Chapter Three

Financial Statement Analysis

Principles of Managerial Finance
First Canadian Edition
Lawrence J. Gitman and Sean Hennessey
 Learning Goals
LG1 – Introduce financial ratio analysis, three types of
ratio comparisons, and four categories of ratios.
LG2 – Analyze liquidity and effectiveness at managing
inventory, accounts receivable, accounts
payable, fixed and total assets.
LG3 – Discuss financial leverage, ratios used to assess
how assets were financed, and ability to cover
financing charges.
 Learning Goals (continued)
LG4 – Evaluate profitability using common-size
analysis, and relative to sales, total assets,
common equity, and common share price.
LG5 – Explore link between various categories of
ratios, liquidity and activity ratios, leverage,
and profitability ratios.
LG6 – Use DuPont system and summary of financial
ratios to perform complete ratio analysis, with
caution.
 Using Financial Ratios
• Financial Ratios are measures of relative
values of key financial information.
• Ratio Analysis involves methods of
calculating and interpreting financial ratios to
assess the firm’s performance.
• Ratios are measured as (1) percentages; (2)
times or multiples; and (3) number of days.
 Parties interested in Ratios
• Ratios are of interest as key indicators of
financial health to:
– shareholders,
– creditors,
– management, and
– prospective investors.
• Ratio analysis directs attention to potential
areas of concern, but are not conclusive
evidence of problems.
 Types of Ratio Comparisons
• Cross-Sectional Analysis involves the
comparison of different firms at the same time.
– Benchmarking firm performance against industry
averages is very popular.
• Time-Series Analysis evaluates performance
over time, allowing for comparisons of current
and past ratio values.
• Combined Analysis mixes both features of
Cross-Sectional and Time Series Analysis.
Categories of Financial Ratios
• Ratios are grouped into four basic
categories:
– liquidity ratios,
– activity ratios,
– leverage ratios, and
– profitability ratios.
 Analyzing Liquidity
• Liquidity refers to the firm’s ability to
satisfy its short-term obligations as they
come due.
• Three areas are of particular concern:
– Net Working Capital,
– The Current Ratio, and
– The Quick (Acid-Test) Ratio.
 Net Working Capital
• This measure of liquidity is simply a measure of
current assets minus liabilities.

Net Working Capital = Current Assets – Current

Liabilities
 Current Ratio
• Commonly used, the Current Ratio measures the
ability to meet short-term obligations.

Current Ratio = Current Assets/Current Liabilities

 Quick (Acid Test) Ratio
• The Quick Ration focuses on only the most
liquid of the firm’s current assets: cash,
marketable securities, and accounts receivable.

Quick Ratio =
Cash+Marketable Securities+Accounts Receivable
Current Liabilities
 Analyzing Activity
• Activity Ratios measure the effectiveness of
managing accounts receivable, inventory,
accounts payable, fixed assets, and total
assets.
• There are Activity Ratios for each of these
management issues.
 Average Age of Inventory
• This ratio measures the effective management of
inventory in terms of number of days inventory is
held.

Average Age of Inventory = Inventory

Daily COGS

Where Daily COGS equals the daily value of the Cost of

Goods Sold.
 Average Collection Period
• Useful for evaluating credit and collections
policies of the firm, this ratio is also
measured in days.

Average Collection Period = Accounts Receivable

Average Sales Per Day
 Average Payment Period
• This ratio evaluates the speed of satisfying the
Accounts Payable for the firm.

Average Payment Period = Accounts Payable

Average Purchase Per Day
 Fixed and Total Asset Turnover

• These ratios evaluate the use of Fixed and

Total Assets to generate Sales.
Fixed Asset Turnover = Sales
Net Fixed Assets

Total Asset Turnover = Sales

Total Assets
 Analyzing Leverage
• Leverage measures the amounts of
borrowed money being used by the firm.
• Leverage Ratios are classified as either
– Capitalization Ratios, focusing on how
investments are financed; or
– Coverage Ratios, focusing on the ability to
service the firm’s sources of financing.
 Debt Ratio
• The Debt Ratio measures the proportion of total
assets financed by creditors.
Debt Ratio = Total Liabilities/Total Assets
• The Preferred Equity Ratio shows only that
portion of total assets financed by preferred
shareholders.
• The Common Equity Ratio shows only that
portion of total assets financed by common
shareholders.
 Debt/Equity Ratio
• The popularly mentioned Debt/Equity Ratio
measures the proportion of long-term debt
to common equity of the firm.

Debt/Equity Ratio = Long-Term Debt

Common Equity
 Times Interest Earned Ratio
• Also called the Interest Coverage Ratio, measures
the ability to make contractual interest payments.

Times Interest Earned = EBIT

Interest

Recall that EBIT stands for Earnings Before Interest and Taxes.
 Fixed-Charge Coverage Ratio
• This ratio measures the ability to meet all fixed
financial payments.

EBIT + Lease Payments

Interest + Lease Payments + ((1-T)*(Principal + Dividends))

Where T is the corporate tax rate.

