Slide Contents

• Learning Objectives
• Principles Applied in this Chapter
1. Why Do We Analyze Financial Statements
2. Common Size Statements – Standardizing Financial Information
3. Using Financial Ratios
4. Selecting a Performance Benchmark
5. Limitations of Ratio Analysis
• Key Terms
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.
4.1 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
Why Do We Analyze Financial Statements?
(cont.)
• 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.
Common Size Statements: Standardizing Financial
Information (cont.)

• 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 4.1 Observations

• Table 4-1 created by dividing each entry in the income statement of

Table 3.1 by firm sales for 2013.
• Cost of goods sold make up 75% of the firm’s sales resulting in a gross profit
of 25%.
• Selling expenses account for about 3% of sales.
• Income taxes account for 4.1% of the firm’s sales.
• After all expenses, the firm generates net income of 7.6% of firm’s sales.
Table 4.2 H. J.
Boswell, Inc.
Table 4.2 Observations

• Table 4.2 created by dividing each entry in the balance sheet of Table
3.2 by total assets.
• Total current assets increased by 5.6% in 2013 while total current liabilities
declined by 2%.
• Long-term debt account for 39.2% of firm’s assets, showing a decline of
1.7%.
• Retained earnings increased by 5.8% .
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
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).
Liquidity Ratios (cont.)

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.
Liquidity Ratios: Current Ratio (cont.)

• What is the current ratio for 2012 for Boswell?

Current Ratio = $477 ÷ 292.5 = 1.63 times

• The firm had $1.63 in current assets for every $1 it owed in current
liability.
Liquidity Ratios: Quick Ratio

• Acid-Test (Quick) Ratio excludes the inventory from current assets as

inventory may not be very liquid.
Liquidity Ratios: Quick Ratio
(cont.)
• What is the quick ratio for Boswell for 2012?

• Quick Ratio
= ($477-$229.50) ÷ ($292.50) = 0.84 times

• The firm has only $0.84 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.
Liquidity Ratios: Accounts Receivable
(cont.)
• What will be the average collection period for Boswell, Inc. for 2012
if we assume that the annual credit sales were $2,500 million?
• Daily Credit Sales
= $2,500 ÷ 365 days = $6.85 million
• Average Collection Period
= $139.5m ÷ $6.85m = 20.37 days
Liquidity Ratios: Accounts Receivable
Turnover Ratio
Accounts Receivable Turnover Ratio measures how many times
receivables are “rolled over” during a year.
Liquidity Ratios: Accounts Receivable
Turnover Ratio (cont.)
• What will be the accounts receivable turnover ratio for Boswell, Inc.
for 2012 if we assume that the annual credit sales were $2,500
million?

• Accounts Receivable Turnover

= $2,500 million ÷ $139.50 = 17.92 times
• The firm’s accounts receivable were turning over at 17.92 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.
Liquidity Ratios:
Inventory Turnover Ratio (cont.)
• What will be the inventory turnover ratio for 2012 for Boswell, Inc. if
we assume that the cost of goods sold were $1,980 million in 2012?

• Inventory Turnover Ratio

= $1,980 ÷ $229.50 = 8.63 times
• The firm turned over its inventory 8.63 times per year.
Liquidity Ratios:
Days’ Sales in Inventory
• Days’ Sales in Inventory
= 365÷ inventory turnover ratio
= 365 ÷ 8.63 = 42.29 days

• The firm, on average, holds it inventory for about 42 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.
 CHECKPOINT 4.1:
CHECK YOURSELF

Evaluating Dell’s Liquidity

Why do you think HP’s inventory turnover ratio is so much lower
than Dell’s inventory turnover ratio?
Step 1: Picture the Problem

• The inventory turnover ratio will measure how many days items
remain in inventory before being sold.

• Inventory turnover ratio is important as it has implications for cash

flows and profitability of a firm.
Step 2: Decide on a Solution Strategy
Step 3: Solve

• We will use the following equation to compute the Inventory

Turnover (IT) ratio
IT ratio = Cost of Goods Sold ÷ Inventories

• Inventory Turnover Ratio for HP

= $97,529,000 ÷ 7,490,000 = 13.02
Step 4: Analyze

• HP’s inventory turnover ratio indicates that the inventory at HP

remains on shelf for (365 ÷ 13.02) days or 28.03 days. This is much
higher than Dell that has an inventory turnover ratio of 34.37 or shelf
life of only 10.61 days.

• The significant difference must be investigated further as the two

firms are in the same industry.
Step 4: Analyze (cont.)

There are two reasons why HP has a lower turnover of inventories

relative to Dell:
• HP sells computers out of inventory of computers while Dell builds
computers only when orders are received.
• HP carries more parts inventory on hand than does Dell.
Capital Structure Ratios
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.
Capital Structure Ratios (cont.)

• What is the debt ratio for H.J. Boswell, Inc. for 2012?

• Debt Ratio
= $1,012.50 million ÷ $1,764 million = 57.40%

• The firm financed 57.39% 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.
Capital Structure Ratios (cont.)

• What will be the times interest earned ratio for Boswell for 2012 if
we assume interest expense of $65 million and EBIT of $350 million?
• Times Interest Earned
= $350m ÷ $65m = 5.38 times
• The firm can pay its interest expense 5.38 times or interest used 1/5.38th or
18.58% of its EBIT.
Capital Structure Ratios (cont.)
 CHECKPOINT 4.2:
CHECK YOURSELF
Comparing the Financing Decisions
of HD and LOW
What would be Home Depot’s times interest earned ratio if interest
payments remained the same, but net operating income dropped by 80%
to only $1.332 billion? Similarly if Lowes’ net operating income dropped by
80%, what would its times interest earned ratio be?
Step 1: Picture the Problem

• Times interest earned ratio is an important ratio for firms that use
debt financing. It measures the firm’s ability to service its debt.

• The ratio requires comparing net operating income or EBIT with

Interest expense. Both items are found on the income statement.
Step 1: Picture the Problem (cont.)

• Picture an Income Statement EBIT

• Sales
• Less: Cost of Good Sold
• Equals: Gross Profit
• Less: Operating Expenses
• Equals: Net Operating Income (EBIT)
• Less: Interest Expense
• Equals: Earnings before Taxes Interest
• Less: Taxes Expense
• Equals Net Income
Step 2: Decide on a Solution Strategy

• Here we are considering the impact of a drop in EBIT on the times

interest earned ratio of Home Depot and Lowes. We will use the
following ratio to measure the times interest earned (TIE) ratio.

• TIE = EBIT ÷ Interest Expense

Step 3: Solve

• TIE (Home Depot)

= $1.332 billion ÷ $0.606 billion = 2.20 times

• TIE (Lowes)
= $0.655 billion ÷$0.371 billion = 1.77 times
Step 4: Analyze

• We observe that a drop in net operating income leads to a significant

drop in times interest earned ratio for both the firms. Should
creditors be worried by this drop?

• The ratio is still reasonably safe. For example, for Home Depot, even
if the EBIT shrank further by 55.55% (1-1/2.20 ), it can still pay its
interest expense.
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.
Asset Management Efficiency Ratios (cont.)

• Total Asset Turnover Ratio represents the amount of sales

generated per dollar invested in firm’s assets.
Asset Management Efficiency Ratios (cont.)

What will be the total asset turnover ratio for Boswell, Inc. for 2012 if
we assume total sales to be $2,500 million?

•Total Asset Turnover

= $2,500 million ÷ $1,764 million = 1.42 times
• The firm generated $1.42 in sales per dollar of assets in 2012.
Asset Management Efficiency Ratios (cont.)

• Fixed asset turnover ratio measures firm’s efficiency in utilizing its

fixed assets (such as property, plant and equipment).
Asset Management Efficiency Ratios (cont.)

What will be the fixed asset turnover ratio for Boswell for 2012 if we
assume sales of $2,500 million for 2012?

•Fixed Asset Turnover

= $2,500 million ÷ $1,287 million = 1.94 times
• The firm generated $1.94 in sales per dollar invested in plant and equipment.
Asset Management Efficiency Ratios (cont.)

The following grid summarizes the efficiency of Boswell’s management

in utilizing its assets to generate sales in 2013.
Profitability Ratios
Profitability Ratios

Profitability ratios address a very fundamental question: Has the firm

earned adequate returns on its investments?
Profitability Ratios (cont.)

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.
Cost Control: Is the Firm Earning Reasonable
Profit Margins? (cont.)
What will be the gross profit margin ratio for 2012 for Boswell if we
assume sales of $2,500 million and gross profit of $650 million?
•Gross Profit Margin
= $650 million ÷ $2,500 million = 26%
• The firm spent $0.74 for cost of goods sold and thus $0.26 out of each dollar
of sales went towards gross profits.
Cost Control: Is the Firm Earning 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.
Cost Control: Is the Firm Earning Reasonable
Profit Margins? (cont.)
What will be the operating profit margin ratio for Boswell for 2012 if
we assume sales of $2,500 million and net operating income of $350
million?

