Ryan Williams
Learning Objectives
 Prepare common-sized Income Statements and
Balance Sheets.
 Compute financial ratios listed in Table 4.1.
 Discuss uses and limitations of the financial ratios in
Table 4.1.
Who does this?
 Creditors
• Firm’s ability to repay borrowed funds, i.e.,
creditworthiness
 Stockholders/owners
• Firm’s future prospects (cash flows )
 Managers
• Identify strengths & weaknesses
• Improve firm performance
Two companies:
Three Months Ended
April 3, 2009
NET OPERATING REVENUES
$
Cost of goods sold
2,590
GROSS PROFIT
4,579
Selling, general and administrative expenses
June 27, 20
10
7,169
2,624
REVENUES
Sales
$
Franchise fees and royalties
1,255
License royalties
1,799
Interest income
Other operating charges
OPERATING INCOME
Interest income
92
1,863
12,350
208
Other income
14
Total revenues
15,626
60
COSTS AND EXPENSES
Interest expense
Equity income — net
85
17
Cost of sales
9,488
Restaurant operating expenses
825
Depreciation and amortization
232
General and administrative expenses
Other income (loss) — net
INCOME BEFORE INCOME TAXES
Income taxes
(40)
2,564
Total costs and expenses
13,109
1,815
456
Income before provision for income taxes
2,517
Provision for income taxes
CONSOLIDATED NET INCOME
1,359
Net income
857
$
1,660
Step 1 -Common Size Statements
 Why common size?
 Allow comparisons through time
• -e.g., did company improve on last year’s performance
 Allow comparisons among firms in same industry
• -did company do better or worse than similar firms in
same industry
Common Size Statements – cont.
How to create common size:
 Balance sheet
• Divide each item by total assets and express the result in
percent
 Income statement
• Divide each item by net sales and express the result in
percent
Common Size Statement - Cont
Note:
 In common size income statement, profit measures are
renamed.
• Gross profit becomes gross profit margin
• Operating income becomes operating profit margin
• Net income becomes net profit margin
Interpretation:
Gross profit margin = gross profit per unit sold
Similar interpretation for operating profit margin, net
profit margin.
Step 2 – Financial Ratios
Examine relationships between
• Balance sheet accounts

E.g., compare current assets to current liabilities
• Balance sheet accounts and values on the income
statement

E.g., compare net income to total assets
What ratios do we use?
 Liquidity ratios
 Activity ratios
 Debt utilization ratios
 Profitability ratios
Liquidity Ratios
Measure how well company can meet short-term
obligations
 Current ratio
 Quick ratio
• Same denominator as current ratio
• But numerator excludes inventory
• Higher ratios mean firm is better able to meet
obligations on time
Activity Ratios
Also called ‘asset utilization’ ratios or ‘efficiency’ ratios
 Unused or inactive assets are nonearning assets
 Either utilize assets more effectively or eliminate them
Activity Ratios
Average collection period (ACP)
 Measures how fast company collects payments from
credit sales.
 In number of days.
 Denominator uses credit sales. If not reported, use total
sales.
Inventory turnover ratio
 Measures how efficiently company is employing
inventory.
 Larger ratio  more efficient. Industry specific.
 If COGS not available, use sales as numerator.
Activity Ratios
Inventory conversion period
 Measures the time period that an inventory item is in
stock before it is sold.
 In number of days
Total asset turnover
 Measures how productive a firm’s total assets are at
producing final sales.
 Higher ratio means firm is more efficient in using total
assets.
 Industry specific.
Activity Ratios
Payables period
 Measures how quickly company pays its trade accounts
(suppliers)
 In number of days
Activity Terms, A/R and A/P
industry credit terms usually include discount for early
payment
 Typical: 2/10 net 30
• For 2/10 net 30, effective cost is 29-45% per year
Debt Utilization Ratios
Measures the extent to which firm uses borrowed
funds to finance operations.
 Leverage: using debt to finance assets/operations
 Debt utilization ratios also known as leverage ratios
Debt Utilization Ratios
Debt ratio
• Measures proportion of all assets financed with debt
• Higher the ratio, higher the risk of default.
Debt to equity ratio
• Ratio of total liabilities to equity
Debt Utilization Ratios
Times interest earned (TIE)
 Measures how many times the firm’s annual operating
earnings cover its debt-servicing charges (mainly
interest).
 Larger ratio means firm is more likely to pay debtservicing charges despite a drop in sales.
Profitability Ratios
Compare a firm’s earnings to various factors that are
needed to generate the earnings (assets, sales, equity)
 Return on assets
 Return on equity
 Gross profit margin
 Operating profit margin
 Net profit margin
Cash conversion cycle
 The length of time (in days) between cash
expenditures and cash collections
• Cash expenditures: spending money to produce goods
for sale or to buy goods for resale
• Cash collections: collecting money from customers
• Firm should shorten CCC without harming business
operations
Cash expenditure
Cash conversion cycle
Cash collection
Time passes
DuPont Equation
Breaks down ROE into three components:
 Activity (total asset turnover)
 Profitability (net profit margin)
 Leverage (equity multiplier = total assets/equity)
ROE = net profit margin x total asset turnover
x Equity multiplier
 If ROE changes, DuPont equation helps you to identify the
reason for the change.
DuPont Equation - 2
Another way to calculate equity multiplier
Equity multiplier =
1
1 – debt ratio
(use the balance sheet identity:
Total assets = Total liabilities + Equity)
What are the limitations?
1) Balance sheet values are stock measures
• Capture values of assets & liabilities on a specific date
• Ratios using balance sheet values may not reflect
company’s situation during rest of the year
• Example: A company that reports $1 million in cash on
last day of fiscal year may have only $100k two days later,
after paying salaries and suppliers
Limitations - 2
2) Financial ratios are calculated using accounting data
not market values
 Accounting data is based on an asset’s historical costs.
 Market values are based on the asset’s market value.
 Example: if inventory value declines below historical
cost but management did not adjust for this – every ratio
involving total assets will be inaccurate.
Limitations - 3
3) Lack of a standard for each ratio.
Example: current ratio. What is a good current ratio
value?
 How about using industry average ratio as standard?
 Not necessarily useful. Deviations from industry average
not always bad.
What did we look at today?
 Reasons for conducting financial statement analysis
 Common size financial statements
 4 types of ratios: liquidity, activity, debt utilization,
profitability
 Cash conversion cycle
 Extended DuPont Equation
 Limitations of financial ratios
Class activity