Fundamentals of Corporate Finance
Fifth Edition, Global Edition
Chapter 2
Introduction to Financial
Statement Analysis
Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.
Chapter Outline
2.1 Firms’ Disclosure of Financial Information
2.2 The Balance Sheet
2.3 The Income Statement
2.4 The Statement of Cash Flows
2.6 Financial Statement Analysis
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2.1 Firms’ Disclosure of Financial Information
• Financial statements are accounting reports issued periodically to
present past performance and a snapshot of the firm’s assets and the
financing of those assets
• Investors, financial analysts, managers, and other interested parties
such as creditors rely on financial statements to obtain reliable
information about a corporation
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Global Corporation Balance Sheet for 2019 and 2018 ($
millions) (1 of 2)
Table 2.1 Global Corporation Balance Sheet for 2019 and 2018 ($ millions)
Assets
2019
2018
blank
Blank
Cash
23.2
20.5
Accounts receivable
18.5
13.2
Inventories
15.3
14.3
Total current assets
57.0
48.0
blank
blank
Net property, plant, and
equipment
113.1
80.9
Total long-term assets
113.1
80.9
Total Assets
170.1
128.9
Current Assets
Long-Term Assets
Net Working Capital = Current Assets − Current Liabilities
Global Corporation Balance Sheet for 2019 and 2018 ($
millions) (2 of 2)
Liabilities and Stockholders’
Equity
2019
2018
blank
blank
Accounts payable
29.2
26.5
Notes payable/short-term debt
5.5
3.2
Total current liabilities
34.7
29.7
blank
blank
Long-term debt
113.2
78.0
Total long-term liabilities
113.2
78.0
Total Liabilities
147.9
107.7
Blank
Blank
Common stock and paid-in surplus
8.0
8.0
Retained earnings
14.2
13.2
Total Stockholders’ Equity
22.2
21.2
Total Liabilities and Stockholders’
Equity
170.1
128.9
Current Liabilities
Long-Term Liabilities
Earnings retained
within the firm for
reinvestment
Stockholders’ Equity
The amount that stockholders have directly contributed to the firm
through the issue of common stock
2.2 The Balance Sheet
• The Balance Sheet Identity
• The two sides of the balance sheet must balance
(Eq. 2.1)
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2.2 The Balance Sheet
• Stockholders’ Equity
• Market Value Versus Book Value
• Book value of equity
• Assets – Liabilities = Equity (that is, net worth)
• True value of assets may be different from book value
• Market capitalization
• Market price per share times number of shares outstanding
• Does not depend on historical cost of assets
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Market versus Book Value (cont’d)
• Sources of value that do not appear on the balance sheet
• These include
• Opportunities for growth
• The quality of the management team
• Relationships with suppliers and customers, etc.
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2.2 The Balance Sheet
• Market to Book Ratio
• The ratio of a firm’s market capitalization to the book value of stockholders’
equity:
Market Value of Equity
Market-to-Book Ratio 
Book Value of Equity
(Eq. 2.3)
• Also called Price-to-Book ratio
• Sometimes used to classify firms as value (low M/B) or growth (high M/B)
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Figure 2.1 Market-to-Book Ratios in 2019
This figure presents market-to-book ratios of different firms and groups of firms in 2019. Firms
that might be classified as value stocks (low market-to-book ratios) are in red and those that
might be classified as growth stocks (high market-to-book ratios) are in blue.
2.2 The Balance Sheet
• Enterprise Value
• The value of a firm’s underlying business.
Enterprise Value = Market Value of Equity +
Debt – Cash
(Eq. 2.4)
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Example 2.2 Computing Enterprise Value (1 of
3)
Problem
• In December 2018, Kraft Heinz Co. (KHC) had 1.22 billion
shares outstanding, a share price of $43.04, a book value of
debt of $30.87 billion, and cash of $1.13 billion. What was Kraft
Heinz’s market capitalization (its market value of equity)? What
was its enterprise value?
Example 2.2
Computing Enterprise Value (cont’d)
Solution:
Plan:
Share Price
$43.04
Shares Outstanding
1.22 billion
Cash
$1.13 billion
Debt (book)
$30.87 billion
We will solve the problem using Eq. 2.4:
Enterprise value = Market capitalization + Debt – Cash
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Example 2.2
Computing Enterprise Value (cont’d)
Execute:
• Heinz’s market capitalization =
• Thus, Heinz’s enterprise value =
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2.3 The Income Statement
• The income statement lists the firm’s revenues and expenses over a
period of time
• Sometimes called the profit and loss statement, or “P&L”
• The last or “bottom” line of the income statement shows net income
• A measure of its profitability during the period
• Also referred to as the firm’s earnings
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Global Corporation’s Income Statement Sheet for 2019 and 2018 (1
of 2)
Table 2.2 Global Corporation’s Income Statement Sheet for 2019 and 2018
Global Corporation
Income Statement
Year ended December 31 (in $ millions)
blank
Net sales
Cost of sales
Gross Profit
Selling, general, and
administrative
expenses
Research and
development
Depreciation and
amortization
Operating Income
2019
186.7
2018
176.1
Minus 153.4
Minus 147.3
-153.4
-147.3
33.3
28.8
Minus 13.5
Minus 13
-13.5
Minus 8.2
-8.2
Minus 1.2
-1.2
10.4
-13
Minus 7.6
-7.6
Minus 1.1
-1.1
7.1
Global Corporation’s Income Statement Sheet
for 2019 and 2018 (2 of 2)
Blank
Blank
10.4
7.1
Minus 7.7
Minus 4.6
Other income
Earnings Before Interest
and Taxes (EBIT)
Interest income (expense)
Pretax Income
2.7
-7.7
2.5
-4.6
Minus 0.7
Minus 0.6
2.0
1.9
Earnings per share:
$0.56
$0.53
Diluted earnings per share:
$0.53
$0.50
Taxes
Net Income
2.3 The Income Statement
• Earnings Per Share
• Net income reported on a per-share basis
(Eq. 2.5)
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2.3 The Income Statement
• Earnings Per Share
• Fully diluted EPS refers to conservative estimate of EPS. It
occurs only if all the convertible securities are exercised in
the current year.
• If all the convertible securities are exercised, the number of
shares outstanding is larger and earnings per share is
reduced.
• Convertible securities include
• Stock options issued to employees
• The right to buy a certain number of shares by a specific date at a
specific price
• Shares issued due to conversion of convertible bonds
• Convertible bonds are corporate bonds with a provision that gives the
bondholder an option to convert each bond into a fixed number of
shares of common stock
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2.4 The Statement of Cash Flows
• The firm’s statement of cash flows uses the information from the
income statement and balance sheet to determine:
• How much cash the firm has changed over the financial year.
• What activities led to the change in cash balance from the previous year to
the current year.
• Cash is important because it is needed to pay bills and maintain
operations.
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2.4 The Statement of Cash Flows
• The statement of cash flows is divided into three sections which
roughly correspond to the three major jobs of the financial manager:
• Operating activities
• Investment activities
• Financing activities
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Global Corporation’s Statement of Cash Flows for 2019 and 2018 (1
of 2)
Table 2.3 Global Corporation’s Statement of Cash Flows for 2019 and 2018
Global Corporation
Statement of Cash Flows
Year ended December 31 (in $ millions)
Blank
Operating activities
Net income
Depreciation and
amortization
Cash effect of changes in
Accounts receivable
Accounts payable
Inventory
Cash from operating
activities
2019
2018
blank
blank
2.0
1.2
1.9
1.1
blank
Blank
Minus 5.3
-5.3
Minus 0.3
-0.3
Minus 0.5
2.7
Minus 1.0
-1.0
-0.5
Minus 1.0
-1.0
Minus 0.4
-0.4
1.2
Global Corporation’s Statement of Cash Flows for 2019
and 2018 (2 of 2)
blank
Investment activities
Capital expenditures
Acquisitions and other investing
activity
Cash from investing activities
Financing activities
Dividends paid
Sale or purchase of stock
2019
2018
blank
blank
Minus 33.4
Minus 4.0
-33.4
-4.0
Blank
Blank
Minus 33.4
Minus 4.0
-33.4
-4.0
blank
blank
Minus 1.0
Minus 1.0
-1.0
-1.0
Blank
Blank
Increase in short-term borrowing
2.3
3.0
Increase in long-term borrowing
35.2
2.5
Cash from financing activities
36.5
4.5
Change in cash and cash
equivalents
2.7
1.7
Profit vs Cash Flows from operating activities
They might be different:
Reason One. Non-cash charges
Some expenses may be listed on the income statement that are not
cash outlays. For instance, depreciation expense.
Reason Two. Accrual accounting
Income Statement uses accrual accounting which means
- revenues are recorded when earned, and not necessarily when cash is
received.
- expenses are recorded when incurred, not necessarily when cash is paid.
- Matching principle - expenses are recorded along with related revenue at
the same period of time.
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Examples
• $1,000 credit sales
• Delay $1,000 wages to worker
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Example
• Buy $1,000 inventory in period 1 and sold out the product in period 2
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Guideline to determine the cash flow from operation
① Add back noncash expenses (e.g.
depreciation)
Net
income
Cash flows
from
operation
② changes in balance in current asset
accounts or current liability accounts
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Example
• During the last year of operations, account receivable increased by
$10,000, account payable increased by $5,000 and inventories
decreased by $2,000. What is the total impact of these changes on
the difference between profits and cash flows?
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2.4 The Statement of Cash Flows
• Investment Activity
• Subtract the actual capital expenditure that the firm made
• Also deduct other assets purchased or investments made by the firm, such as
acquisitions
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2.4 The Statement of Cash Flows
• Financing Activity
• The last section of the statement of cash flows shows the cash flows from
financing activities
• Dividends paid
• Cash received from sale of stock or spent repurchasing its own stock
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2.4 The Statement of Cash Flows
• The last line of the Statement of Cash Flows shows the overall change in the
firm’s cash balance over the time period.
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Exercise
Prepare a statement of Cash Flows for ABC company
Net income
$1000
Depreciation
$500
Increase in A/R Receivable
$200
Increase in Inventory
$100
Decrease in A/C Payable
$100
Purchase of plant and equipment
$500
Purchase of non-current assets
$300
Issuance of bond
$200
Dividends
$100
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ABC
Statement of Cash Flows
Year ended 31 December 2016
Operating Activities
Net Income
Depreciation and Amortization
Changes in working capital
Increase in inventories
Increase in A/R Receivables
Decrease in A/C Payable
Cash from operating activities
Investment Activities
Addition to property, plant and equipment
Addition to non-current assets
Cash from investment activities
Financing Activities
Addition to debt
Dividends paid
Cash from financing activities
Change in cash and cash equivalents
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2.6 Financial Statement Analysis
1. Profitability Ratios
2. Liquidity Ratios
3. Asset Efficiency Ratios
4. Working Capital Ratios
5. Interest Coverage Ratio
6. Leverage Ratios
7. Valuation Ratio
8. Investment Returns
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2.6 Financial Statement Analysis
1. Profitability Ratios
1a. Gross Margin
• How much a company earns from each dollar of sales after paying for the items sold
Gross Profit
Gross Margin 
Sales
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(Eq. 2.9)
35
2.6 Financial Statement Analysis
1. Profitability Ratios
1b.Operating Margin
• How much a company earns before interest and taxes from each dollar of sales
Operating Income
Operating Margin 
(Eq. 2.10)
Sales
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2.6 Financial Statement Analysis
1. Profitability Ratios
1c. Net Profit Margin
• The fraction of each dollar in revenues that is available to equity holders after the firm
pays interest and taxes
Net Income
Net Profit Margin 
(Eq. 2.11)
Sales
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2.6 Financial Statement Analysis
2. Liquidity Ratios
2a. Current Ratio
• The ratio of current assets to current liabilities
Current Assets
Current Ratio =
(Eq. 2.12)
Current Liabilities
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2.6 Financial Statement Analysis
2. Liquidity Ratios
2b. Quick Ratio
• The ratio of current assets other than inventory to current liabilities
Current Assets - Inventory (Eq. 2.13)
Quick Ratio =
Current Liabilities
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2.6 Financial Statement Analysis
2. Liquidity Ratios
2c. Cash Ratio
• The most stringent liquidity ratio:
(Eq. 2.14)
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2.6 Financial Statement Analysis
3. Asset Efficiency
3a. Asset Turnover
• A first broad measure of efficiency is asset turnover
Sales
Asset Turnover =
Total Assets
(Eq. 2.15)
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2.6 Financial Statement Analysis
3. Asset Efficiency
3b. Fixed Asset Turnover
• Since total assets include assets that are not directly involved in generating sales, a
manager might also look at fixed asset turnover
Sales
Fixed Asset Turnover =
(Eq. 2.16)
Fixed Assets
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2.6 Financial Statement Analysis
4. Working Capital Ratios
4a. Accounts Receivable Days
It measures the length of time customers delay the payments after their purchase (or how
quickly credit sales are collected).
Accounts Receivable
Accounts Receivable Days 
(Eq. 2.17)
Average Daily Sales
Average Daily Credit sales;
The average is calculated by adding the beginning balance and the ending balance
and dividing that amount by two.
4b. Account Payable Days – it measures the average number of days a company takes to pay its
bills (or how quickly the unpaid debts owed to suppliers are settled).
𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑃𝑎𝑦𝑎𝑏𝑙𝑒
Account Payable Days =𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
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2.6 Financial Statement Analysis
4. Working Capital Ratios
4b. Inventory Turnover - it measures the number of times, on
average, inventory is sold out and restocked during a year.
Inventory Days - It measures how long the firm’s assets are
tied up in inventory before sales are made.
Cost of Goods Sold
Inventory Turnover =
(Eq. 2.18)
Inventory
inventory at start of year
Inventory Days =
cost of goods sold/365
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2.6 Financial Statement Analysis
5. Interest Coverage Ratios
•
•
•
•
Also known as times interest earned (TIE)
TIE = Earnings divided by interest
Can define earnings as operating income, EBIT, or EBITDA
Assesses how easily a firm is able to cover its interest payments
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2.6 Financial Statement Analysis
6. Leverage – level of debt that a firm is in use.
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2.6 Financial Statement Analysis
6. Leverage Ratios
6a. Debt-Equity Ratio
• The debt-equity ratio is a common ratio used to assess a firm’s leverage
Total Debt
Debt-Equity Ratio 
Total Equity (Eq. 2.19)
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2.6 Financial Statement Analysis
6. Leverage Ratios
6b. Debt-to-Capital Ratio
• The debt-to-capital ratio calculates the fraction of the firm financed by debt:
(Eq. 2.20)
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2.6 Financial Statement Analysis
6.Leverage Ratios
6d. Debt-to-Enterprise Value Ratio
(Eq. 2.22)
• In practice, Net Debt = Total Debt minus cash balance on the balance sheet.
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2.6 Financial Statement Analysis
6. Leverage Ratios
6e. Equity Multiplier
• Total Assets/Book Value of Equity
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2.6 Financial Statement Analysis
7. Valuation Ratios
• Analysts and investors use a number of ratios to gauge the market value of
the firm
• The most important is the firm’s price-earnings ratio (P/E)
• It helps to estimate a corporation’s future earning capacity. Corporations with high
growth potentials generally attract high P/E, whereas those with low growth tends to
have lower P/E.
Market Capitalization
Share Price
P / E Ratio 

(Eq. 2.23)
Net Income
Earnings per Share
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2.6 Financial Statement Analysis
8. Investment Returns
8a. Return on Equity
• Evaluating the firm’s return on investment by comparing its income to its investment
Net Income
(Eq. 2.24)
Return on Equity =
Book Value of Equity
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2.6 Financial Statement Analysis
8. Investment Returns
8b. Return on Assets
• Evaluating the firm’s return on investment by comparing its income to its assets
Return on Assets =
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
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Choosing a Benchmark
• Once you select and calculate the important ratios for a
firm, you must still find some way to judge whether the
results are high or low.
• Do this by comparing them to a benchmark.
• The simplest comparison is to the firm’s performance over the
past years.
• But you can also compare the numbers to those calculated for a
peer firm(s) or
• To the industry average (i.e. the average among all the firms within
an industry).
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Three practical benchmarks (using Price to earnings ratio as an
example):
• The subject stock’s historical price to earnings ratio.
• The price to earnings ratio of the peer’s stock
• The price to earnings ratio of the subject stock’s industry sector
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2.6 Financial Statement Analysis
• The DuPont Identity
• This expression says that ROE can be thought of as net income per dollar of
sales (profit margin) times the amount of sales per dollar of equity
 Net Income  Sales   Net Income 

Sales
ROE = 


 

Total
Equity
Sales
Sales
Total
Equity
 




(Eq. 2.26)
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2.6 Financial Statement Analysis
• The DuPont Identity
• This final expression says that ROE is equal to
• Net income per dollar of sales (profit margin) times
• Sales per dollar of assets (asset turnover) times
• Assets per dollar of equity (equity multiplier)
 Total Assets   Net Income 
Sales
Sales
 Net Income 
 Total Assets 
ROE = 




 


 Sales  Total Equity  Total Assets   Sales  Total Assets  Total Equity 
(Eq. 2.27)
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Example 2.8 DuPont Analysis
Problem:
• The following table contains information about Wal-Mart (WMT) and Nordstrom (JWN)
• Compute their respective ROEs and then determine how much Wal-Mart would need to increase
its profit margin in order to match Nordstrom’s ROE
Profit
Margin
Asset
Turnover
Equity
Multiplier
Wal-Mart
3.6%
2.3
2.7
Nordstrom
6.1%
1.5
4.2
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Example 2.8 DuPont Analysis (cont’d)
Solution:
Plan and Organize:
• The table contains all the relevant information to use the DuPont identity to compute the ROE
• We can compute the ROE of each company by multiplying its profit margin, asset turnover, and
equity multiplier
• In order to determine how much Wal-Mart would need to increase its profit margin to match
Nordstrom’s ROE, we can set Wal-Mart’s ROE equal to Nordstrom’s, keep its turnover and equity
multiplier fixed, and solve for the profit margin
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