Analyzing Financial Statements
Chapter 3
Fin 325, Section 04 - Spring 2010
Washington State University
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Introduction
The real value of financial statements lies in the
fact that managers, investors, and analysts can use
the information in the statements to:
 Assess firm performance
 Plan changes to improve performance
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Ratio Analysis
 Ratios fall into five groups:
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Liquidity ratios
Asset management ratios
Debt management ratios
Profitability ratios
Market value ratios
 Using ratios to make two comparisons:
 Time Series Analysis – comparison to the same firm over
time (Trend)
 Cross Sectional Analysis – comparison to other firms in
the same industry (Competitors)
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Liquidity Ratios
 Liquidity ratios provide an indication of the ability
of the firm to meet its obligations as they come
due
 current ratio
Current Ratio = CA / CL
 quick (or acid-test) ratio
Quick Ratio = (CA – Inventory) / CL
 cash ratio
Cash Ratio = Cash / CL
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Liquidity Ratios for DPH
Current Ratio = CA / CL
Current Ratio = 205 / 120
Current Ratio = 1.71 times
 The industry average current ratio is 1.50
Quick Ratio = (CA – Inventory) / CL
Quick Ratio = (205 – 111) / 120
Quick Ratio = 0.78 times
 The industry average quick ratio is 0.50
Cash Ratio = Cash / CL
Cash Ratio = 24 / 120
Cash Ratio = 0.20 times
 The industry average cash ratio is 0.15
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 Based on all three measures, DPH has more
liquidity on its balance sheet than the industry
average
 The more liquid assets a firm holds, the more likely
the firm can pay its bills, so it has less liquidity risk.
 However, liquid assets do not generate profits for the
firm
 Managers must consider the tradeoff of lower
liquidity risk versus the disadvantages of reduced
profits
 Note that a firm with very predictable cash flows can
safely maintain lower levels of liquidity
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Asset Management Ratios
 Asset management ratios measure how efficiently
assets are being utilized
 Many of these ratios are focused on a specific
asset, such as inventory or accounts receivable
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 Inventory Management
 Inventory Turnover = Sales or COGS / Inventory
 Days’ Sales in Inventory = Inventory x 365 / Sales or COGS
 Accounts Receivable Management
 Average collection period (ACP) = Accounts receivable x
365 / Credit sales
 Accounts receivables turnover = Credit Sales / Accounts
Receivable
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 Accounts Payable Management
 Average payment period (APP) = Accounts payable x 365
/ COGS
 Accounts payable turnover = COGS / Accounts payable
 Fixed Asset and Working Capital Management
 Fixed asset turnover ratio = Sales / Fixed assets
 Sales to Working Capital ratio = Sales / Working capital
 Total Asset Management
 Total assets turnover ratio = Sales / Total assets
 Capital intensity ratio = Total assets / Sales
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Asset Management Ratios for DPH
Asset Management Ratio
Industry Average
Inventory Turnover = Sales / Inventory
Inventory Turnover = 315/ 111
Inventory Turnover = 2.84 times
2.15 times
Days’ Sales in Inventory = Inventory x 365 / Sales
Days’ Sales in Inventory = 111 x 365 / 315
Days’ Sales in Inventory = 129 days
1.70 days
Average collection period (ACP) = Accounts receivable
x 365 / Credit sales
ACP = 70 x 365 / 315
ACP = 81 days
95 days
Accounts receivables turnover = Credit Sales / Accounts 3.84 times
Receivable
Accounts receivables turnover = 315 / 70
Accounts receivables turnover = 4.50 times
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Average payment period (APP) = Accounts payable x 365 / COGS
APP = 55 x 365 / 150
APP = 134 days
102 days
Accounts payable turnover = COGS / Accounts payable
Accounts payable turnover = 150 / 55
Accounts payable turnover = 2.73 times
3.55 times
Fixed asset turnover ratio = Sales / Fixed assets
Fixed asset turnover ratio = 315 / 315
Fixed asset turnover ratio = 1.0
0.85 times
Sales to Working Capital ratio = Sales / Working capital
Sales to Working Capital ratio = 315 / 205-120
Sales to Working Capital ratio = 3.71 times
3.20 times
Total assets turnover ratio = Sales / Total assets
Total assets turnover ratio = 315 / 570
Total assets turnover ratio = 0.55 times
0.40 times
Capital intensity ratio = Total assets / Sales
Capital intensity ratio = 570 / 315
Capital intensity ratio = 1.81 times
2.50 times
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 In all cases DPH has better asset management
than the industry average
 Produces more sales per dollar of inventory
 Collects its accounts receivables faster
 Pays its accounts payables slower
 Produces more sales per dollar of fixed assets,
working capital, and total assets
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Debt Management Ratios
 Debt management ratios measure the extent to
which the firm uses debt (financial leverage)
versus equity to finance its assets
 There are two major types of debt management
ratios
 Ratios that measure the amount of debt
 Ratios that indicate the ability of the firm to service
its debt
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Debt vs. Equity Financing

