Chapter 7

Analysis of Financial
Statements

Need to Know Concepts

Ratio analysis
Common-size analysis
DuPont equation
Limitations of ratio analysis
Qualitative factors

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
3

Income Statement
2015
Sales

2016E

$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
4

Balance Sheets: Assets

Cash
S-T invest.
AR
Inventories
Total CA
Net FA
Total assets

2015
$
7,282
20,000
632,160
1,287,360
1,946,802
939,790
$2,886,592

2016E
$
14,000
71,632
878,000
1,716,480
2,680,112
836,840
$3,516,952
5

Balance Sheets: Liabilities

& Equity
Accts. payable
Notes payable
Accruals
Total CL
Long-term debt
Common stock
Ret. earnings
Total equity
Total L&E

2015
$ 324,000
720,000
284,960
1,328,960
1,000,000
460,000
97,632
557,632
$2,886,592

2016E
$ 359,800
300,000
380,000
1,039,800
500,000
1,680,936
296,216
1,977,152
$3,516,952
6

Other Data
Stock price
# of shares
EPS
DPS
Book val. per
sh.
Lease payments
Tax rate

2015
$6.00
100,000
-$0.95
$0.11

2016E
$12.17
250,000
$1.01
$0.22

$5.58
$40,000
0.40

$7.91
$40,000
0.40
7

Five Categories of Ratios

Liquidity Ratios
Asset Management Ratios
Debt Management Ratios
Profitability Ratios
Market Value Ratios

Liquidity Ratios

Can the company meet its shortterm obligations using the

resources it currently has on hand?

Forecasted Current and

Quick Ratios for 2016.
CR2016 =CA
CL

=$2,680
$1,040

= 2.58

QR2016 = CA - Inv.
CL
=$2,680 - $1,716
$1,040

= 0.93
10

Comments on CR and QR
2016E

2015

2014

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.
Creditors like to see a high current ratio.
11

Self Test 7-2

A company has current liabilities of

$800 million, and its current ratio
is 2.5. What is its level of current
assets? If this firms quick ratio is
2, how much inventory does it
have?

12

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?

13

Fixed Assets and Total

Assets
Turnover Ratios
Fixed assets
Sales
=
turnover
Net fixed assets
$7,036
=
= 8.41
$837
Total assets
Sales
=
Turnover (TAT) Total assets
$7,036
=
= 2.00
$3,517
(More)
14

Comments on FA Turnover
and TAT Ratios

FA turnover is expected to exceed industry

average. Good.
TAT not up to industry average. Caused by
excessive current assets (A/R and inventory).

2016E

2015

2014

Ind.

FA TO

8.4

6.2

10.0

7.0

TA TO

2.0

2.0

2.3

2.5

15

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
16

Appraisal of DSO
DSO is days sales outstanding, also
known as average collection
period
Firm collects too slowly, and
situation is getting worse.
Poor2016E
credit policy.
2015 2014 Ind.
DSO 45.5 39.5 37.4 32.0

17

Inventory Turnover Ratio

vs. Industry Average
Inv. Turnover =COGS
Inventories
= $5,800 + $120
= 3.45
$1,716
2016E 2015
Inv. T. 3.45

4.0

2014

Ind.

4.0

6.1
18

Comments on Inventory
Turnover

Inventory turnover is below

industry average.
Firm might have old inventory, or
its control might be poor.

19

Self Test 7-3

A firm has $200 million annual

sales, $180 million costs of goods
sold, $40 million of inventory, and
$60 million of accounts receivable.
What is its inventory turnover
ratio? What is its DSO based on a
365-day year?
20

Debt Management Ratios

Does the company have too much

debt?
Can the companys earnings meet
its debt servicing requirements?

21

Leverage Ratios: Debt Ratio

(aka debt-to-assets ratio)
Total debt
Debt ratio = Total assets
$300 + $500
=
=
22.7%
$3,517

(More)
22

Leverage Ratios: Debt-toequity ratio

Debt-to-equity ratio = Total debt /

Total common equity
Debt-to-equity ratio = $800 /
$1,977 = 40.5%

23

Times-Interest-Earned
Ratio
TIE =

EBIT

Int.
$502.6 = 6.3
= expense
$80

(More)
24

Debt Management Ratios

vs. Industry Averages
2016E 2015 2014
Ind.
D/TA
TIE

22.7% 59.6% 35.6% 32.0%

6.3
0.1
3.3
6.2

D/TAandTIEimprove,projectedto
exceedindustryaveragesin2016.
25

Profitability Ratios

What is the companys rate of

return on:

Sales?
Assets?

