Financial Management

Lesson 3 - FINANCIAL ANALYSIS

Introduction
Expressing financial statement information in the form of ratios enhances its usefulness. Ratios
permit comparisons over time and among companies, highlighting similarities, differences, and
trends. Proficiency with common financial statement analysis techniques benefits both internal and
external users. Before beginning detailed explanations of numerous ratios and percentages,
however, we consider factors relevant to communicating useful information. 17

In this lesson, you will be analyzing financial statements in another level applying the necessary
skills that will help you understand more the financial information and make sound financial
management decisions.

FINANCIAL ANALYSIS

Financial analysis is a process of selecting, evaluating, and interpreting financial data, along with
other pertinent information, in order to formulate an assessment of a company’s present and future
financial condition and performance.

The primary purpose of FS analysis is to evaluate and forecast the company’s financial health.
Interested parties, such as the managers, investors and creditors, can identify the company’s
financial strengths and weakness and know about the:
1. profitability of the business firm;
2. firm’s ability to meet its obligations;
3. safety of the investment in the business; and
4. effectiveness of management in running the firm
Examples of external uses of statement analysis
• Trade Creditors -- Focus on the liquidity of the firm.
• Bondholders -- Focus on the long-term cash flow of the firm.
• Shareholders -- Focus on the profitability and long-term health of the firm.
Examples of internal uses of statement analysis
• Plan -- Focus on assessing the current financial position and evaluating potential firm
opportunities.
• Control -- Focus on return on investment for various assets and asset efficiency.
• Understand -- Focus on understanding how suppliers of funds analyze the firm.18

Steps in Financial Analysis19

1) Gather Data – Income statement and Balance Sheet data
2) Examine the statement of cash flows
3) Calculate and examine the return on invested capital (ROIC)
ROIC > WACC = the company usually is adding value
ROIC < WACC = the company usually has serious problems
4) Begin ratio analysis

17
highered.mheducation.com/sites/dl/free/0073527122/.../Chapter_13.pdf
18
www.cfainstitute.org/learning/.../inv/.../corporate_finance_chapter9.pptx
19
Brigham, E. F., Gapenski, L. C., & Ehrhardt, M. C. (2011). Financial management: Theory and practice, 13th edition. Fort Worth: Dryden
Press
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VERTICAL AND HORIZONTAL ANALYSIS

There are several ways on how to evaluate financial statements. Let us first discuss the vertical
analysis or also known as common-size analysis and the horizontal analysis also called as trend
analysis.
▪ Common-size analysis/ Vertical analysis
- is the restatement of financial statement information in a standardized form. To get started,
a useful way of standardizing financial statements is to express each item on the balance
sheet as a percentage of assets and to express each item on the income statement as a
percentage of sales. The resulting financial statements are called common-size statements.

▪ Trend Analysis/Horizontal analysis

- This reveals whether the firm’s condition has been improving or deteriorating over time
- Amounts from past financial statements will be restated to be a percentage of the amounts
from a base year.
- Useful when comparing growth of different accounts over time.

Illustration 3.1 Consider the CS Company, which reports the following financial information:

Year 2014 2015 2016 2017 2018 2019

Cash ₱400.00 ₱404.00 ₱408.04 ₱412.12 ₱416.24 ₱420.40
Inventory ₱1,580.00 ₱1,627.40 ₱1,676.22 ₱1,726.51 ₱1,778.30 ₱1,831.65
Accounts receivable ₱1,120.00 ₱1,142.40 ₱1,165.25 ₱1,188.55 ₱1,212.32 ₱1,236.57
Property, plant and equipment ₱3,500.00 ₱3,640.00 ₱3,785.60 ₱3,937.02 ₱4,094.50 ₱4,258.29
Intangibles 400.00 ₱402.00 ₱404.01 ₱406.03 ₱408.06 ₱410.10
Total assets ₱7,000.00 ₱7,215.80 ₱7,439.12 ₱7,670.23 ₱7,909.42 ₱8,157.01

Required:
1. Prepare the vertical analysis for the CS Company’s assets.
2. Prepare the horizontal analysis for the CS Company’s assets (base year is 2014)
Solutions:
REQUIREMENT 1: VERTICAL ANALYSIS
Year 2014 2015 2016 2017 2018 2019
Cash 5.71% 5.60% 5.49% 5.37% 5.26% 5.15%
Inventory 22.57% 22.55% 22.53% 22.51% 22.48% 22.45%
Accounts receivable 16.00% 15.83% 15.66% 15.50% 15.33% 15.16%
Property, plant and equipment 50.00% 50.44% 50.89% 51.33% 51.77% 52.20%
Intangibles 5.71% 5.57% 5.43% 5.29% 5.16% 5.03%
Total assets 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

REQUIREMENT 2: HORIZONTAL ANALYSIS (base year: 2014)

Year 2014 2015 2016 2017 2018 2019
Cash 100.00% 101.00% 102.01% 103.03% 104.06% 105.10%
Inventory 100.00% 103.00% 106.09% 109.27% 112.55% 115.93%
Accounts receivable 100.00% 102.00% 104.04% 106.12% 108.24% 110.41%
Property, plant and equipment 100.00% 104.00% 108.16% 112.49% 116.99% 121.67%
Intangibles 100.00% 100.50% 101.00% 101.51% 102.02% 102.53%
Total assets 100.00% 103.08% 106.27% 109.57% 112.99% 116.53%

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FINANCIAL RATIO ANALYSIS

Financial ratio analysis is the

use of relationships among
financial statement accounts to
gauge the financial condition
and performance of a
company.

