Chapter 3

Working With
Financial Statements
 3-1

Chapter Outline
• Financial statement information
• Ratio Analysis
• The Du Pont Identity
• Internal and Sustainable Growth
 3-2

Financial statement information

• Objectively determinable current values of many
assets do not exist

• Accountants have irrelevant, but objective historical

costs. This means that it is the user’s responsibility to
make adjustments.

• Financial statement information is often our ONLY

source of information. Consequently, we use the
information we have and make adjustments where
appropriate
 3-3

Ratio Analysis
• As we look at each ratio, ask yourself:
• What the ratio is trying to measure?
• How it is computed?
• Why that information is important?
• How could this measure be improved?
 3-4

Benchmarking
• Ratios are not very helpful by themselves; they need
to be compared to something
• Time-Trend Analysis
• Used to see how the firm’s performance is changing
through time
• Internal and external uses
• Peer Group Analysis
• Compare to similar companies or within industries

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 3-5

Categories of Financial Ratios

• Financial ratios can be divided to 5 groups:

• Short-term solvency or liquidity ratios

• Long-term solvency or financial leverage ratios
• Asset management or turnover ratios
• Profitability ratios
• Market value ratios
 3-6

Sample Balance Sheet

Numbers in millions

Cash 98 A/P 344

A/R 188 N/P 196
Inventory 422 Total CL 540
LT Debt 457
Total CA 708 C/S 550
Net FA 2,880 R/E 2,041

Total Assets 3,588 Total Liab. & Equity 3,588

 3-7

Sample Income Statement

Numbers in millions
Sales 2,311
Cost of Goods Sold 1,344
Depreciation & Amortization 276
EBIT 691
Interest Expense 141
Taxable Income 550
Taxes 187
Net Income 363
Dividends 121
Addition to retained earning 242
 3-8

Ratio Analysis Industry Average

Current 2.7
Quick / Cash 1.3 /1.0
Inventory Turnover 6.1
Days’ Sales in Receivables 28.0
Fixed Assets Turnover 7.0
Total Assets Turnover 2.5
Debt Ratio 50.0%
Times Interest Earned 6.2
Cash Coverage 8.0
Profit Margin 16.6%
ROA 15.0%
ROE 14.9%
Price/Earnings (P/E) 6.2
Market/Book 2.9
 3-9

1- Short Term Solvency Or Liquidity Ratios

• Current Ratio = CA / CL
708 / 540 = 1.31 times
• Quick Ratio = (CA – Inventory) / CL
(708 – 422) / 540 = .53 times
• Cash Ratio = Cash / CL (also called the
acid test)
98 / 540 = .18 times
• Short-term solvency, or liquidity, ratios attempt to measure
a firm’s ability to meet its short-term obligations current
assets which can be transferred quickly into cash.
 3-10

• A high current ratio is, in and of itself, a good thing for

example from the point of view of a short-term creditor.
• However, liquid assets are generally less profitable for the
company.

• Consequently, too large an investment in current assets may

reduce the earnings power of the firm and actually reduce the
stock price.
 3-11

A Firm has current liabilities of $5,600, net

working capital of $2,100, inventory of $3,900,
and sales of $13,500. What is the quick ratio?
a. .68
b. .70
c. 1.38
d. 1.47
 3-12

Current assets = current liabilities + net working

capital
Current assets = $5,600 + $2,100 = $7700
Quick ratio = $7700 - $3,900, / $5,600 = .68

Note:
- The quick ratio assumes that it is difficult to
sell inventory and convert it into cash in less
than a year. For this reason, inventory is
removed from current assets.
- The cash ratio assumes that it is also difficult
for the company to collect from its customers
(Acc Rec) within a year.
 3-13

2- Long Term Solvency Measures

A- Leverage Ratios

• Total Debt Ratio = (TA – TE) / TA

• (3,588 – 2,591) / 3,588 = .28 times
• The firm finances slightly over 28% of their assets with debt.
• Debt/Equity = TD / TE
• (997/ 2,591) = .39 times
• Equity Multiplier = TA / TE = 1 + D/E
• 3,588/ 2,591 = 1.39 times
• or 1 + .39 = 1.39 times
 3-14

Roy’s Shop has sales of $639,320, total

assets of $527,200, a debt-equity ratio of
.75, and a profit margin of 5 percent. What
is the equity multiplier?
a. 1.21
b.1.38
c. 1.75
d.1.61
 3-15

If equity is $1, then debt must be $.75, which means

that total assets are $1.75.
Equity multiplier = $1.75 / $1.00 = 1.75
(The equity multiplier = 1 + debt-equity ratio.)
 3-16

B- Coverage Ratios
• Times Interest Earned = EBIT / Interest
• 691/141 = 4.9 times

• Cash Coverage = (EBIT + Depr. & Amort.) / Interest

• (691+ 276) / 141 = 6.9 times
 3-17

Black and White, Inc., has net income of $8,840, a

tax rate of 35%, and interest expense of $3,400.
What is the times interest earned ratio?
a. 2.50
b.2.60
c. 3.33
d.5.00
 3-18

EBIT $17000
Interest ($3,400)
Taxable income $13600 [$8,840/ (1 − .35)]
Net income $8,840

Times interest earned = $17,000 / $3,400 = 5

 3-19

•Long-term solvency, or financial leverage, ratios

attempt to measure a firm’s ability to meet long-
term obligations:

•The level of debt is indicative of the firm’s debt

capacity .

•The ability to service debt and it is more closely

relates to the likelihood of default.

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 3-20

3- Asset Management Or Turnover Measures

A- Inventory Ratios

Inventory Turnover = Cost of Goods Sold / Inventory

1,344 / 422 = 3.2 times
Days’ Sales in Inventory = 365 / Inventory Turnover
365 / 3.2 = 114 days
 3-21

A Company has sales of $984,600, cost of goods

sold of $702,100, and inventory of $5,120. How
long on average does it take to sell its inventory?
a. 1.92 days
b.2.33 days
c. 2.66 days
d.3.71 days
 3-22

Inventory turnover rate =

$702,100 / $5,120 = 137.129

Days’ sales in inventory = 365 / 137.129 = 2.66

 3-23

B- Receivables Ratios
• Receivables Turnover = Sales / Accounts Receivable
• 2,311 / 188 = 12.3 times
• Days’ Sales in Receivables = 365 / Receivables Turnover
• 365 / 12.3 = 30 days
 3-24

A Company has sales of $498,000, cost of goods

sold of $263,000, and accounts receivable of
$61,000. How long on average does it take the
firm’s customers to pay for their purchases?
a. 42.25 days
b.42.33 days
c. 44.71 days
d.84.66 days
 3-25

Accounts receivable turnover rate =

$498,000 / $61,000 = 8.164
Days’ sales in receivables = 365 / 8.164 = 44.71
 3-26

• Suppose a firm’s average collection period is significantly

higher than the industry norm. What questions might one ask
to make a final determination about the firm’s ability to
manage its assets?
• What are the firm’s credit terms?
• What are the industry’s terms on average?
• Has the average collection period been trending
upward, or is this an aberration?
• Which consumers are contributing to the relatively
high average collection period?
• Is this an industry or economy wide phenomenon?
 3-27

C- Fixed Asset Turnover

• Fixed Asset Turnover = Sales / Fixed Assets
2,311 / 2,880 = .80 times

• A high fixed asset turnover ratio relative to that of the industry

can be the result of efficient asset utilization, or it can indicate
that the firm is utilizing old or inefficient equipment, while
others in the industry have invested in modern equipment.

• The firm using inefficient equipment would be likely to display

a higher level of expenses, lower profitability – based on cash
flow.

• In contrast, a fixed assets turnover that is lower than the

industry may indicate a lower efficiency in asset management
or too much investment in fixed assets.
 3-28

D- Total Asset Turnover

• Total Asset Turnover = Sales / Total Assets
2,311 / 3,588 = .64 times
Each dollar invested in total assets generates $0.64 in sales

• Measure of asset use efficiency

• It is not unusual for TAT < 1, especially if a firm has a

large amount of fixed assets
 3-29

A firm has $61,300 in receivables and $391,400

in total assets. The firm has a total asset turnover
rate of 1.4 and a profit margin of 6.3 percent.
What is the days’ sales in receivables?
a. 40.23 days
b.40.83 days
c. 43.40 days
d.43.67 days
 3-30

Total sales = ($391,400)(1.4) = $547,960

Accounts receivable turnover rate =
$547,960 / $61,300 = 8.939
Days’ sales in receivables = 365 / 8.939 = 40.83
 3-31

4- Profitability Measures
A. Profit Margin = Net Income / Sales
363 / 2,311 = 15.7%

