Chapter 17
Financial Statement
Analysis
Topics Covered
Financial Ratios
DuPont System
Using Financial ratios
Measuring Company Performance
The Role of Financial Ratios
Financial Statements
 Income Statement - Financial statement that shows the
revenues, expenses, and net income of a firm over a period
of time.
 Common-Size Income - Statement Income statement that
presents items as a percentage of revenues.
 Balance Sheet - Financial statement that shows the value of
the firm’s assets and liabilities at a particular time.
 Common-Size Balance Sheet - Balance sheet that presents
items as a percentage of total assets.
Type of Financial Ratios
Leverage ratios show how heavily the company is
in debt.
Liquidity ratios measure how easily the firm can
lay its hands on cash.
Efficiency or turnover ratios measure how
productively the firm is using its assets.
Profitability ratios are used to measure the firm’s
return on its investments.
Financial Statements
 The use of fixed cost financing, either debt or preferred stock, is
called financial leverage.
 Financial leverage presents a debt/equity financing choice.
 Creditors, owners, and suppliers are interested in the extent to
which a firm has sought the tax-shielded benefits from financial
leverage producing debt.
 Leverage ratios are two types: balance sheet ratios comparing
leverage capital to total capital or total assets, and coverage ratios
which measure the earnings or cash-flow times coverage of fixed
cost obligations.
Leverage Ratios
The long-term debt ratio measures the proportion of the capital structure or total
capitalization that is made up of debt and lease obligations.
The higher the ratio the greater the use of financial leverage, posing the higher
risk/return situation for investors
long term debt
Long term debt ratio =
long term debt + equity
The debt to equity ratio measures the amount of long-term debt to equity or the
amount of leverage capital in relation to the equity cushion under the debt
Debt equity ratio =
long term debt
equity
Leverage Ratios
The total debt ratio measures total liabilities, current and long-term, relative to total
assets or the proportion of assets financed by debt
A coverage ratio, such as the times interest earned ratio, measures an amount
available relative to amount owed. How many times is the obligation covered?
The cash coverage ratio broadens the numerator to cash flow from operations
relative to the interest expenses
Liquidity Ratios
Liquidity ratios attempt to measure the ability to pay obligations
such as current liabilities and the pool of assets available to cover
the obligations.
Liquidity is the ability of an asset to be converted to cash quickly
at low cost.
Current assets (the pool of circulating cash assets available to be
allocated to pay bills) minus current liabilities(the pool of
obligations the business must pay in the near future) is an
analytical amount called net working capital (NWC). NWC is a
rough measure of the current assets left over if the current
liabilities were paid.
Liquidity Ratios
The NWC to total assets ratio estimates the proportion of assets in
net current assets, another name for NWC:
Net working capital
to total assets ratio
Net working capital
=
Total assets
The current ratio is the classic liquidity ratio, but is merely a variation of
the idea above—what pool of circulating assets is available relative to
the pool of current obligations
Current ratio =
current assets
current liabilities
Liquidity Ratios
Continuing the theme of assets available to pay obligations, the quick or acidtest ratio eliminates inventories, the least liquid current asset, from current
assets
The cash ratio eliminates inventories and accounts receivable from current
assets to review the cash assets relative to the current liabilities
Liquidity Ratios
The interval measure of liquidity measures the firm’s pool of
liquid, quick assets(above), to the daily expenditures from
operations and gives an estimate of the number of days’
obligations that are circulating in the quick assets. The more
days, the greater the ability to meet obligations
Efficiency Ratios
The asset turnover ratio measures the sales activity derived from total assets, or
the revenue generated per dollar of total assets. The asset turnover is also an
important component of asset profitability studied later, measuring the revenue
per dollar invested
Efficiency Ratios
The average collection period is the estimated number of days it
takes to collect accounts receivable
The inventory turnover ratio, measures the number of times the
value of inventory turns over in a period
Profitability Ratios
• Profitability refers to some measure of profit relative to revenue
or an amount invested.
The net profit margin measures the proportion of sales revenue
that is profit available for sources of funds (EBIT-tax).
net income
Net profit margin =
sales
Operating profit margin =
net income  interest
sales
Profitability Ratios
A good performance ratio is the return on total assets (current
and fixed), or the EBIT - tax earned per dollar of average assets
Net Income  Interest
Return on assets =
average total assets
The return on equity measures the profitability of the common
stockholder’s equity or return per dollar of invested equity capital
net income - preffered dividends
Return on equity =
average equity
Profitability Ratios
The proportion of earnings that is paid out as dividends is called the
payout ratio
Payout ratio =
dividends
earnings
earnings - dividends
earnings
= 1 - payout ratio
Plowback ratio =
The plowback ratio times the return on equity (ROE) is an estimate of the
growth rate in common equity from internally generated earnings, or the
sustainable growth rate in assets that the business can support from internal
earnings without changing the total debt/total asset ratio
Growth in equity from plowback =
earnings - dividends
earnings
Market Value Ratios
stock price
PE Ratio =
earnings per share
P0
Div1
1
Forecasted PE ratio =

x
avg EPS1 EPS 1 r - g
dividend per share
Dividend yield =
stock price
Market Value Ratios
Price per share = P0
Div 1
=
r - g
stock price
Market to book ratio =
book value per share
Tobins Q =
market value of assets
estimated replcement cost
The DuPont System
A breakdown of ROE and ROA into
component ratios
Net Income  interest
ROA =
assets
earnings available for common stock
ROE =
equity
The DuPont System
sales Net Income  interest
ROA =
x
assets
sales
asset
turnover
Operating profit
margin
The DuPont System
ROE =
assets sales Net Income  interest
Net Income
x
x
x
equity assets
sales
Net Income  interest
leverage asset
ratio turnover
Operating
profit
margin
debt
burden
Using Financial Ratios
Industry
All manufacturing
Food products
Textiles
Petroleum/coal
Chemicals
Drugs
Machinery
Computers/electronic
Transportation equip.
