FINANCIAL

STATEMENT
ANALYSIS
Part 4
LEARNING OBJECTIVES:
 Perform the steps in doing financial ratio analysis
(Growth and Leverage Ratios), interpretations,
conclusions, and draw the implications based of the
results of the applied ratios.
 Know and explain the Degree of Operating Leverage and
Degree of Financial Leverage
 Perform the Dupont Analysis.
TYPES OF FINANCIAL RATIOS:
3. Growth ratios – these are indicative of the
organization’s potential and attractiveness as
an investment option.

 Example: Price-earnings ratio, Dividend Yield

Ratio, Dividend Payout Ratio, Book Value per
Share
4. Financial Leverage ratios – measure the
financial risk of an entity. Financial leverage
refers to the use of debt to increase shareholder’s
equity.

 Example: Debt Ratio, Debt to Equity Ratio,

Times Interest Earned Also known as Solvency
ratios or Stability ratios.
FINANCIAL LEVERAGE RATIOS
 A lever is an instrument used to move a higher object
 To gain leverage as in financing, the bigger the object to
be moved is the shareholders’ equity. The greater the
shareholders’ equity is, the more wealth the organization
has.
 Financial leverage refers to the use of debt to increase
shareholders’ equity. It is a measure of risk.
 Using debt to finance business activities would mean
greater exposure to financial risk.
 The more leverage the business, the higher the financial
risk is.
GROWTH RATIOS
Ratio Formula Remarks
Price-earnings Market Price per Measures the number of period
Ratio Share/Earnings per investment in stock will be
Share recovered; measures the profitability
of the firm in relation to the market
value of the stock; measures
investors’ beliefs on the growth
potential of the stock
Dividend Yield Dividend per Measures rate of cash return to
Ratio Share/Market Price investment in stock
per Share
GROWTH RATIOS
Ratio Formula Remarks
Dividend Dividend per Represents the percentage of net
Payout Ratio Share/Earnings per income distributed as dividends; a
Share low ratio may indicate the
reinvestment of profits by growth-
oriented firm
Book Value per Shareholders’ Indicates the value of the stock on
Share Equity/Average cost perspective; the relevance of this
Shares Outstanding ratio diminishes when the balance
sheet valuation does not approach
fair market values; may be computed
for both ordinary and preference
shares
GROWTH RATIOS
Ratio Formula Remarks
Dividend Dividend per Represents the percentage of net
Payout Ratio Share/Earnings per income distributed as dividends; a
Share low ratio may indicate the
reinvestment of profits by growth-
oriented firm
Book Value per Shareholders’ Indicates the value of the stock on
Share Equity/Average cost perspective; the relevance of this
Shares Outstanding ratio diminishes when the balance
sheet valuation does not approach
fair market values; may be computed
for both ordinary and preference
shares
LEVERAGE RATIOS
Ratio Formula Remarks
Debt-to-equity Total debt/Net Measures the use of debt to finance
Ratio shareholders’ equity operations; provides a measure of the
relative amount of resources
contributed by the creditors and
owners.
Debt-to-assets Total debt/Total Measures the relative share of
Ratio assets creditors over the resources of the
firm
Equity-to-assets Net shareholder’s Measures the amount of resources
Ratio (Equity equity/Total assets provided by the owners in the firm.
Ratio)
LEVERAGE RATIOS
Ratio Formula Remarks
Equity Total assets/Net Indicates the number of times
multiplier shareholders’ equity owner’s equity is multiplied
Times interest EBIT/Interest Measures the long-term debt paying
earned expense ability of the firm; a high number of
times interest is earned ratio
indicates that the business is under-
leverage and its return on ordinary
equity could still be improved.
EBIT/ (EBIT- Measures the risk associated in using
Financial Interest expense- debt to finance investments. Note:
leverage Preference dividend EBIT = earnings before interest and
before tax) tax
LEVERAGE RATIOS
Ratio Formula Remarks
Total assets-to- Total assets/Total A rough estimate of the firm’s ability
total liabilities liabilities to meet interest payments to
ratio creditors.
.
Non-current Non-current Shows the capability to meet non-
assets-to-long- assets/Total current liabilities using non-current
term liabilities liabilities resources
ratio
Total leverage Degree of Measures the overall leverage of the
operating leverage business, it indicates the variability
x Degree of of the shareholders’ equity with
financial leverage respect to changes in contribution
margin, EBIT, interest expense, and
preferred dividends before tax.
Example:

The Joshua Corp. has the following balance sheet and income
statement. Compute the applicable leverage ratios.
 JOSHUA CORPORATION
BALANCE SHEET
DECEMBER 31, 2019
Assets
Current Assets:
Cash 70,000
Marketable Securities 40,000
Accounts Receivable (net) 250,000
Inventory 200,000
Total Current Assets 560,000
Non-Current Assets:
Investments 100,000
Property, Plant and Equipment 440,000
Total Non-Current Assets 540,000
Total Assets 1,100,000
Liabilities and Shareholders’ Equity
Current Liabilities:
Accounts Payable 130,000
Notes Payable 120,000
Accrued Taxes 30,000
Total Current Liabilities 280,000
Non-Current Liabilities:
Bonds Payable 200,000
Total Liabilities 480,000
Stockholders’ Equity
Preference Share Capital, P 100 par value 150,000
Ordinary Share Capital, P 5 par value 50,000
Share Premium 200,000
Retained Earnings 220,000
Total Shareholders’ Equity 620,000
Total Liabilities and Shareholders’ Equity 1,100,000
 JOSHUA CORPORATION
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2019

Sales (on credit) 2,400,000

Less: Cost of Goods Sold 1,600,000
Gross Profit 800,000
Less: Selling and Administrative Expenses 560,000
Operating Profit (EBIT) 240,000
Less: Interest expense 30,000
Earnings before Income Tax (EBT) 210,000
Less: Income Tax 75,000
Earnings after taxes (EAT) 135,000

*Includes P 40,000 in lease payments

Leverage ratios
1. Debt to total asset = Total debt___
Total assets
= 480,000
1,100,000
= 43.64%
2.Times interest earned = IBIT_____
interest
= 240,000
30,000
= 8x
OPERATING AND
FINANCIAL
LEVERAGE
 Leverage represents the use of fixed cost items to
identify the firm’s results.
 Operating leverage indicates the extent fixed assets
(plant and equipment) are utilized by the firm.
 Financial leverage shows how much debt the firm
employs in its capital structure.
 By increasing leverage, the firm increases its profit
potential, but also its risk of failure.
LEVERAGE
 Capital structure refers to the mix of long term debt and
equity maintained by the firm
 Leverage results from the use of fixed cost assets to
magnify returns to the firm’s owners
- increased leverage raises risk/return
- decreased leverage lowers risk/return
 Management can control leverage in the capital
structure, and in turn affect firm value.
LEVERAGE
Three types of leverage:
1. Operating leverage – relates to sales to EBIT

2. Financial leverage – relates EBIT to EPS

3. Total leverage – relates sales to EPS

TYPES OF LEVERAGE AND INCOME
STATEMENT
Sales revenue
Less Cost of goods sold
Operating Gross profits
Leverage Less Operating Expenses
EBIT
Less Interest Total
Net profits before taxes leverage
Less Taxes
Financial Net profit after taxes
Leverage Less Preference share dividends
Earnings available for ordinary shareholders

Earnings per share (EPS)

OPERATING LEVERAGE
 It reflects the extent to which fixed assets and associated
fixed cost are utilized in the business.
 One potential effect caused by the presence of operating
leverage is that a change in the volume of sales results in a
more than proportional change in operating profit or loss.
 A firm’s operational costs may be classified as fixed,
variable or semivariable.
Fixed – lease, depreciation, executive salaries and
property taxes
Variable – raw material, factory labor and sales
commissions
Semivariable – utilities, repairs and maintenance
IMPACT OF OPERATING LEVERAGE ON PROFITS

(in thousands) Firm F Firm VFirm 2F

Sales P10 P11 P19.5
Operating Costs
Fixed 7 2 14
Variable 2 7 3
Operating profit P 1 P 2 P 2.5

FC/total costs 0.78 0.22 0.82

FC/sales 0.70 0.18 0.72
A MORE CONSERVATIVE APPROACH
Not all firms would choose to operate at the high degree of
operating leverage. Fear of not reaching the break-even
level might discourage some companies from heavy
utilization of fixed assets.
THE RISK FACTOR
 The management follows the path of the leveraged firm
or of the more conservative firm depends on its
perceptions about the future.
 If the vice-president of finance is apprehensive about
economic conditions, the conservative plan may be
undertaken.
 For a growing business in times of relative prosperity,
management might maintain a more aggressive,
leveraged position.
 The Degree of operating leverage may be defined as the percentage change
in units sold.

DOL = percent change in operating income

percent change in unit volume
DOL = Q(P – VC)____
Q(P – VC) – FC
where,
Q = quantity at which DOL is computed
P = price per unit
VC = variable cost per unit
FC = fixed costs
DEGREE OF FINANCIAL LEVERAGE
 It measures the effect of a change in one variable on
another variable.
 Defined as the percentage change in earnings (EPS) that
occurs as a result of a percentage change in earnings
before interest and taxes (EBIT)
DFL = EBIT ___
EBIT - 1
DEGREE OF COMBINED LEVERAGE
(DCL)
 It uses the entire income statement and shows the impact
of a change in sales or volume on bottom-line earnings
per share.
 Degree of operating leverage and degree of financial
leverage are, in effect, being combined.
 The formula is stated as:

Degree of combined= percent change in EPS____________

leverage (DCI) percent change in sales (or volume)
THE DUPONT ANALYSIS OR DUPONT
MODEL
 The Dupont analysis also called the Dupont
model is a financial ratio based on the
return on equity ratio that is used to analyze a
company's ability to increase its return on equity.
 In other words, this model breaks down the
return on equity ratio to explain how companies
can increase their return for investors
THE DUPONT ANALYSIS OR DUPONT
MODEL
 The Dupont analysis looks at three main
components of the ROE ratio.
a. Profit margin
b. Total asset turnover
c. Financial leverage
 Based on these three performances measures, the
model concludes that a company can raise its
ROE by maintaining a high profit margin,
increasing asset turnover, or leveraging assets
more effectively.
THE DUPONT MODEL EQUATES ROE TO PROFIT
MARGIN, ASSET TURNOVER, AND FINANCIAL
LEVERAGE. THE BASIC FORMULA LOOKS LIKE
THIS.
 This model was developed to analyze ROE and the
effects different business performance measures
have on this ratio. So investors are not looking for
large or small output numbers from this model.
Instead, they are looking to analyze what is causing
the current ROE.
 For instance, if investors are unsatisfied with a low
ROE, the management can use this formula to
pinpoint the problem area whether it is a lower profit
margin, asset turnover, or poor financial leveraging.
 Once the problem area is found, management can
attempt to correct it or address it with shareholders.
Some normal operations lower ROE naturally and
are not a reason for investors to be alarmed.
 For instance, accelerated depreciation artificially
lowers ROE in the beginning periods. This paper
entry can be pointed out with the Dupont analysis
and shouldn't sway an investor's opinion of the
company.
LEARNING ACTIVITIES

 Assignment

 Project

 Quiz