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Financial Statement Analysis


Shareholders' Equity represents a residual claim on the firm (in book value terms) ... It is very rare that historical cost equals market value. Examples: ... – PowerPoint PPT presentation

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Title: Financial Statement Analysis

Financial Statement Analysis
  • Review the components of the financial statement
  • Discuss the information contained in the
    financial statements and how it can be used to
    evaluate a firm.
  • Discuss the types of questions can financial
    ratios answer.
  • Discuss the relationship between the notion of
    market efficiency and financial statement

Introduction to Financial Statement Analysis
  • A major source of information regarding a a
    firms operating performance and its resources is
    the firms financial statement package.
  • Analyzing a set of financial statements involves
    using ratios of key financial statement items and
    other tools to gain insight into the
    profitability and risk of a firm.
  • Financial statement analysis can help us to
    better understand the business risk and the
    financial risk of a firm.

Principal Financial Statements
  • Financial statements are intended to provide
    information on the operating performance and
    financial health of a business during a specified
    period of time.
  • In the US, financial statements are required to
    adhere to GAAP (although GAAP does allow some
  • One goal is to make the financial statements of
    one firm comparable across time and to the
    financial statements of other firms.

Principal Financial Statements, cont.
  • GAAP requires firms to present balance sheets for
    the two most recent years and income statements
    and statements of cash flows for the three most
    recent years in a set of financial statements.
  • In addition, firms are required to present notes
    to the financial statements that provide
    information on the accounting methods used by the
    firm to construct the financial statements.

The Balance Sheet
  • The balance sheet is a statement of financial
    position that presents details of the resources
    of a firm and the claims on those resources as of
    a specific point in time (i.e., on March 31,
  • It is a static statement.
  • The asset side of a balance sheet reports the
    effects of a firms past investment decisions
    while the liabilities and shareholders equity
    side reports the effects of a firms past
    financing decisions.

The Balance Sheet, cont.
  • The balance sheet is governed by the accounting
  • Assets are resources that have the potential for
    providing a firm with future economic benefits.
  • Liabilities are obligations to pay for benefits
    or services received in the past.
  • Shareholders Equity represents a residual claim
    on the firm (in book value terms).

The Balance Sheet, cont.
  • It is important to note that most (if not all in
    some cases) assets and liabilities are reported
    on a firms balance sheet are at historical cost
    (less some adjustments).
  • It is very rare that historical cost equals
    market value.
  • Examples
  • Machinery historical cost less depreciation
  • Accounts Receivables historical value less an
    allowance for doubtful accounts
  • Inventory lower of cost or market

The Balance Sheet, cont.
  • It is also important to note that the balance
    sheet may not report all assets and liabilities
    of a firm.
  • Only assets and liabilities meeting certain
    criteria set out by GAAP are required to be
    reported on the balance sheet.
  • The footnotes are a source of information for
    these other off-balance sheet assets and

The Balance Sheet Assets
  • Assets are resources under a firms control that
    have the potential to provide the firm with
    future economic benefit(s).
  • i.e., the ability to generate future cash inflows
    (accounts receivables, inventories, etc.) or
    decrease future cash outflows (i.e., prepayments,
  • Assets are usually presented in order of their
    liquidity (cash, cash equivalents, accounts
    receivables, inventories, etc.).

The Balance Sheet Assets, cont.
  • Assets can be
  • Monetary Assets
  • cash, cash receivables, etc.
  • Monetary assets are reported at the amount of
    cash the firm expects to receive in the future.
  • Non-monetary
  • inventories, PPE, etc.
  • GAAP generally requires reporting non-monetary
    assets at their historical cost (historical cost
    is objective and verifiable).

The Balance Sheet Assets, cont.
  • Assets can be (cont.)
  • Current Assets
  • Cash and other assets (A/R, inventory,
    prepayments, etc.) expected to be converted into
    cash, sold, or consumed either in one year or in
    the operating cycle, whichever is longer.
  • Non-current/Long-term Assets
  • Assets not classified as current (PPE, some
    prepayments, etc.).

