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Chapter 4Analyzing Financial Statements

Learning Objectives

1. Explain the three perspectives from which financial statements can be viewed.

2. Describe common-size financial statements, explain why they are used, and be able to

prepare and use them to analyze the historical performance of a firm.

3. Discuss how financial ratios facilitate financial analysis, and be able to compute and use

them to analyze a firms performance.

4. Describe the DuPont system of analysis and be able to use it to evaluate a firmsperformance and identify corrective actions that may be necessary.

5. Explain what benchmarks are, describe how they are prepared, and discuss why they

are important in financial statement analysis.

6. Identify the major limitations in using financial statement analysis

I. Chapter Outline

4.1 Background for Financial Statement Analysis

Students sometimes get the impression that accounting data is useless because care must be usedwhen interpreting some of the results. They sometimes ask why we bother with financialstatement analysis at all. Robert Higgins provides a good answer to this question:

objectively determinable current values of many assets do not exist. Faced with a trade-off between relevant, but subjective current values, and irrelevant, but objective historicalcosts, accountants have opted for irrelevant, but objective historical costs. This meansthat it is the users responsibility to make adjustments.

Financial statement information is often our ONLY source of information. Consequently,we use the information we have and make adjustments where appropriate.

A. Stockholders Perspective Shareholders focus centers on the value of the stock they hold. Their interest in the financial statement is to gauge the cash flows that the firm

will generate from operations,


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This allows them to determine the firms profitability, their return for that period,and the dividend they are likely to receive.

B. Managers Perspective On one hand, managements interest in the firms financial statement is similar to

that of shareholders. A good performance by the firm will keep the management in the firm, while a

poor performance can cost them their jobs. In addition, management gets feedback on their investing, financing, and working

capital decisions by identifying trends in the various accounts that are reported inthe financial statements.

C. Creditors Perspective Creditors or lenders are primarily concerned about getting their loans repaid and

receiving interest payments on time. Their focus is on:

Amount of debt the firm has.Firms ability to meet short-term obligations.Firms ability to generate sufficient cash flows to meet all legal obligationsfirst and still have sufficient cash flows to meet debt repayment and interest

payments.

D. Guidelines for Financial Statement Analysis Identify whose perspective you are using to analyze a firmmanagement,

shareholder, or creditor. Use only audited financial statements if possible. Perform analysis over a three- to five-year period trend analysis. Compare the firms performance to its direct competitorsthat is, firms that are

similar in size and offer similar products. Perform a benchmark analysis. This involves comparing it to one or more of the

most relevant competitorsAmerican Air with Delta or United Airlines.

Things to consider concerning financial ratios:

-What aspects of the firm are we attempting to analyze?-What information goes into computing a particular ratio and how does that information relate to theaspect of the firm being analyzed?-What is the unit of measurement (times, days, percent)?-What are the benchmarks used for comparison? What makes a ratio good or bad?

In discussing the nature of financial statement analysis, realize that it is a means to an end, rather than an end in itself. That is, financial ratios uncover areas of interest that a good analyst will use todetermine what needs to be investigated further.


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4.2 Common-Size Financial Statements

A common-sized balance is created by dividing each asset or liability by a base number liketotal assets or sales. Such common-size or standardized financial statements allow one tocompare firms that are different in size.

A. Common-Size Balance Sheets Each asset and liability item on the balance sheet is standardized by dividing it by

total assets , This results in these accounts being represented as percentages of total assets.

B. Common-Size Income Statements Each income statement item is standardized by dividing it by the dollar amount of

sales . Each income statement item is now indicated as a percentage of sales.


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4.3 Financial Statement Analysis

A. Overview A ratio is computed by dividing one balance sheet or income statement item by

another. A variety of ratios can be computed to focus on specialized aspects of the firms

performance. The choice of the scale determines the story that can be garnered from the ratio. Different ratios can be calculated based on the type of firm being analyzed or the

kind of analysis being performed. Ratios may be computed to measure liquidity, efficiency, leverage, profitability,

or market-value performance.

B. Liquidity Ratios Liquidity ratios measure the ability of the firm to meet short-term obligations with

short-term assets without putting the firm in financial trouble. There are two commonly used ratios to measure liquiditycurrent ratio and quick ratio.

Current ratio is calculated by dividing the current assets by current liabilities.


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Current ratio =

Current assetsCurrent liabilites

It tells how many dollars of current assets the firm has per dollar of currentliabilities.The higher the number, the more liquid the firm and the better its ability to

pay its short-term bills. Quick ratio or acid-test ratio is calculated by dividing the most liquid of current

assets by current liabilities. Inventory that is not very liquid is subtracted fromtotal current assets to determine the most liquid assets.

Quick ratio=

Current assets - InventoryCurrent liabilities

It tells us how many dollars of liquid assets the firm has per dollar of currentliabilities.The higher the number, the more liquid the firm and the better its ability to

pay its short-term bills. Quick ratios will tend to be much smaller than current ratios for manufacturing

firms or other industries that have a lot of inventory, while service firms that tendnot to carry too much inventory will see no significant difference between thetwo.

C. Efficiency Ratios This set of ratios, sometimes called asset turnover ratios, measures the efficiency

with which a firms management uses the assets to generate sales. While management can use these ratios to identify areas of inefficiency that

require improvement, creditors can use some of these ratios to determine thespeed with which inventory can be converted to receivables, which can then beconverted to cash and help the firm to meet its debt obligations.

These efficiency ratios focus on inventory, receivables, and the use of fixed andtotal assets.

Inventory turnover ratio is calculated by dividing the cost of goods sold byinventory.

Inventory turnover ratio =

Cost of goods soldInventory


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Year-end inventory can be used or, if a firm experiences significant changesin the inventory level during the year, the average inventory level can be used.It measures how many times the inventory is turned over into saleable

products.The more times a firm can turn over the inventory, the better.

Too high a turnover or too low a turnover could be a warning sign. Another ratio that builds on the inventory turnover ratio is the days sales in

inventory .

Days' sales in inventory =

365 daysInventory turnover

It measures the number of days the firm takes to turn over the inventory.

The smaller the number, the faster the firm is turning over its inventory andthe more efficient it is. Accounts receivables turnover ratio measures how quickly the firm collects on

its credit sales.

Accounts receivables turnover =Net sales

Accounts receivablesThe higher the frequency of turnover, the quicker it is converting its creditsales into cash flows.

Another measure of the firms efficiency in this regard is Days SalesOutstanding .

DSO =

365 days Accounts receivables turnover

It measures in days the time the firm takes to convert its receivables into cash.The fewer the days it takes the firm to collect on its receivables, the moreefficient the firm is.Recognize, however, that an overzealous credit department may turn off thefirms customers.

Total asset turnover ratio measures the level of sales a firm is able to generate per dollar of total assets.


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assetsTotalsalesNet

turnover assetTotal =

The higher the total asset turnover, the more efficiently management is usingtotal assets.

Fixed asset turnover ratio measures the level of sales a firm is able to generate per dollar of fixed assets.

assetsfixedNetsalesNet

turnover assetFixed =

The higher the fixed asset turnover, the more efficiently management is usingits plant and equipment.This ratio is more significant for equipment-intensive manufacturing industryfirms, while the total assets turnover ratio is more relevant for service industryfirms.

D. Leverage Ratios The ability of a firm and its owners to use their equity to generate borrowed funds

is reflected in the leverage ratios. Financial leverage refers to the use of long-term debt in a firms capital structure. The use of debt increases shareholders returns thanks to the tax benefits provided

by the interest payments on debt. Two sets of ratios can be used to analyze leveragedebt ratios that quantify the

use of debt in the capital structure and coverage ratios that measure the ability of the firm to meet its debt obligations.

The first ratio, total debt ratio , is calculated by dividing total debt by total assets.

Total debt ratio =Total debt

Total assetsTotal debt includes short-term and long-term debt.The higher the amount of debt, the higher the firms leverage, and the morerisky it is.

The second leverage ratio is debt-to-equity ratio .


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Debt to equity ratio =

Total debtTotal equity

It measures the amount of debt per dollar of equity.

Debt ratio =

Debt to equity ratio1 + Debt to equity ratio

Equity multiplier = 1 + debt to equity ratio The third leverage ratio is called the equity multiplier or leverage multiplier .

equityTotalassetsTotal multiplier Equity =

It tells us the amount of assets that the firm has for every dollar of equity.

It serves as the best measure of the firms ability to leverage shareholdersequity with borrowed funds. Of the coverage ratios , the first one is times interest earned .

TIE =

EBITInterest expense

It measures the number of dollars in operating earnings the firm generates per

dollar of interest expense.The higher the number, the greater the ability of the firm to meet its interestobligations.

The second ratio is the cash coverage ratio .


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Cash coverage ratio =

EBIT + DepreciationInterest expense

It measures the amount of cash a firm has to meet its interest payments.

E. Profitability Ratios These ratios measure the financial performance of the firm. Gross profit margin measures the amount of gross profit generated per dollar of

net sales, while operating profit margin measures the amount of operating profitgenerated by the firm for each dollar of net sales. Net profit margin measures theamount of net income after taxes generated by the firm for each dollar of netsales.

Gross profit margin =Net sales - Cost of goods sold

Net sales

Operating profit margin =

EBITNet sales

Net profit margin = Net income

Net sales In each case, the higher the ratio, the more profitable the firm. While management and creditors are likely to focus on these profitability

measures, shareholders are likely to concentrate on two others. The return on assets (ROA) ratio measures the amount of net income per dollar

of total assets.

ROA = Net incomeTotal assets A variation of this ratio, called the EBIT return on assets , is a powerful measure

of return because it tells us how efficiently management utilized the assets under


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their command, independent of financing decisions and taxes. This measures theamount of EBIT per dollar of total assets.

The return on equity (ROE) ratio measures the dollar amount of net income per dollar of shareholder s equity.

ROE = Net incomeTotal equity

For a firm with no debt ROA = ROE; for firms with leverage ROE > ROA(assuming that ROA is positive).

F. Market-Value Indicators The ratios that follow tell us how the market views the companys liquidity,

efficiency, leverage, and profitability.

The earnings per share (EPS) ratio measures the income after taxes generated by the firm for each share outstanding.

EPS =

Net incomeShares outstanding

The price-earnings (P/E) ratio ties the firms earnings per share to price per share.

P/E ratio =

Price per shareEPS

The P/E ratio reflects investors expectations that the firms earnings willgrow in the future.

The price used to calculate a P/E ratio is usually the most recent price. Theearnings figure used is the most recently available, although this figure may beout of date and may not necessarily reflect the current position of the company.This is often referred to as a trailing P/E, because it involves taking earnings fromthe last four quarters; the 'forward P/E' (or current price compared to estimatedearnings going forward twelve months) is also used.

The P/E ratio of a company is a significant focus for management in many


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companies and industries. This is because management is primarily paid withtheir company's stock (a form of payment that is supposed to align the interests of management with the interests of other stock holders), in order to increase thestock price. The stock price can increase in one of two ways: either throughimproved earnings or through an improved multiple that the market assigns to

those earnings.

Price-sales ratio = price per share / sales per share

A stock's capitalization divided by its sales over the trailing 12 months. The valueis the same whether the calculation is done for the whole company or on a per-share basis. A low price to sales ratio (for example, below 1.0) is usually thoughtto be a better investment since the investor is paying less for each unit of sales.However, sales don't reveal the whole picture, since the company might beunprofitable. Because of the limitations, price to sales ratio are usually used onlyfor unprofitable companies, since such companies don't have a price/earnings ratio

(P/E ratio) . http://stocks.about.com/od/evaluatingstocks/a/ps.htm

http://www.fool.com/investing/high-growth/2006/04/10/foolish-fundamentals-the- pricetosales-ratio.aspx
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4.4 The DuPont System: A Diagnostic Tool

A. An Overview The DuPont system is a set of related ratios that links the balance sheet and the

income statement. It is used as a diagnostic tool to evaluate a firms financial health. Both management and shareholders can use this tool to understand the factors that

drive a firms ROE. It is based on two equations that relate a firms ROA and ROE.


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B. The ROA Equation Return on assets, which is Net income / Total assets, can be broken down into two

componentsprofit margin and total assets turnover ratio. See Equation 4.18.

ROA = Net incomeNet sales

Net salesTotal assets

= Profit margin Total assets turnover The net profit margin measures managements ability to generate sales and

efficiently manage the firms operating expenses; overall, this is a measure of operating efficiency .

Total asset turnover looks at how efficiently management uses the assets under itscommandthat is, how much output can be generated with a given asset base.Thus, asset turnover is a measure of asset use efficiency .

The ROA equation says that if management wants to increase the firms ROA, itcan increase the profit margin, asset turnover, or both.

By the same token, management can examine a poor ROA and determine whether operating efficiency is the problem or asset use efficiency problem.

C. The ROE Equation

This equation is simply a restatement of Equation 4.19. Reorganization of theterms allows ROE to be restated as a product of the ROA and the equitymultiplier.

ROE = Net incomeTotal equity

= Net incomeTotal assets

Total assetsTotal equity

= ROA Equity multiplier ROE is determined by the firms ROA and its use of leverage. A firm with a small ROA can magnify it by using a higher leverage to get a

higher ROE.

D. The DuPont Equation Substituting the ROA into the ROE equations gives us the DuPont equation as

shown in Equations 4.23 and 4.24.


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ROE = Net profit margin x Total asset turnover x Equity multiplier

ROE = Net income/Net sales x Net sales/Total assets x Total assets/Total equity

The DuPont equation shows that a firms ROE is determined by three factors: (1)

net profit margin, which measures the firms operating efficiency, (2) total assetturnover, which measures the firms asset use efficiency, and (3) the equitymultiplier, which measures the firms financial leverage.

Analyzing a firms financial performance will allow one to identify where theinefficiencies are and where the strengths are.

If operational efficiency is the area of weakness, then it calls for a closer look atthe firms income statement items.

If asset turnover or leverage is the problem area, then the focus shifts to the balance sheet.


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You can click below for an excel version of a DuPont Chart:http://investment-db.com/ARTICLES/DupontCalc.xls

E. ROE as a Goal The issue of whether maximizing ROE is equivalent to maximizing shareholders

wealth is something to be discussed. Those who do not agree that they are the same identify three key weaknesses.

The first weakness with ROE is that it is based on after-tax earnings, not cashflows.

Next, ROE does not consider risk.
http://investment-db.com/ARTICLES/DupontCalc.xlshttp://investment-db.com/ARTICLES/DupontCalc.xls


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Third, ROE ignores the size of the initial investment as well as future cashflows.

Those who believe that they are consistent propose that:ROE allows management to break down the performance and identify areas of strengths and weaknesses.

ROE is highly correlated with shareholder wealth maximization.

4.5 Selecting a Benchmark

A ratio analysis becomes relevant only if it can be compared against a benchmark. Financial managers can create a benchmark for comparison in three ways:

through trend analysis, industry average analysis, and peer group analysis. A. Trend Analysis

This benchmark is based on a firms historical performance. It allows management to examine each ratio over time and determine whether the

trend is good or bad for the firm.

B. Industry Analysis Industry analysis is another way of developing a benchmark. Firms in the same industry are grouped by size, sales, and product lines to

establish benchmark ratios.


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One way of identifying industry groups is the Standard IndustrialClassification (SIC) System.

C. Peer Group Analysis Instead of selecting an entire industry, management may choose to identify a set

of firms that are similar in size or sales, or who compete in the same market. The average ratios of this peer group would then be used as the benchmark. Depending on the industry, peer groups can be as small as three or four firms.


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Chapter 4 Sample Questions

Multiple Choice Identify the choice that best completes the statement or answers the question.

1. Liquidity ratio: Bathez Corp. has receivables of $334,227, inventory of $451,000, cash of $73,913, andaccounts payables of $469,553. What is the firm's current ratio?

a. 1.83 b. 0.73c. 1.67d. None of the above

2. Liquidity ratio: Zidane Enterprises has a current ratio of 1.53, current liabilities of $206,938, and inventoryof $161,412. What is the firm's quick ratio?

a. 0.92 b. 0.75c. 2.31d. 0.65

3. Efficiency ratio : Jason Traders has sales of $624,081, a gross profit margin of 36.1 percent, and inventory of $243,392. What is the company's inventory turnover ratio?

a. 1.92 times b. 2.56 timesc. 2.18 timesd. 1.64 times

4. Efficiency ratio : Gateway Corp. has an inventory turnover ratio of 5.6. What is the firm's days' sales ininventory?

a. 65.2 days b. 64.3 daysc. 61.7 daysd. 57.9 days

5. Efficiency ratio: Ellicott City Manufacturers, Inc., has sales of $6,344,210, and a gross profit margin of 67.3 percent. What is the firm's cost of goods sold?

a. $2,074,557 b. $2,745,640c. $274,560d. None of the above


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6. Coverage ratios : Fahr Company had depreciation expenses of $630,715, interest expenses of $112,078, andan EBIT of $1,542,833 for the year ended June 30, 2006. What are the times interest earned and cash coverageratios for this company?

a. 19.4 times; 12.7 times b. 17.3 time; 11.4 times

c. 13.8 times; 19.4 timesd. None of the above

7. Leverage ratio: Your firm has an equity multiplier of 2.47. What is its debt-to-equity ratio?a. 0.60

b. 1.47c. 1.74d. 0

8. Market-value ratio: RTR Corp. has reported a net income of $1,526,990 for the year. The company's share price is $56.26, and the company has 348,685 shares outstanding. Compute the firm's price-earnings ratio.a. 11.69 times

b. 10.92 timesc. 12.85 timesd. 10.41 times

9. Profitability ratio: Juventus Corp has total assets of $2,977,397, total debt of $982,541, and net sales of $4,466,096. Their net profit margin for the year is 6.55 percent. What is Juventus's ROA?

a. 9.83% b. 9.24%c. 8.55%d. 6.19%

10. DuPont equation: Andrade Corp has debt of $2,834,950, total assets of $5,178,235, sales of $8,234,121,and net income of $812,355. What is the firm's return on equity?

a. 7.1% b. 34.7%c. 28.1%d. 43.2%


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Answer Section

MULTIPLE CHOICE

1. ANS: ACurrent assets = $73,913 + $451,000 +$334,227 = $859,140Current liabilities = $469,553

PTS: 1

2. ANS: BCurrent ratio = 1.53; Current liabilities = $206,938; Inventory = $161,412

PTS: 1 MSC: JDK

3. ANS: DSales = $624,081; Gross profit margin = 36.1%; Inventory = $243,392

PTS: 1 MSC: JDK

4. ANS: A

PTS: 1

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5. ANS: A

PTS: 1

6. ANS: CDepreciation = $630,715Interest expenses = $112,078EDIT= $1,542,833

PTS: 1

7. ANS: BEquity multiplier = 1 + Debt to equityDebt to equity = Equity multiplier 1= 2.47 1= 1.47

PTS: 1

8. ANS: C

PTS: 1 MSC: JDK

9. ANS: ATotal assets = $2,977,397; Total debt = $982,541; Sales = $4,466,096; Net profit margin =6.55%

23


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PTS: 1 MSC: JDK

10. ANS: B

Feedback:

PTS: 1

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