Financial Statements and Ratio Analysis: Learning Goals

9/11/2013
Chapter 3
Financial
Statements
and Ratio
Analysis
Copyright © 2012 Pearson Education
Learning Goals
LG1 Review the contents of the stockholders’ report

and the procedures for consolidating international
financial statements.
LG2 Understand who uses financial ratios and how.
LG3 Use ratios to analyze a firm’s liquidity and activity.
© 2012 Pearson Education 3-2
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Learning Goals (cont.)
LG4 Discuss the relationship between debt and

financial leverage and the ratios used to analyze a
firm’s debt.
LG5 Use ratios to analyze a firm’s profitability and its

market value.
LG6 Use a summary of financial ratios and the DuPont

system of analysis to perform a complete ratio
analysis.
The Stockholders’ Report
• Generally accepted accounting principles (GAAP) are

the practice and procedure guidelines used to prepare
and maintain financial records and reports;
authorized by the Financial Accounting Standards
Board (FASB).
• The Sarbanes-Oxley Act of 2002, passed to eliminate
the many disclosure and conflict of interest problems
of corporations, established the Public Company
Accounting Oversight Board (PCAOB), which is a
not-for-profit corporation that overseas auditors.
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Global Focus
More Countries Adopt International Financial Reporting Standards

– International Financial Reporting Standards (IFRS) are
established by the International Accounting Standards Board
(IASB).
– More than 80 countries now require listed firms to comply
with IFRS, and dozens more permit or require firms to follow
IFRS to some degree.
– In the United States, public companies are required to report
financial results using GAAP, which requires more detail
than IFRS.
– What costs and benefits might be associated with a switch to
IFRS in the United States?
Focus on Ethics
Take Earnings Reports at Face Value

– Near the end of each quarter, many companies unveil their
quarterly performance.
– Firms that beat analyst estimates often see their share prices
jump, while those that miss estimates by even a small amount,
tend to suffer price declines.
– The practice of manipulating earnings in order to mislead
investors is known as earnings management.
– Why might financial managers be tempted to manage earnings?
– Is it unethical for managers to manage earnings if they disclose
their activities to investors?
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The Four Key Financial Statements:

The Income Statement
• 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.
Table 3.1 Bartlett Company

Income Statements ($000)
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The Four Key Financial

Statements: The Balance Sheet
• 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).
Table 3.2a Bartlett Company

Balance Sheets ($000)
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Table 3.2b Bartlett Company

Balance Sheets ($000)

Statement of Retained Earnings
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.
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Table 3.3 Bartlett Company Statement of

Retained Earnings ($000) for the Year Ended
December 31, 2012

Statement of Cash Flows
• The statement of cash flows provides a summary
of the firm’s operating, investment, and
financing cash flows and reconciles them with
changes in its cash and marketable securities
during the period.
• This statement not only provides insight into a
company’s investment, financing and operating
activities, but also ties together the income
statement and previous and current balance
sheets.
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Table 3.4 Bartlett Company Statement of

Cash Flows ($000) for the Year Ended
December 31, 2012
Consolidating International
Financial Statements
• FASB 52 mandates that U.S.-based companies
translate their foreign-currency-denominated assets
and liabilities into dollars, for consolidation with the
parent company’s financial statements. This is done by
using the current rate (translation) method.
• The current rate (translation) method is a technique
used by U.S.-based companies to translate their
foreign-currency-denominated assets and liabilities
into dollars, for consolidation with the parent
company’s financial statements, using the year-end
(current) exchange rate.
• Income statement items are usually treated similarly.
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Consolidating International
Financial Statements (cont.)
• Equity accounts, on the other hand, are
translated into dollars by using the
exchange rate that prevailed when the
parent’s equity investment was made (the
historical rate).
• Retained earnings are adjusted to reflect
each year’s operating profits (or losses).
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.
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Interested Parties
Ratio analysis involves methods of
calculating and interpreting financial
ratios to assess a firm’s financial
condition and performance.
It is of interest to shareholders,
creditors, and the firm’s own
management.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-١٩

Types of Ratio Comparisons
Trend or time-series analysis

– Used to evaluate a firm’s performance
over time
– Up Trend
– Down Trend
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Types of Ratio Comparisons (cont.)
Cross-sectional analysis
– Used to compare different firms at the same
point in time
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-٢١

– Industry comparative analysis
• One specific type of cross sectional analysis. Used to
compare one firm’s financial performance to the
industry’s average performance
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-٢٢
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– Benchmarking
• 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
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-٢٣


Combined Analysis
– Combined analysis simply uses a
combination of both time series analysis and
cross-sectional analysis
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Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-٢٥
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-٢٦
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Figure 3.1 Combined Analysis
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.
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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.
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
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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.
Ratio Analysis (cont.)
Liquidity Ratios
The quick ratio for Bartlett Company in 2012 is:
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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?
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
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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
Activity Ratios
The average collection period for Bartlett Company in 2012

is:
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Matter of Fact
Who gets credit?

– Notice in Table 3.5 the vast differences across
industries in the average collection periods.
– Companies in the building materials, grocery, and
merchandise store industries collect in just a few
days, whereas firms in the computer industry take
roughly two months to collect on their sales.
– The difference is primarily due to the fact that
these industries serve very different customers.
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:
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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
Matter of Fact
Sell it fast
– Observe in Table 3.5 that the grocery business
turns over assets faster than any of the other
industries listed.
– That makes sense because inventory is among the
most valuable assets held by these firms, and
grocery stores have to sell baked goods, dairy
products, and produce quickly or throw them
away when they spoil.
– On average, a grocery stores has to replace its
entire inventory in just a few days or weeks, and
that contributes to the rapid turnover of the firms
total assets.
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Table 3.6 Financial Statements

Associated with Patty’s Alternatives
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%
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Debt Ratios
Times interest earned ratio = EBIT ÷ taxes
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
Debt Ratios
Fixed-Payment coverage Ratio (FPCR)
Applying the formula to Bartlett Company’s 2012 data yields:
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Table 3.7 Bartlett Company

Common-Size Income Statements
Profitability Ratios
Bartlett Company’s gross profit margin for 2012 is:
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Operating profit margin = Operating profits ÷
sales
Bartlett Company’s operating profit margin for 2012

is:
$418,000 ÷ $3,074,000 = 13.6%
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%
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Bartlett Company’s earnings per share (EPS) in 2012

is:
$221,000 ÷ 76,262 = $2.90
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%
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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%
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

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Market Ratios
where,
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
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Table 3.8a Summary of

Bartlett Company Ratios
Table 3.8b Summary of

Bartlett Company Ratios
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DuPont System of Analysis
• The DuPont system of analysis is used to dissect the

firm’s financial statements and to assess its financial
condition.
• It merges the income statement and balance sheet into
two summary measures of profitability.
• The Modified DuPont Formula relates the firm’s ROA
to its ROE using the financial leverage multiplier
(FLM), which is the ratio of total assets to common
stock equity:
• ROA and ROE as shown in the series of equations on
the following slide.
• The DuPont system first brings together the net profit

margin, which measures the firm’s profitability on
sales, with its total asset turnover, which indicates how
efficiently the firm has used its assets to generate sales.
ROA = Net profit margin × Total asset turnover
• Substituting the appropriate formulas into the
equation and simplifying results in the formula given
earlier,
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(cont.)
When the 2012 values of the net profit
margin and total asset turnover for
Bartlett Company, calculated earlier,
are substituted into the DuPont
formula, the result is:
ROA = 7.2% × 0.85 = 6.1%

DuPont System of Analysis:

Modified DuPont Formula
• The modified DuPont Formula relates the firm’s return on
total assets to its return on common equity. The latter is
calculated by multiplying the return on total assets (ROA)
by the financial leverage multiplier (FLM), which is the
ratio of total assets to common stock equity:
ROE = ROA × FLM
• Substituting the appropriate formulas into the equation
and simplifying results in the formula given earlier,
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DuPont System of Analysis:

Modified DuPont Formula (cont.)
Substituting the values for Bartlett

Company’s ROA of 6.1 percent, calculated
earlier, and Bartlett’s FLM of 2.06
($3,597,000 total assets ÷ $1,754,000
common stock equity)
into the modified DuPont formula yields:
ROE = 6.1% × 2.06 = 12.6%
Matter of Fact
Dissecting ROA
– Return to Table 3.5 and examine the total asset
turnover figures for Dell and Home Depot.
– Both firms turn their assets 1.6 times per year.
– Dell’s ROA is 4.3%, but Home Depot’s is
significantly higher at 6.5%. Why?
– The answer lies in the DuPont formula.
– Notice that Home Depot’s net profit margin is
4.0% compared to Dell’s 2.7%.
31

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9/11/2013

Copyright © 2012 Pearson Education

LG1 Review the contents of the stockholders’ report

LG2 Understand who uses financial ratios and how.

LG3 Use ratios to analyze a firm’s liquidity and activity.

© 2012 Pearson Education 3-2

Learning Goals (cont.)

LG4 Discuss the relationship between debt and

LG5 Use ratios to analyze a firm’s profitability and its

LG6 Use a summary of financial ratios and the DuPont

© 2012 Pearson Education 3-3

The Stockholders’ Report

• Generally accepted accounting principles (GAAP) are

© 2012 Pearson Education 3-4

More Countries Adopt International Financial Reporting Standards

Take Earnings Reports at Face Value

© 2012 Pearson Education 3-6

The Four Key Financial Statements:

• The income statement provides a financial

© 2012 Pearson Education 3-7

Table 3.1 Bartlett Company

© 2012 Pearson Education 3-8

The Four Key Financial

© 2012 Pearson Education 3-9

Table 3.2a Bartlett Company

© 2012 Pearson Education 3-10

Table 3.2b Bartlett Company

© 2012 Pearson Education 3-11

The Four Key Financial Statements:

The statement of retained earnings

© 2012 Pearson Education 3-12

Table 3.3 Bartlett Company Statement of

© 2012 Pearson Education 3-13

The Four Key Financial Statements:

Table 3.4 Bartlett Company Statement of

© 2012 Pearson Education 3-15

© 2012 Pearson Education 3-17

Using Financial Ratios:

© 2012 Pearson Education 3-18

Using Financial Ratios:

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-١٩

Using Financial Ratios:

Trend or time-series analysis

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-٢٠

Using Financial Ratios:

Trend or time-series analysis

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-٢١

Using Financial Ratios:

Trend or time-series analysis

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-٢٢

Using Financial Ratios:

Trend or time-series analysis

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-٢٣

Using Financial Ratios:

Trend or time-series analysis

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-٢٤

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-٢٥

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-٢٦

Figure 3.1 Combined Analysis