Chapter 3

Financial Statement
Analysis
To Thi Thanh Truc
Faculty of Finance and Banking
University of Economics and Law

3-1
 Learning outcomes
After finishing this chapter you should be able to:
 Explain why financial statement analysis is important to the

firm and to outside suppliers of capital.

 Define, calculate, and categorize the major financial ratios

and understand what they can tell us about the firm.

 Use ratios to analyze a firm’s health and then recommend
reasonable alternative courses of action to improve the
health of the firm.
 Analyze a firm’s return on assets and return on equity using

a Du Pont approach.
 Explain the limitations of financial ratio analysis.

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Outline
 Introduction to financial analysis
 Common-size and index analysis
 Ratio Analysis
 Du Pont system
 Effects of improving ratios
 Limitations of ratio analysis
 Qualitative factors 3-3
 Introduction to financial
statement analysis

Financial statement analysis?

 The application of analytical tools and techniques to
financial statements and related data to drive useful
estimates and inferences.
 Financial statement analysis involves:
 Comparing the firm’s performance to that of other
firms in the same industry (benchmarking).
 Evaluating trends in the firm’s financial position
over time.

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 Introduction to financial
statement analysis
Will I
be paid?
Creditors
How
good is our
investment? How are we
performing?
Stockholders

Management
3-5
 Analytical techniques

 Comparative financial statement

analysis: Year – to – Year change
analysis, Index – number trend Analysis.
 Common-Size Statements analysis
 Ratio Analysis

3-6
 Financial statement analysis:
comparison
Company XYZ
1 intracompany basis
Year 1 Year 2

2 industry averages

3 intercompany basis
Co. A Co. C
Co. B
Co. ABC Co. XYZ
Co. D Co. E

3-7
 Comparative financial
statement analysis
Reviewing consecutive financial
statements from period to period, involves a
review of changes in individual account balances
on a year-to-year or multiyear basis.

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 Comparative financial
statement analysis (Horizontal analysis)

Information revealed is trend:

direction, speed, and extent of
trend.

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Comparative FS analysis

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Common-Size Statements Analysis
(Vertical or Standardized analysis)

An analysis of percentage financial

statements where all balance sheet
items are divided by total assets
and all income statement items are
divided by net sales or revenues

3-11
Common-size statements analysis

3-12
A Case for Comparative &
common-Size analysis

3-13
 Percentage Change Analysis:
Percentage Change from First Year (20X1)

Income St. 20X1 20X2 20X3

Sales 0.0% 70.0% 105.0%
COGS 0.0% 73.9% 102.5%
Other exp. 0.0% 111.8% 80.3%
Depr. 0.0% 518.8% 534.9%
EBIT 0.0% -91.7% 140.4%
Int. Exp. 0.0% 181.6% 28.0%
EBT 0.0% -208.2% 188.3%
Taxes 0.0% -208.2% 188.3%
NI 0.0% -208.2% 188.3%
3-14
Analysis of Percent Change
Income Statement
 We see that 20X3 sales grew 105%
from 20X1 and that NI grew 188%
from 20X1.
 So the firm has become more
profitable.

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Percentage Change Analysis:
Percentage Change from First Year (20X1)

Assets 20X1 20X2 20X3

Cash 0.0% -19.1% 55.6%
ST Invest. 0.0% -58.8% 47.4%
AR 0.0% 80.0% 150.0%
Invent. 0.0% 80.0% 140.0%
Total CA 0.0% 73.2% 138.4%
Net FA 0.0% 172.6% 142.7%
TA 0.0% 96.5% 139.4%
3-16
Percentage Change Analysis:
Percentage Change from First Year (20X1)

Liab. & Eq. 20X1 20X2 20X3

AP 0.0% 122.5% 147.1%
Notes pay. 0.0% 260.0% 50.0%
Accruals 0.0% 109.5% 179.4%
Total CL 0.0% 175.9% 115.9%
LT Debt 0.0% 209.2% 54.6%
Total eq. 0.0% -16.0% 197.9%
Total L&E 0.0% 96.5% 139.4%
3-17
Analysis of Percent Change:
Balance Sheets
 We see that total assets grew at a rate
of 139%, while sales grew at a rate of
only 105%. So asset utilization remains
a problem.

3-18
Common Size Income Statement
Divide all items by Sales

20X1 20X2 20X3 Ind.