Beverages/tobacco
LT Debt,
Assets
0.19
0.28
0.23
0.15
0.19
0.25
0.19
0.11
0.17
0.28
Interest
Coverage
4.13
3.65
2.92
3.64
4.27
9.44
4.64
4.52
2.22
5.25
NWC
Assets
0.07
0.09
0.20
0.04
0.02
0.13
0.14
0.01
–0.02
Quick
Asset
Ratio Turnover
0.91
0.81
0.92
1.00
0.72
0.76
1.02
1.31
0.72
0.70
0.93
1.37
1.47
1.34
0.59
0.87
0.89
0.66
0.94
0.63
Oper Prof.
Margin (%)
6.88
6.20
4.35
3.31
10.37
13.53
8.04
5.30
3.94
14.76
Return on
Assets (%)
Return on
Equity (%)
6.37
8.50
6.39
4.45
6.13
11.72
7.19
3.52
3.69
9.24
15.76
17.80
8.39
18.14
7.31
59.14
14.82
10.06
13.12
27.62
Source: U.S. Department of Commerce, Quarterly Financial Report for Manufacturing, Mining and Trade Corporations, December 2004.
Payout
Ratio
0.31
0.36
0.23
0.25
0.33
0.29
0.17
0.20
0.30
0.51
MVA & Economic Profit
Market Value Added = The difference
between the market value of common stock
and its book value
Economic Profit = capital invested
multiplied by the spread between return on
investment and the cost of capital.
EP  Economic Profit
 ( ROI  r )  Capital Invested
Residual Income & EVA
Residual Income or EVA = Net Dollar return
after deducting the cost of capital
EVA  Residual Income
 Income Earned - income required
 Income Earned - Cost of Capital  Investment
© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
Measuring Performance
Benchmark Financial Ratios
Company
Valuation Ratios
P/E ratio (TTM)
Price to book (MRQ)
Price to cash flow (TTM)
Financial Strength
Quick ratio (MRQ)
Current ratio (MRQ)
LT debt to equity (MRQ)
Total debt to equity (MRQ)
Interest coverage (TTM)
Profitability Ratios (%)
Operating margin (TTM)
Net profit margin (TTM)
Management Effectiveness (%)
Return on assets (TTM)
Return on equity (TTM)
Efficiency
Receivable turnover (TTM)
Inventory turnover (TTM)
Asset turnover (TTM)
Industry
Sector
S&P 500
22.35
6.68
17.17
21.66
6.25
16.85
20.66
7.25
17.19
22.06
4.04
15.93
0.95
1.28
0.18
0.26
31.49
0.87
1.19
0.31
0.54
29.74
0.65
1.26
0.77
0.97
17.14
1.21
1.71
0.6
0.76
12.59
17.97
14.27
20.91
17.01
17.02
11.49
21.97
14.03
15.88
32.84
14.96
31.06
11.31
33.28
7.63
20
9.37
8.67
1.11
10.08
7.49
0.92
13.39
6.75
1.09
10.26
13.29
0.96
Ratios PEPSICO INC (NYS)
Sector: Consumer/Noncyclical | Industry: Beverages (nonalcoholic)
Measuring Performance
Market to
Book Ratio
MVA
($millions)
Return on
Cost of
Capital (%) Capital (%)
Year avergae
capital
($million)
EVA
($million)
Microsoft
7.40
204,168.00
32.90
11.70
31,090.00
6,456.00
Wal-Mart
2.90
169,927.00
13.20
6.20
86,822.00
5,920.00
Johnson & Johnson
3.40
135,584.00
18.10
8.20
57,833.00
5,682.00
Intel
4.00
98,189.00
18.60
13.70
32,394.00
1,645.00
Coca-Cola
4.80
83,080.00
21.30
6.40
21,166.00
3,116.00
IBM
2.20
79,894.00
9.00
11.20
67,369.00
–1,506
Merck
2.10
37,921.00
17.90
8.00
36,887.00
3,705.00
Dow Chemical
1.00
25,403.00
5.90
6.50
44,639.00
–299
Delta Air Lines
1.00
4,090.00
–1.0
–6.7
27,888.00
–2,155
Note: Economic value added is the rate of return on capital less the cost of capital times the amount of capital invested; e.g., for Microsoft, EVA = (.329 –
.177) × $204,168 million
Source: Data provided by Stern Stewart & Co.
Financial Ratios and Default Risk
Three-Year (1998–2000) Medians
Operating income/sales (%)
Free cash flow/sales (%)
EBITDA int. + div. coverage
Total liabilities/net worth (%)
EBITDA/total assets (%)
Total debt/market capitalization (%)
Historical default rate (%)
AAA
AA
A
BBB
BB
B
CCC
24.6
14.8
4
70.3
22.2
0
0.5
23.4
123.6
21.2
8.1
1.3
138.8
16.3
17.2
2.3
14.7
5.6
4.5
152.6
13.7
27.5
6.6
15.9
3.9
3
198.7
12.9
43.5
19.5
13.9
10.9
3.9
18.1
7.8
4.11
9.4
-0.9
1
-208.3
6.9
79.7
54.4
Note: EBITDA is earnings before interest, taxes, depreciation, and amortization.
Sources: Default rates from “Statement of Standard & Poor’s on Credit Rating Agencies to SEC,” Public Hearing, November
2002; all other data from Standard & Poor’s.
1.3
1.7
206.9
10.3
55.8
35.8