Lecture 2

Financial Statements and Analysis

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

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

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The Stockholders’ Report
• General Accepted Accounting Principals (GAAP)
– Authorized by the Financial Accounting Standards Board (FASB)

• International Financial Reporting Standard (IFRS)

– Authorized by the International Accounting Standards Board (IASB)

• Sarbanes-Oxley Act of 2002

– Established the Public Company Accounting Oversight Board
(PCAOB)

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

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The Four Key Financial Statements

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Personal Finance Example (1)

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The Four Key Financial Statements:
(2) The Balance Sheet
• The balance sheet presents a summary of a firm’s
financial position at a given point in time.
• Assets indicate what the firm owns, equity represents
the owners’ investment, and liabilities indicate what
the firm has borrowed.

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The Four Key Financial Statements:
(2) The Balance Sheet
• 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

• 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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The Four Key Financial Statements

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The Four Key Financial Statements (cont.)

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Personal Finance Example (2)

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The Four Key Financial Statements:
(3) Statement of Retained Earnings
• The statement of retained earnings reconciles the net
income earned and dividends paid during the year,
with the change in retained earnings.

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The Four Key Financial Statements:
(4) Statement of Cash Flows
• The statement of cash flows provides a summary of
the cash flows over the period of concern, typically
the year just ended.
• 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.

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The Four Key Financial Statements

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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.

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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.

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Using Financial Ratios:
Types of Ratio Comparisons (cont.)

• Caldwell Manufacturing’s calculated inventory

turnover for 2019 and the average inventory turnover
were as follows:

Inventory turnover, 2019

Caldwell Manufacturing 14.8
Industry average 9.7

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Using Financial Ratios:
Types of Ratio Comparisons (cont.)

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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.

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 Using Financial Ratios:
Types of Ratio Comparisons (cont.)

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Using Financial Ratios:
Cautions for Doing Ratio Analysis
1. Ratios must be considered together; a single ratio by itself
means relatively little.
2. Financial statements that are being compared should be
dated at the same point in time.
3. Use audited financial statements when possible.
4. The financial data being compared should have been
developed in the same way.
5. Be wary of inflation distortions.

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Ratio Analysis Example
• We will illustrate the use of financial ratios for
analyzing financial statements using the Bartlett
Company Income Statements and Balance
Sheets presented earlier in Tables 3.1 and 3.2.

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Categories of Financial Ratios
• Risk measurement
1) Liquidity ratios
2) Activity ratios
3) Debt ratios

• Return measurement
4) Profitability ratios

• Risk and Return measurement

5) Market ratios

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Ratio Analysis: Liquidity ratios
• Liquidity ratios
– A firm’s ability to satisfy its short-term obligations
as they come due.
• Current ratio
• Quick (acid-test) ratio
• Cash ratio

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Ratio Analysis: Liquidity ratios (cont.)
• Current ratio
– A measure of liquidity calculated by dividing the firm’s
current assets by its current liabilities.

Current ratio = Total current assets

Total current liabilities

Current ratio = $1,233,000 = 1.97

$620,000

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Ratio Analysis: Liquidity ratios (cont.)
• Quick (acid-test) ratio
– A measure of liquidity calculated by dividing the firm’s
current assets minus inventory by its current liabilities

Quick ratio = Total Current Assets - Inventory

Total current liabilities

Quick ratio = $1,233,000 - $289,000 = 1.51

$620,000
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Ratio Analysis: Liquidity ratios (cont.)
• Cash ratio
Cash and cash equivalent ÷ Current liability

Quick ratio = Total Cash and cash equivalent

Total current liabilities

Quick ratio = $363,000 + $68,000 - $289,000 = 0.23

$620,000
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Ratio Analysis: Activity ratios
• Activity ratios
– Measure the speed with which various accounts are
converted into sales or cash – inflows or outflows.
– In a sense, measure how efficiently a firm operates
along variety of dimensions such as inventory
management, disbursements and collections.
• Inventory turnover
• Average collection period
• Average payment period
• Total asset turnover

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Ratio Analysis: Activity ratios (cont.)
• Inventory turnover
– Measures the activity, or liquidity, of a firm’s inventory
– Can be converted into an average age of inventory by dividing it into
365.
– E.g. Bartlett average age of inventory is 50.7 (365/7.2).

Inventory Turnover = Cost of Goods Sold

Inventory

Inventory Turnover = $2,088,000 = 7.2

$289,000
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Ratio Analysis: Activity ratios (cont.)
• Average Collection Period (ACP)
– The average amount of time needed to collect accounts receivable
– It is meaningful only in relation to the firm’s credit term.
– If Bartlett Company extends 30-day credit terms to customers, 59.7
days may indicate a poorly managed credit or collection department.

ACP = Accounts Receivable

Net Sales/365

ACP = $503,000 = 59.7 days

$3,074,000/365
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Ratio Analysis: Activity ratios (cont.)

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Ratio Analysis: Activity ratios (cont.)

• Companies in the building materials, grocery, and

merchandise store industries collect in just a few days,
whereas firms in the computer industry take roughly two
months to collect on their sales.

• The difference is primarily due to the fact that these

industries serve very different customers.
• Grocery and retail stores serve individuals who pay cash or
use credit cards. Computer manufacturers sell to retail
chains, businesses and other large organizations that
negotiate agreements that allow them to pay for the
computers they order well after the sale is made.

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Ratio Analysis: Activity ratios (cont.)
• Average Payment Period (APP)
– The average amount of time needed to pay accounts payable.
– It is meaningful only in relation to the average credit term extended to
the firm.

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Ratio Analysis: Activity ratios (cont.)

