CHAPTER 17

FINANCIAL STATEMENT ANALYSIS

CHAPTER IN PERSPECTIVE

This is the first chapter of a three-chapter series covering long-term and short-term
financial planning. Financial analysis is first covered followed by long-term financial
planning, and finally, working capital management and short-term financing. Up until now,
the management of short-term assets and short-term financing has not received much
attention. Working capital greases the skids for the efficient utilization of capital assets
that produce value. Too little working capital (current assets) and production and sales are
hindered; too much working capital and the rate of return on capital diminishes. Working
capital is justified as long as the incremental rate of return of an added dollar invested in
working capital exceeds the opportunity cost of capital.
We start our planning section with a chapter on financial statement analysis. This chapter
categorizes the scope of financial ratio analysis into five areas: (1) leverage, (2) liquidity,
(3) efficiency or turnover, (4) profitability, and (5) market value. Several ratios are
covered for each area, including an explanation of why the ratio is a good proxy for the
concept. Table 17.11 lists the ratios covered and what accounting and other data are
needed for calculation. Table 17.9 presents a variety of ratios for several industries.
We caution our students that financial statements do not present hard “facts”. Although
people refer to “accounting rules”, much of financial accounting involves judgement and
reflects the goals of those putting the statements together. We encourage our students to
be skeptical users of financial statements, to read the footnotes and think about the
accounting conventions followed, rather than blindly accepting the numbers as the truth.
We also encourage our students to take more financial accounting courses. Now, with the
accounting scandals of Enron, WorldCom and many others, we have more reason to tell
our students to use caution when interpreting financial statements, and to draw on other
sources of information about the company in addition to its financial statements.
For professors who wish to cover working capital concepts early in the course, this
section could easily follow Part I after Chapter 3, Accounting and Finance.

CHAPTER OUTLINE

17.1 FINANCIAL RATIOS

Leverage Ratios

Liquidity Ratios

Efficiency Ratios
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 Profitability Ratios

Market-Value Ratios

17.2 THE DUPONT SYSTEM

Other Important Financial Ratios

17.3 ANALYSIS OF THE STATEMENT OF CASH FLOWS

17.4 USING FINANCIAL RATIOS

Accounting Principles and Financial Ratios

Choosing a Benchmark

17.5 MEASURING COMPANY PERFORMANCE

17.6 THE ROLE OF FINANCIAL RATIOS

17.7 SUMMARY

TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS

17.1 FINANCIAL RATIOS

A. Financial ratios are used to summarize financial information about a company.

Information from the income statement, a listing of revenue, expenses, and profits
over a period of time, and the balance sheet, a listing of assets, liabilities, and net
worth at a point in time, are used to calculate financial ratios related to the
performance and risk level of a business.

B. A balance sheet and income statement are often calculated as common-size

statements by dividing the balance sheet ledger items by total assets, and income
statement items by total revenue.

C. Five types of risk-return areas are studied in this chapter, using financial ratios as
proxies to measure each risk.

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Leverage Ratios

A. The use of fixed cost financing, either debt or preferred stock, is called financial
leverage. Financial leverage presents a risk-return opportunity. Shareholders may
magnify their earnings, or returns, by the use of fixed cost financing but, on the
other hand, debt is a fixed cost, contractual commitment to pay regardless of the
asset earning rate.

B. Creditors, owners, and suppliers are interested in the extent to which a firm has
used debt financing because the more debt a company has, everything else being
equal, the greater the chance it will not be able to pay the interest and repay the
debt.

C. Leverage ratios are two types: balance sheet ratios comparing leverage capital to
total capital or total assets, and coverage ratios that measure the earnings or cash-
flow times coverage of fixed cost obligations.

D. The analyst must decide what to consider as debt, or fixed cost financing. This
would include capital leases and may also include operating leases, especially when
they involve significant amounts of money. Wherever a reference is made to debt,
think of fixed cost financing.

E. The long-term debt ratio measures the proportion of the capital structure or total
capitalization that is made up of debt and lease obligations:

Long-term debt ratio =

The higher is the ratio, the greater the use of financial leverage, posing an
increased risk-return situation for investors.

F. No standard definition of "long-term debt" exists. Generally, one looks for

interest-bearing obligations that must be repaid. Often the current portion of long-
term debt is included as part of long-term debt. Capital leases (on-balance sheet
financing), operating leases (off-balance sheet financing) and other debt equivalents
can be included, especially if the amounts owed are material. Preferred shares are
also long-term fixed obligations and may be included with long-term debt.

