P A R T

Valuation Principles
and Practices
WEB CHAPTER 19
Analysis of Financial Statements

WEB CHAPTER 20
An Introduction to Security Valuation

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Early in the textbook, you learned The main source of informa- reviewing the basic factors that
about the purpose of investing, tion regarding a stock or bond is influence the two critical variables
the importance of appropriate the corporation’s financial state- that determine the intrinsic value
asset allocation, and the numerous ments.Web Chapter 19 considers of an asset irrespective of the val-
investment instruments available what financial statements are uation model: (1) the required
on a global basis. In your earlier available and what information return for an investment, and (2)
corporate finance classes, you they provide, followed by a the estimated growth rate of earn-
would have reviewed the major discussion of the financial ratios ings, dividends, and cash flows for
developments in investment used to answer several important the investment.
theory as they relate to efficient questions about a firm’s liquidity, These two chapters, although
capital markets, portfolio theory, its operating performance, its risk much of a review, provide you
capital asset pricing, and multi- profile, and its growth potential. with the tools and the theoretical
factor valuation models.There- Web Chapter 20 considers the understanding to apply the valua-
fore, at this point you are in a basic principles of valuation and tion models to the range of enti-
position to consider the theory applies those principles to the ties included in the top-down
and practice of estimating the valuation of bonds, preferred approach—the aggregate market,
value of various securities, which stock, and common stock. alternative industries, and indi-
is the heart of investing and leads Because it is recognized that the vidual companies and stocks.
to the construction of a portfolio valuation of common stock is the
that is consistent with your risk- most challenging task, we present
return objectives.You will recall two general approaches to equity
that the investment decision is valuation and several techniques
based on a comparison of an for each of these approaches.We
asset’s intrinsic value and its conclude this chapter by
market price.

2 PART 7 Valuation Principles and Practices NEL

W E B C H A P T E R
19
Analysis of Financial
Statements
After you read this chapter, you You have probably already noted that this is a fairly long chapter with
should be able to answer the several financial statements and numerous financial ratios. The reason
following questions: for this extensive discussion of how to analyze financial statements is
1. What are the main financial that our ultimate goal (as noted earlier) is to construct a portfolio of
statements provided by firms investments that will provide returns that are consistent with the risk
and what specific information of the portfolio. In turn, to determine the expected returns on dif-
does each of them contain? ferent assets we must estimate the future value of each asset as a major
component of the return is the change in asset value over time.There-
2. Why do we use financial ratios
fore, the crux of investments is valuation. Although we consider var-
to examine the performance of
ious valuation models for common stocks in Web Chapter 20, you are
a firm, and why is it important
already aware that the value of any financial asset is the present value
to examine performance relative
of the expected cash flows generated by the asset.Therefore we must
to the economy and to a firm’s
derive an estimate of the discount rate for the asset (the required
industry?
return) and its expected cash flows. The main source of information
3. What are the main categories needed to make these two estimates is the financial statement. To
for financial ratios and what derive an estimated return, we need to understand the business and
questions are answered by the financial risk of the firm. To estimate future cash flows, we must
ratios in these categories? understand the composition of cash flows and what will contribute to
4. How can DuPont system analysis the short-run and long-run growth of these cash flows. Financial
help evaluate a firm’s past and statements, business and financial risk, and analysis of the composition
future return on equity? and growth of cash flow are all topics of this chapter.
We begin by introducing financial statements and discuss why and
5. What is a quality balance sheet
how financial ratios are useful. We then review ratios that reflect
or income statement?
internal liquidity, operating performance, risk analysis, and growth
6. Why should you engage in analysis. In addition, we address four main areas in investments where
financial statement analysis if financial ratios have been effectively employed.
markets are efficient and Our example in this chapter is Shoppers Drug Mart, the largest
forward-looking? retail drugstore chain in Canada. It operates in 1,149 drugstores and 66
Shoppers Home Health Care stores. Pharmacy prescription sales gen-
erate over 47% of total sales.The firm’s goal is to be Canada’s most con-
venient health-care retailer. It takes great pride in its steady sales and
earnings growth that have been reflected in strong stock performance.

19.1 Financial Statements

Financial statements are intended to provide information on the
resources available to management, how these resources were
financed, and what the firm accomplished with them. Annual and

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4 PART 7 Valuation Principles and Practices

quarterly reports to the shareholder include three financial statements: the balance sheet, the
income statement, and the statement of cash flows. In addition, reports that must be filed with
the Securities Commission(s) (for example, Annual Information Form or AIF) carry detailed
information about the firm, such as information on loan agreements, material contracts, and
the like. Information from the basic financial statements can be used to calculate financial
ratios and to analyze the operations of the firm to determine what factors influence a firm’s
earnings, cash flows, and risk characteristics.

19.1.1 Generally Accepted Accounting Principles

Among the input used to construct the financial statements are generally accepted
accounting principles (GAAP), which are formulated by the Canadian Institute of Char-
tered Accountants (CICA). The CICA recognizes that it would be improper for all compa-
nies to use identical and restrictive accounting principles. Therefore, the CICA allows
companies some flexibility to choose among appropriate GAAP. This flexibility allows the
firm’s managers to choose accounting standards that best reflect company practice. On the
negative side, this flexibility can allow firms to appear healthier than they really are.1 Given
this possibility, the financial analyst must rigorously analyze the available financial information
to separate those firms that appear attractive from those that actually are in good financial
shape.
Fortunately, the CICA requires that financial statements include notes that indicate which
accounting principles were used by the firm. Because accounting principles frequently differ
among firms, the information in the notes assists the analyst in adjusting the financial state-
ments of companies so that they can better compare “apples with apples.”2

19.1.2 Balance Sheet

The balance sheet shows what resources (assets) the firm controls and how it has financed
these assets. Specifically, it indicates the current and capital assets available to the firm at a point
in time (the end of the fiscal year or the end of a quarter). In most cases, the firm owns these
assets, but some firms lease assets on a long-term basis. How the firm has financed the acqui-
sition of these assets is indicated by its mixture of current liabilities (accounts payable or short-
term borrowing), long-term liabilities (fixed debt and leases), and owners’ equity (preferred
stock, common stock, and retained earnings).
The balance sheet for Shoppers Drug Mart in Exhibit 19.1 represents the stock of assets
and its financing mix as at their fiscal year, 2005–2008.

For updated financial 19.1.3 Income Statement

information for Shoppers, The income statement contains information on the operating performance of the firm
go to http://www.
shoppersdrugmart.ca/
during some period of time (a quarter or a year). In contrast to the balance sheet, which is at a
english/corporate_ fixed point in time, the income statement indicates the flow of sales, expenses, and earnings
information/investor_ during a period of time. The income statement for Shoppers Drug Mart for the years
relations/financial_ 2005–2008 appears in Exhibit 19.2.We concentrate on earnings from operations after tax as
information/index.html. the relevant net earnings figure.

1 The Enron fiasco clearly makes this point. For a general discussion on this topic, see Byrnes and Henry (2001), Henry
(2001), and Byrnes, McNamee, Brady, Lavelle, and Palmeri (2002).
2 The Canadian Accounting Standards Board has confirmed January 1, 2011 as the date that the international financial
reporting standards (IFRS) will replace Canadian GAAP. Although generally similar some significant differences exist.

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 WEB CHAPTER 19 Analysis of Financial Statements 5

Shoppers Drug Mart Corporation Consolidated Balance Sheet ($ millions),

Exhibit 19.1
Years Ended 2005–2008

2008 2007 2006 2005

Assets
Current
Cash 37 27 63 24
Accounts receivable 448 372 308 257
Inventory 1,743 1,546 1,372 1,217
Income taxes recoverable 9 0 0 0
Future income taxes 83 70 46 38
Prepaid expenses 64 135 32 29
Total current assets 2,384 2,150 1,821 1,565
Property and equipment 1,442 1,127 908 749
Deferred costs 47 33 26 22
Goodwill 2,427 2,245 2,122 2,019
Other intangible assets 98 58 45 18
Other assets 21 9 7 3
Total assets 6,419 5,622 4,929 4,376
Liabilities
Current
Bank indebtedness 241 225 134 163
Commercial paper 340 544 504 470
Short-term debt 198 0 0 0
Accounts payable and accrued liabilities 1,018 990 843 698
Income taxes payable 0 65 71 40
Dividends payable 47 35 26 21
Current portion of long-term debt 0 299 0 0
Total current liabilities 1,844 2,158 1,578 1,392
Long-term debt 647 0 300 325
Other long-term liabilities 303 245 189 141
Future income taxes 47 30 21 14
Total liabilities 2,841 2,433 2,088 1,872
Associate interest 119 113 117 117
Shareholder’s equity
Share capital 1,514 1,506 1,491 1,441
Contributed surplus 11 10 7 4
Retained earnings 1,934 1,560 1,226 942
Total shareholder equity 3,459 3,076 2,724 2,387
Total liabilities and shareholder’s equity 6,419 5,622 4,929 4,376
Source: Prepared by Authors using publicly available information for Shoppers Drug Mart

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6 PART 7 Valuation Principles and Practices

Shoppers Drug Mart Consolidated Statement of Earnings and Shareholders’

Exhibit 19.2
Equity ($ Millions, Except per Share Data), Year Ended 2005–2008

2008 2007 2006 2005

Sales 9,423 8,478 7,786 7,151

Cost of goods sold and other
operating expenses 8,335 7,520 6,958 6,431
Amortization 206 172 145 121
Operating income 882 786 683 599
Interest expense 64 53 50 49
Earnings before income taxes 818 733 633 550
Income taxes
Current 254 250 220 177
Future ⫺1 ⫺7 ⫺9 9
Total taxes 253 243 211 186
Net earnings 565 490 422 364
Source: Prepared by Authors using publicly available information for Shoppers Drug Mart

19.1.4 Statement of Cash Flows

The statement of cash flows integrates the effects on the firm’s cash flow of income
flows (based on the most recent year’s income statement) and changes on the balance sheet
(based on the two most recent annual balance sheets). Analysts use these cash flow values
to estimate the value of a firm and to evaluate the risk and return of the firm’s bonds and
stock.
The statement of cash flows has three sections: cash flows from operating activities, cash
flows from investing activities, and cash flows from financing activities. The total cash flows
from the three sections is the net change in the cash position of the firm that should equal
the difference in the cash balance between the ending and beginning balance sheets. The
statements of cash flow for Shoppers for 2005–2008 appear in Exhibit 19.3.
Cash Flows from Operating Activities This section of the statement lists the sources and uses
of cash that arise from the normal operations of a firm.The net cash flow from operations is
computed as the net income reported on the income statement including changes in net
working capital items (i.e., receivables, inventories, and so on) plus adjustments for non-cash
revenues and expenses (such as amortization), or:

19.1 Cash Flow from Operating Activities ⴝ Net Income ⴙ Non-cash

Revenue and Expenses ⴙ Changes in Net Working Capital Items

Consistent with our previous discussion, the cash account is not included in the calculation.
Notably, Shoppers has been able to generate consistently large and growing cash flows from
operations even after accounting for consistent increases in accounts receivable and inventory
required by the firm’s growth.

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 Shoppers Drug Mart Corporation Consolidated Statements of Cash Flows for the Year Ended
Exhibit 19.3
2005–2008 (in thousands)

2008 2007 2006 2005

Operating activities
Net earnings 565 490 422 364
Items not affecting cash
Amortization expense 220 181 150 129
Future income taxes ⫺1 ⫺7 ⫺9 9
Loss on disposal of property and equipment 3 4 7 4
Stock-based compensation 2 4 4 2
789 672 574 508
Net change in non-cash working capital balances ⫺325 ⫺134 ⫺26 ⫺89
Increase in other liabilities 45 49 39 44
Store opening costs ⫺30 ⫺22 ⫺17 ⫺12
Cash flows from operating activities 479 565 570 451
Investing activities
Purchase of property and equipment ⫺522 ⫺395 ⫺287 ⫺249
Proceeds from disposition of property and equipment 25 18 3 ⫺25
Business acquisitions ⫺244 ⫺140 ⫺94 0
Deposits 89 ⫺94 0 0
Other assets ⫺12 ⫺2 ⫺3 0
Cash flows used in investing activities ⫺664 ⫺613 ⫺381 ⫺274
Financing activities
Bank indebtedness, net 16 91 ⫺29 ⫺39
Commercial paper, net ⫺203 41 34 167
Issuance of short-term debt 200 0 0 0
Issuance of Series 2 notes 450 0 0 0
Revolving-term debt 200 0 0 0
Repayment of Series 1 notes ⫺300 0 0 0
Repayment of long-term debt 0 0 ⫺27 ⫺250
Deferred financing costs ⫺6 0 0 ⫺5
Associate interest 6 ⫺4 0 6
Proceeds from shares issued for stock options exercised 7 14 11 18
Repayment of share purchase loans 0 2 1
Repurchase of share capital 0 ⫺42 0
Dividends paid ⫺175 ⫺130 ⫺99 ⫺64

Cash flows from (used in) financing activities 195 12 ⫺150 ⫺166

(Decrease) increase in cash 9 ⫺35 38 10

Cash, beginning of period 28 63 25 14
Cash, end of period 37 28 63 24
Source: Prepared by Authors using publicly available information for Shoppers Drug Mart

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8 PART 7 Valuation Principles and Practices

Cash Flows from Investing Activities A firm makes investments in both its own non-current
and capital assets and the equity of other firms (which may be subsidiaries or joint ventures of
the parent firm—they are listed in the “investment” account of the balance sheet). Increases and
decreases in these non-current accounts are considered investment activities.The cash flow from
investing activities is the change in gross plant and equipment plus the change in the investment
account. The changes are positive if they represent a source of funds (e.g., sale of some plant
and/or equipment); otherwise they are negative.The dollar changes in these accounts are com-
puted using the firm’s two most recent balance sheets. Most firms (including Shoppers) experi-
ence negative cash flows from investments due to significant capital expenditures.
Cash Flows from Financing Activities Cash inflows are created by increasing notes payable
and long-term liability and equity accounts, such as bond and stock issues. Financing uses
(outflows) include decreases in such accounts (i.e., repaying debt or the repurchase of
common shares). Dividend payments are a significant financing cash outflow. For many firms,
the repurchase of shares has also been a main financing outflow in recent years.
The total cash flows from operating, investing, and financing activities are the net increase
or decrease in the firm’s cash. The statement of cash flows provides cash flow detail that is
lacking in the balance sheet and income statement.

