CHAPTER 4:

Analysis of Financial Statements

1) Ratio Analysis I) Liquidity
II) Asset Management
III) Debt Management
IV) Profitability
V) Market Value
2) Du Pont Analysis
3) Limitations of Ratio Analysis
4) Qualitative Factors 3-1
L.T.TEE & S.R.KEW, UKM-FEP © Cengage Learning

Why are ratios useful?

 Ratios standardize numbers and facilitate comparisons.
 Ratios are used to highlight a company’s weaknesses and
strengths.
 The information can be used to improve the company’s
performance and to predict future results.
 Ratio comparisons should be made through time and with
competitors.
 Trend analysis.
 Peer (or industry) analysis.

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 Balance Sheet: Assets

2020 2019
Cash $199,551 $208,323
Accounts receivable 876,897 690,294
Inventories 909,379 942,374
Total current assets $1,985,827 $1,840,991
Gross fixed assets 380,510 317,503
Less accumulated depreciation 67,413 54,045
Net fixed assets $313,097 $263,458
Total assets $2,298,924 $2,104,449

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Balance Sheet: Liabilities and Equity

2020 2019
Short-term Borrow $312,500 $288,798
Accounts payable 650,535 636,318
Accruals 110,157 106,748
Total current liabilities $1,073,192 $1,031,864
Long-term debt 656,600 410,769

Common stock (100,000 shares) 550,000 550,000

Retained earnings 19,132 111,816

Total equity $569,132 $661,816
Total liabilities and equity $2,298,924 $2,104,449

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 Income Statement
2020 2019
Sales $2,069,032 $2,325,967
Cost of goods sold 1,647,925 1,869,326

Other expenses 241,490 287,663

Total operating costs excluding
$1,889,415 $2,156,989
depreciation and amortization
Depreciation and amortization 17,891 25,363
EBIT $161,726 $143,615
Interest expense 27,434 31,422
EBT $134,292 $112,193
Taxes (40%) 53,717 44,877
Net income $80,575 $67,316

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Other Data
2020 2019

EPS $0.81 $0.67

DPS $1.00 $1.00

Book value per share $5.69 $6.62

Stock price $19.20 $15.60

Share outstanding 100,000 100,000

Tax rate 40% 40%

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 What are the five major categories of ratios,
and what questions do they answer?
 I) Liquidity: Can we make required payments?

 II) Asset management: right amount of assets vs. sales?

 III) Debt management: Right mix of debt and equity?

 IV) Profitability: Do sales prices exceed unit costs, and

are sales high enough as reflected in PM, ROE, and ROA?

 V) Market value: Do investors like what they see as

reflected in P/E and M/B ratios?
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Ratio Analysis
I. Liquidity
II. Asset Management
III. Debt Management
IV. Profitability
V. Market Value

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 I) Liquidity Ratios
-Company’s ability to pay off debts that are maturing within a year.

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Everelite’s Current Ratio and Quick Ratio for 2020

Current assets
Current ratio =
Current liabilities
$1,986
=
$1,073
=1.85x
(Current assets - Inventories)
Quick ratio =
Current liabilities
($1,986 - $909)
=
$1,073
=1.00×

Current ratio- size of current asset relative to current liability

-Company has an excess of 85% current assets to pay its current liabilities.

Quick ratio- size of most liquid current assets (excluding inventory) relative to current
liabilities.
-Company has 1.00x (just enough) the amount of quick assets to pay current liabilities.
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 Comments on Liquidity Ratios

2020 2019 2018 Ind.

Current ratio 1.85x 1.78x 2.02x 2.05×
Quick ratio 1.00x 0.87x 1.14x 1×

 Expected to improve but still below the industry

average.
 Liquidity position is weak.

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Ratio Analysis
I. Liquidity
II. Asset Management
III. Debt Management
IV. Profitability
V. Market Value

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 II) Asset Management Ratios

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Everelite’s Inventory Turnover vs. the Industry Average

Inventory turnover = Sales/Inventory

= $2,069/$909 = 2.28

-Every RM1 of inventory generates $2.28 sales.

-Company wants to turn inventory over ASAP to reduce
warehousing, monitoring and insurance costs.
-If inventory is too low then the firm risks losing sales, or running
out of raw material.

2020 2019 2018 Ind.

Inventory turnover 2.28x 2.47x 3.10x 6.1×

 Inventory turnover is below industry average.

 Everelite might have old inventory, or its control might be poor.
 No improvement is currently forecasted.
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 Fixed Assets and Total Assets Turnover Ratios vs. the
Industry Average
FA turnover = Sales/Net fixed assets
= $2,069/$313 = 6.61

TA turnover = Sales/Total assets

= $2,069/$2,299 = 0.90
-Every Ringgit of fixed asset generates RM6.61 sales; Every Ringgit of
total asset generates RM0.90 sales.
2020 2019 2018 Ind.
FA TO 6.61x 8.83x 11.22x 9.3×
TA TO 0.90x 1.11x 1.21x 2.1×
 FA turnover projected to be still below the industry average.
 TA turnover below the industry average. Caused by excessive
currents assets (A/R and Inv).
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Day Sales Outstanding: Average Number of Days

after Making a Sale before Receiving Cash

DSO = Receivables/Avg. sales per day

= Receivables/(Annual sales/365)
= $876/($2,069/365)
= 154.69 days

-The firms takes, on average, 154.69 days to collect account receivable.

2020 2019 2018 Ind.

DSO 154.69 108.32 135.60 56

 Everelite collects on sales too slowly, and is getting worse.

 Everelite has a poor credit policy.
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 Ratio Analysis
I. Liquidity
II. Asset Management
III. Debt Management
IV. Profitability
V. Market Value

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III) Debt Management Ratios

-How the company has financed its assets and the company’s
ability to repay its long-term debt.

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 The Debt Ratio and Times-Interest-Earned Ratio
Debt ratio = Total debt/Total assets
= ($1,073 + $657)/$2,299
= 75.25%
TIE = EBIT/Interest expense
= $161.7/$27.4 = 5.90
Debt ratio- 75.25% of assets have been financed by debt.
TIE- For every ringgit of interest, the company has $5.9 of operating
earnings available to pay.
2020 2019 2018 Ind.
D/A 75.25% 68.55% 64.50% 50.00%
TIE 5.90x 4.57x 19.17x 6.2×
 D/A and TIE are worse than the industry average.
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Ratio Analysis
I. Liquidity
II. Asset Management
III. Debt Management
IV. Profitability
V. Market Value

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 IV) Profitability Ratios

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Profitability Ratios: Operating Margin, Profit Margin,

and Basic Earning Power
Operating margin= EBIT/Sales
= $161.7/$2,069 = 7.82%.

Profit margin= Net income/Sales

= $80.5/$2,069 = 3.89%.

Basic earning power=EBIT/Total assets

= $161.7/$2,299 = 7.03%.

Operating margin- For every RM100 the company makes in sales, it

make RM7.82 EBIT.
Profit margin- For every RM100 the company makes in sales, it make
RM3.89 profit.
BEP- For every RM100 of assets, the firm has EBIT of RM7.03.
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 Appraising Profitability with Operating Margin,
Profit Margin, and Basic Earning Power
2020 2019 2018 Ind.
Operating margin 7.82% 6.17% 11.91% 13%
Profit margin 3.89% 2.89% 6.78% 9.00%
Basic earning power 7.03% 6.82% 14.38% 15.00%

 Operating margin was very bad in 2019. It is projected to improve in

2020, but it is still projected to remain below the industry average.
 Profit margin was very bad in 2019. It is projected to improve in
2020, but it is still projected to remain below the industry average.
 BEP removes the effects of taxes and financial leverage, and is useful
for comparison.
 BEP projected to improve, yet still below the industry average. There
is definitely room for improvement.
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Profitability Ratios: Return on Assets and Return on Equity

ROA = Net income/Total assets
= $80.5/$2,299 = 3.50%

ROE = Net income/Total common equity

= $80.5/$569 = 14.16%.
-For every RM100 of asset, the company has a return of RM3.50.
-For every RM100 common equity financing, the firms generates
net income of RM14.16.
2020 2019 2018 Ind.
ROA 3.50% 3.20% 8.18% 6.50%
ROE 14.16% 10.17% 23.03% 12.00%
 Both ratios rebounded from the previous year, but are still below the
industry average. More improvement is needed.
 Wide variations in ROE illustrate the effect that leverage can have on
profitability. 3-24
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 Effects of debt on ROA and ROE

 ROA is lowered by debt--interest lowers NI, which also

lowers ROA = NI/Assets.
 But use of debt also lowers equity, hence debt could raise
ROE = NI/Equity.