 Analyzing Profitability
• There are many measures of the bottom-
line, the profitability of the firm.
• Four main measures examined here are:
– Common-Size Income Statements,
– Return on Total Assets,
– Return on Equity, and
– Price/Earnings Ratio.
 Common Size Income Statements
• Gross Margin measures the percentage of each sales
dollar after direct cost of goods have been paid.
• Operating Margin measures the percentage of each
sales dollar after all expenses associated with
producing, selling, and operating the company have
bee deducted (EBIT).
• Profit Margin measures the percentage of each sales
dollar after all expenses, including interest and taxes,
have been paid.
 Return on Total Assets (ROA)
• Also called Return On Investment,
measures the overall effectiveness in
generating profits with available assets.

ROA = Net Income After Taxes

Total Assets
 Return on Equity (ROE)
• Measures the return earned on the owners’
investment in the firm.

ROE = Earnings Available for Common Shareholders

Common Equity
 Earnings per Share (EPS)
• Represents the number of dollars earned on
behalf of each outstanding common share.

EPS = Earnings Available for Common Shareholders

Number of Common Shares Outstanding
 Price/Earnings (P/E) Ratio
• This commonly used ratio is more an
appraisal of share value than directly of
profitability.

P/E Ratio = Market Price Per Common Share

Earnings Per Share
 Leverage and Profitability
• Leverage is the advantage gained by using a
lever. In finance, debt financing is the
financial lever.
• Financial leverage allows the firm to
acquire assets beyond those available
through pure equity financing
arrangements.
 Complete Ratio Analysis
• Investors and Analysts want to get a global
view of the various ratios in order to make
their overall assessment of a firm’s health.
• Two popular approaches are:
– The DuPont System of Analysis, and
– A summary analysis of all key ratios.
 DuPont System of Analysis
• Developed by the DuPont Corporation.
• The DuPont System merges Income
Statement and Balance Sheet into two
summary measures of profitability: ROA
and ROE.
 DuPont Formula
• The DuPont Formula links the Profit Margin
with Total Asset Turnover, as their underlying
formulas will summarize Return on Assets.
ROA = Profit Margin ∗ Total Asset Turnover
• Since,
ROA = Net Income After Taxes ∗ Sales
Sales Total Assets
 Modified DuPont Formula
• The Financial Leverage Multiplier (FLM) is the
ratio of Total Assets to Shareholders’ Equity.
• The FLM transforms ROA into ROE.
ROE = ROA ∗ FLM
• Since,
ROE = Net Income After Taxes ∗ Total Assets
Total Assets Shareholders’ Equity
 Summarizing All Ratios
• Simply preparing a table of the ratios from
the four key categories (liquidity, activity,
leverage, and profitability) over a multi-year
period allows for a quick and comprehensive
review of the firm’s performance.
 Table 3.7 Summary of Barlett
Company Liquidity Ratios
Ratio 2000 2001 2002 Industry Ave.
2002
Net Working $583,000 $521,000 $603,000 $427,000
Capital
Current Ratio 2.04 2.08 1.97 2.05

Quick Ratio 1.32 1.46 1.51 1.43

 Table 3.7 Summary of Barlett
Company Activity Ratios
Ratio 2000 2001 2002 Industry Ave.
2002
Ave. Age 71.6 64 50.7 55.3 days
Inventory days days days
Ave. 44.5 51.9 59.7 44.9 days
Collection days days days
Period
Ave. 76.9 82.3 95.4 67.4 days
Payment days days days
Period
Total Asset 0.94 0.79 0.85 0.75
Turnover
 Table 3.7 Summary of Barlett
Company Leverage Ratios
Ratio 2000 2001 2002 Industry Ave.
2002
Debt Ratio 36.8% 44.3% 45.7% 40.0%

Debt/Equity 43.5% 59.7% 58.3% 47.4%

Ratio
Times Interest 5.6 3.3 4.5 4.3
Earned
Fixed Charge 2.4 1.4 1.9 1.5
Coverage
 Table 3.7 Summary of Barlett
Company Profitability Ratios
Ratio 2000 2001 2002 Industry Ave.
2002
Gross Margin 31.4% 33.3% 32.1% 30.0%
Operating Margin 14.6% 11.8% 13.6% 11.0%
Profit Margin 8.8% 5.8% 7.5% 6.4%
ROA 8.3% 4.5% 6.4% 4.8%
ROE 14.1% 8.5% 12.6% 8.0%
EPS $3.26 $1.81 $2.90 $2.26
P/E Ratio 10.5 10.0 11.1 12.5
 Cautions about Ratio Analysis
• A single ratio does not provide sufficient
information to judge overall performance.
• Financial statement comparisons should be dated
at the same point during the year.
• Audited Financial statements should be used for
calculating ratios.
• Data being compared should use the same
accounting rules applied.
• Time series comparisons of ratios may be
distorted by inflation.
• It is difficult to define categorically what a good
or bad ratio value should be.