Topic 9: Financial Statements Analysis

BUS 442 Investment Theory and Portfolio Management

Economic and industry analysis will help investors narrow down their choices of companies as good candidates for
further “investigation” before making any investment decisions. It is now time for them to look at the short list of
companies more closely by analyzing their performances (i.e. financial health) over a period of time to determine if
they should be considered as good investment candidates. In addition to analyzing companies’ performance over
time, investors should also compare the companies’ performance to their competitors.

1. Five Major Categories of Financial Ratios

There are literally thousands of financial ratios. Basically, you get a financial ratio every time you divide two items
in the financial statements. We will focus on five major categories of financial ratios. Based on your readings and
knowledge about financial ratios from other courses, identify the type of information offer by each category of
financial ratios.

Ratio Categories Information Provided?

Liquidity
(or short-term solvency)

Activity
(or asset management)

Leverage
(or long-term solvency or debt
management)

Profitability

Market value

There are a number of financial ratios within each of the five categories. The last few pages of this handout contain
some of the more commonly used ratios among managers. Based on what you learned in an introductory finance
course, provide the formula for each ratio, indicate its strength (i.e. higher or lower the better), and provide any
comments relevant to the ratio.

2. Trend Analysis

Examining financial ratios by themselves does not managers many insights regarding the financial health of the
company. It is important for the managers to examine the patterns (or trends) exhibited by the financial ratios over a
period of time. In other words, performing trend analysis provides clues as to whether a company’s financial health
is improving or deteriorating.

Investment Theory -1- Topic 9 Handout

 Refer to In-class Example 1

Refer to In-class Example 2

Analysis and recommendations:

3. Du Pont Analysis: Breaking Down the ROE

In the previous example, we were able to analyze the financial health of the company by looking at a variety of
ratios in five different categories (with each category providing us information about the company’s performance in
a specific area).

Is there a ratio that can help tie together the performance of a company in different areas? Believe it or not, a
company’s return of equity can be easily broken down into a combination of several financial ratios. The process of
breaking down and analyzing the parts of the ROE is known as the Du Pont analysis.

We know the following is true:

NI NI EBT EBIT Sales Assets

ROE = = × × × ×
Equity EBT EBIT Sales Assets Equity

Basically, the ROE can be broken down as:

ROE = Tax burden × Interest burden × Operating margin × Asset turnover × Leverage

Looking at the break down above, can you identify the different factors that affect a company’s ROE?

Refer to In-class Example 3

Analysis and recommendations:

Investment Theory -2- Topic 9 Handout

4. Peer Group Analysis (or Benchmarking)

Conducting trend analysis helps managers determine how the company performed over time. However, investors
will gain additional information by comparing the company’s financial ratios to its peers. One of the ways of
comparing to its peers is by comparing the company’s ratios to the industry’s averages. However, it would have
been better if the managers compare the company’s ratios to the industry leader and other major competitors. This
type of comparison is known as benchmarking, where investors compare the company’s ratios to a small group of
leading companies in the industry.

Refer to In-class Example 4

Analysis and recommendations:

5. Limitations of Using Financial Ratios Analysis

Keep in mind that even though financial ratios analysis helps investors pinpoint a company’s strengths and
weaknesses, it does have its limitations and investors need to be aware of these limitations.

• Inflation

• Seasonal factors

• Window dressing

Investment Theory -3- Topic 9 Handout

 • Different accounting practices

• No general interpretation

• Mixed (or misleading) signals

6. What Else to Look at?

Financial ratio analysis focuses on analyzing and comparing a number of financial ratios, which qualifies it as a
quantitative analysis. However, quantitative analysis only paints a portion of the picture. Investors also need to
examine qualitative factors to help them “see” the big picture. To fully understand the financial health of a company,
investors need to also address some of the following (qualitative) issues:

• Are the company’s revenues tied to one key customer?

• To what extent are the company’s revenues tied to one key product?
• To what extent does the company rely on a single supplier?
• What percentage of the company’s business is generated overseas?
• What competitions do the company currently faced and will potentially face in the future?
• What are the company’s future prospects?
• What potentially will happen in the legal and regulatory environment?

Why do you think investors need to address the above issues? Provide some explanations.

Investment Theory -4- Topic 9 Handout

I. Liquidity Ratios

Financial Ratio Formula Strength Comments?

Current

Quick

II. Activity Ratios

Financial Ratio Formula Strength Comments?

Inventory turnover

Days’ sales in inventory

Receivable turnover

Days’ sales in receivable

(or average collection
period)

Asset turnover

Fixed asset turnover

Handout 1: Financial Ratios -5- MBA 504 (Thursday Cohort)

Handout 1: Financial Ratios -6- MBA 504 (Thursday Cohort)
III. Leverage Ratios

Financial Ratio Formula Strength Comments?

Total debt

Long-term debt
(or long-term
capitalization)

Debt to equity

Financial leverage

Interest coverage
(or times interest earned)

IV. Profitability Ratios

Financial Ratio Formula Strength Comments?

Net profit margin
(or profit margin on sales)

Pre-tax margin

Operating margin

Handout 1: Financial Ratios -7- MBA 504 (Thursday Cohort)

 Gross margin

Basic earnings power

Return on asset (ROA)

Return on equity (ROE)

V. Market Value Ratios

Financial Ratio Formula Strength Comments?

Price to earnings (P/E)

Market to book

Handout 1: Financial Ratios -8- MBA 504 (Thursday Cohort)