Chapter 2

Financial Statements and Analysis

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The Four Key Financial Statements

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The Four Key Financial Statements: The Balance Sheet The balance sheet presents a summary of a

firm’s financial position at a given point in time.

Assets indicate what the firm owns, equity represents the owners’ investment, and liabilities indicate what the firm has borrowed.

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The Four Key Financial Statements

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The Four Key Financial Statements (cont.)

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The Four Key Financial Statements

The statement of retained earnings reconciles the net income earned and dividends paid during the year, with the change in retained earnings.

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The Four Key Financial Statements: Statement of Cash Flows The statement of cash flows provides a

summary of the cash flows over the period of concern, typically the year just ended.

This statement not only provides insight into a company’s investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets.

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The Four Key Financial Statements

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Using Financial Ratios: Interested Parties Ratio analysis involves methods of calculating

and interpreting financial ratios to assess a firm’s financial condition and performance.

It is of interest to shareholders, creditors, and the firm’s own management.

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Using Financial Ratios: Types of Ratio Comparisons (cont.) Trend or time-series analysis

Used to evaluate a firm’s performance over time

Cross-sectional analysis

Used to compare different firms at the same point in time

Industry comparative analysis

One specific type of cross sectional analysis. Used to compare one firm’s financial performance to the industry’s average performance

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Using Financial Ratios: Types of Ratio Comparisons (cont.) Cross-sectional analysis

Benchmarking A type of cross sectional analysis in which the firm’s

ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate

Combined Analysis

• Combined analysis simply uses a combination of both time series analysis and cross-sectional analysis

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Using Financial Ratios: Types of Ratio Comparisons (cont.)

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Using Financial Ratios: Types of Ratio Comparisons (cont.)

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Using Financial Ratios: Cautions for Doing Ratio Analysis Ratios must be considered together; a single ratio by

itself means relatively little.

Financial statements that are being compared should be dated at the same point in time.

Use audited financial statements when possible.

The financial data being compared should have been developed in the same way.

Be wary of inflation distortions.

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Current ratio = total current assets

total current liabilities

Current ratio = $1,233,000 = 1.97

$620,000

Ratio Analysis

Liquidity Ratios Current Ratio

•We will illustrate the use of financial ratios for analyzing financial statements using the Bartlett Company Income Statements and Balance Sheets presented earlier in Tables 2.1 and 2.2.

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Quick ratio = Total Current Assets - Inventory

total current liabilities

Quick ratio = $1,233,000 - $289,000 = 1.51

$620,000

Ratio Analysis (cont.)

Liquidity Ratios Current Ratio Quick Ratio

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Inventory Turnover = Cost of Goods Sold

Inventory

Inventory Turnover = $2,088,00 = 7.2

$289,000

Ratio Analysis (cont.) Activity Ratios

Inventory Turnover

– Average Age of Inventory

Average Age of Inventory = 365

Inventory Turnover

Inventory Turnover = 365 = 50.7 days

7.2

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ACP = Accounts Receivable

Net Sales/365

ACP = $503,000 = 59.7 days

$3,074,000/365

Ratio Analysis (cont.) Average Collection Period

• Average Payment Period

APP = Accounts Payable

Annual Purchases/365

APP = $382,000 = 95.4 days

(.70 x $2,088,000)/365

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Total Asset Turnover = Net Sales

Total Assets

Total Asset Turnover = $3,074,000 = .85

$3,597,000

Ratio Analysis (cont.)

Liquidity Ratios Activity Ratios

Total Asset Turnover

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Insert Table 2.6 here

Ratio Analysis (cont.)

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Debt Ratio = Total Liabilities/Total Assets

Debt Ratio = $1,643,000/$3,597,000 = 45.7%

Ratio Analysis (cont.) Financial Leverage Ratios

Debt Ratio

45% of assets is financed by debt.

– Times Interest Earned Ratio

Times Interest Earned = EBIT/Interest

Times Interest Earned = $418,000/$93,000 = 4.5

The firm can generate 4.5 times operating income to cover its interest expenses. The higher the ratio, the better .Lower ratio shows a higher default risk for the firm.

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Ratio Analysis (cont.)

Liquidity Ratios

Activity Ratios

Leverage Ratios

Profitability Ratios Common-Size Income Statements

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Ratio Analysis (cont.)

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GPM = Gross Profit/Net Sales

GPM = $986,000/$3,074,000 = 32.1%

Ratio Analysis (cont.) Profitability Ratios

Gross Profit Margin

–Operating Profit Margin (OPM)

OPM = EBIT/Net Sales

OPM = $418,000/$3,074,000 = 13.6%

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NPM = Earnings Available to Common Stockholders Sales

NPM = $221,000/$3,074,000 = 7.2%

Ratio Analysis (cont.) Profitability Ratios

Net Profit Margin (NPM)

– Earnings Per Share (EPS)

EPS = Earnings Available to Common Stockholders Number of Shares Outstanding

EPS = $221,000/76,262 = $2.90

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ROA = Earnings Available to Common Stockholders Total Assets

ROA = $221,000/$3,597,000 = 6.1%

Ratio Analysis (cont.) Profitability Ratios

Return on Total Assets (ROA)

– Return on Equity (ROE)

ROE = Earnings Available to Common Stockholders Total Equity

ROE = $221,000/$1,754,000 = 12.6%

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P/E = Market Price Per Share of Common Stock Earnings Per Share

P/E = $32.25/$2.90 = 11.1

Ratio Analysis (cont.) Market Ratios

Price Earnings (P/E) Ratio

– Market/Book (M/B) Ratio

BV/Share = Common Stock Equity Number of Shares of Common Stock

BV/Share = $1,754,000/72,262 = $23.00

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M/B Ratio = Market Price/Share of Common Stock

Book Value/Share of Common Stock

M/B Ratio = $32.25/$23.00 = 1.40

Ratio Analysis (cont.)

Market Ratios Market/Book (M/B) Ratio

Market Ratios are used to assess whether a firm’s stock is over/undervalued. A very high (low) Market Ratio might be a sign of an overvalued (undervalued) stock. Undervalued stocks are ideal candidates to buy whereas overvalued stocks are ideal for selling.

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Summarizing All Ratios

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Summarizing All Ratios (cont.)

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Summarizing All Ratios (cont.)

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DuPont System of Analysis

The DuPont system of analysis is used to dissect the firm’s financial statements and to assess its financial condition.

It merges the income statement and balance sheet into two summary measures of profitability: ROA and ROE as shown in the equation below and in Figure 2.2 on the following slide.

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DuPont System of Analysis (cont.)

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Modified DuPont Formula

The Modified DuPont Formula relates the firm’s ROA to its ROE using the financial leverage multiplier (FLM), which is the ratio of total assets to common stock equity:

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ROE = 6.1% X 2.06 = 12.6%

Modified DuPont Formula (cont.)

Use of the FLM to convert ROA into ROE reflects the impact of financial leverage on the owner’s return.

Substituting the values for Bartlett Company’s ROA of 6.1 percent calculated earlier, and Bartlett’s FLM of 2.06 ($3,597,000 total assets ÷ $1,754,000 common stock equity) into the Modified DuPont formula yields: