Analysis of Financial Statements

1. Analysis of Financial Statements • Financial analysis is designed to determine the relative strengths and weaknesses of a company • Investors need this information to estimate both future cash flows from the company and the riskiness of those cash flows • Information is provided by analysis both to evaluate a company’s past performance and to map future plans

2. Overview • Financial statement analysis involves a study of the relationships between income statement and balance sheet accounts, how these relationships change over time (trend analysis), and how a particular company compares with other companies in its industry (comparative ratio analysis)

3. Financial Statements • Are used to help predict the company’s future earnings and dividends

4. Financial Ratios • Financial ratios are designed to show relationships between financial statement accounts

5. Liquidity Ratios • Are used to measure a firm’s ability to meet its current obligations as they come due • Current Ratio • Quick, or Acid Test, Ratio

6. Current Ratio • Measures the extent to which the claims of short-term creditors are covered by short-term assets • It is determined by dividing current assets by current liabilities

7. Quick, or Acid Test, Ratio • Is calculated by deducting inventory from current assets and then dividing the remainder by current liabilities • Inventory is excluded because it may be difficult to liquidate it at full book value

8. Asset Management Ratios • Measure how effectively a firm is managing its assets and whether or not the level of those assets is properly related to the level of operations as measured by sales • Inventory Turnover Ratio • Days Sales Outstanding (DSO) • Fixed Assets Turnover Ratio • Total Assets Turnover Ratio

9. Inventory Turnover Ratio • Is defined as sales divided by inventory • It is often necessary to use the average inventory figure rather than the year-end figure, especially if a firm’s business is highly seasonal

10. Days Sales Outstanding (DSO) • Is used to appraise accounts receivable, and it is calculated by dividing average daily sales into accounts receivable to find the number of days’ sales tied up in receivables • DSO represents the average length of time that a company must wait after making a sale before receiving cash

11. Fixed Assets Turnover Ratio • Is the ratio of sales to net fixed assets • It measures how effectively the firm uses its plant and equipment

12. Total Assets Turnover Ratio • Is calculated by dividing sales by total assets • It measures the utilization of all the firm’s assets

13. Debt Management Ratios • Measure the extent to which the firm is using debt financing, or financial leverage, and the degree of safety afforded to creditors • Debt Ratio • Times-Interest-Earned (TIE) Ratio • Fixed Charge Coverage Ratio

14. Debt Ratio • Or ratio of total debt to total assets, measures the proportion of funds provided by creditors • The lower the ratio, the greater the protection afforded creditors in the event of liquidation

15. Times-Interest-Earned (TIE) • Is determined by dividing earnings before interest and taxes (EBIT) by the interest charges • The TIE measures the extent to which operating income can decline before the company is unable to meet its annual interest costs

16. Fixed Charge Coverage Ratio • Is similar to the TIE ratio, but it is more inclusive because it recognizes that many companies lease assets and incur long-term obligations under lease contracts and sinking funds.

17. Review • Financial Analysis • Financial Statements • Financial Ratios • Liquidity Ratios • Asset Management Ratios • Debt Management Ratios

18. Time to Answer a Few Questions