Financial Statement
Analysis
John V. Balanquit
johnthecpa.wikispaces.com
Learning Objectives
1.
2.
3.
4.
5.
6.
Why return on equity is one of the key financial ratios used for
assessing a firm’s performance, and how it can be used to
provide information about three areas of a firm’s operations
Why outsiders and insiders are concerned with a company’s
ratios related to leverage, efficiency, productivity, liquidity and
value
How to calculate, interpret, and evaluate the key ratios related
to leverage, efficiency, productivity, liquidity, and value
Why financial forecasts provide critical information for both
management and external parties
How to prepare financial forecasts by using the percentage of
sales approach
How external financing requirements are related to sales
growth, profitability, dividend payouts, and sustainable growth
rates.
The DuPont System
Financial Statement Analysis and
Forecasting
A Framework for Financial Analysis
Return on Equity (ROE) and DuPont System
• The DuPont System gives a framework for the
analysis of financial statements through the
decomposition of the Return on Equity ratio
ROE 
NI
SE
[4-1]
Net Income
Return on Equity 
Shareholde rs' Equity
(See Figure 4 -2 that illustrates the constituent parts of ROE )
Framework for Financial Analysis
Du Pont System
4 - 2 FIGURE
ROE
NI
ROA 
TA

 NI 
 Sales 

Sales
TA
GOOD OR BAD?
 TA 
 SE 
LEVERAGE RATIOS
EFFICIENCY RATIOS
PRODUCTIVITY
RATIOS
A Framework for Financial Analysis
DuPont System and Decomposition of ROE
• As Figure 4 – 2 illustrates, ROE is a function of:
– Corporate use of leverage (use of debt)
– Efficiency ratios (ability of the firm to control costs in relationship to
sales)
– Productivity ratios (the degree to which the firm can generate sales in
relationship to assets employed)
ROE 
NI
SE
Net Income
Return on Equity 
Shareholde rs' Equity
[4-1]
A Framework for Financial Analysis
Return on Equity (ROE) and DuPont System
• ROE is not a pure ratio because it involves dividing an income
statement item (flow) by a balance sheet (stock) item.
ROE 
NI
SE
[4-1]
Net Income
Return on Equity 
Shareholde rs' Equity
• Instead of using ending SE, many argue you should use
average SE (beginning SE plus ending SE divided by 2)
because SE changes over the year as income is earned and
retained earnings grow.
A Framework for Financial Analysis
Return on Equity (ROE)
ROA
Leverage
NI  NI
Sales  TA
ROE 




SE  Sales TA  SE
[4- 7]
ROE when decomposed shows that it is a function of the
return earned on assets and of the leverage used by the firm.
A Framework for Financial Analysis
Return on Total Assets
• ROA shows the ratio of income to assets that
have been used to produce them.
ROA 
NI
TA
Return on Assets 
Net Income
Total Assets
[4-2]
• ROA can be further decomposed as shown and
the following slide
A Framework for Financial Analysis
Return on Assets (ROA)
• ROA is the product of the net profit margin and
the sales to total asset ratio:
NI
NI
Sales
ROA 


TA Sales
TA
[4- 6]
• The sales cancel and we are left with NI / TA
A Framework for Financial Analysis
Leverage Ratio
• If ROA is multiplied by TA and divided by SE, the TA’s
cancel out and produces ROE.
• TA / SE is the leverage ratio
Leverage 
Leverage 
TA
SE
[4-3]
Total Assets
Shareholde rs' Equity
• It measures how many dollars of total assets are
supported by each dollar of Shareholders Equity.
DuPont System
• The DuPont system provides a good starting point for
any financial analysis
– It shows that financial strength comes from many sources
(profitability, asset utilization, leverage)
– It reinforces the concept that good financial analysis requires
looking at each ratio in the context of the other
– Whenever you are presented with financial statements it is
important that you look at a sample of ratios from each major
category to identify areas of strength and weakness
(Table 4 -1 illustrates E-Trade Canada’s ROE analysis of Rothmans)
A Framework for Financial Analysis
Return on Equity (ROE) and the DuPont System
Table 4-1 E-Trade Canada's Rothman's Dupont ROE Analysis
Return on Equity
(1) Net Sales
(2) Pretax Income
(3) Net Income
(4) Total assets
(5) Shareholders' equity
Pretax margin % (2/1)
× Tax retent % (3/2)
=profit margin % (3/1)
× Asset Utilization % (1/4)
= ROA % (3/4)
× Leverage % (4/5)
=ROE % (3/5)
So urce: Data fro m E-Trade Canada
3/31/2006
652,271
274,829
99,464
449,075
113,860
42.13%
36.19%
15.25%
145.25%
22.15%
394.41%
87.36%
3/31/2005
636,771
261,345
92,997
528,528
193,708
41.04%
35.58%
14.60%
120.48%
17.60%
272.85%
48.01%
3/31/2004
620,104
252,683
90,277
496,757
168,497
40.75%
35.73%
14.56%
124.83%
18.17%
294.82%
53.58%
3/31/2003
575,469
240,197
86,678
429,965
130,537
41.74%
36.09%
15.06%
133.84%
20.16%
329.38%
66.40%
Interpreting Ratios
• A ratio is just one number over another number
– by itself, there is little ‘information’
• To judge whether a ratio is ‘good’ or ‘bad’
requires that it be compared to something else
such as:
– The company’s own ratios over time to ascertain
trends
– Other comparable companies or industry averages
(Table 4 -2 illustrates Rothmans DuPont ratios over time)
A Framework for Financial Analysis
Interpreting Ratios
Table 4-2 Rothman's Dupont Ratios
Rothmans (March 31)
ROE
ROA
Net profit margin
Turnover
Leverage
2004
2005
2006
0.5358
0.1817
0.1456
1.2483
2.9482
0.4801
0.1760
0.1460
1.2048
2.7285
0.8736
0.2215
0.1525
1.4525
3.9441
Do you see trends here?
What factors are driving the
trend in ROE?
A Framework for Financial Analysis
Interpreting Ratios
Table 4-3 Altria's Dupont Ratios
Altria (December 31)
ROE
ROA
Net profit margin
Turnover
Leverage
2003
2004
2005
0.3670
0.0957
0.1132
0.8455
3.8352
0.3066
0.0926
0.1051
0.8816
3.3095
0.2922
0.0967
0.1066
0.9065
3.0232
Do you see trends here?
What factors are driving the trend in ROE?
How do these results compare to Rothmans
on the previous slide?
Leverage Ratios
Financial Statement Analysis and
Forecasting
Leverage
• Leverage = magnification
• Financial leverage occurs when a firm uses
sources of financing that carry a fixed cost
(such as long-term debt), and uses this to
generate greater returns that result in
magnified returns to shareholders.
• Leverage means magnification of either profits
or losses.
Leverage Ratios
• Include:
–
–
–
–
Debt ratio
Debt to equity ratio
Times interest earned ratio
Cash flow to debt ratio
Leverage Ratios
Debt Ratio
• Is a stock ratio indicating the proportion of total
assets financed by debt at a particular point in
time (the balance sheet date)
TL Total Liabilitie s
Debt ratio 

TA
Total Assets
[4- 8]
Leverage Ratios
Debt-Equity Ratio
• Is a stock ratio indicating the proportion that
total debt represents in relationship to the
shareholders equity (common stock and
retained earnings) at the balance sheet date.
D
Total Debt
Debt/Equit y ratio 

SE Shareholde rs' Equity
[4- 9]
Leverage Ratios
Times Interest Earned (TIE)
• Is an income statement (flow) ratio indicating
the number of times the firm’s pre-tax income
exceeds its fixed financial obligations to its
lenders (debt holders)
EBIT
I
Earnings Before Interest and Taxes
TIE 
Interest Expense
Times Interest Earned 
[4- 10]
Leverage Ratios
Cash Flow to Debt Ratio
• Measures how long it would take to payoff a
firm’s debt (D)
CFO
Cash flow to debt ratio 
D
Cash Flow from Operations
CF / D 
Total Debt
[4- 11]
Leverage Ratios
Cash Flow to Debt Ratio
Table 4-4 Leverage Ratios
Rothmans (March 31)
Leverage
Debt ratio
D/E ratio
TIE
Cash flow to debt
Altria (December 31)
2004
2005
2006
2003
2004
2005
2.9482
0.6608
0.8902
46.7842
1.5037
2.7285
0.6335
0.7729
36.1270
1.0823
3.9441
0.7465
1.3152
42.7356
1.2235
3.8352
0.7393
0.9785
13.7035
0.4408
3.3095
0.6978
0.7482
12.9082
0.4739
3.0232
0.6692
0.6703
14.3405
0.4621
Which firm exhibits greater use of leverage?
Which exhibits greater capacity to take on and
service debt?
Efficiency Ratios
Financial Statement Analysis and
Forecasting
Efficiency Ratios
Efficiency ratios measure how efficiently a
dollar of sales is turned into profits.
• Gives insight to the firm’s cost structure
• Whether problems exist with variable costs or fixed costs
(overhead) or both
Efficiency Ratios
• Include:
–
–
–
–
Degree of total leverage
Break-even point
Gross profit margin
Operating margin
Efficiency Ratios
Interpreting Ratios
Table 4-5 Profit Margin and Sales Variability
Sales
Contribution margin (40%)
Fixed cost
Interest
Tax
Net income
120
48
31
5
6
6
132
53
51
5
8.5
8.5
108
43
31
5
3.5
3.5
Net profit margin
5.0%
6.4%
3.2%
The focus of efficiency ratios is with the income statement.
This example demonstrates the leverage effect of using fixed
costs in lieu of variable costs in the cost structure.
Sales varied by +/- of 10% yet profits varied by +/- 40%.
Efficiency Ratios
Degree of Total Leverage Ratio
• An income statement ratio that measures the
exposure of profits to changes in sales.
• The greater the DTL, the greater leverage
effect.
CM
EBT
Contributi on Margin
DTL 
Earnings Before Taxes
Degree of Total Leverage 
[4- 12]
Efficiency Ratios
Break Even Point
• Estimates the volume of units that must be produced and
sold in order for the firm to cover all costs both fixed and
variable.
FC
Break Even Point 
CM
Fixed Costs
BEP 
Contributi on Margin
[4- 13]
• The break even point tends to increase as the use of
fixed costs increases.
Efficiency Ratios
Gross Profit Margin
• Demonstrates the percentage of sales that are available
to cover fixed (period) costs and financing expenses
after variable costs have been paid.
S  CGS
S
Sales - Cost of Goods Sold
GPM 
Sales
Gross Profit Margin 
[4- 14]
• A declining gross profit margin raises concerns about
the firm’s ability to control variable costs such as direct
materials and direct labour.
Efficiency Ratios
Operating Margin
• Operating margin measures the cumulative
effect of both variable and period costs on the
ability of the firm to turn sales into operating
profits to cover, interest, taxes, depreciation
and amortization (EBITDA).
NOI
Sales
Net Operating Income
OM 
Sales
Operating Margin 
[4- 15]
Efficiency Ratios
Interpreting Ratios
Table 4-6 Efficiency Ratios
Rothmans (March 31)
Net profit margin
Gross profit margin
Operating margin
Altria (December 31)
2004
2005
2006
2003
2004
2005
0.1456
0.4261
0.4102
0.1460
0.4305
0.4155
0.1525
0.4426
0.4263
0.1132
0.3519
0.1938
0.1051
0.3348
0.1867
0.1066
0.3286
0.1696
Which firm is able to produce a greater percentage of sales as
profits?
Which firm is able to produce strong and consistent
profitability?
Productivity Ratios
Financial Statement Analysis and
Forecasting
Productivity Ratios
• Measure the ability of the firm to generate sales
from the assets that it employs.
• Excessive investment in assets with little or no
increase in sales reduces the rate of return on
both assets and equity (ROA) and (ROE)
Productivity Ratios
• Include:
–
–
–
–
–
Receivables turnover
Average collection period (ACP)
Inventory turnover
Average days sales in inventory (ADSI)
Fixed asset turnover
Productivity Ratios
Receivables Turnover
• Measures the sales generated by every dollar of
receivables.
Receivable s turnover 
RT 
S
AR
Sales
Accounts Receivable
[4- 16]
Productivity Ratios
Average Collection Period
• Estimates the number of days it takes a firm to collect on
its accounts receivable.
Average Collection Period 
ACP 
AR
365

ADS Receivable s Turnover
[4- 17]
AR
Receivable s turnover
• If ACP is 40 days, and the firm’s credit policy is net 30,
clearly, customers are not paying in keeping with the
firm’s policy, and there may be concerns about the
quality of the firm’s customers, and what might happen if
economic conditions deteriorate.
Productivity Ratios
Inventory Turnover
• Estimates the number of times, ending inventory was
‘turned over’ (sold) in the year.
CGS
Inventory Turnover 
INV
[4- 18]
• A ratio that involves both ‘stock’ and ‘flow’ values
• Is strongly a function of ending inventory
value…managers often try to improve this ratio as they
approach year end through inventory reduction
strategies (cash and carry sales/inventory clearance,
etc.)
Productivity Ratios
Inventory Turnover
• When Cost of Goods Sold is not available, it may be
necessary to estimate inventory turnover using sales.
Sales
Inventory Turnover 
INV
[4- 19]
• Use of the sales figure is less valid than Cost of Goods
Sold because Cost of Goods Sold is based on inventoried
cost, but Sales includes a profit margin on top of
inventoried cost.
Productivity Ratios
Average Days Sales in Inventory (ADSI)
• Estimates the number of days of sales tied up in
inventory (based on ending inventory values)
Average days sales in inventory (ADSI) 

365
Inventory turnover
INV
ADS
[4- 20]
Productivity Ratios
Fixed Asset Turnover
• Estimates the number of dollars of sales
produced by each dollar of net fixed assets.
Fixed Asset Turnover 

S
NFA
Sales
Net Fixed Assets
[4- 21]
Productivity Ratios
Interpreting Ratios
Table 4-7 Productivity Ratios
Rothmans (March 31)
2004
2005
2006
Altria (December 31)
2003
Turnover
1.2483
1.2048
1.4525
0.8455
Receivables turnover 19.3825 19.8254 55.3006
NA
ACP
18.8314 18.4108 6.6003
NA
Inventory turnover
3.1170
3.0349
3.1597
8.5241
(using sales)
ADSI
117.0988 120.2692 115.5165 42.8197
Fixed asset turnover 11.0158 9.2087
8.5490
5.0613
2004
2005
0.8816
15.5735
23.4372
0.9065
18.2529
19.9968
8.9244
40.8991
5.4959
9.2455
39.4788
5.8673
Which firm has been improving its efficiency ratios to a
greater degree?
Liquidity Ratios
Financial Statement Analysis and
Forecasting
Liquidity Ratios
• Measure the ability of the firm to meet its
maturing financial obligations through liquid
(cash and near cash) resources
• Include:
– Working capital ratio
– Current ratio
– Quick (acid-test) ratio
4 - 45
Liquidity Ratios
Working Capital Ratio
• Measures the percentage of total assets that is
invested in current assets.
• Helps to analyze capital intensity as well as
corporate liquidity.
CA
Working Capital Ratio 
TA
Current Assets

Total Assets
[4- 22]
Liquidity Ratios
Current Ratio
• Measures the number of dollars of current
assets for each dollar of current liabilities.
• Helps to estimate the capacity of the firm to
meet its maturing financial obligations.
CA
CL
Current Assets

Current Liabilitie s
Current Ratio 
[4- 23]
Liquidity Ratios
Quick Ratio
• Recognizing that inventories may be less liquid than
other current assets, and in some cases, when
liquidated quickly result in cash flows that are less than
book value, the quick ratio gives a clearer indication of
the firm’s ability to meet its maturing financial
obligations out of current, liquid assets.
C  MS  AR
CL
Current Assets  Inventories

Current Liabilitie s
Quick Ratio 
[4- 24]
Liquidity Ratios
Interpreting Ratios
Table 4-8 Liquidity Ratios
Rothmans (March 31)
Current ratio
Quick ratio
Working capital ratio
Altria (December 31)
2004
2005
2006
2003
2004
2005
2.8868
1.4981
0.8414
2.9310
1.5092
0.8235
2.4756
1.0037
0.7800
NA
NA
NA
1.0987
0.4877
0.2548
0.9856
0.4442
0.2388
Which firm has greater liquidity and capacity to meet its
financial obligations?
Valuation Ratios
Financial Statement Analysis and
Forecasting
Valuation Ratios
• Used to assess how the market is valuing the
firm (share price) in relationship to assets and
current earnings, profits and dividends
• Include:
–
–
–
–
–
–
–
Equity book value per share (BVPS)
Dividend yield
Dividend payout
Price-earnings (P/E) ratio
Forward (P/E) ratio
Market-to-book (M/B) ratio
EBITDA multiple
Valuation Ratios
Interpreting Ratios – Book Value per Share
• Expresses shareholders’ equity on a per share
basis.
Shareholde rs' Equity
Book Value Per Share 
Number of Shares
[4- 25]
Valuation Ratios
Interpreting Ratios – Dividend Yield
• Expresses dividend payout as a percentage of
the current share price.
Dividend Per Share DPS
Dividend Yield 

Price per Share
P
[4- 26]
• Can be compared to other investment
instruments such bonds (current yield) or with
other dividend-paying companies.
Valuation Ratios
Interpreting Ratios – Dividend Payout Ratio
• Expresses dividends as a percentage of
earnings on a per share basis.
Dividend Per Share DPS
Dividend Payout 

Earnings per Share EPS
[4- 27]
Valuation Ratios
Interpreting Ratios – Trailing P/E Ratio
• Earnings multiple based on the most recent earnings.
• Often used in estimating the value of a stock.
Price - earnings ratio 
Share Price
P

Earnings per Share EPS
[4- 28]
• A stock trading at a P/E multiple of 10 will take ten years
at current earnings to recover the price of the stock.
• A stock trading at a P/E multiple of 100 will take 100
years at current annual earnings to recover the price of
the stock.
Valuation Ratios
Interpreting Ratios – Forward P/E Ratio
• Earnings multiple based on forecast earnings per share.
• Often used in estimating the value of a stock especially
with companies with rapid growth in earnings per share.
Forward Price - earnings ratio 
Share Price
P

Estimated Earnings per Share EEPS
• Low P/E shares are regarded as value stocks
• High P/E shares are regarded as growth stocks
[4- 29]
Valuation Ratios
Interpreting Ratios – Market to Book Ratio
• Estimates the dollars of Share Price per dollar of book
value per share.
Market - to - book ratio 
Share Price
P

Book Value per Share BVPS
[4- 30]
• Given historical cost accounting as the basis for book
value per share, the degree to which market value per
share exceeds BVPS indicates the value that has been
added to the company by management.
Valuation Ratios
Interpreting Ratios – EBITDA Multiple
• Total enterprise value is an estimate of the total market
value of the firm (market value of equity plus market
value of debt)
• EBITDA multiple expresses total enterprise value for
each dollar of operating income (EBITDA)
Total Enterprise Value
Earnings before interest, taxes, depreciati on and amortizati on
TEV

EBITDA
EBITDA multiple 
Valuation Ratios
Interpreting Ratios
Table 4-10 Value Ratios
Rothmans (March 31)
Dividend yield
Dividend payout
P/E
M/B
EBITDA multiple
Dividend yield (excl.
special dividend)
Dividend payout (excl.
special dividend)
Altria (December 31)
2004
2005
2006
2003
2004
2005
0.0474
0.6063
12.7799
6.8451
4.8535
0.0438
0.7664
17.5109
8.3685
6.3545
0.1333
1.8621
13.9655
12.0682
5.2095
0.0485
0.5841
12.0398
4.4208
7.8436
0.0462
0.6184
13.3991
4.0979
8.8194
0.0410
0.6132
14.9739
4.6319
9.7774
N/A
N/A
0.0593
N/A
N/A
N/A
N/A
N/A
0.8276
N/A
N/A
N/A
Can you draw any conclusions for the comparative valuation
ratio data summarized in this table?
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Common Size Statements
 A common size financial statement is a
standardized version of a financial statement in
which all entries are presented in percentages.
 A common size financial statement helps to
compare entries in a firm’s financial statements,
even if the firms are not of equal size.
 How to prepare a common size financial statement?
 For a common size income statement, divide each
entry in the income statement by the company’s sales.
 For a common size balance sheet, divide each entry in
the balance sheet by the firm’s total assets.
Whole Foods Market,
Comparative Income Statement
5-62
Common Size
statements
5-63
Business Segment information
5-64
Comparative Balance Sheet
5-65
Comparative Balance Sheet
5-66
Common size and trend analysis
5-67
Common size and trend analysis (Exhibit
5.5 continued)
5-68
Common size and trend analysis
5-69
Common size and trend analysis (Exhibit
5.6 continued)
5-70
Comparative Cash Flows
5-71
Common size trend analysis
5-72
The Limitations of Ratio Analysis
1.
Picking an industry benchmark can sometimes be difficult.
2.
Published peer-group or industry averages are not always
representative of the firm being analyzed.
3.
An industry average is not necessarily a desirable target or
norm.
4.
Accounting practices differ widely among firms.
5.
Many firms experience seasonal changes in their operations.
6.
Financial ratios offer only clues. We need to analyze the
numbers in order to fully understand the ratios.
7.
The results of financial analysis are dependent on the quality of
the financial statements.