Analysis of Financial Statements Financial analysis is designed

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

Overview l 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)

Financial Statements l Are used to help predict the company’s future earnings and dividends

Financial Ratios l Financial ratios are designed to show relationships between financial statement accounts

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

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

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

Asset Management Ratios l l l 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

Inventory Turnover Ratio l Is defined as sales divided by inventory l 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

Days Sales Outstanding (DSO) l 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 l DSO represents the average length of time that a company must wait after making a sale before receiving cash

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

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

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

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

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

Fixed Charge Coverage Ratio l 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.

Review l Financial Analysis l Financial Statements l Financial Ratios l Liquidity Ratios l Asset Management Ratios l Debt Management Ratios

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