ANALYSIS OF FINANCIAL
STATEMENTS
Chapter 4
Outline
Why are ratios useful?



Ratios standardize numbers and facilitate
comparisons.
Ratios are used to highlight weaknesses and
strengths.
Ratio comparisons should be made through
time and with competitors.
 Trend analysis.
 Peer (or industry) analysis.
Major categories of ratios
LIQUIDITY
Liquidity ratios
Current assets
Current ratio=
Current liabilities
Current assets −inventory
Quick ratio=
Current liabilities
Net working capital Net working capital
=
Revenues
to sales
Net working capital=Current assets − current liabilities
Dell
Quick ratio
Net working capital to sales
Current or quick ratio
1.6
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
2006
2007
2008
Fiscal year
2009
2010
NWC to sales
Current ratio
Operating cycle


Operating cycle: The length of time it takes
for the investment of cash in inventory to be
returned in the form of payments from
customers.
The longer the operating cycle, the greater
the need for liquidity
Number of days
Accounts receivable
Days sales outstanding DSO =
Credit sales
365
Inventory
Days sales in inventory (DSI)=
COGS/365
Accounts payable
Days purchases
(DPO)=
outstanding
Purchases
365
Beg. Inv. + Purchases = COGS + End. Inv.
Operating cycle
Operating cycle = DSO + DSI
Cash conversion cycle = DSO + DSI - DPO
Number of days
Dell
120
100
80
60
40
20
0
-20
-40
-60
Days sales outstanding
Days sales in inventory
Days sales in purchases
Operating cycle
Cash conversion cycle
2006
Assumed all sales on credit
2007
2008
Fiscal year
2009
2010
ASSET EFFICIENCY
Turnovers
COGS
Inventory turnover=
Inventory
Credit sales
Accounts receivable turnover=
Accounts receivable
Revenues
Fixed asset turnover=
Fixed assets
Revenues
Total asset turnover=
Total assets
Dell
Inventory turnover
Fixed asset turnover
Total asset turnover
2.5
Number of times
70
2.0
60
50
1.5
40
1.0
30
20
0.5
10
0
0.0
2006
2007
2008
Fiscal year
2009
2010
Total asset turnover
80
Relationships
365
Days sales in inventory=
Inventory turnover
365
Days sales outstanding=
Accounts receivable turnover
PROFITABILITY
Profit margins
Gross profit
Gross profit margin=
Revenues
Operating profit
Operating profit margin=
Revenues
Net profit
Net profit margin=
Revenues
Dell
Gross profit margin
25%
Operating profit margin
Net profit margin
Profit margin
20%
15%
10%
5%
0%
2006
2007
2008
Fiscal year
2009
2010
FINANCIAL LEVERAGE
Debt management ratios
Debt
Debt−to−equity (D/E)=
Equity
Debt
Debt−to−assets=
Assets
Assets
Equity multiplier =
Equity
Debt management ratios, cont.
EBIT
Times interest earned (TIE)=
Interest expense
EBIT + Pfd div
Fixed charge coverage=
Fixed charges
Fixed charges: Interest, preferred dividends, lease
payments
Coverage
0.9
Debt-equity
Debt to total assets
Equity multiplier
Times interest earned
40
0.8
35
0.7
30
0.6
25
0.5
20
0.4
15
0.3
0.2
10
0.1
5
0.0
0
2006
2007
2008
Fiscal year
2009
2010
Multiplier and times interest
earned
Dell
Returns


The return on assets is the net profit
relative to total assets:
Net profit
Return on assets (ROA)=
Total assets
The return on equity is the net profit
relative to equity:
Net profit
Return on equity (ROE)=
Equity
Returns, cont.


The return on invested capital is the net
profit to invested capital:
Net profit
Return on invested
=
capital (ROIC)
Invested capital
Invested capital = Debt + equity
The basic earning power ratio is the
operating return on assets:
Operating profit
Basic earning power=
Total assets
Returns on assets and equity
Return on
equity
Return on
assets
Operating
profit margin
Equity
multiplier
Net profit
margin
Total asset
turnover
1- Tax
burden
1- Interest
burden
Returns on assets and equity
Return on equity
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝐸𝑞𝑢𝑖𝑡𝑦
Return on assets
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝐴𝑠𝑠𝑒𝑡𝑠
Net profit margin
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠
Operating profit
margin
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡
𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠
1-Tax burden
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥𝑒𝑠
Equity multiplier
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
𝐸𝑞𝑢𝑖𝑡𝑦
Total asset turnover
𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
1- Interest burden
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥𝑒𝑠
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡
Du Pont: Dell, FY2010
Return on equity
33.93%
Return on assets
Equity multiplier
6.83%
4.97 𝑡𝑖𝑚𝑒𝑠
Net profit
margin
4.29%
Operating profit
margin
5.00%
1-Tax burden
78.66%
Total asset
turnover
1.59 𝑡𝑖𝑚𝑒𝑠
1-Interest
burden
97.58%
Du Pont: Dell, 2006-2010
Return on equity
Equity multiplier
Return on assets
Total asset turnover
8
80%
7
Number of times
70%
60%
Return
Net profit margin
50%
40%
30%
20%
10%
5%
6
4%
5
4
3%
3
2%
2
1%
1
0%
2006 2007 2008 2009 2010
Fiscal year
6%
0
0%
2006 2007 2008 2009 2010
Fiscal year
Margin
90%
Example: Borders
4%
5%
2%
0%
0%
Net profit margin
10%
Return
-5%
-10%
-15%
-20%
-25%
-30%
2.5
Total asset turnover
Total assets
Net income (loss)
Total revenues
FY2005 FY2006 FY2007 FY2008 FY2009 FY2010
$2,572.2 $2,613.4 $2,302.7 $1,609.0 $1,425.2 $964.7
$101.0 -$151.3 -$157.4 -$186.7 -$109.4 -$299.0
$4,079.2 $4,113.5 $3,820.9 $3,275.4 $2,823.9 $2,274.9
-2%
-4%
-6%
-8%
-10%
-12%
-35%
2005 2006 2007 2008 2009 2010
Fiscal year
-14%
2005 2006 2007 2008 2009 2010
Fiscal year
Filed for bankruptcy 2011
2.0
1.5
1.0
0.5
0.0
2005 2006 2007 2008 2009 2010
Fiscal year
Problems with ROE

ROE and shareholder wealth are correlated,
but problems can arise when ROE is the sole
measure of performance.
 ROE does not consider risk.
 ROE does not consider the amount of capital
invested.
 Might encourage managers to make investment

decisions that do not benefit shareholders.
ROE focuses only on return and a better
measure would consider risk and return.
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
Return
Example: KO
Return on assets
Return on equity
Fiscal year
Return on stock
80%
60%
40%
20%
0%
-20%
-40%
-60%
-80%
Example: GM
Year
2005
2006
2007
2008
2009
2010
End of year
market value
of equity
(in millions)
$10,982
$17,377
$14,089
$1,954
$236
$55,295
ROA
-2.22%
-1.06%
-26.02%
-33.89%
76.91%
4.44%
ROE
-72.39%
36.35%
104.42%
35.82%
371.09%
17.06%
Stock
return
-51.49%
58.23%
-18.92%
-86.13%
-87.94%
NMF
MULTIPLES
Analyzing the market value ratios



Price-earnings ratio (P/E): How much
investors are willing to pay for $1 of earnings.
Market to book value of equity ratio
(M/B): How much investors are willing to pay
for $1 of book value equity.
Issues:
 What is the meaning of the book value of
equity?
 What is the Molodovsky effect?
Beyond ratios


Common size analysis
Qualitative analysis
Common size analysis


Common size analysis provides a “big
picture” of the changing relationships among
accounts over time by standardizing the data.
Two forms:
 Vertical: Each account as % of total
 Horizontal: Each account as % of base year
Vertical Example: Apple
Assets
100%
90%
80%
Net Property Plant & Equip
70%
Other Assets
60%
Deferred Long-term Assets
Prepayments Long-term
50%
Intangible Assets
40%
Long-term Investments
30%
Other Current Assets
20%
Prepayments, short-term
10%
Current Tax Assets
Inventories
09/30/1982
09/30/1983
09/28/1984
09/27/1985
09/26/1986
09/25/1987
09/30/1988
09/29/1989
09/28/1990
09/27/1991
09/25/1992
09/24/1993
09/30/1994
09/29/1995
09/27/1996
09/26/1997
09/25/1998
09/25/1999
09/30/2000
09/29/2001
09/28/2002
09/27/2003
09/25/2004
09/24/2005
09/30/2006
09/29/2007
09/27/2008
09/26/2009
09/25/2010
0%
Fiscal year end
Receivables
Cash & Equivs & ST Investments
Vertical example: Apple, cont.
Liabilities and equity
100%
90%
80%
Retained Earnings
70%
Other Equity
60%
For Curr Trans (BS)
50%
Accum Other Comprehensive Income
Preferred Share Capital
40%
Common Share Capital
30%
Other Liabilities
Deferred LT Liabilities
20%
LT Debt & Leases
Total Current Liabilities
10%
Fiscal year
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
0%
18000%
09/30/1982
09/30/1983
09/28/1984
09/27/1985
09/26/1986
09/25/1987
09/30/1988
09/29/1989
09/28/1990
09/27/1991
09/25/1992
09/24/1993
09/30/1994
09/29/1995
09/27/1996
09/26/1997
09/25/1998
09/25/1999
09/30/2000
09/29/2001
09/28/2002
09/27/2003
09/25/2004
09/24/2005
09/30/2006
09/29/2007
09/27/2008
09/26/2009
09/25/2010
Percentage of FY 1982
Horizontal example: Apple
Cash & Equivs & ST Investments
Receivables
16000%
Inventories
14000%
Net Property Plant & Equip
12000%
10000%
8000%
6000%
4000%
2000%
0%
ISSUES
(1) A single ratio is meaningless


Ratios must be put in context: in context of
other firms, historical, and company-specific
events.
A given value of a ratio is neither good or
bad; rather, it helps paint a picture of the
company’s health and performance.
(2) Comparisons to industry ratios may
be helpful



First challenge: identify the industry
Second challenge: identify comparables
Third challenge: construct industry ratios
 Equal v. value weighted ratios
(3) Trends break
M&A
Divestitures
Regulation change
Product line
changes
$70,000,000
$60,000,000
$50,000,000
$40,000,000
$30,000,000
$20,000,000
$10,000,000
$0
09/30/1982
09/27/1985
09/30/1988
09/27/1991
09/30/1994
09/26/1997
09/30/2000
09/27/2003
09/30/2006
09/26/2009




Apple’s Sales Revenue
In thousands
Analysis must be put
in context of
company-specific
events, e.g.,:
Fiscal year
(4) Seasonality and FY choice can
distort ratios

Companies select FY-end based on the lowpoint of their seasonal cycle.
 Therefore, working capital accounts are likely at

their lowest levels
Fix: Quarterly or monthly averages of
accounts instead of FY balance sheet levels.
(5) Window dressing


“Window dressing” techniques can make
statements and ratios look better.
Compensation plans can result in
distortions/dressing.
(6) Different methods of accounting

Companies have some choices in accounting
method (e.g., FIFO v. LIFO):
 Makes comparisons difficult (across firms and
across time)
 Makes interpretation challenging (because may
not have all the data).
QUALITATIVE ANALYSIS
Qualitative factors






Are the firm’s revenues tied to one key
customer, product, or supplier?
What percentage of the firm’s business is
generated overseas? Which countries?
The firm’s competitive environment: degree
of competitiveness
Future prospects / opportunities
Legal and regulatory environment
Product life cycle
Sources of qualitative information





10-K filings with the SEC
Annual reports
Press releases
Trade groups/associations
Government databases (e.g., Census, FTC,
BEA)
THE END