Chapter 3 Notes

Brigham & Ehrhardt
Financial
Management:
Theory and Practice
14e
2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, 1
except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
CHAPTER 3
Analysis of Financial
Statements
2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, 2
except for use as
Topics in Chapter
Ratio analysis
DuPont system
Effects of improving ratios
Limitations of ratio analysis
Qualitative factors
2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except
3 for use as
Determinants of Intrinsic Value:

Using Ratio Analysis
Net operating
profit after taxes
Required investments
in operating capital
Free cash flow

=
(FCF)
Value =
FCF1
FCF2
+
(1 + WACC)1 (1 + WACC)2
...
+
FCF
+
(1 +
WACC)
Weighted average
cost of capital
(WACC)
Market interest rates
Market risk aversion
Cost of debt
Firms debt/equity mix
Cost of equity
Firms business risk
4 for use as
Overview
Ratios facilitate comparison of:
One company over time

One company versus other companies
Ratios are used by:
Lenders to determine creditworthiness

Stockholders to estimate future cash flows
and risk
Managers to identify areas of weakness and
strength
5 for use as
Income Statement
2013
Sales
2014E
$5,834,400
$7,035,600
4,980,000
5,800,000
Other expenses
720,000
612,960
Deprec.
116,960
120,000
5,816,960
6,532,960
17,440
502,640
176,000
80,000
COGS except depr.
Tot. op. costs

EBIT
Int. expense
EBT
Taxes (40%)
Net income
(158,560)
422,640
(63,424)
169,056
($ 95,136)
$ 253,584
6 for use as
Balance Sheets: Assets

Cash
S-T invest.
AR
Inventories
Total CA
Net FA
Total assets
2013
$
7,282
20,000
632,160
1,287,360
1,946,802
939,790
$2,886,592
2014E
$
14,000
71,632
878,000
1,716,480
2,680,112
836,840
$3,516,952
7 for use as
Balance Sheets: Liabilities

& Equity
Accts. payable
Notes payable
Accruals
Total CL
Long-term debt
Common stock
Ret. earnings
Total equity
Total L&E
2013
$ 324,000
720,000
284,960
1,328,960
1,000,000
460,000
97,632
557,632
$2,886,592
2014E
$ 359,800
300,000
380,000
1,039,800
500,000
1,680,936
296,216
1,977,152
$3,516,952
8 for use as
Other Data
Stock price
# of shares
EPS
DPS
Book val. per
sh.
Lease payments
Tax rate
2013
$6.00
100,000
-$0.95
$0.11
2014E
$12.17
250,000
$1.01
$0.22
$5.58
$40,000
0.4
$7.91
$40,000
0.4
9 for use as
Liquidity Ratios
Can the company meet its shortterm obligations using the

resources it currently has on hand?
10for use as
Forecasted Current and

Quick Ratios for 2014.
CR14 = CA
CL
=$2,680
$1,040
= 2.58.
QR14 = CA - Inv.
CL
= $2,680 - $1,716
$1,040
= 0.93.
11for use as
Comments on CR and QR
2014E
2013
2012
Ind.
CR
2.58
1.46
2.3
2.7
QR
0.93
0.5
0.8
1.0
Expected to improve but still below the

industry average.
Liquidity position is weak.
12for use as
Asset Management Ratios
How efficiently does the firm use

its assets?
How much does the firm have tied
up in assets for each dollar of
sales?
13for use as
Inventory Turnover Ratio

vs. Industry Average
Inv. Turnover =COGS
Inventories
= $5,800 + $120
= 3.45.
$1,716
2014E 2013
Inv. T. 3.45
4.0
2012
Ind.
4.0
6.1
14for use as
Comments on Inventory
Turnover
Inventory turnover is below

industry average.
Firm might have old inventory, or
its control might be poor.
No improvement is currently
forecasted.
15for use as
DSO: average number of

days from sale until cash
received.
DSO =
Receivables
Average sales per day
=Receivables
Sales/365
= $878
$7,036/365
= 45.5 days.
16for use as
Appraisal of DSO
Firm collects too slowly, and

situation is getting worse.
Poor credit policy.
2014 2013 2012 Ind.

DSO 45.5 39.5 37.4 32.0
17for use as
Fixed Assets and Total

Assets
Turnover Ratios
Fixed assets
Sales
=
turnover
Net fixed assets
$7,036
=
= 8.41.
$837
Total assets
Sales
=
turnover
Total assets
$7,036
=
= 2.00.
$3,517
(More)
18for use as
Fixed Assets and Total

Assets
Turnover Ratios
FA turnover is expected to exceed industry

average. Good.
TA turnover not up to industry average.
Caused by excessive current assets (A/R and
inventory).
2014E
2013
2012
Ind.
FA TO
8.4
6.2
10.0
7.0
TA TO
2.0
2.0
2.3
2.5
19for use as
Debt Management Ratios
Does the company have too much

debt?
Can the companys earnings meet
its debt servicing requirements?
20for use as
Leverage Ratios: Debt Ratio

Total debt
Debt ratio = Total assets
$300 + $500
=
=
22.7%.
$3,517
(More)
21for use as
Leverage Ratios:
Liabilities-to-Assets Ratio
Liabilities/TA ratio =Total liabilities
Total assets
=$1,039.8 + $500
$3,517
=43.8%.
(More)
22for use as
Times Interest Earned

Ratio
TIE =
6.3.
EBIT
Int.
$502.6 =
= expense
$80
(More)
23for use as
EBITDA Coverage (EC)

EBIT + Depr. & Amort. + Lease payments
Interest
Lease
+ pmt.
+ Loan
expense
pmt.
$502.6
+
$120
+
$40
=
$80 + $40 + $0
5.5.
24for use as
Debt Management Ratios

vs. Industry Averages
2014E 2013 2012
Ind.
D/TA 22.7% 59.6% 35.6% 32.0%
TL/TA 43.8% 80.7% 54.8% 50.0%
TIE
6.3
0.1
3.3
6.2
EC
5.5
0.8
2.6
8.0 but
Recapitalization
improved
situation,
lease payments drag down EC.
25for use as
Profitability Ratios
What is the companys rate of

return on:
Sales?
Assets?
26for use as
Profit Margins
Net profit margin (PM):
NI
$253.6
PM = Sales= $7,036 = 3.6%.
Operating profit margin
(OM): EBIT
$503
OM = Sales = $7,036 = 7.1%.
(More)
27for use as
Profit Margins
Gross profit margin
(GPM):
Sales
GPM =
COGS
=
Sales
(Continued)
$1,236
GPM = $7,036 = 17.6%.
$7,036
$5,800
$7,036
28for use as
Profit Margins vs. Industry

Averages
2014E 2013 2012
Ind.
PM
3.6% -1.6% 2.6% 3.6%
OPM
7.1
0.3
6.1
7.1
GPM
17.6 14.6 16.6 15.5
Very bad in 2013, but projected to
meet or exceed industry average in
2014.
29for use as
Basic Earning Power (BEP)

EBIT
BEP =
Total assets
= $502.6 = 14.3%.
$3,517
(More)
30for use as
Basic Earning Power vs.

Industry Average
BEP removes effect of taxes and
financial leverage. Useful for
comparison.
Projected to be below average.
Room for improvement.
2014E 2013 2012 Ind.
BEP 14.3% 0.6% 14.2%17.8%
31for use as
Return on Assets (ROA)

and Return on Equity
(ROE)
NI
ROA =
Total assets
= $253.6
$3,517
= 7.2%.
(More)
32for use as
Return on Assets (ROA)

and Return on Equity
(ROE)
NI
ROE =
Common Equity
= $253.6 = 12.8%.
$1,977
(More)
33for use as
ROA and ROE vs. Industry

Averages
2014E
Ind.
ROA
ROE
2013
2012
7.2% -3.3% 6.0% 9.0%

12.8% -17.1%13.3% 18.0%
Both below average but improving.

34for use as
Effects of Debt on ROA

and ROE
ROA is lowered by debt--interest

expense lowers net income, which
also lowers ROA.
However, the use of debt lowers
equity, and if equity is lowered
more than net income, ROE would
increase.
35for use as
Market Value Ratios
Market value ratios incorporate

the:
High current levels of earnings and

cash flow increase market value
ratios
High expected growth in earnings and
cash flow increases market value
ratios
High risk of expected growth in
earnings and cash flow decreases
36
2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
Calculate and appraise the

P/E, P/CF, and M/B ratios.
Price = $12.17.
NI
$253.6
EPS = Shares out. = 250
Price per share $12.17
P/E =
=
EPS
$1.01
= $1.01.
= 12.
37for use as
Market Based Ratios

NI + Depr.
CF per share
=
Shares out.
$253.6 + $120.0
=
=
$1.49.
250
Price per share
P/CF =Cash flow per share
= $12.17
$1.49
= 8.2.
38for use as
Market Based Ratios

(Continued)
Com. equity
BVPS = Shares out.
$1,977
= 250
= $7.91.
Mkt. price per share
M/B =Book value per share
$12.17
= $7.91
= 1.54.
39for use as
Interpreting Market Based

Ratios
P/E: How much investors will pay

for $1 of earnings. Higher is
better.
M/B: How much paid for $1 of book
value. Higher is better.
P/E and M/B are high if ROE is high,
risk is low.
40for use as
Comparison with Industry

Averages
2014E
Ind.
P/E
P/CF
M/B
12.0
8.2
1.5
2013
-6.3
27.5
1.1
2012
9.7
8.0
1.3
14.2
7.6
2.9
41for use as
Sheets:
Divide all items by Total
Assets
Assets
Cash
ST Inv.
AR
Invent.
Total
CA
Net FA
TA
2012
0.6%
3.3%
23.9%
48.7%
76.5%
2013
0.3%
0.7%
21.9%
44.6%
67.4%
2014E
0.4%
2.0%
25.0%
48.8%
76.2%
Ind.
0.3%
0.3%
22.4%
41.2%
64.1%
23.5% 32.6% 23.8% 35.9%

100.0 100.0% 100.0% 100.0%
42
%
Divide all items by Total

Liabilities & Equity
Liab. & Eq.
AP
Notes
pay.
Accruals
Total CL
LT Debt
Total eq.
Total L&E
2012
2013 2014E
9.9% 11.2% 10.2%
13.6% 24.9%
8.5%
Ind.
11.9%
2.4%
9.3%
9.9% 10.8%
9.5%
32.8% 46.0% 29.6% 23.7%
22.0% 34.6% 14.2% 26.3%
45.2% 19.3% 56.2% 50.0%
100.0 100.0 100.0 100.0%
%
%
% 43
Analysis of Common Size

Balance Sheets
Computron has higher proportion

of inventory and current assets
than Industry.
Computron now has more equity
(which means LESS debt) than
Industry.
Computron has more short-term
debt than industry, but less longterm debt than industry.
44for use as
Common Size Income

Statement:
Divide all items by Sales
2012
2013
2014E
Ind.
Sales
100.0%
100.0%
100.0%
100.0%
COGS
83.4%
85.4%
82.4%
84.5%
Depr.
0.6%
2.0%
1.7%
4.0%
Other exp.
9.9%
12.3%
8.7%
4.4%
EBIT
6.1%
0.3%
7.1%
7.1%
Int. Exp.
1.8%
3.0%
1.1%
1.1%
Pre-tax
earn.
4.3%
-2.7%
6.0%
5.9%
Taxes
1.7%
-1.1%
2.4%
2.4%
NI
2.6%
-1.6%
3.6%
3.6%
45for use as
Analysis of Common Size

Income Statements
Computron has lower COGS (86.7)

than industry (84.5), but higher
other expenses. Result is that
Computron has similar EBIT (7.1)
as industry.
46for use as
Percentage Change Analysis:

% Change from First Year
(2012)
Income St.
Sales
COGS
Depr.
Other exp.
EBIT
Int. Exp.
EBT
Taxes
NI
2012
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
2013
70.0%
73.9%
518.8%
111.8%
-91.7%
181.6%
-208.2%
-208.2%
-208.2%
2014E
105.0%
102.5%
534.9%
80.3%
140.4%
28.0%
188.3%
188.3%
188.3%
47for use as
Analysis of Percent
Change Income Statement
We see that 2014 sales grew 105%

from 2012, and that NI grew 188%
from 2012.
So Computron has become more
profitable.
48for use as
Percentage Change
Balance Sheets: Assets
Assets
Cash
ST Invest.
AR
Invent.
Total CA
Net FA
TA
2012
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
2013
-19.1%
-58.8%
80.0%
80.0%
73.2%
172.6%
96.5%
2014E
55.6%
47.4%
150.0%
140.0%
138.4%
142.7%
139.4%
49for use as
Percentage Change
Balance Sheets: Liabilities
& Equity
Liab. &
Eq.
AP
Notes
pay.
Accruals
Total CL
LT Debt
Total eq.
Total L&E
2012
2013
2014E
0.0%
0.0%
122.5%
260.0%
147.1%
50.0%
0.0%
0.0%
0.0%
0.0%
0.0%
109.5%
175.9%
209.2%
-16.0%
96.5%
179.4%
115.9%
54.6%
197.9%
50 139.4%
Analysis of Percent
Change Balance Sheets
We see that total assets grew

139%, while sales grew only 105%.
So asset utilization remains a
problem.
51for use as
Explain the DuPont System
The DuPont system focuses on:
Expense control (PM)

Asset utilization (TATO)
Debt utilization (EM)
It shows how these factors

combine to determine the ROE.
52for use as
The DuPont System
)(
Profit
margin
TA
turnover
NI
Sales
x
Sales
TA
)(
Equity
multiplier
TA
CE
) = ROE
= ROE
53for use as
The DuPont System

NI
Sales
x
Sales
TA
2012: 2.6%
2013:-1.6%
2014: 3.6%
Ind.: 3.6%
x
x
x
x
TA
CE
x
2.3
2.0
2.0
2.5
x
x
x
x
= ROE
2.2 = 13.2%
5.2 = -16.6%
1.8 = 13.0%
2.0 = 18.0%
54for use as
Potential Problems and

Limitations of Ratio
Analysis
Comparison with industry averages

is difficult if the firm operates
many different divisions.
Seasonal factors can distort ratios.
Window dressing techniques can
make statements and ratios look
better.
Different accounting and operating
practices can distort comparisons.
55for use as
Qualitative Factors
There is greater risk if:
revenues tied to a single customer

revenues tied to a single product
reliance on a single supplier?
High percentage of business is generated
overseas?
What is the competitive situation?

What products are in the pipeline?
What are the legal and regulatory
issues?
56for use as

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Brigham & Ehrhardt

Determinants of Intrinsic Value:

Free cash flow

Firms debt/equity mix

Firms business risk

Ratios facilitate comparison of:

One company over time

Ratios are used by:

Lenders to determine creditworthiness

COGS except depr.

Tot. op. costs

Balance Sheets: Assets

Balance Sheets: Liabilities

Can the company meet its shortterm obligations using the

Forecasted Current and

Expected to improve but still below the

Asset Management Ratios

How efficiently does the firm use

Inventory Turnover Ratio

Inventory turnover is below

DSO: average number of

Firm collects too slowly, and

2014 2013 2012 Ind.

Fixed Assets and Total

Fixed Assets and Total

FA turnover is expected to exceed industry

Debt Management Ratios

Does the company have too much

Leverage Ratios: Debt Ratio

Times Interest Earned

EBITDA Coverage (EC)

Debt Management Ratios

What is the companys rate of

Profit Margins vs. Industry

Basic Earning Power (BEP)

Basic Earning Power vs.

Return on Assets (ROA)

Return on Assets (ROA)

ROA and ROE vs. Industry

7.2% -3.3% 6.0% 9.0%

Both below average but improving.

Effects of Debt on ROA

ROA is lowered by debt--interest

Market Value Ratios

Market value ratios incorporate

High current levels of earnings and

Calculate and appraise the

Market Based Ratios

Market Based Ratios

Interpreting Market Based

P/E: How much investors will pay

Comparison with Industry

23.5% 32.6% 23.8% 35.9%

Divide all items by Total

Analysis of Common Size

Computron has higher proportion

Common Size Income

Analysis of Common Size

Computron has lower COGS (86.7)

Percentage Change Analysis:

We see that 2014 sales grew 105%

We see that total assets grew

Explain the DuPont System

The DuPont system focuses on: