BFIN300 - Chapter 4 - Analysis of Financial Statements

CHAPTER 4
Analysis of Financial
Statements
 Ratio Analysis
 Du Pont ROE
3-1
Why are ratios useful?
 Ratios are used to analyze the financial
statements.
 Ratios are calculated using data from
the financial statements.
3-2
Five major categories of ratios
 Liquidity: Can the company make required short
term payments?
 Asset management: is the management
efficient in managing the assets of the company?
 Debt management: Right mix of debt and
equity?
 Profitability: is there a good profitability and
efficient cost control in the company?
 Market value: Do investors like what they see
in the company?
3-3
Balance Sheet: Assets
2003 2002
Cash 85,632 7,282
A/R 878,000 632,160
Inventories 1,716,480 1,287,360
Total CA 2,680,112 1,926,802
Gross FA 1,197,160 1,202,950
Less: Dep. 380,120 263,160
Net FA 817,040 939,790
Total Assets 3,497,152 2,866,592
3-4
Balance sheet:
Liabilities and Equity
2003 2002
Accts payable 436,800 524,160
Notes payable 300,000 636,808
Accruals 408,000 489,600
Total CL 1,144,800 1,650,568
Long-term debt 400,000 723,432
Common stock 1,721,176 460,000
Retained earnings 231,176 32,592
Total Equity 1,952,352 492,592
Total L & E 3,497,152 2,866,592
3-5
Income statement
2003 2002
Sales 7,035,600 6,034,000
COGS 5,875,992 5,528,000
Other expenses 550,000 519,988
EBITDA 609,608 (13,988)
Depr. & Amort. 116,960 116,960
EBIT 492,648 (130,948)
Interest Exp. 70,008 136,012
EBT 422,640 (266,960)
Taxes 169,056 (106,784)
Net income 253,584 (160,176)
3-6
Liquidity: current ratio
Current ratio = Current assets / Current liabilities
= $2,680,112 / $1,144,800
= 2.34 x
2003 2002 2001 Industry average

Current
2.34 x 1.20x 2.30x 2.70x
ratio
 Is improving but still below the industry average.

 Liquidity position is weak.
3-7
Liquidity: Quick ratio
Quick ratio = (CA – Inventories) / CL
= ($2,680,112 - 1,716,480)/ $1,144,800
= 0.84 x
 Quick ratio and current ratio are both used to

analyze the liquidity of the company
 Quick ratio is more accurate when inventories
have big values
3-8
Asset Management:
Inventory turnover ratio
Inv. turnover = Sales / Inventories
= $7,036,000 / $1,716,000
= 4.10x
2003 2002 2001 Ind.
Inv. Turnover 4.1x 4.70x 4.8x 6.1x
 The ratio is decreasing over time.

 Inventory turnover is below industry average.
 Efficiency of inventory mgmt. is poor
3-9
Asset Management: Days
Sales Outstanding (DSO)
DSO = Receivables / (Sales/365)
= $878,000 / ($7,035,600/365)
= 45.6 Days
2003 2002 2001 Ind.
DSO 45.6 38.2 37.4 32 days
 The company collects its sales too slowly.
 The company has a poor credit policy.
3-10
Asset Management: Fixed
Assets (FA) turnover ratio
FA turnover = Sales / Net fixed assets
= $7,035,600 / $817,040
= 8.61x
2003 2002 2001 Ind.
FA TO 8.6x 6.4x 10.0x 7.0x
 FA turnover is increasing over time and is greater
than industry average
 This indicates a good fixed-asset management
3-11
Asset Management: Total
Assets (TA) turnover ratio
TA turnover = Sales / Total assets
= $7,035,600 / $3,497,152
= 2.01x
2003 2002 2001 Ind.
TA TO 2.0x 2.1x 2.3x 2.6x
 TA turnover below the industry average. Caused by

excessive currents assets (A/R and Inv).
3-12
Debt Management:
Debt ratio
Debt ratio = Total debt / Total assets
= ($1,144,800 + $400,000) / $3,497,152
= 44.2%
2003 2002 2001 Ind.

D/A 44.2% 82.8% 54.8% 50%
 Debt ratio decreased in 2003.
 It is also lower than industry average.
 Low financial leverage in the company
3-13
Debt Management: Times
Interest Earned (TIE)
TIE = EBIT / Interest expense
= $492,648/ $70,008 = 7.0 x
2003 2002 2001 Ind.
TIE 7.0x -1.0x 4.3x 6.2x
 TIE ratio increased in 2003.
 It is also higher than industry average.
 This indicates the greater ability of the company to
pay the fixed interest payments from EBIT
3-14
Debt Management: Equity
Multiplier (EM)
EM= Total assets / Total equity
= 3,497,152 / 1,952,352 = 1.79 x
or
EM = 1 / (1-Debt ratio)
 If debt ratio increases EM increases as well

 Higher EM implies higher financial leverage
3-15
Profitability:
Net Profit Margin (NPM)
Net Profit margin= Net income / Sales
= $253,584/$7,035,600 = 3.6%
2003 2002 2001 Ind.

NPM 3.6% -2.7% 2.6% 3.5%
 Net Profit margin was very bad in 2002, but has

exceeded the industry average in 2003. Looking good.
3-16
Profitability: Basic Earning
Power (BEP)
BEP= EBIT / Total assets
= $492,648 / $3,497,152 = 14.1%
2003 2002 2001 Ind.

BEP 14.1% -4.6% 13.0% 19.1%
 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.
3-17
Profitability ratios:
Return on assets (ROA)
ROA= Net income / Total assets
= $253,584 / $3,497,152 = 7.3%
2003 2002 2001 Ind.
ROA 7.3% -5.6% 6.0% 9.1%
• ROA rebounded from the previous year, but is

still below the industry average. More
improvement is needed.
3-18
Profitability ratios: Return on
equity (ROE)
ROE= Net income / Total common equity
= $253,584 / 1,952,352 = 13.0%
2003 2002 2001 Ind.
ROE 13.0% -32.5% 13.3% 18.2%
 ROE rebounded from the previous year, but is still below
the industry average. More improvement is needed.
 Wide variations in ROE illustrate the effect that leverage
can have on profitability.
3-19
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.
3-20
Market Value ratios (2003)
No. of shares 250,000

Stock price $12.17
P/E = Stock Price / Earnings per share
Earnings per share (EPS) =NI / Shares
= 253,584 / 250,000 = $1.01
P/E = 12.17/ 1.01 = 12 x
M/B = Stock price / Book value per share
= $12.17 / (1,952,352 / 250,000) =1.56x
3-21
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.
3-22
DuPont ROE Analysis
Profitability Asset Financial

Management Leverage
3-23
DuPont ROE Analysis
ROE = (Profit margin) x (TA turnover) x (Equity multiplier)

= 3.6% x 2 x 1.8
= 13.0%
PM TATO EM ROE
2001 2.6% 2.3 2.2 13.3%
2002 -2.7% 2.1 5.8 -32.5%
2003 3.6% 2.0 1.8 13.0%
Ind. 3.5% 2.6 2.0 18.2%
3-24

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CHAPTER 4

2003 2002 2001 Industry average

 Is improving but still below the industry average.

 Quick ratio and current ratio are both used to

 The ratio is decreasing over time.

 TA turnover below the industry average. Caused by

2003 2002 2001 Ind.

 If debt ratio increases EM increases as well

2003 2002 2001 Ind.

 Net Profit margin was very bad in 2002, but has

2003 2002 2001 Ind.

• ROA rebounded from the previous year, but is

No. of shares 250,000

Profitability Asset Financial

ROE = (Profit margin) x (TA turnover) x (Equity multiplier)

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