Republic of the Philippines

President Ramon Magsaysay State University

College of Accountancy and Business Administration
(Formerly Ramon Magsaysay Technological University)
Iba, Zambales, Philippines
Tel/Fax No.: (047) 811-1683

FINANCIAL MANAGEMENT
Module 3

ANALYSIS OF FINANCIAL STATEMENT

Name:
Course/Year and Section:
Instructor:
Date:

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 Republic of the Philippines
President Ramon Magsaysay State University
College of Accountancy and Business Administration
(Formerly Ramon Magsaysay Technological University)
Iba, Zambales, Philippines
Tel/Fax No.: (047) 811-1683

College/Department College of Accountancy and Business Administration

Course Code AE 19
Course Title Financial Management
Place of the Course in the
Program
Semester & Academic Year First Semester AY 2020-2021

Introduction

The primary goal of financial management is to maximize shareholders’ wealth, not

accounting measures such as net income or earnings per share (EPS). However, accounting
data influence stock prices, and these data can be used to see why a company is performing
the way it is and where it is heading.
This module describes how the statements are used by managers to improve the firm’s
stock price, by lenders to evaluate the likelihood that borrowers will be able to pay off loans,
and by security analysts to forecast earnings, dividends, and stock prices.

Intended Learning Outcomes

When the students finish this module, they should be able to do the following:
1. Explain what ratio analysis is.
2. List the five groups of ratios and identify, calculate, and interpret the key ratios in each
group.
3. Discuss each ratio’s relationship to the balance sheet and income statement.
4. Discuss why return on equity (ROE) is the key ratio under management’s control and how
the other ratios impact ROE, and explain how to use the DuPont equation for improving
ROE.
5. Compare a firm’s ratios with those of other firms (benchmarking) and analyze a given
firm’s ratios over time (trend analysis).
6. Discuss the tendency of ratios to fluctuate over time (which may or may not be
problematic), explain how they can be influenced by accounting practices as well as other
factors, and explain why they must be used with care.

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Discussion

RATIO ANALYSIS

Ratios are used to make comparisons. They are divided into five (5) categories:
1. Liquidity ratios give an idea of the firm’s ability to pay off debts that are maturing within a
year.
2. Asset management ratios give an idea of how efficiently the firm is using its assets.
3. Debt management ratios give an idea of how the firm has financed its assets as well as the
firm’s ability to repay its long-term debt.
4. Profitability ratios give an idea of how profitably the firm is operating and utilizing its
assets.
5. Market value ratios give an idea of what investors think about the firm and its future
prospects.
We will use the data in Z Company in Module 2 to show how to compute the
different categories of ratio.

Horizontal Analysis of Comparative Statements

It has been a requirement by the Generally Accepted Accounting Principle (GAAP) to

present comparative financial statements for the current year and the previous year. The
balance of accounts in the financial statements of the previous year is subtracted from the
current year.

Vertical Analysis using Common Size Statements

It uses percentages/ratios that present the relationship of the different accounts or

items in the financial statements. In statement of financial position, the base used is total
assets while in statement of financial performance, net sales or net revenue is the base.

LIQUIDITY RATIOS

The liquidity ratios help answer this question: Will the firm be able to pay off its debts
as they come due and thus remain a viable organization?
A liquid asset is one that trades in an active market and thus can be quickly converted
to cash at the going market price.

CURRENT RATIO

The primary liquidity ratio is the current ratio, which is calculated by dividing current
assets by current liabilities.

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 Current assets include cash, marketable securities, accounts receivable, and
inventories. On the other hand, current liabilities consist of accounts payable, accrued wages
and taxes, and short-term notes payable to its bank, all of which are due within 1 year.
If a company is having financial difficulty, it typically begins to pay its accounts
payable more slowly and to borrow more from its bank, both of which increase current
liabilities. If current liabilities are rising faster than current assets, the current ratio will fall,
and this is a sign of possible trouble.
An industry average is not a magic number that all firms should strive to maintain; in
fact, some very well managed firms may be above the average, while other good firms are
below it. However, if a firm’s ratios are far 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 (or management) to check further. A high current ratio
generally indicates a very strong, safe liquidity position. It might also indicate that the firm
has too much old inventory that will have to be written off and too many old accounts
receivable that may turn into bad debts. It also might indicate that the firm has too much cash,
receivables, and inventory relative to its sales, in which case these assets are not being
managed efficiently. So it is always necessary to thoroughly examine the full set of ratios
before forming a judgment as to how well the firm is performing.

