Chapter 04

Analysis of Financial
Statements
Chapter 4
© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Overview
Ratio Analysis
DuPont Equation
Effects of Improving Ratios
Limitations of Ratio Analysis
Qualitative Factors
Balance Sheet: Assets
the expected value
2020E 2019
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
Balance Sheet: Liabilities and Equity
2020E 2019
Accts payable 436,800 524,160
Accruals 408,000 489,600
Notes payable 300,000 636,808
Total CL 1,144,800 1,650,568
Long-term debt 400,000 723,432
Common stock 1,718,986 460,000
Retained earnings 233,366 32,592
Total Equity 1,952,352 492,592
Total L & E 3,497,152 2,866,592
Income Statement
2020E 2019
Sales 6,900,600 6,126,796
COGS 5,875,992 5,528,000
Other expenses 550,000 519,988
EBITDA 474,608 78,808
Deprec. & amort. 116,960 116,960
EBIT 357,648 ( 38,152)
Interest exp.
EBT
70,008 122,024
Taxes 287,640 (160,176)
Net income 31,866 0
255,774 (160,176)
define the firm’s performance
Other Data
2020E 2019
No. of shares 250,000 100,000
EPS $1.023 -$1.602
DPS $0.220 $0.110
Stock price $12.17 $2.25
Lease pmts $40,000 $40,000
Why are ratios useful?
▪ Ratios standardize numbers and facilitate

comparisons.
▪ Ratios are used to highlight weaknesses and
strengths.
▪ Ratio comparisons should be made through time
and with competitors.
• Industry analysis
• Benchmark (peer) analysis
• Trend analysis
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?
D’Leon’s Forecasted Current Ratio and Quick Ratio for
2020
▪ Current ratio = Current assets/Current liabilities

= $2,680/$1,145
= 2.34x
▪ Quick ratio = (Current assets – Inventories) / Current

liabilities
= ($2,680 − $1,716)/$1,145
= 0.84x
Comments on Liquidity Ratios
2020E 2019 2018 Ind.

Current ratio 2.34x 1.17x 2.33x 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.
D’Leon’s Inventory Turnover vs. the Industry Average
Inv. turnover = Sales/Inventories

= $6,901/$1,716
= 4.02x
2020E 2019 2018 Ind.
Inventory turnover 4.02x 4.76x 4.80x 6.10x
Comments on Inventory Turnover
▪ Inventory turnover is below industry average.

▪ D’Leon might have old inventory, or its control
might be poor.
▪ No improvement is currently forecasted.
DSO: Average Number of Days After Making a Sale
Before Receiving Cash
DSO = Receivables/Avg. sales per day

= Receivables/(Annual sales/365)
= $878/($6,901/365)
= 46.44 days
Appraisal of DSO
2020E 2019 2018 Ind.
DSO 46.44 37.66 37.35 32.00
• D’Leon collects on sales too slowly,

and is getting worse.
• D’Leon has a poor credit policy.
Fixed Assets and Total Assets Turnover Ratios vs. the
Industry Average
▪ FA turnover= Sales/Net fixed assets

= $6,901/$817 = 8.45x
▪ TA turnover= Sales/Total assets

= $6,901/$3,497 = 1.97x
Evaluating the FA Turnover (S/Net FA) and TA
Turnover (S/TA) Ratios
2020E 2019 2018 Ind.

FA TO 8.45x 6.52x 9.95x 7.00x
TA TO 1.97x 2.14x 2.34x 2.60x
▪ FA turnover projected to exceed the industry

average.
▪ TA turnover below the industry average.
Caused by excessive currents assets (A/R and
Inv).
Calculate the Debt-to-Capital Ratio and
Times-Interest-Earned Ratio
Debt-to-capital ratio = Total debt / Total invested capital
= ($300 + $400) / ($300 + $400 + $1,952.4) = 26.39%
TIE = EBIT/Interest
= $357.6/$70 = 5.11x
D’Leon’s Debt Management Ratios vs. the Industry
Averages
2020E 2019 2018 Ind.
Debt/Total Inv. Capital 26.39% 73.41% 44.09% 40.00%
TIE 5.11x -0.31x 4.34x 6.20x
▪ Debt/Total invested capital is better than the

industry average.
▪ TIE ratio greatly improved but still below the
industry average.
Profitability Ratios: Operating Margin, Profit Margin,
and Basic Earning Power
Operating margin = EBIT/Sales

= $357.6/$6,901 = 5.18%
Profit margin = Net income/Sales

= $255.8/$6,901 = 3.71%
Basic earning power = EBIT/Total assets

= $357.6/$3,497 = 10.23%
Appraising Profitability with Operating Margin, Profit
Margin, and Basic Earning Power
2020E 2019 2018 Ind.

Operating margin 5.18% -0.62% 5.55% 7.30%
Profit margin 3.71% -2.61% 3.20% 4.30%
Basic earning power 10.23% -1.33% 12.96% 19.10%
Appraising Profitability with Operating Margin, Profit
Margin, and Basic Earning Power
Operating margin was very bad in 2019. It is

projected to improve in 2020, but it is still
projected to remain below the industry average.
Profit margin was very bad in 2019. It is

projected to improve in 2020, but it is still
projected to remain below the industry average.
BEP removes the effects of taxes and financial

leverage, and is useful for comparison.
BEP projected to improve, yet still below the

industry average. There is definitely room for
improvement.
Profitability Ratios: Return on Assets, Return on
Equity, and Return on Invested Capital
▪ ROA= Net income/Total assets

= $255.8/$3,497 = 7.31%
▪ ROE = Net income/Total common equity

= $255.8/$1,952 = 13.10%
▪ ROIC= [EBIT(1 − T)] / Total invested capital

= $268.2 / $2,652.4 = 10.11%
Appraising Profitability with ROA, ROE,
and ROIC
2020E 2019 2018 Ind.

ROA 7.31% -5.59% 7.49% 11.2%
ROE 13.10% -32.52% 16.56% 18.2%
ROIC 10.11% -1.54% 12.03% 16.5%
▪ All 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.
Effects of Debt on ROA and ROE
Holding assets constant, if debt increases:

Equity declines.
Interest expense increases – which leads to a

reduction in net income.
ROA declines (due to the reduction in net income).
ROE may increase or decrease (since both net income and

equity decline).
Problems with ROE
ROE and shareholder wealth

are correlated, but problems
can arise when ROE is the sole
measure of performance. Given these problems,
reliance on ROE may
encourage managers to
ROE does not consider make investments that
risk. do not benefit
shareholders. As a
result, analysts have
ROE does not consider looked to develop other
the amount of capital performance measures,
invested. such as EVA.
Calculate the Price/Earnings and Market/Book Ratios
▪ P/E = Price/Earnings per share

= $12.17/$1.0231 = 11.90x
▪ M/B = Market price/Book value per share

= $12.17/($1,952/250) = 1.56x
2020E 2019 2018 Ind.

P/E 11.90x -1.40x 7.73x 14.20x
M/B 1.56x 0.46x 1.28x 2.40x
Analyzing the Market Value Ratios
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.
For each ratio, the higher the number, the

better.
P/E and M/B are high if expected growth is

high and risk is low.
EV/EBITDA Calculations for Chapter 4 Case
▪ Enterprise Value = MVE + MVD +MVClaims – (Cash and Equivalents)

▪ For D’Leon, EV/EBITDA calculations are as follows (assume bonds
are at par value):
▪ 2020E: [($12.17 x 250,000) + ($300,000 + $400,000) -

$85,632]/$474,608 = 7.7050, or approximately 7.7
▪ 2019: [($2.25 x 100,000) + ($636,808 + $723,432) -

$7,282]/$78,808 = 20.02, or approximately 20
▪ 2018: [($8.50 x 100,000) + ($200,000 + $323,432) -

$57,600]/$209,328 = 6.2860, or approximately 6.3
The DuPont Equation
The DuPont Equation
Total assets Equity

ROE = Profit Margin X X
turnover multiplier
ROE = (NI/Sales) X (Sales/TA) X (TA/Equity)
▪ Focuses on expense control (PM), asset

utilization (TATO), and debt utilization (equity
multiplier).
DuPont Equation:
Breaking Down Return on Equity
ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)

= 3.71% x 1.97 x 1.7913
= 13.1%
PM TATO EM ROE
2018 3.2% 2.34 2.21 16.6%
2019 -2.6% 2.14 5.82 -32.5%
2020E 3.7% 1.97 1.79 13.1%
Ind. 4.3% 2.6 1.63 18.2%
An Example: The Effects of Improving Ratios
Accounts receivable $ 878 Current liabilities $ 845

Other current assets 1,802 Debt 700
Net fixed assets 817 Equity 1,952
Total assets $3,497 Total liabilities & equity $3,497
▪ Sales/Day = $6,900,600/365 = $18,905.75
▪ How would reducing the firm’s DSO to 32 days

affect the company?
Reducing Accounts Receivable and the Days Sales
Outstanding
▪ Reducing A/R will have no effect on sales
Old A/R = $18,905.75 × 46.4 = $878,000
New A/R = $18,905.75 × 32.0 = $604,984

Cash freed up: $273,016
▪ Initially shows up as addition to cash.
Effect of Reducing Receivables on Balance Sheet and
Stock Price
Added cash $ 273 Current liabilities $ 845

Accounts receivable 605
Other current assets 1,802 Debt 700
Net fixed assets 817 Equity 1,952
Total assets $3,497 Total liabilities & equity $3,497
▪ What could be done with the new cash?

▪ How might stock price and risk be affected?
1. What could be done with the new cash?
The balance sheet shows an increase in cash by $273, suggesting that the company has either collected receivables or
generated additional cash. This new cash can be used in several ways:
- Pay Down Debt: The company could use the new cash to reduce its debt of $700. This would decrease interest expenses
and improve the company's financial leverage, potentially lowering financial risk.
- Reinvest in the Business: The cash could be reinvested in operations, such as buying more inventory, expanding capacity,
or funding research and development (R&D). This could lead to future growth and increased profitability.
- Distribute to Shareholders: The company could choose to distribute the cash to shareholders in the form of dividends or
stock buybacks, which can increase shareholder value.
- Improve Liquidity: Maintaining higher cash reserves improves liquidity, which can be a safeguard against economic
downturns or unexpected expenses.
2. How might stock price and risk be affected?
The impact on stock price and risk would depend on how the company uses the new cash and the market's perception of
these actions:
- Stock Price Impact:
+ Positive Impact: If the cash is used effectively, such as paying down debt or reinvesting in profitable projects, the stock
price could increase due to improved financial health and growth prospects.
+ Neutral/Negative Impact: If the cash remains idle or is used in ways that do not add significant value (e.g., excessive
executive compensation), the stock price may not change much or could decrease due to perceived inefficiency.
- Risk Impact:
+ Reduction in Risk: Using cash to pay down debt can reduce financial risk, as lower leverage decreases the company’s
sensitivity to economic downturns and interest rate changes.
+ Increased Risk: If the cash is invested in high-risk projects or ventures, there could be an increase in operational risk.
=> However, if these investments are successful, they could also lead to higher returns.
=> Overall, the management's decision on utilizing the new cash will play a crucial role in determining both the stock
price and the risk profile of the company. An effective use of cash aligning with strategic goals generally positively
influences stock prices and may either reduce risk (e.g., paying down debt) or be a calculated increase in risk (e.g.,
investing in high-return projects).
Potential Uses of Freed Up Cash
▪ Repurchase stock invest in the short term

▪ Expand business
▪ Reduce debt
▪ All these actions would likely improve the
stock price.
Potential Problems and Limitations of Financial Ratio
Analysis
▪ Comparison with industry averages is difficult

for a conglomerate firm that operates in many
different divisions.
▪ Different operating and accounting practices can
distort comparisons.
▪ Sometimes it is hard to tell if a ratio is “good”
or “bad.”
▪ Difficult to tell whether a company is, on
balance, in a strong or weak position.
More Issues Regarding Ratios
▪ “Average” performance is not necessarily good,

perhaps the firm should aim higher.
▪ Seasonal factors can distort ratios.
▪ “Window dressing” techniques can make
statements and ratios look better than they
actually are.
▪ Inflation has distorted many firms’ balance
sheets, so analyses must be interpreted with
judgment.
End of Chapter 4
© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website or school-approved learning management system for classroom use.
Cover image attribution: “Finance District” by Joan Campderrós-i-Canas (adapted) https://flic.kr/p/6iVMd5

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Analysis of Financial

Effects of Improving Ratios

Limitations of Ratio Analysis

the expected value

EPS $1.023 -$1.602

DPS $0.220 $0.110

Stock price $12.17 $2.25

Lease pmts $40,000 $40,000

▪ Ratios standardize numbers and facilitate

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

Market value: Do investors like what they see as reflected in

▪ Current ratio = Current assets/Current liabilities

▪ Quick ratio = (Current assets – Inventories) / Current

2020E 2019 2018 Ind.

• Expected to improve but still below the

Inv. turnover = Sales/Inventories

2020E 2019 2018 Ind.

Inventory turnover 4.02x 4.76x 4.80x 6.10x

▪ Inventory turnover is below industry average.

DSO = Receivables/Avg. sales per day

2020E 2019 2018 Ind.

DSO 46.44 37.66 37.35 32.00

• D’Leon collects on sales too slowly,

▪ FA turnover= Sales/Net fixed assets

▪ TA turnover= Sales/Total assets

2020E 2019 2018 Ind.

▪ FA turnover projected to exceed the industry

Debt-to-capital ratio = Total debt / Total invested capital

= ($300 + $400) / ($300 + $400 + $1,952.4) = 26.39%

2020E 2019 2018 Ind.

Debt/Total Inv. Capital 26.39% 73.41% 44.09% 40.00%

TIE 5.11x -0.31x 4.34x 6.20x

▪ Debt/Total invested capital is better than the

Operating margin = EBIT/Sales

Profit margin = Net income/Sales

Basic earning power = EBIT/Total assets

2020E 2019 2018 Ind.

Operating margin was very bad in 2019. It is

Profit margin was very bad in 2019. It is

BEP removes the effects of taxes and financial

BEP projected to improve, yet still below the

▪ ROA= Net income/Total assets

▪ ROE = Net income/Total common equity

▪ ROIC= [EBIT(1 − T)] / Total invested capital

2020E 2019 2018 Ind.

▪ All ratios rebounded from the previous year, but

Holding assets constant, if debt increases:

Interest expense increases – which leads to a

ROA declines (due to the reduction in net income).

ROE may increase or decrease (since both net income and

ROE and shareholder wealth

▪ P/E = Price/Earnings per share

▪ M/B = Market price/Book value per share

2020E 2019 2018 Ind.

P/E: How much investors are willing to pay

M/B: How much investors are willing to pay

For each ratio, the higher the number, the