Principles of Managerial Finance

Fifteenth Edition, Global Edition

Chapter 3
Financial Statements and
Ratio Analysis

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Learning Goals (1 of 2)
LG 1 Review the contents of the stockholders’ report and the
procedures for consolidating international financial
statements.
LG 2 Understand who uses financial ratios and how.
LG 3 Use ratios to analyze a firm’s liquidity and activity.
LG 4 Discuss the relationship between debt and financial
leverage, as well as the ratios used to analyze a firm’s
debt.

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Learning Goals (2 of 2)
LG 5 Use ratios to analyze a firm’s profitability and its market
value.
LG 6 Use a summary of financial ratios and the DuPont
system of analysis to perform a complete ratio
analysis.

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3.1 The Stockholders’ Report (1 of 8)
• General Accepted Accounting Principals (GAAP)
– Authorized by the Financial Accounting Standards Board
(FASB)
• Sarbanes-Oxley Act of 2002
– Established the Public Company Accounting Oversight
Board (PCAOB)
• The Letter to Stockholders
– The first element of the annual stockholders’ report and the
primary communication from management

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3.1 The Stockholders’ Report (2 of 8)
• The Four Key Financial Statements
– Income Statement
 Provides a financial summary of the firm’s operating results
during a specified period
 Dividends Per Share
– The dollar amount of cash distributed during the period on
behalf of each outstanding share of common stock

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Table 3.1 Bartlett Company Income
Statements ($000) (1 of 2)
For the years ended December 31

blank 2019 2018

Sales revenue $ 3,074 $ 2,567
Less: Cost of goods sold 2,088 1,711
Gross profits $ 986 $ 856
Less: Operating expenses blank blank
Selling expense $ 100 $ 108
General and administrative 194 187
expenses
Other operating expenses 35 35
Depreciation expense 239 223
Total operating expense Copyright © $
2019568 $ Ltd.
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Table 3.1 Bartlett Company Income
Statements ($000) (2 of 2)
For the years ended December 31

blank 2019 2018

Less: Interest expense 93 91
Net profits before taxes $ 325 $ 212
Less: Taxes 94 64
Net profits after taxes $ 231 $ 148
Less: Preferred stock dividends 10 10
Earnings available for common $ 221 $ 138
stockholders
a
Calculated by dividing the earnings available for common stockholders by the number of shares of common stock
Earnings
outstanding: perinshare
76,262 2019 and(EPS) a
$ 2.90 ÷ 76,262 = $2.90;
76,244 in 2018. Earnings per share in 2019: $221,000 $ 1.81
in 2018:
$138,000 ÷ 76,244 = $1.81.
b
Dividend
Calculated per share
by dividing (DPS)
the dollar $ 1.29
amountb of dividends paid to common stockholders $ 0.75
by the number of shares of common
stock outstanding. Dividends per share in 2019: $98,000 ÷ 76,262 = $1.29; in 2018: $57,183 ÷ 76,244 = $0.75.

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Personal Finance Example 3.1 (1 of 4)

Jan and Jon Smith, a mid-30s married couple with no

children, prepared a personal income and expense
statement, which is similar to a corporate income statement.
A condensed version of their income and expense statement
follows.

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Personal Finance Example 3.1 (2 of 4)
Jan and Jon Smith’s Income and Expense Statement for the Year
Ended December 31, 2019

Income BLANK
Salaries $ 91,500
Interest received 195
Dividends received 120
(1) Total income $ 91,815
Expenses blank
Mortgage payments $ 11,500
Auto loan payments 4,280
Utilities 3,180
Home repairs and maintenance 1,050
Food 8,235
Car expense 5,450
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Health care and insurance 3,150
Personal Finance Example 3.1 (3 of 4)
Jan and Jon Smith’s Income and Expense Statement for the Year
Ended December 31, 2019

Expenses BLANK
Clothes, shoes, accessories 2,745
Insurance 1,380
Taxes 36,600
Appliance and furniture payments 1,250
Recreation and entertainment 4,575
Tuition and books for Jan 3,830
Personal care and other items 915
(2) Total expenses $ 88,140
(3) Cash surplus (or deficit) [(1) – (2)] $ 3,675

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Personal Finance Example 3.1 (4 of 4)

During the year, the Smiths had total income of $91,815 and
total expenses of $88,140, which left them with a cash
surplus of $3,675. They can save and invest the surplus.
Notice that the $3,675 represents just about 4% of the
Smiths’ total income. Most financial advisors would suggest
a much higher savings rate, so Jan and Jon may want to
take a hard look at their budget to see where they can cut
expenses.

