Part One

Dr. Doaa El-Diftar

Lecture 2
Chapter Outline

3.1 Standardized Financial Statements

3.2 Ratio Analysis
3.3 The DuPont Identity
3.4 Internal and Sustainable Growth
3.5 Using Financial Statement Information
3.1 Standardized Financial Statements

Present all items in a financial statement in percentage

terms.

• Standardized or common-size balance sheet:

• Items are shown as a % of assets

• Standardized or common-size income statement:

• Items are shown as a % of sales
Prufrock Corporation
PRUFROCK
Balance Sheet - 2023 (millions)
ASSETS Liabilities & Owners Equity
Current Assets Current Liabilities
Cash $ 98 Accounts Payable $ 344
Accounts Receivable $ 188 Notes Payable $ 196
Inventory $ 422 Total $ 540
Total $ 708 Long term debt $ 457
Owners' Equity
Common Stock and paid in surplus $ 550
Fixed Assets Retained Earnings $ 2,041
Net Plant & Equipment $ 2,880 Total $ 2,591
Total Asets $ 3,588 Total Liabilties & Owners' Equity $ 3,588
Prufrock Corporation
PRUFROCK
Income Statement - 2023
Sales $ 2,311
COGS $ 1,344
Depreciation $ 276
EBIT $ 691
Interest $ 141
Taxable Income $ 550
Taxes $ 187
Net Income $ 363

Dividends $ 121
Addition to RE $ 242
3.2 Ratio Analysis

• Financial Ratios:
• Ways of comparing and investigating the relationships
between different pieces of financial information

• Ratio Analysis:
• The interpreting of financial ratios in order to access a
firm's performance or status.
3.2 Ratio Analysis

• Categories of Financial Ratios:

A. Liquidity Ratios (Short-term solvency ratios)
B. Financial Leverage Ratios (Long-term solvency ratios)
C. Asset Management or Turnover Ratios
D. Profitability Ratios
E. Market Value Ratios

• We will directly apply our understanding of each group of

ratios to the financial statements of Prufrock Corporation.
A. Liquidity Ratios

Liquidity refers to the solvency of the firm's overall financial

position, i.e. a "liquid firm" is one that can easily meet its
short-term obligations as they come due.

1) Current Ratio
2) Quick Ratio
3) Cash Ratio
 PRUFROCK
Balance Sheet - 2023 millions
ASSETS Liabilities & Owners Equity
Current Assets Current Liabilities
Cash $ 98 Accounts Payable $ 344
Accounts Receivable $ 188 Notes Payable $ 196
Inventory $ 422 Total $ 540
Total $ 708 Long term debt $ 457
Owners' Equity
Common Stock and paid in surplus $ 550
Fixed Assets Retained Earnings $ 2,041
Net Plant & Equipment $ 2,880 Total $ 2,591
Total Asets $ 3,588 Total Liabilties & Owners' Equity $ 3,588

1) Current Ratio:
Current Assets / Current Liabilities
One of the best and most widely used liquidity ratio

2) Quick (Acid-Test) Ratio:

(Current Assets – Inventory) / Current Liabilities
Provides a measure of short-term liquidity of the firm, after removing the effects of
inventory (the least liquid of all current assets).
3) Cash Ratio:
Cash / Current Liabilities
Represents the ability of the firm to completely pay off its current liabilities balance
with its most liquid asset (cash).
B. Financial Leverage ratios (Long-Term Solvency)
Measure the firm's long-run ability to meet its obligations

This group of ratios measure two different aspects of leverage –

the level of indebtedness and the ability to service (cover) debt.
• Level of indebtedness
1) Total Debt Ratio
2) Debt-Equity Ratio
3) Equity Multiplier
• Ability to cover debt
4) Times Interest Earned Ratio
5) Cash Coverage Ratio
 PRUFROCK
Balance Sheet - 2023
ASSETS Liabilities & Owners Equity
Current Assets Current Liabilities
Cash $ 98 Accounts Payable $ 344
Accounts Receivable $ 188 Notes Payable $ 196
Inventory $ 422 Total $ 540
Total $ 708 Long term debt $ 457
Owners' Equity
Common Stock and paid in surplus $ 550
Fixed Assets Retained Earnings $ 2,041
Net Plant & Equipment $ 2,880 Total $ 2,591
Total Asets $ 3,588 Total Liabilties & Owners' Equity $ 3,588

1) Total Debt Ratio

(Total debt)
(Total Assets – Total Equity) / Total Assets

We can define two useful variations to the total debt ratio.

2) Debt-Equity Ratio (D/E)
Total Debt / Total Equity
Compares the amount of funds supplied by creditors relative to owners

3) Equity Multiplier
Total Assets / Total Equity OR 1 + D/E ratio
It measures the dollar worth of firm assets each equity dollar has a claim to.

NOTE: If we know one of these three ratios, we can easily get the other two
 PRUFROCK
Income Statement - 2023
Sales $ 2,311
The firm's ability to service or cover debt:
COGS $ 1,344 4) Times Interest Earned Ratio (TIE ratio):
Depreciation $ 276
EBIT $ 691 EBIT / Interest
Interest $ 141 The higher the TIE ratio, the better ability of the firm to fulfill
Taxable Income $ 550 its interest obligations
Taxes $ 187
Net Income $ 363

Dividends $ 121
Addition to RE $ 242

5) Cash Coverage Ratio:

(EBITDA)
(EBIT + Depreciation) / Interest
A better indication of a firm's ability to meet interest payments may be to add back the
noncash deductions (depreciation and amortization)