CHAPTER 3

Analysis of Financial
Statements
 Ratio Analysis
 Du Pont system
 Effects of improving ratios
 Limitations of ratio analysis
 Qualitative factors
3-1
Balance Sheet: Assets
2003E 2002
Cash 85,632 7,282
A/R 878,000 632,160
Inventories 1,716,480 1,287,360
Total CA 2,680,112 1,926,802
Gross FA 1,197,160 1,202,950
Less: Dep. 380,120 263,160
Net FA 817,040 939,790
Total Assets 3,497,152 2,866,592
3-2
Balance sheet:
Liabilities and Equity
2003E 2002
Accts payable 436,800 524,160
Notes payable 300,000 636,808
Accruals 408,000 489,600
Total CL 1,144,800 1,650,568
Long-term debt 400,000 723,432
Common stock 1,721,176 460,000
Retained earnings 231,176 32,592
Total Equity 1,952,352 492,592
Total L & E 3,497,152 2,866,592
3-3
Income statement
2003E 2002
Sales 7,035,600 6,034,000
COGS 5,875,992 5,528,000
Other expenses 550,000 519,988
EBITDA 609,608 (13,988)
Depr. & Amort. 116,960 116,960
EBIT 492,648 (130,948)
Interest Exp. 70,008 136,012
EBT 422,640 (266,960)
Taxes 169,056 (106,784)
Net income 253,584 (160,176)
3-4
Other data
2003E 2002
No. of shares 250,000 100,000
EPS $1.014 -$1.602
DPS $0.220 $0.110
Stock price $12.17 $2.25
Lease pmts $40,000 $40,000

3-5
Why are ratios useful?
 Ratios standardize numbers and
facilitate comparisons.
 Ratios are used to highlight
weaknesses and strengths.

3-6
What are the five major categories of
ratios, and what questions do they
answer?
 Liquidity: Can we make required payments?
 Asset management: right amount of assets
vs. sales?
 Debt management: Right mix of debt and
equity?
 Profitability: Do sales prices exceed unit
costs, and are sales high enough as
reflected in PM, ROE, and ROA?
 Market value: Do investors like what they
see as reflected in P/E and M/B ratios?

3-7
 Calculate D’Leon’s forecasted
current ratio for 2003.

Current ratio = Current assets / Current liabilities

= $2,680 / $1,145
= 2.34x

3-8
Comments on current ratio
2003 2002 2001 Ind.
Current
2.34x 1.20x 2.30x 2.70x
ratio

 Expected to improve but still below

thindustry average.
 Liquidity e position is weak.

3-9
What is the inventory turnover
vs. the industry average?
Inv. turnover = Sales / Inventories
= $7,036 / $1,716
= 4.10x

2003 2002 2001 Ind.

Inventory
4.1x 4.70x 4.8x 6.1x
Turnover
3-10
Comments on
Inventory Turnover
 Inventory turnover is below industry
average.
 D’Leon might have old inventory, or its
control might be poor.
 No improvement is currently
forecasted.

3-11
DSO is the average number of days after
making a sale before receiving cash.

DSO = Receivables / Average sales per

day
= Receivables / Sales/365
= $878 / ($7,036/365)
= 45.6

3-12
Appraisal of DSO
2003 2002 2001 Ind.

DSO 45.6 38.2 37.4 32.0

 D’Leon collects on sales too slowly,

and is getting worse.
 D’Leon has a poor credit policy.

3-13
Fixed asset and total asset turnover
ratios vs. the industry average

FA turnover = Sales / Net fixed assets

= $7,036 / $817 = 8.61x

TA turnover = Sales / Total assets

= $7,036 / $3,497 = 2.01x

3-14
Evaluating the FA turnover and
TA turnover ratios
2003 2002 2001 Ind.
FA TO 8.6x 6.4x 10.0x 7.0x
TA TO 2.0x 2.1x 2.3x 2.6x
 FA turnover projected to exceed the industry
average.
 TA turnover below the industry average.
Caused by excessive currents assets (A/R
and Inv).
3-15
 Calculate the debt ratio, TIE, and
EBITDA coverage ratios.

Debt ratio = Total debt / Total assets

= ($1,145 + $400) / $3,497 = 44.2%

TIE = EBIT / Interest expense

= $492.6 / $70 = 7.0x

3-16
 Calculate the debt ratio, TIE, and
EBITDA coverage ratios.

EBITDA (EBITDA+Lease pmts)

=
coverage Int exp + Lease pmts + Principal pmts

$609.6 + $40
=
$70 + $40 + $0
= 5.9x

3-17
 How do the debt management ratios
compare with industry averages?
2003 2002 2001 Ind.
D/A 44.2% 82.8% 54.8% 50.0%
TIE 7.0x -1.0x 4.3x 6.2x
EBITDA
5.9x 0.1x 3.0x 8.0x
coverage
 D/A and TIE are better than the industry
average, but EBITDA coverage still trails the
industry.
3-18
 Profitability ratios:
Profit margin and Basic earning power

Net Profit margin= Net income / Sales

= $253.6 / $7,036 = 3.6%

BEP = EBIT / Total assets

= $492.6 / $3,497 = 14.1%

3-19
 Appraising profitability with the profit
margin and basic earning power
2003 2002 2001 Ind.
NPM 3.6% -2.7% 2.6% 3.5%
BEP 14.1% -4.6% 13.0% 19.1%
 Profit margin was very bad in 2002, but is projected to
exceed the industry average in 2003. Looking good.
 BEP removes the effects of taxes and financial leverage,
and is useful for comparison.
 BEP projected to improve, yet still below the industry
average. There is definitely room for improvement.
3-20
Profitability ratios:
Return on assets and Return on equity

ROA = Net income / Total assets

= $253.6 / $3,497 = 7.3%

ROE = Net income / Total common equity

= $253.6 / $1,952 = 13.0%

3-21
Appraising profitability with the return
on assets and return on equity
2003 2002 2001 Ind.
ROA 7.3% -5.6% 6.0% 9.1%
ROE 13.0% -32.5% 13.3% 18.2%

 Both ratios rebounded from the previous year,

but are still below the industry average. More
improvement is needed.
 Wide variations in ROE illustrate the effect that
leverage can have on profitability.
3-22
Effects of debt on ROA and ROE
 ROA is lowered by debt--interest
lowers NI, which also lowers
ROA = NI/Assets.
 But use of debt also lowers equity,
hence debt could raise
ROE = NI/Equity.

3-23
 Problems with ROE
 ROE and shareholder wealth are correlated,
but problems can arise when ROE is the sole
measure of performance.
 ROE does not consider risk.
 ROE does not consider the amount of capital

invested.
 Might encourage managers to make investment

decisions that do not benefit shareholders.

 ROE focuses only on return. A better
measure is one that considers both risk and
return.
3-24
 Calculate the Price/Earnings, Price/Cash
flow, and Market/Book ratios.

P/E = Price / Earnings per share

= $12.17 / $1.014 = 12.0x

P/CF = Price / Cash flow per share

= $12.17 / [($253.6 + $117.0) ÷
250]
= 8.21x

3-25
 Calculate the Price/Earnings, Price/Cash
flow, and Market/Book ratios.

M/B = Mkt price per share / Book value per

share
= $12.17 / ($1,952 / 250) = 1.56x
2003 2002 2001 Ind.
P/E 12.0x -1.4x 9.7x 14.2x
P/CF 8.21x -5.2x 8.0x 11.0x
M/B 1.56x 0.5x 1.3x 2.4x

3-26
Analyzing the market value ratios
 P/E: How much investors are willing to pay
for $1 of earnings.
 P/CF: How much investors are willing to pay
for $1 of cash flow.
 M/B: How much investors are willing to pay
for $1 of book value equity.
 For each ratio, the higher the number, the
better.
 P/E and M/B are high if ROE is high and risk
is low.
3-27
 Extended DuPont equation:
Breaking down Return on equity

ROE = (Net Profit margin) x (TA turnover) x (Equity multiplier)

= 3.6% x 2 x 1.8
= 13.0%

PM TA TO EM ROE
2001 2.6% 2.3 2.2 13.3%
2002 -2.7% 2.1 5.8 -32.5%
2003E 3.6% 2.0 1.8 13.0%
Ind. 3.5% 2.6 2.0 18.2%
3-28
 The Du Pont system
Also can be expressed as:
ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)
 Focuses on:

 Expense control (PM)

 Asset utilization (TATO)

 Debt utilization (Eq. Mult.)

 Shows how these factors combine to

determine ROE.
3-29
 Trend analysis
 Analyzes a firm’s
financial ratios over
time
 Can be used to
estimate the likelihood
of improvement or
deterioration in
financial condition.

3-30
An example:
The effects of improving ratios
A/R 878 Debt 1,545
Other CA 1,802 Equity 1,952
Net FA 817 _____
TA 3,497 Total L&E 3,497

Sales / day = $7,035,600 / 365 = $19,275.62

How would reducing the firm’s DSO to 32

days affect the company?
3-31
Reducing accounts receivable and
the days sales outstanding
 Reducing A/R will have no effect on
sales
Old A/R = $19,275.62 x 45.6 = $878,000
New A/R = $19,275.62 x 32.0 = $616,820
Cash freed up:
$261,180

Initially shows up as addition to cash.

3-32
Effect of reducing receivables on
balance sheet and stock price
Added cash $261 Debt 1,545
A/R 617 Equity 1,952
Other CA 1,802
Net FA 817 _____
Total Assets 3,497 Total L&E 3,497

What could be done with the new cash?

How might stock price and risk be affected?

3-33
Potential uses of freed up
cash
 Repurchase stock
 Expand business
 Reduce debt
 All these actions would likely improve
the stock price.

3-34
Potential problems and limitations
of financial ratio analysis
 Comparison with industry averages is
difficult for a conglomerate firm that
operates in many different divisions.
 “Average” performance is not necessarily
good, perhaps the firm should aim
higher.
 Seasonal factors can distort ratios.
 “Window dressing” techniques can make
statements and ratios look better.
3-35
More issues regarding ratios
 Different operating and accounting
practices can distort comparisons.
 Sometimes it is hard to tell if a ratio is
“good” or “bad”.
 Difficult to tell whether a company is,
on balance, in strong or weak position.

3-36
Qualitative factors to be considered
when evaluating a company’s future
financial performance
 Are the firm’s revenues tied to 1 key
customer, product, or supplier?
 What percentage of the firm’s business
is generated overseas?
 Competition
 Future prospects
 Legal and regulatory environment
3-37
DEBT RATIO = 50%
ACID TEST RATIO = 0,80
TOTAL ASSETS TURNOVER = 1,5
DAYS SALES OUTSTANDING = 36 HARI
GROSS PROFIT MARGIN = 25%
INVENTORY TURNOVER = 5

NERACA
CASH A/P
A/R LONG TERM DEBT $ 60.000
INV COMMON STOCK
FIX, ASSETS R/E 97.500
TOTAL ASSETS $ 300.000
INCOME STATEMENT
SALES
COST OF GOODS SOLD
GROSS PROFIT
3-38
TOTAL ASSETS TURNOVER = 1,5
ROA = 3%
ROE = 5%
NET PROFIT MARGIN ?
DEBT RATIO ?

NET INCOME = $ 600,000;

ROA = 8%;
INTEREST EXPENSE = $225,000,
TAX = 35%;
BEP…………….?

3-39
CURRENT RATIO The Petry Company has
$1,312,500 in current assets and $525,000
in current liabilities. Its initial inventory
level is $375,000, and it will raise funds as
additional notes payable and use them to
increase inventory.
How much can its short-term debt (notes
payable) increase without pushing its
current ratio below 2.0?
3-40
BALANCE SHEET ANALYSIS
Complete the balance sheet and sales information using the
following financial data:
Debt ratio : 50% Current ratio :1.8×,
Total assets turnover: 1.5×, Days sales outstanding: 36.5 days,
Gross profit margin on sales :(Sales−Cost of goods sold)/Sales 25%,
Inventory turnover ratio: 5×, Calculation is based on a 365-day year.
Balance Sheet
Cash Accounts payable
Accounts receivable Long-term debt 60,000
Inventories Common stock
Fixed assets Retained earnings 97,500
Total assets $300,000 Total liabilities and equity
Sales
Cost of goods sold 3-41
RATIO ANALYSIS
The following data apply to A.L. Kaiser & Company (millions of dollars):
Cash and equivalents :$100.00
Fixed assets :283.50
Sales :1,000.00
Net income :50.00
Current liabilities :105.50
Current ratio :3.00×
DSO :40.55 days
ROE ………………………. :12.00%
This calculation is based on a 365-day year.
Kaiser has no preferred stock—only common equity, current liabilities, and
long-term debt.
a)Find Kaiser’s (1) accounts receivable, (2) current assets, (3) total assets, (4) ROA,

(5) common equity, (6) quick ratio, and (7) long-term debt.
b)In Part a), you should have found that Kaiser’s accounts receivable (A/R)

$111.1 million.
If Kaiser could reduce its DSO from 40.55 days to 30.4 days while holding other
things constant, how much cash would it generate? If this cash were used to
buy back common stock (at book value), thus reducing common equity, how
would this affect (1) the ROE, (2) the ROA, and (3) the total debt/total assets
ratio?
3-42