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3.1 The Stockholders’ Report (3 of 8)
• The Four Key Financial Statements
– Balance Sheet
 Summary statement of the firm’s financial position at a given
point in time
 Current Assets
– Short-term assets, expected to be converted into cash
within 1 year
 Current Liabilities
– Short-term liabilities, expected to be paid within 1 year
 Long-Term Debt
– Debt for which payment is not due in the current year

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3.1 The Stockholders’ Report (4 of 8)
• The Four Key Financial Statements
– Balance Sheet
 Paid-in-Capital in Excess of Par
– The amount of proceeds in excess of the par value
received from the original sale of common stock
 Statement of Stockholders’ Equity
– Shows all equity account transactions that occurred during
a given year

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Table 3.2 Bartlett Company Balance
Sheets ($000) (1 of 2)
December 31

Assets 2019 2018

Cash $ 363 $ 288

Marketable securities 68 51

Accounts receivable 503 365

Inventories 289 300

Total current assets $ 1,223 $ 1,004

Land and buildings $ 2,072 $ 1,903

Machinery and equipment 1,866 1,693

Furniture and fixtures 358 316

Vehicles 275 314

Other (includes financial leases) 98 96

Total gross fixed assets (at cost) $ 4,669 $ 4,322

Less: Accumulated depreciation 2,295 2,056

Net fixed assets $ 2,374 $ 2,266

Total assets $ 3,597 $ 3,270

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Table 3.2 Bartlett Company Balance
Sheets ($000) (2 of 2)
December 31

Assets 2019 2018

Liabilities and Stockholders’ Equity Blank blank
Accounts payable $ 382 $ 270
Notes payable 79 99
Accruals 159 114
Total current liabilities $ 620 $ 483
Long-term debt (includes financial leases) 1,023 967
Total liabilities $ 1,643 $ 1,450
Preferred stock: cumulative 5%, $100 par, 2,000 shares authorized and issued $ 200 $ 200
Common stock: $2.50 par, 100,000 shares authorized, shares issued and outstanding in 2019: 191 191
76,262; in 2018: 76,244

Paid-in capital in excess of par on common stock 428 417

Retained earnings 1,135 1,012
Total stockholders’ equity $ 1,954 $ 1,820
Total liabilities and stockholders’ equity $ 3,597 $ 3,270

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Personal Finance Example 3.2 (1 of 2)

The following personal balance sheet for Jan and Jon Smith
—the couple introduced earlier, who are married, in their
mid-30s, and have no children—is similar to a corporate
balance sheet.
Jan and Jon Smith’s Balance Sheet: December 31, 2019

Assets blank Liabilities and Net Worth blank

Cash on hand $ 90 Credit card balances $ 665

Checking accounts 575 Utility bills 265
Savings accounts 760 Medical bills 75
Money market funds 800 Other current liabilities 45
Total liquid assets $2,225 Total current liabilities $ 1,050
Stocks and bonds $2,250 Real estate mortgage $120,000
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Personal Finance Example 3.2 (2 of 2)
Assets blank Liabilities and Net Worth blank

Mutual funds 1,500 Auto loans 14,250

Retirement funds, IRA 2,000 Education loan 13,800
Total investments $ 5,750 Personal loan 4,000
Real estate $180,000 Furniture loan 800
Cars 34,000 Total long-term liabilities $152,850
Household furnishings 3,700 Total liabilities $153,900
Jewelry and artwork 1,500 Net worth (N/W) 73,275
Total personal property $219,200 Total liabilities and net worth $227,175
Total assets $227,175 Blank blank
The Smiths have total assets of $227,175 and total liabilities of $153,900. Personal net worth
(N/W) is a “plug figure”—the difference between total assets and total liabilities—which in the
case of Jan and Jon Smith is $73,275.

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3.1 The Stockholders’ Report (5 of 8)
• The Four Key Financial Statements
– 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

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Table 3.3 Bartlett Company Statement of
Retained Earnings ($000) for the Year
Ended December 31, 2019
Retained earnings balance (January 1, 2019) $1,012
Plus: Net profits after taxes (for 2019) 231
Less: Cash dividends (paid during 2019) blank

Preferred stock 10
Common stock 98
Total dividends paid $ 108
Retained earnings balance (December 31, 2019) $1,135

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3.1 The Stockholders’ Report (6 of 8)
• The Four Key Financial Statements
– 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

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Table 3.4 Bartlett Company Statement of
Cash Flows ($000) for the Year Ended
December 31, 2019 (1 of 2)
Cash Flow from Operating Activities Blank
Net profits after taxes $ 231
Depreciation 239
Increase in accounts receivable –138a
Decrease in inventories 11
Increase in accounts payable 112
Increase in accruals 45
Cash provided by operating activities $ 500
Cash Flow from Investment Activities blank
Increase in gross fixed assets –347
Change in equity investments in other firms 0
Cash provided by investment activities –$ 347
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Table 3.4 Bartlett Company Statement of
Cash Flows ($000) for the Year Ended
December 31, 2019 (2 of 2)
Cash Flow from Financing Activities Blank
Decrease in notes payable −20
Increase in long-term debts 56
Changes in stockholders’ equity b 11
Dividends paid − 108
Cash provided by financing activities −$ 61
Net increase in cash and marketable securities $ 92
a
As is customary, parentheses are used to denote a negative number, which in this case is a cash outflow.
b
Retained earnings are excluded here because their change is actually reflected in the combination of the “net profits
after taxes” and “dividends paid” entries.

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3.1 The Stockholders’ Report (7 of 8)
• Notes to the Financial Statements
– Explanatory notes keyed to relevant accounts in the
statements; they provide detailed information on the
accounting policies, procedures, calculations, and
transactions underlying entries in the financial statements

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3.1 The Stockholders’ Report (8 of 8)
• Consolidating International Financial Statements
– Financial Accounting Standards Board (FASB) Standard
No. 52
 Mandates that U.S.–based companies translate their foreign-
currency-denominated assets and liabilities into U.S. dollars,
for consolidation with the parent company’s financial
statements
– Current Rate (Translation) Method
 Technique used by U.S.–based companies to translate their
foreign-currency-denominated assets and liabilities into U.S.
dollars, for consolidation with the parent company’s financial
statements, using the year-end (current) exchange rate

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3.2 Using Financial Ratios (1 of 5)

• Interested Parties
– Shareholders
– Creditors
– Management

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3.2 Using Financial Ratios (2 of 5)

• Types of Ratio Comparisons

– Cross-Sectional Analysis
 Comparison of different firms’ financial ratios at the same point
in time; involves comparing the firm’s ratios with those of other
firms in its industry or with industry averages
– Benchmarking
 A type of cross-sectional analysis in which the firm’s ratio
values are compared with those of a key competitor or with a
group of competitors that it wishes to emulate

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 Table 3.5 Financial Ratios for Select Firms
and Their Industry Average Values (1 of 2)
Average Total Return
blank
collectio asset Net Return on Price to
Current Quick Inventory n period turnove Debt profit on total common earning
ratio ratio turnover (days) r ratio margin assets equity s ratio
Apple 1.4 1.3 61.6 49.6 0.7 0.6 21.2% 14.2% 35.6% 16.9
Hewlett- 1.0 0.7 8.8 31.1 1.7 0.7 5.2 8.6 16.4 10.7
Packard
Computer 1.5 0.6 21.0 57.0 0.8 0.4 15.6 11.9 32.3 16.0
s
Home 1.3 0.4 4.3 5.3 1.6 0.5 4.0 6.5 13.7 22.7
Depot
Lowe’s 1.3 0.2 3.7 0.0 1.4 0.4 3.7 5.4 9.3 20.6
Building 2.8 0.8 3.7 5.3 1.6 0.3 4.0 6.5 13.7 26.2
materials
Kroger 0.8 0.2 11.5 5.8 3.2 0.8 1.9 6.0 30.0 13.6

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 Table 3.5 Financial Ratios for Select Firms
and Their Industry Average Values (2 of 2)
Average
blank
collection Total Net Return on Return on Price to
Current Quick Inventory period asset Debt profit total common earnings
ratio ratio turnover (days) turnover ratio margin assets equity ratio
Whole Foods 1.5 1.1 19.9 5.6 2.5 0.5 3.2 8.0 15.7 18.0
Market

Grocery 1.3 0.7 11.1 7.5 2.4 0.6 2.1 3.1 9.8 20.8
stores
Target 0.9 0.3 5.9 3.9 1.8 0.7 3.8 7.1 24.4 10.7
Walmart 0.9 0.3 9.0 3.7 2.4 0.6 3.5 8.4 20.3 16.3
Merchandis 1.7 0.6 4.1 3.7 2.3 0.5 1.5 4.9 10.8 37.1
e stores
The data used to calculate these ratios are drawn from the Compustat North American database.

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Example 3.3 (1 of 3)
In early 2019, Mary Boyle, the chief financial analyst at Caldwell
Manufacturing, a producer of heat exchangers, gathered data on the
firm’s financial performance during 2018, the year just ended. She
calculated a variety of ratios and obtained industry averages. She
was especially interested in inventory turnover, which reflects the
speed with which the firm moves its inventory from raw materials
through production into finished goods and to the customer as a
completed sale. Generally, analysts like to see higher values of this
ratio because they indicate a quicker turnover of inventory and more
efficient inventory management. Caldwell Manufacturing’s inventory
turnover for 2018 and the industry average inventory turnover were
as follows:
blank Inventory Turnover, 2018
Caldwell Manufacturing 14.8
Industry average 9.7
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Example 3.3 (2 of 3)
Initially, Mary believed these data showed that the firm had
managed its inventory much better than the average firm in
the industry. The turnover was nearly 53% faster than the
industry average. On reflection, however, she realized that a
very high inventory turnover could be a sign that the firm is
not holding enough inventories. The consequence of low
inventory could be excessive stockouts (insufficient inventory
to meet customer needs). Discussions with people in the
manufacturing and marketing departments did, in fact,
uncover such a problem.

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Example 3.3 (3 of 3)
Inventories of raw materials during the year were extremely
low, resulting in numerous production delays that hindered
the firm’s ability to meet demand and resulted in disgruntled
customers and lost sales. A ratio that initially appeared to
reflect extremely efficient inventory management was
actually the symptom of a major problem.

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3.2 Using Financial Ratios (3 of 5)

• Types of Ratio Comparisons

– Time-Series Analysis
 Evaluation of the firm’s financial performance over time using
financial ratio analysis
– Combined Analysis
 Combines cross-sectional and time-series analyses

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Figure 3.1 Combined Analysis

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3.2 Using Financial Ratios (4 of 5)

• Cautions About Using Ratio Analysis

– Ratios that reveal large deviations from the norm merely
indicate the possibility of a problem
– A single ratio does not generally provide sufficient
information from which to judge the overall performance of
the firm
– The ratios being compared should be calculated using
financial statements dated at the same point in time during
the year

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3.2 Using Financial Ratios (5 of 5)

• Cautions About Using Ratio Analysis

– It is preferable to use audited financial statements
– The financial data being compared should have been
developed in the same way
– Results can be distorted by inflation

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 Table 3.6 Whole Foods Market Inc. Balance Sheets
for 2016 and 2015 ($ millions)
Assets 2016 2015 Liabilities and Equity 2016 2015
Cash $ 852 $ 519 Accounts payable $307 $295

Accounts receivable 242 218 Other current liabilities 1,034 957

Inventory 517 500 Total current liabilities $1,341 $1,252
Other current assets 364 307 Long-term debt 1,776 720

Total current assets $1,975 $1,544 Total liabilities $3,117 $1,972

Property, plant, and 3,442 3,163 Common stock 907 1,780

equipment (net)
Other long-term assets 924 1,034 Retained earnings 2,317 1,989

Total fixed assets $4,366 $4,197 Total equity $3,224 $3,769

Total assets $6,341 $5,741 Total liabilities plus equity $6,341 $5,741

Note: The company had 318.3 million and 348.9 million shares outstanding in 2016 and 2015, respectively.
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Table 3.7 Whole Foods Market Inc. Income
Statements for 2016 and 2015 ($ millions)
blank 2016 2015
Sales $ 15,724 $ 15,389
Less: Cost of goods sold 10,313 9,973
Gross profit $ 5,411 $ 5,416
Less: Selling, general, and administrative expenses 4,477 4,472
Other operating expenses 77 83
Operating profit (EBIT) $ 857 $ 861
Less: Interest expense 41 0
Plus: Other income 11 17
Pre-tax income (EBT) $ 827 $ 878
Less: Taxes 320 342
Net income (EACS) $ 507 $ 536
Dividends paid $ 177 $ 186
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3.3 Liquidity Ratios (1 of 2)
• Liquidity
– A firm’s ability to satisfy its short-term obligations as they
come due
• Current Ratio = Current Assets ÷ Current Liabilities
– A measure of liquidity calculated by dividing the firm’s
current assets by its current liabilities

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Matter of Fact (1 of 2)
Determinants of Liquidity Needs
Glance back at the first column of data in Table 3.5, which
shows the current ratio for a variety of companies and
industries. Notice that the industry with the highest current
ratio (i.e., most liquidity) is building materials, an industry
notoriously sensitive to business cycle swings. The current
ratio for that industry is 2.8, indicating that the typical firm in
that business has almost 3 times as much in current assets
as in current liabilities.

