CB 3041

Financial Statement Analysis

Statement of Cash Flows

Review
 Purpose of the Statement of Cash Flows
➢ Accrual accounting help investors better predict the nature,
amount, and timing of future cash flows.
➢ In contrast, the statement of cash flows “unravels” the
accrual accounting procedures to reveal the (volatile timing
of) underlying cash flows.
Beg. Cash + Cash inflows – Cash outflows = End. Cash

Net cash flows = Change in cash

Note that we use the term cash to mean cash and cash equivalents. Cash
equivalents include highly liquid short-term investments that are readily
convertible into cash, including commercial paper, and money market funds.
Relations among the Cash Flow Activities
➢The three sections of the statement of cash flows follow
this logical progression:
• Operating activities: directly involving the production
and delivery of goods or services.
• Investing activities: expenditures for and proceeds from
dispositions of assets, such as plant and equipment and
investments in securities.
• Financing activities: cash received from and paid to
capital providers such as banks, other lending
institutions, and shareholders.
 Cash Flow Activities and a Firm’s Life Cycle
➢ Stylized Patterns of Revenues, Net Income, and Cash Flows from Operations,
Investing, and Financing at Various Stages of a Product or Business Life Cycle
 Relation between net income and cash flows
from operations
➢ Under the indirect method, not a single line item in the
operating section reflects an actual cash flow. Instead,
amounts shown are adjustments for noncash components
of net income.
➢ The presentation of cash flows from operations under the
indirect method involves two types of adjustments to net
income: 1) working capital and 2) other noncash
components of income adjustments.
 1) Operating Working Capital Adjustments
➢Adjustments used to reconcile net income to cash flows
from operations involve changes in the working capital
(current asset and current liability) accounts, including:
• Accounts receivable and deferred revenue
• Inventories
• Prepaid expenses
• Accounts payable and accrued expenses
• Income taxes payable
• Other current assets and liabilities
 2) Other Noncash Components of Income
Adjustments
➢Other noncash components of income must be reversed
of the starting point of the statement of cash flows:
• Depreciation and amortization expense
• Bad debt expense
• Deferred tax expense
• Stock-based compensation and pension costs
• Gains/losses on property, plant, and equipment
• Equity method income and noncontrolling interests
• Other comprehensive income
 Preparing the Statement of Cash Flows
➢The statement of cash flows explains the reasons for the
change in cash during a period using this formula:
Δ Cash = Δ Liabilities + Δ Shareholders’ Equity – Δ Noncash Assets

= Δ Liabilities (WC) + Δ Liabilities (NWC) + Δ SE

– Δ Noncash Assets (WC) – Δ Noncash Assets (NWC)
Operating
Activities
= Δ Liabilities (WC) – Δ Noncash Assets (WC)
– Δ Noncash Assets (NWC) + Δ Liabilities (NWC) + Δ SE
Investing Financing
Activities Activities
 Changes in Balance Sheet Accounts
➢Classify the change in each noncash balance sheet account
into an operating, investing, or financing activity:
• Operating Activities: accounts receivable, inventories,
other current assets, depreciation, amortization on
intangible assets, accounts payable, deferred income
taxes, other current and noncurrent liabilities, and net
income
• Investing Activities: marketable and other securities;
property, plant, and equipment
• Financing Activities: notes payable, current portion of
long-term debt, long-term debt, and dividends
Changes in Balance Sheet Accounts
Worksheet for Statement of Cash Flows
 CB 3041
Financial Statement Analysis
Lecture 5
 Ratio Analysis
Analyzing Profitability and Risk
 Learning Objectives
➢ Demonstrate how to interpret return on assets (ROA) and
its components: profit margin and total assets turnover.
➢ Analyze and interpret return on shareholders’ equity
(ROE) and its components and understand how firms can
use financial leverage to increase the return to common
shareholders.
➢ Describe the benefits and limitations of using ratios.
➢ Apply analytical tools to assess working capital
management and short-term liquidity risk.
➢ Apply analytical tools to assess long-term solvency risk.
➢ Analyze credit risk and bankruptcy risk.
 Ratio Analysis
➢ Approach:
• Cross-sectional analysis (i.e., across firms, industry averages).
• Time-series analysis (i.e., over time).
➢ Adjustments, if necessary:
• Items to include or exclude? E.g., consider excluding any unusual
or nonrecurring items (such as impairment/restructuring charges,
merger-related costs, etc.), net of tax.
➢Analysis:
• Identify and/or compare trends, abrupt changes, differences, etc.
• Determine source(s) of change or difference in ratio:
− Driven by change in numerator and/or denominator?
− Driven by which component(s)?
 Reliable Comparisons
➢ Time-series analysis (i.e., over time):
• Any changes in product, geographical, or customer mix?
• Any major acquisitions/divestitures?
• Any change in accounting methods?
➢ Cross-sectional analysis (i.e., across firms):
• Comparable products, operations, and strategies?
• Comparable size, age, and product life cycle stage?
• If compares to industry averages/medians:
− Industry definition?
− Ratio definition?
− Computations (simple or weighted averages)?
 Categorization of Ratios
1. Profitability ratios
2. Liquidity ratios (short term liquidity)
3. Activity ratios
4. Solvency ratios (long term solvency)
5. Market ratios
 Financial Ratios Definition
Gross (Profit) Margin (Sales – Cost of Goods Sold) / Sales
Operating (Profit) Margin Operating Income / Sales
Profitability (Net) Profit Margin Net Income / Sales
Ratios Return on Assets (ROA) {[Net Income + [Interest Expense*(1-Tax Rate)]} / Average Total Assets
Return on (Common) Equity (ROCE or ROE) Net Income Available to Common Shareholders / Average Common Stockholders’ Equity
Net Income Available to Common Shareholders / Weighted Average # of Common Shares
Basic Earnings Per Share (Basic EPS)
Outstanding

