Financial Management:
Principles & Applications
Thirteenth Edition
Chapter 4
Financial Analysis—
Sizing up Firm
Performance
Copyright ©Education,
2018, 2014, 2011 Pearson
Inc. All Rights
Reserved
Copyright © 2018, 2014, 2011 Pearson
Inc. Education,
All Rights
Reserved
Learning Objectives
(1 of 2)
1. Explain what we can learn by analyzing a firm’s
financial statements.
2. Use common size financial statements as a tool
of financial analysis.
3. Calculate and use a comprehensive set of
financial ratios to evaluate a company’s
performance.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Learning Objectives
(2 of 2)
4. Select an appropriate benchmark for use in
performing a financial ratio analysis.
5. Describe the limitations of financial ratio
analysis.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Principles Used in this Chapter
• Principle 3: Cash Flows Are the Source of Value.
• Principle 4: Market Prices Reflect Information.
• Principle 5: Individuals Respond to Incentives.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
4.1 WHY DO WE ANALYZE FINANCIAL
STATEMENTS?
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Why Do We Analyze Financial
Statements? Internal Financial Analysis
• An internal financial analysis might be done:
– To evaluate the performance of employees
– To compare the performance of firm’s different divisions
– To prepare financial projections
– To evaluate the firm’s financial performance in light of
its competitors’ performance
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Why Do We Analyze Financial
Statements? External Financial Analysis
• External financial analysis to determine the credit
worthiness or investment attractiveness is done
by:
– Banks and other lenders
– Suppliers
– Credit-rating agencies
– Professional analysts
– Individual investors
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
4.2 COMMON SIZE STATEMENTS:
STANDARDIZING FINANCIAL
INFORMATION
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Common Size Statements: Standardizing
Financial Information
• A common size financial statement is a
standardized version of a financial statement in
which all entries are presented in percentages.
• It helps to compare a firm’s financial statements
with those of other firms, even if the other firms
are not of equal size.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Preparing Common Size Statements
• How to prepare a common size financial
statement?
– For a common size income statement, divide each
entry in the income statement by sales.
– For a common size balance sheet, divide each entry
in the balance sheet by total assets.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Table 4.1 H. J. Boswell, Inc.
Common-Size Income Statement for the Year Ended
December 31, 2016
Sales
Blank
100.0%
Cost of goods sold
Blank
−75.0%
Gross profits
Blank
25.0%
Operating expenses:
Blank
Blank
Selling expenses
−3.3%
Blank
General and administrative expense
−2.5%
Blank
Depreciation and amortization expense
−5.0%
Blank
Total operating expense
Blank
−10.8%
Net operating income (EBIT, or earnings before interest and taxes)
Blank
14.2%
Interest expense
Blank
−2.5%
Earnings before taxes
Blank
11.7%
Income taxes
Blank
−4.1%
Net income
Blank
7.6%
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Table 4.1 Observations
• Table 4.1 created by dividing each entry in the
income statement of Table 3.1 by firm sales for
2016.
– Cost of goods sold make up 75% of the firm’s sales
resulting in a gross profit of 25%.
– Selling expenses account for about 3% of sales.
– Income taxes account for 4.1% of the firm’s sales.
– After all expenses, the firm generates net income of
7.6% of firm’s sales.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Table 4.2 H. J. Boswell, Inc. (1 of 2)
Common-Size Balance Sheets, December 31, 2015 and
2016
Blank
2015
2016
Change
Cash
5.4%
4.6%
−0.8%
Accounts receivable
7.9%
8.2%
0.3%
Inventory
13.0%
19.2%
6.2%
Other current assets
0.8%
0.7%
−0.1%
Total current assets
27.0%
32.6%
5.6%
Gross plant and equipment
94.6%
93.6%
−1.0%
Less accumulated depreciation
−21.7%
−26.3%
−4.6%
Net plant and equipment
73.0%
67.4%
−5.6%
Total assets
100.0%
100.0%
0.0%
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Table 4.2 H. J. Boswell, Inc. (2 of 2)
Blank
2015
2016
Change
Accounts payable
10.5%
9.6%
−0.9%
Accrued expenses
2.6%
2.3%
−0.3%
Short-term notes
3.6%
2.7%
−0.8%
Total current liabilities
16.6%
14.6%
−2.0%
Long-term debt
40.8%
39.2%
−1.7%
Total liabilities
57.4%
53.8%
−3.6%
Common stockholders’ equity
Blank
Blank
Blank
Common stock—par value
2.6%
2.3%
−0.3%
Paid-in capital
18.4%
16.4%
−1.9%
Retained earnings
21.7%
27.5%
5.8%
Total common stockholders’ equity
42.6%
46.2%
3.6%
Total liabilities and stockholders’ equity
100.0%
100.0%
0.0%
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Table 4.2 Observations
• Table 4.2 created by dividing each entry in the
balance sheet of Table 3.2 (in chapter 3) by total
assets.
– Total current assets increased by 5.6% in 2016 while
total current liabilities declined by 2%.
– Long-term debt account for 39.2% of firm’s assets,
showing a decline of 1.7%.
– Retained earnings increased by 5.8%.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
4.3 USING FINANCIAL RATIOS
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Using Financial Ratios
(1 of 2)
• Financial ratios provide a second method for
standardizing the financial information on the
income statement and balance sheet.
• A ratio by itself may have no meaning. Hence, a
given ratio is generally compared to: (a) ratios
from previous years; or (b) ratios of other firms in
the same industry.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Using Financial Ratios
(2 of 2)
Question
Category of Ratios Used to
Address the
Question
1. How liquid is the firm? Will it be able to pay its bills as they
come due?
Liquidity ratios
2. How has the firm financed the purchase of its assets?
Capital structure ratios
3. How efficient has the firm’s management
been in utilizing its assets to generate sales?
Asset management efficiency ratios
4. Has the firm earned adequate returns on
its investments?
Profitability ratios
5. Are the firm’s managers creating value for
shareholders?
Market value ratios
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
LIQUIDITY RATIOS
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Liquidity Ratios
• Liquidity ratios address a basic question: How
liquid is the firm?
• A firm is financially liquid if it is able to pay its bills
on time. We can analyze a firm’s liquidity from two
complementary perspectives:
– measuring overall liquidity of a firm, and
– measuring the liquidity of individual asset categories.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Measuring the Overall Liquidity of a Firm
The Overall liquidity is analyzed by comparing the
firm’s current assets to the firm’s current liabilities.
Two ratios used to analyze overall liquidity are:
1. Current Ratio
2. Acid-Test (or Quick) Ratio
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Current Ratio (1 of 2)
• Current Ratio: Current Ratio compares a firm’s
current (liquid) assets to its current (short-term)
liabilities.
Current Assets
Current Ratio =
Current Liabilities
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Current Ratio (2 of 2)
• What is the current ratio for 2016 for Boswell?
Current Ratio = $643.5m ÷ $288.0m = 2.23 times
• The firm had $2.23 in current assets for every $1 it
owed in current liability. It is better than peer group
average of $1.80.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Acid—Test (Quick) Ratio (1 of 2)
• Acid-Test (Quick) Ratio excludes the inventory
from current assets as inventory may not be very
liquid.
Acid-Test
Current Assets − Inventory
=
(or Quick) Ratio
Current Liabilities
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Acid—Test (Quick) Ratio (2 of 2)
• What is the quick ratio for Boswell?
• Acid Test (or Quick) Ratio
= ($643.5m−$378m) ÷ ($288.0m) = 0.92 times
• The firm has only $0.92 in current assets (less
inventory) to cover $1 in current liabilities. This
ratio is worse than peer average of $0.94
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Measuring the Liquidity of Individual
Asset Categories
• We can also measure the liquidity of the firm by
examining the liquidity of accounts receivable
and inventories to see how long it takes the firm
to convert its accounts receivables and inventories
into cash.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Average Collection Period
(1 of 2)
Average Collection Period measures the number
of days it takes the firm to collects its receivables.
Average Collection
Accounts Receivable
Accounts Receivable
=
=
Period
Annual Credit Sales/365 days
Daily Credit Sales
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Average Collection Period
(2 of 2)
• What is the average collection period for Boswell,
Inc. for 2016?
• Daily Credit Sales
= $2,700m ÷ 365 days = $7.40 million
• Average Collection Period
= $162m ÷ $7.40 = 21.9 days
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Accounts Receivable Turnover Ratio
(1 of 2)
Accounts Receivable Turnover Ratio measures
how many times receivables are “rolled over” during
a year.
Annual Credit Sales
Accounts Receivable Turnover =
Accounts Receivable
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Accounts Receivable Turnover Ratio
(2 of 2)
• What is the accounts receivable turnover ratio for
Boswell, Inc. for 2016?
• Accounts Receivable Turnover
= $2,700 million ÷ $162million = 16.67 times
– The firm’s accounts receivable were turning over at
16.67 times per year. This is higher than peer group
average of 14.60 times.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Inventory Turnover Ratio
(1 of 2)
Inventory turnover ratio measures how many
times the company turns over its inventory during
the year. Shorter inventory cycles lead to greater
liquidity because the items in inventory are
converted to cash more quickly.
Cost of Goods Sold
Inventory Turnover =
Inventories
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Inventory Turnover Ratio
(2 of 2)
• What is the inventory turnover ratio for H. J.
Boswell, Inc.?
• Inventory Turnover Ratio
= $2,025m ÷ $378m = 5.36 times
– The firm turned over its inventory 5.36 times per year.
This ratio is slower than peer group average of 7.0
times.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Days’ Sales in Inventory
• Days’ Sales in Inventory
= 365÷ inventory turnover ratio
= 365 ÷ 5.36 = 68 days
• The firm, on average, holds it inventory for about
68 days.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Can a Firm Have Too Much Liquidity?
• A high investment in liquid assets will enable the
firm to repay its current liabilities in a timely
manner.
• However, an excessive investments in liquid
assets can prove to be costly as liquid assets
(such as cash) generate minimal return.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
CHECKPOINT 4.1: CHECK YOURSELF
Evaluating Hewlett Packard’s Liquidity
If HP’s management were able to increase its inventory turnover ratio to 30 times a
year while holding firm sales constant, how much this reduce the firm’s investment in
inventory?
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Step 1: Picture the Problem
• The inventory turnover ratio will measure how
many days items remain in inventory before being
sold. Inventory turnover ratio is important as it has
implications for cash flows and profitability of a
firm.
• Changes in inventory turnover ratio will impact the
firm’s investment in inventory.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Step 2: Decide on a Solution Strategy
• We will use the Inventory Turnover (IT) ratio to
compute the investment in inventory.
IT ratio = Cost of Goods Sold ÷ Inventories
We are given the inventories and IT ratio.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Step 3: Solve
• Inventory Turnover Ratio for HP
= $78,596m ÷ Inventory = 30
• Solving for the revised inventory level we get
$78,596 million /30 = $2,619.87 million.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Step 4: Analyze
• Reducing the firm’s inventory turnover ratio has a
major impact on the level of investment in
inventory. With inventory turnover ratio of 30,
investment in inventory drops significantly from
$4,288 million to $2,619.87 million.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
CAPITAL STRUCTURE RATIOS
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Capital Structure Ratios
Capital structure refers to the way a firm finances
its assets using a combination of debt and equity.
Capital structure ratios address the important
question: How has the firm financed the purchase of
its assets? To address this issue, we use two types
of capital structure ratios: the debt ratio, and the
times interest earned ratio.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Debt Ratio (1 of 2)
Debt ratio measures the proportion of the firm’s
assets that were financed using current plus longterm liabilities.
Total Liabilities
Debt Ratio =
Total Assets
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Debt Ratio (2 of 2)
• What is the debt ratio for H.J. Boswell, Inc.?
• Debt Ratio
= $1,059.75 million ÷ $1,971 million = 53.80%
– The firm financed 53.80% of its assets with debt. This
ratio is significantly higher than the peer group average
of 35%.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Times Interest Earned Ratio
(1 of 2)
Times Interest Earned Ratio measures the ability
of the firm to service its debt or repay the interest on
debt.
Times Interest Net Operating Income or EBIT
=
Earned
Interest Expense
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Times Interest Earned Ratio
(2 of 2)
• What is the times interest earned ratio for H.J.
Boswell, Inc. for 2016?
• Times Interest Earned
= $382.5m ÷ $67.5m = 5.67 times
– The firm can pay its interest expense 5.67 times or
interest used 1/5.67th or 17.7% of its operating income,
which means its operating earnings could shrink by
82.3% and it could still pay its interest expense.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
CHECKPOINT 4.2: CHECK YOURSELF
Comparing the Financing Decisions of HD and LOWES
What would be Home Depot’s times interest earned ratio if interest payments
remained the same, but net operating income dropped by 80% to only $2.354 billion?
Similarly if Lowes’ net operating income dropped by 80%, what would its times interest
earned ratio be?
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Step 1: Picture the Problem
(1 of 2)
• Times interest earned ratio is an important ratio for
firms that use debt financing. It measures the
firm’s ability to service its debt.
• The ratio requires comparing net operating
income or EBIT with Interest expense. Both items
are found on the income statement.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Step 1: Picture the Problem
(2 of 2)
Picture an Income Statement
EBIT
– Sales
▪ Less: Cost of Good Sold
▪ Equals: Gross Profit
▪ Less: Operating Expenses
▪ Equals: Net Operating Income (EBIT)
▪ Less: Interest Expense
▪ Equals: Earnings before Taxes
▪ Less: Taxes
Interest
Expense
▪ Equals Net Income
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Step 2: Decide on a Solution Strategy
• Here we are considering the impact of a drop in
operating income on the times interest earned
ratio of Home Depot and Lowes. We will use the
following ratio to measure the times interest
earned (TIE) ratio. Interest expense is assumed to
remain the same.
• TIE = EBIT ÷ Interest Expense
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Step 3: Solve
• TIE (Home Depot)
