CHAPTER 3

Analysis of Financial
Statements

3-1
 Analysis of financial
statements
 Ratio Analysis
 Du Pont system
 Effects of improving ratios
 Limitations of ratio analysis
 Qualitative factors

3-2
What is financial statement analysis and
why it is necessary?
 The art of transforming data from financial
statements into information that is useful for
informed decision making.
 Financial statements are used by managers to
improve performance, by lenders to evaluate
the likelihood of collecting on loans, and by
stockholders to forecast earnings, dividends,
and stock prices.
 Financial statement analysis involves:
1. Comparing the firm’s performance with that of other
firms in the same industry
2. Evaluating trends in the firm’s financial position over
time.
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 Ratio Analysis
 Financial statements report both on a firm’s position at a
point in time and on its operations over some past period.
However, the real value of financial statements lies in the fact
that they can be used to help predict future earnings and
dividends.
 From an investor’s standpoint, predicting the future is what
financial statement analysis is all about, while from
management’s standpoint, financial statement analysis is
useful for both to help anticipate future conditions and more
important as a starting point for planning actions that will
improve the firm’s future performance.
 Ratio analysis involves methods of calculating and
interpreting financial ratios to analyze and monitor the firm’s
performance.
 The next few slides we will look at some of the financial data
of D’Leon company for year 2002 and 2003.
3-4
 Balance Sheet: Assets

2003 2002
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: Dep. 380,120 263,160
Net FA 817,040 939,790
Total Assets $3,497,152 $2,866,592

3-5
Balance sheet: Liabilities and Equity

2003 2002
Accts payable $436,800 $524,160
Notes payable 300,000 636,808
Accruals 408,000 489,600
Total CL 1,144,800 1,650,568
Long-term debt 400,000 723,432
Common stock 1,721,176 460,000
Retained earnings 231,176 32,592
1,952,352 492,592
Total Equity
$3,497,152 $2,866,592
Total L & E

3-6
 Income statement

2003 2002
Sales $7,035,600 $6,034,000
COGS 5,875,992 5,528,000
Other expenses 550,000 519,988
EBITDA 609,608 (13,988)
Depr. & Amort. 116,960 116,960
EBIT 492,648 (130,948)
Interest Exp. 70,008 136,012
EBT 422,640 (266,960)
Taxes 169,056 (106,784)
Net income $253,584 $(160,176)

3-7
 Other data

2003 2002
No. of shares 250,000 100,000
EPS $1.014 -$1.602
DPS $0.220 $0.110
Stock price $12.17 $2.25
$7.809 $4.926
Book Value per share
40% 40%
Tax rate
$40,000 $40,000
Lease pmts
3-8
Why are ratios useful?

 Ratios standardize numbers and facilitate

comparisons.
 Ratios are used to highlight weaknesses
and strengths.

3-9
 What are the five major categories of
ratios?
 Liquidity ratios: Ratios that show the relationship of
a firm’s cash and other current assets to its current
liabilities.
 Asset management ratios: A set of ratios that
measure how effectively a firm is managing its
assets.
 Debt management ratios: Measures the proportion
of total assets financed by the firm’s creditors.
 Profitability ratios: A group of ratios that show the
combined effects of liquidity, asset management,
and debt on operating results.
 Market value ratios: A set of ratios that relate the
firm’s stock price to its earnings, cash flow, and
book value per share.
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 Liquidity Ratio
Calculate D’Leon’s forecasted current ratio for 2003.
Current ratio = Current assets / Current liabilities
= $2,680,112 / $1,144,800
= 2.34x
Current assets normally include cash, short term
investments, accounts receivable, and inventories.
Current liabilities consist of accounts payable, short
term notes payable, accrued taxes, other accrued
expenses (especially accrued wages), and current
maturities of short term debt.
If current liabilities are rising faster than current
assets, the current ratio will fall.
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 Liquidity Ratio

2003 2002 2001 Ind.

Current
2.34x 1.20x 2.30x 2.70x
ratio

Comments on current ratio:

 Expected to improve but still below the
industry average.
 Liquidity position is weak.

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 Asset Management Ratio
Inventory turnover = Sales / Inventories
= $7,035,600/ $1,716,480
= 4.10x
Inventory turnover ratio measures on an
average how many times the company's
inventory is sold and replaced over a period of
time.

2003 2002 2001 Ind.

Inventory
4.1x 4.70x 4.8x 6.1x
Turnover 3-13
 Asset Management Ratio

Comments on Inventory Turnover

 Inventory turnover is below industry
average.
 A low inventory turnover means D’Leon
might have old inventory, overstocking
or poor inventory management.
 No improvement is currently forecasted.

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 Asset Management Ratio
Days Sales Outstanding (DSO) also called the
“average collection period (ACP)” is used to
indicate the average length of time the firm
must wait after making a sale before it receives
cash. In other words this ratio measures on an
average how long it takes for the firm to collect
its accounts receivables.
DSO= Receivables / Average sales per day
= Receivables / Sales/365
= $878,000 / ($7,035,600/365)
= 45.55days 3-15
 Asset Management Ratio

2003 2002 2001 Ind.

DSO 45.55 38.2 37.4 32.0

 D’Leon collects its accounts receivable

too slowly, and is getting worse.
 D’Leon has a poor credit policy.

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 Asset Management Ratio
Fixed assets turnover ratio measures how
effectively/efficiently the firm uses its plant and
equipment to generate sales.
Fixed assets turnover ratio=Sales / Net fixed assets
= $7,035,600 / $817,040 = 8.61x
Total assets turnover ratio measures how
effectively/efficiently the firms is using all of its assets
to generate sales.
Total assets turnover ratio = Sales / Total assets
= $7,035,600 / $3,497,152 = 2.01x
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 Asset Management Ratio

2003 2002 2001 Ind.

FA TO 8.61x 6.4x 10.0x 7.0x
TA TO 2.01x 2.1x 2.3x 2.6x

Evaluating the FA turnover and TA turnover ratios

 FA turnover projected to exceed the industry average.
 TA turnover below the industry average. Caused by
excessive currents assets (A/R and Inv).

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 Debt Management Ratio

Debt ratio: The ratio of total debt to total assets,

generally called the debt ratio, measures the
percentage of funds provided by creditors.

Debt ratio = Total debt / Total assets

= ($1,144,800 + $400,000) / $3,497,152
= 44.2%

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 Debt Management Ratio
Times-Interest-Earned (TIE) ratio is determined
by dividing earnings before interest and taxes
(EBIT) by interest charges. TIE ratio measures
the firm’s ability to meet its annual interest
payments.
TIE = EBIT / Interest expense
= $492,648 / $70,008 = 7.04x

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 Debt Management Ratio

EBITDA = EBITDA + Lease pmts

coverage Interest exp + Lease pmts + Principal pmts

= $609,608 + $40,000
$70,008 + $40,000 + $0
= 5.91x
EBITDA ratio shows in the numerator all cash flows available to
meet fixed financial charges and whose denominator includes
all fixed financial charges.
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 Debt Management Ratio

2003 2002 2001 Ind.

D/A 44.2% 82.8% 54.8% 50.0%
TIE 7.04x -1.0x 4.3x 6.2x
EBITDA
5.91x 0.1x 3.0x 8.0x
coverage
 D/A and TIE are better than the industry
average, but EBITDA coverage still below
the industry average.
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 Profitability Ratio
Profit margin on sales measure net income per
dollar of sales.
Profit margin = Net income / Sales
= $253,584 / $7,035,600 = 3.6%

Basic Earning Power (BEP) ratio indicates the

ability of the firm’s assets to generate operating
income.
BEP = EBIT / Total assets
= $492,648 / $3,497,152 = 14.09%
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 Profitability Ratio

2003 2002 2001 Ind.

PM 3.6% -2.7% 2.6% 3.5%
BEP 14.09% -4.6% 13.0% 19.1%
 Profit margin was very bad in 2002, but is projected to
exceed the industry average in 2003. Looking good.
 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.

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 Profitability Ratio
Return on Total Assets (ROA) measures how
efficiently the management is using its assets
to generate income.
ROA= Net income / Total assets
= $253,584 / $3,497,152 = 7.25%
Return on Common Equity (ROE) measures
the rate of return on common stockholders'
investment.
ROE= Net income / Total common equity
= $253,584 / $1,952,352 = 12.99% 3-25
 Profitability Ratio

2003 2002 2001 Ind.

ROA 7.25% -5.6% 6.0% 9.1%
ROE 12.99% -32.5% 13.3% 18.2%

 Both ratios has increased from the previous year,

but are still below the industry average. More
improvement is needed.

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 Profitability Ratio

Effects of debt on ROA and ROE

 ROA is lowered by debt-interest lowers NI,

which also lowers ROA = NI/Assets.
 But use of debt also lowers equity, hence debt
could raise ROE = NI/Equity.

3-27
 Profitability Ratio
Price/Earnings ratio shows how much investors are
willing to pay per dollar of reported profit.
P/E = Price per share / Earnings per share
= $12.17 / $1.014 = 12.0x
Price/Cash Flow ratio measures the amount an
investor is willing to pay for a dollar generated from a
particular company's operations.
P/CF = Price per share / Cash flow per share
= Price per share/ (NI + Dep. +Amt.)/Common
shares outstanding
= $12.17 / [($253,584+ $116,960) ÷ 250,000]
= 8.21x
3-28
 Profitability Ratio
Market / Book Ratio measures stock’s market value with its relative book
value
M/B = Market price per share / Book value per share
= $12.17 / ($1,952,352 / 250,000) = 1.56x

2003 2002 2001 Ind.

P/E 12.0x -1.4x 9.7x 14.2x
P/CF 8.21x -5.2x 8.0x 11.0x
M/B 1.56x 0.5x 1.3x 2.4x
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 Profitability Ratio

 P/E: How much investors are willing to pay for

$1 of earnings.
 P/CF: How much investors are willing to pay
for $1 of cash flow.
 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 ROE is high and risk is
low.
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 DuPont equation:
DuPont Equation: A formula that shows the rate of return on
assets can be found as the product of the profit margin
times the total asset turnover.
ROE = (Profit margin) x (TA turnover) x (Equity multiplier)
= (NI / Sales) X (Sales / TA) X (TA / Common Equity)
= 3.6% x 2 x 1.8
= 13.0%

PM TA TO EM ROE
2001 2.6% 2.3 2.2 13.3%
2002 -2.7% 2.1 5.8 -32.5%
2003E 3.6% 2.0 1.8 13.0%
Ind. 3.5% 2.6 2.0 18.2%
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 The Du Pont system

Also can be expressed as:

ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)
 Focuses on:
Expense control (PM)
Asset utilization (TATO)
Debt utilization (Equity Multiplier)
 Shows how these factors combine to
determine ROE.
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Trend analysis

 Analyzes a firm’s
financial ratios over
time
 Can be used to
estimate the likelihood
of improvement or
deterioration in
financial condition.

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 Benchmarking

 Benchmarking the process of comparing a

particular company with a group of
“benchmark” companies.
 Example: you would try to compare the
performance of Toyota Motor company with a
group of other “benchmark” companies like:
Honda, Nissan, Mercedes Benz, GM, Ford etc.

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 Potential problems and limitations of
financial ratio analysis
 Comparison with industry averages is difficult
for a conglomerate firm that operates in many
different divisions and offer different types of
products or services.
 “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.

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More issues regarding ratios

 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 strong or weak position.

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 Qualitative factors to be considered
when evaluating a company’s future
financial performance
 Are the firm’s revenues tied to 1 key
customer, product, or supplier?
 What percentage of the firm’s business is
generated overseas?
 Competition
 Future prospects
 Legal and regulatory environment

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End of the Chapter

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