C.  Financial Statement Analysis

1.  Major financial statements

a.  Income statement

• Summary of the profitability of a firm over a period of time

• Revenue - expenses = net earnings (profits)

• Expenses:

(1) Cost of goods sold

(2) General and administrative expenses

(3) Interest expense

(4) Taxes on earnings

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• Should use economic earnings as opposed to accounting earnings

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b.  Balance sheet

• Financial condition of the firm at a particular moment

• Assets = Liabilities + stockholders' equity

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c. Statement of cash flows

• Tracks cash implications of transactions

• Accounts receivable and payable not counted

• Depreciation not counted

• Divided into cash flows from operations, from investments, and from financing activities

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2. Measuring firm performance

• Consider investment decisions and financing decisions

- Investment (capital budgeting) decisions - deals with use of capital

- Financing decisions - deals with sources of capital

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3. Profitability measures

a. Return on assets (ROA)

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b. Return on capital (ROC)

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c. Return on equity (ROE)

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• Financial leverage - based on debt-equity mix

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 d. Economic value added

• Economic value added = (ROC - k) *capital invested

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4.  Ratio analysis

a. Decomposition of ROE

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(1) Tax-burden ratio

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(2) Interest-burden ratio

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• Interest coverage ratio

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(3) Profit margin or return on sales (ROS)

• Operating profit per dollar of sales

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(4) Total asset turnover (ATO)

• Annual sales generated by each dollar of assets

• Measure of efficiency

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(5) Leverage ratio

• Measure degree of financial leverage

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• Return on equity (ROE)

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 b.  Turnover and other asset utilization ratios

• Look at turnover for subcategories of assets

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(1) Fixed-asset turnover ratio

• Sales per dollar of money tied up in fixed assets

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(2) Inventory turnover ratio

• Measures speed at which inventory is turned over

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(3) Days sales in receivables (average collection period)

• Measures efficiency of management of accounts receivable

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c.  Liquidity ratios

• Liquidity - ability to convert assets to cash at short notice

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(1) Current ratio

• Ability to pay off current liabilities by liquidating current assets

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(2) Quick ratio (acid test ratio)

• Same as current ratio but inventory not counted as current assets

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(3)  Cash ratio

• Same as quick ratio but receivables not counted as current assets

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d.  Market price ratios

(1) Market-book-value ratio (P/B)

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(2) Price-earnings ratio (P/E)

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• Relationship between P/B and P/E

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e. Benchmarks

(1) Compare with past values

• Time series analysis

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(2) Compare with other firms in industry