FINANCIAL STATEMENT ANALYSIS
Financial statement analysis is often divided into two sub-parts: profitability analysis and risk analysis. This is a natural division since much of our thinking about firm performance is influenced by our study of the relationship between risk and return in finance.
Measures of performance and risk are relative measures, that is, they are meaningful only when compared to something else. There are a number of comparators that may be available to us including (1) budgeted numbers, (2) past numbers for the same firm, (3) numbers from a similar or competitor firm, or (4) industry averages. Sometimes we may want to compare with more than one of these benchmarks. Often the purpose of the analysis will help us determine which of these comparator numbers is most appropriate.
These notes are organized as follows:
I. Profitability measures
A. Return on assets (ROA)
B. Return on common equity (ROCE)
II. Risk measures
A. Short-term liquidity
B. Longer-term solvency
Two ratios are presented in this: return on assets and return on common equity. The return on assets measures the return generated by the firm (a measure of income) relative to the assets used to generate that income. ROA measure how productively the resources (assets) of the firm are used. How the assets are financed does not affect the analysis. Return on common equity, on the other hand, measures the return available to common stockholders relative to the book value of their investment in the firm. Here the capital structure of the firm makes an important difference, since the return to common stockholders is net of payments to bondholders and preferred stockholders. In essence, ROCE tells us how effective the firm is in using both its resources (assets) and its financing (leverage) in creating wealth for common shareholders.
The essence of the ratio analysis in this section is the disaggregation of ROA and ROCE into sub-parts to give us insight into what happened during the period. Disaggregation allows us to keep asking more detailed and specific questions until we have an understanding of the events and conditions that led to the performance that occurred.
A. Return on Assets (ROA)
Disaggregating Profit Margin:
Disaggregating Asset Turnover:
B. Return on Common Equity (ROE)
Risk reflects the ability of the firm to generate cash flows in order to satisfy its obligations. Failure to do this generally results in bankruptcy for the firm.
The ratios in this section are divided between short-term risk (liquidity) and longer-term risk (solvency). Liquidity risk generally relates to cash flows from operations, while solvency risk is influenced by investment and financing decisions.
A. Short-term Liquidity
B. Longer-term Solvency