FINANCIAL ANALYSIS

SIZING UP FIRM VALUE

Valuasi Bisnis
Learning Objectives (1 of 2)
1. Explain what we can learn by analyzing a firm’s
financial statements.
2. Use common size financial statements as a
tool of financial analysis.
3. Calculate and use a comprehensive set of
financial ratios to evaluate a company’s
performance.
Learning Objectives (2 of 2)
4. Select an appropriate benchmark for use in
performing a financial ratio analysis.
5. Describe the limitations of financial ratio
analysis.
4.1 WHY DO WE ANALYZE FINANCIAL
STATEMENTS?
Why Do We Analyze Financial
Statements? Internal Financial Analysis
• An internal financial analysis might be done:
– To evaluate the performance of employees
– To compare the performance of firm’s different divisions
– To prepare financial projections
– To evaluate the firm’s financial performance in light of
its competitors’ performance
– To determine corporate value
Why Do We Analyze Financial
Statements? External Financial Analysis
• Analisis keuangan eksternal untuk menentukan
kelayakan kredit atau daya tarik investasi
dilakukan oleh:
– Banks and other lenders
– Suppliers
– Credit-rating agencies
– Professional analysts
– Individual investors
4.2 COMMON SIZE STATEMENTS:
STANDARDIZING FINANCIAL
INFORMATION
Common Size Statements: Standardizing
Financial Information
• A common size financial statement is a
standardized version of a financial statement in
which all entries are presented in percentages.
• It helps to compare a firm’s financial statements
with those of other firms, even if the other firms
are not of equal size.
Preparing Common Size Statements
• How to prepare a common size financial
statement?
– For a common size income statement, divide each
entry in the income statement by sales.
– For a common size balance sheet, divide each entry
in the balance sheet by total assets.
Table 3.1 H. J. Boswell, Inc. (1 of 2)
Income Statement ($ millions, except per share data) for the Year Ended
December 31, 2016
Sales Blank $2,700.00
Cost of goods sold Blank (2,025.00)
Gross profit Blank $ 675.00
Operating expenses: Blank Blank
Selling expense $(90.00) Blank
General and administrative expense (67.50) Blank
Depreciation and amortization expense (135.00) Blank
Total operating expenses Blank (292.50)
Net operating income (EBIT, or earnings before interest Blank $ 382.50
and taxes)
Interest expense Blank (67.50)
Earnings before taxes Blank $ 315.00

Income taxes Blank (110.25)

Net income Blank $ 204.75
 Table 4.1 H. J. Boswell, Inc.
Common-Size Income Statement for the Year Ended
December 31, 2016
Sales Blank 100.0%
Cost of goods sold Blank −75.0%
Gross profits Blank 25.0%
Operating expenses: Blank Blank
Selling expenses −3.3% Blank
General and administrative expense −2.5% Blank
Depreciation and amortization expense −5.0% Blank
Total operating expense Blank −10.8%
Net operating income (EBIT, or earnings before interest and taxes) Blank 14.2%
Interest expense Blank −2.5%
Earnings before taxes Blank 11.7%
Income taxes Blank −4.1%
Net income Blank 7.6%
Table 4.1 Observations
• Table 4.1 created by dividing each entry in the
income statement of Table 3.1 by firm sales for
2016.
– Cost of goods sold make up 75% of the firm’s sales
resulting in a gross profit of 25%.
– Selling expenses account for about 3% of sales.
– Income taxes account for 4.1% of the firm’s sales.
– After all expenses, the firm generates net income of
7.6% of firm’s sales.
 Table 3.2 H. J. Boswell, Inc. (1 of 9)
Balance Sheets ($ millions), December 31, 2015 and 2016
Assets Blank Blank Liabilities and Stockholders’ Blank Blank
Equity

Blank 2015 2016 Blank 2015 2016

Cash $ 94.50 $ 90.00 Accounts payable $ 184.50 $ 189.00
Accounts 139.50 162.00 Accrued expenses 45.00 45.00
Receivable