QUICK OR ACID TEST RATIO

Quick or acid test ratio is calculated by deducting inventories from current assets and
then dividing the remainder by current liabilities.

Inventories are typically the least liquid of a firm’s current assets, and if sales
slowdown, they might not be converted to cash as quickly as expected. Also, inventories are
the assets on which losses are most likely to occur in the event of liquidation. Therefore, the
quick ratio, which measures the firm’s ability to pay off short-term obligations without
relying on the sale of inventories is important.
The industry average quick ratio is 2.2, so 1.2 ratio is relatively low. Still, if the
accounts receivable can be collected, the company can pay off its current liabilities even if it
has trouble disposing of its inventories.

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ASSET MANAGEMENT RATIOS

Asset management ratios measure how effectively the firm is managing its assets.
These ratios answer this question: Does the amount of each type of asset seem reasonable, too
high, or too low in view of current and projected sales?

INVENTORY TURNOVER RATIO

Turnover ratios divide sales by some asset: Sales/Various assets. These ratios show
how many times the particular asset is “turned over” during the year.

Sales occur over the entire year, whereas the inventory figure is for point in time. It
might be better to use an average inventory measure. If the 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 an adjustment.
Inventory turnover of 4.9 is lower than the industry average of 10.9. This suggests
that it is holding too much inventory. Excess inventory is unproductive and represents an
investment with a low or zero rate of return. Low inventory turnover ratio also makes us
question its current ratio. With such a low turnover, the firm may be holding obsolete goods
that are not worth their stated value.

DAYS SALE OUTSTANDING

Accounts receivable are evaluated by the days sales outstanding (DSO) ratio, also
called the average collection period (ACP). It is calculated by dividing accounts receivable by
the average daily sales to find how many days’ sales are tied up in receivables. Thus, the
DSO represents the average length of time the firm must wait after making a sale before
receiving cash. Thus, the DSO represents the average length of time the firm must wait after
making a sale before receiving cash.

The DSO can be compared with the industry average, but it is also evaluated by
comparing it with credit terms. Credit policy of Z Corporation calls for payment within 30
days. So the fact that 46 days’ sales are outstanding, not 30 days’, indicate that Z
Corporation’s customers, on average, are not paying their bills on time. This deprives the
company of funds that could be used to reduce bank loans or some other type of costly
capital. Moreover, the high average DSO indicates that if some customers are paying on time,

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quite a few must be paying very late. Late-paying customers often default, so their
receivables may end up as bad debts that can never be collected.

FIXED ASSETS TURNOVER RATIO

The fixed assets turnover ratio is the ratio of sales to net fixed assets. It measures how
effectively the firm uses its plant and equipment.
Z Corporation’s ratio of 3.0 times is slightly above the 2.8 industry average,
indicating that it is using its fixed assets at least as intensively as other firms in the industry.
Therefore, Z Corporation seems to have about the right amount of fixed assets relative to its
sales.

Potential problems may arise when interpreting the fixed assets turnover ratio. Fixed
assets are shown on the statement of financial position at their historical costs less
depreciation. Inflation has caused the value of many assets that were purchased in the past to
be seriously understated. Therefore, if we compare an old firm whose fixed assets have been
depreciated with a new company with similar operations that acquired its fixed assets only
recently, the old firm will probably have the higher fixed assets turnover ratio. However, this
would be more reflective of the age of the assets than of inefficiency on the part of the new
firm.

TOTAL ASSETS TURNOVER RATIO

The total assets turnover ratio measures the turnover of all of the firm’s assets, and it
is calculated by dividing sales by total assets.

Z Corporation’s ratio is below the industry average, indicating that it is not generating
enough sales given its total assets. Z Corporation’s fixed assets turnover is in line with the
industry average; so the problem is with its current assets, inventories, and accounts
receivable, whose ratios were below the industry standards. Inventories should be reduced
and receivables collected faster, which would improve operations.

DEBT MANAGEMENT RATIOS

Debt management ratios are set of ratios that measure how effectively a firm manages
its debt.

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 Firms with relatively high debt ratios typically have higher expected returns when the
economy is normal, but experience lower returns and possibly face bankruptcy if the
economy goes into a recession. Therefore, decisions about the use of debt require firms to
balance higher expected returns against increased risk.

TOTAL DEBT TO TOTAL CAPITAL

The ratio of total debt to total capital measures the percentage of the firm’s capital
provided by debt holders:

Total debt includes all short-term and long-term interest-bearing debt, but it does not
include operating items such as accounts payable and accruals. Z Corporation has total debt
of $860 million, which consists of $110 million in short-term notes payable and $750 million
in long-term bonds. Its total capital is $1.80 billion: $860 million of debt plus $940 million in
total equity. 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 can magnify expected earnings.

TIMES INTEREST EARNED RATIO

The times-interest-earned (TIE) ratio is determined by dividing earnings before

interest and taxes (EBIT) by the interest charges.

The TIE ratio measures the extent to which operating income can decline before the
firm is unable to meet its annual interest costs. Failure to pay interest will bring legal action
by the firm’s creditors and probably result in bankruptcy. Note that earnings before interest
and taxes, rather than net income, are used in the numerator. Because interest is paid with
pretax dollars, the firm’s ability to pay current interest is not affected by taxes.
Z Corporation’s interest is covered 3.2 times. The industry average is 6 times, so Z is
covering its interest charges by a much lower margin of safety than the average firm in the
industry. Thus, the TIE ratio reinforces that Z would face difficulties if it attempted to borrow
additional money.

PROFITABILITY RATIOS

Profitability ratios reflect the net result of the entire firm’s financing policies and
operating decisions.

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OPERATING MARGIN

The operating margin is calculated by dividing operating income (EBIT) by sales.

Z Corporation’s 9.5% operating margin is below the industry average of 10.0%. This
result indicates that Z Corporation’s operating costs are too high.

PROFIT MARGIN

The profit margin, also sometimes called the net profit margin, is calculated by
dividing net income by sales.

Z Corporation’s 3.9% profit margin is below the industry average of 5.0%, and this
result occurred for two reasons. First, Z Corporation’s operating margin was below the
industry average because of the firm’s high operating costs. Second, the profit margin is
negatively impacted by Z Corporation’s heavy use of debt.

RETURN ON TOTAL ASSETS

Net income divided by total assets gives the return on total assets.

Z Corporation’s 5.9% return is well below the 9.0% industry average. A low ROA
can result from a conscious decision to use a great deal of debt, in which case high interest
expenses will cause net income to be relatively low.

RETURN ON COMMON EQUITY

The ratio of net income to common equity measures the rate of return on common
stockholders’ investment.

Stockholders expect to earn a return on their money, and this ratio tells how well they
are doing in an accounting sense. Z Corporation’s 12.5% return is below the 15.0% industry
average, but not as far below as the return on total assets.

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RETURN ON INVESTED CAPITAL

The return on invested capital (ROIC) measures the total return that the company has
provided for its investors.

ROIC differs from ROA in two ways. First, its return is based on total invested capital
rather than total assets. Second, in the numerator it uses after-tax operating income (NOPAT)
rather than net income. The key difference is that net income subtracts the company’s after-
tax interest expense and therefore represents the total amount of income available to
shareholders, while NOPAT is the amount of funds available to pay both stockholders and
debt holders.

BASIC EARNING POWER RATIO

The basic earning power (BEP) ratio is calculated by dividing operating income
(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.

MARKET VALUE RATIOS

The market value ratios are used in three primary ways: (1) by investors when they
are deciding to buy or sell a stock, (2) by investment bankers when they are setting the share
price for a new stock issue and (3) by firms when they are deciding how much to offer for
another firm in a potential merger.

PRICE EARNINGS RATIO

The price/earnings (P/E) ratio shows how much investor is willing to pay per dollar of
reported profits.

Z Corporation’s P/E ratio is below its industry average; so this suggests that the
company is regarded as being relatively risky, as having poor growth prospects, or both.

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MARKET/BOOK RATIO

The ratio of a stock’s market price to its book value gives another indication of how
investors regard the company.

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. This situation occurs primarily
because asset values, as reported by accountants on corporate balance sheets, do not reflect
either inflation or goodwill. Assets purchased years ago at pre-inflation prices are carried at
their original costs even though inflation might have caused their actual values to rise
substantially; successful companies’ values rise above their historical costs, whereas
unsuccessful ones have low M/B ratios.

ENTERPRISE VALUE/EBITDA RATIO

Unlike the P/E and the market/book ratios, both of which focus on the relative market
value of the company’s equity, the EV/EBITDA ratio looks at the relative market value of all
the company’s key financial claims. One benefit of this approach is that unlike the P/E ratio,
the EV/EBITDA ratio is not heavily influenced by the company’s debt and tax situations.

THE DUPONT EQUATION

Dupont Equation 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.

The first term, the profit margin, tells us how much the firm earns on its sales. This
ratio depends primarily on costs and sales prices—if a firm can command a premium price
and hold down its costs, its profit margin will be high, which will help its ROE.
The second term is the total assets turnover. It is a “multiplier” that tells us how many
times the profit margin is earned each year—Z earned 3.92% on each dollar of sales, and its

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assets were turned over 1.5 times each year; so its return on assets was 3.92% x 1.5 = 5.9%.
Note, though, that this entire 5.9% belongs to the common stockholders—the bondholders
earned a return in the form of interest, and that interest was deducted before we calculated net
income to stockholders. So the whole 5.9% return on assets belongs to the stockholders.
Therefore, the return on assets must be adjusted upward to obtain the return on equity.
That brings the third term, the equity multiplier, which is the adjustment factor. Z
Corporation’s assets are 2.13 times its equity, so we must multiply the 5.9% return on assets
by the 2.133 equity multiplier to arrive at its ROE of 12.5%.
Z Corporation’s management can use the DuPont equation to help identify ways to
improve its performance. Focusing on the profit margin, its marketing people can study the
effects of raising sales prices or of introducing new products with higher margins. Its cost
accountants can study various expense items and, working with engineers, purchasing agents,
and other operating personnel, seek ways to cut costs.
The credit manager can investigate ways to speed up collections, which would reduce
accounts receivable and therefore improve the quality of the total assets turnover ratio. And
the financial staff can analyze the effects of alternative debt policies, showing how changes in
leverage would affect both the expected ROE and the risk of bankruptcy.

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SUMMARY OF FINANCIAL RATIOS

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USING FINANCIAL RATIOS TO ASSESS PERFORMANCE

Although financial ratios help us evaluate financial statements, it is often hard to

evaluate a company by just looking at the ratios. A company could look at industry averages;
it could compare itself to specific companies or “benchmarks”; and it can analyze the trends
in each ratio.

1. COMPARISON TO INDUSTRY AVERAGE

One way to assess performance is to compare the company’s key ratios to the industry
averages.

2. BENCHMARKING
The process of comparing a particular company with a subset of top competitors in its
industry is benchmarking.

3. TREND ANALYSIS
The process of comparing a particular company with a subset of top competitors in its
industry.

USES AND LIMITATIONS OF RATIOS

Ratio analysis is used by three main groups: (1) managers who use 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 judge a company’s ability
to repay its debts; and (3) stock analysts who are interested in a company’s efficiency, risk,
and growth prospects. It can provide useful information concerning a company’s operations
and financial condition, it does have limitations. Some potential problems are:

1. Many firms have divisions that operate in different industries; for such companies, it is
difficult to develop a meaningful set of industry averages.
2. Most firms want to be better than average, so merely attaining average performance is not
necessarily good.
3. Inflation has distorted many firms’ balance sheets—book values are often different from
market values. Market values would be more appropriate for most purposes, but we cannot
generally get market value figures because assets such as used machinery are not traded in
the marketplace. Further, inflation affects asset values, depreciation charges, inventory costs,
and thus profits. Therefore, a ratio analysis for one firm over time or a comparative analysis
of firms of different ages must be interpreted with care and 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.
5. Firms can employ “window dressing” techniques to improve their financial statements. To
illustrate, people tend to think that larger hedge funds got large because their high returns
attracted many investors.

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6. Different accounting practices can distort comparisons. Inventory valuation and
depreciation methods can affect financial statements and thus distort comparisons among
firms.
7. 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, but it
can also indicate excessive cash, which is bad because excess cash in the bank is a
nonearning asset.
8. Firms often 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. To deal with this
problem, banks and other lending organizations often use statistical procedures to analyze the
net effects of a set of ratios and to classify firms according to their probability of getting into
financial trouble.

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 Republic of the Philippines
President Ramon Magsaysay State University
College of Accountancy and Business Administration
(Formerly Ramon Magsaysay Technological University)
Iba, Zambales, Philippines
Tel/Fax No.: (047) 811-1683

Student Name:___________________ Email Address:_________________

Course/Year:_____________________ Mobile Number:________________

Kindly answer the questions and submit your answers to my email address
[email protected] on October 03, 2020.

1. RATIO ANALYSIS. Data for Cherry Computer Co. and its industry averages follow. The
firm’s debt is priced at par, so the market value of its debt equals its book value. Since dollars
are in thousands, number of shares is shown in thousands too.
a. Calculate the indicated ratios for Cherry.
b. Construct the DuPont equation for both Cherry and the industry.
c. Suppose Cherry had doubled its sales as well as its inventories, accounts receivable, and
common equity during 2018. How would that information affect the validity of your ratio
analysis? (Hint: Think about averages and the effects of rapid growth on ratios if averages are
not used. No calculations are needed.)

Cherry Computer Co.

STATEMENT OF FINANCIAL POSITION
DECEMBER 31, 2018

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 Cherry Computer Co.
STATEMENT OF FINANCIAL PERFORMANCE
DECEMBER 31, 2018

RATIO CHERRY INDUSTRY AVERAGE

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2. DAYS SALES OUTSTANDING. BB has a DSO of 23 days, and its annual sales are
$3,650,000. What is its accounts receivable balance? Assume that it uses a 365-day year.

3. DEBT TO CAPITAL RATIO. CC has a market/book ratio equal to 1. Its stock price is $12
per share and it has 4.8 million shares outstanding. The firm’s total capital is $110 million
and it finances with only debt and common equity. What is its debt-to-capital ratio?

4. DuPONT ANALYSIS. HH has an ROA of 11%, a 6% profit margin, and an ROE of 23%.
What is its total assets turnover? What is its equity multiplier?

5. PRICE/EARNINGS RATIO A company has an EPS of $2.40, a book value per share of
$21.84, and a market/book ratio of 2.73. What is its P/E ratio?

6. ROE AND ROIC. M Industries’s net income is $24,000, its interest expense is $5,000, and
its tax rate is 40%. Its notes payable equals $27,000, long-term debt equals $75,000, and
common equity equals $250,000. The firm finances with only debt and common equity, so it
has no preferred stock. What are the firm’s ROE and ROIC?

7. Define each of the following terms:

a. Liquid asset
b. Liquidity ratios: current ratio; quick (acid test) ratio
c. Asset management ratios: inventory turnover ratio; days sales outstanding (DSO); fixed
assets turnover ratio; total assets turnover ratio
d. Debt management ratios: total debt to total capital; times-interest-earned (TIE) ratio
e. Profitability ratios: operating margin; profit margin; return on total assets (ROA); return on
common equity (ROE); return on invested capital (ROIC); basic earning power (BEP) ratio
f. Market value ratios: price/earnings (P/E) ratio; market/book (M/B) ratio; enterprise
value/EBITDA ratio

Resources
Mc Graw Hill-Fundamentals of Corporate Finance, 5th Edition.2007.
Keown, Martin, Petty, Scott- Financial Management Principles and Applications, 10th
Edition.Prentice Hall. 2005.
Brigham, Houston-Fundamentals of Financial Management 15th Edition

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