Chapter 9
Analysis of
Financial
Statements
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VII. Ratio Analysis
Builds on firm's financial
statements
Easy to understand
Used by both equity investors
and creditors
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VII. Ratio Analysis
A. Liquidity Ratios – Indicate the ability of the
firm to meet its short-term obligations as
they come due.
B. Activity or Asset Utilization Ratios – Are
concerned with the amount of assets a firm
uses to support its sales.
C. Profitability Ratios – Are a measure of
performance.
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VII. Ratio Analysis
D. Leverage Ratios – Are concerned with
the firm’s capital structure, or the
extent to which debt is used to finance
the firm’s assets.
E. Coverage Ratios – Indicate the extent
to which the firm generates operating
income to cover an expense.
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VII. Ratio Analysis
F. Time series analysis
1.Analysis of a firm over a period of time
G. Cross Sectional Analysis
1.Analysis of several firms in the same
industry at a point in time
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VII. Ratio Analysis
H.
Liquidity Ratios
1. Current Ratio
a) Ratio of current assets to current liabilities: measure of
liquidity. Indicates how well the current liabilities, which
must be paid within a year, are “covered.” Rule of thumb
2:1. The answer is how many dollar’s worth of current
assets you have for every dollar in current liabilities.
(1) Current Ratio = Current assets / current liabilities
2. Quick Ratio (AKA, acid test). Rule of thumb
1:1
a) (Current assets - inventory) / current liabilities
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Current Ratio
Current assets / current liabilities
$698.2 / $279.9 = 2.49
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Quick Ratio
(Current assets - inventory) /
current liabilities
($698.2 - $373.9) / $279.9 = 1.16
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VII. Ratio Analysis
I. Activity Ratios – How fast a company is
turning its assets into cash
1. Inventory Turnover
a) Speed to which inventory is sold
(1) Sales (Cost of Goods Sold)/ average inventory
2. Receivables Turnover
a) Speed with which accounts receivables are collected
(1) Sales / average accounts receivable
b) Average Collection Period (days sales outstanding)
(1) Accounts receivable / sales per day
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VII. Ratio Analysis
3. Fixed Asset Turnover
a) Ratio of sales to fixed assets; measure of fixed assets
necessary to generate sales
(1) Sales / fixed assets
4.
Total Asset Turnover
a) Ratio of sales to total assets
(1) Sales / total assets
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Inventory Turnover
Sales / average inventory
$1,868.2 / $353.6 = 5.3
Inventory turns over 5.3 times a
year or about every 2.3 months.
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Receivables Turnover
Sales / accounts receivable
$1,868,243 / $58,557 = 31.9
31.9 times a year is about every 11
days. This rapid turnover is simply the
result of the fact that Pier 1 Imports has
few receivables. Most sales are cash or
credit cards (different).
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Fixed Asset Turnover
Sales / fixed assets
$1,868 / $290.4 = 6.4
 This indicates that sales are 6.4 times fixed
assets. The more rapidly fixed assets turn
over (the higher the ratio), the smaller the
amount of plant and equipment the firm is
employing. Industry specific.
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Total Asset Turnover
Sales / total assets
$1,868 / $1,052.2 = 1.8
This indicates the firm needs $1.00 in
assets for every $1.80 generated in
revenues.
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VII. Ratio Analysis
J. Profitability Ratios
1. Gross Profit Margin
a) Ratios of revenues minus cost of goods sold to sales;
percentage earnings on sales before considering operating
expenses, interest, and taxes
(1) (revenues - cost of goods sold) / sales
2. Operating Profit Margin
a) Ratio of operating income to sales; percentage earned on
sales before deducting interest expense and taxes
(1) Operating earnings / sales
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VII. Ratio Analysis
3. Net Profit Margin
a) Ratio of earnings after interest and taxes to sales;
percentage earned on sales
(1) Earnings after taxes / sales
4.
Return on Assets
a) Ratio of earnings to total assets; percentage earned on
assets
(1) Earnings after taxes / total assets
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VII. Ratio Analysis
5. Return on Equity
a) Ratio of earnings to owners equity
(1) Earnings after taxes / equity
6.
Basic Earning Power
a) Ratio of operating income to total assets; measure of the
firms ability to generate income before considering interest
and taxes
(1) EBIT / total assets
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Gross Profit Margin
(revenues - cost of goods sold) /
sales
$781.6 / $1,868 = 41.8%
This ratio indicates that the firm earns
$0.42 on every dollar of sales before
considering operating expenses.
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Operating Profit Margin
Operating earnings / sales
$186.2 / $1,868 = 9.96%
This indicates that the company earns
$0.0996 before interest and taxes for
every dollar of sales.
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Net Profit Margin
Earnings after taxes / sales
$118.0 / $1,868 = 6.3%
This indicates that the company earns
$0.0632 after interest and taxes for
every dollar of sales.
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Return on Assets
Earnings after taxes / total assets
$118.0 / $1,052 = 11.2%
This indicates that the firm returns
$0.112 for every dollar invested in
assets.
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Return on Equity
Earnings after taxes / equity
$118.0 / $683.6 = 17.3%
This indicates that the firm returns
$0.173 for every dollar invested by
the common stockholders.
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Basic Earning Power
EBIT (earnings before interest and
taxes)/ total assets
$186.2 / $1,052 = 17.7%
This indicates that $1 of the firm’s assets
generates $0.177 in operating income (that
is, income before paying interest and taxes)
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VII. Ratio Analysis
K. Leverage Ratios
1. Debt Ratio
a) Total debt divided by total assets; proportion of assets
financed by debt
(1) Debt / total assets
2. Debt to Equity Ratio
a) Debt / equity
3. DuPont System of Analysis
a) Measure of earning capacity that combines asset
turnover, profitability, and financial leverage
b) Helps identify source of weakness
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Debt Ratio
Debt / total assets
$368.5 / $1,052.2 = 35.0%
This debt-to-assets ratio indicates that debt
is financing 35.0 percent of the firm’s
assets.
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Debt to Equity Ratio
Debt / equity
$368.5 / $683.6 = 53.9%
The debt-to-equity ratio indicates that
there is $0.542 for every dollar of
equity.
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DuPont System of Analysis
Combines
–Net profit margin
–Turnover
–Leverage
Helps identify source
of weakness
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DuPont System of Analysis
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VII. Ratio Analysis
L. Coverage Ratios
1. Times-interest-earned
a) Ratios of operating income to interest expense; measure of
safety of a debt instrument
(1) Earnings before interest and taxes / interest
(2) Negative Number - Interest earned exceeds interest
paid.
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Times-interest-earned
Earnings before interest and taxes /
interest
$186,157 / $-1,159 = -160.6
Interest earned exceeds interest
paid.
 This means that Pier 1 is in the enviable
position of earning more interest on its shortterm investments than it paid on borrowed
funds.
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VIII. Ratio Comparisons
A. Ratios of firms within an industry
B. Tend to have similar numerical values
C. Differences in numerical values are
reasons for further analysis
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Problems in Interpretation
Different definitions for the same
ratio
Internet sources differ
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