17-1
Fundamentals
of Corporate
Finance
Second Canadian Edition
prepared by:
Carol Edwards
BA, MBA, CFA
Instructor, Finance
British Columbia Institute of Technology
copyright © 2003 McGraw Hill Ryerson Limited
17-2
Chapter 17
Financial Statement Analysis
Chapter Outline
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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17-3
Financial Ratios
• Introduction

Public companies have a variety of
stakeholders:
 Shareholders,
bondholders, bankers,
suppliers, employees, managers, etc.
These stakeholders need to monitor how
well their interests are being served.
 They do so by analyzing the company’s
periodic financial statements.

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17-4
Financial Ratios
• Introduction
Analysts use financial ratios to
summarize large volumes of accounting
information.
 This allows them to assess the firm’s
overall performance and its current
financial standing.
 It also allows them to compare firm
performance.

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17-5
Financial Ratios
• Introduction

You will discover that many of the ratios
described in this chapter may be defined
in several different ways.
 There
is no law stating how they should be
defined.

Thus, you should never accept a ratio at
face value without understanding exactly
how it was calculated!
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17-6
Financial Ratios
• Introduction

This chapter will describe four types of
financial ratios:
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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17-7
Financial Ratios
• Warning!

Before diving into the numbers, make
sure you do your homework first!
 You
cannot understand a business simply by
reading its financial statements and
calculating a few numbers.
 You need to start by researching the industry,
and the firm itself, so that you can put the
results of your calculations into perspective.
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17-8
Financial Ratios
• Income
Statement
The Income Statement summarizes the
firm’s revenues and expenses and shows
the difference between the two,which is
the firm’s profit.
 You can see the Income Statement for Le
Château (LC) in Table 17.1 on page 506
of your text.

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17-9
Financial Ratios
• Income

Notice that 2000 was a poor year for LC.
 Can

Statement
you see why it incurred losses?
It is easier to see how a firm is performing if
you look at the common-size income
statement.
 This
is an income statement which presents each of
the items as a percentage of revenues.

A common-size income statement for LC is
shown in Table 17.2 on page 508.
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17-10
Financial Ratios
• Balance

Sheet
A balance sheet is a financial statement that
shows the value of the firm’s assets and
liabilities at a particular time.
 Remember,
a balance sheet shows assets at
book value, not market value!

LC’s Balance Sheet is in Table 17.2 on page
509.
A
common-size balance sheet, which shows
each of the items as a percent of total assets
may be seen in Table 17.4 on page 510.
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17-11
Financial Ratios
• Leverage

Ratios
Leverage ratios show how much financial
leverage a firm is carrying.
 Financial
leverage adds risk to the firm.
 That is, the higher the level of debt in the
firm, the greater the uncertainty about what
earnings (and eps) will be.
 Also the risk of default increases.

There are several different types of
leverage ratios.
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17-12
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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17-13
Financial Ratios
• Leverage
Ratios
The higher the leverage ratio, the greater
the financial leverage and the higher the
level of risk in a firm’s capital structure.
 Notice that these measures:

 Make
use of book value not market value.
 Take account only of long-term debt.
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17-14
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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17-15
Financial Ratios
• Leverage

The TIE Ratio is a measure of the firm’s ability
to cover its interest payments with its earnings.


Ratios
Banks prefer to lend to firms with high TIE ratios
(earnings are far in excess of interest payments).
The Cash Coverage Ratio recognizes that we
subtract depreciation and amortization when
calculating earnings.
 However,
no cash goes out the door for these
expenses.
 This ratio asks if earnings plus non-cash charges
are sufficient to cover the interest payments.
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17-16
Financial Ratios
• Leverage

Ratios
Interest is not the only cost a firm will have to
meet.
 There
are also principal repayments on the debt and
preferred dividends.

The Fixed Charge Coverage Ratio measures
the ability of the firm to cover its fixed charges
with its earnings.
 Since
these payments are nontax-deductible
payments, you must convert them to a before-tax
basis by dividing by (1 – Corporate Tax Rate).
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17-17
Financial Ratios
• Liquidity
Ratios
If you are making a short-term loan to a
company, you are not interested in their
leverage ratio, but in their ability to comeup with the cash to repay you.
 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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17-18
Financial Ratios
• Liquidity
Ratios
Net Working Capital =
Net Working Capital as a
% of Total Assets
Current Ratio =
Quick Ratio* =
Current Assets – Current Liabilities
=
Net Working Capital
Total Assets
Current Assets
Current Liabilities
Cash + Marketable Securities + Receivables
Current Liabilities
* Also known as the Acid Test Ratio
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17-19
Financial Ratios
• Liquidity

Ratios
Net Working Capital roughly measures
a company’s potential reservoir of cash.
 Usually
it is positive; however, it can be
negative.
 Net Working Capital is often expressed as a
percentage of Total Assets.

The Current Ratio and Quick Ratio
roughly measure a firm’s ability to cover
its liabilities with its most liquid assets.
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17-20
Financial Ratios
• Liquidity

Ratios
The Quick Ratio is a more stringent
measure of liquidity than the Current
Ratio.
 It
excludes the inventory and prepaids from
the calculation.
 These components of the Balance Sheet are
generally the least liquid assets.
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17-21
Financial Ratios
• Efficiency
Ratios
Asset Turnover Ratio
=
Fixed Asset Turnover Ratio =
Sales
Average Total Assets
Sales
Average Fixed Assets
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17-22
Financial Ratios
• Efficiency
Ratios
These ratios measure how efficiently the
firm is using its assets.
 Notice that since the assets are likely to
change over the year, we use an average
of the assets at the beginning and end of
the year.

 Averages
are often used when a flow figure
(Annual Sales) is compared to a snapshot
figure (Total Assets).
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17-23
Financial Ratios
• Efficiency

Ratios
The Asset Turnover Ratio and Fixed Asset
Turnover Ratio indicate how hard the firm’s
assets are being used.
 For
example, for LC, each $1 of assets is
generating $2.36 of sales, while each $1 of fixed
assets is generating $4.43 of sales.
 Note that a high ratio compared with other firms
may indicate that a firm is working close to
capacity.
 It could be difficult to generate further business
without additional investment.
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17-24
Financial Ratios
• Profitability
Ratios
Profitability ratios focus on the firm’s earnings,
giving an indication of its performance.
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.
The definition of profits, or earnings, depends
on the ratio being used.
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17-25
Financial Ratios
• Profitability
Gross Profit Margin
Ratios – Profit Margins
=
Sales – Cost of Goods Sold
Sales
Operating Profit Margin* =
Net Profit Margin =
EBIT – Taxes
Sales
Net Income
Sales
or
Net Income + Interest
Sales`
* Also known as Basic Earning Power
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17-26
Financial Ratios
Ratios – Profit Margins
Other things held constant, a firm would prefer
high profit margins.
• Profitability
 However,
there is a conflict between high prices
and high turnover.
Think of, for example, Walmart’s margins as
compared to those of Holt Renfrew.

 Both
are profitable, but use different strategies:
 Holt Renfrew has a high margin strategy, but
with lower lower sales or turnover.
 Walmart has low margins, but compensates with
higher volume or turnover.
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17-27
Financial Ratios
• Profitability
Ratios – Return Ratios
Return on Assets (ROA)
=
Net Income + Interest
Average Total Assets
Net Income + Interest - Interest Tax Shields
Adjusted ROA =
Average Total Assets
Return on
Invested
Capital
=
Net Income + Interest - Interest Tax Shields
Average Total Debt + Preferred &
Common Equity
Return on Equity =
Net Income
Average Equity
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17-28
Financial Ratios
• Profitability


Ratios
The Payout Ratio measures the proportion of
earnings which are paid out as dividends.
The Plowback Ratio shows the percentage of
earnings which are retained in the business.
Payout Ratio
=
Dividends
Earnings
Plowback Ratio = 1 – Payout Ratio =
Earnings - Dividends
Earnings
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17-29
Financial Ratios
• Profitability

Ratios
If you multiply the Plowback Ratio by the
Return on Equity, you can calculate how fast
shareholders’ equity is growing as a result of
plowing back part of earnings every year.
Growth in Equity from Plowback
=
Earnings - Dividends
Earnings
x
=
Earnings
Earnings - Dividends
Earnings
= Plowback x ROE
Equity
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17-30
Financial Ratios
• DuPont


System - ROA
Some profitability and efficiency measures can be
linked in useful ways.
These relationships are referred to as the DuPont
System, in recognition of the company which
popularized them.
ROA =
=
Net Income + Interest
Assets
Sales
Assets
x
Net Income + Interest
Sales
Asset Turnover x
Profit Margin
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17-31
Financial Ratios
• DuPont




System – Margin vs Turnover
All firms would like to earn a high ROA, but
their ability to do so is limited by competition.
In general, most firms must make a trade-off
between turnover and margin.
To get high turnover, prices generally have to
be low, meaning low margins as well.
(Walmart’s strategy.)
To have high margins, prices generally have to
be high as well, which reduces the firm’s
turnover. (Holt Renfrew’s strategy.)
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17-32
Financial Ratios
• DuPont



System – Margin vs Turnover
For example, fast-food chains tend to have low
margins, which they offset by high turnover.
Hotels tend to have low turnover, but they offset
it with high margins.
The result: both can have identical ROA’s while
their margins and turnover ratios are entirely
different:
Asset Turnover x
Fast Food
2.0
x
Hotels
0.5
x
Profit Margin = ROA
5%
= 10%
20%
= 10%
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17-33
Financial Ratios
• DuPont

We can also break down the ROE into its
component parts:
Net Income
Equity
ROE =
=
System - ROE
Assets
Equity
x
Leverage
Sales
Assets
x
Net Income+Interest
Sales
Asset Turnover
Net Income
x
Net Income+Interest
Profit Margin
Debt Burden
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17-34
Financial Ratios
• Analysis



of the Statement of Cash Flows
The Cash Flow Statement tracks the cash
coming into and flowing out of a corporation
over a specific time period.
Analysis of this statement 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.
 But
its focus on accruals means a healthy looking
income statement can miss a current cash crunch.
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17-35
Financial Ratios
• Analysis


of the Statement of Cash Flows
You can see a Statement of Cash Flows for LC in
Table 17.7 on page 523 of your text.
In Chapter 2, you learned how to calculate the
Free Cash Flow from the firm by rearranging the
statement of cash flows:
Cash Flow from Operating Activities
- Cash Flow from Investing Activities
= Cash Flows from Assets
(Free Cash Flows)
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17-36
Using Financial Ratios
• Finance




in Action
Companies have considerable discretion in
calculating profits.
They also have a great deal of leeway in
deciding what to record on the Balance Sheet.
Thus, when you calculate financial ratios, you
need to look below the surface and understand
the some of the pitfalls of accounting data.
Check the Finance in Action boxes on pages
526 and 527 of your text.
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17-37
Using Financial Ratios
• Choosing


a Benchmark
Once you select and calculate the important
ratios for a firm, you must still find some way to
judge whether the results are high or low.
Do this by comparing them to a benchmark.
 The
simplest comparison is to the firm’s
performance in prior years.
 But you can also compare the numbers to those
calculated for another firm(s).

When making your comparisons, don’t forget to
dig behind the numbers!
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17-38
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.
A
table which ranks MVA for a number of large
Canadian companies is published by Stern Stewart.
 You can see a sample of this data (plus EVA) in
Table 17.10 on page 530 of your text.

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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17-39
Measuring Company Performance
• EVA




EVA or residual income is a better measure of
company performance than accounting profits.
Profits are calculated after deducting all costs
except the cost of capital.
EVA recognizes that companies need to cover
their cost of capital before they can add value.
If a plant or division is not earning a positive
EVA, the financial managers are likely to face
some pointed questions about whether assets
could be better employed elsewhere.
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17-40
The Role of Financial Ratios
• Helping
Financial Managers Make
Decisions


Whenever financial managers discuss the state
of business, you can bet that ratios will enter
into the discussion.
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.
copyright © 2003 McGraw Hill Ryerson Limited
17-41
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.
You may combine these measures with other
data to measure the esteem in which investors
hold your company and its performance.
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17-42
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.


Financial ratios will rarely be useful if applied
mechanically.
You need an understanding of the business and
good judgment to make good decisions using
ratios.
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17-43
Summary of Chapter 17




You need a benchmark for assessing a ratio.
Typically you 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.
Managers of divisions or plants are often judged
and rewarded by their business’s EVA.
copyright © 2003 McGraw Hill Ryerson Limited