CHAPTER 3

ANALYSIS OF FINANCIAL STATEMENTS

LEARNING OBJECTIVES

 Explain why ratio analysis is usually the first step in the analysis of a company’s
financial statements.

 List the five groups of ratios, specify which ratios belong in each group, and explain what
information each group gives us about the firm’s financial position.

 State what trend analysis is, and why it is important.

 Describe how the Du Pont equation is used, and how it may be modified to include the
effect of financial leverage.

 Explain “benchmarking” and its purpose.

 List several limitations of ratio analysis.

 Identify some of the problems with ROE that can arise when firms use it as a sole
measure of performance.

 Identify some of the qualitative factors that must be considered when evaluating a
company’s financial performance.

OVERVIEW

Financial analysis is designed to determine analysis), and how a particular firm compares
the relative strengths and weaknesses of a with other firms in its industry (bench-
company. Investors need this information to marking). Although financial analysis has
estimate both future cash flows from the firm limitations, when used with care and
and the riskiness of those cash flows. judgment, it can provide some very useful
Financial managers need the information insights into a company’s operations
provided by analysis both to evaluate the
firm’s past performance and to map future
plans. Financial analysis concentrates on
financial statement analysis, which highlights
the key aspects of a firm’s operations.
Financial statement analysis involves a
study of the relationships between income
statement and balance sheet accounts, how
these relationships change over time (trend
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OUTLINE

Financial statements are used to help predict the firm’s future earnings and dividends.
From an investor’s standpoint, predicting the future is what financial statement analysis is
all about. From management’s standpoint, financial statement analysis is useful both to
help anticipate future conditions and, more important, as a starting point for planning
actions that will influence the future course of events.

 Financial ratios are designed to help one evaluate a firm’s financial statements.
 The burden of debt, and the company’s ability to repay, can be best evaluated (1) by
comparing the company’s debt to its assets and (2) by comparing the interest it must
pay to the income it has available for payment of interest. Such comparisons are made
by ratio analysis.

A liquid asset is an asset that can be converted to cash quickly without having to reduce the
asset’s price very much. Liquidity ratios are used to measure a firm’s ability to meet its
current obligations as they come due.

 One of the most commonly used liquidity ratios is the current ratio.
 The current ratio measures the extent to which current liabilities are covered by
current assets.
 It is determined by dividing current assets by current liabilities.
 It is the most commonly used measure of short-term solvency.

Asset management ratios measure how effectively a firm is managing its assets and
whether the level of those assets is properly related to the level of operations as measured
by sales.

 The inventory turnover ratio is defined as sales divided by inventories.

 It is often necessary to use average inventories rather than year-end inventories,
especially if a firm’s business is highly seasonal, or if there has been a strong upward
or downward sales trend during the year.

 Days sales outstanding (DSO), also called the “average collection period” (ACP), is used
to appraise accounts receivable, and it is calculated by dividing accounts receivable by
average daily sales to find the number of days’ sales tied up in receivables.
 The DSO represents the average length of time that the firm must wait after making a
sale before receiving cash.
 The DSO can also be evaluated by comparison with the terms on which the firm sells
its goods.
 If the trend in DSO over the past few years has been rising, but the credit policy has
not been changed, this would be strong evidence that steps should be taken to
expedite the collection of accounts receivable.
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 The fixed assets turnover ratio is the ratio of sales to net fixed assets.
 It measures how effectively the firm uses its plant and equipment.
 A potential problem can exist when interpreting the fixed assets turnover ratio of a
firm with older, lower-cost fixed assets compared to one with recently acquired,
higher-cost fixed assets. Financial analysts recognize that a problem exists and deal
with it judgmentally.

 The total assets turnover ratio is calculated by dividing sales by total assets.
 It measures the utilization, or turnover, of all the firm’s assets.

Debt management ratios measure the extent to which a firm is using debt financing, or
financial leverage, and the degree of safety afforded to creditors.

 Financial leverage has three important implications: (1) By raising funds through debt,
stockholders can maintain control of a firm while limiting their investment. (2) Creditors
look to the equity, or owner-supplied funds, to provide a margin of safety, so if the
stockholders have provided only a small proportion of the total financing, the firm’s risks
are borne mainly by its creditors. (3) If the firm earns more on investments financed with
borrowed funds than it pays in interest, the return on the owners’ capital is magnified, or
“leveraged.”
 Firms with relatively high debt ratios have higher expected returns when the economy
is normal, but they are exposed to risk of loss when the economy goes into a
recession.
 Firms with low debt ratios are less risky, but also forgo the opportunity to leverage up
their return on equity.
 Decisions about the use of debt require firms to balance higher expected returns
against increased risk.

 Analysts use two procedures to examine the firm’s debt: (1) They check the balance sheet
to determine the extent to which borrowed funds have been used to finance assets, and
(2) they review the income statement to see the extent to which fixed charges are covered
by operating profits.

 The debt ratio, or ratio of total debt to total assets, measures the percentage of funds
provided by creditors. Total debt includes both current liabilities and long-term debt.
 The lower the ratio, the greater the protection afforded creditors in the event of
liquidation.
 Stockholders, on the other hand, may want more leverage because it magnifies
expected earnings.
 A debt ratio that exceeds the industry average raises a red flag and may make it costly
for a firm to borrow additional funds without first raising more equity capital.

 The times-interest-earned (TIE) ratio is determined by dividing earnings before interest

and taxes (EBIT) by the interest charges.
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 The TIE measures the extent to which operating income can decline before the firm is
unable to meet its annual interest costs.
 Note that EBIT, rather than net income, is used in the numerator. Because interest is
paid with pre-tax dollars, the firm’s ability to pay current interest is not affected by
taxes.
 This ratio has two shortcomings: (1) Interest is not the only fixed financial charge.
(2) EBIT does not represent all the cash flow available to service debt, especially if a
firm has high depreciation and/or amortization charges.

 To account for the deficiencies of the TIE ratio, bankers and others have developed the
EBITDA coverage ratio. It is calculated as EBITDA plus lease payments divided by the
sum of interest, principal repayments, and lease payments.
 The EBITDA coverage ratio is most useful for relatively short-term lenders such as
banks, which rarely make loans (except real estate-backed loans) for longer than
about five years.
 Over a relatively short period, depreciation-generated funds can be used to service
debt.
 Over a longer time, depreciation-generated funds must be reinvested to maintain
the plant and equipment or else the company cannot remain in business.
 Banks and other relatively short-term lenders focus on the EDITDA coverage ratio,
whereas long-term bondholders focus on the TIE ratio.

Profitability ratios show the combined effects of liquidity, asset management, and debt on
operating results.

 The profit margin on sales is calculated by dividing net income by sales.

 It gives the profit per dollar of sales.

 The basic earning power (BEP) ratio is calculated by dividing earnings before interest
and taxes (EBIT) by total assets.
 It shows the raw earning power of the firm’s assets, before the influence of taxes and
leverage.
 It is useful for comparing firms with different tax situations and different degrees of
financial leverage.

 The return on total assets (ROA) is the ratio of net income to total assets.
 It measures the return on all the firm’s assets after interest and taxes.

 The return on common equity (ROE) measures the rate of return on the stockholders’
investment.
 It is equal to net income divided by common equity. Stockholders invest to get a return
on their money, and this ratio tells how well they are doing in an accounting sense.

Market value ratios relate the firm’s stock price to its earnings, cash flow, and book value
per share, and thus give management an indication of what investors think of the
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company’s past performance and future prospects. If the liquidity, asset management,
debt management, and profitability ratios all look good, then the market value ratios will
be high, and the stock price will probably be as high as can be expected.

 The price/earnings (P/E) ratio, or price per share divided by earnings per share, shows
how much investors are willing to pay per dollar of reported profits.
 P/E ratios are higher for firms with strong growth prospects, other things held
constant, but they are lower for riskier firms.

 The price/cash flow ratio is the ratio of price per share divided by cash flow per share.
 It shows the dollar amount investors will pay for $1 of cash flow.

 The market/book (M/B) ratio, defined as market price per share divided by book value
per share, gives another indication of how investors regard the company.
 Higher M/B ratios are generally associated with firms with relatively high rates of
return on common equity.
 An M/B ratio greater than 1.0 means that investors are willing to pay more for stocks
than their accounting book values.

It is important to analyze trends in ratios as well as their absolute levels. Trend analysis
can provide clues as to whether the firm’s financial situation is likely to improve or to
deteriorate.

The Extended Du Pont Equation shows how return on equity is affected by assets turnover,
profit margin, and leverage. This measure was developed by Du Pont managers for
evaluating performance and analyzing ways of improving performance.
 The profit margin times the total assets turnover is called the Du Pont Equation. This
equation gives the rate of return on assets (ROA):
ROA = Profit margin × Total assets turnover.

 The ROA times the equity multiplier (total assets divided by common equity) yields the
return on equity (ROE). This equation is referred to as the Extended Du Pont Equation:
ROE = Profit margin × Total assets turnover × Equity multiplier.

 If a company is financed only with common equity, the return on assets (ROA) and the
return on equity (ROE) are the same because total assets will equal common equity. This
equality holds only if the company uses no debt.

Ratio analysis involves comparisons because a company’s ratios are compared with those
of other firms in the same industry, that is, to industry average figures. Comparative ratios
are available from a number of sources including ValueLine, Dun & Bradstreet, Robert
Morris Associates, and the U. S. Commerce Department.

 Benchmarking is the process of comparing the ratios of a particular company with those
of a smaller group of “benchmark” companies, rather than with the entire industry.
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 Benchmarking makes it easy for a firm to see exactly where the company stands relative
to its competition.

There are some inherent problems and limitations to ratio analysis that necessitate care and
judgment. Ratio analysis conducted in a mechanical, unthinking manner is dangerous, but
used intelligently and with good judgment, it can provide useful insights into a firm’s
operations.

 Financial ratios are used by three main groups:

 Managers, who employ ratios to help analyze, control, and thus improve their firm’s
operations.
 Credit analysts, such as bank loan officers or bond rating analysts, who analyze ratios
to help ascertain a company’s ability to pay its debts.
 Stock analysts, who are interested in a company’s efficiency, risk, and growth
prospects.

 Ratios are often not useful for analyzing the operations of large firms that operate in
many different industries because comparative ratios are not meaningful.

 The use of industry averages may not provide a very challenging target for high-level
performance.
 Inflation affects depreciation charges, inventory costs, and therefore, the value of both
balance sheet items and net income. For this reason, the analysis of a firm over time, or a
comparative analysis of firms of different ages, can be misleading.

 Ratios may be distorted by seasonal factors, or manipulated by management to give the

impression of a sound financial condition (window dressing techniques).

 Different operating policies and accounting practices, such as the decision to lease rather
than to buy equipment, can distort comparisons.

 Many ratios can be interpreted in different ways, and whether a particular ratio is good or
bad should be based upon a complete financial analysis rather than the level of a single
ratio at a single point in time.

Despite its widespread use and the fact that ROE and shareholder wealth are often highly
correlated, some problems can arise when firms use ROE as the sole measure of
performance.

 ROE does not consider risk.

 ROE does not consider the amount of invested capital.

 A project’s return, risk, and size combine to determine its impact on shareholder value.
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 To the extent that ROE focuses only on rate of return and ignores risk and size,
increasing ROE may in some cases be inconsistent with increasing shareholder wealth.
 Alternative measures of performance have been developed, including Market Value
Added (MVA) and Economic Value Added (EVA).

While it is important to understand and interpret financial statements, sound financial

analysis involves more than just calculating and interpreting numbers.

 Good analysts recognize that certain qualitative factors must be considered when
evaluating a company. Some of these factors are:
 The extent to which the company’s revenues are tied to one key customer.
 The extent to which the company’s revenues are tied to one key product.
 The extent to which the company relies on a single supplier.
 The percentage of the company’s business generated overseas.
 Competition.
 Future prospects.
 Legal and regulatory environment.