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Analysis of Financial Analysis of Financial StatementsStatements

Timothy R. Mayes, Ph.D.

FIN 3300: Chapter 3

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Common-size Income Common-size Income StatementsStatements

A common-size income statement restates all expenses as a percentage of sales

This allows the analyst to quickly and easily see which expenses have increased or decreased relative to sales

Elvis Products InternationalCommon-size Income Statement

For the Year Ended Dec. 31, 1997 ($ 000's)1997% 1997 1996% 1996

Sales 100.00% 3900.00 100.00% 3500.00Cost of Goods Sold 83.33% 3250.00 81.83% 2864.00Gross Profit 16.67% 650.00 18.17% 636.00Selling and G&A Expenses 8.47% 330.30 6.86% 240.00Fixed Expenses 2.56% 100.00 2.86% 100.00Depreciation Expense 0.51% 20.00 0.54% 18.90EBIT 5.12% 199.70 7.92% 277.10Interest Expense 1.95% 76.00 1.79% 62.50Earnings Before Taxes 3.17% 123.70 6.13% 214.60Taxes @ 40% 1.27% 49.48 2.45% 85.84Net Income 1.90% 74.22 3.68% 128.76

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Common-size Balance SheetsCommon-size Balance Sheets

A common-size balance sheet restates all assets and liabilities as a percentage of total assets

This allows the analyst to quickly and easily see which accounts have increased or decreased relative to total assets

Elvis Products InternationalCommon-size Balance SheetAs of Dec. 31, 1997 ($ 000's)

Assets 1997% 1997 1996% 1996

Cash and Equivalents 3.03% 50.00 3.92% 57.60 Accounts Receivable 24.35% 402.00 23.91% 351.20 Inventory 50.76% 838.00 48.69% 715.20Total Current Assets 78.14% 1290.00 76.53% 1124.00 Plant & Equipment 31.92% 527.00 33.43% 491.00 Accumulated Depreciation 10.07% 166.20 9.95% 146.20

Net Fixed Assets 21.86% 360.80 23.47% 344.80Total Assets 100.00% 1650.80 100.00% 1468.80

Liabilities and Owner's Equity

Accounts Payable 10.61% 175.20 9.91% 145.60 Short-term Notes Payable 13.63% 225.00 13.62% 200.00 Other Current Liabilities 8.48% 140.00 9.26% 136.00Total Current Liabilities 32.72% 540.20 32.79% 481.60 Long-term Debt 25.72% 424.61 22.02% 323.43Total Liabilities 58.45% 964.81 54.81% 805.03 Common Stock 27.87% 460.00 31.32% 460.00 Retained Earnings 13.69% 225.99 13.87% 203.77Total Shareholder's Equity 41.55% 685.99 45.19% 663.77Total Liabilities and Owner's Equity 100.00% 1650.80 100.00% 1468.80

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Financial RatiosFinancial Ratios

Financial ratios are the analyst’s microscope; they allow us to get a better view of the firm’s financial health than just looking at the raw financial statements

Ratios are used by both internal and external analysts• Internal uses

planning evaluation of management

• External uses credit granting performance monitoring investment decisions

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Categories of Financial RatiosCategories of Financial Ratios

Financial ratios are often divided into categories based on the information that they provide:• Liquidity• Efficiency• Leverage• Coverage• Profitability• Market valuation

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Liquidity RatiosLiquidity Ratios

‘Liquidity’ refers to the speed with which an asset can be converted to cash

Liquidity ratios describe the ability of a firm to meet its current obligations

There are three common liquidity ratios:• The Current Ratio• The Quick Ratio• The Cash Ratio

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The Current RatioThe Current Ratio

For EPI the current ratio in 1997 is:

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The Quick RatioThe Quick Ratio

For EPI the quick ratio in 1997 is:

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The Cash RatioThe Cash Ratio

For EPI the cash ratio in 1997 is:

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Efficiency RatiosEfficiency Ratios

The efficiency ratios (A.K.A. assets utilization ratios) describe how well a firm is using its investment in various asset classes:• Inventory Turnover Ratio• Accounts Receivable Turnover Ratio• Average Collection Period• Fixed Asset Turnover Ratio• Total Asset Turnover Ratio

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The Inventory Turnover RatioThe Inventory Turnover Ratio

For EPI the inventory turnover ratio in 1997 is:

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The A/R Turnover RatioThe A/R Turnover Ratio

For EPI the accounts receivable turnover ratio in 1997 is:

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The Average Collection The Average Collection PeriodPeriod

For EPI the average collection period in 1997 is:

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The Fixed Asset Turnover The Fixed Asset Turnover RatioRatio

For EPI the fixed asset turnover ratio in 1997 is:

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The Total Asset Turnover The Total Asset Turnover RatioRatio

For EPI the total asset turnover ratio in 1997 is:

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Leverage RatiosLeverage Ratios

Leverage ratios describe the amount of debt that the firm has used to finance its investments in assets:• Total Debt Ratio• Long-term Debt Ratio• Debt to Equity• Long-term Debt to Equity

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The Total Debt RatioThe Total Debt Ratio

For EPI the total debt ratio in 1997 is:

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The Long-term Debt RatioThe Long-term Debt Ratio

For EPI the long-term debt ratio in 1997 is:

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The Debt to Equity RatioThe Debt to Equity Ratio

For EPI the debt to equity ratio in 1997 is:

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The Long-term Debt to Equity The Long-term Debt to Equity RatioRatio

For EPI the long-term debt to equity ratio in 1997 is:

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Coverage RatiosCoverage Ratios

Coverage ratios indicate the firm’s ability to pay certain expenses:• Times Interest Earned Ratio• Cash Coverage Ratio

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The Times Interest Earned The Times Interest Earned RatioRatio

For EPI the times interest earned ratio in 1997 is:

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The Cash Coverage RatioThe Cash Coverage Ratio

For EPI the cash coverage ratio in 1997 is:

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The Fixed Charge Coverage The Fixed Charge Coverage RatioRatio

Note: SF Payments are Sinking Fund payments which are not tax deductible. Therefore, we must divide them by (1-t) to find out how much we need before taxes to meet this after-tax expense. Also, you must include preferred dividends in this number.

FixedCh eCoverageEBIT LeasePayments

Int Exp LeasePaymentsSF Payments

t

arg. .

( )

=+

+ +-1

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Profitability RatiosProfitability Ratios

Profitability ratios provide a measure of the returns that a firm is generating:• Gross Profit Margin• Operating Profit Margin• Net Profit Margin• Return on Total Assets• Return on Equity• Return on Common Equity

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The Gross Profit MarginThe Gross Profit Margin

For EPI the gross profit margin in 1997 is:

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The Operating Profit MarginThe Operating Profit Margin

For EPI the operating profit margin in 1997 is:

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The Net Profit MarginThe Net Profit Margin

For EPI the net profit margin in 1997 is:

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The Return on Total AssetsThe Return on Total Assets

For EPI the return on total assets in 1997 is:

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The Return on EquityThe Return on Equity

For EPI the return on equity in 1997 is:

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The Return on Common The Return on Common EquityEquity

For EPI the return on common equity in 1997 is:

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Market Valuation RatiosMarket Valuation Ratios

The market valuation ratios provide an indication of the relative under- or over-pricing of a firm’s stock:• Price/Earnings Ratio• Price/Book Ratio

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The Price/Earnings RatioThe Price/Earnings Ratio

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The Price/Book RatioThe Price/Book Ratio

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Rules for Memorizing RatiosRules for Memorizing Ratios

There can be an infinite number of financial ratios, but knowing a few basic rules will help you to memorize the formulas: The basic rule is that the name tells you how to calculate the ratio.• Any ‘margin’ ratio is something divided by sales• Any ‘turnover’ ratio is sales (or a variation of

sales) divided by something• Any ‘return on’ ratio is net income (or a

variation of net income) divided by something

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Using Financial RatiosUsing Financial Ratios

Calculating ratios is pointless unless you know how to use them

The most basic rule is: a single ratio provides very little information and may be misleading

With that in mind, there are at least 4 uses of ratios:• Trend analysis (internal and external)• Comparison to industry averages (internal and

external)• Setting and evaluating company goals (internal)• Restrictive debt covenants (external)

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Trend Analysis of RatiosTrend Analysis of Ratios

Trend analysis involves the examination of ratios over time

The analyst tries to determine if the ratio is changing in a favorable, or unfavorable, direction

The chart shows EPI’s current ratio for two years (we really need more data)

EPI Current Ratio Trend

2.30 x2.31 x2.32 x2.33 x2.34 x2.35 x2.36 x2.37 x2.38 x2.39 x2.40 x

1996 1997

YearC

urr

ent

Rat

io

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Comparing to Industry Comparing to Industry AveragesAverages

Industry average ratios provide a benchmark for comparison

We assume that if a ratio is too far from the average something is wrong

Industry ratios are available from Robert Morris Associates and Standard & Poor’s

Ratio

Industry 1997 1997 1996

Liquidity Ratios

Current 2.70 x 2.39 x 2.33 xQuick 1.00 x 0.84 x 0.85 x

Efficiency Ratios

Inventory Turnover 7.00 x 3.88 x 4.00 xA/R Turnover 10.70 x 9.70 x 9.97 xAverage Collection Period 33.64 37.11 36.12Fixed Asset Turnover 11.20 x 10.81 x 10.15 xTotal Asset Turnover 2.60 x 2.36 x 2.38 x

Leverage Ratios

Total Debt Ratio 50.00% 58.45% 54.81%Long-term Debt Ratio 20.00% 25.72% 22.02%LTD to Total Capitalization 28.57% 38.23% 32.76%Debt to Equity 1.00 x 1.41 x 1.21 xLTD to Equity 40.00% 61.90% 48.73%

Coverage Ratios

Times Interest Earned 2.50 x 2.63 x 4.43 xProfitabilty Ratios

Gross Profit Margin 17.50% 16.67% 18.17%Operating Profit Margin 6.25% 5.12% 7.92%Net Profit Margin 3.50% 1.90% 3.68%Return on Total Assets 9.10% 4.50% 8.77%Return on Equity 18.20% 10.82% 19.40%

Other Ratios

Payout Ratio 70.06%Plowback (Retention) Ratio 29.94%Internal Growth Rate 1.36%Sustainable Growth Rate 3.35%Capital Intensity Ratio 38.46% 42.33% 41.97%

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Company Goals and Debt Company Goals and Debt CovenantsCovenants

Company goals are often stated in terms of financial ratios• For example, it is common for management

to set goals regarding the firm’s ROE Debt covenants often contain

restrictions on certain ratios• For example, a borrower might be required

to maintain a debt to equity ratio of less than 1.0 and a current ratio greater than 2.0