FINC3131
Business Finance
Chapter 4:
Financial Statement Analysis
1
Learning Objectives
1.
Explain why creditors, stockholders and managers
want to perform financial statement analysis.
2.
Calculate liquidity, asset utilization, debt utilization and
profitability ratios.
3.
Identify 3 limitations of ratio analysis.
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Objectives of
financial statement analysis
1. Creditors
•
Firm’s ability to repay borrowed funds, i.e.,
creditworthiness
2. Stockholders
•
Firm’s future prospects (cash flows )
3. Managers
•
Identify strengths & weaknesses so as to
improve firm performance
3
Why Financial Statement Analysis?
1. Financial Statements provide information
of how well the company is doing
currently and in the past.
2. Financial Statements provide information
that helps to predict the future financial
position and determine the expected
cash flows.
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4
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
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Why look at ratios? (1)
N et Incom e
Total Asset
ROA
Firm A (all num bers are in M illion)
2006
2007
10
12
100
140
10.00%
8.57%
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Financial ratio analysis involves…
Comparison of financial
ratios through time
for a given firm
•
This is trend analysis
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Why look at ratios? (2)
Year 2007 (all numbers are in Millions)
Firm A
Firm B
Net Income
12
8
Total Asset
140
50
8.57%
16.00%
ROA
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Financial ratio analysis involves…
Comparison of the
firm’s financial ratios
with those of the
industry
•
This is industry
comparison
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Types of financial ratios
1. Liquidity ratios
2. Asset management ratios
3. Debt management ratios
4. Profitability ratios
5. Combination ratios
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Liquidity ratios
 Measure how well company can meet
short-term obligations
1. Current ratio
2. Quick (‘acid test’) ratio
•
•
•
Same denominator as current ratio
But numerator excludes inventory
Higher ratios mean firm is better able to
meet obligations on time
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Quick review 1
1)
The ABC company has a current ratio of 2 times. Its
quick ratio is 1. If current assets are $4 million, how
much is inventory?
2)
According to Crefeld Industries’s balance sheet, the
company's assets total $50 million. The company has
$8 million cash and $15 million of A/R. It also has $13
million of inventory. Crefeld's net plant and equipment
(i.e., net fixed assets) is worth $14 million. The
company's current liabilities are $18 million. What is
the current ratio?
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Asset management ratios 1
 Also called ‘asset utilization’ ratios or
‘efficiency’ ratios
 Unused or inactive assets are inefficient
assets
 Either utilize assets more effectively or
eliminate them
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Asset management ratios 2
 Inventory turnover ratio
 Measures how efficiently company is employing
inventory.
 Larger ratio  more efficient. Industry specific.
 Day sales outstanding(DSO)
 Measures how fast company collects payments
from credit sales.
 In number of days.
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Asset management ratios 3
 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.
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Debt management ratios 1
 Measures how effectively a firm
manages its debt.
 Leveraged : using debt to finance
assets/operations
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Debt management ratios 2
 Debt to capital ratio
•
•
•
Debt= short-term + long-term interest-bearing debt
(not including A/P or Accruals)
Higher the ratio, higher the risk of default.
Total capital = debt + equity
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Debt management ratios 3
 Debt to equity ratio
•
total debt / total equity
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Debt management ratios 4
 Times interest earned (TIE)
 Measures how many times the firm’s l
operating earnings (EBIT) cover its debtservicing charges (mainly interest).
 Larger ratio means firm is more likely to pay
debt-servicing charges
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Profitability ratios
 Show the combined effects of liquidity,
asset management, and debt on
operating results.




Return on total assets (ROA)
Return on common equity (ROE)
Operating profit margin on sales
Net profit margin on sales
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Market value ratios 1
Price/Earnings ratio
=(Price per share)/(Earnings per share)
industry average P/E: around 12.
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Market value ratios 2
Market/Book ratio
= Market price per share / book value per share
Book value/share = common equity / shares outstanding
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Combination Ratios: Extended
DuPont Equation

Breaks down ROE into three components:
1. Activity (total asset turnover)
2. Profitability (net profit margin)
3. Leverage (equity multiplier = total assets/equity)
ROE = net income / equity
= net profit margin x total asset turnover
x Equity multiplier
= ROA x equity multiplier
If ROE changes, DuPont equation helps you to identify the reason
for the change.
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You are given the following ratios for Flotsam Inc whose
assets are financed with debt and equity only.
Return on Asset (ROA) = 22%,
Debt to capital ratio is = 20%
What is the ROE?
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If a firm's net profit margin is 7%, and its equity
multiplier is 1.3 times, and return on equity is 16%,
what is its total asset turnover (to two decimal places)?
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Primecare Inc. recently issued long-term debt and
deposited the proceeds in the company’s checking account.
All else constant, does this change the following ratios?
A.increase the firm’s return on assets.
B.increase the firm’s current ratio.
C.increase the firm’s earnings per share.
D.decrease the firm’s net profit margin.
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If a firm that is financed with debt and equity only increases
its sales but keeps its equity, net profit margin, and total
assets constant, what would be the impact of this action on
ROE?
[Hint: ROE = net profit margin x total asset turnover x equity multiplier]
A.
B.
C.
D.
E.
ROE would decrease.
ROE would increase.
ROE would remain unchanged.
ROE may increase or decrease depending on the
interaction between the equity multiplier and sales.
None of the above answers are correct.
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Limitations of ratios 1
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
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Limitations of ratios 2
2) Financial ratios are calculated using
accounting data not market values
 Accounting data is based on an asset’s
historical costs.
Example: if inventory market value declines below
historical cost but management did not adjust for
this – every ratio involving total assets will be
inaccurate.
Ratios not informative when asset market values
deviate from historical costs. ( e.g., Land )
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Limitations of ratios 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.
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Summary
1. Reasons for conducting financial statement
analysis
2. 5 types of ratios
3. Limitations of financial ratios
4. Practice Assignment 4-2, 4-3,4-5,4-6,4-8,411.
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