Financial Statement
Analysis
Assoc.Prof. Oktay Taş
Dr. Kaya Tokmakçıoğlu
What is Financial Analysis
• Financial analysis is the selection, evaluation,
and interpretation of financial data and other
pertinent data.
• The financial analysts must determine which
information is needed and how to use it.
Financial Analysis-Information
• Aside from financial data, other information is
necessary in the prediction of future financial
condition or operating performance of a firm.
• Examples: gross domestic product, the
consumer price index, purchasing price index,
rate of inflation, and corporate specific events
(e.g., mergers, patents, industry of buss.)
Purpose of Analysis
Financial statement analysis helps users
make better decisions.
Internal Users
Managers
Officers
Internal Auditors
External Users
Shareholders
Lenders
Customers
Purpose of Analysis
Financial measures are often used
to rank corporate performance.
Example measures include:
Growth
in sales
Return to
stockholders
Profit
margins
Determined by
analyzing the
financial
statements.
Return on
equity
What do we need for the Financial
Statement Analysis?
–
–
–
–
–
Financial statements
Notes to Financial Statements.
The definition of accounting methods
Auditing reports
5-10 years financial information
Financial Statements Are Designed
for Analysis
Classified
Financial
Statements
Comparative
Financial
Statements
Consolidated
Financial
Statements
Items with certain
characteristics are
grouped together.
Amounts from
several years
appear side by side.
Information for the
parent and subsidiary
are presented.
Results
in standardized,
meaningful
subtotals.
Helps identify
significant
changes and
trends.
Presented as if
the two companies
are a single
business unit.
Tools of Analysis
Dollar &
Percentage
Changes
Trend
Percentages
Component
Percentages
Ratios
Horizontal Analysis
Sales
Expense
Net Income
2002
41,500
40,000
1,500
2001
37,850
36,900
950
Increase/(Decrease)
Amount Percent
3,650
9.6%
3,100
8.4%
550
57.9%
Horizontal Analysis
Sales
2002
$41,500
2001 Difference
$37,850 $3,650
$3,650 ÷ $37,850 = .0964, or 9.6%
Dollar and Percentage Changes
Dollar Change:
Dollar
Change
=
Analysis Period
Amount
–
Base Period
Amount
Percentage Change:
%
Percent
Change
=
Dollar Change
÷
Base Period
Amount
Dollar and Percentage Changes
Evaluating Percentage Changes
in Sales and Earnings
Sales and earnings
should increase at
more that the rate
of inflation.
In measuring quarterly
changes, compare to
the same quarter in
the previous year.
Percentages may be
misleading when the
base amount is small.
Dollar and Percentage Changes
Let’s look at the asset section of Clover,
Inc. comparative balance sheet and
income statement for 2005 and 2004.
Compute the dollar change and the percentage
change for cash.
Clover, Inc.
Comparative Balance Sheets
December 31,
2005
Assets
Current assets:
Cash and equivalents
$ 12,000
Accounts receivable, net
60,000
Inventory
80,000
Prepaid expenses
3,000
Total current assets
$ 155,000
Property and equipment:
Land
40,000
Buildings and equipment, net
120,000
Total property and equipment $ 160,000
Total assets
$ 315,000
* Percent rounded to one decimal point.
2004
$ 23,500
40,000
100,000
1,200
$ 164,700
40,000
85,000
$ 125,000
$ 289,700
Dollar
Change
Percent
Change*
?
?
Clover, Inc.
Comparative Balance Sheets
December 31,
2005
Assets
Current assets:
Cash and equivalents
$ 12,000
Accounts receivable, net
60,000
Inventory
80,000
Prepaid expenses
3,000
$12,000
Total current assets
$ 155,000–
Property and equipment:
Land
40,000
Buildings and equipment, net
120,000
Total property and equipment $ 160,000
Total assets
$ 315,000
* Percent rounded to one decimal point.
2004
Dollar
Change
$ 23,500 $ (11,500)
40,000
100,000
1,200
$23,500
$ 164,700 = $(11,500)
40,000
85,000
$ 125,000
$ 289,700
Percent
Change*
?
Clover, Inc.
Comparative Balance Sheets
December 31,
2005
2004
Dollar
Change
Percent
Change*
Assets
Current assets:
Cash and equivalents
$ 12,000 $ 23,500 $ (11,500)
-48.9%
Accounts receivable, net
60,000
40,000
Inventory
80,000
100,000
Prepaid expenses
3,000
1,200
($11,500
÷ $23,500)
× 100% = 48.94%
Total current assets
$ 155,000
$ 164,700
Property and equipment:
Land
40,000
40,000
Complete the
Buildings and equipment, net
120,000
85,000
analysis for
Total property and equipment $ 160,000 $ 125,000
the other
Total assets
$ 315,000 $ 289,700
assets.
* Percent rounded to one decimal point.
Clover, Inc.
Comparative Balance Sheets
December 31,
2005
Assets
Current assets:
Cash and equivalents
$ 12,000
Accounts receivable, net
60,000
Inventory
80,000
Prepaid expenses
3,000
Total current assets
$ 155,000
Property and equipment:
Land
40,000
Buildings and equipment, net
120,000
Total property and equipment $ 160,000
Total assets
$ 315,000
* Percent rounded to one decimal point.
2004
Dollar
Change
Percent
Change*
$ 23,500 $
40,000
100,000
1,200
$ 164,700
(11,500)
20,000
(20,000)
1,800
(9,700)
-48.9%
50.0%
-20.0%
150.0%
-5.9%
40,000
85,000
$ 125,000
$ 289,700 $
35,000
35,000
25,300
0.0%
41.2%
28.0%
8.7%
Interpretation of Items
•
•
•
•
•
•
•
Current assets-current liabilities
Curent assets- plant assets
Plant assets – L-T Debts
Plant assets – Equity
Total Debt – Equity
Current Liab. – Total Sources
L-T Debts – Total Sources
Intrepretation of Items
•
•
•
•
•
•
•
Accounts recbl.- Accounts payable
Accounts receivable – Sales
Inventory – Sales
Sales – COGS
Sales – Gross Profit
Sales – Operating Income
Sales – Net Income
Trend Analysis
– are computed by selecting a base year
whose amounts are set equal to 100%.
• The amounts of each following year are
expressed as a percentage of the base
amount.
Trend % = Any year $ ÷ Base year $
Trend Percentages
Year
2000
Revenues
$27,611
Cost of sales
15,318
Gross profit
$12,293
1998 is the base year.
