Financial Statement Analysis - (MODULE 2 FUNDAMENTALS OF FINANCIAL STATEMENT ANALYSIS) PDF

M ODULE 2 FUNDAMENTALS
OF F INANCIAL
STATEMENT
A NALYSIS
Topic A
Purposes of Financial
Statement Analysis
Topic B
Cash Flow Analysis
Copyright © 2003. Dearborn Trade, A Kaplan Professional Company. All rights reserved.
Topic C
Comparisons of Financial
Statements
Topic D
Earnings Per Share
Financial Statement Analysis, edited by Andrew Temte, Dearborn Trade, A Kaplan Professional Company, 2003. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/bibpucp-ebooks/detail.action?docID=3016138.
Created from bibpucp-ebooks on 2019-01-28 17:56:43.
P URPOSES OF F INANCIAL S TATEMENT
A NALYSIS
F INANCIAL STATEMENT ANALYSIS – MODULE 2
TOPIC A
S UMMARY
Financial statement analysis can seem uncertain of where to begin. The
like an overwhelming task. There are so purpose of this course is to relieve that
many different factors and sources of uncertainty and provide clear direction
information to consider that a in how to proceed with financial
beginning analyst cannot help but feel statement analysis.
T HE FINANCIAL STATEMENT ANALYSIS P ROCESS
Before we can discuss where to begin the financial statement analysis process, we
must have a clear understanding of where we are going. Figure 1 is a map for
financial statement analysis. The purpose of the map is to give the analyst a clear
sense of direction in the journey. First, let us focus on our destination or goals of
financial statement analysis.
Figure 1: Map of Financial Statement Analysis
Step 1 Step 2 Step 3 Step 4 Step 5
Goals or Sources of Analytical Financial

Audience
Objectives Information Tools position
Financial
Common-size
statements
Investors Valuation financial Valuation
(annual report
statements
or 10-K)
Ability to pay
Creditors Footnotes Ratio Analysis Liquidity
debt
Management Cash flow

Management Efficiency Profitability
discussion projections
Other
Solvency
industry data
Upon beginning financial statement analysis, the first step for an analyst is to
determine the user of the analysis. As illustrated in Figure 1, the user may be
Page 74 ©2003 Schweser Institute Certificate Program
FINANCIAL S TATEMENT ANALYSIS – M ODULE 2
TOPIC A
management, investors, or creditors. It is key to assess the users upfront, so that

their goals or objectives can be established. Investors are most commonly
interested in the valuation and profitability of a firm, while creditors are
concerned with ability to repay debt, and management is interested in assessing
the overall efficiency of the firm (from operations, to use of assets and debt, to
increasing shareholder value).
As indicated in Figure 1, once the audience and their objectives are determined,
the analyst can move on to the various sources of information available for
analysis. The next step is translating the information into useful analytical tools
such as ratios and cash flow projections. Finally, these analytical tools are used to
assess the financial position of the firm and, ultimately, answer the concern of the
audience.
Next we will elaborate on each step of the financial statement analysis process,
beginning with the goals and objectives of financial statement analysis.
GOALS OR OBJECTIVES OF F INANCIAL STATEMENT A NALYSIS
As discussed, investors, creditors, and company management use financial Note that although
statements with different goals in mind. Figure 2 is an overall summary of the financial statement
users, their primary goals, and the underlying objectives they are seeking to users tend to focus
on a few key
accomplish in order to meet those goals.
objectives, it is
common for items
Figure 2: Users of Financial Statements
that they will review
User of Financial in their analysis to
Primary Goal Objectives overlap. For
Statement Analysis
example, both
Profitability equity investors and
Equity investors Valuation Risk analysis management will be
Growth analysis concerned with

profitability,
Liquidity growth analysis,
Creditors Ability to repay debt
Solvency risk analysis, etc.
Profitability
Management Efficiency Solvency
Operating performance Liquidation refers
to the process of
selling a firm’s
EQUITY I NVESTORS assets for cash. For
instance, a
Equity investors use financial statement analysis to estimate the value of the company in
bankruptcy may be
corporation. These investors can purchase ownership in the corporation through
forced to liquidate
common stock, merger, or acquisition. An investor could also purchase the its assets to pay off
corporation with the intention of liquidating it. its debt.
©2003 Schweser Institute Certificate Program Page 75
FINANCIAL S TATEMENT A NALYSIS – M ODULE 2
TOPIC A
Companies with many outside owners who are not usually involved with business
operations are known as publicly traded corporations. Publicly traded corporations
are required by the Securities and Exchange Commission (SEC) in the U.S. to
disclose information publicly so that all outside creditors and equity holders have
access to the same information.
Moral hazard refers The equity investors of publicly traded firms are subject to moral hazard .
to the concern that Therefore, equity owners of publicly traded corporations are at a disadvantage in
management may gathering information. They must rely on management to provide the necessary
not act in the best
interest of the
information to make decisions. In contrast, majority owners of private firms have
equity owners. access to all information.
The profitability of a firm and their ability to generate a return on their

investment (dividends) are of particular interest to equity investors.
Equity investors may analyze the financial statements themselves; however, they
often rely on analysis by third party researchers. Most brokerage houses employ an
equity research staff. There are also companies whose only business is to provide
research to either institutional or individual investors.
CREDITORS
Creditors are most concerned with the corporation’s ability to repay principal and
interest on debt. Corporate bankers, bondholders, and trade creditors focus on the
cash flow of the organization over the life of the debt.
Credit rating There are third party researchers specializing in credit analysis. The best known of
companies issue these researchers are credit rating companies such as Moody’s and Standard &
ratings such as AAA Poor’s (S&P). Brokerage houses and insurance companies also employ credit
(S&P) or Aaa
analysts.
(Moody’s) to
identify whether a
bond has high Fixed income investors rely on the expertise of credit rating agencies to determine
credit quality or the amount of risk and, therefore, the appropriate required return for their debt
ratings such as BB investments.
(S&P) or Ba2
(Moody’s) to
• Short-term credit ratings indicate the ability of an organization to meet
indicate if a bond’s
credit is more liquidity needs.
speculative. • Long-term bond ratings indicate an organization’s ability to remain solvent
and repay debt over longer periods of time.
The higher the rating, the less uncertainty there is regarding the ability of the
organization to meet future financial obligations.
TOPIC A
MANAGEMENT
Management’s use of financial statements focuses on the overall profitability, Management

efficiency, and direction of the firm. Additionally, the financial statements are makes decisions
prepared for and used to analyze specific segments, product lines, and divisions of such as how the
firm should be
the organization. Management is the primary user of financial statements and
financed (i.e., debt
employs the information to make strategic and operating decisions. Management or equity) and
is the driver of the decisions that will ultimately increase shareholder value. whether to take on
new projects, which
ultimately
I NFORMATION SOURCES FOR F INANCIAL STATEMENT A NALYSIS determines the
value of the firm.
There are three financial statements that are used to analyze a company:
BASIC FINANCIAL STATEMENTS
• The income statement was discussed thoroughly in Module 1, Topic B. It

reflects the corporation’s operating results over a period of time.
• Discussed thoroughly in Module 1, Topic C, the balance sheet provides a
snapshot of the assets, liabilities, and owners’ equity of the corporation at a
point in time.
• The statement of owner’s equity was discussed in Module 1, Topic C. It
summarizes the activity within the equity accounts from the balance sheet.
The balance sheet and income statement reflect valuable information regarding
the operations of the organization. However, the format of the balance sheet and
income statement are not well suited for making comparisons and performing
analysis.
STATEMENT OF CASH F LOWS

A fourth common financial statement, the statement of cash flows, reflects The statement of
information from both the balance sheet and the income statement. Its format is cash flows is the
more suitable for analysis. It summarizes the changes in the firm’s cash account link between a
firm’s income
and shows the cash flow changes from operations, investments, and financing. statement and the
changes between a
• Operating cash flows are those that result from the operations of the business. firm’s beginning
Positive cash flow from operations is essential for every organization’s and end of period
longevity. If an organization is unable to generate positive cash flows from balance sheets.
operations, it will eventually be forced to shut down either voluntarily or
involuntarily through bankruptcy.
• Investing cash flows are those resulting from the purchase or sale of long-term
assets.
TOPIC A
• Financing cash flows are those resulting from increased borrowing, the
reduction of existing debt, the sale or repurchase of equity, and cash dividends
paid by the firm to its shareholders.
The statement of cash flows will be thoroughly discussed in Topic B of this

module.
OTHER I NFORMATION IN ANNUAL REPORTS
The 10-K is an In addition to the three financial statements, an annual 10-K report required for
annual submission publicly traded corporations includes other valuable information regarding the
required for all U.S. operations of the corporation.
public companies
by the SEC. The
10-K includes the • The annual report typically has a section entitled management discussion of
audited financial operations . In this section the analyst is able to gain insights regarding
statements, notes to historical and future operations. In addition to this report, management will
the financial often make new information available to investors and analysts regarding their
statements, and expectations of quarterly revenues, earnings, and major events.
management
discussion among
many other SEC The excerpt from the H.J. Heinz Company 2003 10-K Management
requirements. To Discussion1 shown in Figure 3 provides information on the company’s
access a publicly continuing operations results.
traded company’s
10-K online: Figure 3: Results of Continuing Operations – 2003 vs. 2002
www.sec.gov.
Sales for Fiscal 2003 increased $622.8 million, or 8.2% to $8.24 billion.
Sales were favorably impacted by pricing of 4.2%, foreign exchange
translation rates of 5.6% and acquisitions of 2.2%. The favorable impact of
acquisitions is primarily related to prior year acquisitions in the Heinz
North America and U.S. Frozen segments. The favorable pricing was
realized primarily in certain highly inflationary countries, Europe, Asia/
Pacific. Sales were negatively impacted by unfavorable volumes of 2%, due
mainly to certain highly inflationary countries and the U.S. Frozen

segment, as well as the continued impact of the previously announced SKU
(“Stock Keeping Unit”) rationalization of low-margin products across the
Company. Divestitures reduced sales by 1.8%. Domestic operations
contributed approximately 38% of consolidated sales in Fiscal 2003
compared to 41% in Fiscal 2002.
This discussion of the prior year’s results to the current year provides an
analyst with valuable information that is not included in the financial
statements or its footnotes. Looking at the Heinz example, the information on
foreign exchange translations provides important detail which the analyst may
1 At
Home With Heinz, http://www.heinz.com/jsp/index.jsp, Annual Report, 2003 Annual
Report, http://www.heinz.com/2003annualreport/pdf/heinz03_ar_complete.pdf, page 13.
TOPIC A
factor into Heinz’s future performance, based on whether the analyst thinks
the foreign exchange rates will continue at the same rates, increase, or
decrease.
• Footnotes to the financial statements provide valuable information regarding Reviewing the
the depreciation method, inventory methods, and other key financial footnotes can often
information that is necessary in the analysis. give the analyst
good clues as to the
methodology the
For example, the excerpt from The Washington Post Company’s 2002 Notes company used in
to the Consolidated Financial Statements2 shown in Figure 4 discloses the arriving at the
company’s significant accounting policy for determining their fiscal year. numbers on the
financial
Figure 4: Fiscal Year statements.
Footnotes can be
The Company reports on a 52-53 week fiscal year ending on the Sunday good tools for
nearest December 31. The fiscal years 2002, 2001 and 2000, which ended determining
on December 29, 2002, December 30, 2001, and December 31, 2000, whether the
respectively, included 52 weeks. With the exception of the newspaper financial numbers
publishing operations, subsidiaries of the Company report on a calendar- are of high quality,
year basis. or if they have been
subject to
accounting
• There are other sources of information in addition to the financial statements
manipulation by
and footnotes available to analysts. The internet and other technological management.
advances have greatly enhanced the availability of information. Even small
individual investors now have the ability to gather a great deal of information
at relatively nominal cost.
The goal of the analysis determines what sources of information are desirable.
Internal management is obviously able to gather the most detail for
appropriate analysis. Creditors such as corporate banks are also generally able
to gather more information than outside investors because of the confidential
and on-going relationship between corporate banks and borrowers. Large
institutional investors may also get detailed information directly from

corporate officers. Equity investors, creditors, and management rely on
financial research companies that specialize in gathering and monitoring
information. Figure 5 is a list of some of the more common information
providers:
2 The
Washington Post Company, “Notes to Consolidated Financial Statements,” 2002 Annual
Report, n.d., p. 44.
TOPIC A
Figure 5: Information Sources
Corporation records, the outlook,

Standard & Poor’s stock reports and stock guide, and
standardandpoors.com
Corporation the Ratings Handbook and
industry survey
Moody’s Investor Moody’s Manuals and Moody’s

moodys.com
Service Handbook
Value Line, Inc. The Value Line Investment Survey valueline.com
Zack’s Investment
Earnings forecaster zacks.com
Research Inc.
Dow Jones-Irwin The Financial Analyst’s Handbook N/A
Dun and Bradstreet

Industry Norms and Key Business
Information Services dnb.com
Ratios
(D&B)
Robert Morris
Annual Statement Studies rmahq.org
Associates (RMA)
Bloomberg Securities pricing data bloomberg.com
Legal information, news, and

Lexis-Nexis lexisnexis.com
other public records
The Wall Street Global news and financial

wsj.com
Journal information
The Securities and

Corporate 10-K and 10-Q filings sec.gov
Exchange Commission
The size of the firm often determines the amount of information available.
Corporations that have large amounts of bonds outstanding or are widely held
often have more information available from a large number of analysts.
The organizations listed often have areas of specialization or specific firms that are
more closely followed than others. For instance, Dun and Bradstreet Information
Services and Robert Morris Association provide information on smaller firms as
well as larger firms. The ratios provided by RMA are often used by corporate
banks and bondholders and therefore are uniquely designed for the needs of
creditors. For example, RMA provides return on tangible equity, information
valuable to a creditor but not as useful for an investor. Bloomberg specializes in
providing up-to-the-minute information and gathers a wide variety of specific
information to meet analysts’ unique needs.
Being familiar with all information sources and providers will ensure that the
analyst has the necessary information to adequately address the risks and
conditions of the firm.
TOPIC A
ANALYTICAL TOOLS FOR FINANCIAL STATEMENT ANALYSIS
Analysts will use various tools to properly assess the risks and condition of the Relative data
firm. The tools convert the data into a user-friendly format that will highlight illustrates the
relative historical performance and facilitate industry comparisons. Common-size relationship or
comparison to a
and ratio analysis convert absolute data to relative data. Relative data, in the form
firm’s competitors
of percentages, provides insights to trends and comparisons between industries or industry.
and competitors.
COMMON -S IZE FINANCIAL STATEMENTS
Common-size analysis converts balance sheet and income statement data to relative Common-size
measures. For example when analyzing the balance sheet, each balance sheet item balance sheet items
is divided by the amount of total assets. For the income statement, each income are reflected as a
percentage of
statement item is divided by total sales. The following example illustrates why
assets. Common-
relative measures are necessary for comparison purposes: size income
statements are
Figure 6: Relative Measures
reflected as a
percentage of sales.
Company A Company B
Accounts receivable $125,000 Accounts receivable $250,000
Total assets $1,250,000 Total assets $3,000,000
% of total assets 10% % of total assets 8.3%
Company A and Company B have accounts receivable of $125,000 and $250,000

respectively. However, an analyst cannot conclude that since Company B’s
accounts receivable are greater, B is more liquid. It is necessary to know the Liquidity refers to a
percentage of accounts receivable to total assets. Since Company B is larger company’s ability
($3,000,000 in total assets) than Company A ($1,250,000 in total assets), the to pay its short-
term liabilities or
relative percentage of accounts receivable is actually smaller for Company B at 8.3 the ability to
percent versus Company A at 10 percent. convert assets to
cash.
Analyst implication. Relative measures make it easier to compare a firm
to companies of different sizes, as well as the industry norms. Relative
measures enable an analyst to identify strengths and weaknesses and
track historical trends.
RATIO ANALYSIS
Likewise, financial statements are converted into ratios to make them easier to
analyze. The examination of key ratios provides insights into how a firm is
performing historically and how it is performing relative to competitors and the
industry.
TOPIC A
Trend analysis is a valuable planning tool. Historical financial statements will

Trend analysis
compares ratios of reflect peak and trough periods of operations based on seasonality or some other
the firm across relevant factor. These seasonal factors will help management determine staffing
various time and inventory needs and then allow them to deal with the financing impacts of
periods. those needs.
Trend analysis is also of value to prospective buyers of the company. Potential

buyers may be willing to pay top dollar for a business that shows an upward trend
in operating performance, which indicates an efficiently run business that may be
capable of even better results in the future. Flat trends, however, typically indicate
one of two things: a business that has not been efficiently managed or a business
that is in a mature market. If a business has been inefficiently managed, new
management may be able to increase revenues and profits by making
improvements to the business.
Looking ahead: Ratio analysis will be discussed more thoroughly in Topic C of this
module.
FINDING C OMPARABLE FIRMS
It is useful to It is not necessarily valid to compare common-size financial statements and ratios
compare ratios of for two firms. As the old saying goes it is important to compare “apples to apples
comparable firms. and oranges to oranges.” Analysts generally try to make comparisons based on
However, it is often
similar industries. However, even within the same industry the acceptable norms
difficult to find a
comparable firm. may be different for large and small firms. It is highly unlikely to find two firms
that are exactly alike. Firms often try to find unique niches for competitive
advantages and may or may not be more diversified across different industry
segments.
IMPORTANCE OF CASH FLOW

Accrual basis
accounting refers to The key financial variable that investors care most about is cash flow. It is cash
accounting for that pays creditors and creates value for shareholders. Therefore, a thorough
income and
expenses in the
understanding of historical and projected cash flows is essential for analysis.
period when they
are earned or As discussed in Module 1, accounting statements in the U.S. are prepared
incurred rather according to generally accepted accounting procedures (GAAP). Financial
than when cash is statements are often prepared on an accrual basis as opposed to a cash basis. In
actually received. addition there are various methods that are allowable for accounting for key items
The result of
accrual basis
such as revenue recognition and depreciation. Analysts must often rely on details
accounting is provided in the footnotes and 10-Ks to understand the methods being used by the
financial statements firm. Earnings can sometimes be misleading and analysts are always more
that are more interested in the actual cash flows rather than amounts shown on the bottom line
reflective of the of the income statement.
firm’s operations.
TOPIC A
Looing ahead: The cash flow statement is discussed more thoroughly in Topic B of this
module.
PRO FORMA STATEMENTS
After the analyst has obtained a better understanding of where the firm has been
historically, projections or pro forma financial statements are prepared to provide
a better picture of where the firm is headed. Projections are often based on
relevant parameters that drive the performance of the organization. Common
parameters are key ratios such as accounts receivable turnover, accounts payable
turnover, and inventory turnover. Other important variables often identified in
projections are capital expenditures, depreciation, and growth. Market factors
may also be included (e.g., interest rates and leading economic and industry
indicators).
Management, investors, and creditors often project one to five years into the “Pro forma” refers
future to identify capital needs under various growth and economic scenarios. In to the projection of
addition, creditors and management will use monthly and quarterly pro forma future financial
statements
financial statements to identify liquidity needs during peaks in the business cycle. prepared based on a
Sources of capital can then be obtained (if justifiable) in the form that best meets set of assumptions
the firm’s current and future needs and objectives. regarding future
revenues, expenses,
It is important to note, pro forma statements may or may not use historical costs investments in
to forecast future amounts. At times, pro forma statements do not follow GAAP assets, working
capital, and other
or SEC guidelines. In December 2001, the SEC issued a “cautionary advisory” factors.
that companies and their advisors should consider when releasing "pro forma"
financial information. The SEC stated 3, “We believe it is appropriate to sound a
warning about the presentation of company earnings and operating results on the
basis of methodologies other than Generally Accepted Accounting Principles
(GAAP).”
Additionally, the SEC issued an “Investor Alert” that describes how “pro forma” The “Investor
financials should be analyzed, including a reminder that they should be viewed Alert” on “pro
with appropriate and healthy skepticism. Because “pro forma” financial forma” financials
and the SEC’s
information by its very nature departs from traditional accounting conventions, release on
its use can make it hard for investors to compare an issuer’s financial information cautionary advice
with other reporting periods and with other companies. on the use of “pro
forma” financial
On January 16, 2002, the SEC brought its first pro forma financial reporting case information can be
by charging Trump Hotels 4 with issuing misleading earnings in the company’s accessed on the
SEC’s Website at
third-quarter 1999 earnings release. www.sec.gov.
3 U.S.
Securities & Exchange Commission, “SEC Cautions Companies, Alerts Investors to
Potential Dangers of ‘Pro Forma’ Financials,” December 4, 2001, <http://www.sec.gov/news/
headlines/proforma-fin.htm> (October 2003).
TOPIC A
Looking ahead: Pro forma statements will be discussed more thoroughly in Module 6,
Topic C.
RISKS OR CONDITIONS I DENTIFIED

BY F INANCIAL STATEMENT A NALYSIS
The tools described in the previous section are designed to identify specific risks
and conditions of the firm. Common questions raised by analysts can help focus
the analysis to the appropriate areas that are in line with the overall goal or
objective.
There are some risks or issues that are concerns for all three types of analysts:
managers, investors, and creditors. In addition, there are specific risks and issues
that are raised and focused on more by some analysts than others.
COMMON Q UESTIONS ADDRESSED BY ANALYSTS
• What is the company’s position in the industry in terms of market share and
sales?
• What historical trends are deteriorating or improving?
• What financial ratios provide evidence of strengths or weaknesses relative to
competitors or the industry?
• How much does the firm rely on key customers and suppliers?
• How will changes to customer preferences, tastes, substitute products, or
technology impact the firm?
• What are the probabilities of various states of the economy occurring?
SPECIFIC C ONCERNS OF C REDITORS

• What is the purpose of the loan or debt?

