Financial Statement Analysis: Learning Objectives

Excerpt from Prof. C.
Droussiotis Text Book: An Analytical Approach to Investments, Finance and Credit
Chapter 15
FINANCIAL STATEMENT ANALYSIS
In this chapter, you will learn about the information that is included in each financial statement, the
correct term for every item in each statement, and how to read and understand the three types of
statements. By looking at examples of statements, you will see how the information is provided and how
the information is used to perform the analysis to get an overall picture of a company's performance.
Learning Objectives
After reading this chapter, students will be able to:
 Understand and interpret the company’s income statement, balance sheet, and statement of cash
flows.
 Learn how to build an entire cash flow statement based on 2-year balance sheet information
 Learn how to calculate standard measures of the company’s liquidity, solvency and operating
efficiency
 Understand the difference between income and cash flows
 Understand Book Value vs Market Value and Real Assets vs Financial Assets
[Insert boxed text here
AUTHOR’S NOTES:
What makes a perfect financial analysis
To get a perfect financial analysis done when reviewing the financial statements, the analyst needs to answer
the following three questions:
1. How is the company performing versus last year or the last few years (chronological analysis)?
2. How is the company performing versus their peers or versus the benchmark (peer analysis)?
3. How is the company performing versus analyst expectations (expectation analysis)?
End boxed text here]
Financial Statements Overview

There are three primary financial statements: Income Statement, Balance Sheet and Cash Flow
Statement. Public traded companies are required to include audited financial statements in their annual
and quarterly reports. The Securities Exchange Commission (SEC) requires the public traded companies
to file one 10K and three 10Q reports per year representing their annual and quarterly performance,
respectively. These detailed statements can be found on the company’s filings in the SEC’s EDGAR
system. Also are usually available on the company’s website under “Investor Relations” and other
financial websites such as www.finance.yahoo.com and www.google.com/finance. In addition to the
statements, the company discusses their performance found in the Management, Discussion and Analysis
(MD&A) section as well as provides detailed footnotes to each of the statements.
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Excerpt from Prof. C. Droussiotis Text Book: An Analytical Approach to Investments, Finance and Credit
To evaluate publicly traded companies, analysts who represent different investors need uniform financial
standards that are consistent, accurate and complete. Public accounting organizations around the world
have set up global accounting standards. The biggest organization, the International Financial Reporting
Standards (IFRS), is gradually replacing country-specific standards. Developed by the Financial
Accounting Standard Board (FASB), the US still recognizes Generally Accepted Accounting Principals
(GAAP) regulated by the SEC. However, the US is gradually unifying to the IFRS standards.
INCOME STATEMENT
[Insert Boxed text here
KEY TAKEAWAYS:
 The Income statement represents the measurement of Profit and Loss over Period of time
 The “Top Line” is the company’s sales and the “Bottom Line” is the Company’s Net Income
 Revenue (Sales) Less Expenses = Profit or Loss
The Income Statement is a summary of the company’s profit or loss over a period. It reports the
revenues, expenses and net profit or net loss over a quarter or a full year. It’s also referred to as
Profit and Loss Statement or “P&L”. The Income statement drives the company’s reported quarterly
earnings per share (EPS). It is usually accompanied by a Statement of Comprehensive Income, which
reconciles the income statement to account for investments made by owners of the company.
The Income Statement is very useful when comparing revenues, expenses and profits for the period and
for one or more prior periods. For example, this quarter’s results can be compared to two prior quarters
or same quarter from last year (this is called “year-over-year” or “YoY”).
The Income Statement demonstrated in figure 15.1 below is basically broken down into top-line revenues
and two types of expenses including cost-of-revenues and operating expenses. The difference between
revenues and these expenses calculates the company’s income from operations before other expenses
such as interest and taxes. Net income or the company’s bottom line is derived after these expenses are
subtracted.
[INSERT FIGURE 15.1]
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Celerity Technogy Inc. ("CTI")

Financial Statement Analysis
Income Statement (000's) Year 1 Year 2 Operating Ratios for Year 2
8 Revenues by Geography Rev. Growth % Breakdown

9 U.S. 800,000 920,000 15.0% 82.9%
10 Europe 120,000 140,000 16.7% 12.6%
11 Asia 40,000 50,000 25.0% 4.5%
12 Total Revenue 960,000 1,110,000 15.6% 100.0%
14 Cost of Revenues by Geography Gross Margin Gross Profit
15 U.S. 293,000 350,000 62.0% 570,000
16 Europe 39,000 50,000 64.3% 90,000
17 Asia 13,000 20,000 60.0% 30,000
18 Total Cost of Revenue 345,000 420,000 62.2% 690,000
20 Gross Profit 615,000 690,000
22 Operating Expenses As % of Sales

23 Administrative & General 145,000 165,000 14.9%
24 Marketing Expenses 75,000 80,000 7.2%
25 Other Operating Expenses 10,000 12,000 1.1%
26 Total Operating Expenses 230,000 257,000 23.2%
28 EBITDA 385,000 433,000 39.0% (EBITDA Margin)
30 Depreciation 60,000 65,000 5.9% Deprec.as % of Revenues

32 EBIT 325,000 368,000 33.2% EBIT Margin
34 Interest Expense 130,000 120,000 10.0% Interest Rate
36 EBT 195,000 248,000 Interest Exp. / (Avg Debt incl. LT and ST)
38 Taxes 78,000 99,200 40.0% Tax Rate
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40 Net Income 117,000 148,800 13.4% NI Margin
Figure 15.1
Revenues
Revenue (or Sales) is the first line item on the Income Statement. Revenues represent the total dollar
amount realized by companies for the sale of products and services at a given period. Revenues
could be itemized by product, segment, division or geographical location. In analyzing revenues, an
analyst looks at the drivers of such revenues. The drivers could be volume, price or contractual
obligations. These drivers will be discussed in later chapters.
Expenses
Expenses reported in the Income Statement are generally broken down into two parts:
1) Direct cost or Cost of Revenue or Cost of Good Sold (COGS); and
2) Indirect cost or Operating Expenses or Selling, General & Administrative Expenses (SG&A)
Cost of Revenues
Cost of Revenues (or Cost of Goods Sold “COGS”) includes the direct costs of selling the goods of
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the company. These expenses include raw material, labor and overhead (MLO). Cost of Revenues
captures expenses that are variable based on sales volume or units sold.
Operating Expenses
Operating expenses include the fixed cost of running a company that are not directly related to the
sales volume or number of units sold. Operating expenses are also referred to as Selling, General &
Administrative expenses (SG&A). SG&A includes administrative costs such as the CEO’s salary,
marketing costs such as advertising and general costs such as office supplies and other office
expenses. In addition to the SG&A expenses, publicly traded companies include non-cash expenses
such as Depreciation and Amortization.
Operating Income or EBIT

Revenues minus Operating Expenses result to Operating Income or Earnings before Interest and Taxes
(assuming the Depreciation and Amortization Expenses are included in the Operating Expense section).
Usually private companies exclude Depreciation and Amortization Expenses from the Operating
Expense section resulting to Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
– discussed in the next paragraph.
Earnings Before Interest, Taxes, Depreciation and Amortization or EBITDA

For publicly traded companies, Earnings Before Interest, Taxes, Depreciation and Amortization
(EBITDA) is not usually found in the income statement. This is calculated by adding back Depreciation
and Amortization (D&A) to EBIT or operating income. This income line is commonly used to estimate
the operating cash flow of the company. EBITDA is used in various methods to estimate the value of the
firm – discussed in later chapters.
Net Income
Net Income represents the bottom line profit or loss of the company after tax and interest expenses and
after other non-ordinary expenses such as dividends, one-time or non-recurring expenses. Net Income or
earnings after taxes represent the value-added owner’s creating of the firm to last year’s earnings.
BALANCE SHEET STATEMENT
KEY TAKEAWAYS:
 The Balance sheet shows us on a snap shot of the wealth of the company
 The Balance sheet statement is set-up in order of liquidity
 Its called the Balance sheet because the left side representing the assets is showing what the company
processes and the right side representing how they paid for these processions.
The Balance Sheet represents the wealth or the financial condition of the company. Unlike the
Income Statement, which measures company performance over a quarter or a year, the Balance Sheet is
a snapshot of all of company’s assets representing everything the company owns (Cash, Equipment,
investments, etc), liabilities representing what the company owes against those assets and the company’s
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net worth or shareholder’s equity representing what the owner’s keep or earned, taken at a moment in
time as demonstrated in figure 15.2 below.
Assets
This section of the balance sheet gives a list of the assets of the company. The statement is formatted to
start from the most liquid assets to the least liquid. The first section on the top of the Assets is Current
Assets representing assets that should turn to cash within the next 12 months. These are followed by
Non-Current Assets that includes tangible and intangible assets such as Goodwill.
Current Assets: Current assets includes Cash and Cash Equivalents, Accounts Receivable, Inventory and
other current assets.
 Cash & Cash Equivalents: Cash and Cash Equivalents represent the deposit account and/or
short-term investments of the company. This cash is accessible within a day or two.
 Accounts Receivable: Accounts Receivable represent the money owed to the company by the
customer and is considered the second most liquid item on the balance sheet as the customers
typically have 30-60 days to pay the company for goods that they bought.
 Inventory: Inventory represents the cost of raw materials, work-in-process (WIP) and finished
goods that are ready to be shipped. Inventory will usually turn into cash 30-120 days depending
of the type of the inventory the company buys, develops and sells.
 Other Current Assets: Other current assets include moneys owed to the company for reasons
other than customers. It also includes prepaid expenses which are expenses that are prepaid
upfront such as insurance fees, annual license fees, etc.
Non-Current Assets: Non-current assets include both tangible and non-tangible assets. Tangible assets
include Property, Plant & Equipment, Long-Term Investments and other long-term assets. Intangible
assets include Goodwill and other intangible assets such as patterns and trademarks.
 Gross Property, Plant & Equipment (PP&E): PP&E represent tangible assets such as
buildings, land, equipment, cars and trucks at their book value. The Balance Sheet ignores any
appreciation in asset value). Sometimes the company reports the Net PP&E which represents the
value of these assets listed above after all depreciation is subtracted from the gross amount.
 Long-Term Investments: These could be investments such as Joint-Ventures or other long-term
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investments.
 Goodwill: Goodwill is created when the company is acquired for a price greater than book value.
The difference between the acquisition price and book value is recorded as goodwill.
Liabilities
This section of the balance sheet gives a list of the liabilities of the company. The statement is formatted
to start from the most liquid to the least liquid. The first section on top of the Liabilities is Current
Liabilities representing the obligations that the company should pay within the next 12 months. These
are followed by Long-Term Liabilities which are obligations that extend further that a year into the future.
Current Liabilities
Current Liabilities include outstanding payments to suppliers, short-term debts and obligations due
within one year such as accounts payable, short-term interest and tax payables, current portion of long-
term debt and other accrued expenses.
 Accounts Payable: These are payment obligation due by the company to suppliers – primarily
for purchasing inventory or raw material.
 Income Tax Accruals: These are short-term income related taxes that are payable within a year.
 Accrued Expenses: These are expenses that needed to be paid within a year. These accrued
expenses do not include any obligations owed to suppliers.
 Current Portion of Long Term Debt: This is the company’s debt obligations that are due within
a year.
Long-Term Liabilities
 Long-Term Debt: Any debt including loans, bonds or mortgages that are due more than a year
are included in this section.
 Deferred Taxes: These are taxes that are deferred, due and payable in more than a year.
 Other Liabilities: Other Liabilities include long term obligations such as contingent liabilities.
These include potential payments due to lawsuits, environmental obligations and/or insurance
payments.
Net Worth or Shareholder’s Equity

Shareholder’s equity measures the amount by which a company’s assets exceed its liabilities at snap shot
in time – basically if one sold all that the company owns after paying all the obligations against these
assets the balance left is what the ownership will keep (figure 2). Shareholder’s Equity is also referred to
as net worth or book value of equity. Included in this section are Common Stock, Preferred Stock,
Treasury Stock, Paid-in Capital, other Equity and Retained Earnings.
 Common Stock: This represents the original issuance of equity by the owners and it will go
down when the company buys back shares.
 Preferred Stock: This could be an issuance by third party investor that expect the company to
pay certain fixed dividends (like debt obligations).
 Treasury Stock: recorded as a negative number on the balance sheet, Treasury Stock represents
shares that have been issued in the past but were repurchased by the company. The amount
repurchased will reduce both par value and capital surplus on the balance sheet if the company
decides to permanently retire the stock that was repurchased. If the company decides to re-issue
the stock sometime in the future, the treasury stock will be set-up at a separate account – reducing
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common stock and shareholder’s equity.