There are different measures

of a company’s financial
condition and performance,
and these can be categorized
into the following:
RATIO FORMULA SIGNIFICANCE
A. Ratios used to evaluate liquidity
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
1. Current Ratio Test of short-term debt paying ability
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝑞𝑢𝑖𝑐𝑘 𝑎𝑠𝑠𝑒𝑡𝑠 ∗
Measures the firm’s ability to pay its short-term
2. Acid-test ratio or 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
debts from its most liquid assets without having to
Quick ratio quick assets = current assets –
rely on inventory
inventories – prepayments
Compared to the current ratio and the quick ratio, this
𝑐𝑎𝑠ℎ + 𝑐𝑎𝑠ℎ 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡𝑠
is the most conservative measure of a company’s
3. Cash Ratio 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 liquidity position. There is no ideal figure, but a ratio
of at least 0.5 to 1 is usually preferred
𝑤𝑜𝑟𝑘𝑖𝑛𝑔𝑐𝑎𝑝𝑖𝑡𝑎𝑙
4. Working Capital 𝑡𝑜𝑡𝑎𝑙𝑎𝑠𝑠𝑒𝑡𝑠 Indicates relative liquidity of total assets and
to Total Assets Working capital = current assets - distribution of resources employed
current liabilities
(𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
5. Basic Earnings Peso returns on each ordinary share; Indicative of the
𝐴𝑣𝑒. 𝐶𝑜𝑚𝑚𝑜𝑛
per Share (EPS) ability to pay dividends
𝑆𝑡𝑜𝑐𝑘 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

B. Ratios used to evaluate Asset Management

6. Trade Receivable 𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 Measures how many times accounts receivable are
Turnover 𝐴𝑣𝑒. 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 created and collected during the period.
𝑛𝑜. 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
7. Average 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
Collection period/ Or
Measures the average time it takes to collect on
AR Days / Age of 𝐴𝑣𝑒. 𝐴/𝑅
accounts receivable.
Receivables/ Days 𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 /#𝑜𝑓 𝑑𝑎𝑦𝑠 𝑎 𝑦𝑒𝑎𝑟
sales outstanding Or
(DSO) 𝐴𝑅 𝑥 𝑛𝑜. 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠
8. Inventory 𝐶𝑜𝑠𝑡 𝑜𝑓𝑆𝑎𝑙𝑒𝑠 Measures how many times inventory is created and
Turnover 𝐴𝑣𝑒. 𝐼𝑛𝑣𝑡𝑦 sold during the period
𝑛𝑜. 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
or
9. Average Age of 𝐴𝑣𝑒. 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 Average time it takes to create and sell inventory.
inventories /
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠 /#𝑜𝑓 𝑑𝑎𝑦𝑠 𝑎 𝑦𝑒𝑎𝑟
Inventory Days
or
𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑥 𝑛𝑜. 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠

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Measures the length of time required to convert cash

10. Operating Age of Receivables +
to finished goods; then to receivable and then back to
Cycle Age of Inventory
cash
Measures how many times accounts payable are
11. Payable 𝑁𝑒𝑡 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
created and paid during the period.
Turnover 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒
12. Average Age of
Accounts
𝑛𝑜. 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
Payable/ Payable
𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 Average time it takes to pay suppliers
Days/
Payable Deferral
Period
13. Cash Time from investment in inventory to collection of
Conversion Cycle/ Operating Cycle accounts, considering the use of trade credit in
Net Operating – Age of Payables purchases.
Cycle
14. Fixed Assets 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 Measures the level of use of property, plant and
Turnover 𝐴𝑣𝑒. 𝑁𝑒𝑡 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 equipment
15. Total Assets 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 Measures the level of capital investment relative to
Turnover 𝐴𝑣𝑒. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 sales volume
𝐴𝑣𝑒. 𝐶𝑎𝑠ℎ 𝐵𝑎𝑙𝑎𝑛𝑐𝑒
Measures the availability of cash to meet average
16. Days Cash 𝐶𝑎𝑠ℎ 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠
𝑛𝑜. 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟 daily cash requirement
17. Capital 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 Measures the efficiency of the firm to generate sales
Intensity Ratio 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 through employment of its resources
C. Ratios used to evaluate Long-Term Solvency/Leverage
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 Shows proportion of all assets that are financed by
18. Debt Ratio
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 debt
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 Indicates the proportion of assets provided by
19. Equity Ratio
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 owners.
20. Debt to Equity 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 Measures debt relative to amounts of resources
Ratio 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 provided by owners
21. Financial
Amount of total assets financed by equity. The higher
Leverage Ratio/ 𝐴𝑣𝑒. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
the ratio, the greater is the leverage (assets financed
Equity Multiplier/ 𝐴𝑣𝑒. 𝐶𝑜𝑚𝑚𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦
by debt) and the greater the risk
Leverage Factor
22. Financial 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐶𝑜𝑚𝑚𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 index > 1.0, favorable
Leverage Index 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 the use of financial leverage is successful
Degree of Operating Leverage x
Degree of Financial Leverage Measures the overall leverage of the business; it
indicates the variability of the stockholders’ equity
23. Total Leverage % 𝛥 𝑖𝑛 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒
𝐷𝑂𝐿 = with respect to changes in contribution margin, EBIT,
% 𝛥 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠 interest expenses and preferred dividends before tax
% 𝛥 𝑖𝑛 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝐷𝐹𝐿 =
% 𝛥 𝑖𝑛 𝐸𝐵𝐼𝑇
24. Times Interest 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒
Measures how many times interest expense is
Earned or Interest 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥𝑒𝑠 (𝐸𝐵𝐼𝑇)
covered by operating profit
Coverage Ratio 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥𝑒𝑠 (𝐸𝐵𝐼𝑇 )
25. Times Fixed
+ 𝐹𝑖𝑥𝑒𝑑 𝐶ℎ𝑎𝑟𝑔𝑒𝑠 Measures the coverage capability more broadly than
Charges Earned/
𝐹𝑖𝑥𝑒𝑑 𝐶ℎ𝑎𝑟𝑔𝑒𝑠 (𝑅𝑒𝑛𝑡 times interest earned by including other fixed
Fixed Charge
+𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + charges
Coverage Ratio
𝑆𝑖𝑛𝑘𝑖𝑛𝑔 𝐹𝑢𝑛𝑑 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥𝑒𝑠)

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D. Ratios used to measure Profitability and Returns to Investors

26. Gross Profit 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 Measures profit generated after consideration
Margin/ Gross Profit
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 of cost of product sold
Ratio
27. Operating Profit 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 Measures the profit generated after
Margin 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 consideration of operating costs
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 Measures the profit generated after
28. Net Profit Margin
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 consideration of all expenses and revenues

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
29. Return on Assets
(ROA) / 𝐴𝑣𝑒. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
Or
Return on
Asset Turnover x Net Profit Ratio
Investment/ Measures overall efficiency of the firm in
Or
Return on invested managing assets and generating profits
capital 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
+[𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝. (1 − 𝑇𝑥𝑅𝑎𝑡𝑒)]
If interest-bearing--
𝐴𝑣𝑒. 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

30. Return on Equity- 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 Measures the rate of return on resources
common (ROE) 𝐴𝑣𝑒. 𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝐸𝑞𝑢𝑖𝑡𝑦 provided by owners
Measures pesos return on each ordinary share.
31. Basic Earnings per 𝐼𝑛𝑐𝑜𝑚𝑒 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑡𝑜 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠
It is indicative of the ability of the firm to pay
Share (BEPS) 𝐴𝑣𝑒. 𝐶𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
dividends
DuPont analysis tells us that ROE is affected by
Profit Margin x Total Asset Turnover x
three things:
Financial Leverage
- Operating efficiency, which is measured by
OR
profit margin
32. Du Pont Formula
𝑁𝐼 𝑆 𝑇𝐴 - Asset use efficiency, which is measured by
× × total asset turnover
𝑆 𝑇𝐴 𝐸 - Financial leverage, which is measured by the
equity multiplier.
33. Times Preferred
Indicates ability to provide dividends for
Dividend Requirement 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑎𝑓𝑡𝑒𝑟 𝑇𝑎𝑥𝑒𝑠
preference shareholders
Earned 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑅𝑒𝑞𝑡.
E. Ratios used to measure Growth
Shows whether the firm pays out most of its
34. Dividend Payout 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
earnings in dividends or reinvests the earnings
Ratio 𝐸𝑃𝑆 internally

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 Shows the rate earned by shareholders from

35. Dividend Yield
𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 dividends relative to current price of stock
𝑅𝑂𝐴 𝑥 𝑏
1 − (𝑅𝑂𝐴 𝑥 𝑏) Tells us how much the firm can grow assets
36. Internal Growth
using retained earnings as the only source of
Rate
b= Retention Ratio/ Plowback Ratio financing
= 1- Dividend Payout Ratio
𝑅𝑂𝐸 𝑥 𝑏 Tell us how much the firm can grow by using
37. Sustainable Growth
1 − (𝑅𝑂𝐸 𝑥 𝑏) internally generated funds and issuing debt to
Rate
maintain a constant debt ratio

38. Book Value per 𝐸𝑞𝑢𝑖𝑡𝑦 Measures the amount of net assets available to
share 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 the shareholders of a given type of stock
1 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡io
Or Measures the percentage of net income
39. Plow-back ratio 𝐴𝑚𝑜𝑢𝑛𝑡 𝐴𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 available for investment
𝑓𝑜𝑟 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 A high right means less external financing
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

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Net Operating Profit after Taxes – Capital

Charge* or Total Cost of Capital
40. Economic Value
A measure of the shareholder value creation
Added (EVA)
*Capital Charge= total capital employed x
Weighted Average Cost of Capital (WACC)
F. Ratios used to measure the value of a company’s stock relative to that of another company

Measures relationship between price of

41. Price/Earnings 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 ordinary shares in the open market and profit
Ratio 𝐸𝑃𝑆 earned on a per share basis growth companies
are likely to have high PE
𝐸𝑃𝑆 Shows the relationship of earnings per share to
42. Earnings Yield
𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 the market price per share
43. Market to Book 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 Measures how high is the shares’ market price
Ratio or Price to Book
𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 in relation to book value
Ratio

Illustration 3.2 Comprehensive Example

The following information is available for XYZ Company for Years Ending December 31 (millions of
pesos, except for per share data):

Income Statement
2010 2009

Net Sales 3,000.00 2,850.00

Operating costs excluding depreciation and amortization** 2,616.20 2,497.00
Earnings before interest, taxes, depreciation and amortization (EBITDA) 383.80 353.00
Depreciation 100.00 90.00
Amortization - -
Earnings before interest and taxes (EBIT or operating income) 283.80 263.00
Less: Interest 88.00 60.00
Earnings before taxes (EBT) 195.80 203.00
Less: Taxes (40%) 78.30 81.20
Net income before preferred dividends 117.48 121.80
Preferred dividends 4.00 4.00
Net income 113.48 117.80

Common dividends 57.50 53.00

Addition to retained earnings 56.00 64.80

Per share data

Common stock price 23.00 26.00
Earnings per share (EPS) 2.27 2.36
Book value per share (BVPS) 17.92 16.80
Cash flow per share (CFPS) 4.27 4.16

*The bonds have a sinking fund requirement of P20 million per year.
**The cost include lease payments of P28 million per year.

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Income Statement

Assets 2010 2009 Liabilities and Equity 2010 2009

Cash and Cash equivalents 10 15 Accounts payable 60 30
Accounts receivable 375 315 Notes payable 110 60
Marketable securities 0 65 Accrued expenses 140 130
Inventories 615 415 Total current liabilities 310 220
Total current assets 1,000 810 Long-term bonds * 754 580
Property, plant and equipment 1,000 870 Total liabilities 1,064 800
Preferred shares (400,000 sh.) 40 40
Common shares (50,000,000 sh.) 130 130
Retained earnings 766 710
Total common equity 896 840
Total assets 2,000 1,680 Total liabilities and equity 2,000 1,680

Required: Evaluate the company’s performance using the following

1) Vertical analysis
2) Horizontal analysis
3) Financial ratios
Solutions:

1) Vertical analysis

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Industry
Common Size Income Statement XYZ Company
Composite
2010 2010 2009

Net Sales 100.0% 100.00% 100.00%

Operating costs excluding depreciation and amortization** 87.6% 87.21% 87.61%
Earnings before interest, taxes, depreciation and amortization (EBITDA) 12.4% 12.79% 12.39%
Depreciation and amortization 2.8% 3.33% 3.16%
Earnings before interest and taxes (EBIT or operating income) 9.6% 9.46% 9.23%
Less: Interest 1.3% 2.93% 2.11%
Earnings before taxes (EBT) 8.3% 6.53% 7.12%
Less: Taxes (40%) 3.3% 2.61% 2.85%
Net income before preferred dividends 5.0% 3.92% 4.27%
Preferred dividends 0.0% 0.13% 0.14%
Net income 5.0% 3.78% 4.13%

2) Horizontal Analysis
Percent
Income Statement
Change in
Base year = 2009 2010
Net Sales 5.26%
Operating costs excluding depreciation and amortization** 4.77%
Earnings before interest, taxes, depreciation and amortization (EBITDA) 8.73%
Depreciation and amortization 11.11%
Earnings before interest and taxes (EBIT or operating income) 7.91%
Less: Interest 46.67%
Earnings before taxes (EBT) -3.55%
Less: Taxes (40%) -3.57%
Net income before preferred dividends -3.55%
Preferred dividends 0.00%
Net income -3.67%

Percent Change in
Balance Sheet
Base year = 2009 2010
Assets
Cash and Cash equivalents -33.33%
Accounts receivable 19.05%
Marketable securities -100.00%
Inventories 48.19%
Total current assets 23.46%
Property, plant and equipment 14.94%
Total assets 19.05%

Liabilities and Equity

Accounts payable 100.00%
Notes payable 83.33%
Accrued expenses 7.69%
Total current liabilities 40.91%
Long-term bonds * 30.00%
Total liabilities 33.00%
Preferred shares (400,000 sh.) 0.00%
Total common equity 6.67%
Total liabilities and equity 19.05%

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3) Financial Ratios

Industry
Ratio Formula Calculation Ratio Comment
Average
Liquidity
Current 1,000 3.23 4.20 Poor
310
Quick ratio 385 1.24 2.10 Poor
310
Asset Management
Inventory turnover 3,000 4.88 9.00 Poor
615
Days sales 375 45.62 36.0 Poor
outstanding 8.22
Fixed asset 3,000 3.00 3.00 OK
turnover 1,000
Total asset 3,000 1.50 1.80 Poor
turnover 2,000
Debt Management
Debt ratio 1,064 53.20% 40.00% High
2,000 (risky)
Times-interest- 283.8 3.225 6.00 Low
earned (TIE) 88 (risky)