G. The debt-to-equity ratio measures the amount of long-term debt to equity or the
amount of leverage capital in relation to the equity cushion under the debt:

Debt-equity ratio =

H. The total debt ratio measures total liabilities, current and long-term, relative to
total assets or the proportion of assets financed by debt:

Total debt ratio =

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 I. A coverage ratio, such as the times interest earned ratio, measures an amount
available relative to amount owed. How many times is the obligation covered?
Times interest earned =

J. The cash coverage ratio broadens the numerator to cash flow from operations
relative to the interest expenses:

Cash coverage ratio =

K. Fixed charge coverage ratios are even broader. One may include principal
payments necessary per period, on a before-tax basis, in the denominator to assess
the ability of operating earnings to cover the total debt obligation of principal and
interest. Other obligations that may be useful to include are dividend payments on
preferred equity and any sinking fund obligations. Remember, though, these are all
paid out of after-tax cash flow and should be converted to a before-tax amount by
dividing by (1 – tax rate).

Liquidity Ratios

A. Liquidity ratios attempt to measure the ability to pay obligations such as current
liabilities and assess the pool of assets available to cover the obligations. Liquidity
is the ability of an asset to be converted to cash quickly at low cost. Converting an
asset into cash occurs in one of two ways: sell the asset, hoping it has reasonable
liquidity, or in the case of a financial asset, like accounts receivable or Treasury bill,
maturity brings cash. Working capital circulates from inventory to accounts
receivable to cash, etc. Accounting value estimates of liquid assets are reasonable
estimates of their value.

B. Current assets (the pool of circulating cash assets available to be allocated to pay
bills) minus current liabilities (the pool of obligations the business must pay in the
near future) is an analytical amount called net working capital (NWC). NWC is a
rough measure of the current assets left over if the current liabilities were paid. The
NWC to total assets ratio estimates the proportion of assets in net current assets,
another name for NWC:

Net working capital/total asset ratio =

C. The current ratio is the classic liquidity ratio, but is merely a variation of the idea
above—what pool of circulating assets is available relative to the pool of current
obligations:
Current ratio =

D. Continuing the theme of assets available to pay obligations, the quick or acid-test
ratio eliminates inventories, the least liquid current asset, from current assets:

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 Quick ratio =

E. The cash ratio eliminates inventories and accounts receivable from current assets
to review the cash assets relative to the current liabilities:

Cash ratio =

F. The interval measure of liquidity measures the firm’s pool of liquid, quick assets
relative to the daily expenditures from operations and gives an estimate of the
number of days’ obligations that are circulating in the quick assets. The more days,
the greater the ability to meet obligations:

Interval measure =

The denominator represents annual cash (not depreciation) expenses divided by

365.

Efficiency Ratios

A. Another area of financial analysis, efficiency ratios, measures how effectively the
business is using its assets. “Using” relates to liquidity or profitability or
performance. The numerators used in efficiency ratios are activity-based items,
such as sales, cost of sales, etc., while the denominators are generally some balance
sheet amount. Turnover ratios are often converted to a time-line focus by dividing
turnover ratios into 365 days.

B. In a typical efficiency ratio, "flow" data from the income statement is measured
against a "stock" (snapshot) data from the balance sheet, creating the possibility of
distortion from timing differences. For example, a rapidly growing company's total
assets at the end of the year will likely be substantially larger than its assets at the
start of the year. If sales are measured over the entire year, then the end-of-year
assets will be "too" high. Analysts deal with this problem several ways. One way
is to use average assets (average of the assets at the end of the current year and the
assets at the end of the previous year), rather than end-of-year assets. A second
way is to change the sales measure to cover a period closer to end of the year, say
take 12 times the sales during the last month of the year. This won't work if the
company's sales are markedly seasonal. For the purpose of making the presentation
simple, we have chosen to define the activity ratios using end-of-year balance sheet
items. Instructors may wish to define the ratios using averages balance sheet
items.

C. The asset turnover ratio measures the sales activity derived from total assets, or
the revenue generated per dollar of total assets. The asset turnover is also an
important component of asset profitability studied later, measuring the revenue per
dollar invested:

Asset turnover ratio =

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 Sales, a measure of activity, may be compared to a variety of balance sheet
accounts (e.g. fixed assets, net working capital, shareholders’ equity, etc.) to
measure the revenue-generating efficiency of the account.

D. The asset turnover ratio based on average total assets (average of total assets at
the end of the current year and the total assets at the end of the previous year) is

Asset turnover ratio =

E. The inventory turnover ratio, using the cost of goods sold representing the
cumulative amount of inventory sold in a period as the numerator and end of year
inventory as the denominator, measures the number of times the value of inventory
turns over in a period:

Inventory turnover =

The inventory turnover may be converted to a time line concept, the number of day
sales in inventories, by finding the reciprocal (1/x) of the inventory turnover times
365 or:

Days’ sales in inventories =

= × 365

F. The average collection period applies the same concept above to accounts
receivable. The average collection period is the estimated number of days it takes
to collect accounts receivable:

Average collection period =

=

The more days’ sales outstanding, the greater amount of capital is tied up in
accounts receivable relative to sales.

Profitability Ratios

A. Profitability refers to some measure of profit relative to revenue or an amount

invested. A profit margin is the ratio of some measure of profits or earnings to
sales and tells how much was earned per dollar of revenue. Profit or return ratios
compares some measure of profit to an amount invested.

B. There are as many definitions of profit margin as there are ways to measure profit.
We look at a few of the more commonly used margins.

C. A commonly used definition of the net profit margin is net income/sales. It

measures the proportion of revenues that finds its way to shareholders' net income.
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 D. The net profit margin is affected by the firm's capital structure. A company with a
lot of debt will tend to have a higher net profit margin than one with little debt
even when their operating performance is similar. The net profit margin is not
useful to compare operating performance of companies with different capital
structures.

E. The operating profit margin is a more appropriate measure of operating

performance than the net profit margin. It is the ratio of net income and interest to
sales, capturing payments to both lenders and shareholders. The operating profit
margin is less affected by the capital structure choice of the company

operating profit margin =

F. An equivalent expression for operating profit margin can be found by rearranging

the expression for net income. From the income statement we see that

net income = EBIT - taxes - interest

This allows us to write:

net income + interest = EBIT - taxes

Thus the operating profit margin can be expressed as:

operating profit margin =

EBIT - taxes is often referred to as operating profit.

G. A word of warning: if the company has other income or losses that are not directly
related to operating activities, these will be added or subtracted to determine to net
income. In this case, operating profit (EBIT-taxes) will not add up to net income +
interest.

H. A commonly used performance ratio is the return on total assets, ROA.

Return on assets, ROA =

I. The return on assets is affected by the firm's financing choice as well as its
operating decisions. By including interest with net income, the operating return on
assets can be found:

Operating return on assets =

J. The operating return on assets ROA is still not fully adjusted for differences in
capital structure. To make a fairer comparison of the overall operating
performance of two companies that happen to have different capital structures, it is
necessary to remove the tax shield benefit. Recall that interest payments are tax
deductible, whereas dividends are not. A company with more debt has higher
interest payments and enjoys a greater tax benefit. To focus exclusively on the
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 operating performance of a company, remove the benefit from the financing
decision by subtracting the interest tax shield, or tax rate × interest payment:

Adjusted operating return on assets =

K. The return on invested capital, ROIC, is a refinement of the operating return on

assets. The main difference is the denominator: in the operating return on assets,
profit is measure relative to total assets which equals total liabilities plus
shareholders’ equity. In the ROIC, only invested capital, debt plus preferred equity
plus common equity, is put into the denominator. This focuses on the profit relative
to funds that have been invested by suppliers of capital:

Return on invested capital, ROIC

=

Again, to completely remove the impact of borrowing, the interest tax shield must
be removed. This gives the following adjusted ROIC:

Return on invested capital, ROIC =

=

L. The return on equity, ROE measures the profitability of the common shareholder’s
equity or return per dollar of invested equity capital:

Return on equity, ROE =

If the company has preferred dividends, the ratio can be redefined as earnings
available for common shareholders, net income less any preferred dividends, to
common equity.

M. The proportion of earnings (or net income) that is paid out as dividends is called
the payout ratio:

Payout ratio =

The complement of the payout ratio is the plowback ratio studied earlier, or the
proportion of earnings retained in the period:

Plowback ratio = 1 - payout ratio

N. The plowback ratio times the return on equity (ROE) is an estimate of the growth
rate in common equity from internally generated earnings, or the sustainable
growth rate in assets that the business can support from internal earnings without
changing the total debt/total asset ratio:
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 Growth in equity from plowback =

= ×

= plowback ratio × ROE

17.2 THE DUPONT SYSTEM

A. The DuPont System is a process of analyzing component ratios, (also called

decomposition) of the ROA and ROE to explain their level or changes.

B. The ROA is comprised of the product of the net profit margin, what the firm earns
on every dollar of sales, times the asset turnover or the extent to which a business
utilizes its assets:

Return on assets, ROA =

= ×

= total asset turnover × net profit margin

Both the profit margin and asset turnover can be broken down in subcomponents
(decomposed) to assess the cause of the level or changes in the ROA. The ability
to earn on assets is comprised of expense control per sales (net profit margin) and
the effective use of assets to generate revenue (asset turnover). A level of ROA can
be generated or changed by affecting the margin or turnover.

C. The ROE is comprised of the ROA times the leverage ratio, or the ROE is related
to the effective, profitable use of assets, the extent of financial leverage, and the
level of interest rates paid on debt:

ROE =

= × × = × ROA

= leverage ratio × asset turnover × net profit margin = leverage ratio × ROA

Other Important Financial Ratios

A. Some important financial ratios combine accounting information with market data.

B. The market-to-book ratio compares the market value of equity to its book value. If
managers are successful at creating value for shareholders, the ratio should be

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 greater than 1.

C. The price-earnings ratio, price per share divided by earnings per share, and the
dividend yield, current dividends divided by share price, are also measure of how
highly valued is the company.

17.3 ANALYSIS OF THE STATEMENT OF CASH FLOWS

A. The cash flow statement can be used to calculate cash flow from assets, or free
cash flow. Start with cash flow from operating activities and add to it cash flow
from investing activities (likely a negative number) to get cash flow from assets.

B. Cash flow from assets must also equal the distributions to bondholders and
shareholders plus any increase in cash.

C. Ratios based on information from the cash flow statement are used. For example,
the ratio of free operating cash flow to total debt is another type of coverage ratio.

17.4 USING FINANCIAL RATIOS

Accounting Principles and Financial Ratios

A. Generally acceptable accounting principles have considerable leeway in accounting

for asset and liability values and income, so that it is often difficult to make an
absolute comparison of company ratio with other companies or the industry ratios.

B. Goodwill is difficult to assess. Some commitments to pay, such as pensions, lease

obligations, and guarantees, are not always shown as a liability. Often important
information can be found in the footnotes to the financial statement.

Choosing a Benchmark

A. Knowing reasonable ranges for the above ratios calculated requires practice.
Useful information can be found through comparison of the trends over time, and
with the ratios of another business in the same industry or with averages of ratios
for several companies.

B. Industry ratios are available from a number of sources. See Table 17.9. Caution
students that industry ratios can be very misleading for several reasons. First, the
definitions of the industry ratios may be different than the ratios you calculate.
Second, variations in accounting practices may result in major differences in the
financial data. Third, the companies may differ in size and also may not be in the
exact same lines of business. Use industry ratios with caution.

C. Differences from averages or earlier trends do not necessarily indicate the company

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 is in trouble, but provides a beginning for understanding why the differences or
changes occurred.

17.5 MEASURING COMPANY PERFORMANCE

A. Companies that earn positive NPVs on their investments most likely will have
generated market value added, the extent to which market value of equity exceeds
the book value of equity.

B. Market value company performance indicators include:

1. Market-to-book ratio
2. Market value added ($)
3. Return on assets (%)
4. Economic value added (EVA) ($)

C. Market value performance measures have two disadvantages:

1. They are based on expectations that positive NPV projects will continue to be
made.
2. Market value-based indicators are difficult to estimate for privately held
companies.

D. Residual income or economic value added is calculated as after-tax operating

profit minus the dollar cost of invested capital. To measure the dollar cost of
invested capital, multiply the dollar amount of invested capital and the cost of
capital (WACC or required rate of return on the invested capital):

Residual income = after-tax operating profit - cost of capital × invested capital

E. Residual income or EVA is a better measure of company profits than accounting
profit. Accounting profits do not recognize the cost of capital or the minimum
return necessary to return shareholders their opportunity rate of return.

17.6 THE ROLE OF FINANCIAL RATIOS

A. Financial ratios often serve as:

1. Goals representing optimal financial condition or performance.
2. Benchmarking comparisons with competitors or higher valued similar
companies.
3. Minimums below which the company hesitates to venture.

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