Chapter 4: Analysis of Financial Statements
I. Ratio analysis
A. Analysis of financial statements can be used to predict future earnings and dividends
B. Analysis of financial statements is starting point for planning actions that will improve
future performance
C. Ratio analysis: Calculates and interprets financial ratios to analyze firm’s performance
II. The different types of ratios
A. Two liquidity ratios
1. Liquid asset =asset that can be converted to cash quickly without having to reduce
asset’s price very much
2. Liquidity ratios: ratios that show the relationship of a firm’s cash and other current
assets to its current liabilities
3. Current ratio
a. Indicates the extent to which current liabilities are covered by those assets expected
to be converted to cash in the near future
b. Formula:
current assets
current ratio =
cuurent liabilities
4. Quick Ratio or Acid Test Ratio
a. Inventories least liquid of firm’s current assets and are assets on which assets most
likely to occur in event of liquidation. Firm’s ability to pay-off short-term
obligations without relying on sale of inventories is important
b. Formula:
current assets - inventory
quick (acid-test) ratio =
current liabilities
B. Four asset management ratios
1. Asset management ratios = set of ratios that measure how effectively firm manages its
assets
2. Inventory turnover ratio
Sales
Inventory turnover ratio =
Inventory
3. Days sales outstanding (DSO) = average collection period = ACP
a. Indicates the average length of time the firm must wait after making a sale before it
receives cash
b. Formula:
Receivables
Receivables
DSO = days sales outstanding =
=
Average sales per day
Annual sales 365
4. Fixed assets turnover ratio
a. Measures how effectively the firm uses its plant and equipment
b. Formula:
Chapter 4: Analysis of Financial Statements
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fixed assets turnover ratio =
sales
net fixed assets
5. Total assets turnover ratio
total assets turnover ratio =
sales
total assets
C. Debt management ratios
1. Total debt to total assets
debt ratio =
total debt
total assets
2. Times-interest-earned (TIE) ratio
a. Measures firm’s ability to meet its annual interest payments
b. Formula
EBIT
times-interest-earned (TIE) ratio =
interest charges
3. EBITDA coverage ratio
a. Ratio whose numerator includes all cash flows available to meet fixed financial
charges and whose denominator includes all fixed financial charges
b. Formula:
EBITDA + lease payments
EBITDA coverage ratio =
interest + principal payments + lease payments
D. Four profitability ratios
1. Profitability ratios = group of ratios that show combined effects of liquidity, asset
management, and debt on operating results
2. Profit margin on sales
net income
profit margin on sales =
sales
3. Return on total assets (ROA)
net income
return on total assets = ROA =
total assets
4. Basic earning power (BEP) ratio
a. Ratio indicates the ability of firm’s assets to generate operating income
b. Formula
EBIT
basic earning power (BEP) ratio =
total assets
5. Return on common equity
a. Measures rate of return on common stockholders’ investment
b. Formula:
net income
return on common equity = ROE =
common equity
6. An important digression: The effect of leverage on ROE
a. The concept of leverage
i. Financial debt = use of debt financing
ii. Three important implications of using debt financing
Chapter 4: Analysis of Financial Statements
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● By raising funds through debt, stockholders can control a firm with limited
amount of equity investment
● The higher the proportion of total capital provided by stockholders, the less
risk faced by creditors.
● If firm earns more on its assets than the interest it pays on debt, then using
debt “leverages” or magnifies the return on equity (ROE)
b. Example: A leveraged and unleveraged firm
Current assets
Fixed assets
Total assets
Table 4-1: Effects of Financial Leverage on Stockholder Returns
FIRM U [UNLEVERAGED (NO DEBT)]
$50
Debt
50
Common Equity
$100
Total Liabilities & Equity
Sales Revenue
Operating costs
Fixed
Variable
Total operating costs
Operating Income (EBIT)
Interest (Rate = 10%)
Earnings before taxes (EBT)
Taxes (rate = 40%)
Net income
ROE
Current assets
Fixed assets
Total assets
Good
$150.0
45.0
60.0
105.0
$45.0
0.0
$45.0
18.0
$27.0
27.0%
$0
100
$100
Business Conditions
Expected
Bad
$100.0
$75.0
45.0
45.0
40.0
30.0
85.0
75.0
$15.0
$0.0
0.0
0.0
$15.0
$0.0
6.0
0.0
$9.0
$0.0
9.0%
0.0%
FIRM L [LEVERAGED (SOME DEBT)]
$50
Debt
50
Common Equity
$100
Total Liabilities & Equity
$50
50
$100
Sales Revenue
Operating costs
Fixed
Variable
Total operating costs
Operating Income (EBIT)
Interest (Rate = 10%)
Earnings before taxes (EBT)
Taxes (rate = 40%)
Net income
ROE
Chapter 4: Analysis of Financial Statements
Business Conditions
Good
Expected
Bad
$150.0
$100.0
$75.0
45.0
45.0
45.0
60.0
40.0
30.0
105.0
85.0
75.0
$45.0
$15.0
$0.0
5.0
5.0
5.0
$40.0
$10.0
-$5.0
16.0
4.0
0.0
$24.0
$6.0
-$5.0
48.0%
12.0%
-10.0%
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c. Results:
i. Because interest is deductible, use of debt lowers tax bill and leaves more of the
firm’s operating income available to investors
ii. Use of debt require firms to balance higher expected returns against increased
risk
E. Three market value ratios
1. Set of ratios that relate stock price to its earnings, cash flow and book value per share
2. Price/Earnings Ratio = P/E Ratio
a. Shows the dollar amount investors will pay for $1 of current earnings
b. Formula:
price per share
price/earnings (P/E) ratio =
earnings per share
3. Price/cash flow ratio
a. Shows the dollar amount investors will pay for $1 of cash flow
b. Formula:
price per share
price/cash flow =
cash flow per share
4. Market/Book Ratio
a. Book value per share:
common equity
book value per share =
shares outstanding
b. market/book ratio:
market price per share
market/book ratio = M/B =
book value per share
III. Book’s example of Allied Food Products
A. Review financial statements developed in Chapter 3: Tables 3 – 1, 3 – 2, 3 – 3, 3 – 4
Chapter 4: Analysis of Financial Statements
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TABLE 4-2: Allied Food Products: Summary of Financial Ratios (Millions of Dollars)
Liquidity Ratios
Ratio
Current Ratio
Quick
Formula
Calculation
current assets
cuurent liabilities
current assets - inventory
current liabilities
$1,000
= 3.2x
$310
$385
= 1.2x
$310
2004
Value
Industry
Average
Comment
3.7x
4.2x
Poor
1.8x
2.2x
Poor
Asset Management
Ratio
Formula
Calculation
2004
Value
Industry
Average
Comment
Inventory
Turnover
Sales
Inventory
$3,000
= 4.9x
$615
6.9x
10.9x
Poor
Days sales
outstanding
Receivables
Annual sales 365
$375
= 46 days
$8.2192
40.3 days
36 days
Poor
Fixed asset
turnover
sales
net fixed assets
$3,000
= 3.0x
$1,000
3.3x
2.8x
OK
Total assets
turnover
sales
total assets
$3,000
= 1.5x
$2,000
1.7x
1.8x
Somewhat
Low
Debt Management
Ratio
Formula
Calculation
2004
Value
Industry
Average
Comment
Total debt to
total assets
total debt
total assets
EBIT
interest charges
$1,060
= 53.0%
$2,000
47.6%
40.0%
High
(risky)
$283.8
= 3.2x
$88.0
4.4x
6.0x
Low
(risky)
3.5x
4.3x
Low
(risky)
Times-interest-earned
(TIE)
EBITDA + lease payments
$383.8 + $28
$411.8
EBITDA
=
= 3.0x
Coverage*
interest + principal payments + lease payments
$88 + $20 + $28
$136
*
Assumes lease payments = $28 million and principal payments = $20 million
Chapter 4: Analysis of Financial Statements
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TABLE 4-2 (Continued): Allied Food Products: Summary of Financial Ratios (Millions of Dollars)
Profitability
Ratio
Formula
Calculation
2004
Value
Industry
Average
Comment
Profit margin on sale
net income
sales
$117.5
= 3.9%
$3,000
4.3%
5.0%
Poor
Return on total asset
(ROA)
net income
total assets
$117.5
= 5.9%
$2,000
7.3%
9.0%
Poor
Basic earning power
(BEP)
EBIT
total assets
net income
common equity
$283.8
= 14.2%
$2,000
15.7%
18.0%
Poor
$117.5
= 12.5%
$940
13.8%
15.0%
Poor
Return on common equity
(ROE)
Market Value Ratios
Ratio
Formula
Calculation
2004
Value
Industry
Average
Comment
Price/earnings (P/E)
price per share
earnings per share
$23.00
= 9.8x
$2.35
10.7x
11.3x
Low
Price/cash flow
price per share
cash flow per share
$23.00
= 5.3x
$4.35
6.13x
5.4x
Low
Market/book (M/B)
market price per share
book value per share
$23.00
= 1.2x
$18.80
1.5x
1.7x
Low
IV. Benchmarking: cross-sectional and trend comparisons
A. Trend analysis
1. = analysis of a firm’s financial ratios over time
2. Used to estimate the likelihood of improvement or deterioration in its financial condition
B. Cross-sectional analysis: compare company’s financial ratios with a group of “benchmark” companies
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V. Tying ratios together: The Du Pont Equation
A. Basic Du Pont Equation
1. ROA is the product of the profit margin and the total asset turnover
2. Formula
Net Income
Net Income
Sales
ROA =


Total Assets
Sales
Total Assets
3. Book’s 2005 Allied Food Example
ROA = 3.9%  1.5 = 5.9%
B. ROA and ROE
1. If a company were financed only by common equity → no debt → no liabilities → assets
= equity
Net Inocme
Net Income
ROA =
=
= ROE
Total Assets
Common Equity
2. Define the equity multiplier
a. Definition:
Total Assets
Equity Multiplier =
Common Equity
b. Firms with more leverage → ↑ debt and ↓ equity → ↑ equity multiplier
c. Book’s 2005 Allied Food example: equity multiplier = ($2,000)/($940) = 2.13
3. Extended Du Pont equation
a. ROE =
Net Income
Sales
Total Assets


Sales
Total Assets Common Equity
b. ROE = (profit margin)  (total assets turnover)  (equity multipler)
c. Book’s 2005 Allied Food Example: ROE = (3.9%)(1.5)(2.13) = 12.5%
VI. Uses and limitations of ratio analysis
A. Comparison with industry averages more difficult for conglomerate firms that operate
many divisions in different industries
B. “Average” performance is not necessarily good → Perhaps firm should have higher goal
and focus on industry leader’s ratios → Benchmarking will help in this area
C. Inflation distorts balance sheets and income statements and comparisons of ratios across
time must be done with care
D. Seasonal factors can distort ratios
E. Firms may employ “window dressing techniques” to make their financial statements look
better than they really are
F. Different accounting and operating practices can distort comparisons of ratios
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G. It is difficult to determine whether a given ratio value is good or bad
1. A high current ratio may imply excellent liquidity (which is good) or excessive cash
(which is bad because it is a nonearning asset)
2. A high fixed asset turnover ratio may indicate a firm that uses its fixed assets efficiently
or a firm that is short cash and doesn’t have capital for needed investments
H. Some of the firm’s ratios may look strong while some of its ratios look poor
1. Makes it difficult to determine overall position of firm
2. Statistical methods (discriminate analysis) have been used to determine the net effect of
a set of ratios and determine which ones predict financial distress
VII.
Problems with ROE
A. ROE and shareholder wealth are positively correlated but problems can anise when ROE
is the sole measure of performance
B. Types of problems
1. ROE does not consider risk
2. ROE does not consider the amount of invested capital
3. Managers attempts to maximize ROE will ignore other profitable investments
Chapter 4: Analysis of Financial Statements
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