Chapter 3

Financial
Statements
and Ratio
Analysis

Copyright © 2012 Pearson Prentice Hall.

All rights reserved.
 The Stockholders’ Report

• Generally accepted accounting principles (GAAP) are

the practice and procedure guidelines used to prepare and
maintain financial records and reports; authorized by the
Financial Accounting Standards Board (FASB).
• The Sarbanes-Oxley Act of 2002, passed to eliminate the
many disclosure and conflict of interest problems of
corporations, established the Public Company Accounting
Oversight Board (PCAOB), which is a not-for-profit
corporation that overseas auditors.

© 2012 Pearson Prentice Hall. All rights reserved. 3-2

 The Four Key Financial Statements:
The Income Statement
• The income statement provides a financial summary of a
company’s operating results during a specified period.
• Although they are prepared quarterly for reporting
purposes, they are generally computed monthly by
management and quarterly for tax purposes.

© 2012 Pearson Prentice Hall. All rights reserved. 3-3

 Table 3.1 Bartlett Company
Income Statements ($000)

© 2012 Pearson Prentice Hall. All rights reserved. 3-4

 The Four Key Financial
Statements: The Balance Sheet
• The balance sheet presents a summary of a firm’s
financial position at a given point in time.
• The statement balances the firm’s assets (what it owns)
against its financing, which can be either debt (what it
owes) or equity (what was provided by owners).

© 2012 Pearson Prentice Hall. All rights reserved. 3-5

 Table 3.2a Bartlett Company
Balance Sheets ($000)

© 2012 Pearson Prentice Hall. All rights reserved. 3-6

 Table 3.2b Bartlett Company
Balance Sheets ($000)

© 2012 Pearson Prentice Hall. All rights reserved. 3-7

 The Four Key Financial Statements:
Statement of Retained Earnings
The statement of retained earnings reconciles the net
income earned during a given year, and any cash dividends
paid, with the change in retained earnings between the start
and the end of that year.

© 2012 Pearson Prentice Hall. All rights reserved. 3-8

 Table 3.3 Bartlett Company Statement of
Retained Earnings ($000) for the Year Ended
December 31, 2012

© 2012 Pearson Prentice Hall. All rights reserved. 3-9

 The Four Key Financial Statements:
Statement of Cash Flows
• The statement of cash flows provides a summary of the
firm’s operating, investment, and financing cash flows
and reconciles them with changes in its cash and
marketable securities during the period.
• This statement not only provides insight into a company’s
investment, financing and operating activities, but also
ties together the income statement and previous and
current balance sheets.

© 2012 Pearson Prentice Hall. All rights reserved. 3-10

 Table 3.4 Bartlett Company Statement of
Cash Flows ($000) for the Year Ended
December 31, 2012

© 2012 Pearson Prentice Hall. All rights reserved. 3-11

 Consolidating International
Financial Statements (cont.)
• Equity accounts, on the other hand, are translated into
dollars by using the exchange rate that prevailed when the
parent’s equity investment was made (the historical rate).
• Retained earnings are adjusted to reflect each year’s
operating profits (or losses).

© 2012 Pearson Prentice Hall. All rights reserved. 3-12

 Using Financial Ratios:
Interested Parties
• Ratio analysis involves methods of calculating and interpreting
financial ratios to analyze and monitor the firm’s performance.
• Current and prospective shareholders are interested in the firm’s
current and future level of risk and return, which directly affect
share price.
• Creditors are interested in the short-term liquidity of the company
and its ability to make interest and principal payments.
• Management is concerned with all aspects of the firm’s financial
situation, and it attempts to produce financial ratios that will be
considered favorable by both owners and creditors.

© 2012 Pearson Prentice Hall. All rights reserved. 3-13

 Using Financial Ratios:
Types of Ratio Comparisons
• Cross-sectional analysis is the comparison of different firms’
financial ratios at the same point in time; involves comparing the
firm’s ratios to those of other firms in its industry or to industry
averages
• Benchmarking is a type of cross-sectional analysis in which the
firm’s ratio values are compared to those of a key competitor or
group of competitors that it wishes to emulate.
• Comparison to industry averages is also popular, as in the
following example.

