ISBN: 0-03-028931-9
Chapter 3 Analysis of Financial Statements
The primary purpose of this chapter was to discuss techniques used by investors and managers to analyze financial statements. This is an outline of a few of the main concepts, please refer to the textbook for more comprehensive coverage.
Financial statement analysis generally begins with the calculation of a set of financial ratios designed to reveal the relative strengths and weaknesses of a company as compared with other companies in the same industry, and to show whether its financial position has been improving or deteriorating over time.
Liquidity ratios show the relationship of a firm's current assets to its current liabilities, and thus its ability to meet maturing debts.
Two commonly used liquidity ratios are the current ratio and the quick, or acid test, ratio.
Asset management ratios measure how effectively a firm is managing its assets.
Asset management ratios include inventory turnover, day sales outstanding, fixed assets turnover, and total asset turnover.
Debt management ratios reveal (1) the extent to which the firm is financed with debt and (2) its likelihood of defaulting on its debt obligations.
Debt management ratios include the debt ratio, time-interest-earned ratio, and EBITDA coverage ratio.
Profitability ratios show the combined effects of liquidity, asset management, and debt management policies on operating results.
Profitability ratios include the profit margin on sales, the basic earning power ratio, the return on total assets, and the return on common equity.
Market value ratios relate the firm's stock price to its earnings and book value per share, and they give management an indication of what investors think of the company's past performance and future prospects.
Market value ratios include the price/earnings ratio, the price/cash flow ratio, and the market/book ratio.
Trend analysis, where one plots a ratio over time, is important, because it reveals whether the firm's ratios are improving or deteriorating over time.
Du Pont analysis is designed to show how the profit margin on sales, the assets turnover ratio, and the use of debt interacts to determine the rate of return on equity. The firm's management can use the Du Pont system to analyze ways of improving the firm's performance. The ROE can be decomposed into the profit margin times the total asset turnover ratio times the equity multiplier. Or, alternatively, the ROE can be broken down into the return on assets times the equity multiplier.
Benchmarking is the process of comparing a particular company with a group of "benchmark companies".
In analyzing a small firm's financial position, ratio analysis is a useful starting point. However, the analyst must also (1) examine the quality of the financial data, (2) ensure that the firm is sufficiently diversified to withstand shifts in customer's buying habits, and (3) determine whether the firm has a plan for the succession of its management.
Ratio analysis has limitations, but used with care and judgement, it can be very helpful.
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