B. Return on Assets (ROA) = Net Income / Total

Assets
363/ 3,588 = 10.12%

C. Return on Equity (ROE) = Net Income / Total

Equity
363 / 2,591= 14%
 3-32

A Firm has sales of $489,700. Earnings before

interest and taxes is equal to 16 percent of sales.
For the period, the firm paid $5,200 in interest.
The tax rate is 35 percent. What is the profit
margin?
a. 6.91 percent
b.7.25 percent
c. 8.13 percent
d.9.71 percent
 3-33

Earnings before interest and taxes =

($489,700)(.16) = $78,352
Net income = ($78,352 – $5,200)(1 − .35)
= $47,548.80
Profit margin = $47,548.80 / $489,700 =
9.71 percent
 3-34

A firm has total debt of $364,000, total equity of

$520,000, and a return on equity of 12.5 percent.
What is the return on assets?
a. 5.36 percent
b. 6.00 percent
c. 7.35 percent
d. 7.75 percent
 3-35

Net income = $520,000 × .125 = $65,000

Total assets = $364,000 + $520,000 = $884,000
Return on assets = $65,000 ÷ $884,000 = 7.35
percent
 3-36

A Firm has total assets of $212,000, a debt-equity

ratio of .6, and net income of $9,500. What is the
return on equity?
a. 6.87 percent
b.7.17 percent
c. 7.34 percent
d.7.50 percent
 3-37

Equity multiplier = 1 + .6 = 1.6

Total equity = $212,000 ÷ 1.6 = $132,500
Return on equity = $9,500 ÷ $132,500 = 7.17
percent
 3-38

5- Market Value Measures

• Market Price = $88 per share
• Shares outstanding = 33 million

A. Earnings per share = Net Income/ no. of shares

= 363/ 33 = $11
B. P/E Ratio = Price per share/ Earnings per share
= 88/ 11 = 8 times
• Stockholders are willing to pay as a ‘market price’ for the stock 8 times
its EPS.
• A high P/E indicates that the company is overvalued.

C. Market-to-book ratio = market value per share /

book value per share
88/ (2,591 / 33) = 1.12 times
• The higher M/B ratio, the better performance of the stock.
 3-39

Computers Inc., has a market-to-book ratio of 3.5,

net income of $84,000, a book value per share of
$20.16, and 50,000 shares of stock outstanding.
What is the price-earnings ratio?
a. 21
b.27
c. 42
d.49
 3-40

Price = ($20.16)(3.5) = $70.56

Earnings per share = ($84,000 / 50,000) = $1.68
Price-earnings ratio = $70.56 / $1.68 = 42
 3-41

Ratio Analysis Company Industry Average

Current 1.13 2.7
Quick 0.53 1.3
Cash 0.18 1.0
Inventory Turnover 3.2 6.1
Days’ Sales in Receivables 30.0 28.0
Fixed Assets Turnover 10.0 7.0
Total Assets Turnover 0.64 2.5
Debt Ratio 28% 50.0%
Times Interest Earned 4.9 6.2
Cash Coverage 6.9 8.0
Profit Margin 15.7% 16.6%
ROA 10.12% 15.0%
ROE 14% 14.9%
Price/Earnings (P/E) 8 6.2
Market/Book 1.12 2.9
 3-42

Categories of Financial Ratios

 3-43

Problem
Complete the balance sheet and sales information in
the table that follows using the following financial
data:
Debt ratio: 50%
Quick ratio: 0.8x
Total assets turnover: 1.5x
Days’ sales in receivables: 36.5 days (Calculation
based on a 365-day year).
Gross profit margin on sales: (Sales- cost of goods
sold)/sales = 25%
Inventory turnover ratio: 5x
 3-44

Cash Accounts payable

Accounts Long-term debt $60,000

receivable
Inventories Common stock

Fixed assets Retained earnings $97,500

Total assets $300,00 Total liabilities and equity

0
Sales Cost of goods sold
 3-45

Deriving the Du Pont Identity

• The Du Pont identity provides a way to
breakdown ROE and investigates what areas of
the firm need improvement.
• ROE = NI / TE
• ROE = ROA * EM
• ROE = (NI / TA) (TA / TE)
• ROA = PM * TAT
• = (NI / Sales) (Sales / TA)
• ROE = (NI / Sales) (Sales / TA)(TA / TE)

•ROE = PM * TAT * EM
 3-46

Using the Du Pont Identity

• ROE = PM * TAT * EM
• Profit margin is a measure of the firm’s operating
efficiency – how well does it control costs
• Total asset turnover is a measure of the firm’s asset use
efficiency – how well does it manage its assets
• Equity multiplier is a measure of the firm’s financial
leverage
 3-47

A firm has a return on assets of 6.75 percent, a

total asset turnover rate of 1.3, and an equity
multiplier of 1.6. What is the return on equity?
a. 8.30 percent
b.8.78 percent
c. 10.80 percent
d.14.04 percent
 3-48

ROE = ROA * EM
Return on equity = (.0675)(1.6) = 10.80 percent
 3-49

A Firm has total assets of $12,500, a total asset

turnover rate of 1.2, a debt-equity ratio of .8, and
a return on equity of 14.04 percent. What is the
firm’s net income?
a. $975
b. $1,150
c. $1,200
d. $1,275
 3-50

Equity multiplier = 1 + .8 = 1.8

Total equity = $12,500 ÷ 1.8 = $6,944.44
Net income = $6,944.44 × .1404 = $975.00
 3-51

Another Solution

ROE = PM × TAT × EM
14.04% = PM × 1.2 × 1.8
PM = 14.04% / (1.2 × 1.8)
= 14.04% / 2.16 = 6.5%
TAT = Sales / TA
Sales = TAT × TA
= 1.2 × 12500 = 15,000
NI = 15,000 × 6.5% = $975
 3-52

Internal and Sustainable Growth

Dividend Payout and Earnings Retention
Net income = dividends paid + additions to retained
earnings
Retention ratio (b) = 1 – dividend payout ratio
• Dividend payout ratio = Cash dividends / Net income
121 / 363 = 33.33%
• Retention ratio = Addn. to R/E / Net income
242/ 363 = 66.67%
• Or: Retention ratio = 1 – Dividend Payout Ratio
1 - 33.33% = 66.67%
 3-53

The Internal Growth Rate

• The internal growth rate tells us how much the firm
can grow assets using retained earnings as the only
source of financing.

ROA  b
Internal Growth Rate =
1 - ROA  b
.1012  .6667
= = .0723
1 − .1012  .6667
= 7.23
 3-54

A firm has sales of $84,000, total assets of $92,000,

net income of $4,600, and dividends paid of $1,610.
What is the internal growth rate?
a. 3.36 percent
b.3.67 percent
c. 4.04 percent
d.4.25 percent
 3-55

Retention ratio =
($4,600 − $1,610) / $4,600 = 0.65
Return on assets ={($4,600 / $92,000) = 0.05
Internal growth rate =
{0.05 * .65} / {1 − 0.05 * 0.65}
= 0.0325 / .9675 = 3.36 percent
 3-56

The Sustainable Growth Rate

• The sustainable growth rate tells us how much the
firm can grow by using internally generated funds
and issuing debt to maintain a constant debt ratio.

ROE  b
Sustainabl e Growth Rate =
1- ROE  b
.14  .6667
= = .1029
1 − .14  .6667
= 10.29%
 3-57

A Firm maintains a constant debt-equity ratio of

0.60. This year the firm has net income of $43,200
and is paying $15,120 in dividends. The firm has
total assets of $525,000. What is the maximum
growth rate of the firm given this information?
a. 8.08 percent
b.8.31 percent
c. 8.98 percent
d.9.36 percent
 3-58

Plowback ratio =
($43,200 − $15,120) / $43,200 =.65
Total equity = $525,000 / 1.6 = $328,125
ROE = {($43,200 / $328,125) = 13.166 percent
Or: ROE = ROA * EM
= (43,200 / 525,000)* 1.6 = 13.166 percent
Sustainable growth rate =
(13.166 *.65) / (1 − 13.166*.65) =
0.0856 / 0.9144 = 9.36 percent
 3-59

Determinants of Growth
• Profit margin – operating efficiency
• Total asset turnover – asset use efficiency
• Financial leverage – choice of optimal debt ratio
• Dividend policy – choice of how much to pay to
shareholders versus reinvesting in the firm
 3-60

Why Evaluate Financial Statements?

• Internal uses
• Performance evaluation – compensation and
comparison between divisions
• Planning for the future – guide in estimating future
cash flows
• External uses
• Creditors, Suppliers, Customers, and Stockholders

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