Financial Management and

Investment
Dr. Tamer Mohamed Shahwan
Professor of Financial Management,
Department of Management, Faculty of Commerce,
Zagazig University
English Section Coordinator, Faculty of Commerce,
Zagazig University
Ph.D. in Business Administration, Humboldt University of
Berlin, Germany

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY

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 Chapter 3: Financial
Ratios and Financial
Performance
Learning Goals
LG1 Understand who uses financial ratios and how.
LG2 Use ratios to analyze a firm’s liquidity and activity.
LG3 Discuss the relationship between debt and financial
leverage and the ratios used to analyze a firm’s debt.
LG4 Use ratios to analyze a firm’s profitability and its market
value.
LG5 Use a summary of financial ratios and the DuPont system
of analysis to perform a complete ratio analysis.

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 2

 The Four Key Financial
Statements (1)
The Income Statement provides a financial
summary of a company’s operating results during a
specified period.

Although they are prepared quarterly for reporting

purposes, they are generally computed monthly by
management and quarterly for tax purposes.

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 3

Table 3.1 Bartlett Company
Income Statements ($000)

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 The Four Key Financial
Statements (2)

•The Balance Sheet presents a summary of a firm’s

financial position at a given point in time.

•The statement balances the firm’s assets (what it owns)

against its financing, which can be either debt (what it
owes) or equity (what was provided by owners).

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY

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Table 3.2a Bartlett Company
Balance Sheets ($000)

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 6

Table 3.2b Bartlett Company
Balance Sheets ($000)

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY

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 The Four Key Financial
Statements (3)
The Statement of Retained Earnings
reconciles the net income earned during a given
year, and any cash dividends paid, with the change
in retained earnings between the start and the end
of that year.

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY

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Table 3.3 Bartlett Company Statement of Retained Earnings
($000) for the Year Ended December 31, 2012

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY

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 Using Financial Ratios:
Interested Parties
•Ratio analysis involves methods of calculating and interpreting
financial ratios to analyze and monitor the firm’s performance.
•Current and prospective shareholders are interested in the firm’s
current and future level of risk and return, which directly affect
share price.
•Creditors are interested in the short-term liquidity of the
company and its ability to make interest and principal
payments.
•Management is concerned with all aspects of the firm’s financial
situation, and it attempts to produce financial ratios that will be
considered favorable by both owners and creditors.

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY

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 Using Financial Ratios:
Types of Ratio Comparisons

•Cross-sectional analysis is the comparison of different firms’

financial ratios at the same point in time; It involves
comparing the firm’s ratios to those of other firms in its
industry or to industry averages

•Benchmarking is a type of cross-sectional analysis in which

the firm’s ratio values are compared to those of a key
competitor or group of competitors that it wishes to emulate.

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY

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 Using Financial Ratios:
Types of Ratio Comparisons (cont.)

Caldwell Manufacturing’s calculated inventory

turnover for 2012 and the average inventory
turnover were as follows:

Inventory turnover,
2012
Caldwell Manufacturing 14.8
Industry average 9.7

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY

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Table 3.5 Financial Ratios for Select Firms and Their
Industry Median Values

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY

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Using Financial Ratios: Types
of Ratio Comparisons (cont.)
•Time-series analysis is the evaluation of the firm’s
financial performance over time using financial ratio
analysis
•Comparison of current to past performance, using
ratios, enables analysts to assess the firm’s progress.
•Developing trends can be seen by using multiyear
comparisons.
•The most informative approach to ratio analysis
combines cross-sectional and time-series analyses.
PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY
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Figure 3.1 Combined Analysis

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY

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 Using Financial Ratios: Cautions
about Using Ratio Analysis
1. Ratios that reveal large deviations from the norm merely
indicate the possibility of a problem.
2. A single ratio does not generally provide sufficient information
from which to judge the overall performance of the firm.
3. The ratios being compared should be calculated using
financial statements dated at the same point in time during the
year.
4. It is preferable to use audited financial statements.
5. The financial data being compared should have been
developed in the same way.
6. Results can be distorted by inflation.
PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 16
 Ratio Analysis Example

We will illustrate the use of financial ratios for

analyzing financial statements using the Bartlett
Company Income Statements and Balance Sheets
presented earlier in Tables 3.1 and 3.2.

