Chapter

Financial Statement
14 Analysis

Bodie, Kane, and Marcus

Essentials of Investments
2024 Release

© McGraw Hill LLC. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC.
 14.1 Major Financial Statements
• Income Statement
• Statement showing firm’s revenues and expenses during
specified period
Accounting Earnings Economic Earnings
Earnings of a firm as reported Real flow of cash firm could pay
on income statement without impairing productive capacity

• Balance Sheet
• Accounting statement of firm’s financial position at specified time

• Statement of Cash Flows

• Financial statement showing firm’s cash receipts and cash
payments during specified period

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 2
 Table 14.1 Target’s Income Statement, 2022

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 3
 Table 14.2 Target’s Balance Sheet, 2022

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 4
Table 14.3 Target’s Statement of Cash Flows, 2022

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 5
 Figure 14.1 Ratios

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 6
 14.3 Profitability Measures
• Return on Assets (ROA)
EBIT
ROA 
Total Assets

• Return on Capital (ROC)

EBIT
ROC 
Long-Term Capital

• Return on Equity (ROE)

Net Income
ROE 
Shareholders' Equity

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 7
Table 14.4 Nodett’s Profitability over Business Cycle

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 8
Table 14.5 Impact of Financial Leverage on ROE

• Financial Leverage and ROE

 Debt 
ROE (1  Tax Rate)  ROA  ( ROA  Interest Rate)  
 Equity 

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 9
 14.3 Profitability Measures

• Economic Value Added

• Measure of dollar value of firm’s return in
excess of opportunity cost
• Also known as residual income
• Spread between ROA and cost of capital
multiplied by capital invested in firm

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 10
 Table 14.6 Economic Value Added, 2021

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 11
 14.4 Ratio Analysis
• Decomposition of ROE: DuPont System
Net Profit Pretax Profit EBIT Sales Assets
ROE     
Pretax Profit EBIT Sales Assets Equity

Tax Interest Profit Asset Leverage

Burden Burden Margin Turnover Ratio

ROE Tax Burden ROA Compound Leverage Factor

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 12
 Table 14.7 Ratio Decomposition Analysis for Nodett and Somdett

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 13
 Table 14.8 Differences between Profit Margin and Asset
Turnover across Industries

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 14
 Figure 14.2 Median ROA, Profit Margin, and Asset Turnover by
Industry, 2022

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 15
 14.4 Ratio Analysis
• Turnover and Asset Utilization
• Fixed-asset turnover
Sales
Fixed-Asset Turnover Ratio 
Fixed Assets
• Inventory turnover ratio
COGS
Inventory Turnover Ratio 
Average Inventory
• Average collection period
Average Accounts Receivable
Average Collection Period 
Sales / 365

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 16
 14.4 Ratio Analysis
• Liquidity Ratios
• Liquidity: Ability to convert assets into cash at
short notice
• Current ratio
Current Assets
Current Ratio 
Current Liabilities
• Quick ratio
Current Assets  Inventory
Quick Ratio 
Current Liabilities
• Cash ratio
Cash  Marketable Securities
Cash Ratio 
Current Liabilities

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 17
 Table 14.9 Growth Industries Financial Statements

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 18
 14.4 Ratio Analysis
• Market Price Ratios
• Market-to-book-value ratio
• Market price of share divided by book value per share
• Also known as P/B ratio

• Price-earnings ratio
• Ratio of stock’s price to earnings per share
• Also known as P/E multiple

Earnings Market Price Market Price

ROE   
Book Value Book Value Earnings
P/B ratio P/E ratio

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 19
 Table 14.10A Summary of Financial Ratios

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 20
 Table 14.10B Summary of Financial Ratios

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 21
 Figure 14.3 DuPont Composition for Target

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 22
Table 14.11 Financial Ratios for Major Industry Groups

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 23
 14.5 Illustration of Financial Statement Analysis

• Example: Growth Industries

• Sales, assets, operating income increased 20%
• ROE declining
• ROA not declining
• Rapid increase in year-to-year short-term debt
and interest expense

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 24
Table 14.12 Key Financial Ratios: Growth Industries

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 25
 Table 14.13 Growth Industries Cash Flows

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 26
 14.6 Comparability Problems

• Inventory Valuation
• LIFO
• Last-in first-out inventory valuation
• Results in a more realistic estimate

• FIFO
• First-in first-out inventory valuation
• Assumes that the units used up or sold are the ones
added to the inventory

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 27
 14.6 Comparability Problems

• Depreciation
• Economic
• Amount of operating cash flow that must be
reinvested in firm to sustain real cash flow
• Accounting
• Amount of acquisition cost of asset that is allocated to
each accounting period over arbitrarily specified life of
asset

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 28
 14.6 Comparability Problems

• Fair Value Accounting

• Use of current market values rather than
historic costs in firm’s financial statements
• Relies heavily on estimates

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 29
 14.6 Comparability Problems
• Quality of Earnings
• Realism and sustainability of reported earnings
• Factors that affect quality of earnings
• Allowance for bad debt
• Nonrecurring items
• Earnings smoothing
• Revenue recognition
• Off-balance-sheet assets and liabilities

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 30
 14.6 Comparability Problems
• International Accounting Conventions
• Reserving practices
• Subject to more managerial discretion in U.S.

• Depreciation
• Other countries do not allow dual sets of accounts
• Most firms in foreign countries use accelerated
depreciation
• Intangibles
• Treatment varies wildly from country to country

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 31
 14.6 Comparability Problems

• International Accounting Conventions

• International Financial Reporting Standards
(IFRS)
• Principles-based set of accounting rules adopted by
around 100 countries, including European Union

© McGraw Hill LLC. All rights reserved. No reproduction or further distribution permitted without the prior written consent of McGraw Hill LLC. 32