Accounts Receivable (Debtors) Turnover Sales / Average Accounts Receivable

Inventory Turnover Cost of Goods Sold / Average Inventory
Activity
Fixed Asset Turnover Sales / Average Net PP&E
Ratios
Accounts Payable (Creditors) Turnover Purchases / Average Accounts Payable [Note: Purchases = COGS + End. Inv. - Beg. Inv.]
Total Asset Turnover Sales / Average Total Assets

Current Ratio Current Assets / Current Liabilities

(Short-Term)
Quick Ratio (Acid Test Ratio) (Cash + Short-term Investments + Accounts Receivable ) / Current Liabilities
Liquidity
Ratios Cash Ratio Cash / Current Liabilities
CFO to Current Liabilities Ratio Cash Flow from Operations / Average Current Liabilities

Liabilities to Equity Ratio Total Liabilities / Total Stockholders’ Equity

(Long-Term)
Liabilities to Assets Ratio Total Liabilities / Total Assets
Solvency
Ratios Long-Term Debt to Equity Ratio Long-Term Debt / Total Stockholders’ Equity
Interest Coverage Ratio (Net Income + Interest Expense + Income Tax Expense) / Interest Expense

Net Income Available to Common Shareholders / Weighted Average # of Common Shares

Basic Earnings Per Share (Basic EPS)
Outstanding
Market Price-Earnings Ratio Share Price / EPS
Ratios
Dividend Yield Ratio Dividend per share / Share Price
Dividend Payout Ratio Dividend per share / EPS
Complementary Approaches to Analyzing
Net Income
 DuPont Ratio Analysis Framework
Return on Equity (ROE)

Return on Assets (ROA) Financial Leverage

Profit Margin Asset Turnover

▪ Gross Margin
▪A/R Turnover
▪ Operating Margin
▪Inventory Turnover
▪ Various Expense to
▪Fixed Asset Turnover
Sales Ratios
ROE = Net Income/Sales × Sales/Assets × Assets/Equity

Financial
Profitability Efficiency
Leverage
 Overview of Profitability Analysis
➢ Profitability analysis is a way to evaluate whether
managers are effectively executing a firm’s
strategy.
➢ Investors in a firm are interested in how well firm
managers are using the capital they have invested
to generate returns on that investment.
➢ Other stakeholders, such as creditors, employees,
suppliers, and customers, are similarly interested
in profitability as a measure of the continuing
viability of the firm.
 Profitability Ratios
➢ Return on Assets (ROA)
Net Profit + Interest Expense*(1-Tax Rate)
Average Total Assets
• How effectively are resources used to generate profits?
• Ideally, ROA would measure operating performance
independent of the financing decisions
• But, Net Income includes Interest Expense: More Debts-
> higher interest expense-> lower net income
• To remove financing effects from ROA, we de-lever N/I:
De-levered N/I = N/I + Interest Expense * (1-t)
 Disaggregating ROA
➢ ROA can be disaggregated into profit margin for ROA
and total assets turnover
Net Profit +
Interest Expense∗(1−Tax Rate) Sales
ROA = ×
Sales Avg. Asset

Profit Margin for Asset

ROA Turnover
 Profitability Ratios
➢ Profit Margin for ROA
Net Profit + Interest Expense*(1-Tax Rate)
Sales
• Overall profitability of a firm’s operations
• Captures ability to generate earnings given a level of sales
• What are the drivers of profitability?
− To examine profit margin for ROA, we use common-
size analysis, expressing individual income statement
amounts as percentages of sales to identify reasons for
changes in the profit margin for ROA.
 Example
The Clorox Company Consolidated Balance Sheets (in Millions)
 Example
The Clorox Company Consolidated Statements of Earnings (in Millions)
Example
 Profitability Ratios
What are the drivers of profit margin?
➢ Use common-size analysis to reveal the driver
➢ Gross (Profit) Margin (Gross Profit / Sales)
• ability to control price and purchase costs
➢ Operating (Profit) Margin (Operating Profit / Sales)
• ability to control expenses other than COS
• SG&A Expense / Sales
➢ Interest Expense-to-Sales = Interest Expense / Sales
➢ Effective Tax Rate = Income Taxes / Pre-tax Income
 Profitability Ratios
What are the drivers of profit margin?
➢ Use common-size analysis to reveal the driver
 Profitability Ratios
What are the drivers of profit margin?
➢ Use common-size analysis to reveal the driver
➢ Clorox profit margin for ROA increased steadily from
2018 to 2020 due to
• a marked decrease in cost of products sold relative to
sales
• partially offsetting increases in selling and
administrative expenses
• slight offsetting increases in advertising costs
 Profitability Ratios
What are the drivers of profit margin?
➢ Your primary task as an analyst is to identify reasons for
the changes in the revenue and expense percentages.
➢ The MD&A is supposed to provide information for
interpreting such changes in these profitability percentages.
• Firms vary with respect to the informativeness of these discussions
• Some firms give specific reasons for changes in various financial
ratios; others do not.
• Even when firms provide explanations, you should assess their
reasonableness in light of conditions in the economy and the
industry, as well as the firm’s stated strategy and the results for the
firms’ competitors.
 Profitability Ratios
➢ Return on Equity (ROE)
Net Income Available to Common Shareholders
Average Common Stockholders’ Equity

• How much return is generated for the shareholders?

