CHAPTER 3

W O R K I N G W I T H F I N A N C I A L S TAT E M E N T S

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 CHAPTER OUTLINE

• Standardized Financial Statements

• Ratio Analysis

• The DuPont Identity

• Using Financial Statement Information

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STANDARDIZED FINANCIAL STATEMENTS
• Nearly impossible to directly compare the financial statements
for two companies because of differences in size
• Similarly challenging to compare financial statements from
different points in time for the same company if the company’s
size has changed

• To make comparisons, standardize the financial statements

1. Common-size statements present all items in percentage terms
• For example, common-size balance sheets typically express each
item as a percentage of total assets

2. Common-base year statements (i.e., trend analysis) present all

items relative to a certain base year amount
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PRUFROCK CORPORATION: SUMMARY
OF STANDARDIZED BALANCE SHEETS

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 RATIO ANALYSIS
• Another way of avoiding the problems involved in comparing
companies of different sizes is to calculate and compare
financial ratios
• Financial ratios are relationships determined from a firm’s
financial information and used for comparison purposes

• Financial ratios are traditionally grouped into the following

categories:
• Short-term solvency (liquidity) ratios
• Long-term solvency (financial leverage) ratios
• Asset management (turnover) ratios
• Profitability ratios
• Market value ratios
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SHORT-TERM SOLVENCY, OR LIQUIDITY,
RATIOS

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 SHORT-TERM SOLVENCY, OR LIQUIDITY,
MEASURES
• Current ratio is a measure of short-term liquidity
• To a creditor, the higher this ratio, the better
• To a firm, a high current ratio may indicate an inefficient use of
cash and other short-term assets
• Normally expect to see a current ratio of at least 1
• Quick ratio is computed just like the current ratio, except
inventory is omitted since it is often the least liquid current
asset
• Relatively large inventories are often a sign of short-term trouble
• Cash ratio may be of interest to a very short-term creditor
• Net working capital to total assets
• Low values might indicate relatively low levels of liquidity
• Interval measure indicates how long the business can continue
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LONG-TERM SOLVENCY RATIOS

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 LONG-TERM SOLVENCY MEASURES
• Total debt ratio considers all debts of all maturities to all
creditors and has two useful variations:
• Debt-equity ratio
• Equity multiplier
• Long-term debt ratio is calculated as long-term debt divided by
the sum of long-term debt and total equity

• Times interest earned ratio measures how well a company has

its interest obligations covered, and is often called the interest
coverage ratio

• Cash coverage ratio is a basic measure of the firm’s ability to

generate cash from operations and is frequently used as a
measure of cash flow available to meet financial obligations
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ASSET MANAGEMENT, OR TURNOVER,
RATIOS

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 ASSET MANAGEMENT, OR TURNOVER,
MEASURES
• Inventory turnover tells us how many times the firm sold off or
turned over the entire inventory
• Days’ sales in inventory tells us how many days inventory sits (on
average) before it is sold
• Receivables turnover shows how many times a firm collects
outstanding credit accounts and reloans the money
• Days’ sales in receivables provides the average number of days it
takes for a firm to collect on its credit sales
• Asset turnover ratios
• NWC turnover measures how much “work” we get out of our working
capital
• Fixed asset turnover tells us how much the company generates in
sales for every dollar in fixed assets
• Total assets turnover tells us how much the company generates in
sales for every dollar in assets 1-11
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 PROFITABILITY RATIOS

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 PROFITABILITY MEASURES
• Profit margin measures how well a company makes money
(i.e., how much money it generates in profit for every dollar in
sales)
• All other things equal, a relatively high profit margin is desirable
• Significant variation in profit margins across industries

• Remember that ROA and ROE are accounting rates of return; as

such, they should properly be called return on book assets and
return on book equity
• Return on assets (ROA) is a measure of profit per dollar of assets
• Return on equity (ROE) is a measure of how much money the
company generated in profit for every dollar in equity

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 MARKET VALUE RATIOS

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 MARKET VALUE MEASURES
• Price-earnings (PE) ratio measures how much investors are
willing to pay per dollar of current earnings
• Vary significantly across companies, but, in 2020, a typical large
company in the U.S. had a PE in the 15-20 range
• Higher PEs are often taken to mean the firm has significant
prospects for future growth, but it could also mean a firm had no
(or almost no) earnings
• Price-sales ratio is useful if PE ratio is not meaningful due (e.g.,
firm has negative earnings for extended periods)
• Market-to-book ratio compares the market value of the firm’s
equity to its book value
• Value less than 1 could mean that the firm has not been
successful overall in creating value for its stockholders

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MARKET VALUE MEASURES (CONTINUED)
• Tobin’s Q ratio is superior to the market-to-book ratio because
it focuses on what the firm is worth today relative to what it
would cost to replace it today
• Firms with high Q ratios tend to be those with attractive
investment opportunities or significant competitive advantages
(or both)
• Difficult to calculate with accuracy because estimating the
replacement cost of a firm’s assets is not an easy task and market
values for a firm’s debt are often unobservable

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 THE DUPONT IDENTITY

• We could multiply ROE by Assets/Assets, which then expresses

the ROE as the product of ROA and the equity multiplier:

• We can further decompose ROE by multiplying by Sales/Sales:

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 THE DUPONT IDENTITY (CONTINUED)
• If we rearrange things a bit, we can partition ROA into its two
component parts – profit margin and total asset turnover

• The DuPont identity breaks ROE into three parts:

1. Operating efficiency, as measured by profit margin
2. Asset use efficiency, as measured by total asset turnover
3. Financial leverage, as measured by the equity multiplier
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 DUPONT BREAKDOWN:
AMAZON AND ALIBABA

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 CHOOSING A BENCHMARK
• How do we choose a benchmark given we want to evaluate a
firm based on its financial statements?
1. Time trend analysis uses a firm’s historical data as the standard
2. Peer group analysis compares firms to their peer group, firms
similar in the sense that they compete in the same markets,
have similar assets, and operate in similar ways

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PROBLEMS WITH FINANCIAL STATEMENT
ANALYSIS
• No underlying theory exists to help us identify which quantities
to look at and to use in establishing benchmarks
• Many firms are conglomerates, owning unrelated lines of
business, and consolidated financial statements for such firms
do not fit any neat industry category
• Major competitors and natural peer group members in an
industry may be scattered around the globe
• Financial statements from outside the U.S. do not necessarily
conform to all GAAP principles

• Different firms use different accounting procedures

• Different firms end their fiscal years at different times
• Unusual or transient events may affect financial performance
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