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Chapter 03Chapter 03 Analyzing FinancialStatements

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Introduction

• Financial Statement Use– Analyze firm performance– Plan changes to improve performance

• Ratio Analysis– Used to assess firm’s performance

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Five Groups of Financial Ratios

• Liquidity

• Asset management

• Debt management

• Profitability

• Market value

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Ratios Used to Make Comparisons• Trend– Comparison to the same firm over time

• Competitors– Comparison to other firms in the same industry

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Liquidity Ratios

• Relationship between firm’s liquid (current) assets and current liabilities– Commonly-used liquidity ratios• Current ratio• Quick (or acid-test) ratio• Cash ratio

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Current Ratio

• Broadest liquidity measure • Measures current assets available to pay

current liabilities

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Quick Ratio• Excludes inventory in numerator• Measures ability to pay short-term obligations

without inventory sales

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Cash Ratio• Measures ability to pay short-term obligations

with available cash and marketable securities

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Asset Management Ratios

• Measure efficiency of firm’s asset use– Inventory– Accounts receivable– Fixed assets– Accounts payable management

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Inventory Management• Inventory Turnover Ratio– Dollar of sales produced per dollar of inventory– Often uses cost of goods sold instead of sales

because inventory is listed on the balance sheet at cost

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Inventory Management

• Days’ Sales in Inventory Ratio– Measures average number of days inventory held

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Accounts Receivable Management

• The Average Collection Period (ACP) Ratio– Measures number of days accounts receivable

held until collected

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Accounts Receivable Management

• The Accounts Receivable Turnover Ratio– Measures dollars of sales produced per dollar of

accounts receivable

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Accounts Payable Management

• The Average Payment Period (APP) Ratio– Measures the number of days accounts payable held

before extending cash to pay for raw materials

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Accounts Payable Management

• Accounts Payable Turnover Ratio– Measures dollar of COGS per dollar of accounts

payable.

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Fixed Asset and Working Capital Management

• The Fixed Asset Turnover Ratio– Measures dollars of sales produced per dollar of

fixed assets

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Fixed Asset and Working Capital Management

• Sales to Working Capital Ratio– Measures dollar of sales produced per dollar of

working capital • (Current assets minus current liabilities)

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Total Asset Management

• Total Asset Turnover Ratio – Measures dollars of sales produced per dollar of

total assets

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Total Asset Management

• Capital Intensity Ratio – Measures dollars of total assets needed to

produce a dollar of sales

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Debt Management Ratios

• Measure how much debt (financial leverage) versus equity a firm uses to finance assets

• Two major ratio types– Measure debt amount– Measure firm’s ability to service debt

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• Three related measures– Debt Ratio– Debt-to-Equity Ratio– Equity Multiplier Ratio

Debt vs. Equity Financing

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Debt vs. Equity Financing

• Debt Ratio– Measures percentage of total assets financed with

debt

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Debt vs. Equity Financing

• Debt-to-Equity Ratio—Measures dollars of debt financing for every dollar

of equity financing

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• Equity Multiplier Ratio – Measures the dollars of assets on balance sheet

for every dollar of equity financing

Debt vs. Equity Financing

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Coverage Ratios

• Times Interest Earned Ratio – Measures operating earnings dollars available to

meet interest obligations

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Coverage Ratios

• The Fixed-Charge Coverage Ratio – Measures operating earnings available for interest

and other fixed charges

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• Cash Coverage Ratio – Measures operating cash available to meet

interest and other fixed charges– Indicates if debt burden is too large

Coverage Ratios

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Profitability Ratios

• Show the combined effect of liquidity, asset management and debt management on firm’s operating results

• Closely monitored by investors– Stock prices react very quickly to unexpected

changes in these ratios

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• Percent of sales left after all firm expenses are paid

Profit Margin

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Basic Earnings Power Ratio

• Measures the EBIT earned per dollar of assets on the balance sheet

• Represents operating return on assets irrespective of financial leverage and taxes

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Return on Assets (ROA)

• Measures overall return on firm’s assets inclusive of leverage and taxes

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• Measures return on common stockholders’ investment– Affected by net income and amount of financial

leverage– High ROE is usually a positive sign, unless driven

by excessively high leverage

Return on Equity (ROE)

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Dividend Payout Ratio

• Measures fraction of earnings paid out to common stockholders as dividends

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Market Value Ratios

• Market prices of publicly traded firms incorporate risk– Ratios that incorporate stock market values are

important

• Market values reflect what investors think of the company’s future performance and risk

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Price-Earnings Ratio

• Best known and most often quoted figure– Measures price investors will pay per dollar of

earnings– High PE ratio usually indicates projected growth– Drives stock classification as growth or value

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DuPont Analysis

• Uses Balance Sheet and Income Statements

– Breaks ROA and ROE into components to explain why the ratios are low or high

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DuPont Analysis

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Other Ratios

• Spreading the Financial Statement– Divide balance sheet amounts by total assets– Divide all income statement amounts by net sales

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Other Ratios

• Internal Growth Rate• Sustainable Growth Rate• Time Series• Cross-Sectional Analysis

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