CHAPTER 6: ASSESSMENT OF 👉 Ratios differ depending on stage.
THE FIRM'S OPERATING
2. Outputs (Products)
EFFICIENCY AND FINANCIAL
POSITION ● New or outdated?
● With substitutes?
● Complex to produce?
I. FINANCIAL STATEMENT
ANALYSIS (FSA) 👉 Affects profitability and competition.
🔎 Definition 3. Buyers
Financial Statement Analysis is the ● Are customers financially strong?
process of extracting information from ● Do they have bargaining power?
financial statements to understand a ● Can the firm dictate prices?
company’s:
4. Inputs (Suppliers)
● Current performance
● Future performance ● Many suppliers or few?
● Financial condition ● Risk of high input costs?
It helps determine: 5. Competition
● Is the firm strong? ● Is the market competitive?
● Is it risky? ● Are barriers to entry high?
● Is it profitable? ● Can the firm protect its position?
● Is it sustainable?
6. Financing
II. ANALYZING THE BROADER ● Publicly traded?
BUSINESS ENVIRONMENT ● Seeking loans?
● Risk of violating debt covenants?
⚠ IMPORTANT: Financial statements ● Incentive to manipulate earnings?
must NOT be analyzed in isolation.
7. Labor
Before analyzing ratios, we must
understand the company’s business ● Competent management?
context. ● Unionized workforce?
● Good employee relations?
Key Business Environment
Questions: 8. Governance
1. Life Cycle ● Independent board?
● Strong audit committee?
● Startup? ● Managers' wealth tied to stock?
● Growth stage?
● Mature? 9. Risk
● Declining?
● Lawsuits?
● Regulatory investigations? 2. Limitations of Accounting Data
● Auditor changes?
● Political/environmental risks? ● Different accounting policies
📌 KEY IDEA:
● Condensed data
● Inflation not reflected
Financial statements reflect business 3. Limitations of Tools
activities.
They must be analyzed within the ● Ratios depend on averages
broader economic and strategic ● Timing of transactions affects
environment. results
● Must consider nature of business
III. BASICS OF PROFITABILITY 4. Management Manipulation Risk
ANALYSIS
Management may influence results to:
🎯 Goal of Financial Management: ● Attract investors
Maximize shareholders' wealth NOT just ● Avoid default
maximize net income or EPS. ● Obtain financing
However: 📌 Solution:
● Accounting data influence stock Compare with industry averages and
prices. benchmarks.
● Managers, lenders, and analysts
use financial statements differently.
V. FINANCIAL RATIO ANALYSIS
Financial Analysis Involves:
A financial ratio is a comparison of two
1. Comparing performance with significant figures from financial
competitors statements.
2. Evaluating trends over time
It shows relationships between:
This helps:
● Statement of Financial Position
● Identify weaknesses ● Statement of Comprehensive
● Take corrective action Income
● Improve firm value
TYPES OF RATIOS
IV. LIMITATIONS OF FINANCIAL
STATEMENT ANALYSIS 1. LIQUIDITY RATIOS
Measure ability to pay short-term
1. Ratios are NOT absolute
obligations.
measures
They are indicators only.
Examples: Example:
● Current Ratio ● Net Profit Margin
● Quick Ratio ● ROA
● Cash Ratio ● ROE
Necessary for survival.
5. MARKET BOOK RATIOS
2. ASSET MANAGEMENT RATIOS Reflect investor perception.
Measure efficiency in using assets. Examples:
Examples: ● EPS
● P/E Ratio
● Inventory Turnover ● Market-to-Book Ratio
● Receivables Turnover
● Total Asset Turnover Shows:
“What investors think about the firm.”
Good asset management:
✔ Lower costs
✔ Higher net income
3. DEBT MANAGEMENT RATIOS
Measure:
● How assets are financed
● Long-term repayment ability
● Financial risk
Examples:
● Debt Ratio
● Debt-to-Equity
● Times Interest Earned
Higher debt = higher risk.
4. PROFITABILITY RATIOS
Measure how effectively a firm
generates profit.
Combine:
● Asset management
● Debt management
VII. THE DUPONT
DISAGGREGATION ANALYSIS
Very important ⚠
DuPont shows:
Components:
1. Profit Margin
Net Income ÷ Sales
VI. IMPORTANCE OF ROE
How much profit per peso of sales.
ROE is the focal point.
Improved by:
Because:
● Increasing gross profit
High ROE depends on: ● Reducing expenses
● Good liquidity 2. Asset Turnover
● Efficient asset management Sales ÷ Average Total Assets
● Proper use of debt
Measures productivity.
Managers cannot control the stock
market, but they can control ROE Improved by:
drivers.
● Increasing sales without increasing
assets
● Reducing assets without reducing
sales
3. Financial Leverage (Equity
Multiplier)
Average Total Assets ÷ Average Equity
Measures debt usage.
Higher leverage: b. Expense Management
❌
✔ Higher ROE (if profitable)
Higher risk Reduce:
● Manufacturing overhead
ROA vs ROE ● Administrative overhead
● R&D
ROA ● Marketing
● Legal expenses
2. Productivity
Measured by asset turnover.
If productivity declines:
● Increase sales
Measures return without considering OR
financing. ● Reduce asset investment
Encourages managers to manage:
● Profitability
● Asset efficiency
PROFITABILITY ANALYSIS
BREAKDOWN
Two areas:
1. Profitability
Measured by:
NetIncome ÷ Sales
Includes:
a. Gross Profit Margin
(Sales−COGS) ÷ Sales
Affected by:
● Selling price
● Manufacturing cost