RWJ Chapter 3
Financial Statement Analysis
{Grease Gougers, Inc.
Topics Covered
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Financial Ratios
DuPont System
Using Financial ratios
Measuring Company Performance
The Role of Financial Ratios
Why Evaluate Financial
Statements?
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Internal uses
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Performance evaluation –
compensation and comparison between
divisions
Planning for the future – guide in
estimating future cash flows
External uses
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Creditors
Suppliers
Customers
Stockholders
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Ratio Analysis
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Examines firm’s management of
various facets of the company’s
business through its financial
statements.
Scales balance sheet and income
statement information for easy
comparison across time or to other
companies.
Two common approaches
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Trend Analysis - looks at changes in
one company’s ratios over time.
Comparison or Industry Analysis compares company’s ratios against
a similar company or against
industry-wide ratios.
Areas Examined by Ratio Analysis
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Liquidity - measures the ability to meet
short-term obligations
Financial Leverage - measures the use of
financial leverage (debt) and its impact
Asset Utilization - measures the ability to
contain the growth of assets, and the
ability to effectively utilize assets
Profitability - measures the profitability of
various segments of a company
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Liquidity Ratios
Current ratio =
current assets
current liabilities
Quick ratio =
current assets - inventory
current liabilitie s
Cash ratio =
cash + marketable securities
current liabilities
Liquidity Ratios
Net working capital
to total assets ratio
=
Net working capital
Total assets
Interval measure =
Current Assets
Avg. daily operating costs
Liquidity Ratios calculation notes
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Net working capital = total current
assets – total current liabilities
Cash and marketable securities are
in one account
Avg. daily operating costs = cost of
goods sold/365
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Grease Gougers’ Liquidity Ratios
Liquidity Ratios
2005
2004
Current ratio
3.58
3.81
Quick ratio
1.50
1.90
Cash ratio
0.12
0.38
NWC to total assets ratio
0.40
0.39
137.99
124.04
Interval measure
Financial Leverage Ratios
total liabilities
total assets
Total debt ratio =
Debt-Equity ratio = total liabilities/total equity
Equity Multiplier = total assets/total equity
Financial Leverage Ratios
Long term debt ratio =
Times interest earned =
Cash coverage ratio =
long term debt
long term debt + equity
EBIT
interest payments
EBIT + depreciation
interest payments
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Grease Gougers’ Leverage Ratios
Financial Leverage Ratios
2005
2004
Total debt ratio
0.51
0.48
Debt-equity ratio
1.04
0.92
Equity multiplier
2.04
1.92
Long-term debt ratio
0.42
0.40
Times interest earned
3.25
3.80
Cash coverage ratio
4.50
4.94
Asset Utilization Ratios
Inventory turnover = Cost of goods
sold/inventory
Days’ sales in inventory =
365/inventory turnover
Receivables turnover =
Sales/receivables
Days’ sales in receivables =
365/receivables turnover
Asset Utilization Ratios
NWC turnover = Sales/NWC
Fixed asset turnover = Sales/net
fixed assets
Total asset turnover = Sales/total
assets
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Grease Gougers’ Asset Utilization
Ratios
Asset Utilization Ratios
2005
Inventory turnover
4.56
5.89
80.12
62.02
Days' sales in inventory
Receivables turnover
2004
8.33
8.97
43.80
40.70
NWC turnover
4.48
4.86
Fixed asset turnover
3.95
4.10
Total asset turnover
1.78
1.91
Days' sales in receivables
Profitability Ratios
Net profit margin =
net income
sales
Return on assets =
Net Income
total assets
Return on equity =
net income
total equity
Grease Gougers’ Profitability Ratios
Profitability Ratios
2005
2004
Net profit margin
3.6%
4.1%
Return on assets
6.4%
7.9%
Return on equity
13.0%
15.1%
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Deriving the Du Pont Identity
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ROE = NI / TE
Multiply by 1 and then rearrange
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ROE = (NI / TE) (TA / TA)
ROE = (NI / TA) (TA / TE) = ROA * EM
Multiply by 1 again and then
rearrange
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ROE = (NI / TA) (TA / TE) (Sales /
Sales)
ROE = (NI / Sales) (Sales / TA) (TA /
TE)
ROE = PM * TAT * EM
Using the Du Pont Identity
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ROE = PM * TAT * EM
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Profit margin is a measure of the firm’s
operating efficiency – how well does it
control costs
Total asset turnover is a measure of
the firm’s asset use efficiency – how
well does it manage its assets
Equity multiplier is a measure of the
firm’s financial leverage
The DuPont Identity
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Also, the equity multiplier (assets/equity)
can be written in terms of the total debt
ratio and debt/equity ratio.
assets sales Net Income
x
x
sales
equity assets
assets
1
1
total liabilitie s
=
=
= 1+
equity 1 − total debt ratio 1 − total liabilitie s
equity
total assets
ROE =
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Nike and Reebok DuPont Identity
Dupont Identity
2005
2004
Net profit margin
3.6%
4.1%
Total asset turnover
1.78
1.91
Equity multiplier
2.04
1.92
13.0%
15.1%
ROE
DuPont Example
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What total debt ratio was needed by
Grease Gougers in 2005 in order to
match their 2004 ROE assuming all
other 2005 relevant ratios are
constant?
Final Du Pont Identity comments
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When a firm uses no debt financing,
the equity multiplier = 1 and ROE
= ROA.
Using more financial leverage will
increase ROE when the return on
new assets (investment) exceeds
the interest rate on the new debt.
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