1999
$24,215
14,709
$ 9,506
What are the trend percentages?
1998
$21,718
13,049
$ 8,669
Trend Percentages
Year
Revenues
Cost of sales
Gross profit
2000
127%
117%
142%
1999
111%
113%
110%
1998
100%
100%
100%
These percentages were calculated by
dividing each item by the base year.
Trend Analysis
Trend analysis is used to reveal patterns in data
covering successive periods.
Trend
Analysis Period Amount
=
Percent
Base Period Amount
×100%
Trend Analysis
Berry Products
Income Information
For the Years Ended December 31,
Item
Revenues
Cost of sales
Gross profit
Item
Revenues
Cost of sales
Gross profit
2005
$ 400,000
285,000
115,000
2004
$ 355,000
250,000
105,000
2003
$ 320,000
225,000
95,000
2002
$ 290,000
198,000
92,000
2004
2004
2003
2002
2001
base period
its
145%is the129%
116% so 105%
150%
118%
amounts132%
will equal
100%.104%
135%
124%
112%
108%
(290,000  275,000)
(198,000  190,000)
(92,000  85,000)



100% = 105%
100% = 104%
100% = 108%
2001
$ 275,000
190,000
85,000
2001
100%
100%
100%
Component Percentages
Examine the relative size of each item in the financial
statements by computing component
(or common-sized) percentages.
Component
Percent
=
Analysis Amount
Base Amount
Financial Statement
Balance Sheet
Income Statement
× 100%
Base Amount
Total Assets
Revenues
Clover, inc.
Comparative Balance Sheets
December 31,
Complete the common-size analysis for the other
assets.
2005
2004
Common-size
Percents*
2005
2004
Assets
Current assets:
Cash and equivalents
$ 12,000 $ 23,500
3.8%
8.1%
Accounts receivable, net
60,000
40,000
Inventory
80,000
100,000
Prepaid expenses
3,000
1,200
($12,000 ÷ $315,000)
= 3.8%
Total current assets
$ 155,000×$100%
164,700
Property and equipment:
($23,500 40,000
÷ $289,700)
× 100% = 8.1%
Land
40,000
Buildings and equipment, net
120,000
85,000
Total property and equipment $ 160,000 $ 125,000
Total assets
$ 315,000 $ 289,700
100.0% 100.0%
* Percent rounded to first decimal point.
Clover, Inc.
Comparative Balance Sheets
December 31,
2005
Assets
Current assets:
Cash and equivalents
$ 12,000
Accounts receivable, net
60,000
Inventory
80,000
Prepaid expenses
3,000
Total current assets
$ 155,000
Property and equipment:
Land
40,000
Buildings and equipment, net
120,000
Total property and equipment $ 160,000
Total assets
$ 315,000
* Percent rounded to first decimal point.
2004
Common-size
Percents*
2005
2004
$ 23,500
40,000
100,000
1,200
$ 164,700
3.8%
19.0%
25.4%
1.0%
49.2%
8.1%
13.8%
34.6%
0.4%
56.9%
40,000
85,000
$ 125,000
$ 289,700
12.7%
38.1%
50.8%
100.0%
13.8%
29.3%
43.1%
100.0%
Clover, Inc.
Comparative Balance Sheets
December 31,
2005
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable
Notes payable
Total current liabilities
Long-term liabilities:
Bonds payable, 8%
Total liabilities
Shareholders' equity:
Preferred stock
Common stock
Additional paid-in capital
Total paid-in capital
Retained earnings
Total shareholders' equity
Total liabilities and shareholders' equity
* Percent rounded to first decimal point.
2004
Common-size
Percents*
2005
2004
$ 67,000 $ 44,000
3,000
6,000
$ 70,000 $ 50,000
21.3%
1.0%
22.3%
15.2%
2.1%
17.3%
75,000
$ 145,000
80,000
$ 130,000
23.8%
46.1%
27.6%
44.9%
20,000
20,000
60,000
60,000
10,000
10,000
$ 90,000 $ 90,000
80,000
69,700
$ 170,000 $ 159,700
$ 315,000 $ 289,700
6.3%
19.0%
3.2%
28.5%
25.4%
53.9%
100.0%
6.9%
20.6%
3.5%
31.1%
24.1%
55.1%
100.0%
Clover, Inc.
Comparative Income Statements
For the Years Ended December 31,
Common-size
Percents*
2005
2004
2005
2004
Revenues
$ 520,000 $ 480,000
100.0% 100.0%
Costs and expenses:
Cost of sales
360,000
315,000
69.2%
65.6%
Selling and admin.
128,600
126,000
24.7%
26.3%
Interest expense
6,400
7,000
1.2%
1.5%
Income before taxes
$ 25,000 $ 32,000
4.8%
6.7%
Income taxes (30%)
7,500
9,600
1.4%
2.0%
Net income
$ 17,500 $ 22,400
3.4%
4.7%
Net income per share
$
0.79 $
1.01
Avg. # common shares
22,200
22,200
* Rounded to first decimal point.
Ratios
• Ratios are simply relationships between two
financial balances or financial calculations. These
relationships establish our references so we can
understand how well we are performing
financially. Ratios also extend our traditional way
of measuring financial performance; i.e. relying on
financial statements. By applying ratios to a set of
financial statements, we can better understand
financial performance.
Ratios
A ratio is a simple mathematical expression
of the relationship between one item and another.
Along with dollar and percentage changes,
trend percentages, and component percentages,
ratios can be used to compare:
Past performance to
present performance.
Other companies to
your company.
Why are ratios useful
• Ratios standardize numbers and facilitate
comparisons.
• Ratios are used to highlight weaknesses and
strengths.
How can we use ratios?
• Compare with previous ratios
• Compare with standards (average is found
by the academicans, analysts e.g.)
• Compare with industrial average.
What are the five major categories of
ratios, and what questions do they
answer?
• Liquidity ratios: Can we make required payments?
• Activity ratios Asset management: right amount of
assets vs. sales?
• Debt management ratios (leverage Ratios): Right
mix of debt and equity?
• Profitability: Do sales prices exceed unit costs,
and are sales high enough as reflected in PM,
ROE, and ROA?
• Market value: Do investors like what they see as
reflected in P/E and M/B ratios?
Type of ratios
• Liquidity ratios provide information on
a firm's ability to meet its short-term
obligations.
