Chapter 4
Financial Statements Analysis
Tools
4-1
•Ratio analysis
•The six major categories of
ratios
•The du Pont Analysis
•Economic Value Added EVA
Why Analyze Financial Statements
4-2
 Important to both internal & external purposes:
 Internal: identify weakness and emphasize strength, set goals, evaluate
performance of managers

External:

Credit analyst/lenders: help them assess the firms ability to repay its debts and
monitor the financial performance.

Stock analyst: help assess the firms efficiency, risk, and growth prospective
 Thus, the analysis of fin. statements should involves
 Overtime analysis: Evaluate the trends in the firm’s financial position over
time-overtime
 Benchmark (peer) analysis: Comparing the firms performance to the
industry or top firms in the same industry
Analyzing Financial Statement
4-3
 Three common way to perform such analysis:

Ratio Analysis

Common Size Analysis

Percentage Change Analysis
Ratio Analysis
4-4
 Ratio is comparing two numbers by division
(fraction)
 The great advantage of the ratio analysis is that it is
a measure of a relative size.
 Thus, using it makes it easier to compare to
pervious time periods or other firms than if we
used changes in dollar amounts.
Six Major Categories of Ratios
 Liquidity Ratios:

4-5
The speed to convert asset to cash without discounts to value
 Asset management Ratio (Efficiency Ratio):

Right amount of assets vs. sales?
 Debt management Ratio (Leverage Ratios):

Right mix of debt and equity?
 Coverage ratios

Is there enough funds to cover certain expenses, such as interest?
 Profitability Ratios:

How profitable is the firm after taking care of all its obligations.
 Market Value Ratios:

Incorporates the market stock price
1. Liquidity Ratios
4-6
Current assets
1.Current ratio 
Current liabilitie s
2.Quick ratio 
(Current assets  Inventories )
Current liabilitie s
What do think will happen to both
ratios if we sold inventory with cash or
on-credit (holding every thing
constant)?
2. Asset Management Ratios (Efficiency)
4-7
1.
2.
3.
4.
5.
Inventory turnover = Sales/Inventories
A/R turnover
= Sales/ AR
Average collection time (Days sales outstanding)
= AR / (Sales/360)
Fixed asset turnover = Sales/ FA
Total assets turnover= Sales/ TA
3. Leverage Ratios (Debt Ratios)
4-8
 Debt is an important source of funds:

Too much debt  increase financial distress risk, bankruptcy risk,
default risk (especially in bad economic condition).

Few debt
Could come at the expense of lower ROE.
 Conservative managements

 Also, one important issue why firms should consider
debt financing is that

Interest payments are also considered as a tax shield where it
reduces the taxable income.
Illustration
4-9
Cont’d Illustration
4-10
3. Leverage Ratios (Debt Ratios)
4-11
1.
Debt ratio = Total debt (TA-TE)/Total assets
2.
Long -term debt (LTD) ratio= LTD/Total assets
3.
Debt- to-equity = Total Debt / (Total common
Equity+ Preferred stocks)
4.
Debt-to-capital = Debt/(Debt + Common Equity +
Preferred stock) = Debt / Investor Supplied Capital
(ISC)
5.
Long -term debt-equity= LTD/ (Total common
Equity+ Preferred stocks)
4. Coverage Ratio
4-12
1.
Time Interest Earned (TIE) Ratio
TIE = EBIT/Interest charges
2.
Cash coverage ratio = EBIT + noncash
expenses/Interest charges
Noncash expenses such as depreciation
 These ratio shows how many time can operating
income decline before the firm default on its debt.
Note use EBIT not NI coz interest payment is using a
pretax dollars
5. Profitability Ratios
4-13
1.
Gross profit margin = Gross profit / Sales
2.
Operating profit margin = EBIT/ Sales
3.
Net profit margin = NI / Sales
4.
Return on Total Assets (ROA)= NI/ TA
5.
Return on Equity (ROE) = NI / Total Equity (Common stock
+ RE)
6.
Return on common equity = NI-Preferred dividends / Total
Equity
Reflects the firms
operating costs
Reflects the heavy use of debt
Should managers strive to max ROE?
4-14
ROE and shareholder wealth are correlated, but problems can arise
when ROE is the sole measure of performance.
1.
ROE does not consider risk
 Firm1: expected ROE 10% and CF are quite stable over time.
 Firm2: expected ROE 18%, but CF are risky
 there is possibility that ROE might not materialized.
If ROE was achieved, manager1 could receive less
compensation than manager2 even though manager1 adds
more value to shareholders.
 Thus, compensating managers based on ROE is not always right.
Should managers strive to max ROE?
4-15
2. ROE does not consider the amount of capital
invested.
 Project1: expected ROE 10%, but requires investment of
$200,000 to earn that ROE
 Project2: expected ROE 10% but requires investment of
$2,000,000 to earn that ROE
 So if we are looking at only ROE to assess projects, we
will not be able to see how much money these projects
requires us to put upfront.
Should managers strive to max ROE?
4-16
3. Reliance on ROE to evaluate managers may
encourage managers to make decisions that do
not benefit shareholders in the long run.
 If mangers are compensated if they reach the targeted
ROE for this year of 40%,
 And managers have an opportunity to invest in a low
risky project that produce 15% ROE and the cost of
capital is only 10%. (project is very much profitable)

Managers will be reluctant to invest in such project because that will
lower their average ROE and thus year-end bonus.
6. Market Value Ratios
4-17
 Shows what the investors think about the firm & it
operations
1- P/E = Market Price/Earnings per share
= Market Price/(NI/ number of share outstanding)
2- M/B= Market price of shares/Book value of total Equity
per share
= (Price of share X number shares outstanding)/ (Total
Equity / number of shares outstanding)
The DuPont Equation
4-18
ROE 
Profit

Total assets

Equity
margin
turnover
multiplier
ROE  (NI/Sales)  (Sales/TA)  (TA/Equity )
ROE 
ROA
Equity

multiplier
 Focuses on expense control (PM),
 asset utilization (TATO), and
 debt utilization (equity multiplier).
 If the firm is financed by only equity and debt, then
DR = 1 – (1/EM) = 1 – (E/TA) = (TA – E) / TA = D/TA
 High EM  high DR
 EM is always>1 if the firm is financed with debt
Altman Z-score
4-19
 It is a model to predict the possibility the firm is
going to experience financial distress or possible
bankruptcy next year.
 The Idea behind that model is as follows:
 If the firm scores above the threshold, it is safe
 If the firm score below the threshold, the model predict that it
will face bankruptcy within a year.
 If the firm scores in between, it is in the “gray zone”
Altman Z-score
420
 The models: one for public and the other for private
firms.
 Publicly Firms:
 Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + X5



If Z<1.81
 Bankruptcy predicted within one year
If 1.81<Z<2.675  Financial distress, possible BR
If Z>2.675
 No financial distress predicted
 Private Firms:
 Z’ = .717 X1 + .847 X2 + 3.107 X3 + .42 X4 + .998 X5



If Z’<1.21
 Bankruptcy predicted within one year
If 1.23<Z’<2.90  Financial distress, possible BR
If Z’>2.90
 No financial distress predicted
Comparison and Analysis
 Calculating the Ratio is meaningless task if do not know
how to them.
 Thus, to make meaningful decisions and conclusions
using these ratio, we must not draw conclusions by
looking at a single number.
 We should:

Compare the ratio with previous periods for the firm to examine and
identify trends overtime (Trend Analysis)


Note that we need to be extra cautious if we have seasonality.
Compare ratios to an industry average ratios or a peer firm ratio.
Economic Value Added (EVA)
 This is also called Economic Profit.
 It measures the profit in excess of the firm’s both explicit and implicit
costs.


Explicit cost : depreciation, interest rates, taxes,…etc.
Implicit cost: cost of equity, cost of preferred stock
 On the other hand, Accounting profit (NI) provides us with the profit
in excess of only the explicit costs.
 Thus, the benefit of the EVA :
 If +, then shareholders wealth will increase
 If -, shareholder wealth will decrease.
 This is because, in order to increase S/H wealth (the ultimate goal for
managers), the firm must cover all costs, including the implicit ones
(cost of capital provided to the firm).
Economic Value Added (EVA)
EVA or EP = NOPAT – (ISC x WACC)
Where
NOPAT = EBIT (1-T)
ISC: investor supplied capital (interest-bearing debt +
preferred equity + common equity)
Potential Problems and Limitations of
Financial Ratio
Analysis
424
 Comparison with industry averages is difficult for a
conglomerate firm that operates in many different
divisions.
 Different operating and accounting practices can distort
comparisons.

Different depreciation and inventory methods.
 Sometimes it is hard to tell if a ratio is “good” or “bad.”

High current ratio may indicate strong liquidity position (good), but it
can also indicate excessive cash or inventory (bad).
 Inflation and leasing my cause misinterpretation to
financial ratios
 If the firm has sales that are seasonal, thus, measuring
ratios during out-of –season will be misleading.