19.1.5 Measures of Cash Flow

There are several cash flow measures an analyst can use to determine the underlying health
of the corporation.You should become familiar with these alternative measures.
Traditional Cash Flow The traditional measure of cash flow equals net income plus amorti-
zation expense and future taxes. But as we have just seen, it is also necessary to adjust for
changes in operating (current) assets and liabilities that either use or provide cash. These
changes can add to or subtract from the cash flow estimated from the traditional measure of
cash flow: net income plus non-cash expenses.
The table below compares the cash flow from operations figures (Exhibit 19.3) to the tra-
ditional cash flow figures for Shoppers from 2005–2008.

Traditional Cash Flow Equals Net Cash Flow from Operations

Income ⴙ Amortization ⴙ Change from Statement of Cash
in Future Taxes Flows

2008 788 479

2007 671 565
2006 574 570
2005 498 451

For all four years the cash flow from operations was less than the traditional cash flow esti-
mate because of the several adjustments needed to arrive at cash flow from operations. For
many firms, this is fairly typical because the effect of working capital changes is often a large
negative cash flow due to necessary increases in receivables or inventory to support sales
growth (especially for high-growth companies).
Free Cash Flow Free cash flow modifies cash flow from operations to recognize that some
investing and financing activities are critical to the firm. It is assumed that these expenditures
must be made before a firm can use its cash flow for other purposes such as reducing debt out-
standing or repurchasing common stock. Two additional items are considered: (1) capital

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 WEB CHAPTER 19 Analysis of Financial Statements 9

expenditures (investing expenditure) and (2) the disposition of property and equipment
(a source of cash).These two items are used to modify Shoppers cash flow from operations as
follows (most analysts only subtract net capital expenditures, but conservative analysts also
subtract dividends).

Cash Flow Disposition

from Capital of Property Free
Operations ⴚ Expenditures ⴙ and Equipment ⴝ Cash Flow

2008 479 ⫺ 766 ⫹ 25 ⫽ ⫺262

2007 565 ⫺ 535 ⫹ 18 ⫽ 48
2006 570 ⫺ 381 ⫹ 3 ⫽ 192
2005 451 ⫺ 275 ⫹ 0 ⫽ 176

For firms involved in leveraged buyouts, this free cash flow number is critical because
the new owners typically want to use the firm’s free cash flow as funds available for
retiring outstanding debt. It is not unusual for a firm’s free cash flow to be a negative
value. For Shoppers, the free cash flow value had been positive but not large from 2005
to 2007 and negative in 2008 due to the significant capital expenditures related to store
growth. Despite a weakening economy and lower cash flows, the company continued its
growth plans through a corporate acquisition and by opening new stores. Notably, this
free cash flow value or a variation of it will be used in the subsequent cash flow valua-
tion models.3
EBITDA The widely-used EBITDA (earnings before interest, taxes, depreciation, and amor-
tization) measure of cash flow is extremely liberal. It adds back depreciation and amortiza-
tion (as in the traditional measure) along with both interest expense and taxes, but does not
consider the effect of changes in working capital items (such as additions to receivables and
inventory) or the significant impact of capital expenditures. The following table demon-
strates the large differences among these measures. Notably, because EBITDA does not con-
sider several of these necessary expenditures, it consistently has the highest value among cash
flow measures.

Traditional Cash Flow from Free Cash

Year EBITDA Cash Flow Operations Flow

2008 1,088 788 479 ⫺262

2007 958 671 565 48
2006 829 574 570 192
2005 720 498 451 176

Some analysts use EBITDA as a proxy for cash flow and they refer to EBITDA multiples as
other analysts would refer to price-earnings (P/E) multiples.Yet given what this measure does
not consider, we consider this a very questionable practice.4

3 As we will show in Web Chapter 20, small modifications of this free cash flow—called free cash flow to equity (FCFE),
free cash flow to the firm (FCFF), and net operating profits less applicable taxes (NOPLAT)—are used in valuation models
and also the economic value added (EVA) model.
4 For a detailed discussion of the problems with using EBITDA, see Greenberg (2000).

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10 PART 7 Valuation Principles and Practices

19.1.6 Purpose of Financial Statement Analysis

Financial statement analysis seeks to evaluate management performance in several important
areas, including profitability, efficiency, and risk.Although we analyze historical data, the ulti-
mate goal is to provide insights that will help us project future management performance,
including pro forma balance sheets, income statements, cash flows, and risk. It is the firm’s
expected future performance that determines whether we should lend money to a firm or
invest in it.

19.2 Analysis of Financial Ratios

Just as a single number from a financial statement is of little use, an individual financial ratio
has little value except in relation to comparable ratios for other entities. That is, only relative
financial ratios are relevant. Therefore, it is important to compare a firm’s performance relative to
• The aggregate economy
• Its industry or industries
• Its main competitors within the industry
• Its past performance (time-series analysis)
The comparison to the aggregate economy is important because almost all firms are
influenced by economic fluctuations. For example, it is unreasonable to expect a firm’s
profit margins to increase during a recession; a stable margin might be encouraging under
such conditions. In contrast, a small increase in a firm’s profit margin during a major busi-
ness expansion may be a sign of weakness. Thus, this analysis that considers the economic
environment helps investors understand how a firm reacts to the business cycle and should
improve an estimate of the future performance of the firm during subsequent business
cycles.
Probably the most significant comparison relates a firm’s performance to that of its
industry. Different industries affect the firms within them differently, but this relationship is
always significant.The industry effect is strongest for industries with homogeneous products
such as steel, rubber, glass, and wood products, because all firms within these industries expe-
rience coincidental shifts in demand. In addition, these firms employ fairly similar tech-
nology and production processes. As a result, even the best-managed steel firm experiences
a decline in sales and profit margins during a recession. In such a case, the relevant question
is not whether sales and margins declined, but how bad was the decline relative to other steel
firms? In addition, investors should examine an industry’s performance relative to the
economy to understand how the industry responds to the business cycle, as discussed in
Chapter 8.
When comparing a firm’s financial ratios to industry ratios, investors may not want to use
the average (mean) industry value when there is wide variation among firms in the industry.
Alternatively, if we believe that a firm has a unique component, a cross-sectional analysis
in which we compare the firm to a subset of industry firms comparable in size or character-
istics, may be appropriate. As an example, we would compare the performance of George
Weston Limited (Loblaws) to that of other national food chains rather than regional food
chains or specialty food chains.
Another practical problem with comparing a firm to its industry is that many large
firms are multi-industry. Inappropriate comparisons can arise when a multi-industry
firm is evaluated against the ratios from a single industry. To mitigate this problem, we
can use a cross-sectional analysis that compares the firm against a rival that operates in

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 WEB CHAPTER 19 Analysis of Financial Statements 11

many of the same industries. Alternatively, we can construct composite industry average
ratios for the firm. To do this, we use the firm’s annual report to identify each industry
in which the firm operates and the proportion of total firm sales and operating earnings
derived from each industry. The composite industry ratios would be the weighted-
average ratios based on the proportion of firm sales and operating earnings derived from
each industry.
Finally, time-series analysis, in which we examine a firm’s relative performance over
time to determine whether it is progressing or declining, is helpful when estimating future
performance. Calculating the five- or ten-year average of a ratio without considering the
time-series trend can result in misleading conclusions. For example, an average return of 10%
can be the result of returns that have increased from 5% to 15% over time or the result of a
series that declined from 15% to 5%. Obviously, the difference in the trend for these series
would have a significant impact on our estimate for the future. Ideally, an analyst should
examine a firm’s time series of relative financial ratios compared to its industry and the
economy.

19.3 Financial Ratios

We divide the ratios into five main categories that underscore the important economic char-
acteristics of a firm:
1. Common size statements
2. Internal liquidity (solvency)
3. Operating performance
a. Operating efficiency
b. Operating profitability
4. Risk analysis
a. Business risk
b. Financial risk
c. External liquidity risk
5. Growth analysis

19.3.1 Common Size Statements

These normalize balance sheet and income statement items to allow easier comparison of
different-sized firms. A common size balance sheet expresses all balance sheet accounts as a
percentage of total assets. A common size income statement expresses all income statement
items as a percentage of sales. Exhibit 19.4 is the common size balance sheet for Shoppers,
and Exhibit 19.5 contains its common size income statement. Common size ratios are
useful to quickly compare two different-sized firms and to examine trends over time
within a single firm. Common size statements also give insight into a firm’s financial con-
dition, for example, the proportion of liquid assets, the proportion of short-term liabili-
ties, or the percentage of sales consumed by production costs or interest expense. In the
case of Shoppers, the common size balance sheet shows a consistent increase in both the
percent of current assets and net property. Alternatively, the common size income state-
ment shows that Shoppers’ cost of goods sold and other operating expenses were quite
stable from 2003 to 2008 in proportion to sales. As a result of this stability, the firm has
experienced virtually a constant operating profit margin before and after taxes.The ability
of Shoppers to experience consistent growth in sales (around 9% per year) and a constant
profit margin is impressive.

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12 PART 7 Valuation Principles and Practices

Exhibit 19.4 Shoppers Drug Mart Corporation Common Size Balance Sheet, Years Ended 2005–2008

2008 2007 2006 2005

Assets
Current
Cash 0.58% 0.48% 1.28% 0.55%
Accounts receivable 6.98% 6.62% 6.25% 5.87%
Income taxes recoverable 27.15% 0.00% 0.00% 0.00%
Inventory 0.14% 27.50% 27.84% 27.81%
Future income taxes 1.29% 1.25% 0.93% 0.87%
Prepaid expenses 1.00% 2.40% 0.65% 0.66%
Total current assets 37.14% 38.24% 36.94% 35.76%
Property and equipment 22.46% 20.05% 18.42% 17.12%
Deferred costs 0.73% 0.59% 0.53% 0.50%
Goodwill 37.81% 39.93% 43.05% 46.14%
Other intangible assets 1.53% 1.03% 0.91% 0.41%
Other assets 0.33% 0.16% 0.14% 0.07%
Total assets 100.00% 100.00% 100.00% 100.00%
Liabilities
Current
Bank indebtedness 3.75% 4.00% 2.72% 3.72%
Commercial paper 5.30% 9.68% 10.23% 10.74%
Short-term debt 3.08% 0.00% 0.00% 0.00%
Accounts payable and accrued liabilities 15.86% 17.61% 17.10% 15.95%
Income taxes payable 0.00% 1.16% 1.44% 0.91%
Dividends payable 0.73% 0.62% 0.53% 0.48%
Current portion of long-term debt 0.00% 5.32% 0.00% 0.00%
Total current liabilities 28.73% 38.38% 32.01% 31.81%
Long-term debt 10.08% 0.00% 6.09% 7.43%
Other long-term liabilities 4.72% 4.36% 3.83% 3.22%
Future income taxes 0.73% 0.53% 0.43% 0.32%
Total liabilities 44.26% 43.28% 42.36% 42.78%
Associate interest 1.85% 2.01% 2.37% 2.65%
Shareholder’s equity
Share capital 23.59% 26.79% 30.25% 32.93%
Contributed surplus 0.17% 0.18% 0.14% 0.09%
Retained earnings 30.13% 27.75% 24.87% 21.53%
Total shareholder’s equity 53.89% 54.71% 55.26% 54.55%
Total liabilities and shareholder’s equity 100.00% 100.00% 100.00% 100.00%
Source: Calculated by Authors using publicly available information for Shoppers Drug Mart

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 WEB CHAPTER 19 Analysis of Financial Statements 13

Shoppers Drug Mart Corporation Common Size Statement of Income, Years

Exhibit 19.5
Ended 2005–2008

2008 2007 2006 2005

Sales 100.00% 100.00% 100.00% 100.00%

Cost of goods sold and
other operating expenses 88.45% 88.70% 89.37% 89.93%
Amortization 2.19% 2.03% 1.86% 1.69%
Operating income 9.36% 9.27% 8.77% 8.38%
Interest expense 0.68% 0.63% 0.64% 0.69%
Earnings before income taxes 8.68% 8.65% 8.13% 7.69%
Income taxes 0.00% 0.00% 0.00% 0.00%
Current 2.70% 2.95% 2.83% 2.48%
Future ⫺0.01% ⫺0.08% ⫺0.12% 0.13%
Total taxes 2.68% 2.87% 2.71% 2.60%
Net earnings 6.00% 5.78% 5.42% 5.09%
Source: Calculated by Authors using publicly available information for Shoppers Drug Mart

19.4 Evaluating Internal Liquidity

Internal liquidity (solvency) ratios are intended to indicate the ability of the firm to meet
future short-term financial obligations.They compare near-term financial obligations, such as
accounts payable or notes payable, to current assets or cash flows that will be available to meet
these obligations.

19.4.1 Internal Liquidity Ratios

Current Ratio Clearly the best-known liquidity measure is the current ratio, which examines
the relationship between current assets and current liabilities as follows:

Current Assets
19.2 Current Ratio ⴝ
Current Liabilities

For Shoppers, the current ratios were:

2,384
2008: ⴝ 1.29
1,844
2,150
2007: ⴝ 1.00
2,158
1,821
2006: ⴝ 1.15
1,578
1,565
2005: ⴝ 1.12
1,392

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14 PART 7 Valuation Principles and Practices

These current ratios remained stable over the four years and are consistent with the typical
current ratio. Note that the improvement in 2008 is primarily due to restructuring of its
short- and long-term liabilities. As always, it is important to compare these values with sim-
ilar figures for the firm’s industry and the aggregate market. If the ratios differ from the
industry results, we need to determine what might explain it in terms of specific current assets
and liabilities. (We will discuss comparative analysis in a later section.)
Quick Ratio Some observers question using total current assets to gauge the ability of a firm
to meet its current obligations because inventories and some other current assets might not
be very liquid. They prefer the quick ratio, which relates current liabilities to only relatively
liquid current assets (cash items and accounts receivable) as follows:

Cash ⴙ Marketable Securities ⴙ Receivables

19.3 Quick Ratio ⴝ
Current Liabilities

Shoppers’ quick ratios were

485
2008: ⴝ 0.26
1,844
399
2007: ⴝ 0.18
2,158
371
2006: ⴝ 0.24
1,578
281
2005: ⴝ 0.20
1,392

Once again, we see some good stability in this ratio with an improvement in 2008 due to the
debt restructuring. As before, we should compare these values to other firms in the industry
and to the aggregate economy.
Cash Ratio The most conservative liquidity ratio is the cash ratio, which relates the firm’s cash
and short-term marketable securities to its current liabilities as follows:

Cash and Marketable Securities

19.4 Cash Ratio ⴝ
Current Liabilities

Shoppers Drug Mart’s cash ratios were

37
2008: ⴝ 0.02
1,844
27
2007: ⴝ 0.01
2,158

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 WEB CHAPTER 19 Analysis of Financial Statements 15

63
2006: ⴝ 0.04
1,578
24
2005: ⴝ 0.02
1,392

Although low, this ratio indicates Shoppers keeps minimal cash balances and is likely using
lines of credit for working capital needs.
Receivables Turnover In addition to examining total liquid assets, it is useful to analyze the
quality (liquidity) of the accounts receivable by calculating how often the firm’s receivables
turn over, which implies an average collection period.The faster these accounts are paid, the
sooner the firm gets the funds to pay off its own current liabilities. Receivables turnover is
computed as

Net Annual Sales

19.5 Receivable Turnover ⴝ
Average Receivables

The average receivables figure is typically equal to the beginning receivables figure plus the
ending value divided by two. Receivables turnover ratios for Shoppers were

9,423
2008: ⴝ 22.98 times
448 ⴙ 372
2
8,478
2007: ⴝ 24.94 times
372 ⴙ 308
2
7,786
2006: ⴝ 27.56 times
308 ⴙ 257
2

A turnover value for 2005 has not been computed as the information we’ve provided does
not include an ending receivables figure for 2004.
Given these annual receivables turnover figures, the average collection period is

365 Days
19.6 Average Receivable Collection Period
Annual Receivables Turnover

For Shoppers,

365
2008: ⴝ 15.9 days
22.98

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16 PART 7 Valuation Principles and Practices

365
2007: ⴝ 14.6 days
24.94
365
2006: ⴝ 13.2 days
27.56

These results indicate that Shoppers currently is taking about 16 days to collect its accounts
receivable; it is slightly worrisome to see this creeping up since 2006.To determine whether
these account collection numbers are good or bad, it is essential that they be related to the
firm’s credit policy and to comparable numbers for other firms in the industry.The length of
the receivables collection period value varies dramatically for different firms (e.g., from 10 to
over 60), and it is mainly due to the product and the industry.An industry comparison would
indicate similar rapid collection periods for other drugstore chains, as most sales are for cash.
The receivables turnover is one of the ratios in which a firm does not want to deviate too much
from the norm. In an industry where the norm is 40 days, a collection period of 80 days would indi-
cate slow-paying customers, which increases the capital tied up in receivables and the possibility
of bad debts. Therefore, the firm wants to be somewhat below the norm (e.g., 35 days versus
40 days) but a figure substantially below the norm (e.g., 20 days) might indicate overly stringent
credit terms relative to the competition, which could be detrimental to sales in the long run.

19.4.2 Inventory Turnover

We should also examine the liquidity of inventory based on the firm’s inventory turnover
(i.e., how many times it is sold during a year) and the implied processing time. Inventory
turnover can be calculated relative to sales or cost of goods sold.The preferred turnover ratio
is relative to cost of goods sold (CGS),5 which does not include the profit implied in sales.

CGS
19.7 Inventory Turnover ⴝ
Average Inventory

For Shoppers, the inventory turnover ratios were

8,335
2008: ⴝ 5.07 times
1,743 ⴙ 1,546
2
7,520
2007: ⴝ 5.15 times
1,546 ⴙ 1,372
2
6,958
2006: ⴝ 5.38 times
1,372 ⴙ 1,217
2

5 Operating expenses have been included in the COGS figure as Shoppers has not broken them out separately; typically,
operating expenses are around 20% of sales.

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 WEB CHAPTER 19 Analysis of Financial Statements 17

Given these turnover values, we can compute the average inventory processing time as
follows:

365
19.8 Average Inventory Processing Period ⴝ
Annual Inventory Turnover

For Shoppers,

365
2008: ⴝ 72.0 days
5.07
365
2007: ⴝ 70.9 days
5.15
365
2006: ⴝ 67.9 days
5.38

Although this seems low, it is encouraging that the inventory processing period, even with
the slight increase over time, has been relatively stable. Still, it is essential to examine this
turnover ratio relative to an industry norm and/or the firm’s main competition. Notably, this
ratio will also be affected by the products carried—for instance, high-profit margin items,
such as cosmetics, have lower turnover rates. Also note that we have used the cost of goods
sold and other operating expenses, later we will use sales to calculate inventory turnover.
As with receivables, an extremely low inventory turnover value and long processing time
implies that capital is being tied up in inventory and could signal obsolete inventory (especially
for firms in the technology sector). Alternatively, an abnormally high inventory turnover and a
short processing time could mean inadequate inventory that could lead to outages, backorders,
and slow delivery to customers, which would eventually have an adverse effect on sales.
Cash Conversion Cycle A very useful measure of overall internal liquidity is the cash conver-
sion cycle, which combines information from the receivables, inventory, and the accounts
payable turnover ratios. Cash is tied up in receivables and in inventory for a number of days.
At the same time, the firm receives an offset to this capital commitment from its own sup-
pliers who provide interest-free loans to the firm by carrying the firm’s payables. Specifically,
the payables’ payment period is equal to 365 divided by the payables’ turnover ratio. In turn,
the payables’ turnover ratio is

Cost of Goods Sold

19.9 Payables Turnover Ratio ⴝ
Average Trade Payables

For Shoppers, the payables’ turnover ratios were

8,335
2008: ⴝ 8.30 times
1,018 ⴙ 990
2

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18 PART 7 Valuation Principles and Practices

7,520
2007: ⴝ 8.21 times
990 ⴙ 843
2
6,958
2006: ⴝ 8.03 times
843 ⴙ 698
2

365 days
19.10 Payables Payment Period ⴝ
Payable Turnover

365
2008: ⴝ 44.0 days
8.30
365
2007: ⴝ 44.5 days
8.21
365
2006: ⴝ 40.4 days
9.03

Therefore, the cash conversion cycle for Shoppers (with components rounded) equals:

Receivables Inventory Payables Cash

Collection Processing Payment Conversion
Year Days ⴙ Days ⴚ Period ⴝ Cycle

2008 16 ⫹ 72 ⫺ 44 ⫽ 44 days
2007 15 ⫹ 71 ⫺ 45 ⫽ 41 days
2006 13 ⫹ 68 ⫺ 40 ⫽ 41 days

Shoppers has an increase in both its receivables days and in its inventory processing days and
this has been partially offset by taking longer to pay its bills.The overall result is a very small
increase in the cash conversion cycle. Although the overall cash conversion cycle appears to
be quite good (about 44 days), as always we should examine the firm’s long-term trend and
how it compares to peers.

19.5 Evaluating Operating Performance

The operating performance ratios can be divided into two subcategories: (1) operating
efficiency and (2) operating profitability.These ratios examine how management uses its
assets and capital, measured by dollars of sales generated by various asset or capital categories.
Profitability ratios analyze the profits as a percentage of sales and as a percentage of the assets
and capital employed.

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 WEB CHAPTER 19 Analysis of Financial Statements 19

19.5.1 Operating Efficiency Ratios

Total Asset Turnover The total asset turnover ratio indicates the effectiveness of the firm’s use
of its total asset base (net assets equals gross assets minus amortization on capital assets). It is
computed as

Net Sales
19.11 Total Asset Turnover ⴝ
Average Total Net Assets

Shoppers’ total asset turnover values were

9,423
2008: ⴝ 1.57 times
6,419 ⴙ 5,622
2
8,478
2007: ⴝ 1.61 times
5,622 ⴙ 4,929
2
7,786
2006: ⴝ 1.67 times
4,929 ⴙ 4,375
2

This ratio must be compared to that of other firms within an industry because it varies
substantially between industries. For example, total asset turnover ratios range from less than
1 for capital-intensive industries (e.g., steel, automotive, and heavy manufacturing firms) to
over 10 for some retailing or service operations. It also can be affected by the use of leased
facilities.
As well, we must consider a range of turnover values consistent with the industry. It is poor
management to have an exceedingly high asset turnover relative to the industry because this
might imply too few assets for the potential business (sales), or it could be due to the use of
outdated, fully depreciated assets. It is equally poor management to have an extremely low
asset turnover because this implies that the firm is tying up capital in excess assets relative to
the needs of the firm and compared with its competitors.
Beyond the analysis of the firm’s total asset base, it is insightful to examine the utilization
of some specific assets, such as receivables, inventories, and capital assets.This detailed analysis
is especially important if the firm has experienced a substantial decline in its total asset
turnover because we want to know the cause of the decline, that is, which of the component
turnovers (receivables, inventory, capital assets) contributed to the decline.The receivables and
inventory turnover were examined as part of our liquidity analysis; we now examine the cap-
ital asset turnover ratio.
Net Capital Asset Turnover The net capital asset turnover ratio reflects the firm’s utilization
of capital assets.6 It is computed as

6 When analyzing asset turnover it is important to be aware of intangible assets such as goodwill or patents that can be sub-
stantial items. In such cases, analysts will often consider only “tangible” assets or “operating” assets. Given the growth strategy
of Shoppers, this is not a problem.

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20 PART 7 Valuation Principles and Practices

Net Sales
19.12 Capital Asset Turnover ⴝ
Average Net Capital Assets

Shoppers’ capital asset turnover ratios were

9,423
2008: ⴝ 7.34 times
1,442 ⴙ 1,127
2
8,478
2007: ⴝ 8.33 times
1,127 ⴙ 908
2
7,786
2006: ⴝ 9.40 times
908 ⴙ 749
2

These turnover ratios, which indicate a slight decline during the last few years, must be
compared with industry competitors and should consider the impact of leased assets (this is
especially significant for retail firms). Again, an abnormally low or high asset turnover ratio
can indicate poor capital asset management.7
Equity Turnover In addition to specific asset turnover ratios, it is useful to examine the
turnover for capital components. An important one, equity turnover, is computed as

Net Sales
19.13 Equity Turnover ⴝ
Average Equity

Equity includes preferred and common stock, paid-in capital, contributed surplus, and
retained earnings.8 This ratio differs from total asset turnover in that it excludes current lia-
bilities and long-term debt. Therefore, when examining this series, it is very important to
consider the firm’s capital structure ratios, because the firm can increase (or decrease) its
equity turnover ratio by increasing (or decreasing) its proportion of debt.
Shoppers’ equity turnover ratios were

9,423
2008: ⴝ 2.88 times
3,459 ⴙ 3,076
2
8,478
2007: ⴝ 2.92 times
3,076 ⴙ 2,724
2

7 “The DuPont System” section of this chapter contains an analysis of this total asset turnover ratio over a longer term.
8 Some investors prefer to consider only owner’s equity, which would not include preferred stock.

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 WEB CHAPTER 19 Analysis of Financial Statements 21

7,786
2006: ⴝ 3.05 times
2,724 ⴙ 2,387
2

This ratio has decreased slightly indicating that equity and sales growth are proportionate.
In our later analysis of sustainable growth, we examine the variables that affect the equity
turnover ratio to understand what variables might cause changes.
Following an analysis of the firm’s operating efficiency, the next step is to examine its
profitability in relation to its sales and capital.

19.5.2 Operating Profitability Ratios

There are two facets of profitability: (1) the profit on sales (profit margin) and (2) the per-
centage return on capital employed. The analysis of profitability of sales actually entails sev-
eral component profit margins that consider various expense categories. These component
margins provide important information relative to the final net profit margin. Thus, if we
determine that a firm has experienced a significant increase or decrease in its net profit
margin, the analysis of the component profit margins will help us to determine the specific
causes of the change. Therefore, we will briefly discuss each of the margins below but will
defer calculations and comments on the trends until we discuss the common size income
statement.
Gross Profit Margin Gross profit equals net sales minus the cost of goods sold.The gross profit
margin is computed as

Gross Profit
19.14 Gross Profit Margin ⴝ
Net Sales

This ratio indicates the basic cost structure of the firm. An analysis of this ratio over time
shows the firm’s relative cost-price position. As always, we must compare these margins to
comparable industry results and to main competitors. Notably, this margin can also be
impacted by a change in the firm’s product mix toward higher or lower profit-margin items.
As Shoppers does not provide a figure for cost of goods sold, we must consider the operating
profit margin.
Operating Profit Margin Operating profit is gross profit minus sales, general, and admin-
istrative (SG&A) expenses. It is also referred to as EBIT—earnings before interest and
taxes.

Operating Profit
19.15 Operating Profit Margin ⴝ
Net Sales

The variability of the operating profit margin over time is a prime indicator of the business
risk for a firm and should be compared to the volatility of similar ratios for competitors and
the industry.
Deducting interest expense and net foreign exchange loss from operating profit results in
earnings before income taxes.

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22 PART 7 Valuation Principles and Practices

Some investors add back the firm’s amortization expense to operating income (EBIT) to
compute a profit margin (EBITDA) that is then used as a proxy for pretax cash flow, how-
ever, as discussed earlier, we consider this to be biased cash flow estimate.
Net Profit Margin This margin relates after-tax net income to sales. In the case of Shoppers,
this is the same as operating income after taxes, because the firm does not have any significant
non-operating adjustments.This margin is equal to

Net Income
19.16 Net Profit Margin ⴝ
Net Sales

This ratio should be computed using sales and earnings from continuing operations, because
our analysis seeks to derive insights about future expectations.Therefore, we do not consider
earnings from discontinued operations, or the gain or loss from the sale of these operations.
Likewise, you do not want to include any non-recurring income or expenses.
Common Size Income Statement As noted earlier, these profit margin ratios are basically included
in a common size income statement, which lists all expense and income items as a percentage of
sales.This statement provides useful insights regarding the trends in cost figures and profit margins.
Exhibit 19.5 shows a common size income statement for Shoppers for 2005–2008. As
noted earlier, the most striking characteristic of the various profit margins for Shoppers (oper-
ating and net) is the significant stability in those margins over time. This stability is notable
because the firm has experienced a growth rate of sales during this period (better than 9%
per year), and it is generally a challenge to control costs when growing rapidly.
Beyond the analysis of earnings on sales, the ultimate measure of management perfor-
mance is the profits earned on the assets or the capital committed to the enterprise. Several
ratios help us evaluate this important relationship.
Return on Total Invested Capital The return on total invested capital ratio (or ROIC) relates
the firm’s earnings to all the invested capital involved in the enterprise (debt, preferred stock,
and common stock). Therefore, the earnings figure used is the net income from continuing
operations (before any dividends) plus the interest paid on debt.While there might be a ten-
dency to equate total capital with total assets, most analysts differentiate due to the term
invested capital, which does not include non-interest-bearing debt such as trade accounts
payable, accrued expenses, income taxes payable, and future income taxes. In contrast, short-
term debt such as bank borrowings and principal payments due on long-term debt are
interest bearing and would be included as invested capital.Therefore, the ratio would be:

Net Income ⴙ Interest Expense

19.17 Return on Total Invested Capital ⴝ
Average Total Invested Capital*
*Interest bearing debt plus shareholder’s equity

Shoppers incurred interest expense for long- and short-term debt.9

9 Subsequently, in connection with the analysis of financial risk, we discuss why and how to capitalize the operating lease
payments that are reported in notes. When we do this, we will add this capitalized value to the balance sheet in terms of
additional leased assets and also lease obligations along with the implied interest on the leases.At that point, we demonstrate
the affect of this on the firm’s ROIC and several other financial ratios—mainly financial risk ratios.

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 WEB CHAPTER 19 Analysis of Financial Statements 23

Shoppers’ returns on total invested capital (ROIC) were

565 ⴙ 64
2008: ⴝ 13.14%
5,188 ⴙ 4,389
2
490 ⴙ 53
2007: ⴝ 13.18%
4,389 ⴙ 3,851
2
422 ⴙ 50
2006: ⴝ 12.87%
3,851 ⴙ 3,486
2

This ratio indicates the firm’s return on all its invested capital. It should be compared with
the ratio for other firms in the industry and the economy. For Shoppers, the results are stable,
with a slight increase over the 2006 figures.
Return on Owner’s Equity The return on owner’s equity (ROE) ratio is extremely important
to the common shareholder because it indicates the return management has earned on the
capital provided by shareholders, after accounting for payments to all other capital suppliers.
If we consider all equity (including preferred stock), this return would equal

Net Income
19.18 Return on Total Equity ⴝ
Average Total Equity

If we are concerned only with owner’s equity (the common shareholder’s equity), the
ratio would be10

Net Income ⴚ Preferred Dividend

19.19 Return on Owner’s Equity ⴝ
Average Common Equity

Shoppers generated return on owner’s equity of

565 ⴚ 0
2008: ⴝ 17.29%
3,459 ⴙ 3,076
2
490 ⴚ 0
2007: ⴝ 16.90%
3,076 ⴙ 2,724
2
422 ⴚ 0
2006: ⴝ 16.51%
2,724 ⴙ 2,387
2

10 In the case of Shoppers, return on total equity and return on owner’s equity is the same, since there is no preferred stock
outstanding (it is authorized but not issued).

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24 PART 7 Valuation Principles and Practices

An online ratio calculator This ratio should be consistent with the firm’s overall business risk, and it should reflect
can be found at the financial risk assumed by the common shareholder because of the prior claims of the
http://www.bdc.ca/en/
business_tools/
firm’s bondholders.
calculators/overview.htm. The DuPont System The importance of ROE as an indicator of performance makes it desir-
able to divide the ratio into several component ratios that provide insights into the causes of
a firm’s ROE or any changes in it. This breakdown is generally referred to as the DuPont
system. First, ROE can be broken down into two familiar ratios—net profit margin and
equity turnover.

Net Income Net Income Net Sales

19.20 ROE ⴝ ⴝ ⴛ
Common Equity Net Sales Common Equity

This breakdown is an identity because we have both multiplied and divided by net sales.To
maintain the identity, the common equity value used is the year-end figure rather than the
average of the beginning and ending value.11 This identity reveals that ROE equals the net
profit margin times the equity turnover, which implies that a firm can improve its return on
equity by either using its equity more efficiently (increasing its equity turnover) or by
becoming more profitable (increasing its net profit margin).
Recall that a firm’s equity turnover can be increased by using more debt.We can see this
effect by considering the following:

Net Sales Net Sales Total Assets

19.21 ⴝ ⴛ
Common Equity Total Assets Common Equity

Similar to the prior breakdown, this is an identity because we have both multiplied and
divided the equity turnover ratio by total assets. This equation indicates that the equity
turnover ratio equals the firm’s total asset turnover (a measure of efficiency) times the ratio of
total assets to equity (a measure of financial leverage). Specifically, this financial leverage ratio
indicates the proportion of total assets financed with debt. All assets have to be financed by either
equity or some form of debt (either current or long-term).Therefore, the higher the ratio of assets
to equity, the higher the proportion of debt to equity. A total asset-equity ratio of 2, for
example, indicates that for every two dollars of assets there is a dollar of equity, which means
the firm financed one-half of its assets with equity and the other half with debt. Likewise, a
total asset-equity ratio of 3 indicates that only one-third of total assets was financed with
equity and two-thirds must have been financed with debt.Thus a firm can increase its equity
turnover either by increasing its total asset turnover (becoming more efficient) or by
increasing its financial leverage ratio (financing assets with a higher proportion of debt).This
financial leverage ratio is also referred to as the financial leverage multiplier, because the first
two ratios (profit margin times total asset turnover) equal return on total assets (ROTA), and
ROTA times the financial leverage multiplier equals ROE.

11 The effect of using the year-end equity rather than the average for the year will cause a lower ROE since the equity is
generally increasing over time.Two points regarding this difference: First, the conservative bias is generally small—for Shop-
pers (which is growing fast), the average equity result above for 2008 was 17.29% versus 16.41% using the year-end equity.
Second, the important trend results will be evident, along with the component trends that are very important.

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 WEB CHAPTER 19 Analysis of Financial Statements 25

Combining these two breakdowns, we see that a firm’s ROE is composed of three ratios,
as follows:

Net Income Net Income Net Sales Total Assets

19.22 ⴝ ⴛ ⴛ
Common Equity Net Sales Total Assets Common Equity
Profit Total Assets Financial
ⴝ ⴛ ⴛ
Margin Turnover Leverage

As an example of this important set of relationships, the data in Exhibit 19.6 indicate what
has happened to the ROE for Shoppers and the components of its ROE during the six-year
period from 2003 to 2008.As noted, these ratio values employ year-end balance sheet figures
(assets and equity) rather than the average of beginning and ending data, so they will differ
from our individual ratio computations.
The DuPont results in Exhibit 19.6 indicate several significant trends:
1. The total asset turnover ratio was relatively stable: a total range of 1.34 to 1.63.
2. The profit margin series experienced a consistent increase from 2004.
3. The product of the total asset turnover and the net profit margin is equal to return on total
assets (ROTA), which experienced an overall increase from 2005 to 2007 after the decline
between 2004 and 2005.The 2008 decline was due primarily from the asset growth.
4. The financial leverage multiplier (total assets/equity) experienced a decline from 2005 to
2007 and then increased again to 1.96. Most of this debt is non-interest-bearing trade credit,
bank indebtedness, and commercial paper.The impact of the long-term leases are discussed
and analyzed in the subsequent financial risk section.
5. Finally, as a result of the overall increase in ROTA and a declining financial leverage, the
firm’s ROE has experienced steady improvement overall except for 2004 when profit margins
were down. In 2008, total asset turnover decreased slightly while the firm borrowed more,
leaving the ROE close to the previous year.

Exhibit 19.6 Components of Return on Total Equity for Shoppers Drug Marta

(1) (2) (3)b (4) (5)c

Sales/Total Net Profit Return on Total Return on

Assets Margin Total Assets Assets/Equity Equity
Year (Times) (%) (%) (Times) (%)

2003 1.34 5.82 7.80 1.96 15.29

2004 1.59 4.68 7.44 1.97 14.66
2005 1.63 5.09 8.30 1.83 15.19
2006 1.58 5.42 8.56 1.81 15.49
2007 1.51 5.78 8.73 1.83 15.97
2008 1.47 6.00 8.82 1.86 16.41
aRatiosuse year-end data for total assets and common equity rather than averages of the year.
bColumn (3) is equal to column (1) times column (2).
cColumn (5) is equal to column (3) times column (4).

Note: When the three component ratios are multiplied the product may not equal the ROE based on year-end state-
ments due to the rounding of the three ratios.

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26 PART 7 Valuation Principles and Practices

An Extended DuPont System Beyond the original DuPont system, some analysts have sug-
gested using an extended DuPont system,12 which provides additional insights into the effect
of financial leverage on the firm and also pinpoints the effect of income taxes on the firm’s
ROE. Because both financial leverage and tax rates have changed over the past decade, these
additional insights are important.The concept and use of the model is the same as the basic
DuPont system except for a further breakdown of components.
We now begin with the operating profit margin (EBIT divided by sales) and introduce
additional ratios to derive an ROE value. Combining the operating profit margin and the
total asset turnover ratio yields the following:

EBIT Net Sales EBIT

ⴛ ⴝ
Net Sales Total Assets Total Assets

This ratio is the operating profit return on total assets. To consider the negative effects of
financial leverage, we examine the effect of interest expense as a percentage of total assets:

EBIT Interest Expense Net Before Tax (NBT)

ⴚ ⴝ
Total Assets Total Assets Total Assets

We consider the positive effect of financial leverage with the financial leverage multiplier as
follows:

Net Before Tax (NBT) Total Assets Net Before Tax (NBT)
ⴛ ⴝ
Total Assets Common Equity Common Equity

This indicates the pretax return on equity. Finally, to arrive at ROE, we must consider
the tax-rate effect. We do this by multiplying the pre-tax ROE by a tax-retention rate as
follows:

ⴛ a 100% ⴚ b ⴝ
Net Before Tax Income Taxes Net Income
Common Equity Net Before Tax Common Equity

In summary, we have the following five components:

EBIT
1. ⴝ Operating Profit Margin
Sales
Sales
2. ⴝ Total Asset Turnover
Total Assets
Interest Expense
3. ⴝ Interest Expense Rate
Total Assets

12 The original DuPont system was the three-component breakdown discussed in the prior section. Because this extended
analysis also involves the components of ROE, some still refer to it as the DuPont system. In our presentation, we refer to
it as the extended DuPont system to differentiate it from the original three-component analysis.

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 WEB CHAPTER 19 Analysis of Financial Statements 27

Total Assets
4. ⴝ Financial Leverage Multiplier
Common Equity

5. a 100% ⴚ b ⴝ Tax Retention Rate

Income Taxes
Net Before Tax

Exhibit 19.7 contains the calculations, using the five components for 2003 through 2008.The
first column indicates that the firm’s operating profit margin has been growing steadily since
2004.We know from the prior discussion that the firm’s total asset turnover (Column 2) has
also been improving after a drop in 2006 and 2008.The resulting operating profit return on
assets has shown steady improvement from 2004. As discussed, the amount of interest and
non-interest-bearing debt has increased proportionately to asset growth (combined with a
low-interest rate environment). Column 4 shows little negative impact on leverage until
2008, however, this is no worse than the 2003 figure.
Column 5 reflects the firm’s operating performance before the positive impact of
financing (the leverage multiplier) and the impact of taxes.These results are virtually iden-
tical to Column 3 due to extensive use of non-interest-bearing debt. Column 6 reflects a
slow decline in non-lease financial leverage, with a slight increase in 2008. As a result of the
overall declining leverage and improved profitability multiplier, the before-tax ROE in
Column 7 has remained constant except for 2004. Column 8 shows the strong positive
effect of lower tax rates, which caused a higher tax-retention rate, even with the increased
taxes paid in 2008.
In summary, this breakdown helps you to understand what happened to a firm’s ROE and
why it happened.The intent is to determine what happened to the firm’s internal operating

Exhibit 19.7 Extended DuPont System Analysis for Shoppers: 2003–2008a

1 2 3 4 5 6 7 8 9

Interest Total Net Before

Sales/ EBIT/ Expense/ Net Before Assets/ Tax/
EBIT/ Total Total Total Tax/ Total Common Common Tax Return on
Sales Assets Assets Assets Assets Equity Equity Retention Equity
Year (%) (Times) (%)b (%) (%)c (Times) (%)d Rate (%)e

2003 11.03 1.34 14.74 2.30 12.44 1.96 24.40 0.63 15.29
2004 8.16 1.59 13.02 1.46 11.56 1.97 22.82 0.64 14.72
2005 8.38 1.63 13.69 1.12 12.57 1.83 23.04 0.66 15.26
2006 8.77 1.58 13.86 1.01 12.84 1.81 23.24 0.67 15.50
2007 9.27 1.51 13.98 0.94 13.04 1.83 23.83 0.67 15.94
2008 9.36 1.47 13.76 1.00 12.76 1.86 23.74 0.69 16.38
aThe percents in this table may not be the same as in Exhibit 19.6 due to rounding.
bColumn 3 is equal to column 1 times column 2.
cColumn 5 is equal to column 3 minus column 4.
dColumn 7 is equal to column 5 times column 6.
eColumn 9 is equal to column 7 times column 8.

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28 PART 7 Valuation Principles and Practices

results, what has been the negative and positive effect of its financial leverage policy, and what
was the effect of external government tax policy. Although the two breakdowns should pro-
vide the same ending value, they typically differ by small amounts because of the rounding of
components.

19.6 Risk Analysis

Risk analysis examines the uncertainty of income flows for the total firm and for the indi-
vidual sources of capital (i.e., debt, preferred stock, and common stock).The typical approach
examines the main factors that cause a firm’s income flows to vary. More volatile income
flows mean greater risk (uncertainty) facing the investor.
The total risk of the firm has two internal components: business risk and financial risk.
We first discuss the concept of business risk: how to measure it, what causes it, and how to
measure its individual causes.Then we consider financial risk and the several ratios by which
we measure it. Following this analysis of a firm’s internal risk factors, we discuss an important
external risk factor, external liquidity risk—that is, the ability to buy or sell the firm’s stock
in the secondary equity market.

19.6.1 Business Risk

Recall that business risk is the uncertainty of operating income caused by the firm’s
industry. In turn, this uncertainty is due to the firm’s variability of operating earnings caused
by its products, customers, and the way it produces its products. Specifically, a firm’s operating
earnings vary due to two factors: (1) the volatility of the firm’s sales over time, and (2) how
the firm produces its products in terms of its mix of fixed and variable costs—that is, its oper-
ating leverage. For example, the earnings for a steel firm will probably vary more than those
of a grocery chain because (1) over the business cycle, steel sales are more volatile than gro-
cery sales; and (2) the steel firm’s large fixed production costs (high operating leverage) make
its earnings vary more than its sales.
Business risk is generally measured by the variability of the firm’s operating income over time
determined by the standard deviation of the historical operating earnings series.You will recall
from Chapter 1 that the standard deviation is influenced by the size of the numbers, so investors
standardize this measure of volatility by dividing it by the mean value for the series (i.e., the average
operating earnings).The resulting ratio of the standard deviation of operating earnings divided by
the average operating earnings is the coefficient of variation (CV) of operating earnings:

Business Risk ⴝ f (Coefficient of Variation of Operating Earnings )

Standard Deviation of Operating Earnings (OE )
ⴝ
Mean Operating Earnings

ⴝ
Ba
n

iⴝ1
a OEi ⴚ OE b
—–
冒
2
n
n
冒
a OEi n
iⴝ1

The CV of operating earnings allows comparisons between standardized measures of business

risk for firms of different sizes. To compute the CV of operating earnings, you need a min-
imum of 5 years up to about 10 years. Less than 5 years is not very meaningful, and data more

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 WEB CHAPTER 19 Analysis of Financial Statements 29

than 10 years old are typically out of date. Besides measuring overall business risk, it is very
insightful to examine the two factors that contribute to the variability of operating earnings:
sales variability and operating leverage.
Sales Variability Sales variability is the prime determinant of operating earnings variability.
In turn, the variability of sales is affected by a firm’s industry and is largely outside of man-
agement control. For example, in a cyclical industry such as automobiles or steel, sales will be
quite volatile over the business cycle compared to those in a non-cyclical industry, such as
retail food or hospital supplies. Like operating earnings, the variability of a firm’s sales is typ-
ically measured by the CV of sales during the most recent 5 to 10 years.