= $2.354 billion ÷ $0.919 billion = 2.56 times
• TIE (Lowes)
= $0.509 billion ÷$1.873 billion = .271 times
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Step 4: Analyze
• We observe that a drop in net operating income
leads to a significant drop in times interest earned
ratio for both the firms. Should creditors be
worried by this drop? The drop in earnings would
be bad for Home Depot but devastating for
Lowe’s.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
ASSET MANAGEMENT EFFICIENCY RATIOS
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Asset Management Efficiency Ratios
Asset management efficiency ratios measure a
firm’s effectiveness in utilizing its assets to generate
sales. These ratios are commonly referred to as
turnover ratios as they reflect the number of times
a particular asset account balance turns over during
the year.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Total Asset Turnover Ratio
• Total Asset Turnover Ratio represents the
amount of sales generated per dollar invested in
the firm’s assets.
Total Assets
Sales
$2, 700 million
=
=
= 1.37 times
Turnover
Total Assets $1, 971 million
Peer-group total asset turnover = 1.15 times
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Fixed Asset Turnover Ratio
• Fixed asset turnover ratio measures firm’s
efficiency in utilizing its fixed assets (such as
property, plant and equipment).
Fixed Asset
Sales
$2, 700 million
=
=
= 2.03 times
Turnover
Net Plant and Equipment $1, 327 million
Peer-group fixed asset turnover = 1.75 times
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Asset Management Efficiency Ratios:
Summary
The following grid summarizes the efficiency of
Boswell’s management in utilizing its assets to
generate sales. Overall, the managers utilized the
firm’s total investment in assets efficiently.
Asset Utilization Efficiency
Boswell
Peer Group
Assessment
Total asset turnover
1.37
1.15
Good
Fixed asset turnover
2.03
1.75
Good
Receivables turnover
16.67
14.60
Good
Inventory turnover
5.36
7.0
Poor
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
PROFITABILITY RATIOS
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Profitability Ratios
(1 of 2)
Profitability ratios address a very fundamental
question: Has the firm earned adequate returns on
its investments?
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Profitability Ratios
(2 of 2)
Two fundamental determinants of firm’s profitability
and returns on investments are the following:
• Cost Control – How well has the firm controlled
its costs relative to each dollar of firm sales?
• Efficiency of asset utilization – How effective is
the firm in using the assets to generate sales?
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Cost Control: Is the Firm Earning
Reasonable Profit Margins?
Gross profit margin shows how well the firm’s
management controls its expenses to generate
profits.
Gross Profit Gross Profits
=
Margin
Sales
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Cost Control: Gross Profit Margin
What is the gross profit margin ratio for 2016 for H.
J. Boswell, Inc.?
• Gross Profit Margin
= $675 million ÷ $2,700 million = 25%
– The firm spent $0.75 for cost of goods sold and thus
$0.25 out of each dollar of sales went towards gross
profits.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Cost Control: Operating Profit Margin
Operating Profit Margin measures how much
profit is generated from each dollar of sales after
accounting for both costs of goods sold and
operating expenses. It also indicates how well the
firm is managing its income statement.
Operating Profit Net Operating Income or EBIT $382.5 million
=
=
= 14.2%
Margin (OPM)
Sales
$2, 700 million
Peer-group operating profit margin = 15.5%
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Cost Control: Net Profit Margin
(1 of 2)
Net Profit Margin measures how much income is
generated from each dollar of sales after adjusting
for all expenses (including income taxes).
Net Profit Net Income
=
Margin
Sales
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Cost Control: Net Profit Margin
(2 of 2)
What is the net profit margin ratio for H. J. Boswell,
Inc.?
• Net Profit Margin
= $204.75 million ÷ $2,700 million = 7.6%
– The firm generated $0.076 for each dollar of sales after
paying all of the firm’s expenses, whereas the peergroup firms earn $0.102.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Return on Invested Capital
Operating Return on Assets ratio is the summary
measure of operating profitability. It takes into
account both management’s success in controlling
expenses and its efficient use of assets.
Operating Return
Net Operating Income or EBIT
=
on Assets (OROA)
Total Assets
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Operating Return on Assets
What will be the operating return on assets ratio for
H. J. Boswell, Inc. ?
• Operating Return on Assets
= $382.5 million ÷$1,971 million = 19.4%
– The firm generated $0.194 of operating profits for every
$1 of its invested assets, which is higher than peer
group average of $0.178.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Decomposing the Operating Return on
Assets Ratio
Operating Return
Cost Control
Asset Utilization
=

on Assets
 Operating Profit   Total Asset 

 

Margin
(OPM)
Turnover
(TATO)

 

Operating Return  Net Operating Income or EBIT  
Sales

=

  Total Assets 
on Assets
Sales

 

 Net Operating Income or EBIT 
=

Total Assets


Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Figure 4.1 Analyzing H. J. Boswell, Inc.’s Operating Return
on Assets (OROA) (1 of 2)
Panel A. Decomposing the Operating Return on
Assets Ratio
Blank
=
Operating Profit Margin
× Total Asset
Turnover
Net Operating Income or EBIT
Total Assets
=
Net Operating Income or EBIT
Total Assets
×
Sales
Total Assets
H. J. Boswell
19.4%
=
14.2%
×
1.37
Peer Group
17.8%
=
15.5%
×
1.15
Equation
Operating Return on Assets
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Figure 4.1 Analyzing H. J. Boswell, Inc.’s Operating Return
on Assets (OROA) (2 of 2)
Panel B. Analyzing the Determinants of the Total
Asset Turnover Ratio
Blank
Accounts Receivable
Turnover
= Inventory Turnover
× Fixed Asset Turnover
Equation
Annual Credit Sales
Accounts Receivable
=
Cost of Goods Sold
Inventory
×
Sales
Net Plant and Equipment
H. J.
Boswell
16.67
=
5.8
×
2.03
Peer
Group
14.60
=
7.0
×
1.75
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Figure 4-1 Observations
• Firm’s OROA (operating return on assets) is
higher than that of its peers.
• Firm’s OPM (operating profit margin) is lower than
that of its peers.
• Firm’s TATO (total asset turnover ratio) is higher
than that of its peers.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Figure 4-1 Recommendations
1. Reduce costs - The firm must investigate the
cost of goods sold and operating expenses to
see if there are opportunities to reduce costs.
2. Reduce inventories -The firm must investigate if
it can reduce the size of its inventories.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
CHECKPOINT 4.3: CHECK YOURSELF
Evaluating the Operating Return on Assets (OROA) for HD and LOW
If Home Depot were able to raise its total asset turnover ratio to 2.5 while maintaining
its current operating profit margin, what would happen to its operating return on
assets?
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Step 1: Picture the Problem
• The operating return on assets ratio for a firm is
determined by two factors: cost control and asset
utilization. Here the focus is on asset utilization.
Operating Return
Cost Control
Asset Utilization
=

on Assets
 Operating Profit   Total Asset 

 

Margin
(OPM)
Turnover
(TATO)

 

Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Step 2: Decide on a Solution Strategy
We will analyze the impact on operating return on
assets of improvement on the total asset turnover
ratio by using the following equation:
• Operating Return on Assets (OROA)
= Total Asset Turnover × Operating Profit Margin
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Step 3: Solve
• Operating Return on Assets (OROA)
= Total Asset Turnover × Operating Profit Margin
• Before
= 2.08 × 13.3% = 27.67%
• Now
= 2.5 × 13.3% = 33.25%
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Step 4: Analyze
• An improvement in total asset turnover ratio has a
favorable impact on Home Depot’s operating
return on assets (OROA).
• If Home Depot wants to increase its OROA more,
it should focus on cost control that will help
improve the net operating profit.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Is the Firm Providing a Reasonable Return
on the Owner’s Investment? (1 of 2)
Return on Equity (ROE) ratio measures the
accounting return on the common stockholders’
investment.
Return on
Net Income
=
Equity
Common Equity
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Is the Firm Providing a Reasonable Return
on the Owner’s Investment? (2 of 2)
What is the ROE ratio for H. J. Boswell, Inc.?
• ROE = $204.75 million ÷ $911.25 million = 22.5%
– Thus the shareholders earned 22.5% on their
investments. This is higher than peer average of 18%
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Using the DuPont Method for
Decomposing the ROE ratio (1 of 4)
• DuPont method analyzes the firm’s ROE by
decomposing it into three parts.
– ROE = Profitability × Efficiency × Equity Multiplier
• Equity multiplier captures the effect of the firm’s
use of debt financing on its return on equity. The
equity multiplier increases in value as the firm
uses more debt.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Using the DuPont Method for
Decomposing the ROE ratio (2 of 4)
Return on
Equity
= Profitability  Efficiency 
Equity
Multiplier
Net Profit
Total Asset
Equity
=


Margin
Turnover
Multiplier
Net Income
Sales
1
=


Sales
Total Assets 1 − Debt Ratio
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Using the DuPont Method for
Decomposing the ROE ratio (3 of 4)
The following table shows why Boswell’s return on equity
was higher than its peers.
Blank
Return on
Equity
=
Net Profit
Margin
Equation
Net Income
=
Common Equity
H. J.
Boswell,
Inc.
22.5%
Blank
7.6%
1.37
Blank
2.16
PeerGroup
Averages
18.0%
Blank
10.2%
1.15
Blank
1.54
Net Income
Sales
×
×
Total Asset
Turnover
Sales
Total Assets
×
×
Financial
Leverage
or Equity
Multiplier
1
1 − Debt Ratio
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Using the DuPont Method for
Decomposing the ROE ratio (4 of 4)
Figure 4.2 Expanded DuPont Analysis for H. J. Boswell, Inc.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
MARKET VALUE RATIOS
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Market Value Ratios
Market value ratios address the question, how are
the firm’s shares valued in the stock market?
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Price—Earnings Ratio
Price-Earnings (PE) Ratio indicates how much
investors have been willing to pay for $1 of reported
earnings.
Market Price per Share
Price-Earning Ratio =
Earnings per Share
$32.00
Price-Earning Ratio =
= 14.07 times
$2.28
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Market—to—Book Ratio
Market-to-Book Ratio measures the relationship
between the market value and the accumulated
investment in the firm’s equity.
Market Price per
Market Price per
Market-to
Share
Share
=
=
Book Value
Common Shareholders'/ Common Shares
Book Ratio
per Share
Equity
Outstanding
Market-to
$32.00
$32.00
=
=
= 3.16
Book Ratio $911.25 million / 90 million $10.13
Peer-firm market-to-book ration = 2.7X
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
CHECKPOINT 4.4: CHECK YOURSELF
Comparing the Valuation of APPL to MSFT Using Market Value Ratios
What would be the price per share have to be for Apple to increase its PE ratio to that
of Microsoft’s if we assume Apple’s earnings remain the same as reported above?
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Step 1: Picture the Problem
Price-to-earnings (PE) ratio depends on earnings
per share and price per share, pictured as follows:
Price per share standardized by
EPS =
Net income ÷ number
Of shares outstanding
PE Ratio =
Price per share ÷
Earnings per share
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Step 2: Decide on a Solution Strategy
We need to determine the price per share that will
make PE ratio of Apple (10.39) equal to the PE ratio
of Microsoft (35.09).
PE ratio
= Price per share ÷ Earnings per share
==> 35.09 =
?
÷
9.22
Price per share = 35.09 x 9.22 = $323.53
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Step 3: Solve
From Step 2, note that the PE ratio of Microsoft is
35.09.
PE ratio
= Price per share ÷ Earnings per share
==> 35.09 =
?
÷
9.22
Price per share = 35.09 x 9.22 = $323.53
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Step 4: Analyze
• PE ratio allows us to compare two stocks with
different prices by standardizing the stock prices
by earnings.
• Microsoft has a much higher PE ratio. To reach
the same PE valuation, the stock price of Apple
will have to increase from $95.76 to $323.53.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
4.4 SELECTING A PERFORMANCE BENCHMARK
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Selecting a Performance Benchmark
There are two types of benchmarks that are
commonly used to analyze a firm’s financial
performance by means of its financial statements:
• Trend Analysis – compares a firm’s financial
statements over time (time-series comparisons).
• Peer Group Comparisons – compares the subject
firm’s financial statements with “peer” firms.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Trend Analysis
Comparing a firm’s recent financial ratios with the
past financial ratios provides insight into whether
the firm is improving or deteriorating over time. This
type of financial analysis is referred to as trend
analysis.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Figure 4-3 A Time—Series (Trend) Analysis of the Inventory
Turnover Ratio: Home Depot Versus Lowe’s, 2001–2015
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Peer—Firm Comparisons
A peer firm is simply one that the analyst believes
will provide a relevant benchmark for the analysis at
hand. Peer groups often consist of firms from the
same industry. Industry average financial ratios can
be obtained from a number of financial databases
(such as Compustat) and internet sources (such as
yahoo finance and google finance).
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Figure 4-4 Financial Analysis of the Gap, Inc., 2016
Financial Ratios
Gap, Inc.
Industry Average
Price-earnings ratio
10.52
21.69
Market-to-book ratio
3.21
13.40
Gross margin
39.63%
36.98%
Net profit margin
5.82%
6.61%
Operating profit margin
9.65%
11.88%
Return on equity
36.15%
46.22%
Debt ratio
65.94%
39.39%
Current ratio
1.57
1.62
Total assets turnover ratio
2.11
1.87
Inventory turnover ratio
5.38
4.69
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
4.5 LIMITATIONS OF RATIO ANALYSIS
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Limitations of Ratio Analysis
(1 of 2)
1. Picking an industry benchmark can sometimes
be difficult.
2. Published peer-group or industry averages are
not always representative of the firm being
analyzed.
3. An industry average is not necessarily a
desirable target or norm.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Limitations of Ratio Analysis
(2 of 2)
4. Accounting practices differ widely among firms.
5. Many firms experience seasonal changes in
their operations.
6. Financial ratios offer simply clues that can
suggest the need for further investigation.
7. The results of financial analysis are no better
than the quality of the financial statements.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Key Terms (1 of 4)
• Accounts receivable turnover ratio
• Acid-test (quick) ratio
• Average collection period
• Book value per share
• Capital structure
• Current ratio
• Days’ sales in inventory
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Key Terms (2 of 4)
• Debt ratio
• DuPont method
• Equity Multiplier
• Earnings per share (EPS)
• Financial leverage
• Financial ratios
• Fixed asset turnover ratio
• Inventory turnover ratio
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Key Terms (3 of 4)
• Liquidity ratios
• Market-to-book ratio
• Market value ratios
• Notes payable
• Operating return on assets (OROA)
• Price-earnings (PE) ratio
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Key Terms (4 of 4)
• Return on equity
• Times interest earned
• Total asset turnover ratio (TATO)
• Trend analysis
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Copyright
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved