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Ch 03 Financial Statements and Ratio Analysis
Financial statements are a major source of information for financial decision makers.
They provide financial managers with a great deal of the information needed to estimate
future cash flows and the value of the firm.
Financial Statements for publicly traded corporations are available in annual reports (and
10-K’s), and in abridged form in quarterly reports (10-Q’s). The annual report also
contains a letter from the CEO providing a general overview of the firm’s recent results
and future plans.
3.1 Major Financial Statements
1.The income statement (see table 3.1) shows the firm’s performance over a period of
time. The income statement can be broken down as follows:
-Sales (“the top line”) minus Cost of Goods Sold (CGS) gives Gross Profits
-Gross profits minus operating expenses, such as wages and depreciation, gives
operating income, or EBIT (earnings before interest and taxes)
-Deducting Financing Expenses, such as interest paid, gives pre-tax income
-Deducting taxes gives net income, or net profits after tax.
-Preferred dividends are deducted from net income to get the earnings available to
common shareholders (sometimes referred to as “the bottom line”).
2. The balance sheet (see table 3.2) gives a picture of the firm’s condition at one point in
time.
The Fundamental Equation of Accounting:
Assets = Liabilities + Stockholder’s Equity
this implies that: Assets - Liabilities = Stockholder’s Equity
(“What you own minus what you owe is what you’re worth”)
Assets appear on the balance sheet in descending order of liquidity. Liability order
reflects time to maturity. It is also important to point out that more liquid assets also
provide lower returns. Consequently, too much liquidity can be just as detrimental to
shareholder wealth maximization as too little liquidity.
Assets made up of:
-Current assets such as Cash, Inventory, and Accounts Receivable
-Fixed assets such as machinery, buildings, and vehicles.
Liabilities made up of:
-Current liabilities, such as notes payable, accounts payable, and accruals (such as
accrued wages and taxes).
-Long-term debt, such as bonds.
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Stockholder’s equity made up of:
-Par value of stock
-Equity contributed by preferred and common shareholders.
-Retained earnings
3. The statement of retained earnings (see table 2.3) shows how retained earnings
changed through the year.
REend = REbeg + Net Income - Dividends Paid
The change in retained earnings is equal to net income earned minus dividends paid.
Total retained earnings is equal to past year’s retained earnings plus net income minus
dividends paid.
4. The statement of cash flows (see table 3.4) shows the change in the firm’s holdings of
cash and marketable securities over the previous year. The statement of cash flows is
discussed in more detail later in the notes and in Chapter 4 of the text.
The idea is to group cash flows into one of three categories: operating activities,
investment activities, and financing activities.
(1) Operating flows are cash inflows and outflows directly related to the sale and
production of the firm’s products and services.
(2) Investment flows result from the purchases and sales of fixed assets and business
interests.
(3) Financing flows result from borrowing and repayment of debt obligations and from
equity transactions such as the sale or purchase of stock and dividend payments.
5. Common Size Financial Statements Assume that we want to use financial statements
to compare the recent performance and financial condition of McDonald’s and Wendy’s.
It’s meaningless to compare the two firms directly because McDonald’s is so much larger
in terms of sales and assets. One way to compare them is to construct common size
financial statements by dividing all balance sheet items by assets and all income
statement items by sales.
Common-Size Statements are Useful in comparison of firms of unequal size.
· Common-Size Balance Sheet – express each account as a percent of total assets
· Common-Size Income Statement – express each item as a percent of sales
3.2 RATIO ANALYSIS
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Ratio analysis provides a method for comparing the financial statements of
different firms at the same time (cross-sectional analysis), and of individual firms
through time (time-series analysis). It is similar to common size analysis, but we are not
limited to ratios involving sales and assets in the denominators.
In cross-sectional analysis, analysts compare the financial ratios of a firm to other firms
in the same industry, and to industry averages. Average industry ratios can be obtained
from sources such as Dun & Bradstreet’s Industry Norms, Value line, and Robert Morris
Associates Statement Studies.
