Financial Management I

Chap 03
Analysis of Financial Statements
Ratio Analysis
 Financial statements report Both on a firm’s position at
a point in time & on its operations over some past
period.
 Real Value of Financial Statements?
 Usefulness of Financial Statement Analysis?
 Ratio Analysis?
Ratio Analysis
1. Liquidity Ratios
2. Asset Management Ratios
3. Debt Management Ratios
4. Profitability Ratios
5. Market Value Ratios
6. DuPont Analysis
Liquidity Ratios
 A liquid Asset is one that can be converted to cash
quickly without having to reduce the Asset’s price very
much.
 Liquidity Ratios are ratios that show the relationship of
a firm’s cash & other Current Assets to its liabilities.
 Usefulness of Liquidity Ratios?
 Most Commonly Used liquidity Ratios?
Liquidity Ratios – Current Ratio
Current Ratio indicates the extent to which Current
Liabilities are covered by those Assets expected to be
converted to cash in near future.

Current Ratio = Current Assets/Current Liabilities

Too High Ratio? Too low Ratio?

Increasing Trend? Decreasing Trend?
Current Ratio - Example
Cartwright Brothers has the following balance sheet (all
numbers are expressed in millions of dollars):

Cash $ 250 Accounts payable $ 300

Accounts receivable 250 Notes payable 300
Inventories 250 Long-term debt 600
Net fixed assets 1,250 Common stock 800
Total assets $2,000 Total claims $2,000

Calculate Current Ratio:

Current Ratio - Example
Current Ratio = Cash + A/R +Inventory
A/P + N/P
= 250 +250 + 250
300 +300
= 1.25
Current Ratio - Example
 Iken Berry Farms has $5 million in current assets, $3 million
in current liabilities, and its initial inventory level is $1
million. The company plans to increase its inventory, and it
will raise additional short-term debt (that will show up as
notes payable on the balance sheet) to purchase the
inventory. Assume that the value of the remaining current
assets will not change. The company’s bond covenants
require it to maintain a current ratio that is greater than or
equal to 1.5. What is the maximum amount that the
company can increase its inventory before it is restricted
by these covenants?
Current Ratio - Example
 Iken Berry Farms has $5 million in current assets, $3 million in current
liabilities, and its initial inventory level is $1 million. The company plans to
increase its inventory, and it will raise additional short-term debt (that will
show up as notes payable on the balance sheet) to purchase the inventory.
Assume that the value of the remaining current assets will not change.
The company’s bond covenants require it to maintain a current ratio that is
greater than or equal to 1.5. What is the maximum amount that the
company can increase its inventory before it is restricted by these
covenants?

Iken Berry Farms has a current ratio of 1.67

If notes payable are going to be raised to buy inventories,
both the numerator and the denominator of the ratio will
increase causing Ratio to decrease.
 Current Ratio - Example

CA  X
 1.5
CL  X
$5,000,000  X
 1.5
$3,000,000  X
$5,000,000  X  $4,500,000  1.5X
$500,000  0.5X
$1,000,000  X
X  $1,000,000.
Asset Management Ratios
 Asset Management ratios is a set of ratios that measure
how effectively a firm is managing its assets
 Problem with having too many Assets? Or, too less
Assets?
 Most Commonly used Asset Management Ratios?
Asset Management Ratios
 Asset Management ratios is a set of ratios that
measure how effectively a firm is managing its assets
 Problem with having too many Assets? Or, too less
Assets?
 Most Commonly used Asset Management Ratios:

1. Inventory Turnover ratio

2. Days Sales Outstanding
3. Fixed Asset Turnover Ratio
4. Total Asset Turnover Ratio
Asset Management Ratios – Inventory
Turnover Ratio
Inventory Turnover is an approximation indicating how
many times in a year, a company’s inventory is sold out
or converted to sales.

Inventory T.O = Sales / Inventory

Too high Ratio? Too Low ratio?

Increasing Trend? Decreasing Trend?
Inventory Turnover Ratio - Example
XYZ’s balance sheet and income statement are given below:
Balance Sheet:
Cash $ 50 Accounts payable $ 100
A/R 150 Notes payable 0
Inventories 300 Long-term debt (10%) 700
Fixed assets 500 Common equity 200
Total assets $1,000 Total liabilities & equity $1,000
Sales $1,000

Calculate Inventory Turnover Ratio? If Industry’s

Inventory Turnover Ratio is 5, what would that imply for
XYZ?
Inventory Turnover Ratio - Example
Inventory Turnover Ratio = 1000/ 300
= 3.33
Asset management ratios – Days Sales
outstanding
Days Sales outstanding (DSO), also called the collection
period, indicates the average length of time the firm
must wait after making a sale before it receives cash.

DSO = Receivables / Average Sales Per Day

= Receivables / (Annual Sales/ 365)

Should be compared with the terms on which the firm

sells its goods!!
Days Sales outstanding - Example
Ruth Company currently has $1,000,000 in accounts
receivable. Its days sales outstanding (DSO) is 50 days.
The company wants to reduce its DSO to the industry
average of 32 days by pressuring more of its customers
to pay their bills on time. The company’s CFO estimates
that if this policy is adopted the company’s average
sales will fall by 10 percent. Assuming that the company
adopts this change and succeeds in reducing its DSO to
32 days and does lose 10 percent of its sales, what will
be the level of accounts receivable following the
change? Assume a 365-day year.
Days Sales outstanding - Example
First, solve for current annual sales using the DSO equation as
follows:
50 = $1,000,000/(Sales/365)
annual sales = $7,300,000

If sales fall by 10%,

The new sales level = $7,300,000(0.9) = $6,570,000.

Again, using the DSO equation, solve for the new accounts
receivable figure as follows:
32 = AR/($6,570,000/365)
AR = $576,000.
Asset management ratios – Fixed Asset
Turnover Ratio
The Fixed Asset Turnover ratio measures how effectively
the firm uses its Plant & Equipment.

Fixed Asset T.O = Sales / Net Fixed Assets

Net Fixed Assets = Gross Fixed Assets – Accumulated
Depreciation

Potential Problem with interpreting Fixed Asset T.O

ratio?
Fixed Asset Turnover Ratio - Example
Your company had the following balance sheet and
Sales of $10,000 for 2002:
Balance Sheet:
Cash $ 20
A/R 1,000
Inventories 5,000
Total current assets $6,020 Debt $4,000
Net fixed assets 2,980 Equity 5,000
Total assets $9,000 Total claims $9,000

If Company wants to increase its sales by 10% &

maintain a Fixed Asset Turnover Ratio of 4.45, what
would should be the level of Net Fixed Assets. Also,
calculate increase or Decrease in Net Fixed Assets.
Fixed Asset Turnover Ratio - Example
New Level of Sales = 10,000 (1.10) = 11,000
Fixed Asset T.O = 4.45

Solve for New Level of Fixed assets:

4.45 = 11,000 / X
X = 11,000 / 4.45
= 2472

Decrease in Fixed Assets = 2980 – 2472

= 508
Asset management ratios – Total Asset
Turnover Ratio
The Total Asset Turnover Ratio measures the turnover of
all the firm’s Assets.

Total Asset T.O = Sales / Total Assets

Asset Management Ratios - Example
Taft Technologies has the following relationships:
Annual sales $1,200,000.00
Current liabilities $ 375,000.00
Days sales outstanding (DSO) 40.00
Inventory turnover ratio 4.80
Current ratio 1.20

The company’s current assets consist of cash,

inventories, and accounts receivable. How much cash
does Taft have on its balance sheet?
Asset Management Ratios - Example
First, find the amount of current assets:
Current ratio = Current assets/Current liabilities
Current assets = (Current liabilities)(Current ratio)
= $375,000(1.2) = $450,000.
Next, find the accounts receivables:
DSO = AR/(Sales/365)
AR = DSO(Sales)(1/365)= (40)($1,200,000)(1/365)
=$131,506.85.
Next, find the inventories:
Inventory turnover = Sales/Inventory
Inventory = $1,200,000/4.8 =$250,000.

Finally, find the amount of cash:

Cash = Current assets - AR - Inventory
= $450,000 - $131,506.85 - $250,000
= $68,493.15  $68,493.
Debt Management Ratios
The extent to which a firm has debt financing or
Financial Leverage, has three important implications:
1. By raising funds through debt, stockholders can
maintain the control of the firm while limiting their
investments
2. Creditors look at the equity as owner supplied funds ,
to provide a margin of safety.
3. If the firm earns more on investments financed with
borrowed funds than it pays in interest, the return on
owner’s capital is magnified.
 THE Effects of Financial Leverage -
Example

 We consider case of company X which has no debt & is

considering restructuring to include debt in its capital
structure.

 We look at DEBT & NO DEBT situations

 Taxes are ignored
 THE Effects of Financial Leverage -
Example

Current Proposed
Assets $8,000,000 $8,000,000
Debt 0 4,000,000
Equity 8,000,000 4,000,000
Debt-Equity Ratio 0 1
Share Price 20 20
# of Shares 400,000 200,000
Interest Rate 10% 10%
 THE Effects of Financial Leverage -
Example

Current Capital Structure: No Debt

Recession Normal Expansion
EBIT $500,000 $1,000,000 $1,500,000
Interest 0 0 0
Net Income 500,000 1,000,000 1,500,000
ROE 6.25% 12.5% 18.75%
EPS 1.25 2.50 3.75
 THE Effects of Financial Leverage -
Example
Proposed Capital Structure: Debt - $4 Million

Recession Normal Expansion

EBIT $500,000 $1,000,000 $1,500,000
Interest 400,000 400,000 400,000
Net Income 100,000 600,000 1,100,000
ROE 2.50% 15.50% 27.50%
EPS 0.50 3.00 5.50
Debt Management Ratios – Debt Ratio
The Debt Ratio measures the percentage of funds
provided by creditors. Total Debt includes both Current
Liabilities & Long Term Debt.

Debt Ratio = Total Debt / Total Assets

Creditors prefer low Debt ratio because the lower the

ratio, the greater the cushion against Creditor’s losses in
the event of liquidation.

What about Stockholders?

Debt Ratio - Example
Kansas Office Supply had $24,000,000 in sales last year.
The company’s net income was $400,000, its total
assets turnover was 6.0, and the company’s ROE was 15
percent. The company is financed entirely with debt
and common equity. What is the company’s debt ratio?
Debt Ratio - Example
Sales/Total assets =6
Total assets = $24,000,000/6
= $4,000,000.

ROE = NI/Equity
Equity = NI/ROE
= $400,000/0.15
= $2,666,667.
Debt = Total assets - Equity
= $4,000,000 - $2,666,667
= $1,333,333.
Debt ratio = $1,333,333/$4,000,000
= 0.3333.
Debt Management Ratios – Times Interest
Earned Ratio
Times Interest Earned Ratio is a measure of the firm’s
ability to meet its annual interest payments.

TIE = EBIT / Interest Charges

Point to Note:
Earnings before interest & taxes, rather than Net
income is used in the numerator because interest is paid
with pre-tax dollars, the firm’s ability to pay current
interest is not effected by taxes.
Times Interest Earned Ratio - Example
Culver Inc. has earnings after interest but before taxes
of $300. The company’s times interest earned ratio is
7.00. Calculate the company’s interest charges.
Times Interest Earned Ratio - Example
Culver Inc. has earnings after interest but before taxes
of $300. The company’s times interest earned ratio is
7.00. Calculate the company’s interest charges.

TIE = EBIT/INT
7 = ($300 + INT)/INT
7INT = $300 + INT
6INT = $300
INT = $50.
Times Interest Earned Ratio –
Disadvantages
1. Interest is not the only financial charge- companies
must also pay back principle & many firms lease
assets & must make lease payments.

2. EBIT does not reflect all the cash flows available to

service debt, especially if a firm has high depreciation
and/or amortization charges.
Debt Management Ratios – EBITDA
Coverage Ratio
The EBITDA coverage ratio is most useful for relatively
short term lenders as over a relatively short period,
depreciation generated funds can be used to service
debt.

EBITDA Coverage Ratio:

EBITDA + lease Payments

Interest +Principal Payment +Lease Payments
Profitability Ratios
Profitability ratios include a group of ratios that show
the combined effect of liquidity, asset management &
debt on operating results.

Profitability ratios constitute of:

1. Profit Margin on Sales

2. Basic Earning Power (BEP)
3. Return on Total Assets (ROA)
4. Return on Common Equity (ROE)
Profitability Ratios – Profit Margin on
Sales
Profit Margin Ratio measures Net Income per dollar of
Sales.

Profit Margin on Sales = Net Income / Sales

Special Case of Financial Leverage!!

Profitability Ratios - Basic Earning Power
The BEP ratio indicates the ability of the firm’s Assets to
generate operating Income.

BEP = EBIT / Total Assets

This ratio shows the raw earning power of the firm’s

Assets, before the influence of taxes & leverage, and it
is useful for comparing firms with different tax
situations & different degrees of financial leverage.
BEP - Example
Peterson Packaging Corp. has $9 billion in total assets.
The company’s basic earning power (BEP) ratio is 9
percent, and its times interest earned ratio is 3.0.
Peterson’s depreciation and amortization expense totals
$1 billion. It has $0.6 billion in lease payments and $0.3
billion must go towards principal payments on
outstanding loans and long-term debt. What is
Peterson’s EBITDA coverage ratio?
BEP - Example
EBIT/$9,000,000,000 = 0.09
EBIT = $810,000,000.

3 = EBIT/INT
3 = $810,000,000/INT
INT = $270,000,000.

EBITDA = EBIT + DA
= $810,000,000 + $1,000,000,000
= $1,810,000,000.

EBITDA coverage ratio = (1.81+0.6)/(0.27+0.6+0.3)

= 2.0598  2.06.
Profitability Ratios – Return on Total
Assets
The ratio of Net Income to total Assets measures the
return on total Assets (ROA) after interest & taxes.

ROA = Net Income / Total Assets

ROA - Example
Aaron Aviation recently reported the following
information:
Net income $500,000
ROA 10%
Interest expense $200,000

The company’s average tax rate is 40 percent. What is

the company’s basic earning power (BEP)?
ROA - Example
Given ROA = 10% and net income of $500,000, total assets
must be $5,000,000.

To calculate BEP, we still need EBIT. To calculate EBIT

construct a partial income statement:
EBIT $1,033,333 ($200,000 + $833,333)
Interest 200,000 (Given)
EBT $ 833,333 ($500,000/0.6)
Taxes (40%) 333,333
NI $ 500,000

BEP = EBIT /TA = 1033,333 / 5,000,000

= 0.2067 or 20.67%.
Profitability Ratios – Return on Common
Equity
The Return on Common Equity Ratio measures the
Return on Common Stockholders’ investments.

ROE = Net Income / Common Equity

Return on Common Equity - Example
Tapley Dental Supply Company has the following data:
Net income $240
Sales $10,000
Total assets $6,000
Debt ratio 75%
TIE ratio 2.0
Current ratio 1.2
BEP ratio 13.33%

If Tapley could streamline operations, cut operating costs, and

raise net income to $300 without affecting sales or the balance
sheet (the additional profits will be paid out as dividends), by
how much would its ROE increase?
Return on Common Equity - Example
Equity = 0.25($6,000)
= $1,500.
Current ROE = 240/1500
= 16%.
New ROE =300/1500
= 0.20 or 20%.

ROE = 20% - 16%

= 4%.
Financial Management I

Chap 03
Analysis of Financial Statements
Ratio Analysis
1. Liquidity Ratios
2. Asset Management Ratios
3. Debt Management Ratios
4. Profitability Ratios
5. Market Value Ratios
6. DuPont Analysis
Market Value Ratios
Market Value Ratios constitute set of ratios that relate
the firm’s stock price to its earnings, cash flows &
book value per share:

1. Price/ Earning Ratio

2. Price/ Cash flow ratio
3. Market/Book Value Ratio
Market Value Ratios – Price/Earnings
Ratio
The ratio of Price per Share to earnings per share shows
the dollar amount investors will pay for $1 of current
earnings.

P/E Ratio = Price Per Share / Earnings Per Share

Purpose?
Price/Earnings Ratio - Example
Cleveland Corporation has 100,000 shares of common
stock outstanding, its net income is $750,000, and its
P/E is 8. What is the company’s stock price?
Price/Earnings Ratio - Example
Cleveland Corporation has 100,000 shares of common
stock outstanding, its net income is $750,000, and its
P/E is 8. What is the company’s stock price?

EPS = $750,000/100,000 = $7.50.

P/E = Price/EPS = 8.
Thus,
Price = 8  $7.50 = $60.00.
Market Value Ratios/ Price/Cash flow
Ratio
The ratio of Price per Share to cash flow per share
shows the dollar amount investors will pay for $1 of
cash flows.

P/CF Ratio = Price Per Share / Cash Flow Per Share

Where:
CF = (NI + Non Cash Charges)

Purpose?
Market Value Ratios - Market/Book Value
Ratio
The ratio of stock’s Market price to its book value gives
another indication of how investors regard the
company.

Companies with relatively high rates of return on Equity

generally sell at higher multiples of book Value than
those with low Returns.

Market/Book Ratio = Market Price per share

Book Value per Share
Market/Book Value Ratio - Example
Strack Houseware Supplies Inc. has $2 billion in total assets.
The other side of its balance sheet consists of $0.2 billion in
current liabilities, $0.6 billion in long-term debt, and $1.2 billion
in common equity. The company has 300 million shares of
common stock outstanding, and its stock price is $20 per share.
What is Strack’s market/book ratio?
Market/Book Value Ratio - Example
TA = $2,000,000,000; CL = $200,000,000;
LT debt = $600,000,000; CE = $1,200,000,000;
Shares outstanding = 300,000,000; P0 = $20;
M/B = ?

Book value = 1200 Million / 300 Million

= $4.00.
M/B = 20/4
= 5.0.
The DuPont Equation
The DuPont Equation is the formula which shows that
the rate of return on Assets can be found as the product
of the profit Margin times the total Asset Turnover.

Thus,
ROA = Profit Margin * Total Asset Turnover
= (NI/Sales) * (Sales/Total Assets)
The Extended DuPont Equation

ROA = Net Income / Total Assets

ROE = Net Income/Total Equity
Equity Multiplier = Total Assets/Common Equity
The Extended DuPont Equation
ROA = Net Income / Total Assets
ROE =Net Income/Total Equity
Equity Multiplier = Total Assets/Common Equity

Thus,

ROE = Profit Margin * TATO * Equity Multiplier

= (NI/Sales) * (Sales/TA) * (TA/Equity)
The Extended DuPont Equation - Example
Company A has sales of $1,000, assets of $500, a debt
ratio of 30 percent, and an ROE of 15 percent. Company
B has the same sales, assets, and net income as
Company A, but its ROE is 30 percent. What is B’s debt
ratio? (Hint: Begin by looking at the Du Pont equation.)
The Extended DuPont Equation - Example
ROE = (NI/Sales) * (Sales/TA) * (TA/Equity)
0.15 = (NI/1000) * (1000/500) * (500/0.7*500)
Thus,
NI = 52.50

Therefore,

NPM (B) = 52.5/1000

= 5.25%
The Extended DuPont Equation - Example
Data for Co. B:
ROE = (NI/Sales) * (Sales/TA) * (TA/Equity)
0.30 = 0.0525 * 2 * ( TA / Equity)
0.30 = 0.1050 * (500 /Equity)

Hence,
Equity = $175
Debt = 500 – 175
= 325
Therefore,
Debt Ratio = 325 /500
= 65 %
Limitations of Ratio Analysis
 Multiple Divisions in different Industries
 Average Not Enough for Most firms
 Inflation
 Seasonal Factors
 Window Dressing Techniques
 Different Accounting Practices
 Difficult to generalize
Thank you for your Time &
Patience 