Basics of Financial Management Basics of Financial Management 3rd edition 3rd edition Bacon et. al. Bacon et. al. 2004 2004 Copley Publishing GroupCopley Publishing Group

CHAPTER THREE CHAPTER THREE

3-1

©2005 All rights reservedSlides by Hassan Moussawi, Ph.D., M.B.A.

FINANCIAL STATEMENT ANALYSIS

Financial Statements AnalysisFinancial Statements Analysis

The two fundamental corporate financial statements are:The two fundamental corporate financial statements are:

1.1. Balance Sheet (assets, liabilities, and stockholders’ Balance Sheet (assets, liabilities, and stockholders’ equity on a given date)equity on a given date)

2.2. Income Statement (revenues, expenses, taxes and Income Statement (revenues, expenses, taxes and profits during a particular period of time)profits during a particular period of time)

The analysis of these two statements combined with the The analysis of these two statements combined with the analysis of other financial data is called financial analysis of other financial data is called financial statements analysis.statements analysis.

Balance SheetBalance Sheet

Income StatementIncome Statement

Uses of Ratio AnalysisUses of Ratio Analysis

The four major interest groups of the company are:The four major interest groups of the company are:

1.1. Short-term creditors (the ability of the company to meet Short-term creditors (the ability of the company to meet its short term obligation)its short term obligation)

2.2. Long-term creditors (the company will be able to make Long-term creditors (the company will be able to make its interest and principal payment when they come due)its interest and principal payment when they come due)

3.3. Managers (measure the firm’s performance from period Managers (measure the firm’s performance from period to period)to period)

4.4. Stockholders (value maximization of their stock)Stockholders (value maximization of their stock)

InflationInflation

Inflation can distort some financial data, manager should Inflation can distort some financial data, manager should explore the impact of inflation on ratiosexplore the impact of inflation on ratios

Examples of distortion are:Examples of distortion are:

1. Accounting for Inventory”1. Accounting for Inventory”

FIFO methodFIFO method

LIFO methodLIFO method

2. Depreciation2. Depreciation

Financial AnalysisFinancial Analysis

Different types of ratio are important for two reason:Different types of ratio are important for two reason:

No single ratio provides us with sufficient informationNo single ratio provides us with sufficient information

Ratios means different things to different peopleRatios means different things to different people

Financial Analysis, continued … Financial Analysis, continued …

Five categories of financial ratios:Five categories of financial ratios:

1.1. Liquidity ratios: firm's ability to pay short-term debtsLiquidity ratios: firm's ability to pay short-term debts

2.2. Leverage ratios: firm's ability to serve long-term debtsLeverage ratios: firm's ability to serve long-term debts

3.3. Activity ratios: to judge how well resources are usedActivity ratios: to judge how well resources are used

4.4. Profitability ratios: to determine management's performanceProfitability ratios: to determine management's performance

5.5. Common stock, market value, or investment ratios: to Common stock, market value, or investment ratios: to determine the value of the firm's stock and its growth potentialdetermine the value of the firm's stock and its growth potential

Ratio Ratio Definitions Definitions and Valuesand Values

Ratio Ratio Definitions Definitions

and Values, and Values, continued …continued …

DuPont SystemDuPont System

The DuPont system I an important technique for examining the The DuPont system I an important technique for examining the relationship among factors affecting the rate of return on relationship among factors affecting the rate of return on equity.equity.

ROA {Return on Assets (Investment)}ROA {Return on Assets (Investment)} = Profit Margin (PM) x Asset Turnover (AT)= Profit Margin (PM) x Asset Turnover (AT) = (Net Income After Tax / Sales ) X ( Sales / Total Asset)= (Net Income After Tax / Sales ) X ( Sales / Total Asset)

ROE (Return on Equity) ROE (Return on Equity) == Return on Assets / Equity Ratio Return on Assets / Equity Ratio ═ ═ (Profit Margin x Asset Turnover) / (1 - Debt Ratio)(Profit Margin x Asset Turnover) / (1 - Debt Ratio)

Where; Debt Ratio = Total Debt / Total Asset = D / TAWhere; Debt Ratio = Total Debt / Total Asset = D / TA

Common-size (Percentage) Financial StatementsCommon-size (Percentage) Financial Statements

It is important for the financial manager to compare changes It is important for the financial manager to compare changes on the financial statements that take place from period to on the financial statements that take place from period to period.period.

Common-size Financial Statements are:Common-size Financial Statements are:

1.1. Balance sheet: $ amount of each item divided by total Balance sheet: $ amount of each item divided by total assetsassets

2.2. Income statement: $ amount of each item divided by net Income statement: $ amount of each item divided by net salessales

Common-Size Balance SheetCommon-Size Balance Sheet

Common-Size Income StatementCommon-Size Income Statement

Comparative Ratio AnalysisComparative Ratio Analysis

(1) Historical standards: getting better, worse, (1) Historical standards: getting better, worse, or about the sameor about the same

(2) Industry standards: industry average ratios(2) Industry standards: industry average ratios

Comparing to The IndustryComparing to The Industry

Comparing to The Industry, Comparing to The Industry, continued …continued …

Limitations of Ratios AnalysisLimitations of Ratios Analysis

1.1. Distortion of comparative dataDistortion of comparative data

2.2. Varied product linesVaried product lines

3.3. Differences in accounting methodsDifferences in accounting methods

4.4. Window dressingWindow dressing

5.5. Other limitationsOther limitations