Financial Management

Analysis of Financial Statements

 Financial Analysis
Some Basic Financial Ratios
1. Liquidity ratios
2. Asset management ratios
3. Debt management ratios
4. Profitability ratios
5. Market value ratios
 Financial Analysis
• Liquidity ratios give an idea of the firm’s ability
to pay off its debts that are maturing within a
year.
• Asset management ratios give an idea of how
efficiently the firm is using its assets.
• Debt management ratios give an idea of how
the firm financed its assets as well as the
firm’s ability to repay its long term debt.
 Financial Analysis
• Profitability ratios give an idea of how
profitably the firm is operating and utilizing its
assets.
• Market value ratios give an idea of what
investors think about the firm and its future
prospects.
 Financial Analysis
• Satisfactory liquidity ratios are necessary if the
firm is to continue operating.
• Good asset management ratio is necessary for
the firm to keep its costs low and thus its net
income high.
• Debt management ratios indicate how risky
the firm is and how much of its operating
income must be paid to bondholders rather
than stockholders.
 Financial Analysis
• Profitability ratios combine the asset and debt
management categories and show their
effects on ROE.
• Finally the market value ratios tell us what
investors think about the company and its
prospects.
 Financial Analysis
• All of these ratios are important, but different
ones are more important than others for some
other companies.
• İf a firm borrowed too much in the past and its
debt now threatens to drive it into bankruptcy,
the debt ratios are key.
• If a firm expanded too rapidly and now find itself
with excess inventory and manufacturing
capacity, the asset management ratios take
center stage.
 ROE
• The ROE is always important.
• However, high ROE depends on maintaining
liquidity on efficient asset management, and on
the proper use of debt.
• Managers of course vitally concerned with the
stock price.
• But managers have little direct control over the
stock market’s performance while they do have
control over their firm’s ROE.
• So ROE tends to be the main crucial point.
 1) Liquidity Ratios
• The liquidity ratios help answer these
questions:
- Will the firm be able to pay off its debts as
they come due?
- and thus, will the firm remain a viable
organization?
 Liquidity Ratios
• A liquid asset is one that trades in an active
market and thus, it can be quickly converted
to cash at the going market price.
 Allied
• Allied has $310 million current liabilities that
must be paid off within the coming year.
• Will it have trouble meeting that obligation?
• A full liquidity analysis requires the use of cash
budget, we will discuss later, ratio analysis
provides a quick and easy-to-use measure of
liquidity.
 Current Ratio
• The primary liquidity ratio is the current ratio.
• Which is calculated by dividing current assets
by current liabilities.
Current assets $1000
• Current ratio = =
Current liabilities $310

= 𝟑. 𝟐𝟐

Industry average = 𝟒. 𝟐
 Current Ratio
• As we know, current assets include cash,
marketable securities, accounts receivable,
and inventories.
• Allied’s current liabilities consists of accounts
payable, accrued wages and taxes, and short
term notes payable to its bank.
• All of which are due within one year.
 Current Ratio
• İf a company is having financial difficulty, it
typically begins to pay its accounts payable
more slowly and to borrow more from its bank.
• Both of which increase current liabilities.
• İf current liabilities are rising faster than current
assets, the current ratio will fall.
• This is a sign of possible trouble.
 Current Ratio
• Allied’s current ratio is 3.2%,
• which is well below the industry average of 4.2%.
• Therefore, its liquidity position is somewhat weak.
• Note that industry average is not a magic number,
that all firms should strive to maintain.
• In fact, some very well-managed firms may be
above the average while other good firms below it.
 Current Ratio
• However, if a firm’s ratios are far away from the
averages for its industry, an analyst should be
concerned about why this variance occurs.
• A deviation from the industry should signal the
analyst or management to check further.
• Note too that a high current ratio generally
indicates a very strong, safe liquidity position.
• İt might also indicate that the firm has too much
old inventory that would have to be written off.
 Current Ratio
• And/or too many old accounts receivable that
may turn into bad debts.
• Or the high current ratio might indicate that the
firm has too much cash, receivables, and
inventory relative to its sales.
• In which case these assets are not being managed
effectively.
• So it is always necessary to thoroughly examine
the full set of ratios before forming a judgement
as to how well the firm is performing.
 Quick Ratio or Acid Test Ratio
• The second liquidity ratio is quick, or acid test,
ratio.
• Which is calculated by deducting inventories
from current assets and then dividing the
remainder by current liabilities.
Current assets−Inventories
• Quick, or acit test, ratio=
Current liabilities
$385
= = 1.2
$310
Industry average = 2.2
 Quick Ratio or Acid Test Ratio
• Inventories are the least liquid of a firm’s current
assets;
• And if sales slow down, they might not be
converted to cash as expected.
• Also inventories are the assets on which loses are
most likely to occur in the event of liquidation.
• Therefore the quick ratio is important.
• Because it measures the firm’s ability to pay off
short term obligations, without relying on the
sale of inventories.
 Quick Ratio or Acid Test Ratio
• The industry average of quick ratio is 2.2.
• So Allied’s 1.2 ratio is relatively low.
• If the accounts receivable can be collected,
the company pay off its current liabilities even
if it has trouble disposing of its inventories.
 2) Asset Management Ratios
• The second group of ratios,
• the asset management ratios, measure how
effectively the firm is managing its assets.

