Cornett Finance M 5e Chapter 03

3
Analyzing Financial
Statements
Finance 5th Edition

Cornett, Adair, and Nofsinger
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education .
Introduction
• Various uses of financial statements
• Provide information on firm’s financial position at
a point in time or its operations over some past
period
• Information contained in financial statements
may be used to analyze the current financial
performance of the firm
• Information provided assists in decision-making
that improves the firm’s future performance, and
ultimately, its market value
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 3-2
Ratio Analysis
• Ratio analysis is the process of calculating
and analyzing financial ratios to assess a
firm’s performance and to identify actions
needed to improve firm performance
• Five groups of ratios
• Liquidity
• Asset management
• Debt management
• Profitability
• Market value
Ratio Analysis Options
• Trend analysis
• Comparison to the same firm over time
• Industry analysis
• Comparison to other firms in the same industry
Liquidity Ratios
• Liquidity ratios measure the relationship
between a firm’s liquid (or current) assets
and its current liabilities
• Commonly-used liquidity ratios
• Current ratio
• Quick (or acid-test) ratio
• Cash ratio
Current Ratio
• Broadest liquidity measure
• Measures the dollars of current assets
available to pay each dollar of current
liabilities
Quick Ratio
• Measures the firm’s ability to pay off short-
term obligations without relying on
inventory sales
• Inventories are generally the least liquid of a
firm’s current assets
Cash Ratio
• Measures a firm’s ability to pay short-term
obligations with its available cash and
marketable securities
Asset Management Ratios
• Asset management ratios measure how
efficiently a firm uses its assets, as well as
how efficiently the firm manages its
accounts payable
• Inventory management
• Accounts receivable management
• Accounts payable management
• Fixed asset and working capital management
• Total asset management
Inventory Management
• The inventory turnover ratio measures the
number of dollars of sales produced per
dollar of inventory
• Cost of goods sold is used as the numerator
when managers want to emphasize that
inventory is listed on the balance sheet at cost,
that is, the cost of sales generated per dollar of
inventory
Inventory Management (continued)
• The days’ sales in inventory ratio measures
the number of days that inventory is held
before the final product is sold
Accounts Receivable Management
• The accounts receivable turnover
measures the number of dollars of sales
produced per dollar of accounts receivable
Accounts Receivable Management (continued)
• The average collection period (ACP)

measures the number of days accounts
receivable are held before the firm collects
cash from the sale
• Also referred to as days’ sales outstanding
(DSO)
Accounts Payable Management
• The accounts payable turnover ratio
measures the dollar cost of goods sold
(COGS) per dollar of accounts payable
Accounts Payable Management (continued)
• The average payment period (APP) ratio
measures the number of days that the firm
holds accounts payable before it has to
extend cash to pay for its purchases
Fixed Asset and Working Capital Management
• The fixed asset turnover ratio measures the

dollar of net fixed assets
Fixed Asset and Working Capital Management (continued)
• The sales to working capital ratio measures

the number of dollar of sales produced per
dollar of net working capital (current assets
minus current liabilities)
Total Asset Management
• The total asset turnover ratio measures the
dollar of total assets
Total Asset Management (continued)
• The capital intensity ratio measures the
dollars of total assets needed to produce a
dollar of sales
Debt Management Ratios
• Debt management ratios measure the
extent to which the firm uses debt (or
financial leverage) versus equity to finance
its assets as well as how well the firm can
pay off its debt
• Two major types of debt management ratios
• Evaluate whether a firm is financing its assets with a
reasonable amount of debt versus equity financing
• Measure whether the firm is generating sufficient
earnings or cash to make promised debt payments
Debt versus Equity Financing
• Capital structure refers to the amount of
debt versus equity financing held on the
balance sheet
• Three primary ratios
• Debt ratio
• Debt-to-equity
• Equity multiplier
Debt Ratio
• The debt ratio measures the percentage of
total assets financed with debt
Debt-to-Equity Ratio
• The debt-to-equity ratio measures the
dollars of debt financing used for every
dollar of equity financing
Equity Multiplier Ratio
• The equity multiplier ratio measures the
dollars of debt financing used for every
dollar of equity financing
Times Interest Earned Ratio
• The times interest earned ratio measures
the number of dollars of operating earnings
dollars available to meet each dollar of
interest obligations on the firm’s debt
Fixed Charge Coverage Ratio
• The fixed charge coverage ratio measures
the number of dollars of operating earnings
available to meet the firm’s interest
obligations and other fixed charges
Cash Coverage Ratio
• The cash coverage ratio measures the
number of dollars of operating cash
available to meet each dollar of interest and
other fixed charges that the firm owes
Profitability Ratios
• Ratios that show the combined effect of
liquidity, asset management, and debt
management on the firm’s overall operating
results are profitability ratios
• Closely monitored by investors
• Stock prices react very quickly to unexpected
changes in these ratios
Profit Margin
• The gross profit margin is the percent of sales left
after cost of goods sold are deducted
• The operating profit margin is the percent of sales left
after all operating expenses are deducted
• The profit margin is the percent of sales left after all
firm expenses are deducted
Basic Earnings Power Ratio
• The basic earnings power ratio measures
the operating return on the firm’s assets,
regardless of financial leverage and taxes
Return on Assets (ROA)
• Return on assets (ROA) measures the
overall return on the firm’s assets, including
financial leverage and taxes
Return on Equity (ROE)
• Return on equity (ROE) measures the
return on common stockholders’ investment
in the assets of the firm
• Affected by net income and amount of financial
leverage used by the firm
• High ROE is usually a positive sign, unless
driven by excessively high leverage
Dividend Payout Ratio
• The dividend payout ratio is the percentage
of net income available to common
stockholders that the firm actually pays as
cash to these investors
Market Value Ratios
• Market value ratios relate a firm’s stock
price to its earnings and book value
• Market values measure what investors think of
the company’s future performance and risk
Market-to-Book Ratio
• The market-to-book ratio measures the
amount that investors will pay for the firm’s
stock per dollar of equity used to finance
the firm’s assets
• Compares the market (current) value of the
firm’s equity to its historical cost
Price-Earnings Ratio
• The price-earnings ratio measures how
much investors are willing to pay for each
dollar the firm earns per share of its stock
• Best known and most often quoted figure
• Often quoted in multiples – the number of
dollars per share – that fund managers,
investors, and analysts compare within industry
classes
• High PE ratio usually indicates projected growth
3-36
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DuPont Analysis
• The DuPont system of analysis is an
analytical method that uses the balance
sheet and income statement to break the
ROA and ROE ratios into component
pieces
• ROA is evaluated as the product of the profit
margin and the total asset turnover ratios
• ROE is evaluated as the product of ROA and
the equity multiplier
DuPont System Analysis
Other Ratios
• Spreading the financial statement occurs
when balance sheet amounts are divided
by total assets and income statement
amounts are divided by net sales
• Result in common-size financial statements
• Year-to-year growth rates provide useful ratios
for identifying trends and allow for an easy
comparison across firms in the industry
Internal and Sustainable Growth Rates
• The internal growth rate is the growth rate
a firm can sustain if it uses only internal
financing – that is, retained earnings – to
finance future growth
• The sustainable growth rate is the growth
rate a firm can sustain if it finances growth
using both debt and internal financing such
that the debt ratio remains constant
Time Series and Cross-Sectional Analyses
• Time series analysis occurs when one is
analyzing firm performance by monitoring
ratio trends
• I.e., performance of the firm over time
• Cross-sectional analysis occurs when

one is analyzing the performance of a firm
against one of more companies in the
same industry
Cautions in Using Ratios
• Caution should be exercised in using ratios to
evaluate firm performance
• Historical data may not reflect future performance
• Firms utilize different account procedures
• Competitors may be based outside of the U.S.
• Sales and expenses vary throughout the year
• Large firms have multiple divisions/business units
• Firms often employ window dressing techniques
• Individual analysts may calculate ratios in modified
forms

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Finance 5th Edition

• The average collection period (ACP)

• The fixed asset turnover ratio measures the

• The sales to working capital ratio measures

• Cross-sectional analysis occurs when

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