Chapter 3

Analysis of Financial
Statements
 Ratio Analysis
 DuPont System
 Effects of Improving Ratios
 Limitations of Ratio Analysis
 Qualitative Factors
3-1
Balance Sheet: Assets

2009E 2008
Cash 85,632 7,282
A/R 878,000 632,160
Inventories 1,716,480 1,287,360
Total CA 2,680,112 1,926,802
Gross FA 1,197,160 1,202,950
Less: Deprec. 380,120 263,160
Net FA 817,040 939,790
Total Assets 3,497,152 2,866,592

3-2
 Balance Sheet: Assets

2009(E) 2008
Cash $199,551 $208,323
Accounts receivable 876,897 690,294
Inventories 909,379 942,374
Total current assets $1,985,827 $1,840,991
Gross fixed assets 380,510 317,503
Less accumulated depreciation 67,413 54,045
Net fixed assets $313,097 $263,458
Total assets $2,298,924 $2,104,449
4-3
Balance Sheet: Liabilities and Equity

2009(E) 2008
Short-term Borrow $312,500 $288,798
Accounts payable 650,535 636,318
Accruals 110,157 106,748
Total current liabilities $1,073,192 $1,031,864
Long-term debt 656,600 410,769

Common stock (100,000 shares) 550,000 550,000

Retained earnings 19,132 111,816

Total equity $569,132 $661,816
Total liabilities and equity $2,298,924 $2,104,449
3-4
 Income Statement
2009(E) 2008
Sales $2,069,032 $2,325,967
Cost of goods sold
1,647,925 1,869,326
Other expenses
241,490 287,663
Total operating costs excluding
$1,889,415 $2,156,989
depreciation and amortization
Depreciation and amortization
17,891 25,363
EBIT $161,726 $143,615
Interest expense
27,434 31,422
EBT $134,292 $112,193
Taxes (40%) 53,717 44,877
Net income $80,575 $67,316 3-5
Other Data

2009(E) 2008

EPS $0.81 $0.67

DPS $1.00 $1.00

Book value per share $5.69 $6.62

Stock price $19.20 $15.60

Share outstanding 100,000 100,000

Tax rate 40% 40%

3-6
Why are ratios useful?

 Ratios standardize numbers and facilitate

comparisons.
 Ratios are used to highlight weaknesses and
strengths.
 Ratio comparisons should be made through
time and with competitors.
 Trend analysis.
 Peer (or industry) analysis.

3-7
Five Major Categories of Ratios and the
Questions They Answer

 Liquidity: Can we make required payments?

 Asset management: right amount of assets
vs. sales?
 Debt management: Right mix of debt and
equity?
 Profitability: Do sales prices exceed unit
costs, and are sales high enough as reflected
in PM, ROE, and ROA?
 Market value: Do investors like what they see
as reflected in P/E and M/B ratios?
3-8
Everelite’s Forecasted Current Ratio and
Quick Ratio for 2009

Current assets
Current ratio =
Current liabilities
$1,986
=
$1,073
=1.85x
(Current assets - Inventories)
Quick ratio =
Current liabilities
($1,986 - $909)
=
$1,073
=1.00×
3-9
Comments on Liquidity Ratios

2009E 2008 2007 Ind.

Current ratio 1.85x 1.78x 2.02x 2.05×
Quick ratio 1.00x 0.87x 1.14x 1×

 Expected to improve but still below the

industry average.
 Liquidity position is weak.

3-10
Everelite’s Inventory Turnover vs. the
Industry Average

Inventory turnover09
= Sales/Inventory
= $2,069/$909 = 2.28

2009E 2008 2007 Ind.

Inventory turnover 2.28x 2.47x 3.10x 6.1×

3-11
Comments on Inventory Turnover

 Inventory turnover is below industry average.

 Everelite might have old inventory, or its
control might be poor.
 No improvement is currently forecasted.

3-12
DSO: Average Number of Days after
Making a Sale before Receiving Cash

DSO = Receivables/Avg. sales per day

= Receivables/(Annual sales/365)
= $876/($2,069/365)
= 154.69 days

3-13
Appraisal of DSO

2009E 2008 2007 Ind.

DSO 154.69x 108.32x 135.60x 56×

 Everelite collects on sales too slowly, and

is getting worse.
 Everelite has a poor credit policy.

3-14
Fixed Assets and Total Assets Turnover
Ratios vs. the Industry Average

FA turnover = Sales/Net fixed assets

= $2,069/$313 = 6.61

TA turnover = Sales/Total assets

= $2,069/$2,299 = 0.90

3-15
Evaluating the FA Turnover and TA
Turnover Ratios

2009E 2008 2007 Ind.

FA TO 6.61x 8.83x 11.22x 9.3×
TA TO 0.90x 1.11x 1.21x 2.1×

 FA turnover projected to be still below the

industry average.
 TA turnover below the industry average.
Caused by excessive currents assets (A/R
and Inv).
3-16
Calculate the Debt Ratio and
Times-Interest-Earned Ratio

Debt ratio = Total debt/Total assets

= ($1,073 + $657)/$2,299
= 75.25%
TIE = EBIT/Interest expense
= $161.7/$27.4 = 5.90

3-17
Everelite’s Debt Management Ratios vs.
the Industry Averages

2009E 2008 2007 Ind.

D/A 75.24% 68.55% 64.50% 50.00%
TIE 5.90x 4.57x 19.17x 6.2×

 D/A and TIE are worse than the industry

average.

3-18
Profitability Ratios: Operating Margin,
Profit Margin, and Basic Earning Power

Operating margin09= EBIT/Sales

= $161.7/$2,069
=7.82%.
Profit margin09= Net income/Sales
= $80.5/$2,069
= 3.89%.
Basic earning power09=EBIT/Total assets
= $161.7/$2,299
= 7.03%.

3-19
 Appraising Profitability with Operating Margin,
Profit Margin, and Basic Earning Power

2009E 2008 2007 Ind.

Operating margin 7.82% 6.17% 11.91% 13%
Profit margin 3.89% 2.89% 6.78% 9.00%
Basic earning power 7.03% 6.82% 14.38% 15.00%

3-20
Appraising Profitability with Operating Margin,
Profit Margin, and Basic Earning Power

 Operating margin was very bad in 2008. It is

projected to improve in 2009, but it is still
projected to remain below the industry average.
 Profit margin was very bad in 2008. It is
projected to improve in 2009, but it is still
projected to remain below the industry average.
 BEP removes the effects of taxes and financial
leverage, and is useful for comparison.
 BEP projected to improve, yet still below the
industry average. There is definitely room for
improvement.
3-21
Profitability Ratios: Return on Assets and
Return on Equity

ROA = Net income/Total assets

= $80.5/$2,299 = 3.50%

ROE = Net income/Total common equity

= $80.5/$569 = 14.16%.

3-22
Appraising Profitability with ROA
and ROE

2009E 2008 2007 Ind.

ROA 3.50% 3.20% 8.18% 6.50%
ROE 14.16% 10.17% 23.03% 12.00%

 Both ratios rebounded from the previous

year, but are still below the industry
average. More improvement is needed.
 Wide variations in ROE illustrate the effect
that leverage can have on profitability.
3-23
Effects of Debt on ROA and ROE

 ROA is lowered by debt ─ interest lowers NI,

which also lowers ROA = NI/Assets.
 But use of debt also lowers equity, hence
debt could raise ROE = NI/Equity.

3-24
Problems with ROE

 ROE and shareholder wealth are correlated,

but problems can arise when ROE is the sole
measure of performance.
 ROE does not consider risk.
 ROE does not consider the amount of capital
invested.
 Might encourage managers to make investment
decisions that do not benefit shareholders.
 ROE focuses only on return and a better
measure would consider risk and return.
3-25
Calculate the Price/Earnings and
Market/Book Ratios

P/E = Price/Earnings per share

= $19.20/$0.81 = 23.70

M/B = Market price/Book value per share

= $19.20/$5.69 = 3.37

2009E 2008 2007 Ind.

P/E 23.83x 23.17x 14.49x 10.00×
M/B 3.37x 2.36x 3.34x 3.00×
3-26
Analyzing the Market Value Ratios

 P/E: How much investors are willing to pay

for $1 of earnings.
 M/B: How much investors are willing to pay
for $1 of book value equity.
 For each ratio, the higher the number, the
better.
 P/E and M/B are high if ROE is high and risk
is low.

3-27
The DuPont System

Profit Total assets Equity

ROE   
margin turnover multiplier

ROE  (NI/Sales)  (Sales/TA)  (TA/Equity )

 Focuses on expense control (PM), asset

utilization (TA TO), and debt utilization
(equity multiplier).

3-28
DuPont Equation:
Breaking Down Return on Equity

ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)

=3.89%  0.90  1/(1 – 0.7524)
= 14.16%.

PM TA TO EM ROE
2007 6.78% 1.21 2.82 23.03%
2008 2.89% 1.11 3.18 10.17%
2009E 3.89% 0.90 4.04 14.16%

3-29
An Example:
The Effects of Improving Ratios
A/R $ 877 Debt $1,730
Other CA 1,109 Equity 569
Net FA 313
TA $2,299 Total L&E $2,299

Sales/Day = $2,069/365 = $5.67

How would reducing the firm’s DSO to 56 days

affect the company?

3-30
Reducing Accounts Receivable and
the Days Sales Outstanding
Reducing A/R will have no effect on sales.
Accounts receivable under new policy
= $5.67  56 days= $377.44.
Freed cash= old A/R – new A/R
= $876.86 – $377.44
= $559.42

Initially shows up as addition to cash.

3-31
Effect of Reducing Receivables on
Balance Sheet and Stock Price

What could be done with the new cash?

How might stock price and risk be affected?

3-32
Potential Uses of Freed up Cash

 Repurchase stock
 Expand business
 Reduce debt
 All these actions would likely improve the
stock price.

3-33
Potential Problems and Limitations of
Financial Ratio Analysis

 Comparison with industry averages is difficult

for a conglomerate firm that operates in
many different divisions.
 “Average” performance is not necessarily
good, perhaps the firm should aim higher.
 Seasonal factors can distort ratios.
 “Window dressing” techniques can make
statements and ratios look better.

3-34
More Issues Regarding Ratios

 Different operating and accounting practices

can distort comparisons.
 Sometimes it is hard to tell if a ratio is “good”
or “bad.”
 Difficult to tell whether a company is, on
balance, in strong or weak position.

3-35
Consider Qualitative Factors When Evaluating
a Company’s Future Financial Performance

 Are the firm’s revenues tied to one key

customer, product, or supplier?
 What percentage of the firm’s business is
generated overseas?
 The firm’s competitive environment
 Future prospects
 Legal and regulatory environment

3-36