There are 5 types of financial ratios that are of most interest:
1. Short-term solvency, or liquidity, ratios: The ability to pay bills in the short-run
2. Asset management, or turnover, ratios: Efficiency of asset use
3. Long-term solvency, or financial leverage, ratios: The ability to meet long-term
obligations
4. Profitability ratios: Efficiency of operations and how that translates to the “bottom
line”
5. Market value of ratios: How the market values the firm relative to the book values
1. Liquidity ratios provide information on the firm’s ability to meet its short-term debt
obligations when they come due.
Some students get a little confused when they try to understand that excessive cash
holdings can be undesirable. Occasionally, they leave an accounting principles class
with the belief that a large current ratio is, in and of itself, a good thing. Short-term
creditors like a company to have a large current ratio, but that doesn’t mean that excess
cash is good for the firm.
a. Current Ratio = current assets / current liabilities = 1.97
The firm has $1.97 in current assets for every $1 in current liabilities. A value’s
acceptability depends on the industry in which the firm operates. The more predictable a
firm’s cash flows, the lower the acceptable current ratio. For example, a current ratio of
1.0 would be acceptable for a public utility but might not be acceptable for a
manufacturing firm. If the current ratio falls below one, the firm has negative net
working capital (net working capital equals current assets minus current liabilities). In
general, the more volatile a firm’s cash flows are, the higher their liquidity ratios should
be.
b. Quick (acid-test) Ratio = (current assets - inventory) / current liabilities =1.52
Inventory is the least liquid asset. The quick ratio provides a better measure of overall
liquidity only when a firm’s inventory cannot be easily converted into cash.
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2. Asset Management ratios reflect the efficiency of the firm’s operations. Activity
ratios indicate how well a firm is using its assets to generate cash.
a. Inventory Turnover = cost of goods sold / inventory=7.2
The firm sold off or turned over the entire inventory 7.2 times. As long as we not
running out of stock and thereby forgoing sales, the higher this ratio is, the more
efficiently we are managing inventory. Since inventory ties up cash, a higher inventory
turnover ratio is generally desirable.
b. Average Age of Inventory= 360 days/ inventory turnover =50.7 days
Inventory sits 50.7 days on average before it is sold. It gives the average age of
inventory, or the average number of day’s sales in inventory. Letting this number get too
low could lead to “stockouts.”
c. Average Collection Period = accounts receivable / average sales per day = 94.7 days
The faster you can collect receivables the better (remember that money has a time
value). Receivables tie up cash.
An example of a firm with efficient asset management practices is Dell Computer. Dell’s
average collection period is very short, since customers pay in full when they place their
order. Dell then builds the computer to the customer’s specifications, which means that
they don’t keep a lot of cash tied up in inventory. The firm is financed partly by accounts
payable to suppliers, who get paid after Dell gets paid for the finished computers.
Contrast this with a traditional computer manufacturer that bases production on forecasts
of future demand and sells to retail stores on credit.
d. Average Payment Period = accounts payable / average purchases per day
Other things equal, the longer your average payment period, the better. However,
this doesn’t imply that firms should pay their bills late.
e. Total Asset Turnover = sales / assets = 0.85
The firm is generating about $0.85 in revenues from every dollar invested in
assets. This measures how efficient you are at turning assets into sales.
3. Debt management ratios give information about the firm’s borrowings. Debt ratios
measure how much of the firm is financed with other people's money and the firm's
ability to meet fixed charges.
Interest and principal payments on debt have to be paid before cash may be paid to
stockholders. The company’s gains and losses are magnified as the company increases
the amount of debt in the capital structure. This is why we call the use of debt financial
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leverage. This group of ratios really measures two different aspects of leverage – the
level of indebtedness and the ability to service debt. The former is indicative of the firm’s
debt capacity, while the latter more closely relates to the likelihood of default.
a. Total Debt Ratio = total liabilities / total assets = 45.7%
About 46 % of the assets is financed with debts. The remaining 54% of assets is
financed with equity. In other words, the firm has $0.457 in debt for every $1 in assets.
