CHAPTER 3

Analysis of Financial Statements

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Overview
 Ratios facilitate comparison of:
 One company over time
 One company versus other companies
 Ratios are used by:
 Lenders to determine creditworthiness
 Stockholders to estimate future cash flows and
risk
 Managers to identify areas of weakness and
strength

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Liquidity Ratios
 Can the company meet its short-term
obligations using the resources it
currently has on hand?
 Current and Quick Ratios:
 CR = CA/CL
 QR = (CA-Inv)/CL

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Asset Management Ratios
 How efficiently does the firm use its
assets?
 How much does the firm have tied up in
assets for each dollar of sales?
 ITO, DSO, FATO, TATO

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 Inventory Turnover

Sales
Inv. turnover = Inventories

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Day Sales Outstanding:

average number of days from sale until cash

received.

Receivables
DSO = Average sales per day

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Fixed Assets and Total Assets
Turnover Ratios

Fixed assets Sales

turnover Net fixed assets

Total assets Sales

=
turnover Total assets

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Debt Management Ratios
 Does the company have too much
debt?
 Can the company’s earnings meet its
debt servicing requirements?

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Debt Ratio, TIE, and EBITDA
coverage ratio.

Total liabilities
Debt ratio = Total assets

EBIT
TIE =
Int. expense

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 EBITDA Coverage (EC)

EBIT + Depr. & Amort. + Lease payments

Interest Lease
expense + pmt. + Loan pmt.

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Profitability Ratios
 What is the company’s rate of return
on:
 Sales?
 Assets?

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Profit Margins
Net profit margin (PM):

PM = NI
Sales
Operating profit margin (OM):
EBIT
OM = Sales

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 Profit Margins (Continued)

Gross profit margin (GPM):

Sales − COGS
GPM = Sales

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Basic Earning Power (BEP)

EBIT
BEP =
Total assets

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Return on Assets (ROA)

NI
ROA =
Total assets

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Return on Equity (ROE)

NI
ROE =
Common Equity

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 Market Value Ratios:
P/E, P/CF, and M/B ratios.

EPS = NI
Shares out.

P/E = Price per share

EPS

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 NI + Depr.
CF per share = Shares out.

Price per share

P/CF = Cash flow per share

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 Com. equity
BVPS = Shares out.

Mkt. price per share

M/B = Book value per share

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Interpreting P/E and M/B
 P/E: How much investors will pay for $1
of earnings. Higher is better.
 M/B: How much paid for $1 of book
value. Higher is better.
 P/E and M/B are high if ROE is high,
risk is low.

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Common Size Balance Sheets:
Divide all items by Total Assets
Assets 2009 2010 2011E Ind.
Cash 0.6% 0.3% 0.4% 0.3%
ST Inv. 3.3% 0.7% 2.0% 0.3%
AR 23.9% 21.9% 25.0% 22.4%
Invent. 48.7% 44.6% 48.8% 41.2%
Total CA 76.5% 67.4% 76.2% 64.1%
Net FA 23.5% 32.6% 23.8% 35.9%
TA 100.0% 100.0% 100.0% 100.0%
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Common Size Income Statement:
Divide all items by Sales
2009 2010 2011E Ind.
Sales 100.0% 100.0% 100.0% 100.0%
COGS 83.4% 85.4% 82.4% 84.5%
Other exp. 9.9% 12.3% 8.7% 4.4%
Depr. 0.6% 2.0% 1.7% 4.0%
EBIT 6.1% 0.3% 7.1% 7.1%
Int. Exp. 1.8% 3.0% 1.1% 1.1%
EBT 4.3% -2.7% 6.0% 5.9%
Taxes 1.7% -1.1% 2.4% 2.4%
NI 2.6% -1.6% 3.6% 3.6%
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Percentage Change Analysis: %
Change from First Year (2009)
Income St. 2009 2010 2011E
Sales 0.0% 70.0% 105.0%
COGS 0.0% 73.9% 102.5%
Other exp. 0.0% 111.8% 80.3%
Depr. 0.0% 518.8% 534.9%
EBIT 0.0% -91.7% 140.4%
Int. Exp. 0.0% 181.6% 28.0%
EBT 0.0% -208.2% 188.3%
Taxes 0.0% -208.2% 188.3%
NI 0.0% -208.2% 188.3%
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Explain the Du Pont System
 The Du Pont system focuses on:
 Expense control (PM)
 Asset utilization (TATO)
 Debt utilization (EM)
 It shows how these factors combine to
determine the ROE.

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 The Du Pont System

( Profit
margin )( TA
turnover )( Equity
multiplier ) = ROE
NI Sales TA = ROE
Sales x TA x CE

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Potential Problems and
Limitations of Ratio Analysis
 Comparison with industry averages is
difficult if the firm operates many
different divisions.
 Seasonal factors can distort ratios.
 Window dressing techniques can make
statements and ratios look better.
 Different accounting and operating
practices can distort comparisons.

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