Sales Volatility ⴝ f (Coefficient of Variation of Sales)

ⴝ
Ba
n

iⴝ1
a Si ⴚ S b 冒
2
n
n

a Si
iⴝ1
冒n

Adjusting Volatility Measures for Growth Besides normalizing the standard deviation of
EBIT and sales for size by computing the CV, it is also important to recognize that the stan-
dard deviation is measured relative to the mean value for the series or deviations from
“expected value.” A problem arises for firms that experience significant growth even if it is
constant as there will be very large deviations from the mean for the series.To avoid this bias
we measure deviations from the growth path of the series.
Operating Leverage The variability of a firm’s operating earnings also depends on its mixture
of production costs.Total production costs of a firm with no fixed production costs would vary
directly with sales, and operating profits would be a constant proportion of sales. In such an
example, the firm’s operating profit margin would be constant and its operating profits would
have the same relative volatility as its sales. Realistically, firms always have some fixed produc-
tion costs such as buildings, machinery, or relatively permanent personnel. Fixed production
costs cause operating profits to vary more than sales over the business cycle. Specifically, during
slow periods, operating profits will decline by a larger percentage than sales, while during an
economic expansion, operating profits will increase by a larger percentage than sales.
The use of fixed production costs is referred to as operating leverage. Clearly, greater
operating leverage (caused by a higher proportion of fixed production costs) makes the oper-
ating earnings series more volatile relative to the sales series.This basic relationship between
operating profit and sales leads us to measure operating leverage as the average of the annual
percentage change in operating earnings relative to the percentage change in sales during a
specified period as follows:

a ` % ¢S `
n
%¢OE
iⴝ1
Operating Leverage ⴝ
n

We take the absolute value of the percentage changes because the two series can move in
opposite directions.The direction of the change is not important, but the relative size of the

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30 PART 7 Valuation Principles and Practices

change is relevant. By implication, the more volatile the operating earnings as compared to
the volatility of sales, the greater the firm’s operating leverage.

19.6.2 Financial Risk

Financial risk, you will recall, is the additional uncertainty of returns to equity holders due
to a firm’s use of fixed financial obligation securities.This financial uncertainty is in addition
to the firm’s business risk.When a firm issues bonds, the interest payments are fixed contrac-
tual obligations. As with operating leverage, during an economic expansion, the net earnings
available for common stock after the fixed interest payments will experience a larger per-
centage increase than operating earnings. In contrast, during a business decline, the earnings
available to shareholders will decline by a larger percentage than operating earnings because
of these fixed financial costs (i.e., interest payments). Remember, as a firm increases its rela-
tive debt financing with fixed contractual obligations, it increases its financial risk and the pos-
sibility of default and bankruptcy.
Relationship between Business Risk and Financial Risk Remember that the acceptable level of
financial risk for a firm depends on its business risk. If the firm has low business risk (i.e., stable
operating earnings), investors are willing to accept higher financial risk. For example, retail
food companies typically have stable operating earnings over time, which implies low busi-
ness risk and means that investors and bond-rating firms will allow the firms to have higher
financial risk. In contrast, if a firm is in an industry that is subject to high business risk (i.e.,
it experiences high sales volatility and it has high operating leverage), such as steel, automo-
bile, and airline companies, an investor would not want these firms to also have high finan-
cial risk. The two risks would compound and the probability of bankruptcy would be
substantial.13
In our analysis, we employ three sets of financial ratios to measure financial risk, and all
three sets should be considered. First, there are balance sheet ratios that compare the propor-
tion of capital derived from debt and equity sources. Second are ratios that compare the earn-
ings or cash flows available to the required fixed financial charges. Third are ratios that
consider the cash flows available and relate these cash flows to the book value of the out-
standing debt. Before we discuss and demonstrate these financial risk ratios, it is necessary to
consider the topic of operating lease obligations.
Consideration of Lease Obligations Many firms lease buildings and equipment rather than
borrow the funds and purchase the assets.The accounting for the lease obligation depends on
the type of lease. For a capital lease, the value of the asset and the lease obligation is included
on the balance sheet as an asset and liability. If it is an operating lease, it is recorded in the notes
and perhaps the Management, Discussion and Analysis (M, D & A) but is not specifically
included on the balance sheet.14 Because operating leases are a form of financing used exten-
sively by retailers (such as Shoppers, Sears, and Danier) and airlines, it is necessary to recog-
nize this obligation, capitalize estimated future lease payments, and include this capitalized
lease value on the balance sheet as both an asset and a long-term liability. In the following
subsection, we discuss how to do this, and demonstrate the significant impact this adjustment
can have on several financial risk ratios.

13 Support for this specific relationship is found in a set of tables (see Standard & Poor’s, 2008, p. 21) that suggest specific
required financial risk ratios necessary for a firm to be considered for a specific bond rating. The required ratios differ on
the basis of the perceived business risk of the firm.
14 A discussion of the technical factors that will cause a lease to be capital versus operating is beyond the scope of this
book, but it is covered in most intermediate accounting texts.

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 WEB CHAPTER 19 Analysis of Financial Statements 31

Capitalizing Operating Leases Capitalizing leases basically involves an estimate of the present
value of a firm’s future required lease payments. Therefore, an analyst must estimate both an
appropriate discount rate (typically the firm’s long-term debt rate) and the firm’s future lease
payment obligations.
An estimate of the discounted value of the future lease payments can be done one of two
ways: (1) a multiple of the forthcoming minimum lease payments or (2) the discounted value
of the future lease payments provided in the annual report at the firm’s cost of long-term
debt.The traditional multiple technique multiplies the minimum lease payment in year t ⫹ 1
(next year) by 8. In the case of Shoppers, the future minimum lease payments in the 2008
annual report are as follows:15

Years Relating to Year-End 1 2 3 4 5 Later

Minimum Payments ($ millions) 314 325 318 302 287 2,154

Given these data, the estimate using the multiple technique would produce an estimate of
8 ⫻ $314 million ⫽ $2.51 billion. To derive an estimate using the discounted value tech-
nique, we need to estimate the firm’s cost of long-term debt and consider how to handle the
lump-sum later payments. Our debt rate estimate is 7.00%, which is consistent with the pre-
vailing interest rate on 20-year, A-rated corporate bonds. For the later lump-sum payment,
we need to derive a reasonable estimate regarding how many years to assume for this payout.
A liberal assumption is that the lump-sum payment is spread evenly over 15 years, based on
the standard building lease for Shoppers of 20 years ($2,154/15 ⫽ $144 million per year).An
alternative estimate of the spread period is derived by dividing the lump-sum payment in the
later period t ⫹ 6 by the t ⫹ 5 payment, which implies a time estimate (2,154/287 ⫽ 7.51).
If we round this up to 8 years, we have an annual payment of $2,154/8 ⫽ $269 million per
year for 8 years.
If all the annual and “later” flows over 15 years are discounted at 7.00%, we derive an esti-
mate of the lease debt of $2.21 billion. A similar calculation using the 8-year spread indicates
an estimate of lease debt of $2.42 billion.Therefore, we have the following three estimates:16
8 times the t ⫹ 1 lease payment $2.51 billion
Discounting the lease payments assuming a 15-year spread $2.21 billion
Discounting the lease payments assuming an 8-year spread $2.42 billion
We will use the $2.21 billion discount method given that the figure is not substantially dif-
ferent from the conservative discounting method that assumes an 8-year spread. If we add this
amount (or that estimated by the other methods) to both capital assets and long-term debt
we will have a better measure of the assets utilized by the firm and the complete funding of
the assets (recognition of substantially more debt).
Implied Interest for Leased Assets When computing the return on total capital (ROTC)
that considers these leased assets, we must also add the implied interest expense for the leases.
The interest expense component of a lease is typically estimated by bond-rating agencies and
many other analysts as equal to one-third of the lease payment in year t ⫹ 1 (in our example,
$314 million/3 ⫽ $105 million).

15 These minimum lease payments have been assumed to occur annually although the annual report provides only
bi-annual lease obligations.
16 Notably, the “8 times” estimate almost always provides the lowest estimate of debt value, which means that this general
rule will tend to underestimate the financial leverage for these firms and the resulting implied interest expense.

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32 PART 7 Valuation Principles and Practices

An alternative to this general rule would be to derive a specific estimate based on an esti-
mate of the firm’s cost of debt (7%) and the estimate of the present value (PV) of the lease
obligation, as follows:

PV of Lease Obligation Interest Expense at 7%

Estimating Technique ($ billion) ($ million)

8 times estimate of t ⫹ 1 payment 2.51 176

PV with 15-year spread 2.21 155
PV with 8-year spread 2.42 169

Notably, all of these estimates of the implied interest expense are substantially higher than the
one-third general rule estimate of $105 million. Again, the general rule underestimates the
financial leverage related to these lease obligations.
To calculate the ROTC for 2007 and 2008, we need to compute the value of the lease obli-
gations and the implied interest expense for the three years (2006, 2007, and 2008) as follows:

Estimate of PV of Estimate of Interest

Year Lease Obligation ($ billion) Component of Leasea ($ million)

2008 2.21 155

2007 1.91 134
2006 1.57 110
aEqual to 0.07 of the PV of lease obligation.

Adding these values to the prior ROIC ratio (see Equation 19.17) results in the following
lease-adjusted return on total invested capital (ROIC) values:

565 ⴙ 64 ⴙ 155
2008: ⴝ 11.45%
7,398 ⴙ 6,299
2
490 ⴙ 53 ⴙ 134
2007: ⴝ 11.55%
6,299 ⴙ 5,421
2

As shown, the ROICs that include the leased assets and lease debt are lower (around 11.5%
versus 13%), but they are still quite reasonable.
Implied Amortization on Leased Assets Another factor is the implied amortization
expense that would be taken if these were not leased assets. One way to calculate this value
is to simply use the typical term of the lease or weighted-average term. In the case of Shop-
pers, this is reasonably clear because almost all leases are 20-year leases on buildings. However,
if the value were not clear, a second alternative would be the average percent of amortization
as a percent of beginning-of-year net capital assets. In our example, for 2008 this would be

Amortization (2008 )$206 million; net capital assets

at end of 2007: $1,127 million

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 WEB CHAPTER 19 Analysis of Financial Statements 33

This implies a 18.30% (206/1,127), which is clearly higher than the 5% on buildings. Obvi-
ously, Shoppers has many assets being amortized over shorter lives. For these calculations
related to leases on buildings, we assume the 20-year life as follows:

Estimate of Implied
Estimate of PV of Lease Amortization
Year Obligation ($ billion) Expense of Lease* ($ million)

2008 2.21 111

2007 1.91 96
2006 1.57 79
2005 1.29 65
*Assumes straight-line amortization over a 20-year life.

These implied amortization charges should be included in ratios that include amortiza-
tion expenses.

19.6.3 Proportion of Debt (Balance Sheet) Ratios

The proportion of debt ratios indicate what proportion of the firm’s capital is derived from
debt compared to other sources of capital, such as preferred stock, common stock, and
retained earnings. A higher proportion of debt compared to equity makes earnings more
volatile (i.e., more financial leverage) and increases the probability that a firm could default
on the debt. Therefore, higher proportion of debt ratios indicate greater financial risk. The
following are the most common debt ratios used to measure financial risk.
Debt–Equity Ratio The debt–equity ratio is

Total Long - Term Debt

19.23 Debt–Equity Ratio ⴝ
Total Equity

The debt figure includes all long-term fixed obligations, including subordinated convertible
bonds. The equity typically is the book value of equity and includes preferred stock, common
stock, and retained earnings. Some analysts prefer to exclude preferred stock and consider only
common equity.Total equity is preferable if some of the firms being analyzed have preferred stock.
Notably, debt ratios can be computed with and without future taxes. Most balance sheets
include an accumulated future tax figure.There is some controversy regarding whether these
future taxes should be treated as a liability or as part of permanent capital. Some argue that if
the future tax has accumulated because of the difference in capital cost allowance and straight-
line amortization, this liability may never be paid. That is, as long as the firm continues to
grow and add new assets, this total future tax account continues to grow. Alternatively, if the
future tax account is caused by differences in the recognition of income on long-term con-
tracts, there will be a reversal and this liability must eventually be paid.To resolve this ques-
tion, the analyst must determine the reason for the future tax account and examine its
long-term trend. Shoppers’ future tax account is because of a amortization difference and it
has typically grown over time.
A second consideration when computing debt ratios is the existence of operating leases.
As noted, given a firm like Shoppers with extensive leased facilities, it is necessary to include
an estimate of the present value of the lease payments as long-term debt.

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34 PART 7 Valuation Principles and Practices

To show the effect of these two significant items on the financial risk of Shoppers, we
define the ratios to include both of these factors, but they will be broken out to identify the
effect of each of the components of total debt.Thus, the debt–equity ratio is

Total Long - Term Debt

19.24 Debt– Equity Ratio ⴝ
Total Equity
Non - current Liabilities ⴙ Future Taxes ⴙ PV of Lease Obligations
ⴝ
Total Equity

For Shoppers, the debt–equity ratios were

647 ⴙ 303 ⴙ 47 ⴙ 2,210

2008: ⴝ 92.71%
3,459
245 ⴙ 30 ⴙ 1,910
2007: ⴝ 71.03%
3,076
300 ⴙ 189 ⴙ 21 ⴙ 1,570
2006: ⴝ 76.40%
2,724

These ratios demonstrate the significant impact of including the present value of the lease
payments as part of long-term debt—for example, the debt–equity ratio for 2008 went from
roughly 29% without lease obligations to over 92% when capitalized leases are included.
Long-Term Debt-Total Capital Ratio The long-term debt-total capital ratio indicates the pro-
portion of long-term capital derived from long-term debt. It is computed as

Total Long - Term Debt

19.25 Long - Term Debt–Total Capital Ratio ⴝ
Total Long - Term Capital

The total long-term debt values are the same as above. The total long-term capital would
include all long-term debt, any preferred stock, and total equity. The long-term debt-total
capital ratios for Shoppers were

Including Future Taxes and Lease Obligations as Long - Term Debt

3,207
2008: ⴝ 48.11%
3,207 ⴙ 3,459
2,185
2007: ⴝ 41.53%
2,185 ⴙ 3,076
2,081
2006: ⴝ 43.31%
2,081 ⴙ 2,724

Again, this ratio, which includes the present value of lease obligations, shows that a significant
percent of long-term capital is debt obligations.This differs substantially from a ratio without
the lease obligations.

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 WEB CHAPTER 19 Analysis of Financial Statements 35

Total Debt–Total Capital Ratios In many cases, it is useful to compare total debt to total
invested capital. Earlier when we computed return on invested capital, we did not consider
non-interest-bearing capital such as accounts payable, accrued expenses, income taxes payable,
or future taxes (caused by amortization). In such a case, total debt would be long-term debt
(without future taxes), which would be other non-current liabilities plus capitalized leases.
Total capital would be this interest-bearing debt plus shareholder’s equity, as follows:

Total Interest - Bearing Debt

19.26 Total Debt–Total Capital Ratio ⴝ
Total Invested Capital

Capitalized Leases ⴙ Non - Current Liabilities

ⴝ
Total Interest - Bearing Debt ⴙ Shareholders Equity

2,210 ⴙ 647 ⴙ 303

2008: ⴝ 47.74%
2,210 ⴙ 647 ⴙ 303 ⴙ 3,459
1,910 ⴙ 245
2007: ⴝ 41.20%
1,910 ⴙ 245 ⴙ 3,076
1,570 ⴙ 300 ⴙ 189
2006: ⴝ 43.05%
1,570 ⴙ 300 ⴙ 189 ⴙ 2,724

While these adjustments cause the debt percents to be lower, they are still quite high.These
ratios confirm the importance of considering the impact of lease obligations on the financial
risk of firms like Shoppers that employ lease financing.

19.6.4 Earnings and Cash Flow Coverage Ratios

In addition to ratios that indicate the proportion of debt on the balance sheet, investors are
very conscious of ratios that relate the flow of earnings or cash flows available to meet the
required interest and lease payments. A higher ratio of available earnings or cash flow relative
to fixed financial charges indicates lower financial risk.
Interest Coverage Ratio The standard interest coverage ratio is computed as

Earnings before Interest and Taxes (EBIT)

19.27 Interest Coverage ⴝ
Debt Interest Charges
Net Income ⴙ Income Taxes ⴙ Interest Expense
ⴝ
Interest Expense

This ratio indicates how many times the fixed interest charges are earned, based on the earnings
available to pay these expenses.Alternatively, one minus the reciprocal of the interest coverage ratio
indicates how far earnings could decline before it would be impossible to pay the interest charges
from current earnings. For example, a coverage ratio of 5 means that earnings could decline by
80% (1 minus 1/5), and the firm could still pay its fixed financial charges.Again, for firms like Shop-
pers that have heavy lease obligations, it is necessary to consider the impact of the lease obligations
on this ratio. If we recognize the lease obligations as debt and include the implied interest on the
capitalized leases as computed earlier, the coverage ratio would be restated as follows:

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36 PART 7 Valuation Principles and Practices

19.28 Fixed Financial Cost Coverage

Earnings before Interest and Taxes ⴙ Implied Lease Interest
ⴝ
Interest Expense ⴙ Implied Lease Interest

Hence, the fixed financial cost coverage ratios for Shoppers were

882 ⴙ 155
2008: ⴝ 4.74 times
64 ⴙ 155
786 ⴙ 134
2007: ⴝ 4.92 times
53 ⴙ 134
683 ⴙ 110
2006: ⴝ 4.96 times
50 ⴙ 110

These fixed financial cost coverage ratios show a substantially different picture than the
coverage ratios that do not consider the impact of the lease obligations. Even so, these cov-
erage ratios are not unreasonable for a firm with very low business risk.
The trend of Shoppers’ coverage ratios has been consistent with the overall trend in the
proportion of debt ratios. The proportion of debt ratios and the earnings flow ratios do not
always give consistent results because the proportion of debt ratios are not sensitive to changes
in earnings or to changes in the interest rates on the debt. For example, if interest rates
increase or if the firm replaces old debt with new higher yielding debt, no change would
occur in the debt ratios, but the interest coverage ratio would decline. Also, the interest cov-
erage ratio is sensitive to an increase or decrease in earnings.Therefore, the results using bal-
ance sheet ratios and coverage ratios can differ. Given a difference between the two sets of
ratios, we have a strong preference for the earning or cash flow coverage ratios that reflect the
ability of the firm to meet its financial obligations.
Alternatives to these earnings coverage ratios are several ratios that relate the cash flow
available from operations to either interest expense or total fixed charges.
Cash Flow Coverage Ratio The motivation for this ratio is that a firm’s earnings and cash flow
typically will differ substantially (these differences have been noted and will be considered in
a subsequent section). The cash flow value used is the cash flow from operating activities
figure contained in the cash flow statement. As such, it includes amortization expense, future
taxes, and the impact of all working capital changes.Again, it is appropriate to specify the ratio
in terms of total fixed financial costs including leases,17 as follows:

19.29 Cash Flow Coverage of Fixed Financial Cost ⴝ

Net Cash Flow from Operating Activities ⴙ Interest Expense ⴙ Implied Lease Interest
Interest Expense ⴙ Implied Lease Interest

17 Note that some analysts adjust both Equations 19.28 and 19.29 to include the impact of before tax preferred divi-
dends. This impact would be added to the numerator and denominator of Equation 19.28 and just the denominator of
Equation 19.28.

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 WEB CHAPTER 19 Analysis of Financial Statements 37

We use the values given in the cash flow statement, because we are specifically interested in
the cash flow effect.The cash flow coverage ratios for Shoppers were:

479 ⴙ 64 ⴙ 155
2008: ⴝ 3.19 times
64 ⴙ 155
565 ⴙ 53 ⴙ 134
2007: ⴝ 4.02 times
53 ⴙ 134
570 ⴙ 50 ⴙ 110
2006: ⴝ 4.56 times
50 ⴙ 110

While these coverage ratios are not alarming for a firm with very low business risk, it is note-
worthy that they have been slowly deteriorating.

19.6.5 Cash Flow-Outstanding Debt Ratios

Cash Flow–Long-Term Debt Ratio Several studies have used a ratio that relates cash flow from
operating activities to a firm’s outstanding debt. The cash flow-outstanding debt ratios are
unique because they relate the flow of earnings plus non-cash expenses to the stock of out-
standing debt. These ratios have been significant variables in numerous studies concerned
with predicting bankruptcies and bond ratings.18 Obviously, the higher the percent of cash
flow to long-term debt, the stronger the company—i.e., the lower its financial risk.This ratio
would be computed as

Cash Flow
19.30
Long - Term Debt
Cash Flow from Operating Activities
ⴝ
Book Value of Long - Term Debt ⴙ Present Value of Lease Obligations

For Shoppers, the ratios were as follows, assuming that future taxes are not included, as they are
not interest bearing.Thus, the long-term debt is non-current liabilities and the lease obligations:

479
2008: ⴝ 15.16%
647 ⴙ 303 ⴙ 2,210
565
2007: ⴝ 26.21%
245 ⴙ 1,910
570
2006: ⴝ 27.68%
300 ⴙ 189 ⴙ 1,570

Cash Flow–Total Debt Ratio Investors also should consider the relationship of cash flow to
total debt to check that a firm has not had a significant increase in its short-term borrowing.

18 These studies are listed in the reference section.

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38 PART 7 Valuation Principles and Practices

Cash Flow
19.31 ⴝ
Total Debt
Cash Flow from Operating Activities
Total Long - Term Debt ⴙ Interest - Bearing Current Liabilities

Given that Shoppers uses interest-bearing short-term debt, the percents for this ratio will
be lower; how much lower will indicate the amount of short-term borrowing by the firm.
As before, it is important to compare these flow ratios with similar ratios for other companies
in the industry and with the overall economy to gauge the firm’s relative performance.
Alternative Measures of Cash Flow As noted, many past studies that included a cash flow
variable used the traditional measure of cash flow.The requirement that companies must pre-
pare and report the statement of cash flows to shareholders has raised interest in other exact
measures of cash flow. The first alternative measure is the cash flow from operations, which is
taken directly from the statement of cash flows and is the one we have used. A second alter-
native measure is free cash flow, which is a modification of the cash flow from operations—that
is, capital expenditures (minus the cash flow from the sale of assets) are also deducted. Finally,
some analysts also subtract dividends.The following table summarizes the values for Shoppers
derived earlier in the chapter (page 9).

FREE CASH FLOW

Traditional Cash Flow from Net Cap

Year Cash Flow Operations Exp Before Div. Div. After Div.

2008 788 479 741 ⫺262 175 ⫺437

2007 671 565 517 48 130 ⫺82
2006 574 570 378 192 99 93
2005 498 451 275 176 64 112

As shown, Shoppers has strong cash flow from operations even after considering significant
working capital requirements, but the firm has been experiencing declining free cash flow because
of substantial net capital expenditures necessitated by the firm’s growth, particularly in 2008.

19.6.6 External Market Liquidity Risk

External Market Liquidity Defined In Chapter 1 we discussed external market liquidity as the
ability to buy or sell an asset quickly with little price change from a prior transaction assuming
no new information.
Determinants of External Market Liquidity Investors should know the liquidity characteris-
tics of the securities they currently own or may buy because liquidity can be important if they
want to change their portfolio composition. Although the main determinants of market liq-
uidity are reflected in market trading data, several internal corporate variables are good
proxies for these market variables. The most important determinant of external market liq-
uidity is the number of shares or the dollar value of shares traded (the dollar value adjusts for
different price levels). More trading activity indicates a greater probability that one can find
someone to take the other side of a desired transaction. A very good measure that is usually
available is trading turnover (the percentage of outstanding shares traded during a period

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 WEB CHAPTER 19 Analysis of Financial Statements 39

of time), which indicates relative trading activity. In 2008, Shoppers had a trading volume
of around 177 million, which indicates annual trading turnover of approximately 82%
(177/217). This compares with the average turnover for the TSX of about 90%. Another
measure of market liquidity is the bid-ask spread, where a smaller spread indicates greater liq-
uidity. In addition, certain corporate variables are correlated with these trading variables:
1. Total market value of common shares outstanding
2. Number of security owners
Numerous studies have shown that the main determinant of the bid-ask spread (besides price)
is the dollar value of trading, which is highly correlated with the market value of the out-
standing securities.
We can estimate the market value of Shoppers’ outstanding stock as the average number
of shares outstanding during the year (as computed above) times the average market price for
the year (equal to the high price plus the low price divided by 2) as follows:19

48 ⴙ 41
2008: 217 ⴛ ⴝ $9.66 billion
2
58 ⴙ 47
2007: 216 ⴛ ⴝ $11.34 billion
2
51 ⴙ 40
2006: 214 ⴛ ⴝ $9.74 billion
2

These market values clearly would place Shoppers in the large-cap category, which usually
begins at about $5 billion.

19.7 Analysis of Growth Potential

19.7.1 Importance of Growth Analysis
Analysis of a firm’s growth potential is important for both lenders and owners. Owners know
that the value of the firm depends on its future growth in earnings, cash flow, and dividends.
Creditors are also interested in a firm’s growth potential because the firm’s future success is
the main determinant of its ability to pay obligations, and the firm’s future success is influ-
enced by its growth. Some credit analysis ratios measure the book value of a firm’s assets rel-
ative to its financial obligations, assuming that the firm can sell these assets to pay off the loan
in case of default. Selling assets in a forced liquidation will typically yield only about 10 to 15
cents on the dollar. Currently, it is widely recognized that the more relevant analysis is the
ability of the firm to pay off its obligations as an ongoing enterprise, which is impacted by its
growth potential. This analysis of growth is also relevant to changes of bond ratings. In Web
Chapter 20, we review various valuation models.

19.7.2 Determinants of Growth

The growth of business, like the growth of any economic entity, including the aggregate
economy, depends on
1. The amount of resources retained and reinvested in the entity
2. The return earned on those funds

19 These stock prices (which are for the calendar year) are rounded to the nearest whole dollar.

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40 PART 7 Valuation Principles and Practices

The more a firm reinvests, the greater its potential for growth.Therefore, the growth rate of
equity earnings and cash flows is a function of two variables: (1) the percentage of net earn-
ings retained (the firm’s retention rate) and (2) the return earned on the firm’s equity (the
firm’s ROE), because when earnings are retained they become part of the firm’s equity.

19.32 g ⴝ Percentage of Earnings Retained ⴛ Return on Equity ⴝ RR ⴛ ROE

where:
g ⫽ potential (i.e., sustainable) growth rate
RR ⫽ the retention rate of earnings
ROE ⫽ the firm’s return on equity
The retention rate is a decision by the board of directors based on the investment opportu-
nities available to the firm.Theory suggests that the firm should retain earnings and reinvest
them as long as the expected return on the investment exceeds the firm’s cost of capital.
As discussed earlier regarding the DuPont system, a firm’s ROE is a function of three
components:
• Net profit margin
• Total asset turnover
• Financial leverage (total assets/equity)
Therefore, a firm can increase its ROE by increasing its profit margin, by becoming more efficient
(increasing its total asset turnover), or by increasing its financial leverage (and its financial risk).All
three components should be examined when estimating or evaluating the ROE for a firm.
The sustainable growth potential analysis for Shoppers begins with the retention rate
(RR):

Dividends Declared
19.33 Retention Rate ⴝ 1 ⴚ
Net Earnings

Shoppers’ RR figures were

175
2008: 1 ⴚ ⴝ 0.69
565
130
2007: 1 ⴚ ⴝ 0.73
490
99
2006: 1 ⴚ ⴝ 0.77
422
64
2005: 1 ⴚ ⴝ 0.82
364

Exhibit 19.8 reinforces our understanding of the importance of the firm’s ROE. Shoppers’
retention rate was quite stable from 2005 to 2008 once they began paying dividends.We can
see that the firm’s ROE has mainly driven its sustainable growth rate. This analysis con-
firms that the long-run outlook for the components of return on equity is important. Investors need

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 WEB CHAPTER 19 Analysis of Financial Statements 41

Exhibit 19.8 Shoppers’ Components of Growth and the Implied Sustainable Growth Rate

(1) (2) (3)b

Year Retention Rate Return on Equitya (%) Sustainable Growth Rate (%)

2003 1.00 15.29 15.29

2004 1.00 14.66 14.66
2005 0.82 15.19 12.46
2006 0.77 15.49 11.93
2007 0.73 15.97 11.66
2008 0.69 16.41 11.32
aFrom Exhibit 19.6.
bColumn (3) is equal to column (1) times column (2).

to project changes in each of the components of ROE and employ these projections to esti-
mate an ROE to use in the growth model along with an estimate of the firm’s long-run
retention rate. Particularly for growth companies where the ROEs are notably above average
for the economy and, therefore, vulnerable to competition.

19.8 Comparative Analysis of Ratios

We have discussed the importance of comparative analysis, but so far we have concentrated
on the selection and calculation of specific ratios. Exhibit 19.9 contains many of the ratios
discussed for Shoppers and the retail drugstore industry (as derived from Dun & Bradstreet
Canada Industry Norms and Ratios).The three-year comparison should provide some insights,
although we typically would want to examine data for a 5- to 10-year period.

19.8.1 Internal Liquidity

The current and quick ratio indicate less liquidity for Shoppers relative to the industry.The firm’s
receivables collection period is below the retail drugstore industry. Because the collection period
has been fairly steady, the difference is likely due to the firm’s basic credit policy with associates.
Overall, the comparisons indicate reasonably strong internal liquidity.An additional positive
liquidity factor is the firm’s ability to borrow by way of commercial paper and bank credit lines.

19.8.2 Operating Performance

Shoppers’ turnover ratios were generally consistent although below those of the retail drug-
store industry. Part of this might be explained by the different ratio components used by Dun
and Bradstreet (ending versus average, definition of capital assets, and so on).
Although the industry norms did not provide information on operating profit margins,
we would want to investigate this figure.
The profit performance related to invested capital was historically strong. The return on
total assets for Shoppers was consistently above the retail drugstore industry. Shoppers like-
wise always attained higher ROEs than its industry.

19.8.3 Risk Analysis

Shoppers’ financial risk ratios, measured in terms of proportion of debt, were consistently superior
to those of the industry, however, given the industry data it was not possible to compare ratios that

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42 PART 7 Valuation Principles and Practices

Exhibit 19.9 Summary of Financial Ratios for Shoppers Drug Mart and Industry Averages 2005–2008

2008 2007 2006 2005

Retail Retail Retail Retail

Shoppers Drug Shoppers Drug Shoppers Drug Shoppers Drug

Internal liquidity
Current ratio 1.29 1.5 1.00 1.9 1.15 2.1 1.12 1.5
Acid test 0.26 0.5 0.18 0.5 0.24 0.7 0.2 0.5
Average collection period 15.9 17.9 14.6 14.4 13.24 13.8 12.6 18.6
Operating performance
Total asset turnover 1.57 2.29 1.61 2.4 1.67 2.4 1.7 2.7
Capital asset turnover 7.34 21.1 8.33 15.0 9.40 25.9 10.5 23.45
Inventory turnover (sales) 5.73 6.8 5.81 8.7 6.00 6.8 6.1 7.3
Equity turnover 2.88 6.57 2.92 4.58 3.05 6.65 3.2 7.36
Profitability
Net profit margin 6.00% 2.5% 5.78% 2.60% 5.42% 2.60% 5.10% 3.50%
Return on owner’s equity 17.29% 15.9% 16.90% 14.70% 16.51% 14.70% 16.3% 15.30%
Return on total assets 9.38% 8.2% 9.29% 7.9% 9.07% 7.90% 8.60% 8.00%
Financial risk
Debt–equity ratio 0.93 1.8 0.71 1.7 0.77 1.7 0.78 1.7
Growth analysis
Retention rate 0.69 n/a 0.73 n/a 0.77 n/a 0.82 n/a
Return on equity 16.41% 15.90% 15.93% 8.70% 15.49% 14.70% 15.25% 15.30%
Total asset-equity 1.86 2.67 1.83 2.31 1.81 2.72 1.83 2.71
Sustainable growth rate 11.32 11.63% 11.93% 12.51%
Source: Dun and Bradstreet Canada, Industry Norms and Ratios, some figures derived by Authors

adjusted for capitalized leases and future income taxes. Based on the information available, it would
appear Shoppers has a reasonable amount of financial risk, but it is not of major concern because
the firm has very low business risk based on consistently high growth in sales and operating profit.
Notably, there are no specific comparative ratios available for both business and external liquidity
risk.Also, the trading turnover and market value data indicated low external liquidity risk.

19.8.4 Growth Analysis

Shoppers had recently experienced a consistent sustainable growth rate based on both
a higher ROE and a high retention rate. In sum, Shoppers has adequate liquidity; a good
operating record, including a very consistent growth record that implies low business risk;
above-average financial risk even when we consider the leases on stores; and above-average
growth performance relative to the aggregate market.Your success as an investor depends on
how well you use these historical numbers to derive meaningful estimates of future perfor-
mance for use in a valuation model. As noted previously, everybody is generally aware of
the valuation models, so it is the individual who can provide the best estimates of relevant
valuation variables (including the rate of growth and the duration of growth) who will expe-
rience superior risk-adjusted performance.

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 WEB CHAPTER 19 Analysis of Financial Statements 43

19.8.5 Comparator Numbers

As our brief analysis has shown, comparator numbers may be lacking, incomplete for your
purposes, or calculated differently. In order to be confident in comparing trends, you may
have to do a full analysis of comparator companies.

19.9 Analysis of Non-Canadian Financial Statements

As we have stressed several times, your portfolio should encompass other economies and mar-
kets, numerous global industries, and many foreign firms in these global industries. However,
because accounting conventions differ among countries, non-Canadian financial statements
will differ from those in this chapter and from what you will see in a typical accounting
course.While it is beyond the scope of this text to discuss these alternative accounting con-
ventions in detail, we encourage you to examine the sources in the “Suggested Readings”
section entitled Analysis of International Financial Statements.

19.10 The Quality of Financial Statements

Analysts sometimes speak of the quality of a firm’s earnings or the quality of a firm’s balance
sheet. In general, quality financial statements are a good reflection of reality; accounting
tricks and one-time changes are not used to make the firm appear stronger than it really is.
Some factors that lead to lower quality financial statements were mentioned previously when
we discussed ratio analysis. Other quality influences are discussed here and in Palepu, Healy,
and Bernard (2007, chapter 3).

19.10.1 Balance Sheet

A high-quality balance sheet typically has limited use of debt or leverage. Therefore, the
potential of financial distress resulting from excessive debt is quite low. Little use of debt also
implies the firm has unused borrowing capacity, which implies that the firm can draw on that
unused capacity to make profitable investments.
A quality balance sheet contains assets with market values greater than their book value.
The capability of management and the existence of intangible assets—such as goodwill, trade-
marks, or patents—will make the market value of the firm’s assets exceed their book values.
In general, as a result of inflation and historical cost accounting, we might expect the market
value of assets to exceed their book values. Overpriced assets on the books occur when a firm
has outdated, technologically inferior assets; obsolete inventory; and non-performing assets
such as receivables that have not been written off.
The presence of off-balance-sheet liabilities also harms the quality of a balance sheet. Such
liabilities may include joint ventures and loan commitments or guarantees to subsidiaries,
which are discussed in Stickney, Brown, and Wahlen (2007, chapter 6).

19.10.2 Income Statement

High-quality earnings are repeatable earnings. For example, they arise from sales to customers
who are expected to do repeat business with the firm and from costs that are not artificially
low as a result of unusual and short-lived input price reductions. One-time and non-recur-
ring items—such as accounting changes, mergers, and asset sales—should be ignored when
examining earnings. Unexpected exchange rate fluctuations that work in the firm’s favour to
raise revenues or reduce costs should also be viewed as non-recurring.
High-quality earnings result from the use of conservative accounting principles that do not
result in overstated revenues and understated costs.The closer the earnings are to cash, the higher
the quality of the income statement. Suppose a firm sells furniture on credit by allowing customers

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44 PART 7 Valuation Principles and Practices

to make monthly payments.A higher quality income statement will recognize revenue using the
“installment” principle; that is, as the cash is collected each month, in turn, annual sales will reflect
only the cash collected from sales during the year. A lower quality income statement will recog-
nize 100% of the revenue at the time of sale, even though payments may stretch well into next
year.A detailed discussion of income items is in Stickney, Brown, and Wahlen (2007, chapter 5).

19.10.3 Notes
A word to the wise: read the notes! The purpose of the notes is to provide information on
how the firm handles balance sheet and income items.While the notes may not reveal every-
thing you should know (e.g., Enron), if you do not read them you cannot hope to be
informed.The fact is, many analysts recommend that you should read an annual report back-
ward, so that you read the notes first!

19.11 The Value of Financial Statement Analysis

Financial statements, by their nature, are backward-looking.They report the firm’s assets, lia-
bilities, and equity as of a certain (past) date; they report a firm’s revenues, expenses, or cash
flows over some (past) time period.An efficient capital market will have already incorporated
this past information into security prices; so it may seem, at first glance, that analysis of a firm’s
financial statements and ratios is a waste of the analyst’s time.
The fact is, the opposite is true. Financial statement analysis allows the investor to gain knowl-
edge of a firm’s operating and financial strategy and structure.This, in turn, assists them in deter-
mining the effects of future events on the firm’s cash flows. Combining knowledge of the firm’s
operating and financial leverage, its strategy, and possible macro- and microeconomic scenarios is
necessary to determine an appropriate market value for the firm’s stock. Combining the analysis
of historical data with potential future scenarios allows analysts to evaluate the risks facing the
firm and then to develop an expected return and cash flow forecast based on these risks.The final
outcome of the process, as detailed in other chapters detail, is the determination of the firm’s cur-
rent intrinsic value based on expected cash flows, which is compared to the stock’s current market
price to determine your investment decision.The point is, the detailed analysis of the historical
results ensures a better estimation of the expected cash flows and an appropriate discount rate
which in turn leads to a superior estimate of the intrinsic value of the firm.

19.12 Specific Uses of Financial Ratios

In addition to measuring firm performance and risk, financial ratios have been used in four
main areas in investments: (1) stock valuation, (2) the identification of internal corporate
variables that affect a stock’s systematic risk, (3) assigning credit quality ratings on bonds, and
(4) predicting insolvency (bankruptcy) of firms.

19.12.1 Stock Valuation Models

As we will discuss in Web Chapter 20, most valuation models attempt to derive a stock value
based on one of several present value of cash flow models or appropriate relative valuation ratios.
All the models require a growth rate estimate for earnings, cash flows, or dividends and the
required return on the stock. Clearly, financial ratios can help in estimating these critical inputs.
The typical empirical valuation model has examined a cross-section of companies and used
a multiple regression model that relates one of the relative valuations ratios for the sample firms
to some of the following (the averages generally consider the past 5 or 10 years).20

20 A list of studies in this area appears in the “Suggested Readings” section at the end of the chapter.

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 WEB CHAPTER 19 Analysis of Financial Statements 45

Financial Ratios
1. Average debt-equity
2. Average interest coverage
3. Average dividend payout
4. Average return on equity
5. Average retention rate
6. Average market price to book value
7. Average market price to cash flow
8. Average market price to sales
Variability Measures
1. Coefficient of variation of operating earnings
2. Coefficient of variation of sales
3. Coefficient of variation of net income
4. Systematic risk (beta)
Non-ratio Variable
1. Average growth rate of earnings and cash flows
An alternative use of these ratios is to act as a filter to derive a subset of stocks to analyze
from some total universe of stocks. For example, starting with a universe of 5,000 stocks, you
would screen on the basis of consistent growth rates, profitability, and stability to generate a
subset of 250 stocks that you would analyze in depth.

19.12.2 Estimating Systematic Risk

As discussed in Chapter 7, the capital asset pricing model (CAPM) asserts that the relevant
risk variable for an asset should be its systematic risk, which is its beta coefficient related to
the market portfolio of all risky assets. In efficient markets, a relationship should exist between
internal corporate risk variables and market-determined risk variables such as beta. Numerous
studies have tested the relationship between a stock’s systematic risk (beta) and the firm’s
internal corporate variable intended to reflect business risk and financial risk.21 The signifi-
cant variables (usually five-year averages) included were as follows:
Financial Ratios
1. Dividend payout
2. Total debt–total assets
3. Cash flow–total debt
4. Interest coverage
5. Working capital–total assets
6. Current ratio
Variability Measures
1. Coefficient of variation of net earnings
2. Coefficient of variation of operating earnings
3. Coefficient of variation of operating profit margins
4. Operating earnings beta (company earnings related to aggregate earnings)
Non-ratio Variables
1. Asset size
2. Market value of stock outstanding

21 A list of studies in this area appears in the “Suggested Readings” section at the end of the chapter.

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46 PART 7 Valuation Principles and Practices

19.12.3 Estimating the Ratings on Bonds

Recall from Chapter 3 that various agencies assign credit ratings to bonds on the basis of the
issuing company’s ability to meet its obligations related to the bond. Numerous studies have
used various financial ratios to predict the rating to be assigned to a bond; these ratios include:22
Financial Ratios
1. Long-term debt–total assets
2. Total debt–total capital
3. Net income plus amortization (cash flow)–long-term senior debt
4. Cash flow–total debt
5. Earnings before interest and taxes (EBIT)–interest expense (fixed charge coverage)
6. Cash flow from operations plus interest–interest expense
7. Market value of stock–par value of bonds
8. Net operating profit–sales
9. Net income–owners’ equity (ROE)
10. Net income–total assets (ROA)
11. Working capital–sales
12. Sales–net worth (equity turnover)
Variability Measures
1. Coefficient of variation of sales
2. Coefficient of variation of operating earnings
3. Coefficient of variation of net earnings
4. Coefficient of variation of return on assets
Non-ratio Variables
1. Subordination of the issue
2. Size of the firm (total assets)
3. Issue size for alternative bond issues
4. Par value of all publicly traded bonds of the firm

19.12.4 Predicting Insolvency (Bankruptcy)

Analysts have always been interested in using financial ratios to identify firms that might default
on a loan or declare bankruptcy.23 The typical study examines a sample of firms that have
declared bankruptcy against a matched sample of firms in the same industry and of compa-
rable size that have not failed. The analysis involves examining a number of financial ratios
expected to reflect declining liquidity for several years prior to the declaring of bankruptcy.
The goal is to determine which set of ratios correctly predict that a firm will be in the bank-
rupt or non-bankrupt group.The better models have typically correctly classified more than
80% of the firms one year prior to failure. Some of the financial ratios included in successful
models were as follows:
Financial Ratios
1. Cash flow–total debt
2. Cash flow–long-term debt
3. Sales–total assets*
4. Net income–total assets
5. EBIT/total assets*

22 A list of studies in this area appears in the “Suggested Readings” section at the end of the chapter.
23 A list of studies in this area appears in the “Suggested Readings” section at the end of the chapter.

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 WEB CHAPTER 19 Analysis of Financial Statements 47

6. Total debt/total assets

7. Market value of stock–book value of debt*
8. Working capital–total assets*
9. Retained earnings–total assets*
10. Current ratio
11. Working capital–sales
An insolvency predictor In addition to the several studies that have used financial ratios to predict bond ratings and fail-
calculator can be found at ures, other studies have also used cash flow variables or a combination of financial ratios and cash
http://www.creditguru.com/
CalcAltZ.shtml
flow variables for these predictions, and the results have been quite successful.These studies are
listed in the “Suggested Readings” section at the end of the chapter.The five ratios designated by
an asterisk (*) are the ratios used in the well-known Altman Z-score model (Altman, 1968).

19.12.5 Limitations of Financial Ratios

We must reinforce an earlier point:You should always consider relative financial ratios. In addi-
tion, you should be aware of other questions and limitations of financial ratios:
1. Are firms’ accounting treatments comparable? From your prior accounting courses, you
know there are several generally accepted methods for treating various accounting items,
which can cause a difference in results.Therefore, you should check on the accounting treat-
ment of significant items and adjust the values if necessary. Comparability is a critical consid-
eration when dealing with foreign firms.
2. How homogeneous is the firm? Many companies have divisions that operate in different
industries, which can make it difficult to derive comparable industry ratios.
3. Are the implied results consistent? It is important to develop a total profile of the firm and
not depend on only one set of ratios (e.g., internal liquidity ratios). As an example, a firm
may be having short-term liquidity problems but be very profitable—the profitability will
eventually alleviate the short-run liquidity problems.
4. Is the ratio within a reasonable range for the industry? As noted on several occasions, you
typically want to consider a range of appropriate values for the ratio because a value that is
either too high or too low for the industry can be a problem.

Summary
1. Financial statements are intended to provide information management uses its assets and capital, measured by dollars
on the resources available to management, how these of sales generated by various asset or capital categories
resources were financed, and what the firm accomplished and the profits as a percentage of sales and as a percentage
with them.Annual and quarterly reports to the shareholder of the assets and capital employed. Risk analysis ratios
include three financial statements: the balance sheet, the examine various components of risk and their sources,
income statement, and the statement of cash flows. whether business, financial or external liquidity. Growth
2. The overall purpose of financial statement analysis is to ratios look at sources of growth for the company and the
help investors make decisions on investing in a firm’s firm’s ability to fund some of that growth internally.
bonds or stock. Financial ratios should be examined rela- 4. The DuPont system divides the ROE ratio into component
tive to the economy, the firm’s industry, the firm’s main ratios that provide insights into the causes of a firm’s ROE
competitors, and the firm’s past relative ratios. or any changes in it.The component ratios, net profit
3. The specific ratios can be divided into four categories, margin, total asset turnover, and equity turnover when
depending on the purpose of the analysis: internal broken out give some indication on how a firm can
liquidity, operating performance, risk analysis, and growth improve its return on equity by using more debt (increasing
analysis. Internal liquidity ratios are intended to indicate its equity turnover), by becoming more profitable
the ability of the firm to meet future short-term financial (increasing its net profit margin), by increasing its asset effi-
obligations. Operating performance ratios examine how ciency (total asset turnover), or a combination of these.

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48 PART 7 Valuation Principles and Practices

5. A high-quality balance sheet typically has limited use of 6. Financial statement analysis allows investors to gain
debt and assets with market values greater than their knowledge of a firm’s operating and financial strategy
book value. A high-quality income statement has repeat- and structure.This, in turn, assists them in determining
able earnings and the earning result from the use of the effects of future events on the firm’s cash flows.
conservative accounting principles that do not result in
overstated revenues and understated costs.

Key Terms
balance sheet, p. 4 generally accepted accounting operating profitability ratios, p. 18
business risk, p. 28 principles (GAAP), p. 4 quality financial statements, p. 43
cross-sectional analysis, p. 10 income statement, p. 4 statement of cash flows, p. 6
DuPont system, p. 24 internal liquidity (solvency) ratios, p. 13 sustainable growth rate, p. 40
financial risk, p. 30 operating efficiency ratios, p. 19 time-series analysis, p. 11
free cash flow to equity, p. 8 operating leverage, p. 29 trading turnover, p. 38

Suggested Readings
General Financial Ratios and Systematic Risk (Beta)
Byrnes, Nanette, Mike McNamee, Diane Brady, Louis Lavelle, Campbell, John Y., Christopher Polk, and Tuomo Vuolteenaho.
and Christopher Palmeri. 2002. “Accounting in Crisis.” “Growth or Glamour? Fundamentals and Systematic Risk in
Business Week, January 28, pp. 44–48. Stock Return,” Working Paper, February 2007 retrieved at
Fridson, Martin, and Fernando Alvarez. Financial Statement http://personal.lse.ac.uk/polk/research/gorg20070219.pdf.
Analysis, 3rd ed. New York:Wiley, 2002. Mandelker, Gershon M., and S. Ghon Rhee. “The Impact of
Helfert, Erich A. Techniques of Financial Analysis, 11th ed. New Degrees of Operating and Financial Leverage on the
York: McGraw-Hill, 2002. Systematic Risk of Common Stock.” Journal of Financial and
Penman, Stephen. Financial Statement Analysis and Security Quantitative Analysis 19, no. 1 (March 1984).
Valuation, 3rd ed. New York: McGraw-Hill, 2007.
Financial Ratios and Bond Ratings
Analysis of International Financial Statements
Cantor, R., and F. Packer. “The Credit Rating Industry.”
Doupnik,Timothy, and Hector Perera. International Accounting, Journal of Fixed Income 5, no. 3 (December 1995).
1st ed. New York: McGraw-Hill, 2007. Fisher, Lawrence.“Determinants of Risk Premiums on Corpo-
Rueschhoff, Norlin, and David Strupeck. “Equity Returns: rate Bonds.” Journal of Political Economy 67, no. 3 (June 1959).
Local GAAP versus US GAAP for Foreign Issuers from Parnes, Dror. “Applying Credit Score Models to Multiple
Developing Countries,” Journal of International Accounting States of Nature,” Journal of Fixed Income, Winter 2007.
33, no. 3 (Spring 2000). Standard and Poor’s Corporation. “Corporate Ratings
Criteria,” 2008.
Financial Ratios and Stock Valuation Models Zhou, Chunsheng. “Credit Rating and Corporate Defaults.”
Damodaran, Aswath. Investment Valuations: Tools and Techniques Journal of Fixed Income 11, no. 3 (December 2001).
for Determining the Value of Any Asset, 2nd ed. New York:
Financial Ratios and Corporate Bankruptcy
Wiley, 2002.
Danielson, M. G.“A Simple Valuation Model and Growth Expec- Altman, Edward I. “Financial Ratios, Discriminant Analysis,
tations.” Financial Analysts Journal 54, no. 3 (May–June 1998). and the Prediction of Corporate Bankruptcy.” Journal of
Farrell,James L.“The Dividend Discount Model:A Primer.”Finan- Finance 23, no. 4 (September 1968).
cial Analysts Journal 41, no. 6 (November–December 1985). Altman, Edward I., and Edith Hotchkiss. Corporate Financial
Kaplan, S. N., and R. S. Ruback.“The Valuation of Cash Flow Distress and Bankruptcy, 3rd ed. New York:Wiley, 2006.
Forecasts:An Empirical Analysis.” Journal of Finance 50, no. 4 Altman, Edward I., and Herbert Rijken. “A Point-in-Time
(September 1995). Perspective on Through-the-Cycle Ratings.” Financial
Penman, S. H.“The Articulation of Price-Earnings Ratios and Analysts Journal 62, no. 1 (January–February 2006).
Market-to-Book Ratios and the Evaluation of Growth.” De Servigney, Arnaud, and Olivier Renault. Measuring and
Journal of Accounting Research 34, no. 2 (Spring 1996). Managing Credit Risk. New York: McGraw-Hill, 2004.

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 WEB CHAPTER 19 Analysis of Financial Statements 49

Dumbolena, I. G., and J. M. Shulman. “A Primary Rule of Bottom Line,What Is?” Financial Analysts Journal 41, no.
Detecting Bankruptcy: Watch the Cash.” Financial Analysts 5 (September–October 1985).
Journal 44, no. 5 (September–October 1988). Helwege, J., and P. Kleiman. “Understanding High Yield
Gentry, James A., Paul Newbold, and David T.Whitford.“Classi- Bond Default Rates.” Journal of Fixed Income 7, no. 1
fying Bankrupt Firms with Funds Flow Components.” (June 1997).
Journal of Accounting Research 23, no. 1 (Spring 1985). Jonsson, J. G., and M. S. Fridson.“Forecasting Default Rates on
Gentry, James A., Paul Newbold, and David T. Whitford. High Yield Bonds.” Journal of Fixed Income 6, no. 1 (June
“Predicting Bankruptcy: If Cash Flow’s Not the 1996).

❏
CFA For Chapter CFA Questions and Problems, please see Appendix A at the end of this text.

Questions
1. Discuss briefly two decisions that require the analysis of firm (e.g., the cash flow ratios indicate high financial risk,
financial statements. while the proportion of debt ratio indicates low risk),
2. Why do analysts use financial ratios rather than the which ratios would you follow? Justify your choice.
absolute numbers? Give an example. 9. Why is the analysis of growth potential important to the
3. Besides comparing a company’s performance to its total common shareholder? Why is it important to the debt
industry, discuss what other comparisons should be investor?
considered within the industry. 10. Discuss the general factors that determine the rate of
4. How might a jewellery store and a grocery store differ in growth of any economic unit.
terms of asset turnover and profit margin? Would you 11. A firm is earning 24% on equity and has low business
expect their return on total assets to differ assuming and financial risk. Discuss why you would expect it to
equal business risk? Discuss. have a high or low retention rate.
5. Describe the components of business risk, and discuss 12. The Gold Company earned 18% on equity, whereas the
how the components affect the variability of operating Blue Company earned only 14% on equity. Does this
earnings (EBIT). mean that Gold will grow faster than Blue? Explain.
6. Would you expect a steel company or a retail food chain 13. In terms of the factors that determine market liquidity,
to have greater business risk? Discuss this expectation in why do investors consider real estate to be a relatively
terms of the components of business risk. illiquid asset?
7. When examining a firm’s financial structure, would you be 14. Discuss some internal company factors that would indi-
concerned with the firm’s business risk? Why or why not? cate a firm’s market liquidity.
8. Give an example of how a cash flow ratio might differ from 15. Select one of the limitations of ratio analysis and indicate
a proportion of debt ratio.Assuming these ratios differ for a why you believe it is a major concern.

Problems
1. The Shamrock Vegetable Company has the following a. Compute Shamrock’s ROE directly. Confirm this using
results. the three components.
b. Using the ROE computed in part (a), what is the
Net sales 6,000,000 expected sustainable growth rate for Shamrock?
Net total assets 4,000,000 c. Assuming the firm’s net profit margin went to 0.04,
what would happen to Shamrock’s ROE?
Amortization 160,000
d. Using the ROE in part (c), what is the expected
Net income 400,000 sustainable growth rate? What if dividends were only
Long-term debt 2,000,000 $40,000?
Equity 1,160,000 2. Three companies have the following results during the
Dividends 160,000 recent period.

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50 PART 7 Valuation Principles and Practices

K L M GENERAL ENTERPRISES CONSOLIDATED

STATEMENT OF INCOME,YEARS ENDED
Net profit margin 0.04 0.06 0.10 DECEMBER 31, 20X8 AND 20X9
Total assets turnover 2.20 2.00 1.40 ($ THOUSANDS)
Total assets/equity 2.40 2.20 1.50 20X9 20X8

Net sales $3,500 $2,990

a. Derive for each its return on equity based on the three
DuPont components. Cost of goods sold 2,135 1,823
b. Given the following earnings and dividends, compute Selling, general, and
the estimated sustainable growth rate for each firm. administrative expenses 1,107 974
Operating profit 258 193
K L M
Net interest expense 62 54
Earnings/share 2.75 3.00 4.50 Income from operations 196 139
Dividends/share 1.25 1.00 1.00 Income taxes 66 47
3. Given the following balance sheet, fill in the ratio values Net income 130 92
for 20X9 and discuss how these results compare with Preferred dividends 15 15
both the industry average and prior average performance Net income available
of General Enterprises. for common shares 115 77
GENERAL ENTERPRISES CONSOLIDATED Dividends declared 35 30
BALANCE SHEET,YEARS ENDED DECEMBER General General’s Industry
31, 20X8 AND 20X9 (20X9) Average Average
Assets ($ Thousands) 20X9 20X8
Current ratio —— 2.000 2.200
Cash $ 100 $ 90
Quick ratio —— 1.000 1.100
Receivables 220 170
Receivables turnover —— 18.000 18.000
Inventories 330 230
Average collection period —— 20.000 20.000
Total current assets 650 490
Total asset turnover —— 1.500 1.400
Property, plant, and equipment 1,850 1,650
Inventory turnover —— 11.000 12.500
Amortization 350 225
Capital-asset turnover —— 2.500 2.400
Net properties 1,500 1,425
Equity turnover —— 3.200 3.000
Intangibles 150 150
Gross profit margin —— 0.400 0.350
Total assets 2,300 2,065
Operating profit margin —— 8.000 7.500
Liabilities and Return on capital —— 0.107 0.120
Shareholders’ Equity 20X9 20X8 Return on equity —— 0.118 0.126
Accounts payable $ 85 $ 105 Return on common equity —— 0.128 0.135
Short-term bank notes 125 110 Debt–equity ratio —— 0.600 0.500
Current portion of long-term debt 75 — Debt–total capital ratio —— 0.400 0.370
Accruals 65 85 Interest coverage —— 4.000 4.500
Total current liabilities 350 300 Fixed charge coverage —— 3.000 4.000
Long-term debt 625 540 Cash flow–long-term debt —— 0.400 0.450
Future taxes 100 80 Cash flow–total debt —— 0.250 0.300
Preferred stock 150 150 Retention rate —— 0.350 0.400
Common stock 200 200
Additional paid-in capital 325 325
Retained earnings 550 470
Common shareholders’ equity 1,075 995
Total liabilities and shareholders’
equity 2,300 2,065

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