CHAPTER
18
FINANCIAL STATEMENT ANALYSIS
On Friday, June 6: Quiz or nothing
depending on how hard people work
Mon to Thursday.
Ratio Analysis
• Ratio Analysis expresses the relationships
between selected financial statement items.
•There are 3 types of ratio analysis:
1. Liquidity Ratios : Measure short-term ability of
the enterprise to pay its debts and to meet
unexpected needs for cash.
2. Solvency ratios : Measure the ability of the enter
prise to survive over a long period of time.
3. Profitability ratios: Measure the income or
operating success of an enterprise for a given
period of time.
PROFITABILITY RATIOS
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Profit margin
Gross profit margin
Asset turnover
Return on assets
Return on common
shareholders’ equity
• Earnings per share (EPS)
• Price-earnings (PE) ratio
• Payout ratio
PROFITABILITY RATIOS
• Who would be interested in finding out profitability
ratios?
• CEO, other executives, Bankers, investors and owners
• Many CEO (CFO, CMO etc)’s bonuses are tied to EPS,
PE ratio and profit margin.
GROSS PROFIT MARGIN
• Measures margin between selling price and cost of
goods sold generated by each dollar of sales
• This ratio indicates a company’s ability to keep a
selling price that is high enough above its cost of
goods sold.
• Gross profit = Net Sales - COGS
Gross profit margin =
Gross profit
Net sales
(Discussed in Chapter 5)
Gross Profit Margin
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Let’s say Hometown Tire’s numbers are:
2004 GPM = 597000 / 1837000 = 32.5%
2005 GPM = 616000 / 1997000 = 30.8%
Industry Average GPM = 23.5%
Canadian Tire GPM = 20%
How would you interpret GPM of Hometown?
Gross Profit Margin
• How would you interpret GPM of Hometown?
1. GPM’s trend: GPM is decreasing from 2004, which is not
a good sign. (Instead of 32.5% in 2004) In 2005, only 31%
of its net sales was used to cover operating expenses and
owner’s profit.
2. Hometown’s GPM is higher than industry average and
Canadian Tire, so it is a positive sign.
3. Perhaps, Hometown Tire sells more quality tires whereas
Canadian Tire sells cheap tires. This means it is critical
that Hometown Tire maintains high GPM in order to cover
operating expenses and to maintain decent net income.
PROFIT MARGIN
• Measures net income generated by each
dollar of sales
• What is the percentage of net sales, which
ended up making net income?
Profit margin =
Net income
Net sales
(Discussed in Chapter 5)
Profit Margin
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2004 PM = 75000 / 1837000 = 4.1%
2005 PM = 82000 / 1997000 = 4.1%
Industry Average = 5.4%
Canadian Tire = 4.2%
Only 4.1% of their net sales ended up becoming their
net income.
Profit Margin
• PM did not change from 2004 to 2005  neutral
• PM of Hometown is lower than industry average and
also Canadian Tire’s PM, although their Gross profit
margin is higher than Canadian Tire’s number.
• Perhaps Hometown’s operating expenses are too
high compared to Canadian Tire or industry’s average
operating expenses.
EARNINGS PER SHARE (EPS)
• Measures net income earned on each
common share
Earnings per share =
Net income
Number of common shares
(Discussed in Chapter 15)
EPS
• There are two types of shares:
• Prefered shares : They do not give voting rights to
the shareholder.
– In return, shareholders get fixed income.
– Companies issue prefered shares to raise money and willing
to pay fixed payments such as 6% of the investment.
• Common shares : They give voting right to the
shareholder.
– Shareholders do not get fixed income.
– Dividends can change depending on the net income for the
quarter.
– Companies issue common shares to raise money for the
business without increasing their mandatory payments like
interests.
EPS
• Most companies are required to present this ratio
directly on income statement.
• Hometown Tires has 30,000 common shares issued.
• There has been no change in this number over the
past 3 years, so the weighted average number of
shares is just 30,000 shares.
• 2004: (75000-0) / 30,000 = 2.50
• 2005: (82000 -0) / 30,000 = 2.73
• Industry average = NA
• Canadian Tire = $4.04
• EPS has grown year over year, which is a positive
sign. (9% increase)
EPS
• Comparison to Canadian Tire is not meaningful
because Canadian Tire is a public company, which
issued much more common shares.
• EPS shows how much net income is made from
one share, so it is extremely important number for
investors.(people who want to buy or already
purchased the common shares of this company)
• Let’s say Samsung’s EPS is 5 whereas Apple’s EPS
is 10, which one is a better stock to own? (assuming
same price)
• If the price for Samsung shares is $50 per share
whereas Apple’s shares is $500, then which one is
better one to buy?
PRICE-EARNINGS (PE) RATIO
• Measures relationship between market price per
share and earnings per share
• It shows how expensive the stock is considering its
net income.
• A valuation ratio of a company's current share price
compared to its per-share earnings.
Price-earnings ratio =
Share price
Earnings per share
(Discussed in Chapter 15)
PE Ratio
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2004: $5 / 2.50 = 2
2005: $5 / 2.75 = 1.8
Industry Average = 15
Canadian Tire = 17.2
Hometown’s PE in 2005 is 1.8, meaning for every
one dollar of earning per share, the investor has to
pay $1.80.
• Since the PE decreased year over year, this is a
positive sign. (because EPS increased year over
year)
• Since Hometown’s PE is lower than Canadian Tire’s
PE or industry average PE, it is worth to buy
Hometown’s common shares.
PE Ratio
• In general higher PE ratio means that this
company is popular and more expensive than
another company with low PE ratio.
• Companies with high PE ratio: Although the
company makes small net income, people are still
buying this company? Why?
– People feel that this company has good prospect for growth
in the future.
– People believe that there will be a breakout of this
company’s revenue and net income in the future. For
example, Bio Tech companies and High Tech companies
typically have high PE ratio.
• Many professional money managers (Mutual Fund
manager and Hedge Fund manager) use EPS and PE
ratio to make their buy or sell decisions everyday.
Classwork / Homework
• P960 E18.9, E18.10 (only the ratios we learned so
far) E18.11(C)
• P964 P18.3 – only the ratios we learned so far