ANALYSIS OF

FINANCIAL
STATEMENT
 2

Why are ratios useful?

• Ratios standardize numbers and facilitate

comparisons.
→ Analyze firm’s performance
• Ratios are used to highlight weaknesses and
strengths.
• Ratio comparisons should be made through time
and with competitors.
• Trend: Evaluating trends in the firm’s financial position
over time
• Industry analysis: Comparing firm’s performance with
that other firms in the same industry
• Benchmark (peer) analysis
 3

Five Major Categories of Ratios and

the Questions They Answer
• Liquidity:
• Can we make required payments?
• Asset management:
• Right amount of assets vs. sales?
• Debt management:
• Right mix of debt and equity?
• Profitability:
• Do sales prices exceed unit costs, and are sales high
enough as reflected in PM, ROE, and ROA?
• Market value:
• Do investors like what they see as reflected in P/E
and M/B ratios?
 4

Balance Sheet: Assets

2013E 2012
Cash 85,632 7,282
A/R 878,000 632,160
Inventories 1,716,480 1,287,360
Total CA 2,680,112 1,926,802
Gross FA 1,197,160 1,202,950
Less: Deprec. 380,120 263,160
Net FA 817,040 939,790
Total Assets 3,497,152 2,866,592
 5

Balance Sheet: Liabilities and

Equity
2013E 2012
Accts payable 436,800 524,160
Notes payable 300,000 636,808
Accruals 408,000 489,600
Total CL 1,144,800 1,650,568
Long-term debt 400,000 723,432
Common stock 1,721,176 460,000
Retained earnings 231,176 32,592
Total Equity 1,952,352 492,592
Total L & E 3,497,152 2,866,592
 6

Income Statement
2013E 2012
Sales 7,035,600 6,034,000
COGS 5,875,992 5,528,000
Other expenses 550,000 519,988
EBITDA 609,608 (13,988)
Deprec. & amort. 116,960 116,960
EBIT 492,648 (130,948)
Interest exp. 70,008 136,012
EBT 422,640 (266,960)
Taxes 169,056 (106,784)
Net income 253,584 (160,176)
 7

Other Data
2013E 2012
No. of shares 250,000 100,000
EPS $1.014 -$1.602
DPS $0.220 $0.110
Stock price $12.17 $2.25
Lease pmts $40,000 $40,000
 Liquidity Ratios

• The ratios help answer the question of:

Will the firm be able to pay off its debts as they
come due?
• Ability to meet short-term obligations
• The ratios Show the relationship of a firm’s cash
and other current assets to its current liabilities
• The most common ratios are:
• Current ratio
• Acid-test ratio
 9

Liquidity Ratios
Current assets
Current ratio 
Current liabilitie s
$2,680

$1,145
 2.34 

• Current assets include: cash, marketable securities,

accounts receivable, and inventories
• If a company is having financial difficulties, it begins to
pay its accounts payable more slowly and borrow more
from its bank
• If current liabilities are rising faster than current assets,
the current ratio will fall; hence this is a sign of possible
trouble
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Liquidity Ratios

(Current assets  Inventorie s)

Quick ratio 
Current liabilitie s
($2,680  $1,716 )

$1,145
 0.84 

• Inventories are the least liquid of a firm’s current assets.

• If sales slow down, they might not be converted to cash
as quickly as expected.
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Comments on Liquidity Ratios

2013E 2012 2011 Ind.

Current ratio 2.34x 1.20x 2.30x 2.70x
Quick ratio 0.84x 0.39x 0.85x 1.00x

• Expected to improve but still below the industry

average.
• Liquidity position is weak.
 Asset Management Ratios

• The asset management ratios measure how

effectively the firm is managing its assets
• The ratios help answer the question of:
• Does the amount of each type of asset seem reasonable,
too high, or too low in view of current and projected
sales?
• The most common ratios are:
• Inventory turnover ratio
• Days sales outstanding
• Fixed assets turnover ratio
• Total assets turnover ratio
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Asset Management Ratios

• Evaluating Inventories
• The Inventory Turnover Ratio
= Sales ÷ Inventories
• Evaluating Receivables
• The Days Sales Outstanding (DSO)
= Receivable ÷ (Annual sales ÷ 365)
• Evaluating Fixed Assets
• Fixed Assets Turnover Ratio
= Sales ÷ Net Fixed Assets
• Evaluating Total Assets
• Total Assets Turnover Ratio
= Sales ÷ Total Assets
 14

Inventory Turnover
Inv. turnover = Sales/Inventories
= $7,036/$1,716
= 4.10x

2013E 2012 2011 Ind.

Inventory turnover 4.1x 4.70x 4.8x 6.1x

• Inventory turnover is below industry average.

• The company might have old inventory, or its control
might be poor.
• No improvement is currently forecasted.
 15

The Days Sales Outstanding

(DSO)
• Also called average collection period (ACP)
• DSO represents the average length of time the firm
must wait after making a sale before receiving cash

• Receivables turnover = Sales/Receivables

• DSO = 365/Receivable turnover

OR

• DSO= Receivables/Avg. sales per day

= Receivables/(Annual sales/365)
= $878/($7,036/365)
= 45.6 days
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DSO (cont’d)

• The firm collects on sales too slowly, and is

getting worse.
• The high average DSO indicates that if some
customers are paying on time, quite a few
must be paying very late
• The firm has a poor credit policy.
 17

Fixed Assets Turnover Ratio

(FATO)

FATO = Sales/Net fixed assets

= $7,036/$817
= 8.61x

• The ratio measures how effectively the firm uses its

plant and equipment
• The interpretation for this ratio might be biased as
fixed assets are shown on the balance sheet at their
historical costs
 18

Total Assets Turnover Ratio

(TATO)
TATO = Sales/Total assets
= $7,036/$3,497
= 2.01x

• The ratio measures the turnover of all of the

firm’s assets
• The low level of this ratio might be caused by
the problem with the firm’s current assets
 19

Fixed Assets and Total Assets

Turnover Ratios
2013E 2012 2011 Ind.
FA TO 8.6x 6.4x 10.0x 7.0x
TA TO 2.0x 2.1x 2.3x 2.6x

• FATO projected to exceed the industry average.

• TATO below the industry average. Caused by
excessive currents assets (A/R and Inventories).
 20

Debt Management Ratios

• The use of debt can “leverage up” a firm’s ROE if the

firm earns more on its assets than the interest rate it
pays on debt.
• The debt management ratios measure how
effectively the firm is managing its debts.
• Evaluate how the firm has financed its assets as well
as the firm’s ability to repay its debt.
• The firms with a high level of debt ratios typically
have higher expected return when the economy is
normal, but lower return and possibly bankruptcy if
the economy goes into a recession.
 21

Debt Management Ratios

Debt ratio = Total debt/Total assets
= ($1,145 + $400)/$3,497
= 44.2%
• DAR measures the percentage of funds provided by
creditors
• Creditors prefer low debt ratios because the lower
the ratio, the greater the cushion against creditors’
losses in the event of liquidation
• Stockholders may want more leverage because it
can magnify the expected earnings
 22

Debt Management Ratios

Times-Interest-Earned (TIE) Ratio

TIE = EBIT/Interest charges

= $492.6/$70
= 7.0x
• The TIE ratio measures the extent to which
operating income can decline before the firm is
unable to meet its annual interest costs
• The low level of TIE ratio indicates that the firm is
covering its interest charges by a relatively low
margin of safety
 23

Debt Management Ratios

• D/A and TIE ratios are better than the

industry average.
 Profitability Ratios

• Evaluate how profitably the firm is operating and

utilizing its assets.
• Common profitability ratios:
• Operating Margin
• Profit Margin
• Basic Earning Power
• ROA
• ROE
 25

Profitability Ratios: Operating Margin,

Profit Margin, and Basic Earning Power

Operating margin = EBIT/Sales

= $492.6/$7,036 = 7.0%

Profit margin = Net income/Sales

= $253.6/$7,036 = 3.6%

Basic earning power = EBIT/Total assets

= $492.6/$3,497 = 14.1%

Operating Margin
• This ratio measures operating income per dollar sales.
• The low level of this ratio indicates that the firm’s
operating costs are too high, and vice versa.
 26

Profitability Ratios: Operating Margin,

Profit Margin, and Basic Earning Power

Operating margin = EBIT/Sales

= $492.6/$7,036 = 7.0%

Profit margin = Net income/Sales

= $253.6/$7,036 = 3.6%

Basic earning power = EBIT/Total assets

= $492.6/$3,497 = 14.1%

Profit Margin
• This ratio measures net income per dollar sales.
• Low profit margin can be caused by the high operating
costs or the heavy use of debt.
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Profitability Ratios: Operating Margin,

Profit Margin, and Basic Earning Power

Operating margin = EBIT/Sales

= $492.6/$7,036 = 7.0%

Profit margin = Net income/Sales

= $253.6/$7,036 = 3.6%

Basic earning power = EBIT/Total assets

= $492.6/$3,497 = 14.1%

Basic Earning Power

• This ratio measures the ability of the firms’ assets to generate
operating income.
• Low BEP ratio can be caused by low turnover ratios and poor
profit margin ratio
 28

Appraising Profitability with Operating

Margin, Profit Margin, and Basic Earning
Power
2013E 2012 2011 Ind.
Operating margin 7.0% -2.2% 5.6% 7.3%
Profit margin 3.6% -2.7% 2.6% 3.5%
Basic earning power 14.1% -4.6% 13.0% 19.1%

• Operating margin was very bad in 2012. It is projected

to improve in 2013, but it is still projected to remain
below the industry average.
• Profit margin was very bad in 2012 but is projected to
exceed the industry average in 2013. Looking good.
• BEP projected to improve, yet still below the industry
average. There is definitely room for improvement.
 29

Profitability Ratios: Return on Assets

(ROA) and Return on Equity (ROE)

ROA = Net income/Total assets

= $253.6/$3,497
= 7.3%

• This ratio measures the profitability of the firm’s

total assets.
• Low return on total assets can result from a
conscious decision to use a great deal of debt,
hence high interest expenses will cause lower net
income.
 30

Profitability Ratios: Return on Assets

(ROA) and Return on Equity (ROE)

ROE = Net income/Total common

equity
= $253.6/$1,952
= 13.0%

• The ROE is one of the most important accounting

ratio.
• This ratio measures the rate of return on common
shareholders’ investment.
 31

Profitability Ratios: Return on Assets

(ROA) and Return on Equity (ROE)

2013E 2012 2011 Ind.

ROA 7.3% -5.6% 6.0% 9.1%
ROE 13.0% -32.5% 13.3% 18.2%

• Both ratios rebounded from the previous year, but

are still below the industry average. More
improvement is needed.
• Wide variations in ROE illustrate the effect that
leverage can have on profitability.
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Problems with ROE

• ROE and shareholder wealth are correlated, but
problems can arise when ROE is the sole measure
of performance.
• ROE does not consider risk.
• ROE does not consider the amount of capital
invested.
• Given these problems, reliance on ROE may
encourage managers to make investments that do
not benefit shareholders.
• As a result, analysts have looked to develop other
performance measures, such as EVA.
Market Value Ratios
• Although ROE is one of the best accounting measure of
performance, the investors need to take a concern about
financial leverage.
• If a high ROE is achieved by using a great deal of debt,
the stock price might be lower than if the firm had been
using less debt, as financial leverage increases the firm’s
risk.
• To address the above situation, the users of financial
statement can have a look on a set of market value ratios,
which relate the stock price to earning and book value
price.
Market Value Ratios
• Evaluate what investors think about the firm and its
future prospects.
• The market value ratios are used in three primary
ways:
• By investors – when they are deciding to buy or sell a
stock.
• By investment bankers – when they are setting the
share price for a new stock issue.
• By firms – when they are deciding how much to offer
for another firm in a potential merger.
• The most important ratios are:
• Price/Earning (P/E) ratio
• Market/Book (M/B) ratio
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Price/Earning Ratio

P/E = Price/Earnings per share

= $12.17/$1.014
= 12.0x
• The P/E ratio shows how much investors are willing
to pay per dollar of reported profit.
• The P/E ratios are relatively high for firms with
strong growth and little risk, but low for slowly
growing and risky firms.
 36

Market/Book Ratio

M/B = Market price/Book value per share

= $12.17/($1,952/250)
= 1.56x
• The M/B ratio shows the ratio of a stock’s market
price to its book value.
• Companies that are well regarded by investors –
which means low risk and high growth – have high
M/B ratio.
• Supposedly, M/B ratio exceeds 1.0, which means that
investors are willing to pay more for stocks than the
accounting book value of the stocks.
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Analyzing the Market Value

Ratios
2013E 2012 2011 Ind.
P/E 12.0x -1.4x 9.7x 14.2x
M/B 1.56x 0.5x 1.3x 2.4x

• P/E: How much investors are willing to pay for $1

of earnings.
• M/B: How much investors are willing to pay for $1
of book value equity.
• P/E and M/B are high if ROE is high and risk is low.
The DuPont Equation
• The DuPont equation shows the relationship among
asset management (TATO), debt management
(equity multiplier) and profitability (profit margin)
ratios.
• Therefore, the DuPont equation can be used to
help identify ways to improve a firm’s performance.
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The DuPont Equation

Profit Total assets Equity

ROE  margin  turnover 
multiplier

ROE  (NI/Sales)  (Sales/TA)  (TA/Equity )

• Focuses on expense control (PM), asset

utilization (TATO), and debt utilization (equity
multiplier).
 40

DuPont Equation: Breaking Down Return

on Equity (ROE)

ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)

= 3.6% x 2 x 1.8
= 13.0%
PM TA TO EM ROE
2011 2.6% 2.3 2.2 13.3%
2012 -2.7% 2.1 5.8 -32.5%
2013E 3.6% 2.0 1.8 13.0%
Ind. 3.5% 2.6 2.0 18.2%