FIN202- PRINCIPLES OF CORPORATE FINANCE

Session 3
CHAPTER 4: ANALYZING FINANCIAL STATEMENTS

Taught by Que Anh Nguyen - FPT School of Business (FSB)

Original Slides by Robert Parrino, Ph.D. & David S. Kidwell, Ph.D.

Based on: Parrino, R., KidWell, D., 2019, Fundamentals of Corporate

Finance (4ed)

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 OBJECTIVES

1. Explain the three perspectives from which financial statements can be viewed.

2. Describe common-size financial statements, explain why they are used, and be able to prepare
and use them to analyze the historical performance of a firm.

3. Discuss how financial ratios facilitate financial analysis and be able to compute and use them to
analyze a firm's performance.

4. Describe the DuPont system of analysis and be able to use it to evaluate a firm’s performance
and identify corrective actions that may be necessary.

5. Explain what benchmarks are, describe how they are prepared, and discuss why they are
important in financial statement analysis.

6. Identify the major limitations in using financial statement analysis.

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1. Background for Financial Statement Analysis
1.1. Perspectives on Financial Statement Analysis
▪ A firm’s financial statements can be analyzed from the perspective of different stakeholders.
▪ Important perspectives:
▪ Centers on value of stock held.
Stockholders ▪ Interest in the FS is to gauge cash flows firm will generate from operations.
▪ Allows determination of firm’s profitability, return for that period, and likely dividends.

▪ Interest in firm’s financial statement is similar to stockholders’.

Managers ▪ Manager’s job security depends on firm’s performance.
▪ Management gets feedback on investing, financing, and working capital decisions by
identifying trends in various accounts reported in FS in more details than outsiders.

▪ Focus on getting loans repaid and receiving interest payments on time.

Creditors ▪ A firm’s creditors closely monitor: Amount of debt firm has; Ability to meet short-term
obligations; Ability to generate sufficient cash flows to meet all legal obligations, debt
repayment, and interest payments.
1. Background for Financial Statement Analysis

1.2. Guidelines for Financial Statement Analysis

▪ From whose perspective firm analysis is done, e.g. management, shareholder or

creditor.

▪ Always use audited financial statements if available.

▪ Perform analysis over 3-5 year period–time-trend analysis.

▪ Compare firm’s performance to direct competitors’ performance.

▪ Perform a benchmark analysis comparing it to most relevant competitors – American

Airlines with Delta or United Airlines.
2. Common-Size Financial Statements
2.1. Common-Size Balance Sheets

▪ Each asset and liability item on balance sheet

is standardized by dividing by total assets.

▪ Accounts are then represented as

percentages of total assets.

Exhibit 4.1: Common-Size Balance Sheets

 2. Common-Size Financial Statements
2.2. Common-Size Income Statement

▪ Each income statement item standardized

by dividing it by dollar amount of net sales.

▪ Each income statement item now

indicated as percent of sales.

Exhibit 4.2: Common-Size Income Statements

3. Financial Ratios and Firm Performance
3.1. Why Ratios Are Better Measures

▪ A financial ratio is computed by dividing one balance sheet or income statement

item by another.
▪ Variety of ratios can be computed to focus on specialized aspects of firm’s performance.

▪ Choice of scale determines story garnered from ratio.

▪ Different ratios calculated based on type of firm being analyzed or kind of analysis
being performed.

▪ Ratios may be computed to measure liquidity, efficiency, leverage, profitability, or

market value performance.
3. Financial Ratios and Firm Performance
3.1. Why Ratios Are Better Measures

Exhibit 4.3: Ratios for Time-Trend Analysis

3. Financial Ratios and Firm Performance
3.2. Short-Term Liquidity Ratios

Measures ability of firm to meet short-term obligations with short-term assets,

without endangering the firm.

Current ratio is calculated by dividing current assets by current liabilities.

→Amount of current assets firm has per dollar of current liabilities.
→Higher number = more liquidity

Current assets
Current rati𝑜2017 = (4.1)
Current liabilites
$1,039.8
= = 2.75
$377.8
 3. Financial Ratios and Firm Performance
3.2. Short-Term Liquidity Ratios
Quick (acid-test) ratio is calculated by dividing most liquid current assets by current liabilities.
→Inventory subtracted from total current assets determines most liquid assets. (*)
→Amount of liquid assets firm has per dollar of current liabilities.
→Higher number = more liquidity
Current assets − Inventory
Quick ratio = (4.2)
Current liabilities
$1,039.8 − $423.8
= $377.8
= 1.63

✓ Quick ratios typically smaller than current ratios for firms carrying significant inventory (e.g. mfg).
✓ Firms carrying little inventory (e.g. service) will see no significant difference between the two.

(*) Please note different formulas to calculate quick ratio in FIN202 vs. ACC101.
3. Financial Ratios and Firm Performance
3.3. Efficiency Ratios

▪ Sometimes called asset turnover ratios.

→ how efficiently firm’s management uses assets to generate sales. Efficiency ratios

focus on inventory, receivables and use of fixed and total assets.

→ Used by management to identify areas of inefficiency.

→ Used by creditors to determine speed of converting inventory to receivables.

Receivables convert to cash to help firm meet debt obligations.

 3. Financial Ratios and Firm Performance
3.3. Efficiency Ratios
Inventory turnover ratio–measures how many times inventory turned over into saleable
products. → In general, more often a firm can turn over inventory, the better.
→ Too high or too low a turnover could be warning sign.
Cost of goods sold
Inventory turnover ratio = (4.3)
Inventory (∗)
$1,081.1 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑖𝑛𝑣. +𝐸𝑛𝑑𝑖𝑛𝑔 𝑖𝑛𝑣.
= = 2.55 ∗ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
$423.8 2

Days’ sales in inventory ratio also builds on inventory turnover ratio.

→ Measures number of days firm takes to turn over inventory.
→ The smaller the number, the faster the firm turns over inventory, more efficient it is.
365 days
Days’ sales in inventory = (4.4)
Inventory turnover
365 days
= = 143.14 days
2.55
3. Financial Ratios and Firm Performance
3.3. Efficiency Ratios
Accounts receivable turnover ratio –measures how quickly firm collects on its credit sales. →
In general, more often a firm can turn over inventory, the better.
→ The higher the frequency of turnover, the faster it converts credit sales into cash flows
Net sales
Accounts receivable turnover = (4.5)
Accounts receivable
$1,563.7
= = 5.11
$306.2

Days Sales Outstanding (DSO) measures number of days firm takes to convert receivables
into cash → The fewer the days, the more efficient the firm.
→Note: an overzealous credit department may offend firm’s customers.
365 days
DSO = (4.6)
Accounts receivable turnover

365 days
= = 71.43 days
5.11
 3. Financial Ratios and Firm Performance
3.3. Efficiency Ratios
Total asset turnover ratio measures level of sales firm generates per dollar of total assets.
→ The higher the turnover, the more efficiently management is using total assets.
→ More relevant for service industry firms.
Net sales
Total asset turnover = (4.7)
Total assets

$1,563.7
= = 0.83
$1,889.2

Fixed asset turnover ratio measures level of sales firm generates per dollar of fixed assets.
→ Higher the fixed asset turnover, the more efficiently management uses plant and equipment.
Net sales
Fixed asset turnover = (4.8)
Net fixed assets

$1,563.7
= = 3.92
$399.4
3. Financial Ratios and Firm Performance
3.4. Leverage Ratios-Debt Ratios
▪ Leverage ratios reflect ability of firm and owners to use equity to generate borrowed
funds.
▪ Financial leverage refers to use of debt in firm’s capital structure.
→ Use of debt increases shareholders’ returns; tax benefits from interest payments on debt.

Total debt ratio is calculated using short-term and long-term debt.

→ Debt ratios quantify use of debt in capital structure;
→ The higher the amount of debt, the higher the firm’s leverage, and the more risky it is.
Total debt
Total debt ratio = (4.9)
Total assets
$951.8
=
$1,889.2
= 0.50
3. Financial Ratios and Firm Performance
3.4. Leverage Ratios-Debt Ratios

Debt to equity ratio is a second leverage ratio, measuring amount of debt per dollar of equity.
→ Debt ratios quantify use of debt in capital structure;
→ The higher the amount of debt, the higher the firm’s leverage, and the more risky it is.

Debt-to-equity ratio = Total debt (4.10)

Total equity
$951.8
=
$937.4
= 1.01
 3. Financial Ratios and Firm Performance
3.4. Leverage Ratios-Debt Ratios

Equity multiplier or leverage multiplier reveals amount of assets firm has for every
dollar of equity.
→ Best measure of firm’s ability to leverage shareholders’ equity with borrowed funds.

Total assets
Equity multiplier = (4.11)
Total equity
$1,889.2
=
$937.4
= 2.02

Debt to equity ratio

Debt ratio =
RELATIONSHIPS 1+ Debt to equity ratio

Equity multiplier = 1 + Debt to equity ratio

3. Financial Ratios and Firm Performance
3.5. Leverage Ratios-Coverage Ratios
▪ Coverage ratios measure firm’s ability to meet debt obligations.

Times interest earned measures number of dollars in operating earnings firm generates per
dollar of interest expense.
EBIT
Times interest earned = (4.12)
Interest expense
$168.4
=
$5.6
=30.07
Cash coverage ratio measures amount of cash firm has to meet its interest payments.
EBITDA
Cash coverage = (4.13)
Interest expense
$251.5
=
$5.6
= 44.91
3. Financial Ratios and Firm Performance
3.6. Profitability Ratios
Gross profit margin measures amount of gross profit generated per dollar of net sales.

Gross profit margin = Net sales - Cost of Goods Sold (4.14)

Net sales
$1,563.7 - $1,081.1
=
$1,563.7
= 30.86%
Operating profit margin measures the amount of operating profit generated by firm for
each dollar of net sales.
EBIT
Operating profit margin = (4.15)
Net sales
$168.4
=
$1,563.7
= 10.77%
3. Financial Ratios and Firm Performance
3.6. Profitability Ratios

Net profit margin measures amount of net income after taxes generated by firm for each
dollar of net sales.

• In each case, the higher the ratio, the more profitable the firm.

• Management and creditors likely to focus on these profitability measures; shareholders

likely to concentrate on two others

Net Income
Net profit margin = (4.16)
Net sales
$118.5
=
$1,563.7
= 7.58%
3. Financial Ratios and Firm Performance
3.6. Profitability Ratios
Return on assets (ROA) ratio measures amount of net income per dollar of total assets.
There are two approaches to calculate the return on assets.
➢ This ratio reveals how efficiently management utilized assets under their command.
EBIT
EROA = (4.17)
Total assets
$168.4
=
$1,889.2
= 8.91%
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒. +𝐸𝑛𝑑𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒.
Some analysts calculate return on assets as: ∗ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑠𝑠𝑒𝑡𝑠 =
2
Net income
ROA = (4.18)
Total assets
$118.5
=
$1,889.2
= 6.27%
3. Financial Ratios and Firm Performance
3.6. Profitability Ratios

Return on equity (ROE) ratio measures dollar amount of net income per dollar
of shareholders’ equity.

Net income
Return on equity = (4.19)
Total equity
$118.5
=
$937.4 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒. +𝐸𝑛𝑑𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒.
∗ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑒𝑞𝑢𝑖𝑡𝑦 =
= 12.64% 2

▪ For firm with no debt, ROA = ROE

▪ For firm with debt, ROE >ROA
 3. Financial Ratios and Firm Performance
3.7. Market Value Ratios
▪ The following ratios reveal how market views company’s liquidity, efficiency, leverage, profitability.
Earnings per share (EPS) ratio measures income after taxes generated by firm for each share
outstanding.
Net income
Earnings per share = (4.20)
Shares outstanding
$118,500,000
=
$54,566,054
= 2.17 per share
Price-earnings (P/E) ratio ties firm’s earnings per share to price per share.
→ P/E ratio reflects investors’ expectations of firm’s future earnings growth.
Price per share
Price-earnings ratio = (4.21)
Earnings per share
$48.61
=
$2.17
= 22.4
 4. The DuPont System
4.1. An Overview of the DuPont System

▪ Set of related ratios that links balance sheet and income statement.
▪ Diagnostic tool for evaluating firm’s financial health in order to maximize the firm's ROE:
 how much profit management can earn on sales
 how efficient management is in using the firm's assets,
 how much financial leverage management is using.

