1.E Financial Statement Analysis

Financial Statement Analysis

Financial statement analysis uses quantitative methods to evaluate a company's performance, financial position, and cash flows. This analysis is essential for investors, creditors, and management decision-making.

Types of Financial Analysis

Liquidity Ratios

Liquidity ratios measure a company's ability to meet short-term obligations as they come due.

1. Current Ratio

Current Ratio = Current Assets / Current Liabilities

• Measures ability to pay short-term obligations with short-term assets
• Generally, a ratio of 2:1 is considered healthy, but varies by industry
• Too high may indicate inefficient use of assets

2. Quick Ratio (Acid-Test Ratio)

Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities

Or: (Current Assets - Inventory - Prepaid Expenses) / Current Liabilities

• More stringent test of liquidity
• Excludes inventory (less liquid) and prepaids (won't convert to cash)
• Generally, 1:1 or higher is considered adequate

3. Cash Ratio

Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities

• Most conservative liquidity measure
• Shows ability to pay current liabilities with cash on hand

Example: Current assets: $500,000 (Cash $50,000, Receivables $150,000, Inventory $250,000, Prepaids $50,000) Current liabilities: $200,000

• Current Ratio = $500,000 / $200,000 = 2.5
• Quick Ratio = ($50,000 + $150,000) / $200,000 = 1.0
• Cash Ratio = $50,000 / $200,000 = 0.25

Profitability Ratios

Profitability ratios assess management's ability to generate returns for investors.

1. Gross Profit Margin

Gross Profit Margin = Gross Profit / Net Sales = (Net Sales - COGS) / Net Sales

• Measures efficiency of production and pricing strategy
• Higher margin indicates better control over production costs

2. Operating Profit Margin

Operating Profit Margin = Operating Income / Net Sales

• Measures profitability from core operations before interest and taxes
• Excludes financing decisions and tax effects

3. Net Profit Margin

Net Profit Margin = Net Income / Net Sales

• "Bottom line" profitability measure
• Shows how much profit is generated per dollar of sales

4. Return on Assets (ROA)

ROA = Net Income / Average Total Assets

Or: Net Income / Total Assets (using ending balance)

• Measures how efficiently assets are used to generate profit
• Higher ROA indicates more efficient asset utilization

5. Return on Equity (ROE)

ROE = Net Income / Average Stockholders' Equity

• Measures return to common shareholders
• Key metric for investors evaluating management performance
• Can be inflated by high leverage

Exam Tip: When comparing ROA and ROE, remember that financial leverage magnifies ROE. A company with high debt will have higher ROE than ROA.

DuPont Analysis

DuPont analysis decomposes ROE into three components to identify drivers of return:

Basic DuPont Model:

ROE = Net Profit Margin x Asset Turnover x Equity Multiplier

Where:

• Net Profit Margin = Net Income / Sales
• Asset Turnover = Sales / Average Total Assets
• Equity Multiplier = Average Total Assets / Average Stockholders' Equity

Expanded DuPont Model (5-factor):

ROE = (EBIT/Sales) x (Sales/Assets) x (Assets/Equity) x (EBT/EBIT) x (NI/EBT)

Example:

• Net Income: $100,000
• Sales: $1,000,000
• Average Assets: $500,000
• Average Equity: $250,000

DuPont Analysis:

• Net Profit Margin = $100,000 / $1,000,000 = 10%
• Asset Turnover = $1,000,000 / $500,000 = 2.0x
• Equity Multiplier = $500,000 / $250,000 = 2.0x
• ROE = 10% x 2.0 x 2.0 = 40%

Leverage Ratios

Leverage ratios indicate the degree to which a company relies on debt financing and its ability to meet debt obligations.

1. Debt-to-Equity Ratio

Debt-to-Equity = Total Debt / Total Stockholders' Equity

• Higher ratio indicates greater financial risk
• Creditors prefer lower ratios; shareholders may prefer higher ratios for leverage benefits

2. Debt-to-Assets Ratio (Debt Ratio)

Debt Ratio = Total Liabilities / Total Assets

• Shows percentage of assets financed by creditors
• Higher ratio means greater financial risk

3. Equity Ratio

Equity Ratio = Total Stockholders' Equity / Total Assets

• Complement of debt ratio (Debt Ratio + Equity Ratio = 1)
• Higher ratio indicates more conservative financing

4. Times Interest Earned (Interest Coverage Ratio)

Times Interest Earned = EBIT / Interest Expense

• Measures ability to cover interest payments from operating earnings
• Higher ratio indicates better ability to service debt
• Generally, TIE > 2.5 is considered adequate

5. Debt Service Coverage Ratio

DSCR = (Net Operating Income) / (Principal + Interest Payments)

• Used by lenders to assess ability to service total debt payments
• DSCR > 1 indicates cash flow covers debt service

Efficiency (Activity) Ratios

Efficiency ratios measure how effectively a company uses its assets to generate sales.

1. Inventory Turnover

Inventory Turnover = Cost of Goods Sold / Average Inventory

Days Inventory Outstanding = 365 / Inventory Turnover

• Higher turnover indicates efficient inventory management
• Too high may indicate stockouts; too low may indicate obsolescence

2. Receivables Turnover

Receivables Turnover = Net Credit Sales / Average Accounts Receivable

Days Sales Outstanding (DSO) = 365 / Receivables Turnover

• Higher turnover indicates efficient collection
• Compare to credit terms to assess collection effectiveness

3. Payables Turnover

Payables Turnover = Purchases (or COGS) / Average Accounts Payable

Days Payable Outstanding = 365 / Payables Turnover

• Lower turnover (more days) may indicate the company is stretching payments
• Compare to supplier terms and industry norms

4. Total Asset Turnover

Asset Turnover = Net Sales / Average Total Assets

• Measures efficiency of total asset utilization
• Higher turnover indicates more efficient use of assets

5. Fixed Asset Turnover

Fixed Asset Turnover = Net Sales / Average Net Fixed Assets

• Measures efficiency of long-term asset utilization
• Important for capital-intensive industries

Cash Conversion Cycle

The cash conversion cycle (CCC) measures the time it takes to convert inventory investments into cash from sales:

CCC = Days Inventory Outstanding + Days Sales Outstanding - Days Payable Outstanding

Example:

• DIO = 60 days
• DSO = 45 days
• DPO = 30 days
• CCC = 60 + 45 - 30 = 75 days

A shorter CCC indicates more efficient working capital management.

Market Ratios

Market ratios relate stock price to financial performance:

1. Earnings Per Share (EPS)

Basic EPS = (Net Income - Preferred Dividends) / Weighted Average Common Shares Outstanding

2. Price-to-Earnings (P/E) Ratio

P/E Ratio = Market Price per Share / Earnings per Share

• Higher P/E suggests investors expect higher future growth
• Compare to industry average and historical trends

3. Dividend Yield

Dividend Yield = Annual Dividends per Share / Market Price per Share

4. Dividend Payout Ratio

Payout Ratio = Dividends per Share / Earnings per Share

• Shows percentage of earnings distributed as dividends
• Retention ratio = 1 - Payout Ratio