Chapter

Financial Ratio Analysis

1
 Learning Objectives

 Calculate and explain a variety of financial

ratios.
 Explain the value of common-size and
common-base-year financial statements.
 Use the DuPont equation to calculate a
company’s return on equity.
 Understand the strengths and weaknesses of
financial statement analysis.

2
 Common-Size and Common-Base-Year
Financial Statements
 Income statement items as a percentage of
total sales.
 Provides insight into how the relative items
contribute to revenues and expenses.
 Balance sheet items as a percentage of total
assets.
 Provides a insight into the structure of the
company’s assets and financing.
 Common-base-year financial statements
provide such comparisons to a base year.
3
 General Procedure

 Compute financial ratios for the company,

using financial statements from the last few
years.
 Compare trends in key financial ratios for the
company.
 Compare the company’s financial ratios to
industry averages.

4
 Classification of Financial Ratios

 Liquidity Ratios

 Asset Activity Ratios

 Leverage Ratios

 Coverage Ratios

 Profitability Ratios

 Market Value Ratios

5
 Liquidity Ratios

 Current Ratio

 Quick Ratio

 Working Capital Ratio

 Cash Ratio

6
 Current Ratio

Current Assets
Current Ratio 
Current Liabilities
s

$ 400
  1.58
$ 253

7
 Quick Ratio

Current Assets  Inventories

s
Quick Ratio 
Current Liabilities
s

$ 400  $140
  1.03
$ 253

8
 Working Capital Ratio

Working Capital Ratio 

Current Assets  Current Liabilities


Sales

$ 400  $ 253
  13.61%
$1,080

9
 Cash Ratio

Cash & Equivalents

Cash Ratio 
Total Assets

$ 26
  2.26%
$1,150

10
 Summary of Liquidity Ratios

Ratio 1996 1995 Ind. Average

(1996)
Current 1.58 1.98 2.00
Quick 1.03 1.30 1.00
Working Capital 13.61% 20.48% 18.00%
Cash 2.26% 2.05% 2.61%

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 Asset Activity Ratios

 Receivables Turnover Ratio

 Days Sales Outstanding

 Inventory Turnover Ratio

 Days Sales in Inventory

 Fixed Asset Turnover Ratio

 Total Asset Turnover Ratio

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 Receivables Turnover Ratio

Receivables Turnover Ratio 

Annual Credit Sales


Accounts Receivable

$1,080
  4.62
$ 234

13
 Days Sales Outstanding (DSO)

Days Sales Outs tan ding 

365

Receivables Turnover

365
  79.08
4.62
14
 Inventory Turnover Ratio

Inventory Turnover Ratio 

Cost of Goods Sold


Inventory

$ 560
  4.00
$140

15
 Days Sales In Inventory

Days Sales In Inventory 

365

Inventory Turnover

365
  91.25
4.00
16
 Fixed Asset Turnover Ratio

Fixed Asset Turnover Ratio 

Sales

Net Fixed Assets

$1,080
  1.44
$ 750

17
 Total Asset Turnover Ratio

Total Asset Turnover Ratio 

Sales

Total Assets

$1,080
  0.94
$1,150

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 Summary of Asset Activity Ratios

Ratio 1996 1995 Ind. Average

(1996)
Receivables T.O. 4.62 4.00 6.02
Days Sales Outst. 79.08 91.25 60.63
Inventory T.O. 4.00 3.57 4.15
Days Sales in Inv. 91.25 102.34 87.95
Fixed Asset T.O. 1.44 1.59 1.53
Total Asset T.O. 0.94 0.96 1.16
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 Leverage Ratios

 Debt Ratio

 Debt-to-Equity Ratio

 Equity Multiplier

20
 Debt Ratio

Total Debt
Debt Ratio 
Total Assets

$ 488.50
  0.42
$1,150.00

21
 Debt-to-Equity Ratio

Total Debt
Debt / Equity Ratio 
Shareholder' s Equity

$ 488.50
  0.74
$ 661.50

22
 Equity Multiplier

Total Assets
Equity Multiplier 
Shareholder’s Equity

$1,150.00
  1.74
$ 661.50

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 Summary of Leverage Ratios

Ratio 1996 1995 Ind. Average

(1996)
Debt Ratio 0.43 0.37 0.40
Debt - To - Equity 0.74 0.58 0.67
Equity Multiplier 1.74 1.58 1.67

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 Coverage Ratios

 Interest Coverage Ratio

 Fixed Charge Coverage Ratio

25
 Interest Coverage Ratio

Interest Coverage Ratio 

EBIT

Interest Expense

$ 85
  5.67
$15

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 Fixed Charge Coverage Ratio

Fixed Charge Coverage Ratio 

EBIT  Rental Pmts.


Interest Expense  Rental Pmts.

$ 85  $ 6
  4.33
$15  $ 6

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 Summary of Coverage Ratios

Ratio 1996 1995 Ind. Average

(1996)
Interest 5.67 5.00 6.21
Fixed Charge 4.33 3.89 5.12

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 Profitability Ratios

 Gross Profit Margin

 Net Profit Margin

 Earning Power

 Return on Assets

 Return on Equity

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 Gross Profit Margin

Gross Profit
Gross Profit Margin 
Sales

$ 520.00
  48.15%
$1,080.00

30
 Net Profit Margin

Net Income
Net Profit Margin 
Sales

$ 42.00
  3.89%
$1,080.00

31
 Earning Power

EBIT
Earning Power 
Total Assets

$ 85.00
  7.39%
$1,150.00

32
 Return on Assets

Net Income
Re turn on Assets 
Total Assets

$ 42.00
  3.65%
$1,150.00

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 Return on Equity

Net Income to Common

Return on Equity 
Common Equity

$ 36.00
  6.35%
$ 641.50

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 Summary of Profitability Ratios Ratios

Ratio 1996 1995 Ind. Average

(1996)
Gross Profit Margin 48.51% 49.05% 48.28%
Net Profit Margin 3.89% 3.69% 3.75%
Earning Power 7.39% 7.42% 8.25%
Return on Assets 3.65% 3.54% 3.98%
Return on Equity 6.35% 5.58% 6.65%

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 Market Value Ratios

 P/E Ratio

 Market-to-Book Ratio

 Earnings Yield

 Dividend Yield

36
 P/E Ratio

Pr ice per Share

P / E Ratio 
Earnings per Share

$ 29.00
  12.89
$ 2.25

37
 Market-to-Book Ratio

Market to Book Ratio 

Pr ice per Share


Book Value per Share

$ 29.00
  0.72
$ 40.09

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 Earnings Yield

Earnings per Share

Earnings Yield 
Pr ice per Share

$ 2.25
  7.76%
$ 29.00

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 Dividend Yield

Dividends per Share

Dividend Yield 
Pr ice per Share

$1.25
  4.31%
$ 29.00

40
 Summary of Market Value Ratios

Ratio 1996 1995 Ind. Average

(1996)
P/E 12.89 15.60 16.25
Earnings Yield 7.76% 6.41% 6.15
Dividend Yield 4.31% 3.85% 4.50
Market - to - Book 0.72 0.73 1.20

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 DuPont Analysis

ROE = (Profit marg.)(Asset TO)(Eq. Mult.)

ROE = (3.889%) (0.939) (1.738)
ROE= 0.0635 or 6.35%
Therefore,
Net Inc. , Sales , Tot. Assets = NI to Common
Sales Tot. Assets Shldr. Eq Common Eq.

42
 Using Financial Statements

 Requires judgment, experience, hard work.

 Does not provide new information.

 Can provide insight into why the company’s

stock has its current selling price.

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