Week 14 Analysis of Financial Statements Rev March 2021-Titman

Chapter 4
Financial
Analysis—
Sizing up Firm
Performance
1
Learning Objectives
1. Explain what we can learn by analyzing a firm’s
financial statements.
2. Use common size financial statements as a tool
of financial analysis.
3. Calculate and use a comprehensive set of
financial ratios to evaluate a company’s
performance.
4. Select an appropriate benchmark for use in
performing a financial ratio analysis.
5. Describe the limitations of financial ratio
analysis.
Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-2

4.1 WHY DO WE ANALYZE
FINANCIAL STATEMENTS?

Why Do We Analyze Financial
Statements?
• An internal financial analysis might be done:
– To evaluate the performance of employees
– To compare the performance of different divisions
– To prepare financial projections
– To evaluate the firm’s financial performance in
light of its competitors’ performance
• External financial analysis is done by:
– Banks and other lenders
– Suppliers
– Credit-rating agencies
– Professional analysts
– Individual investors

4.2 COMMON SIZE
STATEMENTS:
STANDARDIZING FINANCIAL
INFORMATION

Common Size Statements:
Standardizing Financial Information
• A common size financial statement is a
standardized version of a financial statement in
which all entries are presented in percentages.
• It helps to compare a firm’s financial
statements with those of other firms, even if
the other firms are not of equal size.
• How to prepare a common size financial
statement?
– For a common size income statement, divide
each entry in the income statement by sales.
– For a common size balance sheet, divide each
entry in the balance sheet by total assets.

Table 4.1 H. J. Boswell, Inc.

Table 4.2 H. J.
Boswell, Inc.

4.3 USING FINANCIAL
RATIOS

Using Financial Ratios
• Financial ratios provide a second method

for standardizing the financial information
on the income statement and balance sheet.
• A ratio by itself may have no meaning.

Hence, a given ratio is generally compared
to: (a) ratios from previous years; or (b)
ratios of other firms in the same industry.

Using Financial Ratios (cont.)

LIQUIDITY RATIOS

Table 3.2 H. J. Boswell, Inc.

H. J. Boswell, Inc. Balance Sheet

Liquidity Ratios
• Liquidity ratios address a basic question: How
liquid is the firm?
• A firm is financially liquid if it is able to pay its
bills on time. We can analyze a firm’s liquidity
from two perspectives (see next slide).
1.Overall liquidity - analyzed by comparing the
firm’s current assets to the firm’s current
liabilities.
2.Liquidity of specific assets - analyzed by
examining the timeliness in which the firm’s
liquid assets (accounts receivable and
inventories) are converted into cash.

Liquidity Ratios: Current Ratio
• The overall liquidity of a firm is analyzed by computing
the current ratio and acid-test ratio. Current Ratio:
Current Ratio compares a firm’s current (liquid) assets to
its current (short-term) liabilities.
• What is the current ratio for 2016 for Boswell?
• The firm had $2.23 in current assets for every $1 it owed

in current liability, and better than peer-group

Liquidity Ratios: Quick Ratio
• Acid-Test (Quick) Ratio excludes the inventory from
current assets as inventory may not be very liquid.
• What is the quick ratio for Boswell for 2016?
• The firm has only $0. 92 in current assets (less

inventory) to cover $1 in current liabilities.

Liquidity Ratios:
Individual Asset Categories
We can also measure the liquidity of the firm

by examining the liquidity of accounts
receivable and inventories to see how long
it takes the firm to convert its accounts
receivables and inventories into cash.

Liquidity Ratios: Accounts
Receivable
Average Collection Period measures the number of
days it takes the firm to collects its receivables.
•What will be the average collection period for

Boswell, Inc. for 2012 if we assume that the
annual credit sales were $2,700 million?

Liquidity Ratios: Accounts
Receivable Turnover Ratio
Accounts Receivable Turnover Ratio measures how many
times receivables are “rolled over” during a year.
•What will be the accounts receivable turnover ratio for Boswell,

Inc. for 2016 if we assume that the annual credit sales were
$2,700 million?
•Note that H. J. Boswell collected its accounts receivable every 21.90 days in
2016, which means that the receivables were turning over at a rate of 16.67
times per year (365 days:
•21.90 days = 16.67 times per year).

Liquidity Ratios: Inventory Turnover Ratio
Inventory turnover ratio measures how many
times the company turns over its inventory during the
year. Shorter inventory cycles lead to greater liquidity
since the items in inventory are converted to cash
more quickly.
•What will be the inventory turnover ratio for 2016 for

Boswell, Inc. if we assume that the cost of goods sold
were $2.025 million in 2016?

Liquidity Ratios:
Days’ Sales in Inventory
• The number of days the inventory sits unsold

on the firm’s shelves (or elsewhere).
• Days’ Sales in Inventory
= 365÷ inventory turnover ratio
= 365 ÷ 5.36 = 68 days
• The firm, on average, holds it inventory for
about 68 days.
• Whereas the average peer firm carries its
inventory only 52 days (365 days , 7.0 times
per year = 52 days).
Can a Firm Have Too Much Liquidity?
• A high investment in liquid assets will enable

the firm to repay its current liabilities in a
timely manner.
• However, an excessive investments in liquid

assets can prove to be costly as liquid
assets (such as cash) generate minimal
return.

CAPITAL STRUCTURE RATIOS
CAPITAL STRUCTURE REFERS TO THE WAY

A FIRM FINANCES ITS ASSETS. CAPITAL
STRUCTURE RATIOS ADDRESS THE
IMPORTANT QUESTION: HOW HAS THE
FIRM FINANCED THE PURCHASE OF ITS
ASSETS?

Capital Structure Ratios (cont.)
Debt ratio measures the proportion of the firm’s assets
that are financed by borrowing or debt financing.
•What is the debt ratio for H.J. Boswell, Inc. for

2016?
– The firm financed 53.8% of its assets with debt.

Capital Structure Ratios (cont.)
• Times Interest Earned Ratio measures the ability of
the firm to service its debt or repay the interest on debt.
• What will be the times interest earned ratio for Boswell

for 201 if we assume interest expense of $65 million and
EBIT of $350 million?
– The firm can pay its interest expense 5.67 times or

interest used 1/5.67th or 17.63% of its EBIT.

ASSET MANAGEMENT
EFFICIENCY RATIOS

Asset Management Efficiency Ratios
• Asset management efficiency ratios

measure a firm’s effectiveness in utilizing its
assets to generate sales.
• They are commonly referred to as turnover
ratios as they reflect the number of times a
particular asset account balance turns over
during a year.

(cont.)
• Total Asset Turnover Ratio represents the
amount of sales generated per dollar invested in
firm’s assets.
What will be the total asset turnover ratio for Boswell,
Inc. for 2016 if we assume total sales to be $2,700
million?
– The firm generated $1.37 in sales per dollar of

assets in 2016.

(cont.)
• Fixed asset turnover ratio measures firm’s
efficiency in utilizing its fixed assets (such as
property, plant and equipment).
What will be the fixed asset turnover ratio for Boswell
for 2016 if we assume sales of $2,700 million for
2016?
– The firm generated $2.03 in sales per dollar

invested in plant and equipment.

(cont.)
The following grid summarizes the efficiency

of Boswell’s management in utilizing its assets
to generate sales in 2016.

PROFITABILITY RATIOS

Profitability Ratios
• Profitability ratios address a very

fundamental question: Has the firm earned
adequate returns on its investments?
• Two fundamental determinants of firm’s
profitability and returns on investments:
– Cost Control – How well has the firm controlled
its costs relative to each dollar of firm sales?
– Efficiency of asset utilization – How effective
is the firm in using the assets to generate sales?

Cost Control: Is the Firm Earning
Reasonable Profit Margins?
Gross profit margin shows how well the firm’s
management controls its expenses to generate profits.
What will be the gross profit margin ratio for 2012 for
Boswell if we assume sales of $2,700 million and gross
profit of $382.5 million?
– The firm spent $0.75 for cost of goods sold and thus $0.25
out of each dollar of sales went towards gross profits.

Reasonable Profit Margins? (cont.)
Operating Profit Margin measures how much profit is
generated from each dollar of sales after accounting for both
costs of goods sold and operating expenses. It also indicates
how well the firm is managing its income statement.
What will be the operating profit margin ratio for Boswell for
2012 if we assume sales of $2,700 million and net
operating income of $382.5 million?
– The firm generates $0.142 in operating profit for each

dollar of sales.

Reasonable Profit Margins? (cont.)
Net Profit Margin measures how much income is
generated from each dollar of sales after adjusting for
all expenses (including income taxes).
•Net Profit Margin =$204.75 million/$2,700 million =

0.076 or 7.6%
•Peer group net profit margin = 10.2%
– The firm generated $0.076 for each dollar of

sales after all expenses were accounted for.

Return on Invested Capital
Operating Return on Assets ratio is the summary
measure of operating profitability. It takes into account
the management’s success in controlling expenses and its
efficient use of assets.
– The firm generated $0.194 of operating profits for

every $1 of its invested assets.

Decomposing the Operating Return
on Assets Ratio
Decompose the OROA ratio into two other ratios that capture the
firm’s ability to control costs and its ability to utilize its investment
in assets efficiently, as follows:

Figure 4.1 Analyzing H. J. Boswell, Inc.’s
Operating Return on Assets (OROA)

Figure 4-1 Observations
• Firm’s OROA (operating return on assets) is

better than its peers.
• Firm’s OPM (operating profit margin) is

lower than its peers.
• Firm’s TATO (total asset turnover ratio) is

higher than that of its peers.

Figure 4-1 Recommendations
1. Reduce costs - The firm must investigate

the cost of goods sold and operating
expenses to see if there are opportunities
to reduce costs.
2. Reduce inventories – The firm must

investigate if it can reduce the size of its
inventories.

Is the Firm Providing a Reasonable
Return on the Owner’s Investment?
Return on Equity (ROE) ratio measures the
accounting return on the common stockholders’
investment.
– Thus the shareholders earned 22.5% on their

investments.

Using the DuPont Method for
Decomposing the ROE ratio
• DuPont method analyzes the firm’s ROE by

decomposing it into three parts.
– ROE = Profitability × Efficiency × Equity

Multiplier
• Equity multiplier captures the effect of the

firm’s use of debt financing on its return on
equity. The equity multiplier increases in
value as the firm uses more debt.

Decomposing the ROE ratio (cont.)
ROE = Profitability × Efficiency × Equity

Multiplier

Decomposing the ROE ratio (cont.)
The following table shows why Boswell’s

return on equity was higher than its peers.

Using the DuPont Method for Decomposing the
ROE ratio (cont.)
Figure 4.2

MARKET VALUE RATIOS

Market Value Ratios
Market value ratios address the question, how
are the firm’s shares valued in the stock market?
– To this point, we have relied exclusively on
accounting data to assess the performance of a
firm’s managers.
– We now want to look at their performance in terms
of how the stock market values the firm’s equity.
– To do this, we examine two market value ratios that
indicate what investors think of both the managers’
past performance and the firm’s future prospect

Price-Earnings Ratio
Price-Earnings (PE) Ratio indicates how much
investors are currently willing to pay for $1 of reported
earnings.
•H. J. Boswell, Inc.’s PE ratio tells us that the investors

were willing to pay $14.07 for every $1.00 of earnings
per share that H. J. Boswell, Inc., produced compared
to an average PE ratio of 12 times for the firms making
up the peer group

Market Value Ratios (cont.)
• What will be the PE ratio for 2012 for Boswell, Inc. if
we assume the firm’s stock was selling for $22 per
share at a time when the firm reported a net income of
$217.75 million, and the total number of common
shares outstanding are 90 million?
• Earnings per share
= $217.75 million ÷ 90 million = $2.42
• PE ratio = $22 ÷ $2.42 = 9.09
• The investors were willing to pay $9.09 for every dollar

of earnings per share that the firm generated.

• Market-to-Book Ratio measures the relationship
between the market value and the accumulated
investment in the firm’s equity.
• A market-to-book ratio greater than 1 indicates
that the market value of the firm’s shares is greater
than the book value or the accumulated investment
in the firm’s equity.