Inventory 229.50 378.00 Short-term notes 63.00 54.00

Other current 13.50 13.50 Total current liabilities $ 292.50 $ 288.00
assets

Total current $ 477.00 $ 643.50 Long-term debt 720.00 771.75

assets

Gross plant 1,669.50 1,845.00 Total liabilities $1,012.50 $1,059.75

and
equipment
 Table 3.2 H. J. Boswell, Inc. (2 of 9)
Assets Blank Blank Liabilities and Blank Blank
Stockholders’ Equity

Blank 2015 2016 Blank 2015 2016

Less (382.50) (517.50) Common stockholders’ Blank Blank

accumulated equity
depreciation

Net plant and $1,287.00 $1,327.50 Common stock-par value 45.00 45.00
equipment

Total assets $1,764.00 $1,971.00 Paid-in capital 324.00 324.00

Blank Blank Blank Retained earnings 382.50 542.25

Blank Blank Blank Total common $ 751.50 $ 911.25

stockholders’ equity

Blank Blank Blank Total liabilities and $1,764.00 $1,971.00

stockholders’ equity
Table 4.2 H. J. Boswell, Inc. (1 of 2)
Common-Size Balance Sheets, December 31, 2015 and
2016
Blank 2015 2016 Change

Cash 5.4% 4.6% −0.8%

Accounts receivable 7.9% 8.2% 0.3%

Inventory 13.0% 19.2% 6.2%

Other current assets 0.8% 0.7% −0.1%

Total current assets 27.0% 32.6% 5.6%

Gross plant and equipment 94.6% 93.6% −1.0%

Less accumulated depreciation −21.7% −26.3% −4.6%

Net plant and equipment 73.0% 67.4% −5.6%

Total assets 100.0% 100.0% 0.0%

Table 4.2 H. J. Boswell, Inc. (2 of 2)
Blank 2015 2016 Change
Accounts payable 10.5% 9.6% −0.9%
Accrued expenses 2.6% 2.3% −0.3%
Short-term notes 3.6% 2.7% −0.8%
Total current liabilities 16.6% 14.6% −2.0%
Long-term debt 40.8% 39.2% −1.7%
Total liabilities 57.4% 53.8% −3.6%
Common stockholders’ equity Blank Blank Blank
Common stock—par value 2.6% 2.3% −0.3%
Paid-in capital 18.4% 16.4% −1.9%
Retained earnings 21.7% 27.5% 5.8%
Total common stockholders’ equity 42.6% 46.2% 3.6%
Total liabilities and stockholders’ equity 100.0% 100.0% 0.0%
Table 4.2 Observations
• Table 4.2 created by dividing each entry in the
balance sheet of Table 3.2 (in chapter 3) by total
assets.
– Total current assets increased by 5.6% in 2016 while
total current liabilities declined by 2%.
– Long-term debt account for 39.2% of firm’s assets,
showing a decline of 1.7%.
– Retained earnings increased by 5.8%.
4.3 USING FINANCIAL RATIOS
Using Financial Ratios (1 of 2)
• Financial ratios provide a second method for
standardizing the financial information on the
income statement and balance sheet.
• A ratio by itself may have no meaning. Hence,
a given ratio is generally compared to: (a) ratios
from previous years; or (b) ratios of other firms in
the same industry.
Using Financial Ratios (2 of 2)
Question Category of Ratios Used to
Address the
Question

1. How liquid is the firm? Will it be able to pay its bills as they Liquidity ratios
come due?

2. How has the firm financed the purchase of its assets? Capital structure ratios

3. How efficient has the firm’s management Asset management efficiency ratios
been in utilizing its assets to generate sales?

4. Has the firm earned adequate returns on Profitability ratios

its investments?

5. Are the firm’s managers creating value for Market value ratios
shareholders?
LIQUIDITY RATIOS
Liquidity Ratios
• Liquidity ratios address a basic question: How
liquid is the firm?
• A firm is financially liquid if it is able to pay its bills
on time. We can analyze a firm’s liquidity from two
complementary perspectives:
– measuring overall liquidity of a firm, and
– measuring the liquidity of individual asset categories.
Measuring the Overall Liquidity of a Firm
The Overall liquidity is analyzed by comparing the
firm’s current assets to the firm’s current liabilities.
Two ratios used to analyze overall liquidity are:
1. Current Ratio
2. Acid-Test (or Quick) Ratio
Current Ratio (1 of 2)
• Current Ratio: Current Ratio compares a firm’s
current (liquid) assets to its current (short-term)
liabilities.

Current Assets
Current Ratio =
Current Liabilities
Current Ratio (2 of 2)
• What is the current ratio for 2016 for Boswell?
Current Ratio = $643.5m ÷ $288.0m = 2.23 times
• The firm had $2.23 in current assets for every $1 it
owed in current liability. It is better than peer group
average of $1.80.
Acid—Test (Quick) Ratio (1 of 2)
• Acid-Test (Quick) Ratio excludes the inventory
from current assets as inventory may not be very
liquid.

Acid-Test Current Assets − Inventory

=
(or Quick) Ratio Current Liabilities
Acid—Test (Quick) Ratio (2 of 2)
• What is the quick ratio for Boswell?
• Acid Test (or Quick) Ratio
= ($643.5m−$378m) ÷ ($288.0m) = 0.92 times
• The firm has only $0.92 in current assets (less
inventory) to cover $1 in current liabilities. This
ratio is worse than peer average of $0.94
Measuring the Liquidity of Individual
Asset Categories
• We can also measure the liquidity of the firm by
examining the liquidity of accounts receivable
and inventories to see how long it takes the firm
to convert its accounts receivables and inventories
into cash.
Average Collection Period (1 of 2)
Average Collection Period measures the number
of days it takes the firm to collects its receivables.

Average Collection Accounts Receivable Accounts Receivable

= =
Period Annual Credit Sales/365 days Daily Credit Sales
Average Collection Period (2 of 2)
• What is the average collection period for Boswell,
Inc. for 2016?
• Daily Credit Sales
= $2,700m ÷ 365 days = $7.40 million
• Average Collection Period
= $162m ÷ $7.40 = 21.9 days
Accounts Receivable Turnover Ratio (1 of 2)
Accounts Receivable Turnover Ratio measures
how many times receivables are “rolled over” during
a year.

Annual Credit Sales

Accounts Receivable Turnover =
Accounts Receivable
Accounts Receivable Turnover Ratio (2 of 2)
• What is the accounts receivable turnover ratio for
Boswell, Inc. for 2016?
• Accounts Receivable Turnover
= $2,700 million ÷ $162million = 16.67 times
– The firm’s accounts receivable were turning over at
16.67 times per year. This is higher than peer group
average of 14.60 times.
Inventory Turnover Ratio (1 of 2)
Inventory turnover ratio measures how many
times the company turns over its inventory during
the year. Shorter inventory cycles lead to greater
liquidity because the items in inventory are
converted to cash more quickly.

Cost of Goods Sold

Inventory Turnover =
Inventories
Inventory Turnover Ratio (2 of 2)
• What is the inventory turnover ratio for H. J.
Boswell, Inc.?
• Inventory Turnover Ratio
= $2,025m ÷ $378m = 5.36 times
– The firm turned over its inventory 5.36 times per year.
This ratio is slower than peer group average of 7.0
times.
Days’ Sales in Inventory
• Days’ Sales in Inventory
= 365÷ inventory turnover ratio
= 365 ÷ 5.36 = 68 days
• The firm, on average, holds it inventory for about
68 days.
Can a Firm Have Too Much Liquidity?
• A high investment in liquid assets will enable the
firm to repay its current liabilities in a timely
manner.
• However, an excessive investments in liquid
assets can prove to be costly as liquid assets
(such as cash) generate minimal return.
 CHECKPOINT 4.1: CHECK YOURSELF
Evaluating Hewlett Packard’s Liquidity
If HP’s management were able to increase its inventory turnover ratio to 30 times a
year while holding firm sales constant, how much this reduce the firm’s investment in
inventory?
Data Keuangan Hewlett Packard
Step 1: Picture the Problem
• The inventory turnover ratio will measure how
many days items remain in inventory before being
sold. Inventory turnover ratio is important as it has
implications for cash flows and profitability of a
firm.
• Changes in inventory turnover ratio will impact the
firm’s investment in inventory.
Step 2: Decide on a Solution Strategy
• We will use the Inventory Turnover (IT) ratio to
compute the investment in inventory.
IT ratio = Cost of Goods Sold ÷ Inventories
We are given the inventories and IT ratio.
Step 3: Solve
• Inventory Turnover Ratio for HP
= $78,596m ÷ Inventory = 30
• Solving for the revised inventory level we get
$78,596 million /30 = $2,619.87 million.
Step 4: Analyze
• Reducing the firm’s inventory turnover ratio has a
major impact on the level of investment in
inventory. With inventory turnover ratio of 30,
investment in inventory drops significantly from
$4,288 million to $2,619.87 million.
CAPITAL STRUCTURE RATIOS
Capital Structure Ratios
Capital structure refers to the way a firm finances
its assets using a combination of debt and equity.
Capital structure ratios address the important
question: How has the firm financed the
purchase of its assets? To address this issue, we
use two types of capital structure ratios: the debt
ratio, and the times interest earned ratio.
Debt Ratio (1 of 2)
Debt ratio measures the proportion of the firm’s
assets that were financed using current plus long-
term liabilities.

Total Liabilities
Debt Ratio =
Total Assets
Debt Ratio (2 of 2)
• What is the debt ratio for H.J. Boswell, Inc.?
• Debt Ratio
= $1,059.75 million ÷ $1,971 million = 53.80%
– The firm financed 53.80% of its assets with debt. This
ratio is significantly higher than the peer group average
of 35%.
Times Interest Earned Ratio (1 of 2)
Times Interest Earned Ratio measures the ability
of the firm to service its debt or repay the interest on
debt.

Times Interest Net Operating Income or EBIT

=
Earned Interest Expense
Times Interest Earned Ratio (2 of 2)
• What is the times interest earned ratio for H.J.
Boswell, Inc. for 2016?
• Times Interest Earned
= $382.5m ÷ $67.5m = 5.67 times
– The firm can pay its interest expense 5.67 times or
interest used 1/5.67th or 17.7% of its operating income,
which means its operating earnings could shrink by
82.3% and it could still pay its interest expense.
 CHECKPOINT 4.2: CHECK YOURSELF
Comparing the Financing Decisions of HD and LOWES
What would be Home Depot’s times interest earned ratio if interest payments
remained the same, but net operating income dropped by 80% to only $2.354 billion?
Similarly if Lowes’ net operating income dropped by 80%, what would its times interest
earned ratio be?
Data Home Depot
Step 1: Picture the Problem (1 of 2)
• Times interest earned ratio is an important ratio for
firms that use debt financing. It measures the
firm’s ability to service its debt.
• The ratio requires comparing net operating
income or EBIT with Interest expense. Both items
are found on the income statement.
Step 1: Picture the Problem (2 of 2)
Picture an Income Statement
– Sales EBIT

▪ Less: Cost of Good Sold

▪ Equals: Gross Profit
▪ Less: Operating Expenses
▪ Equals: Net Operating Income (EBIT)
▪ Less: Interest Expense Interest
▪ Equals: Earnings before Taxes Expense
▪ Less: Taxes
▪ Equals Net Income
Step 2: Decide on a Solution Strategy
• Here we are considering the impact of a drop in
operating income on the times interest earned
ratio of Home Depot and Lowes. We will use the
following ratio to measure the times interest
earned (TIE) ratio. Interest expense is assumed to
remain the same.
• TIE = EBIT ÷ Interest Expense
Step 3: Solve
• TIE (Home Depot)
= $2.354 billion ÷ $0.919 billion = 2.56 times
• TIE (Lowes)
= $0.509 billion ÷$1.873 billion = .271 times
Step 4: Analyze
• We observe that a drop in net operating income
leads to a significant drop in times interest earned
ratio for both the firms. Should creditors be
worried by this drop? The drop in earnings would
be bad for Home Depot but devastating for
Lowe’s.
ASSET MANAGEMENT EFFICIENCY RATIOS
Asset Management Efficiency Ratios
Asset management efficiency ratios measure a
firm’s effectiveness in utilizing its assets to
generate sales. These ratios are commonly
referred to as turnover ratios as they reflect the
number of times a particular asset account balance
turns over during the year.
Total Asset Turnover Ratio
• Total Asset Turnover Ratio represents the
amount of sales generated per dollar invested in
the firm’s assets.

Total Assets Sales $2, 700 million

= = = 1.37 times
Turnover Total Assets $1, 971 million
Peer-group total asset turnover = 1.15 times
 Fixed Asset Turnover Ratio
• Fixed asset turnover ratio measures firm’s
efficiency in utilizing its fixed assets (such as
property, plant and equipment).

Fixed Asset Sales $2, 700 million

= = = 2.03 times
Turnover Net Plant and Equipment $1, 327 million
Peer-group fixed asset turnover = 1.75 times
Asset Management Efficiency Ratios:
Summary
The following grid summarizes the efficiency of
Boswell’s management in utilizing its assets to
generate sales. Overall, the managers utilized the
firm’s total investment in assets efficiently.
Asset Utilization Efficiency Boswell Peer Group Assessment

Total asset turnover 1.37 1.15 Good

Fixed asset turnover 2.03 1.75 Good

Receivables turnover 16.67 14.60 Good

Inventory turnover 5.36 7.0 Poor

PROFITABILITY RATIOS
Profitability Ratios (1 of 2)
Profitability ratios address a very fundamental
question: Has the firm earned adequate returns on
its investments?
Profitability Ratios (2 of 2)
Two fundamental determinants of firm’s profitability
and returns on investments are the following:
• Cost Control – How well has the firm controlled
its costs relative to each dollar of firm sales?
• Efficiency of asset utilization – How effective is
the firm in using the assets to generate sales?
Cost Control: Is the Firm Earning
Reasonable Profit Margins?
Gross profit margin shows how well the firm’s
management controls its expenses to generate
profits.

Gross Profit Gross Profits

=
Margin Sales
Cost Control: Gross Profit Margin
What is the gross profit margin ratio for 2016 for H.
J. Boswell, Inc.?
• Gross Profit Margin
= $675 million ÷ $2,700 million = 25%
– The firm spent $0.75 for cost of goods sold and thus
$0.25 out of each dollar of sales went towards gross
profits.
 Cost Control: Operating Profit Margin
Operating Profit Margin measures how much
profit is generated from each dollar of sales after
accounting for both costs of goods sold and
operating expenses. It also indicates how well the
firm is managing its income statement.

Operating Profit Net Operating Income or EBIT $382.5 million

= = = 14.2%
Margin (OPM) Sales $2, 700 million
Peer-group operating profit margin = 15.5%
Cost Control: Net Profit Margin (1 of 2)
Net Profit Margin measures how much income is
generated from each dollar of sales after adjusting
for all expenses (including income taxes).

Net Profit Net Income

=
Margin Sales
Cost Control: Net Profit Margin (2 of 2)
What is the net profit margin ratio for H. J. Boswell,
Inc.?
• Net Profit Margin
= $204.75 million ÷ $2,700 million = 7.6%
– The firm generated $0.076 for each dollar of sales after
paying all of the firm’s expenses, whereas the peer-
group firms earn $0.102.
Return on Invested Capital
Operating Return on Assets ratio is the summary
measure of operating profitability. It takes into
account both management’s success in controlling
expenses and its efficient use of assets.

Operating Return Net Operating Income or EBIT

=
on Assets (OROA) Total Assets
Operating Return on Assets
What will be the operating return on assets ratio for
H. J. Boswell, Inc. ?
• Operating Return on Assets
= $382.5 million ÷$1,971 million = 19.4%
– The firm generated $0.194 of operating profits for every
$1 of its invested assets, which is higher than peer
group average of $0.178.
Decomposing the Operating Return on
Assets Ratio

Operating Return Cost Control Asset Utilization

= 
on Assets  Operating Profit   Total Asset 
   
 Margin (OPM)   Turnover (TATO) 

Operating Return  Net Operating Income or EBIT   Sales 

= 
  Total Assets 
on Assets  Sales   
 Net Operating Income or EBIT 
= 
 Total Assets 
 Figure 4.1 Analyzing H. J. Boswell, Inc.’s Operating Return
on Assets (OROA) (1 of 2)

Panel A. Decomposing the Operating Return on

Assets Ratio

Blank Operating Return on Assets = Operating Profit Margin × Total Asset

Turnover
Equation Net Operating Income or EBIT = Net Operating Income or EBIT × Sales
Total Assets Sales Total Assets

H. J. Boswell 19.4% = 14.2% × 1.37

Peer Group 17.8% = 15.5% × 1.15

 Figure 4.1 Analyzing H. J. Boswell, Inc.’s Operating Return
on Assets (OROA) (2 of 2)

Panel B. Analyzing the Determinants of the Total

Asset Turnover Ratio

Blank Accounts Receivable = Inventory Turnover × Fixed Asset Turnover

Turnover
Equation Annual Credit Sales = Cost of Goods Sold × Sales
Accounts Receivable Inventory Net Plant and Equipment

H. J. 16.67 = 5.8 × 2.03

Boswell
Peer 14.60 = 7.0 × 1.75
Group
Figure 4-1 Observations
• Firm’s OROA (operating return on assets) is
higher than that of its peers.
• Firm’s OPM (operating profit margin) is lower than
that of its peers.
• Firm’s TATO (total asset turnover ratio) is higher
than that of its peers.
Figure 4-1 Recommendations
1. Reduce costs - The firm must investigate the
cost of goods sold and operating expenses to
see if there are opportunities to reduce costs.
2. Reduce inventories -The firm must investigate if
it can reduce the size of its inventories.
Is the Firm Providing a Reasonable Return
on the Owner’s Investment? (1 of 2)
Return on Equity (ROE) ratio measures the
accounting return on the common stockholders’
investment.

Return on Net Income

=
Equity Common Equity
Is the Firm Providing a Reasonable Return
on the Owner’s Investment? (2 of 2)
What is the ROE ratio for H. J. Boswell, Inc.?
• ROE = $204.75 million ÷ $911.25 million = 22.5%
– Thus the shareholders earned 22.5% on their
investments. This is higher than peer average of 18%
Using the DuPont Method for
Decomposing the ROE ratio (1 of 4)
• DuPont method analyzes the firm’s ROE by
decomposing it into three parts.
– ROE = Profitability × Efficiency × Equity Multiplier
• Equity multiplier captures the effect of the firm’s
use of debt financing on its return on equity. The
equity multiplier increases in value as the firm
uses more debt.
Using the DuPont Method for
Decomposing the ROE ratio (2 of 4)

Return on Equity
= Profitability  Efficiency 
Equity Multiplier
Net Profit Total Asset Equity
=  
Margin Turnover Multiplier
Net Income Sales 1
=  
Sales Total Assets 1 − Debt Ratio
Using the DuPont Method for
Decomposing the ROE ratio (3 of 4)
The following table shows why Boswell’s return on equity
was higher than its peers.