 Paid-in-Capital: This represents proceeds from any additional equity investments that invested
in the company.
 Retained Earnings: Retained Earnings represent the cumulative income net of loses over time.
The Retained Earnings could also be reducing if the company pays out dividends to shareholders
or records loses.
As the example above shows that it is possible for companies to continue paying dividends even in years
that the company shows losses. These will of course reduce the Retained Earnings.
Figure 16.3 below shows an example of a balance sheet. Total assets equal to total liabilities plus net
worth – hence is called the “balance” sheet statement.
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Balance Sheet (000's) Year 1 Year 2 $ Change % Change
7 Current Assets
8 Cash 45,000 65,800 20,800 46.2%
9 Accounts Receivable 45,000 60,000 15,000 33.3%
10 Inventories 35,000 40,000 5,000 14.3%
11 Prepaid Expenses 10,000 9,000 (1,000) -10.0%
12 Total Current Assets 135,000 174,800 39,800 29.5%
14 Property and Equipment

15 Land 2,500,000 2,500,000 - 0.0%
16 Building 450,000 550,000 100,000 22.2%
17 Furniture & Equipment 50,000 75,000 25,000 50.0%
18 Total Gross P&E 3,000,000 3,125,000 125,000 4.2%
19 Less Accumulated Depreciaition (300,000) (365,000) (65,000) 21.7%
20 Net P&E 2,700,000 2,760,000 60,000 2.2%
22 Long-Term Investments 200,000 250,000 50,000 25.0%
24 Total Assets 3,035,000 3,184,800 149,800 4.9%
26 Liabilities and Owners Equity
28 Current Liabilities
29 Accounts Payable 35,000 40,000 5,000 14.3%
30 Accrued Income Taxes 12,000 10,000 (2,000) -16.7%
31 Accrued Expenses 10,000 8,000 (2,000) -20.0%
32 Current Portion of Long Term Debt 20,000 10,000 (10,000) -50.0%
33 Total Current Liabilities 77,000 68,000 (9,000) -11.7%
35 Long-Term Debt: 1,200,000 1,180,000 (20,000) -1.7%
37 Deferred Income Taxes 12,000 17,000 5,000 41.7%
39 Total Liabilties 1,289,000 1,265,000 (24,000) -1.9%
41 Owners' Equity
42 Common Stock 1,000,000 1,000,000 - 0.0%
43 Paid-in-Capital - 25,000 25,000
44 Retained Earnings 746,000 894,800 148,800 19.9%
45 Total Owners' Equity 1,746,000 1,919,800 173,800 10.0%
47 Total Liabilities & Owner's Equity 3,035,000 3,184,800 149,800 4.9%
Figure 15.3
CASH FLOW STATEMENT

KEY TAKEAWAYS:
 The Cash Flow statement shows the Company’s Cash Inflow and Outflow activities over a cer-
tain period
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 The differences between Income Statement and Cash Flow Statement are:
o Timing Differences (Working Capital Activities)
o Capital Expenses Vs Operating Expenses (Investment Activities)
o Financing Expenses not included in the Income Statement (Financing Activities)
 The Cash Flow Statement represents the changes from last Year’s Balance Sheet to this Year’s
Balance Sheet
o Asset goes Up = Cash Negative
o Asset goes down = Cash Positive
o Liability goes up = Cash Positive
o Liability goes down = Cash Negative
o Owner’s Equity goes up = Cash Positive
o Owner’s Equity goes down = Cash Negative
The Cash Flow Statement represents the cash inflow and outflow of the company. The Cash Statement
is like the Income Statement when it comes to measuring performance over a period of time. However,
it focuses on the actual cash generated or spent by the business. In a perfect world you might not need
both the income and cash flow statements. A perfect scenario is described in figure 15.4 below where we
use an example of a 9-year old setting up a lemonade stand. In this humorous example the young 9-year
old Joey decides to set up a lemonade stand in front of his house. His dad helps him with a $20 to start
his lemonade business. Joe uses all the $20 to buy a box of 100 cups ($5), a lemonade concentrated juice
($5) and 4 gallons of bottled water ($10). In this story, we assume that he sells all his lemonade and uses
of all 100 cups (no inventory left). Assuming he sold each lemonade for $1, after the end of the day, Joey
will set-up an income statement to show his profit. Revenues are recorded at $100 ($1x100 cups) minus
his cost of $20 showing a profit of $80. This should match his cash on hand. In this case his simple
income statement will be the same as his cash flow statement since every transaction was done with all
cash. See both statements below (figure 15.4):
[INSERT FIGURE 16.4a – picture (Left of figure 15.4] [INSERT FIGURE 15.4]
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Income Vs Cash (timing diference)

The Perfect World: Cash = Income
If every business is run like a lemonade stand by 9-year old
Income Statement Cash Flow Statement Statement
Lemonade Sales: Profit $ 80.00

Sold 100 cups @ $1 each $ 100.00
Expenses: Cash Flows:

Box of 100 Cups $ 5.00 Plus Money that we owe $ -
Lemonade Conctrate Juice $ 5.00 Less Money owed to us $ -
4 Gallons of Water $ 10.00 Net Working Capital $ -
Total Expenses $ 20.00
Net Income: $ 80.00 Cash $ 80.00
Figure 15.4
If we slightly change the story you will see a need for creating both the income and cash flow statements.
Suppose that while Joey was selling his lemonade, his friend Billy bought a lemonade but did not have
any money to pau for it. He was very thirty he explained, so Joey allowed Billy to have a lemonade and
expect to get his one dollar later. At the end of the day, Billy has not showed up. Now if Joey had to build
both his income and cash flow statement to keep up with the difference between what he earned and what
cash he has as is demonstrated in the figure below (figure 15.5). Joey’s Income statement will show a
profit of $80 since he sold all his lemonade, but when he looks at his cash flow statement he notices a
cash profit of $79. The difference of course is the $1 owed (earned because Joey should eventually get
his $1 from Billy the next day). This $1 will recorded as Accounts Receivable and it will be adjusted in
cash flows statement to reflect the timing difference between income and cash. This timing difference is
basically the definition of working capital as described later in this chapter. We are living is non-perfect
world – a world of IOUs.
[INSERT FIGURE 15.4a – picture (Left of figure 15.5] [INSERT FIGURE 15.5]
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Income Vs Cash (timing diference)