© 2012 Pearson Prentice Hall. All rights reserved. 3-14

 Using Financial Ratios:
Types of Ratio Comparisons (cont.)
Caldwell Manufacturing’s calculated inventory turnover for
2012 and the average inventory turnover were as follows:

 
Inventory turnover, 2012
Caldwell Manufacturing 14.8
Industry average 9.7

© 2012 Pearson Prentice Hall. All rights reserved. 3-15

 Table 3.5 Financial Ratios for Select Firms
and Their Industry Median Values

© 2012 Pearson Prentice Hall. All rights reserved. 3-16

 Using Financial Ratios: Types
of Ratio Comparisons (cont.)
• Time-series analysis is the evaluation of the firm’s
financial performance over time using financial ratio
analysis
• Comparison of current to past performance, using ratios,
enables analysts to assess the firm’s progress.
• Developing trends can be seen by using multiyear
comparisons.
• The most informative approach to ratio analysis combines
cross-sectional and time-series analyses.

© 2012 Pearson Prentice Hall. All rights reserved. 3-17

 Figure 3.1 Combined Analysis

© 2012 Pearson Prentice Hall. All rights reserved. 3-18

 Using Financial Ratios: Cautions
about Using Ratio Analysis
1. Ratios that reveal large deviations from the norm merely indicate
the possibility of a problem.
2. A single ratio does not generally provide sufficient information
from which to judge the overall performance of the firm.
3. The ratios being compared should be calculated using financial
statements dated at the same point in time during the year.
4. It is preferable to use audited financial statements.
5. The financial data being compared should have been developed in
the same way.
6. Results can be distorted by inflation.

© 2012 Pearson Prentice Hall. All rights reserved. 3-19

 Ratio Analysis

Liquidity Ratios

Current ratio = Current assets ÷ Current liabilities

The current ratio for Bartlett Company in 2012 is:

$1,223,000 ÷ $620,000 = 1.97

© 2012 Pearson Prentice Hall. All rights reserved. 3-20

 Matter of Fact

Determinants of liquidity needs

– Large enterprises generally have well established
relationships with banks that can provide lines of
credit and other short-term loan products in the event
that the firm has a need for liquidity.
– Smaller firms may not have the same access to credit,
and therefore they tend to operate with more liquidity.

© 2012 Pearson Prentice Hall. All rights reserved. 3-21

 Ratio Analysis (cont.)

Liquidity Ratios

The quick ratio for Bartlett Company in 2012 is:

© 2012 Pearson Prentice Hall. All rights reserved. 3-22

 Ratio Analysis (cont.)

Activity Ratios

Inventory turnover = Cost of goods sold ÷ Inventory

Applying this relationship to Bartlett Company in 2012 yields:

$2,088,000 ÷ $289,000 = 7.2

© 2012 Pearson Prentice Hall. All rights reserved. 3-23

 Ratio Analysis (cont.)

Activity Ratios

Average Age of Inventory = 365 ÷ Inventory turnover

For Bartlett Company, the average age of inventory in 2012 is:

365 ÷ 7.2 = 50.7 days

© 2012 Pearson Prentice Hall. All rights reserved. 3-24

 Ratio Analysis (cont.)

Activity Ratios

The average collection period for Bartlett Company in 2012 is:

© 2012 Pearson Prentice Hall. All rights reserved. 3-25

 Table 3.6 Financial Statements
Associated with Patty’s Alternatives

© 2012 Pearson Prentice Hall. All rights reserved. 3-26

 Ratio Analysis (cont.)

Debt Ratios

Debt ratio = Total liabilities ÷ Total assets

The debt ratio for Bartlett Company in 2012 is

$1,643,000 ÷ $3,597,000 = 0.457 = 45.7%

© 2012 Pearson Prentice Hall. All rights reserved. 3-27

 Ratio Analysis (cont.)

Debt Ratios

Times interest earned ratio = EBIT ÷ Interest Expense

The figure for earnings before interest and taxes (EBIT) is the
same as that for operating profits shown in the income statement.

Applying this ratio to Bartlett Company yields the following

2012 value:

$418,000 ÷ $93,000 = 4.5

© 2012 Pearson Prentice Hall. All rights reserved. 3-28

 Ratio Analysis (cont.)

Debt Ratios
Fixed-Payment coverage Ratio (FPCR)

Applying the formula to Bartlett Company’s 2012 data yields:

© 2012 Pearson Prentice Hall. All rights reserved. 3-29

 Table 3.7 Bartlett Company
Common-Size Income Statements

© 2012 Pearson Prentice Hall. All rights reserved. 3-30

 Ratio Analysis (cont.)

Profitability Ratios

Bartlett Company’s gross profit margin for 2012 is:

© 2012 Pearson Prentice Hall. All rights reserved. 3-31

 Ratio Analysis (cont.)

Profitability Ratios

Operating profit margin = Operating profits ÷ sales

Bartlett Company’s operating profit margin for 2012 is:

$418,000 ÷ $3,074,000 = 13.6%

© 2012 Pearson Prentice Hall. All rights reserved. 3-32

 Ratio Analysis (cont.)

Profitability Ratios

Net profit margin = Earnings available for common

stockholders ÷ Sales

Bartlett Company’s net profit margin for 2012 is:

$221,000 ÷ $3,074,000 = 0.072 = 7.2%

© 2012 Pearson Prentice Hall. All rights reserved. 3-33

 Ratio Analysis (cont.)

Profitability Ratios

Bartlett Company’s earnings per share (EPS) in 2012 is:

$221,000 ÷ 76,262 = $2.90

© 2012 Pearson Prentice Hall. All rights reserved. 3-34

 Ratio Analysis (cont.)

Profitability Ratios

Return on total assets (ROA) = Earnings available for common

stockholders ÷ Total assets

Bartlett Company’s return on total assets in 2012 is:

$221,000 ÷ $3,597,000 = 0.061 = 6.1%

© 2012 Pearson Prentice Hall. All rights reserved. 3-35

 Ratio Analysis (cont.)

Profitability Ratios

Return on Equity (ROE) = Earnings available for common

stockholders ÷ Common stock equity

This ratio for Bartlett Company in 2012 is:

$221,000 ÷ $1,754,000 = 0.126 = 12.6%

© 2012 Pearson Prentice Hall. All rights reserved. 3-36

 Ratio Analysis (cont.)

Market Ratios

Price Earnings (P/E) Ratio = Market price per share of common

stock ÷ Earnings per share

If Bartlett Company’s common stock at the end of 2012 was

selling at $32.25, using the EPS of $2.90, the P/E ratio at
year-end 2012 is:

$32.25 ÷ $2.90 = 11.1

© 2012 Pearson Prentice Hall. All rights reserved. 3-37

 Ratio Analysis (cont.)

Market Ratios

where,

© 2012 Pearson Prentice Hall. All rights reserved. 3-38

 Ratio Analysis (cont.)

Substituting the appropriate values for Bartlett Company from its

2012 balance sheet, we get:

Substituting Bartlett Company’s end of 2012 common stock price of

$32.25 and its $23.00 book value per share of common stock
(calculated above) into the M/B ratio formula, we get:

$32.25 ÷ $23.00 = 1.40

© 2012 Pearson Prentice Hall. All rights reserved. 3-39

Predicting Corporate Bankruptcy:
The Z-score model

Many potential lenders use credit scoring models to

assess the creditworthiness of prospective
borrowers.
The general idea is to find factors that enable the
lenders to discriminate between good and bad credit
risks.
Edward Altman has developed a model using financial
statement ratios and multiple discriminant analyses
to predict bankruptcy for publicly traded
manufacturing firms
 Predicting Corporate Bankruptcy: The
Z-score model (continued)
The resultant model is of the form:
Z = 3.3(EBIT/Total assets) + 1.2(Net working capital/Total
assets) + 1.0(Sales/Total assets) + 0.6(Market value of
equity/Book value of debt) + 1.4(Accumulated retained
earnings/Total assets)

where Z is an index of bankruptcy.

Bankruptcy would be predicted if Z  1.81 and nonbankruptcy if

Z  2.99.
 Predicting Corporate Bankruptcy: The
Z-score model (continued)
Altman uses a revised model to make it applicable for private
firms and non-manufacturers.
The resulting model is:
Z = 6.56(Net working capital/Total assets)
+ 3.26(Accumulated retained earnings/Total assets)
+ 1.05(EBIT/Total assets) + 6.72(Book value of equity/Total
liabilities)
where Z  1.23 indicates a bankruptcy prediction.
1.23  Z  2.90 indicates a grey area,
and Z  2.90 indicates no bankruptcy.
 Table 3.8a Summary of
Bartlett Company Ratios

© 2012 Pearson Prentice Hall. All rights reserved. 3-43

 Table 3.8b Summary of
Bartlett Company Ratios

© 2012 Pearson Prentice Hall. All rights reserved. 3-44

 DuPont System of Analysis

• The DuPont system of analysis is used to dissect the

firm’s financial statements and to assess its financial
condition.
• It merges the income statement and balance sheet into two
summary measures of profitability.
• The Modified DuPont Formula relates the firm’s ROA to
its ROE using the financial leverage multiplier (FLM),
which is the ratio of total assets to common stock equity:
• ROA and ROE as shown in the series of equations on the
following slide.

© 2012 Pearson Prentice Hall. All rights reserved. 3-45

 DuPont System of Analysis

• The DuPont system first brings together the net profit

margin, which measures the firm’s profitability on sales,
with its total asset turnover, which indicates how
efficiently the firm has used its assets to generate sales.
ROA = Net profit margin  Total asset turnover
• Substituting the appropriate formulas into the equation
and simplifying results in the formula given earlier,

© 2012 Pearson Prentice Hall. All rights reserved. 3-46

 DuPont System of Analysis
(cont.)
When the 2012 values of the net profit margin and total
asset turnover for Bartlett Company, calculated earlier, are
substituted into the DuPont formula, the result is:

ROA = 7.2%  0.85 = 6.1%

© 2012 Pearson Prentice Hall. All rights reserved. 3-47

 DuPont System of Analysis:
Modified DuPont Formula
• The modified DuPont Formula relates the firm’s return on total
assets to its return on common equity. The latter is calculated by
multiplying the return on total assets (ROA) by the financial
leverage multiplier (FLM), which is the ratio of total assets to
common stock equity:
ROE = ROA  FLM
• Substituting the appropriate formulas into the equation and
simplifying results in the formula given earlier,

© 2012 Pearson Prentice Hall. All rights reserved. 3-48

 DuPont System of Analysis:
Modified DuPont Formula (cont.)
Substituting the values for Bartlett Company’s ROA of 6.1
percent, calculated earlier, and Bartlett’s FLM of 2.06
($3,597,000 total assets ÷ $1,754,000 common stock equity)
into the modified DuPont formula yields:
ROE = 6.1%  2.06 = 12.6%

© 2012 Pearson Prentice Hall. All rights reserved. 3-49

 Figure 3.2: DuPont System of Analysis

© 2012 Pearson Prentice Hall. All rights reserved. 3-50

 Matter of Fact

Dissecting ROA
– Return to Table 3.5 and examine the total asset
turnover figures for Dell and Home Depot.
– Both firms turn their assets 1.6 times per year.
– Dell’s ROA is 4.3%, but Home Depot’s is
significantly higher at 6.5%. Why?
– The answer lies in the DuPont formula.
– Notice that Home Depot’s net profit margin is 4.0%
compared to Dell’s 2.7%.

© 2012 Pearson Prentice Hall. All rights reserved. 3-51