• What is the source of cash for repayment?
Covenants are • What loan or bond covenants should be in place to protect the position of the
terms and creditor?
restrictions in the • What liquidity needs will be present when accounts receivable and inventory
lending agreement
are at their peak levels?
and include
restrictions based • How should the loan be priced, and what fees are reasonable based on the
on management’s amount of risk and required rate of return?
ability to make • If the loan or bond has collateral, what environmental concerns or laws might
financial and impact the value of the collateral?
operating • What is the value of the collateral in liquidation?
decisions that may
be adverse to the
interests of 4 U.S.
Securities & Exchange Commission, “SEC Brings First Pro Forma Financial Reporting
debtholders. Case: Trump Hotels Charged With Issuing Misleading Earnings Release,” January 16, 2002,
<http://www.sec.gov/news/press/2002-6.txt> (October 2003).
TOPIC A
SPECIFIC C ONCERNS OF E QUITY I NVESTORS
• What is the fundamental value of the firm?

• What is a realistic range of growth for the firm?
• What are the key performance factors that drove the historical numbers and
will influence the future performance of the firm?
• What is the required rate of return based on economic, industry, and company
specific risks?
• What factors would adversely affect the value of the firm?
• What factors could potentially increase the value of the firm?
SPECIFIC C ONCERNS OF M ANAGEMENT
• How will management performance be measured and rewarded?

• How are profitability, capital structure, and efficiency related as illustrated by The DuPont
the DuPont equation? equation is a way of
• How should resources be allocated to best meet organizational objectives? breaking down a
firm’s return on
• What strengths or weaknesses are identified based on industry and competitor
equity (ROE) by
comparisons? how ROE is
• What policies should be put in place to reduce risks? impacted by firm
• What changes can be implemented to enhance future performance? profitability, capital
structure, and
efficiency. DuPont
STEPS IN F INANCIAL STATEMENT ANALYSIS analysis will be
discussed in depth
in Topic C of this
With our map (Figure 1) in hand we are ready to proceed on our journey. But module.
before we continue, it would be useful to list the various steps that will provide us
additional direction.
Equity investors typically use what is called a top-down approach or economy,

industry, company (EIC) approach. With the EIC approach, an analyst would
identify:
• The state of the economy.

• The industries that are expected to outperform in that state.
• The companies in that industry that are undervalued relative to other firms in
the industry.
Likewise, key changes in the overall economy will impact all industries and all
companies. Creditors, like equity investors, will base their required returns on
market and industry factors as well as company specific factors.
Management of the firm is concerned not only with the perspectives of investors
and creditors, but they must also focus on allocating resources controlling growth
and managing key areas of the firm to maximize the value of the organization. An
TOPIC A
understanding of the state of the economy and industry is essential for making
wise decisions for the future.
STEPS OF FINANCIAL STATEMENT A NALYSIS
The appropriate steps for financial statement analysis are summarized as follows:
Step 1: Identify the goals and objectives of the analysis.
• Valuation of the firm.

• Ability to repay debt.
• Overall management of the firm.
Step 2: Gather appropriate information for analysis.
Step 3: Use appropriate tools to prepare common-size statements and ratio

analysis to look for historical trends and compare the firm to
competitors and the industry.
Step 4: Identify the risks and conditions of the firm based on evaluations using
the appropriate financial statement analysis tools.
Step 5: Use knowledge of key ratios, trends, industry, and economic data to
prepare pro forma financial statements.
Step 6: Summarize findings based on analysis and make appropriate

recommendations related to the overall objectives.
TOPIC A
CONCEPT CHECKERS
1. The key financial variable that investors care most about is:
A. cash.
B. assets.
C. debt.
D. common equity.
2. Once the appropriate end-user has been defined, the next two steps in the process of financial
statement analysis are:
A. Step 1: Gather appropriate information; and Step 2: Use knowledge of key ratios to prepare
pro forma statements.
B. Step 1: Gather appropriate information; and Step 2: Use appropriate tools to prepare
common-size statements and ratio analysis.
C. Step 1: Identify the goals and objectives of the analysis; and Step 2: Identify relevant risks.
D. Step 1: Identify the goals and objectives of the analysis; and Step 2: Gather appropriate
information.
3. The conflict that exists between investors and the managers of a firm is referred to as:
A. moral hazard.
B. counterparty risk.
C. credit risk.
D. residual cash flow.
4. Which of the following is most critical to maintaining the long-term viability of a firm?
A. Investing cash flows.
B. Financing cash flows.
C. Operating cash flows.
D. Allocation cash flows.
5. Which of the following is TRUE regarding the preparation of common-size financial

statements? Income statement items are expressed as a percentage of:
A. COGS. Balance sheet items are expressed as a percentage of assets.
B. sales. Balance sheet items are expressed as a percentage of assets.
C. COGS. Balance sheet items are expressed as a percentage of liabilities.
D. operating income. Balance sheet items are expressed as a percentage of equity.
TOPIC A
ANSWERS: PURPOSES OF FINANCIAL STATEMENT ANALYSIS
1. A Cash is used to meet debt obligations and create value for shareholders.
2. D The first step in the process of analyzing financial statements is to identify the goals and objectives of the analysis.
Is the analysis going to be used to value the firm? assess the ability of the firm to repay debt? or, assess management’s
overall performance? The second step is to gather the information that is necessary to accomplish the goals and
objectives specified in Step 1.
3. A Moral hazard, which is often referred to in the general area of agency problems, exists because of the sometimes
conflicting goals of managers and investors.
4. C Positive cash flows from operations are necessary to keep a firm from being forced to shut down through voluntary
or involuntary bankruptcy.
5. B Common-size statements express income statement items relative to sales and balance sheet items in terms of assets.
CASH FLOW A NALYSIS
F INANCIAL STATEMENT ANALYSIS – M ODULE 2

TOPIC B
S UMMARY
It is commonly thought that the best company even if those flows do not
way to understand the financial affect net income. Cash flow statements
prospects of a company is to analyze the tell us where cash is generated and what
firm’s income statement. However, the cash is spent on.
cash flow statement is nearly as
important, and in some instances, may The statement of cash flow summarizes
shed more light on the health of the a firm’s cash inflows and cash outflows
company. A company that is producing over a period of time and, ultimately,
income but is not generating cash can shows the net change in the cash
default on its loans. Moreover, the balance from the beginning to the end
existence of large cash outflows can of the period.
significantly detract from the value of a
RELEVANCE OF CASH F LOW A company may

control the
accounting of
While income statement analysis provides an indication about the financial health revenues or
(profitability) of a company, using cash flow analysis along with the income expenses to
statement can provide even more useful information about the firm. smooth earnings
or meet earnings
expectations.
CHOICE OF ACCOUNTING POLICY Earnings
manipulation or
Cash flow is less likely than accounting income to be affected by management’s earnings
choice of accounting policies and estimates. The review of cash flow can help an management will
analyst determine whether changes in net income reflect true economic changes or be thoroughly
discussed in
are caused by earnings manipulation. Module 6,
Topic B.
VALUATION
Understanding the differences between income and cash flow are very important The value of any
when determining the value of a company. The cash flow statement illustrates a company can be
firm’s continual investment in working capital and fixed assets required to operate thought of as the
present value of its
the firm, while the income statement does not. Suppose two companies are future cash flows.
expected to have identical net income, but the first company requires much larger
TOPIC B
continual investments in accounts receivable, inventory, and machinery than the

second. The first company is not as valuable because it produces less cash flow.
Only a cash flow statement, not an income statement, would reveal this
information.
LIQUIDITY
Profitable high Companies can be quite profitable and still have difficulty with liquidity or long-
growth companies term solvency. If the cash required for working capital and fixed-asset investments
may become is continually higher than the income produced by the company, the firm will
insolvent if they
eventually become insolvent. Review of cash flow information can indicate
have trouble
getting external whether a firm has the ability to finance its growth from internal operations.
financing to meet
working capital
and fixed asset TYPES OF CASH FLOWS
requirements.
Items on the cash flow statement come from two sources: (1) income statement
items and (2) changes in balance sheet accounts. The cash flow statement classifies
cash flow into three components: operating, investing, and financing.
OPERATING C ASH FLOW
A potentially Cash flow from operations (CFO), also known as operating cash flow, reports the
confusing item is cash generated from sales and the cash used in the production process. The key
interest expense. elements are:
Intuitively,
interest expense
may appear to be a
• Cash collections from sales.
financing cash • Cash inputs into the manufacturing or retail process.
flow, but under • Cash operating expenses.
SFAS 95, it is • Cash interest expense, interest income, and dividend income.
classified as an • Cash tax payments.

operating cash
flow.
INVESTING C ASH FLOW
Investing cash flow (CFI) reports the cash used for property, plant, and equipment;
investments; acquisitions; and the cash generated from sales of assets or
businesses. Key elements are:
• Purchases of property, plant, and equipment.

• Investments in affiliates.
• Payments for businesses acquired.
• Proceeds from sales of assets.
• Investments (or sales of investments) in marketable securities.
TOPIC B
FINANCING CASH FLOWS
Financing cash flow (CFF) reports capital structure transactions. Key elements are: Note that cash
dividends paid are
• Cash dividends paid. classified as a
financing cash
• Increases or decreases in short-term borrowings.
flow, while cash
• Long-term borrowings and payments of long-term borrowings. dividends received
• Stock sales and repurchases. (from investments
in another firm’s
A cash flow statement is shown in Figure 1. Become familiar with the cash flow stock) is classified
components and classifications. as cash flow from
operations.
Figure 1: Statement of Cash Flows
Year ended December 31 2002 2001
As we will discuss
Operating activities later in this topic,
Net income $1,625 2,175 depreciation is a
Depreciation 700 625 non-cash expense
Deferred income tax 40 10 that is added back
Gains on sales of assets (65) 0 to net income to
Other operating charges 35 40 determine CFO.
Net cash provided by operating activities 2,335 2,850
Investing activities
Purchases of property, plant & equipment (1,250) (1,355)
Proceeds disposals of property, plant & equipment 75 155
Purchases of investments and other assets (600) (415)
Net cash used in investing activities (1,775) (1,615)
Financing activities
Issuances of debt 1,250 500
Repayments of debt (435) (295)

Dividends (900) (675)
Net cash used in financing activities (85) (470)
Cash and cash equivalents

Net increase (decrease) during the year 475 765
Balance at the beginning of the year 1,059 294
Balance at the end of year $1,534 1,059
CLASSIFICATION OF C ASH FLOWS
In most cases, the classification of cash flows is straightforward. Items that affect
cash flow are either an income statement account or a change in a balance sheet
account.
TOPIC B
Note that a positive cash flow (source) is generated by:
• A decrease in an asset account.

• An increase in a liability or equity account.
A negative cash flow (use) is generated by:
• An increase in an asset account.

• A decrease in a liability or equity account.
For example, when a firm receives a cash payment (source) for an accounts
receivable (an asset) the accounts receivable balance decreases . This decrease in
accounts receivable is reflected as an increase to cash flows.
OPERATING C ASH FLOWS
All items affecting a firm’s typical operations are reflected as an operating cash
flow. For instance, changes in asset or liability accounts that are a result of the
sales or production process are classified as operating cash flows. Examples of
items that are classified as operating cash flows include changes in:
• Receivables.
• Inventories.
• Prepaid expenses.
• Accounts, taxes, interest, and miscellaneous payables.
• Deferred taxes.
INVESTING C ASH FLOWS
Cash outflows to Transactions related to a capital investment in the firm are classified as investing
invest in property, cash flows. Specifically, changes in asset accounts, typically long-term assets (and
plant, and potentially corresponding liability accounts). Examples of items that are classified
equipment, or
as investing cash flows include changes in:
cash inflows from
sales of fixed assets
are examples of • Most fixed asset accounts.
two of the more • Marketable securities.
common investing
cash flows. FINANCING C ASH FLOWS
Transactions relating to payment or purchase of debt necessary as part of the

company’s capital structure are classified as financing cash flows. An example of
financing cash flow is changes in equity accounts, including dividends paid to
shareholders, and changes in liabilities. Examples of items that are classified as
financing cash flows include:
TOPIC B
• Dividends paid to the company’s shareholders.

• Changes in liability accounts that represent financing.
• Changes in equity accounts.
• Investment in affiliates.
Some investing and financing activities do not flow through the statement of cash
flows because they do not require the use of cash. Examples include:
• Retiring debt securities by issuing equity securities to the lender.

• Converting preferred stock to common stock.
• Acquiring assets through a capital lease. We will discuss
capital leases in
• Obtaining long-term assets by issuing notes payable to the seller. depth in Module
• Exchanging one noncash asset for another noncash asset. 4, Topic C.
• The purchase of noncash assets by issuing equity or debt securities.
While these activities do not flow through the statement of cash flows, they Be careful not to
should be disclosed in either footnotes or on a separate schedule as investing or double count
financing events that did not affect cash. income or
increases in
retained earnings.
Example: Cash Flow Classification If the inputs of
cash income, such
Given the following information, calculate the company’s cash flow from as collections from
operations, investing cash flow and financing cash flow. sales and
payments to
Sale of land $ 20,000 suppliers, are
Collections from customers 70,000 included as cash
Payment of interest 1,000 flow, then net
Net income 62,000 income should not
Cash payment of dividends 6,000 be added into cash
Cash received from issue of long-term debt 40,000 flow. Likewise, if
Payment of wages 10,000 dividends are
included as cash
Purchase of equipment 90,000

Payment to suppliers $ 5,000 flow, then the
change in retained
earnings should
Note: Net income is not included as a cash flow because the components of cash net not be included as
income are already included. a cash flow. We
will take a closer
look at this issue
in the discussion
on the direct and
indirect methods.
TOPIC B
Answer:
Operating Cash Flow
Source or use of Collections from customers (Source) $ 70,000

cash is noted next Less:
to each activity. Payment to suppliers (Use) (5,000)
Sources are always Payment of wages (Use) (10,000)
inflows of cash Payment of interest (Use) (1,000)
(positives) and Equals operating cash flow 54,000
uses are always
outflows of cash Investing cash flow
(negatives). Sale of land (Source) 20,000
Less: purchase of equipment (Use) (90,000)
Equals investing cash flow (70,000)
Financing cash flow

Cash received from issue of long-term debt (Source) 40,000
Less: cash payment of dividends (Use) (6,000)
Equals financing cash flow $ 34,000
STATEMENT OF CASH FLOWS
The statement of cash flow can be presented two ways—using the direct method or
indirect method . The direct method presents more information (and requires more
information to prepare) and is better for analysis. The final result is the same for
both methods. While the Financial Accounting Standards Board (FASB)
encourages firms to use the direct method, most firms use the indirect method for
financial reporting.
DIRECT M ETHOD
The direct method calculates cash flows based on the income statement’s income
and expenses and is adjusted for the balance sheet’s noncash (accruals) items.
Unlike the indirect method, the direct method does not require beginning
account balances to calculate cash flows. The direct method presents major classes
of cash flows as cash receipt and cash payments. The major classes1 are:
• Cash received from customers.

• Interest and dividends received.
• Other operating cash receipts.
• Cash paid to employees and suppliers.
1 Financial
Accounting Standards Board, “Statement of Financial Accounting Standards No.
95: Statement of Cash Flows,” November 1987, <http://www.fasb.org/pdf/fas95.pdf> (October
2003), p. 10.
TOPIC B
• Interest paid.
• Income taxes paid.
• Other operating payments.
Operating cash flow. To present operating cash flow using the direct method, it is
best to think of what the income statement would look like on a purely cash basis.
Let’s start with a simple example.
• In January, a ticket brokerage company begins the year with a cash investment
of $5,000.
• The company plans to purchase tickets one month before an event and sell
them the day of the event at three times the purchase price.
• Half of its sales are credit sales and are collected the month after the event.
• In January the company buys $1,000 worth of tickets. February and March
ticket purchases are $2,000 and $3,000 respectively.
• February and March sales are $3,000 and $6,000 respectively.
• Collections in February are $1,500 (half of February’s sales) and collections in
March are $4,500 (half of February’s sales and half of March’s sales).
• Note that the company uses $1,000 of cash to purchase tickets in January, and
$500 of cash over and above the $1,500 of collections in February to purchase
the $2,000 of tickets in February.
• In March, the company receives $1,500 of net cash as it collects $4,500 and
purchases only $3,000.
Since no sales occurred in January, the accrual method would not recognize any
revenue or expense in January. The income statement and balance sheet accounts
for this example are presented in Figure 2 and Figure 3, respectively:
Figure 2: Income Statement
February March
Sales $3,000 6,000

Cost of goods sold 1,000 2,000 The matching
Net income $2,000 4,000 principle causes a
one-month lag in
the COGS.
Figure 3: Balance Sheet
January February March
Cash $4,000 3,500 5,000

Receivables 1,500 3,000
Inventories 1,000 2,000 3,000
Total assets 5,000 7,000 11,000
Common stock 5,000 5,000 5,000

Retained earnings 2,000 6,000
Total equity $5,000 7,000 11,000
TOPIC B
Cash was calculated by:
change in cash = opening balance − purchase of tickets + receipt of cash from sales
January decrease in cash = $5,000 − $1,000 = $4,000
February decrease in cash = $4,000 − $2,000 + $1,500 = $3,500
March increase in cash = $3,500 − $3,000 + $4,500 = $5,000
Receivables were calculated by:
increase in receivables = sales − cash collections from sales
February increase in receivables = $3,000 − $1,500 = $1,500
March increase in receivables = $6,000 − $4,500 = $1,500
Inventories were calculated by:
increase in inventories = cash purchases − cost of goods sold
January increase in inventories = $1,000 − 0 = $1,000
February increase in inventories = $2,000 − $1,000 = $1,000
March increase in inventories = $3,000 − $2,000 = $1,000

The direct method presents operating cash flow by taking each income statement
item and converting it to its cash equivalent by adding or subtracting the changes
in the corresponding balance sheet accounts.
Suppose in our example, we only had the balance sheet and income statement
accounts shown in Figure 2 and Figure 3. We would need to convert sales and cost
of goods sold to their cash equivalents. This can be done by reversing the
equations for the receivables and inventories.
TOPIC B
For cash collections from sales:
increase in receivables = sales − cash collections from sales
cash collections from sales = sales − increase in receivables
February cash collections from sales = $3,000 − $1,500 = $1,500
March cash collections from sales = $6,000 − $1,500 = $4,500
For inventories:
increase in inventories = cash purchases − cost of goods sold
cash purchases = increase in inventories + cost of goods sold
January cash purchases = $1,000 + 0 = $1,000
February cash purchases = $1,000 + $1,000 = $2,000
March cash purchases = $1,000 + $2,000 = $3,000
So for our simple example, the cash flow statement is presented in Figure 4:
Figure 4: Cash Flow Statement
For 3 months ended March
Cash collections from sales $ 6,000
Cash payments for inventory $ 6,000

Net change in cash $ 0
January Beginning March End Net Change in Cash

Cash balance $5,000 $5,000 $0
GENERAL P RESENTATION OF O PERATING CASH FLOW The footnotes to

financial
statements are
As discussed earlier, the direct method presents operating cash flow by converting often helpful in
income statement items to their cash equivalent by adding or subtracting the learning how
changes in the corresponding balance sheet accounts. inflows and
outflows have
The following are some common examples of operating cash flow components: affected the
balance sheet
accounts.
• Cash collections from sales = sales – increases in accounts receivable (use).
TOPIC B
• Cash inputs = cost of goods sold + increases in inventory (use) – increases in

accounts payable (source) and other liabilities for inputs.
• Cash operating expenses = operating expenses – increases in operating
liabilities (source).
• Cash interest = interest expense ± changes in accrued interest.
• Cash taxes = tax expense – increase in taxes payable (source) – increase in
deferred taxes.
Investing cash flows are calculated by finding the changes in the appropriate gross
fixed asset account. Changes in noncash fixed assets (e.g., accumulated
depreciation and goodwill) are not included since they do not represent a cash
transaction. Any gains or losses from the disposal of an asset must also be reflected
in cash flow:
cash from asset disposal = decrease in asset (source) + gain from sale
Financing cash flows are calculated by finding the changes in the appropriate
liability or equity account and subtracting cash dividends, which are:
cash dividends = dividends – increase in dividends payable (source)
CFO + CFI + CFF Finally, total cash flow, or the change in cash balance, is equal to:
should equal the
change in cash cash flow from operations
balance from one
+ cash flow from investments
balance sheet
period to the next. + cash flow from financing
If prepared correctly, total cash flow will equal the change in the cash balance
from the beginning-of-period balance sheet to the end-of-period balance sheet.
Example: Direct Method

Prepare a statement of cash flow using the direct method for a company with
the income statement and balance sheet presented in Figure 5 and Figure 6,
respectively:
TOPIC B
Figure 5: Income Statement

Remember,
2002 increases in assets
Sales revenue $ 100,000 and decreases in
Expenses liabilities
Cost of goods sold 40,000 represent negative
Wages 5,000 cash flows, which
Depreciation 7,000 means that they
Interest 500 will decrease cash
Total expenses 52,500 inflows (e.g.,
collections from
Income from continuing operations 47,500 sales) and increase
Gain from sale of land 10,000 cash outflows
Pretax income 57,500 (e.g., cash
Provision for taxes 20,000 operating
Net income 37,500 expenses).
Likewise,
Common dividends declared $ 8,500 decreases in assets
and increases in
liabilities will
Figure 6: Balance Sheet cause higher cash
2002 2001 inflows and lower
cash outflows.
Assets
Current assets
Cash $33,000 9,000
Accounts receivable 10,000 9,000
Inventory 5,000 7,000
Noncurrent assets
Land 35,000 40,000
Gross plant and equipment 85,000 60,000
less: Accumulated depreciation (15,000) (9,000)
Net plant and equipment 70,000 51,000
Goodwill 9,000 10,000
Total assets $162,000 126,000
Liabilities and Stockholders’ Equity

Current liabilities
Accounts payable $9,000 5,000
Wages payable 4,500 8,000
Interest payable 3,500 3,000
Taxes payable 5,000 4,000
Dividends payable 6,000 1,000
Noncurrent liabilities
Bonds 15,000 10,000
Deferred taxes 20,000 15,000
Stockholders' equity
Common Stock 40,000 50,000
Retained Earnings 59,000 30,000
Total liabilities and stockholders' equity $162,000 126,000
TOPIC B
Answer:
The direct method Cash from operations:

starts with sales
(cash collections)
and works forward cash collections = sales − increase in receivables
through the
income statement = $100,000 − $1,000 = $99,000
to calculate CFO.
cash inputs = COGS + increase in inventory − increase in accounts payable
= $40,000 + ( −$2,000 ) − $4,000 = $34,000
cash expenses = wages − increase in wages payable
= $5,000 − ( −$3,500 ) = $8,500
cash interest = interest expense − increase in interest payable
= $500 − $500 = $0
cash taxes = tax expense − increase in taxes payable − increase in deferred taxes
= $20,000 − $1,000 − $5,000 = $14,000
Cash collections $99,000

Less:
cash inputs 34,000
cash expenses 8,500

cash interest 0
cash taxes 14,000
Cash flow from operations $42,500
Investing cash flow:
cash from sale of land = decrease in asset + gain on sale
= $5,000 + $10,000 = $15,000
increase in gross plant and equipment = $85,000 − $60,000 = $25,000
TOPIC B
Cash from sale of land $ 15,000

Less: purchase of plant and equip 25,000 If the dividend
Cash flow from investments $ (10,000) declared/paid
amount is not
provided, you can
Financing cash flow: calculate the
amount as follows:
increase in bonds = $15,000 − $10,000 = $5,000 Dividends
declared =
beginning
increase in common stock = $40,000 − $50,000 = −$10,000 retained earnings
+ net income –
ending retained
cash dividends = dividends − increase in dividends payable earnings. Here,
8,500 = 30,000 +
37,500 – 59,000.
= $8,500 − $5,000 = $3,500
Sale of bonds $ 5,000

Less: repurchase of stock 10,000
Less: Cash dividends 3,500
Cash flow from financing $ (8,500)
Total cash flow: Note that the total

cash flow of
Cash flow from operations $ 42,500 $24,000 is equal
Cash flow from investments (10,000) to the increase in
Cash flow from financing (8,500) the cash account
Total cash flow $ 24,000 from 2001 to
2002 ($33,000 –
$9,000).
INDIRECT METHOD
The indirect method calculates cash flow from operations by reconciling net The indirect
income to the changes in the operating account balances between the beginning of method starts with
the year and the end of the year. net income and
works backwards
through the
The three components of cash flow using the indirect method have the same income statement
values as those computed using the direct method. The only difference between to calculate CFO.
the two techniques is that CFO is calculated in a different manner, using four
steps:
CFO using the
direct method will
Step 1: Begin with net income. always equal CFO
using the indirect
Step 2: Subtract gains or add losses that result from financing or investment method.
cash flows (such as gains from the sale of land).
Step 3: Add back all noncash charges (such as depreciation) and subtract
noncash additions to income.
TOPIC B
Step 4: For asset and liability balance sheet accounts that result from
The use of the
direct and indirect
operations, add increases in liability accounts, and subtract increases in
methods only asset accounts.
applies to the
calculation of Cash flow from investments and cash flow from financing are calculated the same
CFO. The way as when using the direct method. As was true for the direct method, total cash
calculation for flow is equal to the sum of CFO, CFI, and CFF. If done correctly, the total cash
CFI and CFF is
the same no
flow will be equal to the increase in the cash balance over the period.
matter which
method is used. Example: Indirect Method
Calculate CFO using company data from Figure 5 and Figure 6, using the
indirect method.
Answer:
Step 1: Start with net income of $37,500.
Step 2: Subtract gain from sale of land of $10,000.
Step 3: Add back noncash charges of depreciation of $6,000 and goodwill

of $1,000.
Step 4: Subtract increases in receivables and inventories and add increases

in payables and deferred taxes.
Net income $ 37,500

Note: Investing Subtract gain from sale of land (10,000)
cash flow Add depreciation 6,000
(–$10,000), Add goodwill 1,000
financing cash Subtotal 34,500
flow (–$8,500),
and total cash flow Changes in operating accounts:
($24,000) are Subtract increase in receivables (1,000)
calculated the Add decrease in inventories 2,000
same way as in the Add increase in accounts payable 4,000
direct method. Subtract decrease in wages payable (3,500)
Add increase in interest payable 500
Add increase in taxes payable 1,000
Add increase in deferred taxes 5,000
Cash flow from operations $ 42,500
INTERPRETATION OF C ASH FLOWS
Operating cash flow tells an analyst how much cash is generated by the sales
activity of the company. It is the most important component of cash flow analysis.
TOPIC B
• The cash flow statement can indicate problems with liquidity and solvency.
Negative operating cash flows indicate that the company will have to rely on
external sources of financing to fund operations. This might be expected from
a company experiencing high growth, but would indicate a problem for a
stable, mature company.
• Trends in cash flows can be extrapolated to estimate how the company will be
performing over the next few years. Trend analysis is particularly useful when
compared to the trend of income over time. Discrepancies between the trends
in income and cash flow can suggest that earnings trends are not reliable.
• Interrelationships between cash flow components (e.g., cash inputs and cash
collections) can give insight similar to ratio analysis with income statement
figures.
• Positive cash flows are desired, particularly with respect to operating cash flow.
Analysts should, however, view a company’s continual reliance on investing
and financing activities to generate positive cash flows as a red flag.
Analyst implication. Keep in mind, while cash flows show whether a

firm is generating a positive or negative cash flow, when analyzed
alone, an analyst cannot make judgments on the firm’s ability to
continue and be profitable. The cash flow statement must be reviewed
in combination with the balance sheet and income statement.
F REE CASH F LOW
Free cash flow is a calculation analysts often use to predict future cash flows. Since Free cash flow is
net income is subject to varying accounting methods, free cash flow is less the amount of
subjective and more useful when analyzing a firm. Free cash flow attempts to cash left over after
a firm has paid all
measure the cash available for discretionary purposes. The result is the firm’s cash
of the necessary
available for creditors and owners. expenses to
maintain the
Formally, it should be the operating cash flow minus those cash flows necessary to firm’s current
maintain the firm’s productive capacity. The analyst must use discretion in productive
determining which capital expenditures are necessary to maintain capacity. If the capacity. In other
words, all the bills
analyst has no additional information available to make such a determination,
are paid, so the
then it might be prudent to assume all capital expenditures are necessary to cash is “free” to be
maintain capacity. In that case, free cash flow is measured by: used for other
purposes.
free cash flow = operating cash flow – net capital expenditures
When used for valuation purposes, some adjustments to free cash flow must be
made. If the analyst is interested in free cash flow to all investors, after-tax interest
expense must be added back (I × [1 – t]). If the analyst is interested in free cash
flow to shareholders, debt repayments may be subtracted.
TOPIC B
Example: Free Cash Flow

The amount of
free cash flow
produced by a firm Continuing with our previous example, compute free cash flow for our sample
is an indicator for company. Assume a 35 percent tax rate and that the company’s purchase of
the analyst how equipment is necessary to maintain current production capacity.
well a firm can
maintain or Answer:
expand its
productive
capacity and also
The only necessary capital expenditure is the equipment purchase of $25,000.
how much We assume that the land can still be sold for $10,000 without disrupting the
flexibility a firm operations. Hence:
has to pay down
debt or repurchase free cash flow = operating cash flow – necessary capital expenditures
shares of stock.
= $42,500 – $25,000 = $17,500
To compute free cash flow to all investors (free cash flow to the firm), add
back the after-tax interest expense of $500(1 – 0.35) = $325. Hence, free cash
flow to all investors is $17,825.
TOPIC B
CONCEPT CHECKERS
Use the following data to answer Questions 1 and 2.
Hardy’s Inc. recently acquired land and a building for $275,000 from Lee’s Properties. The transaction
was structured so that Hardy’s made a direct $150,000 cash payment to Lee and then Hardy’s assumed
Lee’s existing $125,000 mortgage on the land and building.
1. In the Hardy’s cash flow statement, which amount should be included as investing cash flow?
A. $0.
B. $125,000.
C. $150,000.
D. $275,000.
2. In the Hardy’s cash flow statement, which amount should be included as financing cash flow?
A. $0.
B. $125,000.
C. $150,000.
D. $275,000.
3. In a statement of cash flows using the indirect method, which of the following is the
CORRECT way to treat a loss from the sale of property, plant, and equipment? It should be
recognized in the:
A. operating cash flows section as a deduction from net income.
B. operating cash flows section as an addition to net income.
C. investing cash flows section as a cash outflow.
D. financing cash flows section as a cash inflow.
4. In a statement of cash flows using the direct method, which of the following is the CORRECT
way to treat a decrease in income taxes payable during the year? The cash payments for income
taxes is income tax expense:

A. minus income taxes payable at the beginning of the year.
B. minus the decrease in income taxes payable during the year.
C. plus income taxes payable at the beginning of the year.
D. plus the decrease in income taxes payable during the year.
TOPIC B
5. An analyst has gathered the following information about a company for the year ended,
December 31, 2003.
Net income $ 45,250

Loss from sale of land $ 12,000
Increase in inventories $ 11,525
Depreciation $ 5,000
Capital expenditures to maintain capacity $ 22,000
Capital expenditures to expand capacity $ 7,000
Tax rate 40%
Principal amount of note payable $ 75,000
The note payable has been outstanding since March 31, 2003, and it bears interest at a rate of 6
percent annually (assume simple interest).
Which of the following amounts is closest to the company’s free cash flow to all investors?
A. $19,700.
B. $23,750.
C. $26,700.
D. $30,750.
6. Which of the following statements about cash flows and cash flow statements is FALSE?
A. Cash flow is more likely than net income to be affected by management’s choice of
accounting policies and estimates.
B. Cash flow can be used for liquidity analysis to determine if a firm has the ability to finance
its growth from internal operations.
C. Even profitable firms may experience large negative cash flows. Such firms might become
insolvent despite their positive incomes.
D. The cash flow statement is best used in conjunction with the firm’s income statement rather
than the balance sheet, to understand the future financial prospects of the firm.
7. Which of the following items would be classified as a financing cash flow?

A. Cash interest received.
B. Cash interest paid.
C. Cash dividends received.
D. Cash dividends paid.
TOPIC B
ANSWERS: CASH FLOW ANALYSIS
1. C Cash payments to acquire property, plant, and equipment are classified as investing cash flows.
2. A The assumption of the vendor’s mortgage does not involve any flow of cash and thus, is considered a non cash
financing activity.
3. B The total proceeds from the sale of property, plant, and equipment is reported as a cash inflow in the investing cash
flows section. That amount includes the loss. So, to avoid double counting, the loss is added back to net income to
“balance” the amounts (i.e., the loss included in investing cash flows is “offset” by an entry to the operating cash
flows).
4. D Cash paid = income tax expense plus decrease in income taxes payable, or
Cash paid = income tax expense minus increase in income taxes payable
5. D Net income $45,250

Add: loss on sale of land 12,000
Deduct: increase in inventory (11,525)
Add: depreciation 5,000
Operating cash flows $50,725
Necessary capital expenditures $22,000
Note: The capital expenditures for expansion would not reasonably be considered necessary to maintain capacity.
After-tax interest expense = ($75,000 × 9/12 × 6%)(1 – 0.40) = $2,025
Operating cash flow $50,725

Deduct: necessary capital expenditures (22,000)
Add: after-tax interest expense 2,025
Free cash flow to all investors $30,750
6. A Cash flow is less likely than accounting income to be affected by management’s choice of accounting policies and
estimates. Unlike accounting income, where it has been relatively easy to alter the true economic changes in a firm
through earnings manipulation (i.e, Enron and WorldCom), it is difficult to do the same with cash flow.
All of the other statements are true. The income statement is generally a better predictor of future financial
performance than the balance sheet. This is because the balance sheet amounts represent “static” figures at one
given point in time, which makes it difficult to use them to accurately predict future performance. On the other
hand, the income statement amounts represent “flows” over a period of time, which makes it easier to use the
figures to predict future performance.
7. D Cash dividends paid are included in financing cash flow. All of the other items are included in operating cash flow.
C OMPARISONS OF FINANCIAL
S TATEMENTS
TOPIC C
S UMMARY
Financial statement analysis regularly Financial ratios can be viewed as
relies on financial ratios to assess a equalizers, allowing for relative
firm’s financial position. These ratios comparisons to be made. For instance,
are calculated from a company’s income via ratio analysis, current year ratios
statement and balance sheet. Financial can be compared with the ratios from
ratios are one of an analyst’s most previous years to assess trends in the
powerful tools—converting financial performance of the company. Financial
statement information into a form that ratios can also be compared to those of
is easier to analyze. As introduced in other firms as well as the overall
Topic A of this module, the industry and economy-wide averages to
examination of financial ratios provides assess the relative performance of a
insights into how a firm has performed company. These comparisons are
historically and how it is performing critical for analysts who are evaluating a
relative to its competitors and its company’s common stock or credit
industry. worthiness.
C ALCULATION AND I NTERPRETATION OF FINANCIAL RATIOS

Using ratios to
compare a firm’s Financial statement analysis is a key element in security analysis and valuation.
current Analysts review a company’s financial statements to gain insight into the firm’s
performance to its financial decision-making and operating performance. Financial data is converted
past performance into ratios in order to make the data easier to analyze. The examination of key
is called time
series analysis.
ratios provides insight into how a firm is performing relative to past years and how
Using ratios to it is performing relative to other companies in its industry and the overall
compare a firm’s economy. Although there are literally thousands of ratios that can be computed,
performance to there is a relatively small subset on which an analyst needs to focus.
similar firms in
the industry is Ratios can be used to evaluate four different facets of a company’s performance
called cross-
sectional analysis.
and condition: internal liquidity, financial risk, operating performance, and
Both of these will growth.
be discussed in
more depth later
in this topic.
TOPIC C
INTERNAL LIQUIDITY
Liquidity ratios indicate the ability of the company to pay its short-term
liabilities. The current ratio is the best-known measure of liquidity:
current assets
current ratio =
current liabilities
The higher the current ratio, the more likely it is that the company will be able to Net working
pay its short-term bills. A current ratio of less than one means that the company capital equals
has negative net working capital and is facing a liquidity crisis. current assets
minus current
liabilities.
The quick ratio is a more stringent measure of liquidity because it does not include
inventories and other assets that might not be very liquid.
In cases of highly
( cash + marketable securities + receivables )
specialized
quick ratio = inventory, there
current liabilities may be few
alternative uses
and the inventory
The higher the quick ratio, the more likely it is that the company will be able to can only be sold
pay its short-term bills. for scrap if not
used in the
The most conservative liquidity measure is the cash ratio: business’s normal
course of
operations.
( cash + marketable securities )
cash ratio =
current liabilities
Like the other liquidity measures, the higher the cash ratio, the more probable it is The cash ratio
that the company will pay its short-term bills. only assumes that
highly liquid
assets (cash and
The current, quick, and cash ratios differ only in the assumed liquidity of the
highly liquid
current assets that the analyst projects will be used to pay off current liabilities. investments) are
available to meet
A measure of accounts receivable liquidity is the receivables turnover: current
obligations.
net annual sales
receivables turnover =
average receivables
Note: In most cases, when a ratio compares a balance sheet account (such as
receivables) with an income or cash flow item (such as sales), the balance sheet item to
be used will be the average of the account instead of simply the end-of-year balance.
Averages are calculated as follows:
TOPIC C
( balance at beginning of year + balance at end of year )

average balance =
2
Since receivables turnover measures the number of times, on average, receivables

are collected during the year; it is desirable to see a steady or increasing trend from
year to year. Additionally, it is typically desirable to have a receivables turnover
figure close to the industry norm.
The average collection period is the average number of days it takes for the
company’s customers to pay their bills:
365
average collection period =
receivables turnover
If the average A steady or declining average collection period is attractive when comparing a
collection period firm from year to year because this indicates that the firm’s collection efforts are
is too short, the not deteriorating. Again, it is usually desirable to have a collection period (and
firm could be
losing customers
receivables turnover) close to the industry norm. A collection period that is too
to competitors high might mean that customers are too slow in paying their bills, which means
with more lenient too much capital is tied up in assets. A collection period that is too low might
collection policies. indicate that the firm has a credit policy that is too stringent, which might be
hampering sales.
A measure of a firm’s efficiency with respect to its processing and inventory

management is the inventory turnover:
cost of goods sold

inventory turnover =
average inventory
Note: Cost of goods sold (COGS) is used to calculate inventory turnover instead of sales
because, like inventory, it is valued at cost; consequently, it gives the ratio more
economic meaning.
The inverse of the inventory turnover times 365 is the average inventory processing
period:
365
average inventory processing period =
inventory turnover
As is the case with accounts receivable, it is considered desirable to have an

inventory processing period (and inventory turnover) close to the industry norm.
A processing period that is too high might mean that too much capital is tied up
TOPIC C
in inventory and could mean that the inventory is obsolete. A processing period
that is too low might indicate that the firm has inadequate stock on hand, which
could adversely impact sales.
A measure of the use of trade credit by the firm is the payables turnover ratio:
COGS
payables turnover ratio =
average payables
The inverse of the payables turnover ratio multiplied by 365 is the average
payment period, which is the average amount of time it takes the company to pay
its bills:
365
average payment period =
payables turnover ratio
Again, industry averages are a useful benchmark for determining an appropriate Most firms want
average payment period. If a firm has a below-average payment period it may be to take as long as
able to slow payments and improve its cash conversion rate and working capital possible to pay
bills, but delaying
requirements. If a firm is well above the industry average it may indicate liquidity
too long may
problems for the firm. cause ill will or
loss of trade
The cash conversion cycle is the length of time it takes to turn the firm’s investment credit.
into cash. In other words, it is the number of days a firm’s cash is tied up in the
business in accounts such as inventory. The cash conversion cycle is computed
from days of receivables, days of inventory, and the payables payment period.
cash conversion cycle = average collection period + average inventory processing period
− average payment period
If the cash conversion cycle shortens, cash is freed up for other uses in the firm. If
the cycle lengthens, the firm’s cash is used. High cash conversion cycles are
considered undesirable. A conversion cycle that is too high implies that the
company has an excessive amount of capital investment in the sales process.
FINANCIAL R ISK
Financial risk is the volatility of equity returns caused by the firm’s use of debt.
Financial risk can be measured using balance sheet ratios, earnings, and cash flow
ratios. While financial risk may be measured by financial ratios, operating risk
cannot. The only way to analyze operating risk is to perform a statistical analysis
of a time series of financial statement items or ratios.
TOPIC C
A measure of the firm’s use of fixed-cost financing sources is the debt-to-equity

ratio:
long-term debt
debt-equity ratio =
total equity
Some analysts exclude preferred stock and use only owners’ equity. Increases and
decreases in this ratio suggest a greater or lesser reliance on debt as a source of
financing.
Should deferred Note: For all ratios in which debt is part of the equation, the analyst has a choice of
taxes be whether to include deferred taxes as part of debt. Deferred taxes that are expected to be
considered debt or paid in the future (i.e., reverse), such as deferred taxes resulting from income
equity?
recognition on long-term contracts, should be included as long-term debt. If deferred
taxes are mainly a result of accelerated and straight line depreciation differences, the
amount will likely not reverse and should not be included as part of long-term debt.
Another way of looking at the usage of debt is the long-term-debt-to-total-capital

ratio:
long-term debt
long-term debt-to-total-capital ratio =
total long-term capital
Total long-term capital equals all long-term debt plus preferred stock and equity.
Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a
source of financing.
A slightly different way of analyzing debt utilization is the debt ratio, which
includes current liabilities in both the numerator and the denominator.
total debt
debt ratio =
total capital
Total capital Total capital in this case means total debt plus total equity. However, as discussed
equals total debt earlier, it may or may not include deferred taxes. Increases and decreases in this
plus total equity. ratio suggest a greater or lesser reliance on debt as a source of financing.
Because of the
accounting
identity, assets =
There is an apparent multitude of definitions for “total capital.” In our discussion
liabilities + equity, of the return on total capital, we said that total capital equaled total assets. This
total capital is also statement is particularly true for companies that employ a significant amount of
equal to total short-term liabilities in their capital structure. We could have just as easily
assets.
TOPIC C
analyzed the return on long-term capital, which would define total long-term
capital as long-term debt plus equity (both preferred and common).
The remainder of the risk ratios analyze the firm’s ability to repay its debt
obligations. The first of these is the interest coverage ratio:
earnings before interest and taxes

interest coverage =
interest expense
The lower this ratio, the more likely it is that the firm will have difficulty meeting
its debt payments.
A variation of the coverage ratio is to use cash flow instead of income in the
numerator. The cash flow coverage ratio is:
( net income + depreciation + increase in deferred taxes )

cash flow coverage =
interest expense
Again, the lower this ratio, the more likely it is that the firm will have difficulty The traditional
meeting its fixed obligations. Alternatively, instead of using traditional cash flow, measure of cash
an analyst might want to use cash flow from operations or free cash flow. flow takes net
income and adds
back non-cash
Looking back: Free cash flow = operating cash flow – net capital expenditures.
expenses. It is
equal to net
Another variation on the interest coverage ratio is to recognize that firms that use income +
leased facilities are in essence borrowing the capital to utilize those facilities. depreciation + the
These lease payments are accounted for in the fixed financial cost ratio: increase in
deferred taxes.
EBIT + ELIE
fixed financial cost ratio =

gross interest expense + ELIE
where:
EBIT = earnings before interest and taxes
ELIE = estimated lease interest expense (portion of current annual lease payments)
This ratio is interpreted in the same manner as the earlier version. Higher
coverage ratios suggest the firm is better able to manage its current debt levels or
that the firm has unused borrowing capacity.
A different type of variation in the coverage ratio is to use cash flow instead of
income in the numerator. The basis of the cash flow measure is cash flow from
operations (CFO) found in the financial statements. In this form, the cash flow
TOPIC C
measure includes depreciation expense, deferred taxes, and the impact of changes
in net working capital. This version of the coverage ratio is defined as:
net CFO + interest expense + ELIE

cash flow coverage of fixed financial costs =
interest expense + ELIE
EVALUATING OPERATING PERFORMANCE
Performance ratios indicate how well management operates the business. They can
be divided into two categories: operating efficiency ratios and operating
profitability ratios. Operating efficiency ratios are comprised of the total asset
turnover, net fixed asset turnover, and equity turnover ratios. All of these ratios
take some asset or equity account and divide it into sales to determine how
efficiently the company uses assets and capital. Operating profitability ratios
include profit margins, return on total capital, and return on equity. All of these
calculate some income item as a percentage of sales, assets or capital.
The effectiveness of the firm’s use of its total assets is measured by the total asset
turnover:
net sales
total asset turnover =
average total assets
Depending on the Different types of industries might have considerably different turnover ratios.
industry a firm is Manufacturing businesses that are capital-intensive might have asset turnover
in, asset turnover ratios near one, while retail businesses might have turnover ratios near ten. As was
ratios can vary
significantly. It is
the case with the current asset turnover ratios discussed earlier, it is desirable for
generally best to an asset turnover to be close to the industry norm. Low asset turnover ratios might
mean that the company has too much capital tied up in its asset base. A turnover
have a total or
fixed asset ratio that is too high might imply that the firm has too few assets for potential
turnover ratio that sales or that the asset base is outdated.
is close to the
industry average.
The utilization of fixed assets is measured by the net fixed asset turnover:
net sales
fixed asset turnover =
average net fixed assets
As was the case with the total asset turnover ratio, it is desirable to have a fixed
asset turnover close to the industry norm. Low fixed asset turnover might mean
that the company has too much capital tied up in its asset base. A turnover ratio
that is too high might imply that the firm has obsolete equipment.
TOPIC C
The equity turnover is a measure of the employment of owners’ capital:
net sales
equity turnover =
average equity
For this ratio, equity capital includes only owners’ equity (excluding preferred
stock) as follows:
owners' equity = common stock + paid-in capital + retained earnings
Analysts need to consider the capital structure of the company in evaluating this It is important to
ratio because a company can increase this ratio simply by using more debt consider a firm’s
financing. capital structure
when analyzing its
equity turnover. A
Profit margins indicate various measures of profit compared to sales. firm with higher
(lower) debt will
The most commonly used profit margin is the net profit margin, which is the ratio tend to have a
of net income to sales: comparatively
higher (lower)
equity turnover
net income ratio.
net profit margin =
net sales
The net profit margin should be based on net income from continuing operations,
because analysts should be primarily concerned about future expectations; below
the line items, such as discontinued operations, will not impact the company in
the future.
The gross profit margin is the ratio of gross profit (sales less COGS) to sales: The gross profit
margin is helpful
in providing the
gross profit
gross profit margin = analyst with an
net sales indication of the
basic cost
structure of the
The operating profit margin is the ratio of operating profit (gross profit less sales, firm.
general, and administrative expenses) to sales. Operating profit is also referred to
as earnings before interest and taxes (EBIT):
operating profit EBIT

operating profit margin = =
net sales net sales
TOPIC C
Some analysts prefer to calculate the operating profit margin by adding back
depreciation expense to arrive at earnings before interest, taxes, depreciation, and
amortization (EBITDA).
The variation in Analysts should be concerned if profit margins are too low.
operating profit
margin can be A popular way of measuring profitability is the return on assets (ROA), which is
helpful in
analyzing the
the ratio of net income before interest expense to total assets:
business risk for a
firm. ( net income + interest expense )
return on assets =
Because assets Analysts should be concerned if this ratio is too low. If the assets of a firm are not
equal total capital, earning a return that is commensurate with the firm’s risk, investors may be better
ROA is sometimes off if the underlying capital of the firm were used elsewhere. The interest expense
referred to as the
that should be added back is gross interest expense, not net interest expense
return on total
capital. (which is gross interest expense less interest income).
Another common measure of profitability is the return on owners’ equity (ROE),

which is the ratio of net income to owners’ equity:
net income − preferred dividends

return on owners' equity =
average owners' equity
Preferred dividends are subtracted so that the numerator only includes income
available to common shareholders.
A ratio similar to the ROE is the return on total equity, which includes preferred
stock:
net income
return on total equity =
average total equity
This ratio differs from the ROE in that ROE only measures the returns paid to
and the capital invested by common stockholders, while the return on total equity
measures returns to and capital invested by common and preferred stockholders.
Analysts should be concerned if these return ratios are too low.
The return on common equity is often more thoroughly analyzed using the
DuPont analysis, which will be discussed later.
TOPIC C
GROWTH ANALYSIS
Owners and creditors are interested in the firm’s growth potential. Owners worry
about growth because stock valuation is dependent on the future growth rate of
the firm. The analysis of growth potential is important to the debt investor
because the firm’s future prospects are crucial to its ability to pay existing debt
obligations. If the company doesn’t grow, it stands a much greater chance of
defaulting on its loans. In theory, the way that a company grows is by earning a
return on its equity capital and reinvesting a proportion of that return into the
company.
The return on equity capital is the ROE. The proportion of earnings reinvested is
the retention rate (RR).
The formula for the sustainable growth rate is: The sustainable
growth rate
g = RR × ROE represents the
fastest rate at
which a firm can
The growth rate calculated using this formula is the highest growth rate the firm grow without
can maintain without using external financing. It assumes that the debt-to-equity issuing any
ratio will stay constant and that the firm will not issue any new equity. If the firm external debt or
issues new equity or increases its debt-to-equity ratio, it is possible to grow faster equity capital.
than the rate indicated by the formula.
As you may have
The calculation of the RR is:
noticed from the
sustainable
RR = 1 − 
dividends declared  growth equation,
 there are two ways
 net income  a firm can increase
its internal growth
Example: Sustainable Growth rate—retain and
reinvest more of
Figure 1 contains financial data for three companies: the firm’s earnings
back into the firm
Figure 1: Company Data or earn a higher
rate of return on
Company A B C the earnings that
are already being
Earnings per share 3.00 4.00 5.00 reinvested.
Dividends per share 1.50 1.00 2.00
Return on equity 14% 12% 10%
Calculate the sustainable growth rate for each company.
TOPIC C
Answer:
 dividends 
• RR = 1 −  
 earnings 
 1.50 
Company A: RR = 1 −   = 0.500
 3.00 
Company B: RR = 1 − 
1.00 
 = 0.750
 4.00 
 2.00 
Company C: RR = 1 −   = 0.600
 5.00 
• g = RR × ROE
Company A: g = 0.500 ×14% = 7.0%
Company B: g = 0.750 ×12% = 9.0%
Company C: g = 0.600 ×10% = 6.0%

TOPIC C
SUMMARY OF RATIOS BY A REA OF A NALYSIS
Figure 2 provides a summary of the financial statement analysis objectives and the
relevant ratios to use to achieve these objectives.
Figure 2: Financial Ratio Applications
Area of Analysis Goal of Analysis Related Ratios
• Current ratios
• Accounts receivable ratios
Assess firm’s ability to pay
Internal liquidity • Inventory ratios
short-term liabilities
• Payables ratios
• Cash conversion cycle
Evaluate volatility of equity • Debt-to-equity ratios

Financial risk returns caused by use of • Interest coverage ratio
debt • Cash flow coverage ratio
• Asset turnover ratio

• Fixed asset ratio
Interpret how well
• Equity ratio
Operating performance management operates
• Profit margin ratios
business
• Return on assets ratio
• Return on owners’ equity ratios
Evaluate firm’s growth • Sustainable growth rate

Growth
potential • Retention rate
INTERRELATIONSHIP OF F INANCIAL RATIOS
A financial ratio is not meaningful when analyzed individually. It should be noted A ratio is only
that financial ratios are interrelated—requiring the analyst to evaluate a ratio meaningful when
relative to other ratios. Ratios alone do not answer questions. They are designed compared to other
ratios, such as
to assist the analyst in determining where to look and what questions to ask in
ratios computed
conducting financial statement analysis. from past data of
the same firm,
For instance, when an analyst encounters a ratio that may indicate poor other firms in the
performance, such as a high current ratio compared to the industry norm, it could industry, or the
be a sign of poor efficiency of working capital. Before making that conclusion, the overall economy.
next step is to analyze the related ratios. The table shown in Figure 3 shows how a
ratio that is indicative of a problem can affect (or be affected by) other ratios.
Note: The terms “increasing” and “decreasing” relate to year-to-year comparisons of the
firm, while “high” and “low” are relative to the industry norm.
TOPIC C
Figure 3: Relationship Amond Financial Ratios
Symptom Diagnosis Related Symptoms
High cash conversion cycle

Low receivables turnover
Low inventory turnover
Increasing or high current Poor efficiency of High payables turnover
ratio working capital Low total asset turnover
Low return on assets
Low return on equity
Low equity turnover
Decreasing or low current

Liquidity problems High debt ratio
ratio
Increasing or high receivables Too restrictive credit

Low or declining sales growth
turnover policy
High current ratio

Decreasing or low receivables Poor management of Low total asset turnover
turnover receivables Low return on assets
Low equity turnover
Increasing or high inventory Inadequate stock on

Low or declining sales growth
turnover hand
High current ratio

Decreasing or low inventory Poor management of Low total asset turnover
turnover inventory Low return on assets
Low equity turnover
Increasing or high payables

Poor use of trade credit High cash conversion cycle
turnover
Decreasing or low payables Low current ratio

Liquidity problems
turnover High debt ratio
High current ratio

Increasing or high cash Poor efficiency of High payables turnover
conversion cycle working capital Low total asset turnover
Low equity turnover
Low interest coverage ratio

Increasing or high debt ratio High use of leverage
Low cash flow coverage ratio
Decreasing or low interest High debt ratio

High use of leverage
coverage ratio Low cash flow coverage ratio
TOPIC C
Figure 3: (Continued) Relationship Amond Financial Ratios
Symptom Diagnosis Related Symptoms
High debt ratio

Low cash flow coverage ratio High use of leverage
Low interest coverage ratio

Low equity turnover
Low total asset turnover Poor efficiency of assets High current ratio
Low fixed asset turnover
Low total asset turnover

Poor efficiency of fixed Low return on assets
assets Low return on equity
Low equity turnover

Low equity turnover Poor efficiency of equity High current ratio

Low net profit margin Poor profitability
Low profit margin

Poor profitability based Low equity turnover
on assets High current ratio
Low profit margin

Poor profitability based Low equity turnover
on equity High current ratio
TOPIC C
COMMON -S IZE F INANCIAL STATEMENTS
The most Common-size financial statements restate key financial information relative to a
commonly used common basis to allow for more informative comparisons between different sized
bases are sales for firms.
the income
statement and
total assets for Common-sized ratios convert the individual financial statement line items to
balance sheets. percentages. Raw numbers often hide relevant information that percentages
frequently uncover.
We will use common-size financial statements in a comprehensive example at the

end of this topic.
DU P ONT A NALYSIS
The DuPont The DuPont system is an approach that can be used to analyze ROE. It uses basic
system was the algebra to breakdown ROE into a function of different ratios, so an analyst can
idea of Donaldson see the impact of leverage, profit margins, and turnover on shareholder returns.
Brown, who
There are two variants of the DuPont system: the traditional approach and the
developed the
formula in the extended system.
1920s while at E.I.
DuPont de For the traditional approach, we start with ROE defined as:
Nemours.
net income
ROE =
DuPont analysis is equity
used to evaluate
the components
that comprise Note that there are two subtle differences between this ROE measure and the
ROE defined previously. First, the numerator does not subtract preferred
ROE.
dividends as the topic did when ROE was first defined. Second, the common
equity figure that is used is not average equity, but simply end-of-year equity. For
the algebra of the DuPont system to work, only end-of-year balance sheet figures
can be used.
Multiplying ROE by sales/sales and rearranging terms produces:
net income   sales 

ROE =   ×  equity 
 sales   
The first term in this expression of ROE is the profit margin and the second term
is the equity turnover. Thus, we have:
TOPIC C
ROE = net profit margin × equity turnover
We can expand this further by multiplying these terms by assets/assets and

rearranging terms:
net income   sales   assets 

ROE =  × × 
 sales   assets   equity 
The first term is still the profit margin, the second term is now asset turnover, and
the third term is an equity multiplier that will increase as the use of debt financing
increases. Here, we can state:
ROE = net profit margin × total asset turnover × equity multiplier
This is the traditional DuPont equation. It is arguably the most important

equation in ratio analysis, since it breaks down a very important ratio (ROE) into
three key components. If ROE is too low, at least one of the following must be
true:
• The company has a poor profit margin. DuPont analysis is

• The company has poor asset turnover. helpful in showing
• The firm is not highly leveraged. that although two
firms may have
very similar ROEs,
Example: Traditional DuPont Analysis the makeup of
each firm’s ROE
Explain how an Internet-based car dealer and a traditional car dealership can be very
might differ in terms of asset turnover and gross profit margin and how those different (i.e., one
differences may impact ROE. firm has a lower
profit margin but
employs more
Answer:
financial
leverage).
One would expect that the traditional car dealership would have much lower
asset turnover than the Internet-based dealership. The regular dealer has to
have a large amount of capital tied up in its physical facility. Also, most dealers
have repair facilities that require a lot of equipment. An Internet dealership
will not have the same investment needs.
Conversely, the traditional dealership would likely have a higher gross profit
margin than the Internet dealer. Selling a commodity over the Internet is very
competitive, and price pressures would likely drive the sales price to slightly
above cost. Traditional dealers attempt to keep margins higher by
differentiation—offering various services—and through salesmanship.
TOPIC C
Assume that the asset turnover of the Internet-based car dealership is twice as
much as the asset turnover of the traditional dealership. Further assume that
the profit margin of the traditional dealership is twice as high as the profit
margin for the Internet-based dealership. If the amount of leverage employed
for the two dealerships were the same, their ROE would be identical, albeit for
very different reasons. This example illustrates the importance of the DuPont
equation—an analyst is able to attribute the sources of ROE, making the
information provided by the ratio much more meaningful.
Example: Traditional DuPont Analysis
A company has a profit margin of 4 percent, asset turnover of 2.0, and a debt-
to-assets ratio of 60 percent. What is the ROE?
Answer:
Debt to assets is 60 percent, which means equity to assets is 40 percent; this

implies assets over equity of 1/0.4 is 2.5.
assets
ROE = net profit margin × total asset turnover ×
equity
= 0.04 × 2.0 × 2.5 = 0.20, or 20%
The extended DuPont equation takes the net profit margin and breaks it down
further. The numerator of the net profit margin is net income. Since net income is
equal to earnings before taxes multiplied by 1 minus the tax rate (1 – t), the
DuPont equation can be written as:
earnings before tax   sales   assets 

ROE = 
× ×  × (1 − t )
Earnings before tax is simply EBIT minus interest expense. If this substitution is
made, the equation becomes (after some fancy algebra):
 EBIT   sales   interest expense    assets 

ROE =  × −  ×  × (1 − t )
 sales   assets   assets    equity 
The first term is the operating profit margin. The second term is the asset
turnover. The third term is new and is called the interest expense rate. The fourth
term is the same leverage multiplier defined in the traditional DuPont equation;
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and the fifth term, (1 – t), is called the tax retention rate. The equation can now
be stated as:
ROE = ( operating profit margin × asset turnover − interest expense rate )

× leverage multiplier × tax retention rate
Note that in general, high profit margins, leverage, and asset turnover will lead to The purpose of
high levels of ROE. However, this version of the formula shows that more leverage the extended
does not always lead to higher ROE. As leverage rises, so does the interest expense DuPont equation
is to separate the
rate. Hence, the positive effects of leverage can be mitigated by the higher interest
positive effects of
payments that accompany more debt. Note that higher taxes will always lead to leverage (financial
lower levels of ROE. leverage
multiplier) from
Example: Extended DuPont Analysis the negative
effects of leverage
An analyst has gathered data presented in Figure 4 for two companies in the (interest expense
rate).
same industry. Calculate the ROE for both companies, and explain the critical
factors that can lead to a higher ROE.
Figure 4: Company Data
Company A Company B
Revenues 500 900
Operating income 35 100
Interest expense 5 0
Income before taxes 30 100
Taxes 10 40
Net income 20 60
Total assets 250 300
Total debt 100 50
Owners’ equity 150 250
Answer:
operating income
• operating margin =
sales
35
Company A: operating margin = = 7.0%
500
100
Company B: operating margin = = 11.1%
900
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sales
• asset turnover =
assets
500
Company A: asset turnover = = 2.0
250
900
Company B: asset turnover = = 3.0
300
interest expense
• interest expense rate =
assets
5
Company A: interest expense rate = = 2.0%
250
0
Company B: interest expense rate = = 0.0%
300
assets
• financial leverage =
equity
250
Company A: financial leverage = = 1.67
150
300
Company B: financial leverage = = 1.2
250
taxes
• income tax rate =
pretax income
10
Company A: income tax rate = = 33.3%
30
40
Company B: income tax rate = = 40.0%
100
• ROE = ( operating margin × asset turnover − interest expense rate )

× leverage × (1 − tax rate )
Company A: ROE = ( 7.0% × 2.0 − 2.0% ) × 1.67 × (1 − 33.3% ) = 13.3%

Company B: ROE = (11.1% × 3.0 − 0% ) ×1.2 × (1 − 40% ) = 24.0%
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Asset turnover for Company B is much higher, which is the main reason that
its ROE is higher. Profit margin is also a contributing factor. Company B’s
ROE is higher despite the fact that it is using less leverage.
RELATIVE FINANCIAL R ATIOS
A single value of a financial ratio is not meaningful by itself, but must be

examined relative to industry norms and the company’s own historical
performance.
Comparison to industry norms is the most common type of comparison. Industry

comparisons are particularly valid when the products generated by the industry
are similar.
Primarily, comparisons are made to industry averages. However, if there are wide
variations within the industry, it may be more appropriate not to use all of the
firms in the industry, but to use a subset of firms with similar size and
characteristics. Using a subset of firms with similar characteristics relative to the
firm being analyzed is called cross-sectional analysis.
For firms that operate in multiple industries, an analyst can calculate composite
industry averages by using a weighted average based on the proportion of the
company’s sales in each industry segment.
Comparing a firm with its own history is very common. Analysts often conduct Because time-
time-series analysis, which considers the trend in a ratio. Indeed, it is problematic series analysis
to simply consider long-term averages of ratios without taking their trend into indicates whether
a firm’s ratios are
account. It is particularly useful to look at trends in a company’s ratios in relation
progressing or
to trends in the industry’s average ratios. declining, it is
particularly useful
When analyzing trends in a company’s ratios, an analyst should consider the when an analyst is
condition of the overall economy—this is particularly important when overall making forecasts
business conditions are changing. For example, a stable profit margin might be about the firm’s
future.
considered good if the economy is in recession and the economy-wide average
profit margin is declining. On the other hand, it might be considered problematic
if a stable profit margin occurs during an economic expansion, when overall
average profit margins are increasing.
In most ratio comparisons, it is considered desirable to be near the industry (or

economy) average. For example, in all turnover ratios, a value could be considered
too high or too low if it differs widely from the industry average. However, for
some ratios, simply being high is considered good, even if it deviates from the
industry average. This is true for most ratios involving income or cash flow. For
example, most analysts would agree that having a high return on assets or high
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profit margin is good. An analyst would not suggest that a company with a return
on assets of 15 percent had an ROA that was too high when the industry average
was 10 percent.
Sometimes the goodness of a ratio depends on the context. A high ROE that results
from high profit margins or asset turnover is typically looked upon favorably.
However, high ROEs that result from high levels of leverage are typically met with
a great deal of skepticism.
Example: Trend Analysis and Industry Comparisons
The following is a company’s balance sheet for 2002 and 2003 and its income
statement for 2003.
Using the company information presented in Figure 5 and Figure 6, calculate

the ratios listed in Figure 7, and discuss how these ratios compare with the
company’s performance last year and with the industry’s performance.
Figure 5: Sample Balance Sheets
Balance Sheets
2002 2001
Assets
Cash $ 105 95
Receivables 205 195
Inventories 310 290
Total current assets 620 580
Gross property, plant, and equipment 1,800 1,700

Accumulated depreciation 360 340
Net property, plant, and equipment 1,440 1,360
Total assets $ 2,060 1,940
Liabilities and Equity

Payables $ 110 90
Short-term debt 160 140
Current portion of long-term debt 55 45
Current liabilities 325 275
Long-term debt 610 690

Deferred taxes 105 95
Common stock 300 300

Additional paid in capital 400 400
Retained earnings 320 180
Common shareholders equity 1,020 880
Total liabilities and equity $ 2,060 1,940
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Figure 6: Sample Income Statement

Income Statement
2002
Sales $ 4,000
COGS 3,000
Gross profit 1,000
Operating expenses 650
Operating profit 350
Interest expense 50
Earnings before taxes 300
Taxes 100
Net income $ 200
Common dividends 60
Figure 7: Company and Industry Ratios
Company Last Year Industry
Current ratio ? 2.1 1.5
Quick ratio ? 1.0 0.9
Receivables collection period ? 18.9 18.0
Inventory turnover ? 10.7 12.0
Total asset turnover ? 2.3 2.4
Equity turnover ? 4.8 4.0
Gross profit margin ? 27.4% 29.3%
Net profit margin ? 5.8% 6.5%

Return on capital ? 13.3% 15.6%
Return on equity ? 24.1% 19.8%
Debt-to-equity ? 78.4% 35.7%
Interest coverage ? 5.9 9.2
Retention rate ? 50.0% 43.6%
Sustainable growth rate ? 12.0% 8.6%
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Answer:
current assets
current ratio =
current liabilities
620
= = 1.9
325
The current ratio indicates lower liquidity levels when compared to last year
and more liquidity than the industry average.
cash + receivables
quick ratio =
current liabilities
105 + 205
= = 0.95
325
The quick ratio is lower than last year, indicating liquidity has slightly
declined, but is higher the industry average.
365
average collection period =
sales
average receivables
365
= = 18.2
4,000
 205 + 195 
 
 2 
The average collection period is a bit lower relative to the company’s past
performance but slightly higher than the industry average. This suggests that
customers are paying their bills more quickly than they did in the prior year
but not as quickly as customers of other firms in the industry.
COGS
inventory turnover =
average inventories
3,000
= = 10.0
 310 + 290 
 
 2 
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The inventory turnover is much lower than last year and the industry average.
This suggests that the company is not managing inventory efficiently and may
have obsolete stock.
sales
total asset turnover = The lower asset
average assets turnover could
indicate: (1) the
4,000 firm has newer
= = 2.0
 2,060 + 1,940  equipment
  compared to the
 2  industry, or (2) the
firm has excessive
capital tied up in
The total asset turnover is slightly lower than last year and the industry average.
fixed assets. The
analyst would
sales need more
equity turnover = information
average equity
before drawing
any conclusions.
4,000
= = 4.2
 1,020 + 880 
 
 2  Remember that a
higher equity
turnover could be
The equity turnover is lower than last year but still above the industry average. the result of more
debt used in the
gross profit capital structure.
gross profit margin = Again, the analyst
net sales would need more
information
1,000
= = 25.0% before drawing
4,000 any conclusions.
The gross profit margin is lower than last year and much lower than the
industry average. This suggests that the firm has a higher cost structure
relative to the industry and is a reason for concern.
net income
net profit margin =
net sales
200
= = 5.0%
4,000
The net profit margin is lower than last year and much lower than the industry
average. Again, this suggests higher costs and/or expenses compared to other
firms in the industry and is a cause for concern on the part of the analyst.
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net income + interest expense

return on capital =
average total capital
200 + 50
= = 12.5%
 2,060 + 1,940 
 
 2 
The return on capital is below last year and the industry average. This suggests
a problem stemming from the low asset turnover and low profit margin.

return on common equity =
average owners' equity
200
= = 21.1%
 1,020 + 880 
 
 2 
The return on common equity is below the last year but better than the industry
average. The reason it is higher than the industry average is probably because
of greater use of leverage.
long-term debt (not including deferred taxes)

debt-to-equity ratio =
total equity
610
= = 59.8%
1,020
Note: This calculation assumes that deferred taxes are not a part of long-term
debt.
The debt-to-equity ratio is lower than last year but still much higher than the
industry average. This suggests the company is trying to get its debt level more
in line with the industry.
net income + income taxes + interest expense

interest coverage =
interest expense
200 + 100 + 50
= = 7.0
50
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The interest coverage is better than last year but still worse than the industry
average. This, along with the slip in profit margin and return on assets, might
cause some concern.
 dividends 
retention rate = 1 −  
 earnings 
 60 
=1−   = 70%
 200 
The retention rate is much higher than last year and much higher than the
industry. This might suggest that the company is aware of its cash flow and
earnings issues and is reinvesting cash into the company to improve the ratios.
net income
ROE =
equity
200
= = 19.6%
1,020
sustainable growth rate, g = retention rate × ROE
= 0.7 × 0.196 = 13.7%
With the high retention rate and good ROE, the company is positioned to
grow at a faster rate than last year and faster than the rest of the industry.
Summary: The company has average liquidity. However, performance figures

suggest that earnings have declined and turnover has worsened. Coverage
ratios are worse than the industry average, which might cause some concern,
particularly for lenders.
L IMITATIONS OF FINANCIAL RATIOS
There are several limitations of analyzing a company using financial ratios.
• Financial ratios are not useful when viewed in isolation. They are only valid
when compared to other firms or the company’s historical performance.
• Comparisons with other companies are made more difficult because of
different accounting treatments. This is particularly important when analyzing
foreign owned companies.
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• It is difficult to find comparable industry ratios when analyzing companies

that operate in multiple industries.
• Conclusions cannot be made from viewing one set of ratios. All ratios must be
viewed relative to one another.
• Determining the appropriate target or comparison value for a ratio is difficult.
There might be cases in which the industry average is not the optimal target to
which a firm should be compared.
C OMPREHENSIVE EXAMPLE
Now that we have introduced the various financial statement ratios, let’s put them
to use and analyze a set of financial statements.
For our example we are going to look at the financial statements of Kraft Foods,
Inc., for the fiscal years 2002 1, 2001, and 20002 (dollars reported in millions).
Figure 8: Excerpt From Kraft Foods’ Form 10-K 2002 and 2001 Annual Reports
(in millions of dollars) 2002 2001 2000

Assets
Cash and cash equivalents $ 215 162 191
Accounts receivable 3,116 3,131 3,231
Inventories 3,382 3,026 3,041
Deferred income taxes 511 466 504
Other current assets 232 221 185
Total current assets 7,456 7,006 7,152
Gross Fixed assets 14,450 13,272 13,042

Accumulated depreciation 4,891 4,163 3,637
Net gross fixed assets 9,559 9,109 9,405
Other long-term assets 40,085 39,683 35,514
Total assets $57,100 55,798 52,071

Accounts payable $ 1,939 1,897 1,971
Short-term debt 572 1,221 859
Other current liabilities 4,658 5,757 4,760
Total current liabilities 7,169 8,875 7,590
Long-term debt 10,416 8,134 2,695

Other long-term liabilities 13,683 15,311 27,738
Total liabilities 31,268 32,320 38,023
Preferred equity 0 0 0
Common equity 25,832 23,478 14,048
Total liabilities and equity $57,100 55,798 52,071
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Figure 8: (Continued) Excerpt From Kraft Foods’ Form 10-K 2002 and 2001 Annual
(in millions of dollars) 2002 2001 2000 In some financial

Revenues $29,723 $ 29,234 $ 22,922 statements, sales
COGS 17,720 17,566 13,959 are referred to as
Gross Profit 12,003 11,668 8,963 revenue—the
Selling, general & administrative 5,000 5,068 4,089 meaning is the
Depreciation 709 680 499 same.
Amortization 7 962 535
Other operating expenses 173 74 (172)
Operating income 6,114 4,884 4,012
Interest and other debt expense 847 1,437 597
Income before taxes 5,267 3,447 3,415
Provision for income taxes 1,873 1,565 1,414
Net Income $ 3,394 $ 1,882 $ 2,001
Using Kraft’s 2002 statements, let’s calculate some of the key ratios we have
discussed (refer to earlier section for ratio formulas):
Liquidity ratios:
7, 456
current ratio = = 1.04
7,169
215 + 3,116
quick ratio = = 0.46
7,169
215
cash ratio = = 0.03
7,169
29,723
receivables turnover = = 9.52
3,123.5
3,116 + 3,131
where: average receivables = = 3,123.5
2
1 U.S.
Securities and Exchange Commission, “Kraft Foods’ 2002 Annual Report, Form 10-K,”
March 25, 2003, <http://www.sec.gov/Archives/edgar/data/1103982/000104746903010159/
a2105346zex-13.txt> (October 2003), pp. 43–44.
2 Ibid., “Kraft Foods’ 2001 Annual Report, Form 10-K,” March 14, 2002, <http://
www.sec.gov/Archives/edgar/data/1103982/000095012302002512/y57670e10-k.txt>.
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17,720
inventory turnover = = 5.53
3,204
3,382 + 3,026
where: average inventory = = 3,204
2
17,720
payables turnover = = 9.24
1,918
1,939 + 1,897
where: average payables = = 1,918
2
365
receivables collection period = = 38.34
9.52
365
inventory processing period = = 66.00
5.53
365
payables payment period = = 39.50
9.24
cash conversion period = 38.34 + 66.00 − 39.50 = 64.84
Financial risk ratios:
10, 416
debt-to-equity ratio = = 0.40
25,832
572 + 10, 416

debt ratio = = 0.19
57,100
6,114
interest coverage = = 7.22
847
Operating performance ratios:
29,723
total asset turnover = = 0.53
56, 449
57,100 + 55,798
where: average total assets = = 56, 449
2
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29,723
fixed asset turnover = = 3.18
9,334
9,559 + 9,109
where: average fixed assets = = 9,334
2
29,723
equity turnover = = 1.21
24,655
25,832 + 23, 478

where: average equity = = 24,655
2
12,003
gross profit margin = = 0.40
29,723
6,114
operating profit margin = = 0.21
29,723
3,394
net profit margin = = 0.11
29,723
DuPont analysis:
3,394
return on equity = = 13.14%
25,832
3,394
net profit margin = = 11.42% Remember that
29,723 end of year values
rather than
29,723 averages are used

total asset turnover = = 0.52 in the DuPont
57,100 analysis ratios.
57,100
equity multiplier = = 2.21
25,832
Now let’s perform a time series analysis of Kraft’s ratios by comparing the ratios
over a period of years. The ratios for 2002, 2001, and 2000 are presented in
Figure 9.
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Figure 9: Kraft’s Financial Ratios, 2000–2002
Ratios 2002 2001 2000

current ratio 1.04 0.79 0.94
quick ratio 0.46 0.37 0.45
cash ratio 0.03 0.02 0.03
receivable turnover 9.52 9.19 7.09
inventory 5.53 5.79 4.59
payables turnover 9.24 9.08 7.08
receivables collection period 38.36 39.72 51.45
inventory processing 66.00 63.03 79.52
payables payment period 39.50 40.19 51.54
cash conversion period 64.84 62.56 79.43
debt-to-equity ratio 0.40 0.35 0.19
debt ratio 0.19 0.17 0.07
interest coverage 7.2 3.4 6.7
total asset turnover 0.53 0.54 0.44
fixed asset turnover 3.18 3.21 3.16
equity turnover 1.21 1.58 2.12
gross profit margin 0.40 0.40 0.39
operating profit margin 0.21 0.17 0.18
Net profit margin 0.11 0.06 0.09
DuPont Analysis
Return on equity 13.14% 8.02% 14.24%
= Net profit margin 11.42% 6.44% 8.73%
× Total asset turnover 0.52 0.52 0.44
× Equity multiplier 2.21 2.38 3.71
Examining the liquidity ratios, we can see that Kraft’s liquidity has increased in
2002 as measured by the current ratio. The current ratio is higher than 1.0
indicating that Kraft has a positive working capital balance. The increasing trend
of Kraft’s current ratio could indicate decreasing efficiency of working capital. We
should look at the other related ratios to determine if Kraft’s working capital
efficiency truly is decreasing.
Further analysis reveals that Kraft’s cash conversion cycle and inventory processing
period have increased from 2001, while the payables payment period has steadily
decreased for the last three years. These relationships also indicate a decrease in
working capital efficiency. It is taking Kraft longer to sell its inventory, while the
declining payables payment period means that Kraft is paying its suppliers more
quickly. Kraft’s receivable turnover increased from the prior year, meaning that
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customers are also paying their bills more quickly, which can indicate an
improvement in efficiency. As mentioned before, ratios are only an indicator of
financial performance, so an analyst should be aware of these relationships when
continuing their financial statement analysis.
Other points of interest:
• Kraft’s receivable turnover ratio indicates that the company’s receivables have
decreased slightly relative to sales. The amount of credit extended to
customers at the end of 2002 declined compared to year end 2001, while sales
increased.
• The decreasing inventory turnover ratio indicates that Kraft may be becoming
less efficient in managing inventory. Inventories from 2001 to 2002 increased
by almost 12 percent (from $3,026 to $3,382), while sales increased by only
1.67 percent. This increase in inventory could indicate further problems in the
future. Kraft’s main products are cheese, cookies, meats, and cereal. All of
these goods could spoil if left in a warehouse too long, resulting in a write-off
of inventory or a decline in profit margins if Kraft is forced to discount its
goods in order to increase sales.
• The payable ratio indicates that Kraft utilizing slightly less trade credit,
relative to the COGS. Kraft is paying its suppliers more quickly, which could
be a result of the company’s suppliers demanding payment sooner. If this is the
case, the analyst should do some research to identify whether the tighter credit
terms are an industry trend, or specific to the firm.
• The number of days to collect credit sales has been decreasing over the past
two years indicating that Kraft is becoming more efficient at collecting cash
from its customers. The analyst should be aware, however, that if Kraft were to
force tighter credit terms on its customers, it could hurt sales in the long run.
Putting this all together, we can see that Kraft has increased their cash conversion
cycle from the previous year. This could be unfavorable since cash is tied up for a
longer period of time in the operating cycle.
Next let’s look at the operating performance measures for Kraft:
• The total and fixed assets turnover ratios have decreased.

• The equity turnover ratio has decreased.
• The profitability ratios have been steadily improving over the past two years.
The decreasing asset turnover ratios indicate that Kraft may have too much capital
tied up in its asset base. As for the declining equity turnover, the analyst should
check to see if the decrease is the result of a decrease in debt in the firm’s capital
structure. If so, the declining equity turnover may not be considered a negative,
particularly for creditors. Profitability has been steadily increasing from year to
year. The gross profit margin has remained relatively unchanged, which means the
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overall cost structure of the firm has been consistent. However, the operating and
net profit margins have increased considerably. This implies that the firm has been
able to increase sales at a faster rate than costs, which is very positive. The astute
analyst will see that a large portion of the increase in net profit margin is the result
of a decrease in the tax rate. In 2002, Kraft is paying an effective tax rate of 36
percent ($1,873/$5,267) compared to an effective tax rate of 45 percent ($1,565/
$3,447) in 2001. This may indicate a larger action on the part of the government
to reduce taxes, which would benefit the margins of competitors in addition to
Kraft.
It is important to note that while these ratios are increasing the changes are not
drastic. At this point in the analysis, the analyst should keep these trends in mind
while continuing their analysis, but not draw any conclusions.
In addition to performing historical analysis on Kraft using ratio analysis, we can

use common-size statements. The common-size balance sheet states balance sheet
items as a percentage of assets, and the common-size income statement shows all
items as a percentage of sales. The common-size statements for 2002, 2001, and
2000 are presented in Figure 10.
Figure 10: Kraft’s Common-Size Statements, 2000–2002

Balance Sheet 2002 2001 2000
Assets
Cash & cash equivalents 0.38% 0.29% 0.37%
Accounts receivable 5.46% 5.61% 6.20%
Inventories 5.92% 5.42% 5.84%
Deferred income taxes 0.89% 0.84% 0.97%
All balance sheet Other current assets 0.41% 0.40% 0.36%
items are Total current assets 13.06% 12.56% 13.74%
expressed as a Gross Fixed assets 25.31% 23.79% 25.05%
percentage of total Accumulated depreciation 8.57% 7.46% 6.98%
assets. Net gross fixed assets 16.74% 16.32% 18.06%

Other long-term assets 70.20% 71.12% 68.20%
Total assets 100.00% 100.00% 100.00%

Accounts payable 3.40% 3.40% 3.79%
short-term debt 1.00% 2.19% 1.65%
Other current liabilities 8.16% 10.32% 9.14%
Total current liabilities 12.56% 15.91% 14.58%
Long-term debt 18.24% 14.58% 5.18%
Other long-term liabilities 23.96% 27.44% 53.27%
Total liabilities 54.76% 57.92% 73.02%
Preferred equity 0.00% 0.00% 0.00%
Common equity 45.24% 42.08% 26.98%
Total liabilities & equity 100.00% 100.00% 100.00%
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Figure 10: (Continued) Kraft’s Common-Size Statements, 2000–2002

Income Statement
Revenues 100.00% 100.00% 100.00%
CGS 59.62% 60.09% 60.90%
Gross Profit 40.38% 39.91% 39.10%
Selling, general & administrative 16.82% 17.34% 17.84% All income
Depreciation 2.39% 2.33% 2.18% statement items
Amortization 0.02% 3.29% 2.33% are expressed as a
Other operating expenses 0.58% 0.25% –0.75% percentage of
Operating income 20.57% 16.71% 17.50% revenues (sales).
Interest and other debt expense 2.85% 4.92% 2.60%
Income before taxes 17.72% 11.79% 14.90%
Provision for income taxes 6.30% 5.35% 6.17%
Net Income 11.42% 6.44% 8.73%
The common-size balance sheet illustrates that Kraft has been relatively consistent Review of Kraft’s
from year to year. A notable change is the increase in debt, specifically long-term, financial
over the years. Long-term debt represents 18.24 percent of the company’s statement
footnotes will
liabilities and equity in 2002 versus 14.58 percent and 5.18 percent in 2001 and
reveal the cause of
2000, respectively. Additionally, there is a substantial decrease in other long-term the change in debt
liabilities from 2000 to 2001. The analyst will want to identify the reason behind and long-term
the increase in debt and project any impact the increase could have on the firm in liabilities.
the future. For example, a firm with more debt has higher financial risk. This
could cause creditors to determine that Kraft’s debt is more risky, thus assigning
the firm a lower credit rating, and increasing the firm’s cost of capital.
Review of the income statement shows that decreases in Kraft’s COGS and
amortization expenses improved operating income by 4 percent from 2001 to
2002. The analyst should review why the amortization expense declined and
whether the resulting increase in income is sustainable. For example, if the decline
in amortization expense is the result of a significant asset being paid off (no longer
amortized), it implies that the asset is toward the end of its useful life. If Kraft has
to replace the asset, amortization expense could increase again, and the increase in
income could be a one-time event.
Also, a decrease in interest expense added to Kraft’s significant improvement of

their bottom line as a percentage of net sales. Again, the analyst should research to
identify the cause of the lower interest expense (i.e., did the firm pay off a high-
interest debt issue?) and see if the resulting increase in income is sustainable.
Time series analysis reveals that Kraft’s working capital efficiency may be
decreasing. Otherwise, the company has been relatively consistent during the last
three years. However, as discussed earlier, we should not draw conclusions about
Kraft’s ratios unless we compare them to an industry average or a competitor.
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For example, is net profit of 11.4 percent good or bad for a food manufacturer? To
answer this question, we must perform cross-sectional analysis.
We will now compare the ratios for the Kraft Corporation and a major
competitor, Heinz Inc., for the same periods of time. The ratios for Kraft and
Heinz for 2002 are presented in Figure 11:
Figure 11: Ratio Comparison – Kraft vs. Heinz, 2002
Kraft Heinz
Current ratio 1.04 1.71
Quick ratio 0.46 1.02
Cash ratio 0.03 0.42
Receivable turnover 9.52 6.87
Inventory 5.53 4.51
Payables turnover 9.24 5.83
Receivables collection period 38.36 53.13
Inventory processing 66.00 80.93
Payables payment period 39.51 62.66
Cash conversion period 64.85 71.40
Debt-to-equity ratio 0.40 3.98
Debt ratio 0.19 0.53
Interest coverage 7.22 3.89
Total asset turnover 0.53 0.84
Fixed asset turnover 3.18 4.26
Equity turnover 1.21 5.65
Gross profit margin 0.40 0.36
Operating profit margin 0.21 0.14
Net profit margin 0.11 0.07
DuPont Analysis
Return on equity 13.14% 47.22%
= Net profit margin 11.42% 6.88%
× Total asset turnover 0.52 0.89
× Equity multiplier 2.21 7.69
Comparing liquidity ratios:
• Heinz’s current ratio is significantly higher than Kraft’s.

• Taking inventory out of the equation via the quick ratio, Heinz still appears to
be better able to meet its short-term liabilities.
TOPIC C
These ratios may indicate that Heinz has higher liquidity and greater ability to
All ratios have a
meet current obligations. However, they may also indicate that Heinz has higher numerator and a
levels of current assets because portions of their receivables are not collectable, or denominator.
portions of their inventory are obsolete. However, further examination of the cash Therefore, a high
ratio reinforces that Heinz has higher liquidity than Kraft. Let’s look at this issue ratio can result
further by analyzing current asset and turnover ratios: from a large
numerator and a
small
The turnover ratios indicate that Kraft has higher receivables and inventory denominator, or
turnover and is managing their current assets more efficiently. The payables combination of
turnover illustrates that Kraft’s payables relative to COGs is higher than Heinz’s. both. So a high
current ratio may
Next let’s look at these ratios based on number of days: be the result of too
many current
assets or too few
• Heinz spends more time collecting on their sales versus Kraft. current liabilities.
• Heinz takes an extra two weeks to sell their inventory.
• Heinz takes 23 days longer to pay their suppliers which can be seen as a
positive versus Kraft.
• The net effect, Heinz’s operating cycle uses cash for 6 days longer than Kraft.
Looking at the other turnover ratios:
• Kraft’s lower asset turnover ratio may indicate that Heinz does a better job
managing its current assets.
• Kraft has a lower fixed asset turnover which may indicate that they are less
efficient in obtaining a dollar in sales relative to the level of fixed assets.
• Alternatively, it could indicate that Heinz’s fixed assets are older and
depreciated further. Or that Kraft has recently invested in their manufacturing
equipment to increase operational efficiencies.
The gross profit margins illustrate:

• Relative to their COGS, Kraft sales margins are higher than Heinz.
• Additionally, Kraft has higher operating and net profit margins indicating that
Kraft is doing a better job at controlling their operating expenses.
The financial risk ratios show:
• Heinz has greater financial risk.

• Both Kraft’s debt-to-equity ratio (0.4) and debt ratios are significantly lower
than Heinz’s (3.98), indicating a lesser reliance on debt as a source of
financing for Kraft.
• Also of concern, Heinz has lower interest coverage, which may indicate less of
an ability to pay its debt.
TOPIC C
This cross-sectional analysis is also a great example of “equalizing” the financial

statements of competitors. What the ratios above do not show is that Kraft is a
food giant with net sales of $29 billion, compared to Heinz net sales of $8 billion.
The use of ratios allowed us to compare “apples to apples” for Kraft to Heinz.
Cross sectional analysis is not very difficult and provides an analyst with very
meaningful perspectives. The combination of the time series and cross-sectional
analysis is not particularly time consuming, especially for publicly traded
companies. Given these attributes, it’s easy to see why ratio analysis is a mainstay
in financial statement analysis.
TOPIC C
CONCEPT CHECKERS
1. Which of the following statements about using financial ratios is FALSE?