• Activity ratios relate information on a
firm's ability to manage its resources
(that is, its assets) efficiently.
Type of ratios
• Financial leverage ratios provide
information on the degree of a firm's fixed
financing obligations and its ability to
satisfy these financing obligations.
• Profitability ratios provide information
on the amount of income from each
dollar of sales.
Type of ratios
• Return on investment ratios provide
information on the amount of profit,
relative to the assets employed to
produce that profit.
• Shareholder ratios describe the firm's
financial condition in terms of amounts per
share of stock.
Liquidity Ratios
Liquidity Ratios help us understand if we can meet our
obligations over the short-run. Higher liquidity levels indicate that
we can easily meet our current obligations. We can use several
types of ratios to monitor liquidity.
Let’s see if they can cover their shortterm obligations …
Liquidity ratios
• The current ratio is the ratio of current assets
to current liabilities; indicates a firm's ability
to satisfy its current liabilities with its current
assets.
• Quick ratio is the ratio of quick assets
(generally current assets less inventory) to
current liabilities; indicates a firm's ability to
satisfy current liabilities with its most liquid
assets.
Current ratio
current assets
Current ratio=
current liabilities
Example:
If current assets are $5 million and current
liabilities are $2 million,
Current ratio =
$5 / $2
=
2.5
Comments on current ratio
Current
ratio
2003
2002
2001
Ind.
2.34x
1.20x
2.30x
2.70x
• Expected to improve but still below the
industry average.
• Liquidity position is weak.
Quick ratio
current assets  inventory
Quick ratio 
current liabilities
Also referred to as the acid test ratio
or liquidity ratio
Liquidity ratios: example
Suppose the firm has the following:
Cash
Accounts receivables
Inventory
Accounts payable
a.
b.
$ 5
16
20
12
What is the firm’s current ratio?
What is the firm’s quick ratio?
Liquidity ratios: example, cont.
Cash
$ 5
Accounts receivables 16
Inventory
20
Accounts payable
12
a. What is the firm’s current ratio?
Current ratio = ($5 + 16 + 20) / $12 = 3.42
b.What is the firm’s quick ratio?
Quick ratio = ($5 + 16) / $12 = 1.75
Nike
Working capital, 2002, in millions
Cash and cash equivalents
Receivables
$ 575.5
1,621.1
Inventory
Other
Total current assets
1,373.8
275.8
$4,157.7
Accounts payable
Debts due
$ 504.4
480.5
Other
Total current liabilities
851.3
$1,836.2
Source: Nike Annual Reports, various years
Problem
• Suppose a company has a current ratio of
1.5 and a quick ratio of 0.8. If its current
liabilities are $2 million, what is its
inventory?
Activity ratios
But are they any good at this stuff?
Activity ratios
• Accounts receivable turnover is the ratio
of net credit sales to accounts receivable.
• Indicates how many times in the period
credit sales have been created and collected.
A/R Turnover Ratio
• Accounts Receivable Turnover measures the number of
times we were able to convert our receivables over into
cash. Higher turnover ratios are desirable.
•Net Sales / Average Accounts Receivable
•Avrg. accounts receivable = (Beg.A/R + End. A/R) / 2
If there is only one year of information can be calculated as follows:
A/R turnover =
credit sales
 ..times
accounts receivable s
A/R Turnover Ratio
• EXAMPLE — Sales are $ 480,000, the average
receivable balance during the year was $ 40,000 and
we have a $ 20,000 allowance for sales returns.
Accounts Receivable Turnover is ($ 480,000 - $
20,000) / $ 40,000 or 11.5. We were able to turn our
receivables over 11.5 times during the year.
• NOTE — We are assuming that all of our sales are
credit sales; i.e. we do not have any significant cash
sales.
Number of Days in Accounts
Receivable
• The Number of Days in Accounts Receivable is the average
length of time required to collect our receivables. A low
number of days is desirable. Days in Accounts Receivable is
calculated as follows:
365 or 360 / Accounts Receivable Turnover Ratio
• EXAMPLE — If we refer to our previous example and we
base our calculation on the full calendar year, we would
require 32 days on average to collect our receivables. 365 /
11.5 = 32 days.
Inventory Turnover Ratio
•Inventory Turnover is similar to accounts receivable turnover.
We are measuring how many times did we turn our inventory
over during the year. Higher turnover rates are desirable. A high
turnover rate implies that management does not hold onto excess
inventories and our inventories are highly marketable. Inventory
Turnover is calculated as follows:
Cost of Sales / Average Inventory
Avrg.Inventory = (Beg.Inventory + End.Inventory) / 2
EXAMPLE — Cost of Sales were $ 192,000 and the average inventory
balance during the year was $ 120,000. The Inventory Turnover Rate is 1.6 or
we were able to turn our inventory over 1.6 times during the year.
Inventory Turnover Ratio
• Days in Inventory is the average number of days we held our
inventory before a sale. A low number of inventory days is
desirable. A high number of days implies that management is
unable to sell existing inventory stocks. Days in Inventory is
calculated as follows:
• Inv.Turnover Ratio=365 or 360 / Inventory Turnover
EXAMPLE — If we refer back to the previous example and
we use the entire calendar year for measuring inventory, then
on average we are holding our inventories 228 days before a
sale. 365 / 1.6 = 228 days.
Activity ratios, continued.
• Total asset turnover is the ratio of sales to
total assets; indicates the extent that the
investment in total assets results in sales.
• Fixed asset turnover is the ratio of sales to
fixed assets; indicates the ability of the
firm's management to put the fixed assets to
work to generate sales.
Capital Turnover
Capital Turnover measures our ability to turn capital over into
sales. Remember, we have two sources of capital: Debt and
Equity. Capital Turnover is calculated as follows:
Net Sales / Interest Bearing Debt + Shareholders Equity
EXAMPLE — Net Sales are $ 460,000, we have $ 50,000 in Debt
and $ 200,000 of Equity. Capital Turnover is $ 460,000 / ($
50,000 + $ 200,000) = 1.84. For each $ 1.00 of capital invested
(both debt and equity), we are able to generate $ 1.84 in sales.
Turnover examples
Company
Nike (NKE)
Total asset turnover
for 2001
1.5355 times
Skechers (SKX)
2.3569 times
Timberland (TBO)
2.3456 times
Source: Companies’ respective annual reports
The operating cycle
• The operating cycle is the length of time it
takes to turn the investment of cash in
inventory back into cash.