• Total Asset Turnover

– Indicates the efficiency with which the firm uses its assets to generate
sales.
– The higher a firm’s total asset turnover, the more efficiently its assets
have been used.

Total Asset Turnover = Net Sales

Total Assets

Total Asset Turnover = $3,074,000 = .85

$3,597,000
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Ratio Analysis: Debt ratios
• Debt ratios
– The debt position of a firm indicates the amount of
other people’s money being used to generate profits.
– In general, the more debt a firm has, the greater its
risk of being unable to meet its contractual debt
payments.
– There are two general types of debt measures:
• Measures of the degree of indebtedness (debt ratio)
• Measures of the ability to service debts (times interest
earned ratio & fixed-payment coverage ratio).

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Ratio Analysis: Debt ratios (cont.)

• Debt ratio
– Measures the proportion of total assets financed
by the firm’s creditor
– The higher this ratio, the greater the firm’s degree
of indebtedness.

Debt Ratio = Total Liabilities/Total Assets

Debt Ratio = $1,643,000/$3,597,000 = 45.7%

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Ratio Analysis: Debt ratios (cont.)

• Times Interest Earned Ratio

– Measures the firm’s ability to make contractual interest
payments; sometimes called the interest coverage ratio.
– The higher its value, the better able the firm is to fulfill
its interest obligations.

Times Interest Earned = EBIT/Interest

Times Interest Earned = $418,000/$93,000 = 4.5

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Ratio Analysis: Debt ratios (cont.)

• Fixed-Payment coverage Ratio (FPCR)

– Measures the firm’s ability to meet all fixed-payment obligations.
– This ratio allows interested parties to assess the firm ability to meet
additional fixed-payment obligations without being driven into
bankruptcy.
– The greater the ratio, the lower the risk.

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Ratio Analysis: Profitability ratios
• The profitability ratios enable analysts to evaluate the firm’s
profits with respect to:
– A given level of sales
• Gross profit margin
• Operating profit margin
• Net profit margin
• Earning per share (EPS)
– A certain level of assets
• Return on total assets (ROA)
– A certain level of owners’ investment
• Return on common equity (ROE)

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Ratio Analysis: Profitability ratios (cont.)
• A useful tool for
evaluating profitability
in relation to sales is the
common-size income
statement.

• Each item on this

statement is expressed as
a percentage of sales.

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Ratio Analysis: Profitability ratios (cont.)
• Gross Profit Margin
– Measures the percentage of each sales dollar
remaining after the firm has paid for its goods.

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Ratio Analysis: Profitability ratios (cont.)
• Operating Profit Margin
– 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.

Operating profit margin = EBIT/Net Sales

$418,000 ÷ $3,074,000 = 13.6%

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Ratio Analysis: Profitability ratios (cont.)
• Net Profit Margin
– Measures the percentage of each sales dollar remaining
after all costs and expenses, including interest, taxes and
preferred stock dividends, have been deducted.

Net Profit Margin = Earnings Available to Common Stockholders

Sales

$221,000 ÷ $3,074,000 = 7.2%

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Ratio Analysis: Profitability ratios (cont.)
• Earning Per Share (EPS)
– EPS represents the number of dollars earned during the
period on behalf of each outstanding share of common
stock.
– EPS is closely watched by the investing public and is
considered an important indicator of corporate success.

EPS = Earnings Available to Common Stockholders

Number of Shares Outstanding

$221,000 ÷ 76,262 = $2.90

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Ratio Analysis: Profitability ratios (cont.)
• Return on total assets (ROA)
– Measures the overall effectiveness of management in
generating profits with its available assets.
– Also called the return on investment (ROI).

ROA = Earnings Available to Common Stockholders

Total Assets

$221,000 ÷ $3,597,000 = 6.1%

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Ratio Analysis: Profitability ratios (cont.)
• Return on common equity (ROE)
– Measures the return earned on the common stockholders’
investment in the firm.
– Generally, owners are better off the higher is this return.

ROE = Earnings Available to Common Stockholders

Total Equity

ROE = $221,000 ÷ $1,754,000 = 12.6%

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Ratio Analysis: Market ratios
• Market ratios
– Relate a firm’s market value, as measured by its
current share price, to certain accounting values.
– These ratios give insight into how investors in the
marketplace feel the firm is doing in terms of risk and
return.
– Two widely quoted market ratios:
• Price Earnings (P/E) Ratio
• Market/Book (M/B) Ratio

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Ratio Analysis: Market ratios (cont.)
• Price Earnings (P/E) Ratio
– Measures the amount that investors are willing to pay for each
dollar of a firm’s earning.
– The higher the P/E ratio, the greater the investor confidence.
– The P/E ratio is most informative when applied in cross-sectional
analysis using an industry average P/E ratio or the P/E ratio of a
benchmark firm.

P/E = Market Price Per Share of Common Stock

Earnings Per Share

$32.25 ÷ $2.90 = 11.1

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Ratio Analysis: Market ratios (cont.)
• Market/Book (M/B) Ratio
– Provide an assessment of how investors view the firm’s
performance.
– Firms expected to earn high returns relative to their risk typically
sell at higher M/B multiples

$32.25 ÷ $23.00 = 1.40

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Summarizing All Ratios

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Summarizing All Ratios (cont.)

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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.

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DuPont System of Analysis (cont.)
• 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

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DuPont System of Analysis (cont.)
• 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

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DuPont System of Analysis (cont.)
• 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

ROE = 6.1% X 2.06 = 12.6%

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DuPont System of Analysis (cont.)
• 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).

• The total return to owners therefore can be analyzed in these

important dimensions.

• It can also be used to isolate the probable cause of resulting

above-average (or below-average) value.

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