I I
.
Aitalys is of Financial Statements
T o guide or not to guide, that is the
question. Or a~ least it's the question
many comparues are wrestling with
regarding earnings forecasts. Should a com- ings expectations. In 2000 the SEC ado a;n-
pany provide earnings estimates to investors?
In 2006, Best Buy answered this question by prevented comparues from disclosing infor.
announcing that it would no longer provide
quarterly earnings forecasts. It's no coinci-
dence that Best Buy's decision came shortly
after its actual earnings came in j~t 2 cents
below the forecast, yet its stock price fell by
12%. Coca-Cola, Motorola, and Citigroup are
among the growing number of companies that
no longer provide quarterly earnings forecasts.
Virtually no one disputes that investors
as
need as much information possible to accu-
rately evaluate a company, and academic
studies show that companies with greater
transparency have higher valuations. However,
greater disclosure often brings the possibility
of lawsuits if investors have reason to believe
that the disclosure is fraudulent. The Private
Securities Litigation Reform Act of 1995
helped prevent "frivolous" lawsuits, but still,
,.- .,. ..
.
. , .. ·- , , ,, 'dance lite• CFO, Jun• 2006, 16-17, ond William F. Colf'n
_._, from Joseph McCafferty, ~u, Whit~ Paper, available al http://wwwA#j,.-.J e;,/•ond Crocker Coul~on,
~
do
...~,--...-·
Sc,urctU: A f''~d
•1, faming• ~~ -..11
DlsaPf""'ring In 2006' 2006'
(
I I
before 2000, many companies providect
ings information to brokerage firms' ana~rn-
and the analysts then forecast their own ; sts,
Reg FD (Regulation Fair Disclosure) ...Ph_ed
l~h • • I ....
mation only to select groups, such as analy t
s s.
Reg FD led many companies to begin provid-
ing quarterly earnings forecasts directly to the
public, and a survey by the National Investors
Relations Institute showed that 95% of respon-
dents in 2006 provided either annual or quar-
terly earnings forecasts, up from 45% in 1999.
Two trends are now in evidence. First, the
number of. companies reporting quarterly r
earnings forecasts is falling, but the number
reporting' annual forecasts is increasing.
Second, many companies are providing other
types of forward-looking information, includ-
ing key operating ratios plus qualitative infor-
mation about the 'company and its industry.
Ratio analysis can' help investors use such
information, so keep that in mind as you read
this chapter. '
I • l
f • I
I '
!..JC!Pln/pcf/Eam1ngs
 tatement analysis involves nn
cfal 5 fiJ"l]lS in the same indu..~
~...t of er . tion over time. This anal"UaL.
0th
"~ ·-• pos1 .
~CJcU take actions to improve pedw.
r-
;ttd tJtell lies in the fact that they can be ~
tedlents nd free cash flow. From an inYellor•
:;:..,;,:1en~5, a cial statement analysis is all ~ 1
• flJl,IJt _finan_ 1statement analysis is useful both t o ~
t5 financuz . . •-,,lffll:ll!fllillt:
p0i.11t~ rtant, as a startmg point for planning •ctions that
,nore ,,nPo 1
,kirtnance.
pe~v •

.1 alto Analysis
4 ·-
" . f os are designed to help evaluate financial sta
1
fiJtailc al _rah; have debt of $5,248,760 and interest c"''"- lementsfe"• Por
0 '"19
an interest charges of ~.94S ,900•
· A nug 647 980 d · ·--1:,~
f~ have debt of $52, ,
6 JIUg~t tr nger? The burden of these debts, and the comna.,,.~· Whtai
is s o db . ,._._ . . .....,
panY best be evaluate y companng (1) each firm's debt to. ~
mean
the . , h . . h 1~
tit must pay tot e mcome 1t as available forpaymentofm
the inte~es s are made by ratio analysis. teiest.
mpanson
co We Wl·u calculate the Year fin .
d .2007 anCJ.al tatios for MicroDri.¥e ,ua:.,
__ ,.;.,,....
h balance sheets an mcorne statements given in Table 4- .~
froJll tte the ratios in relation to the industry averages. Note that
evalua e
are in millions. . .

4.2 Liquidity Ratios

A liquid asset is one th~ t trades in an ~ctive market and hence can be quickly am-
verted to cash at the gomg market pnce, and a firm's "liquidity ratios" deal will H....,Jc.w
this question: Will the firm be able to pay off its debts .as they come due over the
next year or so? As show~ in Table 4-1, MicroDrive has current liabilitielDf Q

Corporate Valuation and Analysis of Financial ateme1 l'.:·

Stateme11(·
':111
The value Qf a firm is determined by the size, timing,
and risk of its expected future free cash flows (FCF).
This chapter shows you how to use financial

FCF 1 FCF2
VaIue = - -- - -1 + - --~--=-2
( 1 + WACC) (1 + WACC)
•' I

~Widespread accounting fraud has cast doubt on whether all firms' published ftnancialhcM bal
ol':eregulotio_ns ~y the SEC and the exchanges, and new l~ws enacted by C ~
OCcounttng industry and increased the criminal penalties an managemettl fraudulaal ..
•·
=•
 ,.
Statem_. for Yi
For Per Share Cata)
Uabililies and ~ .
. ~payable
• $
-60
110
$
2006

30
60
65
~15
.415
"Notes ~ble
Accruals
Total current liabilities
-$
754
1.40
310
130 · I
220
580
$ 810
Long-f8"" t,ancfso
$ 1,064 $80Q
I Total liabilities
870
. 1,0CXJ preferred stoek ~ AO 40
(400,00o shares)
common stoek 130 130
. (50,00o,OOo shares) •, .
766 ' 710 ·
Retained earnings
Total common equity
$ 896 ~
I•
Total liabilities and equity
$ 2,000 ~
-
$1,680
2007 2006
$3,000.0 $2,850.0
• J4 # 2,616.2 2.497 0 .
-:----:..:.
dep(acialion and amortizationb
taxeS,depreciation, and amortization (EBITDA) .
$ 383 .8
100.0
0 .0
$ 353.0
-
90.0
0.0
$ 100.0 $ 90.0
$ 283 .8 $ 263.0
l\!ltlll--' and ,axes (EBIT', or operating income) 88 .0 60.0
$ 195.8 203.0
78.3 81.2-
$ 117.5 $ 121.8
4.0 4.0·
$ 113 .5 $ 117.8
$ 57 .5 $ 53.0
$ 56.0 $ 64.8

$ 23 .00 $ 26.00
$ 2.36
$ 2.27
$ 16.80
$ 17.92
.. $ A.16
$ 4.27

ol $20 million a year.

)9(11'•
 . .0 n that must be paid off within the

,
'f
xnilli obligations? A full liquidity analysis"'.8blilltil
th°sen·ng the amount of cash and other
re1aIysis provt"d es a qw·c1c, easy-t0awie ftteaal
ana . d·.,,.., ...__.... .
liquidity ratios are •~~ in this section.
-

Ability to Meet Short-term Obligations: The ~m-...,__,,,•

The current ratio is calculated by dividing~ asaeta by.