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 17

 Ratio Analysis

Liquidity Ratios

Current ratio = Current assets ÷ Current liabilities

The current ratio for Bartlett Company in 2012 is:

$1,223,000 ÷ $620,000 = 1.97

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 18

 Matter of Fact
Determinants of liquidity needs
◦ Large enterprises generally have well
established relationships with banks that can
provide lines of credit and other short-term
loan products in the event that the firm has a
need for liquidity.
◦ Smaller firms may not have the same access to
credit, and therefore they tend to operate with
more liquidity.

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 19

 Ratio Analysis (cont.)
Liquidity Ratios

The quick ratio for Bartlett Company in 2012 is:

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 20

 Matter of Fact
The importance of inventories:
◦ From Table 3.5:
Company Current ratio Quick ratio
Dell 1.3 1.2
Home Depot 1.3 0.4
Lowes 1.3 0.2

◦ All three firms have current ratios of 1.3. However, the quick
ratios for Home Depot and Lowes are dramatically lower
than their current ratios, but for Dell the two ratios are
nearly the same. Why?
PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 21
 Ratio Analysis (cont.)
Activity Ratios

Inventory turnover = Cost of goods sold ÷ Inventory

Applying this relationship to Bartlett Company in

2012 yields:

$2,088,000 ÷ $289,000 = 7.2

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 22

 Ratio Analysis (cont.)
Activity Ratios

Average Age of Inventory = 365 ÷ Inventory turnover

For Bartlett Company, the average age of inventory

in 2012 is:

365 ÷ 7.2 = 50.7 days

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 23

 Ratio Analysis (cont.)
Activity Ratios

The average collection period for Bartlett Company in

2012 is:

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 24

Ratio Analysis (cont.)
Activity Ratios

If we assume that Bartlett Company’s purchases equaled 70

percent of its cost of goods sold in 2012, its average payment
period is:

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 25

 Ratio Analysis (cont.)
Activity Ratios

Total asset turnover = Sales ÷ Total assets

The value of Bartlett Company’s total asset turnover

in 2012 is:

$3,074,000 ÷ $3,597,000 = 0.85

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 26

 Ratio Analysis (cont.)
Debt Ratios

Debt ratio = Total liabilities ÷ Total assets

The debt ratio for Bartlett Company in 2012 is

$1,643,000 ÷ $3,597,000 = 0.457 = 45.7%

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 27

 Ratio Analysis (cont.)
Debt Ratios

Times interest earned ratio = EBIT ÷ interests

The figure for earnings before interest and taxes (EBIT) is

the same as that for operating profits shown in the income
statement.

Applying this ratio to Bartlett Company yields the

following
2012 value:

$418,000 ÷ $93,000 = 4.5

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PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY
 Ratio Analysis (cont.)
Debt Ratios
Fixed-Payment coverage Ratio (FPCR)

Applying the formula to Bartlett Company’s 2012 data yields:

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 29

 Ratio Analysis (cont.)
Profitability Ratios

Bartlett Company’s gross profit margin for 2012 is:

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 30

 Ratio Analysis (cont.)
Profitability Ratios

Operating profit margin = Operating profits ÷

sales

Bartlett Company’s operating profit margin for

2012 is:

$418,000 ÷ $3,074,000 = 13.6%

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 31

 Ratio Analysis (cont.)
Profitability Ratios

Net profit margin = Earnings available for

common
stockholders ÷ Sales

Bartlett Company’s net profit margin for 2012

is:

$221,000 ÷ $3,074,000 = 0.072 = 7.2%

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 32

 Ratio Analysis (cont.)
Profitability Ratios

Return on total assets (ROA) = Earnings available

for common stockholders ÷ Total assets

Bartlett Company’s return on total assets in 2012

is:

$221,000 ÷ $3,597,000 = 0.061 = 6.1%

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 34

 Ratio Analysis (cont.)
Profitability Ratios

Return on Equity (ROE) = Earnings available for

common stockholders ÷ Common stock equity

This ratio for Bartlett Company in 2012 is:

$221,000 ÷ $1,754,000 = 0.126 = 12.6%

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 35

 Ratio Analysis (cont.)
Market Ratios

Bartlett Company’s earnings per share (EPS) in 2012 is:

$221,000 ÷ 76,262 = $2.90

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 33

 Ratio Analysis (cont.)
Market Ratios

Price Earnings (P/E) Ratio = Market price per share of

common stock ÷ Earnings per share

If Bartlett Company’s common stock at the end of 2012

was selling at $32.25, using the EPS of $2.90, the P/E
ratio at year-end 2012 is:

$32.25 ÷ $2.90 = 11.1

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 36

 Ratio Analysis (cont.)
Market Ratios

where,

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 37

 Ratio Analysis (cont.)
Substituting the appropriate values for Bartlett Company
from its 2012 balance sheet, we get:

Substituting Bartlett Company’s end of 2012 common stock

price of $32.25 and its $23.00 book value per share of common
stock (calculated above) into the M/B ratio formula, we get:

$32.25 ÷ $23.00 = 1.40

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 38

 Table 3.8a Summary of
Bartlett Company Ratios

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 39

 Table 3.8b Summary of
Bartlett Company Ratios

PROF. DR. TAMER MOHAMED SHAHWAN, FACULTY OF COMMERCE, ZAGAZIG UNIVERSITY 40

 The Du Pont Identity (1)
The Du Pont Identity tells us that ROE is affected by three
factors.
If ROE is unsatisfactory by some measure, then the Du Pont
tells you where to start looking for the reasons. The main
components of ROE according to the Du Pont Identity are:
◦ Operating efficiency (as measured by profit margin).
◦ Asset use efficiency (as measured by total asset turnover).
◦ Financial leverage (as measured by the equity multiplier).
Weakness in either operating or asset use efficiency (or both)
will show up in a diminished return on assets, which will
translate into a lower ROE.
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The Du Pont Identity (2)

ROE = Net Income/ Total Equity Capital

ROA = Net Income/Total Assets x Equity Multiplier =

Total Assets/Equity Capital

Net Profit Margin = Asset Utilization =

x
Net Income/Total Operating Total Operating Revenue/Total Assets
Revenue

Accordingly, ROE= Profit margin × Total asset turnover × Equity multiplier

= 15.7% × 0.64 × 1.39
= 14%
© 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
 Standardized Financial Statements
It is almost impossible to directly compare the financial
statements for two companies of differences in size.
To start making comparisons, it is necessary to standardize the
financial statements.
One very common and useful way of doing this is to work with
percentages instead of total dollars.
The resulting financial statements are called common-size
statements.
Common-size balance sheets can be constructed by expressing
each item as a percentage of total assets.
Common-size income statements can also be constructed by
expressing each item as a percentage of total sales.

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 Al GANDOUR Corporation Balance Sheets as of December 31, 2008 and 2009
Assets ($ in millions) 2008 2009
Current assets
Cash $84 $98
Accounts receivable 165 188
Inventory 393 422
Total $642 $708
Fixed Assets
Balance
Net Plant and Equipment $2,731 $2,880
Sheets Total Assets $3,373 $3,588
2008 and Liabilities and owner’s Equity
2009 Current Liabilities
Accounts Payable $312 $344
Notes Payable 231 196
Total $543 $540
Long-term debt $531 $457
Owner’s equity
Common stock and paid-in surplus $500 $550
Retained earnings $1,799 $2,041
Total $2,299 $2,591
Total Liabilities and owners’ equity 3,373 $3,588
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 Al GANDOUR Corporation Common -Size Balance Sheets as of December 31, 2008 and 2009
Assets 2008 2009 Change
Current assets
Cash 2.5% 2.7% + 0.2%
Accounts receivable 4.9 5.2 + 0.3%
Inventory 11.7 11.8 + 0.1%
Total 19.1 19.7 + 0.6%
Fixed Assets
Net Plant and Equipment 80.9 80.3 -0 .6%
Total Assets 100.0% 100.0% 0.0%
Common- Liabilities and owner’s Equity

Size Current Liabilities

Balance Accounts Payable

Notes Payable
9.2%
6.8
9.6%
5.5
+ 0.4%
- 1.3%
Sheets Total 16 15.1 - 0.9
Long-term debt 15.7 12.7 -3.0%
Owner’s equity
Common stock and paid-in surplus 14.8% 15.3% + .5
Retained earnings 53.3 56.9 + 3.6
Total 68.1 72.2 + 4.1
Total Liabilities and owners’ equity 100% 100% 0%
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 Al GANDOUR Corporation 2009Income
statement ($ in millions)

Sales $2,311
Income
Cost of goods sold (1,344)
statement
Depreciation (276)
Earnings before interest and taxes 691
Interest paid (141)
Taxable income $550
Taxes (34%) (187)
Net income $363
Dividends $121
Addition to retained earnings $242

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 Al GANDOUR Corporation 2009 Common-
Size Income statement ($ in millions)

Sales 100%
Common- Cost of goods sold 58.2
Size Depreciation 11.9
Income Earnings before interest and taxes 29.9
statement Interest paid 6.1
Taxable income 23.8
Taxes (34%) 8.1
Net income 15.7%
Dividends 5.2%
Addition to retained earnings 10.5%

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