Like most ratios, the appropriate debt ratio varies greatly by industry. It also depends on
the stability of the firm’s cash flows and the types of assets it owns.
b. Times Interest Earned = earnings before interest and taxes / interest = 4.5
This ratio measures how well a company has its interest obligations covered, and
it is often called the interest coverage ratio. For this company, the interest bill is covered
4.9 times over. Or the firm has about $4.5 available to cover every dollar of interest
expense.
The liquidity and debt ratios are most important to present and prospective creditors.
4. Profitability ratios give a picture of the returns earned by the firm. Profitability ratios
measure a firm's return with respect to sales, assets, or equity (overall performance).
a. Common Size Financial Statements: Assume that we want to use financial statements
to compare the recent performance and financial condition of McDonald’s and Wendy’s.
It’s meaningless to compare the two firms directly because McDonald’s is so much larger
in terms of sales and assets. One way to compare them is to construct common size
financial statements by dividing all balance sheet items by assets and all income
statement items by sales.
b. Gross Profit Margin = (sales-cost of goods sold) / sales = gross profit / sales= 32%
c. Operating Profit Margin = operating profits / sales = 13.6%
Operating profits are also known as EBIT
c. Net Profit Margin = net profits after taxes / sales = 7.2%
The firm generates 7.2 cents in profits for every dollar in sales. Firms that have
high gross profit margins and low net profit margins have high levels of expenses other
than cost of goods sold. In this case, the high expenses more than compensate for the low
cost of goods sold (i.e., high gross profit margin) thereby resulting in a low net profit
margin.
d. ROA = net profits after-tax / total assets = 6.1%
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This ratio measures how effectively a firm manages its assets to generate profits
and it is often called the return on investment (ROI). The firm earns 6.1 cents on each
dollar of asset investment.
e. ROE = net profits after-tax / stockholder’s equity
ROE measures the return earned on the common stockholders’ investment in the
firm. The firm earns 11 cents in profits for every dollar of equity. A grocery store chain
may have a very low net profit margin but still earn a respectable return on equity. How
do you think they achieve this?
5. Market Ratios relate the firm’s market value (per share) to its accounting values from
the balance sheet and income statement. Market ratios give insight into how well
investors in the marketplace feel that the firm is doing in terms of return and risk.
a. Price / Earnings (P/E) ratio = Market price per share / Earnings per share
The P/E ratio can be thought of as the price that an investor is willing to pay for
$1 of the firm’s earnings. It is sometimes referred to as “the multiple.” The level of the
P/E ratio indicates the degree of confidence that investors have in the firm's future.
The P/E is generally higher for growing firms (greater growth prospects) and for less
risky firms. Other things being equal, you’d like to find stocks with rising P/E ratios,
because higher P/E multiples usually translate into higher future stock prices and better
returns to stockholders. However, when it becomes too high, it my be a signal that the
stock is becoming overvalued and may be due for a fall.
Stocks with high P/E is called as Growth stocks while stocks with low P/E is called as
value stocks.
b. Market / Book (M/B) ratio=Price per share / Book Value of Equity per share
where Book Value per share = Common equity / shares of common outstanding
Stock should sell for more than its book value. Firms with high M/B ratios are expected
to perform better than firms with lower relative M/B values. This ratio is expected to be
higher for firms with few tangible assets, such as software firms, and lower for firms with
high levels of tangible assets.
c. Earning Per Share (EPS) = net profits after taxes/# of shares outstanding
2.3 The DuPont Formula: The DuPont system of analysis combines profitability (the
net profit margin), asset efficiency (the total asset turnover) and leverage (the debt
ratio). The division of ROE among these three ratios allows the analyst to the
segregate the specific factors that are contributing to the ROE into profitability,
asset efficiency, or the use of debt.
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Dupont Formula shows the inter-relationship among ratios:
Return NI NI Sales
Dupont Formula on = --- = ------- x -------
Asset TA Sales TA
Return Profit TA
on = x Turnover
Asset Margin Ratio
all income statement all balance sheet
items affect the ratio items
All items (ratios) in both income (profit margin) and balance sheet items (TA turnover
ratio) affect return on asset.
The return on equity (the most important ratio to common shareholders) is affected also
by financial leverage.
NI
Return on Equity = = ROA X EM
OE
ROE = (net profits after taxes / sales) * (sales / total assets)
* (total assets / stockholder’s equity)
ROE = Net Profit Margin * Total Asset Turnover*Equity Multiplier
: The first term describes the firm’s profit margin, the second term is a measure of the
efficiency with which it uses its assets, and the third term is the financial leverage
multiplier.
Assets/Equity ratio =(total-equity + total-debt) / total-equity
Equity multiplier = 1 + debt/equity ratio.
Even a firm with a low ROA can achieve a relatively high ROE through heavy use of
debt (leverage) and minimal use of owner’s capital.
ROE = 0.01*10 = 10%
ROE = 0.005*20 = 10%
More debt more returns on equity At the expense of high bankruptcy possibility.
The problem with ROE is that it says nothing about what risks a company has taken to
generate it. Here is a simple example. Take-a-Risk, Inc earns an ROA of 6 percent
combined with an asset-to-equity ratio of 5.0 to produce an ROE of 30 percent (6% *
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5.0). Never-Dare earns an ROA of 10 percent combined with an asset-to-equity ratio of
2.0 to produce an ROE of 20 percent (10% * 2.0).
Which company is better performer? My answer is Never-Dare. Take-a-Risk’s ROE is
high, but its high business risk and extreme financial leverage make it a very uncertain
enterprise.
The first two terms taken together equal ROA.
The owners are probably most interested in the Return on Equity (ROE) since it indicates
the rate of return they earn on their investment in the firm. ROE is calculated by taking
net profits after taxes and dividing by stockholders' equity.
3.4 Tips on using financial ratios:
1. Look for large deviations from past ratios for your firm. This could indicate that a
problem is developing. However, keep seasonal variation and patterns in mind.
Look for large deviations from past ratios for your firm. The analyst should
devote primary attention to any significant deviations from the norm, whether
above or below. Positive deviations from the norm are not necessarily favorable.
An above-normal inventory turnover ratio may indicate highly efficient inventory
management but may also reveal excessively low inventory levels resulting in
stockouts. Further examination into the deviation would be required.
2. Compare ratios with similar firms in the industry, but keep in mind that the ratios
derived from financial statements for some firms in the industry may include
information from unrelated subsidiaries.
3. Remember that while profitability ratios provide useful measures of cash flows,
they don’t take risk into account.
4. Keep in mind that ratios for different firms may have resulted from different
accounting methods in use.
5. When comparing ratios over time, keep in mind the effects of inflation and
depreciation on asset values. Firms with older assets may appear to be more
efficient and profitable than firms with newer assets.
6. Who is interested in ratio analysis? Primarily creditors, investors, and financial
managers.
* Ratio users: Most important ratios
a. Financial manager -------- All ratios
b. Creditor short term ------ Short term solvency
long term ------ Financial leverage, Profitability.
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c. Stock investor ---------- Profitability
* Ratio Analysis also can be used for:
a. Projection of Bankruptcy
b. Bond Rating (evaluation of quality of Bond)
c. Evaluation of Management Performance
d. Common Stock Valuation & Projection of future stock price
e. Debt Valuation
f. Auditors
g. Merger and acquisition Analysts
h. Regulators (IRS and SEC)
