FIN 300 – FINANCIAL MANAGEMENT JEAN Y.

ELIA
Chapter 3 – Analysis of Financial Statements
I - Introduction
If management is to maximize a firm’s value, it must take advantage of the firm’s strengths
and correct its weaknesses. Financial statement analysis involves (1) comparing the firm’s
performance with that of other firms in the same industry and (2) evaluating trends in the
firm’s financial position over time. These studies help management identify deficiencies and
then take actions to improve performance.
The primary purpose of this chapter is to discuss techniques used by investors and managers to
analyze financial statements.

II – Ratio Analysis
A ratio is the quantitative relation between two amounts (numerator / denominator). The
amounts are extracted from the financial statements mainly the Balance sheet and the Income
statement. Ratios are important during the financial analysis of an enterprise using trend
analysis and comparison with the indicators from the sector. It is essential to compare two
enterprises of different sizes.
Discussion:
An enterprise holding $1 000 000 of inventory compared to another holding $200 of inventory.
An enterprise collecting cash for its receivables after 30 days compared to 20 days for other
companies within the sector.
⚠ Usually, financial ratios shouldn’t be interpreted as a unique value (one amount). Rather, a
trend analysis or a comparison with the indicators from the sector.
⚠ When the ratio involves accounts from both the balance sheet and the income statement at the
same time, then the accounts of the balance sheet are considered as average (beginning +
ending / 2).

2.1 - LIQUIDITY RATIOS

Liquid Asset - An asset that can be converted to cash quickly without having to reduce the
asset’s price very much.
Liquidity Ratios - Ratios that show the relationship of a firm’s cash and other current assets to
its current liabilities.
ABILITY TO MEET SHORT-TERM OBLIGATIONS: THE CURRENT RATIO
Current Ratio - This ratio is calculated by dividing current assets by current liabilities. It
indicates the extent to which current liabilities are covered by those assets expected to be
converted to cash in the near future.
The current ratio is calculated by dividing current assets by current liabilities:
Current assets
Current ratio =
Current liabilities
Current assets normally include cash, marketable securities, accounts receivable, and inventories.
Current liabilities consist of accounts payable, short-term notes payable, current maturities of
long-term debt, accrued taxes, and other accrued expenses (principally wages).
QUICK, OR ACID TEST, RATIO
Quick (Acid Test) Ratio - This ratio is calculated by deducting inventories from current assets
and dividing the remainder by current liabilities.
The quick, or acid test, ratio is calculated by deducting inventories from current assets and then
dividing the remainder by current liabilities:

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FIN 300 – FINANCIAL MANAGEMENT JEAN Y. ELIA
Chapter 3 – Analysis of Financial Statements
Current assets−Inventories
Quick, or acid test, ratio =
Current liabilities

2.2 ASSET MANAGEMENT RATIOS

Asset Management Ratios - A set of ratios that measure how effectively a firm is managing its
assets.
EVALUATING INVENTORIES: THE INVENTORY TURNOVER RATIO
Inventory Turnover Ratio - This ratio is calculated by dividing sales by inventories.
As a rough approximation, this ratio shows how many time each item of a firm’s inventory is
sold out and restocked, or “turned over,” per year.
Sales
Inventory turnover ratio =
Inventories
⚠ Note that sales occur over the entire year, whereas the inventory figure is for one point in
time. For this reason, it is better to use an average inventory measure.

EVALUATING RECEIVABLES: THE DAYS SALES OUTSTANDING

Days sales outstanding (DSO), also called the “average collection period” (ACP).
This ratio is calculated by dividing accounts receivable by average sales per day; indicates the
average length of time the firm must wait after making a sale before it receives cash.
Receivables Receivables
DSO = Days sales outstanding = =
Average sales per day Annual sales/365

EVALUATING FIXED ASSETS: THE FIXED ASSETS TURNOVER RATIO

Fixed Assets Turnover Ratio - The ratio of sales to net fixed assets (net Property, Plant, and
Equipment).
The fixed assets turnover ratio measures how effectively the firm uses its plant and equipment. It
is the ratio of sales to net fixed assets:
Sales
Fixed assets turnover ratio = assets ¿
Net ¿
⚠ Net fixed assets (Net Book Value) = V0 – Accumulated Depreciation

EVALUATING TOTAL ASSETS: THE TOTAL ASSETS TURNOVER RATIO

Total Assets Turnover Ratio - This ratio is calculated by dividing sales by total assets.
The final asset management ratio, the total assets turnover ratio, measures the turnover of all the
firm’s assets; it is calculated by dividing sales by total assets:
Sales
Total assets turnover ratio =
Total assets

2.3 DEBT MANAGEMENT RATIOS

Financial Leverage - The use of debt financing.
Debt management ratios - reveal (1) the extent to which the firm is financed with debt and (2)
its likelihood of defaulting on its debt obligations. They include the debt ratio, and times-
interest- earned ratio.

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FIN 300 – FINANCIAL MANAGEMENT JEAN Y. ELIA
Chapter 3 – Analysis of Financial Statements
Firms with relatively high debt ratios have higher expected returns when the economy is normal,
but they are exposed to risk of loss when the economy goes into a recession (bad conditions).
Therefore, decisions about the use of debt require firms to balance higher expected returns
against increased risk.

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FIN 300 – FINANCIAL MANAGEMENT JEAN Y. ELIA
Chapter 3 – Analysis of Financial Statements

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Chapter 3 – Analysis of Financial Statements
HOW THE FIRM IS FINANCED: TOTAL DEBT TO TOTAL ASSETS
The ratio of total debt to total assets, generally called the debt ratio, measures the percentage of
funds provided by creditors:
Total debt
Debt ratio =
Total assets
Total debt includes both current liabilities and long-term debt. Creditors prefer low debt ratios
because the lower the ratio, the greater the cushion against creditors’ losses in the event of
liquidation. Stockholders, on the other hand, may want more leverage because it magnifies
expected earnings.

ABILITY TO PAY INTEREST: TIMES-INTEREST-EARNED RATIO

Times-Interest-Earned (TIE) Ratio - The ratio of earnings before interest and taxes (EBIT) to
interest charges; a measure of the firm’s ability to meet its annual interest payments.
The times-interest-earned (TIE) ratio is determined by dividing earnings before interest and taxes
(EBIT) by the interest charges:
EBIT
Times-interest-earned (TIE) ratio =
Interest charges
The TIE ratio measures the extent to which operating income can decline before the firm is
unable to meet its annual interest costs. Failure to meet this obligation can bring legal action by
the firm’s creditors, possibly resulting in bankruptcy.
It is a coverage ratio that measures the proportionate amount of income that can be used to cover
interest expenses in the future.

2.4 PROFITABILITY RATIOS

Profitability is the net result of a number of policies and decisions. The ratios examined thus far
provide useful clues as to the effectiveness of a firm’s operations, but the profitability ratios
show the combined effects of liquidity, asset management, and debt on operating results.
PROFIT MARGIN ON SALES
The profit margin on sales, calculated by dividing net income by sales, gives the profit per
dollar of sales:
¿
Profit margin on sales = Net income avaiable ¿ common stockholders Sales

BASIC EARNING POWER (BEP)

Basic Earning Power (BEP) Ratio - This ratio indicates the ability of the firm’s assets to
generate operating income; calculated by dividing EBIT by total assets.
EBIT
Basic earning power ratio (BEP) =
Total assets
This ratio shows the raw earning power of the firm’s assets, before the influence of taxes and
leverage, and it is useful for comparing firms with different tax situations and different degrees
of financial leverage.

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FIN 300 – FINANCIAL MANAGEMENT JEAN Y. ELIA
Chapter 3 – Analysis of Financial Statements

RETURN ON TOTAL ASSETS

The ratio of net income to total assets measures the return on total assets (ROA) after interest
and taxes:
¿
Return on total assets = ROA = Net income avaiable ¿ common stockholders Total assets

RETURN ON COMMON EQUITY

Return on Common Equity (ROE) - The ratio of net income to common equity; measures the
rate of return on common stockholders’ investment.
¿
Return on common equity = ROE = Net income avaiable ¿ common stockholders Common equity
Stockholders invest to get a return on their money, and this ratio tells how well they are doing in
an accounting sense.

TREND ANALYSIS
Trend Analysis - An analysis of a firm’s financial ratios over time; used to estimate the
likelihood of improvement or deterioration in its financial condition.

TYING THE RATIOS TOGETHER: THE DU PONT CHART AND EQUATION

The DuPont equation is an expression which breaks return on equity down into three parts: profit
margin, asset turnover, and leverage.
ROE = Profit Margin x Assets Turnover x Financial Leverage

Net income Sales Total Assets

ROE = x x
Sales Total Assets Common Equity
⚠ Note that
Common Equity Total Debt
=1-
Total Assets Total Assets
 By splitting ROE into three parts, companies can more easily understand changes in their
returns on equity over time.
 As profit margin increases, every sale will bring more money to a company’s bottom line,
resulting in a higher overall return on equity.
 As asset turnover increases, a company will generate more sales per asset owned,
resulting in a higher overall return on equity.
 Increased financial leverage will also lead to an increase in return on equity, since using
more debt financing brings on higher interest payments, which are tax deductible.

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 FIN 300 – FINANCIAL MANAGEMENT JEAN Y. ELIA
Chapter 3 – Analysis of Financial Statements

Summary of ALL the Ratios

Ratio Category Ratio Formula

Current assets
Current Ratio
Current liabilities
Liquidity Ratios
Current assets−Inventories
Quick or Acid Test Ratio
Current liabilities
Sales
Inventory Turnover Ratio
Inventories
Receivables Receivables
Days Sales Outstanding (DSO) =
Average sales per day Annual sales/ 365
Asset Management Ratios
Sales
Fixed Assets Turnover Ratio assets ¿
Net ¿
Sales
Total Assets Turnover Ratio
Total assets
Total debt
Debt Ratio
Total assets
Debt Management Ratios
Times-Interest-Earned (TIE) EBIT
Ratio Interest charges
Net income avaiable ¿ common stockholders ¿
Profit Margin on Sales Sales
Basic Earning Power (BEP) EBIT
Ratio Total assets
Profitability Ratios
Net income avaiable ¿ common stockholders ¿
Return on Total Assets (ROA) Total a
Return on Common Equity Net income avaiable ¿ common stockholders
(ROE) Comm

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Chapter 3 – Analysis of Financial Statements
Problems:

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FIN 300 – FINANCIAL MANAGEMENT JEAN Y. ELIA
Chapter 3 – Analysis of Financial Statements
3-17 Data for Barry Computer Company and its industry averages are presented as follow.
Ratio analysis Calculate the indicated ratios for Barry.

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