Current ratio = Cunent a&ef!!..:1. ·

Current liuiJlttea .
$1,000
= $310
Industry average = 4.2~

Current asset_s normally i~cl~~e. cash, marketable securities, acc:omds

and inventories. Current hab1hties consist of accounts payable
payable, current maturities of long-term debt, acaued ~~d'liltier
expenses (principally wages). . .
Micro Drive has a lower current ratio than the average for ibl i:d4u•r, i,i
good or bad? Sometimes th~ an_swer ~epends on who J$ asking the
example, suppose a supplier 1s trymg to decide whether to extend
~A
Mic~oD~i ve. I~ gen_eral,_ c~editor~ lik~ to s~ a high current ratio. If a, q\m~yjp

more slowly, borrowing from it~ bank, and so on, so its current liabilities
increas~ng. If curren! liabilities are rising faster than ~ t assets,~~
will•
gettmg mto financial d1ff1culty, 1t will begm paying its bills (accounts paya-.,

ratio will fall, and this could spell trouble. Because the current ratio proy:i4es:t.
best single indicator of the extent to which the claims of short-term crecUtoriM,'8
covered by assets that are expected to Qe converted to cash fairly qui<:kly, itJs.\he
most commonly used measure of short-term solvency.. '
Now consider the current 'ratio .,from the perspective ~fa sharehold~ A ~
current ratio could mean that the compcµty has a lot of m~. tied up i n ~
productive assets, such as excess cash or marketa~le securi~es. Or perhaps=
current ratio is due to large inventory holdings, which ntj.ght well become
before they can be sold. Thus, shareholders might not want a high current ratio.
An industry average is not a magic n~ber that all firms should sttj:
maintain-in fact, some very well-man~ged firms ·w~l be _a~ve ~ea
while other good firms will be below 1t. H_o~ever, if a firms ratipf
removed from the averages for its industry, this IS a red flag, a~d ana~
be concerned about why the variance OC~S- For exa~rle, suppose a
rent ratio is traced to low inventories. Is this a competitive advantage
from the firm's mastery of just-in-time inventory management, OJ
heel that is causing the firm to miss shipments and lose sales?
doesn' t answer such questions, but it does point to areas of
 ventories 1roU::
·es:
- Inventories - • ·
current liabilities
$S85
==- = 1.2mn~: C •

$310 . .
buiustry average= 2.1 runes. ,. ';
Jfae~t liquid of a firm's current asse~s; hence they are
hHt losses are most likely to occur ~ a . bankrupt
~ the1hm's ability to pay off short-term obligations Witho~
Inventories is important. . , . .
i1,1iwraaequick ratio is 2.1, so MicroDnve s 1.2 r~ho IS low in coll\.
~ '--Jinns in its industry. Still, if the. accounts rec~1vable can be Col.
• •u:irGIil pay off its current liabilities without havmg to liquidate its

..., ID~• a .firm's liquidity position, and write out their equations..
P. liauid a~? Give_some ~,;camples.
the least l,quid? . .. h . . ·
al $800 million, and its current ratio 1s 2.5. w_ at 1s its level of current
iA~ finn's quick ratio is 2, how much inventory does 1t have? 1$400 million)

'
t Management Ratios ,

group of ratios, the asset management ratios, measures how effectively

ismanaging its assets. These ratios are designed to answer this question:
Ital amount of each type of asset as reported on the balance sheet seem
too high, or too low in view of current and projected sales levels? If a
i... . ,. __ excessive investments in assets, then its operating assets and capital

unduly high, which will reduce its free cash flow and its stock price. On the
ila mmpany does not have enough assets, it will lose sales, which will
llabi!lil'tv., free cash flow, and the stock price. Therefore, it is important to
Wght amount inv~ted in assets. Ratios· that analyze the different types of
.
'6saibed in this section. ·

Inventories: The Inventory Turnover Ratio

turnover ratio is defined as sales divided by inventories:
. turnover ratio= Sales ·
· Inventories

- $3,000
$615 = 4.9 times.
Industry average = 9.0 times.
lfMllnation, each item of Mi......oDr· , · d
over." 4 9 . ~, ive s inventory is sold out an
with 'the·0 l~es per year. ''Turnover" is a term that origi·
ankee peddler, who would load up his wagon
 ___.tsaad--
- r""""~" betlQ&e
~~ts, whereas ~
~ J\IU'ual sales divided OV(IIM
~ - 10 trips per year, st()~lff
niade ual gross profit would be(l
}1iS ~ per year, his gross profit w'MUI._.
zo tr1 er direCtly affected his profits.
tutt'~ croDrive's turnover of 4.9 tiJN1i it
ti:nes. This suggests that MicroD1':
of 9 tory is of course, unproductive, ••Wt-lilliii;;.;i
· venro rate ' of return. MicroDrive's -
iJ1 low ·
or zet. n the current ratio. With such a low
q.uesto .
•s actually holding b
o solete goods not - 1 . .
f1rnt l th nv,-....
Note t~at _sales occur_over e ~n~ year,~
. oint m time. For this reason, 1t 15 better to .._
one pIf the firm' s b usmess
. . highiy seasonal, or _,
3 1s if
ured. wnward sales trend during the year, it is ~..11..:
or o . t . -r-.,
. stment. To mam am comparabill"ty with ind,ullhv
ad JU . t fi ·- --,
not use the average mven ory gure. . , ,

Evaluating Receivables: The Days Sales

Days sales outst~nding (DSO), ~so called the "average
is used to appraise accounts receivable, and it is
receivable by average daily sales to find the number o f ~
calcula., _•
in receivables.4 Thus~ the DSO represents the average 1 ~
must wait after making a sale before receiving cash, w~ ls
tion period. MicroDrive has 46 days sales outstanding, well.
industry average: ,.
Days
Receivables . , ,
DSO = sales -
Average sales per day ::
outstanding
$375 $375
= $3,000>365 = $8.2192 = 45•6
In~ustry I

The DSO can also be evaluated by comparison with the

, firm sells its goods. For example, MicroDrive's sales terms
30 ~ays. The fact that 45 days of sales are outstanding· '
the average, are not paying their bills on time. This depive,
that it could u se to invest in productive assets. Moreover, m

;fThtnventon~s
proble'." arises when calculating and analyzing the
ore carried at cost, as they the
generally ore,
inventory lumOWII' • ·
calc~ "'"'°':i
Herefore, it would be more appropriate to use cost of goods sold in ~
t'
I . owever, established compilers of financial ratio statistics such as Dun &
or c~rri~ at cost. To develop a figure that con be c~pared.!WIIII
rtes ·d · .,.i. .i....-.....
"Ill!"
lp9 ntzahons, it is necessary to measure inventory turnover wilh salN"
0
/~!~rably, the average inventory value should be calculatad by lUlilM . .
t' '"9 by 12. If monthly data are nof available~one can odd
'Ir 2. ~dwever, most industry ratios are calculate<I as above,'-:.
,;~~e. be better to use overage receivables, but we used y«JI
0 1
 .-ma,agnil that the customer is in finan .
M¥e a haid time ever collecting the ~ ~
"""O"OerlY the past few years has been risin~ \ t~
jlll_.$lhgllMI this would be strong evidence rha~t "
••me.me collection of accounts receivable. t s,
~d Assets:_The Fixed Asset~ ~ur~over R~tio · .(
turnover ratio measures ho_w effectively the firm uses its .
iP.1111~,.t is the ratio of sales to net fixed assets: P~t\t
·. Sales
1ft;ted aS9ets ~o~er ratio = Net fixed assets

. $3,000
= 3.0 times.
., I
~ $1,000
Industry average
• t
= 3.0 times.
Uiaol)rive's ratio of 3.0 times is equal to the _ind us try average~ indicating that t
using its fixed assets about as intensively as are other firms in its ind he
croDrive seems to have about the right amount of fixed assutsti:J.
, Mi es~
. . . . . to other firms. . . .
~1-1-1 problem can exist when mterpretmg the fixed assets turn
~- . fl I l. .
~ R«all fmm accounting that fixed assets re ect t 1e ustoncal costs of the
over
,,_...fnlJatlon has caused the value of rn~ny assets that we~e purchased in the
JI.Ills be seriously understated. Therefore, 1f we were comparing an old firm th t
had~ many of its fixed assets years ago at low prices with a new compana
fhatflad KqUired its fixed assets only recently, we would probably find that th~
cild finn had the higher fixed assets turnover ratio. However, this would be more
~ v e of the difficulty accountants have in dealing with inflation than of any
~ on the part of the new firm. Financial analysts must recognize that this
pml,Jent exists and deal with it judgmentally.

laluating Total Assets: The Total Assets Turnover Ral io

Thefinal asset management 'ratio, the total assets turnover ratio, measures the
~ e r o f all the firm's assets; it is calculated by dividing sales by total assets:
' I

. Sales
Total assets turnover ratio = - - - -
Total assets

$3,000
= -- = 1.5 times.
$2,000

Industry average = 1.8 times.

~v_e's ratio is somewhat below the industry average, indicating that the ,
JS>.not generating ~ sufficient volume of business given its total asset
t 'Sales should be increased, some assets should be sold, or a combina·
11mase steps should be taken.
 Identify~
their equatiOM•.
t-loW might ~ IroWer
Whot~tia pc
A firm has ~n!l~
able. What 1s ,ts 1mren

Debt Management Ratios

4.4 .; financing, or
t 0 which a firm uses debt
'1'he e"tent_ plications: (1) By raising funds throughdet,it,
• .-.ant u:n .h t . . their. m'Ye8biseM.•
iJ11po•• ol of a firm wit ou mcreasmg
tai11 con~ stments financed with borrowed funds thmtt
inve .fied: or •",everaged," "8
p1ore on holders' returns are magru
jts sh~i:e d (3) Creditors look to the eqwty, or owneHQpp&d:
p1ag~1fi~f ·safety, so the higher the proportion of funding
p1argltl risk creditors face. Chapter 16 explains the
the 1ess · examme · leverage from a creditor's ~ .a.
ers, f Bowing ratios
while the o . . •~ ·
.
ffoW the firm Is Financed: Total Liabilities tn Total As
. of total liabilities to total assets is called the debtn~.IW "l-
· _::;~
The ratiobt ratio. It measures t h e percentage o f funds pruv1U.ai·-.-,,_w;
tota1 d e long-term d eb t.. .
ties and . .
Total liabilities
Debt ratio = T al
ot assets .
·

$310 + $754 $1,()64 ·

~ $2,000 = $~,000 =__53:2%.
Industry average = 40.°"'.

Creditors prefer low debt ratios because the lower the ratio, t h e ~
ion against creditors' losses in the event of liquidation. Stockhoklers, on~
hand, may want more leverage because it magnifies expected eaminga.
MicroDrive' s debt ratio is 53.2%, which means thatits creditors have
d.
more than half the total financing. As_we will discuss in Chapter 16, av:
factors determine a company's optimal debt ratio. Nevertheless, the 1ad
Micro Ori ve' s debt ratio exceeds the industry average raises a red flag u,ias.1111
make it costly for MicroDrive to borrow additional funds witboul :PJ!illi:i~
more equity capital. Creditors may be reluctant to lend the firm more
management would probably be subjecting the firm to the risk of
increased the d ebt ratio by borrowing additional funds. .
If you u se a debt ratio that you did not calculate yourself, be 8U118 lo.i
how the ratio was defined. Some sources provide the ratio of
total assets, and some provide the ratio of debt to equity, so be sme'la
source's definition. 5

~T~~ debt-to-assets (D/ A) and debt-t~uity (D/E} ratios are ,imply tranwrmatianl ol eodl
e ined as total liabilities: ·
DIA 0/E
DIE= l -OtA anclD tA= l +O/E;

L
 l.'M4IJI~: Times-Interest-~arned . . . .
(TIE) ratio is determmed by dividing earni
and tax5(BJll1' in Table 4-1) by the interest charges: ngs ' .
EBIT ;
nme,-intereSt-eamed (TIE) ratio= Int~rest charges J
$283.8
$88 "'." 3.2 times.
=

Industry average = 6 times.

· ·the extent to which operating income can dect·
1he TIE ratio measures · F. tne '-~
. bl to meet its annual interest costs. a11ure to meet this obJ· ~fo11.
the fimu~ una e red' 'bl It· . li>a~ ·1:
can brin legal action by the firm's c itors, possi y res~ mg in ban~ ' Ott
Note thaf
earnings before interest _and _taxes, rather than net m~o~e, is Used i Pt~.
n-..
numerator. DC\.,Cluse
m·terest is paid with pre-tax dollars, the firm s ability n t~
to
current interest is not affected by taxes. . . . P~y
MicroDrive's interest is covered 3.2 tunes. Smee the_industry average is 6 f
MicroDrive is covering its interest charges by a relatively _low margin of 8 :es,
Thus, the TIE ratio reinforces the co~c_lusion from our analysis of ~l~e debt ratio ety.
MicroDrive would face difficulties if it attempted to borrow additional funds. tha.1

Ability to Service Debt: EBITDA Coverage Ratio

The TIE ratio is useful for assessing a company's ability to meet interest ch
on its debt, but this ratio has two shortcomings: (1 ) Interest is not the only
financial charge-companies must also reduce debt on schedule, and many f
~r;:
lease assets and thus must make lease payments. If they fail to repay debt or l :ns
lease payments, they can be forced into ban~ptcy: (2) ~BIT does _not represent:
the cash flow available to service debt, especially if a firm has high depreciati
and/or amortization charges. To account for these deficiencies, bankers and 0;~
ers have developed the EBITDA coverage ratio, defined as follows: 0
EBITDA + Lease payments
EBITDA coverage ratio = - - -- -.- .- - -- - - - -- - -
Interest + Prmc1pal payments + Lease payments

= $383.8 + $28 = $411 .8 = 3_0 times.

$88 + $20 + $28 $136
Industry average = 4.3 times.
MiaoDrive had $383.8 million of earnings before interest, taxes, depreciation, and
amortization (EBITDA). Also, lease payments of $28 million were deducted while
calculating EBITDA. That $28 million was available to meet financial charges;
hence it must be added back, bringing the total available to cover fixed financial
charges to $411.8 qullion. Fixed financial charges consisted of $88 million of inter-
est, $20 million of sinking fund payments, and $28 million for lease payments, for

~ onalysb define the EBITDA cOYerage ratio in different ways. For example, some would omit the lease payment
lmorrnalion, ~ olher1 would •grou up• principal payments by dividing them by (l
- T] because these payments are
nol lax deducfion1, and hence mu51 be mode with ofter-lox cash Rows. We included lease payments because for many
firms, !hey~ quill i'!1portant, a~ foiling to make them con lead to bankruptcy just as surely os con fo11ure ;o moke.
regular debt. We
poymenls
lox roll WI1probably be
did not gross up principal payments because, if a company is in f1nanc1al difficulty, its
the
zero; lO gross up is not necessary whenever the rotio is really important
 " ternotionol Accounring ;)ifft.· fL\l(;-
...
l
be O good financial deteclive lo
'(ou rn.ujt statements, ,-spec.lolly if at.
10
fioCJOC: ••os Despite attemptl to
ates
over.... ·
.
th
practices, ere are many csn.,..,c:i
occountllf~ onciol information is reporled In lffllill91ir
th• wo_Y inond these differences creole heailac.t.a
untnes, . k • L_......1 __
co . t rs trying to ma e crosa-uorU91" C°"'fXll'IV
for inves o
orisons. II
corn P t dy by two Rider Co ege accounting pro- ace
A s demonstrated thot huge differences can
fes_sor~he professors developed a computer model lional
e,<• st · I te the net income of a hypothetical but toward a ·
t0 evo
.
uo
I company operating . . d' ff
I erent countries.
in e,cgmple.lheE~~
typ•~a. the standard accounting practices of each
APP ying the hypothetical company would have .by listed C0111pan1ei \o ~ ·
the lntemalional
countryd net income of $34,600 in the United OAS&}. There
are Q\so onpng
reporte $ 2 60,600 in the United Kingdom, and
States, . the IAS6 and the U.S. R
1
40 6 00 in Austra 10 . Standards Boord \fASll lo cs-.lop
$ 2 • h variances occur for a number of reasons. finonclal standards for al\
5
u~ countries, including the United States, on Second, IAS6 slandarda ~
on gen
In mt?s balance sheet value is reported at original
osse s I dd . t' H . while FAS& standards are •
cost less any accumu ate I eprec1ad1~n. edoweverR, m accounting scandals demonatrote,
countries, asset va ues are a 1ust to re ect nies hove been able to comp\y
some market prices.
current · Al so, ·mventory vdaIuat'10n .L.
mem- violating the principle, or lnlant unc:tatMlia
d ary from country to country, as oes the treot- This Is fueling a debate fY,lflf
0 s ; of goodwill. Other differences arise · from the
of principlea-based "9f'IUS

and pension plans. and..,,...,,_....,._

;:~tment of leases, research and development costs, Sources: See the w.b sitn of the IASI and'- FAS:
hllp://ww.........

total of $136 million .7 Therefore, MicroDrive covered its fixed financial charges
~y 3.o times. H owever, if EBITDA declines, the coverage will fall, and EBITDA cer-
tainly can decline. Moreover, MicroDrive's ratio is well below the industry aver-
age, ·so again, the company seems to have a relatively high level of debt. .
The EBlTDA coverage ratio is most useful for relatively short-term \enders
such as banks, which rarely make loans (except real estate-backed loans) for
longer than abou t 5 years. Over a relatively short period, depreciation-generated
funds can be used to service debt. Over a longer time, those funds must be rein-
vested. to ma in tain the plant and equipment or else the company cannot remain in
business. Therdore, banks and other relatively short-term lenders focus on the
EBITD A coverage ratio, whereas long-term bondholders focus on the TIE ratio.
I

SELF-TEST
He# does the use of financial leverage affect current stockholden' conlfo\ position?
Ir. what way do taxes influence a firm's willingness to finance with debt?
In whCJt w ay does the use of debt involve o risk-versus-return trade-off?
£,c plain the following statement. "Analysts look at both balance sheet and intame stalM.m ~
r,ppro1sing a firm's financial condition."
Name three ratios that are used to measure the extent to which a firm uws f\ncmaal ~ -. .
out their equations. ·
A company has EBITDA of $600 million, interest payments of $60 million, lease payments ci
a nd required principal payments ldue this year\ of $30 million. What i, ill EIITD.. ccwen:age
\I - - ----
]A sinking fund 15 a required annua l payment designed ta reduce the balance ol a bond or
preferred stock 15 sue
 of, policies and decisions. Th ·
~ ~ to the effectiveness of a fhln• e ra.__
.BP on to show the combin~ effects of lis ~
.operating results. q~

•~~
--•es calcuhlted bv dividing net iricome by sales· g·
J ·~~-
oiales: ' . .."
Net income available to common stockhold
on sales =. . Sales ~

= $113.5 = 3.8%.
$3,000 .
Ipdustry average = 5.0%.
$ pro.fit margin is· below th'e industry average of 5%. This sub--
lod::utS because costs are too ~gh. H!gh co_sts; in turn, ?enerally
ofinefficientoperations. However, M1cro~nve s l~w_prof1t margin is also
oc:
of it:; heavy use of debt. Recall that net mcome 1s mcome after inter,
, iJ you consider two firms that have identical operations in these:
sales, operating costs, and EBIT are the s~me, then the firm that USes
debt will have higher interest charges. Those mterest charges will pull net
doMl, and since sales are constant, the result will be a relatively low profit
• In such a case, th~ lo_w·profit_ margin ~o~ld n~t indicate _an operating
pmlem-rath er, it would md1cate a difference m fmancmg strategies. Thus, the
. . . with the low profit margin might end up with a higher rate of return on its
~lders ' investment due to its use of financial leverage. We will see exactly
tiowpmfit matgins and t.he use of debt interact to affect the return on stockhold-
ffl' equity later in the chapter, when we examine the Du Pont model.

J!!!sic ~arning Power (BEPJ

TIie- bask earning power (BEP) ratio is calculated by dividing earnings before
4alm!st and taxes (EBIT) by total assets:

. power
. earnmg .
, (BEP) ratio EBIT
= -- ---
Bas1c
Total assets
$283.8
= $2,000 = 14·2 %.

Industry average = 18.0%.

ratio shows the raw earning power of the firm's assets, before the influence
ad ~everage, and it is useful for comparing firms with different tax situ·
W different degrees of financial leverage. Because of its low turnover
 ai.d JoW profit margu\
~ ts as is the averagp O'!fflPlllr
"";u;.sse
tuf1l 00 Total ~sets i • •
Jle . of ~et income to total . . .
..-he ratio d taXes:
'•· interest an .
aft~ ' - ' .' .' . Net
.; ·' total assets = ROA =
Return on
$113.5
= $2,000 = 5.7'1.
Industry average = 9.0CJo.
• I

. roDnv
,.,,. . e's 5·7% return is well below the 9% avPraoe f&1.t.i.m
---o toe.;
J.V..c ults from (1) the company's low basic earning power
return resresulting from its
. above-average use of debt both
of _,..-,,L
est costs . 1 . . '
to be relative1y ow. · · - ,1 1 ~
income .

Return on Con1mon Equity.

. ately, the most important, or ."bottomline," accountingratioisthe
01
. ~e to common equity, which measures the return on common eq
J,J\C , , , •

. _ ROE ~ Net income available• A•W

Return on common equity - - . , . . Conmlcm e&!(ifltJ
' '
$113.5
= $896 = 12.7%.
Industry average = 15.0%.
Stockholders invest to get a return on their money, and this ratio~
they are doing in an accounting sense; MicroDrive's 12.7% return is below
industry average, but not as far below as the return on total assets. This
better result is due to the company's greater use of debt, a point that'w
1
in detail later in the chapter. · · •· · .

SELF-TEST
Identify and write out the equations for four ratios that show the comliftil
ogement, and debt management on profitability.
Why is the basic earning power ratio useful?
Why does the use of debt lower the ROA? ·
What does ROE measure? Since interest expense lowers Dl'Ofn, do. •
A company has $200 billion of sales and $10 billion al net inca-. II
financed half by debt and half by common equity. What is its ~
What is its ROE? (20%) Would ROA increase if the firm used•
J I

;~otlce thot EBIT is earned throughout the year, whereas the tolol mse1s figure is an _ _._.. . .
E d~efore, 11 would be conceptually better to calculate this ratio as EBIT/Awrage osllll --au:
dn ing ,0 ssetsl/2). We hove not made this adjustment because the published raliol uied
tho not include it. However, when we construct our own comporoti-.. raliol, wt dd . . .
e some adjustment would also be appropriate for the next two ratios, ROA and RC*-,
 ket value ratios, relates .the firm's st<>ck p . ~
~ofrat i:::::-~ alue per share. These ratios give :rnanag;:t oita ,
r~~:,
A

£1::-1, of the company's past performan ce :1 ...d et\t 1..

~• ftt ""II

ntl.ifJf,~ look , en
:e
tionot'1Vllildnvestots uwlA
. . . sset management, debt manageme nt, and Proa ~
liqmthdity, market value ratios will be high, and the stn..~~
pn,sped& If thgoode
:wJil probably be as high as can be expect .
ed ., ""~ Dtl:
.. • -~ '

Price/Earnings Ratio
. eamin 5 (PIE) ratio shows how much investors are _w illing to a
Thellarpncdif rtedgprofits MicroDrive's stock sells for $23, so with an EPs Pfy Per
do o ~ . · o $2-27
its P/E ratio IS 10.1. ,. •
. , ,, Price per share
Price/earnings (P/E) ratio = Earnings per share

$23.00
= $2 _27 = 10.1 times.
Industry average = 12.5 times.
. .
pIE ratios are higher for finns with strong growth prospects, other things h 1
constant, but they are lower for riskier firms. Because MicroDriv e's P/E rati e~
below the average, this suggests that the company is regarded as being somew~~
riskier than most, as havi~g poo:er g~owth prospects, or both. I~ th_e spring of
2006, the average PIE ratio for firms m the S&P 500 was ~1.52, md1cating that ~
investors were willing to pay $21.52 for every dollar of earnmgs.

Price/Cash Flow Ratio

In some industries , stock price is tied more closely to cash flow than to net income.
Consequently, investors often look at the price/cash flow ratio, where cash flow is
defined as net income plus depreciation and amortizati on:
Price per share
Price/ cash flow ratio = C .fl h
as11 ow p er s arc

$23.00 .
=- - = 5.4 times.
$4.27
Industry average = 6.8 times.
MicroDrive's price/cash flow ratio is also below the industry average, once again sug·
gesting that its growth prospects are below average, its risk is above average, or both.
Note that some analysts look at multiples beyond just the price / earnings and
the price/cash flow ratios. For example, dependin g on the industry, some may
look at ~easures such as price/sale s, price/cus tomers, or price/EBITDA ~r
share. U1timately, though, value depends on free cash flows so if these "exotic"
ratios do not forecast future free cash flow, they may turn o~t to be misleading.
 in the case of the dot~
..c: trtle 1.:n:--:..
~;costing 1nvestors many uUUUI15.
JJ1

ket/Book Ratio
~af . of a stock's market price to its book fllqe -Ill
.t 1 4 1

ft,e i:'tlestors regard the co~pany. Companies With

0
ta"'W.r
t,oW iJl~ enerally sell at higher multiples of book ~·-..~
ott eqUJ1i!t,
returns-
we find MicroDrive's book value per shaie:
.
Book value per share = Common ~
· Shares outs~
$896
= 50 = $17.92.
ow we divide the market price by the book value to get a market/book (M/B)
~tio of 1.3 times:

. Market price per share

Market/ book ratio = M/ B = -::--:---=--:---=--~:..:
. Book value per share
$23.00
Id = $17.92 = 1.3 times.
is Industry average = 1.7 times.
at . . .
of Investors are w illing to pay relatively little for a dollar of MicroDrive'~ book value.
3f ~ The average compa ny in the S&P 500 had a market/book ratio of about 4.03 in
the spring of 2006. Since M / 8 ratios typically exceed 1.0, this means that investors
are willing to pay m o re for stocks than their accounting book values. The book
vJlue is a record of the past, showing the cumulative amount that stockholders
have invested , eithe r directly by purchasing newly issued shares or indirectly
through retaining earnings. In contrast, the market price is forward-looking, incor-
porating investors' expectations of future cash flows. For example, in May 2006
Alaska Air had a m a rke t/ book ratio of only 1.69, reflecting the crisis in the airlines
industry caused by the terrorist attacks and oil price increases, whereas Dell
Computer 's m arket/ book ratio was 14.79, indicating that investors expected Dell's
past successes to continue.
Table 4-2 su mmarizes MicroDrive's financial ratios. As the table indicates, the
company has ma ny p roblem s.
., .
SELF-TEST
Describe three ratios that relate a firm's stock price to its earnings, cash Row, and book
and write out their equations. · ·
How do market value ratios reflect what investors think about a stock's risk and expedld
What does the price/ earnings (P/El ratio show? If one firm's P/E ratio is lower than that of
are some factors that might explain the differe~e? · •
How is book value per share calculated? Explain why book values often deviate M
A company has $6 billion of net income, S2 ~illion of dep~ation and amort~
mon equity, and 1 billion shores of stock. If its stock pnce is. $96 per share,
ratio? (16) Its price/cash flow ratio? (121 Its market/book ratio? (1.2)
 Calculation
.
Ratio A~ 1
'
$1,000
~ ;
=3.2x 4.2x
$310 P0a,

o...nta um - lmwdories $385 =1 .2x

$310 2.1 X
c.nntWties P0a,

.,..
.....Sales $3,000
$615

$375
=4.9X 9.ox
P0a,
'

R.c.iwables =46 days 36 days

Annual sales/ 365 $8.21 9 P0a,

Sales $3,000
=3 .0 x 3.0x
'
Net fucad assets $1,000 0~

Sales $3,000
= 1.Sx 1.8x
Total assets $2,000 So~I
Total tMJbt"lities $1,064
=53.2% 40.0%
Total assets $2,000 Highlri~

Earnings bebw interest and taxes (EBIT) $283.8

= 3.2 x · 6.0x
lnlarest charges $88 Low 1,~ ~-
$411.8
1
I
f811DA + lease payments = 3.0 x 4 .3x
$136 lowlri~
..,_, + Principal payments + lease payments

Net income available lo common stockholders $1 13.5

-- = 3.8% 5.0% Poor
Sales $3,000

Earnings before interest and taxes (EBIT) $283.8

-- = 14.2% 17.2% Poor
• powsflEPJ Total assets $2,000

Net income available lo common stockholders $113.5

-- = 5.7% 9 .0% Poor
..... fROAJ Total assets $2,000

Net income available to common stockholders $113.5 15 .0% Poor

-- = 12.7%
Common equity $896

Price per share $23.00 Low

(P/EJ - - = 10. l X 12.5 x
Earnings per share $2.27

Price per share $23.00 6 .8 X Low

l:,w = 5 .4 x
J Cosh flow per share $4.27

Market price per share $23.00

= 1.3 x l .7X Low
WBJ Boolt value per share $17.92
 d Analysis, Comm
1re;
· 3Jl
percent Change Anl1ll
d' ti ell
lyzetren smra os~Wi ~~~
....,,, to ~ether a firm'~ finan"':'1 COndilion i,, 11\o\y
;, lfl'P"s as to trend analysis, one sunply Plots a ,_,..,_
du•••·
I'.,,. 'fo do_• raph shows that MicmDrive's rate of ntur,,
f_.,;or• 4-J. This lning since 2004, even though the industry•-
illfiS"[," s - n d";; ~he other ratios could be analy>.ed sinulai\y;
,qoitY ,; stabl~- A alysis and percent change analysis an, two otbe,
,.iati•• !JlOD size10';entify
1 trends in financtal statements, Conu.o., 'i,11!!Ql,mq._
CO!Jli,e used arative analysis, and some sou- of industry ~
""' can seful in cor;tsociates, are presented exclusively in con-.. aiae lii,,,_
T
iS•"?,°3 nagernent . se analysis, a\1 income statement items an, diVided by llloa
JtiS1'JJ\iv•a common e shsiz
eet items are . divided by total " - f · Thus, a """'- .;,
all balanc t shows each item as a percentage o sa1es, and a coll\Dlon B\r.e
and staternen ach item as a percentage of total " - · The amoantage al
iJ1CO!Jl; sh••' sho';"s: is that it facilitates comparisons of balance sbeet,i 111d
t,alaJ\ oJ\ size ana Y er time and across companies.
coJllJll e statementsst ovtements are very easy to generate if the finandal 8""""-
in'°~o!Jlrnon size al fact, if you obtain your financial statemenis from a ~

~r~
in a spreadshee;;n;ncial statements, then it is easy to cut and \10Sle 11,,e data (<ii:
wit standardized
h
a new com
pany over Your original company's data, and all of your ~

Rate o f Return on Common Equity, 2003-2007

ROE
(%)

16.0%

12.0%

8.0%

4.0%

0.0°10 L____
2003
.....J__ _ _ _ _l , __ _ _

2004
--:2006~----;2001
2005

9R"k
. Management Associates was formerly known as RObert Morris Associates.
·
 mon Size Income Statement

1JW1
JaclUIU'Y 200'1 2006
I
Com 100.09'.
100.0,. 100.0-.
~ 87.69',
IM"" U.8'll> 12.4%
2.fl'll,
....... 111-.depr. & amart. (EBITDA) ~ J .2%
, 90.4..
w ...... 9.6% 9.5% 9.2%
... tuea (EBln 2.9% ~
!,!'& 7.1%
8.3% 6.5%
. . . . . . . . . . . . . . . (EBT) 2.6% ~8~
) V"" 3.9% 4.3%
5.0%
WGn pie.'altd dtvidellds 0.0% 0.1 % 0.1 ~
lhlllllwltedad di,..._ ~ J.llt ~tl
. . . . . . _ . . C011U11oa stodmolden (proffl margin)

~ ~ may not lofal exactly due to rounding wfien printed.

iu1as will be valid for the new company. We generated Table 4-3 in the Excel fil

•
;;:;2 Ch 04 Tool Kit.xis. This table contains MicroDrive's 2006 an~ 2007 conun0 ~
size income statements, along with the composite stateme~t for the md us try. (Note:
Rounding may cause addition/subt~action differences m Tables 4-~ a~d 4-4.)
S.. FM 12 Ch tu Tool MicroDrive's operating costs are slightly above _average, as are its interest
K1l.m for all details.
expenses, but its taxes are relatively I~w bec~use of its low EBJT. The net effect of
ail these forces is a relatively low profit margm.
Table 4-4 shows MicroDrive's common size balance sheets, along with the
industry average. Its accounts receivable are si?nificantly ~1igher than the indus-
try average, its inventories are significantly higher, _a nd it uses fa r more fixed
charge capital (debt and preferred) than the average firm .
A final technique used to help analyze a firm's finandal statements is percent-
age change analysis. In this type of analysis, grow th rates are calculated for all
income statement items and balance sheet accounts. To illustra te, Table 4-5 con-
tains MieroDrive's income statement percentage change analysis for 2007. Sales
increased at a 5.3% rate during 2007, whi]e total operating costs increased at a
slower 4.8% rate, leading to 7.9% growth in EBIT. The fact that sa les increased
faster than operating costs is positive, but this "good news " was offset by a 46.7%
increase in interest expense. The significant grow th in interest l'>-. pense caused
growth in both earnings before taxes and net income to be nega ti ve. Thus, the per-
centage change analysis points o~t that the d ecrease in reported income in 2007
resulted almost exclusively from an increase in interest expense. This conclusion
could be reached by analyzing dollar amounts, but percentage cha nge analysis
simplifies the task. The same type of analysis applied to the ba lance sheets would
s~ow that assets grew at a 19.0% rate, largely because inventories g revv at a whop-
pmg 48.2% rate (see FM12 Cit 04 Tool Kit.xis). With only a 5.3o/c g rowth in sales,
the extreme growth in inventories should be of great concern to MicroDrive's
managers.

-
~ -110 tu Tool
. ."'al delails.
The conclusions reach~d in common size and percentage cha nge analyses
generally parallel those derived from ratio analysis. H owever occasio na lly a seri-
~~s deficiency is highlighted by only one of the three analy ti~a l tecchniques. Also,
Jt 1s often useful to have all three and to drive home to m a nagem ent, in slightly
 Tre nd Analy •
sis, Common Size An I .
a ys1s, a nd Percent Cha nge Ana lysis

M icroDrive Inc .: Comm on Size Bolo

nee SLneet
A B
C
0
2007 E F
Indust ry
188 ets--= == --- --- ---- S!! !!!l !~L ---- ~~ Com ite
---. ..M2006
2007 l~
189 MS h and equiva lents
19<1 C~rt-term invest ments 1.0%
0.5%
191 Sh nts receivable l .2% 0.9%
A,CCOU 0.0% 3.9 %
92 17.8%
1 invent ories 18.8% 18.8%
193 T tal curren t assets 19.8%
30.8%
194 °
195 r,let p
!ant and equip ment 40.8%
59.2%
50.0%
24.7~
48.2%
gt; Total assets 50.0% 51.8%
1 ~ \00.0.2'P,
197 [)abilities and equity ~
198 unts payab le
~ ,\cCO 1.8%
j ..iotes payable 3.0% 1.8%
200 ... 4.4%
5.5%
,\ccru als 3.6%
20 1 Total curren t liabili ties 3.6% 7.0% 7.7%
9.8%
20; 1,ong- term ~~~ds 30.2%
15.5% 13.1%
2~ Total liab1ht1es 37.7% 34.5%
40.0% 53.2%
205 Preferred stock . 0.0% 47.6%
2 Total comm on equity . 2.0% 2.4%
, 60.0% 44.8%
Total liabilities a nd equity 50.0%
~ ~
208 ~

Note: Percentages may not total exactly due to rounding whe

n printed .

.-

Micr oDrive Inc.: Incom e Statement Percentage Chan

ge Analysis

A B C D E
Percent Change
218 Base year = 2006 in
219
2007
220 Net sales
5.3%
221 Oper ating costs
4.8%
222 Earnings befor e interest, taxes, depr. & amort. (EBIT
DA) 8.7%
223 Depreciation and amortization 11.1%
224 Earn ings before interest and taxes (EBIT) 7.9%
225 Less interest 46.7%
226 Earn ings bdor e taxes (EBT) (3.5% )
227 Taxes (40 % ) (3.5% )
228 Net Income befor e prefe rred dividends (3.5% )
229 Preferred dividends 0.0%
230 Net Income available to common stockholders (3,R )
231

Note: Percentages may not total e xactly due to rounding

when printed.

n
 -~-~~~e,hange,
tilli•dflie=adKl~-Thus, a
.. t. .. .
and co
..

tios Together: " I

tEquation I ••

: sometimes easy-to miss the forest for all the trees: Ma ,

"'t 15
1 bil·ty, . nagerg
raniteWOl'IC that ties together a firm' s prof't
1a 1 , its asset usa
'USeofifebt. This section provides just such a m~del. The effi. prolt
total assets turnover is called the Du Pont equation, and it givesU:
on assets<ROA):
ROA= Profit margin X Total assets turnover
l •
.._ Net income X Sales
_ _ . ~ _. Sales . Total assets

wl ~roDrive, the ROA is

ROA= 3.8% X 1.5 = 5.7%.
Drive made 3.8%, or 3.8 cents, on each dollar of sales, a nd its as.sets were ~
over 1.5 times during the year. Therefore, the compan y earned a return of
OIi Is assets. .
lo-find the return on equity (ROE), multiply the rate of return on assets (ROA)
flf"U, multiplier, whieh is the ratio of assets to common equity:
. .
. ul . li Total assets
Eqwty m tip er = Common eqmty . 14·21

,._.have a lot of leverage (i.e., a lot of liabilities or preferred stock) ~ill nee·
have a high equity multiplier-the more leverage, the less the equity,
higher the equity multiplier. For example, if a firm has $1,000 of assets
Ni1111nced with $800 (or 80%) liabilities and preferred s tock, then its equity
$D), and its equity multiplier will be $1,000/$200 = 5. Had it used only
lfabilities and preferred stock, then its equity would have been $800, and
multiplier would have been only $1,000 / $800 = 1.25 .10
, the mum on equity (ROE) depends on the ROA and the use of

Dtllt---~ .;. ~ A E I
•- A A • --
A A- = 1- - --
E ·1y 1· -
. · qui mu hp1,er .

al cWit, olhw liabilities and . . lhCJII

. - .equ1y, A Is lolal ~ andp,eferr~ Slock; in other words, D is all finonc,ng other .
• A/E IS the equity multiplier.
 . e's ROE is
tJi01'I)rlV

<") = 5.7%
,. = 12.7
n combine Equations 4-1 and 4-3 to
w we ca . the assets
r,.o. h 0 ws how the prot 1t
-...1 · margm,
which 5 bine to determine the ROE: i '
tiplier c.orn , - .
ROE = (Profit margin)(Total assets~
Net income Sales "Total
- - - - - X - - - - X ~-__;~;;;;.,~~-::
- Sales Total assets · Common emilltr.._..

For MicroDrive, we_have

ROE = (3.8%)(1.5)(2.23) . .
=·12.7%. ·
The 12.7% rate of return could, of com:se, be calculated ·
Total assets cancel, leaving Net income/Common equity_= $1!
However, the Du Pont equation· shows how the profit~
turnover, and the use of debt interact to 'determine the return on equity.
The insights provided by the Du Pont model are valuable, and.it
for "quick and dirty" estimates of the impact that operating ohan
returns. For example, holding all else equal, if MicroDrive can dnve
of sales/total assets to 1.8, then its ROE will improve to (3A~
15.25%. For a more complete "what if'! analysis, most oom~
ing model such as the one described in Chapter 14. . ·· .:. ,; .'
• • l

SELF-TEST .
Expla in how the extended, or modified, Du Pont ·
of ROE. · ;. · , . . ,
What is the equity multiplier? . ,. . ,
A company has a profit margin of 6%, a total asset
Wha t is its ROE? (18~) ' , .. .
I' 1

4.9 Compar~tive Ratios and Bencbmar ! . . . •' . . . •

.
Ratio analysis involves comparisons-a: company's rati..°"
th0se of other firms in the same industry, that is, with ·
However, like most firms , MicroDrive's managers goen~ •
co .
. rnpare their ratios with those of a smaller set of the
rue~. This technique is called benchmarking, and the
~ar~son are called benchmark companies. For exaro.p•
gainst five other firms that its management ea
companies with operations similar to its own. •
l

b
 - •" ph,aacial Slalefflellls

. · fo Dell Computer Corporation, the C

Comparative RatiOSth r Technology Sector, and the S&p soo°"' I
Hardware Industry,.
8
,. . •Computer
~
Hardware Technology .
Del Industry' Sectorh ' ~ . SI,

11:96 " 27.13 32.75 ~

P/E ratio 1.4.79 9.13 5.60 - .s2
Market to book 14.79 9.71 7.47 7.03
Price to 1angible book 16.18 ., 28.39 26.57 15.~
76
Price to cash Row 26 1482 ·
6.39 ~• I • 14.~
Net ~ t ~ .rgin: .. 0.91 ,, , 1.48 1• ~.7J ' 1.29
~ratio 1. n 1.05 J .22 1.ao
Current ratio 0.12 0.08 0.21 0.55
1.ong-1erm debt to equity , 0.12 -' 0 .09 0.24 0.69
Total debt to equity 5.87 12.99. 14.21
Interest coverage (TIE)c 11.82 11.05 7.96
15.60
Return on assets 35.60 18.60 19.32
67.22
Return on equity 61.88 12.77 12.54
86.06
Inventory turnover 1.86 0.84 0.96
2.44
Asset turnover
.d • secl of 50 firms including IBM, Dell, Apple, Sun Microsystems

~z:=~:-
an. computer hardware 1n ~shy ,s compo

11 industries,
•
including_communications
netwc,IU, ..,..k;onductofs, and software and progra~ming.
equipment, computer hardware,
•
c0111pgar
., '
-Dell hod men Interest income than interest expense. ·
Soun:i,: Adopi.d from http:/jwww.investor.reufen.com, May 2, 2006 .

• -, • f

· Many c~mpanies also benchmark v~rious parts _of their overall operatioq
against top companies, whether they are m th~ sam~ mdustry or not. For exam-
ple, MicroDrive has a division that sells hard dnves directly to consumers through
catalogs and the Internet. This division's shipping department benchmarks
against L.L Bean, even.though they are in different industries, because L.L. Bean's
shipping department is one of the best. MicroDrive wants its own shippers to
sbive to match L.L. Bean's record for on-time shipments. ·
Comparative ratios are available from a number of sources, including Valut
Line, Dun and Bradstreet (D&B), and the Annual Statement Studies published by
Risk Management Associates, which is the national association of bank loan offi·
cers. Table 4-6 reports selected ratios from Reuters.
Each data-supplying organization uses a somewhat different set of ra~
designed fo~ its own purposes. For example, D&B deals mainly with small firms,
many of which are proprietorships, and it sells its services primarily to banks and
oth~ lend~. Theref~re, D&B is toncerned largely with the creditor 's viewpoint,

:=u
and its ratios emphasize current assets and liabilities, not market value ratios, So,

dm:
often
select a comparative data source, you should be sure that your empha.SiS
!1'8t of !he agency whose ratios you plan to use. Additionally, there are
,.a..111r tiorut! differences in the ratios presented by different sources so before
=,! a ~thrce, be sure to verify the exact definitions of the ratios to ens~e consit
- . , WI your own work. l •
 Ratio Analysis on the Web

: A greot source for comparative ratios is hllp: ~

ifWeS'°'•,euters.com . You have to regfsler lo 1111 the
, ~ite, but registration is free . .9nce you register and
in this web page contains a ~eld to enter O CCllft.
1
ogny'~ ticker symbol. Once you do this, ctick the
.. t>°symbol" ratio button, and then click lhe •Go" but. .._~
ledor,11111

SELF-TEST Differentiate between trend analysis and comparative ratio analysi

Why is it useful to do a comparative ratio analysis" '·
What is benchmarking? ·

4.10 Uses and Limitations of Ratio Analysis

Ratio analysis is used by three ~ groups: (1) ~nagers, who employ ratios to
help analyze, control, an~ thus improve the~ firms' operations; (2) crtdit analysts,
including bank loan offi~ers ~d bond rating analysts, who analyze ratios to
help ascertain a company s a~1~ty to pay its debts; and (3) stock analysts, who are
interested in a company s effic1ency,_risk, and growth prospects. In later chapters
we will look more closely at the basic factors that underlie each ratio, which will
give you a better ~dea about_ how to i~terpr~t.and use ratios. Note, ~ough, that
while ratio a~alys~s can pr?~1de _useful information concerning a C?~pany's oper-
ations and fmanc1al condition, 1t does ha~e limitations that necessitate care and
judgment. Some potential problems are list~ l;,elo~: · .·· , . , • .• ..
1
1. Many large firms operate different divisions in different industries, and for
such companies it is difficult to develop a meaningful set of industry aver•
ages. Therefore, ratio analysis is more useful for small, narrowly focused firms -
than for large, multidivisional ones. .. '· · .
2. Most firms want to be better than average, so merely attaining av~ge per- .
formance is not necessarily g?Od, As a ~arget f~r high~level performance, it is
best to focus on the industry leaders' ratios. Benchmarking helps in this
3. Inflation may have badly distorted firms' balance sheets-recorded values are
regard.
often substantially different from "true" values. Furth~,·because inflation
affects both depreciation charges and inventory costs, profits are also affected.
Thus, a ratio analysis for one firm over time, or a comparative ~ i s ·of
firms of different ages, must·be interpreted with judgment. ' ' ' '
4. Seasonal factors can also distort a ratio analysis. For example, the inventory
turnover ratio for a food P!'C>Cessor will be radically different if ~e ~
sheet figure used for inventory is the one just before versus just ~er the dose
of the canning season. This problem c a n ~ ~ by using 1:1\~thlf~":
ages for inventory (and recei_vables) when calcula~g tumov~.ra~~ ,
5. Firms can employ "window dressing" techniques to make theit financial state-
ments look stronger. To illusl!ate, a Chic;ago builder borrpwed on ~-~~
basis in late December. Because the loan was,for more than 1 year_ it.was not
included in current liabilities. The builder held ~e proceeds of the~ as tash.
This improved his current and quick raqps, and ~de~ year -end ~.-
look stronger. However, the improvement was strictly window ~ li,_.
later the builder paid off the loan and the balance sheet was back at tlle"okl level.
 lttnllll!ii'U lliQ.~

•
~ As -
can affect financial stat~
:ambng firmS. A)so, if one firm leases a substan~
~
• ,

ra~
.
.:s•.:c-- ~ ~ -
t then its assets may appear low reiati
not appear on the balance sheet. At the \1e to ~
. ..--~ted with the lease obligation may not be sho\Vn~s
I

abtillli'
tw;...: . . : artificially improve both the turnover and the d ill ~
~.....
~ .,, can . about whether a particular ratio is "g00ct•• ebt,ralicie
C O ~ n t ratio may indicate a strong liquidity or ~ ;
8
' or excessive cash, which is bad (because excess cas~•tioti,
fs good, . asset). Similarly, a high fixed assets turnove.. .11\ 1-1.
lllllltllf a.noneanung ffi . t1 th t . . ,,. ratio ..,
deQP.leav.her that a firm uses its assets e c1en y or a 1t 1s undercapi ~y
and cannot afford to b1:1y enough assets. ,, ,, ~
8 A mm may have some ratios that look good and othe~s that look ''I.~,
· ~ it difficult to tell whether the company overall 1s strong or ;;1,-
..:...;caJ procedures can be used to analyze the net effects of 'al
l{owevei; sta u.,u . tt· d. . a set
tios. Man banks and other lending orgaruza ons use 1scnminant anai ~
: statistical ~que, to analyze firms' ~an~ial r~tios, _a nd then dassifiSJa,
films according to their probability ?f getting mt? fma~c1al trouble. . the
9. .JM«tive use of financial ratios reqwres that the finanaal statements on Whi
. they are based be accurate. Revelations in 2001 and 2002 of accounting fra ch
t,ysuch industiy giants as WorldO;>m and Enron showed that financial staUd
ments are not always accurate; hence information based on reported data C:
be misleading.
Ratio ·analysis is useful, ·b ut analy~ts should_be a~are of th~se problems and
ina1-e adjustments as necessary. Ratio a~alys!s conducted_ m a mechanical,
unthinldng manner is danger(?US, bu_t u~ed mtell~gently an~ with goo? j~d8"IIJent,
it can provide useful insights into a firms opera~ons. Yo_ur J~d? ment m interpret. ~
mg a set of ratios is bound to be weak at this pomt, but 1t will unprove as you go
duwgh the remainder of the book.

,.,,
• ••
,,,_ al usen of rotio analysis. Would the different users emphasize the some or different types
~ pro&lems with ratio analysis.
'

f.11 ·Looking Beyond the Numbers

,
HopeluUy, working through this chapter has helped your unders tanding of finan·
daJ statements and improved your ability to interpret accounting numbers. These
important and basic skills are necessary when making business d ecisions, evalu-
ating perfo.rmance, and forecasting likely future developments.
So~ ~ndal analysis involves more than just calculating numbers-good
:IP¥¥51:8 reqwres that certain qualitative factors be considered when evaluating a
' ~ ~y. These factors, a~ summarized by the American Association of
•a11111wf¥.1µal Inv~tors (AAII), include the following:

le c:omp~y's re~enues tied to one key customer? If so, the company's

~ may decline dramatically if the cust~mer goes elsewhere.
. extent are the company's revenues tied to one key produd?
that 1!!1Y on a single product may be more efficient and focused,
m diversification
, .
increases
. risk.
 bat exten t does the COIDpUIJ 111J •
-r;
3. .. ~e supplier roay lead to · ·
lle1Mlli
, ·W:a t . percen:tage of the conq,.._y'• "-M--~l'!l
.
4. ' panie s with a large percentage of
~~~g her grow th an~ large r profit ~
,. iZ opera tions also find that the value <>f ~
se:~
P
on the value o~ th~ ~~ currency. Thus, ~ lions
te addit ional nsks for firms with large ~A Mi ~fflWL~
~apoliti cal stabi lity of the regio n is impo rtant.
~at abou t the competitio~?. It is important tD ~
5. actio ns of the curre nt comp etitio n and the likelihood of lleW
_....,.--.
the futur e.
What are the comp any's future prospects? Does the company
m-~-- -
~ c:rilkallv~
6. in resea rch and devel opme nt? If so, i~ future prospects may d
...~ ~
on the succe ss of produ cts curre ntly m the pipeline.
}low does the legal and regula~ory envir onme nt affect the
~ ..:.4ili'-\t
7· crucial to facto r in the effects of p ~ ~. regulations m\d ~
~
lawsu its. , . . ·

SELF-TEST What are some qualitative factors analysts should corisNlir whiri
'· ": · , · , .. ,
financial performance?

summary '. I J

used by ~
The prima ry purp ose of this chapt er was\t o discuss techniques
vedd areb bdi
and mana gers to analy ze financial statements.'The key conce ptsco
below. :, t , , 1 • • 1 , •

• finan cial state ment analy sis generally begins '_Vith a set
o_~ fioaad,J ,. . ,
d esigned to r~ve~l a comp anys streng ths and weaknesses as
5011!-~ -
~~ ~ -
other compan~es m th_e same md~stry,_ and to sh~~ wh~ er i~
_ . ... . .
tion has been 1mpr ovmg or deten oratin g over time.
• Liqu idity ratio s show the relationship of a firm's current
assets to its C1,1,ffeDt
mmollJ,y ~
liabilities, and thus its ability to meet maturing de~.ts. Two .~ ~
liquid ity ratios are the curre nt ratio and th~ qui~ or acid tat, rati9. ·
ti1ft::
• Asset mana geme nt ratios meas ure ~ow effec tivelf a fimi
is ~
assets . Thes e ra tios inclu de inve~ tory turnove~ ~ay~ ,sales out
s~~ ,-..
asset s turno ver, and total assets turno ver.
e • Debt mana geme nt ratios reveal (1) the extent to which the firm
is~ wlh,
hey, ~ -
debt and (2) its likelihood of defaulting on its debt obligations. iT
debt ratio, times -inter est-ea rned ratio, and EBITDA cover age ratio.
,~~
:I • Profi tabili ty ratio s show the combined eff~ of liqu idity
~ ~
a and debt mana geme nt policies OJ\ operating results. ~
1f marg in on sales , the basic earni ng powe r ratio, the return
on taqffl ,. . . .
..-........-'-fl
and the retur n on comm on equity. _ - _- _ .~: . _:· . .-::-.
• Mark et value ratios relate the firm's stock price to its earnin
P.1
s book value per share, thus giving management an indica tion
think of the comp any's past perf o~c e a~d future prospects.
Tbele
:? the price /earn ings ratio, price/cash flow ratio, and th&
I, • Trend analy sis, wher e one plots a ratio ov~ time,.is ·
whet her the firm's condition has been impro ving 91'
 ~
ififi!analal··Statements

~ is designed to show how the profit lllargin

---'OD
~ ta.rnever ratio and the use of debt interact to detellnin °n Sille.
equity. The'firm1 1J management can use the Du Pont s e the
,,_ ways ofimproving performance. · . , .
l'il.'
YSletri tott Qf \
• Bendunaddng is the process of companng a particular coin , ,
of similar, successful companies. , ., Pany """'
group . . - .'I!\ ~
.. ~tio analysis has limitations! but used with. care and judgment, it can
helpful. · · he "~

(lue_stions
(4-1) Define each of the following terms: ,
a. Uquidity ratios: current ratio; quick, or acid test, r~tio
b. Asset management ratios: inve~tory ,ru,rnover ratio; days sales outst · .
(OS()); fixed assets turnover ratio; total assets turnover ratio at\dlt\g
c. Financial leverage: debt ratio; times-interest-earned (TIE) ratio; coverag
d. Profitability ratios: profit margin on sales; basic earning power (BEPt ra~o
return on total assets (ROA); return on common equity (ROE) ratio;
e. Market value ratios: price/earnings (P /E) ratio; price/ cash flow ratio·
market/book (M/B) ratio; book value per share ,
· f. Trend analysis; comparative ratio analysis; benchmarking
g. Du Pont equation; window dressing; seasonal effects on ratios

(4-2) f"mancial ratio analysis is co~ducted by_ manag~rs, equity inv.estors, Iong-tenn
aeditors, and short-term creditors. What 1s the pnmary emphasis of each of these
groups in evaluating ratios? I

(4-3) Over the past year, M. D. Ryngaert & Co. has realized an increase in its current
ratio and a drop mits total assets turnover ratio. However, the company's sales,
quick ratio, and fixed assets turnover ratio have remained constant. What explains
these changes?

(4-4) Profit margins and turnover ratios vary from one industry to another. What
differences would you expect to find between a grocery chain such as Safeway
and a steel company? Think particularly about the turnover ratios, the profit
margin, and the Du Pont equation.
How might (a) seasonal factors and (b) different growth rates distort a comparative
ratio analysis? Give some examples. How might these problems be alleviated?

(.UJ Why is it sometimes misleading to compare a company's financial ratios with

~ of other firms that operate in the same industry?

Self-Test Problellls Solutions Appear in Appendix A

nd
Argent~ratio1_1 had_earnings per shar~ of $4 last year, and it paid a $2 divide ~
Total retained earnings increased by $12 million during the year while book valu
per share at year-end was $40. Argent has no preferred stock, and no new cornrnon
 Problems 147

s_t~ -':as issued during the year. If Argent's year-end debt (which equals its to~l
liabilities) was $120 million, what was the company's year-end debt/ assets ratio .

IST-2) The following data apply to Jacobus and Associates (millions of dollars):
Ratio Analysis
Cash and marketable securities $100.00
Fixed assets $283.50
Sales $1,000.00
Net income $50.00
Quick ratio 2.0X
Current ratio 3.0X
DSO 40.55 days
ROE 12%
Jacobus has no preferred stock-only common equity, current liabilities, and long-
term debt.
a. Find Jacobus's (1) accounts receivable (A/R), (2) current liabilities, (3) current
assets, (4) total assets, (5) ROA, (6) common equity, and (7) long-term debt.
b. In part a, you should have found Jacobus's accounts receivable (A/ R) =
$111.1 million. If Jacobus could reduce its DSO from 40.55 days to 30.4 days
while holding other things constant, how much cash would it generate? If this
cash were used to buy back common stock (at book value), thus reducing the
amount of common equity, how would this affect (1) the ROE, (2) the ROA,
and (3) the total debt/ total assets ratio?

Easy
Problems 1- 5
pf0blefilS Answers Appear in Appendix B

14-1) Greene Sisters has a DSO of 20 days. The company's average daily sales are $20,000.
Days Sales Outstanding What is the level of its accounts receivable? Assume there are 365 days in a year.

(4-2) Vigo Vacations has an equity multiplier of 2.5. The company's assets are financed
Debt Ratio with some combination of long-term debt and common equity. What is the com-
pany's debt ratio?

(4-3) Winston Washers' stock price is $75 per share. Winston has $10 billion in total
Market/ Book Ratio assets. Its balance sheet shows $1 billion in current liabilities, $3 billion in long-
term debt, and $6 billion in common equity. It has 800 million shares of common
stock outstanding. What is Winston's market/book ratio?

14-4) A company has an EPS of $1.50, a cash flow per share of $3.00, and a price/ cash
Price/Earnings Ratio flow ratio of 8.0 times. What is its P/E ratio?

(4-5) Needham Pharmaceuticals has a profit margin of 3% and an equity multiplier of

ROE 2.0. Its sales are $100 million and it has total assets of $.50 million. What is its ROE?
Intermediate
Problems 6-10
14-6) Donaldson & Son has an ROA of 10%, a 2% profit margin, and a return on equity
Du Pont Analysis equal to 15%. What is the company'-s total assets turnover? What is the firm's
equity multiplier?