FoCFinance CH 2

Fundamentals of Corporate Finance
Fifth Edition, Global Edition
Chapter 2
Introduction to Financial
Statement Analysis
Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Chapter Outline
2.1 Firms’ Disclosure of Financial Information
2.2 The Balance Sheet
2.3 The Income Statement
2.4 The Statement of Cash Flows
2.5 Other Financial Statement Information
2.6 Financial Statement Analysis
2.7 Financial Reporting in Practice

Learning Objectives
• Know why the disclosure of financial information through
financial statements is critical to investors
• Understand the function of the balance sheet
• Understand how the income statement is used
• Interpret a statement of cash flows
• Understand the management’s discussion and analysis
and the statement of stockholder’s equity
• Analyze a firm through its financial statements, including
using the DuPont Identity
• Understand the main purpose and aspects of the
Sarbanes-Oxley reforms following Enron and other
financial scandals

2.1 Firms’ Disclosure of Financial
Information (1 of 5)
• Financial Statements
– Accounting reports issued periodically that present past
performance information and a snapshot of the firm’s
assets and the financing of those assets
– Investors, financial analysts, managers, and other
interested parties such as creditors rely on financial
statements to obtain reliable information about a
corporation

• Public companies in the United States must file
financial results with the U.S. Securities and
Exchange Commission (SEC)
– On a quarterly basis (10-Q)
– On an annual basis (10-K)
• The annual report with financial statements must be
sent to their shareholders every year

• Preparation of Financial Statements
– Generally Accepted Accounting Principles (GAAP)
▪ Set by the Financial Accounting Standards Board
(FASB) to provide a common set of rules and a
standard format for public companies’ reports
▪ Corporations are required to hire an auditor to
– Check the annual financial statements
– Ensure they are prepared according to GAAP
– Provide evidence that the information is reliable

– International Financial Reporting Standards
▪ International Accounting Standards Board (IASB)
– Established in 2001 by representatives from 10
countries, including the U.S.
– Since 2005 all publicly traded European Union
companies are required to follow IFRS
– Used by many other countries, including
Australia, and several countries in Latin America
and Africa
– Accepted by all major stock exchanges around
the world except U.S. and China

– Convergence to IFRS in the United States is likely in
the near future
▪ The Sarbanes-Oxley Act of 2002 included a
provision that U.S. accounting standards move
toward international convergence
▪ AS of early 2019, the SEC looks likely to allow U.S.
companies to use IFRS to provide supplemental
information, but will still require them to file their
financials in accordance with U.S. GAAP

2.2 The Balance Sheet (1 of 11)
• Also called “Statement of Financial Position”
• Lists the firm’s assets and liabilities
• Provides a snapshot of the firm’s financial position at a
given point in time

Global Corporation Balance Sheet for
2019 and 2018 ($ millions) (1 of 2)
Table 2.1 Global Corporation Balance Sheet for 2019 and 2018 ($ millions)
Assets 2019 2018

blank Blank
Current Assets
Cash 23.2 20.5
Accounts receivable 18.5 13.2
Inventories 15.3 14.3
Total current assets 57.0 48.0
blank blank
Long-Term Assets
Net property, plant, and 113.1 80.9
equipment
Total long-term assets 113.1 80.9
Total Assets 170.1 128.9

Global Corporation Balance Sheet for
2019 and 2018 ($ millions) (2 of 2)
Liabilities and Stockholders’ 2019 2018
Equity
blank blank
Current Liabilities
Accounts payable 29.2 26.5
Notes payable/short-term debt 5.5 3.2
Total current liabilities 34.7 29.7
blank blank
Long-Term Liabilities
Long-term debt 113.2 78.0
Total long-term liabilities 113.2 78.0
Total Liabilities 147.9 107.7
Blank Blank
Stockholders’ Equity
Common stock and paid-in 8.0 8.0
surplus
Retained earnings 14.2 13.2
Total Stockholders’ Equity 22.2 21.2
Total Liabilities and 170.1 128.9
Stockholders’ Equity

• The Balance Sheet Identity

– The two sides of the balance sheet must balance
The Balance Sheet Identity
Assets = Liabilities + Stockholders’ Equity

• Current Assets
– Cash and other marketable securities
▪ Short-term, low-risk investments
▪ Easily sold and converted to cash
– Accounts receivable
▪ Amounts owed to the firm by customers who have
purchased on credit
– Inventories
▪ Raw materials, work-in-progress and finished goods
– Other current assets
▪ Catch all category that includes items such as
prepaid expenses

• Long-Term Assets
– Assets that produce tangible benefits for more than
one year
– Recorded value reduced through a yearly deduction
called depreciation according to a schedule that
depends on an asset’s life span
▪ Depreciation is not an actual cash expense, but a
way of recognizing that fixed assets wear out and
become less valuable as they get older

• Long-Term Assets
– The book value of an asset is its acquisition cost less
its accumulated depreciation
– Other long-term assets can include such items as
property not used in business operations, start-up
costs in connection with a new business, trademarks
and patents, and property held for sale

• Liabilities
– Current Liabilities
▪ Accounts payable
– The amounts owed to supplier's purchases
made on credit
▪ Notes payable and short-term debt
– Loans that must be repaid in the next year
– Repayment of long-term debt that will occur
within the next year
▪ Accrual items
– Items such as salary or taxes that are owed but
have not yet been paid, and deferred or
unearned revenue
• Liabilities
– Net working capital
▪ The capital available in the short term to run the
business:
Net Working Capital = Current Assets - Current Liabilities

• Liabilities
– Long-Term Liabilities
▪ Long-term debt
– A loan or debt obligation maturing in more than a
year

• Stockholders’ Equity
– Market Value Versus Book Value
▪ Book value of equity
– Net worth from an accounting perspective
– Assets – Liabilities = Equity
– True value of assets may be different from book

value
▪ Market capitalization
– Market price per share times number of shares
– Does not depend on historical cost of assets
Example 2.1 Market versus Book
Value (1 of 4)
Problem
• If Global has 3.6 million shares outstanding, and these
shares are trading for a price of $10.00 per share, what is
Global’s market capitalization? How does the market
capitalization compare to Global’s book value of equity?

Value (2 of 4)
Solution
Plan
• Market capitalization is equal to price per share times
shares outstanding. We can find Global’s book value of
equity at the bottom of the right side of its balance sheet.

Value (3 of 4)
Execute
• Global’s market capitalization is
( $10.00/share )× ( 3.6 million shares ) = $36 million.
This market capitalization is significantly higher than
Global’s book value of equity of $22.2 million.

Value (4 of 4)
Evaluate
• Global must have sources of value that do not appear on
the balance sheet. These include potential opportunities
for growth, the quality of the management team,
relationships with suppliers and customers, etc.

Example 2.1a Market versus Book
Value (1 of 3)
Problem:
– Rylan Enterprises has 5 million shares outstanding.
– The market price per share is $108.
– The firm’s book value of equity is $50 million.
– What is Rylan’s market capitalization?

Value (2 of 3)
Solution:
Plan:
• Market capitalization is equal to price per share times
shares outstanding

Value (3 of 3)
Execute:
– Rylan’s market capitalization is $540 million
▪ 5 million shares×$108 share = $540 million

• Market to Book Ratio

– The ratio of a firm’s market capitalization to the book
value of stockholders’ equity:
Market Value of Equity
Market-to-Book Ratio=
Book Value of Equity
– Also called Price-to-Book (P/B ) ratio

– Sometimes used to classify firms as value stocks
(low M/B ) or growth stocks (high M/B )

Figure 2.1 Market-to-Book Ratios in
2019
This figure presents market-to-book ratios of different firms and groups of firms in 2019.
Firms that might be classified as value stocks (low market-to-book ratios) are in red and
those that might be classified as growth stocks (high market-to-book ratios) are in blue.

• Enterprise Value
– The value of the underlying business assets,
unencumbered by debt and separate from any cash
and marketable securities
Enterprise Value = Market Value of Equity + Debt - Cash

Example 2.2 Computing Enterprise
Value (1 of 3)
Problem
• In December 2018, Kraft Heinz Co. (KHC) had 1.22 billion
shares outstanding, a share price of $43.04, a book value
of debt of $30.87 billion, and cash of $1.13 billion. What
was Kraft Heinz’s market capitalization (its market value of
equity)? What was its enterprise value?

Value (2 of 3)
Solution
Plan
Share Price $43.04
Shares 1.22 billion
Outstanding
Cash $1.13 billion
Debt (book) $30.87 billion
• We will solve the problem using Enterprise

Value = Market Value of Equity + Debt-Cash.
We can compute the market capitalization by multiplying the share
price times the number of shares outstanding. We are given the
amount of cash and the amount of debt.

Value (3 of 3)
Execute
• Kraft Heinz had a market capitalization of
$43.04/share×1.22 billion shares = $52.51 billion.
Thus, Kraft Heinz’s enterprise value was
52.51 + 30.87-1.13 = $82.25 billion
Evaluate
• The value of Kraft Heinz’s underlying business, separate from any
cash it holds, should be equal to the total value of the financial claims
(equity and debt) on that business, which is its enterprise value of
$82.25 billion.

Example 2.2a Computing Enterprise
Value (1 of 3)
Problem:
• Rylan Enterprises has a share price of $108 and 5 million
shares outstanding
• The firm also has $107 million in total debt and $33 million
in cash
• What was Rylan’s enterprise value?

Value (2 of 3)
Solution:
Plan:
Share Price $108
Shares 5 million
Outstanding
Cash $33 billion
Debt $107 billion
We will solve the problem using

Enterprise value = Market capitalization + Debt - Cash

Value (3 of 3)
Execute:
• As computed in Example 2.1a, Rylan had a market
capitalization of
$108/share×5million shares = $540 million
Evaluate:
• Rylan’s Enterprise
Value = $540 + $107-$33 = $614 million
Enterprise Value = Market Value of Equity + Debt - Cash

2.3 The Income Statement (1 of 4)
• The income statement lists the firm’s revenues and
expenses over a period of time
– Sometimes called the profit and loss or “P&L”
statement
• The last or “bottom” line of the income statement shows
net income
– A measure of its profitability during the period
– Also referred to as the firm’s earnings

• Earnings Calculations
– Gross Profit
▪ Revenues (Net Sales ) - Cost of Sales = Gross Profit
– Operating Expenses
▪ Gross Profit-Operating Expenses = Operating Income

– Earnings Before Interest and Taxes (EBIT)
▪ Operating Income +/-Other Income = Earnings Before Interest and Taxes
– Pretax and Net Income

▪ EBIT +/-Interest Income (Expense ) = Pretax Income
▪ Pretax Income-Taxes = Net Income

Global Corporation’s Income Statement
Sheet for 2019 and 2018 (1 of 2)
Table 2.2 Global Corporation’s Income Statement Sheet for 2019 and 2018
Global Corporation
Income Statement
Year ended December 31 (in $ millions)
blank
2019 2018
Net sales 186.7
Minus 153.4
176.1
Minus 147.3
Cost of sales -153.4 -147.3

Gross Profit 33.3
Minus 13.5
28.8
Minus 13
Selling, general,
and administrative -13.5 -13
expenses Minus 8.2 Minus 7.6
Research and -8.2 -7.6

development Minus 1.2 Minus 1.1
Depreciation and -1.2

amortization -1.1
Operating Income 10.4 7.1
Global Corporation’s Income Statement
Sheet for 2019 and 2018 (2 of 2)
Blank Blank
Other income
Earnings Before 10.4 7.1
Interest and Taxes
(EBIT)
Minus 7.7 Minus 4.6
Interest income -7.7 -4.6

(expense)
Pretax Income 2.7 2.5
Minus 0.7 Minus 0.6
Taxes -0.7 -0.6

Net Income 2.0 1.9
Earnings per share: $0.56 $0.53
Diluted earnings per $0.53 $0.50
share:

• Earnings Per Share
– Net income reported on a per-share basis
Net Income $2.0 million

EPS= = =$0.56 per Share
Shares Outstanding 3.6 million Shares

• Earnings Per Share
– Fully diluted EPS increases number of shares by:
▪ Stock options issued to employees
– The right to buy a certain number of shares by a
specific date at a specific price
▪ Shares issued due to conversion of convertible
bonds
– Convertible bonds are corporate bonds with a
provision that gives the bondholder an option to
convert each bond into a fixed number of shares
of common stock

2.5 Income Statement Analysis
• EBITDA
– Financial analysts often compute a firm’s earnings
before interest, taxes, depreciation, and amortization,
or EBITDA
– Because depreciation and amortization are not cash
flows, this subtotal reflects the cash a firm has earned
from operations

2.6 The Statement of Cash Flows (1 of 9)
• The firm’s statement of cash flows uses the information
from the income statement and balance sheet to
determine, during a set period:
– How much cash the firm has generated
– How that cash has been allocated
• Cash is important because it is needed to pay bills and
maintain operations and is the source of any return of
investment for investors

• The statement of cash flows is divided into three sections
which roughly correspond to the three major jobs of the
financial manager:
1. Operating activities
2. Investment activities
3. Financing activities

Global Corporation’s Statement of
Cash Flows for 2019 and 2018 (1 of 2)
Table 2.3 Global Corporation’s Statement of Cash Flows for 2019 and 2018
Global Corporation
Statement of Cash Flows
Year ended December 31 (in $ millions)
Blank
2019 blank
2018 blank
Operating activities
Net income 2.0 1.9
Depreciation and 1.2 1.1
amortization blank Blank
Cash effect of changes

in Minus 5.3 Minus 0.3
Accounts receivable -5.3 -0.3

Minus 0.5
Accounts payable 2.7 -0.5

Minus 1.0 Minus 1.0
Inventory -1.0
Minus 0.4
-1.0
Cash from operating
-0.4
activities 1.2
Global Corporation’s Statement of
Cash Flows for 2019 and 2018 (2 of 2)
blank
2019 blank
2018 blank
Investment activities Minus 33.4 Minus 4.0
Capital expenditures -33.4

Blank
-4.0
Blank
Acquisitions and other

investing activity Minus 33.4 Minus 4.0
Cash from investing -33.4 -4.0

activities blank blank
Financing activities Minus 1.0 Minus 1.0
Dividends paid -1.0 -1.0

Blank Blank
Sale or purchase of stock

Increase in short-term 2.3 3.0
borrowing
Increase in long-term 35.2 2.5
borrowing
Cash from financing 36.5 4.5
activities
Change in cash and cash 2.7 1.7
equivalents

• Operating Activity
– Use the following guidelines to adjust for changes in
working capital:
▪ Accounts receivable:
– Adjust the cash flows by deducting the
increases in accounts receivable
– This increase represents additional lending by
the firm to its customers and it reduces the cash
available to the firm

– Accounts payable:
▪ Similarly, we add increases in accounts payable
▪ Accounts payable represents borrowing by the firm
from its suppliers
▪ This borrowing increases the cash available to the
firm

– Inventory:
▪ Finally, we deduct increases to inventory
▪ Increases to inventory are not recorded as an
expense and do not contribute to net income
▪ However, the cost of increasing inventory is a cash
expense for the firm and must be deducted
– We also add depreciation to net income, since it is not
a cash outflow

• Investment Activity
– Subtract the actual capital expenditure that the firm
made
– Also deduct other assets purchased or investments
made by the firm, such as acquisitions

• Financing Activity
– The last section of the statement of cash flows shows
the cash flows from financing activities
▪ Dividends paid
▪ Cash received from sale of stock or spent
repurchasing its own stock
▪ Changes to short-term and long-term borrowing

• Financing Activity
– Payout Ratio and Retained Earnings
Retained Earnings = Net Income - Dividends
Dividends
Payout Ratio=
Net Income

• The last line of the Statement of Cash Flows combines the

cash flows from these three activities to calculate the
overall change in the firm’s cash balance over the time
period of the statement

Example 2.3 The Impact of
Depreciation on Cash Flow (1 of 5)
Problem
• Suppose Global had an additional $1 million depreciation
expense in 2019. If Global’s tax rate on pretax income is
26%, what would be the impact of this expense on Global’s
earnings? How would it impact Global’s cash at the end of
the year?

Solution
Plan
• Depreciation is an operating expense, so Global’s
operating income, EBIT, and pretax income would be
affected. With a tax rate of 26%, Global’s tax bill will
decrease by 26 cents for every dollar that pretax income is
reduced. In order to determine how Global’s cash would be
impacted, we have to determine the effect of the additional
depreciation on cash flows. Recall that depreciation is not
an actual cash outflow, even though it is treated as an
expense, so the only effect on cash flow is through the
reduction in taxes.
Execute
• Global’s operating income,E B I T, and pretax income would fall by $1
million because of the $1 million in additional operating expense due to
depreciation.
• This $1 million decrease in pretax income would reduce Global’s tax
bill by
26%×$1 million = $0.26 million. Therefore, net income would fall by

$1-$0.26 = $0.74 million.

• On the statement of cash flows, net income would fall by
$0.74 million, but we would add back the additional
depreciation of $1 million because it is not a cash expense.
Thus, cash from operating activities would rise by
-$0.74 + 1 = $0.26 million.
Therefore, Global’s cash balance at the end of the year
would increase by $0.26 million, the amount of the tax
savings that resulted from the additional depreciation
deduction.

Evaluate
• The increase in cash balance comes completely from the
reduction in taxes. Because Global pays $0.26 million
bless in taxes even though its cash expenses have not
increased, it has $0.26 million more in cash at the end of
the year.

Example 2.3a The Impact of
Problem:
• Suppose Global wants to accelerate its depreciation
method so that it can generate $2 million in cash
• If its tax rate is 34%, how much additional depreciation
expense would it need to generate the extra cash?

Solution:
Plan:
• With a tax rate of 34%, Global’s tax bill will decrease by 34 cents for
every dollar that pretax income is reduced
• In order to generate $2 million in extra cash, Global would need to
increase cash flow from operations (NI+ depreciation) by $2 million
• CF from operations =( EBITDA - Dep) (1-t) + Dep = EBITDA (1-t) + t × Dep
• Since there’s no change in EBITDA because of additional

depreciation,
t×Dep must equal $2 million

Execute:
• 0.34×Dep = $2 million
• Dep = $5.88 million
• This $5.88 million decrease in pretax income would reduce

Global’s tax bill by
34%  $5.88 million = $2 million
• Therefore, net income would fall by 5.88-2 = $3.88 million

Execute:
• On the statement of cash flows, net income would fall by $3.88 million,
but we would add back the additional depreciation of $5.88 million
because it is not a cash expense
• Thus, cash from operating activities would rise by
-$3.88 + 5.88 = $2 million
• Thus, Global’s cash balance at the end of the year would increase by
$2 million, the amount of the tax savings that resulted from the
additional depreciation deduction

Evaluate:
• The increase in cash balance comes completely from the
reduction in taxes
• Because Global pays $2 million less in taxes even though
its cash expenses have not increased, it has $2 million
more in cash at the end of the year

2.5 Other Financial Statement
Information
• Statement of Stockholders’ Equity
– Change in Stockholders’ Equity
= Retained Earnings + Net Sales of Stock

= Net Income – Dividends + Sales of Stock –Repurchases of stock
• Management Discussion and Analysis

• Notes to the Financial Statements

2.6 Financial Statement Analysis (1 of 24)
• Investors often use accounting statements to:

– Compare the firm with itself by analyzing how the firm
has changed over time
– Compare the firm to other similar firms using a
common set of financial ratios

• Profitability Ratios
– Gross Margin
▪ How much a company earns from each dollar of
sales after paying for the items sold
Gross Profit
Gross Margin=
Sales

– Operating Margin
▪ How much a company earns before interest and
taxes from each dollar of sales
Operating Income
Operating Margin=
Sales

– Net Profit Margin
▪ The fraction of each dollar in revenues that is
available to equity holders after the firm pays its
expenses, interest, and taxes
Net Income
Net Profit Margin=
Sales

• Liquidity Ratios
– Current Ratio
▪ The ratio of current assets to current liabilities
Current Assets
Current Ratio=
Current Liabilities

– Quick Ratio
▪ The ratio of only cash and “near cash” assets to
current liabilities
Current Assets-Inventory
Quick Ratio=
Current Liabilities

– Cash Ratio
▪ The most stringent liquidity ratio:
Cash
Cash Ratio=
Current Liabilities

• Asset Efficiency
– Asset Turnover
▪ A first broad measure of efficiency
Sales
Asset Turnover=
Total Assets

• Asset Efficiency
– Fixed Asset Turnover
▪ Since total assets include assets that are not directly
involved in generating sales, a manager might also
look at fixed asset turnover
Sales
Fixed Asset Turnover=
Fixed Assets

2.6 Financial Statement Analysis (10 of
24)
• Working Capital Ratios

– Accounts Receivable Days
▪ The firm’s accounts receivable in terms of the
number of days’ worth of sales that it represents
Accounts Receivable
Accounts Receivable Days=
Average Daily Sales

24)
• Working Capital Ratios

– Inventory Days and Inventory Turnover
▪ Inventory Days is the number of days’ cost of goods
sold represented by inventory
▪ Inventory Turnover tells how efficiently a company
turns its inventory into sales
Cost of Goods Sold

Inventory Turnover=
Inventory

Example 2.4 Computing Working
Capital Ratios (1 of 3)
Problem
• Compute Global’s accounts payable days, inventory days,
and inventory turnover for 2019.

Solution
Plan and Organize
• Working capital ratios require information from both the
balance sheet and the income statement. For these ratios,
we need inventory and accounts payable from the balance
sheet and cost of goods sold from the income statement
(often listed as cost of sales).
• Inventory = 15.3,
• Accounts payable = 29.2,
• Cost of goods sold ( cost of sales ) = 153.4
Execute
Accounts payable 29.2

Accounts payable days= = =69.48
Average Daily Cost of Goods Sold (153.4/365 )
Inventory 15.3
Inventory days= = =36.40
Average Daily Cost of Goods Sold (153.4/365 )
Cost of Goods Sold 153.4
Inventory turnover= = =10.03
Inventory 15.3

Example 2.4a Computing Working
Problem:
• Compute Rylan’s accounts receivable days, accounts payable days,
and inventory days based on the following information:
‒ Accounts Receivable = $635

‒ Inventory= $925.0
‒ Accounts payable = $1,259
‒ Sales = $8,052
‒ Cost of goods sold ( cost of sales ) = $5,140

Solution:
Plan and Organize:
• Working capital ratios require information from both the
balance sheet and the income statement

Accounts Receivable 635

Accounts Receivable Days= = =28.8
Sales/365 ( 8,052/365 )
Inventory 925
Inventory Days= = =65.7
Cost of Goods Sold/365 ( 5,140/365 )
Accounts Payable 1,259
Accounts Payable Days= = =89.4
Cost of Goods Sold/365 ( 5,140/365 )

Evaluate:
• Assuming that Rylan’s accounts payable at year-end on its
balance sheet is representative of the normal amount
during the year, Rylan is able, on average, to take about
89.4 days to pay its suppliers
• This compares with the 28.8 days that it waits on average
to be paid (its accounts receivable days)
• Rylan typically takes 65.7 days to sell its inventory

24)
• Interest Coverage Ratios

– Also known as times interest earned (TIE)
‒ TIE = Earnings divided by interest
– Can define earnings as operating income, EBIT, or

EBITDA
– Assesses how easily a firm is able to cover its interest
payments

Example 2.5 Computing Interest
Coverage Ratios (1 of 4)
Problem
• Assess Global’s ability to meet its interest obligations by
calculating interest coverage ratios using both EBIT and
EBITDA.

Solution
Plan and Organize
• Gather the EBIT, depreciation, and amortization and
interest expense for each year from Global’s income
statement.
2018: EBIT = 7.1, EBITDA = 7.1 + 1.1, Interest expense = 4.6
2019: EBIT = 10.4, EBITDA = 10.4 + 1.2, Interest expense = 7.7

Execute
• In 2018 and 2019, Global had the following interest
coverage ratios:
EBIT 7.1 EBITDA 7.1+1.1

2018: = =1.54 and = =1.78
Interest 4.6 Interest 4.6
EBIT 10.4 EBITDA 10.4+1.2
2019: = =1.35 and = =1.51
Interest 7.7 Interest 7.7

Evaluate
• The coverage ratios indicate that Global is generating
enough cash to cover its interest obligations. However,
Global’s low—and declining—interest coverage could be a
source of concern for its creditors.

Example 2.5a Computing Interest
Problem
• Assess Rylan’s ability to meet its interest obligations by
calculating interest coverage ratios using both EBIT and
EBITD

Solution:
Plan and Organize:
• Selected information from Rylan’s income statement

blank
2018 2019
EBIT 1,090 1,163
1,090 + 407 = 1,497 1,163 + 262 = 1,425
EBITDA 1,090 + 407=1,497 1,163 + 262=1,425

Interest Expense 135 114

• In 2018 and 2019, Rylan had the following interest
coverage ratios:
EBIT 1,090 EBITDA 1,497

2018: = =8.07 and = =11.09
Interest 135 Interest 135
EBIT 1,163 EBITDA 1,425
2019: = =10.20 and = =12.50
Interest 114 Interest 114

Evaluate:
• The coverage ratios indicate that Rylan’s is generating
enough cash to cover its interest obligations
• Increasing interest coverage is a good sign for creditors,
though it may reflect relatively low use of leverage

24)
• Leverage Ratios
– Debt-Equity Ratio
▪ The debt-equity ratio is a common ratio used to
assess a firm’s leverage
Total Debt
Debt-Equity Ratio =
Total Equity
▪ This ratio can be calculated using book or market

values

24)
• Leverage Ratios
– Debt-to-Capital Ratio
▪ The debt-to-capital ratio calculates the fraction of
the firm financed by debt:
Total Debt
Debt-to-Capital Ratio =
Total Equity + Total Debt
▪ This ratio can also be calculated using book or

market values

24)
• Leverage Ratios
– Net Debt
▪ While leverage increases risk to equity holders,
firms may also hold cash reserves in order to reduce
risk
– Another useful measure is net debt
Net Debt =Total Debt-Excess Cash and Short-Term Invesments

24)
• Leverage Ratios
– Debt-to-Enterprise Value Ratio
Net Debt
Debt-to-Enterprise Value Ratio =
Market Value of Equity + Net Debt
Net Debt
=
Enterprise Value

24)
• Leverage Ratios
– Equity Multiplier
▪ Total Assets/Book Value of Equity

24)
• Valuation Ratios
– Analysts and investors use a number of ratios to
gauge the market value of the firm
– The most important is the firm’s price-earnings ratio
(P/E )
▪ The P/E ratio is often used to assess
whether a stock is over- or under-valued based on
the idea that the value of a stock should be
proportional to the earnings it can generate
Market Capitalization Share Price
P / E Ratio = =
Net Income Earnings per Share
24)
• Valuation Ratios
– P/E ratios can vary widely across industries and tend to
be higher for industries with higher growth rates
– P/E to Growth (PEG) Ratio
▪ One way to capture the idea that a higher P/E

can be justified by higher expected earnings growth
▪ It is the ratio of the firm’s
P/E to its expected earnings growth rate
▪ The higher the PEG ratio, the higher the price relative to
growth, so some investors avoid companies with PEG
ratios over 1

Example 2.6 Computing Profitability
and Valuation Ratios (1 of 4)
Problem
• Consider the following data for Walmart Stores and Target Corporation ($ billions):
blank
Walmart Target
Stores Corporation
(WMT) (TGT)
Sales 514 75
Operating
22 4
Income
Net Income 7 3
Market
Capitalization 276 38
Cash 8 2
Debt 55 13
• Compare Walmart’s and Target’s operating margin, net profit margin, P/E
ratio, and the ratio of enterprise value to operating income and sales.

Solution
Plan
• The table contains all of the raw data, but we need to compute the
ratios using the inputs in the table.
‒ Operating Margin = Operating Income/Sales
‒ Net Profit Margin = Net Income/Sales
‒ P/E Ratio = Price/Earnings = Market Capitalization/Net Income
‒ Enterprise Value to Operating Income = Enterprise

Value/Operating Income
‒ Enterprise Value to Sales = Enterprise Value/Sales

Execute
22
Walmart had an operating margin of =4.3%, a net profit margin of
514
7 276
=1.4%, and a P/E ratio of =39.4.
514 7
Its enterprise value was 276 + 55-8 = $323 billion. Its ratio to operating income is
323 323
=14.7, and its ratio to sales is 514
=0.63.
22
4 a net profit margin of

Target had an operating margin of =5.3%,
75
3 38
75
=4.0%, and a P/E ratio of =12.7.
3
Its enterprise value was 38 + 13-2 = $49 billion. Its ratio to operating income is
49 49
=12.3, and its ratio to sales is =0.65.
4 75

Evaluate
• Target has a higher operating margin, net profit margin,
and enterprise value-to-sales ratio, but a significantly lower
P/E ratio.

Example 2.6a Computing Profitability
Problem:
• Consider the following data for Campbell Soup Co. and General Mills, Inc. ($ millions):
blank
Campbell’s General Mills,
Soup Co. (CPB) Inc. (GIS)
Sales $8,052.0 $17,774.1
Operating
Income $1,080.0 $2,851.8
Net Income $458.0 $1,855.2
Market
Capitalization $13,371.0 $31,660.0
Cash $333.0 $741.4
Debt $7,106.0 $15,018.3
• Compare Campbell’s and General Mill’s operating margin, net profit margin,
P/E ratio, and the ratio of enterprise value to operating income and sales

Solution
Plan:
• The table contains all of the raw data, but we need to compute the
ratios using the inputs in the table.
‒ Operating Margin = Operating Income / Sales

‒ Net Profit Margin = Net Income / Sales
‒ P/E ratio = Price / Earnings = Market Capitalization/Net Income
‒ Enterprise value to operating income = Enterprise
Value / Operating Income
‒ Enterprise value to sales = Enterprise Value / Sales

Execute:
Ratio Campbell’s General Mills
2, start fraction 851.8 over 17 end fraction, 774.1 = 16.0%
Operating Margin 080

1, start fraction 080 over 8 end fraction, 052 = 13.4%
851.8
1, , 052=13.4% 2, , 774.1 = 16.0%
8 17
1, start fraction 855.2 over 17 end fraction, 774.1 = 10.4%
Net Profit Margin 855.2

start fraction 458 over 8 end fraction, 052 = 5.7%
458 1, , 774.1 = 10.4%

, 052=5.7%
8 17
start fraction 13,371 over 458 end fraction = 29.19 31, start fraction 660.0 over 1 end fraction, 855.2 = 17.07
P/E Ratio 13,371

=29.19 31,
660.0
, 855.2 = 17.07
458 1
Enterprise Value 31,660.0+15,018.3 – 741.4 =

31,660.0 + 15,018.3 minus 741.4 = 45,936.9
13,371.0+7,106.0-333.0 =
13,371.0 + 7,106.0 minus 333.0 = 20,144.0
45,936.9
20,144.0
Enterprise Value to
936.9
45, start fraction 936.9 over 2 end fraction, 851.8 = 16.11
144.0
20, start fraction 144.0 over 1 end fraction, 080.0 = 18.65
Operating Income 20, , 080.0 = 18.65 45, , 851.8 = 16.11

1 2
20, start fraction 144.0 over 8 end fraction, 052.0 = 2.50 45, start fraction 936.9 over 2 end fraction, 851.8 = 16.11.
Enterprise Value to Sales 144.0 936.9

20, , 052.0 = 2.50 45, , 774.1 = 2.58
8 17

Example 2.6a Computing Profitability and
Valuation Ratios (4 of 4)
Evaluate:
• Note that Campbell’s operating and net profit margins are
quite a bit lower than General Mill’s
• Campbell’s had a larger
P/E
ratio, which can be explained in part by their greater use of
leverage as seen later in Example 2.8a
• However, the ratios of enterprise value to sales were
almost the same for the two firms

24)
• Operating Returns
– Return on Equity
▪ Evaluating the firm’s return on investment by
comparing its income to its investment
Net Income
Return on Equity =

24)
– Return on Assets
▪ Evaluating the firm’s return on investment by
comparing its income to its assets
Net Income
Return on Assets =
Total Assets

24)
– Return on Invested Capital
▪ After-tax profit generated by the business, excluding
interest, compared to capital raised that has already
been deployed
EBIT (1 - tax rate )
Return on Invested Capital =
Book Value of Equity + Net Debt

Example 2.7 Computing Operating
Returns (1 of 3)
Problem
• Assess how Global’s ability to use its assets effectively has
changed in the last year by computing the change in its
return on assets.

Returns (2 of 3)
Solution
Plan and Organize
• In order to compute ROA, we need net income, interest
expense, and total assets.
blank
2018 2019
Net Income 1.9 2.0
Interest Expense 4.6 7.7
Total Assets 128.9 170.1

Returns (3 of 3)
Execute
In 2019, Global’s ROAwas
( 2.0+7.7 )
=5.7%,
170.1
compared to an ROA in 2018 of (1.9+4.6 )

=5.0%,
128.9
Evaluate
• The improvement in Global’s ROA from 2018 to 2019
suggests that Global was able to use its assets more
effectively and increase its return over this period.

24)
• The DuPont Identity

– This expression says that ROE can be thought of as
net income per dollar of sales (profit margin) times the
amount of sales per dollar of equity
 Net Income   Sales   Net Income   Sales 

ROE =   =   
 Total Equity   Sales   Sales   Total Equity 

24)
• The DuPont Identity

– This final expression says that ROE is equal to
▪ Net income per dollar of sales (profit margin) times
▪ Sales per dollar of assets (asset turnover) times
▪ Assets per dollar of equity (equity multiplier)
 Net Income   Sales   Total Assets   Net Income   Sales   Total Assets 
ROE =    =    
 Sales   Total Equity   Total Assets   Sales   Total Assets   Total Equity 

Example 2.8 DuPont Analysis (1 of 4)
Problem
• The following table contains information about Walmart
(WMT) and Macy’s (M). Compute their respective ROEs
and then determine how much Walmart would need to
increase its profit margin in order to match Macy’s ROE.
blank
Profit Margin Asset Turnover Equity

Multiplier
Walmart 1.4% 2.3 2.8
Macy’s 4.3% 1.3 3.0

Solution
Plan and Organize
• The table contains all the relevant information to use the
DuPont Identity to compute the ROE. We can compute the
ROE of each company by multiplying together its profit
margin, asset turnover, and equity multiplier. In order to
determine how much Walmart would need to increase its
profit margin to match Macy’s ROE, we can set Walmart’s
ROE equal to Macy’s, keep its turnover and equity
multiplier fixed, and solve for the profit margin.

Execute
Using the DuPont Identity, we have:
ROE WMT = 1.4% × 2.3 × 2.8 = 9.0%

ROEM = 4.3% × 1.3 × 3.0 = 16.8%
Now, using Macy’s ROE, but Walmart’s asset turnover and equity
multiplier, we can solve for the profit margin that Walmart needs to
achieve Macy’s ROE:
16.8% = Margin × 2.3 × 2.8
16.8%
Margin= =2.6%
6.44

Evaluate
• Walmart would have to increase its profit margin from 1.4%
to 2.6% in order to match Macy’s ROE. It would be able to
achieve Macy’s ROE with lower profit margin than Macy’s
because of its higher turnover.

Example 2.8a DuPont Analysis (1 of 4)
Problem:
• The following table contains information about Campbell’s
(CPB) and General Mills (GIS)
• Compute their respective ROEs and then determine how
much General Mills would need to increase its equity
multiplier in order to match Campbell’s ROE
Blank
Profit Asset Equity
Margin Turnover Multiplier
Campbell’s 5.7% 0.97 6.84
General Mills 10.4% 0.78 2.97

Solution:
Plan:
• We can compute the ROE of each company by multiplying
together its profit margin, asset turnover, and equity
multiplier
• In order to determine how much General Mills would need
to increase its equity multiplier to match Campbell’s ROE,
we can set General Mills’ ROE equal to Campbell’s, keep
its profit margin and turnover fixed, and solve for the equity
multiplier

Execute:
• Using the DuPont Identity, we have:
‒ ROECPB = 5.7%×0.97×6.84 = 37.8%
‒ ROEGIS = 10.4%×0.78×2.97 = 24.1%
• Now, using Campbell’s ROE, but General Mills’ profit margin and
asset turnover, we can solve for the equity multiplier that General
Mills needs to achieve Campbell’s ROE:
‒ 37.8% = 10.4%×0.78 x Equity Multiplier

37.8%
‒ Equity Multiplier =4.67
8.1%

Evaluate:
• General Mills would have to increase its equity multiplier
from 2.97 to 4.67 in order to match Campbell’s ROE
• This large increase in equity multiplier is required because
of its lower asset turnover (0.78 vs. 0.97) (lower efficiency),
despite its higher profit margin (10.4% vs. 5.7%)

A Summary of Key Financial Ratios (1
of 7)
Table 2.4 A Summary of Key Financial Ratios
Manufactu
Ratio Formula Retail Service S&P 500
ring
blank blank blank Blank blank
Profitabilit
y Ratios
Gross Gross Profit start fraction gross profit over sales end fraction
Sales 35.3% 31.1% 52.8% 39.9%

Margin
Operating Operating Income
9.2% 7.1% 10.9% 15.7%
start fraction operating income over sales end fraction
Sales
Margin
Net Profit Net Income
start fraction net income over sales end fraction.
Sales
2.0% 2.4% 1.5% 5.3%
Margin

of 7)
Manufactu
ring
blank
Liquidity
Ratios Blank blank Blank blank
start fraction current assets over current liabilities end fraction
Current Current Assets

Ratio Current Liabilities 2.5 1.4 1.6 1.9
start fraction current assets minus inventory over current liabilities end fraction
Quick Ratio Current Assets-Inventory

Current Liabilities 1.8 0.7 1.5 1.5
start fraction cash over current liabilities end fraction
Cash Ratio Cash

0.9 0.3 0.8 0.6
Current Liabilities

of 7)
Manufacturi
ng
Efficiency
and
Working blank blank blank Blank Blank
Capital
Ratios
Accounts Accounts Receivable
Receivable Average Daily Sales
start fraction accounts receivable over average daily sales end fraction
58.6 8.8 67.2 62.8

Days
Fixed Asset Sales
start fraction accounts receivable over average daily sales end fraction
4.5 6.8 12.3 4.5