• The longer the operating cycle, the greater
the need for liquid assets.
• The operating cycle is the sum of:
 Number of days of inventory
 Number of days of receivables
The operating cycle
• Now that we have calculated the number of days for receivables
and the number of days for inventory, we can estimate our
operating cycle. Operating Cycle = Number of Days in
Receivables + Number of Days in Inventory. In our previous
examples, this would be 32 + 228 = 260 days. So on average, it
takes us 260 days to generate cash from our current assets.
• If we look back at our Current Ratio, we found that we had 2.5
times more current assets than current liabilities. We now want to
compare our Current Ratio to our Operating Cycle.
• Our turnover within the Operating Cycle is 365 / 260 or 1.40.
This is lower than our Current Ratio of 2.5. This indicates that we
have additional assets to cover the turnover of current assets into
cash. If our current ratio were below that of the Operating Cycle
Turnover Rate, this would imply that we do not have sufficient
current assets to cover current liabilities within the Operating
Cycle. We may have to borrow short-term to pay our expenses.
The number of days inventory
• The number of days inventory
= inventory / avg. day’s cost of goods
sold
• This the number of days a company could
go without adding inventory until they
deplete inventory.
The number of days receivable
• The number of days receivable
= accounts receivable / average day’s credit
• This is the number of days it takes to collect
on credit accounts.
Net operating cycle
• The net operating cycle is the number of
days it takes to turn the investment in
inventory into cash, considering that
purchases are acquired with credit.
• The number of days payables
= accounts payable / average day’s
purchases
Net operating cycle, continued
+

Number of days inventory
Number of days receivable
Number of days payables
Net operating cycle
Example
Number of days
…
Inventory
Receivables
Payables
Net operating
cycle
General Electric
2002
41.4 days
148.9 days
93.7 days
96.6 days
Financial leverage ratios
But can they handle their debt load?
Leverage Ratios measure the use of debt
and equity for financing of assets.
Financial leverage ratios
• The debt to assets ratio indicates the
proportion of assets that are financed with
debt (both short-term and long-term debt).
• The debt to equity ratio indicates the
relative uses of debt and equity as sources
of capital to finance the firm's assets,
evaluated using book values of the capital
sources.
Debt to Equity Ratios
• Debt to Equity is the ratio of Total Debt to Total Equity. It
compares the funds provided by creditors to the funds
provided by shareholders. As more debt is used, the Debt to
Equity Ratio will increase. Since we incur more fixed interest
obligations with debt, risk increases. On the other hand, the
use of debt can help improve earnings since we get to deduct
interest expense on the tax return. So we want to balance the
use of debt and equity such that we maximize our profits, but
at the same time manage our risk. The Debt to Equity Ratio is
calculated as follows:
• Total Liabilities / Shareholders Equity
Debt to Equity Ratios
• Total Liabilities / Shareholders Equity
• EXAMPLE — We have total liabilities of $ 75,000 and
total shareholders equity of $ 200,000. The Debt to Equity
Ratio is 37.5%, $ 75,000 / $ 200,000 = .375. When
compared to our equity resources, 37.5% of our resources
are in the form of debt.
• KEY POINT — As a general rule, it is advantageous to
increase our use of debt (trading on the equity) if earnings
from borrowed funds exceeds the costs of borrowing.
Times Interest Earned
• Times Interest Earned is the number of times our
earnings (before interest and taxes) covers our
interest expense. It represents our margin of safety
in making fixed interest payments. A high ratio is
desirable from both creditors and management.
Times Interest Earned is calculated as follows:
• Earnings Before Interest and Taxes /
Interest Expense
Times Interest Earned
• The interest coverage ratio indicates the
firm's ability to satisfy interest obligations
on its debt.
• Also known as the times-interest-earned
ratio.
EBIT
Interest coverage =
interest expense
Financial leverage examples
Debt-to-assets
Nike (NKE)
40.41%
July,2002
Skechers (SKX)
51.16%
December, 2001
Timberland
40.47%
(TBL)
December,
2001
Source: Data from Yahoo! Finance
Debt-toequity
67.82%
104.75%
67.97%
Profitability ratios
But can they make any money doing
this stuff?
Gross profit margin
• Gross profit margin: the ratio of gross
profit to sales.
• Indicates how much of every dollar of sales
is left after costs of goods sold.
Gross profit margin
gross profit
=
sales
Operating profit margin
• Operating profit margin: the ratio of
operating profit (EBIT) to sales.
• Indicates how much of each dollar of sales
is left over after operating expenses.
operating profit
Operating profit margin =
sales
Net profit margin
• Net profit margin: the ratio of net income
to sales.
• Indicates how much of each dollar of sales
is left over after all expenses are paid.
Net profit margin
net profit
=
sales
IBM’s 2002 Income statement
in millions
Revenues
Less: Total costs
Gross profit
Less: Operating expenses
Operating income
Add: Other income
Less: Interest expense
Income before income taxes
Less: Provision for income taxes
Net income
Source: IBM 2002 Annual Report
$88,396
55,972
$32,424
20,790
$11,634
617
717
$11,534
3,441
$8,093
Profitability ratios: IBM in
2002
Gross profit margin
= $32,424 / $88,396
Operating profit margin
= $12,251 / $88,396
Net profit margin
= $8,093 / $88,396 =
=
36.68%
=
13.86%
9.16%
K Mart
Income Statement, 1/31/2001 in millions
Net revenues
$37,028
Less: Cost of revenues
29,658
Gross profit
$7,370
Less: Operating expenses
7,461
Operating income
-$91
Less: Interest expense
287
Add: Taxes (carryover)
134
Net income
-$244
Source: Kmart 10-K Report
Return on investment
Hey, what’s the bottom line?
Return on investment ratios
• Basic earning power ratio is a measure of the
operating income resulting from the firm's
investment in total assets.
Basic earning power = EBIT / Total assets
• Return on assets indicates the firm's net profit
generated per dollar invested in total assets.
Return on assets = Net profit / Total assets
Return on investment
• Return on equity is the profit generated
per dollar of shareholders' investment (i.e.,
shareholders' equity).
net profit
Return on equity =
book value of equity
Coming attractions
• Return on investment ratios & the Du Pont
system
• Shareholder ratios
• Common size analysis
• Effective use of financial analysis
Market Value (Shareholder)
Ratios
The view of the firm from the
perspective of the owners, investor
and general public …
Market Value (Shareholder)
Ratios
These ratios attempt to measure the economic status
of the organization within the marketplace.
Investors use these ratios to evaluate and monitor
the progress of their investments.
Market Value Ratios
• Earnings per share (EPS) is the amount of
income earned during a period per share of
common stock.
• Basic EPS & Diluted EPS
• Book value equity per share is the amount of
the book value of common equity per share of
stock.
• The price-earnings ratio (P/E or PE ratio) is
the ratio of the price per share of stock to the
earnings per share of stock.
Market Value Ratios, continued
• Dividends per share (DPS) is the dollar
amount of cash dividends paid during a
period, per share of common stock.
• The dividend payout ratio is the ratio of
cash dividends paid to earnings for a period.
Dividend payout ratio = DPS / EPS
Earning Per Share
• Growth in earnings is often monitored with Earnings per
Share (EPS). The EPS expresses the earnings of a company
on a "per share" basis. A high EPS in comparison to other
competing firms is desirable. The EPS is calculated as:
• Earnings Available to Common Shareholders /
Number of Common Shares Outstanding
• EXAMPLE — Earnings are $ 100,000 and preferred stock
dividends of $ 20,000 need to be paid. There are a total of
80,000 common shares outstanding. Earnings per Share
(EPS) is ($ 100,000 - $ 20,000) / 80,000 shares outstanding
or $ 1.00 per share.
Price to Earnings (P/E)
• The relationship of the price of the stock in relation to EPS
is expressed as the Price to Earnings Ratio or P / E Ratio.
Investors often refer to the P / E Ratio as a rough indicator
of value for a company. A high P / E Ratio would imply
that investors are very optimistic (bullish) about the future
of the company since the price (which reflects market
value) is selling for well above current earnings. A low P /
E Ratio would imply that investors view the company's
future as poor and thus, the price the company sells for is
relatively low when compared to its earnings. The P / E
Ratio is calculated as follows:
Price to Earnings (P/E)
• Price of Stock / Earnings per Share *
• * Earnings per Share are fully diluted to
reflect the conversion of securities into
common stock.
• EXAMPLE — Earnings per share is $ 3.00
and the stock is selling for $ 36.00 per share.
The P / E Ratio is $ 36 / $ 3 or 12. The
company is selling for 12 times earnings.
Price to Book Value (P/B)
• Book Value per Share expresses the total net assets of a
business on a per share basis. This allows us to compare the
book values of a business to the stock price and gauge
differences in valuations. Net Assets available to
shareholders can be calculated as Total Equity less Preferred
Equity. Book Value per Share is calculated as follows:
• Net Assets Available to Common Shareholders * /
Outstanding Common Shares
• * Calculated as Total Equity less Preferred Equity.
• EXAMPLE — Total Equity is $ 5,000,000 including $
400,000 of preferred equity. The total number of common
shares outstanding is 80,000 shares. Book Value per Share is
($ 5,000,000 - $ 400,000) / 80,000 or $ 57.50
Dividend Yield
• The percentage of dividends paid to shareholders in
relation to the price of the stock is called the
Dividend Yield. For investors interested in a source
of income, the dividend yield is important since it
gives the investor an indication of how much
dividends are paid by the company. Dividend Yield
is calculated as follows:
• Dividends per Share / Price of Stock
• EXAMPLE — Dividends per share are $ 2.10 and
the price of the stock is $ 30.00 per share. The
Dividend Yield is $ 2.10 / $ 30.00 or 7%
The DuPont system
• The Du Pont system was developed by
E.I. du Pont Nemours.
• The system is a method of decomposing
the return ratios into their profit margin
and turnover components. e.g.,
 Return  =  total asset  x  net profit 
 on assets   turnover   margin 

 
 

A further breakdown
• Return on equity can be broken down into
the return on assets and the equity
multiplier.
• The greater the financial leverage, the
greater the equity multiplier.
return on = return on × equity
equity
assets multiplier
net income net income assets
=
×
equity
assets
equity
Du Pont system: Return on assets
Return on assets
Net profit / Total assets
Net profit margin
Net profit / Sales
Operating profit margin
Operating profit / Sales
or EBIT / Sales
Earnings retention
(1 - tax rate)
Interest burden
Earnings before taxes / Operating profit
or EBT/EBIT
Total asset turnover
Total assets / Net profit
Du Pont system: Return on
equity
Return on equity
Net profit / Shareholders' equity
Net profit margin
Net profit / Sales
Operating profit margin
Operating profit / Sales
or EBIT / Sales
Earnings retention
(1 - tax rate)
Interest burden
Earnings before taxes / Operating profit
or EBT / EBIT
Total asset turnover
Total assets / Net profit
Equity multiplier
Total assets / Shareholders' equity
Kmart and the Du Pont system
8%
3.0
6%
2.5
4%
2.0
Number of
1.5 times
2%
Return 0%
-2%
1.0
-4%
Return on assets
Net profit margin
Total asset turnover
-6%
-8%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Source: Kmart Inc., Annual Reports
0.5
0.0
Wal-Mart: ROA & ROE
30%
25%
ROA
ROE
20%
15%
10%
5%
0%
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Source: Wal-Mart Stores, Inc., Annual Reports
Wal-Mart DuPont, 1991-2002
20%
3,5
3
2,5
2
times
1,5
1
0,5
0
15%
return
and 10%
margin
5%
Return on assets
Total asset turnover
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
0%
Net profit margin
Source: Wal-Mart Annual Reports, various years
Problems
• Suppose a company has a return on equity
of 10% and a return on assets of 5%. What
is its debt-to-equity ratio?
• If a company has a return on assets of 5%
and a total asset turnover of 5 times, what is
its net profit margin?
An example
Time to see if you can really do this
stuff.
For a selected company …
• Calculate the following ratios:
 Current ratio
 Debt-to-equity ratio
 Total asset turnover
 Net profit margin
 Equity multiplier
 Return on equity
• and turnover components.
Common size analysis
Common size analysis
• Common size analysis is the analysis of
financial statement items through comparisons
among financial statement or market data.
• Common size analysis compares each item in a
financial statement with a benchmark item.
• Common size analysis is useful in analyzing
trends in profitability and trends in investments
and financing activity.
Common size analysis, continued.
• For the income statement, the benchmark is
sales; each item in the income statement is
restated as a percentage of sales.
• For the balance sheet, the benchmark is
total assets; each item in the balance sheet is
restated as a percentage of total assets.
Common size example:
Toys R Us
100%
Assets
75%
Other
Intangibles
Plant and equipment
Current assets
50%
25%
0%
1997 1998 1999 2000 2001 2002
Source: Toys R Us Annual Reports
Common size example:
Toys R Us
Liabilities
& equity
100%
75%
Shareholders' equity
50%
Other long-term
liabilities
Long-term debt
25%
Deferred taxes
Current liabilities
0%
1997 1998 1999 2000 2001 2002
Source: Toys R Us Annual Reports
Effective use of financial
analysis
Now what do we do with this stuff?
Uses of financial analysis
• Valuation
• Use financial relations to predict future cash
flows
• Determine creditworthiness
• Rating services (e.g., Moody’s)
• Bankruptcy prediction
• Develop a statistical model that predicts
bankruptcy on the basis of financial
characteristics
Case in point
IMC Global
IMC Global
• Industry: Agricultural chemicals
• Largest of the few companies in the
industry
• Chemical prices are cyclical and sensitive to
agricultural economy and world trade
IMC Global: Returns
10%
0%
-10%
-20%
-30%
-40%
-50%
-60%
-70%
-80%
ROE
ROA
1997
1998
1999
2000
Source: IMC Global 10-K Reports
2001
2002
IMC Global: Profit margins
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
-30%
-35%
Operating profit
margin
Net profit margin
1997
1998
1999
2000
Source: IMC Global 10-K Reports
2001
2002
IMC Global: Cash flows
600
400
200
0
CFO
CFI
CFF
-200
-400
-600
-800
1997
1998
1999
2000
Source: IMC Global 10-K Reports
2001
2002
IMC Global: Financial leverage
100%
Debt as a %
of assets
80%
60%
40%
20%
0%
1993
1995
1997
Source: IMC Global 10-K Reports
1999
2001
IMC Global:
Additional considerations
• IMC Global is in a cyclical industry
• IMC Global has many environmental
liabilities that are not shown in the balance
sheet
• The reaction of competitors/industry to
slump in phosphate prices affects the firm
Problems and dilemmas
There had to be a catch …
Problems and dilemmas
• Using accounting information
• historical data [book v. market value]
• flexibility regarding methods of accounting
[i.e., the possibility of earnings management]
• “fuzzy” items [i.e., Enron, Enron, Enron]
• the possibility of earnings manipulation [Enron,
Sunbeam, Waste Management …]
Problems and Dilemmas, continued
• Selecting a benchmark
• Financial ratios are most useful when
compared with ratios of similar
companies (e.g., by industry).
• It is difficult to choose comparison firms
or to determine the industry.
Shoe companies
Net profit margin
1997-2002
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
Nike
Reebok
Skechers
1997
1998
1999
2000
2001
2002
Source: Companies’ annual reports, various years
Problems and dilemmas, continued.
• Selecting and interpreting ratios
• A single ratio is not indicative of a
“good” or “bad” firm.
• Some ratios are not applicable to some
firms.
• Some ratios don’t make sense in certain
circumstance.
Forecasting with financial ratios
• Financial ratios are often used to determine
a trend over time, which may then be used
to develop expectations about the future.
• It is important to understand the accounting
numbers to adequately forecast based on
historical trends.
Wal-Mart Sales, 1971-2002
Sales $250,000
in
millions $200,000
$150,000
$100,000
$50,000
Fiscal year
Source: Wal-Mart Annual Reports, various years
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
1975
1973
1971
$0
Enron Sales, 1991-2000
$120
$100
$80
Revenues
$60
(in billions)
$40
$20
$0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Fiscal year
Source: Enron 10-K Reports, various years
Matrix, Inc.
2005
Use this
informatio
n to
calculate
the
liquidity
ratios for
Matrix,
Cash
Accounts receivable, net
Beginning of year
End of year
Inventory
Beginning of year
End of year
Total current assets
Total current liabilities
Total liabilities
Total assets
Beginning of year
End of year
Revenues
$
30,000
17,000
20,000
10,000
15,000
65,000
42,000
103,917
300,000
346,390
494,000
Working Capital
Working capital is the excess of current
assets over current liabilities.
12/31/05
Current assets
Current liabilities
Working capital
$ 65,000
(42,000)
$ 23,000
Current Ratio
This ratio measures the
short-term debt-paying
ability of the company.
Current
Current Assets
=
Ratio
Current Liabilities
Current
=
Ratio
$65,000
$42,000
= 1.55 : 1
Quick Ratio
Quick
Ratio
=
Quick Assets
Current Liabilities
Quick assets are cash, marketable
securities, and receivables.
This ratio is like the current
ratio but excludes current assets
such as inventories that may be
difficult to quickly convert into cash.
Quick Ratio
Quick
Ratio
Quick
Ratio
Quick Assets
Current Liabilities
=
=
$50,000
$42,000
This ratio is like the current
ratio but excludes current assets
such as inventories that may be
difficult to quickly convert into cash.
= 1.19 : 1
Debt Ratio
A measure of creditor’s long-term risk.
The smaller the percentage of assets that
are financed by debt, the smaller the risk
for creditors.
Debt
Debt
Ratio
Ratio
==
Total
Total
Liabilities
Liabilities
÷ ÷ Total
Total Assets
Assets
=
$103,917 ÷
=
30.00%
$346,390
Uses and Limitations of Financial
Ratios
Uses
Limitations
Ratios help users
understand
financial relationships.
Management may enter
into transactions merely
to improve the ratios.
Ratios provide for
quick comparison
of companies.
Ratios do not help with
analysis of the company's
progress toward
nonfinancial goals.
Measures of Profitability
An income statement can be prepared in either a
multiple-step or single-step format.
The single-step format is simpler.
The multiple-step format provides
more detailed information.
Income Statement (Multiple-Step)
Proper Heading
{
{
Gross
Margin
Operating
Expenses
Nonoperating
Items
{
Remember to
compute EPS.
{
Martin Company
Income Statement
For the Year Ended 12/31/05
Sales, net
Cost of goods sold
Gross margin
Operating expenses:
Selling expenses
General & Admin.
Depreciation
Income from Operations
Other revenues & gains:
Interest income
Gain
Other expenses:
Interest
Loss
Income before taxes
Income taxes
Net income
$
$
$
$
$
785,250
351,800
433,450
$
293,350
140,100
197,350
78,500
17,500
62,187
24,600
86,787
27,000
9,000
$
$
(36,000)
190,887
62,500
128,387
Income Statement (Single-Step)
{
Proper Heading
Revenues
& Gains
Expenses
& Losses
Remember to
compute EPS.
{
{
Martin Company
Income Statement
For the Year Ended 12/31/05
Revenues and gains:
Sales, net
Interest income
Gain on sale of plant assets
Total revenues and gains
Expenses and losses:
Cost of goods sold
Selling Expenses
General and Admin. Exp.
Depreciation
Interest
Income taxes
Loss: sale of investment
Total expenses & losses
Operating income
$
$
$
785,250
62,187
24,600
872,037
$
743,650
128,387
351,800
197,350
78,500
17,500
27,000
62,500
9,000
Matrix, Inc.
2005
Use this
information
to calculate
the
profitability
ratios for
Matrix, Inc.
Number of common shares
outstanding all of 2005
Net income
Shareholders' equity
Beginning of year
End of year
Revenues
Cost of sales
Total assets
Beginning of year
End of year
$
27,400
53,690
180,000
234,390
494,000
140,000
300,000
346,390
Return On Assets (ROA)
This ratio is generally considered
the best overall measure of a
company’s profitability.
ROA
=
Operating
income
= $
=
53,690
16.61%
÷
Average total assets
÷ ($300,000 + $346,390) ÷ 2
Return On Equity (ROE)
This measure indicates how well the
company employed the owners’
investments to earn income.
ROE
Operating
=
income
= $ 53,690
=
25.91%
Average total stockholders'
÷
equity
÷ ($180,000 + $234,390) ÷ 2
More issues regarding ratios
• Different
operating
and
accounting
practices can distort comparisons.
• Sometimes it is hard to tell if a ratio is
“good” or “bad”.
• Difficult to tell whether a company is, on
balance, in strong or weak position.
Qualitative factors to be considered
when evaluating a company’s future
financial performance
• Are the firm’s revenues tied to 1 key
customer, product, or supplier?
• What percentage of the firm’s business is
generated overseas?
• Competition
• Future prospects
• Legal and regulatory environment
Objective 2
Perform a vertical analysis
of financial statements.
Vertical Analysis...
– compares each item in a financial statement
to a base number set to 100%.
• Every item on the financial statement is
then reported as a percentage of that base.
Vertical Analysis
Revenues
Cost of sales
Gross profit
Total operating expenses
Operating income
Other income
Income before taxes
Income taxes
Net income
1999
$38,303
19,688
$18,615
13,209
$ 5,406
2,187
$ 7,593
2,827
$ 4,766
%
100.0
51.4
48.6
34.5
14.1
5.7
19.8
7.4
12.4
Vertical Analysis
Assets
Current assets:
Cash
Receivables net
Inventories
Prepaid expenses
Total current assets
Plant and equipment, net
Other assets
Total assets
1999
$ 1,816
10,438
6,151
3,526
$21,931
6,847
9,997
$38,775
%
4.7
26.9
15.9
9.1
56.6
17.7
25.7
100.0
Objective 3
Prepare common-size
financial statements.
Common-size Statements
• On the income statement, each item is
expressed as a percentage of net sales.
• On the balance sheet, the common size is
the total on each side of the accounting
equation.
• Common-size statements are used to
compare one company to other companies,
and to the industry average.
Benchmarking
Percent of Net Sales
Lucent Technologies
MCI
10,8%
12,4%
8,0%
7,4%
43,0%
51,4%
28,8%
38,2%
Cost of goods sold
Income tax
Operating expenses
Net income
Objective 4
Compute the standard
financial ratios.
Ratio Classification
1 Measuring ability to pay current liabilities
2 Measuring ability to sell inventory and
collect receivables
3 Measuring ability to pay short-term and
long-term debt
4 Measuring profitability
5 Analyzing stock as an investment
Ratio Classification
Liquidity ratios: Mesuring ability to pay
current
liabilities
Activity ratios: Measuring ability to sell
inventory
and
collect
receivables
Financial leverage ratios: Measuring ability to
pay
short-term
and
long-term
debt
Profitability ratios: Measuring profitability of
the bussines.
Palisades Furniture Example
Net sales (Year 2002)
Cost of goods sold
Gross profit
Total operating expenses
Operating income
Interest revenue
Interest expense
Income before taxes
Income taxes
Net income
$858,000
513,000
$345,000
244,000
$101,000
4,000
(24,000)
$ 81,000
33,000
$ 48,000
Palisades Furniture Example
Assets
20x2
20x1
Current assets:
Cash
$ 29,000 $ 32,000
Receivables net
114,000
85,000
Inventories
113,000
111,000
Prepaid expenses
6,000
8,000
Total current assets
$262,000 $236,000
Long-term investments
18,000
9,000
Plant and equipment, net
507,000
399,000
Total assets
$787,000 $644,000
Palisades Furniture Example
Liabilities
Current liabilities:
Notes payable
Accounts payable
Accrued liabilities
Total current liabilities
Long-term debt
Total liabilities
20x2
$ 42,000
73,000
27,000
$142,000
289,000
$431,000
20x1
$ 27,000
68,000
31,000
$126,000
198,000
$324,000
Palisades Furniture Example
Stockholders’ Equity
Common stock, no par
Retained earnings
Total stockholders’ equity
Total liabilities and
stockholders’ equity
20x2
$186,000
170,000
$356,000
20x1
$186,000
134,000
$320,000
$787,000
$644,000
Measuring Ability to
Pay Current Liabilities
The current ratio measures
the company’s ability to pay
current liabilities with current assets.
Current ratio =
Total current assets ÷ Total current liabilities
Measuring Ability to
Pay Current Liabilities
•
•
•
•
•
Palisades’ current ratio:
20x1: $236,000 ÷ $126,000 = 1.87
20x2: $262,000 ÷ $142,000 = 1.85
The industry average is 1.80.
The current ratio decreased slightly
during 20x2.
Measuring Ability to
Pay Current Liabilities
The acid-test ratio shows the company’s
ability to pay all current liabilities
if they come due immediately.
Acid-test ratio =
(Cash + Short-term investments
+ Net current receivables)
÷ Total current liabilities
Measuring Ability to
Pay Current Liabilities
•
•
•
•
•
Palisades’ acid-test ratio:
20x1: ($32,000 + $85,000) ÷ $126,000 = .93
20x2: ($29,000 + $114,000) ÷ $142,000 = 1.01
The industry average is .60.
The company’s acid-test ratio improved
considerably during 20x2.
Measuring Ability to
Sell Inventory
Inventory turnover is a measure
of the number of times the average
level of inventory is sold during a year.
Inventory turnover = Cost of goods sold
÷ Average inventory
Measuring Ability to
Sell Inventory
•
•
•
•
Palisades’ inventory turnover:
20x2: $513,000 ÷ $112,000 = 4.58
The industry average is 2.70.
A high number indicates an ability to
quickly sell inventory.
Measuring Ability to
Collect Receivables
Accounts receivable turnover measures a company’s
ability to collect cash from credit customers.
Accounts receivable turnover =
Net credit sales ÷ Average accounts receivable
Measuring Ability to
Collect Receivables
•
•
•
•
Palisades’ accounts receivable turnover:
20x2: $858,000 ÷ $99,500 = 8.62 times
The industry average is 22.2 times.
Palisades’ receivable turnover is much
lower than the industry average.
• The company is a home-town store that
sells to local people who tend to pay their
bills over a lengthy period of time.
Measuring Ability to
Collect Receivables
Days’ sales in receivable ratio measures how
many day’s sales remain in Accounts Receivable.
One day’s sales = Net sales ÷ 365 days
Days’ sales in Accounts Receivable =
Average net Accounts Receivable ÷ One day’s sales
Measuring Ability to
Collect Receivables
• Palisades’ days’ sales in Accounts
Receivable for 20x2:
• One day’s sales:
• $858,000 ÷ 365 = $2,351
• Days’ sales in Accounts Receivable:
• $99,500 ÷ $2,351 = 42 days
• The industry average is 16 days.
Measuring Ability to
Pay Debt
The debt ratio indicates the proportion
of assets financed with debt.
Total liabilities ÷ Total assets
Measuring Ability to
Pay Debt
•
•
•
•
•
Palisades’ debt ratio:
20x1: $324,000 ÷ $644,000 = 0.50
20x2: $431,000 ÷ $787,000 = 0.55
The industry average is 0.61.
Palisades Furniture expanded operations
during 20x2 by financing through
borrowing.
Measuring Ability to
Pay Debt
Times-interest-earned ratio
measures the number of times
operating income can cover interest expense.
Times-interest-earned
= Income from operations
÷ Interest expense
Measuring Ability to
Pay Debt
•
•
•
•
•
Palisades’ times-interest-earned ratio:
20x1: $ 57,000 ÷ $14,000 = 4.07
20x2: $101,000 ÷ $24,000 = 4.21
The industry average is 2.00.
The company’s times-interest-earned ratio
increased in 20x2.
• This is a favorable sign.
Measuring Profitability
Rate of return on net sales shows the percentage
of each sales dollar earned as net income.
Rate of return on net sales =
Net income ÷ Net sales
Measuring Profitability
•
•
•
•
•
Palisades’ rate of return on sales:
20x1: $26,000 ÷ $803,000 = 0.032
20x2: $48,000 ÷ $858,000 = 0.056
The industry average is 0.008.
The increase is significant in itself and also
because it is much better than the industry
average.
Measuring Profitability
Rate of return on total assets measures
how profitably a company uses its assets.
Rate of return on total assets = (Net income
+ interest expense) ÷ Average total assets
Measuring Profitability
• Palisades’ rate of return on total assets
for 20x2:
• ($48,000 + $24,000) ÷ $715,500 = 0.101
• The industry average is 0.049.
• How does Palisades compare to the
industry?
• Very favorably.
Measuring Profitability
Common equity includes additional
paid-in capital on common
stock and retained earnings.
Rate of return on common stockholders’ equity
= (Net income – preferred dividends)
÷ Average common stockholders’ equity
Measuring Profitability
• Palisades’ rate of return on common
stockholders’ equity for 20x2:
• ($48,000 – $0) ÷ $338,000 = 0.142
• The industry average is 0.093.
• Why is this ratio larger than the return on
total assets (.101)?
• Because Palisades uses leverage.
Measuring Profitability
Earnings per share of common stock
= (Net income – Preferred dividends)
÷ Number of shares of common stock
outstanding
Measuring Profitability
•
•
•
•
Palisades’ earnings per share:
20x1: ($26,000 – $0) ÷ 10,000 = $2.60
20x2: ($48,000 – $0) ÷ 10,000 = $4.80
This large increase in EPS is considered
very unusual.
Analyzing Stock as an
Investment
• Price/earning ratio is the ratio of market
price per share to earnings per share.
• 20x1: $35 ÷ $2.60 = 13.5
• 20x2: $50 ÷ $4.80 = 10.4
• Given Palisades Furniture’s 20x2 P/E ratio
of 10.4, we would say that the company’s
stock is selling at 10.4 times earnings.
Analyzing Stock as an
Investment
Dividend yield shows the percentage
of a stock’s market value returned as
dividends to stockholders each period.
Dividend per share of common
(or preferred) stock ÷ Market price per share
of common (or preferred) stock
Analyzing Stock as an
Investment
•
•
•
•
Dividend yield on Palisades’ common stock:
20x1: $1.00 ÷ $35.00 = .029 (2.9%)
20x2: $1.20 ÷ $50.00 = .024 (2.4%)
An investor who buys Palisades Furniture
common stock for $50 can expect to receive
2.4% of the investment annually in the form
of cash dividends.
Analyzing Stock as an
Investment
Book value per share of common stock
= (Total stockholders’ equity – Preferred equity)
÷ Number of shares of common stock outstanding
Analyzing Stock as an
Investment
• Book value per share of palisades’ common
stock:
• 20x1: ($320,000 – $0) ÷ 10,000 = $32.00
• 20x2: ($356,000 – $0) ÷ 10,000 = $35.60
• Book value bears no relationship to market
value.
Objective 5
Use ratios in decision making.
Limitations of Financial
Analysis
• Business decisions are made in a world of
uncertainty.
• No single ratio or one-year figure should be
relied upon to provide an assessment of a
company’s performance.
Objective 6
Measure economic value added.
Economic Value Added (EVA®)
• Economic value added (EVA®) combines
accounting income and corporate finance to
measure whether the company’s operations
have increased stockholder wealth.
• EVA® = Net income + Interest expense –
Capital charge