Chapter Three Financial Statement Analysis

Principles of Managerial Finance First Canadian Edition Lawrence J. Gitman and Sean Hennessey

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Learning Goals
LG1

Introduce financial ratio analysis, three types of ratio comparisons, and four categories of ratios. LG2 Analyze liquidity and effectiveness at managing inventory, accounts receivable, accounts payable, fixed and total assets. LG3 Discuss financial leverage, ratios used to assess how assets were financed, and ability to cover financing charges.

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Learning Goals (continued)

LG4

Evaluate profitability using common-size analysis, and relative to sales, total assets, common equity, and common share price. LG5 Explore link between various categories of ratios, liquidity and activity ratios, leverage, and profitability ratios. LG6 Use DuPont system and summary of financial ratios to perform complete ratio analysis, with caution.
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Using Financial Ratios

Financial Ratios are measures of relative values of key financial information. Ratio Analysis involves methods of calculating and interpreting financial ratios to assess the firms performance. Ratios are measured as (1) percentages; (2) times or multiples; and (3) number of days.

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Parties interested in Ratios

Ratios are of interest as key indicators of financial health to:
shareholders, creditors, management, and prospective investors.

Ratio analysis directs attention to potential areas of concern, but are not conclusive evidence of problems.
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Types of Ratio Comparisons

Cross-Sectional Analysis involves the comparison of different firms at the same time.
Benchmarking firm performance against industry averages is very popular.

Time-Series Analysis evaluates performance over time, allowing for comparisons of current and past ratio values. Combined Analysis mixes both features of Cross-Sectional and Time Series Analysis.
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Categories of Financial Ratios

Ratios are grouped into four basic categories:
liquidity ratios, activity ratios, leverage ratios, and profitability ratios.

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Analyzing Liquidity
Liquidity refers to the firms ability to satisfy its short-term obligations as they come due. Three areas are of particular concern:
Net Working Capital, The Current Ratio, and The Quick (Acid-Test) Ratio.

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Net Working Capital

This measure of liquidity is simply a measure of current assets minus liabilities.
Net Working Capital = Current Assets Current Liabilities

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Current Ratio
Commonly used, the Current Ratio measures the ability to meet short-term obligations.
Current Ratio = Current Assets/Current Liabilities

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Quick (Acid Test) Ratio

The Quick Ration focuses on only the most liquid of the firms current assets: cash, marketable securities, and accounts receivable.
Quick Ratio = Cash+Marketable Securities+Accounts Receivable Current Liabilities

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Analyzing Activity
Activity Ratios measure the effectiveness of managing accounts receivable, inventory, accounts payable, fixed assets, and total assets. There are Activity Ratios for each of these management issues.

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Average Age of Inventory

This ratio measures the effective management of inventory in terms of number of days inventory is held.
Average Age of Inventory = Inventory Daily COGS
Where Daily COGS equals the daily value of the Cost of Goods Sold.

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Average Collection Period

Useful for evaluating credit and collections policies of the firm, this ratio is also measured in days.
Average Collection Period = Accounts Receivable Average Sales Per Day

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Average Payment Period

This ratio evaluates the speed of satisfying the Accounts Payable for the firm.
Average Payment Period = Accounts Payable Average Purchase Per Day

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Fixed and Total Asset Turnover

These ratios evaluate the use of Fixed and Total Assets to generate Sales. Fixed Asset Turnover = Sales Net Fixed Assets
Total Asset Turnover = Sales Total Assets

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Analyzing Leverage
Leverage measures the amounts of borrowed money being used by the firm. Leverage Ratios are classified as either
Capitalization Ratios, focusing on how investments are financed; or Coverage Ratios, focusing on the ability to service the firms sources of financing.

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Debt Ratio
The Debt Ratio measures the proportion of total assets financed by creditors. Debt Ratio = Total Liabilities/Total Assets The Preferred Equity Ratio shows only that portion of total assets financed by preferred shareholders. The Common Equity Ratio shows only that portion of total assets financed by common shareholders.
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Debt/Equity Ratio
The popularly mentioned Debt/Equity Ratio measures the proportion of long-term debt to common equity of the firm.
Debt/Equity Ratio = Long-Term Debt Common Equity

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Times Interest Earned Ratio

Also called the Interest Coverage Ratio, measures the ability to make contractual interest payments. Times Interest Earned = EBIT Interest
Recall that EBIT stands for Earnings Before Interest and Taxes.

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Fixed-Charge Coverage Ratio

This ratio measures the ability to meet all fixed financial payments.
EBIT + Lease Payments Interest + Lease Payments + ((1-T)*(Principal + Dividends))
Where T is the corporate tax rate.

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Analyzing Profitability
There are many measures of the bottomline, the profitability of the firm. Four main measures examined here are:
Common-Size Income Statements, Return on Total Assets, Return on Equity, and Price/Earnings Ratio.

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Common Size Income Statements

Gross Margin measures the percentage of each sales dollar after direct cost of goods have been paid. Operating Margin measures the percentage of each sales dollar after all expenses associated with producing, selling, and operating the company have bee deducted (EBIT). Profit Margin measures the percentage of each sales dollar after all expenses, including interest and taxes, have been paid.
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Return on Total Assets (ROA)

Also called Return On Investment, measures the overall effectiveness in generating profits with available assets.
ROA = Net Income After Taxes Total Assets

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Return on Equity (ROE)

Measures the return earned on the owners investment in the firm.
ROE = Earnings Available for Common Shareholders Common Equity

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Earnings per Share (EPS)

Represents the number of dollars earned on behalf of each outstanding common share.
EPS = Earnings Available for Common Shareholders Number of Common Shares Outstanding

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Price/Earnings (P/E) Ratio

This commonly used ratio is more an appraisal of share value than directly of profitability.
P/E Ratio = Market Price Per Common Share Earnings Per Share

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Leverage and Profitability

Leverage is the advantage gained by using a lever. In finance, debt financing is the financial lever. Financial leverage allows the firm to acquire assets beyond those available through pure equity financing arrangements.

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Complete Ratio Analysis

Investors and Analysts want to get a global view of the various ratios in order to make their overall assessment of a firms health. Two popular approaches are:
The DuPont System of Analysis, and A summary analysis of all key ratios.

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DuPont System of Analysis

Developed by the DuPont Corporation. The DuPont System merges Income Statement and Balance Sheet into two summary measures of profitability: ROA and ROE.

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DuPont Formula
The DuPont Formula links the Profit Margin with Total Asset Turnover, as their underlying formulas will summarize Return on Assets. ROA = Profit Margin Total Asset Turnover Since, ROA = Net Income After Taxes Sales Sales Total Assets
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Modified DuPont Formula

The Financial Leverage Multiplier (FLM) is the ratio of Total Assets to Shareholders Equity. The FLM transforms ROA into ROE. ROE = ROA FLM Since,
ROE = Net Income After Taxes Total Assets Total Assets Shareholders Equity

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Summarizing All Ratios

Simply preparing a table of the ratios from the four key categories (liquidity, activity, leverage, and profitability) over a multi-year period allows for a quick and comprehensive review of the firms performance.

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Table 3.7 Summary of Barlett Company Liquidity Ratios

Ratio
Net Working Capital Current Ratio Quick Ratio

2000

Industry Ave. 2002 $583,000 $521,000 $603,000 $427,000

2001

2002

2.04 1.32

2.08 1.46

1.97 1.51

2.05 1.43

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Table 3.7 Summary of Barlett Company Activity Ratios

Ratio
Ave. Age Inventory
Ave. Collection Period

2000
71.6 days 44.5 days

2001
64 days 51.9 days

2002
50.7 days 59.7 days

Industry Ave. 2002

55.3 days 44.9 days

Ave. Payment Period

Total Asset Turnover

76.9 days 0.94

82.3 days 0.79

95.4 days 0.85

67.4 days
0.75
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Table 3.7 Summary of Barlett Company Leverage Ratios

Ratio
Debt Ratio Debt/Equity Ratio Times Interest Earned

2000
36.8% 43.5%

2001
44.3% 59.7%

2002

Industry Ave. 2002 45.7% 40.0%

58.3% 47.4%

5.6

3.3

4.5

4.3

Fixed Charge Coverage

2.4

1.4

1.9

1.5

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Table 3.7 Summary of Barlett Company Profitability Ratios

Ratio
Gross Margin Operating Margin Profit Margin

2000 2001 2002 Industry Ave.

2002 31.4% 33.3% 32.1% 14.6% 11.8% 13.6% 8.8% 5.8% 7.5% 30.0% 11.0% 6.4%

ROA
ROE

8.3%
14.1%

4.5%

6.4%

4.8%
8.0%

8.5% 12.6%

EPS
P/E Ratio

$3.26
10.5

$1.81 $2.90
10.0 11.1

$2.26
12.5

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Cautions about Ratio Analysis

A single ratio does not provide sufficient information to judge overall performance. Financial statement comparisons should be dated at the same point during the year. Audited Financial statements should be used for calculating ratios. Data being compared should use the same accounting rules applied. Time series comparisons of ratios may be distorted by inflation. It is difficult to define categorically what a good or bad ratio value should be.
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