The Balance Sheet Liabilities
  • A liability represents a firms obligation to
    make payments of cash, goods, or services in a
    reasonably definite amount at a reasonably
    definite time in the future for benefits or
    services received in the past.
  • Liabilities are generally monetary (require a
    payment of a fixed amount of cash) but can be

The Balance Sheet Liabilities, cont.
  • Liabilities can be
  • Current Liabilities
  • Obligations whose liquidation is reasonably
    expected to require the use of existing resources
    classified as current assets or the creation of
    other current liabilities.
  • Non-current/Long-term Liabilities
  • Obligations not classified as current.

The Balance Sheet Shareholders Equity
  • The shareholders equity in a firm is the firms
    owners residual interest or claim on the firm.
  • The accounting identity can be re-written as
  • Therefore, the valuation of assets and
    liabilities in the balance sheet determines the
    book value of the shareholders equity.

The Balance Sheet Shareholders Equity, cont.
  • The shareholders equity portion of the balance
    sheet is commonly presented in three parts.
  • Capital Stock the par value of shares issued
  • Additional Paid-In Capital excess amounts paid
    in (by shareholders) in excess of the par value
    of the shares issued
  • Retained Earnings the firms undistributed

The Balance Sheet - Conclusion
  • In summary, the balance sheet views resources
    from two perspectives
  • As a list of the specific form in which the firm
    holds the resources (i.e., cash, inventory,
  • As a list of the persons or entities that
    provided the funding to obtain those resources
    (and thus the persons who have a claim on those
    resources, i.e. debt holders and equity holders).
  • ?The balance sheet presents the equality of
    investing and financing.

The Income Statement
  • The income statement is sometimes titled the
    Statement of Operations, Statement of Earnings,
    or the Statement of Income.
  • The income statement presents details on the
    operating profitability of a firm over a
    particular time period (i.e., performance for the
    year ending on March 31, 20XX).
  • It is a dynamic statement.

The Income Statement, cont.
  • GAAP requires publicly traded firms to use an
    accrual basis of accounting (as opposed to a cash
    basis) in measuring operating performance.
  • Accrual basis accounting records revenues when
    they are earned and expenses when they are
    incurred (regardless of when actual cash flows
  • Cash basis accounting records revenues when cash
    is received and expenses when cash is paid.
  • It is this accrual concept that links the balance
    sheet and the income statement.

The Income Statement, cont.
  • The bottom line
  • Revenues measure the inflows of net assets from
    selling goods and providing services.
  • Expenses measure the outflows of net assets that
    a firm uses in the process of generating
  • Gains and losses arise from the sale of assets
    that arent directly related to the firms

The Income Statement, cont.
  • The goal of the income statement is to give a
    measure of operating performance that matches the
    firms outputs with the firms inputs.
  • But, keep in mind, because the accrual basis of
    accounting is required
  • revenues reflect sales for cash and sales for
    credit, and
  • expenses reflect purchases made in cash and
    purchases made on credit.
  • Therefore, net income includes cash and non-cash

The Statement of Cash Flows
  • The statement of cash flows reports for a period
    of time the net cash flows (inflows less
    outflows) from three principal business
    activities of a firm
  • (1) cash flows from operating activities
  • (2) cash flows from investing activities
  • (3) cash flows from financing activities
  • As this statement reports on the actual cash
    flows for a period, it can be used to disentangle
    the effects of the accrual basis of accounting
    (where non-cash items affect reported net income).

The Statement of Cash Flows, cont.
  • Question Why is the statement of cash flows so
    important to a financial analyst?
  • Answer Cash flows are vital to a firms
    survival. The statement of cash flows integrates
    the information contained in the balance sheet
    and income statement in a manner that allows an
    analyst to determine what the sources and uses of
    cash were for a firm for the specified time

Cash Flows from Operating Activities
  • This section of the statement of cash flows lists
    the sources and uses of cash that arise from the
    normal operations of a firm
  • Operating activities involve the cash effects of
    transactions that enter into the determination of
    net income (i.e., income statement items).

Cash Flows from Investing Activities
  • This section of the statement of cash flows lists
    the sources and uses of cash that arise from the
    investing activities of a firm (generally related
    to long-term assets).
  • Investing activities include
  • buying and selling debt of OTHER firms,
  • collecting principal payments on debt of other
  • buying and selling securities of OTHER firms, and
  • buying and selling property, plant, and equipment.

Cash Flows from Financing Activities
  • This section of the statement of cash flows lists
    the sources and uses of cash that arise from the
    financing activities of a firm (generally related
    to long-term liabilities and equity).
  • Financing activities include
  • sales and repurchases of the firms equity,
  • dividends to the firms stockholders, and
  • issuances and retirements of the firms debt.

The Statement of Cash Flows, cont.
  • The purpose of the statement of cash flows is to
    describe how the firm generated and used cash
    during the reporting period.
  • The bottom line of the statement of cash flows
    reports the change in the firms cash balance
    from the beginning of the reporting period to the
    end of the reporting period.

The Notes to the Financial Statements
  • The notes to the financial statements generally
    explain the items presented in the main body of
    the statements.
  • Examples of notes include
  • descriptions of the accounting policies used in
    measuring the elements reported in the statements
  • explanations of uncertainties or contingencies.
  • The notes to the financial statements are an
    integral part of the financial statements and
    should be viewed as such.

Common Size Financial Statements
  • Often, it may be difficult to compare two firms
    because they differ in size (in terms of sales
    levels or total asset levels).
  • To resolve this problem, an analyst can create
    common size financial statements.
  • A common size balance sheet states all numbers as
    a percentage of total assets.
  • A common size income statement states all numbers
    as a percentage of sales.

Common Size Financial Statements, cont.
  • However, interpretation of common size financial
    statements must be made with care.
  • One item in a common size statement is not
    independent of the other items (all items are
    presented as relative values to some base
  • The dollar amount of any one item might increase
    over the period but the items relative size can
    decrease at the same time.

Percentage Change Statements
  • A percentage change statement will present the
    percentage changes of individual items from the
    previous period to the current period.
  • Again, care must be taken in interpreting the
    numbers in a percentage change statement. For

A Final (??) Comment on the Financial Statement
  • It is always important to remember who the
    authors of a financial statement package are (the
    firms managers) and what their
    incentives/motivations are (make the firm look
  • Only the actual financial statements and
    accompanying notes are independently viewed by a
    team of auditors!
  • More often than not, quarterly financial
    information is un-audited.

Economic vs. Accounting Earnings
  • Keep in mind that the financial statement package
    is only an approximation of reality though.
  • If the world were certain, we could measure
    economic earnings as
  • where the market value of net assets is equal to
    the present value of their future cash flows
    discounted at the risk-free rate.

Economic vs. Accounting Earnings, cont.
  • Unfortunately (or fortunately depending on your
    taste) we live in an uncertain world.
  • We cannot say, with certainty, what will happen
    tomorrow most of the time.
  • Therefore, we cannot say, with certainty, what an
    assets market price should be.
  • In this world of uncertainty, no matter how we
    record earnings, they are only a proxy for
    economic income.

Economic vs. Accounting Earnings, cont.
  • Because of this uncertainty, analysts have
    developed different proxies for economic
  • Distributable earnings the value of dividends
    that could be paid without changing the value of
    the firm.
  • Sustainable income the level of income that can
    be maintained given the firms stock of capital
  • Permanent earnings the amount that can normally
    be earned given the firms assets.

Economic vs. Accounting Earnings, cont.
  • But, the accounting framework weve begun to
    describe gives us another measure Accounting
  • The accrual accounting system does not directly
    provide a measure equivalent to those previously
  • It is the analysts task to use the accounting
    information to determine the numbers he/she
    wants/needs to value a firm.

Financial Statement Analysis
  • Financial statement analysis in general focuses
    on five primary categories
  • the firms internal liquidity,
  • the firms operating performance,
  • an analysis of firm risk,
  • an analysis of growth potential, and
  • external market liquidity.
  • The common approach is to start with ratio
  • We will only highlight a handful of key ratios.

Evaluating Internal Liquidity
  • Internal liquidity ratios indicate the ability of
    the firm to meet future short-term financial
  • The probability of financial distress decreases
    as the relative liquidity of a firms assets
  • Liquidity means nearness to cash, i.e., cash is
    the most liquid asset a firm can have, a machine
    might be very illiquid if it is difficult to sell
    to generate cash.
  • The focus is on the current portion of the
    balance sheet.