Blank Return on = Net Profit × Total Asset × Financial

Equity Margin Turnover Leverage
or Equity
Multiplier
Equation Net Income = Net Income × Sales × 1
Common Equity Sales Total Assets 1 − Debt Ratio
H. J. 22.5% Blank 7.6% 1.37 Blank 2.16
Boswell,
Inc.
Peer- 18.0% Blank 10.2% 1.15 Blank 1.54
Group
Averages
Using the DuPont Method for
Decomposing the ROE ratio (4 of 4)
Figure 4.2 Expanded DuPont Analysis for H. J. Boswell, Inc.
MARKET VALUE RATIOS
Market Value Ratios
Market value ratios address the question, how are
the firm’s shares valued in the stock market?
Price—Earnings Ratio
Price-Earnings (PE) Ratio indicates how much
investors have been willing to pay for $1 of reported
earnings.

Market Price per Share

Price-Earning Ratio =
Earnings per Share
$32.00
Price-Earning Ratio = = 14.07 times
$2.28
 Market—to—Book Ratio
Market-to-Book Ratio measures the relationship
between the market value and the accumulated
investment in the firm’s equity.

Market Price per Market Price per

Market-to Share Share
= =
Book Ratio Book Value Common Shareholders'/ Common Shares
per Share Equity Outstanding
Market-to $32.00 $32.00
= = = 3.16
Book Ratio $911.25 million / 90 million $10.13
Peer-firm market-to-book ration = 2.7X
4.4 SELECTING A PERFORMANCE BENCHMARK
Selecting a Performance Benchmark
There are two types of benchmarks that are
commonly used to analyze a firm’s financial
performance by means of its financial statements:
• Trend Analysis – compares a firm’s financial
statements over time (time-series comparisons).
• Peer Group Comparisons – compares the
subject firm’s financial statements with “peer”
firms.
Trend Analysis
Comparing a firm’s recent financial ratios with the
past financial ratios provides insight into whether
the firm is improving or deteriorating over time. This
type of financial analysis is referred to as trend
analysis.
Figure 4-3 A Time—Series (Trend) Analysis of the Inventory
Turnover Ratio: Home Depot Versus Lowe’s, 2001–2015
Peer—Firm Comparisons
A peer firm is simply one that the analyst believes
will provide a relevant benchmark for the analysis at
hand. Peer groups often consist of firms from the
same industry. Industry average financial ratios can
be obtained from a number of financial databases
(such as Compustat) and internet sources (such as
yahoo finance and google finance).
Figure 4-4 Financial Analysis of the Gap, Inc., 2016

Financial Ratios Gap, Inc. Industry Average

Price-earnings ratio 10.52 21.69

Market-to-book ratio 3.21 13.40

Gross margin 39.63% 36.98%

Net profit margin 5.82% 6.61%

Operating profit margin 9.65% 11.88%

Return on equity 36.15% 46.22%

Debt ratio 65.94% 39.39%

Current ratio 1.57 1.62

Total assets turnover ratio 2.11 1.87

Inventory turnover ratio 5.38 4.69

4.5 LIMITATIONS OF RATIO ANALYSIS
Limitations of Ratio Analysis (1 of 2)
1. Picking an industry benchmark can sometimes
be difficult.
2. Published peer-group or industry averages are
not always representative of the firm being
analyzed.
3. An industry average is not necessarily a
desirable target or norm.
Limitations of Ratio Analysis (2 of 2)
4. Accounting practices differ widely among firms.
5. Many firms experience seasonal changes in
their operations.
6. Financial ratios offer simply clues that can
suggest the need for further investigation.
7. The results of financial analysis are no better
than the quality of the financial statements.
Key Terms (1 of 4)
• Accounts receivable turnover ratio
• Acid-test (quick) ratio
• Average collection period
• Book value per share
• Capital structure
• Current ratio
• Days’ sales in inventory
Key Terms (2 of 4)
• Debt ratio
• DuPont method
• Equity Multiplier
• Earnings per share (EPS)
• Financial leverage
• Financial ratios
• Fixed asset turnover ratio
• Inventory turnover ratio
Key Terms (3 of 4)
• Liquidity ratios
• Market-to-book ratio
• Market value ratios
• Notes payable
• Operating return on assets (OROA)
• Price-earnings (PE) ratio
Key Terms (4 of 4)
• Return on equity
• Times interest earned
• Total asset turnover ratio (TATO)
• Trend analysis