Eugene F. Brigham & Joel F. Houston
Fundamentals of Financial
Management Concise 8E
2-1
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Chapter 4
Analysis of Financial Statements
Ratio Analysis
DuPont Equation
Effects of Improving Ratios
Limitations of Ratio Analysis
Qualitative Factors
4-2
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Balance Sheet: Assets
Cash
A/R
Inventories
Total CA
Gross FA
Less: Deprec.
Net FA
Total Assets
2015E
85,632
878,000
1,716,480
2,680,112
1,197,160
380,120
817,040
3,497,152
2014
7,282
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
4-3
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Balance Sheet: Liabilities and Equity
Accts payable
Accruals
Notes payable
Total CL
Long-term debt
Common stock
Retained earnings
Total Equity
Total L & E
2015E
436,800
408,000
300,000
1,144,800
400,000
1,721,176
231,176
1,952,352
3,497,152
2014
524,160
489,600
636,808
1,650,568
723,432
460,000
32,592
492,592
2,866,592
4-4
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Income Statement
Sales
COGS
Other expenses
EBITDA
Deprec. & amort.
EBIT
Interest exp.
EBT
Taxes
Net income
2015E
7,035,600
5,875,992
550,000
609,608
116,960
492,648
70,008
422,640
169,056
253,584
2014
6,034,000
5,528,000
519,988
(13,988)
116,960
(130,948)
136,012
(266,960)
(106,784)
(160,176)
4-5
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Other Data
No. of shares
EPS
DPS
Stock price
Lease pmts
2015E
250,000
$1.014
$0.220
$12.17
$40,000
2014
100,000
-$1.602
$0.110
$2.25
$40,000
4-6
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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.
 Industry analysis
 Benchmark (peer) analysis
 Trend analysis
4-7
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Five Major Categories of Ratios and the Questions
They Answer
•
•
Liquidity: Can we make required payments?
•
•
Debt management: Right mix of debt and equity?
•
Asset management: Right amount of assets vs.
sales?
Profitability: Do sales prices exceed unit costs, and
are sales high enough as reflected in PM, ROE, and
ROA?
Market value: Do investors like what they see as
reflected in P/E and M/B ratios?
4-8
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D’Leon’s Forecasted Current Ratio and Quick Ratio
for 2015
Current assets
Current liabilitie s
$2,680

$1,145
 2.34 
Current ratio 
(Current assets  Inventorie s)
Current liabilitie s
($2,680  $1,716 )

$1,145
 0.84 
Quick ratio 
4-9
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Comments on Liquidity Ratios
2015E
2014
2013
Ind.
Current ratio
2.34x
1.20x
2.30x
2.70x
Quick ratio
0.84x
0.39x
0.85x
1.00x
•
•
Expected to improve but still below the industry
average.
Liquidity position is weak.
4-10
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D’Leon’s Inventory Turnover vs. the Industry Average
Inv. turnover = Sales/Inventories
= $7,036/$1,716
= 4.10x
Inventory turnover
2015E
2014
2013
Ind.
4.1x
4.70x
4.8x
6.1x
4-11
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Comments on Inventory Turnover
•
•
Inventory turnover is below industry average.
•
No improvement is currently forecasted.
D’Leon might have old inventory, or its control
might be poor.
4-12
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DSO: Average Number of Days After Making a Sale
Before Receiving Cash
DSO = Receivables/Avg. sales per day
= Receivables/(Annual sales/365)
= $878/($7,036/365)
= 45.6 days
4-13
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Appraisal of DSO
DSO
•
•
2015E
2014
2013
Ind.
45.6
38.2
37.4
32.0
D’Leon collects on sales too slowly, and is getting
worse.
D’Leon has a poor credit policy.
4-14
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Fixed Assets and Total Assets Turnover Ratios vs. the
Industry Average
FA turnover = Sales/Net fixed assets
= $7,036/$817 = 8.61x
TA turnover = Sales/Total assets
= $7,036/$3,497 = 2.01x
4-15
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Evaluating the FA Turnover (S/Net FA) and TA
Turnover (S/TA) Ratios
•
•
2015E
2014
2013
Ind.
FA TO
8.6x
6.4x
10.0x
7.0x
TA TO
2.0x
2.1x
2.3x
2.6x
FA turnover projected to exceed the industry
average.
TA turnover below the industry average. Caused by
excessive currents assets (A/R and Inv).
4-16
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Calculate the Debt-to-Capital Ratio and
Times-Interest-Earned Ratio
Debt-to-capital ratio = Total debt/Total invested capital
= ($300 + $400)/($300 + $400 + $1,952.4)
= 26.4%
TIE = EBIT/Interest
= $492.6/$70 = 7.0x
4-17
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D’Leon’s Debt Management Ratios vs. the Industry
Averages
2015E
2014
2013
Ind.
Debt/Total Inv. Capital
26.4%
73.4%
44.1%
40.0%
TIE
7.0x
-1.0x
4.3x
6.2x
•
Debt/Total invested capital and TIE are better than
the industry average.
4-18
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Profitability Ratios: Operating Margin, Profit
Margin, and Basic Earning Power
Operating margin = EBIT/Sales
= $492.6/$7,036 = 7.0%
Profit margin = Net income/Sales
= $253.6/$7,036 = 3.6%
Basic earning power = EBIT/Total assets
= $492.6/$3,497 = 14.1%
4-19
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Appraising Profitability with Operating Margin,
Profit Margin, and Basic Earning Power
Operating margin
Profit margin
Basic earning power
2015E 2014
7.0% -2.2%
3.6% -2.7%
14.1% -4.6%
2013
Ind.
5.5% 7.3%
2.6% 3.5%
13.0% 19.1%
4-20
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Appraising Profitability with Operating Margin,
Profit Margin, and Basic Earning Power
•
•
•
•
Operating margin was very bad in 2014. It is
projected to improve in 2015, but it is still projected
to remain below the industry average.
Profit margin was very bad in 2014 but is projected
to exceed the industry average in 2015. Looking
good.
BEP removes the effects of taxes and financial
leverage, and is useful for comparison.
BEP projected to improve, yet still below the
industry average. There is definitely room for
improvement.
4-21
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Profitability Ratios: Return on Assets, Return on
Equity, and Return on Invested Capital
ROA = Net income/Total assets
= $253.6/$3,497 = 7.3%
ROE = Net income/Total common equity
= $253.6/$1,952 = 13.0%
ROIC = [EBIT(1  T)]/Total invested capital
= $295.6/$2,652.4 = 11.1%
4-22
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Appraising Profitability with ROA, ROE,
and ROIC
ROA
ROE
ROIC
•
•
2015E
7.3%
13.0%
11.1%
2014
-5.6%
-32.5%
-4.2%
2013
6.0%
13.3%
9.6%
Ind.
9.1%
18.2%
14.5%
All ratios rebounded from the previous year, but are
still below the industry average. More
improvement is needed.
Wide variations in ROE illustrate the effect that
leverage can have on profitability.
4-23
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Effects of Debt on ROA and ROE
•
Holding assets constant, if debt increases:
 Equity declines.
 Interest expense increases – which leads to a
•
•
reduction in net income.
ROA declines (due to the reduction in net income).
ROE may increase or decrease (since both net
income and equity decline).
4-24
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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.
Given these problems, reliance on ROE may
encourage managers to make investments that do
not benefit shareholders. As a result, analysts have
looked to develop other performance measures,
such as EVA.
4-25
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Calculate the Price/Earnings and Market/Book Ratios
P/E = Price/Earnings per share
= $12.17/$1.014 = 12.0x
M/B = Market price/Book value per share
= $12.17/($1,952/250) = 1.56x
2015E
2014
2013
Ind.
P/E
12.0x
-1.4x
9.7x
14.2x
M/B
1.56x
0.5x
1.3x
2.4x
4-26
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Analyzing the Market Value Ratios
•
•
•
•
P/E: How much investors are willing to pay for $1 of
earnings.
M/B: How much investors are willing to pay for $1
of book value equity.
For each ratio, the higher the number, the better.
P/E and M/B are high if expected growth is high and
risk is low.
4-27
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The DuPont Equation
Equity
Profit
Total assets
ROE  margin  turnover 
multiplier
ROE  (NI/Sales)  (Sales/TA)  (TA/Equity )
•
Focuses on expense control (PM), asset utilization
(TA TO), and debt utilization (equity multiplier).
4-28
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DuPont Equation:
Breaking Down Return on Equity
ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)
= 3.6%
x
2.01
x
1.7913
= 13.0%
2013
2014
2015E
Ind.
PM
2.6%
-2.7%
3.6%
3.5%
TA TO
2.3
2.1
2.0
2.6
EM
2.2
5.8
1.79
2.0
ROE
13.3%
-32.5%
13.0%
18.2%
4-29
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An Example:
The Effects of Improving Ratios
Accounts receivable
Other current assets
Net fixed assets
Total assets
$ 878
1,802
817
$3,497
Current liabilities
Debt
Equity
Total liabilities & equity
$ 845
700
1,952
$3,497
Sales/Day = $7,035,600/365 = $19,275.62
How would reducing the firm’s DSO to 32 days affect
the company?
4-30
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Reducing Accounts Receivable and the Days Sales
Outstanding
•
Reducing A/R will have no effect on sales
Old A/R = $19,275.62 × 45.6
= $878,000
New A/R = $19,275.62 × 32.0
= $616,820
Cash freed up:
•
$261,180
Initially shows up as addition to cash.
4-31
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Effect of Reducing Receivables on Balance Sheet
and Stock Price
Added cash
Accounts receivable
Other current assets
Net fixed assets
Total assets
$ 261
617
1,802
817
$3,497
Current liabilities
Debt
$ 845
700
Equity
Total liabilities & equity
1,952
$3,497
What could be done with the new cash?
How might stock price and risk be affected?
4-32
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Potential Uses of Freed Up Cash
•
•
•
•
Repurchase stock
Expand business
Reduce debt
All these actions would likely improve the stock
price.
4-33
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Potential Problems and Limitations of Financial
Ratio Analysis
•
•
•
•
Comparison with industry averages is difficult for a
conglomerate firm that operates in many different
divisions.
Different operating and accounting practices can
distort comparisons.
Sometimes it is hard to tell if a ratio is “good” or
“bad.”
Difficult to tell whether a company is, on balance, in
a strong or weak position.
4-34
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More Issues Regarding Ratios
•
•
•
•
“Average” performance is not necessarily good,
perhaps the firm should aim higher.
Seasonal factors can distort ratios.
“Window dressing” techniques can make
statements and ratios look better than they actually
are.
Inflation has distorted many firms’ balance sheets,
so analyses must be interpreted with judgment.
4-35
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Consider Qualitative Factors When Evaluating a
Company’s Future Financial Performance
•
•
•
•
•
Are the firm’s revenues tied to one key customer,
product, or supplier?
What percentage of the firm’s business is generated
overseas?
Firm’s competitive environment
Future prospects
Legal and regulatory environment
4-36
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