Sales 100.0% 100.0% 100.0% 100.0%
COGS 83.4% 85.4% 82.4% 84.5%
Other exp. 9.9% 12.3% 8.7% 4.4%
Depr. 0.6% 2.0% 1.7% 4.0%
EBIT 6.1% 0.3% 7.1% 7.1%
Int. Exp. 1.8% 3.0% 1.1% 1.1%
EBT 4.3% -2.7% 6.0% 5.9%
Taxes 1.7% -1.1% 2.4% 2.4%
NI 2.6% -1.6% 3.6% 3.6%
3-19
Analysis of Common Size
Income Statements
 The firm has lower COGS (82.4) than
industry (84.5), but higher other
expenses. Result is that the firm has
similar EBIT (7.1) as industry.

3-20
 Common Size Balance Sheets:
Divide all items by Total Assets

Assets 20X1 20X2 20X3 Ind.

Cash 0.6% 0.3% 0.4% 0.3%
ST Invest. 3.3% 0.7% 2.0% 0.3%
AR 23.9% 21.9% 25.0% 22.4%
Invent. 48.7% 44.6% 48.8% 41.2%
Total CA 76.5% 67.4% 76.2% 64.1%
Net FA 23.5% 32.6% 23.8% 35.9%
TA 100.0% 100.0% 100.0% 100.0%
3-21
 Common Size Balance Sheets:
Divide all items by
Total Liabilities & Equity
20X1 20X2 20X3 Ind.
AP 9.9% 11.2% 10.2% 11.9%
Notes pay. 13.6% 24.9% 8.5% 2.4%
Accruals 9.3% 9.9% 10.8% 9.5%
Total CL 32.8% 46.0% 29.6% 23.7%
LT Debt 22.0% 34.6% 14.2% 26.3%
Total eq. 45.2% 19.3% 56.2% 50.0%
Total L&E 100.0% 100.0% 100.0% 100.0%
3-22
 Analysis of Common Size
Balance Sheets
 The firm has higher proportion of
inventory and current assets than
Industry.
 The firm now has more equity (which
means LESS debt) than Industry.
 The firm has more short-term debt than
industry, but less long-term debt than
industry.

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Ratio Analysis

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Ratio analysis: Definition
A ratio expresses a mathematic relation
between two quantities (two accounts on
financial statements).
A ratio must refer to an economically
important relation.

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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
 Trend analysis
 Peer (or Industry) analysis

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 What are the major categories of ratios,
and what questions do they answer?
Give us an idea of:
1. Liquidity: the firm’s ability to pay off debts maturing within a
year.
2. Asset management: how efficiently the firm uses its assets,
whether the firm has the right amount of assets vs. sales.
3. Debt management: how the firm has financed its assets and
its ability to repay its long-term debt. Whether the firm has
the right mix of debt and equity.
4. Profitability: How profitably the firm is operating and
utilizing its assets.
5. Market value: what investors think about the firm and its
prospects.
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 Ratio analysis

 As we look at each ratio, ask yourself:

 How is the ratio computed?
 What is the ratio trying to measure and why?
 What is the unit of measurement?
 What does the value indicate?
 How can we improve the company’s ratio?
 All of the ratios are important, but different
ones are more important for some companies
than for others
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The D’Leon Inc. case
Balance Sheet: Assets
2019E 2018
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: Dep. 380,120 263,160
Net FA 817,040 939,790
Total Assets 3,497,152 2,866,592
3-29
The D’Leon Inc. case
Balance sheet: Liabilities and Equity
2019E 2018
Accts payable 436,800 524,160
Notes payable 300,000 636,808
Accruals 408,000 489,600
Total CL 1,144,800 1,650,568
Long-term debt 400,000 723,432
Common stock 1,721,176 460,000
Retained earnings 231,176 32,592
Total Equity 1,952,352 492,592
Total L & E 3,497,152 2,866,592
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 The D’Leon Inc. case
Income statement
2019E 2018
Sales 7,035,600 6,034,000
COGS 5,875,992 5,528,000
Other expenses 550,000 519,988
EBITDA 609,608 (13,988)
Depr. & Amort. 116,960 116,960
EBIT 492,648 (130,948)
Interest Exp. 70,008 136,012
EBT 422,640 (266,960)
Taxes 169,056 (106,784)
Net income 253,584 (160,176)
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The D’Leon Inc. case
Other data
2019E 2018
No. of shares 250,000 100,000
EPS $1.014 -$1.602
DPS $0.220 $0.110
Stock price $12.17 $2.25
Lease pmts $40,000 $40,000

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Liquidity ratio

3-33
 Liquidity Ratios
 Will the firm be able to pay off its debts as they
come due and thus remains a viable organization?
 Liquidity Ratios: show the relationship of a firm’s
cash and other current assets to its current liabilities
 Current ratio
 Quick ratio

3-34
 Liquidity Ratios
Current ratio (CR)

 Indicates the extent to which current liabilities are covered by those

assets expected to be converted to cash in the near future.
 If current liabilities are rising faster than current assets, the current
ratio will fall, and this is a sign of possible trouble.
 High CR indicates a very strong, safe liquidity position; it might also
indicate that the firm has too much old inventory and old accounts
receivable that may turn into bad debts Or that the firm has too much
cash, receivables, and inventory relative to its sales.

3-35
 Liquidity Ratios
Quick (acid test) ratio

 The extent to which current liabilities are covered by

those assets expected to be easily converted to cash
in the near future.
 Inventories are typically the least liquid of current
assets.
 Also, inventories are the assets on which losses are
most likely to occur in the event of liquidation.

3-36
 Calculate D’Leon’s forecasted current
ratio and quick ratio for 2019.

Current ratio = Current assets / Current liabilities

= $2,680 / $1,145
= 2.34x
Quick ratio = (CA – Inventories) / CL
= ($2,680 – $1,716) / $1,145
= 0.84x

3-37
 Comments on D’Leon’s
liquidity ratios
2019E 2018 2017 Ind.
Current Ratio 2.34x 1.20x 2.30x 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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Assets Management ratio
A set of ratios that measure how effectively a
firm is managing its assets.

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 Asset Management Ratios
 Does the amount of each type of asset seem reasonable, too
high, or too low in view of current and projected sales?
 If firm has too many assets, its cost of capital will be too high,
which will depress its profits. On the other hand, if its assets
are too low, profitable sales will be lost
 Inventory turnover ratio

 Days sales outstanding

 Fixed assets turnover ratio

 Total assets turnover ratio

3-40
 Asset Management Ratios
Inventory turnover ratio (ITR)
 Calculated by dividing sales by inventories. It indicates how
many times inventory is turned over during the year

 Indicates how many times per year inventory is sold and restocked.
 ITR helps businesses make smarter decisions in a variety of areas
(pricing, manufacturing, marketing, purchasing and warehouse
management)
 A low turnover implies weak sales and possibly excess inventory, also
known as overstocking
 A high ratio implies either strong sales or insufficient inventory
 Make an adjustment if the business is highly seasonal
3-41
 Asset Management Ratios
Days sales outstanding (Average
collection period)
Calculated by dividing accounts receivable by average sales per day. It
indicates the average length of time the firm must wait after making a
sale before it receives cash

 Can be compared with the industry average or firm’s credit terms

 A high DSO suggests that the firm is experiencing delays in receiving
payments -> can cause a cash flow problem. If DSO is increasing, it's
a warning sign that something is wrong
 A low DSO value means it takes fewer days to collect its accounts
receivable. However, low AR could lead to lower sales
3-42
 Asset Management Ratios
Fixed assets turnover ratio

The ratio of sales to net fixed assets. It measures how

effectively the firm uses its plant and equipment

 A high ratio indicates that the firm efficiently uses its

fixed assets to generate sales
 Inflation has caused the value of many assets that were
purchased in the past to be seriously understated, as
well as depreciation, causing problems If we compare an
old firm with a new one

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 Asset Management Ratios
Total assets turnover ratio

This ratio is calculated by dividing sales by total assets. It

measures how effectively the firm uses its total assets

 The higher the asset turnover ratio, the better the company
is performing, since higher ratios imply that the company is
generating more revenue per dollar of assets
 The TAT ratio tends to be higher for companies in certain
sectors than in others
 The TAT ratio may be artificially deflated when a firm makes
large asset purchases in anticipation of higher growth. Also,
factors (seasonality) can affect a firm’s TAT ratio
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What is D’Leon’s inventory turnover
vs. the industry average?
Inv. turnover = Sales / Inventories
= $7,036 / $1,716
= 4.10x

2019E 2018 2017 Ind.

Inventory
4.1x 4.70x 4.8x 6.1x
Turnover

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Comments on
D’Leon’s 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.

3-46
 Calculate D’Leon’s DSO

DSO = Receivables / Avg sales per day

= Receivables / (Annual sales/365)
= $878 / ($7,036/365)
= 45.6 days
The average number of days after making a sale
before receiving cash is 45.6 days.

