Analysis of Financial Statements |

FINANCIAL RATIO ANALYSIS control over their firm’s ROE. So ROE tends to be the main focal
point.
There are a number of different ways to analyze financial
statements. The most applied is the financial ratio. Financial ratio A summary of the ratios, their formula and significance is
is a comparison in fraction, proportion, decimal or percentage of presented in Figure 12-1.
two significant figures taken from financial statements. It expresses
the direct relationship between two or more quantities in the I. Ratios Used to Evaluate Short-Term Financial Position (Short-
statement of financial position and statement of comprehensive Term Solvency and Liquidity)
income of a business firm.
Name Formula Significance

1. Current ratio Total Current Assets Primary test of

The ratio can be categorized as follows: Total Current Liabilities solvency to meet
current
1. Liquidity ratios. These ratios give us an idea of the firm’s obligations from
current assets as
ability to pay off debts that are maturing within a year or a going concern;
within the next operating cycle. Satisfactory, liquidity ratios measure of
are necessary if the firm is to continue operating. adequacy for
working capital.
2. Asset management ratios. These ratios give us an idea of
how efficiently the firm is using its assets. Good asset 2. Acid-test Total Quick Assets* A more severe
ratio or Total Current Liabilities test of
management ratios are necessary for the firm to keep its
quick ratio immediate
cost low and thus, its net income high. solvency; test of
ability to meet
3. Debt management ratios. These ratios would tell us how demands from
the firm has financed its assets as well as the firm’s ability to current assets.
repay its long-term debt. Debt management ratios indicate
how risky the firm is and how much of its operating income 3. a) Working Working Capital Indicates
Capital to Total Assets relative liquidity
must be paid to bondholders rather than stockholders. total assets of total assets
and distribution
4. Profitability. These ratios give us an idea of how of resources
profitability the firm is operating and utilizing its assets. employed.
Profitability ratios combine the asset and debt management b) Working Current Assets less
categories and show their effects on return on equity. Capital Current Liabilities

4. Cash Flow Cash + Marketable Measures short-

5. Market book ratios. These ratios which consider the stock Liquidity Securities + Cash term liquidity by
price give us an idea of what investors think about the firm ratio Flow from Operating considering as
and its future prospects. Market book ratios tell us what Activities cash resources
investors think about the company and its prospects. Current Liabilities (numerator)
cash plus cash
equivalents plus
All of the ratios are important, but different ones are more cash flow from
important for some companies than for others. For example, if a operating
activities.
firm borrowed too much in the past and its debt now threatens to
drive it into bankruptcy, the debt ratios are the key. Similarly, if a 5. Defensive Quick Assets Measures length
firm expanded too rapidly and now finds itself with excess Interval of time in days
Projected Daily
inventory and manufacturing capacity, the asset management ratios ratio the firm can
Operational operate on its
take center stage. The ROE is always important, but a high ROE
Expenses present liquid
depends on maintaning liquidity, on efficient asset management,
resources.
and on the proper use of debt. Managers are, of course, vitally
* Cash + Marketable Securities + Accounts receivable
concerned with the stock price, but managers have little direct
control over the stock market’s performance while they do have
 Analysis of Financial Statements |

II. Ratios Used to Evaluate Asset Liquidity and Management 3. Working Net Sales Indicates
Efficiency Capital Ave. Working adequacy and
turnover Capital activity of
Name Formula Significance working capital

1. a) Trade Net credit sales * Velocity of 4. Percent of Amount of each Indicates

receivable collection of each current asset item relative
Average Trade
turnover trade accounts current Total Current investment in
Receivable (net) asset to total each current
and notes’ test Assets
of efficiency of current asset.
collection. assets

b) Average 360 days Evaluates the 5. Current Cost of Sales + Measures

Collection liquidity of assets Operating Expenses movement and
Receivable Turnover
period or accounts turnover + Income Taxes + utilization of
number of or receivable and Other Expenses current
days’ sales Accounts Receivable the firm’s credit (net) (excluding resources to
uncollected Net Sales / 360 policies. depreciation and meet operating
amortization) requirements.
2. Inventory Turnover Ave. Current Assets

a)Merchandise Cost of goods sold Measures 6. Payable Net purchases Measures

turnover efficiency of the turnover Ave. Accounts efficiency of the
Average Merchandise
firm in Payable company in
Inventory meeting trade
managing and
selling payable.
inventories.
7. Operating Average Conversion Measures
Cost of goods sold -do- cycle Period of efficiency of the
b) Finished
goods Inventories company in
Average Finished
inventory + meeting trade
goods Inventory Average Collection payable.
Period of Receivable
c) Goods in Cost of goods Measures +
process manufactured efficiency of the Days Cash
turnover
Average Goods-on firm in
managing and 8. Days cash Ave. Cash balance Measures
Process Inventory Cash operating availability of
selling
inventories. costs cash to meet
average daily
d) Raw Raw Materials Used Number of + 360 days cash
materials Average Raw Materials times raw requirement.
turnover materials
Inventory 9. Free cash Net cash from Excess of
inventory was
used and flow operating activities – operating cash
replenished Cash used for flow over basic
during the Investing activities needs.
period. and Dividends

e) Days supply 360 days Measures 10. Investment Net Sales Measures
in inventory Inventory Turnover average number or assets Ave. Total efficiency of the
of days to sell or turnover Investment firm in
consume the managing all
average or assets
inventory.
Total Assets

* or Net Sales if net credit sales figure is not available

 Analysis of Financial Statements |

11. Sales to Net Sales Tests roughly 7. Book value Ordinary Measures
fixed assets Ave. Fixed Assets the efficiency of per share of shareolder’s equity recoverable
(plant assets (net) management in ordinary No. of outstanding amount in the
turnover) keeping plant shares event of
ordinary shares
properties liquidation if
employed. assets are
realized at their
12. Capital Total Assets Measures book values.
intensity Net Sales efficiency of the
ratio firm to generate 8. Time Net Income before Measures how
sales through interest Interest and Taxes many times
employment of earned Annual Interest interest expense
its resources. is covered by
Charges
operating profit.
III. Ratios Used To Evaluate Long-Term Financial Position or
Stability / Leverage 9. Times Net Income After Indicates ability
preferred Taxes to provide
Name Formula Significance dividend Preferred dividends for
requirement preference
earned Dividends
1. Debt ratio Total Liabilities Shows shareholders.
Requirement
Total Assets proportion of all
assets that are 10. Times fixed Net Income before Measures
financed with charges Taxes and Fixed coverage
debt. earned Charges capability more
Fixed Charges broadly than
2. Equity ratio Total Equity Indicates times interest
Total Assets proportion of (Rent + Interest + earned by
assets provided Sinking Fund including other
by owners. payment before fixed charges.
Reflects
taxes*)
financial
strength and IV. Ratios Used To Measure Profitability and Returns to
caution to Investors
creditors.
Name Formula Significance
3. Debt to Total Liabilities Measures debt
equity ratio Total Equity relative to 1. Gross profit Gross Profit Measures profit
amounts of margin Net Sales generated after
resources consideration of
provided by cost of
owners. production sold.

4. Fixed Assets Fixed Assets (net) Reflects extent 2. Operating Operating Profit Measures profit
to long-term Total Long-term of investment in profit margin Net Sales generated after
liabilities Liabilities long term assets consideration of
financed from operating costs.
long-term debt.
3. Net profit Net Profit Measures profit
5. Fixed assets Fixed Assets (net) Measures the margin (Rate Net Sales generated after
to total Total Equity proportion of of return on consideration of
equity owners’ capital net sales) all expenses and
invested in fixed revenues.
assets.
4. Cash Flow Cash Flow for Measures ability
6. Fixed assets Fixed Assets (net) Measures Margin operating activities of the firm to
to total Total Assets investment in Net Sales translate sales to
equity long-term cash.
capital assets.
* Sinking fund payment before taxes = Sinking fund payment after taxes
1 – Tax rate
 Analysis of Financial Statements |

5. Rate of Net Profit Measures 11. Dividends Dividends Paid/ Shows portion
return on Ave. Total Assets overall per share Declared of income
assets (ROA) efficiency of the Ordinary share distributed to
* Alternative Formula: firm in shareholders on
outstanding
managing assets a per share
Asset Turnover and generating basis.
x profits.
Net Profit Margin 12. Rate of Net Income Measures the
return on Ave. Current Assets profitability of
6. Rate of Net Income Measures rate average current assets
return on Ave. Ordinary Equity of return on current assets invested.
equity ** resources
provided by 13. Rate of Rate of return on Shows
owners. return per Ave. Current assets profitability of
turnover of Current Assets each turnover of
7. Earnings per Net Income less Peso return on current assets current assets.
turnover
share preference dividends each ordinary
requirement share. Indicative Figure 12 – 1. Summary of Most Commonly Used Ratios: Their
Ave. ordinary shares of ability to pay Formulas and Basic Significance
outstanding dividends.
Illustrative Case 12 – 1.

8. Price/ Market Value per Measures The financial statements of EBC Enterprises, Inc. will used to
earnings ratio Share of Ordinary relationship illustrate the use of financial ratios in analyzing the company’s (1)
Shares between price of
liquidity. (2) activity of efficiency in managing resources, (3)
Earnings per share of ordinary shares
in the open leverage, and (4) profitability.
Ordinary Shares
market and
profit earned on Liquidity ratios are ratios that measure the firm’s ability to
a per share meet cash needs as they arise (e. g., payment of accounts
basis. payable, bank loans and operating costs).

9. Dividend Dividends per share Shows Activity ratios are ratios that measure the liquidity of specific
Payout Earnings per share percentage of assets and efficiency on managing assets such as accounts
earnings paid to receivable, inventory and fixed assets.
shareholders.
Leverage ratios are ratios that measure the extent of a firm’s
10. Dividend Annual Dividends Shows the rate,
financing, with debt relative equity and its ability to cover
Yield per share earned by
shareholders interest and other fixed charges such as rent and sinking fund
Market Value per payments.
from dividends
share of Ordinary
relative to
Shares current price of Profitability ratios are ratios that measure the overall
stock. performance of the firm and its efficiency managing assets,
liabilities and equity.

* If there is interest-bearing debt, Rate of return on asset is computed

as follows:
REQUIRED:
Net Income + [Interest expense(1 – Tax rate)] A measure of the
Average Total Assets productivity of Using the financial ratios, evaluate the company’s financial
assets regardless position and operating results for years 2011 and 2010.
** May also be computed as follows: of how the assets
are financed. Solution: EBC Enterprises, Inc.
ROE = Return on Assets x Equity Multiplier

Equity Multiplier = 1 .
Equity Ratio
 Analysis of Financial Statements |

I. Analysis of Liquidity or Short – Term Solvency Quick or Acid test ratio

Current ratio Formula: Quick Assets

(Cash + Marketable Securities +
Formula: Current Assets
Current Liabilities Accounts Receivable, net)
Current Liabilities

2011: 32, 923 = 2.40 times 2011: 9, 146.5 = 0.67 times

13, 703.5 13, 703.5

2010: 28, 132 = 2.75 times 2010: 9, 368 = 0.92 times

10, 216 10, 216

Current ratio is widely regarded as a measure of short-
term debt-paying ability. Current liabilities are used as the
denominator because they are considered to represent
the most urgent debts requiring retirement within one
year or one operating cycle. A declining ratio could
indicate a deteriorating financial condition or it might be
the result of paring of obsolete inventories or other
stagnant current assets. An increasing ratio might be the
result of an unwise stock piling of inventory or it might
indicate an improving financial situation. The current
ratio is useful but tricky to interpret and therefore. the
analyst must look closely at the individual assets and
liabilities involved.
Some analysts eliminate prepaid expenses from the
numerator because they are not potential sources of cash
but, rather, represent future obligations that have already
been satisfied.
EBC’s current ratio indicates that a year-end 2011current
assets covered current liabilities 2.4 times down from
2010. Its significance could be best evaluated by
comparing this with industry competitors or the
company’s trend of liquidity over a longer period.
The acid-test (quick) ratio is a much more rigorous test of
a company’s ability to meet its short-term debts.
Inventories and prepared expenses are excluded from
total current assets leaving only the more liquid assets to
be divided by current liabilities. This is designed to
measure how well a company can meet its obligations
without having to liquidate or depend too heavily on its
inventory. Since inventory is not an immediate source of
cash and may not even be saleable in times of economic
stress, it is generally felt that to be properly protected;
each peso of liabilities should be backed by at least ₱1 of
quick assets.
EBC’s quick ratio indicates deterioration between year
2011 and year 2010. An analyst might be quite
concerned about several disquieting trends revealed in
rising short-term debts and increasing inventories. The
acid-test ratio must also be examined in relation to other
firms in the same industry.
Cash-Flow Liquidity Ratio
Formula: Cash + Marketable Securities + Cash
Flow from Operating Activities

As a measure of short-term liquidity, the current ratio is Current Liabilities

limited by the nature of the component. The liquidity of
the assets may vary considerably from the date on which 2, 030.5 + 2, 636 + 5, 012
2011: = 0.70 times
the statement of financial position is prepared. 13, 703.5
Furthermore, it could have a relatively high current ratio
but not be able to meet the demands for cash because
the accounts receivable are of interior quality or the 2010: 1, 191 + 4, 002 + (1, 883.5) = 0.32 times
inventory is saleable only at discounted price.
10, 216

The cash flow liquidity ratio considers cash flow from

operating activities (from the statements of cash flows) in
addition to the truly liquid assets, cash and marketable
securities.
 Analysis of Financial Statements |

365
EBC’s current ratio and acid-test ratio both decreased 2010: = 19.9 days or 20 days
18.32
between 2010 and 2011 which could be interpreted as a
deterioration of liquidity. But the cash flow ratio The average collection period helps evaluate the liquidity
increased indicating an improvement in short-term of accounts receivable and the firm’s credit policies. The
solvency. Furthermore, the reason for the decline in the long collection period may be a result of the presence of
current ratio and acid-test ratio could be traced to the many old accounts of doubtful collectability, or it may be
88% increase in accounts payable which could actually be the result of poor day-to-day credit management such as
a plus if it means that EBC, Inc. strengthened its ability to inadequate checks on customers or perhaps no follow-
obtain supplier credit. Also, the firm’s cash flow from ups are being made on slow accounts. There could be
operating activities turned around from negative to other explanations such as temporary problem caused by
positive amount which contributed to the stronger short- a depressed economy.
term solvency in 2011.
The average collection period of accounts receivable is
II. Analysis of Asset Liquidity and Asset Management Efficiency the average number of days required to convert
receivable into cash. The ratios for EBC, Inc. indicate
Accounts Receivable Turnover that during 2011, the firm collected its accounts in 15
days on average, an improvement over the 20-day
Formula: Net Sales * collection period in 2010. Whether the average of 15
Average Accounts Receivable
days taken to collect an account is good or bad depends
balance
on the credit terms EBC is offering its customers. If the
107, 800 credit terms are 10 days, then a 15-day average collection
2011: = 24.90 times
4, 480 + 4, 175 period would be viewed as good. Most customers will
2
tend to withhold payments for as long as the credit terms
will allow and may even go over a few days. This factor,
2010: 76, 500 = 18.32 times added to ever-present problems with a few slow-paying
4, 175 **
customers, can cause the average collection period to
The accounts receivable turnover roughly measures how
exceed normal credit terms by a week or so and should
many times a company’s accounts receivable have been
not cause great alarm.
turned into cash during the year. EBC, Inc. converted
accounts receivable into cash 24.9 times in 2011, up from Inventory Turnover
18 times in 2010. The turnover if receivable has
Cost of good sold
improved and this may indicate better quality of Formula:
Average inventory balance
receivable and improvement of the firm’s collection and
credit policies. Generally, a high turnover is good
because it could indicate efficiency in the collection of 64, 682
2011: = 3.09 times
receivable, but a very high turnover may not be favorable 23, 520.5 + 18, 384.5
because it may indicate that credit and collection policies 2
are overly restrictive.
2010: 45,939.5 = 2.50 times
Average Collection Period 18.384.5*
* Assumed average for 2010
Formula: 365 days
Accounts Receivable Turnover
The inventory turnover measures the efficiency of the
or firm in managing and selling inventory. It is computed by
Average Accounts Receivable dividing the cost of goods sold by the average level of
Average daily sales inventory on hand. The ratio is sometimes calculated
with net sales as the numerator and the average level of
inventory as the denominator. The inventory turnover of
2011: 365 = 14.6 days or 15 days EBC, Inc. was 3.09 times in 2011, an improvement over
24.9
2010’s 2.50 times.

* When available, credit sales can be substituted for net sales since credit Generally a high turnover is preferred because it is a sign
sales produce receivable.
of efficient inventory management and profit for the firm.
** Assumed average for 2010.
 Analysis of Financial Statements |

But a high turnover could also mean underinvestment in the framework of the overall analysis of the company as
inventory and lost orders, a decrease in prices, a shortage well as that of the industry.
of materials or more sales than planned. A relatively low
turnover could mean that the company is carrying too Total Asset Turnover
much inventory or it has obsolete, slow-moving or
Formula:
inferior inventory stock. Net sales
Average Total Assets
The inventory turnover varies, from industry to industry.
Flowers and vegetables sellers would have a relatively 107,800
2011: = 2.52 times
high turnover because they deal with perishable products 47,649 + 37,954.5
2
but a jewelry store would have lower turnover but high
profit margin. 76,500
2010: = 2.02 times
37,954.5 *
Average Sale Period
* Assumed average for 2008.
365 days
Formula:
Inventory Turnover The total asset turnover is a measure of efficiency of
management to generate sales and thus earn more profit
365 days for the firm. When the asset turnover ratios are low
2011: = 118 days relative to the industry or the firm’s historical record, it
3.09
could mean that either the investment in assets is too
heavy or sales are sluggish. There may however be
365 days justification for the low turnover. For example, the firm
2010: = 146 days
2.50 may have undertaken an extensive plant modernization
The number of days being taken to sell the entire or placed in assets is service at year-end which will
inventory one time (called the average sale or conversion generate positive results in the long-term.
period) is composed by dividing 365 days by the
inventory turnover period. Generally, the faster inventory For EBC, Inc. the total asset turnover has improved
sells, the fewer funds are tied up in inventory and more primarily because of the improvement in fixed assets,
profits are generated. EBC’s average sale or conversion inventory and accounts receivable turnover.
period decreased from 146 day in 2010 to 118 days in
III. Analysis of Leverage: Debt Financing and Coverage
2011. This is evidence of efficiency in managing the
inventories in 2011. Debt Ratio
Fixed Asset Turnover Total Liabilities
Formula:
Total Assets
Formula: Net Sales
Average net property, plant and equipment
24,681.5
2011: = 51.8%
47,649
107,800
2011: = 8.97 times
14,539.5 + 9,488.5
2 19,021
2010: = 50.1%
37,954.5
76,500
2010: = 8.06 times The debt ratio measures the proportion of all assets that
9,488.5*
are financed with debt. Generally, the higher the
* Assumed average for 2010.
proportion of debt, the greater the risk because creditors
The fixed asset turnover is another approach to assessing must be satisfied before owners in the event of
management’s effectiveness in generating sales from bankruptcy.
investments in fixed assets particularly for a capital-
The use of debt involves risk because debt carries a fixed
intensive firm. For EBC, Inc. the fixed assets turnover
obligation in the form of interest charges and principal
improved slightly because of the 41% in sales as
repayment. Failure to satisfy the fixed charges associated
compared with 26% increase in average fixed assets. This
with debt will ultimately result in bankruptcy.
occurrence however should be further examined within
 Analysis of Financial Statements |

EBC’s debt ratios in 2011 and 2010 indicate relatively
heavy reliance on borrowed capital and they have
reached the generally considered maximum ratio for 50%
debt and 50% equity. Too much debt would pose
difficulty in obtaining additional debt financing when
needed or that credit is available only at extremely high
rates of interest and most onerous terms.
While EBC, Inc. increased its use of debt in 2011, the
company improved its ability to cover interest payment
from operating profits.
Fixed Charge Coverage
Operating Profit + Lease payments
Formula:
Interest Expense + Lease payments

Debt to Equity Ratio

9,621.5 + 6,529
Total Liabilities 2011: = 2.06 times
Formula: 1,292.5 + 6,529
Total Equity

5,903 + 3,555.5
24,681.5 2010: = 2 times
2011: = 107.46% 1,138.5 + 3,555.5
22,967.5
The fixed charge coverage measures the firm’s coverage
capability to cover not only interest payments but also the
19,021 fixed payment associated with leasing which must be met
2010: = 100.46%
18,933.5 annually. This ratio is particularly important for firms
The amount and proportion of debt and equity in a that operate extensively with leasing arrangements,
company’s capital structure are extremely important to whether operating leases or capital leases.
the financial analyst because of the trade off between risk
and return. While debt implies risk, it also provides the EBC, Inc. experienced a significant increased in the
potential for increased benefit to the firm’s owners. amount of annual lease payment in 2011 but was still
When debt is used successfully, operating earnings able to improve its fixed charge coverage.
exceed the fixed charges associated with debt, the return
IV. Operating Efficiency and Profitability
to the stockholders are magnified through financial
leverage or “trading on the equity.” Gross Profit Margin
The debt to equity ratio measure the riskiness of the Formula: Gross Profit
firm’s capital structure in terms of relationship between Net Sales
the funds supplied by creditors (debt) and investors
(equity). EBC’s debt to equity ratio has increased 43,118
between 2011 and 2010, implying a slightly riskier capital 2011: = 40%
107,800
structure.

Times Interest Earned 30,560.5

2010: = 39.95%
76,500
Formula: Operating Profit
Interest Expense Gross profit margin which shows the relationship
between sales and the cost of products sold, measures the
ability of a company both to control costs and inventories
9,621.5
2011: = 7.44 times or manufacturing of products and to pass along price
1,292.5
increases through sales to customers.

5,903 EBC’s gross profit margin for both 2011 and 2010 have
2010: = 5.18 times been stable which is considered a positive sign even if the
1,138.5
company had to offer probably discounted items to
Times interest earned ratio is the most common measure
attract customers or feature “sale” to hasten up inventory
of the ability of a firm’s operations to provide protection
turnover.
to long-term creditors. The more times a company can
cover its annual interest expense from operating earnings, Operating Profit Margin
the better off will be the firm’s investors.
Formula: Operating Profit
Net Sales
 Analysis of Financial Statements |

EBC’s cash flow margin in 2011 was higher than the

9,621.5 operating margin. This indicates a strong positive
2011: = 8.9% generation of cash. The performance in 2011 represents
107,800
a solid and impressive improvement over 2010 when the
firm failed to generate cash from operations and had a
5,903 negative cash flow margin.
2010: = 7.7%
76,500
The operating profit margin is a measure of overall Return on Investment as Assets (ROA)
operating efficiency and incorporates all of the expenses
Formula:
associated with ordinary or normal business activities.
or
EBC’s operating profit margin improved from 7.7% in
Net Profit Margin x Total Asset Turnover
2010 to 8.9% in 2011. This is favorable because it
indicates ability of the company to control its operating
If the firm has interest bearing debt, ROA is computed
expenses while sharply increasing sales.
using the following formula:
Net Profit Margin Net Income + [Interest (1 – Tax rate)]
Average Total Assets
Formula:

2011: 4,697 + [ 121.5 (1 – 43 %)] = 10.88%

4,697 43,803
2011: = 4.36%
107,800
2,955 + [1,138.3 (1 – 43%)]
2010: = 9.02%
39,955
2,955
2010: = 3.87%
76,500 Return on Equity (ROE)
Net profit margin measures profitability after considering Net Income
Formula:
all revenue and expenses, including interest, taxes and Average Shareholders’ Equity
nonoperating items such as extraordinary items, or
cumulative effect of accounting change, etc. Return on Assets x Financial Leverage or Equity Multiplier

EBC’s net profit margin slightly increased despite 1

Equity Multiplier =
increased interest and tax expenses and a reduction in Equity Ratio
interest revenue for marketable security investment.

Cash Flow Margin 2011: 4,697 = 22.42%

22,967.5 + 18,933.5
Formula: Cash flow from operating activities 2
Net Sales
2,955 .
2010: = 15.60%
18,933.5
5,012
2011: = 4.65% Return on assets and return on equity are two ratios that
107,800
measure the overall efficiency of the firm in managing its total
investment in assets and in generating return to shareholders.
(1,883.5) These ratios indicate the amount of profit earned relative to the
2010: = (2.5%)
76,500 level of investment in total assets and investment of common
Cash flow margin is another important measure or shareholders.
perspective on operating performance. This measures
the ability of the firm to translate sales to cash to enable it These ratios will also measure how effectively the company is
to service debt, pay dividends or invest in new capital using financial leverage. The Financial Leverage Index (FLI) is
assets. computed as follows:
 Analysis of Financial Statements |

Return on Equity
Return on Assets b) Price Earnings Ratio (P/E)
Formula: Market Price of ordinary shares
If the FLI is greater than 1 indicating the return on equity Earnings per share
exceeds return on assets, the firm is using debt
effectively. If FLI is less than 1, the financial leverage is 2011: 30 = 15
negative which means that the firm is not using debt 2
successfully. 2010: 17 = 13.39
1.27
EBC’s registered a solid improvement in 2011 of both
The P/E ratio related earnings per ordinary share to the
return ratios. Financial Leverage Index is calculated as
market price at which the stock trades, expressing the
follows:
“multiple” which the stock market places on a firm’s
22.42% earnings. It is a combination of a number of factors such
2011: = 2.06
10.88% as the quality of earnings, future earnings, potential and
performance history of the company.
15.60%
2010: = 1.73 EBC’s price to earnings ratio is higher in 2011 than in
9.02%
2010. This could be because the market is reacting
EBC’s FLI of 2.06 in 2011 and 1.73 in 2010 indicates a
favorably to the firm’s good year.
successful use of financial leverage although borrowing
increased. The firm has generated sufficient operating
c) Dividend payout ratio
returns to more than cover the interest payments on
borrowed funds.
Formula:
Other Ratios used to Measure Returns to Investors 0.33
2011: = 16.5%
2
a) Earnings per share (EPS)
Formula: 2010: 0.41 = 31.78%
1.29
Net Income EBC, Inc. reduced its cash dividend payment in 2011. It
Basic EPS =
Weighted Average number of
is particularly unusual for a firm to reduce dividends
ordinary shares outstanding
during a good year. A possible explanation for this
though may be the adoption of a new policy that will
Net Income lower dividend payments in order to increase the
Diluted EPS =
Weighted Average number of
ordinary shares outstanding and availability of funds that may be reinvested for expansion
potential diluters purposes.

Basic EPS d) Dividend yield

2011: = P2.00 Dividends per share
4,697,000 Formula:
2,401,500 + 2,297,000 Market value per share
2 0.33
2011: = 1.1%
2010: = P1.29 30
2,955,000
2,297,000 2010: 0.41 = 2.41%
The Diluted EPS need not be computed because there 17
are no potential diluters (e.g., convertible bonds, A low dividend yield would indicate that an investor
convertible preference shares or stock options and would choose EBC, Inc. as an investment more for its
warrants) outstanding. PAS 33 issued by the ASC in 2005 long-term capital appreciation than for its dividend yield.
is used to compute the Earnings per share.

EBC’s earnings per ordinary share increased from P1.29

in 2010 to P2.00 in 2011 which is a clear indication in the
improvement on the investment return of ordinary
shareholders.

Summary of Financial Statements Analysis of EBC, Inc.
Short-Term Liquidity and Activity
Short-term liquidity analysis is of particular significance to
trade and short-term creditors, management and other parties
concerned with the ability of a firm to meet near-term
demands for cash.
EBC’s current and quick ratios decreased indicating a
deterioration of short-term liquidity. However, the cash flow
liquidity ratio improved in 2011 after a negative cash
generation in 2010.
The average collection period for accounts receivable and the
inventory turnover improved in 2011 which could indicate
improvement in the quality of accounts receivable and
liquidity of inventory. The increase in inventory level has
been accomplished by reducing holdings of cash and cash
equivalents. This represents a trade-off of highly liquid assets
for potentially less liquid assets. The efficient management of
inventories is critical for the firm’s ongoing liquidity.
Presently, there appears to be no major problems with the
firm’s short-term liquidity position.
Long-term Solvency
The debt ratios for EBC show a steady increase in the use of
borrowed funds. Total debt has increased relative to total
assets, long-term debt has increased as a proportion of the
firm’s permanent financing and external or debt financing has
risen relative to internal financing.
Why has debt increased? The statement of cash flows shows
that EBC has substantially increased its investment in capital
or fixed assets and their investments have been financed
largely by borrowing especially in 2010 when the firm had a
rather sluggish operating performance and no internal cash
generation.
Given the increased level of borrowing, the times interest
earned and fixed charge coverage improved slightly in 2011.
These ratios should however be monitored closely in the
future particularly if EBC continues to expand.
Operating Efficiency and Profitability
As noted earlier, EBC has increased its investment in fixed
asset as a result of store expansion. The asset turnover
increased in 2011, the progress traceable to improved
management of inventories and receivable. There has been
substantial sales growth which suggests future performance
potential.
Analysis of Financial Statements |
The gross profit margin was stable, a positive sign in the light
of new store openings featuring discounted and “sale” items
to attract customers. The firm also managed to improve its
operating profit margin in 2011 principally due to the firm’s
ability to control operating costs. The net profit margin also
improved despite increased interest and tax expenses and a
reduction in interest income from marketable security
investment.
Return on assets and return on equity increased considerably
in 2011. These ratios measure the overall success of the firm
in generating profits from its investment and management
strategies.
Conclusion: It appears that EBC Enterprises, Inc. is well
positioned for future growth. Close monitoring
the firm’s management of inventories is
important considering the size of the company’s
capital tied up in it. “The expansion in their
operation may necessitate a sustained effort to
advertise more, to attract customers to both new
and old areas. EBC has financed much of its
expansion with debt, and so far, its shareholders
have benefited from the use of debt through
financial leverage. The company should
however be cautious of the increased risk
associated with debt financing.
THE DUPONT DISAGGREGATION ANAYLSIS
DuPont Equation is the formula that shows that the rate of return
on equity can be found as the product of profit margin, total assets
turnover and the equity multiplier. It shows the relationships
among asset management, financial leverage management and
profitability ratios.
Disaggregation of return on equity (ROE) was initially introduced
by E. I. DuPont de Nemours and Company to help its managers
in performance evaluation.
The basic DuPont model disaggregates ROE as follows:
Net Net Sales Average
Income income total assets
ROE = Average = x Average x Average
stockholders' Sales total Stockholders’
equity
equity assets
Profit Asset Financial
Margin Turnover Leverage
 Analysis of Financial Statements |

These three components are described as follows:

1. Profit Margin is the amount of profit that the company

earns from each peso of sales. A company can increase its
profit margin by increasing its gross profit margin (Gross
profit + Sales), and/or by reducing its expenses (other than
cost of sales) as a percentage of sales.

2. Asset Turnover is a productivity measure that reflects the

volume of sales that a company generates from each peso
invested in assets. A company can increase its asset
turnover by increasing sales volume with no increase in
assets and/or by reducing asset investment without reducing
sales.

3. Financial Leverage measures the degree to which the

company finances its assets with debt rather than equity.
Increasing the percentage of debt relative to equity
increases the financial leverage. Although financial leverage
increases ROE (when performance is positive), debt must
be used with care as it increases the company’s relative
riskiness.

The profit margin and asset turnover relates the company

operations and combine to yield on assets (ROA) as follows:

Net Net Sales

Income income
ROE = Average = x Average
total assets Sales total assets

Profit Asset
Margin Turnover

Return On Assets (ROA)

Return on assets measures the return on investment for the

company without regard to how it is financed (the relative
proportion of debt and equity in its capital structure). Operating
managers of a company typically grasp the income statement.
They readily understand the pricing of products, the management
of production costs and importance of controlling overhead costs.
However, many managers do not appreciate the importance of
managing the statement of financial position.