Chapter 4

Analysis of Financial
Statements

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Learning Objectives

 Explain what ratio analysis is.

 List the five groups of ratios and identify, calculate, and interpret the key ratios in each group.
 Discuss each ratio’s relationship to the balance sheet and income statement.
 Discuss why return on equity (ROE) is the key ratio under management’s control and how the other ratios
impact ROE, and explain how to use the DuPont equation for improving ROE.
 Compare a firm’s ratios with those of other firms (benchmarking) and analyze a given firm’s ratios over
time (trend analysis).
 Discuss the tendency of ratios to fluctuate over time (which may or may not be problematic); explain how
they can be influenced by accounting practices as well as other factors; and explain why they must be
used with care.

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 Overview

• Ratio Analysis

• DuPont Equation

• Effects of Improving Ratios

• Limitations of Ratio Analysis

• Qualitative Factors

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Balance Sheet: Assets

2022E 2021
Cash 85,632 7,282
A/R 878,000 632,160
Inventories 1,716,480 1,287,360
Total CA 2,680,112 1,926,802
Gross FA 1,197,160 1,202,950
Less: Deprec. 380,120 263,160
Net FA 817,040 939,790
Total Assets 3,497,152 2,866,592
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 Balance Sheet: Liabilities and Equity

2022E 2021
Accts payable 436,800 524,160
Accruals 408,000 489,600
Notes payable 300,000 636,808
Total CL 1,144,800 1,650,568
Long-term debt 400,000 723,432
Common stock 1,718,986 460,000
Retained earnings 233,366 32,592
Total Equity 1,952,352 492,592
Total L & E 3,497,152 2,866,592
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Income Statement

2022E 2021
Sales 6,900,600 6,126,796
COGS 5,875,992 5,528,000
Other expenses 550,000 519,988
EBITDA 474,608 78,808
Deprec. & amort. 116,960 116,960
EBIT 357,648 ( 38,152)
Interest exp. 70,008 122,024
EBT 287,640 (160,176)
Taxes 31,866 0
Net income 255,774 (160,176)
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 Other Data

2022E 2021
No. of shares 250,000 100,000

EPS $1.023 −$1.602

DPS $0.220 $0.110

Stock price $12.17 $2.25

Lease pmts $40,000 $40,000

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Why are ratios useful?

• Ratios standardize numbers and facilitate comparisons.

• Ratios are used to highlight weaknesses and strengths.

• Ratio comparisons should be made through time and with competitors.

• Industry analysis

• Benchmark (peer) analysis

• Trend analysis

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 Five Major Categories of Ratios and the
Questions They Answer
Liquidity: Can we make required payments?

Asset management: Right amount of assets vs. sales?

Debt management: Right mix of debt and equity?

Profitability: Do sales prices exceed unit costs, and are sales high enough as
reflected in PM, ROE, and ROA?

Market value: Do investors like what they see as reflected in P/E and M/B ratios?

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D’Leon’s Forecasted Current Ratio and Quick

Ratio for 2022
• Current ratio = Current assets/Current liabilities

= $2,680/$1,145

= 2.34x

• Quick ratio = (Current assets − Inventories) / Current liabilities

= ($2,680 − $1,716)/$1,145

= 0.84x

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 Comments on Liquidity Ratios

2022E 2021 2020 Ind.

Current ratio 2.34x 1.17x 2.33x 2.70x
Quick ratio 0.84x 0.39x 0.85x 1.00x

• Expected to improve but still below the industry average.

• Liquidity position is weak.

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D’Leon’s Inventory Turnover vs. the Industry

Average
Inv. turnover = COGS/Inventories

= $5,876/$1,716

= 3.42x

2022E 2021 2020 Ind.

Inventory turnover 3.42x 4.29x 4.00x 5.50x

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 Comments on Inventory Turnover

• Inventory turnover is below industry average.

• D’Leon might have old inventory, or its control might be poor.

• No improvement is currently forecasted.