▪ Used by management and shareholders to understand factors that drove firm’s ROE.
▪ Based on two equations that relate firm’s ROA and ROE.
4. The DuPont System
4.2. The ROA Equation
▪ Return on assets (net income/total assets) can be broken down into two components:

ROA = Net income  Net sales

Net sales Total assets
= Profit margin  Total assets turnover (4.22)

Management’s ability to Level of efficiency

generate sales & manage management is using total
operating expenses. assets.
▪ Management can examine a poor ROA and determine whether the problem is operating
efficiency or asset use efficiency.
luxury stores, such as jewelry stores,
 profit margin high-end department stores, etc.
➢ To increase firm’s ROA  asset turnover discount stores and grocery stores

 both
4. The DuPont System
4.2. The ROA Equation
Exhibit 4.4: Two Basic Strategies to Earn a Higher ROA

- The two luxury-item retailers (Tiffany & Co. and Burberry) have lower asset turnover and higher profit
margins,
- While the grocery and discount stores have lower profit margins and much higher asset turnover.
Whole Foods and Wal-Mart are strong financial performers in their industry sectors.
- Their relatively low ROAs of 7.99 and 7.38 percent, respectively, reflect the high degree of competition
in the grocery and discount store businesses.
4. The DuPont System
4.3. The ROE Equation
This equation is simply a restatement of equation 4.19.

ROE = Net income = Net income  Total assets

Total equity Total assets Total equity

= ROA Equity multiplier (4.23)

ROE = Net profit margin  Total asset turnover
 Equity multiplier (4.24)
Net income Net sales Total assets
ROE =   (4.25)
Net sales Total assets Total equity
Net profit margin: Total asset
Equity multiplier:
operating turnover: asset
financial leverage.
efficiency. use efficiency.
 4. The DuPont System
4.3. The ROE Equation Exhibit 4.5: Relations in the DuPont System of Analysis

▪ Firm with small ROA can increase ROE

by using higher leverage.
▪ Analyzing firm’s financial performance
will reveal inefficiencies and strengths.
▪ Weak operational efficiency calls for
closer look at firm’s income statement
items.
▪ Asset turnover or leverage problems
shift focus to balance sheet.
4. The DuPont System
4.4. ROE as a Goal

Those who DO NOT agree that maximizing

ROE is equivalent to shareholder wealth Those who BELIEVE that they are consistent
maximization propose.
▪ ROE is based on after-tax earnings, not ▪ ROE allows management to break
cash flows. down performance, identify areas of
strengths and weaknesses.
▪ ROE does not consider risk.
▪ ROE is highly correlated with
▪ ROE ignores size of initial investment shareholder wealth maximization.
as well as future cash flows.
 5. Selecting a Benchmark

A ratio analysis becomes relevant only when compared against a benchmark.

▪ Based on firm’s historical performance.

Time-trend
analysis ▪ Allows management to examine each ratio over time, determine whether trend is
good or bad for firm.

▪ Firms in same industry grouped by size, sales, and product lines, to establish
Industry average benchmark ratios.
analysis
▪ Can identify industry groups with Standard Industrial Classification (SIC) system.

▪ Instead of selecting an entire industry, management may select firms similar in size
Peer group or sales, or who compete in same market.
analysis
▪ Average ratios of this peer group would then be used as benchmark.
▪ Peer groups can be only 3 or 4 firms, depending on industry.
 5. Selecting a Benchmark

The exhibit shows the average financial ratios for public

companies that make up the peer group for Diaz
Manufacturing for 2015, 2016, and 2017.

Exhibit 4.6: Peer Group Ratios for Diaz Manufacturing

 5. Selecting a Benchmark

Exhibit 4.7: Peer Group Analysis for Diaz Manufacturing

▪ Diaz Manufacturing's ROE of 12.64% is
below the benchmark value of 13.07% , a
difference of 0.43% which is not good news.
▪ Diaz's ROA is 3.07% below the peer group
benchmark, which is a serious difference (*)
▪ Equity multiplier value of 2.02, versus the
benchmark value of 1.40
→ Diaz Manufacturing is using more
leverage than the average firm in the
benchmark sample.
▪ ROA = net profit margin x total asset
turnover → continue…
5. Selecting a Benchmark

Limitations of Ratio Analysis

 Ratio analysis depends on accounting data based on historical costs.

 No theoretical backing in making judgments based on financial statement and ratio
analysis.
 When doing industry or peer group analysis, one often encounters large, diversified
firms that do not fit into any one SIC code.
 Time trend analysis could be distorted by financial statements affected by inflation.
 Multinational firms deal with many accounting standards → Difficult to compare
financial reports.
 Even among domestic firms, differences in accounting practices make comparisons
difficult (FIFO versus LIFO)
Homework

HOMEWORK:
Q4.14 → 4.17, pg. 265, 4.18 → 4.20, 4.23, 4.26 pg. 266,
Q4.28, 4.31→ 4.33, pg. 268
Q4.38 → 4.41, pg 271 (Parrino, R., KidWell, D., 2019, 4ed)

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