• This ratios answer the question:

• Does the amount of each type of asset seem
‘reasonable, too high, or too low’ in view of
current and projected sales?
 Asset Management Ratios
• These ratios are important because
- when companies acquire assets,
- they must obtain funds from banks or other
sources, and capital is expensive.
 Asset Management Ratios
• Therefore, if Allied has too many assets, then
cost of capital will be too high, which will depress
its profits.
• On the other hand, if its assets too low, profitable
sales will be lost.
• So Allied must strike a balance between too
many and too few assets.
 Asset Management Ratios
• Inventory turnover ratio
• Days sales outstanding
• Fixed assets turnover ratio
• Total assets turnover ratio
 Inventory Turnover Ratio
• Turnover ratios divide sales by some related assets.
• As the name implies these ratios show how many times the
particular assets is «turned over» during the year.
• Here is the ‘Inventory turnover ratio’:

𝐒𝐚𝐥𝐞𝐬
𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐫𝐚𝐭𝐢𝐨 =
𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐢𝐞𝐬

$𝟑, 𝟎𝟎𝟎
𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐫𝐚𝐭𝐢𝐨 = = 𝟒. 𝟗
$𝟔𝟏𝟓

𝐈𝐧𝐝𝐮𝐬𝐭𝐫𝐲 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 = 𝟏𝟎. 𝟗

 Inventory Turnover Ratio
• As a rough approximation, each item of Allied’s inventory is
sold and restocked, or ‘turned over’, 4.9 times per year.
• ‘Turnover’ is a term that originated many years ago with the
old Yankee peddler who would load up his wagon with pots
and pans, and then they go off on his route to peddle his
wares.
• If he made for example 10 trips per year, stocked 100 pots
and pans and, made a gross profit of $5 for each item, his
annual gross profit was $ 5,000.
• If he went faster for example 20 times per year his gross
profit doubled, so his turnover directly affected his profits.
 Inventory Turnover Ratio
• Allied’s inventory turnover ratio of 4.9 is much lower
than the industry average of 10.9.
• This suggests that it is holding too much inventory.
• Excess inventory is, of course, unproductive and
represents an investment with a low or zero rate of
return.
• Allied’s low inventory turnover ratio also makes us
question its current ratio.

• With such a low turnover ratio, the firm may be

holding obsolete goods that are not worth their stated
value.
 Days Sales Outstanding
• Accounts receivable are evaluated by the ‘days
sales outstanding’ (DSO) ratio, also called the
‘average collection period’ (ACP)
• DSO (or ACP) is calculated by dividing accounts
receivable by the average daily sales to find how
many days’ sales are tied up in receivables.
• Thus, the DSO represents the average lenght of
time the firm must wait after making a sale
before receiving cash.
 Days Sales Outstanding
• 𝐃𝐒𝐎 = 𝐃𝐚𝐲𝐬 𝐬𝐚𝐥𝐞𝐬 𝐨𝐮𝐭𝐬𝐭𝐚𝐧𝐝𝐢𝐧𝐠 =
𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞𝐬 𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞𝐬
= 𝐀𝐧𝐧𝐮𝐚𝐥 𝐬𝐚𝐥𝐞𝐬 =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐬𝐚𝐥𝐞𝐬 𝐩𝐞𝐫 𝐝𝐚𝐲 ൗ𝟑𝟔𝟓
$𝟑𝟕𝟓 $𝟑𝟕𝟓
= = 𝟒𝟓. 𝟔 𝐝𝐚𝐲𝐬 ≈ 𝟒𝟔 𝐝𝐚𝐲𝐬
$𝟑,𝟎𝟎𝟎/𝟑𝟔𝟓 $𝟖.𝟐𝟏𝟗𝟐

• The DSO can be compared with industry average,

• but it is also evaluated by comparing it with
Allied’s credit terms.
 Days Sales Outstanding
• Allied’s credit policy calls for payment within
30 days.
• So the fact that 46 days’ sales are outstanding,
not for 30 days’.
• It indicates that Allied’s customers, on
average, are not paying their bills on time.
 Days Sales Outstanding
• Moreover, the high average DSO indicates that if some
customers are paying on time, quite a few must be
paying very late.
• Late paying customers often default, so their
receivables may end up as bad debts that can never be
collected.
• Note too that the trend in the DSO over the past few
years has been rising, but the credit policy has not
been changed.
• This reinforces our belief that Allied’s credit manager
should take steps to collect receivables faster.
 Fixed Asset Turnover Ratio
• The ratio of sales to net fixed assets measures
how efficiently the firm uses its plant and
equipment.

𝐒𝐚𝐥𝐞𝐬
F𝐢𝐱𝐞𝐝 𝐚𝐬𝐬𝐞𝐭 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐫𝐚𝐭𝐢𝐨 = =
𝐍𝐞𝐭 𝐟𝐢𝐱𝐞𝐝 𝐚𝐬𝐬𝐞𝐭𝐬
$𝟑,𝟎𝟎𝟎
= 𝟑. 𝟎
$𝟏,𝟎𝟎𝟎

𝐈𝐧𝐝𝐮𝐬𝐭𝐫𝐲 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 = 𝟐. 𝟖
 Fixed Asset Turnover Ratio
• Allied’s ratio of 3.0 times slightly above the 2.8
industry average.
• This is indicating that it is using its fixed assets
at least as intensively as other firms in the
industry.
• Therefore, Allied seems to have about the
right amount of fixed assets relative to its
sales.
 Fixed Asset Turnover Ratio
• Note that if we compare an old firm whose
fixed assets have been depreciated with a new
company that acquired its fixed assets only
recently, the old firm will probably have the
higher fixed asset turnover ratio.
• The accounting profession is trying to develop
procedures for making financial statements
reflect current values than historical values,
• Which would help us make better comparison.
 Total Assets Turnover Ratio
• The final asset management ratio is the total asset
turnover ratio.
• It measures the turnover of all of the firm’s assets, and
is calculated by dividing sales by total assets.
𝐒𝐚𝐥𝐞𝐬
𝐓𝐨𝐭𝐚𝐥 𝐚𝐬𝐬𝐞𝐭 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐫𝐚𝐭𝐢𝐨 =
𝐓𝐨𝐭𝐚𝐥 𝐚𝐬𝐬𝐞𝐭𝐬
$𝟑, 𝟎𝟎𝟎
= = 𝟏. 𝟓
$𝟐, 𝟎𝟎𝟎

𝐈𝐧𝐝𝐮𝐬𝐭𝐫𝐲 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 = 𝟏. 𝟖
 Total Assets Turnover Ratio
• Allied’s ratio of 1.5 is somewhat below the
industry average of 1.8.
• So, it is not generating enough sales given its total
assets.
• We just saw that Allied’s fixed assets turnover
ratio is in the line with the industry average.
• The problem is with its current assets, inventories
and accounts receivables, whose ratios were
below the industry standards.
• Inventories should be reduced and receivables
collected faster, which would improve operations.
 3) Debt Management Ratios

• Total debt to total capital

• Times-interest-earned ratio
 Debt Management Ratios
• The use of more debt will increase, or
«leverage up» a firm’s ROE, If the firm earns
more on its assets than the interest rate it
pays on debt.

• However, debt exposes the firm to more risk

than if it financed only or less with equity.
 Total Debt to Total Capital
• This ratio measures the percentage of the firm’s
capital provided by debtholders.

𝐓𝐨𝐭𝐚𝐥 𝐝𝐞𝐛𝐭 𝐓𝐨𝐭𝐚𝐥 𝐝𝐞𝐛𝐭

=
𝐓𝐨𝐭𝐚𝐥 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐓𝐨𝐭𝐚𝐥 𝐝𝐞𝐛𝐭 + 𝐄𝐪𝐮𝐢𝐭𝐲
$ 𝟖𝟔𝟎$ (𝟏𝟏𝟎 + $𝟕𝟓𝟎) $𝟖𝟔𝟎
= = = 𝟒𝟕. 𝟖%
$𝟏, 𝟖𝟎𝟎(𝟖𝟔𝟎 + 𝟗𝟒𝟎) $𝟏, 𝟖𝟎𝟎

𝐈𝐧𝐝𝐮𝐬𝐭𝐫𝐲 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 = 𝟑𝟔. 𝟒%

 Total Debt to Total Capital
• As you know now that total debt includes all
short-term and long term interest-bearing debts,
• But it doesn’t include operating items such as
accounts payable and accruals.
• Allied has total debt of $860 million,
• Which consists of $110 million in short-term
notes payable and $750 million in long term
bonds.
• Its total capital is $1.80 billion= $860 million of
debt plus $940 million in total equity.
 Total Debt to Total Capital
• To keep the things simple, unless otherwise, we
will generally refer to total debt to total capital
ratio as the company’s «debt ratio».
• Creditors prefer low debt ratios because the
lower the ratio, the greater the ability of the
firm’s to pay the debt in the event of liquidation.
• Stockholders, on the other hand, may want more
leverage because it can magnify their expected
earnings.
 Total Debt to Total Capital
• Allied’s debt ratio is 47.8%,
• Which means that its creditors have supplied roughly half
of its total funds.
• A number of factor affect a firm’s optimal debt ratio.
• Nevertheless, the fact that Allied’s debt ratio exceeds the
industry average by a large amount raises a red flag.
• This will make it relatively costly for Allied to borrow
additional funds from financial markets, without raising
more equity.
• Creditors will be reluctant to lend the firm more money.
 Times-Interest-Earned (TIE) Ratio
• Times-interest-earned ratio is determined by
dividing earnings before interest and taxes
(EBIT) by the interest charges:

𝐓𝐢𝐦𝐞𝐬 − 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 − 𝐞𝐚𝐫𝐧𝐞𝐝 𝐓𝐈𝐄 𝐫𝐚𝐭𝐢𝐨

𝐄𝐁𝐈𝐓 $𝟐𝟖𝟑. 𝟖
= = = 𝟑. 𝟐
𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐜𝐡𝐚𝐫𝐠𝐞𝐬 $𝟖𝟖

𝐈𝐧𝐝𝐮𝐬𝐭𝐫𝐲 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 = 𝟔. 𝟎
 Times-Interest-Earned Ratio
• The TIE ratio measures the extent to which
operating income can decline before the firm
unable to meet its annual interest costs.
• Failure to pay the interest will bring legal action
by the firm’s creditors and probably result in
bankruptcy.
• Earning before interest and taxes, rather than net
income, are used in generally.
• Because interest is paid before taxes, the firm’s
ability to pay current interest is not affected by
taxes.
 Times-Interest-Earned Ratio
• Allied’s interest is covered 3.2 times.
• The industry average is 6 times.
• So Allied is covering its interest charges by a
much lower margin of safety than the average
firm in the industry.
• Thus, the TIE ratio reinforces our conclusion
from the debt ratio,
• That Allied would face difficulties if it
attempted to borrow additional funds.
 4) Profitability Ratios
• Operating margin
• Profit margin
• Return on total assets
• Return on common equity
• Return on invested capital
• Basic earning power ratio
 Profitability Ratios
• Accounting statements reflect events that happened in the
past,
• But they also provide clues about what is really important.
• That is, what is likely to happen in the future.
• The liquidity, asset management, and the debt ratios far
tell us something about the firm’s policies and operations.
• Now, we must turn to the profitability ratios,
• Which reflect the net result of all of the firm’s financing
policies and operating decisions.
 Operating Margin
• The operating margin calculated by dividing
operating income (EBIT) by sales.
• It gives the operating profit per dollar of sales:

