ACCY801: ACCOUNTING AND FINANCIAL MANAGEMENT

Week 3
Learning objectives
1. Explain what we can learn by analysing 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 ratio analysis.
Principles used in this topic
• Principle 3: Cash flows are the source of value
• Principle 4: Market prices
reflect information
• Principle 5: Individuals
respond to incentives
 Part 1

Introduction
Why do we analyse financial statements?
• An internal financial analysis might be done:
• to evaluate the performance of employees to determine pay raises and
bonuses
• to compare the performance of different divisions
• to prepare financial projections (e.g. for the launch of a new product)
• to evaluate the firm s financial performance in light of its competitors
performance and determine how to improve the firm’s own operations .

• External financial analysis is done by:

• banks and other lenders deciding to lend money
• suppliers deciding to grant credit
• credit-rating agencies determining credit worthiness
• professional analysts deciding to invest in the company
• individual investors deciding to invest in the company
Common-size
statements
Common-size statements: Standardising
financial information
• A common-size financial statement is a standardised
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.
• 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 Ltd
Observations
• Table 4.1 is created by
Table 4.1
dividing each entry in
the income statement
of Table 3.1 by firm
sales for 2013.
• Cost of goods sold
make up 75% of the
firm s sales resulting in
a gross profit of 25%.
• Selling expenses
account for 3.3% of
sales.
• Income taxes account
for 4.1% of the firm’s
sales.
• After all expenses, the
firm generates net
income of 7.6% of
firm’s sales.
Table 4.2 H. J. Boswell Ltd Table 4.2
Observations
• Table 4.2 was created by
dividing each entry in the
balance sheet of Table 3.2
by total assets.
• Total current assets
increased by 5.6% (from
27% to 32.6%) in 2013
while total current
liabilities declined by 2%
(from 16.6% to 14.6%).
• Long-term debt
accounts for 39.2% of
firm’s assets, showing a
decline of 1.7%.
• Retained earnings
increased by 5.8%.
Using financial ratios
• Financial ratios provide a second method for standardising 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: (1) ratios from previous years; or (2) ratios of other firms in
the same industry.
 Part 2

Liquidity ratios
 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 analyse a firm’s liquidity from two perspectives.

1. Overall liquidity − analysed by comparing the firm’s

current assets to the firm’s current liabilities.
2. Liquidity of specific assets − analysed by examining the
timeliness in which the firm’s liquid assets (accounts
receivable and inventories) are converted into cash.
 Liquidity ratios: Current ratio

• The overall liquidity of a firm is analysed by computing the current ratio and
acid-test ratio.
• Current ratio: Current ratio compares a firm’s current (liquid) assets to its
current (short-term) liabilities.

• What is the current ratio for 2015 for H.J. Boswell Ltd?

Current ratio = $643.5 288 = 2.23 times

• The firm had $2.23 in current assets for every $1 it owed in current
liability.
 Liquidity ratios: Quick ratio

• Acid-test (Quick) ratio excludes the inventory from current assets as

inventory may not be very liquid.

• What is the quick ratio for H.J. Boswell Ltd for 2015?

• Quick ratio
= ($643.5-378) ($288) = 0.92 times

• The firm has only $0.92 in current assets (less inventory) to cover $1 in
current liabilities.
 Liquidity ratios: 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.
 Liquidity ratios: Accounts receivable

Average collection period measures the number of days it takes the firm to
collect its receivables.

• What will be the average collection period for H.J. Boswell Ltd for
2015 if we assume that the annual credit sales were $2700 million?

• Daily credit sales

= $2700 365 days = $7.4 million

• Average collection period

= $162m $7.4m = 21.9 days
Liquidity ratios: Accounts receivable turnover ratio

Accounts receivable turnover ratio measures how many times receivables

are rolled over during a year.

• What will be the accounts receivable turnover ratio for H.J. Boswell
Ltd for 2015 if we assume that the annual credit sales were $2700
million?

• Accounts receivable turnover

= $2700 million $162 = 16.67 times
• The firm s accounts receivable were turning over 16.67 times per year.
 Liquidity ratios: 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 since the items in inventory are converted
to cash more quickly.

• What will be the inventory turnover ratio for 2015 for H.J. Boswell Ltd
if we assume that the cost of goods sold were $2025 million in 2015?

• Inventory turnover ratio

= $2025 $378 = 5.36 times
The firm turned over its inventory 5.36 times per year.
Liquidity ratios: 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, excessive investments in liquid assets can prove to be

costly as liquid assets (such as cash) generate a minimal return.
 CHECKPOINT 4.1:
CHECK YOURSELF

Evaluating PRY’s Liquidity

Does the average collection period ratio confirm that primary health care is
able to collect debt more quickly than Ramsay and Sonic?
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.
Step 2: Decide on a solution strategy
Step 3: Solve
• To assess the firms’ liquidity, we will look at several ratios,
including the current ratio, quick ratio, inventory turnover
ratio, and accounts receivable turnover ratio.
• The following financial information was taken from the
companies’ 2014 financial statements:
Step 4: Analyse
Based on reviewing the liquidity ratios:
• Primary health care looks similar to Ramsey and Sonic; its liquidity
is better in some areas, worse in others.
• Primary’s current and quick ratios (0.8 and 0.7) are slightly worse
than those of Ramsey and Sonic (0.97/0.83 and 0.89/0.83) and
worse than the peer-group average (0.89/0.79).
• Primary manages its inventory less efficiently, only turning over its
inventory 5.4 times per year.
• Primary’s management of receivables is better, with accounts
receivable turnover of 10.17 times.
Step 4: Analyse (cont.)
If we look closer at the three companies, what might we find:
1. Inventory levels, as well as cost of goods sold, are low for all
three companies because the healthcare industry is largely
based on the provision of services rather than products.
2. Accounts receivable levels are considerably higher than
inventory levels; therefore, accounts receivable turnover is
more likely to have a high impact on liquidity.
3. Current and quick ratios are lower for primary than
competitors, which is sending a mixed message.
Step 5: Check yourself

Calculations: Primary Ramsay Sonic

Accounts receivable $149 861 $543 090 $575 999

Sales 1 524 115 4 909 314 3 913 475

Days: 365 365 365 365
Daily credit sales 4 176 13 450 10 722

Average collection period 35.89 40.38 53.72

 Part 3
Capital Structure and Asset
Management Ratios
 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?
 Capital structure ratios: Debt ratio

Debt ratio measures the proportion of the firm’s assets that are financed by
borrowing or debt financing.

• What is the debt ratio for H. J. Boswell Ltd for 2015?

• Debt ratio
= $1059.75 million $1971 million = 53.8%

The firm financed 53.8% of its assets with debt.

 Capital structure ratios: interest coverage ratio

• The interest coverage ratio measures the ability of the firm to service
its debt or repay the interest on the debt.

• What will be the interest coverage ratio for Boswell for 2015 if we assume an
interest expense of $67.5 million and EBIT of $382.5 million?
• Interest coverage ratio
= $382.5m $67.5m = 5.67 times
The firm can pay its interest expense 5.67 times; said another way, the interest used was
1/5.67th or 17.7% of its operating profit.
 CHECKPOINT 4.2:
CHECK YOURSELF

Comparing the financing decisions

of WES and WOW
What would Wesfarmer’s interest coverage ratio be if
interest payments remained the same, but operating
profit dropped by 80% to only $578 million? Similarly,
if Woolworth’s operating profit dropped by 80%, what
would its interest coverage ratio be?
Step 1: Picture the problem
• Interest coverage ratio is an important ratio for firms that use debt
financing. It determines how much debt the firm has used and if the
firm can afford to pay the interest on 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
Less: Cost of good sold
Equals: Gross profit
Less: Operating expenses Operating Profit (EBIT)
Equals: Net operating income (EBIT)
Less: Interest expense
Equals: Earnings before taxes
Less: Taxes Interest Expense

Equals: Net income

Step 2: Decide on a solution strategy

• Here we are considering the impact of a drop in EBIT on the

interest coverage ratio of Wesfarmers and Woolworths. We will
use the following ratio to measure the interest coverage ratio.

• Interest coverage =
Operating profit (EBIT) Interest expense
Step 3: Solve

Wesfarmers Woolworths
Total liabilities $13 740 $13 680
Total assets 39 727 24 205
Debt ratio 34.59% 56.52%
Step 4: Analyse
• The debt ratio of Woolworths exceeds that of Wesfarmers by ~ 22% (56.52%
compared to 34.59%).
• However, the interest coverage ratio of Woolworths is considerably higher
(14.52 compared to 8.35).
• Woolworths clearly makes greater use of debt in its capital structure but is
better able to service the debt from operating profit or EBIT.
The differences in the two companies could be because:
1. Wesfarmers is not performing as well as Woolworths and has
lower operating profit.
2. Wesfarmers is paying a higher interest rate on debt.
3. A greater proportion of Wesfarmers liabilities incur interest
charges.
• What we do not yet know from this analysis is whether shareholders are
benefiting from higher leverage.
• The key concern is whether Woolworths is able to consistently earn a
higher rate of return on its investments than it must pay to its creditors.
Step 5: Check yourself
Wesfarmers Woolworths

Operating profit (EBIT) $2890 $3775

Interest expense 346 260

Interest coverage ratio 8.35 14.52

Decrease
80% Wesfarmers Woolworths

Operating profit (EBIT) $578 $755

Interest expense 346 260

Interest coverage ratio 1.67 2.90

Asset Management Ratios
Asset management efficiency
ratios

• Asset management efficiency ratios measure a firm’s effectiveness in

utilising its assets to generate sales.

• They are commonly referred to as turnover ratios as they reflect the

number of times a particular asset account balance turns over during
a year.
 Asset management efficiency ratios:
Total asset turnover ratio
• Total asset turnover ratio represents the amount of sales generated per
dollar invested in firm’s assets.

Total asset Sales

turnover = Total assets

What will be the total asset turnover ratio for H.J. Boswell Ltd for 2015 if we
assume total sales to be $2700 million?

Total asset turnover

= $2700 million $1,971 million = 1.37 times
The firm generated $1.37 in sales per dollar of assets in 2015.
 Asset management efficiency ratios:
Fixed asset turnover ratio
• Fixed asset turnover ratio measures a firm’s efficiency in utilising its
fixed assets (such as property, plant and equipment).

Sales
Fixed asset Net property, plant
turnover =
and equipment

What will be the fixed asset turnover ratio for H.J. Boswell Ltd for 2015
if we assume sales of $2700 million for 2015?

Fixed asset turnover

= $2700 million $327.5 million = 2.03 times
The firm generated $2.03 in sales per dollar invested in plant and equipment.
Asset management efficiency ratios (cont.)
The following table summarizes the efficiency of H.J. Boswell
Ltd’s management in utilizing its assets to generate sales.
 Part 4

Profitability
 Profitability ratios
Profitability ratios address a very fundamental question: Has the firm earned
adequate returns on its investments?

To answer this question, analysis turns to two measures:

1. The firm’s profit margins to predict the ability to control expenses
2. The firm’s rate of return on investments.

Two fundamental determinants of a firm’s profitability and returns on

investments:

• Cost control – How well has the firm controlled its costs relative to each dollar
of firm sales?

• Efficiency of asset utilisation – How effective is the firm in using the assets to
generate sales?
Cost control: Is the firm earning reasonable profit
margins? Gross profit margin

Gross profit margin shows how well the firm’s management controls its
expenses to generate profits.

What will be the gross profit margin ratio for 2015 for H.J. Boswell Ltd if we
assume sales of $2500 million and gross profit of $650 million?

Gross profit margin

= $675 million $2700 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: Is the firm earning reasonable
profit margins? Operating profit margin
Operating profit margin measures how much profit is generated from each
dollar of sales after accounting for both costs of goods sold and operating
expenses. It also indicates how well the firm is managing its income statement.

Operating Operating profit or EBIT

profit margin = Sales

What will be the operating profit margin ratio for H.J. Boswell Ltd for 2015 if
we assume sales of $2700 million and net operating income of $382.5 million?

Operating profit margin

= $382.5 million $2700 million = 14.17%
The firm generates $0.14 in operating profit for each dollar of sales.
 Cost control: Is the firm earning reasonable
profit margins? Net profit margin

Net profit margin measures how much income is generated from each dollar
of sales after adjusting for all expenses (including income taxes).

What will be the net profit margin ratio for 2015 if we assume sales of $2700
million and net income of $204.75 million?

Net profit margin

= $204.75 million $2700 million = 7.58%
The firm generated $0.0758 for each dollar of sales after all expenses were accounted
for.
 Return on invested capital: Return on assets

Return on assets ratio is the summary measure of operating profitability. It

takes into account the management s success in controlling expenses and its
efficient use of assets.

What will be the operating return on assets ratio for H.J. Boswell Ltd for 2015 if
we assume EBIT or net operating income of $382.5 million for 2015?

Return on assets (ROA)

= $382.5 million $1971 million = 19.41%
The firm generated $0.1941 of operating profits for every $1 of its invested assets.
Decomposing the operating return on assets ratio
Figure 4.1 Analyzing H. J. Boswell Ltd’s return on
assets (ROA)
Figure 4.1 Observations
• Firm s ROA (return on assets) is better than that of its peers.
• Firm s OPM (operating profit margin) is lower than that of its peers.
• Firm s TATO (total asset turnover ratio) is higher than that of its peers.

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
investment in inventory.
 CHECKPOINT 4.3:
CHECK YOURSELF

Evaluating the return on assets (ROA)

for WES and WOW
If Wesfarmers were able to raise its total asset turnover ratio to that of
Woolworths (2.51) while maintaining its current operating profit margin,
what would happen to its 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 asset utilisation. Here the
focus is on asset utilisation.

• Or, substituting:
Step 2: Decide on a solution strategy
We will analyse the impact on return on assets of improvement on the
total asset turnover ratio by using the following equation:

Return on assets (ROA)

= Total asset turnover Operating profit margin
Step 3: Solve

54
Step 3: Solve
Return on assets (ROA)
= Operating profit margin X Total asset turnover

Wesfarmers Woolworths
Operating profit (EBIT) $2 890 $3 775

Sales 60 181 60 773

Operating profit margin 4.8% 6.2%

Wesfarmers Woolworths

Sales $60 181 $60 773

Total assets 39 727 24 205

Total asset turnover 1.51 2.51

Return on assets 7.27% 15.60%

Step 4: Analyse
• Woolworths has a substantially higher operating profit margin (6.21%
compared to 4.6% for Wesfarmers).

• Woolworths also has a higher total asset turnover at 2.51 (compared to 1.51
for Wesfarmers).

• We may assume there are some differences given that Woolworths has more
diversified operations.
Step 5: Check yourself
If Wesfarmers were to raise its total asset turnover to the
level of Woolworths (2.51) while maintaining its current
operating margin, what would happen to its return on assets?

Wesfarmers Woolworths
Operating profit (EBIT) $2 890 $3 775
Sales 60 181 60 773
Operating profit margin 4.8% 6.2%
To 2.51 Wesfarmers Woolworths
Total asset turnover 2.51 2.51
Return on assets 12.05% 15.60%
Is the firm providing a reasonable return on the
owner s investment? Return on equity (ROE)
Return on equity (ROE) ratio measures the accounting return on the
common stockholders investment.

What will be the ROE ratio for H.J. Boswell Ltd for 2015 if we assume net
income of $217.75 million?

ROE = $204.75m $866.25 m= 23.6%

Thus the shareholders earned 23.6% on their investments.
Using the DuPont method for decomposing
the ROE ratio

• DuPont method analyses the firm’s ROE by decomposing it into three parts.

ROE = Profitability Efficiency Equity multiplier

• Equity multiplier captures the effect of the firm’s use of debt financing on its
return on equity. The equity multiplier increases in value as the firm uses
more debt.
Using the DuPont method for decomposing the
ROE ratio (cont.)

ROE = Profitability Efficiency Equity multiplier

Using the DuPont method for decomposing
the ROE ratio (cont.)
What will be the equity multiplier for H.J. Boswell Ltd for 2015 if we
assume total assets of $1971 million, $911.25 million in common
shares and $45 million in preference shares?

•Equity multiplier
= $1971m $(911.25-45) m= 2.28
Using the DuPont method for decomposing
the ROE ratio (cont.)
The following table shows why H.J. Boswell Ltd s return on equity was
higher than that of its peers.
Using the DuPont method for decomposing the ROE
ratio (cont.)
Figure 4.2
 Part - 5

Market Value
 Market value ratios

Market value ratios address the question: How are the firm’s shares
valued in the stock market?
 Market value ratios: Price-earnings ratio
Price-earnings (PE) Ratio indicates how much investors are currently willing to
pay for $1 of reported earnings.

What will be the PE ratio for 2015 for H.J. Boswell Ltd if we assume the firm’s
stock was selling for $32 per share at a time when the firm reported a net
income of $204.75 million, and the total number of shares outstanding are 90
million?
• Earnings per share
= $204.75 million 90 million = $2.275
• PE ratio = $32 $2.275 = 14.07

• The investors were willing to pay $14.07 for every dollar of earnings per share
that the firm generated.
 Market value ratios: Market-to-book ratio
Market-to-book ratio measures the relationship between the market value and
the accumulated investment in the firm’s equity.

What will be the market-to-book ratio for 2015 for H.J. Boswell Ltd if the market
price of the stock is $32 and the firm has 90 million shares outstanding?

• Book value per share

= $866.25 million 90 million = $9.63 per share
• Market-to-Book ratio
= Market price per share Book value per share
= $32 $9.63
= 3.32 times
 CHECKPOINT 4.4:
CHECK YOURSELF
Comparing the valuation of RHC to SHL using
market value ratios
What price per share for Sonic would it take to
increase the firm s price-to-earnings ratio to the
level of Ramsay?
Step 1: Picture the problem

Price-to-earnings (PE) ratio depends on earnings per share and price

per share, pictured as follows:

Price per • Compared to . . .

share • Standardised by . . .

EPS • Net profit / # of shares outstanding

PE ratio • Price per share / EPS

Step 1: Picture the problem (cont.)

Market-to-book ratio depends on price per share and book value per
share, pictured as follows:

Price per • Compared to . . .

share • Standardised by . . .

Book value • Ordinary equity/ # of shares outstanding

per share

Market-to- • Price per share / book value

Book ratio per share
Step 1: Picture the problem (cont.)
Step 2: Decide on a solution strategy
• Calculate the price earnings ratio and the market-to-book
value ratio for Ramsay and Sonic.
• This will tell us how much investors are willing to pay for one
dollar of earnings and one dollar of book value of equity.
Step 3: Solve
The price earnings ratio and the market-to-book value ratio for
Ramsay and Sonic are as follows:

PE Ratio: Ramsay Sonic

Earnings per share $1.441 $0.962

Price per ordinary share $45.50 $17.33
Price-earnings ratio 31.58 18.01

Market-to-book ratio: Ramsay Sonic

Book value per share $8.67 $7.77

Price per ordinary share $45.50 $17.33
Market-to-book ratio 5.25 2.23
Step 4: Analyze
• PE ratio allows us to compare two stocks with different prices by
standardising the stock prices by earnings.
• Ramsay’s share price is higher than Sonic’s, but this does not tell us
how investors are valuing the two companies.
• Sonic has two times the shares outstanding.
• When we standardise, we see:
1. Ramsay has a higher price per share compared to earnings.
2. Ramsay has a higher book-to-market value ratio.
Step 5: Check yourself
• What price per share for Sonic would it take to increase the
firm’s price earnings ratio to the same level as Ramsay’s?

Ramsay Sonic

To 31.58
Earnings per share $1.441 $0.962
Price earnings ratio 31.58 31.58
Price per ordinary share $45.51 $30.38
 Part 6

Performance benchmarks
and Limitations
Selecting a performance benchmark
There are two types of benchmarks that are commonly used:

• Trend analysis – compares a firm s financial statements over time (time-

series comparisons)

• Peer group comparisons – compares the subject firm s financial statements

with that of peer firms.
 Trend analysis
• Comparing a firm s recent financial ratios with its past financial ratios provides
insight into whether the firm is improving or deteriorating over time.
• This type of financial analysis is referred to as trend analysis.

Figure 4.3 A time-series (Trend) analysis: Dell s inventory turnover ratio versus Hewlett Packard s:
1995–2011
 Peer firm comparisons
Peer groups often consist of firms from the same industry. Industry
average financial ratios can be obtained from a number of financial
databases and internet sources (such as Yahoo Finance and Google
finance).
Figure 4.4 Financial analysis of Ramsay Health Care Ltd, September
2014
 The limitations of ratio analysis

1. Picking an industry benchmark can sometimes be difficult.

2. Published peer-group or industry averages are not always
representative of the firm being analysed.
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 only clues.
7. The results of financial analysis are no better than the quality of
the financial statements.
 Key terms
• accounts receivable turnover ratio
• acid-test (quick) ratio
• average collection period
• book value per share
• capital structure
• current ratio
• days sales in inventory
• debt ratio
• DuPont method
• earnings per share (EPS)
• equity multiplier
• financial leverage
• financial ratios
• 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 assets (ROA)
• return on equity (ROE)
• times interest earned
• total asset turnover ratio (TATO)
• trend analysis
Resources
• Basic ratio analysis and equity valuation
• Harvard business school, Case 9-185-149, David F. Hawkins
• Yahoo finance
• Google finance
• Morningstar www.morningstar.com/
• Investopedia www.investopedia.com/university/ratios/
• Demonstrating value (social impact) www.demonstratingvalue.org/resources/financial-
ratio-analysis