Analysis of Financial Statements: Chapter No.07

Chapter No.
07
Analysis of Financial
Statements
What major financial ratios help analysts in the
following areas: stock valuation, estimating and
evaluating systematic risk, predicting the credit
ratings on bonds, and predicting bankruptcy?
SAIF ULLAH, Saifullah271@yahoo.com,

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Major Financial Statements
Corporate shareholder annual and quarterly reports
must include

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must include
Balance sheet

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must include
Balance sheet
Income statement

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must include
Balance sheet
Income statement
Statement of cash flows

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must include
Balance sheet
Income statement
Reports filed with Securities and Exchange
Commission (SEC)

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must include
Balance sheet
Income statement
Reports filed with Securities and Exchange
Commission (SEC)
10-K and 10-Q

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Purpose of
Financial Statement Analysis
Evaluate management performance in
Profitability
Efficiency
Risk

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Importance of
Relative Financial Ratios
Compare to other entities
Examine a firm’s performance relative to:
The aggregate economy
Its industry or industries
Its major competitors within the industry
Its past performance (time-series analysis)

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Six Categories of Financial Ratios
1. Common size statements
2. Internal liquidity (solvency)
3. Operating performance
a. Operating efficiency
b. Operating profitability
4. Risk analysis
a. Business risk
b. Financial risk

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5. Growth analysis

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5. Growth analysis
6. External liquidity (marketability)

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Common Size Statements
Normalize balance sheets and income statement
items to allow easier comparison of different size
firms
A common size balance sheet expresses accounts as a
percentage of total assets
A common size income statement expresses all items
as a percentage of sales

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Evaluating Internal Liquidity
Internal liquidity (solvency) ratios indicate the ability
to meet future short-term financial obligations
Current Ratio examines current assets and current
liabilities
Current Assets
Current Ratio 
Current Liabilitie s

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Quick Ratio adjusts current assets by removing less
liquid assets
Cash  Marketable Securities  Receivable s

Quick Ratio 

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Cash Ratio is the most conservative liquidity ratio
Cash  Marketable Securities

Cash Ratio 

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Receivables turnover examines the quality of
accounts receivable
Net Annual Sales

Receivable s Turnover 
Average Receivable s
• Receivables turnover can be converted into

an average collection period
365
Average Receivable s Collection Period 
Annual Turnover
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Evaluating

Internal Liquidity
Inventory turnover relates inventory to sales or
cost of goods sold (CGS)
Cost of Goods Sold

Inventory Turnover 
Average Inventory
• Given the turnover values, you can compute
the average inventory processing time
365
Average Invetory Processing Period 
Annual Turnover
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Cash conversion cycle combines information from
the receivables turnover, inventory turnover, and
accounts payable turnover
Receivable Days
+Inventory Processing Days
-Payables Payment Period
Cash Conversion Cycle
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Evaluating Operating Performance
Ratios that measure how well management is
operating a business
(1) Operating efficiency ratios
 Examine how the management uses its assets and capital,
measured in terms of sales dollars generated by asset or
capital categories
(2) Operating profitability ratios
 Analyze profits as a percentage of sales and as a percentage of
the assets and capital employed

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Operating Efficiency Ratios
Total asset turnover ratio indicates the effectiveness
of a firm’s use of its total asset base (net assets equals
gross assets minus depreciation on fixed assets)
Net Sales
Total Asset Turnover 
Average Total Net Assets

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Operating Efficiency Ratios
Net fixed asset turnover reflects utilization of fixed
assets
Net Sales
Fixed Asset Turnover 
Average Net Fixed Assets

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Operating Profitability Ratios
Operating profitability ratios measure
1. The rate of profit on sales (profit margin)
2. The percentage return on capital

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Gross profit margin measures the rate of profit on
sales (gross profit equals net sales minus the cost of
goods sold)
Gross Profit
Gross Profit Margin 
Net Sales

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Operating profit margin measures the rate of profit
on sales after operating expenses (operating profit is
gross profit minus sales, general and administrative
(SG + A) expenses)
Operating Profit
Operating Profit Margin 
Net Sales

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Net profit margin relates net income to sales
Net Income
Net Profit Margin 
Net Sales

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Return on total capital relates the firm’s earnings to
all capital in the enterprise
Net Income  Interest Expense

Return on Total Capital 
Average Total Capital

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Return on owner’s equity (ROE) indicates the rate of
return earned on the capital provided by the
stockholders after paying for all other capital used
Net Income
Return on Total Equity 
Average Total Equity

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Return on owner’s equity (ROE) can be computed for
the common- shareholder’s equity
Net Income - Preferred Dividend

Return on Owner' s Equity 
Average Common Equity

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The DuPont System divides the ratio into several
components that provide insights into the causes
of a firm’s ROE and any changes in it
Net Income Net Income Net Sales

ROE   
Common Equity Net Sales Common Equity
Sales Sales Total Assets

 
Equity Total Assets Equity
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Net Income

Common Equity
Net Income Sales Total Assets

  
Sales Total Assets Common Equity
Profit Total Asset Financial

= Margin
x Turnover x Leverage

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EBIT
1.  Operating Profit Margin
Sales
Sales
2.  Total Asset Turnover
Total Assets
Interest Expense
3.  Interest Expense Rate
Total Assets
Total Assets
4.  Financial Leverage Multiplier
Common Equity
 Income Taxes 
5. 100%    Tax Retention Rate
 NetSAIFBefore Tax 
ULLAH, Saifullah271@yahoo.com,
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Risk Analysis
Risk analysis examines the uncertainty of income
flows for the total firm and for the individual sources
of capital
Debt
Preferred stock
Common stock

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Risk Analysis
Total risk of a firm has two components:
Business risk
 The uncertainty of income caused by the firm’s industry
Financial risk
 Additional uncertainty of returns to equity holders due to a
firm’s use of fixed obligation debt securities

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Business Risk
Variability of the firm’s operating income over time

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Business Risk
Variability of the firm’s operating income over time
Standard deviation of the historical operating
earnings series

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Business Risk
Two factors contribute to the variability of operating
earnings
Sales variability
 Earnings must be as volatile as sales
 Some industries are cyclical
Operating leverage
 Production has fixed and variable costs
 Fixed production costs cause profit volatility with changes in
sales
 Fixed production costs are operating leverage

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Financial Risk
Bonds interest payments come before earnings are
available to stockholders
These are fixed obligations
Similar to fixed production costs, these lead to larger
earnings during good times, and lower earnings
during a business decline
This debt financing increases the financial risk and
possibility of default

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Financial Risk
Two sets of financial ratios help measure financial
risk
Balance sheet ratios
Earnings or cash flow available to pay fixed financial
charges
Acceptable levels of financial risk depend on business
risk

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Financial Risk
Proportion of debt (balance sheet) ratios
Total Long - Term Debt
Debt - Equity Ratio 
Total Equity
This may be computed with and without deferred taxes

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Financial Risk
Long-term debt/total capital ratio indicates the
proportion of long-term capital derived from long-
term debt capital

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Financial Risk
Long-term debt/total capital ratio indicates the
proportion of long-term capital derived from long-
term debt capital
L.T. Debt - Total L.T. Capital Ratio
Total Long - Term Debt


Total Long - Term Capital
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Financial Risk
Total debt ratios compare total debt (current
liabilities plus long-term liabilities) to total capital
(total debt plus total equity)

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Financial Risk
Total debt ratios compare total debt (current
liabilities plus long-term liabilities) to total capital
(total debt plus total equity)
Total Interest - Bearing Debt/Total Capital
Total Interest Debt


Total Capital
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Financial Risk
Earnings or Cash Flow Ratios
Relate the flow of earnings
Cash available to meet the payments
Higher ratio means lower risk

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Financial Risk
Interest Coverage

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Financial Risk
Income Before Interest and Taxes (EBIT)


Debt Interest Charges

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Financial Risk
Income Before Interest and Taxes (EBIT)


Debt Interest Charges
Net Income  Income Taxes  Interest Expense


Interest Expense

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Determinants of Growth
Resources retained and reinvested in the entity
Rate of return earned on equity
= RR x ROE
g  Percentage of Earnings Retained  Return on Equity
where:
g = potential growth rate
RR = the retention rate of earnings
ROE = the firm’s return on equity Safdar
iqbal
Problem No.01
The Shamrock Vegetable Company has the following results:
Net sales $6,000,000
Net total assets 4,000,000
Depreciation 160,000
Net income 400,000
Long-term debt 2,000,000
Equity 1,160,000
Dividends 160,000
Required:
a. Compute Shamrock’s ROE directly. Confirm this using the three Du Pont
components.
b. Using the ROE computed in Part a, what is the expected sustainable growth
rate for Shamrock?
c. Assuming the firm’s net profit margin went to 0.04, what would happen to
Shamrock’s ROE?
d. Using the ROE in Part c, what is the expected sustainable growth rate? What
if dividends were only $40,000?

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Problem No.02
Three companies have the following results during the recent period.
K L M
Net profit margin .04 .06 .10
Total asset turnover 2.20 2.00 1.40
Total assets/equity 2.40 2.20 1.50
a. Derive for each its return on equity based on the three DuPont
components.
b. Given the following earnings and dividends, compute the estimated
sustainable growth rate for each firm.
K L M
Earnings/share 2.75 3.00 4.50
Dividends/share 1.25 1.00 1.00

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Problem No.03
 Given the following balance sheet, fill in the ratio values for 2003 and discuss
how these results compare with both the industry average and E ddies’ past
performance.
 EDDIES ENTERPRISES CONSOLIDATED BALANCE SHEET:
 YEARS ENDED DECEMBER 31, 2002 AND 2003
 ASSETS (DOLLARS IN THOUSANDS)
2003 2002
 Cash $ 100 $ 90
 Receivables 220 170
 Inventories 330 230
 Total current assets 650 490
 Property, plant, and equipment 1,850 1,650
 Depreciation 350 225
 Net properties 1,500 1,425
 Intangibles 150 150
 Total assets 2,300 2,065

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 LIABILITIES AND SHAREHOLDERS’ EQUITY
2003 2002
 Accounts payable $ 85 $ 105
 Short-term bank notes 125 110
 Current portion of long-term debt 75 —
 Accruals 65 85
 Total current liabilities 350 300
 Long-term debt 625 540
 Deferred taxes 100 80
 Preferred stock (10%, $100 par) 150 150
 Common stock ($2 par, 100,000 issued) 200 200
 Additional paid-in capital 325 325
 Retained earnings 550 470
 Common shareholders’ equity 1,075 995
 Total liabilities and shareholders’ equity 2,300 2,065

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 EDDIES ENTERPRISES CONSOLIDATED STATEMENT OF INCOME:
 YEARS ENDED DECEMBER 31, 2002 AND 2003
 (DOLLARS IN THOUSANDS)
2003 2002
 Net sales $3,500 $2,990
 Cost of goods sold 2,135 1,823
 Selling, general, and administrative expenses 1,107 974
 Operating profit 258 193
 Net interest expense 62 54
 Income from operations 195 139
 Income taxes 66 47
 Net income 129 91
 Preferred dividends 15 15
 Net income available for common shares 114 76
 Dividends declared 40 30

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Eddies (2003) Eddies’Average Industry Average
Current ratio ____________ 2.00 2.20
Quick ratio ____________ 1.00 1.10
Receivable turnover ___________18.00 18.00
Average collection period ______ 20.00 21.00
Total asset turnover ____________ 1.50 1.40
Inventory turnover ____________ 11.00 12.50
Fixed-asset turnover ____________ 2.50 2.40
Equity turnover ____________ 3.20 3.00
Gross profit margin ____________ .40 .35
Operating profit margin _________8.00 7.50
Return on capital ____________ .107 .120
Return on equity ____________ .118 .126

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Return on common equity ____________ .128 .135
Debt/equity ratio ____________ .60 .50
Debt/total capital ratio ____________ .40 .37
Interest coverage ____________ 4.00 4.50
Fixed charge coverage ____________ 3.00 4.00
Cash flow/long-term debt ____________ .40 .45
Cash flow/total debt ____________ .25 .30
Retention rate ____________ .35 .40
CF

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Analysis of Financial Statements: Chapter No.07

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Chapter No.

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

Cash  Marketable Securities  Receivable s

SAIF ULLAH, Saifullah271@yahoo.com,

Cash  Marketable Securities

SAIF ULLAH, Saifullah271@yahoo.com,

Net Annual Sales

• Receivables turnover can be converted into

Cost of Goods Sold

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

Net Income  Interest Expense

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

Net Income - Preferred Dividend

SAIF ULLAH, Saifullah271@yahoo.com,

Net Income Net Income Net Sales

Sales Sales Total Assets

Net Income Sales Total Assets

Profit Total Asset Financial

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

L.T. Debt - Total L.T. Capital Ratio

Total Long - Term Debt

SAIF ULLAH, Saifullah271@yahoo.com,

Total Interest - Bearing Debt/Total Capital

Total Interest Debt

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

Income Before Interest and Taxes (EBIT)

SAIF ULLAH, Saifullah271@yahoo.com,

Income Before Interest and Taxes (EBIT)

Net Income  Income Taxes  Interest Expense

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,

SAIF ULLAH, Saifullah271@yahoo.com,