These lectures cover financial statements analysis including common size financial statement, horizontal analysis, vertical analysis, financial ratios and the dupont identity.

At the most fundamental level, firms do two different things: They generate cash and they spend it. Cash is generated by selling a product, an asset, or a security. Selling a security involves either borrowing or selling an equity interest (shares of stock) in the firm. Cash is spent in paying for materials and labor to produce a product and in purchasing assets. Payments to creditors and owners also require the spending of cash.

Cash flow from assets = Cash flow to creditors + Cash flow to owners

This cash flow identity summarizes the total cash result of all transactions a firm engages in during the year.

To start making comparisons, one obvious thing we might try to do is to somehow standardize the financial statements by preparing vertical and horizontal financial statements. One common and useful way of doing this is to work with percentages instead of total dollars.

nother way of avoiding the problems involved in comparing companies of different sizes is to calculate and compare financial ratios. Such ratios are ways of comparing and investigating the relationships between different pieces of financial information. Using ratios eliminates the size problem because the size effectively divides out. We’re then left with percentages, multiples, or time periods.

There is a problem in discussing financial ratios. Because a ratio is simply one number divided by another, and because there are so many accounting numbers out there, we could examine a huge number of possible ratios. Everybody has a favorite. We will restrict ourselves to a representative sampling.

In this section, we only want to introduce you to some commonly used financial ratios. These are not necessarily the ones we think are the best. In fact, some of them may strike you as illogical or not as useful as some alternatives. If they do, don’t be concerned. As a financial analyst, you can always decide how to compute your own ratios.

One of the best known and most widely used ratios is the current ratio. As you might guess, the current ratio is defined as follows:

Current assets divided by current liabilities.

Inventory is often the least liquid current asset. It’s also the one for which the book values are least reliable as measures of market value because the quality of the inventory isn’t considered. Some of the inventory may later turn out to be damaged, obsolete, or lost.

More to the point, relatively large inventories are often a sign of short-term trouble. The firm may have overestimated sales and overbought or overproduced as a result. In this case, the firm may have a substantial portion of its liquidity tied up in slow-moving inventory.

To further evaluate liquidity, the quick, or acid-test, ratio is computed just like the current ratio, except inventory is omitted.

LONG-TERM SOLVENCY MEASURES

Long-term solvency ratios are intended to address the firm’s long-term ability to meet its obligations, or, more generally, its financial leverage. These are sometimes called financial leverage ratios or just leverage ratios.

The total debt ratio takes into account all debts of all maturities to all creditors.

Considering the DuPont identity, it appears that the ROE could be leveraged up by increasing the amount of debt in the firm. However, notice that increasing debt also increases interest expense, which reduces profit margins, which acts to reduce ROE. So, ROE could go up or down, depending.