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Problems with ROE

 ROE and shareholder wealth are correlated, but

problems can arise when ROE is the sole measure of
performance.
 ROE does not consider risk.
 ROE does not consider the amount of capital invested.
 Might encourage managers to make investment decisions
that do not benefit shareholders.
 ROE focuses only on return. A better measure is one
that considers both risk and return.

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 Ratio Analysis
I. Liquidity
II. Asset Management
III. Debt Management
IV. Profitability
V. Market Value

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V) Market Value Ratios

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 Price/Earnings and Market/Book Ratios
P/E = Price/Earnings per share
= $19.20/$0.81 = 23.70

M/B = Market price/Book value per share

= $19.20/$5.69 = 3.37

P/E- Investors are willing to pay RM23.70 for RM1 of earnings.

M/B- Investors are willing to pay RM3.37 for RM1 of book value equity.

2020 2019 2018 Ind.

P/E 23.83x 23.17x 14.49x 10.00×
M/B 3.37x 2.36x 3.34x 3.00×

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Analyzing the Market Value Ratios

 P/E: How much investors are willing to pay for $1 of
earnings.
 M/B: How much investors are willing to pay for $1 of
book value equity.
 For each ratio, the higher the number, the better.
 P/E and M/B are high if ROE is high and risk is low.

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 The DuPont System
ROE

ROA Equity Multiplier

Profit Margin Total Asset Turnover

 DuPont equation- shows that the rate of return on equity (ROE)

can be found as the product of profit margin, total asset turnover, and
the equity multiplier.
 Method to breakdown ROE into: ROA and Equity Multiplier
 ROA is further broken down as: Profit Margin and Asset Turnover
 Helps to identify sources of strength and weakness in current
performance.
 Helps to focus attention on value drivers.
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The DuPont System

ROE

ROA Equity Multiplier

Profit Margin Total Asset Turnover

RO E  RO A  Equity Multiplier
N et Income Total Assets
 
Total Assets C ommon Equity
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 The DuPont System
ROE

ROA Equity Multiplier

Profit Margin Total Asset Turnover

RO A  Profit M argin  Total Asset Turnover

N et Income Sales
 
Sales Total Assets
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The DuPont System

ROE

ROA Equity Multiplier

Profit Margin Total Asset Turnover

ROE  Profit Margin  Total Asset Turnover  Equity Multiplier

Net Income Sales Total Assets
  
Sales Total Assets Common Equity

 Focuses on expense control (PM), asset utilization (TA TO), and

debt utilization (equity multiplier).
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 The DuPont System
RO E  P rofit M argin  Total Asset Turnover  Equity M ultiplier
Net Income Sales Total Assets
ROE   
Sales Total Assets Common Equity
 Profit Margin  Total Asset Turnover  Equity Multiplier
 ROA  Equity Multiplier

ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)

=3.89%  0.90  (2298924/569132)
= 14.14%.

PM TA TO EM ROE
2018 6.78% 1.21 2.82 23.03%
2019 2.89% 1.11 3.18 10.17%
2020 3.89% 0.90 4.04 14.14%3-35
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An Example: The Effects of Improving Ratios

L.T.TEE & S.R.KEW, UKM-FEP

A/R $ 877 Debt $1,730

Other CA 1,109 Equity 569
Net FA 313
TA $2,299 Total L&E $2,299

How would reducing the firm’s DSO from 155 to 56 days affect the
company?
DSO= Acc receivable/(Sales/365)
New Acc Receivable= DSO x(Sales/365) = $317.44
Reducing Accounts Receivable:
Freed cash= old A/R – new A/R = $876.86 – $317.44 = $559.42
(Initially shows up as addition to cash.)
What could be done with the new cash?- Repurchase stock, Expand
business, Reduce debt
How might stock price be affected? 3-36
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Potential problems of financial ratio analysis

 A firm’s industry category is often difficult to identify.

(Comparison with industry averages is difficult for a
conglomerate firm that operates in many different
divisions.)

 Published industry averages are only guidelines.

(“Average” performance is not necessarily good, perhaps
the firm should aim higher.)

 Different operating and accounting practices can distort

comparisons.

 Sometimes difficult to tell if a ratio is GOOD or BAD

 Seasonal factors can distort ratios.

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Consider Qualitative Factors When Evaluating a

Company’s Future Financial Performance
 Are the firm’s revenues tied to one key customer, product, or
supplier?
 What percentage of the firm’s business is generated overseas?
 The firm’s competitive environment
 Future prospects
 Legal and regulatory environment

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