3-47
Appraisal of D’Leon’s DSO
2019E 2018 2017 Ind.
DSO 45.6 38.2 37.4 32.0

 D’Leon collects on sales too slowly,

and is getting worse.
 D’Leon has a poor credit policy.

3-48
D’Leon’s Fixed assets and total assets
turnover ratios vs. the industry average

FA turnover = Sales / Net fixed assets

= $7,036 / $817 = 8.61x

TA turnover = Sales / Total assets

= $7,036 / $3,497 = 2.01x

3-49
Evaluating D’Leon’s FA turnover
and TA turnover ratios
2019E 2018 2017 Ind.
FA TO 8.6x 6.4x 10.0x 7.0x
TA TO 2.0x 2.1x 2.3x 2.6x

 FA turnover projected to exceed the industry

average.
 TA turnover below the industry average.
Caused by excessive current assets (A/R and
Inv).
3-50
Debt Management Ratios
A set of ratios that measure how
effectively a firm manages its debt.

3-51
 Debt Management Ratios
 Decisions about the use of debt require firms to balance
higher expected returns against increased risk
 We examine: (1) the proportion of total funds represented by
debt; (2) the extent to which interest is covered by operating profits
 Total Debt ratio

 Debt to total capital

 Equity Multiplier

 Times-interest-earned ratio

 EBITDA coverage ratio

3-52
Debt Management Ratios
The Impact of Debt on Return and Risk

3-53
Debt Management Ratios
The Impact of Debt on Return and Risk

3-54
 Debt Management Ratios
Total Debt ratio

 The total debt ratio takes into account all debts of all
maturities to all creditors. It can be defined in several
ways, the easiest of which is this:

 How many percent of the total assets are financed with

liabilities

3-55
 Debt Management Ratios

It measures the percentage of the firm’s capital provided

by debtholders.

How many times the company's assets are compared

to its equity.

3-56
 Debt Management Ratios

 All else being equal, the higher the debt ratios, the riskier
the company
 Creditors prefer low debt ratios because the lower the
ratio, the greater the cushion against creditors’ losses in
the event of liquidation
 Stockholders may want more leverage because it can
magnify expected earnings

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 Debt Management Ratios
Times-Interest-Earned (TIE) ratio

 The ratio of earnings before interest and taxes (EBIT) to

interest charges; a measure of the firm’s ability to meet
its annual interest payments.
 A better TIE number means a company has enough cash
after paying its debts to continue to invest in the business
 Failure to pay interest will bring legal action by the firm’s
creditors and probably result in bankruptcy.
 Because interest is paid with pretax dollars, the firm’s
ability to pay current interest is not affected by taxes.

3-58
 Debt Management Ratios
EBITDA coverage ratio

 Measures the ability of an organization to pay off its loan

and lease obligations. This measurement is used to review
the solvency of entities that are highly leveraged.
 This ratio is more complete than the TIE ratio because it
recognizes that DA expenses are not cash expenses, and
thus are available to service debt and that lease payments
and principal repayments on debt are fixed charges.

3-59
 Calculate Debt ratios for D’Leon

Total Debt ratio = Total Assets - Equity / Total assets

= ($3,947 – $1,952) / $3,497
= 44.2%
Debt to capital = Total debt/ Total debt + Equity)
= ($300 + $400) / ($300 + $400 + $1,952)
= 26.4%
Equity Multiplier = Total Assets / Equity
= $3,947 / $1,952
= 2.02

3-60
 Calculate the TIE and EBITDA coverage
ratios for D’Leon.
TIE = EBIT / Interest expense
= $492.6 / $70 = 7.0x

EBITDA (EBITDA + Lease pmts)

=
coverage Int exp + Lease pmts + Principal pmts
$609.6 + $40
=
$70 + $40 + $0
= 5.9x

3-61
 How do D’Leon’s debt management
ratios compare with industry averages?
2019E 2018 2017 Ind.
D/A 44.2% 82.8% 54.8% 50.0%
TIE 7.0x -1.0x 4.3x 6.2x
EBITDA
5.9x 0.1x 3.0x 8.0x
coverage

 D/A and TIE are better than the industry

average, but EBITDA coverage still trails the
industry.
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Profitability ratios

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Profitability Ratios
A group of ratios that show the combined effects of
liquidity, asset management, and debt on operating
results; reflect the net result of all of the firm’s
financing policies and operating decisions.
Profit margin (Return on sales)
 Gross profit margin
 Operating margin
 (Net) profit margin
Return on Capital
 ROA
 RO(C)E
 ROIC
 BEP ratio
3-64
 Profit margin
 Gross Profit margin
Gross profit as a percentage of net sales; Shows the amount of profit
made before deducting selling, general, and administrative costs.