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DSO: Average Number of Days After Making a

Sale Before Receiving Cash
DSO = Receivables/Avg. sales per day
= Receivables/(Annual sales/365)
= $878/($6,901/365)
= 46.44 days

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 Appraisal of DSO

2022E 2021 2020 Ind.

DSO 46.44 37.66 37.35 32.00

• D’Leon collects on sales too slowly, and is getting worse.

• D’Leon has a poor credit policy.

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Fixed Assets and Total Assets Turnover

Ratios vs. the Industry Average
• FA turnover = Sales/Net fixed assets

= $6,901/$817 = 8.45x

• TA turnover = Sales/Total assets

= $6,901/$3,497 = 1.97x

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 Evaluating the FA Turnover (S/Net FA) and TA
Turnover (S/TA) Ratios
2022E 2021 2020 Ind.

FA TO 8.45x 6.52x 9.95x 7.00x

TA TO 1.97x 2.14x 2.34x 2.60x

• FA turnover projected to exceed the industry average.

• TA turnover below the industry average. Caused by excessive currents
assets (A/R and Inv).

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Calculate the Debt-to-Capital Ratio and

Times-Interest-Earned Ratio
Debt-to-capital ratio = Total debt / Total invested capital

= ($300 + $400) / ($300 + $400 + $1,952.4) = 26.39%

TIE = EBIT/Interest

= $357.6/$70 = 5.11x

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 D’Leon’s Debt Management Ratios vs. the
Industry Averages
2022E 2021 2020 Ind.
Debt/Total Inv. Capital 26.39% 73.41% 44.09% 40.00%
TIE 5.11x −0.31x 4.34x 6.20x

• Debt/Total invested capital is better than the industry average.

• TIE ratio greatly improved but still below the industry average.

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Profitability Ratios: Operating Margin, Profit

Margin, and Basic Earning Power
Operating margin = EBIT/Sales
= $357.6/$6,901 = 5.18%

Profit margin = Net income/Sales

= $255.8/$6,901 = 3.71%

Basic earning power = EBIT/Total assets

= $357.6/$3,497 = 10.23%

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 Appraising Profitability with Operating Margin,
Profit Margin, and Basic Earning Power (1 of 2)

2022E 2021 2020 Ind.

Operating margin 5.18% −0.62% 5.55% 7.30%

Profit margin 3.71% −2.61% 3.20% 4.30%
Basic earning power 10.23% −1.33% 12.96% 19.10%

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Appraising Profitability with Operating Margin,

Profit Margin, and Basic Earning Power (2 of 2)
Operating margin was very bad in 2021. It is projected to improve in
2022, but it is still projected to remain below the industry average.

Profit margin was very bad in 2021. It is projected to improve in 2022,

but it is still projected to remain below the industry average.

BEP removes the effects of taxes and financial leverage and is useful
for comparison.

BEP projected to improve, yet still below the industry average. There
is definitely room for improvement.

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 Profitability Ratios: Return on Assets and
Return on Equity
• ROA = Net income/Total assets
= $255.8/$3,497 = 7.31%

• ROE = Net income/Total common equity

= $255.8/$1,952 = 13.10%

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Appraising Profitability with ROA and ROE

2022E 2021 2020 Ind.

ROA 7.31% −5.59% 7.49% 11.2%
ROE 13.10% −32.52% 16.56% 18.2%

• Both ratios rebounded from the previous year but are still below the industry
average. More improvement is needed.

• Wide variations in ROE illustrate the effect that leverage can have on
profitability.

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 Effects of Debt on ROA and ROE

Holding assets constant, if debt increases:

Equity declines.

Interest expense increases – which leads to a reduction in net

income.

ROA declines (due to the reduction in net income).

ROE may increase or decrease (since both net income and equity decline).
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Problems with ROE

ROE and shareholder wealth are

correlated, but problems can arise when
ROE is the sole measure of performance.
Given these problems,
reliance on ROE may
ROE does not consider encourage managers to
risk. make investments that do
not benefit shareholders.
As a result, analysts have
ROE does not consider looked to develop other
the amount of capital performance measures,
invested. such as EVA.

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 Calculate the Price/Earnings and
Market/Book Ratios
• P/E = Price/Earnings per share
= $12.17/$1.0231 = 11.90x

• M/B = Market price/Book value per share

= $12.17/($1,952/250) = 1.56x

2022E 2021 2020 Ind.

P/E 11.90x −1.40x 7.73x 14.20x
M/B 1.56x 0.46x 1.28x 2.40x

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Analyzing the Market Value Ratios

P/E: How much investors are willing to pay for $1 of

earnings.

M/B: How much investors are willing to pay for $1 of

book value equity.

For each ratio, the higher the number, the better.

P/E and M/B are high if expected growth is high and

risk is low.

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 EV/EBITDA Calculations for Chapter 4 Case

• Enterprise Value = MVE + MVD +MVClaims − (Cash and Equivalents)

• For D’Leon, EV/EBITDA calculations are as follows (assume bonds are at par
value):
• 2022E: [($12.17 × 250,000) + ($300,000 + $400,000) − $85,632]/$474,608 =
7.7050, or approximately 7.7
• 2021: [($2.25 × 100,000) + ($636,808 + $723,432) − $7,282]/$78,808 =
20.02, or approximately 20
• 2020: [($8.50 × 100,000) + ($200,000 + $323,432) − $57,600]/$209,328 =
6.2860, or approximately 6.3
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The DuPont Equation

The DuPont Equation

ROE = Profit Margin × Total assets turnover × Equity multiplier

ROE = (NI/Sales) × (Sales/TA) × (TA/Equity)

• Focuses on expense control (PM), asset utilization (TATO), and debt utilization
(equity multiplier).

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 DuPont Equation: Breaking Down Return on
Equity
ROE = (NI/Sales) × (Sales/TA) × (TA/Equity)
= 3.71% × 1.97 × 1.7913
= 13.1%

PM TATO EM ROE
2020 3.2% 2.34 2.21 16.6%
2021 −2.6% 2.14 5.82 −32.5%
2022E 3.7% 1.97 1.79 13.1%
Ind. 4.3% 2.6 1.63 18.2%
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An Example: The Effects of Improving Ratios

Accounts receivable $ 878 Current liabilities $ 845

Other current assets 1,802 Debt 700

Net fixed assets 817 Equity 1,952

Total assets $3,497 Total liabilities & equity $3,497

• Sales/Day = $6,900,600/365 = $18,905.75

• How would reducing the firm’s DSO to 32 days affect the company?

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 Reducing Accounts Receivable and the Days
Sales Outstanding
• Reducing A/R will have no effect on sales

Old A/R = $18,905.75 × 46.4 = $878,000

New A/R = $18,905.75 × 32.0 = $604,984

Cash freed up: $273,016

• Initially shows up as addition to cash.

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Effect of Reducing Receivables on Balance

Sheet and Stock Price
Added cash $ 273 Current liabilities $ 845

Accounts receivable 605

Other current assets 1,802 Debt 700

Net fixed assets 817 Equity 1,952

Total assets $3,497 Total liabilities & equity $3,497

• What could be done with the new cash?

• How might stock price and risk be affected?

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 Potential Uses of Freed Up Cash

• Repurchase stock
• Expand business
• Reduce debt
• All these actions would likely improve the stock price.

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Potential Problems and Limitations of

Financial Ratio Analysis
• Comparison with industry averages is difficult for a conglomerate firm that
operates in many different divisions.
• Different operating and accounting practices can distort comparisons.
• Sometimes it is hard to tell if a ratio is “good” or “bad.”
• Difficult to tell whether a company is, on balance, in a strong or weak position.

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 More Issues Regarding Ratios

• “Average” performance is not necessarily good, perhaps the firm should aim
higher.
• Seasonal factors can distort ratios.
• “Window dressing” techniques can make statements and ratios look better than
they actually are.
• Inflation has distorted many firms’ balance sheets, so analyses must be
interpreted with judgment.

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