Chapter - 02

Analysis of Financial
Statements
What is Financial
Statements?
• Financial Statements are the formal records
that summarize the financial performance and
position of a business over a specific period.
• A complete set of financial statements includes:
• Income statements presents the revenues &
expenses and resulting net income or net loss
for a specific period of time.
• Balance Sheet reports the firm's financial
position at a given point in time. It built in the
accounting equation: Assets = Liabilities +
Owner’s Equity
What is Financial
Statements?
• Statement of Stockeholders' Equity shows
the changes in stockeholders' equity for a
specific period of time.
• Cash Flow Statement summarizes information
about the cash inflows (receipts) and outflows
(payments) for a specific period of time.
• Notes to the Financial Statements provide
detailed information on the accounting policies,
procedures, calculations, and transactions
underlying entries in the financial statements.
Ratio Analysis

In financial analysis, a ratio is

Ratio is the relationship used as a benchmark for
between two or more aspects evaluating the financial
of a particular data. position and performance of a
firm.

Ratio analysis is a method for The inputs required to conduct

evaluating financial ratio analysis come from the
performance on a relative firm’s income statement and
basis. balance sheet.
 Liquidity Ratios
The liquidity of a firm reflects its ability to satisfy its short-term obligations as they come due.

Generally speaking, a firm with greater liquidity will have an easier time paying its bills and is
less likely to become insolvent.

How much liquidity is enough?

The liquidity needed depends on a variety of factors, including the firm’s size, its access to short-
term financing sources like bank credit lines, and the volatility of its business.

All firms have to balance the need for safety that liquidity provides against the low returns that
liquid assets generate for investors.
 • The current ratio is used to measure a
company's ability to meet its short-term
obligations.
• It measures liquidity by comparing a firm’s
current assets to its current liabilities.
• As a norm a CR of 2 is cited as acceptable.
Current Ratio • The company’s current ratio is above the
industry average by a significant amount
and equal as standard.
• The mathematical expression for the current
ratio is:

Current Ratio = Current Assets ÷ Current Liabilities

Current Ratio
Current Assets Current Liabilities
• Cash and Cash Equivalents • Accounts Payable
• Accounts Receivable • Short-Term Debt
• Inventory • Accrued Liabilities
• Prepaid Expenses • Unearned Revenue (Deferred Revenue)
• Short-Term Investments • Dividends Payable
• Other Current Assets
 • The Tedex Limited has the following
information in its financial statements:
• Cash: Tk 15,000, Accounts Receivable:
Tk 25,000, Inventory: Tk 30,000,
Prepaid Expenses: Tk 5,000, Short-
Current Ratio: term Investments: Tk 10,000, Plant and
Equipment: Tk 50,000, Allowance for
Problem 1 Doubtful Accounts: Tk
Accounts Payable: Tk 20,000, Short-
2,000,

term Loan: Tk 15,000, Salaries

Payable: Tk 10,000, Bonds Payable
(due in 5 years), Interest Payable: Tk
5,000.
 • A measure of liquidity calculated by
dividing the firm’s current assets less
inventory by its current liabilities.
• Inventory is generally the least liquid
current asset. Its low liquidity results
from two primary factors:
1. Many types of inventory cannot be easily
Quick (Acid- sold.
test) Ratio 2. Inventory is typically sold on credit,
• It is stricter than the current ratio.
• The mathematical expression for the
current ratio is:

Current Ratio = (Current Assets — Inventory) ÷ Current Liabilities

Quick (Acid-test) Ratio

As with the current ratio, the quick ratio level that a firm should
strive to achieve depends largely on the nature of the business in
which it operates.

The quick ratio provides a better measure of overall liquidity only

when a firm’s inventory cannot be easily converted into cash.

If inventory is liquid, the current ratio is a preferred measure of

overall liquidity.
 Activity ratios measure the speed
with which various asset and liability
accounts convert into sales or cash.

Activity Activity ratios measure how

efficiently a firm manages inventory,
Ratios disbursements, and collections.

Firms can use activity ratios to

assess the efficiency with which it
manages its total assets.
 • Inventory turnover ratio measures the
activity, or liquidity, of a firm’s
inventory.
• It helps to determine how many times
Inventory firm sells and replaces its inventory
Turnover within a given period.
• Here again, the value of the inventory
Ratio ratio that represents good management
depends on the nature of the business.
• The formula for calculating inventory is:
Inventory Turnover Ratio = Cost of Goods Sold ÷ Average Inventory
Inventory Turnover Ratio: Problem 2
Cost of Goods Sold (COGS): Tk 500,000

Aramit
Limited has Beginning Inventory: Tk 100,000
the
following
data for the
year, 2024: Ending Inventory: Tk 150,000
 • Average Age of Inventory measures
how long, on average, a company holds
inventory before selling it.
Average Age • You can easily convert inventory
of Inventory turnover into an average age of
inventory by dividing the turnover ratio
into 365.
• It is calculated as:

Average Age of Inventory = 365 ÷ Inventory Turnover Ratio

 • Accounts receivable turnover measures
the number of times, on average, a
company collects receivables during the
Accounts period.
Receivable • The accounts receivable turnover is
computed by dividing net credit sales
Turnover (net sales less cash sales) by average net
accounts receivable during the year.
• It is calculated as:
Accounts Receivable Turnover = Net Credit Sales ÷ Average
Net Accounts Receivable
 Altex Limited has the
following data for the year:
Accounts • Total Sales: Tk 500,000
Receivable • Cash Sales: Tk 150,000
Turnover: • Beginning Accounts Receivable: Tk
40,000
Problem 3 • Ending Accounts Receivable: Tk
70,000
• Returns and Allowances: Tk 10,000
• Discounts on Credit Sales: Tk 5,000
 • A popular variant of the accounts
receivable turnover converts it into an
average collection period in days.
Average • The Average Collection Period refers
to the average number of days it takes
Collection for a company to collect payments from
Period its customers after making a credit sale.
• It is calculated as:

Average Collection Period = 365 ÷ Accounts Receivable

Turnover Ratio
 Solvency ratios measure the ability
of a company to survive over a
long period of time.

Solvency It is used to assess a company's

ability to meet its long-term
Ratios financial obligations.

High solvency ratios indicate

financial stability and low risk of
default.
 • The debt ratio measures the proportion
of total assets financed by the firm’s
creditors.
Debt Ratio • A higher debt ratio means that a firm is
using a larger amount of other people’s
money to finance its operations.
• It is calculated as:

Debt Ratio = Total Assets ÷ Total Liabilities

Debt Ratio
 • The debt-to-equity ratio (D/E ratio) is a
financial ratio that compares a
company's total liabilities to its
Debt-to- shareholders' equity.
• Generally, creditors prefer a low debt
Equity Ratio ratio since it implies a greater protection
of their position.
• It is calculated as:

Debt-to-Equity Ratio = Total Liabilities ÷ Common Stock Equity

 Debt-to-
Equity Ratio
 • The Times Interest Earned Ratio, also
called the Interest Coverage Ratio,
measures a company's ability to meet its
Times Interest interest obligations using its earnings.
Earned Ratio • High ratio indicates a stronger ability to
cover interest expenses, signaling lower
financial risk.
• It is calculated as:

Interest Coverage Ratio = EBIT (Earnings Before Interest and Taxes) ÷

Interest Expense
 Times Interest Earned Ratio
Income Statement
Particulars Amount (Tk)
Sales Revenue 1000000
Cost of Goods Sold (COGS) 400000
Gross Profit 600000
Operating Expenses 200000
Earnings Before Interest & Taxes (EBIT) 400000
Interest Expense 50000
Net Income Before Tax 350000
Taxes (30%) 105000
Net Income 245000
Profitability
Ratios
 Income Statement
Particulars Amount (Tk)
Sales Revenue 5,000,000
Cost of Goods Sold (COGS) (3,000,000)
Gross Profit 2,000,000
Operating Expenses (600,000)
Earnings Before Interest & Taxes (EBIT) 1,400,000
Interest Expense (100,000)
Net Income Before Tax 1,300,000
Taxes (30%) (325,000)
Net Income 975,000
Preferred Stock Dividend (150,000)
Earnings Available for Common Shareholders 8,25,000
 Balance Sheet
Assets Amount (Tk)
Cash and Cash Equivalents 150,000
Accounts Receivable 400,000
Inventory 500,000
Total Current Assets 1,050,000
Property, Plant & Equipment (PPE) 2,800,000
Total Assets 3,850,000
 Balance Sheet
Liabilities and Equity Amount (Tk)
Accounts Payable 300,000
Short-Term Debt 200,000
Total Current Liabilities 500,000
Long-Term Debt 800,000
Total Liabilities 1,300,000
Preferred Stock Capital 500,000
Common Stock Capital 1,500,000
Retained Earnings 550,000
Total Shareholders' Equity 2,550,000
Total Liabilities and Equity 3,850,000
Note: 1. The company has 150,000 common shares outstanding.
2. The company has 5,000 preferred shares outstanding.
Gross profit Margin
• It measures the percentage • It is calculated as:
of each sales amount
remaining after the firm has
paid for its goods. • Gross Profit Margin = Gross
Profit ÷ Sales
• The higher the gross profit
margin is, the better.
Operating Profit Margin
• It measures the percentage of each sales amount remaining after
deducting all costs and expenses other than interest, taxes, and
preferred stock dividends.
• Operating profits are “pure” because they measure only the
profits earned on operations.
• It is calculated as:
Operating Profit Margin = Operating Profit ÷ Sales
Net Profit Margin
• It measures the percentage of each sales amount remaining after
all costs and expenses, including interest, taxes, and preferred
stock dividends, have been deducted.
• Naturally, managers and analysts view a high net profit margin
in a positive light.
• It is calculated as:
Net Profit Margin = Earnings Available for Common
Stockholdes ÷ Sales
Earnings Per Share (EPS)
• Earnings Per Share (EPS) is a key financial metric that
indicates how much profit a company generates for each
outstanding common share.
• It is used by investors to assess a company's profitability on a
per-share basis.
• It is calculated as:
Earnings Per Share (EPS) = Earnings Available for Common
Stockholdes ÷ Number of Common Stock Outstanding
Return on Total Assets (ROA)
• The return on total assets (ROA), a ratio that is sometimes called
the return on investment (ROI).
• It is measures the overall effectiveness of management in
generating profits with its available assets.
• It is calculated as:
Return on Total Assets (ROA) = Earnings Available for
Common Stockholdes ÷ Total Assets
Return on Equity (ROE)
• Measures the return earned on the common stockholders’ investment
in the firm.
• When a firm has positive earnings available for common
stockholders, its ROE will be greater than its ROA (ROE > ROA).
• When a firm does not have positive earnings available for common
stockholders (e.g., when the firm experiences a loss), its ROE will be
more negative than its ROA (ROE < ROA if earnings are negative).
• It is calculated as:
Return on Equity (ROE) = Earnings Available for Common
Stockholdes ÷ Common Stock Equity
Market Ratios
Market ratios relate the firm’s market value, as measured by its
current share price, to certain accounting values.

These ratios give insight into how investors in the marketplace

believe the firm is doing in terms of risk and return.

An interesting aspect of these ratios is that they combine

backward-looking and forward-looking perspectives.
Price/Earnings (P/E) Ratio
• The P/E ratio reveals what investors are willing to pay for each
dollar of a firm’s earnings.
• A variety of factors can influence whether a firm’s P/E ratio is
high or low, but one of the primary determinants of the P/E ratio
is the rate of growth that investors believe a firm will achieve.
• It is calculated as:
Price/Earnings (P/E) Ratio = Market Price per Share of
Common Stock ÷ Earnings per Share
Market/Book (M/B) Ratio
• It provides an assessment of how investors view the firm’s
performance by comparing the market price of the stock to its
book value.
• For most companies, the M/B ratio will be greater than one, and
often it is much greater than one.
• It is calculated as:
Market/Book (M/B) Ratio = Market Price per Share of Common
Stock ÷ Book Value per Share of Common Stock
 • A company has a net income of Tk
5 million, with 2 million
outstanding shares. The stock is
currently trading at Tk 50 per share,
Problem 4 and the company's book value of
equity is Tk 40 million. Calculate
the Price/Earnings (P/E) Ratio and
Market/Book (M/B) Ratio.