A. Financial ratios are not very useful when viewed in isolation.
B. The industry average is often the best target to which a firm should be compared.
C. Comparisons with other companies may be difficult when analyzing firms located in other
countries.
D. It is easy to find comparable industry ratios when analyzing companies, especially those that
operate in multiple industries.
An analyst has gathered the following data regarding selected account balances for Mazeppa Horses Inc.
(MHI):
Cash $425,000
Accounts receivable (gross) $180,000
Allowance for doubtful accounts $55,000
Inventories $174,000
Prepaid expenses $43,000
Fixed assets (net) $275,000
Accounts payable $112,000
Accrued expenses $86,000
2. Which of the following amounts most closely represents MHI’s quick ratio?
A. 2.78.
B. 3.06.
C. 4.91.
D. 5.26.
3. Which of the following amounts most closely represents MHI’s current ratio?
A. 3.66.
B. 3.87.
C. 4.15.
D. 5.26.
TOPIC C
4. The following information relates to a company’s balance sheet as of July 31, 2003:
• Common stock with a book value of $550,000.
• Preferred shares with an 8% stated rate for dividends, dividends are cumulative, and book
value is $250,000.
• Contributed surplus of $100,000.
• Long-term portion of notes payable of $225,000.
• Interest payable on notes payable of $17,000.
• Current-portion of notes payable of $25,000.
Which of the following amounts most closely represents the company’s debt-to-equity ratio?
A. 0.25.
B. 0.73.
C. 0.80.
D. 4.00.
5. A company is experiencing a low receivables turnover. Which of the following is NOT likely to
be a related symptom?
A. Low current ratio.
B. Low return on assets.
C. Low return on total equity.
D. High cash conversion cycle.
6. A company had sales of $85,450,000 in 2002. Due to the on-going effects of the September 11,
2001, terrorist attacks, there was necessary restructuring of the business. Specifically, it was
required that a substantial one-time charge of $5,100,000 for sales, general, and administrative
(SG&A) expenses be incurred in 2002. The SG&A expense related to severance payments for
departing employees. Such an expense of that magnitude is not expected to occur on a recurring
basis.
Based on this information, which of the following profit margins is the most appropriate one for
an analyst to use to analyze the company’s future profit compared to sales?

A. Net profit margin.
B. Gross profit margin.
C. Operating profit margin.
D. All of the above would be equally appropriate.
TOPIC C
7. An analyst has gathered the following information about a company for the year ended
December 31, 2002:
Net income $45,000,000

Income tax expense $14,300,000
Sales $325,000,000
Assets $995,000,000
Interest expense $12,400,000
Equity $380,000,000
Tax rate 35%
The analyst wants to use the extended DuPont equation to calculate return on equity (ROE).
Which of the following amounts is closest to the ROE for 2002?
A. 8%.
B. 9%.
C. 10%.
D. 11%.
8. Which of the following statements about ratio analysis is TRUE?

A. Time-series analysis is a statistical method for a firm to compare itself with its own history.
B. In most ratio comparisons, it is usually most desirable to be above the industry (or economy)
average.
C. It is usually most appropriate to use all of the firms in the industry in terms of calculating
industry averages.
D. A high ROE that results from high levels of leverage is generally highly regarded because it
shows that debt is being used efficiently to increase return.
TOPIC C
ANSWERS: COMPARISONS OF FINANCIAL STATEMENTS
1. D Finding comparable industry ratios can be difficult, especially if companies operate in more than one industry.
Conclusions cannot be made from viewing one set of ratios; all ratios must be viewed relative to one another.
Comparisons with other companies are made more difficult because of differences in accounting treatments
between countries.
cash + marketable securities + receivables

2. A quick ratio =
current liabilities
$425,000 + $180,000 − $55,000

= = 2.78
$112,000 + $86,000
Allowance for doubtful accounts is a contra account that reduces the accounts receivable balance. Inventory and
prepaid expenses are not included in the quick ratio. Accrued expenses represent a current liability.
current assets
3. B current ratio =
current liabilities
$425,000 + $180,000 − $55,000 + $174,000 + $43,000

= = 3.87
$112,000 + $86,000
Fixed assets are long-term assets, therefore, they are not included in current assets.
long-term debt
4. A debt-to-equity ratio =
total equity
$225,000
= = 0.25
$550,000 + $250,000 + $100,000
Interest payable and current portion of notes payable are current liabilities and, therefore, should not be included as
long-term debt.
net annual sales

5. A receivables turnover =
average receivables
If receivables turnover is low, it would imply that average receivables is relatively high. A relatively high receivables
balance, would imply a high current ratio.
net income + interest expense

return on assets =
net income
return on total equity =
average total equity
If average receivables is high, it would imply that average total assets and average total equity are relatively high.
This would reduce the returns.
TOPIC C
cash conversion cycle = average collection period + average inventory processing period − average payment period
If average receivables is high, it implies that there is a longer than average collection period. A longer than average
collection period implies a long (high) cash conversion cycle.
sales − COGS
6. B gross profit margin =
net sales
sales − COGS − SG&A expenses

operating profit margin =
net sales
net income
net profit margin =
net sales
The SG&A expense is a one-time expense that is not typical of the operations of the company. Therefore, an analyst
would be prudent not to consider this expense when analyzing the future prospects of the company.
Since both operating profit margin and net profit margin consider the SG&A expense, they are not appropriate to
use in this case. Therefore, gross profit margin is the only appropriate profit measure to use in this case.
7. C Extended DuPont equation
 net income + taxes + interest   sales   interest expense    assets 

ROE =  × −  ×   × (1 − t )
 sales   assets   assets    equity 
 $45,000,000 + $14,300,000 + $12, 400,000   $325,000,000   $12, 400,000    $995,000,000 

=   ×  $995,000,000  −  $995,000,000   ×  $380,000,000  × (1 − 0.35 ) = 10.14%
 $325,000,000       
8. A Time series analysis compares ratios using current firm data with ratios using past firm data in order to compare the
firm with its own history.
Being consistently above the industry average is not necessarily a good idea (i.e., average collection period).
We need to consider if there are wide variations in the ratios among the firms in the industry. In such a case, it may
be more appropriate not to use all of the firms in the industry but to use a subset of firms with similar size and
characteristics.
A high ROE that results from high levels of leverage is typically met with a great deal of skepticism because it would
appear that the high ROE is mainly a result of the greater use of leverage. It masks the “true” ROE had the level of
leverage been normal.
E ARNINGS P ER S HARE

TOPIC D
S UMMARY
Earings per share (EPS) is the amount A complex capital structure contains
of income a company earns for every securities such as warrants or
share of common stock outstanding. It convertible bonds that can increase the
is the standard for reporting company number of outstanding shares of
earnings. EPS is a key component in common stock without changing a
the firm valuation process, thus it is company’s earnings. The change in the
necessary that financial analysts number of shares outstanding from
understand its calculation. In this these contingent securities may dilute
topic, we will take net income as a earnings per share. Firms with a
given, though we know from other complex structure will report both
topics that net income is subject to basic EPS, which does not consider
interpretation and manipulation. We dilutive securities, and diluted EPS,
will examine how EPS is affected and which does consider dilutive securities.
measured when a complex capital As analysts, we need to understand the
structure creates the potential for an calculation of both basic and diluted
increase in firm common shares. EPS.
REPORTING EPS
Earnings per share (EPS) is the most commonly used corporate performance
statistic for publicly traded firms. EPS’s wide publication and use in forming the
price-to-earnings ratio has prompted the Financial Accounting Standards Board
(FASB) to specify rules governing the computation of EPS as a component of the
income statement.
EPS reporting is governed by FASB and International Accounting Standards (IAS)

statements (SFAS 128,1 SFAS 1292, IAS 333). EPS is only reported for shares of
1 FinancialAccounting Standards Board, “Statement of Financial Accounting Standards No.

128: Earnings Per Share,” February 1997, <http://www.fasb.org/pdf/fas128.pdf> (October 2003).
2 Ibid., “Statement of Financial Accounting Standards No. 129: Disclosure of Information
about Capital Structure,” February 1997, <http://www.fasb.org/pdf/fas129.pdf> (October 2003).

3 International Accounting Standards Board, “IAS 33: Earnings per Share,” n.d., <http://
www.iasb.org.uk/cmt/> (October 2003).
TOPIC D
common stock. The disclosure requirements are set forth in Standard of Financial
Accounting Standard (SFAS) 128 and SFAS 129.
The reporting of EPS requires calculation of EPS on an undiluted basis for the Dilutive
number of shares currently outstanding and on a diluted basis, which accounts for securities, such as
potential ownership dilution from contingent equity claims such as warrants. convertible bonds
and warrants, will
There are several things to remember about the reporting of EPS: decrease earnings
per share if
• EPS is reported for all components of net income, including income from converted to
continuing operations, income before extraordinary operations, income before common stock.
accounting changes, and, of course, net income.
• The per share amounts for discontinued operations, extraordinary operations,
and accounting changes must at least be disclosed in the footnotes.
• A reconciliation of the basic EPS and diluted EPS numerators and
denominators is provided.
• Reduction in income available to common shareholders for preferred stock
dividends is also reported.
• The company must disclose potentially dilutive securities that were not Antidilutive
included in the current period’s computation because they are antidilutive. securities actually
• The company must disclose transactions occurring after the end of the year increase earnings
per share if
(but prior to the issuance of the firm’s financial statements) that would have converted to
changed the number of common shares or the potential number of shares if common shares.
the transaction had occurred before the end of the period.
• If diluted EPS is shown for one period, it must be reported for all periods,
even those in which it is the same as basic EPS.
• The rights and provisions of all outstanding securities (debt, common and
preferred stock, options, warrants) must be disclosed.
• The number of shares issued during the period due to conversions, exercises,
and contingent issuance is reported.
• With respect to preferred stock, the following are disclosed:
Liquidating value of preferred shares when this value is significantly
greater than the par or stated values.

Call and redemption provisions.
Redemption requirements for the next five years. Think of dividend
Dividend arrears for cumulative preferred shares. arrears as a
dividends payable-
type account for
preferred stock.
The dividends to
cumulative
preferred stock
must be current
(i.e., up-to-date
before dividends
can be paid to
common stock).
TOPIC D
Figure 1 shows the EPS reported in The J.M. Smucker Company’s 2003 Annual
Report.4 Let’s look at the EPS reported in the income statement:
Figure 1: Excerpt from the J.M. Smucker Company’s 2003 Annual Report
The J.M. Smucker Company
2003 Annual Report
Five-Year Summary of Collected Financial Data
2003 2002 2001
Earnings per Common Share:
Income before accounting method change $2.04 $1.33 $1.17
Cumulative effect of change in accounting method — — (0.04)
Net Income per Common Share $2.04 $1.33 $1.13
Income before accounting method change – assuming dilution $2.02 $1.31 $1.16
Cumulative effect of account method change – assuming dilution — — (0.04)
Net Income per Common Share – assuming dilution $2.02 $1.31 $1.12
Note that Smucker did report an accounting change; however, the company had
no extraordinary operations. Therefore, there was no required reporting. Also
note that Smucker’s is reporting diluted EPS. The footnotes disclose that the
diluted EPS is a result of stock options and restricted stock.
Additionally disclosed in Smucker’s footnotes are the computations of simple EPS

and diluted EPS including weighted average shares, the effects of stock options,
and restricted stocks. We will explain these calculations in the following sections.
I MPACT OF CAPITAL STRUCTURE ON EPS REPORTING
In a simple world, the computation (and reporting) of EPS would be

straightforward:
net income
EPS =
shares outstanding
However, the world is not simple. In fact, many firms have issued securities that
have the potential to affect the numerator, the denominator, or both the
numerator and denominator in the calculation of EPS. Hence, to understand EPS,
you must understand the influence of capital structure on EPS reporting. Let’s
begin by defining some common terms:
4 Securities
Exchange Commission, “The J.M. Smucker Company Annual Report,” July 24,
2003, <http://www.sec.gov/Archives/edgar/data/91419/000095015203007045/
l02007aexv13.txt> (October 2003), p. 1.
TOPIC D
• Dilutive securities are stock options, warrants, convertible debt, or convertible

preferred stocks that decrease EPS if they are exercised or converted to
common stock.
• Antidilutive securities increase EPS if exercised or converted to common stock.
For example, if convertible debt is converted to common stock, income
available to holders of common stock increases because interest payments
decrease. If the decrease in interest is sufficiently large relative to the increased
number of shares, EPS will rise.
The proportional increase in the numerator of EPS may outweigh the

proportional increase in the denominator (number of common shares) such that
EPS actually increases. In this case, the conversion of the convertible debt would
be antidilutive. Antidilutive securities are not considered in the calculation of
diluted EPS.
• A simple capital structure is one that contains no potentially dilutive securities. A simple capital
A simple capital structure contains only common stock and non-convertible structure contains
senior securities. no potentially
dilutive securities.
• A complex capital structure contains potentially dilutive securities such as
options, warrants, or convertible securities.
The following section presents methods for reporting EPS for firms with both
simple and complex capital structures.
B ASIC AND DILUTED EPS
All firms with complex capital structures must report both basic EPS and diluted
EPS. Firms with a simple capital structure report only basic EPS.
Companies that report intermediate components of income (e.g., income from

continuing operations, or income before extraordinary items) must report these
components as EPS amounts in either the income statement or in the notes of the
financial statements.
BASIC EARNINGS PER S HARE
The basic earnings-per-share calculation does not consider the effects of dilutive Remember, EPS is
securities. It is the only EPS you can report for firms with simple capital earnings available
structures, and it is one of the two earnings-per-share calculations you must to common
stockholders per
present for firms with complex capital structures. The calculation of basic EPS is:
share of common
stock.
basic EPS =
weighted average number of common shares outstanding
TOPIC D
We subtract the current year’s preferred dividends from net income because EPS
refers to earnings available to the common shareholder. Preferred dividends are paid
from net earnings before common dividends, thus net income minus preferred
dividends is the income accruing to holders of common stock. If preferred
dividends are cumulative and were not paid during the year, then the amount of
preferred dividends that should have been declared for that year is used in the
calculation of EPS. Dividends in arrears from previous years should not be
included in the calculation of EPS.
Example: Basic EPS Calculation
A company has net income of $1,400,000 in 2003. It has $4,000,000 of 10

percent cumulative preferred stock that has not declared dividends in the past
two years. The company had 1,000,000 shares outstanding at the beginning
and the end of 2003. Calculate EPS.
Answer:
The preferred dividends included in the calculation are only those dividends
that should have been paid in 2003: $4,000,000 × 10% = $400,000.
Common stock  net income − preferred dividends 

EPS =  
 ( weighted average number of shares ) 
dividends are not
subtracted from
net income in
calculating EPS. ( $1, 400,000 – $400,000 )
= = $1.00
1,000,000
With a stock
dividend, all The weighted average number of common shares is the number of outstanding
current shares during the year weighted by the portion of the year they were outstanding.
shareholders of Consider the following:

record receive
additional shares
of the company’s • In computing the weighted average number of shares, stock dividends and
stock. Since all stock splits are changes in the units of measurement, not changes in the
shareholders ownership of earnings. Stock dividends and splits do not change the owners’
receive their stock proportionate claim on the firm’s earnings.
dividend • The effect of stock dividends and splits is applied retroactively to the
allotment based
beginning of the year and is not weighted by the portion of the year after the
on the existing
shares they own, stock dividend or split occurred. In other words, the stock split or dividend is
their applied to all share issuances prior to the split and to the beginning-of-period
proportionate weighted-average shares. A split or dividend is not applied to any shares that
claim on the are issued or repurchased after the dividend or split date.
company’s
earnings remains
unchanged.
TOPIC D
Example: Effect of Stock Dividends on EPS
During 2003, a company had net income of $100,000 and paid dividends of
$50,000 to its preferred stockholders and $30,000 to its common
shareholders. The company’s common stock account is shown in Figure 2:
Figure 2: Common Stock Account

1/1/03 Shares issued and outstanding at the beginning of the year 10,000
4/1/03 Shares issued 4,000
7/1/03 10% stock dividend
9/1/03 Shares repurchased for the treasury 3,000
Compute the weighted average number of common shares outstanding during

2003 and basic EPS.
Answer:
Step 1: Adjust the number of pre-stock dividend shares to their post-stock

dividend units to reflect the 10% stock dividend by multiplying by
1.1 all share numbers prior to the stock dividend. Shares issued or
retired after the stock dividend are not affected. Figure 3 contains
the adjusted common stock account.
Figure 3: Adjusted Common Stock Account All shares issued

1/1/03 Initial shares adjusted for the 10% dividend 11,000 before the stock
4/1/03 Shares issued adjusted for the 10% dividend 4,400 dividend are
9/1/03 Shares of treasury stock repurchased (no adj.) –3,000 adjusted for the
impact of that
dividend. The
Step 2: Compute the weighted average number of post-stock dividend
same practice
shares as shown in Figure 4. applies to stock
splits.
Figure 4: Weighted Average Number of Shares
Initial shares (11,000)(12 months outstanding) 132,000

Issued shares (4,400)(9 months outstanding) 39,600
Retired treasury shares (3,000)(4 months retired) – 12,000
Total shares × months outstanding 159,600
Average shares 159,600/12 = 13,300
Step 3: Compute basic EPS.
net income − pref div.

basic EPS =
wt. avg. shares of common
$100,000 − $50,000
= = $3.76
13,300
TOPIC D
Looking ahead: A pooling of interests is an accounting method that is applied when two
companies merge. The pooling of interests method is no longer employed under U.S.
GAAP. Methods of business combinations, including the purchase and pooling methods,
will be discussed in Module 5, Topic B.
Things to know about the weighted average shares outstanding:
• The weighting system is days outstanding divided by the number of days in a

year.
• Shares issued enter into the computation from the date of issuance.
• Reacquired shares are excluded from the computation from the date of
reacquisition.
• Previously reported EPS data is restated to reflect stock splits and dividends.
• Shares sold or issued in a purchase of assets are included from the date of
issuance.
• Stock issued in pooling of interests is included as of the beginning of all
periods presented.
Example: Basic EPS Calculation
A company has net income of $10,000. Cash dividends of $1,000 were paid to
preferred, and $1,750 in dividends were paid to common. At the beginning of
the year, there were 10,000 shares outstanding, and 2,000 new shares were
issued on July 1. Assuming a simple capital structure, calculate the company’s
basic EPS.
Answer:
First, calculate the company’s weighted average number of shares:
Shares outstanding all year 10,000(12/12) = 10,000

= 1,000
Shares outstanding half year 2,000(6/12)

Weighted average shares = 11,000 shares
Since the original shares were outstanding the entire year, their weight is 12/
12. The shares issued on July 1 were outstanding for half of the year or 6 of 12
months.
net income − pref div. $10,000 − $1,000

basic EPS = = = $0.82
wt. avg. shares of common 11,000
TOPIC D
DILUTED E ARNINGS PER SHARE
If a firm has a complex capital structure containing dilutive securities, then Diluted EPS is
diluted EPS will treat these securities as if they were converted to common stock calculated
from the first of the year ( or when issued if issued during the current year). assuming that all
dilutive securities
are converted into
Basic EPS does not consider these dilutive securities in its computation, and common stock.
neither basic nor diluted EPS consider antidilutive securities in their computations.
If a firm only has antidilutive securities that serve to increase EPS, then the firm
will only report basic EPS. Diluted EPS does not consider antidilutive securities
in its calculation, meaning basic and diluted EPS will be equal.
Each issue of potential common shares (potentially dilutive financial instruments)

must be considered separately. You should only consider income from continuing
operations (excluding discontinued operations, extraordinary items, and
accounting changes) in determining diluted EPS.
The numerator of the basic EPS equation contains income available for common Key point: The
shareholders (net income from continuing operations less preferred dividends). idea behind
Remember, the idea behind diluted EPS is to present a conservative estimate of diluted EPS is to
present a
EPS in the case of ownership dilution. conservative
estimate of EPS in
To calculate EPS, you must do the following: case of ownership
dilution.
• If there are dilutive securities, adjust the income measure accordingly (i.e.,
adjust the numerator).
• If convertible preferred stock is dilutive, add the convertible preferred Multiplying by
dividends back to the previously calculated income from continuing (1 – t) converts the
operations less preferred dividends. before-tax interest
expense to its
• If convertible bonds are dilutive, their interest expense multiplied by (1 – t )
after-tax
must be added back to the numerator. contribution to

net income.
Summary of the important points to remember in calculating diluted EPS:
• The effect of the contingent securities is only impounded into diluted EPS if
the effect is dilutive.
• If the denominator in the EPS calculation is adjusted (i.e., the weighted
average shares outstanding changes), the numerator may also need to be
adjusted to reflect an increase in earnings available to common shareholders.
• The denominator contains the number of shares of common stock issued,
weighted by the days that the shares have been outstanding. A share
outstanding all year is counted as one share; but a share outstanding for only a
third of a year is counted as a third of a share.
TOPIC D
• The numerator contains income available to common shareholders. When

