Financial analysis, though varying according to the
particular interests of the analyst, always involves
the use of various financial statements – primarily the
balance sheet and income statement.
l The balance sheet summarizes the assets, liabilities,
and owners’ equity of a business at a point in time,
and the income statement summarizes revenues and
expenses of a firm over a particular period of time.
l International and national accounting standard setters,
are working toward “convergence” in accounting
standards around the world. “Convergence” aims to
narrow or remove accounting differences so that
investors can better understand financial statements
prepared under different accounting frameworks.
l A conceptual framework for financial analysis provides the analyst with an interlocking means for
structuring the analysis. For example, in the analysis
of external financing, one is concerned with the firm’s
funds needs, its financial condition and performance,
and its business risk. Upon analysis of these factors,
one is able to determine the firm’s financing needs
and to negotiate with outside suppliers of capital.
l Financial ratios are the tools used to analyze financial condition and performance. We calculate ratios
because in this way we get a comparison that may prove
more useful than the raw numbers by themselves.
l Financial ratios can be divided into five basic types:
liquidity, leverage (debt), coverage, activity, and
profitability. No one ratio is itself sufficient for realistic
assessment of the financial condition and performance of a firm. With a group of ratios, however,
reasonable judgments can be made. The number of key
ratios needed for this purpose is not particularly large
– about a dozen or so.
l The usefulness of ratios depends on the ingenuity and
experience of the financial analyst who employs them.
By themselves, financial ratios are fairly meaningless; they must be analyzed on a comparative basis.
Comparing one company with similar companies and
industry standards over time is crucial. Such a comparison uncovers leading clues in evaluating changes
and trends in the firm’s financial condition and profitability. This comparison may be historical, but it
may also include an analysis of the future based on
projected financial statements.
l Additional insights can be gained by common-size and
index analysis. In the former, we express the various
balance sheet items as a percentage of total assets and
the income statement items as a percentage of net
sales. In the latter, balance sheet and income statement items are expressed as an index relative to an
initial base year.
Summary of Key Ratios
LIQUIDITY
CURRENT Measures ability to meet current
debts with current assets.
ACID-TEST (QUICK) Measures ability to meet current
debts with most-liquid (quick)
current assets.
= Current assets less inventories
Current liabilities
= Current assets
Current liabilities
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LEVERAGE
DEBT-TO-EQUITY
Indicates the extent to which debt
financing is used relative to equity
financing.
DEBT-TO-TOTAL-ASSETS
Shows the relative extent to which
the firm is using borrowed
money.
COVERAGE
INTEREST COVERAGE Indicates ability to cover interest
charges; tells number of times
interest is earned.
ACTIVITY
RECEIVABLE TURNOVER (RT) Measures how many times the
receivables have been turned over
(into cash) during the year;
provides insight into quality of
the receivables.
RECEIVABLE TURNOVER Average number of days
IN DAYS (RTD) receivables are outstanding
(Average collection period) before being collected.
INVENTORY TURNOVER (IT) Measures how many times the
inventory has been turned over
(sold) during the year; provides
insight into liquidity of inventory
and tendency to overstock.
INVENTORY TURNOVER Average number of days the
IN DAYS (ITD) inventory is held before it is
turned into accounts receivable
through sales.
TOTAL ASSET TURNOVER Measures relative efficiency of
(Capital turnover) total assets to generate sales.
PROFITABILITY
NET PROFIT MARGIN Measures profitability with respect
to sales generated; net income per
dollar of sales.
RETURN ON INVESTMENT Measures overall effectiveness in
(ROI) generating profits with available
(Return on assets) assets; earning power of invested
capital.
= NET PROFIT MARGIN × TOTAL ASSET TURNOVER
RETURN ON EQUITY (ROE) Measures earning power on
shareholders’ book-value
investment.
NET PROFIT TOTAL ASSET EQUITY = MARGIN × TURNOVER × MULTIPLIER
= ××
*Earnings before interest and taxes.
**An average, rather than an ending, balance may be needed.
Total assets**
Shareholders’ equity**
Net sales
Total assets**
Net profit after taxes
Net sales
= Net profit after taxes
Shareholders’ equity**
Net sales
Total assets** = Net profit after taxes
Net sales
= Net profit after taxes
Total assets**
= Net profit after taxes
Net sales
= Net sales
Total assets**
= 365
IT
= Cost of goods sold
Inventory**
= 365
RT
= Annual net credit sales
Receivables**
= EBIT*
Interest expense
= Total debt
Total assets
= Total debt
Shareholders’ equity
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10Deferred taxes are not the same thing as taxes payable. Taxes payable are tax payments due within
the year, whereas
deferred taxes are “due” at some indefinite long-term date.
Appendix Deferred Taxes and Financial Analysis
Deferred taxes10 – an item that often appears in the long-term liability portion of a firm’s
balance sheet – pose some real problems for the financial analyst attempting to do ratio
analysis. Though its position on the balance sheet would make it appear to be a long-term
debt item, analysts (and especially accountants) can’t agree on whether to treat the deferred
taxes account as debt or equity, or neither, in ratio and other analyses. Why the confusion?
Where Do Deferred Taxes Come From?
Deferred taxes most commonly arise when a firm determines depreciation expense in its
published financial statements on a different basis from that in its tax returns. Most likely,
a company chooses straight-line depreciation for its published income statement but uses a
type of accelerated depreciation (MACRS) for tax purposes. (See Table 6A.1 for an example.)
This action “temporarily” defers the payment of taxes by making tax-return profits less than
book profits. When a higher tax expense is reported on the firm’s books than is actually paid,
the firm’s books won’t balance. To solve this problem, accountants create a deferred tax
account in the long-term liability section of the balance sheet to maintain a running total of
these differences between taxes reported and taxes actually due. If the firm slows or ceases
buying new assets, there will eventually be a reversal – reported taxes will be less than actual
taxes due – and the deferred taxes account will need to be reduced to keep the balance sheet
in balance. In this particular situation, our deferred tax liability item is truly a “debt” that
eventually comes due. On the other hand, if the firm continues to invest in depreciable assets,
payment of the deferred tax may continue to be delayed indefinitely.
So What’s the Problem?
The catch is that for stable or growing firms there is no foreseeable reversal, and the deferred
taxes account balance continues to grow. For many firms, a growing, never-reversing,
deferred taxes account is the norm. Faced with this reality, the analyst may decide to modify
the financial statements for purposes of analysis.
Depending on the situation (for example, the nature and magnitude of the tax deferrals,
whether the account has been growing, and the likelihood of a reversal), the analyst may
decide to make one or both of the following adjustments to the firm’s financial statements:
Deferred taxes
A “liability” that
represents the
accumulated
difference between
the income tax
expense reported on
the firm’s books and
the income tax
actually paid. It arises
principally because
depreciation is
calculated differently
for financial reporting
than for tax reporting.
Table 6A.1
Income statements
highlighting deferred
taxes for year ending
December 31, 20X2
(in millions)
FINANCIAL REPORTING TAX REPORTING
Net sales $100.0 $100.0
Costs and expenses, except for depreciation 45.0 45.0
Depreciation
Straight-line 15.0
Accelerated (MACRS) 20.0
Earnings before taxes $ 40.0 $ 35.0
Taxes (40%) 16.0* 14.0
Earnings after taxes $ 24.0 $ 21.0
*Taxes
Current (involves cash payment) $14.0
Deferred (noncash charge added to
deferred taxes account on balance sheet) 2.0
Total tax shown $16.0
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l The current period’s deferred tax expense (a noncash charge) is added back to net
income – the argument is that profits were understated because taxes were, in effect,
overstated.
l The deferred taxes reported on the firm’s balance sheet are added to equity – here the
argument is that because this amount is not a definite, legal obligation requiring payment in the
foreseeable future, it overstates the debt position of the firm. In short, it is
more like equity than debt.
Such adjustment will, of course, affect the calculation of the firm’s debt and profitability
ratios.
Still another school of thought rejects both of the previous adjustments. Called the “netof-tax”
approach, this viewpoint calls for most deferred taxes to be treated as adjustments to
the amounts at which the related assets are carried on the firm’s books. An analyst subscribing to this
approach would make the following financial statement adjustment:
l The deferred taxes on the firm’s balance sheet are subtracted from net fixed assets – the
reason is that when there is an excess of tax depreciation over book depreciation, an
asset’s value is decreased, rather than a liability created. Accelerated depreciation, in
effect, uses up an additional part of an asset’s tax-reducing capacity relative to straightline depreciation.
The immediate loss of the future tax-reducing (i.e., tax-shield) benefit
should be deducted from the related asset account.
This adjustment will affect the calculation of various leverage, activity, and profitability
ratios.
Questions
1. What is the purpose of a balance sheet? An income statement?
2. Why is the analysis of trends in financial ratios important?
3. Auxier Manufacturing Company has a current ratio of 4 to 1 but is unable to pay its bills.
Why?
4. Can a firm generate a 25 percent return on assets and still be technically insolvent (unable
to pay its bills)? Explain.
5. The traditional definitions of collection period and inventory turnover are criticized
because in both cases balance sheet figures that are a result of approximately the last
month of sales are related to annual sales (in the former case) or annual cost of goods sold
(in the latter case). Why do these definitions present problems? Suggest a solution.
6. Explain why a long-term creditor should be interested in liquidity ratios.
7. Which financial ratios would you be most likely to consult if you were the following?
Why?
a. A banker considering the financing of seasonal inventory
b. A wealthy equity investor
c. The manager of a pension fund considering the purchase of a firm’s bonds
d. The president of a consumer products firm
8. In trying to judge whether a company has too much debt, what financial ratios would you
use and for what purpose?
9. Why might it be possible for a company to make large operating profits, yet still be unable
to meet debt payments when due? What financial ratios might be employed to detect such
a condition?
10. Does increasing a firm’s inventory turnover ratio increase its profitability? Why should
this ratio be computed using cost of goods sold (rather than sales, as is done by some
compilers of financial statistics)?
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11. Is it appropriate to insist that a financial ratio, such as the current ratio, exceed a certain
absolute standard (e.g., 2:1)? Why?
12. Which firm is more profitable – Firm A with a total asset turnover of 10.0 and a net profit
margin of 2 percent, or Firm B with a total asset turnover of 2.0 and a net profit margin
of 10 percent? Provide examples of both types of firm.
13. Why do short-term creditors, such as banks, emphasize balance sheet analysis when considering
loan requests? Should they also analyze projected income statements? Why?
14. How can index analysis be used to reinforce the insight gained from a trend analysis of
financial ratios?
Self-Correction Problems
1. Barnaby Cartage Company has current assets of $800,000 and current liabilities of
$500,000. What effect would the following transactions have on the firm’s current ratio
(and state the resulting figures)?
a. Two new trucks are purchased for a total of $100,000 in cash.
b. The company borrows $100,000 short term to carry an increase in receivables of the
same amount.
c. Additional common stock of $200,000 is sold and the proceeds invested in the expansion of several
terminals.
d. The company increases its accounts payable to pay a cash dividend of $40,000 out of
cash.
2. Acme Plumbing Company sells plumbing fixtures on terms of 2/10, net 30. Its financial
statements over the last three years are as follows:
20X1 20X2 20X3
Cash $ 30,000 $ 20,000 $ 5,000
Accounts receivable 200,000 260,000 290,000
Inventory 400,000 480,000 600,000
Net fixed assets 800,000 800,000 800,000
$1,430,000 $1,560,000 $1,695,000
Accounts payable $ 230,000 $ 300,000 $ 380,000
Accruals 200,000 210,000 225,000
Bank loan, short term 100,000 100,000 140,000
Long-term debt 300,000 300,000 300,000
Common stock 100,000 100,000 100,000
Retained earnings 500,000 550,000 550,000
$1,430,000 $1,560,000 $1,695,000
Sales $4,000,000 $4,300,000 $3,800,000
Cost of goods sold 3,200,000 3,600,000 3,300,000
Net profit 300,000 200,000 100,000
Using the ratios discussed in the chapter, analyze the company’s financial condition and
performance over the last three years. Are there any problems?
3. Using the following information, complete the balance sheet found on the next page:
Long-term debt to equity 0.5 to 1
Total asset turnover 2.5 times
Average collection period* 18 days
Inventory turnover 9 times
Gross profit margin 10%
Acid-test ratio 1 to 1
*Assume a 360-day year and all sales on credit.
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Cash $ Notes and payables $100,000
Accounts receivable Long-term debt
Inventory Common stock $100,000
Plant and equipment Retained earnings $100,000
Total assets Total liabilities and
$ shareholders’ equity $
4. Kedzie Kord Company had the following balance sheets and income statements over the
last three years (in thousands):
20X1 20X2 20X3
Cash $ 561 $ 387 $ 202
Receivables 1,963 2,870 4,051
Inventories 2,031 2,613 3,287
Current assets $ 4,555 $ 5,870 $ 7,540
Net fixed assets 2,581 4,430 4,364
Total assets $ 7,136 $10,300 $11,904
Payables $ 1,862 $ 2,944 $ 3,613
Accruals 301 516 587
Bank loan 250 900 1,050
Current liabilities $ 2,413 $ 4,360 $ 5,250
Long-term debt 500 1,000 950
Shareholder’s equity 4,223 4,940 5,704
Total liabilities and
shareholder’s equity $ 7,136 $10,300 $11,904
Sales $11,863 $14,952 $16,349
Cost of goods sold 8,537 11,124 12,016
Selling, general, and
administrative expenses 2,276 2,471 2,793
Interest 73 188 200
Profit before taxes $ 977 $ 1,169 $ 1,340
Taxes 390 452 576
Profit after taxes $ 587 $ 717 $ 764
Using common-size and index analysis, evaluate trends in the company’s financial condition and
performance.
Problems
1. The data for various companies in the same industry are as follows:
COMPANY
A BC D E F
Sales (in millions) $10 $20 $8 $5 $12 $17
Total assets (in millions) 8 10 6 2.5 4 8
Net income (in millions) 0.7 2 0.8 0.5 1.5 1
Determine the total asset turnover, net profit margin, and earning power for each of the
companies.
2. Cordillera Carson Company has the following balance sheet and income statement for
20X2 (in thousands):
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BALANCE SHEET INCOME STATEMENT
Cash $ 400 Net sales (all credit) $12,680
Accounts receivable 1,300 Cost of goods sold 8,930
Inventories 2,100 Gross profit $ 3,750
Current assets $3,800 Selling, general, and
Net fixed assets 3,320 administration expenses 2,230
Total assets $7,120 Interest expense 460
Profit before taxes $ 1,060
Accounts payable $ 320 Taxes 390
Accruals 260 Profit after taxes $ 670
Short-term loans 1,100
Current liabilities $1,680
Long-term debt 2,000
Net worth 3,440
Total liabilities and net worth $7,120
Notes: (i) current period’s depreciation is $480; (ii) ending inventory for 20X1 was $1,800.
On the basis of this information, compute (a) the current ratio, (b) the acid-test ratio,
(c) the average collection period, (d) the inventory turnover ratio, (e) the debt-to-net-worth
ratio, (f ) the long-term debt-to-total-capitalization ratio, (g) the gross profit margin,
(h) the net profit margin, and (i) the return on equity.
3. Selected financial ratios for RMN, Incorporated, are as follows:
20X1 20X2 20X3
Current ratio 4.2 2.6 1.8
Acid-test ratio 2.1 1.0 0.6
Debt-to-total-assets 23% 33% 47%
Inventory turnover 8.7× 5.4× 3.5×
Average collection period 33 days 36 days 49 days
Total asset turnover 3.2× 2.6× 1.9×
Net profit margin 3.8% 2.5% 1.4%
Return on investment (ROI) 12.1% 6.5% 2.8%
Return on equity (ROE) 15.7% 9.7% 5.4%
a. Why did return on investment decline?
b. Was the increase in debt a result of greater current liabilities or of greater long-term
debt? Explain.
4. The following information is available on the Vanier Corporation:
BALANCE SHEET AS OF DECEMBER 31, 20X6 (in thousands)
Cash and marketable securities $500 Accounts payable $ 400
Accounts receivable ? Bank loan ?
Inventories ? Accruals 200
Current assets ? Current liabilities ?
Long-term debt 2,650
Net fixed assets ? Common stock and retained earnings 3,750
Total assets ? Total liabilities and equity ?
INCOME STATEMENT FOR 20X6 (in thousands)
Credit sales $8,000
Cost of goods sold ?
Gross profit ?
Selling and administrative expenses ?
Interest expense 400
Profit before taxes ?
Taxes (44% rate) ?
Profit after taxes ?
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OTHER INFORMATION
Current ratio 3 to 1
Depreciation $500
Net profit margin 7%
Total liabilities/shareholders’ equity 1 to 1
Average collection period 45 days
Inventory turnover ratio 3 to 1
Assuming that sales and production are steady throughout a 360-day year, complete the
balance sheet and income statement for Vanier Corporation.
5. A company has total annual sales (all credit) of $400,000 and a gross profit margin of
20 percent. Its current assets are $80,000; current liabilities, $60,000; inventories, $30,000;
and cash, $10,000.
a. How much average inventory should be carried if management wants the inventory
turnover to be 4?
b. How rapidly (in how many days) must accounts receivable be collected if management
wants to have an average of $50,000 invested in receivables? (Assume a 360-day year.)
6. Stoney Mason, Inc., has sales of $6 million, a total asset turnover ratio of 6 for the year, and
net profits of $120,000.
a. What is the company’s return on assets or earning power?
b. The company is considering the installation of new point-of-sales cash registers
throughout its stores. This equipment is expected to increase efficiency in inventory
control, reduce clerical errors, and improve record keeping throughout the system. The
new equipment will increase the investment in assets by 20 percent and is expected to
increase the net profit margin from 2 to 3 percent. No change in sales is expected. What
is the effect of the new equipment on the return on assets ratio or earning power?
7. The long-term debt section of the balance sheet of the Queen Anne’s Lace Corporation
appears as follows:
91
/4% mortgage bonds $2,500,000
123
/8% second mortgage bonds 1,500,000
101
/4% debentures 1,000,000
141
/2% subordinated debentures 1,000,000
$6,000,000
If the average earnings before interest and taxes of the company is $1.5 million and all debt
is long term, what is the overall interest coverage?
8. Tic-Tac Homes has had the following balance sheet statements the past four years (in
thousands):
20X1 20X2 20X3 20X4
Cash $ 214 $ 93 $ 42 $ 38
Receivables 1,213 1,569 1,846 2,562
Inventories 2,102 2,893 3,678 4,261
Net fixed assets 2,219 2,346 2,388 2,692
Total assets $5,748 $6,901 $7,954 $9,553
Accounts payable $1,131 $1,578 $1,848 $2,968
Notes payable 500 650 750 750
Accruals 656 861 1,289 1,743
Long-term debt 500 800 800 800
Common stock 200 200 200 200
Retained earnings 2,761 2,812 3,067 3,092
Total liabilities and
shareholders’ equity $5,748 $6,901 $7,954 $9,553
Using index analysis, what are the major problems in the company’s financial condition?
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9. US Republic Corporation balance sheet, December 31, 20X3
ASSETS LIABILITIES AND SHAREHOLDERS’ EQUITY
Cash $ 1,000,000 Notes payable, bank $ 4,000,000
Accounts receivable 5,000,000 Accounts payable 2,000,000
Inventory 7,000,000 Accrued wages and taxes 2,000,000
Fixed assets, net 17,000,000 Long-term debt 12,000,000
Preferred stock 4,000,000
Common stock 2,000,000
Retained earnings 4,000,000
Total liabilities and
Total assets $30,000,000 shareholders’ equity $30,000,000
US Republic Corporation statement of income and retained earnings,
year ended December 31, 20X3
Net sales
Credit $16,000,000
Cash 4,000,000
Total $20,000,000
Cost and Expenses
Cost of goods sold $12,000,000
Selling, general, and administrative expenses 2,200,000
Depreciation 1,400,000
Interest 1,200,000 $16,800,000
Net income before taxes $ 3,200,000
Taxes on income 1,200,000
Net income after taxes $ 2,000,000
Less: Dividends on preferred stock 240,000
Net income available to common shareholders $ 1,760,000
Add: Retained earnings at 1/1/X3 2,600,000
Subtotal $ 4,360,000
Less: Dividends paid on common stock 360,000
Retained earnings 12/31/X3 $ 4,000,000
a. Fill in the 20X3 column in the table that follows.
US Republic Corporation
INDUSTRY
RATIO 20X1 20X2 20X3 NORMS
1. Current ratio 250% 200% 225%
2. Acid-test ratio 100% 90% 110%
3. Receivable turnover 5.0× 4.5× 6.0×
4. Inventory turnover 4.0× 3.0× 4.0×
5. Long-term debt/total capitalization 35% 40% 33%
6. Gross profit margin 39% 41% 40%
7. Net profit margin 17% 15% 15%
8. Return on equity 15% 20% 20%
9. Return on investment 15% 12% 12%
10. Total asset turnover 0.9× 0.8× 1.0×
11. Interest coverage ratio 5.5× 4.5× 5.0×
b. Evaluate the position of the company using information from the table. Cite specific
ratio levels and trends as evidence.
c. Indicate which ratios would be of most interest to you and what your decision would
be in each of the following situations:
(i) US Republic wants to buy $500,000 worth of merchandise inventory from you,
with payment due in 90 days.
(ii) US Republic wants you, a large insurance company, to pay off its note at the bank
and assume it on a 10-year maturity basis at a current rate of 14 percent.
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(iii) There are 100,000 shares outstanding, and the stock is selling for $80 a share. The
company offers you 50,000 additional shares at this price.
Solutions to Self-Correction Problems
1. Present current ratio = $800/$500 = 1.60.
a. $700/$500 = 1.40. Current assets decline, and there is no change in current liabilities.
b. $900/$600 = 1.50. Current assets and current liabilities each increase by the same
amount.
c. $800/$500 = 1.60. Neither current assets nor current liabilities are affected.
d. $760/$540 = 1.41. Current assets decline, and current liabilities increase by the same
