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# CHAPTER 17: FINANCIAL STATEMENT AND RATIO ANALYSIS

A. OVERVIEW

## Definition: A ratio is simply a numerator divided by a denominator

• Percentage (e.g. earnings as a % of sales revenue)
• Times (e.g. asset as xx times of debt)
• Number of days for certain activities to be completed (e.g. inventory to be sold)

Definition: Ratio analysis refers to methods of calculating and interpreting financial ratios to assess a
firm’s performance

## Question: Why is ratio analysis useful?

• Provide details for financial planning
• Put details into perspective
• Manage expectations (creditors and investors)

## Types of ratio comparisons:

• Cross-sectional analysis
• Time-series analysis
• Combined (mixed)

## Cross-sectional: Compares different firms’ financial ratios at the same time

– Benchmarking: relative to other firm(s) or the industrial average; check for deviations
– Caution: Large deviations as symptoms but inconclusive
– Example: Interested in average age of inventory
• What might have caused the firm to have an AAI so much lower than the industrial
average? Is it an indicator of “good” performance?

## Avg. age of inventory,

2003 (AAI)
Caldwell manufacturing 24.7 days

## Time-series: Evaluate a firm’s financial performance over time

– Establish trends to assess the firm’s performance over time

Combined / mixed:
– Use both cross-sectional and time-series

1. Liquidity
2. Activity
3. Leverage
4. Profitability

## Note: When commenting on the performance of a firm, be sure to

• organize your ideas by these four types of ratios
• compare these ratios of the firm over time
• compare with the industrial averages
B. ANALYZING LIQUIDITY

Definition: Liquidity measures a firm’s ability to satisfy its short-term obligations as they come due
• Can the firm pay its bills?

Types of ratios used for analyzing liquidity (See Tables 3.3 and 3.4 for examples):
1. Net working capital (not a ratio)
2. Current ratio
3. Quick ratio (acid test)

1. NET WORKING CAPITAL: Dollar amount of current assets exceeds / falls short of current liabilities

## Example: Net working capital = \$1,223,000-\$620,000 = \$603,000

Interpretation: Current assets exceed current liabilities by \$603,000 at the end of 2002.
• Working capital: usually refers to current assets only
• Cash component: does not earn a return! So, too large a number does not necessarily imply a
“good” performance

## Note: Not a useful measure for comparing among firms. Why?

• Nature of activities is different
• Size of operation is different
2. CURRENT RATIO: Size of current assets relative to current liabilities

## Example: Current ratio = \$1,223,000/\$620,000 = 1.97

Interpretation: For each dollar the firm owes (short-term liabilities), the firm has \$1.97 in its asset.

Rule of thumb: current ratio=2, but if cash flow is predictable, a lower current ratio is acceptable

Twist: % of current assets that can be reduced such that the firm can still cover its short-term
obligations as they come due

## Example: (1-1/1.97) * 100% = 49.24

Interpretation: The firm can reduce its current asset by 49.24% and still be able to meet its short-term
obligations

Question: What would be the net working capital when current ratio=1?

3. QUICK RATIO (ACID-TEST): Size of most liquid current assets relative to current liabilities

## Note: Inventories excluded

• Inventories generally take longer to sell, often at discounted prices
• Inventories may be accounts receivable before they can be turned into cash

## Rule of thumb: quick ratio=1

Note: Quick ratio vs. current ratio: depends on how liquid are the inventories

Final remarks
• Higher ratios Æ firm is in a more liquid position
• Trade-off between liquidity (risk) and profitability
– Higher ratio Æ lower current liabilities, less costly than long-term financing (lower risk)
– Higher ratio Æ larger current assets, less profitable than fixed assets (lower return

C. ANALYZING ACTIVITY
Definition: Activity ratios measure the firm’s effectiveness at managing accounts receivable, inventory,
accounts payable, fixed assets, and total assets

## Supplement to liquidity ratios: focus on the composition of current assets

Four ratios:
1. Average age of inventory
2. Average collection period
3. Average payment period
4. Fixed and total asset turnover
1. AVERAGE AGE OF INVENTORY
• Average time inventory is held by the firm (unsold)

## Average age of inventory = Inventory / daily cost of goods sold (COGS)

= Inventory / (COGS/365)

Example: Average age of inventory = \$289,000 / (\$2,088,000 / 365 days) = 50.7 days

Interpretation: The firm takes, on average, 50.7 days to sell an “average” item of its inventory

## Note: Importance of benchmarking against other firms in the same industry

• Too high: Risk of not being able to sell inventory
• Too low: Under-investment in inventory

## 2. AVERAGE COLLECTION PERIOD

• Average time taken to collect accounts receivable

## Avg. collection period = Accts rec’ble / avg. daily sales

= Accts rec’ble / (Annual sales/365)

Example: Avg. collection period = \$503,000 / (\$3,074,000 / 365 days) = 59.7 days

Interpretation: The firm takes, on average, 59.7 days to collect accounts receivable

## 3. AVERAGE PAYMENT PERIOD

• Average time taken to pay its purchases

## Avg. payment period = Accts payable / avg. daily purchase

= Accts payable / (% COGS/365)

Example: Suppose the firm purchases 70% of its COGS. Avg. payment period = \$382,000 /
(0.7*\$2,088,000 / 365 days) = 95.4 days

## Note: Important to compare with terms of credit given by creditors

4. FIXED AND TOTAL ASSET TURNOVER
• Efficiency with which the firm uses its net fixed assets to generate sales

## Fixed asset turnover = Sales / Net fixed assets

Total asset turnover = Sales / Total assets

Example:
Fixed asset turnover = \$3,074,000 / \$2,374,000 = 1.29
Total asset turnover = \$3,074,000 / \$3,597,000 = 0.85

Interpretation: Every dollar of fixed asset generates \$1.29 sales; every dollar of asset (total) generates
\$0.85 sales

Question: High fixed asset turnover and low total asset turnover Æ low fixed-to-current assets. Why?