 Operating margin
Measures operating income, or EBIT, per dollar of sales

 Measures how much profit on a dollar of sales after paying for

operatin cost the cost of production, but before paying interest or tax.
 Higher margins are considered better than lower margins.

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 Profit margin
 Net Profit margin
This ratio measures net income per dollar of sales and is
calculated by dividing net income by sales

 Represents what percentage of sales has turned into profits

(after all other expenses, including interest and taxes, have been
removed from revenue).
 When two companies have the same operating margin but
different debt ratios, we can expect the company with a higher
debt ratio to have a lower profit margin.
 While a high return on sales is good, we must also be concerned
with turnover.
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 Return on Capital
 Return on Total assets (ROA)
The ratio of net income to total assets; it measures the rate of return on
the firm’s assets

 An indicator of how well a firm utilizes its assets in terms of

profitability by comparing the profit it generates to the capital it
invests in assets.
 The higher the return, the more productive and efficient
management is in utilizing economic resources.
 Be careful with the scale of a business and the operations
performed when comparing two different firms using ROA.
 ROA does not take into account a company’s debt, while ROE
does. 3-67
 Return on Capital
 Return on Common equity (ROE)
The ratio of net income to common equity; it measures the rate of
return on common stockholders’ investment

 Measures firm’s profitability in relation to stockholders’ equity;

how efficiently a firm can use the money from shareholders to
generate profits and grow the company.
 Investors want to see a high ROE because this indicates that the
company is using its investors’ funds effectively
 However, ROE can be indicative of a number of issues - such as
inconsistent profits or excessive debt (financial leverage
generally increases the ROE but also increases the firm’s risk).
3-68
 Return on Capital

 Return on Invested capital (ROIC)

The ratio of after-tax operating income to total invested capital; it
measures the total return that the company has provided for its
investors.

 ROIC differs from ROA in two ways: (1) its return is based on
total invested capital (Total debt + equity) rather than total
assets; (2) it uses NOPAT rather than net income.
 ROIC simply tells how well the firm is using its money to
generate profit. Besides, ROIC can be compared with WACC. If
ROIC > WACC, managers are creating value in the business.
3-69
 Return on Capital
 Basic earning power (BEP) ratio
 This ratio indicates the ability of the firm’s assets to generate
operating income; it is calculated by dividing EBIT by total
assets

 This ratio shows the 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
 Together with ROA, BEP allows for more accurate
comparisons of companies
3-70
 Calculate D’Leon’s Profit margin

Profit margin = Net income / Sales

= $253.6 / $7,036 = 3.6%

Operating Margin = EBIT / Sales

= $492.6 / $3,497 = 14.1%

3-71
 D’Leon’s Basic earning power (BEP)

BEP = EBIT / Total assets

= $492.6 / $3,497 = 14.1%

3-72
 Appraising D’Leon’s profitability with the
profit margin and basic earning power
2019E 2018 2017 Ind.
PM 3.6% -2.7% 2.6% 3.5%
BEP 14.1% -4.6% 13.0% 19.1%

 Profit margin was very bad in 2018, but is projected to

exceed the industry average in 2019. Looking good.
 BEP removes the effects of taxes and financial leverage
and is useful for comparison.
 BEP is projected to improve, yet still below the industry
average. There is room for improvement.
3-73
 D’Leon’s Return on Capital
ROA = Net income / Total assets
= $253.6 / $3,497 = 7.3%
ROE = Net income / Total common equity
= $253.6 / $1,952 = 13.0%
ROIC= EBIT(1-T)/ (Debt + Equity)
= $492.6(1 – 0.4) / ($700 + 1,952)
= 11.14%
3-74
Appraising D’Leon’s profitability with the
return on assets and return on equity
2019E 2018 2017 Ind.
ROA 7.3% -5.6% 6.0% 9.1%
ROE 13.0% -32.5% 13.3% 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.
3-75
Effects of debt on ROA and ROE
 ROA is lowered by debt--interest
lowers NI, which also lowers ROA =
NI/Assets.
 But use of debt also lowers equity,
hence debt could raise ROE =
NI/Equity.

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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.
 ROE does not consider risk.
 ROE does not consider the amount of capital
invested.
 Might encourage managers to make investment
decisions that do not benefit shareholders.
 ROE focuses only on return and a better
measure would consider risk and return.
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Market value ratios

3-78
 Market Value Ratios
 Ratios that relate the firm’s stock price to its earnings and
book value per share
 The market value ratios are used in three primary ways:

(1) by investors when they are deciding to buy/sell a stock

(2) by investment bankers when they are setting the share
price for a new stock issue (an IPO)
(3) by firms when they are deciding how much to offer for
another firm in a potential merger
 P/E ratio
 P/CF
 M/B (P/B) ratio
 EV/EBITDA ratio
3-79
 Price/Earnings (P/E) ratio
 The ratio of the price per share to earnings per share; shows the
dollar amount investors are willing to pay for $1 of current earnings

 P/E ratio indicates how much an investor is willing to pay for one
dollar of earnings
 A high P/E ratio could mean that a company's stock is
overvalued, or else that investors are expecting high
growth rates in the future (indicates increased demand).
 The P/E ratio can be used to determine the relative value of a
company's shares (valuation).
 Firms with high P/E are considered to be growth stocks.

E=Net income/number of share outstanding 3-80

 Market/Book (M/B or P/B) ratio

 The ratio of a stock’s market price to its book value

 Companies that are well regarded by investors - which

means low risk and high growth - have high M/B ratios
 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

B=Equity on balance sheet/ number of share outstanding

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 Enterprise value / EBITDA
(EV/EBITDA) ratio
 The ratio of a firm’s enterprise value relative to its EBITDA

 EV/EBITDA ratio looks at the relative market value of all

the company’s key financial claims
 Unlike the P/E ratio, the EV/EBITDA ratio is not heavily
influenced by the company’s debt and tax situations
 The subtraction of excess cash makes it easier to compare
companies with very different levels of excess cash

Note: *We may assume that company’s debt is priced at par

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 Calculate D’Leon’s Price/Earnings,
Price/Cash flow ratios.

P/E = Price / Earnings per share

= $12.17 / $1.014 = 12.0x

P/CF = Price / Cash flow per share

= $12.17 / [($253.6+$117.0) ÷ 250]
= 8.21x

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Calculate D’Leon’s Market/Book ratio.

M/B = Market price / Book value per share

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

2019E 2018 2017 Ind.

P/E 12.0x -1.4x 9.7x 14.2x
P/CF 8.21x -5.2x 8.0x 11.0x
M/B 1.56x 0.5x 1.3x 2.4x

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Analyzing D’Leon’s market value
ratios
 P/E: How much investors are willing to pay
for $1 of earnings.
 P/CF: How much investors are willing to pay
for $1 of cash flow.
 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 ROE is high and risk
is low.
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 The DuPont equation

Video
 A formula that shows that the rate of return on equity
can be found as the product of profit margin, total
assets turnover, and the equity multiplier. It shows the
relationships among asset management, debt
management, and profitability ratios
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 The DuPont equation
Profit Total assets Equity
ROE  margin  turnover 
multiplier
ROE  (NI/Sales)  (Sales/TA)  (TA/Equity)

 Focuses on expense control (PM), asset

utilization (TA TO), and debt utilization
(Equity multiplier.)

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Extended DuPont equation:
Breaking down D’Leon’s Return On Equity

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

= 3.6% x 2 x 1.8
= 13.0%
PM TA TO EM ROE
2017 2.6% 2.3 2.2 13.3%
2018 -2.7% 2.1 5.8 -32.5%
2019E 3.6% 2.0 1.8 13.0%
Ind. 3.5% 2.6 2.0 18.2%

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Effects of improving ratios

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An example:
The effects of improving ratios
A/R $ 878 Debt $1,545
Other CA 1,802 Equity 1,952
Net FA 817 _____
TA $3,497 Total L&E $3,497

Sales / day = $7,035,600 / 365 = $19,275.62

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 = $19,275.62 x 45.6 = $878,000
New A/R = $19,275.62 x 32.0 = $616,820
Cash freed up: $261,180

Initially shows up as addition to cash.

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Effect of reducing receivables on
balance sheet and stock price
Added cash $ 261 Debt $1,545
A/R 617 Equity 1,952
Other CA 1,802
Net FA 817 ______
Total Assets $3,497 Total L&E $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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Limitation of ratios &
qualitative factors

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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.
 “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.
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More issues regarding ratios
 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 strong or weak position.

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Qualitative factors to be considered
when evaluating a company’s future
financial performance
 Are the firm’s revenues tied to one key
customer, product, or supplier?
 What percentage of the firm’s business
is generated overseas?
 Competition
 Future prospects
 Legal and regulatory environment

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