Debt ratio = Total debt / Total assets

Debt-to-equity ratio = Total debt / Total equity

Equity multiplier ratio = Total assets / Total
equity
Equity multiplier =
1 / (1 – Debt ratio) = Debt-to-equity ratio +1
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 Coverage Ratios

Times interest earned = EBIT / Interest expense

Fixed charge coverage = Earnings available to meet
fixed charges / Fixed charges

Cash coverage ratio = (EBIT + Depreciation) / Fixed
charges
 These coverage measures can indicate whether a
firm has taken on a debt burden that is too large
 A value less than 1 means that the firm has less
than $1 of earnings or cash available to pay each
dollar of interest or fixed charges
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Profitability Ratios
 These ratios show the combined effect of liquidity,
asset management, and debt management on the
overall operating results of the firm
 These ratios are closely monitored by investors
 Stock prices react very quickly to unexpected
changes in these ratios
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Profitability Ratios
 Profit margin = Net income available to common stockholders /
Sales
 Basic earnings power ratio (BEP) = EBIT / Total assets
 Return on Assets (ROA) = Net income available to common
stockholders / Total Assets
 Return on Equity (ROE) = Net income available to common
stockholders / Common stockholders’ equity
 Dividend payout ratio = Common stock dividends / Net income
available to common stockholders
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Market Value Ratios
 While ROE is a very important financial statement
ratio, it doesn’t specifically incorporate risk.
 Market prices of publicly traded firms do
incorporate risk, and so ratios that incorporate
stock market values are important.
 Market values reflect what investors think of the
company’s future performance and risk
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 The Market-to-Book ratio measures the amount
that investors will pay for the firm’s stock per
dollar of equity used to finance the firm’s assets
Market-to-book ratio = Market price per share / Book value per
share
 Book value per share is an accounting-based
number reflecting historical costs
 This ratio compares the market (current) value of
the firm's equity to their historical costs.
 If liquidity, asset management, and accounting
profitability are good for a firm, then the market-tobook ratio will be high
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 The Price-Earnings ratio (P/E) is the best
known and most often quoted figure
Price-earnings ratio = Market price per share / Earnings per share
 Measures how much investors are willing to pay
for each dollar of earnings
 A high P/E ratio is often an indication of
anticipated growth

Stocks are classified as growth stocks or value stocks
based on the P/E ratio
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DuPont Analysis
 ROA and ROE can be broken down into
components in an effort to explain why they may
be low (or high).
 The Basic DuPont equation
ROA = Profit Margin x Total asset turnover
Net Income Net Income
Sales



Total Assets
Sales
Total Assets
The ROA depends on the firm’s profit margin (which is an indicator of
expense control) and total asset turnover, an indicator of how efficiently the
firm manages its assets
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 The full DuPont formula looks at the decomposition of
ROE:
ROE = Profit Margin x Total Asset Turnover x Equity Multiplier

Net Incom e
Com m onStockholders ' Equity
Net Incom e
Total Assets
Sales



Sales
Total Assets Com m onStockholders ' Equity
ROE = ROA x Equity Multiplier
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Other Ratios
 Spreading the Financial Statements
 Managers, analysts, and investors often create
“common size” financial statements
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Balance sheet items are divided by total assets
Income statement items are divided by sales
 Common size statements are conducive to:


Identifying trends for the firm
Comparisons across firms in the industry
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Internal Growth Rate
 The internal growth rate measures the amount of
growth a firm can sustain if it uses only internal
financing (retained earnings)
Internal growth rate = (ROA x RR) / [1-(ROA x RR)]


where RR = Retention Ratio
Retention ratio = 1 – Dividend Payout Ratio
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Sustainable Growth Rate
 The sustainable growth rate measures the
amount of growth a firm can achieve using
internal equity and maintaining a constant
debt ratio:
Sustainable growth rate = (ROE x RR) / [1-(ROE x RR)]
 Combining this with the DuPont equation, the
sustainable growth rate depends on four factors:
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Profit margin (operating efficiency)
Total asset turnover (efficiency in asset use)
Financial leverage (using debt vs. equity to finance assets)
Profit retention (reinvestment of NI rather paying
dividends)
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Cautions in Using Ratios
 Financial statement data are historical
 Firms use different accounting procedures

E.g. LIFO/FIFO, depreciation methods
 Non-U.S. firms do not necessarily comply with
GAAP
 Sales and expenses may be seasonal
Some items may be unusually high at the close of the
fiscal year
 Firms can use ‘window dressing’ to make
financial statement look better
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