FINANCIAL ACCOUNTING MODULE 6

Analyzing Financial Statements

Note: This summary is longer and more comprehensive than most Module Summaries, as it will be helpful for you to
have a list of all the ratios we covered in this module in one place.

 Analyzing financial statements is critical in order to understand the performance of a business. To do so, we can
use different types of ratios that uncover important relationships between financial statement items.

 Ratios are typically most useful when making comparisons to other companies or to the past performance of the
company itself. Therefore, it’s important to first get an overall understanding of the company and the industry in
which it operates.

 One of the most commonly evaluated ratios is a firm’s return on equity or ROE, which shows the return that a
business generated during a period on the equity invested in the business by the owners of the business.

 The DuPont Framework expands the ROE formula to consist of three factors:

 The DuPont Framework measures profitability using Profit Margin, efficiency using Asset Turnover, and leverage
using the Leverage Ratio (or Equity Multiplier), as shown above. Although they are not used in the DuPont
Framework, there are many other ratios that measure profitability, efficiency, and leverage, which can provide
useful insights in financial statement analysis.

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FINANCIAL ACCOUNTING MODULE 6

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 PROFITABILITY RATIOS:
 Profitability reveals how much profit is left from each dollar of sales after all expenses have been subtracted.
Profit margin is calculated by dividing net income by the total sales for the period.

 The gross profit margin ratio tells us what percentage of our revenue is left to cover other expenses after the
cost of goods sold is subtracted. Recall that gross profit is equal to sales minus cost of goods sold.

 Earnings before interest after taxes or EBIAT, is a measure of how much income the business has generated
while ignoring the effect of financing and capital structure, or the proportion of debt that the business has.

 EFFICIENCY RATIOS:
 To measure Operating Efficiency, asset turnover tells us how well a business is using its assets to produce
sales. A business that can create more revenue with fewer assets is more efficient. This ratio uses both the
income statement and the balance sheet; we typically use the average of the beginning and ending balance
sheet amounts to estimate the average level of assets during the period.
 Inventory turnover helps understand how efficiently a business is managing its inventory levels. Excess
inventory costs money to store and uses up the firm’s cash that could be used for other investments. A
higher inventory turnover represents more efficient inventory management.

Here we used average inventory balance instead of the ending balance displayed on the balance sheet. This
is especially significant and provides better results than using the ending balance, especially for a firm that is
growing quickly, as the level of inventory could have fluctuated during the year.

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 Days Inventory relates to inventory turnover. The only difference is that it is expressed as the average number
of days the inventory is held before it is sold rather than how many times the inventory turned over during the
period. At times it may be more intuitive to consider and discuss ratios and changes to these ratios when the
terms are expressed in days.

or
 The accounts receivable turnover or AR turnover indicates a business’ efficiency in collecting receivables
from customers. Uncollected receivables represent cash that is tied up and can’t be used for other purposes.
A higher AR turnover represents more efficient cash collections.

 The average collection period, sometimes referred to as Days Sales Outstanding or Days Sales in
Receivables, is the average number of days it took for a business to collect payment from a customer. This
helpful measure can be compared to the cash collection policy of the firm. If payment is expected from
customers within 30 days, but the average collection period is 40 days, it may be a sign of concern.

or
 To measure Accounts payable turnover, or AP turnover we look at how long it takes us to pay our
vendors. Vendors include suppliers of inventory and also suppliers of services or other non-inventory items.
One input for this ratio is credit purchases, which can be estimated by looking at COGS. We are also
assuming that all goods are bought on credit and not paid for with cash. In both cases other adjustments
may have to be made.
(where credit purchases data is available) (where credit purchases data is NOT available)

 Another way to gauge our accounts payable is to look at days purchases outstanding. Again this simply
shows the AP turnover measured in average days outstanding.
(where credit purchases data is available) (where credit purchases data is NOT available)

It can also be calculated by:

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 The days purchases outstanding, days inventory, and average collection period combine into what is called
a cash conversion cycle. This metric, is a measure of how long it takes a business from the time it has to pay
for inventory from its suppliers until it collects cash from its customers.

 LEVERAGE RATIOS:
 Financial Leverage, also known as the Equity Multiplier, is calculated as average total assets divided by
average total equity and measures the impact of all non-equity financing, or debt of all sorts, on the firm’s
ROE. If all of the assets are financed by equity, the multiplier is 1. As liabilities, which are forms of debt,
increase, the multiplier increases from 1 demonstrating the leverage impact of the debt.

 Another very common indicator of leverage is the debt to equity ratio.

 OTHER RATIOS:
 The current ratio helps us understand the business’ ability to pay its short term obligations. It focuses on the
business’ more liquid assets and liabilities, or those that are convertible to cash or coming due, within a year.

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 The quick ratio is similar to the current ratio except only highly liquid current assets can be used in the
nominator. It’s also sometimes called an acid test ratio.

 The interest coverage ratio, also known as the times interest earned, is a good way to gauge how capable a
business is of making the interest payments on its debt. For this, we use a common income number called
EBIT (Earnings Before Interest and Taxes). This number has to be calculated from the income statement by
adding back interest expense and tax expense for the period to net income.

or
 Something to consider is the impact of Seasonality in a business’ performance, as it can cause repeating
fluctuations. Comparing financial statements for a full period to those for several smaller periods throughout
the year can help reveal these performance cycles.

 Ratios can be very useful when comparing one company to another because they allow you to eliminate to a large
extent the impact of size differences that exists among companies. Most ratios, however, are in some ways
influenced by managerial judgment in recording transactions that have a great impact on the financial statement.
As a financial analyst, in some cases you will need to make adjustments to the financial statements to account for
the differences before they can be used for comparisons.

 The impact of policy differences is most noticeable on how companies recognize revenue; whether purchased
assets are expensed or capitalized; and how a long-lived asset will be depreciated.

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