Chapter- 03

Financial Statements and Ratio Analysis

All Values in
Thousand
dollars

Page-108
From Book
All Values in
Thousand
dollars

Page-111
From Book
• Generally accepted accounting principles (GAAP)- The practice and
procedure guidelines used to prepare and maintain financial records and
reports; authorized by the Financial Accounting Standards Board (FASB).

• Financial Accounting Standards Board (FASB)- The accounting

profession’s rule-setting body, which authorizes generally accepted
accounting principles (GAAP).

• Four Key Financial Statements

▪ Income Statement
▪ Balance sheet
▪ Statement of retained earnings
▪ Statement of cash flows

• Ratio analysis- Involves methods of calculating and interpreting financial

ratios to analyze and monitor the firm’s performance.
▪ Income statement- Provides a financial summary of the firm’s
operating results during a specified period.

▪ Balance sheet- Summary statement of the firm’s financial position

at a given point in time.

▪ 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.

▪ 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.
Current assets- Short-term assets, expected to be converted into
cash within 1 year or less.

Current liabilities- Short-term liabilities, expected to be paid

within 1 year or less.

Long-term debt- Debts for which payment is not due in the current
year.

Paid-in capital in excess of par- The amount of proceeds in excess

of the par value received from the original sale of common stock.

Retained earnings- The cumulative total of all earnings, net of

dividends, that have been retained and reinvested in the firm since
its inception.
 Liquidity Ratios
1. Current ratio- A measure of liquidity calculated by dividing the
firm’s current assets by its current liabilities.

The current ratio, one of the most commonly cited financial ratios,
measures the firm’s ability to meet its short-term obligations. It is
expressed as follows:
2. Quick (acid-test) ratio- A measure of liquidity calculated by dividing
the firm’s current assets minus inventory by its current liabilities.

The quick (acid-test) ratio is similar to the current ratio except that it
excludes inventory, which is generally the least liquid current asset.
The quick ratio is calculated as follows:

A quick ratio of 1.0 or greater is occasionally recommended, but as

with the current ratio, what value is acceptable depends largely on the
industry. The quick ratio provides a better measure of overall liquidity
only when a firm’s inventory cannot be easily converted into cash. If
inventory is liquid, the current ratio is a preferred measure of overall
liquidity.
 Activity Ratios
Activity ratios- Measure the speed with which various accounts are converted
into sales or cash—inflows or outflows.
1. Inventory turnover- Measures the activity, or liquidity, of a firm’s
inventory. It is calculated as follows:

The resulting turnover is meaningful only when it is compared with that of other
firms in the same industry or to the firm’s past inventory turnover. An inventory
turnover of 20.0 would not be unusual for a grocery store, whereas a common
inventory turnover for an aircraft manufacturer is 4.0.
2. Average age of inventory- Average number of days’ sales in inventory.

Inventory turnover can be easily converted into an average age of

inventory by dividing it into 360—the assumed number of days in a year.
For Bartlett Company, the average age of inventory in 2003 is 50.0 days
(360/7.2). This value can also be viewed as the average number of days’
sales in inventory.

3. Average collection period- The average amount of time needed to

collect accounts receivable. It is arrived at by dividing the average daily
sales into the accounts receivable balance:
On the average, it takes the firm 58.9 days to collect an account receivable.
The average collection period is meaningful only in relation to the firm’s
credit terms. If Bartlett Company extends 30-day credit terms to
customers, an average collection period of 58.9 days may indicate a poorly
managed credit or collection department, or both. It is also possible that the
lengthened collection period resulted from an intentional relaxation of
credit-term enforcement in response to competitive pressures. If the firm
had extended 60-day credit terms, the 58.9-day average collection period
would be quite acceptable. Clearly, additional information is needed to
evaluate the effectiveness of the firm’s credit and collection policies.
4. Average payment period- The average amount of time needed to pay
accounts payable.

The difficulty in calculating this ratio stems from the need to find annual
purchases, 11 a value not available in published financial statements.
Ordinarily, purchases are estimated as a given percentage of cost of goods
sold. If we assume that Bartlett Company’s purchases equaled 70 percent
of its cost of goods sold in 2003, its average payment period is

This figure is meaningful only in relation to the average credit terms

extended to the firm. If Bartlett Company’s suppliers have extended, on
average, 30-day credit terms, an analyst would give Bartlett a low credit
rating. Prospective lenders and suppliers of trade credit are most interested
in the average payment period because it provides insight into the firm’s
bill-paying patterns.
5. Total asset turnover- Indicates the efficiency with which the firm
uses its assets to generate sales. Total asset turnover is calculated as
follows:

This means the company turns over its assets 0.85 times a year.

