ANALYZING THE FINANCIAL STATEMENTS
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reflect the views or policies of the Asian Development Bank (ADB), or its Board of
Directors or the governments they represent. ADB makes no representation
concerning and does not guarantee the source, originality, accuracy, completeness or
reliability of any statement, information, data, finding, interpretation, advice, opinion, or
ANALYZING THE FINANCIAL STATEMENTS
The objectives of this module are to present some
of the fundamentals of financial statement analysis
to afford the non-accountant a very basic
understanding of how the investor and analysts use
financial statements in making investment
decisions and what should be necessary for the
company to report to the regulator in order to
provide the investor with the information needed.
Rate of Return
Return on Investment (ROI)
Return on Equity (ROE)
Days’ Sales in Accounts Receivable and
Days’ Sales in Inventory
Debt Ratio and Debt/Equity Ratio
The learner might consider printing out each financial statement from
Module eight so that he or she may refer to it as the elements of each are
discussed. For this reason, each is displayed on a single screen. The
learner is encouraged to review the information in Module eight before
beginning this Module.
A ratio is the relationship between two numbers. In most cases a single ratio does not
describe very much about the company. When these ratios are compared over time, a
trend will emerge which will indicate the direction that these ratios are taking and when
ratios are compared over time the process is known as trend analysis. Analysis and
investors use ratios and trend analysis as tools to interpret and evaluate the figures on a
Of course, consistency in financial reporting and in defining the ratio components is
crucial if either the ratio or the trend is to be meaningful.
The ratios and trends that are calculated can be categorized under the four areas of
profitability, liquidity, activity and leverage.
Three of the most important measures of profitability are the return on investment (ROI)
and return on equity (ROE). Each of these measures, derived from the income
statement, relates net income to an element on the balance sheet.
Investors look at the rate of return of an investment to evaluate an individual investment
and to compare potential investments. If investment A is paying a return of $80 and
investment B is paying a return of $90, which investment should you buy? The answer
is not as easy as it may first appear. The amount of the return is not enough information
to make an informed decision. You also need to know how much each investment cost
and what is the time period that the investment takes to yield that return. If we assume
an annual rate of return, the formula for the rate of return is:
annual rate of return =
amount of return = %
The rate of return is calculated by dividing the amount of the return by the amount of the
investment. If the cost of the investment for each of the two options above is the same,
then investment B has the higher rate of return. For example, if both cost $1,000, then
the amount of the return ($80for A, $90 for B) divided by the amount invested ($1,000)
would yield a return of 8% for A ($80 / $1,000) and 9% for B ($90 / $1,000)..
If the costs of the investments are different, the return on the investment must be
calculated. If investment A above costs $1,000, but investment B above costs $500 then
the amount of return of B ($90 divided by $500) would be 18% and the better
RETURN ON INVESTMENT
The return on investment (ROI) is used as an indication of the effectiveness of
management since it describes the rate of return that management was able to achieve
on the assets that it had available to use in operating the business. Before we get to
ROI, let’s first look at the rate of return. The return on investment (ROI) is the name for
the rate of return on the assets for a company and can be expressed by the formula:
ROI = net income = %
The income statement of ATC in Module eight reported that the net income was $18,000
and the total assets from the balance sheet were $284,000. An average of the total
assets for the current year and the total assets for the previous year is used after the
company’s first year of operation because the net income was earned over that one-year
period and therefore should relate to that one-year period. For ATC, the ROI was
approximately 6.3% ($18,000/$284,000).
If we assume that ATC had been in business the previous year and that the total assets
for that year were $194,000, the average total assets would be $239,000 ($194,000 plus
$284,000 divided by 2). The ROI in that case would be approximately 7.5% ($18,000 /
As mentioned in Module eight, the standards of accounting are not a codified set of rules
to be blindly followed. In accounting, consistency in the definition of terms is more
important than the definition itself. So it should come as no surprise that the above ROI
formula is not the only ROI formula that can be used.
The balance sheet element in the formula is average total assets. By now you should
have developed a healthy skepticism about the assumptions, methods and calculations
of these “average” amounts and how they relate, or don’t relate, to “true” rates of returns
based upon real economic profit and fair market values. Therefore, actual rates are
usually used instead of averages and again, the raw ratios are not as important as the
trend of these ratios.
Some financial analysts will use operating income and average operating assets in the
formula because they believe that excluding interest expense, income taxes, and assets
not used in operating the business results in a better measurement of the operating
results. That formula would be:
ROI = operating income / operating assets
Another popular approach to ROI is known as the DuPont model, because it was
developed by the financial analysts at E.I. DuPont de Nemours & Co. a large chemical
company in the Untied States. The significance of the DuPont model is that it has led
many managements to consider utilization of assets, including keeping investment in
asserts as low as feasible to be just as important to overall performance as generating
profit from sales. That formula is:
ROI = net income X sales
sales average total assets
Net income divided by sales is also called margin. Margin emphasizes that a portion of
every cash unit of sales revenue must appear in net income.
Sales divided by average total assets is asset turnover or turnover. Turnover relates to
the efficiency with which the company’s assets are used in generating revenue.
ROI = Margin x Turnover
Return on Equity (ROE) is the primary measure of a company’s profitability. It is the
percentage of net income divided by average owners’ equity for the fiscal period in which
the net income was earned.
ROE = net income / average owner’s equity
As with the formula for ROI, operating income, which excludes other income and
expense (mainly interest expense) and income taxes, is also frequently used in
calculating ROE because it is a more direct measure of the results of management’s
activities than is net income. Interest expense (included in net income) is a function of
the board of director’s decision about capital structure (debt and owner’s equity) and not
a function of the operating activities of the company. Income taxes are a function of the
tax laws and therefore also not under the control of management.
The other three most common profitability ratios are the P/E, dividend yield and the
dividend payout ratios.
We previously discussed the price/earnings (P/E) ratio and said that is was:
P/E = price of a share of stock / earnings per share
The denominator of this equation is used extensively by investors and market analysts to
evaluate the market price of a stock against the market price as a whole. The P/E ratio
(or P/E) is also known as the earnings multiple of a stock. The term refers to the fact
that the market price of a stock is equal to the earnings per share multiplied by the P/E
The P/E ratio, or earnings multiple, is one of the most important measures used by
investors and analysts to evaluate the market price of a share of common stock.
When the decision to buy a share of common stock is made, it is most often based upon
the fact that the buyer anticipates the company will pay dividends (usually cash but
maybe stock) based upon profits and the price of the stock will rise. So, in a very real
sense, the market price of a share of common stock is a reflection of investor
expectations of dividends. The greater the probability of increased earnings, the more
investors are willing to pay for the stock. For example, company A is trading at
HK$48.00 and company B is trading at HK$75.00. Which is the better investment? One
might be tempted to say company B because the stock is trading at a higher price and
therefore, it would be assumed, that company B is worth more than company A.
However, suppose we also knew that company A’s last quarter earnings per share were
HK$4.00 and company B’s last quarters earnings per share were HK$7.50. Now which
is the better investment? It still may look to some that company B is the better
investment due to higher price and higher earnings. Now, calculate the P/E ratio. Which
is the better investment? (Answer appears in the answers to the questions at the end of
As your calculations reveal, investor’s are willing to pay more for the stock of company A
than for the stock of company B, because investors expect better future earnings and
growth from company A than they do from company B. This is the reason that stock
tables publish the P/E ratio. High P/E ratios indicate high investor expectations, low
multiples indicate low expectations.
Analysts will also use the expected earnings of a company and the current market price
to determine the future market price of a company’s stock. Other approaches are to use
the expected future earnings per share and the current (or expected future) earnings
Another ratio used by investors and analysts is the dividend yield:
dividend yield = dividend per share / market price per share
The yields for different investments are compared to help investors and analysts
evaluate the extent to which the investment objectives are being met.
DIVIDEND PAYOUT RATIO
Another ratio involving the dividend is the dividend payout ratio which reflects the
company’s dividend policy is the dividend pay-out ratio.
dividend pay-out ratio = dividend per share / earnings per share
Most companies that pay dividends have a dividend pay-out policy of some specified
percentage. Knowing the dividend pay-out ratio permits the investor and analyst to
project future dividends from projected earnings as well as track the company’s ability to
earn profits consistently enough to pay or increase the dividend pay-out target. Again, a
trend here is more important than one static figure.
Liquidity is the company’s ability to meet its current obligations. There are three
principal tests of liquidity. The figures are obtained from the balance sheet.
working capital = current asset – current liabilities
current ratio = current assets / current liabilities
acid test ratio = cash* + accounts receivable
*cash includes temporary cash investments
The acid test ratio is also known as the quick ratio and is a short-term measurement
because merchandise inventories are excluded from the computation. This is the ability
of the company to meet its current obligations without selling any of its inventory.
Working capital is not as significant as the current ratio and as we said earlier, it is the
trend of this ratio that is the most important information. The working capital
measurement merely reports a figure, without a reference this figure is not very
meaningful. If working capital is HK$3.2million, what does that tell you?
From the balance sheet of ATC set forth in Module eight, we found that the current
assets are $284,000 and the current liabilities are $67,000. Therefore, working capital is
$217,000 ($284,000-$67,000). Is that good or bad? Is our company liquid? How can
The current ratio is 4.2 ($284,000/$67,000) and the acid test ratio is 1.7. As a general
rule, a current ratio of 2 and an acid test ratio of 1 are considered indicative of
good liquidity. Now can you tell if ATC is liquid?
You will recall that it was stated in Module eight that the accounting standards were not
detailed proscriptions but rather general guidelines for operation that left choices in
assumptions, methods and calculations up to the accountant. Financial statement
analysis involves careful observation of those assumptions made by the accountant and
the methods chosen to account for the reporting. The analysis attempts an
understanding of the basis for the assumptions and methods used to acquire the figures
reported. It further attempts to work those figures into ratios that may be compared to
reveal relative standing and to discern trends in those ratios to determine direction of the
figures, the future of the company and therefore the direction of the stock price.
For example, let’s look at the effect of the inventory cost-flow assumption on the working
capital ratio. The value of inventory that is reported on the balance sheet will depend on
whether the weighted-average, FIFO (first in, first out), or LIFO (last in, first out)
assumption is used. In periods of rising prices, a company using FIFO will report a
relatively higher asset value for inventories than a similar firm using the LIFO cost-flow
assumption. Therefore, even though two companies may be similar in all other respects,
they will report different amounts of working capital and they will have a different current
ratio. Without analyzing the assumptions, the reader of the financial reports for these
two companies would not know that a direct comparison of current ratios cannot be
made because of the different inventory accounting methods used. The better
comparison to be made for these two companies would be the trend of the two ratios.
Physical measures of activity, rather than financial measures, are also frequently used.
For example, it may be more informative to know the number of units sold rather than
the sales value of those units. The amount will reflect inflation, deflation and currency
changes, unit numbers will not. The same is true for reporting the total number of
employees rather than the payroll costs of a company.
Many analysts combine the physical and financial measures to develop useful statistics
and plot trends in order to compare results over time of a company or the differences
between companies. Sales values per employee and operating income per employee
may be used as productivity measures. Plant operating expenses per square foot or
gross profit per square foot might also be used as a productivity measure.
When comparing the operating results of different sized companies, many analysts
convert the items on the balance sheets into percentages of total assets and the items
on the income statement into percentage of sales. This process results in common size
As is the case with the accounting standards themselves, there are no absolutes in
measurements and analysis. The goal is to look behind the figures and determine the
company’s objectives, procedures and methods and to develop measurements that are
meaningful when used in comparison with each other within the company, between
companies and across sectors. It is often the case, that the trend of a ratio is more
informative than any single ratio.
Activity measures the efficiency with which assets have been utilized to generate sales
revenue. Therefore, activity measures focus primarily on the relationship between asset
levels and sales (called turnover). The formula for calculating turnover is:
Turnover = sales / average assets
Remember that we said that financial statements were a snapshot of the financial
condition of a company at a given point in time. Because sales are generated over a
period of time, it is appropriate that the average asset investment over the same period
be used rather than the amount of assets at any single point in time, such as the balance
sheet amount reported at the end of a fiscal period.
Usually the average asset amount is determined by using the balance sheet amount
reported at the beginning and end of the period. However, if available, monthly and
quarterly balance sheet amounts can be used to calculate an average.
Turnover is usually calculated for:
turnover = sales/average accounts receivable
turnover = cost of goods sold* / average inventories
Plant and equipment;
turnover = sales / average plant and equipment**
*because inventories are reported at cost, it is possible to substitute the
cost of goods sold for the sales amount in the turnover formula.
**some analysts use the cost of plant and equipment rather than the net
book value (cost minus accumulated depreciation) when calculating plant
and equipment turnover. This removes the differences in depreciation
calculation methods. However, since the assets or each company are
reported at original cost and not current value or replacement cost, as
they are acquired over time, the cost data are not as likely to be