What will be the market-to-book ratio for 2012 for Boswell
if the market price of the stock is $22 and the firm has 90
million shares outstanding with a value of 751.50 million?
•Book Value per Share

– = 751.50 million ÷ 90 million = $8.35 per share
•Market-to-Book Ratio
= Market price per share ÷ Book value per share
= $22 ÷ $8.35
= 2.63 times

4.4 SELECTING A
PERFORMANCE BENCHMARK

Selecting a Performance Benchmark
• There are two types of benchmarks that are commonly
used:
– Trend Analysis – compares a firm’s financial statements over time
(time-series comparisons).
– Peer Group Comparisons – compares the subject firm’s financial
statements with “peer” firms.
• Comparing a firm’s recent financial ratios with the past
financial ratios provides insight into whether the firm is
improving or deteriorating over time. This type of financial
analysis is referred to as trend analysis.
• Peer groups often consist of firms from the same industry.
Industry average financial ratios can be obtained from a
number of financial databases and internet sources (such
as yahoo finance and google finance).

Figure 4-3 A Time-Series (Trend) Analysis: Dell’s
Inventory Turnover Ratio Versus Hewlett
Packard’s: 1995–2011

Figure 4-4 Financial Analysis of the
Gap, Inc., June 2009

4.5 LIMITATIONS OF RATIO
ANALYSIS

The Limitations of Ratio Analysis
1. Picking an industry benchmark can sometimes be
difficult.
2. Published peer-group or industry averages are not
always representative of the firm being analyzed.
3. An industry average is not necessarily a desirable
target or norm.
4. Accounting practices differ widely among firms.
5. Many firms experience seasonal changes in their
operations.
6. Financial ratios offer only clues.
7. The results of financial analysis are no better than
the quality of the financial statements.

Key Terms
• Accounts receivable turnover ratio

• Acid-test (quick) ratio
• Average collection period
• Book value per share
• Capital structure
• Current ratio
• Days’ sales in inventory

Key Terms (cont.)
• Debt ratio
• DuPont method
• Equity Multiplier
• Earnings per share (EPS)
• Financial leverage
• Financial ratios
• Fixed asset turnover ratio
• Inventory turnover ratio

Key terms (cont.)
• Liquidity ratios
• Market-to-book ratio
• Market value ratios
• Notes payable
• Operating return on assets (OROA)
• Price-earnings (PE) ratio

Key terms (cont.)
• Return on assets (ROA)

• Return on equity (ROE)
• Times interest earned
• Total asset turnover ratio (TATO)
• Trend analysis

Assignment
• Problem/Exercise 4.25 and 4.26 from

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Week 14 Analysis of Financial Statements Rev March 2021-Titman

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Chapter 4

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-2

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-3

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-4

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-5

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-6

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Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-9

• Financial ratios provide a second method

• A ratio by itself may have no meaning.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-10

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-11

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-12

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Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-14

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-15

• What is the current ratio for 2016 for Boswell?

• The firm had $2.23 in current assets for every $1 it owed

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-16

• What is the quick ratio for Boswell for 2016?

• The firm has only $0. 92 in current assets (less

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-17

We can also measure the liquidity of the firm

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-18

•What will be the average collection period for

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-19

•What will be the accounts receivable turnover ratio for Boswell,

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-20

•What will be the inventory turnover ratio for 2016 for

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-21

• The number of days the inventory sits unsold

• A high investment in liquid assets will enable

• However, an excessive investments in liquid

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-23

CAPITAL STRUCTURE REFERS TO THE WAY

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-25

•What is the debt ratio for H.J. Boswell, Inc. for

– The firm financed 53.8% of its assets with debt.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-26

• What will be the times interest earned ratio for Boswell

– The firm can pay its interest expense 5.67 times or

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-27

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-29

• Asset management efficiency ratios

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-30

– The firm generated $1.37 in sales per dollar of

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-31

– The firm generated $2.03 in sales per dollar

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-32

The following grid summarizes the efficiency

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-34

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-35

• Profitability ratios address a very

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-36

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-37

– The firm generates $0.142 in operating profit for each

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-38

•Net Profit Margin =$204.75 million/$2,700 million =

– The firm generated $0.076 for each dollar of

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-39

– The firm generated $0.194 of operating profits for

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-40

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-41