CHAPTER 2

Analysis of Financial Statements

 Ratio Analysis
 Du Pont system
 Effects of improving ratios
 Limitations of ratio analysis
 Qualitative factors
 Source: Fundamentals of Financial Management,
Eleventh Edition Eugene F. Brigham and Joel F. Houston
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 RATIO ANALYSIS
Financial statements report both on a firm’s position at a point
in time and on its operations over some past period.
However, the real value of financial statements lies in the fact
that they can be used to help predict future earnings and
dividends.
From an investor’s standpoint, predicting the future is what
financial statement analysis is all about,
While from management’s standpoint, financial statement
analysis is useful both to help anticipate future conditions and,
more important, as a starting point for planning actions that
will improve the firm’s future performance.

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 RATIO ANALYSIS

LIQUIDITY RATIOS
ASSET MANAGEMENT RATIOS
DEBT MANAGEMENT RATIOS
PROFITABILITY RATIOS
MARKET VALUE RATIOS

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 LIQUIDITY RATIOS
Liquid Asset
An asset that can be converted to cash quickly
without having to reduce the asset’s price very
much.
Liquidity Ratios
Ratios that show the relationship of a firm’s cash
and other current assets to its current liabilities.

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 OBLIGATIONS:
CURRENT RATIO
This ratio indicates the extent to which current liabilities
are covered by those assets expected to be converted
to cash in the near future.
This ratio is calculated by dividing current assets by
current liabilities.

Current assets normally include cash, marketable

securities, accounts receivable, and inventories.
Current liabilities consist of accounts payable, short-
term notes payable, current maturities of long-term
debt, accrued taxes, and other accrued expenses
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 THE BALANCE SHEET

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It should be noted that an industry average is not a
magic number that all firms should strive to maintain
—in fact, some very well-managed firms will be
above the average while other good firms will be
below it. However, if a firm’s ratios are far removed
from the averages for its industry, an analyst should be
concerned about why this variance occurs. Thus, a
deviation from the industry average should signal the
analyst
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 QUICK, OR ACID TEST, RATIO
Inventories are typically the least liquid of a firm’s current
assets, hence they are the assets on which losses are most
likely to occur in the event of liquidation.
This ratio is calculated by deducting inventories from current
assets and dividing the remainder by current liabilities.

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 ASSET MANAGEMENT RATIOS
 Does the total amount of each type of asset as
reported on the balance sheet seem reasonable,
too high, or too low in view of current and
projected sales levels?
 When they acquire assets, companies must
borrow or obtain capital from other sources.
 If a firm has too many assets, its cost of capital
will be too high, hence its profits will be
depressed.
 On the other hand, if assets are too low, profitable
sales will be lost.

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 ASSET MANAGEMENT RATIOS
 A set of ratios that measure how effectively a firm is
EVALUATING
managing INVENTORIES:
its assets.
THE INVENTORY TURNOVER
RATIO
This ratio is calculated by dividing sales by inventories.

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Note that sales occur over the entire year, whereas the
inventory figure is for one point in time. For this
reason, it is better to use an average inventory
measure.
If the firm’s business is highly seasonal, or if there has
been a strong upward or downward sales trend during
the year, it is especially useful to make some such
adjustment. To maintain comparability with industry
averages, however, we did not use the average
inventory figure.
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 EVALUATING RECEIVABLES:
THE DAYS SALES OUTSTANDING
This ratio indicates the average length of time the firm must
wait after making a sale before it receives cash.
It is calculated by dividing accounts receivable by average
sales per day;

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 with a high average DSO, it is likely that a
number of customers are paying very late, and
those customers may well be in financial trouble,
in which case Allied may never be able to collect
the receivable.
Therefore, if the trend in DSO over the past
few years has been rising, but the credit policy
has not been changed, this would be strong
evidence that steps should be taken to expedite
the collection of accounts receivable

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 EVALUATING FIXED ASSETS:
THE FIXED ASSETS TURNOVER
RATIO
The fixed assets turnover ratio measures how effectively
the firm uses its plant and equipment.
It is the ratio of sales to net fixed assets:

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 A potential problem can exist when interpreting the fixed assets
turnover ratio.
 Recall from accounting that fixed assets reflect the historical costs
of the assets.
 Inflation has caused the value of many assets that were purchased
in the past to be seriously understated.
 Therefore, if we were comparing an old firm that had acquired
many of its fixed assets years ago at low prices with a new
company that had acquired its fixed assets only recently, we
would probably find that the old firm had the higher fixed assets
turnover ratio.
 However, this would be more reflective of the difficulty
accountants have in dealing with inflation than of any inefficiency
on the part of the new firm.

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EVALUATING TOTAL ASSETS:
THE TOTAL ASSETS TURNOVER
RATIO
The total assets turnover ratio, measures the turnover of all
the firm’s assets
It is calculated by dividing sales by total assets

If it is below the industry average, it indicates that the company

is not generating a sufficient volume of business given its total
assets investment.
In that case, sales should be increased, some assets should
be disposed of, or a combination of these steps should be
taken.

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 DEBT MANAGEMENT RATIOS
The extent to which a firm uses debt financing, or financial
leverage, has three important implications:
1. By raising funds through debt, stockholders can maintain
control of a firm while limiting their investment.
2. Creditors look to the equity, or owner-supplied funds, to
provide a margin of safety, so the higher the proportion of the
total capital that was provided by stockholders, the less the
risk faced by creditors.
3. If the firm earns more on investments financed with borrowed
funds than it pays in interest, the return on the owners’
capital is magnified, or “leveraged.”
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 To understand better how financial leverage affects
risk and return, consider Table 3-1. Here we analyze
two companies that are identical except for the way
they are financed.
Firm U (for “unleveraged”) has no debt, whereas
Firm L (for “leveraged”) is financed with half equity
and half debt that costs 15 percent.
Both companies have $100 of assets and $100 of
sales, and their expected operating income (also called
earnings before interest and taxes, or EBIT) is $30.
Thus, both firms expect to earn $30, before taxes, on
their assets.
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 HOW THE FIRM IS FINANCED:
Debt Ratio
The ratio of total debt to total assets, generally called the
debt ratio, measures the percentage of funds provided by
creditors:

Total debt includes both current liabilities and long-term

debt.

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Creditors prefer low debt ratios because the lower the
ratio, the greater the cushion against creditors’ losses in
the event of liquidation. Stockholders, on the other hand,
may want more leverage because it magnifies expected
earnings.
Allied’s debt ratio exceeds the industry average raises a
red flag and may make it costly for Allied to borrow
additional funds without first raising more equity capital.
Creditors may be reluctant to lend the firm more money,
and management would probably be subjecting the firm
to the risk of bankruptcy if it sought to increase the debt
ratio any further by borrowing additional funds

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 ABILITY TO PAY INTEREST:
TIMES-INTEREST-EARNED RATIO
Times Interest Earned (TIE) is a measure of the firm’s ability
to meet its annual interest payments.
It is the ratio of earnings before interest and taxes (EBIT) to
interest charges

Allied is covering its interest charges by a relatively low

margin of safety. Thus, the TIE ratio reinforces the conclusion
from our analysis of the debt ratio that Allied would face
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 ABILITY TO SERVICE DEBT:
EBITDA COVERAGE RATIO
The TIE ratio is useful for assessing a company’s ability to meet
interest charges on its debt, but this ratio has two shortcomings:
 Interest is not the only fixed financial charge — companies must
also reduce debt on schedule, and many firms lease assets and
thus must make lease payments. If they fail to repay debt or
meet lease payments, they can be forced into bankruptcy.
 EBIT does not represent all the cash flow available to service
debt, especially if a firm has high depreciation and/or
amortization charges.
1. To account for these deficiencies, bankers and others have
developed the EBITDA coverage ratio, defined as follows:

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  Also, lease payments of $28 million were deducted while calculating EBITDA.
 That $28 million was available to meet financial charges; hence it must be
added back, bringing the total available to cover fixed financial charges to
$411.8 million.
 Allied’s ratio is well below the industry average, so again, the company seems
to have a relatively high level of debt.
 The EBITDA coverage ratio is most useful for relatively short-term lenders such as
banks, which rarely make loans (except real estate-backed loans) for longer than
about five years.
 Over a relatively short period, depreciation generated funds can be used to service
debt. Over a longer time, those funds must be reinvested to maintain the plant and
equipment or else the company cannot remain in business.
 Therefore, banks and other relatively short-term lenders focus on the EBITDA
coverage ratio, whereas long-term bondholders focus on the TIE ratio.

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 PROFITABILITY RATIOS
 A group of ratios that show the combined effects of liquidity, asset management,
and debt on operating results.

Profit Margin on Sales

 This ratio measures net income per dollar of sales; it is calculated by dividing
net income by sales.

 Allied’s profit margin is below the industry average of 5 percent. This sub-par
result occurs because costs are too high. High costs, in turn, generally occur
because of inefficient operations. However, Allied’s low profit margin is also a
result of its heavy use of debt.

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 Basic Earning Power (BEP) Ratio
This ratio indicates the ability of the firm’s assets to generate operating income;
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 leverage, and it is useful for comparing firms with different tax
situations and different degrees of financial leverage.

Because of its low turnover ratios and low profit margin on sales, Allied is not
earning as high a return on its assets as is the average food-processing company.

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 RETURN ON TOTAL ASSETS
The ratio of net income to total assets measures the return on
total assets (ROA) after interest and taxes:

Allied’s 5.7 percent return is well below the 9 percent average

for the industry. This low return results from
(1) the company’s low basic earning power plus
(2) high interest costs resulting from its above-average use of
debt, both of which cause its net income to be relatively low.

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 RETURN ON COMMON EQUITY
Stockholders invest to get a return on their money, and this ratio tells
how well they are doing in an accounting sense.
Common equity is the ratio of net income to common equity, which
measures the return on common equity (ROE):

Allied’s 12.7 percent return is below the 15 percent industry average,

but not as far below as the return on total assets.

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 MARKET VALUE RATIOS
These ratios give management an indication of what investors
think of the company’s past performance and future prospects.

Price/Earnings (P/E) Ratio

• The ratio of the price per share to earnings per share.
• This ratio shows the dollar amount investors will pay for $1 of
current earnings.

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 PRICE/CASH FLOW RATIO
The ratio of price per share divided by cash flow per share
This ratio shows the dollar amount investors will pay for $1 of cash flow.

Allied’s price/cash flow ratio is also below the industry average, once again suggesting that its growth prospects are below average, its risk is above average, or
both.

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 MARKET/BOOK RATIO
Theratio of a stock’s market price to its book value
It
gives an indication of how investors regard the company.
Companies with relatively high rates of return on equity generally sell at higher multiples of book value than those with low returns. First, we find Allied’s book value per share:

Investors are willing to pay less for a dollar of Allied’s book value than for one of an average food-processing company.

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 TREND ANALYSIS
An analysis of a firm’s financial ratios over time
It is used to estimate the likelihood of improvement or
deterioration in its financial condition.

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TYING THE RAT I O S TOGETHER:
THE DU PONT CHART AND EQUATION
A chart designed to show the relationships among return on
investment, asset turnover, profit margin, and leverage.

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 Du Pont Equation
A formula which shows that the rate of return on assets can be
found as the product of the profit margin times the total assets
turnover.
It gives the rate of return on assets (ROA).

If the company is financed only with common equity, the rate
of return on assets (ROA) and the return on equity (ROE)
would be the same because total assets would equal common
equity

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This equality holds if and only if
Total assets = Common equity,
that is, if the company uses no debt. Allied does use debt, so
its common equity is less than total assets. Therefore, the
return to the common stockholders (ROE) must be greater
than the ROA of 5.7 percent. Specifically, the rate of return on
assets (ROA) can be multiplied by the equity multiplier,
which is the ratio of assets to common equity:

Firms that use a large amount of debt financing (more

leverage) will necessarily have a high equity multiplier—the
more the debt, the less the equity, hence the higher the equity
multiplier.

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For example, if a firm has $1,000 of assets and is financed
with $800, or 80 percent debt, then its equity will be $200,
and its equity multiplier will be $1,000/$200 = 5.
Had it used only $200 of debt, then its equity would have
been $800, and its equity multiplier would have been only
$1,000/$800 = 1.25
Allied’s return on equity (ROE) depends on its ROA and its
use of leverage

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The Du Pont equation shows how the profit margin, the total
assets turnover, and the use of debt interact to determine the
return on equity

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Allied’s management can use the Du Pont system to analyze ways of
improving performance.
Focusing on the left, or “profit margin,” side of its modified Du Pont
chart, Allied’s marketing people can study the effects of raising sales
prices (or lowering them to increase volume), of moving into new
products or markets with higher margins, and so on.
The company’s cost accountants can study various expense items and,
working with engineers, purchasing agents, and other operating
personnel, seek ways to hold down costs.
On the “turnover” side, Allied’s financial analysts, working with both
production and marketing people, can investigate ways to reduce the
investment in various types of assets.
At the same time, the treasury staff can analyze the effects of alternative
financing strategies, seeking to hold down interest expense and the risk
of debt while still using leverage to increase the rate of return on equity.

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 COMPARATIVE RATIOS AND
“BENCHMARKING”
Ratio analysis involves comparisons — a company’s ratios are
compared with those of other firms in the same industry, that
is, to industry average figures
The process of comparing a particular company with a group
of “benchmark” companies (Leading companies)
Then the ratios are listed in descending order, as shown below
for the profit margin on sales (as reported on the firms’ latest
quarterly financial statements for 2000 by Hoover’s Online)

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 The benchmarking setup makes it easy for Allied’s
management to see exactly where the company stands
relative to its competition.
As the data show, Allied is in the middle of its benchmark
group with respect to its profit margin, so the company has
room for improvement. Other ratios are analyzed similarly.

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 USES AND LIMITATIONS OF RATIO
ANALYSIS
Ratio analysis is used by three main groups:
(1) managers, who employ ratios to help analyze, control, and thus
improve their firms’ operations;
(2) credit analysts, including bank loan officers and bond rating
analysts, who analyze ratios to help ascertain a company’s ability
to pay its debts; and
(3) stock analysts, who are interested in a company’s efficiency,
risk, and growth prospects.
Some potential problems are listed below:
1. Many large firms operate different divisions in different
industries, and for such companies it is difficult to develop a
meaningful set of industry averages. Therefore, ratio analysis is
more useful for small, narrowly focused firms than for large,
multidivisional ones.
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2. Most firms want to be better than average, so merely attaining
average performance is not necessarily good. As a target for high-level
performance, it is best to focus on the industry leaders’ ratios.
Benchmarking helps in this regard.
3. Inflation may have badly distorted firms’ balance sheets—recorded
values are often substantially different from “true” values. Further,
since inflation affects both depreciation charges and inventory costs,
profits are also affected. Thus, a ratio analysis for one firm over time, or
a comparative analysis of firms of different ages, must be interpreted
with judgment.
4. Seasonal factors can also distort a ratio analysis. For example, the
inventory turnover ratio for a food processor will be radically different
if the balance sheet figure used for inventory is the one just before
versus just after the close of the canning season. This problem can be
minimized by using monthly averages for inventory (and receivables)
when calculating turnover ratios.

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 5. Firms can employ “window dressing” techniques to make their
financial statements look stronger. To illustrate, a Chicago builder
borrowed on a two-year basis on December 29, 2001, held the proceeds
of the loan as cash for a few days, and then paid off the loan ahead of
time on January 2, 2002. This improved his current and quick ratios,
and made his year-end 2001 balance sheet look good. However, the
improvement was strictly window dressing; a week later the balance
sheet was back at the old level.
 6. Different accounting practices can distort comparisons. As noted
earlier, inventory valuation and depreciation methods can affect
financial statements and thus distort comparisons among firms. Also, if
one firm leases a substantial amount of its productive equipment, then
its assets may appear low relative to sales because leased assets often do
not appear on the balance sheet. At the same time, the liability
associated with the lease obligation may not be shown as a debt.
Therefore, leasing can artificially improve both the turnover and the
debt ratios. However, the accounting profession has taken steps to
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Leykun Fentaw 3-48
It is difficult to generalize about whether a particular ratio is
“good” or “bad.” For example, a high current ratio may indicate
a strong liquidity position, which is good, or excessive cash,
which is bad (because excess cash in the bank is a nonearning
asset). Similarly, a high fixed assets turnover ratio may denote
either a firm that uses its assets efficiently or one that is
undercapitalized and cannot afford to buy enough assets.
7. A firm may have some ratios that look “good” and others that
look “bad,” making it difficult to tell whether the company is, on
balance, strong or weak. However, statistical procedures can be
used to analyze the net effects of a set of ratios. Many banks and
other lending organizations use such procedures to analyze
firms’ financial ratios, and then to classify them according to
their probability of getting into financial trouble.

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 PROBLEMS WITH ROE
 If a firm takes steps to improve its ROE, does it mean that shareholder
wealth will also increase? Not necessarily, for despite its widespread
use and the fact that ROE and shareholder wealth are often highly
correlated, some problems can arise when firms use ROE as the sole
measure of performance.
 First, ROE does not consider risk. While shareholders clearly care
about returns, they also care about risk. To illustrate this point, consider
two divisions within the same firm. Division S has very stable cash
flows and a predictable 15 percent ROE. Division R, on the other hand,
has a 16 percent expected ROE, but its cash flows are very risky, so the
expected ROE may not materialize. If managers were compensated
solely on the basis of ROE, and if the expected ROEs were actually
achieved, then Division R’s manager would receive a higher bonus than
Division S’s manager, even though Division S may actually create
more value for shareholders as a result of its lower risk.
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Second, ROE does not consider the amount of invested
capital. To illustrate this point, let’s consider a rather extreme
example. A large company has $1 invested in Project A,
which has an ROE of 50 percent, and $1 million invested in
Project B, which has a 40 percent ROE. The projects are
equally risky, and the two returns are both well above the cost
the company had to pay for the capital invested in the projects.
In this example, Project A has a higher ROE, but since it is so
small, it does little to enhance shareholder wealth. Project B,
on the other hand, has the lower ROE, but it adds much more
to shareholder value.

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Consider one last problem with ROE. Assume that you manage a
division of a large firm. The firm uses ROE as the sole measure of
performance, and it determines bonuses on the basis of ROE. Toward
the end of the fiscal year, your division’s ROE is an impressive 45
percent. Now you have an opportunity to invest in a large, low-risk
project that has an estimated ROE of 35 percent, which is well above
the cost of the capital you need to make the investment. Even though
this project is profitable, you might be reluctant to make the
investment because it would reduce your division’s average ROE, and
therefore reduce the size of your year-end bonus.
These three examples suggest that a project’s return must be combined
with its risk and size to determine its effect on shareholder value.

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 Any Questions???

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