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Matter of Fact (2 of 2)
Two of the largest competitors in that industry, Home Depot
and Lowe’s, operate with a current ratio of 1.3, less than half
the industry average. Does this ratio mean that these firms
have a liquidity problem? Not necessarily. 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 needs liquidity. Smaller firms may
not have the same access to credit and therefore tend to
operate with more liquidity.

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Personal Finance Example 3.4 (1 of 3)

Individuals, like corporations, can use financial ratios to

analyze and monitor their performance. Typically, personal
finance ratios are calculated using the personal income and
expense statement and personal balance sheet for the
period of concern. Here we use these statements, presented
in the preceding personal finance examples, to demonstrate
calculation of Jan and Jon Smith’s liquidity ratio for calendar
year 2019.

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Personal Finance Example 3.4 (2 of 3)

The personal liquidity ratio is calculated by dividing total

liquid assets by total current debt. It indicates the percentage
of annual debt obligations that an individual can meet using
current liquid assets. The Smiths’ total liquid assets were
$2,225. Their total current debts are $18,080 (total current
liabilities of $1,050 + mortgage payments of $11,500 + auto
loan payments of $4,280 + appliance and furniture payments
of $1,250). Substituting these values into the ratio formula,
we get

Total liquid assets $2, 225

Liquidity ratio    0.123, or 12.3%
Total current debts $18,880

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Personal Finance Example 3.4 (3 of 3)

The ratio indicates that the Smiths can cover only about 12%
of their existing 1-year debt obligations with their current
liquid assets. Clearly, the Smiths plan to meet these debt
obligations from their income, but this ratio suggests that
their liquid funds do not provide a large cushion. As one of
their goals, they should probably build up a larger fund of
liquid assets to meet unexpected expenses.

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3.3 Liquidity Ratios (2 of 2)
• Quick (Acid-Test) Ratio = (Current Assets – Inventory) ÷
Current Liabilities
– A measure of liquidity calculated by dividing the firm’s
current assets less inventory by its current liabilities

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Matter of Fact (1 of 2)
The Importance of Inventories
Turn again to Table 3.5 and examine the columns listing
current and quick ratios for different firms and industries.
Notice that Apple has a current ratio of 1.4, almost identical
to current ratios for Home Depot and Lowe’s, which are both
1.3. The quick ratios for Home Depot and Lowe’s are much
lower than their current ratios, but for Apple that is not true—
that firm’s current and quick ratios are nearly equal.

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Matter of Fact (2 of 2)
Why? First, Apple relies primarily on contract manufacturers
to make its products, so it holds little or no inventory while its
devices are being made. Second, the popularity of Apple’s
products means that inventory does not sit on retail store
shelves very long. In contrast, all it takes is a trip to your
local Home Depot or Lowe’s store to see that the business
model in this industry requires a massive investment in
inventory, which implies that the quick ratio will be much less
than the current ratio for building materials firms.

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3.4 Activity Ratios (1 of 3)
• Activity Ratios
– Measure the speed with which various accounts are
converted into sales or cash, or inflows or outflows
• Inventory Turnover = Cost of Goods Sold ÷ Inventory
– Measures the activity, or liquidity, of a firm’s inventory
 Average Age of Inventory = Inventory Turnover ÷ 365
– Average number of days’ sales in inventory

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3.4 Activity Ratios (2 of 3)
• Average Collection Period = Accounts Receivable ÷ Average
Sales Per Day
or
Accounts Receivable ÷ (Annual Sales ÷ 365)
– The average amount of time needed to collect accounts
receivable

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Matter of Fact (1 of 2)
Who Gets Credit?
Notice in Table 3.5 the vast differences across industries in
the average collection periods. Companies in the building
materials, grocery, and merchandise store industries collect
in just a few days, whereas firms in the computer industry
take a month or two to collect on their sales. This difference
exists primarily because these industries serve very different
customers.

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Matter of Fact (2 of 2)
Grocery and retail stores serve individuals who pay cash or
use credit cards (which, to the store, are essentially the
same as cash). Computer manufacturers sell to retail chains,
businesses, and other large organizations that negotiate
agreements allowing them to pay well after the sale is made.

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3.4 Activity Ratios (3 of 3)
• Average Payment Period = Accounts Payable ÷ Average
Purchases Per Day
or
Accounts Payable ÷ (Annual Purchases ÷ 365)
– The average amount of time needed to pay accounts
payable
• Total Asset Turnover = Sales ÷ Total Assets
– Indicates the efficiency with which the firm uses its assets to
generate sales

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Matter of Fact (1 of 2)
Sell It Fast
Observe in Table 3.5 that the grocery business has more
rapid total asset turnover than any other industry. That
makes sense because inventory is among the most valuable
asset held by these firms, and grocery stores must sell
baked goods, dairy products, and produce quickly or throw
such items away when they spoil.

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Matter of Fact (2 of 2)
It’s true that some items in a grocery store have a shelf life
longer than anyone really wants to know (think Twinkies),
but on average a grocery store has to replace its entire
inventory in just a few days or weeks, and that practice
contributes to the rapid turnover of the firm’s total assets.

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3.5 Debt Ratios (1 of 3)
• Financial Leverage
– The magnification of risk and return through the use of fixed-
cost financing, such as debt and preferred stock
• Degree of Indebtedness
– Ratios that measure the amount of debt relative to other
significant balance sheet amounts

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Example 3.5 (1 of 2)
Patty Akers is incorporating her new business. After much
analysis, she determines that an initial investment of
$50,000—$20,000 in current assets and $30,000 in fixed
assets—is necessary. These funds can be obtained in one
of two ways. The first is the no-debt plan, under which she
would invest the full $50,000 without borrowing. The other
alternative, the debt plan, involves investing $25,000 and
borrowing the balance of $25,000 at 6% annual interest.

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Example 3.5 (2 of 2)
Patty expects $30,000 in sales, $18,000 in operating
expenses, and a 21% tax rate. Projected balance sheets and
income statements associated with the two plans appear
below in Table 3.8. The no-debt plan results in after-tax
profits of $9,480, which represent a 19% rate of return on
Patty’s $50,000 investment. The debt plan results in $8,295
of after-tax profits, which represent a 33.2% rate of return on
Patty’s investment of $25,000. The debt plan provides Patty
with a higher rate of return, but also has a greater risk
because the annual $1,500 of interest must be paid whether
Patty’s business is profitable or not.

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Table 3.8 Financial Statements Associated
with Patty’s Alternatives

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3.5 Debt Ratios (2 of 3)
• Debt Ratio = Total Liabilities ÷ Total Assets
– Measures the proportion of total assets financed by the
firm’s creditors
• Debt-to-Equity Ratio = Total Liabilities ÷ Common Stock
Equity
– Measures the relative proportion of total liabilities and
common stock equity used to finance the firm’s total assets
• Times Interest Earned Ratio = Earnings Before Interest
and Taxes ÷ Interest
– Measures the firm’s ability to make contractual interest
payments; sometimes called the interest coverage ratio

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3.5 Debt Ratios (3 of 3)
• Fixed Payment Coverage Ratio =

Earnings Before Interest and Taxes  Lease Payments

  1 
Interest  Lease Payments  (Principal Payments  Prefereed Stock Dividends)   
  1  T 

– Measures the firm’s ability to meet all fixed-payment

obligations

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3.6 Profitability Ratios (1 of 5)
• Common-Size Income Statements
– An income statement in which each item is expressed as a
percentage of sales

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Table 3.9 Whole Foods Common-Size
Income Statements
blank 2016 2015 Evaluationa 2015–
2016
Sales revenue 100.0% 100.0% Blank
Less: Cost of goods sold 65.6 64.8 Worse
(1) Gross profit margin 34.4% 35.2% Worse
Less: Operating expenses blank Blank Blank
Less: Selling, general, and administrative 28.5% 29.1% Better
expenses
Other operating expenses 0.5 0.5 Same
(2) Operating profit margin 5.4% 5.6% Worse
Less: Interest expense 0.3 0.0 Blank
Plus: Other income 0.1% 0.1% blank
Pre-tax income 5.2% 5.7% Worse
a
Less: Taxes
Subjective assessments based on data provided. 2.0 2.2 Better
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3.6 Profitability Ratios (2 of 5)
• Gross Profit Margin = (Sales – Cost of Goods Sold) ÷ Sales
= Gross Profits ÷ Sales
– Measures the percentage of each sales dollar remaining after
the firm has paid for its goods
• Operating Profit Margin = Operating Profit ÷ Sales
– Measures the percentage of each sales dollar remaining after
all costs and expenses other than interest, taxes, and
preferred stock dividends are deducted; the “pure profits”
earned on each sales dollar