Turnover Fixed Assets

of 7)
Manu
facturing
start fraction sales over total assets end fraction
Total Asset Sales

0.7 1.7 0.6 0.4
Turnover Total Assets
start fraction costs of goods sold over inventory end fraction
Inventory Cost of Goods Sold

Inventory 3.9 5.9 30.2 5.3
Turnover
blank
Interest
Coverage blank blank blank Blank
Ratios
start fraction E B I T over interest expense end fraction
EBIT/Interest EBIT
3.4 4.9 2.8 3.5
Coverage Interest Expense
start fraction E B I T D A over Interest expense end fraction
EBITD
EBITDA
A/Interest 6.3 8.8 6.2 6.2
Interest Expense
Coverage

of 7)
Manu
facturing
blank
Leverage Ratios blank blank blank blank
start fraction total debt over book value of total equity end fraction
Book Debt-to- Total Debt

Equity Ratio Book Value of Total Equity 28.3% 50.1% 28.5% 51.6%
start fraction total debt over book value of total equity end fraction
Market Debt-to-
Equity Ratio Total Debt 9.3% 21.9% 7.4% 20.7%
Book Value of Total Equity
start fraction total debt over total debt + total debt end fraction
Debt-to-Capital
Ratio Total Debt
21.7% 33.3% 21.7% 35.1%
Total Equity+Total Debt
start fraction total assets over total equity end fraction
Debt-to- Total Assets

Enterprise Value 0.0% 8.0% 0.0% 2.2%
Total Equity
start fraction net debt over enterprise value end fraction
Equity Multiplier Net Debt

Enterprise Value 1.8 2.4 2.1 2.4

of 7)
Manu
facturing
blank
Operating
Returns
blank blank blank blank
start fraction net income over book value of equity end fraction
Return on
Equity
Net Income
1.3% 10.0% 2.9% 6.2%
start fraction E B I T left parenthesis 1 minus tax rate right parenthesis over Book value of equity + net debt end fraction
Return on
Assets
Net Income+Interest Expense
Total Assets 2.4% 5.8% 2.7% 3.8%
start fraction net income + interest expense over total assets end fraction.
Return on
Invested EBIT (1 -Tax Rate )
Capital (ROI Book Value of Equity+Net Debt

17.1% 18.9% 17.5% 16.4%
C)

of 7)
Ratio Formula Manufacturig Retail Service S&P 500

Blank
Valuation Blank Blank blank blank
Ratios
start fraction market value of equity over book value of equity end fraction
Market-to-
Book Market Value of Equity 2.9 2.1 3.5 2.2
Ratio
start fraction share price over earning per share end fraction.
Price-to-
Share Price
Earnings 23.4 18.7 29.1 22.0
Earning per Share
Ratio
start fraction enterprise value over E B I T or E B I T D A or sales end fraction
Enterprise
Value
Ratios (typical Enterprise Value
values shown
EBIT or EBITDA or Sales 9.9 11.4 13.6 13.3
are based on
EV/EBITDA)
Source : Standard and Poors’ Compustat based on averages of fiscal year 2017.

2.7 Financial Reporting in Practice (1 of
4)
• Even with safeguards such as GAAP and auditors,

though, financial reporting abuses unfortunately do
take place
• Enron
– One of the most infamous recent examples of fraud

4)
• The Sarbanes-Oxley Act

– In 2002, Congress passed the Sarbanes-Oxley Act
(SOX)
– While SOX contains many provisions, the overall intent
of the legislation was to improve the accuracy of
information given to both boards and to shareholders

4)
• The Sarbanes-Oxley Act

– SOX attempted to achieve this goal in three ways:
1. Overhauling incentives and independence in

the auditing process
2. Stiffening penalties for providing false
information
3. Forcing companies to validate their internal
financial control processes

4)
• Dodd-Frank Act
– The Dodd-Frank Wall Street Reform and Consumer
Protection Act was passed in 2010:
▪ To mitigate compliance burden on small firms
– Exempts firms with less than $75 million in
publicly held shares from the SOX Section 404
requirements
– Requires SEC to study how it might reduce cost
for medium-sized firms with public float of less
than $250 million
▪ Broadened the whistle-blower provisions of SOX

Chapter Quiz (1 of 2)
• What is the role of an auditor?
• What is depreciation designed to capture?
• What does a high debt-to-equity ratio tell you?
• What do a firm’s earnings tell you?
• How do you use the price-earnings
(P/E) ratio to gauge the market value of a firm?

Chapter Quiz (2 of 2)
• Why does a firm’s net income not correspond to cash
earned?
• What information do the notes to financial statements
provide?
• What is the Sarbanes-Oxley Act?

FoCFinance CH 2

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

FoCFinance CH 2

Uploaded by

Copyright:

Available Formats

Fundamentals of Corporate Finance

Fifth Edition, Global Edition

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Assets 2019 2018

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

• The Balance Sheet Identity

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

– Assets – Liabilities = Equity

– True value of assets may be different from book

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

• Market to Book Ratio

– Also called Price-to-Book (P/B ) ratio

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

• We will solve the problem using Enterprise

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

We will solve the problem using

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

▪ Gross Profit-Operating Expenses = Operating Income

– Pretax and Net Income

▪ Pretax Income-Taxes = Net Income

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Cost of sales -153.4 -147.3

Research and -8.2 -7.6

Depreciation and -1.2

Interest income -7.7 -4.6

Taxes -0.7 -0.6

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Net Income $2.0 million

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Cash effect of changes

Accounts receivable -5.3 -0.3

Accounts payable 2.7 -0.5