Republic of the Philippines

SORSOGON STATE UNIVERSITY

Sorsogon Campus
Sorsogon City
LEARNING MODULE
FINANCIAL MANAGEMENT

Module 4: ANALYSIS OF FINANCIAL STATEMENTS

I. OVERVIEW

The primary goal of financial management is to maximize shareholders’ wealth, not accounting measures
such as net income or earnings per share (EPS). However, accounting data influence stock prices, and these
data can be used to see why a company is performing the way it is and where it is heading. Module 3
described the key financial statements and showed how they change as a firm’s operations change. Now,
in Module 4, we show how the statements are used by managers to improve the firm’s stock price, by
lenders to evaluate the likelihood that borrowers will be able to pay off loans, and by security analysts to
forecast earnings, dividends, and stock prices.

If management is to maximize a firm’s value, it must take advantage of the firm’s strengths and correct its
weaknesses. Financial analysis involves (1) comparing the firm’s performance to that of other firms in the
same industry and (2) evaluating trends in the firm’s financial position over time. These studies help
managers identify deficiencies and take corrective actions. In this module, we focus on how managers and
investors evaluate a firm’s financial position.

II. LEARNING OUTCOMES

After reading and studying this module, you will be able to:

• Explain what ratio analysis is.

• List the five groups of ratios and identify, calculate, and interpret the key ratios in each group.
• Discuss each ratio’s relationship to the balance sheet and income statement.
• Discuss why return on equity (ROE) is the key ratio under management’s control and how the other
ratios impact ROE, and explain how to use the DuPont equation for improving ROE.
• Compare a firm’s ratios with those of other firms (benchmarking) and analyze a given firm’s ratios
over time (trend analysis).

III. LEARNING EXPERIENCE

Ratios help us evaluate financial statements. For example, at the end of 2018, Allied Food Products had
P860 million of interest-bearing debt and interest charges of P88 million, while Midwest Products had P52
million of interest-bearing debt and interest charges of P4 million. Which company is stronger? The burden
of these debts and the companies’ ability to repay them can best be evaluated by comparing each firm’s
total debt to its total capital and comparing interest expense to the income and cash available to pay that
interest. Ratios are used to make such comparisons. Ratios are calculated using data from the balance
sheets and income statements. As you will see, we can calculate many different ratios, with different ones
used to examine different aspects of the firm’s operations. You will get to know some ratios by name, but
it’s better to understand what they are designed to do than to memorize names and equations.

We divide the ratios into five categories:

1. Liquidity ratios, which give an idea of the firm’s ability to pay off debts that are maturing within a
year.
2. Asset management ratios, which give an idea of how efficiently the firm is using its assets.
3. Debt management ratios, which give an idea of how the firm has financed its assets as well as the
firm’s ability to repay its long-term debt.
4. Profitability ratios, which give an idea of how profitably the firm is operating and utilizing its assets.
5. Market value ratios, which give an idea of what investors think about the firm and its future
prospects.

Liquidity Ratios

The liquidity ratios help answer this question: Will the firm be able to pay off its debts as they come due and
thus remain a viable organization? If the answer is no, liquidity must be addressed.

Liquid Asset. An asset that can be converted to cash quickly without having to reduce the asset’s price very
much.

Liquidity Ratios. Ratios that show the relationship of a firm’s cash and other current assets to its current
liabilities.

a. The primary liquidity ratio is the current ratio, which is calculated by dividing current assets by current
liabilities:

Current ratio = Current assets

Current liabilities

Current assets include cash, marketable securities, accounts receivable, and inventories. Current liabilities
consist of accounts payable, accrued wages and taxes, and short-term notes payable to its bank, all of which
are due within 1 year.

If a company is having financial difficulty, it typically begins to pay its accounts payable more slowly and to
borrow more from its bank, both of which increase current liabilities. If current liabilities are rising faster
than current assets, the current ratio will fall, and this is a sign of possible trouble.

An industry average is not a magic number that all firms should strive to maintain; in fact, some very well
managed firms may be above the average, while other good firms are below it. However, if a firm’s ratios
are far removed from the averages for its industry, an analyst should be concerned about why this variance
occurs. Thus, a deviation from the industry average should signal the analyst (or management) to check
further. Note too that a high current ratio generally indicates a very strong, safe liquidity position; it might
also indicate that the firm has too much old inventory that will have to be written off and too many old
accounts receivable that may turn into bad debts. Or the high current ratio might indicate that the firm has
too much cash, receivables, and inventory relative to its sales, in which case these assets are not being
managed efficiently. So, it is always necessary to thoroughly examine the full set of ratios before forming a
judgment as to how well the firm is performing.

b. The second liquidity ratio is the quick, or acid test, ratio, which is calculated by deducting inventories
from current assets and then dividing the remainder by current liabilities:

Quick, or acid test ratio = Current assets - Inventories

Current liabilities

Inventories are typically the least liquid of a firm’s current assets, and if sales slow down, they might
not be converted to cash as quickly as expected. Also, inventories are the assets on which losses are most
likely to occur in the event of liquidation. Therefore, the quick ratio, which measures the firm’s ability to
pay off short-term obligations without relying on the sale of inventories, is important.

Asset Management Ratios

The second group of ratios, the asset management ratios, measure how effectively the firm is managing its
assets. These ratios answer this question:

These ratios are important because when a company acquires assets, it must obtain capital from banks or
other sources and capital is expensive. Therefore, if it has too many assets, its cost of capital will be too
high, which will depress its profits. On the other hand, if its assets are too low, profitable sales will be lost.
So, the company must strike a balance between too many and too few assets, and the asset management
ratios will help it strike this proper balance.

a. Inventory Turnover Ratio

“Turnover ratios” divide sales by some asset: Sales/Various assets. As the name implies, these ratios show
how many times the particular asset is “turned over” during the year. Here is the inventory turnover ratio:

Inventory turnover ratio = Sales___

Inventories

If a company’s inventory turnover is much lower than the industry average, it suggests that it is holding
too much inventory. Excess inventory is, of course, unproductive and represents an investment with a low
or zero rate of return. With such a low turnover, the firm may be holding obsolete goods that are not worth
their stated value.

Note that sales occur over the entire year, whereas the inventory figure is for one point in time. For this
reason, it might be better to use an average inventory measure. If the business is highly seasonal or if there
has been a strong upward or downward sales trend during the year, it is especially useful to make an
adjustment.

b. Days Sales Outstanding

Accounts receivable are evaluated by the days sales outstanding (DSO) ratio, also called the average
collection period (ACP). It is calculated by dividing accounts receivable by the average daily sales to find
how many days’ sales are tied up in receivables. Thus, the DSO represents the average length of time the
firm must wait after making a sale before receiving cash.

DSO = Receivables______ = __Receivables____

Average sales per day Annual Sales/365

The DSO can be compared with the industry average, but it is also evaluated by comparing it with the
company’s credit terms. If the credit policy calls for payment within 30 days but the fact is that 46 days’
sales are outstanding, not 30 days’, indicates that customers, on average, are not paying their bills on time.
This deprives the company of funds that could be used to reduce bank loans or some other type of costly
capital. Moreover, the high average DSO indicates that if some customers are paying on time, quite a few
must be paying very late. Late-paying customers often default, so their receivables may end up as bad debts
that can never be collected.

c. Fixed Assets Turnover Ratio

The fixed assets turnover ratio, which is the ratio of sales to net fixed assets, measures how effectively
the firm uses its plant and equipment:

Fixed assets turnover ratio = Sales_____

Net fixed assets

Potential problems may arise when interpreting the fixed assets turnover ratio. Recall that fixed assets are
shown on the balance sheet at their historical costs less depreciation. Inflation has caused the value of many
assets that were purchased in the past to be seriously understated. Therefore, if we compare an old firm
whose fixed assets have been depreciated with a new company with similar operations that acquired its
fixed assets only recently, the old firm will probably have the higher fixed assets turnover ratio. However,
this would be more reflective of the age of the assets than of inefficiency on the part of the new firm.

The accounting profession is trying to develop procedures for making financial statements reflect current
values rather than historical values, which would help us make better comparisons. However, at the
moment, the problem still exists; so financial analysts must recognize this problem and deal with it
judgmentally.

d. Total Assets Turnover Ratio

The final asset management ratio, the total assets turnover ratio, measures the turnover of all of the firm’s
assets, and it is calculated by dividing sales by total assets:

Total assets turnover ratio = __Sales____

Total assets

It measures how effectively the firm uses its total assets.

Debt Management Ratios

The use of debt will increase, or “leverage up,” a firm’s ROE if the firm earns more on its assets than the
interest rate it pays on debt. However, debt exposes the firm to more risk than if it financed only with
equity. Debt management ratios are ratios that measure how effectively a firm manages its debt.

Debt ratios measure the firm’s ability to repay long-term debt. It is a financial ratio that indicates the
percentage of a company’s assets that are provided via debt. It is the ratio of total debt (the sum of current
liabilities and long-term liabilities) and total assets (the sum of current assets, fixed assets, and other assets
such as ‘goodwill’).

Total Debt to Total Assets

• Debt ratio = Total debt / Total assets

Or alternatively:

• Debt ratio = Total liability / Total assets

The higher the ratio, the greater risk will be associated with the firm’s operation. In addition, high debt to
assets ratio may indicate low borrowing capacity of a firm, which in turn will lower the firm’s financial
flexibility. Like all financial ratios, a company’s debt ratio should be compared with their industry average
or other competing firms.

Total liabilities divided by total assets. The debt/asset ratio shows the proportion of a company’s assets
which are financed through debt. If the ratio is less than 0.5, most of the company’s assets are financed
through equity. If the ratio is greater than 0.5, most of the company’s assets are financed through debt.
Companies with high debt/asset ratios are said to be “highly leveraged,” not highly liquid as stated above.
A company with a high debt ratio (highly leveraged) could be in danger if creditors start to demand
repayment of debt.

Total Debt to Total Capital

The ratio of total debt to total capital measures the percentage of the firm’s capital provided by
debtholders:

_Total debt__ = ___Total debt____

Total Capital Total debt + Equity

To keep things simple, unless we say otherwise, we will generally refer to the total debt to total capital ratio
as the company’s debt ratio. Creditors prefer low debt ratios because the lower the ratio, the greater the
cushion against creditors’ losses in the event of liquidation. Stockholders, on the other hand, may want
more leverage because it can magnify expected earnings.

Times Interest Earned Ratio

Times Interest Earned ratio (EBIT or EBITDA divided by total interest payable) measures a company’s
ability to honor its debt payments.

Times-interest-earned ratio = _____EBIT______

 Interest charges

Times interest earned (TIE), or interest coverage ratio, is a measure of a company’s ability to honor its
debt payments. It may be calculated as either EBIT or EBITDA, divided by the total interest payable.

Times-Interest-Earned = EBIT or EBITDA / Interest charges

• Interest Charges = Traditionally “charges” refers to interest expense found on the income
statement.
• EBIT = Earnings Before Interest and Taxes, also called operating profit or operating income.
EBIT is a measure of a firm’s profit that excludes interest and income tax expenses. It is the
difference between operating revenues and operating expenses. When a firm does not have
non-operating income, then operating income is sometimes used as a synonym for EBIT and
operating profit.
• EBIT = Revenue – Operating Expenses (OPEX) + Non-operating income.
• Operating income = Revenue – Operating expenses.
• EBITDA = Earnings Before Interest, Taxes, Depreciation and Amortization. The EBITDA of a
company provides insight on the operational profitability of the business. It shows the
profitability of a company regarding its present assets and operations with the products it
produces and sells, taking into account possible provisions that need to be done.

If EBITDA is negative, then the business has serious issues. A positive EBITDA, however, does not
automatically imply that the business generates cash. EBITDA ignores changes in Working Capital (usually
needed when growing a business), capital expenditures (needed to replace assets that have broken down),
taxes, and interest.

Times Interest Earned or Interest Coverage is a great tool when measuring a company’s ability to meet its
debt obligations. When the interest coverage ratio is smaller than 1, the company is not generating
enough cash from its operations EBIT to meet its interest obligations. The Company would then have to
either use cash on hand to make up the difference or borrow funds. Typically, it is a warning sign when
interest coverage falls below 2.5x.

Profitability Ratios

A group of ratios that show the combined effects of liquidity, asset management, and debt on operating
results.

Operating Margin

The operating margin, calculated by dividing operating income (EBIT) by sales, gives the operating profit
per dollar/peso of sales:

Operating Margin = _EBIT_

Sales
Profit Margin
This ratio measures net income per dollar or peso of sales. The profit margin, also sometimes called the
net profit margin, is calculated by dividing net income by sales:

Profit Margin = Net income

Sales

Suppose two firms have identical operations in the sense that their sales, operating costs, and operating
income are identical. However, one firm uses more debt; hence, it has higher interest charges. Those
interest charges pull down its net income, and because sales are identical, the result is a relatively low profit
margin for the firm with more debt.

Note too that while a high return on sales is good, we must also be concerned with turnover. If a firm sets
a very high price on its products, it may earn a high return on each sale but fail to make many sales. It might
generate a high profit margin but realize low sales, and hence experience a low net income. We will see
shortly how, through the use of the DuPont equation, profit margins, the use of debt, and turnover ratios
interact to affect overall stockholder returns.

Return on Total Assets

The ratio of net income to total assets; it measures the rate of return on the firm’s assets. Net income
divided by total assets gives us the return on total assets (ROA):

Return on Total Assets (ROA) = Net Income

Total Assets

It is better to have a higher than a lower return on assets. Note, though, that a low ROA can result from a
conscious decision to use a great deal of debt, in which case high interest expenses will cause net income
to be relatively low.

Return on Common Equity

The ratio of net income to common equity; it measures the rate of return on common stockholders’
investment.

Return on Common Equity (ROE) = Net income__

Common Equity

Stockholders expect to earn a return on their money, and this ratio tells how well they are doing in an
accounting sense.

Return on Invested Capital

The return on invested capital (ROIC) measures the total return that the company has provided for its
investors:

Return on invested capital (ROIC) = ____EBIT (1 – T)____

 Total invested capital

Basic Earning Power (BEP) Ratio

This ratio indicates the ability of the firm’s assets to generate operating income; it is calculated by dividing
EBIT by total assets.

Basic earning power (BEP) = EBIT___

Total Assets

Market Value Ratios

ROE reflects the effects of all of the other ratios, and it is the single best accounting measure of
performance. Investors like a high ROE, and high ROEs are correlated with high stock prices. However, other
things come into play. For example, financial leverage generally increases the ROE but also increases the
firm’s risk; so if a high ROE is achieved by using a great deal of debt, the stock price might end up lower
than if the firm had been using less debt and had a lower ROE. We use the final set of ratios—the market
value ratios, which relate the stock price to earnings and book value price—to help address this situation.

The market value ratios are used in three primary ways: (1) by investors when they are deciding to buy or
sell a stock, (2) by investment bankers when they are setting the share price for a new stock issue (an IPO),
and (3) by firms when they are deciding how much to offer for another firm in a potential merger.

Price/Earnings Ratio

The price/earnings (P/E) ratio shows how much investors are willing to pay per dollar of reported profits.

Price/Earnings Ratio = Price per share___

Earnings per share

P/E ratios are relatively high for firms with strong growth prospects and little risk but low for slowly growing
and risky firms.

P/E ratios vary considerably over time and across firms.15 In February 2017, the S&P 500’s P/E ratio was
23.23. At this same point in time, Apple Inc. had a P/E of 16.443, while Under Armour, Inc., a rapidly growing
apparel company, had a P/E of 42.943. Moreover, a once high-flying growth stock such as Intel (which a
decade ago had a P/E ratio above 20) has seen its P/E fall below that level as it has become a larger, more
stable company with fewer growth opportunities.

Market/Book Ratio

The ratio of a stock’s market price to its book value gives another indication of how investors regard the
company. Companies that are well regarded by investors— which means low risk and high growth—have
high M/B ratios. We first find its book value per share:

Book value per share = Common equity

 Shares outstanding

We then divide the market price per share by the book value per share to get the market/book (M/B) ratio,

Market/book ratio = Market price per share

Book value per share

M/B ratios typically exceed 1.0, which means that investors are willing to pay more for stocks than the
accounting book values of the stocks. This situation occurs primarily because asset values, as reported by
accountants on corporate balance sheets, do not reflect either inflation or goodwill. Assets purchased years
ago at pre-inflation prices are carried at their original costs even though inflation might have caused their
actual values to rise substantially; successful companies’ values rise above their historical costs, whereas
unsuccessful ones have low M/B ratios.

Enterprise Value/EBITDA Ratio

In recent years, a lot of analysts have begun to focus intently on another key ratio, the enterprise
value/EBITDA (EV/EBITDA) ratio. Unlike the P/E and the market/book ratios, both of which focus on the
relative market value of the company’s equity, the EV/EBITDA ratio looks at the relative market value of all
the company’s key financial claims. One benefit of this approach is that unlike the P/E ratio, the EV/EBITDA
ratio is not heavily influenced by the company’s debt and tax situations.

Enterprise Value (EV) = Market value of equity + Market value of total debt + Market value of other
financial claims - (Cash and equivalents)

This measure of enterprise value subtracts out the company’s cash holdings. This adjustment makes it
easier to compare companies with very different levels of excess cash. For example, if we didn’t make this
assumption, a company with large cash holdings but inefficient operations would mistakenly appear to be
outperforming a peer that is much more efficient but has less cash on hand.

Finally, we divide the enterprise value by the company’s EBITDA.

The DuPont Equation

The DuPont equation is an expression which breaks return on equity down into three parts. The name
comes from the DuPont Corporation, which created and implemented this formula into their business
operations in the 1920s. This formula is known by many other names, including DuPont analysis, DuPont
identity, the DuPont model, the DuPont method, or the strategic profit model.

Under DuPont analysis, return on equity is equal to the profit margin multiplied by asset turnover multiplied
by financial leverage. By splitting ROE (return on equity) into three parts, companies can more easily
understand changes in their ROE over time.
Components of the DuPont Equation: Profit Margin

Profit margin is a measure of profitability. It is an indicator of a company’s pricing strategies and how well
the company controls costs. Profit margin is calculated by finding the net profit as a percentage of the total
revenue. As one feature of the DuPont equation, if the profit margin of a company increases, every sale will
bring more money to a company’s bottom line, resulting in a higher overall return on equity.

Components of the DuPont Equation: Asset Turnover

Asset turnover is a financial ratio that measures how efficiently a company uses its assets to generate sales
revenue or sales income for the company. Companies with low profit margins tend to have high asset
turnover, while those with high profit margins tend to have low asset turnover. Similar to profit margin, if
asset turnover increases, a company will generate more sales per asset owned, once again resulting in a
higher overall return on equity.

Components of the DuPont Equation: Financial Leverage

Financial leverage refers to the amount of debt that a company utilizes to finance its operations, as
compared with the amount of equity that the company utilizes. As was the case with asset turnover and
profit margin, Increased financial leverage will also lead to an increase in return on equity. This is because
the increased use of debt as financing will cause a company to have higher interest payments, which are
tax deductible. Because dividend payments are not tax deductible, maintaining a high proportion of debt
in a company’s capital structure leads to a higher return on equity.

Using Financial Ratios to Assess Performance

• Comparison to industry average. To compare the company’s key ratios to the industry averages.
• Benchmarking. T compare the company with a subset of top competitors in the industry to see
where it exactly stands relative to the competition.
• Trend Analysis. An analysis of a firm’s financial ratios over time; used to estimate the likelihood of
improvement or deterioration in its financial condition.

IV.SUMMARY

In this module, we described how ratios are used to analyze the statements to identify weaknesses that
need to be strengthened to maximize the stock price. Ratios are grouped into five categories:
• Liquidity
• Asset management
• Debt management
• Profitability
• Market value

The firm’s ratios are compared with averages for its industry and with the leading firms in the industry
(benchmarking), and these comparisons are used to help formulate policies that will lead to improved
future performance. Similarly, the firm’s own ratios can be analyzed over time to see if its financial situation
is getting better or worse (trend analysis). The single most important ratio over which management has
control is the ROE—the other ratios are also important, but mainly because they affect the ROE.
One tool used to show how ROE is determined is the DuPont equation. If the firm’s ROE is below the industry
average and that of the benchmark companies, a DuPont analysis can help identify problem areas that
should be strengthened.

V. ASSESSMENT ACTIVITIES: (Posted in Google Classroom)

VI. REFERENCES

• https://courses.lumenlearning.com/boundless-finance/chapter/debt-management-ratios/
• E. F. Brigham and P. R. Daves, Intermediate Financial Management, 13th edition (Mason, OH:
Cengage Learning, 2019)

Prepared by:

MARIA LUISA P. MIRASOL

Assistant Professor II
mirasol.luisa@sorsu.edu.ph