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3.6 Profitability Ratios (3 of 5)
• Net Profit Margin = Earnings Available for Common
Stockholders ÷ Sales
– Measures the percentage of each sales dollar remaining
after all costs and expenses, including interest, taxes, and
preferred stock dividends, have been deducted

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3.6 Profitability Ratios (4 of 5)
Earnings Available for Common Stockholders
• Earnings Per Share (EPS) = Number of Shares of Common Stock Outstanding

– Represents the number of dollars earned during the period on

behalf of each outstanding share of common stock
Earnings Available for Common Stockholders
• Return on Total Assets (ROA) =
Total Assets

– Measures the overall effectiveness of management in generating

profits with its available assets; also called the return on
investment (ROI)

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3.6 Profitability Ratios (5 of 5)

• Return on Equity = Earnings Available for Common Stockholders

Common stock equity

– Measures the return earned on the common stockholders’

investment in the firm

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3.7 Market Ratios (1 of 2)
• Price/Earnings Ratio = Market Price Per Share of Common
Stock ÷ Earnings Per Share
– Measures the amount that investors are willing to pay for
each dollar of a firm’s earnings
• Market/Book Ratio

– Book Value Per Share of Common Stock 

Total Common Stock Equity
Number of Shares of Common Stock Outstanding

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3.7 Market Ratios (2 of 2)
Market Price Per Share of Common Stock
• Market/Book (M/B) Ratio = Book Value Per Share of Common Stock

– Provides an assessment of how investors view the firm’s

performance

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3.8 A Complete Ratio Analysis (1 of 5)
• Summary of Whole Foods’ Financial Condition
– Liquidity
 Overall liquidity of the firm increased significantly in 2016
– Activity
 Whole Foods is managing its current assets and liabilities
reasonably well
 Total asset turnover slowed significantly in 2016
– Debt
 Whole Foods’ indebtedness increased sharply in 2016, though
the company still uses less debt than does the average
grocery company

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3.8 A Complete Ratio Analysis (2 of 5)
• Summary of Whole Foods’ Financial Condition
– Profitability
 Whole Foods was more profitable than the average grocery
firm in 2016 by all measures
– Market
 Both the P/E and M/B ratios fell in 2016, suggesting that
investors have a little less confidence in the firm in 2016,
although both ratios are above the industry average

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Table 3.10 Summary of Whole Foods’
Ratios (2015–2016, Including 2016 Industry
Averages) (1 of 2)

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Table 3.10 Summary of Whole Foods’
Ratios (2015–2016, Including 2016 Industry
Averages) (2 of 2)

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3.8 A Complete Ratio Analysis (3 of 5)
• DuPont System of Analysis
– System used to dissect the firm’s financial statements and
to assess its financial condition
– Dupont Formula
 Multiplies the firm’s net profit margin by its total asset turnover
to calculate the firm’s return on total assets (ROA)

Earnings Available for Common Stockholders Sales

ROA  
Sales Total Assets
Earnings Available for Common Stockholders

Total Assets

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Figure 3.4 DuPont System of Analysis

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Matter of Fact (1 of 2)
Dissecting ROA
Return to Table 3.5, and examine the ROA figures for Home
Depot and Kroger. Those two firms have very similar ROAs,
with Home Depot earning 6.5% and Kroger earning 6.0%.
Now look at their net profit margins. By that measure, Home
Depot is more than twice as profitable as Kroger (net margin
of 4.0% versus 1.9% for Kroger). If Home Depot’s net profit
margin is so much bigger than Kroger’s, why do the two
firms earn very similar ROAs? The answer lies in total asset
turnover.

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Matter of Fact (2 of 2)
Kroger turns its assets 3.2 times per year, which is much
faster than Home Depot’s asset turnover of 1.6 times. Simply
put, Kroger uses its assets twice as efficiently as Home
Depot, but Home Depot’s net profit margin is about twice as
large as Kroger’s; the end result is that both firms earn close
to a 6% ROA.

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3.8 A Complete Ratio Analysis (4 of 5)
• DuPont System of Analysis
– Modified Dupont Formula
 Relates the firm’s return on total assets (ROA) to its return on
equity (ROE) using the financial leverage multiplier (FLM)
– Financial Leverage Multiplier = Total Assets ÷ Common
Stock Equity
• The ratio of the firm’s total assets to its common stock
equity

Earnings Available for Common Stockholders Total Assets

ROE  
Total Assets Common Stock Equity
Earnings Available for Common Stockholders

Common Stock Equity

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3.8 A Complete Ratio Analysis (5 of 5)
• DuPont System of Analysis
– Applying the DuPont System
 The advantage of the DuPont system is that it allows the firm
to break its return on equity into a profit-on-sales component
(net profit margin), an efficiency-of-asset use component (total
asset turnover), and a use-of-financial-leverage component
(financial leverage multiplier)
 Analysts can decompose the total return to owners into these
important components

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Example 3.6
In Table 3.10 we saw that Whole Foods’ 2016 ROE was
15.7%, above the 13.8% industry average. What are the
drivers of this difference? Start at the far right of Figure 3.4
and move left. Whole Foods’ ROA was 8.0%, well above the
industry average of 3.1%. Whole Foods’ FLM was just under
2.0, whereas the industry average was 2.5.4 Therefore,
Whole Foods’ shareholders enjoyed a higher-than-average
ROE because the firm’s underlying profitability, its ROA, was
much higher than that of the typical grocery chain.
Continuing to move left in Figure 3.4, we see that the ROA
figure resulted from Whole Foods’ above-average net profit
margin of 3.2% and its asset turnover of 2.48, which just
barely rose above the industry average.
4
We estimate the industry average FLM by dividing the industry average debt-to-equity ratio of 1.5 in Table 3.10 by the
industry average debt ratio of 0.6.

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Review of Learning Goals (1 of 7)
• LG 1
– Review the contents of the stockholders’ report and the
procedures for consolidating international financial
statements.
 The annual stockholders’ report, which publicly owned
corporations must provide to stockholders, documents the
firm’s financial activities of the past year
 It includes the letter to stockholders and other information
about the firm’s activities and strategies
 It also contains four key financial statements: the income
statement, the balance sheet, the statement of stockholders’
equity (or its abbreviated form, the statement of retained
earnings), and the statement of cash flows

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Review of Learning Goals (2 of 7)
• LG 1 (Cont.)
– Review the contents of the stockholders’ report and the
procedures for consolidating international financial
statements.
 Notes describing the technical aspects of the financial
statements follow. Financial statements of companies that
have operations whose cash flows are denominated in one or
more foreign currencies must be translated into U.S. dollars in
accordance with FASB Standard No. 52

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Review of Learning Goals (3 of 7)
• LG 2
– Understand who uses financial ratios and how.
 Ratio analysis enables stockholders, lenders, and the firm’s
managers to evaluate the firm’s financial performance
 It can be performed on a cross-sectional or a time-series basis
 Benchmarking is a popular type of cross-sectional analysis;
users of ratios should understand the cautions that apply to
their use

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Review of Learning Goals (4 of 7)
• LG 3
– Use ratios to analyze a firm’s liquidity and activity.
 Analysts can assess a firm’s liquidity, or the ability of the firm
to pay its bills as they come due, by calculating the current
ratio and the quick (acid-test) ratio
 Activity ratios measure the speed with which accounts are
converted into sales or cash
 Analysts use the inventory turnover ratio, the accounts
receivable collection period, and the average payment period
(for accounts payable) to assess the activity of those current
assets and liabilities
 Total asset turnover measures the efficiency with which the
firm uses its assets to generate sales

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Review of Learning Goals (5 of 7)
• LG 4
– Discuss the relationship between debt and financial
leverage, as well as the ratios used to analyze a firm’s debt.
 The more debt a firm uses, the greater its financial leverage,
which magnifies both risk and return
 Financial debt ratios measure both the degree of indebtedness
and the ability to service debts
 A common measure of indebtedness is the debt ratio
 The ability to pay fixed charges can be measured by times
interest earned and fixed-payment coverage ratios

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Review of Learning Goals (6 of 7)
• LG 5
– Use ratios to analyze a firm’s profitability and its market
value.
 The common-size income statement, which shows each item
as a percentage of sales, can be used to determine gross
profit margin, operating profit margin, and net profit margin
 Other measures of profitability include earnings per share,
return on total assets, and return on common equity
 Market ratios include the price/earnings ratio and the
market/book ratio

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Review of Learning Goals (7 of 7)
• LG 6
– Use a summary of financial ratios and the DuPont system of
analysis to perform a complete ratio analysis.
 A summary of all ratios can be used to perform a complete
ratio analysis using cross-sectional and time-series analysis
 The DuPont system of analysis is a diagnostic tool used to find
the key areas responsible for the firm’s financial performance
 It enables the firm to break the return on common equity into
three components: profit on sales, efficiency of asset use, and
use of financial leverage

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