EBITDA Coverage 𝐸𝐵𝐼𝑇𝐷𝐴 + 𝐿𝑒𝑎𝑠𝑒 𝑝𝑚𝑡𝑠

411.8 3.03 4.30 Low
𝐼𝑛𝑡. +𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 + 136 (risky)
𝐿𝑒𝑎𝑠𝑒 𝑃𝑚𝑡𝑠

Profitability
Profit margin on 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 113.5 3.78% 5.00% Poor
sales 𝑡𝑜 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠
𝑆𝑎𝑙𝑒𝑠
3,000
Basic earning 283.8 14.2% 17.20% Poor
EBIT/Total Assets
power 2,000
Return on total 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒
113.5 5.68% 9.00% Poor
assets (ROA) 𝑡𝑜 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 2,000
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

Return on 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 113.5 12.67% 15.00% Poor

Common Equity 𝑡𝑜 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 896
𝐶𝑜𝑚𝑚𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦
(ROE)
Market value
Price/earnings 23.00 10.13 12.50 Low
(P/E) 2.27
Price/Cash Flow 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 23.00 5.39 6.80 Low
𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 4.27
Market/Book (M/B) 23.00 1.28 1.70 Low
17.92

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LIMITATIONS OF FINANCIAL RATIO ANALYSIS

Despite the usefulness of financial ratio analysis, it comes with some limitations:

1. Many large firms operate different divisions in different industries and for such companies it
is difficult to develop a meaningful set of industry averages. Therefore, industry averages are
more applicable to small, narrowly focused firms than to large, multidivisional ones.
2. To set goals for high-level performance, it is best to benchmark on the industry leaders’ ratios
than the industry average ratios.
3. Inflation may have badly distorted firms’ balance sheets – reported values are often
substantially different from “true” values. Further, because inflation affects depreciation
charges and inventory costs, reported profits are also affected. Thus, inflation can distort a
ratio analysis for one firm over time or a comparative analysis of firms of different ages.
4. Seasonal factors can also distort a ratio analysis. For example, the inventory turnover ratio
for a food processor will be radically different if the balance sheet figure used for inventory is
the one just before versus the one just after the close of the canning season. The problem can
be minimized by using monthly averages for inventory when calculating turnover ratios.
5. Firms can employ “window dressing” techniques to make their financial statements look
stronger.
6. Companies’ choices of different accounting practices can distort comparisons.

End-of-Lesson Exercises

Concept Questions
1. Financial ratio analysis is conducted by managers, equity investors, long-term creditors and
short-term creditors. What is the primary emphasis of each of these groups in evaluating
ratios?
2. Why is it sometimes misleading to compare a company’s financial ratios with those of other
firms that operate in the same industry?

PROBLEM 1. Short Problems

1. Tulips Company has Days sales outstanding (DSO) of 40 days, and its annual sales are P7.3M.
What are its accounts receivable balance? Assume a 365-day year.

2. A firm has sales of P1.2 M and 10% of the sales are for cash. The year-end accounts
receivable balance is P180,000. What is the average collection period? (Use 360-day year)

3. Charlie Company has accounts receivable turnover equal to 12 times. If the accounts
receivable are equal to P90,000, what is the value for average daily credit sales?

4. The following information pertains to Batalla Company for 200B:

Inventory December 31, 200B 16,000
Purchases of mdse, all on credit 72,000
COGS 80,000
The company’s merchandise inventory turnover for 200B was ____________.
5. A & B Industries has current assets equal to P5 million. The company’s current ratio is 1.2
and its quick ratio is 1.0. What is the firm’s level of current liabilities? What is the firm’s level
of inventories?

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6. The following information pertains to Cenon Company for 200B:

A/R, Jan. 1, 200B 8,000
A/R, Dec.31, 200b 9,600
Net cash sales 3,200
Accounts Receivable turnover for 200B 5 times
The company’s net sales for 200B were _______________.

7. Jasmine Inc. has an equity multiplier of 2.4 and its assets are financed with some combination
of long-term debt and common equity. What is its debt ratio?

8. Alessandra Company has P10 B in total assets. Its balance sheet shows P1 B in current
liabilities, P3 Bin long-term debt and P6 B in common equity. It has 800 M shares of common
stock outstanding, and its stock price is P32 per share. What is Alessandra Company
market/book ratio?

9. A company has an EPS of P2, a book value per share of P20, and a market/book ratio of 1.2x.
What is its P/E ratio?

10. Nottingham Pharma has a profit margin of 3% ad an equity multiplier of 2.5. Its sales are
P200 million, and it has total assets of P150 million. What is its ROE?

11. S & M has a ROA of 10%, a 3% profit margin and a return on equity to 20%. What is the
company’s total assets turnover? What is the firm’s equity multiplier?

12. Assume you are given the following relationships for the CC Corporation:
Sales/total assets 2.5 ROE 4%
ROA 2%
Calculate CC’s profit margin and debt ratio.

13. If Roten, Inc., has an equity multiplier of 1.35, total asset turnover of 2.15, and a profit margin
of 5.8 percent, what is its ROE?

14. Thomsen Company has a debt–equity ratio of .90. Return on assets is 10.1 percent, and total
equity is P645,000. What is the equity multiplier? Return on equity? Net income?

15. Y3K, Inc., has sales of P3,100, total assets of P1,580, and a debt–equity ratio of 1.20. If its
return on equity is 16 percent, what is its net income?

16. If the Layla Corp. has a 15 percent ROE and a 10 percent payout ratio, what is its sustainable
growth rate?

17. Assuming the following ratios are constant, what is the sustainable growth rate? Total asset
turnover = 1.90 Profit margin = 8.1% Equity multiplier = 1.25 Payout ratio = 30%

18. A Mindanao mining has P6 M in sales; its ROE is 12% and its total assets turnover is 3.2x. The
company is 50% equity financed, and it has no preferred stock outstanding. What is its net
income?
19. King Company has a return on assets ratio of 12%. If the debt-to-total assets ratio is 40%,
what is the return on equity?

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20. The D Company has P1,500,000 in current assets and P600,000 in current liabilities. Its initial
inventory level is P425,000, and it will raise funds as additional notes payable and use them
to increase inventory. How much can D’s short-term debt (notes payable) increase without
pushing its current ratio 2.5? What will be the firm’s quick ratio after D has raised the
maximum amount of short-term funds?

21. Esther Company can open a new store that will do an annual sales volume of P960,000. It
will turn over its assets 2.4 times per year. The profit margin on sales will be 7%. What would
net income and return on assets (investment) be for the year?

22. The Steiben Company has an ROE of 10.5 percent and a payout ratio of 40 percent.
a. What is the company’s sustainable growth rate?
b. Can the company’s actual growth rate be different from its sustainable growth rate?
Why or why not?
c. How can the company increase its sustainable growth rate?

PROBLEM 2
We are given the following information for Cathy Corporation.
Sales (credit) P 3,000,000
Cash 150,000
Inventory 850,000
Current liabilities P 700,000
Asset Turnover 1.25 times
Current Ratio 2.50 times
Debt-to-assets ratio 40%
Receivables turnover 6 times
Current assets are composed of cash, marketable securities, accounts receivable and inventory.

Required: Calculate the

1. Accounts Receivable
2. Marketable securities
3. Fixed assets
4. Long-term debt

PROBLEM 3
Complete the balance sheet and sales information in the table that follows for EE Industries using
the following financial data:
Debt ratio: 50%
Quick ratio: 0.80
Total assets turnover: 1.5
Days sales outstanding: 36.5 days* (based on a 365-day year)
Gross profit margin on sales: 25%
Inventory turnover ratio: 5.0
Balance sheet
Cash Accounts payable
Accounts receivable Long-term debt 60,000
Inventories Common stock
Fixed assets Retained earnings 97,500
Total assets P 300,000 Total Liabilities and equity

Sales Cost of goods sold

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PROBLEM 4 Use the information below:

KYLE COMPANY
Statement of Financial Position Dividends during Year 2 totaled
December 31, Year 1 and Year 2 P127,000, of which P5,000 were
(Pesos in thousands) preferred dividends. The market
price of a share of common stock
Current Assets Year 2 Year 1 on December 31, Year 2 was P140.
Cash and Marketable Securities 140 130
Accounts Receivable, net 120 110 Required:
Inventory 100 110 Compute the following for Year 2
Prepaid Expenses 50 40 (365-day year):
Total Current Assets 410 390 1. Earnings per share of
Non-current Assets common stock
Plant and Equipment, net 1,840 1,830 2. Price-earnings ratio
Total Assets 2,250 2,220 3. Dividend pay-out ratio
4. Dividend yield
Current Liabilities 5. Return on total assets (use
Accounts Payable 100 100 adjusted net income)
Accrued Liabilities 80 80 6. Return on common
Notes payable, short term 210 230
stockholders’ equity
Total Current Liabilities 390 410
7. Book value per share
Non-current Liabilities
8. Working capital
Bonds payable 460 500
9. Current ratio
Total Liabilities 850 910
10. Acid-test (quick) ratio
Stockholders’ Equity
11. Accounts receivable turnover
Preferred Stock, P5 par, 5% 100 100 12. Average collection period
Common Stock,P10 par 200 200 (age of receivables)
Additional paid-in capital 260 260 13. Inventory turnover
Retained Earnings 840 750 14. Average sale period (turnover
Total Stockholders’ Equity 1,400 1,310 in days)
Total Liabilities & Stockholders’ Equity 2,250 2,220 15. Times-interest earned
16. Debt-to-equity ratio
KYLE COMPANY
Income Statement
For the year ended December 31, Year 2
(Pesos in thousands)

Sales (all on account) 2,000

Cost of Goods Sold 1,400
Gross Margin 600
Operating Expenses 240
Operating Income 360
Interest Expense 50
Income before taxes 310
Income taxes (30%) 93
Net Income 217

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PROBLEM 5

Financial statements for Larned Company appear below:

Dividends during 20x2 totaled P263
Larned Company
thousand, of which P12 thousand
Statement of Financial Position
December 31, 20x2 and 20x1
were preferred dividends.
(pesos in thousands) The market price of a share of
common stock on December 31,
20x2 20x1
20x2 was P160.
Current assets:
Cash and marketable securities ............. 130 100 Compute the following:
Accounts receivable, net ................... 150 130
Inventory .................................. 100 100 a. earnings per share of
Prepaid expenses ........................... 20 20 common stock
Total current assets ..................... 400 350 b. price-earnings ratio
Noncurrent assets: c. dividend payout ratio
Plant & equipment, net ..................... 1640 1,600
d. dividend yield ratio
Total assets ................................. 2,040 1,950
e. return on total assets
f. return on common
Current liabilities:
Accounts payable ........................... 120 120
stockholders’ equity
Accrued liabilities ........................ 110 80 g. book value per share
Notes payable, short term .................. 170 160
Total current liabilities ............... 400 360
Noncurrent liabilities:
Bonds payable .............................. 370 400
Total liabilities ........................ 770 760
Stockholders' equity:
Preferred stock, P20 par, 10% .............. 120 120
Common stock, P10 par ...................... 180 180
Additional paid-in capital--common stock 110 110
Retained earnings .......................... 860 780
Total stockholders' equity ............... 1270 1190
Total liabilities & stockholders' equity ..... 2,040 1950

Larned Company
Income Statement
For the Year Ended December 31, 20x2
(pesos in thousands)

Sales (all on account) ................... 2930

Cost of goods sold ....................... 2050
Gross margin ............................. 880
Operating expenses ....................... 350
Net operating income ..................... 530
Interest expense ......................... 40
Net income before taxes .................. 490
Income taxes (30%) ....................... 147
Net income ............................... 343

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PROBLEM 6

Use the following information and analyze the Financial Position and Operations of the company.
SMOLIRA GOLF CORP.
Balance Sheets as of December 31, 20xx and 20xy

ASSETS 20xx 20xy LIABILITIES AND OWNERS’ EQUITY 20xx 20xy

Current assets Current liabilities
Cash 650.00 710.00 Accounts payable 987.00 1,215.00
Accounts receivable 2,382.00 2,106.00 Notes payable 640.00 718.00
Inventory 4,408.00 4,982.00 Other 90.00 230.00
Total 7,440.00 7,798.00 Total 1,717.00 2,163.00
Long-term debt 4,318.00 4,190.00
Owners’ equity
Common stock and paid-in surplus 10,000.00 10,000.00
Fixed assets Retained earnings 5,397.00 10,029.00
Net plant and equipment 13,992.00 18,584.00 Total 15,397.00 20,029.00
Total assets 21,432.00 26,382.00 Total Liabilities & Equity 21,432.00 26,382.00

SMOLIRA GOLF CORP.

20xy Income Statement

Sales 28,000 Dividends P4,000

Cost of goods sold 11,600 Addition to retained earnings 4,632
Depreciation 2,140
Earnings before interest and taxes 14,260
Interest paid 980
Taxable income 13,280
Taxes (35%) 4,648
Net income 8,632

A. Perform the vertical analysis on Smolira Golf Corp. financial statements

B. Perform the horizontal analysis on Smolira Golf Corp. financial statements
C. Smolira Golf Corp. has 1,250 shares of common stock outstanding, and the market price for
a share of stock at the end of 20xy was P63. Find the following financial ratios for Smolira
Golf Corp.:
a) Current ratio i) Equity multiplier
b) Quick ratio j) Times-interest-earned
c) Cash ratio k) Profit margin
d) Total asset turnover l) Return on Assets
e) Inventory turnover m) Return on equity
f) Receivables turnover n) Price-earnings ratio
g) Total debt ratio o) Dividends per share
h) Debt-equity ratio p) Market-book ratio

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PROBLEM 7

The Mango Corporation’s 20xx and 20xy financial statements are as follows along with some industry
average ratios.
Mango Corporation
Statements of Financial Position as of December 31, 20xy and 20xx
20xy 20xx
Assets
Cash 72,000 65,000
Accounts Receivable 439,000 328,000
Inventories 894,000 813,000
Total Current Assets 1,405,000 1,206,000
Land and Building 238,000 271,000
Machinery 132,000 133,000
Other fixed assets 61,000 57,000
Total Noncurrent Assets 431,000 461,000
Total Assets 1,836,000 1,667,000

Liabilities and Owners' Equity

Accounts and Notes Payable 432,000 409,500
Accrued Liabilities 170,000 162,000
Total Current Liabilities 602,000 571,500
Long-term debt 404,290 258,898
Common Stock 575,000 575,000
Retained Earnings 254,710 261,602
Total Equity 829,710 836,602
Total Liabilities and Equity 1,836,000 1,667,000

Mango Corporation
Income Statement for the years ended December 31, 20xy and 20xx

Sales 4,240,000 3,635,000

Cost of Goods Sold 3,680,000 2,980,000
Gross Profit 560,000 655,000
Gen. and Admin. Expenses 236,320 213,550
Depreciation 159,000 154,500
Miscellaneous 134,000 127,000
Earnings before taxes 30,680 159,950
Taxes (40%) 12,272 63,980
Net Income 18,408 95,970

Per-Share Data
20xy 20xx
EPS P 0.80 P 4.17
Cash Dividends P 1.10 P 0.95
Market Price (average) P 12.34 P 23.57
P/E ratio 15.43 x 5.65 x
Numbers of shares outstanding 23,000 23,000

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 Financial Management

Industry Financial Ratios*

20xy
Current Ratio 2.7x
Inventory Turnover** 7.0x
Days sales outstanding*** 32 days
Fixed Assets turnover ** 13 x
Total Assets Turnover ** 2.6 x
Return on Assets 9.1%
Return on Equity 18.2%
Debt-to-assets ratio 50%
Profit margin 3.5%
P/E ratio 6x

*Industry average ratios have been constant for the past 4 years.
**Based on year-end balance sheet figures.
***calculation is based on 365-day year.

REQUIRED:

A. Assess Mango Company’s liquidity position and determine how it compares with peers and
how the liquidity position has changed over time.
B. Assess Mango Company’s asset management position and determine how it compares with
peers and how its asset management efficiency has changed over time.
C. Assess Mango Company’s debt management position and determine how it compares with
peers and how its debt management efficiency has changed over time.
D. Assess Mango Company’s profitability ratios and determine how they compare with peers
and how the profitability position has changed over time.
E. Assess Mango Company’s market value ratios and determine how its valuation compares
with peers and how it has changed over time.
F. Calculate Mango Company’s ROE as well as industry average ROE using Du Pont Equation.
From the analysis, how does Mango Company’s financial position compare with the industry
average numbers?
G. What do you think would happen to its ratios if the company initiated cost-cutting measures
that allowed it to hold lower levels of inventory and substantially decreased the cost of
goods sold? No calculations are necessary. Think about which ratios would be affected by
changes in these accounts.

Mini Case: RATIOS AND FINANCIAL PLANNING AT EAST COAST YACHTS

Dan Ervin was recently hired by East Coast Yachts to assist the company with its short-term financial
planning and also to evaluate the company’s financial performance. Dan graduated from college five
years ago with finance degree and he has been employed in the treasury department of a Fortune
500 company since then.

East Coast Yachts was founded 10 years ago by Larissa Warren. The company’s operations are
located near Hilton Head Island, South Carolina, and the company is structured as an LLC. The
company has manufactured custom midsize, high-performance yachts for clients over this period,
and its products have received high reviews for safety and reliability. The company’s yachts have
also recently received the highest award for customer satisfaction. The yachts are primarily
purchased by wealthy individuals for pleasure use. Occasionally, a yacht is manufactured for
purchase by a company for business purposes.

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 Financial Management

The custom yacht industry is fragmented, with a number of manufacturers. As with any industry,
there are market leaders, but the diverse nature of the industry ensures that no manufacturer
dominates the market. The competition in the market, as well as the product cost, ensures that
attention to detail is a necessity. For instance, East Coast Yachts will spend 80 to 100 hours on hand-
buffing the stainless-steel stem-iron, which is the metal cap on the yacht’s bow that conceivably
could collide with a dock or another boat.

To get Dan started with his analyses, Larissa has provided the following financial statements. Dan
has gathered the industry ratios for the yacht manufacturing industry.

INCOME STATEMENT BALANCE SHEET

Sales 167,310,000 Assets

Costs (117,910,000) Current assets
Depreciation (19,994,000) Cash 3,042,000
Accounts receivable 5,473,000
Other Expenses (5,460,000)
Inventory 6,136,000
EBIT 23,946,000
Fixed assets 93,964,000
Interest (3,009,000)
Total assets 108,615,000
EBT 20,937,000
Taxes (40%) (8,374,800)
Liabilities and equity
Net income 12,562,200
Current liabilities
Accounts payable 6,461,000
Dividends 7,537,320 Notes payable 13,078,000
Addition to RE 5,024,880 Long-term debt 33,735,000
Shareholders' equity
Common stock 5,200,000
Retained earnings 50,141,000
Total iabilities and equity 108,615,000
YACHT INDUSTRY RATIOS

Lower Quartile Median Upper Quartile

Current ratio 0.50 1.43 1.89
Quick ratio 0.21 0.38 0.62
TA turnover 0.68 0.85 1.38
Inventory turnover 4.89 6.15 10.89
Receivables turnover 6.27 9.82 14.11
Debt ratio 0.44 0.52 0.61
Debt-equity ratio 0.79 1.08 1.56
Equity multiplier 1.79 2.08 2.56
Interest coverage 5.18 8.06 9.83
Profit margin 4.05% 6.98% 9.87%
ROA 6.05% 10.53% 13.21%
ROE 9.93% 16.54% 26.15%

Required:

1. Calculate all of the ratios listed in the industry table for East Coast Yachts.
2. Compare the performance of East Coast Yachts to the industry as a whole. For each ratio,
comment on why it might be viewed as positive or negative relative to the industry. Suppose you
create an inventory ratio calculated as inventory divided by current liabilities. How do you
interpret this ratio? How does East Coast Yachts compare to the industry average?

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