FIN 2704/2704X

Week 2
Financial Statement Analysis
The Importance of Accounting
Regulators looking into Hyflux’s disclosure and
accounting practices for possible breaches
Singapore’s regulators said in response to media queries that they are looking into
whether the public-listed firm had flouted any laws and regulations….They are also
reviewing whether the company had complied with accounting and auditing standards.
The Securities Investors Association of Singapore (SIAS) questioned what could have
happened during those two months, and at what point did the board realise that Hyflux
was not able to pay its debts….It also asked how is it possible for Hyflux to report profits
every year before 2017 despite a negative operating cashflow….“Numbers at that time
already suggested that the company's capital structure was hardly sustainable.”
DBS conducted due diligence checks to ensure that material information relating to
Hyflux was highlighted in the offering document…the bank also reminded investors,
when distributing the bonds via its automatic-teller machines, to read disclosure
documents before applying, MAS added.
- August 14, 2019

Read more at https://www.todayonline.com/singapore/regulators-looking-hyfluxs-disclosure-and-accounting-

practices-possible-breaches 2
 Learning objectives
• Explain and list the type of information found in an annual
report, including the four basic financial statements
– Balance Sheet
– Income Statement
– Statement of Retained Earnings
– Statement of Cashflows

• Understand the difference between Book value & Market value

• Know how to compute the Enterprise Value of a firm

• Understand the finance concept of cash flow
• Know how to compute and interpret important financial ratios

• Know how to compute and interpret the Du Pont Identity

3
Financial Statements and the Annual Report

• The Annual Report is a report issued annually by a

corporation to its stockholders.
– Contains basic financial statements as well as
management’s analysis of the firm’s past operations
and future prospects.

• Example: Berkshire Hathaway’s website: visit

www.berkshirehathaway.com for its annual reports for the
past 2 decades.

• In general, see also www.annualreportservice.com

4
The Annual Report
1. Balance sheet – provides a snapshot of a
firm’s financial position at one point in time.

2. Income statement – summarizes a firm’s

revenues and expenses over a given period
of time.

3. Statement of retained earnings – shows how

much of the firm’s earnings were retained,
rather than paid out as dividends.

4. Statement of cash flows – reports the impact

of a firm’s activities on cash flows over a
given period of time.

5
Balance Sheet
 Balance Sheet Characteristics

ASSETS = LIABILITIES + EQUITY

1. Resources must equal Claims

2. Order of Listing – _________
Highest to _____
Lowest Liquidity
3. Valuing of Items – Generally at _________
original cost
(also known as Historical Cost)
Exceptions: Marketable Securities and Inventories

7
 Sample Balance Sheet
Profrock Corporation
2020 and 2021 Balance Sheets
(in millions)
2020 2021 2020 2021
Cash $ 84 $ 146 Accounts Payable $ 312 $ 344
Accounts
165 188 Notes Payable 231 196
Receivable
Inventory 393 422 Total CL $ 543 $ 540
Total CA $ 642 $ 756 Long-Term Debt $ 531 $ 457

Net Fixed Assets $ 2,731 $ 2,880 Common Stock $ 500 $ 550

Retained Earnings 1,799 2,089
Total OE $ 2,299 $ 2,639

TOTAL Assets $ 3,373 $ 3,636 TOTAL Liabilities & OE $ 3,373 $ 3,636

Equity = Assets - Liabilities 8

 Book Values and Market Values
• Book Values (historical costs less accumulated depreciation)
are determined by IFRS, GAAP*
• Market Values are determined by current trading values in the
market
NOTE: Market Value of Shareholders’ Equity
= “Market Capitalization”
= Share Price x Number of Outstanding Shares

EXAMPLE: Market Value vs Book Value

According to IFRS (and/or GAAP), a firm has equity worth $6 billion,
debt worth $4 billion, assets worth $10 billion. The market values the
firm’s 100 million shares at $75 per share and the debt at $4 billion.
What is the market value of the firm’s assets?

