CHAPTER 4
Analysis of Financial
Statements
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

Ratio Analysis
Usefulness of ratios.
Limitations of ratio analysis
Lecture 4-350
4-1
Last week we learned how to calculate free cash flow
(FCF), which will be useful when we come to stock
valuation.


This week we will talk about analyzing
financial ratios.
The ratios I focus are relatively more
important.
Lecture 4-350
4-2
Financial Ratios:
Accounting data stated in relative terms
Why are financial ratios useful?
 Ratios standardize numbers and
facilitate comparisons.
 Ratios are used to highlight
weaknesses and strengths.
 Ratios might be useful to predict
future.
Lecture 4-350
4-3
Ratios are not to be read in
isolation.

When Analyzing Financial Ratios, always
examine:


Trends across time
Comparisons with other firms’ (industry
average) ratios
Lecture 4-350
4-4
Balance Sheet: Assets
Cash
A/R
Inventories
Total CA
Gross FA
Less: Dep.
Net FA
Total Assets
2003E
85,632
878,000
1,716,480
2,680,112
1,197,160
380,120
817,040
3,497,152
Lecture 4-350
2002
7,282
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
4-5
Balance sheet:
Liabilities and Equity
2003E
Accts payable
436,800
Notes payable
300,000
Accruals
408,000
Total CL
1,144,800
Long-term debt
400,000
Common stock
1,721,176
Retained earnings 231,176
Total Equity
1,952,352
Total L & E
3,497,152
Lecture 4-350
“E” means
“estimates”.
2002
524,160
636,808
489,600
1,650,568
723,432
460,000
32,592
492,592
2,866,592
4-6
Income statement
Sales
COGS
Other expenses
EBITDA
Depr. & Amort.
EBIT
Interest Exp.
EBT
Taxes
Net income
2003E
7,035,600
5,875,992
550,000
609,608
116,960
492,648
70,008
422,640
169,056
253,584
Lecture 4-350
2002
6,034,000
5,528,000
519,988
(13,988)
116,960
(130,948)
136,012
(266,960)
(106,784)
(160,176)
4-7
Other data
No. of shares
EPS
DPS
Stock price
2003E
250,000
$1.014
$0.220
$12.17
Lecture 4-350
2002
100,000
-$1.602
$0.110
$2.25
4-8
What are some important ratios, and
what questions do they answer?
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Liquidity: Can the firm meet short term
obligations?
Asset management: is the firm generating good
revenue from assets? (Sales is important, at least
from your marketing class:)
Profitability: Is the firm sufficiently profitable as
reflected in PM, ROE, and ROA?
Debt management: is the firm using the right
mix of debt and equity?
Market value: Do investors like the form’s
earnings and future growth prospect as reflected in
P/E and M/B ratios?
Lecture 4-350
4-9
How liquid is a firm?

Liquidity is the ability to meet maturing
debt obligations.

Comparing cash and assets that can be
converted into cash within the year with
liabilities that are due within the year.
Lecture 4-350
4-10
Calculate D’Leon’s forecasted
current ratio for 2003.
Current ratio = Current assets / Current liabilities
= $2,680 / $1,145
= 2.34
Lecture 4-350
4-11
Comments on current ratio
Current
ratio
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
2003
2002
2001
Ind.
2.34
1.20
2.30
2.70
Expected to improve but still below
the industry average.
Liquidity position is weak.
Lecture 4-350
4-12
Is Management Generating Adequate
Sales on the Firm’s Assets?

How efficiently a firm is using its
assets in generating sales
Lecture 4-350
4-13
Fixed asset and total asset turnover
ratios vs. the industry average
FA turnover = Sales / Net fixed assets
= $7,036 / $817 = 8.61
TA turnover = Sales / Total assets
= $7,036 / $3,497 = 2.01
Lecture 4-350
4-14
Evaluating the FA turnover and
TA turnover ratios
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
2003
2002
2001
Ind.
FA TO
8.6
6.4
10.0
7.0
TA TO
2.0
2.1
2.3
2.6
FA turnover projected to exceed the industry
average.
TA turnover below the industry average.
Caused by excessive currents assets (A/R
and Inv).
Lecture 4-350
4-15
What is the inventory turnover
vs. the industry average?
Inv. turnover
Inventory
Turnover
= Sales / Inventories
= $7,036 / $1,716
= 4.10
2003
2002
2001
Ind.
4.1
4.70
4.8
6.1
Lecture 4-350
4-16
Comments on
Inventory Turnover
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Inventory turnover is below industry
average.
D’Leon might have old inventory, or its
control might be poor.
No improvement is currently
forecasted.
Lecture 4-350
4-17
DSO is the average number of days after
making a sale before receiving cash.
DSO = Receivables / Average sales per day
= Receivables / Sales/365
= $878 / ($7,036/365)
= 45.6
Lecture 4-350
4-18
Appraisal of DSO
DSO
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2003
2002
2001
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.
Lecture 4-350
4-19
How is the Firm Financing Its
Assets?
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Does the firm finance assets more by
debt or equity?
Debt Ratio
Lecture 4-350
4-20
Calculate the debt ratio.
Debt ratio (D/A)= Total debt / Total assets
= ($1,145 + $400) / $3,497
= 44.2%
It measures financial leverage.
(1) If a firm is profitable, borrowing appropriate
debt can leverage up return on shareholder
equity.
(2) Too much debt may increase risk of
bankruptcy.
Lecture 4-350
4-21
How does the debt ratio compare with
industry averages?
D/A

2003
2002
44.2%
82.8%
2001
Ind.
54.8% 50.0%
D/A is better than the industry average.
Lecture 4-350
4-22
Is Management Generating Adequate
Operating Profits on the Firm’s Assets?
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Operating Profit Margin
Basic earning power (BEP)
Return on Assets
Return on equity
Lecture 4-350
4-23
Profitability ratios:
Profit margin and Basic earning power
Profit margin (2003)= Net income / Sales
= $253.6 / $7,036 = 3.6%
BEP (2003) = EBIT / Total assets
= $492.6 / $3,497 = 14.1%
Lecture 4-350
4-24
Appraising profitability with the profit
margin and basic earning power
PM
BEP
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2003
3.6%
14.1%
2002
-2.7%
-4.6%
2001
2.6%
13.0%
Ind.
3.5%
19.1%
Profit margin was very bad in 2002, but is projected to exceed the
industry average in 2003. Looking good.
BEP removes the effects of taxes and financial leverage, and is useful
for comparison of operating performance.
BEP projected to improve, yet still below the industry average.
There is definitely room for improvement.
Lecture 4-350
4-25
Profitability ratios:
Return on assets and Return on equity
ROA = Net income / Total assets
= $253.6 / $3,497 = 7.3%
ROE = Net income / Total common equity
= $253.6 / $1,952 = 13.0%
Lecture 4-350
4-26
Appraising profitability with the return
on assets and return on equity
ROA
ROE
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2003
7.3%
13.0%
2002
-5.6%
-32.5%
2001
6.0%
13.3%
Ind.
9.1%
18.2%
Both ratios rebounded from the previous year, but are still
below the industry average.
Note ROE=ROA*(total asset/total equity)=ROA/(1-total
debt/total asset)=ROA/(1-debt ratio).
If ROA>0, the higher the debt ratio, the higher ROE.
If ROA<0, the higher the debt ratio, the lower ROE.
Wider variations in ROE illustrate the effect that leverage can
4-27
Lecture 4-350
have on profitability.
Calculate the Price/Earnings and
Market/Book ratios.
P/E
M/B
= Price / Earnings per share
= $12.17 / $1.014 = 12.0
= Mkt price per share / Book value per share
= $12.17 / ($1,952 / 250) = 1.56
P/E
M/B
2003
12.0
1.56
2002
-1.4
0.5
Lecture 4-350
2001
9.7
1.3
Ind.
14.2
2.4
4-28
Analyzing the market value ratios
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P/E: How much investors are willing to pay for $1 of
earnings. When investors believe that the earnings
are “real”, or earnings will grow, the P/E ratios is
generally high.
M/B: How much investors are willing to pay for $1 of
book value equity. When investors believe that the
growth prospect of the firm is good, M/B will be high.
For each ratio, generally the higher the number, the
better.
However, higher ratios might also indicate that the
stock is overvalued. (dot.com bubble.)
Lecture 4-350
4-29
The Du Pont system
Also can be expressed as:
ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)
ROA = (NI/Sales) x (Sales/TA)
 Focuses on:
 Expense control (PM)
 Asset utilization (TATO)
 Debt utilization (TA/Equity)
 Shows how these factors combine to determine
ROE.
Lecture 4-350
4-30
Potential problems and limitations
of financial ratio analysis
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Comparison with industry averages is difficult
for a conglomerate firm that operates in many
different divisions.
“Average” performance is not necessarily good,
perhaps the firm should aim higher. Sometimes
it is hard to tell if a ratio is “good” or “bad”.
Seasonal factors. (Macy, Marriot)
“Window dressing” and “big baths” techniques
can make statements and ratios look better.
Lecture 4-350
4-31
Window dressing

To get a smaller debt ratio
12/23/2003 1/6/2004
12/31/2003
Pay back debt
12/31/2004
Borrow new debt
Lecture 4-350
4-32
Big bath

Recognize more expense and charge in
bad years to ensure a growing string of
profits in the future, so investors might
think the firm is making turnaround and
growing.
Lecture 4-350
4-33
More issues regarding ratios
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Different operating and accounting
practices can distort comparisons.
Off sheet liabilities.
Lecture 4-350
4-34
To mitigate the limitation,
1. consider ratios together
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For example, if a firm has negative ROA in
recent years and debt ratio is high, the high
debt ratio may indicate risk of default.
If a firm has been profitable in recent years,
the high debt ratio may indicate that the firm
is borrowing debt to expand business.
Thus it pays to consider ROA and debt ratio
together.
Lecture 4-350
4-35
2. Consider qualitative factors
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Are the firm’s revenues tied to 1 key
customer, product, or supplier?
Competition (will high profit attract
competitors?)
Future prospects (does the firm spend
any R&D?)
Legal and regulatory environment (is it
a regulated industry?)
Lecture 4-350
4-36