A not so Perfect World: Cash is different than Income
If every business is run like a lemonade stand by 9-year old
Income Statement Cash Flow Statement Statement
Lemonade Sales: Profit $ 80.00

Sold 100 cups @ $1 each $ 100.00
Expenses: Cash Flows:

Box of 100 Cups $ 5.00 Plus Money that we owe $ -
Lemonade Conctrate Juice $ 5.00 Less Money owed to us $ (1.00)
4 Gallons of Water $ 10.00 Net Working Capital $ (1.00)
Total Expenses $ 20.00
Net Income: $ 80.00 Cash $ 79.00
Figure 15.5
The cash flow statement also reflects the fact that the company receives and spends cash other than their
primary business (these transactions are not recorded in the income statement which represents the
company’s direct or primary operations). For example, a company may spend money on new equipment,
conduct improvements of manufacturing facilities or decide to issue bonds in the capital markets.
The company’s cash position per period (going up or down) does not necessarily represent the company’s
operating health. For example, the company might decide to use extra cash to repay debt. This decision
will result in a lower cash outflow even though it may be positive over time – reducing interest
obligations.
The Cash Flow Statement which represents the change in position from one period to the next has three
primary sections:
1. Cash Flows from Operating Activities

2. Cash Flow from Investment Activities
3. Cash Flow from Financing Activities
Basically, it is important to realize that one could build an entire cash flow statement by looking at 2
years of balance sheet. The difference of each item on the balance sheet from one year to the next
represents the activity for that year and can been seen on the cash flow statement as graphically explained
below:
Building the Cash Flow Statement spreadsheet
[Insert boxed text here
KEY TAKEAWAYS:
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In building the Cash Flow Statement spreadsheet as demonstrated in [figures 16.9-16.12] the following
rules apply regarding the balance sheet changes between two periods:
 If the Asset items increase between two periods, then the cash recorded in the cash flow state-
ment as outflow (negative)
 If the Asset items decrease between two periods, then the cash recorded in the cash flow state-
ment as inflow (positive)
 If the Liability items increase between two periods, then the cash recorded in the cash flow state-
ment as inflow (positive)
 If the Liability items decrease between two periods, then the cash recorded in the cash flow
statement as outflow (negative)
 If the Shareholder’s items increase between two periods, then the cash recorded in the cash flow
statement as inflow (positive)
 If the Shareholder’s items decrease between two periods, then the cash recorded in the cash flow
statement as outflow (negative)
Forming the Cash Flow Statement

The Cash Flow Statement was built to reconcile income to cash. The first line of the statement is Net
Income and the last line is free cash flow. The Balance Sheet statement is presented the same way except
the first line on the Balance sheet is the cash balance and the last line being Retained Earnings. The
changes of these balance sheet items represent free cash flow and net income, respectively.
Starting from Net Income we first need to add any non-cash items that are included in the income
statement moving upwards. This includes depreciation, amortization, deferred taxes or even deferred
interest representing the cash portion of net income before any timing differences in cost of goods sold
and revenue.
As you can see in this example, we add Depreciation and deferred taxes to Net Income– both items can
be found on the balance sheet as demonstrated in [figure 15.6]. After adding or subtracting these items
we calculate Cash Income. Net Income could also be found on the balance sheet as the difference in
Retained Earnings from one year to the next.
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Celerity Technogy Inc. ("CTI") Celerity Technogy Inc. ("CTI")

Financial Statement Analysis Financial Statement Analysis
Balance Sheet (000's) Year 1 Year 2 $ Change % Change Cash Flow Statement (000's) Year 2
7 Current Assets Net Income 148,800

8 Cash 45,000 65,800 20,800 46.2% Plus Depreciation 65,000
9 Accounts Receivable 45,000 60,000 15,000 33.3% Plus Deffered Taxes 5,000
10 Inventories 35,000 40,000 5,000 14.3% Cash Income 218,800
12 Total Current Assets 135,000 174,800 39,800 29.5%
14 Property and Equipment

15 Land 2,500,000 2,500,000 - 0.0%
16 Building 450,000 550,000 100,000 22.2%
17 Furniture & Equipment 50,000 75,000 25,000 50.0%
18 Total Gross P&E 3,000,000 3,125,000 125,000 4.2%
19 Less Accumulated Depreciaition (300,000) (365,000) (65,000) 21.7%
20 Net P&E 2,700,000 2,760,000 60,000 2.2%
24 Total Assets 3,035,000 3,184,800 149,800 4.9%
35 Long-Term Debt: 1,200,000 1,180,000 (20,000) -1.7%
41 Owners' Equity
42 Common Stock 1,000,000 1,000,000 - 0.0%
43 Paid-in-Capital - 25,000 25,000
Figure 15.6 Figure 15.6
Once the cash flow statement is adjusted for any non-cash expense addbacks as described above the
statement is broken down to three different activities representing different parts of the balance sheet as
follows:
1. Cash Flows from Operating Activities (figure 15.7) or Working Capital represents changes in
current assets and current liabilities on the balance sheet. Out of these sections of the balance
sheet we omit cash balances and current portion long term debt as these are included in other
sections of the activity sectors.
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12 Total Current Assets 135,000 174,800 39,800 29.5% Working Capital Activities
Change in Accounts Receivable (15,000)
14 Property and Equipment Change in Inventory (5,000)
15 Land 2,500,000 2,500,000 - 0.0% Change in Prepaid Expenses 1,000
16 Building 450,000 550,000 100,000 22.2% Change in Accounts Payable 5,000
17 Furniture & Equipment 50,000 75,000 25,000 50.0% Change in Accrued Income Taxes (2,000)
18 Total Gross P&E 3,000,000 3,125,000 125,000 4.2% Change in Accrued Expenses (2,000)
19 Less Accumulated Depreciaition (300,000) (365,000) (65,000) 21.7% Total Change in Working Capital (18,000)
20 Net P&E 2,700,000 2,760,000 60,000 2.2%
Operating Cash Flow (OCF) 200,800
24 Total Assets 3,035,000 3,184,800 149,800 4.9%
35 Long-Term Debt: 1,200,000 1,180,000 (20,000) -1.7%
41 Owners' Equity
42 Common Stock 1,000,000 1,000,000 - 0.0%
43 Paid-in-Capital - 25,000 25,000
Figure 15.7
2. Cash Flow from Investment Activities (figure 15.8) are activities that represent the balance
sheet changes between two periods in long term assets such as Property, Plant & Equipment,
Long-term Investments and other assets. Goodwill and Intangibles are not included in this
section. The changes in PP&E are called Capital Expenditures (Capex). If the company decides
to sell assets a new line could be created called Asset Disposition or sometimes the Capex is net
of asset sales.
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Current Assets Net Income 148,800

Cash 45,000 65,800 20,800 46.2% Plus Depreciation 65,000
Accounts Receivable 45,000 60,000 15,000 33.3% Plus Deffered Taxes 5,000
Inventories 35,000 40,000 5,000 14.3% Cash Income 218,800
Prepaid Expenses 10,000 9,000 (1,000) -10.0%
Total Current Assets 135,000 174,800 39,800 29.5% Working Capital Activities
Property and Equipment Change in Inventory (5,000)
Land 2,500,000 2,500,000 - 0.0% Change in Prepaid Expenses 1,000
Building 450,000 550,000 100,000 22.2% Change in Accounts Payable 5,000
Furniture & Equipment 50,000 75,000 25,000 50.0% Change in Accrued Income Taxes (2,000)
Total Gross P&E 3,000,000 3,125,000 125,000 4.2% Change in Accrued Expenses (2,000)
Less Accumulated Depreciaition (300,000) (365,000) (65,000) 21.7% Total Change in Working Capital (18,000)
Net P&E 2,700,000 2,760,000 60,000 2.2%
Long-Term Investments 200,000 250,000 50,000 25.0%
Investment Activities
Total Assets 3,035,000 3,184,800 149,800 4.9% Capital Expenditures (125,000)
Investments (Change) (50,000)
Liabilities and Owners Equity Total Financing Activities (175,000)
Current Liabilities Cash Available Before Financing Activities 25,800

Accounts Payable 35,000 40,000 5,000 14.3%
Accrued Income Taxes 12,000 10,000 (2,000) -16.7%
Accrued Expenses 10,000 8,000 (2,000) -20.0%
Current Portion of Long Term Debt 20,000 10,000 (10,000) -50.0%
Total Current Liabilities 77,000 68,000 (9,000) -11.7%
Long-Term Debt: 1,200,000 1,180,000 (20,000) -1.7%
Deferred Income Taxes 12,000 17,000 5,000 41.7%
Total Liabilties 1,289,000 1,265,000 (24,000) -1.9%
Owners' Equity
Common Stock 1,000,000 1,000,000 - 0.0%
Paid-in-Capital - 25,000 25,000
Retained Earnings 746,000 894,800 148,800 19.9%
Total Owners' Equity 1,746,000 1,919,800 173,800 10.0%
Total Liabilities & Owner's Equity 3,035,000 3,184,800 149,800 4.9%
Figure 15.8
3. Cash Flow from Financing Activities [figure 15.9] are activities that represent the balance sheet
changes between two periods in long-term liabilities and shareholder’s equity (except for
Retained earnings).
15


12 Total Current Assets 135,000 174,800 39,800 29.5% Working Capital Activities
14 Property and Equipment Change in Inventory (5,000)
15 Land 2,500,000 2,500,000 - 0.0% Change in Prepaid Expenses 1,000
16 Building 450,000 550,000 100,000 22.2% Change in Accounts Payable 5,000
17 Furniture & Equipment 50,000 75,000 25,000 50.0% Change in Accrued Income Taxes (2,000)
18 Total Gross P&E 3,000,000 3,125,000 125,000 4.2% Change in Accrued Expenses (2,000)
19 Less Accumulated Depreciaition (300,000) (365,000) (65,000) 21.7% Total Change in Working Capital (18,000)
20 Net P&E 2,700,000 2,760,000 60,000 2.2%
Investment Activities
24 Total Assets 3,035,000 3,184,800 149,800 4.9% Capital Expenditures (125,000)
Investments (Change) (50,000)
26 Liabilities and Owners Equity Total Financing Activities (175,000)
28 Current Liabilities Cash Available Before Financing Activities 25,800

30 Accrued Income Taxes 12,000 10,000 (2,000) -16.7% Financing Activities
31 Accrued Expenses 10,000 8,000 (2,000) -20.0% ST Debt Payments (10,000)
32 Current Portion of Long Term Debt 20,000 10,000 (10,000) -50.0% LT Debt Payments (20,000)
33 Total Current Liabilities 77,000 68,000 (9,000) -11.7% Equity Contribution 25,000
Total Financing Activities (5,000)
35 Long-Term Debt: 1,200,000 1,180,000 (20,000) -1.7%
Free Cash Flow 20,800
Beginning Cash 45,000
Ending Cash 65,800
41 Owners' Equity
42 Common Stock 1,000,000 1,000,000 - 0.0%
43 Paid-in-Capital - 25,000 25,000
Figure 15.9
The book “The Four Cornerstones of Corporate Finance Value” written by Tim Koller, Richard Dobbs
and Bill Huyett discuss the importance for the company create value (value creation). In one of the
chapters of the book the authors elaborate how important it is for management to seek revenue growth
and return on invested capital (ROIC) and compare this to the use of cash to achieve such growth.
“Disaggregating cash flow into revenue growth and ROIC clarifies the underlying drivers of the
company’s performance” they stated. The book goes on to say that “this doesn’t tell us much about its
economic performance since an increase of cash flow come from many sources, including revenue
growth or reduction in capital spending, or a reduction in marketing expenses. But if we told the company
was growing at 7% per year and would earn ROIC of 15%, you could then evaluate its performance”.
Basically, management needs to invest more in Capex today, so it could achieve higher revenue growth
in the future. This relationship between Capex and revenues is one that the analyst needs to address in
the analysis.
FINANCIAL RATIO ANALYSIS

Understanding how to interpret financial statements does not purely involves looking at the trends
between years such as revenue growth to determine how the company is performing. Though this
approach is usually the first line of every financial analysis the analyst needs to get deeper in the analysis
to determine specific results that should enhance the assessment of the company’s performance. For
example, by combining a few items from the income statement and the balance sheet or by comparing
16
cash flow statement and income statement lines, the analyst could better interpret the company’s
performance. This process is called ratio analysis and is designed to give the analyst a better story about
the performance of the company. Ratio analysis is broken down into liquidity ratios, solvency ratios,
operating ratios and profitability ratios (figure 15.10).
17

Year 1 Year 2 Definition
7 Trend Analysis Ratios

8 Revenue Growth 15.6% This Year's Revenue / Last Year's Revenue - 1
9 Stock one-year Return (HPR) 25.0% This Year's SP/ Last Year's SP -1
11 Liquidity Ratios
12 Current Ratio 1.75x 2.57x CA/CL
13 Quick ratio 1.17x 1.85x (Cash + A/R) / CL
14 Cash ratio 0.58x 0.97x Cash / CL
15 Accounts Receivable Turnover (ART) 21.14x Revenue/Avg AR
16 Accounts Receivable Days 17.26 365 / ART
18 Solvency Ratios
19 Debt/Equity Ratio 68.7% 61.5% LTD / Equity
20 LTD / Total Capitalization 40.7% 38.1% LTD / (LTD + Equity)
21 EBITDA / Interest (Coverage Ratio) 2.96x 3.61x EBITDA / Interest
22 EBIT / Interest 2.50x 3.07x EBIT / Interest
23 Fixed Charge Coverage Ratio 2.05x (EBITDA-Capex)/(Int+ST+ LT Pmts)
24 Cash Avail.for Debt Service / Debt Svce 0.97x (CABFA + int.) / (Int. + ST+LT Pmts)
25 LTD / EBITDA (Leverage Ratio) 3.12x 2.73x LTD / EBITDA
27 Activity Ratios / Operating Ratios

28 Inventory Ratio (IR) 11.20x Cost of Revenues/Avg Inventory
29 Inventory Ratio - Days 32.59 365 / IR
30 Fixed Asset Turnover Ratio 0.407x Rev / Avg of FA
31 Asset Turnover Ratio 0.36x Rev / Avg of Total Assets
33 Profitability Ratios
34 Gross Margin 64.1% 62.2% Gross Margin / Revenues
35 EBITDA Margin 40.1% 39.0% EBITDA / Revenue
36 EBIT Margin 33.9% 33.2% EBIT / Revenue
37 Return on Assets (ROA) 4.8% NI / Avg Assets
38 Gross Return on Assets 11.8% EBIT / Avg Assets
39 Return on Equity (ROE) 8.1% NI / Avg Equity
50 Other Ratios
51 Altma's Z-score 2.15x 2.67x
53 Z Formula
54 Z = 1.2x(WC/TA) + 1.4x(RE/TA)+3.3x(EBIT/TA)+0.6x(MVE/Liabilities) + 0.99x(Sales/TA)
56 WC = Working Capital
57 TA=Total Assets
58 RE=Retained Earnings
59 MVE=Market Value of Equity
61 Z-Score Bankruptcy
62 1.8x or less Likely
63 Between 1.8 - 3.0 Uncertain
64 3.0 or above Not likely
Figure 15.10
Liquidity Ratios
Liquidity ratios measure how the company manages cash. This of course is more relevant when the
company is in distress and having liquidity is its top priority. The following ratios are considered liquidity
ratios (figure 15.11):

18
5 Liquidity Ratios
6 Current Ratio 1.75x 2.57x CA/CL
7 Quick ratio 1.17x 1.85x (Cash + A/R) / CL
8 Cash ratio 0.58x 0.97x Cash / CL
9 Accounts Receivable Turnover (ART) 21.14x Revenue/Avg AR
10 Accounts Receivable Days 17.26 Days 365 / ART
Figure 15.11
Current Ratio: Current Assets / Current Liabilities. This ratio measures the ability of the
company to pay off its short-term obligations such as payment to vendors or accrued taxes by
liquidating its current assets – basically, using the cash balances and proceeds from turning
receivable and inventory into cash. Companies with lower than 1.0x current ratio, by definition,
do not have enough liquidity to cover their short-term obligations. The example above shows that
the current ratio improves from 1.75x in 2016 to 2.57x in 2017 showing that even if the
company’s liquidity is cut in half they have enough cash left to cover its short-term obligations.
This indicates the ability to avoid insolvency for the near future.
Quick Ratio: (Cash & Cash Equivalents + Accounts Receivable)/ Current Liabilities. This ratio,
also known as acid test ratio, has the same denominator as the current ratio but better represents
the immediate liquidity of the company. Sometimes, converting inventory to cash is more
challenging. In distress companies that liquidity is the most important assessment of insolvency,
inventory is usually sold at a discount to what is reported in the books. In this case the current
ratio could be overestimating the company’s liquidity position.
Accounts Receivable Turnover (ART) and Days: ART = Revenue / Average Receivables and
ART/365 Days. This ratio is called a mixed ratio as it combines items from the income statement
and balance sheet. In most cases when an analyst combines items from the income statement and
balance sheet, they would need to use the an average approach for the balance sheet. Due to the
the application of periodic information to “snap shot” information. ART takes the Revenue
divided by the average receivable amounts between periods found on the balance sheet. This ratio
represents how many times a year the receivables convert to cash revenue. Taking that result
further someone can calculate how often the receivables are paid. In the example above (figure
11) the company shows that the receivables turned 21 times per year or every 17.3 days.
Solvency Ratios
Solvency ratios measure how a company manages debt. Debt can be a friend or a foe. Using the right
amount of debt to grow your business is considered good and effective management. Debt though, a lot
of it, can put a lot of pressure on the company’s performance. Solvency ratios include, Debt to Equity,
Capitalization Ratio or Long-Term Debt to Total Capitalization, Coverage ratio or EBITDA to interest
Expenses, EBIT to interest Expenses, Fixed Charge Coverage, Cash Flow Available for Debt Service to
Debt Service and Leverage Ratio of Long-Term Debt to EBITDA. All these are important ratios that
gives the analyst a clear understanding of the company’s solvency status (figure 15.12).
19
5 Solvency Ratios
6 Debt/Equity Ratio 68.7% 61.5% LTD / Equity
7 LTD / Total Capitalization 40.7% 38.1% LTD / (LTD + Equity)
8 EBITDA / Interest (Coverage Ratio) 2.96x 3.61x EBITDA / Interest
9 EBIT / Interest 2.50x 3.07x EBIT / Interest
10 Fixed Charge Coverage Ratio 2.05x (EBITDA-Capex)/(Int+ST+ LT Pmts)
11 Cash Avail.for Debt Service / Debt Svce 0.97x (CABFA + int.) / (Int. + ST+LT Pmts)
12 LTD / EBITDA (Leverage Ratio) 3.12x 2.73x LTD / EBITDA
Figure 15.12
Debt to Equity: Debt / Equity. This ratio is generally used for comparing the strength of the
equity as it compares to its debt. Basically, for investment grade companies (BBB+ and better
under Standards & Poor grading system) have Debt to Equity ratio of less than 1.0x showing that
the composition of book value of equity is higher than the value of debt. Companies with higher
than 1.0x are considered riskier as the debt is higher than the equity.
Total Capitalization: Total Debt / (Total Debt + Shareholder’s Equity) or Long-Term Debt /
(Long-Term Debt + Shareholders Equity): This ratio measures the proportion of debt in the
company’s capital structure. This ratio is very common ratio to measure balance sheet leverage,
an important measurement for a company to effectively access the capital markets.
Coverage Ratios: EBITDA / Interest Expense and EBIT / Interest: Both ratios could be found in
many loan agreements as financial covenant. This covenant measures how much cushion does a
company has to be able to make its periodical debt obligations such as Interest expenses. Other
coverage ratios are Fixed Charge Coverage, Cash Flow Available for Debt Service to Debt
Service. These ratios are more specific to the ability of the company to make its debt obligations
– both principal and interest payments.
Leverage Ratio: Total Debt / EBITDA or Long-Term Debt / EBITDA: This one of the most
popular solvency ratios. This ratio is typically included as a covenant in many loan agreements
primarily for companies that are non-investment grade (BB- or below rated by Standard & Poors).
It’s also a market benchmark for raising debt in the loan and bond markets. Even the government,
after the financial crisis, implemented guidelines to discourage regulated banks to lend money to
companies that the ratio is higher than 6.0x. In 2013, the Fed published the Leveraged Lending
Guidelines to guide banks to run debt capacity measurements before providing credit. This ratio
measures how long will take the company to pay off its debt. In a later chapter regarding debt
capacity, this ratio is one of the ratios that we will use to derive debt capacity at certain
transactions.
Altman’s Z-Score:
Altman’s Z-score measures the credit strength of a publicly traded manufacturing company that
faces bankruptcy. The five combined ratios as illustrated below are measuring the strength of the
company’s cash collateral and the likelihood of bankruptcy. Four out of the five ratios have Total
Assets as the denominator putting emphasis on the relationship between income and cash flow to
the collateral of the company. A special relevant factor when a company is facing bankruptcy.
These ratios include Working Capital / Total Assets, Retained Earnings / Total Assets, EBIT /
Total Assets and Sales / Total Assets. The other ratio, Market Value of Equity / Total Liabilities,
measures the company’s market value of the equity in relationship to the total liabilities. In most
20
distress situations where the company is facing bankruptcy, the stock price will significantly
decline and simultaneously the liability increases. As a result, the company finances it loses by
accessing its credit facilities (figure 15.13).
Year 1 Year 2
5 Other Solvency Ratios

6 Altma's Z-score 2.15x 2.67x
8 Z Formula
9 Z = 1.2x(WC/TA) + 1.4x(RE/TA)+3.3x(EBIT/TA)+0.6x(MVE/Liabilities) + 0.99x(Sales/TA)
11 WC = Working Capital
12 TA=Total Assets
13 RE=Retained Earnings
14 MVE=Market Value of Equity
16 Z-Score Bankruptcy
17 1.8x or less Likely
18 Between 1.8 - 3.0 Uncertain
19 3.0 or above Not likely
Figure 15.13
Each ratio that makes the combined 5-ratio formula called Z-Score have different weights assigned to
them to calculate the credit strength of the company. If the Company’s Z-score is less than 1.8x the
likelihood of bankruptcy is high. Between 1.8x and 3.0x results in uncertainty, in this case what is most
important is the negative or positive trend towards or away from bankruptcy. The likelihood of
bankruptcy is remote if the z-score is calculated at 3.0x or above indicating that the numerator number
of each ratio has a relationship to with collateral that is healthy.
Activity or Operating Ratios

These ratios measure how well and efficiently the company manages the overall business operations
including inventory, working capital, revenue and cost. For example, the hotel sector uses occupancy
ratio (OR) which represents the percentage amount of rooms booked divided by the total available rooms.
It is a perfect example to measure how active the hotel is with less vacancies. The restaurant sector uses
Turnover Ratio which represents how often tables are turned over or reused during a lunch shift. For a
manufacturing company, Inventory turnover measures how well the company manages inventory
(figure 15.14).
21
5 Activity Ratios / Operating Ratios

6 Inventory Ratio (IR) 11.20x Cost of Revenues/Avg Inventory
7 Inventory Ratio - Days 32.59 365 / IR
8 Fixed Asset Turnover Ratio 0.407x Rev / Avg of FA
9 Asset Turnover Ratio 0.36x Rev / Avg of Total Assets
Figure 15.14
Inventory Turnover: Cost of Revenues / Average Inventory: This is a ratio that measures how
effectively inventory is managed compared to cost of goods that are sold. The result shows how
many times a year your inventory is turned. The example above shows 11.2x -basically the
inventory as it moves from raw material to work-in-process, to being at finished good stored in
the warehouse, and eventually sold is done approximately 11 times per year.
Inventory Days: Inventory Turnover /365 days: Using the example above, the inventory is turned
every 32.6 days – basically the inventory as it moves from raw material to work-in-process, then
to finished good stored in the warehouse, and eventually sold – is done every 32.6 days before
new inventory goes though the cycle.
Fixed Asset Turnover Ratio and Total Asset Turnover: Revenue / Average Fixed Assets or
Revenue / Total Assets: Both ratios measure how well the business is using its long-term assets,
primarily plant and equipment to generate revenue. A declining ratio would show that the business
is over invested in plant and equipment or other assets to yield the revenues. This is a good ratio
to demonstrate how the company is trending from year to year and how it compares versus its
peers that manufacture the same products.
Profitability Ratios
These ratios measure how profitable the companies are. These ratios are very popular for pier comparison
and trend analysis. These ratios include gross margin ratios expressed in percentage, EBITDA or EBIT
margin ratios, Return of Assets and Return of Equity (figure 15.15).
5 Profitability Ratios
6 Gross Margin 64.1% 62.2% Gross Margin / Revenues
7 EBITDA Margin 40.1% 39.0% EBITDA / Revenue
8 EBIT Margin 33.9% 33.2% EBIT / Revenue
9 Return on Assets (ROA) 4.8% NI / Avg Assets
10 Gross Return on Assets 11.8% EBIT / Avg Assets
11 Return on Equity (ROE) 8.1% NI / Avg Equity
Figure 15.15
Gross Margin: Gross Profit / Revenues: This is one of the most common profitability ratios. This
22
ratio, usually expressed as a percentage, measures what the direct profit of a unit of sale. In figure
15 above, a gross margin of 62.2% (2017) is stating that every $1 of unit sale yields 62.2 cents of
gross profit.
EBITDA Margin and EBIT Margin: EBITDA / Revenues and EBIT / Revenues: These ratios
measure the percentage profit after operating expense for every single unit of sale. EBITDA
represents profit before depreciation and amortization reflecting as close to cash profit as
possible.
Return on Assets (ROA) and Gross Return on Assets: Net Income / Average Total Assets and
EBIT / Total Assets: This ratio represents the % of income that the company generates from the
all the assets they own. Based on figure 15 above the ROA is 4.8% which basically means that if
the company decides to sell its assets at book value of an average $3 billion and deposit at a bank
would they do better than 4.8% return.
Return on Equity (ROE): Net Income / Average Total Shareholder’s Equity: This ratio takes the
ROA one step further. Since the value of the Assets are offset by liabilities, the net difference
which is owner’s equity represent the book value of the investment in the company. ROE
measures the return on the shareholders equity or how much net income does the company
generate for every $1 of investment value.
CASE STUDY AND PRACTICE CASES

1. Based on the information below, complete the spreadsheet that includes a brief cash flow
statement, balance sheet and ratios. (access spreadsheet www.professordrou.com)
[INSERT PROBLEM 15.1a]
[INSERT PROBLEM 15.1b]
2. Complete the Cash Flow Statement 2017 based on the two year balance sheet and income
statements provided below (access the spreadsheet at www.professordou.com ).
[INSERT PROBLEM 15.2a]
[INSERT PROBLEM 15.2b]
[INSERT PROBLEM 15.2c]
23
3. Download the financial statements for any public traded company from websites such as
www.finance.yahoo.com and www.google.com/finance and calculate the following ratios (to
access spreadsheet www.professordrou.com).
[INSERT PROBLEM 15.3]
References (Chapter 15)

 Boddie, Kane and Marcus – “Essentials of Investments”, 10 th edition, McGraw Hill Education
 Knopman Financial Training, “Limited Representative – Investment Banking Exam – Series 79”.
 Tim Koller, Richard Dobbs, Bill Huyett, “The Four Cornerstones of Corporate Finance – Value”,
McKinsey & Company publishing.
24

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Excerpt from Prof. C.

Droussiotis Text Book: An Analytical Approach to Investments, Finance and Credit

[Insert boxed text here

End boxed text here]

Financial Statements Overview

[Insert Boxed text here

End boxed text here]

[INSERT FIGURE 15.1]

Celerity Technogy Inc. ("CTI")

Income Statement (000's) Year 1 Year 2 Operating Ratios for Year 2

8 Revenues by Geography Rev. Growth % Breakdown

22 Operating Expenses As % of Sales

30 Depreciation 60,000 65,000 5.9% Deprec.as % of Revenues

Operating Income or EBIT

Earnings Before Interest, Taxes, Depreciation and Amortization or EBITDA

BALANCE SHEET STATEMENT

[Insert Boxed text here

End boxed text here]

[INSERT FIGURE 15.2]

Net Worth or Shareholder’s Equity

common stock and shareholder’s equity.

[INSERT FIGURE 15.3]

Celerity Technogy Inc. ("CTI")

Balance Sheet (000's) Year 1 Year 2 $ Change % Change

14 Property and Equipment

22 Long-Term Investments 200,000 250,000 50,000 25.0%

24 Total Assets 3,035,000 3,184,800 149,800 4.9%

26 Liabilities and Owners Equity

35 Long-Term Debt: 1,200,000 1,180,000 (20,000) -1.7%

37 Deferred Income Taxes 12,000 17,000 5,000 41.7%

39 Total Liabilties 1,289,000 1,265,000 (24,000) -1.9%

47 Total Liabilities & Owner's Equity 3,035,000 3,184,800 149,800 4.9%

CASH FLOW STATEMENT

End boxed text here]

Income Vs Cash (timing diference)

If every business is run like a lemonade stand by 9-year old

Income Statement Cash Flow Statement Statement

Lemonade Sales: Profit $ 80.00

Expenses: Cash Flows:

Net Income: $ 80.00 Cash $ 80.00

Income Vs Cash (timing diference)

If every business is run like a lemonade stand by 9-year old

Income Statement Cash Flow Statement Statement

Lemonade Sales: Profit $ 80.00

Expenses: Cash Flows:

Net Income: $ 80.00 Cash $ 79.00

1. Cash Flows from Operating Activities

Building the Cash Flow Statement spreadsheet

[Insert boxed text here

Forming the Cash Flow Statement

[INSERT FIGURE 15.6]

Celerity Technogy Inc. ("CTI") Celerity Technogy Inc. ("CTI")

7 Current Assets Net Income 148,800

14 Property and Equipment

22 Long-Term Investments 200,000 250,000 50,000 25.0%

24 Total Assets 3,035,000 3,184,800 149,800 4.9%

26 Liabilities and Owners Equity

35 Long-Term Debt: 1,200,000 1,180,000 (20,000) -1.7%