•Operating Profit Margin

= $350 million ÷ $2,500 million = 14%
• The firm generates $0.14 in operating profit for each dollar of sales.
Cost Control: Is the Firm Earning 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).
Cost Control: Is the Firm Earning Reasonable
Profit Margins? (cont.)
What will be the net profit margin ratio for 2012 if we assume sales of
$2,500 million and net income of $217.75 million?

•Net Profit Margin

= $217.75 million ÷ $2,500 million = 8.71%
• The firm generated $0.087 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.
Profitability Ratios (cont.)

What will be the operating return on assets ratio for Boswell for 2012
if we assume EBIT or net operating income of $350 million for 2012?

•Operating Return on Assets

= $350 million ÷$1,764 million = 19.84%
• The firm generated $0.1984 of operating profits for every $1 of its invested
assets.
Decomposing the Operating Return on Assets
Ratio
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.
 CHECKPOINT 4.3:
CHECK YOURSELF
Evaluating the Operating Return on Assets (OROA) for HD
and LOW
If Home Depot were able to raise its total asset turnover ratio to
2.5 while maintaining its current operating profit margin, what
would happen to its operating return on assets?
Step 1: Picture the Problem

• The operating return on assets ratio for a firm is determined by two

factors: cost control and asset utilization. Here the focus is on asset
utilization.
Step 2: Decide on a Solution Strategy

We will analyze the impact on operating return on assets of

improvement on the total asset turnover ratio by using the following
equation:

•Operating Return on Assets (OROA)

= Total Asset Turnover × Operating Profit Margin
Step 3: Solve

• Operating Return on Assets (OROA)

• = Total Asset Turnover × Operating Profit Margin

• Before = 1.74 × 9.46% = 16.46%

• Now = 2.5 × 9.46% = 23.65%

Step 4: Analyze

• An improvement in total asset turnover ratio has a favorable impact

on Home Depot’s operating return on assets (OROA).

• If Home Depot wants to increase its OROA more, it should focus on

cost control that will help improve the net operating profit.
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.
 Is the Firm Providing a Reasonable Return on the
Owner’s Investment (cont.)
What will be the ROE ratio for Boswell for 2012 if we assume net income of
$217.75 million?

•ROE = $217.75m ÷ $751.50 mi = 28.98%

• Thus the shareholders earned 28.97% 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.
Using the DuPont Method for Decomposing
the ROE ratio (cont.)
ROE = Profitability × Efficiency × Equity Multiplier
Using the DuPont Method for 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?
Price-Earnings Ratio

Price-Earnings (PE) Ratio indicates how much investors are currently

willing to pay for $1 of reported earnings.
Price-Earnings Ratio (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?
Market Value Ratios (cont.)

• 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 Value Ratios (cont.)

Market-to-Book Ratio measures the relationship between the market

value and the accumulated investment in the firm’s equity.
Market Value Ratios (cont.)

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?
Market Value Ratios (cont.)

• 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
 CHECKPOINT 4.4:
CHECK YOURSELF

Comparing the Valuation of DELL to APPL Using Market Value Ratios

What price per share for Dell would it take to increase the firm’s
price-to-earnings ratio to the level of Apple?
Step 1: Picture the Problem

Price-to-earnings (PE) ratio depends on earnings per share and price

per share, pictured as follows:

Price per share standardized by

EPS =
Net income ÷ number
Of shares outstanding
PE Ratio =
Price per share ÷
Earnings per share
Step 2: Decide on a Solution Strategy

We need to determine the price per share that will make PE ratio of
Dell (4.83) equal to the PE ratio of Apple (13.22).

•PE ratio = Price per share ÷ Earnings per share

==> 13.22 = ? ÷ 2.01
•Price per share = 13.22 × 2.01 = $26.57
Step 4: Analyze

• PE ratio allows us to compare two stocks with different prices by

standardizing the stock prices by earnings.

• Apple has a much higher PE ratio. To reach the same PE valuation,

the stock price of Dell will have to increase from $9.70 to $26.57.
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.
Trend Analysis

• 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.
Figure 4-3 A Time-Series (Trend) Analysis: Dell’s Inventory
Turnover Ratio Versus Hewlett Packard’s: 1995–2011
 Peer Firm Comparisons
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 4-4 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.
The Limitations of Ratio Analysis (cont.)

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