Chapter 4
1 Observations
Financial Analysis— Sizing up Firm Performance\
Learning Objectives (1 of 2)
1. Explain what we can learn by analyzing a firm’s
financial statements.
2. Use common size financial statements as a tool
of financial analysis.
3. Calculate and use a comprehensive set of
financial ratios to evaluate a company’s
performance.
4. Select an appropriate benchmark for use in
performing a financial ratio analysis.
5. Describe the limitations of financial ratio
analysis.
Principles Used in this Chapter
• Principle 3: Cash Flows Are the Source of Value.
• Principle 4: Market Prices Reflect Information.
• Principle 5: Individuals Respond to Incentives.
4.1 WHY DO WE ANALYZE FINANCIAL
STATEMENTS?
Why Do We Analyze Financial
Statements? Internal Financial Analysis
• An internal financial analysis might be done:
– To evaluate the performance of employees
– To compare the performance of firm’s different
divisions
– To prepare financial projections
– To evaluate the firm’s financial performance in
light of its competitors’ performance
• External financial analysis to determine the credit
worthiness or investment attractiveness is done
by:
– Banks and other lenders
– Suppliers
– Credit-rating agencies
– Professional analysts
– Individual investors
4.2 COMMON SIZE STATEMENTS:
STANDARDIZING FINANCIAL INFORMATION
Common Size Statements: Standardizing
Financial Information
• A common size financial statement is a
standardized version of a financial statement in
which all entries are presented in percentages.
• It helps to compare a firm’s financial statements
with those of other firms, even if the other firms
are not of equal size.
Preparing Common Size Statements
• How to prepare a common size financial
statement?
– For a common size income statement, divide
each entry in the income statement by sales.
– For a common size balance sheet, divide
each entry in the balance sheet by total assets.
Table 4.1 H. J. Boswell, Inc.
Common-Size Income Statement for the Year Ended
December 31, 2016
Table 4.
Measuring the Overall Liquidity of a Firm
• Table 4.1 created by dividing each entry in the
income statement of Table 3.1 by firm sales for
2016.
– Cost of goods sold make up 75% of the firm’s
sales resulting in a gross profit of 25%.
– Selling expenses account for about 3% of sales.
– Income taxes account for 4.1% of the firm’ssales.
– After all expenses, the firm generates net income
of 7.6% of firm’s sales.
Table 4.2 H. J. Boswell, Inc. (1 of 2)
Common-Size Balance Sheets, December 31, 2015 and
2016
Table 4.2 Observations
• Table 4.2 created by dividing each entry in the
balance sheet of Table 3.2 (in chapter 3) by total
assets.
– Total current assets increased by 5.6% in 2016
while total current liabilities declined by 2%.
– Long-term debt account for 39.2% of firm’s
assets, showing a decline of 1.7%.
– Retained earnings increased by 5.8%.
4.3 USING FINANCIAL RATIOS
Using Financial Ratios (1 of 2)
• Financial ratios provide a second method for
standardizing the financial information on the
income statement and balance sheet.
• A ratio by itself may have no meaning. Hence, a
given ratio is generally compared to: (a) ratios
from previous years; or (b) ratios of other firms in
the same industry.
LIQUIDITY RATIOS
• Liquidity ratios address a basic question: How
liquid is the firm?
• A firm is financially liquid if it is able to pay its bills
on time. We can analyze a firm’s liquidity from two
complementary perspectives:
– measuring overall liquidity of a firm, and
– measuring the liquidity of individual asset
categories.
The Overall liquidity is analyzed by comparing the
firm’s current assets to the firm’s current liabilities.
Two ratios used to analyze overall liquidity are:
1. Current Ratio
2. Acid-Test (or Quick) Ratio
Current Ratio (1 of 2)
• Current Ratio: Current Ratio compares a firm’s
current (liquid) assets to its current (short-term)
liabilities.
Current Ratio = Current Assets_
Current Liabilities
• What is the current ratio for 2016 for Boswell?
Current Ratio = $643.5m ÷ $288.0m
= 2.23 times
• The firm had $2.23 in current assets for every $1 it
owed in current liability. It is better than peer group
average of $1.80.
Acid—Test (Quick) Ratio (1 of 2)
• Acid-Test (Quick) Ratio excludes the inventory
from current assets as inventory may not be
very liquid.
Acid-Test = Current Assets - Inventory
(or Quick) Ratio Current Liabilities
• What is the quick ratio for Boswell?
• Acid Test (or Quick) Ratio
= ($643.5m−$378m) ÷ ($288.0m) = 0.92 times
• The firm has only $0.92 in current assets (less
inventory) to cover $1 in current liabilities. This
ratio is worse than peer average of $0.94
Measuring the Liquidity of Individual
Asset Categories
• We can also measure the liquidity of the firm by
examining the liquidity of accounts receivable
and inventories to see how long it takes the firm to
convert its accounts receivables and inventories into
cash.
Average Collection Period (1 of 2)
Average Collection Period measures the number of
days it takes the firm to collects its receivables.
• What is the average collection period for Boswell,
Inc. for 2016?
• Daily Credit Sales
= $2,700m ÷ 365 days = $7.40 million
• Average Collection Period
= $162m 􀃗 $7.40 = 21.9 days
Accounts Receivable Turnover Ratio (1 of 2)
Accounts Receivable Turnover Ratio measures how
many times receivables are “rolled over” during a
year.
Accounts Receivable Turnover =
Annual Credit Sales
Accounts Receivable
• What is the accounts receivable turnover ratio
for Boswell, Inc. for 2016?
• Accounts Receivable Turnover
= $2,700 million ÷ $162million = 16.67 times
– The firm’s accounts receivable were turning
over at 16.67 times per year. This is higher
than peer group average of 14.60 times.
Inventory Turnover Ratio
Inventory turnover ratio measures how many
times the company turns over its inventory during
the year. Shorter inventory cycles lead to greater
liquidity because the items in inventory are
converted to cash more quickly.
Inventory Turnover = Cost of Goods Sold
Inventories
• What is the inventory turnover ratio for H. J.
Boswell, Inc.?
• Inventory Turnover Ratio
= $2,025m ÷ $378m = 5.36 times
– The firm turned over its inventory 5.36 times
per year. This ratio is slower than peer group
average of 7.0 times.
Days’ Sales in Inventory
• Days’ Sales in Inventory
= 365÷ inventory turnover ratio
= 365 ÷ 5.36 = 68 days
• The firm, on average, holds it inventory for
about 68 days.
Can a Firm Have Too Much Liquidity?
• A high investment in liquid assets will enable the
firm to repay its current liabilities in a timely
manner.
• However, an excessive investments in liquid
assets can prove to be costly as liquid assets
(such as cash) generate minimal return.
CHECKPOINT 4.1: CHECK YOURSELF
Evaluating Hewlett Packard’s Liquidity
If HP’s management were able to increase its
inventory turnover ratio to 30 times a year while
holding firm sales constant, how much this reduce the
firm’s investment in inventory?
Step 1: Picture the Problem
• The inventory turnover ratio will measure how
many days items remain in inventory before being
sold. Inventory turnover ratio is important as it has
implications for cash flows and profitability of a firm.
• Changes in inventory turnover ratio will impact the
firm’s investment in inventory.
Step 2: Decide on a Solution Strategy
• We will use the Inventory Turnover (IT) ratio to
compute the investment in inventory.
IT ratio = Cost of Goods Sold ÷ Inventories
We are given the inventories and IT ratio.
Step 3: Solve
• Inventory Turnover Ratio for HP
= $78,596m ÷ Inventory = 30
• Solving for the revised inventory level we get
$78,596 million /30 = $2,619.87 million.
Step 4: Analyze
• Reducing the firm’s inventory turnover ratio has a
major impact on the level of investment in
inventory. With inventory turnover ratio of 30,
investment in inventory drops significantly from
$4,288 million to $2,619.87 million.
CAPITAL STRUCTURE RATIOS
Capital structure refers to the way a firm finances its
assets using a combination of debt and equity.
Capital structure ratios address the important question:
How has the firm financed the purchase of its assets?
To address this issue, we use two types of capital
structure ratios: the debt ratio, and the times interest
earned ratio.
Debt Ratio
Debt ratio measures the proportion of the firm’s
assets that were financed using current plus longterm
liabilities.
Debt Ratio = Total Liabilities
Total Assets
• What is the debt ratio for H.J. Boswell, Inc.?
• Debt Ratio
= $1,059.75 million ÷ $1,971 million = 53.80%
– The firm financed 53.80% of its assets with
debt. This ratio is significantly higher than the
peer group average of 35%.
Times Interest Earned Ratio
Times Interest Earned Ratio measures the ability of
the firm to service its debt or repay the interest on
debt.
Times Interest = Net Operating Income or EBIT
Earned Interest Expense
• What is the times interest earned ratio for H.J.
Boswell, Inc. for 2016?
• Times Interest Earned
= $382.5m ÷ $67.5m = 5.67 times
– The firm can pay its interest expense 5.67
times or interest used 1/5.67th or 17.7% of its
operating income, which means its operating
earnings could shrink by 82.3% and it could
still pay its interest expense.
CHECKPOINT 4.2: CHECK YOURSELF
Comparing the Financing Decisions of HD and
LOWES
What would be Home Depot’s times interest earned
ratio if interest payments remained the same, but net
operating income dropped by 80% to only $2.354
billion? Similarly if Lowes’ net operating income
dropped by 80%, what would its times interest earned
ratio be?
Step 1: Picture the Problem (1 of 2)
• Times interest earned ratio is an important ratio for
firms that use debt financing. It measures the
firm’s ability to service its debt.
• The ratio requires comparing net operating
income or EBIT with Interest expense. Both items
are found on the income statement.
Picture an Income Statement
– Sales EBIT
§ Less: Cost of Good Sold
§ Equals: Gross Profit
§ Less: Operating Expenses
§ Equals: Net Operating Income (EBIT)
§ Less: Interest Expense
§ Equals: Earnings before Taxes
§ Less: Taxes INTEREST
§ Equals Net Income EXPENSE
S Reasonable Profit Margins?
Step 2: Decide on a Solution Strategy
• Here we are considering the impact of a drop in
operating income on the times interest earned
ratio of Home Depot and Lowes. We will use the
following ratio to measure the times interest
earned (TIE) ratio. Interest expense is assumed to
remain the same.
• TIE = EBIT ÷ Interest Expense
Step 3: Solve
• TIE (Home Depot)
= $2.354 billion ÷ $0.919 billion = 2.56 times
• TIE (Lowes)
= $0.509 billion ÷$1.873 billion = .271 times
Step 4: Analyze
• We observe that a drop in net operating income
leads to a significant drop in times interest earned
ratio for both the firms. Should creditors be
worried by this drop? The drop in earnings would
be bad for Home Depot but devastating for
Lowe’s.
ASSET MANAGEMENT EFFICIENCY RATIOS
Asset management efficiency ratios measure a firm’s
effectiveness in utilizing its assets to generate sales.
These ratios are commonly referred to as turnover
ratios as they reflect the number of times a particular
asset account balance turns over during the year.
Total Asset Turnover Ratio
• Total Asset Turnover Ratio represents the
amount of sales generated per dollar invested in
the firm’s assets.
Fixed Asset Turnover Ratio
• Fixed asset turnover ratio measures firm’s
efficiency in utilizing its fixed assets (such as
property, plant and equipment).
Asset Management Efficiency Ratios:
Summary
The following grid summarizes the efficiency of
Boswell’s management in utilizing its assets to
generate sales. Overall, the managers utilized the
firm’s total investment in assets efficiently.
PROFITABILITY RATIOS
Profitability ratios address a very fundamental
question: Has the firm earned adequate returns on its
investments?
Two fundamental determinants of firm’s profitability
and returns on investments are the following:
• Cost Control – How well has the firm controlled
its costs relative to each dollar of firm sales?
• Efficiency of asset utilization – How effective
is the firm in using the assets to generate sales?
Cost Control: Is the Firm Earning
Gross profit margin shows how well the firm’s
management controls its expenses to generate
profits.
Gross Profit = Gross Profits
Margin Sales
Cost Control: Gross Profit Margin
What is the gross profit margin ratio for 2016 for H.J.
Boswell, Inc.?
• Gross Profit Margin
= $675 million ÷ $2,700 million = 25%
– The firm spent $0.75 for cost of goods sold
and thus $0.25 out of each dollar of sales
went towards gross profits.
Cost Control: Operating Profit Margin Panel B. Analyzing the Determinants of the Total Is the Firm Providing a Reasonable Return
Asset Turnover Ratio on the Owner’s Investment? (2 of 2)
Operating Profit Margin measures how much What is the ROE ratio for H. J. Boswell, Inc.?
profit is generated from each dollar of sales after • ROE = $204.75 million ÷ $911.25 million =
accounting for both costs of goods sold and 22.5%
operating expenses. It also indicates how well the – Thus the shareholders earned 22.5% on
firm is managing its income statement. their investments. This is higher than peer
average of 18%

Using the DuPont Method for

Cost Control: Net Profit Margin (1 of 2)
Net Profit Margin measures how much income is
generated from each dollar of sales after adjusting for
all expenses (including income taxes).
Net Profit = Net Income
Margin Sales
What is the net profit margin ratio for H. J. Boswell,
Inc.?
• Net Profit Margin
= $204.75 million ÷ $2,700 million = 7.6%
– The firm generated $0.076 for each dollar of
sales after paying all of the firm’s expenses,
whereas the peer group firms earn $0.102.
Return on Invested Capital
Operating Return on Assets ratio is the summary
measure of operating profitability. It takes into
account both management’s success in controlling
expenses and its efficient use of assets.
Operating Return Net Operating Income or
on Assets (OROA) = EBIT______
Total Assets
Figure 4-1 Observations Decomposing the ROE ratio (1 of 4)
• Firm’s OROA (operating return on assets) is • DuPont method analyzes the firm’s ROE by
higher than that of its peers. decomposing it into three parts.
– ROE = Profitability 􀂺 Efficiency 􀂺 Equity
• Firm’s OPM (operating profit margin) is lower
Multiplier
than that of its peers.
• Equity multiplier captures the effect of the firm’s
• Firm’s TATO (total asset turnover ratio) is
use of debt financing on its return on equity.
higher than that of its peers.
The equity multiplier increases in value as the
firm uses more debt.
Figure 4-1 Recommendations
1. Reduce costs - The firm must investigate the
cost of goods sold and operating expenses to
see if there are opportunities to reduce costs.
2. Reduce inventories -The firm must investigate
if it can reduce the size of its inventories.
CHECKPOINT 4.3: CHECK YOURSELF
Evaluating the Operating Return on Assets
The following table shows why Boswell’s return on
(OROA) for HD and LOW
If Home Depot were able to raise its total asset
turnover ratio to 2.5 while maintaining its current
operating profit margin, what would happen to its
operating return on assets?
Step 1: Picture the Problem
• The operating return on assets ratio for a firm is
determined by two factors: cost control and
equity was higher than its peers.

Operating Return on Assets asset utilization. Here the focus is on asset

What will be the operating return on assets ratio for
H. J. Boswell, Inc. ?
• Operating Return on Assets
= $382.5 million ÷$1,971 million = 19.4%
– The firm generated $0.194 of operating profits
for every $1 of its invested assets, which is
higher than peer group average of $0.178.
utilization.
Step 2: Decide on a Solution Strategy
We will analyze the impact on operating return on
assets of improvement on the total asset turnover
ratio by using the following equation:
• Operating Return on Assets (OROA)

Decomposing the Operating Return on = Total Asset Turnover × Operating Profit Margin

Step 3: Solve Figure 4.2 Expanded DuPont Analysis for H. J.

• Operating Return on Assets (OROA)
= Total Asset Turnover 􀂺 Operating Profit
Margin
• Before = 2.08 ÷ 13.3% = 27.67%
• Now = 2.5 ÷ 13.3% = 33.25%
Boswell, Inc.
MARKET VALUE RATIOS
Market value ratios address the question, how are
the firm’s shares valued in the stock market?

Assets Ratio Step 4: Analyze Price—Earnings Ratio

Figure 4.1 Analyzing H. J. Boswell, Inc.’s Operating
Return on Assets (OROA) (1 of 2)
Panel A. Decomposing the Operating Return on
Assets Ratio
• An improvement in total asset turnover ratio has a
favorable impact on Home Depot’s operating return
on assets (OROA).
• If Home Depot wants to increase its OROA more, it
should focus on cost control that will help improve
the net operating profit.
Is the Firm Providing a Reasonable Return
on the Owner’s Investment? (1 of 2)
Return on Equity (ROE) ratio measures the
accounting return on the common
stockholders’investment.
Return on = __Net Income__
Equity Common Equity
Price-Earnings (PE) Ratio indicates how much
investors have been willing to pay for $1 of reported
earnings.
Market Price-Earning Ratio = Price per Share
Earnings per Share
Price-Earning Ratio = $32.00 = 14.07 times
$2.28
Market—to—Book Ratio
Market-to-Book Ratio measures the relationship
between the market value and the accumulated
investment in the firm’s equity.
CHECKPOINT 4.4: CHECK YOURSELF Key Terms (1 of 4)
• Accounts receivable turnover ratio
Comparing the Valuation of APPL to MSFT Using Trend Analysis • Acid-test (quick) ratio
Market Value Ratios Comparing a firm’s recent financial ratios with the • Average collection period
What would be the price per share have to be for past financial ratios provides insight into whether
• Book value per share
• Capital structure
Apple to increase its PE ratio to that of Microsoft’s if the firm is improving or deteriorating over time. This • Current ratio
we assume Apple’s earnings remain the same as type of financial analysis is referred to as trend an • Days’ sales in inventory
reported above? alysis.
• Debt ratio
• DuPont method
• Equity Multiplier
• Earnings per share (EPS)
Step 1: Picture the Problem Figure 4-3 A Time—Series (Trend) Analysis of the Inventory Turnover • Financial leverage
Price-to-earnings (PE) ratio depends on earnings • Financial ratios
per share and price per share, pictured as follows: • Fixed asset turnover ratio
• Inventory turnover ratio
• Liquidity ratios
• Market-to-book ratio
• Market value ratios
• Notes payable
• Operating return on assets (OROA)
• Price-earnings (PE) ratio
• Return on equity
• Times interest earned
• Total asset turnover ratio (TATO)
• Trend analysis
Ratio: Home Depot Versus Lowe’s, 2001–2015

Step 2: Decide on a Solution Strategy

We need to determine the price per share that will
make PE ratio of Apple (10.39) equal to the PE ratio
of Microsoft (35.09).
Step 3: Solve
From Step 2, note that the PE ratio of Microsoft is
Peer—Firm Comparisons
A peer firm is simply one that the analyst believes will
provide a relevant benchmark for the analysis at hand.
Peer groups often consist of firms from thesame
industry. Industry average financial ratios can be
obtained from a number of financial databases (such
as Compustat) and internet sources (such as yahoo
finance and google finance).

Figure 4-4 Financial Analysis of the Gap, Inc., 2016

35.09.

Step 4: Analyze
• PE ratio allows us to compare two stocks with
different prices by standardizing the stock prices
by earnings.
• Microsoft has a much higher PE ratio. To reach
the same PE valuation, the stock price of Apple
will have to increase from $95.76 to $323.53. 4.5 LIMITATIONS OF RATIO ANALYSIS

4.4 SELECTING A PERFORMANCE Limitations of Ratio Analysis (1 of 2)

BENCHMARK
Selecting a Performance Benchmark
There are two types of benchmarks that are
commonly used to analyze a firm’s financial
performance by means of its financial statements:
• Trend Analysis – compares a firm’s financial
statements over time (time-series comparisons).
• Peer Group Comparisons – compares the
subject firm’s financial statements with “peer”
firms.
1. Picking an industry benchmark can sometimes
be difficult.
2. Published peer-group or industry averages are
not always representative of the firm being
analyzed.
3. An industry average is not necessarily a
desirable target or norm.
4. Accounting practices differ widely among
firms.
5. Many firms experience seasonal changes in
their operations.
6. Financial ratios offer simply clues that can
suggest the need for further investigation.
7. The results of financial analysis are no better
than the quality of the financial statements.