• Return on common equity (ROE) measures the return to common
shareholders after subtracting operating expenses, cost of financial
debt, and preferred stock from revenues.
• ROE is a more complete measure of firm performance because it
incorporates the results of a firm’s operating, investing, and
financing decisions.
• If there are preferred dividends, it needs to be subtracted from Net
Profit Attributable to Shareholders
 Disaggregating ROE
Net Income Available to
Common Shareholders Sales Avg. Assets
ROE = × ×
Sales Avg. Asset Avg. Equity
Profit Margin for Asset Financial
ROE Turnover Leverage

➢ Note that profit margin for ROA and profit margins for
ROE use different numerators.
➢ Financial leverage = 1 + Debt to Equity Ratio
➢ Strategic use of financial leverage increase returns to
equity investors.
Example of How Equity Investors Use Leverage to
Increase Their Returns on Investment
 Disaggregating ROE
➢ However, there are two offsetting effects of increasing
leverage:
➢ First, increasing leverage assumes the firm can deploy the
financing proceeds into assets that maintain the current
levels of profitability and turnover (that is, the first and
second terms).
➢ This deployment is surely not instantaneous and further
depends on the firm’s ability to scale up operations
without experiencing diminishing returns on investments,
market saturation, and other strategic roadblocks.
 Disaggregating ROE
➢ Second, increasing leverage increases interest expense
because of higher debt levels.
➢ Higher debt levels from incremental debt may also trigger
lenders to require higher interest rates on the additional
debt. These effects reduce profit margins (that is, the first
term in the disaggregation) and increase demands for
future cash.
 Economic and Strategic Determinants of
ROA and ROE
➢ ROA and ROE differ across industries depending on their
economic characteristics and across firms within an
industry depending on their business strategies.
➢ Determinants of ROA and ROE
• Product Life Cycle: introduction, growth, maturity,
and decline
• Operating Leverage: fixed cost vs. variable cost
• Cyclicality of Sales: sales sensitivity to economic
conditions
Economic and Strategic Determinants of
ROA and ROE
 Disaggregating ROE - Revisit
➢ Increasing leverage has potential benefits and risks. A
shortcoming of the standard disaggregation of ROE is the
inability to directly gauge the extent to which a firm can
strategically increase leverage to increase returns to
common shareholders without offsetting profitability.
➢ We refer to this as financial flexibility. To gauge a firm’s
financial flexibility, it is helpful to disaggregate ROE into
the operating and financing components of ROE.
 Reformulating the Balance Sheet
➢The alternative disaggregation requires that we first
reformulate the balance sheet and income statement into
operating and financing groupings.
➢Each of the amounts in the standard balance sheet equation
is decomposed into primary components as shown in the
next slide.
Reformulating the Balance Sheet
 Reformulating the Balance Sheet
➢The reformulated balance sheet equation is as follows:

➢ Net Operating Assets = Net Financing Obligations + Common Equity

➢The primary change of this financial statement

reformulation is that operating liabilities—both current and
noncurrent—are netted against operating assets, leaving net
financing obligations as the net of financing liabilities and
financial assets, with common equity balancing the right
side of the equation.
 Reformulating the Income Statement
➢Each line item on the income statement is designated as
either an operating or financing component of reported
profitability.
➢Any item designated as a financing asset or liability should
have a corresponding “flow” amount on the income
statement, most commonly interest income (for financial
assets) or interest expense (for financing liabilities).
➢Preferred dividends and income attributable to
noncontrolling interests are considered a financing cost.
Insights from Disaggregated ROE
 Insights from Disaggregated ROE
➢The result is an alternative disaggregation of ROE:

➢ ROE = Operating ROA + (Leverage ×Spread)

➢Operating ROA is the rate of return the firm generates on its

net operating assets (NOPAT/Net Operating Assets).
 Insights from Disaggregated ROE
➢Operating ROA is the rate of return available to all sources
of financing, including debt, preferred equity, and common
equity.
➢The new ROE equation will increase returns to common
equity shareholders with:
➢ Increases in the rate of return on the firm’s net operating assets
➢ Increases in leverage
➢ Decreases in the after-tax cost of debt and preferred equity
 Operating ROA vs. ROE

➢Under what circumstances will ROE exceed

operating ROA?
➢Under what circumstances will operating
ROA exceed ROE?
 Quick Check Question 1
➢ Which of the following is a more complete measure of a
firm’s performance because it incorporates the results of the
firm’s operating, investing, and financing decisions?

a. Return on assets (ROA)

b. Return on equity (ROE)
c. Earnings per share (EPS)
 Quick Check Question 2
➢ ABC Inc. has a net profit margin of 12%, a total asset
turnover of 1.2 times, and a financial leverage multiplier of
1.2 times. ABC’s return on equity is closest to:

a. 12.0%
b. 14.2%
c. 17.3%
Benefits and Limitations of Using Ratios
➢Financial ratios are easy to compute, but the most important
and valuable step is interpreting and gleaning key insights
from a financial ratio.
➢Interpreting ratios must be done with an understanding of
the firm’s economic environment and business strategy,
which includes the following:
➢ A firm’s industry
➢ A firm’s organizational structure
➢ An expectation of what to expect in terms of financial position,
profitability, risk, and growth
 Comparisons with Earlier Periods
➢Useful insights include comparing a firm with itself over
time.
➢Questions to consider from earlier periods before
interpreting ratios for the current period include:
➢ Has the firm made a significant change in its product, geographic,
or customer mix that affects the comparability of financial statement
ratios over time?
 Comparisons with Earlier Periods
➢Questions to consider (continue):
➢ Has the firm made a major acquisition or divestiture?
➢ Has the firm changed its methods of accounting over time? For
example, does the firm now consolidate a previously unconsolidated
entity?
➢ Are there any unusual or nonrecurring amounts that impair a
comparable analysis of financial results across years?
 Comparisons with Other Firms
➢The major task in performing a cross-sectional analysis is
identifying the other firms to use for comparison.
➢The objective is to select firms with similar products and
strategies and similar size and age.
➢An alternative approach uses average industry ratios, which
provide an overview of the performance of an industry.
 Comparisons with Other Firms
➢Consider the following when using standardized industry
ratios:
➢ Definition of the industry
➢ Calculation of industry average
➢ Distribution of ratios around the mean
➢ Definition of financial statement ratios
 Activity Ratios – Turnover Ratios
➢ Asset Turnover (Sales / Avg. Total Assets)
– How efficiently the firm utilizes assets to generate
revenues, hence the indication of efficient use of assets
– We can decompose asset turnover into turnover ratios of
individual assets to gain more insights. E.g., A/R turnover,
Inventory turnover, Fixed assets turnover
➢How many times per year do we cycle through accounts?
E.g., Inventory turnover of 8 means that we build and sell
Inventory 8 times per year, on average.
 Activity Ratios – Turnover Ratios
What are the drivers of Asset Turnover ?
➢ Decompose turnover ratios for individual classes
of assets:
• Accounts receivable turnover
• Inventory turnover
• Fixed assets turnover
 Activity Ratios – Turnover Ratios
➢Accounts Receivable Turnover (Sales / Avg. Accounts
Receivable)
– Ability to claim back outstanding trade debts
➢Inventory Turnover (Cost of sales / Avg. Inventory)
– How efficient a company is at selling its inventories.
➢Fixed Asset Turnover (Sales / Avg. Net PP&E)
– How efficient a company is at using its existing fixed
assets to generate sales.
 Activity Ratios – Turnover Ratios
➢Accounts Receivable Turnover (Sales / Avg. Accounts
Receivable)
• Ability to claim back outstanding trade debts, hence lower
turnover suggest greater risk of uncollectibility.
• However, it also relates to a firm’s credit extension
policies. Firms often use credit terms to stimulate sales.
Such actions would lead to greater sales, hence the
decrease in accounts receivable turnover would not
necessarily signal negative news.
• Thus, you must consider a firm’s credit strategy and
policies when interpreting the accounts receivable turnover
and days receivables outstanding ratios.
 Activity Ratios – Turnover Ratios
➢Inventory Turnover (Cost of sales / Avg. Inventory)
• How efficient a company is at selling its inventories.
• An increase in inventory turnover indicate more profitable
use of the investment in inventory and lowering costs for
financing and carrying inventory.
• On the other hand, a firm does not want to have so little
inventory on hand that shortages result and the firm misses
sales opportunities.
Activity Ratios - Days Outstanding Ratios
➢How many days, on average, are accounts outstanding?
E.g., Days Inventory of 50 means, on average, inventories
are on hand for 50 days, or it takes 50 days from building
inventory to selling it.
➢ In “days” = 365 / Turnover.
✓ Days Receivable (Sales) Outstanding (365 ÷ A/R Turnover)
✓ Days Inventory Outstanding (365 ÷ Inventory Turnover)
✓ Days Payable Outstanding (365 ÷ A/P Turnover)
 Example
➢ AR turnover:
• Sales: $1 Mil;
Beginning accounts receivables: $300,000;
Ending accounts receivables : $100,000.
• AR turnover: 5
• Interpretation: On average, AR turned over 5
times during the financial year, or 72 days per
year.
• However, there may be some AR that take
more than 72 days or less than that.
 More on Inventory Turnover
➢Interpretation of inventory turnover involves two
opposing considerations.
– Keep minimum inventories because inventories are subject to
obsolescence or spoilage ➔ High inventory turnover indicate more
profitable use of investment in inventory
– But, not too little inventories on hand because the firm might misses
sales opportunities ➔ High inventory turnover may indicate a loss of
sales opportunities

➢Firms try to decide optimum level of inventories based on

trade-off between these two considerations.
– E.g., Which company has higher inventory turnover? Tiffany vs. Starbucks
 More on Inventory Turnover
Inventory Turnover
Increase Decrease
▪Lowers prices to sell ▪Weak economic conditions
inventory quickly lead to reduced demand,
▪Shift product mix to low requiring the firm reduce the
Increase margin, fast-moving prdt. price.
▪Outsources the product ▪Despite price reduction,
requiring the firm share inventory builds up.
COGS margin with outsourcers
/ Sales
▪Strong economic ▪Raise prices to increase gross
conditions lead to high margin
demand, allowing price ▪Shift product mix to high
Decrease increases. margin, slow-moving product.
▪Implementing better ▪Produces higher proportion of
inventory management the product
system (e.g., JIT).
 Example
2019 2018 2017 2016 2015
Net Sales $244,524 $217,799 $191,329 $165,013 $137,634
Cost of Goods Sold
191,838 171,562 150,255 129,664 108,725

Beginning
Inventory
22,614 21,442 19,793 17,076 16,497
Ending Inventory
24,891 22,614 21,442 19,793 17,076

Find inventory turnover and days in inventory.

What’s your interpretation?
 Example
2019 2018 2017 2016 2015
Net Sales $244,524 $217,799 $191,329 $165,013 $137,634
Cost of Goods Sold
191,838 171,562 150,255 129,664 108,725
COGS/Sales 78.45% 78.77% 78.53% 78.58% 79.00%
Turnover 8.08 7.79 7.29 7.03 6.48
Days in inventory 45.19 46.86 50.08 51.89 56.35

Find inventory turnover and days in inventory.

What’s your interpretation?
 Activity Ratios – Turnover Ratios
➢Fixed Asset Turnover (Sales / Avg. Net PP&E)
• How efficient a company is at using its existing fixed
assets to generate sales.
• An increasing fixed assets turnover ratio generally
indicates greater efficiency in the use of existing fixed
assets to generate sales.
• Firms invest in fixed assets in anticipation of higher
production and sales in future periods. Thus, a temporarily
low or decreasing rate of fixed assets turnover may be a
positive signal of an expanding firm preparing for future
growth.
 Summary of Profitability Analysis
Level 1 ROA

Level 2 Profit Margin Asset Turnover

Expense ratios for Turnover ratios for

Level 3
individual cost items individual assets

Profit Margin Asset Turnover

Level 4 Segment Analysis Segment Analysis
 Quick Check Question 3
➢ Which of the following is least likely a limitation of
financial ratios?

a. Data on comparable firms are difficult to acquire.

b. Determining the target or comparison value for a ratio
requires judgements.
c. Different accounting treatments require the analyst to
adjust the data before comparing ratios.
 Quick Check Question 4
➢ PQR Inc. has a gross profit of $45,000 on sales of $150,000.
The balance sheet shows average total assets of $75,000
with an average inventory balance of $15,000. PQR’s total
asset turnover and inventory turnover are closest to:
➢ Asset turnover Inventory turnover
a. 7 times 2 times
b. 2 times 7 times
c. 0.5 times 0.33 times
 Quick Check Question 5
➢ ABC Inc. an annual sales of $100,000, average accounts
payable of $30,000, and average accounts receivable of
$25,000, ABC’s receivable turnover and average collection
period are closest to:
➢ Receivable turnover Average collection period
a. 2.1 times 174 days
b. 3.3 times 111 days
c. 4.0 times 91 days
 Quick Check Question 6
➢ LMN Inc.’s receivable turnover is ten times, the inventory
turnover is five times, and the payables turnover is nine
times. LMN’s cash conversion cycle is closest to:

a. 69 days
b. 104 days
c. 150 days
 (Short-term) Liquidity Ratios
➢ The firm’s ability to satisfy near-term payment obligations
to suppliers, employees, and creditors
➢ Current Ratio (Current Assets / Current Liabilities)
– ability to pay current liabilities within one year
➢ Acid (Quick) Ratio [(Cash + Short-term investments +
Accounts Receivable) / Current Liabilities]
– ability to pay current liabilities within about 90 days
 (Short-term) Liquidity Ratios
➢ The firm’s ability to satisfy near-term payment obligations
to suppliers, employees, and creditors
➢ Cash Ratio (Cash / Current Liabilities)
– ability to pay current liabilities from cash, i.e. without
liquidating other assets
➢ CFO to Current Liability (CFO / Avg. Current Liabilities)
– indicator of a firm’s ability to generate cash in the near
term
 (Short-term) Liquidity Ratios
➢ Current Ratio (Current Assets / Current Liabilities)
• Ability to pay current liabilities within one year
• Average current ratios is hovering around 1.0, or even just
below 1.0, are now common.
• A firm with stable and large CFO may function effectively
with a low current ratio, whereas a firm with volatile CFO
may not.
• During a recession, firms may have difficulties in selling
inventories and collecting receivables, causing the current
ratio to increase. In a boom period, the reverse can occur.
• The current ratio is susceptible to window dressing; managers
can take deliberate steps prior to the balance sheet date to
produce a better current ratio.
 (Short-term) Liquidity Ratios
➢ Acid (Quick) Ratio [(Cash + Short-term investments +
Accounts Receivable) / Current Liabilities]
• Ability to pay current liabilities within about 90 days
• The quick ratio requires a similar contextual interpretation as
the current ratio. That is, you should interpret quick ratios in
the context of the many other factors that affect the firm’s
liquidity, including the firm’s ability to generate cash flows
from operations.
 (Short-term) Liquidity Ratios
➢ CFO to Current Liability (CFO / Avg. Current Liabilities)
• Ability to generate cash in the near term from operations
relative to the liabilities due within one year
• A ratio of 0.40 or more is common for a typical healthy
manufacturing or retailing firm.
 (Short-term) Liquidity Ratios
➢ Working Capital Turnover Ratios : A/R, Inventory, A/P
• Accounts Payable Turnover (Purchases / Avg. A/P)
– The speed at which the firms pays for purchases of raw materials
and inventories on account.
– Note: Purchases = Ending Inv.+COGS-Begging Inv.
• Cash Conversion Cycle = Days A/R + Days Inv. - Days A/P,
– represent the gap between cash outflows and cash inflows that we
have to bridge with short-term borrowing

Raw Materials Sales Cash In

Days Inv. Days A/R

Days A/P CCC

A/P Cash Out
 Example
Current Assets: Current Liabilities:
Cash $ 23,000 Accounts Payable $104,000
Accounts Receivable 79,000 Accrued Liabilities 40,000
Merchandise 184,000 Short-Term Notes 47,000
Inventory Payable
Total Current Assets $286,000 Total Current Liabilities $191,000
Long-Term Liabilities $221,000
Total Liabilities $412,000

Find current ratio, acid ratio, cash ratio.

 Example
Current ratio = CA/CL = 286/191 = 1.50

Acid ratio = (23 + 79)/191 = 0.53

Cash ratio = 23/191 = 0.12

 Asset Composition

➢ The various compositions of asset structure

may influence the interpretation of an
accounting ratio

➢ Because each item of asset exhibits different

characteristics that affect ratio analysis
 Example
A B
Current ratio 2.3 2.3
Current Assets (%)
Cash 35% 11%
Marketable Securities 16% 00%
Debtors (A/R) 16% 45%
Inventories 28% 42%
Prepayments 5% 2%
Total Current Assets 100% 100%
Do you think they are similar? Which company
looks more sound in terms of liquidity?
 (Long-term) Solvency Ratios
➢ Indicate how does the company finance its growth?
➢ Also provide measure of bankruptcy risk and borrowing
capacity. In general, the higher a debt ratio, the greater is
long-term solvency.
➢ Liabilities to Equity
(Total Liabilities / Total Shareholders’ Equity)
➢ Liabilities to Assets
(Total Liabilities / Total Assets)
➢ Long-term Debt to Equity Ratio
(Long-term debt / Total Shareholders’ Equity)
– indicates level of financial leverage and capital risks
 (Long-term) Solvency Ratios
➢ Interest Coverage Ratio
– Indicate the number of times a firm’s income or cash
flows could cover interest charges.
– Two versions of the interest coverage ratio include the
net income basis and the cash flow basis:
– (Net Income + Interest Expense + Tax Expense) / Interest
Expense
– (Cash from Operations + Cash Interest Paid + Cash
Taxes) / Cash Interest Paid
 Analyzing Credit Risk
➢Credit risk is the likelihood that a firm will be
unable to repay periodic interest and all principal
borrowed; to assess credit risk, lenders start with
short-term liquidity and long-term solvency ratios.
 Analyzing Credit Risk
➢They also consider these factors:
➢ Circumstances leading to the need for the loan
➢ Credit history
➢ Cash flows
➢ Collateralized assets
➢ Capacity for debt
➢ Contingencies
➢ Character of management and communications
➢ Conditions or covenants
 Credit History and Cash Flows
➢Lenders like to see that a firm has borrowed in the past
and successfully repaid the loans.
➢Lenders prefer that firms generate sufficient cash flows
to pay interest and repay principal on a loan
(collectively referred to as debt service) rather than
having to rely on selling collateral.
➢Tools for studying the cash-generating ability of a firm
include examining the statement of cash flows for
recent years, computing various cash flow financial
ratios, and studying cash flows in projected financial
statements.
 Statement of Cash Flows
➢ The statement of cash flows for recent years is analyzed to
determine whether a firm is experiencing potential cash flow
problems.
➢ Some indicators of potential cash flow problems include:
➢ Growth rate in accounts receivable or inventories that exceeds
the growth rate in sales
➢ Increases in accounts payable that exceed increases in
inventories
➢ Persistent negative cash flows from operations because of net
losses or substantial increases in net working capital
➢ Capital expenditures that substantially exceed cash flows from
operations
➢ Reductions in capital expenditures that occur over time
➢ A reduction or elimination of dividend payments or stock
repurchases
➢ Available revolving lines of credit that are fully utilized
 Collateral and Capacity for Debt
➢The availability and value of collateral for a loan are
important determinants of a firm’s ability to borrow.
➢Commonly collateralized assets include marketable
securities; accounts receivable; inventories; and
property, plant, and equipment.
➢Cash flows and collateral represent the means to repay
debt.
➢Most firms do not borrow up to the limit of their debt
capacity, and lenders like to see a “margin of safety.”
 Contingencies and Character of
Management
➢ The credit standing of a firm can change abruptly if current
uncertainties turn out negatively for the firm.
➢ Possible contingencies include:
➢ Environmental matters
➢ Indemnifications provided as part of business divestitures
➢ Lawsuits or various purchase obligations
➢ Receivables sold with recourse or guarantor on a loan
➢ Loss of key employees, contracts, license agreements, or
technology
➢ The character of the firm’s management is an intangible
element that can offset to some extent otherwise weak
signals about the creditworthiness of a firm.
 Communication and Conditions or
Covenants
➢ Developing relationships with lenders requires effective
communication at the outset and on an ongoing basis.
➢ Lenders often place restrictions, or constraints, on a firm to
protect their interests, known as covenants.
➢ Such restrictions might include minimum or maximum
levels of certain financial ratios.
➢ Violation of such covenants can trigger immediate
repayment of loans, higher interest rates, or other
burdensome restrictions on the operations and financing
decisions of a firm.
 Analyzing Bankruptcy Risk
➢ During the recession of 2008 to 2009, a staggering
number of large, well-known firms filed for bankruptcy,
including Lehman Brothers (September 2008),
Washington Mutual (September 2008), Chrysler (April
2009), and General Motors (June 2009).
➢ Subsequently, many more typically healthy firms filed
for bankruptcy.
 Analyzing Bankruptcy Risk
➢ Firms typically file for bankruptcy when they have
insufficient cash to pay creditors’ claims coming due. If
such firms did not file for bankruptcy, creditors could
exercise their right to take possession of any collateral
pledged to secure their lending and effectively begin
liquidation of the firm.
➢ To keep assets intact and operating activities functioning
and to allow time for the firm to reorganize, the firm files
for bankruptcy.
 Analyzing Bankruptcy Risk
➢ Because of the potential for extreme losses by investors,
empirical studies of bankruptcy attempt to distinguish
the financial characteristics of firms that file for
bankruptcy from those that do not.
➢ The objective is to develop a model that predicts which
firms will likely file for bankruptcy within the near-term.
These models use financial statement ratios.
 Analyzing Bankruptcy Risk
➢ Early research on bankruptcy prediction in the mid-
1960s used univariate analysis to predict the likelihood
of bankruptcy.
➢ For example, William Beaver, one of the preeminent
scholars in accounting research, studied 29 financial
statement ratios for the five years preceding bankruptcy
using a sample of 79 bankrupt and 79 nonbankrupt firms.
➢ The objective was to identify the ratios that best
differentiated between these two groups of firms and to
determine how many years prior to bankruptcy the
differences in the ratios emerged.
 Analyzing Bankruptcy Risk
➢ The six ratios with the best discriminating power (and
the nature of the risk that each ratio measures) were as
follows:
• Net Income plus Depreciation, Depletion, and
Amortization/Total Liabilities (long-term solvency risk)
• Net Income/Total Assets (profitability)
• Total Debt/Total Assets (long-term solvency risk)
• Net Working Capital/Total Assets (short-term liquidity risk)
• Current Assets/Current Liabilities (short-term liquidity risk)
• Cash, Marketable Securities, Accounts Receivable/Operating
Expenses Excluding Depreciation, Depletion, and
Amortization (short-term liquidity risk)
 Analyzing Bankruptcy Risk
➢ During the late 1960s and throughout the 1970s,
deficiencies of univariate analysis led researchers to use
multiple discriminant analysis (MDA), a multivariate
statistical technique, to develop bankruptcy prediction
models.
➢ Researchers typically selected a sample of bankrupt
firms and matched them with healthy firms of
approximately the same size in the same industry. This
matching procedure attempts to control factors for size
and industry so you can examine the impact of other
factors that might explain bankruptcy.
 Analyzing Bankruptcy Risk
➢ Analysis of distress risks of a company using a quantitative model
➢ The Altman Z-Score (1968) –
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6 X4 + 1.0X5
X1 = Working Capital / Total Assets
X2 = Retained Earnings / Total Assets
X3 = EBIT / Total Assets
X4 = Market Value Equity / Book Value Liabilities
X5 = Sales / Total Assets
Above 3.00 = Healthy Firm; Below 1.81 = Distressed Firm
3.00 > Z > 1.81 = Gray Area
 Analyzing Bankruptcy Risk
➢ We can convert the Z-score into a more intuitive
probability of bankruptcy using the normal density
function.
➢ A Z-score of 3.00 translates into a probability of
bankruptcy of 2.75%. A Z-score of 1.81 translates into a
probability of bankruptcy of 20.90%.
 Analyzing Bankruptcy Risk
➢ Thus, Z-scores that correspond to probabilities of less
than 2.75% indicate low probability of bankruptcy,
probabilities between 2.75% and 20.90% are in the gray
area, and probabilities above 20.90% are in the high
probability area.
➢ Altman obtained a 95% correct prediction accuracy rate
one year prior to bankruptcy. The correct prediction rate
two years before bankruptcy was 83%.
 Analyzing Bankruptcy Risk
➢ Thus, Z-scores that correspond to probabilities of less
than 2.75% indicate low probability of bankruptcy,
probabilities between 2.75% and 20.90% are in the gray
area, and probabilities above 20.90% are in the high
probability area.
➢ Altman obtained a 95% correct prediction accuracy rate
one year prior to bankruptcy. The correct prediction rate
two years before bankruptcy was 83%.
 Analyzing Bankruptcy Risk
The calculation of Altman’s Z-score for Clorox for 2020.
Clorox’s Z-score of 5.9 clearly indicates
a very low probability of bankruptcy (0.0%).
 Analyzing Bankruptcy Risk
➢ The principal strengths of MDA are as follows:
• It incorporates multiple financial ratios simultaneously.
• It provides the appropriate coefficients for combining the
independent variables.
• It is easy to apply once the initial model has been developed.
 Analyzing Bankruptcy Risk
➢ The principal criticisms of MDA are as follows:
• The researcher cannot be sure that the MDA model includes
all relevant discriminating financial ratios. MDA selects the
best ratios from those provided, but that set does not
necessarily provide the best explanatory power.
• The researcher must subjectively judge the value of the cut-
off score that best distinguishes bankrupt from nonbankrupt
firms.
• The development and application of the MDA model requires
firms to disclose the information needed to compute each
financial ratio. Firms excluded because they do not provide
the necessary data may bias the MDA model.
 Analyzing Bankruptcy Risk
➢ The principal criticisms of MDA are as follows:
(continue)
• MDA assumes that each of the financial ratios for bankrupt
and nonbankrupt firms is normally distributed. Firms
experiencing financial distress often display unusually large
or small ratios that can skew the distribution away from
normal. In addition, the researcher cannot include indicator
variables (for example, 0 if financial statements are audited
and 1 if they are not audited). Indicator variables are not
normally distributed.
• MDA requires that the variance-covariance matrix of the
explanatory variables be the same for bankrupt and
nonbankrupt firms.
 Quick Check Question 7
➢ All other things held constant, which of the following
transactions will increase a firm’s current ratio if the ratio is
greater than one?

a. Accounts receivable are collected, and the funds received

are deposited in the firm’s cash account.
b. Fixed assets are purchased from the cash account.
c. Accounts payable are paid with funds from the cash
account.
 Quick Check Question 8
➢ ABC Inc.’s income statement shows sales of $1,000, cost
of goods sold of $400, pre-interest expense of $300, and
interest expense of $100. ABC’s interest coverage ratio is
closest to:

a. 2 times
b. 3 times
c. 4 times
 Market Ratios
➢ Earnings per Share (EPS)
(Net profit attributable to common shareholders /
Weighted average # of common shares outstanding)
– One of the most widely used measures of profitability
– EPS is the only financial ratio that IFRS and U.S. GAAP
requires firms to disclose and audited by auditors.
– Criticisms of using EPS as profitability measure
➢ Price-Earnings Ratio
(Share price per share / Earnings per share)
– Willingness of investors in paying premiums for a share
– Indication whether the stock is over-/under-valued
 Market Ratios
➢ Dividend Yield Ratio
(Dividend per share / Share price per share)
– Relative return rate of investment through receipt of
dividends
➢ Dividend Payout Ratio
(Dividend per share / Earnings per share)
–Indication of management intention to retain earnings.
Also indicates management practice in dividend
payment.
 Average versus Ending Values
➢ Turnover ratios:
• Inventory turnover, AR turnover, AP turnover, Asset
turnover, etc.
➢ Aims to measure performance during the
financial year. For instance,
• On average, how frequent each inventory item is sold
during the year
• On average, how long a company takes to collect cash
from account receivables
• On average, how long a company takes to pay back its
payables to suppliers
• On average, how much sales a company generates
using its asset
 Average versus Ending Values

➢ ROA and ROE

➢ As before, aims to measure performance
during the financial year
• How profitable a company has been during the
financial year

Note that some textbooks and practitioners use the yearly

end figures
 Average versus Ending Values
➢ Liquidity ratios: current ratio, quick ratio, cash
ratio, etc.
➢ Each of liquidity ratios aims to measure the
ability of a firm to pay its current obligations (at
the moment).
➢ In this case, it makes sense to use yearly end
figures instead of average.
 Average versus Ending Values
➢ Long-term solvency ratios: Debt to equity ratio,
Total liabilities to total equity, etc.
➢ Each of these ratios aims to measure the ability of
a firm to meet long-term obligations (at the
moment).
➢ In this case, it makes sense to use yearly end
figures instead of average.
Adjustments for Nonrecurring or Special Items
➢ Whether reported net income includes any nonrecurring
or special items affects assessments of a firm’s ongoing
profitability.
➢ The notes to the financial statements and the MD&A
provide information for making these assessments.
➢ Sometimes companies provide forward-looking
information that helps you assess the persistence of such
items.
Adjustments for Nonrecurring or Special Items
➢ When deciding whether to eliminate any of these special
items as part of assessing sustainable profitability, you
should consider whether the event that triggered the gain
or loss is likely to persist.
➢ If an amount is likely to persist, then you should leave it
in the reported profitability in the numerator of ROA or
ROE, but if it is likely to be nonrecurring, then you would
remove its effect from the numerator.
➢ Another approach is to leave the special items in earnings
but specifically highlight them as nonrecurring when
qualitatively analyzing ongoing profitability, which is also
a fairly common, and perhaps preferable, approach.
Adjustments for Nonrecurring or Special Items
➢ To adjust a nonrecurring item in the ROA or ROE
calculation, simply add back a one-time expense or
deduct a one-time gain to the numerators.
➢ All adjustments should be net of income tax effects, as we
did for the interest adjustment previously.
➢ If a firm discloses the effect of the unusual item net of tax
effects, we could use that reported amount.
➢ Otherwise, we assume that the current marginal statutory
tax rate applies.
➢ Adjusted NI = Net Income - one-time gain*(1-tax rate)
or Net Income + one-time loss*(1-tax rate)