended here 1.0.recommended here 1.0.

sLiabilitieCurrent

sInventorieAssetsCurrent

Ratio Analysis: Analyzing Ratio Analysis: Analyzing ActivityActivity

• Evaluate the firm’s overall performance and show Evaluate the firm’s overall performance and show how effectively it is putting its funds to work.how effectively it is putting its funds to work.

1.1. Inventory Turnover Ratio:Inventory Turnover Ratio: Measures the activity, or Measures the activity, or liquidity, of a firm’s inventory.liquidity, of a firm’s inventory.

Inventory Turnover = Inventory Turnover = Inventory

COGS


Average inventory for yearAverage inventory for year Beginning inventory + Ending inventory Beginning inventory + Ending inventory

2 2

• A low inventory turnover implies a large A low inventory turnover implies a large investment in inventories relative to the investment in inventories relative to the amount needed to services sales. amount needed to services sales. Excess inventory ties up resources Excess inventory ties up resources unproductively.unproductively.


• Average Collection Period Ratio/Days Sales Average Collection Period Ratio/Days Sales Outstanding (DSO):Outstanding (DSO): Tells how long it takes from the Tells how long it takes from the time the sales is made to the time the cash is time the sales is made to the time the cash is collected from the customer from its accounts collected from the customer from its accounts receivablereceivable. .

Average Collection Period=Average Collection Period=

DayPer Sales Average

Receivable Accounts


It indicates the firm’s efficiency in collecting It indicates the firm’s efficiency in collecting on its sales. It may also reflects the firm on its sales. It may also reflects the firm credit policy. If customers are given more credit policy. If customers are given more time to pay, then the collection period will time to pay, then the collection period will generally be greatergenerally be greater..


• Fixed Assets turnover ratio:Fixed Assets turnover ratio: This ratio indicates how This ratio indicates how intensively the fixed assets of the firm are being used.intensively the fixed assets of the firm are being used.

Fixed Asset Turnover = Fixed Asset Turnover =

An inadequately low ratio implies excessive An inadequately low ratio implies excessive investments in plant and equipment relative to the investments in plant and equipment relative to the value of the output being produced.value of the output being produced.

Assets Fixed Total

Sales


• Total Assets Turnover-Total Assets Turnover- reflects how well the reflects how well the company’s assets are being used to generate company’s assets are being used to generate sales.sales.

Total Asset Turnover = Total Asset Turnover =

Assets Total

Sales

Ratio Analysis: Analyzing Ratio Analysis: Analyzing LeverageLeverage

• Leverage:Leverage: Simply the degree of the firm’s Simply the degree of the firm’s borrowing or, the use of fixed costs in an borrowing or, the use of fixed costs in an attempt to increase (or lever up) profitability.attempt to increase (or lever up) profitability.

• Leverage ratioLeverage ratio measure the extent of the measure the extent of the firm’s total debt burden. They reflect the firm’s total debt burden. They reflect the company’s ability to meet its short-term and company’s ability to meet its short-term and long-term debt obligations.long-term debt obligations.


• Leverage ratios are importantLeverage ratios are important to creditors, to creditors, since they indicate whether or not the firm’s since they indicate whether or not the firm’s revenues can support interest and other fixed revenues can support interest and other fixed charges, as well as whether or not there are charges, as well as whether or not there are sufficient assets to pay off the debt if the firm sufficient assets to pay off the debt if the firm liquidatesliquidates

• Share holders, too, are concerned with Share holders, too, are concerned with leverage, since interest is a company expense leverage, since interest is a company expense that increase with greater debt. If borrowing and that increase with greater debt. If borrowing and interest are excessive, the company may interest are excessive, the company may become bankrupt.become bankrupt.


1.1. Debt to Total Assets Ratio:Debt to Total Assets Ratio: Measures the proportion of total Measures the proportion of total assets financed by the firm’s creditors.assets financed by the firm’s creditors.

Debt Ratio = Debt Ratio =

Generally, creditors prefer a low debt ratio since it implies a Generally, creditors prefer a low debt ratio since it implies a greater protection of their position. A higher debt ratio greater protection of their position. A higher debt ratio generally means that the firm must pay a higher interest rate generally means that the firm must pay a higher interest rate on its borrowing. Macro’s debt ratio of 0.4 is satisfactory in on its borrowing. Macro’s debt ratio of 0.4 is satisfactory in that it is less than the acceptable level of 0.45 for the firm that it is less than the acceptable level of 0.45 for the firm indicated.indicated.

Assets Total

sLiabilitie Total


2. Time Interest Earned Ratio:2. Time Interest Earned Ratio: Measures the Measures the firm’s ability to make contractual interest firm’s ability to make contractual interest payments.payments.Times Interest Earned Ratio:Times Interest Earned Ratio:

Between 3-5 is suggested. Higher the ratio, better it is Between 3-5 is suggested. Higher the ratio, better it is for the firm. Macro’s times interest earned ratio of 8.55 for the firm. Macro’s times interest earned ratio of 8.55 times means that Macro’s earning available to pay times means that Macro’s earning available to pay interest is 8.55 times the interest is due. This is more interest is 8.55 times the interest is due. This is more than the appropriate level for Macro of 6.5.than the appropriate level for Macro of 6.5.

ExpensesInterest

EBIT

Ratio Analysis: Analyzing Ratio Analysis: Analyzing ProfitabilityProfitability

Profitability ratiosProfitability ratios measure the success of the firm measure the success of the firm in earning a net return on sales or on investment. in earning a net return on sales or on investment.

Since profit is the indicator of firm’s good performance, Since profit is the indicator of firm’s good performance, poor ratio indicates here a basic failure that, if not poor ratio indicates here a basic failure that, if not corrected, would probably result in the firm’s going out corrected, would probably result in the firm’s going out of business. Common size income statement may be of business. Common size income statement may be used to analyze the profitability of a firm.used to analyze the profitability of a firm.– Common-size income statement: Expressed as a Common-size income statement: Expressed as a

percentage of sales. Example P. 62percentage of sales. Example P. 62– Common-size balance sheet: Expressed as a percentage of Common-size balance sheet: Expressed as a percentage of

either total assets or total liabilities and owners equity.either total assets or total liabilities and owners equity.


• Gross Margin Gross Margin Reflects the effectiveness of Reflects the effectiveness of pricing policy and of production efficiency (that pricing policy and of production efficiency (that is how well the purchase or production cost of is how well the purchase or production cost of goods is controlled). By equation:goods is controlled). By equation:

Gross-Profit Margin =Gross-Profit Margin =Sales

Profit Gross


• Operating/Net Profit Margin measures the Operating/Net Profit Margin measures the percentage of each sales taka remaining after percentage of each sales taka remaining after all costs and expenses other than interest and all costs and expenses other than interest and tax are deducted. Example-2.4tax are deducted. Example-2.4Operating Profit Margin = Operating Profit Margin =

Net Profit Margin = Net Profit Margin =

EPS = EPS =

Sales

Profit Operating

Sales

Common toEarning

gOutstandin SharesCommon of No.

Common toEarnings


• Return on Total Assets (ROA), also called the return Return on Total Assets (ROA), also called the return on investment (ROA), measures the firm’s overall on investment (ROA), measures the firm’s overall effectiveness in generating profits with its available effectiveness in generating profits with its available assets.assets.

ROA = ROA = Assets Total

Common toEarnings


• Return on Equity (ROE) measures the return earned on the Return on Equity (ROE) measures the return earned on the owners’ investment in the firm. Generally, the higher this owners’ investment in the firm. Generally, the higher this return, the better off are the owners.return, the better off are the owners.

ROA = ROA =

EquityStock Common

Common toEarning

Categories of Financial RatiosCategories of Financial Ratios• Market Ratios:Market Ratios: measures a firm’s current market price measures a firm’s current market price

measured by its current share price to certain measured by its current share price to certain accounting values.accounting values.– P/E (Price/Earning) Ratio:P/E (Price/Earning) Ratio: measures the amount that the measures the amount that the

investors are willing to pay for each taka of a firm’s earnings.investors are willing to pay for each taka of a firm’s earnings.P/E Ratio = Market price per share/ EPSP/E Ratio = Market price per share/ EPS

The higher the P/E ratio greater the investor’s confidence on The higher the P/E ratio greater the investor’s confidence on the firm’s future performance.the firm’s future performance.

– M/B (Market/Book Value) Ratio:M/B (Market/Book Value) Ratio: measures how much the measures how much the investors are willing to pay for each dollar of the company’s investors are willing to pay for each dollar of the company’s stock.stock.M/B Ratio = Market price per share/Book value per shareM/B Ratio = Market price per share/Book value per share

Book Value per share = Common stock equity/No. of common Book Value per share = Common stock equity/No. of common share outstandingshare outstanding

Caution about Using RatiosCaution about Using Ratios

• Ratio analysis directs attention to potential areas of Ratio analysis directs attention to potential areas of concern, not about the existence of a problem.concern, not about the existence of a problem.

• Group of ratios are more conclusive than a single ratio.Group of ratios are more conclusive than a single ratio.• Ratios should be calculated during the same period of Ratios should be calculated during the same period of

the year.the year.• Use only the audited financial statements.Use only the audited financial statements.• Use identical accounting methods for calculating, Use identical accounting methods for calculating,

specially for inventory and depreciation related figures.specially for inventory and depreciation related figures.• Results such as the book value of inventory and Results such as the book value of inventory and

depreciable assets may differ from their true values due depreciable assets may differ from their true values due to inflation.to inflation.

Suggested QuestionsSuggested Questions

• Define financial statement. What are their purposes.Define financial statement. What are their purposes.• Compare and contrast between time series and Compare and contrast between time series and

cross-sectional analysis of financial statement.cross-sectional analysis of financial statement.• State the parties interested in using the financial State the parties interested in using the financial

statement. Which ratios are the greatest concern for statement. Which ratios are the greatest concern for the creditors? Why?the creditors? Why?

• Name the four different types of ratios. What does Name the four different types of ratios. What does each of them indicate?each of them indicate?

• What care should you take in using the financial What care should you take in using the financial ratios.ratios.

chapter 02 l. j. gitman chapter 02 l. j. gitman analysisof financial statements

Documents

financial position

income statements

taxes net

net income

net loss

earnings slide

specific period of time

net profit b4 taxes