*International Financial Reporting Standards, Generally Accepted Accounting Principles 9

 Example: Market Value vs. Book Value
Answer:
Since (Assets = Liabilities + Equity), your assets must have a
market value of $11.5 billion

Market Value “Balance Sheet”

Assets = $11.5b = Debt ($4b) +

Equity ($7.5b)

10
 Financial Statements & Market Value
• Detailed pieces of market information for assets are
needed, but often not readily available
• Although accounting figures are often pale reflections of
economic reality, they are frequently the best available
} Thus we have to rely on accounting figures as a starting
point to extract the information we actually seek
“Objectively determinable current values of many assets do not exist.
Faced with a trade-off between relevant, but subjective current values,
and irrelevant, but objective historical costs, accountants have opted for
irrelevant, but objective historical costs. This means that it is the user’s
responsibility to make adjustments”
Robert Higgins of Highland Capital Partners

11
 Enterprise Value
• Enterprise value of a firm:
Assesses the value of the underlying _________________
business assets (however
financed) while excluding the value of any non-operating assets.
(asset not required for operation)
– A common non-operating asset is “excess cash” (i.e., the amount
of cash that the firm has that is cash not needed for the firm’s
operations) but can include other assets like unused land, etc.

• Thus, generally when there are no other non-operating assets:

Enterprise Value
= Market Value of Equity + Debt – Excess Cash

• In theory, it is the cost of a company’s operating assets if

someone were to acquire only those assets.
12
 Computing Enterprise Value example
Problem: Lulu Co. is a public company with a share price of
$46.78/share, 319.1 million shares outstanding, a market-to-book
equity ratio of 8.00, a book debt-equity ratio of 2.62, and excess
cash of $576 million. What is Lulu’s market capitalization?
What is its enterprise value?

Share Price $46.78

Shares outstanding 319.1 million
Market-to-book 8.00
Cash $576 million
Debt-to-equity (book) 2.62
13
 Computing Enterprise Value example (answer)
• Lulu, Co. has a market capitalization of
= 319.1M shares x $46.78/share = $14.93B
• Since Lulu, Co.’s market-to-book ratio
(= market value of equity ÷ book value of equity) = 8.00
market-to-book ratio = market capitalization ÷ book equity
then book equity = $14.93B ÷ 8.00 = $1.865B

• Given that the book equity is $1.865B and the book debt-to-equity
ratio is 2.62, the total value of Lulu, Co.’s debt is $4.888B

Enterprise Value = $14.93B + $4.888B - $0.576B = $19.254B

Notice that:
1. We have used Book Value of Debt in this example. However, where available, the
Market Value of Debt is preferred.
2. We have used Cash in this example and not just Excess Cash. Practically, it is
often a challenge to split Excess Cash and Operating Cash. Hence we simply use
Cash if not able to split. 14
 Income Statement &
Statement of Retained Earnings
 Sample Income Statement

• Dividend Payout Ratio = 145 ÷ 435 = 33.3%

16
 Sample Statement of Retained Earnings

Prufrock Corporation
2021 Statement of Retained Earnings
(in millions)

Retained Earnings, beginning of year $ 1,799

Add: Net Income 435
$ 2,234 435 − 145 = 290
Less: Dividends ($ 145)
Retained Earnings, end of year $ 2,089 Addition to RE
(refer back to
Income Statement)

17
Statement of Cash Flows
 Statement of Cash Flows
Summarizes the sources and uses of cash over the period
under consideration.

Changes divided into 3 major categories:

1. _________
Operating Activities – includes net income and changes in
most current accounts (A/P, A/R, Inv)

2. __________
Investment Activities – includes changes in fixed assets

3. __________
Financing Activities – includes changes in notes payable,
long-term debt and equity accounts as well as dividends

19
Sample Statement of Cash Flows

Refer to Income
Statement

- (Change in net fixed assets

+ depreciation for the year)

Refer to Balance Sheet

20
 Profits vs. Cash flows
• Profits and Cash Flow are not the same.
• A large Net Income figure in the Income Statement need
not translate to a healthy liquidity position for the company
• What are the differences?
– “Profits” are reduced by depreciation (a non-cash expense)
– “Profits” ignore cash expenditures on new fixed assets (the
expense is capitalized)
– “Profits” record income and expenses at the time of sales,
not when the cash exchanges actually occur
– “Profits” do not consider changes in working capital
21
 The Importance of Cash Flows
• Cash is King: firms generate cash and they spend it

• Sources of cash (activities that bring in cash):

– decreases in assets (other than cash)
– increases in equity and liabilities

• Uses of cash (activities that involve cash outflows):

– increases in assets (other than cash)
– decreases in equity & liabilities

22
 Understanding the Statement of Cash Flows
The Balance Sheet Identity
Assets = Liabilities + Equity

Current Assets Current Liabilities Common Stock

+ Net Fixed Assets = + LT Debt + + Retained Earnings

Cash + Current Assets other than cash + Net Fixed Assets =

Current Liabilities + Long-term Debt + Retained Earnings + Common Stock

DCash = DRetained Earnings - DCurrent Assets other than cash - DNet Fixed Assets
+ DCurrent Liabilities + DLong-term Debt + DCommon Stock
23
The Finance Concept
of Cash Flow
 The Finance Concept of Cash Flow
• __________
Cash Flow is one of the most important pieces of information
that a financial manager can derive from financial statements.
• We will look at how cash is generated from utilizing assets and
how it is paid to those that finance the purchase of the assets.
• “Cash is King” in the study of finance. Finance professionals
are not concerned with accrual accounting, but rather whether
there is enough cash generated to pay bills, investors, etc.
• In finance, our concept of “cash flow from assets” is different
from the accounting “Statement of Cash Flows”. We care about
cash generated from ____________
operations over the life of the
asset/investment.
25
 We are interested in “Operating Working Capital”
• Business operations generally require investment in net
operating working capital.
– We may need operating cash on hand
– Inventory
– Accounts receivable
– But we may also enjoy increases in Accounts Payable from
our suppliers

• Funds are required for the above items to support sales

although the related cash has not yet been collected from
any sale.

• Note that we only consider operating working capital.

26
 Operating Working Capital
Working capital that stem from our operating policies (A/R, Inventory,
A/P, etc.) and removed from our financing decisions
• Thus, we exclude non-operating working capital such as Notes
Payable from our calculation of Changes in Net Operating Working
Capital

Recall that there are two types of Current Liabilities

1. _________
Interest Bearing Liabilities (a result of financing activities)
– Short Term Loans (less than 1 year maturity)
– Notes Payables
These are part of our financing choices, not our operating choices

2. ____________
Non- Interest Bearing Liabilities (a result of operating activities)
– Accounts Payables (extended from our suppliers)
27
 Cash Flow From Assets* (CFFA)
*also referred to as Free Cash Flows (FCF)
Note: The textbook uses a different formula from ours shown here. Please use the
formula shown here and disregard the textbook for calculation of CFFA.

Cash Flow From Assets (CFFA^) =

Operating Cash Flow (OCF)
– Net Capital Spending (NCS)
– Change in Net Operating Working Capital (∆NOWC)

^CFFA à Cash flow generated from a firm’s operating assets after taking into
account all present investment needed for its on-going operations.

Cash Flow From Assets (CFFA) + Interest Tax Shield =

Cash Flow to Creditors + Cash Flow to Stockholders
28
 Note: Interest is tax deductible
• Recall from the Income Statement that interest payments are deducted
from EBIT (Earnings Before Interest and Tax) before calculation of Taxes.
– This means that interest payments function to reduce the amount of taxes paid.
Thus although interest payments are paid out in cash, they also result in the
company paying less tax than it otherwise would. The reduction in the amount
of tax paid is referred to as the ____________________.
interest tax shield
– Dividend payments do not reduce the amount of taxes paid. Thus dividend
payments are paid out in cash, with no offsetting tax shield.

• When determining “Cash Flow From Assets” we do not take into account
the interest tax shield
– We separate operations from financing thus we consider the Interest Tax
Shield separately. In other words, our formula for CFFA is “without or ignoring
financing effect”.
– The Interest Tax Shield increases the amount of cash flow available to
Creditors and Shareholders
 Prufrock Corporation CFFA 2021
• Operating Cash Flow:
𝐎𝐂𝐅 = EBIT× 1 − Tax rate + Depreciation
= 691× 1 − 0.21 + 276 = $822

• Net Capital Spending:

𝐍𝐂𝐒 = Ending Net Fixed Assets − Beginning Net Fixed Assets
+ Depreciation
= 2880 − 2731 + 276 = $425

• Change in Net Operating Working Capital

∆𝐍𝐎𝐖𝐂 = Ending NOWC − Beginning NOWC
= (146 + 188 + 422 – 344) – (84 + 165 + 393 – 312) = $82

• CFFA (without financing effect) = $822 – $425 – $82 = $315

30
 Prufrock Corporation CFFA 2021
Interest Tax Shield
= Cash generated from the reduction in the amount of taxes
paid due to tax deductibility of interest
= $141 × 0.21
= $30

31
 Prufrock Corporation CFFA 2021
• Cash Flow to Creditors
= interest paid – net new borrowing (LT Debt and Notes Payable)
= 141 – [(196+457) – (231+531)] = 141 – (-109) = $250

• Cash Flow to Stockholders

= dividends paid – net new equity raised
= 145 – (550 - 500) = $95

• Cash flow to Creditors and Stockholders

= $250 + $95 = $345

ü Cross Check Answer:

CFFA + Interest Tax Shield = $315 + $30 = $345
(CFFA with financing effect)
32
Ratio Analyses
 Ratio Analysis
• Ratios are not very helpful by themselves; they need to
be compared to something
– Time-Trend Analysis (over time)
Used to see how the firm’s performance is changing
through time
– Peer Group Analysis (with others)
Compare to similar companies or within industries
(e.g. based on SIC codes)

• As we look at each ratio, ask yourself what the ratio is

trying to measure and why that information is important
• Ratios are used both internally and externally
34
Things To Consider Concerning Financial Ratios

1. What aspects of the firm are we attempting to analyze?

2. What information goes into computing a particular ratio

and how does that information relate to the aspect of the
firm being analyzed?

3. What is the unit of measurement (times, days, percent)?

4. What are the benchmarks used for comparison?

5. What makes a ratio “good” or “bad”?

35
 The 5 Major Categories of Ratios
1. Liquidity ratios (Short-term solvency)
– Measure the firm’s ability to pay bills in the short run
– Can we make required payments as they fall due?

2. Long-Term Solvency ratios (Financial leverage)

– Show how heavily the company is in debt
– Do we have the right mix of debt and equity?

3. Asset Management ratios (Turnover / Efficiency)

– Measure how productively the firm is using its assets
– Do we have the right amount of assets for the level of
sales?

36
 The 5 Major Categories of Ratios
4. Profitability ratios
– Measure the firm’s return on its investments
– Do sales prices exceed unit costs, and are sales high
enough as reflected in PM, ROE, and ROA?

5. Market Value ratios

– Provides indications on the firm’s prospects and how
the market values the firm
– Do investors like what they see as reflected in
Price-Earning (P/E) and Market-to-Book (M/B) ratios?

37
 1. Liquidity ratios
• Liquidity is the ability to convert assets to cash quickly
without a significant _________________
loss in value .
• Liquidity ratios indicate a firm’s ability to meet its maturing
short-term obligations
Hoard Cash --> shareholders unhappy that
business does not use money to grow
Is high liquidity always good?
Kirk Kerkorian’s takeover bid for Chrysler in April, 1995, is an example
of investor dissatisfaction with excess liquidity. At the time, Chrysler’s
management had accumulated $7.3 billion in cash and marketable
securities as a cushion against an economic downturn. Mr. Kerkorian
instigated a takeover bid because Chrysler’s management refused to
pay this cash to stockholders.
38
 Example: US Companies’ Cash Pile hits $1.7tn

tax code.
in an effort to skirt the tax charge of moving profits back to US shores under the country’s complex

that amount.
according to a new report from rating agency Moody’s. The top 50 holders accounted for $1.1tn of
nearly a third of the total $1.7tn held on the balance sheets of US non-financial companies,
Apple, Microsoft, Alphabet, Cisco and Oracle had amassed $504bn of cash by the end of 2015,

how cash has become increasingly concentrated at a handful of groups seeking to avoid a tax hit.
Five US tech giants are hoarding more than half a trillion dollars, a record sum that underscores
Five tech groups hold $504bn in cash between them, nearly a third of the $1.7tn on balance sheets of US non-financials


Five US tech giants are hoarding more than half a trillion dollars, a

Share 
record sum that underscores how cash has become increasingly


Author alerts
concentrated at a handful of groups seeking to avoid a tax hit.
Apple, Microsoft, Alphabet, Cisco and Oracle had amassed $504bn

US multinationals have left roughly $1.2tn of their earnings overseas


Print
of cash by the end of 2015, nearly a third of the total $1.7tn held on


the balance sheets of US non-financial companies, according to a

Clip

new report from rating agency Moody’s.

Gift Article
The ever increasing amount of cash also highlights how US

©Companies; Getty Images

boardrooms are reticent to invest in their businesses, choosing
instead to increase dividends, in a sign of the continued anxiety
that economic activity could still slow at home or in China.


Comments
The failure of companies to invest their cash pile has frustrated investors who say
companies are not ploughing enough back into their underlying businesses, in
research and development, to reinvigorate sales.
- Financial Times, 20 May 2016 39
 Prufrock Liquidity Ratios 2021
Current ratio = Current Assets ÷ Current liabilities
= $756 ÷ $540 = 1.40x

Quick Ratio = (CA – Inventory) ÷ CL

= ($756 – $422) ÷ $540 = 0.62x

Cash Ratio = Cash ÷ CL

= 146 ÷ 540 = 0.27x

NWC to Total Assets = NWC ÷ TA

= (756 – 540) ÷ 3,636 = 0.06x

Interval Measure = CA ÷ Avg. daily operating costs

= 756 ÷ (1,344 ÷ 365) = 205 days
40
 Prufrock Liquidity Ratios 2021
2019 2020 2021 Ind.

Current ratio 1.14x 1.18x 1.40x 1.67x

Quick ratio 0.45x 0.46x 0.62x 0.89x
Cash ratio 0.15x 0.15x 0.27x 0.44x
NWC to TA ratio 0.02x 0.03x 0.06x 0.07x
Interval Measure 206 days 186 days 205 days 217 days

• Seemingly improving but still below the industry average

• Liquidity position is weak

41
 2. Long-Term Solvency Ratios
Also known as financial leverage ratios
Financial leverage relates to the extent that a firm relies on ______
debt
financing rather than __________.
equity
– Generally, the more debt a firm has, the more likely it is the firm will
become unable to fulfill its contractual obligations.

Total Debt Ratio = (Total assets – Total equity) ÷ Total assets

= (3,636 – 2,639) ÷ 3,636 = 0.274 or 27.4%

Debt/Equity Ratio = (Total assets – Total equity) ÷ Total equity

= (3,636 – 2,639) ÷ 2,639 = 0.378 or 37.8%

Equity Multiplier = Total assets ÷ Total equity = 1 + debt/equity ratio

= 3,636 ÷ 2,639 = 1.38 times
42
 Prufrock Long-Term Solvency Ratios 2021
Long-Term Debt Ratio = Long-term debt ÷ (Long-term debt + Total equity)
= 457 ÷ (457 + 2639) = 0.148 or 14.8%

Times Interest Earned Ratio = EBIT ÷ interest

= 691 ÷ 141 = 4.90 times

Cash Coverage Ratio = (EBIT + depreciation) ÷ interest

= (691 + 276) ÷ 141 = 6.86 times

43
Prufrock Long-Term Solvency Ratios 2021
2019 2020 2021 Ind.

Total debt ratio 33.2% 31.8% 27.4% 24.7%

Debt/Equity ratio 49.6% 46.7% 37.8% 32.8%
Equity multiplier 1.50x 1.47x 1.38x 1.33x
Long-term debt ratio 19.5% 18.8% 14.8% 15.8%
TIE ratio 3.94x 4.60x 4.90x 6.21x
Cash coverage ratio 5.96x 6.53x 6.86x 7.90x

• Solvency ratios are improving but still worse than industry

average.
44
 3. Asset Management Ratios
Also known as Activity Ratios
They measure how effectively the firm’s assets are being
managed
• __________
Inventory ratios measure how quickly inventory is
produced and sold
• _____________
Receivable ratios provide information on the success
of the firm in managing its collection from credit customers
• Fixed Asset and Total Asset ___________
Turnover ratios show how
effective the firm is in using its assets to generate sales

45
 Prufrock Asset Management Ratios 2021
Inventory Turnover = COGS ÷ Inventory = $1,344 ÷ $422 = 3.18x

Days’ Sales in Inventory = 365 ÷ Inventory Turnover

= 365 ÷ 3.18 = 115 days

Receivables Turnover = Credit Sales* ÷ Receivables

= $2,311 ÷ $188 = 12.29x sales

Days Sales Outstanding = 365 ÷ Receivables Turnover

= 365 ÷ 12.29 = 30 days

FA Turnover = Sales ÷ Net fixed assets = $7,036 ÷ $817 = 8.61x 0.8x

TA Turnover = Sales ÷ Total assets = $7,036 ÷ $3,497 = 2.01x 0.64x

* Assume all sales are on credit 46

 Prufrock Asset Management Ratios 2021
2019 2020 2021 Ind.

Inventory Turnover 2.93x 3.21x 3.18x 3.60x

Days’ Sales in Inventory 124 days 114 days 115 days 101 days

Receivables Turnover 11.26x 12.75x 12.29x 14.0x

Days’ Sales Outstanding 32 days 29 days 30 days 26 days

Fixed Assets Turnover 0.71x 0.77x 0.80x 0.80x

Total Assets Turnover 0.57x 0.62x 0.64x 0.66x

• Inventory turnover below industry average. Prufrock might have old

inventory, or its control might be poor.
• Receivables turnover below industry average. Prufrock collects on sales too
slowly, albeit this is improving from 2019.
• Total Asset Turnover below the industry average. Caused by excessive
currents assets (A/R and Inventory). 47
 4. Profitability Ratios
Measure how successfully a business earns a return on its investment
Show the combined effects of ___________,
liquidity __________________,
asset management and
_______
debts on operating results.

Profit margin (PM) = Net income ÷ Sales = $253.6 ÷ $7,036 = 3.6%

Basic Earning Power (BEP) = EBIT ÷ Total assets = $492.6 ÷ $3,497 = 14.1%
BEP removes the effects of taxes and financial leverage. It is useful for comparison

Return On Assets (ROA) = Net income ÷ Total assets

= $253.6 ÷ $3,497 = 7.3%

Return On Equity (ROE) = Net income ÷ Total common equity

= $253.6 ÷ $1,952 = 13.0%
48
 Prufrock Profitability Ratios 2021
2019 2020 2021 Ind.

PM 15.6% 17.4% 18.8% 28.6%

BEP 15.1% 17.6% 19.0% 28.5%

ROA 8.9% 10.9% 11.9% 18.9%

ROE 13.3% 15.9% 16.5% 25.1%

• Profitability ratios are improving but still below the industry average.
More improvement needed.

49
 Effects of Debt on ROA and ROE
• ROA is lowered by debt
– Interest expense lowers net income, which also lowers ROA
• However, the use of debt lowers equity (assuming TA stays the
same), and if equity is lowered more than net income, ROE would
increase

Problems with ROE

• ROE and shareholder wealth are correlated, but problems can
arise when ROE is the sole measure of performance
– ROE does not consider risk
– ROE does not consider the amount of capital invested
– Might encourage managers to make investment decisions that
do not benefit shareholders 50
 5. Market Value Ratios
A set of ratios that relate the firm’s stock price to its earnings, cash flows and
book value per share
1. P/E: How much investors are willing to pay for $1 of earnings.
2. M/B: How much investors are willing to pay for $1 of book value equity.
For each ratio, in general, the higher the number, the better.

Let’s say Prufrock has 33 million shares outstanding and the stock sold for
$88 per share at the end of 2021.

!"#$% &%" '()"% $..

P/E ratio = = $"#$ = 6.68x
*)"+#+,' &%" '()"%
##

/)"0%1 2)34% &%" '()"% $..

M/B = = $%,'#( = 1.10x
5660 2)34% &%" '()"%
##

51
 Prufrock Market Value Ratios 2021
2019 2020 2021 Ind.

P/E 7.66x 6.55x 6.68x 11.25x

M/B 1.02x 1.04x 1.10x 1.47x

• Both ratios improving from 2020 but still far below the industry
average.

52
 The Dupont System
• Some profitability and efficiency measures can be linked
in useful ways
• These relationships are often referred to as the Du Pont
system in recognition of the chemical company that
popularized them

53
 Deriving the extended Du Pont Identity
• ROE = NI
TE

• Multiply by TA/TA (=1) and then rearrange

NI TA
• ROE = ×
TE TA
NI TA
• ROE = × = ROA × EM
TA TE

• Multiply by Sales/Sales (=1) and then rearrange

NI TA Sales
• ROE = × ×
TA TE Sales
NI Sales TA
• ROE = × × = PM × TATO × EM
Sales TA TE

54
The Three Ratios of the Dupont Identity

ROE = PM * TATO * EM

1. Profit margin (PM) is a measure of the firm’s _________

operating

efficiency – how well it controls prices and costs

2. Total asset turnover (TATO) is a measure of the firm’s

__________
asset-use efficiency – how well it manages its assets

3. Equity multiplier (EM) is a measure of the firm’s financial

___________
leverage – how much debt it uses
55
 Prufrock’s Extended DuPont Equation:
Return on Equity
ROE = (Profit Margin) x (TA Turnover) x (Equity Multiplier)
= 18.8% x 0.64 x 1.38
= 16.5%

PM TATO EM ROE
2019 15.6% 0.57 1.50 13.3%
2020 17.4% 0.62 1.47 15.9%
2021 18.8% 0.64 1.38 16.5%
Ind. 28.6% 0.66 1.33 25.1%
56
Ratio Analysis: Potential Problems/ Limitations
• Comparison with industry averages is difficult if the firm operates
many different divisions (a diversified firm).
• “Average” performance is not necessarily good. Use the leader’s?
• Seasonal factors can distort ratios.
• Window dressing techniques can make statements and ratios look
better.
• Different accounting and operating practices can distort comparisons.
• Sometimes it is difficult to tell if a ratio value is “good” or “bad.”
• Often, different ratios give different signals, so it is difficult to tell, on
balance, whether a company is in a strong or weak financial
condition.

57
 Some Qualitative Factors
Analysts should also consider the followings when
evaluating a company’s likely future financial performance:
• Are the company’s revenues tied to a single customer?
• To what extent are the company’s revenues tied to a single
product?
• To what extent does the company rely on a single supplier?
• What percentage of the company’s business is generated
overseas?
• What is the competitive situation?
• What is the company’s legal and regulatory environment?

58
 Final Note: Calculation of Ratios
• If the ratio uses only balance sheet line items, then ending period
:4""%+1 ;''%1'%)%*
numbers should be used, e.g. Current Ratio7879 = :4""%+1 <#)=#3#1#%'
%)%*

• If the ratio uses both balance sheet item(s) and income statement
item(s), then sometimes, using the average (of two years) of the
balance sheet items would make sense, e.g.
>?@A :LMN%)%*
Inventory Turnover7879 = = +,-.,/012%)%) 3+,-.,/012%)%*
BCD EFCGFHIJK
%

• It depends on the purpose of the calculation. If we are interested

in understanding the past, then using the average numbers would
be appropriate, but if we are interested in the future, then using
the end-of-period numbers might be better.
• In any case, to keep things simple, we will be using end-of-period
numbers for this stage of the module.
59
 Overall Summary
1. Annual report & financial statements 2. Enterprise Value (EV)
a) Balance sheet:
3. Finance concept of cash flows:
Assets = Liabilities + Equity
CFFA = OCF − NCS − ∆NOWC
– Book value vs. Market value
CFFA + Interest Tax Shield
• Market value of equity
(market capitalization) = CF to Creditors + CF to Stockholders
• Market value of assets
4. Computing and Interpreting
b) Income Statement: financial ratios
Revenue, Expenses, Taxes a) Liquidity ratios
à Net Income b) Long-term Solvency ratios
c) Statement of Retained Earnings: c) Asset Management ratios
Add net income, Less dividend d) Profitability ratios
d) Statement of Cash Flows: e) Market ratios
Operating activities, Investment
activities, Financing activities 5. Du Pont Identity:
－ Profit vs. Cash: ROE = PM × TATO × EM
Importance of cash flows 60