Evaluating Internal Liquidity The Current Ratio
  • The current ratio is calculated as
  • The analyst must consider how much inventory the
    company carries in assessing this ratio.
  • Problem
  • The effect on the current ratio of an equivalent
    increase in current assets and current
    liabilities depends on whether or not the current
    ratio was previously greater than or less than
  • Can be greatly affected by economic conditions.

Evaluating Internal Liquidity The Quick Ratio
  • Sometimes, inventories and some other current
    assets may not be very liquid (i.e., easily
    converted into cash).
  • Therefore, they shouldnt be considered in
    assessing a firms ability to meet its current
    obligations since they dont really add to this
  • The quick ratio is calculated as

Evaluating Internal Liquidity The Cash Ratio
  • An even more conservative measure is the cash
    ratio. This ratio assumes that only cash and
    marketable securities should be considered in
    evaluating a firms ability to meet its current
  • The cash ratio is calculated as

Evaluating Internal Liquidity Accounts
Receivables Turnover
  • The rate at which A/R turn gives an indication of
    how quickly a firms receivables are converted
    into cash.
  • The A/R turnover ratio is calculated as

Evaluating Internal Liquidity Accounts
Receivables Turnover
  • This rate implies an average A/R collection
  • i.e., if the Average A/R collection period is
    10, this implies that on average it takes the
    firm 10 days to collect cash from sales on
  • Potential problem Where do we get credit sales

Evaluating Internal Liquidity Accounts
Receivables Turnover, cont.
  • Firms might extend credit to induce sales, how
    might this affect receivables turnover?
  • Firms make a trade-off in deciding the desirable
    receivables turnover rate.
  • Receivables turnover too high strict credit
    policies, may be refusing credit to the
  • Receivables turnover too low lax credit
    policies, may be extending too much credit to the
  • ?Large deviations from the industry average A/R
    collection period may be a red flag.

Evaluating Internal Liquidity Inventory
  • The rate at which inventories turn gives an
    indication of how soon they will be sold.
  • The inventory turnover ratio is calculated as

Evaluating Internal Liquidity Inventory
Turnover, cont.
  • This rate implies an average inventory processing
  • Question What would you expect Wal-Marts
    average processing time to be? What would you
    expect a jewelers average processing time to be?
  • These ratios vary widely by industry. Be careful
    when comparing across industries.

Evaluating Internal Liquidity Inventory
Turnover, cont.
  • Increasing inventory turnover ratios might
    indicate more efficient inventory control
  • A JIT inventory system will increase the
    inventory turnover rate to infinity.
  • Firms make a trade-off in deciding the desirable
    inventory turnover rate.
  • Inventory turnover too high potential inventory
    shortages, may have to turn away customers and
    lose sales
  • Inventory turnover too low excess inventory on
    hand, increased carrying costs, inventory

Evaluating Internal Liquidity Inventory
  • These ratios are affected by inventory valuation
  • Three common inventory valuation methods
  • Average cost values each unit of inventory at
    the same cost, a weighted average of all
    inventory units EVER purchased.
  • First-In-First-Out (FIFO) assumes goods are
    sold in order of their purchase by the firm.
  • Last-In-First-Out (LIFO) assumes goods are sold
    in reverse order of their purchase by the firm.

Evaluating Internal Liquidity Inventory
Valuation, cont.
  • What we are measuring is cost flow and NOT the
    actual flow of goods.
  • Inventory valuation is a cost allocation
  • If input prices are
  • Constant FIFO Average LIFO
  • Rising FIFO lt Average lt LIFO
  • Declining FIFO gt Average gt LIFO
  • In making a comparison across firms, if the two
    firms dont use the same valuation method the
    comparison is NOT reasonable.

Evaluating Internal Liquidity Inventory
Valuation, cont.
  • FIFO has good balance sheet effects but poor
    income statement effects.
  • On the B/S, inventory is listed closer to
    replacement cost.
  • On the I/S, COGS reflects possibly old input
  • LIFO has good income statement effects but poor
    balance sheet effects.
  • On the I/S, COGS reflects more recent input
  • On the B/S, inventory is listed at old
    replacement costs.

Evaluating Internal Liquidity The Operating
  • The operating cycle is the sum of the number of
    days it takes for a firm to sell its inventory
    and convert the resulting receivables into cash.
  • Weve already discussed the components of this.
    The operating cycle can be calculated as

Evaluating Internal Liquidity Accounts
Payables Turnover
  • The rate at which A/P turn gives an indication
    of how quickly a firm pays for purchases on
  • A/P turnover is calculated as

Evaluating Internal Liquidity Accounts
Payables Turnover
  • This rate implies an average A/P payment period
  • But how do we calculate purchases?

Evaluating Internal Liquidity The Cash
Conversion Cycle
  • The cash conversion cycle represents, on average,
    the net time interval between the collection of
    cash receipts from product sales and the cash
    payments for the firms various resource
  • The cash conversion cycle is defined as

Evaluating Operating Performance
  • A study of operating performance attempts to the
    assess the managerial ability/competence by
    focusing on operating efficiency and operating
  • Operating efficiency refers to how well
    management uses its assets and capital.
  • Operating profitability refers to the returns
    management earns by using its assets and capital.

Evaluating Operating Efficiency -Fixed Asset
  • Fixed asset turnover is defined as
  • Fixed asset turnover indicates the extent to
    which a firm is utilizing existing property,
    plant, and equipment to generate sales.
  • Should be used with caution. Might be better for
    year-to-year comparisons within the same company
    rather than for cross company comparisons.
  • Affected by depreciation methods.

Evaluating Operating Efficiency -Fixed Asset
Turnover, cont.
  • Potential problems with the use of this ratio
  • Sales growth is continuous (smooth) while fixed
    asset growth is lumpy, so, a time series of fixed
    asset turnovers may have a strange pattern.
  • The accumulation of depreciation expense
    increases the fixed asset turnover by reducing
    the average fixed assets (in the denominator).
    Has there really been an increase in efficiency
    as would be implied by an increasing ratio?

Evaluating Operating Efficiency -Fixed Asset
Turnover, cont.
  • Possible interpretations
  • Firms make investments in fixed assets in
    anticipation of higher sales in the future. Thus
    a low or decreased fixed asset turnover may
    indicate an expanding firm.
  • On the other hand, a firm may cut back on capital
    expenditures if future sales outlooks are not
    good. Thus a high or increasing fixed asset
    turnover may indicate managerial pessimism.

Evaluating Operating Efficiency -Depreciation
  • Accounting and economic depreciation are two
    different things.
  • Accounting depreciation allocates plant and
    equipment costs over the assets useful life.
  • Economic depreciation relates to the real world
    usefulness of an asset.
  • An asset might have little real economic value
    but still be carried on a firms books because it
    is not fully depreciated in the accounting sense.

Evaluating Operating Efficiency -Depreciation,
  • Firms have flexibility in choosing their
    depreciation method.
  • Most use straight-line for financial reporting
  • Virtually all (are required to) use accelerated
    methods for tax purposes.
  • Straight-line depreciation allocates the cost of
    a depreciable asset evenly over the assets
    expected useful life.
  • Accelerated methods allocate a larger portion of
    the depreciable assets cost in the earlier
    portion of the assets expected useful life.

Evaluating Operating Efficiency -Total Asset
  • Total asset turnover is defined as
  • Total asset turnover indicates the ability to
    manage the level of investment in assets for a
    particular level of sales.
  • In other words, the ability to generate sales
    from a particular investment in assets.

Evaluating Operating Profitability Gross Profit
  • The gross profit margin is defined as
  • The gross profit margin indicates the basic cost
    structure of the firm.
  • This ratio varies widely by industry. It may not
    be reasonable to compare gross profit margins
    across dissimilar industries.
  • Even a small change in the gross profit margin is
    likely to have a major impact on the bottom line.

Evaluating Operating Profitability Operating
Profit Margin
  • The operating profit margin is defined as
  • The variability of the operating profit margin
    over time is an indicator of the business risk
    for a firm.
  • Another option is to replace operating profit by
    earnings before interest, taxes, and depreciation

Evaluating Operating Profitability Net Profit
  • The net profit margin is defined as
  • The net profit margin measures how profitable a
    firms sales are after all expenses have been
  • Since this factors in interest expense it may be
    more suitable to use for comparing the profit
    performance of different companies than the
    operating profit margin.

Evaluating Operating Profitability Return on
Total Capital/Assets
  • Return on assets is defined as
  • The return on assets indicates the return from
    operations independent of financing.
  • In practice, different analysts may use different
    numbers in the numerator (EAT, EBIT, EBIAT, etc.).

Evaluating Operating Profitability Return on
Total Capital/Assets, cont.
  • The return on assets might have two
  • it measures a firms ability and efficiency in
    using its assets to generate profits or
  • it reports the total return accruing to all who
    have provided the firm with capital (long- and
    short-term debt holders AND equity holders).

Evaluating Operating Profitability Return on
Owners Equity
  • Considering all equity (includes preferred stock)
    the return on total equity is defined as
  • Considering only common equity the return on
    owners equity is defined as
  • ROE indicates the return that management has
    earned on the capital provided by the owner.

Evaluating Operating Profitability The Dupont
  • ROE can be disaggregated into various components
    that can provide explanations for changes in ROE.
  • Weve previously discussed two of these ratios,
    financial leverage will be discussed soon.

Risk Analysis
  • Risk analysis examines the uncertainty of income
    flows for the total firm and for the individual
    sources of capital.
  • In this sense, risk comes in two forms, business
    risk and financial risk.
  • Business risk is the uncertainty of income caused
    by the firms industry/line of business.
  • Financial risk/leverage is the uncertainty of
    returns to equity holders due to the firms use
    of fixed financing obligations.

Business Risk
  • Business risk has two main components, sales
    variability and operating leverage.
  • Sales variability is a prime determinant of
    earnings variability. Sales volatility can be
    measured by the coefficient of variation of
  • Operating leverage refers to the employment of
    fixed production costs. It can be measured as

Operating Leverage
  • Operating leverage refers to the relative
    portions of fixed versus variable costs in the
    firms total cost structure.
  • Greater operating leverage (a larger fixed cost
    portion) makes the operating earnings of a firm
    more volatile than sales.
  • During slow periods, operating profits will
    decline by a larger percentage than sales.
  • During expansionary periods, operating profits
    will increase by a larger percentage than sales.

Financial Leverage
  • The employment of fixed financing costs is
    referred to as financial leverage.
  • The financial leverage effect relates operating
    income to net income as follows
  • Another measure of financial leverage is
  • Although the two measures look different they
    reflect on the same issue.

Financial Risk Analysis The Debt to Equity Ratio
  • The debt to equity ratio is defined as
  • As the debt to equity ratio increases, earnings
    per share become more volatile and the
    probability of default increases.
  • Recall the MM propositions which state that (in
    perfect markets) a firms WACC is constant.
  • Question Should market values or book values be

Financial Risk Analysis Total Debt Ratio (Debt
to Assets Ratio)
  • The total debt ratio (debt to assets ratio) is
    defined as
  • This ratio measures the proportion of the firms
    assets that are financed with creditors funds.
  • Note,

Financial Risk Analysis Interest Coverage
  • The interest coverage ratio is defined as
  • This ratio indicates how many times the fixed
    interest charges are earned based on the earnings
    available to pay these expenses.
  • Obviously, a coverage ratio less than one
    indicates an inability to make necessary interest

Financial Risk Analysis Cash Flow to Cap Ex
  • The cash flow to capital expenditures ratio is
    defined as
  • This provides information about a firms ability
    to generate cash flow from operations in excess
    of the capital expenditures needed to maintain
    and build plant capacity.

Analysis of Growth Potential
  • Investors are concerned about growth potential
    because a firms value depends on its ability to
    grow its earnings and dividends.
  • Creditors are concerned about growth potential
    because a firms future success is a major
    determinant in its ability to pay future
  • Growth depends on two factors, (1) the amount of
    resources retained and reinvested in the entity
    and (2) the rate of return earned on the retained

Analysis of Growth Potential, cont.
  • The firms growth potential is defined as
  • This is sometimes called the sustainable growth
    rate. It assumes a constant debt to equity
  • The retention rate is defined as
  • We will use this growth rate later when trying to
    value the equity of firms.

External Market Liquidity
  • Market liquidity is defined as the ability to buy
    or sell an asset quickly with little price change
    from the prior transaction.
  • Liquidity relates to the ease with which one can
    convert an asset into cash or convert cash into
    an asset.
  • Hence, shares of Microsoft are highly liquid
    while a stamp collection (or shares of Berkshire
    Hathaway Inc.) may not be.

External Market Liquidity, cont.
  • High trading volumes and low bid-ask spreads
    imply liquidity.
  • The bid-ask spread is the difference between the
    price paid to purchase a security and the price
    received for selling a security (bid lt ask).
  • Another measure of liquidity is trading
  • Trading turnover is the percentage of shares
    outstanding traded during a period of time.

The Pitfalls of Ratio Analysis
  • Ratios provide a convenient way to analyze a firm
    from a financial perspective.
  • This approach is not without problems though.
  • A good analyst needs to be wary of some issues
    that can affect the interpretation of a set of
    financial ratios.

Financial Statements and Inflation
  • Virtually no allowances are made for inflation in
    the actual statements themselves.
  • Some mention of it may be found in the notes or
    in the Managements Discussion and Analysis but
    the numbers reported in the statements have no
    correction for inflation.
  • The primary areas inflation may affect include
  • interest expense,
  • inventory valuation, and
  • depreciation calculation.

Economic Assumptions of Ratio Analysis
  • An implicit assumption in (most of) ratio
    analysis is that size is not important.
  • ?We make a proportionality assumption.
  • We know that this is assumption is not really
    reasonable though.
  • Economies of scale (or other factors) often exist
    causing a nonlinear relationship between the
    numerator and denominator of a financial ratio.
  • If output doubles, do we expect total costs to
    double? If output then doubles again, do we
    expect total costs to then double again? etc.

Benchmark Issues for Ratio Analysis
  • A ratio, by itself, doesnt tell us much. We
    need to compare the ratio to something.
  • Perhaps the same ratio for a competitor, perhaps
    the same ratio for the firm from last year, etc.
  • The comparison must be an appropriate one.
  • An appropriate benchmark is determined by the
    needs of the analyst.
  • Lenders may wish to see certain firm traits or
    characteristics that an equity investor might not

Timing Issues for Ratio Analysis
  • In the U.S., firms are only required to
    periodically report financial information (four
    times a year). Its worse outside of the U.S.
  • The times when financial information is reported
    may not correspond to times of regular operations
    for a firm.
  • Or, knowing that analysts use key ratios in
    making an investment recommendation, managers may
    have an incentive to try to manipulate the
    reported figures (to the extent that GAAP will

Negative Numbers and Ratio Analysis
  • Often times a ratio has little (if any) meaning
    if the numerator and denominator have a different
    sign (i.e., a positive numerator and a negative
    denominator or vice versa).
  • Or, if both the numerator and denominator are
    negative a ratio may lead the analyst to a false

Accounting Methods and Ratio Analysis
  • As the numbers reported in the financial
    statement package are affected by various
    accounting methods employed, any ratios computed
    using those numbers are also affected by the
    various accounting methods employed.
  • ?The analyst must try to disentangle the effects
    of accounting method choices on financial ratios
    and financial statement analysis in general.

Financial Statement Analysis vs. Efficient
Capital Markets
  • A general description of an efficient market is
    one in which, on average, asset prices
    immediately reflect changes in underlying
    economic variables (i.e., market participants are
  • Most (but not all) people/investors believe in
    some degree of market efficiency.
  • By nature, the financial statement package
    contains historical information. So

Financial Statement Analysis vs. Efficient
Capital Markets, cont.
  • Question If capital markets are believed to be
    efficient, why analyze a set of publicly
    available documents about a firm (that, by their
    very nature, contain stale information)?
  • Possible answers
  • (1) Someone must perform the analysis in order
    for the market to initially react to the
    information contained in the financial
  • (2) Markets might be efficient on average in the
    aggregate but temporarily inefficient at the
    individual firm level.

Financial Statement Analysis vs. Efficient
Capital Markets, cont.
  • Possible answers, cont.
  • (3) Financial statements may potentially be
    biased views (even in accordance with GAAP) of a
    firms performance if managers have incentives to
    make them so.
  • ? The Quality of Earnings may actually be poor
    even if the firm reports profits.
  • (4) There are other needs for financial
    statement analysis aside from investing in
    publicly traded common stocks (bank lending,
    credit analysis, etc.)