D. ANALYZING LEVERAGE
Definition: Amount of debt used in an attempt to maximize shareholders’ wealth

Two types:
– Capitalization ratios: How a firm has financed its investment
• Debt ratio
• Debt/Equity ratio

– Coverage ratios: Assess the firm’s ability to service the source of financing (payment debt,
interest, leases, dividend payments i.e., fixed financial charges)
• Times interest earned ratio
• Fixed-charge coverage ratio

Capitalization ratios
1. DEBT RATIO
• Proportion of total assets financed by creditors

## Interpretation: 45.7% of assets have been financed by debt

Related ratios:
– Preferred equity ratio
– Common equity ratio

## 1b. PREFERRED EQUITY RATIO

• Proportion of total assets financed by preferred shareholders

## 1c. COMMON EQUITY RATIO

• Proportion of total assets financed by common shareholders

## Note: Common equity includes retained earnings

Note: Debt ratio + preferred equity ratio + common equity ratio = 100%. Why?

## 2. DEBT / EQUITY RATIO

• Proportion of long-term debt to common equity

## Example Debt/Equity ratio = \$1,023,000 / \$1,754,000 = 0.583 (58.3%)

Interpretation: For every dollar of common equity financing, the firm uses \$0.583 of long-term debt

## Suggested maximum: 100%

Coverage ratios
1. TIMES INTEREST EARNED (INTEREST COVERAGE) RATIO
• Firm’s ability to pay contractual interest
• The higher is the ratio, the more capable is the firm to pay

Interest coverage ratio = Earnings before interest and taxes (EBIT) / Interest

## Example Interest coverage ratio = \$418,000 / \$93,000 = 4.49

Interpretation: For every dollar of interest, the firm has \$4.49 of operating earnings available to pay

Rule of thumb: 3 to 5
Twist: (1 - 1/interest coverage ratio)*100%

## Example: (1-1/4.49)*100% = 78%

Interpretation: The firm can shrink its earnings by 78% and still be able to pay its contractual interest
payment

Question: Suppose a firm has times interest earned ratio of 28.63 but the industry’s average is 12.31.
Why might the company’s ratio be so much higher than the industry average?
• Little debt
• Lower risk (Æ financial leverage and lower return)

## 2. FIXED-CHARGE COVERAGE RATIO

• Firm’s ability to pay fixed charges
• The higher is the ratio, the more capable is the firm to pay
• 4 types of fixed financial charges
– Interest on debt
– Principal repayment on debt
– Lease payment
– Preferred-share dividend payments

Example A firm has EBIT: \$418,000 with lease payments of \$35,000 and interest payment of \$93,000.
Principal payments are \$71,000. Preferred share dividends are \$10,000. Find fixed-charge coverage
ratio.

Interpretation: For every dollar of fixed financial charges, the firm has \$1.87 available to make the
payment

Note: The lower the ratio, the higher the risk to lenders and owners (harder for firm to pay fixed
charges)

E. ANALYZING PROFITABILITY
• Concerned with evaluating a firm’s earnings with respect to a given level of sales / assets / owners’
investment or share value

## 1. Common-size income statements

2. Return on total assets (ROA)
3. Return on equity (ROE)
4. Earnings per share (EPS)
5. Price/Earning (P/E) ratio

## 1. COMMON-SIZE INCOME STATEMENT

• Express every item on the income statement as a % of sales
– Gross margin
– Operating margin
– Profit margin
• Gross margin: % of each sales dollar remaining after the firm has paid the direct COGS
• Operating margin: % of each sales dollar remaining after the firm has paid all expenses
(excluding financing expenses and taxes)
• Profit margin: % of each sales dollar remaining after the firm has paid all expenses (including
interest and taxes)

## 2. RETURN OF TOTAL ASSETS (ROA)

• Return on investment (ROI)
• Effectiveness in generating profits with its available assets
• The higher the better

## Example ROI = \$231,000 / \$3,597,000 = 0.064 (6.4%)

Interpretation: For every \$100 of assets, the firm has a return of \$6.4.

## 3. RETURN ON EQUITY (ROE)

• Return on owners’ equity
• The higher the better

## Example: ROE = \$221,000 / \$1,754,000 = 0.126 (12.6%)

Interpretation: For every \$100 of common equity financing, the firm generates \$12.6.

## 4. EARNINGS PER SHARE (EPS)

• Dollar amount earned on behalf of each common share
• The higher the better
EPS = Earnings available for common shareholders / Number of common shares outstanding

## 5. PRICE/EARNING (P/E) RATIO

• Amount investors are willing to pay for each dollar of earnings
• Indicates investors’ confidence

## P/E = Market price per share / Earnings per share

Example: Suppose market price is \$32.25 per share. P/E = \$32.25 / \$2.90 = \$11.12 per share

Interpretation: Investors are paying \$11.2 for each \$1 of earnings for each share
F. COMPLETE RATIO ANALYSIS
1. DuPont System : Diagnostic
2. Summary analysis : Consider all aspects

1. DUPONT SYSTEM
• System used by management to dissect the firm’s financial statements and to assess the firm’s
financial conditions
• Merge income statement with balance sheet information
• Focus on
– ROA
– ROE

2. SUMMARY ANALYSIS
• Tabulate all ratios discussed earlier
– Liquidity
– Activity
– Leverage
– Profitability
• Combining cross-sectional with time-series analyses