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FMGT 3510 Chapter 3 Page 1

Financial Statement Analysis (FSA)


(Chapter 3)
Overview of FSA
FSA allows us to evaluate and compare the financial position and financial
performance of a firm. It can also help us predict future earnings, dividends and free
cash flow. The analytical tools that are available to us include the following:
Comparative financial statements: the current financial position and the operating
results for the current year are compared to previous years.
Common size financial statements: the items on the balance sheet and income
statement are expressed as a percentage of a total (total assets for the balance
sheet and total revenue for the income statement).
Financial ratios: the examination of relationships between certain key items on the
financial statements.
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There are two general approaches that we can take with this analysis:

The inward approach: examines the firms performance overtime (trend analysis)
against its own past record.

The outward approach: compares the firms performance against other companies in
the same industry.

The inward approach is usually more successful. The outward approach is often
flawed and must be used with caution. Regional differences, size differences,
differences in the application of accounting policies and poor category differentiation
often make it difficult to find truly comparable companies within an industry.
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Attributes of Performance
Profitability: The firms ability to generate sufficient profits in
comparison to its level of sales and invested capital.

Productivity: The firms ability to put its assets to good use. Is the
(asset firm generating sufficient sales from its various
management) investments?
Liquidity: The firms ability to meet sudden cash requirements
and to meet its short-term obligations as they come
due.
Leverage: The degree to which the firm is financed with
borrowed money. How much financial risk does the
firm have based on its mix of debt and equity.
Valuation: The value that investors assign to the firm. This can
be easily measured for public companies. It is more
difficult to establish the value of private companies
as their shares are not traded in the capital markets.
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Which attribute is more important? It depends on your perspective.

Suppliers and banks (short-term lenders):


Liquidity, Leverage, profitability

Shareholders:
Profitability, valuation, leverage

Long-term creditors:
Leverage, liquidity

Management:
Valuation, productivity
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We will calculate Ellington Ltd.s 2012 ratios using these financial


statements.
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Profitability Analysis
Ratio What it Formula Example
measures
Net profit Net income Net income available
margin relative to sales common shareholders 363/2311=15.7%
Sales

Gross Gross profit per SalesCost of Goods Sold


profit $ of sales Sales (2311-1344)/2311=41.8%
margin before other
expenses
Basic Earning power EBIT
earnings of assets Total assets 691/3588=19.3%
power before taxes
and impact of
leverage
Operatin Profit before EBIT
g profit impact of Sales 691/2311=29.9%
margin interest and
taxes
Return Net income Net income available

on assets available to common shareholders
Total AssetsSales
363/3588=10.1%
(ROA) common
relative to total
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assets
Return Net income Net income available

on available to common shareholders
Common Equity
363/2591=14.0%
common common
equity relative to
(ROE) common equity
Return Ratio of NOPAT
on NOPAT to Operating Capital 691x(1-
invested Operating 0.34)/3244=14.1%
capital Capital (see Ch
(ROIC) 2)

Generally, the higher the above ratios, the better the firms performance. Low
profitability may indicate poor cost control and/or a sales mix that is skewed toward
lower margin products. Large variations in the gross profit margin from year-to-year
may indicate inventory valuation problems.
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Productivity (Asset Management) Analysis


Ratio (1) What it measures Formula Example
Inventory Number of times Sales
turnover ratio inventory must be Inventories 2311/422=5.5 x
replaced during the year
Days sales Average length of time Receivables
outstanding between sale and Annual Sales/365 188/(2311/365)=29.7
(DSO) receiving cash days
Average Average number of days Payables
payables period of COGS not yet paid Annual COGS /365 344/(1344/365)=93.4
(APP) days
Fixed assets $ of sales per $ of fixed Net
turnover ratio assets Sales 2311/2880=0.80
assets
Total assets $ of sales per $ of total Sales
turnover ratio assets Total Assets 2311/3588=0.644

Generally, a firm is looking for high asset turnovers and a low payables turnover.
However, excessively high asset turnovers can indicate an unsustainable level of
operations or an insufficient investment in certain necessary assets. Extremely low
asset turnovers may indicate that the firms investment in certain assets is too high or
that management is doing a poor job.
1.Year end balances used in calculations; average balances are also sometimes used
FMGT 3510 Chapter 3 Page 10

Liquidity Ratios

Ratio What it Formula Example


measures
Current ratio $s of current assets Current assets
per $ of current Current liabilites 708/540=1.31
liabilities
Quick ratio $s of liquid current Current assetsinventories
assets per $ of Current liabilites (708-422)/540=0.53
current liabilites

In comparison to industry averages, a low current ratio may indicate a liquidity shortage, which
could lead to future cash flow problems. An excessively high current ratio may indicate over
investment in short-term assets and/or underutilization of trade credit or short-term borrowing
facilities. A rising trend in the current ratio and a falling trend in the quick ratio may indicate
rising inventory levels and/or slower inventory turnover.
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Leverage (Debt Management) Analysis


Ratio What it measures Formula Example
Debt ratio % of capital provided by Total liabilites
current liabilities and long Total assets (540+457)/3588=
term debt 27.8%
Times interest $ of operating earnings EBIT
earned ratio available to pay each $ of Interest expense 691/141=4.9
(TIE) interest expense
EBITDA $ of operating cash flow EBITDA+ lease payments (691+276+25)/
coverage ratio available to pay each $ of Interest + principal payments +lease payments (141+25)=6.0
fixed charges
Debt to equity $ of debt for each $ of Total liabilites (540+457)/2591=
equity Shareholder s ' equity 38.5%
Assets-to-equity $ of assets for each $ of Total assets 3588/2591=1.385
(Equity equity Shareholder s ' equity
multiplier)

The leverage or debt management ratios help us asses the firms degree of financial
leverage and financial risk. A firm with excessively high levels of debt may be
considered too risky and be penalized with poor credit ratings and high required rates
of return on its debt and equity. A firm with too low levels of debt may be considered
under levered and its value may not be maximized.
FMGT 3510 Chapter 3 Page 12

Market Value Ratios


Ratio What it Formula Example
measures
Price/earnings Amount investors Common share price
ratio (P/E) pay per $ of EPS EPS $51/$6.91=7.4

Price/cash flow Amount investors Common share price CFPS=(363+276)/52.5=$12.17


ratio pay per $ of cash CFPS $51/$12.78=4.2
flow per share
Market/book How much investors Common share price BVPS=2591/52.5=$49.35
ratio pay per $ of book BVPS $51/$49.35=1.03
value per share
Dividend yield return provided by Dividend per common share DVPS=121/52.5=$2.30
dividends per share Common share price $2.30/$51=4.5%

A firm may have a high P/E ratio due to excessively low earnings and/or high expected
growth. Investors may be very optimistic about the firms future prospects. Dividend
yield is usually tied to rates of growth. High-growth firms typically reinvest most of their
earnings instead of paying them out as dividends, resulting in low yields. Slow-growth
firms in stable industries typically pay out a higher percentage of their earnings and
have a higher yield.
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Trend Analysis, Common Size Analysis, Percent Change Analysis


Trend analysis involves plotting a ratio over time. This figure shows ROE over a
five year period
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Common size statements make it easier to compare changes in income


statements and balance sheets over time.
o Income statement items are divided by sales
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o Balance sheet items are divided by total assets


o Percent change analysis calculates the % growth in balance sheet and
income statement items over time.
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DuPont Analysis
The DuPont system of financial analysis integrates three of the performance attributes
profitability, productivity and leverage in order to help us understand the firms
financial strategy. DuPont analysis focuses on return on equity (ROE) which is
calculated by the following three ratios:
1) How many cents of after-tax profit does each dollar of sales generate (i.e. the
net profit margin)?
2) How many dollars of sales does each dollar of assets generate (i.e. the total
asset turnover)?
3) How many dollars of assets does the firm have for every dollar of invested by
equity holders (i.e. assets to equity)?
The extended DuPont equation is as follows:
ROE = Profitability x Productivity x Leverage

Net income Net income Sales Total assets


ROE= = X X
Shareholders' equity Sales Total assets Shareholders' equity
DuPont analysis for Ellington Ltd.:
ROE=14.0%=15.7% x 0.644 x 1.385 = 14.0% = 363/2591=14.0%
FMGT 3510 Chapter 3 Page 19

Limitations of FSA
Amounts on the balance sheet are generally based on historic cost and not market
value.
Ratios that involve various balance sheet accounts may not be very meaningful
if there is a big difference between market value and book value.
They may have very little direct relationship to the firm's ability to generate cash
flow.
The use of different accounting policies. This may make comparisons between
different companies difficult.
Firms may use "window dressing" to make their financial statements look better.
Many firms have highly summarized financial statements with few details. This
makes it difficult to perform FSA.
High levels of inflation or deflation can cause distortions in the firms financial results.
It is difficult to make industry comparisons when the firm operates businesses that
cross many different industries.