If the exercise
calculating diluted EPS, the numerator must be adjusted for the dividends
price of a stock
option is greater (preferred stock) or interest (convertible bonds) of the dilutive securities.
than the average • All dilutive securities must be considered in calculating EPS.
market price of the • Antidilutive securities must not be included in calculating EPS.
stock, it is unlikely
that the options Dilutive stock options. Dilutive stock options increase the number of outstanding
will be exercised
common shares in the denominator for diluted EPS. There is no adjustment to
(it would be
cheaper to buy the net income in the numerator.
stock in the
market), and • Stock options are dilutive only when the exercise price is less than the average
therefore no market price.
dilution will • To calculate the adjustment to the number of shares in the denominator, you
occur.
must use the treasury stock method, which we will discuss next.
A warrant is a Warrants. If there are restrictions on the proceeds received when warrants are
long-term call exercised (e.g., must be used to retire debt), then you must reflect the results of
option to purchase those agreements in the dilutive EPS calculations.
the issuing
company’s • Treasury stock method. This method is used to account for the increase in
common stock at a
shares stemming from the exercise of options and warrants:
predefined price.
The treasury stock method assumes that the funds received by the
company from the exercise of the options (called the boot ) are used to
The treasury stock purchase shares of the company’s common stock in the market at the
method is used average market price.
when there is a The net increase in the number of outstanding shares (the adjustment to
cash inflow the denominator) will therefore be the number of shares created by
associated with
the conversion to
exercising the options less the number of shares repurchased.
common stock.
• The diluted EPS equation is:
adjusted income available for common shares

diluted EPS =
weighted-average common and potential common shares outstanding
where adjusted income available for common shares is:
Earnings available for common shares

+ Dividends on convertible preferred stock
+ After-tax interest on convertible debt
= Adjusted income available for common shares
TOPIC D
Therefore, diluted EPS is as follows:
 convertible   convertible 
 preferred     
 net income − dividends  +  preferred  +  debt  (1 − t)
  
diluted  dividends   interest 
=
EPS  weighted   shares from   shares from   shares 
       
 average  +  conversion of  +  conversion of  +  issuable from 
 shares   conv. pfd. shares   conv. debt   stock options 
       
Well, that’s a big equation! However, if you take it one step at a time, it’s not quite
as bad as it looks. Let’s walk through some examples.
Example 1: EPS With Convertible Debt
During 2003, Priority Support Corp. reported net income of $11,560 and had
2,000 shares of common stock outstanding for the entire year. Priority
Support also had 1,000 shares of 10 percent, par $100 preferred stock
outstanding during 2003 (total preferred dividend = $10,000). On January 1,
2003, Priority Support issued 60, $1,000 par, 8 percent bonds for $60,000
(issued at par). Each of these bonds is convertible to 100 shares of common
stock. The tax rate is 40 percent. Compute the 2003 basic EPS and calculate
the diluted EPS.
Answer:
Step 1: Compute 2003 basic EPS.
$11,560 − $10,000
basic EPS = = $0.78
2,000
Step 2: Calculate diluted EPS.
• Compute the increase in outstanding common stock if the

convertible debt is converted to common stock at the beginning
of 2003.
• Shares issuable for debt conversion = (60)(100) = 6,000 shares.
TOPIC D
• If the convertible debt were considered common stock, then

there would be no interest expense related to the convertible
debt. Therefore, increase Priority Support’s after-tax net income
for the after tax effect of the decrease in interest expense.
increase in income stemming from conversion =

[(60)($1,000)(0.08)](1 – 0.40) = $2,880
• Compute diluted EPS as if the convertible debt were common

If diluted EPS is stock.
more than basic
EPS, the
net inc − pref div + convert int (1 − t)
convertible bonds diluted EPS =
are antidilutive wt. avg. shares + convertible debt shares
and should not be
treated as common 11,560 − 10,000 + 2,880
stock in = = $0.56
computing diluted 2,000 + 6,000
EPS.
• Check to make sure that diluted EPS is less than basic EPS
($0.56 < $0.78)
Example 2: EPS With Convertible Preferred Stock
During 2003, Priority Support reported net income of $11,560 and had 2,000
shares of common stock and 1,000 shares of outstanding convertible preferred
stock for the entire year. Priority Support’s 10 percent, $100 par value
preferred stock shares are each convertible into 20 shares of common stock.
The tax rate is 40 percent. Compute the 2003 basic EPS and calculate the
diluted EPS.
Answer:
Step 1: Calculate 2003 basic EPS.
$11,560 − $10,000
basic EPS = = $0.78
2,000
Step 2: Calculate diluted EPS.
• Compute the increase in outstanding common stock if the

preferred stock is converted to common stock at the beginning
of 2002: (1,000)(20) = 20,000 shares.
TOPIC D
• If the convertible preferred stock were converted to common

stock, then there would be no preferred dividends paid;
consequently, you should add back to net income the
convertible preferred dividends that had previously been
subtracted out.
• Compute diluted EPS as if the convertible preferred stock were
common stock.
net inc − pref div + convert pref dividends

diluted EPS =
wt. avg. shares + convert pref common shares
11,560 − 10,000 + 10,000

= = $0.53
2,000 + 20,000
• Check to see if diluted EPS is less than basic EPS ($0.53 <
$0.78).
Example 3: EPS With Stock Options
During 2003, Priority Support reported net income of $11,560 and had 2,000 The difference
shares of common stock outstanding for the entire year. Priority Support also between exchange-
had 1,000 shares of 10 percent, par $100 preferred stock outstanding during traded equity call
options and
2003. Priority Support has 1,000 stock options (or warrants) outstanding the
warrants is that
entire year. Each option can be exercised, allowing the holder to purchase 10 the company
shares of common stock at $15 a share. The average market price of Priority issues new shares
Support's common stock during 2002 is $20 a share. Calculate the increase in when warrants are
shares with the treasury stock method and calculate the diluted EPS. exercised.
Answer:
Step 1: Calculate the increase in shares with the treasury stock method as
shown in Figure 5:
The cash inflow
Figure 5: Treasury Stock Method from the exercise
of the options is
Number of common shares created if the options called the boot. In
are exercised 10,000 shares this example, the
boot is $150,000
Cash inflow if the options are exercised ($15/ and is assumed to
share)(10,000) $150,000 be used to
repurchase shares
Number shares that can be purchased with these of the company’s
funds is $150,000/$20 7,500 shares common stock in
the open market at
Net increase in common shares outstanding from the average share
the exercise of the stock options 2,500 shares price.
TOPIC D
Step 2: Calculate the diluted EPS:
$11,560 − $10,000
diluted EPS = = $0.35
2,000 + 2,500
Thus, the options are dilutive (i.e., $0.35 < $0.78).
Example 4: EPS With Convertible Bonds, Convertible Preferred, and

Options (i.e., let’s put it all together!)
During 2003, Priority Support reported net income of $11,560 and had 2,000
shares of outstanding common stock for the entire year. Priority Support also
had 1,000 shares of 10 percent, $100 par convertible preferred convertible
into 20 shares each outstanding for the entire year. Priority Support had 60
$1,000 par value convertible bonds convertible into 100 shares each
outstanding for the entire year. Priority Support also had 1,000 stock options
outstanding during the year. Each option is convertible into ten shares of stock
at $15 per share. The average market price of the stock for the year was $20.
The firm’s tax rate is 40 percent. Calculate Priority Support’s basic and diluted
EPS.
Answer:
Step 1: Calculate basic EPS.
$11,560 − $10,000
basic EPS = = $0.78
2,000
Step 2: Check to see if the convertible preferred and convertible bonds are
antidilutive (which they are not). EPS with convertible bonds

equals $0.56 and with convertible preferred equals $0.53. (See
previous example for solution.)
Step 3: Compute the number of shares created by converting the

convertible securities.
• Converting the convertible preferred shares 20,000 shares

• Converting the convertible bonds 6,000 shares
• Exercising the options 2,500 shares
TOPIC D
Step 4: Compute Priority Support’s diluted EPS.
$11,560 − $10,000 + 10,000 + 2,880

diluted EPS = = $0.47
2,000 + 20,000 + 6,000 + 2,500
Note: The $2,880 in the numerator is from Example 1.
Example 5: Treasury Stock Method
Baxter Company has 5,000 shares outstanding all year. Baxter had 2,000
outstanding warrants all year that were convertible into one share each at $20
per share. The year-end price of Baxter stock was $40, and the average stock
price was $30. Baxter earned $10,000 during the year, and there are no
preferred dividends. Calculate Baxter’s basic and diluted EPS.
Answer:
Using the treasury stock method, the effect of the warrant is computed as
follows:
collect upon conversion of warrants = ( 2,000 )($20 ) = $40,000
$40,000
number of shares if proceeds buy stock = = 1,333 shares
$30 shares
net new shares created = 2,000 − 1,333 = 667 shares
$10,000
basic EPS = = $2 per share
5,000 shares
$10,000
diluted EPS = = $1.76 per share
5,000 + 667 shares
When convertible
In summary, the calculation of EPS will differ as the firm adds dilutive debt is converted
securities to its capital structure: to common stock,
after-tax interest
• When debt is converted to common stock, the analyst will add the after- expense savings is
added back to
tax interest expense saved back to earnings and account for the increase in
earnings to
shares in the denominator of EPS. account for the
• Preferred dividends are added into the numerator. fact that the firm
• For convertible stock options and warrants, we assume the proceeds are no longer pays
used to repurchase common stock and the net common shares are added interest on the
into the denominator of EPS. debt.
TOPIC D
As important as EPS is, its calculation has resulted in considerable discussion over
time with subsequent changes in reporting, which we examine in the next section.
U SES AND LIMITATIONS OF EPS AS AN ANALYTICAL TOOL
EPS is a fundamental determinant of firm valuation, and financial statement users

should have a solid understanding of how reported EPS is calculated. Yet, the
reporting of EPS is not without controversy.
Under U.S. GAAP, Earnings per share is a very important figure because the market price of common
EPS is always stock is sensitive to EPS through its use in the price-earnings (P/E) ratio. Analysts
reported on the will use relative P/Es to value common shares. They may also use EPS to calculate
company’s income
the present value of common shares.
statement.
Prior to the adoption of basic and diluted EPS computation rules, accountants
calculated primary and fully diluted EPS.
• Primary EPS differed from basic EPS because it included convertibles deemed
to be “common stock equivalents.”
• Fully diluted EPS was based on treasury stock method calculations using end-
of-period prices rather than average prices since they were considered more
conservative. Aside from the end-of-year-stock-price treasury stock method,
calculations using the old fully diluted EPS are the same as the current diluted
method EPS.
• Dropping the old primary and fully diluted EPS calculations has eliminated
several arbitrary rules and changed the disclosure of the dilutive effect of
securities used in calculating EPS.
The controversy surrounding EPS calculations, however, is still ongoing.

• The current classification of convertible debt as equity in diluted EPS is

inconsistent with the balance sheet classification of convertible debt as debt.
• The treasury stock method uses the average stock price in its calculation,
which can result in circular causality. This means that lower stock prices will
lead to higher diluted EPS, which may cause higher future stock prices and
eventually lead to lower future diluted EPS. Because of these and other
problems, only with great caution should you use basic EPS for a firm with a
complex capital structure.
• The usefulness of earnings per share is limited by questions and criticisms of
the accounting computation of earnings (e.g., FIFO versus LIFO, depreciation
expense, etc.).
The financial statement user will want to keep abreast of new developments in
EPS reporting. For example, the impact of executive stock options on existing
TOPIC D
shareholder wealth has generated a good deal of discussion. The accounting

profession is almost certain to develop new methods of calculating EPS in the
future.
EPS WRAP -UP
The stating of net income on a per-share basis results in EPS. Rarely though is the
calculation as simple as dividing net income by the current shares outstanding.
Firms with stock splits, stock dividends, and new stock issued will need to have
their outstanding shares adjusted for the timing of these events. More complex
calculations will be needed if the firm has convertible securities or options
outstanding that result in dilution of EPS. In this case, the analyst will want to
examine both basic and diluted EPS to determine the impact on common
shareholders from these dilutive securities. The calculation of EPS has changed
through time, and disagreement still exists over the best way to account for
potentially dilutive securities. Furthermore, in this topic, we took earnings as a
given in the calculation of EPS. As other topics illustrate, accounting earnings are
subject to management discretion and deliberate manipulation. Hence, the astute
analyst will not only understand the nuances of EPS calculation but will also be
able to assess the quality of the earnings reported as net income.
TOPIC D
CONCEPT CHECKERS
1. Which of the following does NOT have to be presented on a per share basis? Income:
A. from continuing operations.
B. before unusual items.
C. before accounting change.
D. before extraordinary items.
2. A company paid stock dividends in January 2001, 2002, and 2003. Its fiscal year ends on
December 31. Which of the following is TRUE concerning presentation of earnings per share
(EPS)? EPS for:
A. 2001 and 2002 must be restated using all stock dividends up to year-end 2002.
B. 2002 should be restated using the 2002 stock dividend; 2001 EPS need not be restated.
C. 2001 and 2002 must be restated using all stock dividends.
D. 2002 must be restated using all stock dividends; 2001 EPS need not be restated.
3. In the treasury stock method, the proceeds from the exercise of warrants are assumed to:
A. buy common stock at the average market price.
B. increase income available to common stockholders.
C. be invested in government bonds.
D. be off-income statement income.
4. At the beginning of 2003, a company had 400,000 shares of common stock outstanding. The
company paid a 10 percent stock dividend on March 31, 2003. The company issued 90,000 new
common shares on June 30, 2003, and repurchased 12,000 shares on December 1, 2003. The
number of shares the company should use in computing basic EPS at the end of 2003 is:
A. 440,000.
B. 476,000.
C. 484,000.
D. 490,500.
5. Given the following information, how many shares should be used in computing diluted EPS?
• 300,000 shares outstanding.
• 100,000 warrants exercisable at $50 per share.
• Average share price is $55.
• Ending share price is $60.
A. 9,091.
B. 90,909.
C. 309,091.
D. 390,909.
TOPIC D
6. An analyst gathered the following information about a company:

• 100,000 common shares outstanding all year.
• Earnings of $125,000.
• 1,000, 7% $1,000 par bonds convertible into 40 shares each outstanding all year.
• The tax rate is 40%.
The company’s diluted EPS is:

A. $1.09.
B. $1.19.
C. $1.23.
D. $1.25.
7. An analyst has gathered the following information about a company:

• Net income for 2003 was $13,000.
• The company had 3,000 shares of common stock and 1,200 shares of outstanding preferred
stock for the entire year.
• The company’s 9%, $100 par value preferred stock shares are each convertible into 5 shares
of common stock.
Calculate EPS on a basic and diluted basis.

Basic Dilutive
A. $1.44 $4.33
B. $1.44 $0.73
C. $0.73 $0.73
D. $0.73 $1.44
TOPIC D
ANSWERS: EARNINGS PER SHARE
1. B Simple EPS should be shown for income from continuing operations, income before extraordinary operations, and
income before accounting changes.
2. C All EPS must be stated on the basis of the date that the financial statements are issued.
3. A The treasury stock method assumes that the proceeds from the exercise of warrants is used to purchase common
shares at the average market price, thus reducing the denominator in EPS.
4. C There were (400,000 × 1.1 =) 440,000 shares for six months, 530,000 shares for five months, and 518,000 shares
for one month. The weighted average number of shares is:
1 5 1
× 440,000 + × 530,000 + × 518,000 = 484,000
2 12 12
5. C Proceeds from sale = 100,000 × $50 = $5,000,000.
$5,000,000
Number of shares purchased = = 90,909
$55
(Note: The average stock price of $55 should be used.)
Number of total shares = 300,000 + 100,000 – 90,909 = 309,091.
6. B The exercise of the bonds would increase pretax income by $1,000 × 1000 × 7% × (1 – 0.40) = $42,000. The
number of shares would increase by 1,000 × 40 = 40,000.
$125,000 + $42,000
EPS = = $1.19
100,000 + 40,000
13,000 − 10,800
7. C Basic EPS = = $0.73
3,000
Check for dilutive items:
13,000 − 10,800 + 10,800

Diluted EPS = = $1.44
3,000 + 1,200 × 5
Since this amount is greater than basic EPS, the bonds are antidilutive and dilutive EPS = basic EPS.
MODULE 2: FUNDAMENTALS OF FINANCIAL
STATEMENT ANALYSIS – R EVIEW TEST
1. Using the following information, what is the firm’s cash flow from operations?
Net income $120

Decrease in accounts receivable $20
Depreciation $25
Increase in inventory $10
Increase in accounts payable $7
Decrease in wages payable $5
Increase in deferred taxes $15
Profit from the sale of fixed assets $2
A. $142.
B. $158.
C. $170.
D. $174.
Use the following data to answer Questions 2 to 4.
Net income $45

Depreciation $75
Taxes paid $25
Interest paid $5
Dividends paid $10
Cash received from sale of company building $40
Sale of preferred stock $35
Repurchase of common stock $30
Purchase of machinery $20

Issuance of bonds $50
Debt retired through issuance of common stock $45
Paid off long-term bank borrowings $15
Profit on sale of building $20
2. The cash flow from operations is:

A. $70.
B. $100.
C. $120.
D. $185.
R EVIEW TEST
3. The cash flow from investing activities is:

A. –$30.
B. $20.
C. $50.
D. $70.
4. The cash flow from financing activities is:

A. $30.
B. $55.
C. $75.
D. $85.
5. Given the following:
Sales $1,500
Increase in inventory $100
Depreciation $150
Increase in accounts receivable $50
Decrease in accounts payable $70
After tax profit margin 25%
Gain on sale of machinery $30
The cash flow from operations is:

A. $25.
B. $115.
C. $275.
D. $375.
REVIEW TEST
Balance Sheet 2001 2000

Assets
Cash $290 $100
Accounts receivable 250 200
Inventory 740 800
Property, plant, & equipment 920 900
Accumulated depreciation (290) (250)

Accounts payable $470 $450
Interest payable 15 10
Dividend payable 10 5
Mortgage 535 585
Bank note 100 0
Common stock 430 400
Retained earnings 350 300
Income Statement 2001

Sales $1,425
Cost of goods sold 1,200
Depreciation 100
Interest expense 30
Gain on sale of old machine 10
Taxes 45
Net income $60
Notes:
• Dividends declared to shareholders were $10.
• New common shares were sold at par for $30.
• Fixed assets were sold for $30. Original cost of these assets was $80, and $60 of accumulated
depreciation has been charged to their original cost.
• The firm borrowed $100 on a 10-year bank note—the proceeds of the loan were used to pay
for new fixed assets.
• Depreciation for the year was $100 (depreciation increased $40 and depreciation on sold
assets $60).
R EVIEW TEST
6. The cash flow from operations, using the indirect method, equals:
A. $125.
B. $145.
C. $165.
D. $185.
7. Cash collections equal:

A. $1,250.
B. $1,375.
C. $1,425.
D. $1,475.
8. Cash inputs equal:

A. $1,000.
B. $1,020.
C. $1,120.
D. $1,280.
9. Other cash expenses equal:

A. $45.
B. $65.
C. $70.
D. $75.
10. Cash flow from operations, using the direct method, equals:
A. $125.
B. $145.
C. $165.
D. $185.
11. Cash flow from financing equals:

A. –$90.
B. $65.
C. $75.
D. $85.
12. Cash flow from investing equals:

A. –$80.
B. –$70.
C. $75.
D. $85.
REVIEW TEST
13. Total cash flow is:

A. –$190.
B. $100.
C. $190.
D. $290.
14. Free cash flow, considering flows available to shareholders, is:

A. $115.
B. $165.
C. $195.
D. $215.
15. Which of the following would be the impact on investing cash flow and financing cash flow if
the company leased the new fixed assets instead of borrowing the money and purchasing the
equipment?
A. There would be no change in either type of cash flow.
B. Investing cash flow would be higher and financing cash flow would be the same.
C. Investing cash flow would be the same and financing cash flow would be lower.
D. Investing cash flow would be higher and financing cash flow would be lower.
16. Which of the following items is NOT considered a cash flow from a financing activity in the
statement of cash flows?
A. Receipt of cash from the sale of capital stock.
B. Receipt of cash from the sale of bonds.
C. Payment of cash for dividends.
D. Payment of interest on debt.
17. Which of the following would NOT cause a change in investing cash flow?
A. The sale of a division of the company.
B. The purchase of new machinery.
C. An increase in the depreciation expense.

D. The sale of obsolete equipment with no remaining book value.
18. Which of the following would NOT cause a change in cash flow from operations?
A. A decrease in notes payable.
B. An increase in interest expense.
C. An increase in accounts payable.
D. An increase in cost of goods sold.
19. Sales of inventory would be classified as:

A. operating cash flow.
B. investment cash flow.
C. financing cash flow.
D. no cash flow impact.
R EVIEW TEST
20. Sale of land would be classified as:

21. Increase in taxes payable would be classified as:

22. Increase in interest payable would be classified as:

23. Write off of obsolete equipment would be classified as:

24. Interest expense would be classified as:

25. Depreciation expense would be classified as:

26. To study trends in a firm’s cost of goods sold (COGS), the analyst should standardize the cost of
goods sold numbers to a common-sized basis by dividing COGS by:
A. assets.
B. sales.
C. net income.
D. the prior year’s COGS.
REVIEW TEST
27. A company’s current ratio is 1.9 times. If some of the accounts payable are paid off from the cash
account, the:
A. numerator and the current ratio would remain unchanged.
B. numerator would decrease more than the denominator, resulting in a lower current ratio.
C. denominator would decrease more than the numerator, resulting in a higher current ratio.
D. numerator and denominator would decrease proportionally, leaving the current ratio
unchanged.
28. A company’s quick ratio is 1.2 times. If inventory were purchased with cash, the:
A. numerator and the quick ratio would remain unchanged.
B. numerator would decrease more than the denominator, resulting in a lower quick ratio.
C. denominator would decrease more than the numerator, resulting in a higher quick current
ratio.
D. numerator and denominator would decrease proportionally, leaving the current ratio
unchanged.
29. All other things held constant, which of the following transactions will increase a firm’s current
ratio if the ratio is greater than one?
A. Accounts receivable are collected and the funds received are deposited in the firm’s cash
account.
B. Fixed assets are purchased from the cash account.
C. Accounts payable are paid with funds from the cash account.
D. Inventory is purchased on account.
30. RGB, Inc.’s, income statement indicates COGS of $100,000. The balance sheet shows an
average accounts payable balance of $12,000. Which of the following amounts is closest to RGB’s
average payment period?
A. 28 days.
B. 37 days.
C. 44 days.
D. 52 days.
31. RGB, Inc., has a gross profit margin of $45,000 on sales of $150,000. The balance sheet shows
average total assets of $75,000 with an average inventory balance of $15,000. What are RGB’s
total asset turnover and inventory turnover, respectively?
Total asset turnover Inventory turnover
A. 0.50 times 0.33 times
B. 2.00 times 7.00 times
C. 7.00 times 2.00 times
D. 10.00 times 0.60 times
R EVIEW TEST
32. If RGB, Inc., has annual sales of $100,000, average accounts payable of $30,000, and average
accounts receivable of $25,000, what are RGB’s receivables turnover and average collection
period, respectively?
Receivables turnover Average collection period
A. 1.8 times 203 days
B. 2.1 times 174 days
C. 3.3 times 111 days
D. 4.0 times 91 days
33. If RGB, Inc.’s, receivable turnover is 10 times, the inventory turnover is 5 times, and the
payables turnover is 9 times, RGB’s cash conversion cycle is:
A. 69 days.
B. 104 days.
C. 150 days.
D. 170 days.
34. If RGB, Inc.’s, income statement shows: sales of $1,000; COGS of $400; pre-interest expense of
$300; and operating expenses excluding interest expense of $100, RGB’s interest coverage ratio
is:
A. 1 times.
B. 2 times.
C. 3 times.
D. 4 times.
35. Return on equity using the traditional duPont formula equals:

A. (net profit margin)(interest component)(solvency ratio).
B. (net profit margin)(total asset turnover)(tax retention rate).
C. (net profit margin)(total asset turnover)(financial leverage multiplier).
D. (tax rate)(interest expense rate)(financial leverage multiplier).
36. If RGB, Inc., has a net profit margin of 12 percent, a total asset turnover of 1.2 times, a
financial leverage multiplier of 1.2 times, and a return on assets of 14.4 percent, which of the
following amounts is closest to RGB’s return on equity?
A. 12.0%.
B. 14.2%.
C. 17.3%.
D. 18.9%.
REVIEW TEST
37. What is RGB, Inc.’s, return on equity given the following information?
EBIT/Sales = 10% Tax retention rate = 60%

Sales/Assets = 1.8 times Current ratio = 2 times
Interest/Assets = 2% Return on assets (ROA) = 0.096
Assets/Equity = 1.9 times
A. 10.50%.
B. 11.32%.
C. 12.16%.
D. 18.24%.
38. All of the following equations represent return on equity EXCEPT:

A. (net profit margin)(equity turnover).
B. (net profit margin)(total asset turnover)(assets/equity).
C. (ROA)(interest burden)(tax retention rate).
D. [(operating profit margin)(total asset turnover) – interest expense rate)]
(financial leverage multiplier)(tax retention rate).
39. A firm has a dividend payout ratio of 40 percent, a net profit margin of 10 percent, an asset
turnover of 0.9 times, and a financial leverage multiplier of 1.2 times. Which of the following
amounts is closest to the firm’s sustainable growth rate?
A. 5.5%.
B. 6.5%.
C. 7.5%.
D. 8.0%.
Use the following data for Questions 40 to 45. (Answers may be rounded off.)
Alpha Company
Sales $5,000
Cost of goods sold 2,500
Average inventories 600
Accounts receivable 450
Working capital 750
Cash 200
Accounts payable 500
Fixed assets 4,750
Total assets $6,000
Annual purchases $2,400
R EVIEW TEST
40. Alpha’s inventory turnover is closest to:

A. 3.1 times.
B. 4.2 times.
C. 6.3 times.
D. 8.4 times.
41. Alpha’s average inventory processing period is:

A. 37 days.
B. 44 days.
C. 65 days.
D. 88 days.
42. Alpha’s receivables turnover is:

A. 11.11 times.
B. 12.12 times.
C. 13.50 times.
D. 15.00 times.
43. Alpha’s average collection period is closest to:

A. 25 days.
B. 30 days.
C. 33 days.
D. 45 days.
44. Alpha’s payables turnover is:

A. 4.0 times.
B. 4.8 times.
C. 5.0 times.
D. 10.0 times.
45. Alpha’s average days payable is:

A. 37 days.
B. 62 days.
C. 73 days.
D. 76 days.
46. Alpha’s cash conversion cycle is:

A. 19 days.
B. 33 days.
C. 48 days.
D. 127 days.
REVIEW TEST
Beta Co. has a loan covenant requiring it to maintain a current ratio of 1.5 or better. As Beta
approaches year-end, current assets are $20 million ($1 in cash, $9 in accounts receivable and $10 in
inventory) and current liabilities are $13.5 million.
47. What is Beta’s current ratio?

A. 0.675 times.
B. 0.740 times.
C. 1.480 times.
D. 1.500 times.
48. What can Beta Co. do to meet its loan covenant?

A. Sell $1 million in inventory, and deposit the proceeds in the company’s checking account.
B. Borrow $1 million short term, and deposit the funds in their checking account.
C. Sell $1 million in inventory, and pay off some of its short-term creditors.
D. Do nothing at all.
49. If Beta sells $2 million in inventory on credit, the current ratio will:
A. increase and if Beta sells $1 million in inventory and pays off accounts payable the quick
ratio will remain the same.
B. remain the same and if Beta sells $1 million in inventory and pays off accounts payable the
quick ratio will decrease.
C. remain the same and if Beta sells $1 million in inventory and pays off accounts payable the
quick ratio will increase.
D. increase and if Beta sells $1 million in inventory and pays off accounts payable the quick
ratio will increase.
50. In 1991, RGB, Inc.’s operating profit margin (EBIT/S) was 15 percent; total asset turnover (S/
A) was 1 times; financial leverage multiplier (A/E) was 2; tax retention rate was 70 percent; and
interest expense rate (I/A) was 7 percent. In 2001 RGB’s operating profit margin was 10 percent;
total asset turnover 1.5 times; financial leverage multiplier was 2 times; tax retention rate 70
percent; interest expense rate 7 percent. Which statement is TRUE? Return on equity:
A. increased because the firm’s asset turnover increased.
B. fell because the firm’s profit margin fell.
C. remained constant because the fall in profits offset the increase in sales.
D. remained constant because the increase in profits offset the decrease in sales.
51. Which of the following securities would NOT be found in a simple capital structure?
A. 6%, $1,000 par value convertible bond.
B. 7%, $5,000 par value debenture.
C. 8%, $1,000 par value callable mortgage bond.
D. 9%, $100 par value nonconvertible preferred.
R EVIEW TEST
52. Which of the following actions require a restatement of prior earnings per share (EPS)?
A. New issuance of common stock for cash.
B. Stock repurchases.
C. Issuance of common stock in a purchase of assets.
D. Issuance of common stock in a pooling of interests.
53. The Hall Corporation had 100,000 shares of common stock outstanding at the beginning of the
year. Hall issued 30,000 shares of common May 1. On July 1, the company issued a 10 percent
stock dividend. On September 1, Hall issued 1,000, 10 percent bonds convertible into 21 shares
of stock each. What is the weighted average number of shares to be used in computing basic and
diluted EPS, assuming the convertible bonds are dilutive?
Basic Dilutive
A. 130,000 132,000
B. 132,000 139,000
C. 132,000 146,000
D. 139,000 146,000
An analyst gathered the following information about a company:

• Net income of $800,000 for the year.
• At the beginning of the year, there were 70,000 common shares outstanding.
• There are 30,000 shares of 8 percent, $100 par cumulative nonconvertible preferred outstanding.
• In the past year, the company has had the following common stock transactions:
March 30: declared a 10% stock dividend.
March 31: issued 10,000 shares for cash.
54. How many common shares should be used in computing the company’s EPS?
A. 70,000.
B. 82,750.
C. 84,500.
D. 85,250.
55. What is the company’s EPS?

A. $4.98.
B. $6.63.
C. $9.47.
D. $11.43.
REVIEW TEST
An analyst gathered the following information about a company:

• 2,500,000 shares outstanding at the beginning of the year.
• 2,000,000 weighted average number of shares outstanding for the year.
• $40 average stock price for the period.
• $50 ending stock price.
• 1,000,000 warrants outstanding exercisable at $30 per share.
• 100,000 7%, $1,000 par value convertible bonds (conversion ratio 15 to 1) issued two years ago.
• $5,000,000 net after tax income for the year.
• 30% tax rate.
56. Basic EPS is:

A. $2.10.
B. $2.22.
C. $2.50.
D. $2.64.
57. Diluted EPS is:

A. $1.33.
B. $2.22.
C. $2.33.
D. $3.64.

• 100,000 common shares outstanding from the beginning of the year.
• Earnings of $125,000.
• 1,000 7%, $1,000 par bonds convertible into 25 shares each outstanding as of the beginning
of the year.
What is the company’s diluted EPS?

A. $1.22.
B. $1.25.
C. $1.34.
D. $1.42.
R EVIEW TEST

• Warrants outstanding all year on 50,000 shares, exercisable at $20 per share.
• Stock is selling at year-end for $15.
• The average price of the company’s stock for the year was $25.
How many shares should be used in calculating the company’s diluted EPS?
A. 10,000.
B. 50,000.
C. 60,000.
D. 90,000.
60. An analyst has gathered the following information about a company:

• Warrants outstanding all year on 50,000 shares, exercisable at $20 per share.
• Stock is selling at year-end for $25.
• The average price of the company’s stock for the year was $15.
How many shares should be used in calculating the company’s diluted EPS?
A. 16,667.
B. 33,333.
C. 50,000.
D. 66,667.
M ODULE 2: F UNDAMENTALS OF F INANCIAL
S TATEMENT ANALYSIS – R EVIEW T EST ANSWERS
1. C Net income – profits from sale of land + depreciation + decrease in receivables – increase in inventories + increase
in accounts payable – decrease in wages payable + increase in deferred taxes = 120 – 2 + 25 + 20 – 10 + 7 – 5 + 15
= $170. Note that the profit on the sale of land should be subtracted back from net income (to avoid double
counting the gain in net income and investing activities).
2. B Net income – profits from sale of building + depreciation = 45 – 20 + 75 = $100. Note that taxes and interest are
already included in net income, and the profit on the sale of the building should be subtracted from net income.
3. B Cash from sale of building – purchase of machinery = 40 – 20 = $20
4. A Sale of preferred + issuance of bonds – payment of bank borrowings – repurchase of common stock – dividends =
35 + 50 – 15 – 30 – 10 = $30. Note that we did not include $45 of debt retired through issuance of common stock
as this was a noncash transaction. Knowing how to handle noncash transactions is important. For example, assume
there was a noncash transaction where the firm acquired some PP&E assets by issuing mortgage debt. Since no cash
was involved in these transactions, they should not appear on the statement of cash flows.
5. C Net income = $1,500 × 0.25 = $375, and cash flow from operations = net income – gain on sale of machinery +
depreciation – increase in receivables – increase in inventories – decrease in accounts payable = 375 – 30 + 150 – 50
– 100 – 70 = $275
6. D Net income – gain on sale of machinery + depreciation – increase in receivables + decrease in inventories + increase
in accounts payable + increase in interest payable = 60 – 10 + 100 – 50 + 60 + 20 + 5 = $185
7. B Sales – increase in receivables = 1,425 – 50 = $1,375
8. C Cost of goods sold – decrease in inventory – increase in accounts payable = 1,200 – 60 – 20 = $1,120
9. C Interest expense – increase in interest payable + taxes = 30 – 5 + 45 = $70
10. D The easiest way is to use the answer to question 6, because it will be the same as cash flow from operations under
the indirect method. Or you can calculate cash collections – cash inputs – cash expenses = 1,375 – 1120 – 70 =
$185.
11. C Sale of stock + new bank note – payment of mortgage – dividends + increase in dividends payable = 30 + 100 – 50
– 10 + 5 = $75
12. B Sale of fixed assets – new fixed assets = 30 – 100 = –$70
13. C The easiest way is to simply take the change in cash from the balance sheet. However, adding the three components
of cash flow will yield 185 – 70 + 75 = $190.
14. A Cash flow from operations – capital spending + sale of fixed assets = $185 – 100 + 30 = $115. Note that we are not
asked for FCF to the firm. If we were asked about FCF to the firm, then we would have added back I(1 – t).
15. D The company would spend less on investments but would have not have inflows from the borrowing.
16. D The payment of interest on debt is an operating cash flow.
R EVIEW TEST ANSWERS
17. C Depreciation does not represent a cash flow.
18. A Changes in notes payable represent a financing cash flow.
19. A Sales of inventory would be classified as operating cash flow.
20. B Sale of land would be classified as investment cash flow.
21. A Increase in taxes payable would be classified as operating cash flow.
22. A Increase in interest payable would be classified as operating cash flow.
23. D Write off of obsolete equipment would be classified as no cash flow impact.
24. A Interest expense would be classified as operating cash flow.
25. D Depreciation expense would be classified as no cash flow impact.
26. B With a common-size income statement, all income statement accounts are divided by sales.
27. C CR = (Cash + AR + Inv)/AP. If cash and AP decrease by the same amount and the CR is > 1, then the denominator
falls faster than the numerator and the current ratio increases.
28. B quick ratio = (cash + AR)/AP. If cash decreases, the quick ratio will also decrease. The denominator is unchanged.
29. C current ratio = current assets/current liabilities. If CR is > 1, then if CA and CL both fall, the overall ratio will
increase.
30. C payables turnover = (COGS/avg. AP) = 100/12 = 8.33. Payables payment period = 365/8.33 = 43.8
31. B total asset turnover = (sales / total assets) = 150/75 = 2
inventory turnover = (COGS/avg. inventory) = (150 – 45)/15 = 7
32. D RT = (S/avg. AR) = 100/25 = 4; CP = 365/4 = 91.25

33. A (365/10 + 365/5 – 365/9) = 69
34. C ICR = EBIT/I = (1000 – 400 – 300)/100 = 3
35. C This is the correct formula for the 3-ratio duPont model for ROE.
 net income   sales   assets 

36. C return on equity =     = ( 0.12 )(1.2 )(1.2 ) = 0.1728
37. D ROE = [(EBIT/S)(S/A) – (I/A)](A/EQ)(1 – t) = [(0.1)(1.8) – (0.02)](1.9)(0.6) = 0.1824
38. C (ROA)(interest burden)(tax retention rate) is not one of the duPont models for calculating ROE.
F INANCIAL STATEMENT ANALYSIS – M ODULE 2
REVIEW TEST A NSWERS
net profit   asset   equity 

39. B g = (retention rate)(ROE), return on equity =     = (0.1)(0.9)(1.2) = 0.108,
 margin   turnover   multiplier 
g = (1 – 0.4)(0.108) = 6.5%
40. B inventory turnover = COGS / avg. inventory = 2500/600 = 4.166
41. D average inventory processing period = 365 / inventory turnover = 365/4.166 = 87.6
42. A receivables turnover = sales / avg. account receivable = 5,000/450 = 11.11
43. C average collection period = 365 / receivables turnover = 365/11.11 = 32.85
44. C payables turnover = COGS / avg. payables = 2,500/500 = 5
45. C average days payable = 365 / payables turnover = 365/5 = 73
 payables 
 average receivables   average inventory  
46. C cash conversion cycle =  +
   payment  = 33 + 88 − 73 = 48
−
 collection period   processing period   period 
 
current assets (1 + 9 + 10 ) 20
47. C current ratio = = = = 1.48
current liabilities 13.5 13.5
48. C This transaction would increase the current ratio: (20 – 1)/(13.5 – 1) = 19 / 12.5 = 1.52. Selling $1 million in
inventory and deposit the proceeds in the company’s checking account would leave the ratio unchanged: (20 + 1 –
1) / 13.5 = 1.48. Borrowing $1 million short term and depositing the funds in their checking account would
decrease the current ratio: (20 + 1)/(13.5 + 1) = 21 / 14.5 = 1.45.
49. C If inventory goes down and receivables rise by the same amount, the numerator would be unchanged. QR = (cash +
AR)/AP. AP will decrease without any change to the numerator, thus increasing the overall ratio.
50. C 1991 ROE = [(0.15)(1) – (0.07)](2)(0.7) = 0.112 and 2001 ROE = [(0.10)(1.5) – (0.07)](2)(0.7) = 0.112
51. A The convertible bond is potentially dilutive and, therefore, would not be found in a simple capital structure.
52. D In a pooling of interests merger, all prior financial statements are restated, thus resulting in a restatement of prior
EPS.
53. B The new stock is weighted by 8/12. The bonds are weighted by 4/12 and are not affected by the stock dividend.
{[100,000 × (12 / 12)] + [30,000 × (8 / 12)]} × 1.10 = 132,000; 132,000 + [21,000 × (4 / 12)] = 139,000
54. C 70,000 × 1.1 = 77,000. 77,000 + [10,000 × (9 / 12)] = 84,500
55. B Don’t forget to subtract the preferred stock dividends. (800,000 – 240,000)/84,500 = $6.63
56. C $5,000,000/2,000,000 = $2.50
57. B The warrants are dilutive because the exercise price is less than the average stock price. Next, check if the
convertible bonds are dilutive. Numerator impact =[(100,000 × 1,000 × 0.07 × (1.0 – 0.3)] = 4,900,000.
Denominator impact = (100,000 × 15) = 1,500,000. EPS = (5,000,000 + 4,900,000) / (2,000,000 + 1,500,000) =
R EVIEW TEST ANSWERS
$2.82. Since this is greater than the basic EPS calculated in question 11, the bonds are antidilutive. Thus, diluted
EPS includes only the warrants. Numerator impact: none. Denominator impact (using treasury stock method):
(1,000,000 × $30) / $40 = 30,000,000/40 = 750,000. Thus, the denominator will increase by 1,000,000 – 750,000
= 250,000 to 2,250,000. Diluted EPS =$5,000,000/2,250,000 = $2.22.
58. B First, calculate basic EPS = 125,000 / 100,000 = $1.25. Next, check if the convertible bonds are dilutive.
Numerator impact = (1,000 × 1,000 × 0.07) × (1.0 – 0.4) = 42,000. Denominator impact = (1,000 × 25) = 25,000.
EPS = (125,000 + 42,000) / (100,000 + 25,000) = $1.34. Since this is greater than the basic EPS, the bonds are
antidilutive. Thus, diluted EPS = basic EPS = $1.25.
59. C Since the exercise price of the warrants is less than the average share price, the warrants are dilutive. Using the
treasury stock method to determine the denominator impact: (50,000 × $20) / $25 = 40,000. Thus, the
denominator will increase by 50,000 – 40,000 = 10,000 to 60,000 shares.
60. C The warrants in this case are antidilutive. The average price per share of $15 < strike price $20. (The year-end price
per share is not used). Don’t use the treasury stock method. The denominator consists of only the common stock.

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M ODULE 2 FUNDAMENTALS

T HE FINANCIAL STATEMENT ANALYSIS P ROCESS

Step 1 Step 2 Step 3 Step 4 Step 5

Goals or Sources of Analytical Financial

Management Cash flow

Page 74 ©2003 Schweser Institute Certificate Program

management, investors, or creditors. It is key to assess the users upfront, so that

GOALS OR OBJECTIVES OF F INANCIAL STATEMENT A NALYSIS

Growth analysis concerned with

©2003 Schweser Institute Certificate Program Page 75

The profitability of a firm and their ability to generate a return on their

Page 76 ©2003 Schweser Institute Certificate Program

Management’s use of financial statements focuses on the overall profitability, Management

BASIC FINANCIAL STATEMENTS

• The income statement was discussed thoroughly in Module 1, Topic B. It

STATEMENT OF CASH F LOWS

©2003 Schweser Institute Certificate Program Page 77

The statement of cash flows will be thoroughly discussed in Topic B of this

OTHER I NFORMATION IN ANNUAL REPORTS

mainly to certain highly inflationary countries and the U.S. Frozen

Page 78 ©2003 Schweser Institute Certificate Program

institutional investors may also get detailed information directly from

©2003 Schweser Institute Certificate Program Page 79

Figure 5: Information Sources

Corporation records, the outlook,

Moody’s Investor Moody’s Manuals and Moody’s

Value Line, Inc. The Value Line Investment Survey valueline.com

Dow Jones-Irwin The Financial Analyst’s Handbook N/A

Dun and Bradstreet

Bloomberg Securities pricing data bloomberg.com

Legal information, news, and

The Wall Street Global news and financial

The Securities and

Page 80 ©2003 Schweser Institute Certificate Program

ANALYTICAL TOOLS FOR FINANCIAL STATEMENT ANALYSIS

COMMON -S IZE FINANCIAL STATEMENTS

Accounts receivable $125,000 Accounts receivable $250,000

Total assets $1,250,000 Total assets $3,000,000

% of total assets 10% % of total assets 8.3%

Company A and Company B have accounts receivable of $125,000 and $250,000

©2003 Schweser Institute Certificate Program Page 81

Trend analysis is a valuable planning tool. Historical financial statements will

Trend analysis is also of value to prospective buyers of the company. Potential

FINDING C OMPARABLE FIRMS

IMPORTANCE OF CASH FLOW

Page 82 ©2003 Schweser Institute Certificate Program

PRO FORMA STATEMENTS

©2003 Schweser Institute Certificate Program Page 83

RISKS OR CONDITIONS I DENTIFIED

COMMON Q UESTIONS ADDRESSED BY ANALYSTS

SPECIFIC C ONCERNS OF C REDITORS

• What is the purpose of the loan or debt?

Page 84 ©2003 Schweser Institute Certificate Program

SPECIFIC C ONCERNS OF E QUITY I NVESTORS

• What is the fundamental value of the firm?

SPECIFIC C ONCERNS OF M ANAGEMENT

• How will management performance be measured and rewarded?

Equity investors typically use what is called a top-down approach or economy,

• The state of the economy.

©2003 Schweser Institute Certificate Program Page 85

STEPS OF FINANCIAL STATEMENT A NALYSIS

Step 1: Identify the goals and objectives of the analysis.

• Valuation of the firm.