Generally, the higher a firm’s total asset turnover, the more efficiently its
assets have been used. This measure is probably of greatest interest to
management, because it indicates whether the firm’s operations have
been financially efficient.
 Debt Ratios

• The debt position of a firm indicates the amount of other people’s money
being used to generate profits.
• In general, the financial analyst is most concerned with long-term debts,
because these commit the firm to a stream of payments over the long run.
• Because creditors’ claims must be satisfied before the earnings can be
distributed to shareholders, present and prospective shareholders pay close
attention to the firm’s ability to repay debts.
• Lenders are also concerned about the firm’s indebtedness.
• Management obviously must be concerned with indebtedness.
 Debt Ratios

1. Debt ratio- Measures the proportion of total assets financed by the

firm’s creditors.
The higher this ratio, the greater the amount of other people’s money
being used to generate profits. The ratio is calculated as follows:

This value indicates that the company has financed close to half of its
assets with debt.
2. Times interest earned ratio- Measures the firm’s ability to make
contractual interest payments; sometimes called the interest coverage
ratio.
The higher its value, the better able the firm is to fulfill its interest
obligations. The times interest earned ratio is calculated as follows:

The times interest earned ratio for Bartlett Company seems acceptable. A
value of at least 3.0—and preferably closer to 5.0—is often suggested.

**Earnings before interest and taxes (EBIT) is also known as

Operating Profits [Please check Income Statement from Table 2.1
in Slide-02]
 3. Fixed-payment coverage ratio- Measures the firm’s ability to meet
all fixed-payment obligations such as loan interest and principal, lease
payments, and preferred stock dividends.
As is true of the times interest earned ratio, the higher this value, the
better. The formula for the fixed-payment coverage ratio is:

where T is the corporate tax rate applicable to the firm’s income.

Applying the formula to Bartlett Company’s 2003 data yields:

**All the values required in this formula will be given in the question paper
 Profitability Ratios

Profitability ratios- Enable the analyst to evaluate the firm’s profits with
respect to a given level of sales, a certain level of assets, or the owners’
investment. Without profits, a firm could not attract outside capital. Owners,
creditors, and management pay close attention to boosting profits because
of the great importance placed on earnings in the marketplace.

1. Gross profit margin- Measures the percentage of each sales dollar

remaining after the firm has paid for its goods.
The higher the gross profit margin, the better (that is, the lower the relative
cost of merchandise sold). The gross profit margin is calculated as follows:
2. Operating profit margin- Measures the percentage of each sales
dollar remaining after all costs and expenses other than interest, taxes,
and preferred stock dividends are deducted; the “pure profits” earned on
each sales dollar.

A high operating profit margin is preferred. The operating profit margin

is calculated as follows:
3. Net profit margin- Measures the percentage of each sales dollar
remaining after all costs and expenses, including interest, taxes, and
preferred stock dividends, have been deducted.

The higher the firm’s net profit margin, the better. The net profit margin is
calculated as follows:

The net profit margin is a commonly cited measure of the firm’s success
with respect to earnings on sales. “Good” net profit margins differ
considerably across industries. A net profit margin of 1 percent or less
would not be unusual for a grocery store, whereas a net profit margin of
10 percent would be low for a retail jewelry store.
 Profitability Ratios
4. Earnings per Share (EPS) - The firm’s earnings per share (EPS) is
generally of interest to present or prospective stockholders and
management. EPS represents the number of dollars earned during the
period on behalf of each outstanding share of common stock. Earnings
per share is calculated as follows:

Value of ‘Number of shares of common stock outstanding’ is given in

the “Common Stock” portion of the Balance Sheet (Table 2.2). This
figure represents the dollar amount earned on behalf of each share.
EPS is closely watched by the investing public and is considered an
important indicator of corporate success.
5. Return on total assets (ROA)- Measures the overall effectiveness of
management in generating profits with its available assets; also called
the return on investment (ROI).

The higher the firm’s return on total assets, the better. The return on
total assets is calculated as follows:
6. Return on common equity (ROE)- Measures the return earned on
the common stockholders’ investment in the firm.
Generally, the higher this return, the better off are the owners. Return
on common equity is calculated as follows:

**Total Stockholders’ Equity includes Preferred Stock, Common

Stock, Pain-in Capital and Retained Earnings [Please check
Balance Sheet from Table 2.2 in Slide-03]
 Market Ratios
Market ratios- Relate a firm’s market value, as measured by its current
share price, to certain accounting values. These ratios give insight into how
well investors in the marketplace feel the firm is doing in terms of risk and
return.

1. Price/earnings (P/E) ratio- Measures the amount that investors are

willing to pay for each dollar of a firm’s earnings.
The level of the price/earnings ratio indicates the degree of confidence that
investors have in the firm’s future performance. The higher the P/E ratio,
the greater is investor confidence. The P/E ratio is calculated as follows:

This figure indicates that investors were paying $11.10 for each $1.00 of
earnings.
2. Market/book (M/B) ratio- Provides an assessment of how investors
view the firm’s performance. Firms expected to earn high returns relative
to their risk typically sell at higher M/B multiples.

It relates the market value of the firm’s shares to their book—strict

accounting—value. To calculate the firm’s M/B ratio, we first need to find
the book value per share of common stock: