Chapter 17

Fundamentals of
Corporate Financial Statement
Finance Analysis
Fifth Edition

Slides by
Matthew Will

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Topics Covered

Financial Ratios
DuPont System
Using Financial ratios
Measuring Company Performance
The Role of Financial Ratios

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Type of Financial Ratios

 Leverage ratios show how heavily the company is
in debt.
 Liquidity ratios measure how easily the firm can
lay its hands on cash.
 Efficiency or turnover ratios measure how
productively the firm is using its assets.
 Profitability ratios are used to measure the firm’s
return on its investments.

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Financial Statements
 Income Statement - Financial statement that shows the
revenues, expenses, and net income of a firm over a period
of time.

 Common-Size Income - Statement Income statement that

presents items as a percentage of revenues.

 Balance Sheet - Financial statement that shows the value

of the firm’s assets and liabilities at a particular time.

 Common-Size Balance Sheet - Balance sheet that presents

items as a percentage of total assets.

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Leverage Ratios

long term debt

Long term debt ratio =
long term debt + equity

long term debt

Debt equity ratio =
equity

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Leverage Ratios

total liabilities
Total debt ratio =
total assets

EBIT
Times interest earned =
interest payments

EBIT + depreciation
Cash coverage ratio =
interest payments

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Liquidity Ratios

Net working capital Net working capital

=
to total assets ratio Total assets

current assets
Current ratio =
current liabilities

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Liquidity Ratios
cash + m arketable securities + receivables
Quick ratio =
current liabilities

cash + m arketable securities

Cash ratio =
current liabilities

cash + m arketable securities + receivables

Interval m easure =
average daily expenditures from operations

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Efficiency Ratios

Sales
Asset turnover ratio =
Average total assets

sales
NW Cturnover =
average net working capital

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Efficiency Ratios
average receivables
Average collection period =
average daily sales

cost of goods sold

Inventory turnover ratio =
average inventory

average inventory
Days' sales in inventory =
cost of goods sold / 365

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Profitability Ratios
net income
Net profit margin =
sales

net income  interest

Operating profit margin =
sales

Net Income  Interest

Return on assets =
average total assets

net income
Return on equity =
average equity

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Profitability Ratios
dividends
Payout ratio =
earnings

earnings - dividends
Plowback ratio =
earnings
= 1 - payout ratio

earnings - dividends
G row th in equity from plow back =
earnings

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Market Value Ratios

stock price
PE Ratio =
earnings per share

P0 Div1 1
Forecasted PE ratio =  x
avg EPS1 EPS1 r - g

dividend per share

Dividend yield =
stock price

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Market Value Ratios

Div 1
Price per share = P0 =
r - g

stock price
M arket to book ratio =
book value per share

market value of assets

Tobins Q =
estimated replcement cost

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The DuPont System

A breakdown of ROE and ROA into

component ratios

Net Income  interest

ROA =
assets

earnings available for common stock

ROE =
equity

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The DuPont System

sales Net Income  interest

ROA = x
assets sales

asset Operating profit

turnover margin

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The DuPont System

assets sales Net Income  interest Net Income

ROE = x x x
equity assets sales Net Income  interest

leverage asset Operating debt

ratio turnover profit burden
margin

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Using Financial Ratios

LT Debt, Interest NWC Quick Asset Oper Prof. Return on Return on Payout
Industry Assets Coverage Assets Ratio Turnover Margin (%) Assets (%) Equity (%) Ratio
All manufacturing 0.19 4.13 0.07 0.91 0.93 6.88 6.37 15.76 0.31
Food products 0.28 3.65 0.09 0.81 1.37 6.20 8.50 17.80 0.36
Textiles 0.23 2.92 0.20 0.92 1.47 4.35 6.39 8.39 0.23
Petroleum/coal 0.15 3.64 0.04 1.00 1.34 3.31 4.45 18.14 0.25
Chemicals 0.19 4.27 - 0.72 0.59 10.37 6.13 7.31 0.33
Drugs 0.25 9.44 0.02 0.76 0.87 13.53 11.72 59.14 0.29
Machinery 0.19 4.64 0.13 1.02 0.89 8.04 7.19 14.82 0.17
Computers/electronic 0.11 4.52 0.14 1.31 0.66 5.30 3.52 10.06 0.20
Transportation equip. 0.17 2.22 0.01 0.72 0.94 3.94 3.69 13.12 0.30
Beverages/tobacco 0.28 5.25 –0.02 0.70 0.63 14.76 9.24 27.62 0.51

Source: U.S. Department of Commerce, Quarterly Financial Report for Manufacturing, Mining and Trade Corporations, December 2004.

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MVA & Economic Profit

Market Value Added = The difference
between the market value of common stock
and its book value

Economic Profit = capital invested

multiplied by the spread between return on
investment and the cost of capital.

EP  Economic Profit
 ( ROI  r )  Capital Invested

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Residual Income & EVA

Residual Income or EVA = Net Dollar return
after deducting the cost of capital

EVA  Residual Income

 Income Earned - income required
 Income Earned -  Cost of Capital  Investment

© EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.

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Measuring Performance
Benchmark Financial Ratios

Company Industry Sector S&P 500

Valuation Ratios
P/E ratio (TTM) 22.35 21.66 20.66 22.06
Price to book (MRQ) 6.68 6.25 7.25 4.04
Price to cash flow (TTM) 17.17 16.85 17.19 15.93
Financial Strength
Quick ratio (MRQ) 0.95 0.87 0.65 1.21
Current ratio (MRQ) 1.28 1.19 1.26 1.71
LT debt to equity (MRQ) 0.18 0.31 0.77 0.6
Total debt to equity (MRQ) 0.26 0.54 0.97 0.76
Interest coverage (TTM) 31.49 29.74 17.14 12.59
Profitability Ratios (%)
Operating margin (TTM) 17.97 20.91 17.02 21.97
Net profit margin (TTM) 14.27 17.01 11.49 14.03
Management Effectiveness (%)
Return on assets (TTM) 15.88 14.96 11.31 7.63
Return on equity (TTM) 32.84 31.06 33.28 20
Efficiency
Receivable turnover (TTM) 9.37 10.08 13.39 10.26
Inventory turnover (TTM) 8.67 7.49 6.75 13.29
Asset turnover (TTM) 1.11 0.92 1.09 0.96

Ratios PEPSICO INC (NYS)

Sector: Consumer/Noncyclical | Industry: Beverages (nonalcoholic)

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Measuring Performance
Year avergae
Market to MVA Return on Cost of capital EVA
Book Ratio ($millions) Capital (%) Capital (%) ($million) ($million)

Microsoft 7.40 204,168.00 32.90 11.70 31,090.00 6,456.00

Wal-Mart 2.90 169,927.00 13.20 6.20 86,822.00 5,920.00
Johnson & Johnson 3.40 135,584.00 18.10 8.20 57,833.00 5,682.00
Intel 4.00 98,189.00 18.60 13.70 32,394.00 1,645.00
Coca-Cola 4.80 83,080.00 21.30 6.40 21,166.00 3,116.00
IBM 2.20 79,894.00 9.00 11.20 67,369.00 –1,506
Merck 2.10 37,921.00 17.90 8.00 36,887.00 3,705.00
Dow Chemical 1.00 25,403.00 5.90 6.50 44,639.00 –299
Delta Air Lines 1.00 4,090.00 –1.0 –6.7 27,888.00 –2,155

Note: Economic value added is the rate of return on capital less the cost of capital times the amount of capital invested; e.g., for Microsoft, EVA = (.329 –
.177) × $204,168 million
Source: Data provided by Stern Stewart & Co.

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Financial Ratios and Default Risk

Three-Year (1998–2000) Medians

AAA AA A BBB BB B CCC

Operating income/sales (%) 24.6 23.4 18.1 14.7 15.9 13.9 9.4
Free cash flow/sales (%) 14.8 10.9 7.8 5.6 3.9 1.3 -0.9
EBITDA int. + div. coverage 4 3.9 4.11 4.5 3 1.7 1
Total liabilities/net worth (%) 70.3 123.6 138.8 152.6 198.7 206.9 -208.3
EBITDA/total assets (%) 22.2 21.2 16.3 13.7 12.9 10.3 6.9
Total debt/market capitalization (%) 0 8.1 17.2 27.5 43.5 55.8 79.7
Historical default rate (%) 0.5 1.3 2.3 6.6 19.5 35.8 54.4

Note: EBITDA is earnings before interest, taxes, depreciation, and amortization.

Sources: Default rates from “Statement of Standard & Poor’s on Credit Rating Agencies to SEC,” Public Hearing, November
2002; all other data from Standard & Poor’s.

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