𝐄𝐁𝐈𝐓 $𝟐𝟖𝟑. 𝟖
𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐦𝐚𝐫𝐠𝐢𝐧 = = = 𝟗. 𝟓%
𝐒𝐚𝐥𝐞𝐬 $𝟑, 𝟎𝟎𝟎

𝐈𝐧𝐝𝐮𝐬𝐭𝐫𝐲 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 = 𝟏𝟎. 𝟎%

 Operating Margin
• Allied’s 9.5% operating margin is below the
industry average of 10.0%.
• This subpar result indicates that Allied’s
operating costs are high.
• This is consistent with the low inventory
turnover and high days’ sales outstanding
ratios calculated before.
 Profit Margin
• The profit margin, sometimes called the «net
profit margin», is calculated by dividing net
income by sales:

𝐍𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞 $𝟏𝟏𝟕. 𝟓

𝐏𝐫𝐨𝐟𝐢𝐭 𝐦𝐚𝐫𝐠𝐢𝐧 = = = 𝟑. 𝟗%
𝐒𝐚𝐥𝐞𝐬 $𝟑, 𝟎𝟎𝟎

𝐈𝐧𝐝𝐮𝐬𝐭𝐫𝐲 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐬 = 𝟓. 𝟎%
 Profit Margin
• Allied’s 3.9% profit margin is below the industry
average of 5.0%.
• This subpar result is occurred for two reason.
• First, Allied’s operating margin was below the
industry average because of the firm’s high
operating costs.
• Second, the profit margin is negatively impacted
by Allied’s heavy use of debt.
• Hence it has higher interest charges.
• Those interest charges pull down it’s net income.
 Return on Total Assets
ROA
• Net income divided by total assets gives us the
«return on total assets» (ROA).

𝐑𝐞𝐭𝐮𝐫𝐧 𝐨𝐧 𝐭𝐨𝐭𝐚𝐥 𝐚𝐬𝐬𝐞𝐭𝐬 𝐑𝐎𝐀

𝐍𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞 $𝟏𝟏𝟕. 𝟓
= = = 𝟓. 𝟗%
𝐓𝐨𝐭𝐚𝐥 𝐚𝐬𝐬𝐞𝐭𝐬 $𝟐, 𝟎𝟎𝟎

𝐈𝐧𝐝𝐮𝐬𝐭𝐫𝐲 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 = 𝟗. 𝟎%
 Return on Total Assets
• Allied’s 5.9% ROA is well below the 9.0%
industry average. It is not good.
• Note, that a low ROA can result from a
conscious decision to use great deal of debt,
• In which case high interest expenses will cause
net income to be relatively low.
• That is a part of reasons for Allied’s low ROA.
 Return on Common Equity
• Another important financial ratio is the return
on common equity (ROE), is found as follows:

𝐑𝐞𝐭𝐮𝐫𝐧 𝐨𝐧 𝐜𝐨𝐦𝐦𝐨𝐧 𝐞𝐪𝐮𝐢𝐭𝐲 𝐑𝐎𝐄

𝐍𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞 $𝟏𝟏𝟕. 𝟓
= = = 𝟏𝟐. 𝟓%
𝐂𝐨𝐦𝐦𝐨𝐧 𝐞𝐪𝐮𝐢𝐭𝐲 $𝟗𝟒𝟎

𝐈𝐧𝐝𝐮𝐬𝐭𝐫𝐲 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 = 𝟏𝟓. 𝟎%

 Return on Common Equity
• Stockholders expect to earn a return on their
money, and this ratio tells how well they are
doing it.
• Allied’s 12.5% return is below the 15.0% industry
average,
• But not as far below as the return on total assets.
• This somewhat better ROE results from the
company’s greater use of debt, discussed earlier.
 Return on Invested Capital
(ROIC)
• ROIC measures the total return that the company has
provided for its investors.

𝐑𝐞𝐭𝐮𝐫𝐧 𝐨𝐧 𝐢𝐧𝐯𝐞𝐬𝐭𝐞𝐝 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐑𝐎𝐈𝐂 =

𝐄𝐁𝐈𝐓𝐱(𝟏 − 𝐓𝐚𝐱 %) 𝐄𝐁𝐈𝐓𝐱(𝟏 − 𝐓𝐚𝐱 %) $𝟏𝟕𝟎. 𝟑

= =
𝐓𝐨𝐭𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐞𝐝 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐃𝐞𝐛𝐭 + 𝐄𝐪𝐮𝐢𝐭𝐲 $𝟏, 𝟖𝟎𝟎
= 𝟗. 𝟓%

𝐈𝐧𝐝𝐮𝐬𝐭𝐫𝐲 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 = 𝟏𝟎. 𝟖%

 Return on Invested Capital
• ROIC differs from ROA in two ways.
• First its return based on total invested capital rather
than total assets.
• Second, in the numerator it uses after-tax operating
income (NOPAT) rather than net income.
• The key difference is that net income subtracts the
company’s after-tax interest expense and therefore
represents the total amount of income available to
shareholders.
• While NOPAT is the amount of funds available to pay
both stockholders and the debtholders.
 Basic Earning Power (BWP) Ratio
• BEP ratio is calculated by dividing operating
income (EBIT) by total assets.

𝐄𝐁𝐈𝐓
𝐁𝐚𝐬𝐢𝐜 𝐞𝐚𝐫𝐧𝐢𝐧𝐠 𝐩𝐨𝐰𝐞𝐫 =
𝐓𝐨𝐭𝐚𝐥 𝐚𝐬𝐬𝐞𝐭𝐬
$𝟐𝟖𝟑. 𝟖
= = 𝟏𝟒. 𝟐%
$𝟐, 𝟎𝟎𝟎

𝐈𝐧𝐝𝐮𝐬𝐭𝐫𝐲 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 = 𝟏𝟖. 𝟎%

 Basic Earning Power (BEP) Ratio
• This ratio shows raw earning power of the
firm’s assets before the influence of taxes and
debt,
• And it is useful when comparing firms with
different debt and tax situations.
• Because of this low turnover ratios and poor
profit margin on sales, Allied has lower BEP
ratio than the average food processing
company.
 5) Market Value Ratios
• Price/Earning ratio
• Market/Book ratio
 Market Value Ratios
• ROE reflects the effects of the other ratios, and it is the
single best accounting measure of performance.
• Investors like a high ROE, and high ROEs are correlated
with high stock prices.
• However, other things come into play.
• For example financial leverage generally increases the
ROE but also increases the firm’s risk.
• So if a high ROE is achieved by using a great deal of
debt, the stock price might end up lower than
• If the firm had been using less debt and had a lower
ROE.
 Market Value Ratios
• If the liquidity, asset management, debt
management, and profitability ratios all look
good and
• If the investors think these ratios will continue
to look good in the future,
• The market value ratios will be high,
• The stock price will be as high as expected, and
• Management will be judged as having done a
good job.
 Market Value Ratios
• The market value ratios are used in three
primary ways;
(1) by investors when they are deciding to buy
or sell a stock,
(2) by investment bankers when they are setting
the share price for a new stock issue (an IPO-
initial public offering), and
(3) by firms when they are deciding how much
to offer for another firm in a potential merger.
 Price Earning Ratio
(P/E)
• The P/E ratio shows how much investors are willing to
pay per dollar of reported profit.
• Allied stock sells for $23.06.
• So, with an EPS of $2.35.
• Its P/E ratio is 9.81.
𝐏𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
𝐏𝐫𝐢𝐜𝐞 𝐞𝐚𝐫𝐧𝐢𝐧𝐠 𝐫𝐚𝐭𝐢𝐨 =
𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
$𝟐𝟑. 𝟎𝟔
= = 𝟗. 𝟖𝟏
$𝟐. 𝟑𝟓

𝐈𝐧𝐝𝐮𝐬𝐭𝐫𝐲 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 = 𝟏𝟏. 𝟑

 Price Earning Ratio
• P/E ratio is relatively high for firms with strong
growth prospects and little risk but low for
slowly growing and risky firms.
• Allied’s P/E ratio is below its industry average.
• So this suggests that the company is regarded
as being relatively risky,
• As having poor growth prospects, or both.
 Market Value/Book Value Ratio
• The ratio of a stock’s market price to its book
value gives another indication of how the
investors regard the company.
• The companies that are well regarded by
investors-which means with low risk and high
growth-have high M/B ratios.
• For Allied, we first find its book value per
share:
 Market Value/Book Value Ratio
𝐂𝐨𝐦𝐦𝐨𝐧 𝐞𝐪𝐮𝐢𝐭𝐲 $𝟗𝟒𝟎 𝐦𝐢𝐥𝐥𝐢𝐨𝐧
𝐁𝐨𝐨𝐤 𝐯𝐚𝐥𝐮𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞 = =
𝐒𝐡𝐚𝐫𝐞𝐬 𝐨𝐮𝐭𝐬𝐭𝐚𝐧𝐝𝐢𝐧𝐠 𝟓𝟎 𝐦𝐢𝐥𝐥𝐢𝐨𝐧
= $𝟏𝟖. 𝟖𝟎
Then we divide the market price per share by the book value per share to
get the market/book (M/B) ratio,
Which for Allied is 1.2 :

𝐌𝐚𝐫𝐤𝐞𝐭 𝐌 𝐌𝐚𝐫𝐤𝐞𝐭 𝐩𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞 $𝟐𝟑. 𝟎𝟔

𝐫𝐚𝐭𝐢𝐨 = = = 𝟏. 𝟐
𝐁𝐨𝐨𝐤 𝐁 𝐁𝐨𝐨𝐤 𝐯𝐚𝐥𝐮𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞 $𝟏𝟖. 𝟖𝟎

𝐈𝐧𝐝𝐮𝐬𝐭𝐫𝐲 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 = 𝟏. 𝟕
 Market Value/Book Value Ratio
• Investors are willing to pay less for a dollar of
Allied’s book value than for one of an average
food processing company.
• This is consistent with other findings!
• M/B ratios typically exceed 1.0,
• Which means that investors are willing to pay
more for stocks than the accounting book
values of the stocks.
 The DuPont Equitation:
Tying the Ratios Together
• Discussed many ratios.
• How they work together?

𝐑𝐎𝐄 = 𝐑𝐎𝐀 𝐱 𝐄𝐪𝐮𝐢𝐭𝐲 𝐦𝐮𝐥𝐭𝐢𝐩𝐥𝐢𝐞𝐫

= 𝐏𝐫𝐨𝐟𝐢𝐭 𝐦𝐚𝐫𝐠𝐢𝐧 𝐱 𝐓𝐨𝐭𝐚𝐥 𝐚𝐬𝐬𝐞𝐭𝐬 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐱 𝐄𝐪𝐮𝐢𝐭𝐲 𝐦𝐮𝐥𝐭𝐢𝐩𝐥𝐢𝐞𝐫
𝐍𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞 𝐒𝐚𝐥𝐞𝐬 𝐓𝐨𝐭𝐚𝐥 𝐚𝐬𝐬𝐞𝐭𝐬
= 𝐱 𝐱
𝐒𝐚𝐥𝐞𝐬 𝐓𝐨𝐭𝐚𝐥 𝐚𝐬𝐬𝐞𝐭𝐬 𝐓𝐨𝐭𝐚𝐥 𝐜𝐨𝐦𝐦𝐨𝐧 𝐞𝐪𝐮𝐢𝐭𝐲
$𝟏𝟏𝟓. 𝟓 $𝟑, 𝟎𝟎𝟎 $𝟐, 𝟎𝟎𝟎
= 𝐱 𝐱
$𝟑, 𝟎𝟎𝟎 $𝟐, 𝟎𝟎𝟎 $𝟗𝟒𝟎
= 𝟑. 𝟗𝟐% 𝐱 𝟏. 𝟓 𝐭𝐢𝐦𝐞𝐬 𝐱 𝟐. 𝟏𝟑 𝐭𝐢𝐦𝐞𝐬 = 𝟏𝟐. 𝟓%

𝐈𝐧𝐝𝐮𝐬𝐭𝐫𝐲 = 𝟓. 𝟎% 𝐱 𝟏. 𝟖 𝐭𝐢𝐦𝐞𝐬 𝐱 𝟏. 𝟔𝟕 𝐭𝐢𝐦𝐞𝐬 = 𝟏𝟓. 𝟎%