Fundamentals
of Corporate
Finance
Third Canadian Edition
prepared by:
Sujata Madan
McGill University
Copyright © 2006 McGraw Hill Ryerson Limited
17-1
Chapter 17 Financial Statement
Analysis
 Financial Ratios
 The DuPont System
 Analysis of the Statement of Cash Flows
 Using Financial Ratios
 Measuring Company Performance
 The Role of Financial Ratios
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Financial Ratios
 Introduction
 This chapter will describe:
1. Leverage ratios – show how heavily a
company is in debt.
2. Liquidity ratios – measure how easily a
firm can lay its hands on cash.
3. Efficiency or Turnover Ratios – measure
how productively a firm is using its assets.
4. Profitability Ratios – measure the firm’s
return on its investments.
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Financial Ratios
Leverage Ratios
 Leverage ratios show how much financial
leverage a firm is carrying.
 Financial leverage adds risk to the firm.
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Financial Ratios
Leverage Ratios
Long Term Debt Ratio =
Debt-Equity Ratio =
Total Debt Ratio =
LT Debt + Value of Leases
LT Debt + Value of Leases + Equity
LT Debt + Value of Leases
Equity
Total Liabilities
Total Assets
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Financial Ratios
Leverage Ratios
Times Interest Earned (TIE) =
Cash Coverage Ratio =
EBIT
Interest Payments
EBIT + Depreciation & Amortization
Interest Payments
Fixed Charge Coverage Ratio =
EBIT + Depreciation & Amortization
Interest Pymts+(Current Debt Repymt+Current Lease Obligations)
(1 - Tax Rate)
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Financial Ratios
 Liquidity Ratios
 Liquidity Ratios measure how much of
the company’s assets are liquid.
 Liquid refers to an asset which can be
converted to cash quickly and at low cost.
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Financial Ratios
Liquidity Ratios
Net Working Capital =
Net Working Capital as a
% of Total Assets
Current Assets – Current Liabilities
=
Net Working Capital
Total Assets
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Financial Ratios
Liquidity Ratios
Current Ratio =
Quick Ratio =
Current Assets
Current Liabilities
Cash + Marketable Securities + Receivables
Current Liabilities
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Financial Ratios
Efficiency Ratios
Asset Turnover Ratio
=
Fixed Asset Turnover Ratio =
Sales
Average Total Assets
Sales
Average Fixed Assets
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Financial Ratios
Efficiency Ratios
Average Collection
Period
=
Inventory Turnover Ratio =
Days’ Sales in Inventories =
Average Receivables
Average Daily Sales
Cost of Goods Sold
Average Inventory
Inventory
Cost of Goods Sold/365
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Financial Ratios
Profitability Ratios
One group, called profit margins, look at
profits or earnings as a fraction of sales.
The other group, called return ratios,
measure profits earned as a fraction of the
assets used.
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Financial Ratios
Profitability Ratios – Profit Margins
Gross Profit Margin
=
Sales – Cost of Goods Sold
Sales
Operating Profit Margin =
Net Profit Margin =
EBIT – Taxes
Sales
Net Income
Sales
or
Net Income + Interest
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Sales
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Financial Ratios
Profitability Ratios – Return Ratios
Return on Assets (ROA)
Return on Equity =
=
Net Income + Interest
Average Total Assets
Net Income
Average Equity
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Financial Ratios
 Profitability Ratios
Payout Ratio
=
Dividends
Earnings
Plowback Ratio = 1 – Payout Ratio =
Earnings - Dividends
Earnings
Growth in Equity from Plowback
=
Earnings - Dividends
Earnings
= Plowback x ROE
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The DuPont System
 DuPont System - ROA
 Some profitability and efficiency measures can be
linked in useful ways.
ROA =
=
Net Income + Interest
Assets
Sales
Assets
x
Asset Turnover
Net Income + Interest
Sales
Profit Margin
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The DuPont System
 DuPont System - ROE
Net Income
Equity
ROE =
=
Assets
Equity

Leverage
Sales
Assets

Net Income+Interest
Sales
Asset Turnover
Net Income

Net Income+Interest
Profit Margin
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Debt Burden
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Analysis of the Statement of
Cash Flows
 Analysis of the Statement of Cash Flows can tell
you a lot about the financial health of a firm.
 By contrast, the Income Statement gives a
better sense of the long-run profitability of the
firm.
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Using Financial Ratios
Choosing a Benchmark
 Once financial ratios have been calculated for a
firm, they need to be compared to a
benchmark.
 The benchmark could be:
 The firm’s performance in prior years.
 Another firm’s performance.
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Using Financial Ratios
 Financial Ratios for Selected Industry
Groups, 2004
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Measuring Company Performance
MVA and EVA
 Market Value Added is the difference between
the market value of a firm’s equity and its book
value.
 Economic Value Added (EVA or Residual
Income) measures the net profit of a firm after
deducting the cost of the capital employed.
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Measuring Company Performance
EVA
 EVA or residual income is a better measure of
company performance than accounting profits.
 EVA recognizes that companies need to cover
their cost of capital before they can add value.
 Residual income = After-tax operating profit cost of capital x invested capital
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The Role of Financial Ratios
 Helping Financial Managers Make
Decisions
 Ratios can help you understand, and improve,
your company’s financial health by making
sure that its leverage, liquidity, efficiency and
profitability are kept at optimal levels.
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Summary of Chapter 17
 As a financial manager, you will be responsible
for analyzing your company’s financial
statements.
 You will be looking at its income statement,
balance sheet and statement of cash flows.
 You will use financial ratios to summarize the
firm’s leverage, liquidity, profitability and
efficiency.
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Summary of Chapter 17
 The DuPont System provides a useful way to link
ratios to explain the firm’s return on assets and
equity.
 ROE is a function of the firm’s leverage ratio, asset
turnover, profit margin and debt burden.
 ROA is a function of asset turnover and profit margin.
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Summary of Chapter 17
 Financial ratios need a benchmark for
comparison. You can compare ratios with the
company’s ratios in prior years and/or with the
ratios of other firms in the same business.
 Other measures, such as Market Value Added
(MVA) and Economic Value Added (EVA) are
available to help you assess a firm’s
performance.
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