26

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)
27

Profit Margins
Gross profit margin
(GPM):
Sales
GPM =
COGS
=
Sales

(Continued)

$1,236
GPM = $7,036 = 17.6%

$7,036
$5,800
$7,036

28

Profit Margins vs. Industry

Averages
2016E 2015 2014
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 2015, but projected to
meet or exceed industry average in
2016.
29

Return on Assets (ROA)

and Return on Equity
(ROE)
NI
ROA =
Total assets
= $253.6
$3,517

= 7.2%

(More)
30

Return on Assets (ROA)

and Return on Equity
(ROE)
NI
ROE =
Common Equity
= $253.6
$1,977

= 12.8%

(More)
31

ROA and ROE vs. Industry

Averages
2016E
Ind.
ROA
ROE

2015

2014

7.2% -3.3% 6.0% 9.0%

12.8% -17.1%13.3% 18.0%

Both below average but improving.

32

Effects of Debt on ROA

and ROE

ROA is always less than ROE when

a firm uses debt in its capital
structure.

33

Self Test 7-5

A company has $200 billion of

sales and $10 billion of net
income. Its total assets are $100
billion, financed half by debt and
half by common equity. What is its
profit margin? What is its ROA?
What is its ROE?
34

Market Value Ratios:

Price/Earnings (P/E) ratio
Price = $12.17
NI
$253.6
EPS = Shares out. = 250

= $1.01

Price per share $12.17

P/E =
=
EPS
$1.01

= 12
35

Price/Cash Flow (P/CF)

Ratio
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
36

Market/Book (M/B) Ratio

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
37

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.

38

Comparison with Industry

Averages
2016E
Ind.
P/E
P/CF
M/B

12.0
8.2
1.5

2015
-6.3
27.5
1.1

2014
9.7
8.0
1.3

14.2
7.6
2.9
39

Self Test 7-6

A company has $6 billion of net

income, $2 billion of depreciation
and amortization, $80 billion of
common equity, and 1 billion
shares of stock. If its stock price is
$96 per share, what is its
price/earnings ratio? Its price/cash
flow ratio? Its market/book ratio?
40

Trend Analysis

Observe a ratio over time

Determine whether the firms
condition is improving or declining
Conclude whether the firm underor over-perform relative to its
competitors or industry average

41

Sheets:
Divide all items by Total
Assets
Assets
Cash
ST Inv.
AR
Invent.
Total
CA
Net FA
TA

2014
0.6%
3.3%
23.9%
48.7%
76.5%

2015
0.3%
0.7%
21.9%
44.6%
67.4%

2016E
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

2014
2015 2016E
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

Higher proportion of inventory and

current assets than industry
More equity (which means less
debt) than industry
More short-term debt than
industry, but less long-term debt
than industry

44

Common Size Income

Statement:
Divide all items by Sales
2014

2015

2016E

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%
45

Analysis of Common Size

Income Statements

Lower COGS (82.4%) than industry

(84.5%), but higher other
expenses.

46

Percentage Change Analysis:

% Change from First Year
(2014)
Income St.
Sales
COGS
Depr.
Other exp.
EBIT
Int. Exp.
EBT
Taxes
NI

2014
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%

2015
70.0%
73.9%
518.8%
111.8%
-91.7%
181.6%
-208.2%
-208.2%
-208.2%

2016E
105.0%
102.5%
534.9%
80.3%
140.4%
28.0%
188.3%
188.3%
188.3%
47

Analysis of Percent
Change Income Statement

We see that 2016 sales are

projected to grow 105% from
2014, and that NI is projected to
grow 188% from 2014.
So the Firm is projected to become
more profitable.

48

Percentage Change
Balance Sheets: Assets
Assets
Cash
ST Invest.
AR
Invent.
Total CA
Net FA
TA

2014
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%

2015
-19.1%
-58.8%
80.0%
80.0%
73.2%
172.6%
96.5%

2016E
55.6%
47.4%
150.0%
140.0%
138.4%
142.7%
139.4%
49

Percentage Change
Balance Sheets: Liabilities
& Equity
Liab. &
Eq.
AP
Notes
pay.
Accruals
Total CL
LT Debt
Total eq.
Total L&E

2014

2015

2016E

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 are

projected to grow 139%, while
sales are projected to only grow
105%. So asset utilization appears
to be a problem.

51

Explain the DuPont

Equation

The DuPont equation focuses on:

Expense control (PM)

Asset utilization (TAT)
Debt utilization (EM)

It shows how these factors

combine to determine the ROE.

52

The DuPont System

)(

Profit
margin

TA
turnover

NI
Sales
x
Sales
TA

)(

Equity
multiplier

) = ROE

TA
CE

= ROE

53

The DuPont System

NI
Sales
x
Sales
TA
2014: 2.6% x
2015:-1.6% x
2016E:3.6% x
Ind.: 3.6% 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%
54

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 misrepresent
55
comparisons.

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

56

Self Test 7-2 (Answer)

Current ratio = current assets / current

liabilities
2.5 = current assets / $800
Current assets = $2,000 million
Quick ratio = (current assets inventories) /
current liabilities
2 = ($2,000 inventories) / current liabilities
Inventories = $400 million
57

Self Test 7-3 (Answer)

Inventory turnover = COGS / inventory

Inventory turnover = $180m / $40m
Inventory turnover = 4.5
DSO = Receivables /(Annual sales / 365)
DSO = $60m / ($200m / 365)
DSO = 109.5 days

58

Self Test 7-5 (Answer)

Profit margin = Net income / Sales

Profit margin = $10 / $200 = 5%
ROA = Net income / Total assets
ROA = $10 / $100 = 10%
ROE = Net income / Common
equity
ROE = $10 / $50 = 20%
59

Self Test 7-6 (Answer)

Earnings (EPS) = Net income / # of shares =

$6 / 1 = $6
P/E ratio = $96 / $6 = 16
Cash flow per share = (Net income +
depreciation and amortization) / # of shares =
($6 + $2) / 1 = $8
P/CF ratio = $96 / $8 = 12
BVPS = Common equity / # of shares = $80 / 1
= $80
M/B ratio = $96 / $80 = 1.20
60

Chapter 7 Quiz

61

Question 1

To perform trend analysis, the

manager should standardize
inventories to a common-size basis
by dividing inventories by:

A. Sales.
B. Assets.
C. Net income.
D. COGS.
62

Question 1 (Answer) B

Inventories appear on the balance

sheet, in which all items are
divided by assets in a commonsize analysis.

63

Question 2

All else equal, which of the

following activities will increase a
firms debt ratio?

A. Issue equity to pay a portion of

long-term debt.
B. Issue long-term debt to repurchase
stock.
C. Borrow a short-term loan.
64

Question 2 (Answer) B

Issue long-term debt to repurchase

stock is essentially changing the
capital structure by increasing
debt and decreasing equity, hence
increasing a firms debt allocation.

65

Question 3

Which of the following is NOT a

component of the DuPont system?

A. Gross profit margin.

B. Total asset turnover.
C. Equity multiplier.

66

Question 3 (Answer) A

Three components of the DuPont

equation includes profit margin,
total asset turnover, and equity
multiplier.

67

Question 4

According to The World Might Be Flat

reading on page 266, which of the
following is a correct statement?

A. Both U.S. and EU companies follow

standards set by FASB.
B. U.S. companies follow standards set by
FASB while EU companies follow standards
set by IFRS.
C. U.S. companies follow standards set by
IFRS while EU companies follow standards
set by FASB.
68

Question 4 (Answer) B

U.S. companies follow standards

set by FASB while EU companies
follow standards set by IFRS. All
other choices are incorrect
statements.

69

Question 5

XYZ corporation reported a net profit margin and

current ratio of 12% and 4.5, respectively. The industry
averages net profit margin and current ratio are 10%
and 2, respectively. Relative to the industry average and
from a shareholders perspective, which of the following
is correct?

A. Net profit margin outperforms; shareholders might

prefer high current ratio.
B. Net profit margin outperforms; shareholders might not
prefer high current ratio.
C. Net profit margin underperforms; shareholders might
prefer high current ratio.
D. Net profit margin under performs; shareholders might
not prefer high current ratio.
70

Question 5 (Answer) B

XYZs net profit margin of 12%

outperforms the industry average
of 10%. High current ratio might
indicate problems of ineffective
managing current assets: cash,
accounts receivable, and
inventories. Excess cash drags
XYZs performance.
71