Chapter 3

Financial
Statements
and Ratio
Analysis

Copyright 2012 Pearson Prentice Hall.

All rights reserved.

The Stockholders Report

Generally accepted accounting principles (GAAP) are
the practice and procedure guidelines used to prepare and
maintain financial records and reports; authorized by the
Financial Accounting Standards Board (FASB).
The Sarbanes-Oxley Act of 2002, passed to eliminate the
many disclosure and conflict of interest problems of
corporations, established the Public Company Accounting
Oversight Board (PCAOB), which is a not-for-profit
corporation that overseas auditors.

2012 Pearson Prentice Hall. All rights reserved.

3-2

The Stockholders Report

(cont.)
The PCAOB is charged with protecting the interests of
investors and furthering the public interest in the
preparation of informative, fair, and independent audit
reports.
Public corporations with more than $5 million in assets
and more than 500 stockholders are required by the
Securities and Exchange Commission (SEC) to provide
their stockholders with an annual stockholders report,
which summarizes and documents the firms financial
activities during the past year.
2012 Pearson Prentice Hall. All rights reserved.

3-3

Global Focus
More Countries Adopt International Financial Reporting Standards
International Financial Reporting Standards (IFRS) are established by the
International Accounting Standards Board (IASB).
More than 80 countries now require listed firms to comply with IFRS, and
dozens more permit or require firms to follow IFRS to some degree.
In the United States, public companies are required to report financial
results using GAAP, which requires more detail than IFRS.
What costs and benefits might be associated with a switch to IFRS in the
United States?

2012 Pearson Prentice Hall. All rights reserved.

3-4

Focus on Ethics
Take Earnings Reports at Face Value
Near the end of each quarter, many companies unveil their quarterly
performance.
Firms that beat analyst estimates often see their share prices jump, while
those that miss estimates by even a small amount, tend to suffer price
declines.
The practice of manipulating earnings in order to mislead investors is
known as earnings management.
Why might financial managers be tempted to manage earnings?
Is it unethical for managers to manage earnings if they disclose their
activities to investors?

2012 Pearson Prentice Hall. All rights reserved.

3-5

The Four Key Financial Statements:

The Income Statement
The income statement provides a financial summary of a
companys operating results during a specified period.
Although they are prepared quarterly for reporting
purposes, they are generally computed monthly by
management and quarterly for tax purposes.

2012 Pearson Prentice Hall. All rights reserved.

3-6

Table 3.1 Bartlett Company

Income Statements ($000)

2012 Pearson Prentice Hall. All rights reserved.

3-7

Personal Finance Example

2012 Pearson Prentice Hall. All rights reserved.

3-8

The Four Key Financial

Statements: The Balance Sheet
The balance sheet presents a summary of a firms
financial position at a given point in time.
The statement balances the firms assets (what it owns)
against its financing, which can be either debt (what it
owes) or equity (what was provided by owners).

2012 Pearson Prentice Hall. All rights reserved.

3-9

Table 3.2a Bartlett Company

Balance Sheets ($000)

2012 Pearson Prentice Hall. All rights reserved.

3-10

Table 3.2b Bartlett Company

Balance Sheets ($000)

2012 Pearson Prentice Hall. All rights reserved.

3-11

Personal Finance Example

2012 Pearson Prentice Hall. All rights reserved.

3-12

The Four Key Financial Statements:

Statement of Retained Earnings
The statement of retained earnings reconciles the net
income earned during a given year, and any cash dividends
paid, with the change in retained earnings between the start
and the end of that year.

2012 Pearson Prentice Hall. All rights reserved.

3-13

Table 3.3 Bartlett Company Statement of

Retained Earnings ($000) for the Year Ended
December 31, 2012

2012 Pearson Prentice Hall. All rights reserved.

3-14

The Four Key Financial Statements:

Statement of Cash Flows
The statement of cash flows provides a summary of the
firms operating, investment, and financing cash flows
and reconciles them with changes in its cash and
marketable securities during the period.
This statement not only provides insight into a companys
investment, financing and operating activities, but also
ties together the income statement and previous and
current balance sheets.

2012 Pearson Prentice Hall. All rights reserved.

3-15

Table 3.4 Bartlett Company Statement of

Cash Flows ($000) for the Year Ended
December 31, 2012

2012 Pearson Prentice Hall. All rights reserved.

3-16

Financial Statement (Ratio)

Analysis
Ratios are accounting numbers translated
into relative values
Ratios are designed to show relationships
between financial statement accounts within
firms and between firms

17

The Purpose of Ratio Analysis

Gives an idea of how well the company
is doing
Standardizes numbers; facilitates
comparisons
Used to highlight weaknesses and strengths

18

Table 3.5 Financial Ratios for Select Firms

and Their Industry Median Values

2012 Pearson Prentice Hall. All rights reserved.

3-19

Cautions When Using Ratio

Analysis
1. Ratios that reveal large deviations from the norm
merely indicate the possibility of a problem.
2. Do not rely on a single ratio.
3. Financial statements should be dated at same
point in time.
4. Preferable to use audited financial statements.
5. Financial data should have been developed using
same methods.
6. Inflation can distort results.

20

Types of Ratio Comparisons

1.

Cross-Sectional Analysis analyzing multiple firms at same

point in time
10 banks as of December 31, 20xx
Can use industry averages for comparison

2.

Time Series Analysis analyzing one firm over a period of

time
One bank over last 8 quarters
Allows for a trend analysis (positive and negative)
Panel Data or Combined Analysis allows for comparison or
multiple firms over various points in time
Most useful because more data used

3.

21

Five Major Categories of Ratios

Liquidity Ratios: Demonstrate firms ability to meet short-term obligations as they
come due..Is the firm able to meet its current obligations?
Activity Ratios: Measure how effectively the firm manages its assets..Is the firm
effectively managing its assetsagency problem?
Debt Management Ratios: Indicates the degree to which the firm uses other peoples
money to generate profits..Does the firm have the right mix of debt and equity?
Profitability Ratios: Measures the returns of the firm relative to various financial
variables..What are the combined effects of liquidity, asset and debt
management?
Market Value Ratios: Give management an indication of what investors think of the
companys past performance and future prospects..How does the firms stock
price relate to its earnings and the book value per share?

22

Ratio Analysis Example

We will illustrate the use of financial ratios for analyzing
financial statements using the Bartlett Company Income
Statements and Balance Sheets presented earlier in
Tables 3.1 and 3.2.

2012 Pearson Prentice Hall. All rights reserved.

3-23

Liquidity Ratios
Current ratio
Quick (Acid test) ratio

24

Current Ratio

Current Ratio =

Current Assets
Current Liabilities

Measures the margin of liquidity

Rule of thumb measure for adequacy is 2

25

Quick (Acid Test) Ratio

Quick Ratio =

Current Assets- Inventories

Current Liabilities

Inventories subtracted due to illiquid nature

Rule of thumb measure for adequacy is 1

26

Matter of Fact
Determinants of liquidity needs
Large enterprises generally have well established
relationships with banks that can provide lines of
credit and other short-term loan products in the event
that the firm has a need for liquidity.
Smaller firms may not have the same access to credit,
and therefore they tend to operate with more liquidity.

2012 Pearson Prentice Hall. All rights reserved.

3-27

Personal Finance Example

The personal liquidity ratio is calculated by dividing total
liquid assets by total current debt. It indicates the percent
of annual debt obligations that an individual can meet
using current liquid assets.
Calculate Jan and Jon Smiths liquidity ratio for calendar
year 2012:
Liquidity ratio = ($2,225/$21,539) = 0.1033, or 10.3%
That ratio indicates that the Smiths can cover only about
10 percent of their existing 1-year debt obligations with
their current liquid assets.

2012 Pearson Prentice Hall. All rights reserved.

3-28

Activity Ratios
Inventory Turnover Ratio
Average Collection Period or Days Sales
Outstanding
Average Payment Period
Fixed Assets Turnover Ratio
Total Assets Turnover Ratio

29

Inventory Turnover Ratio

Cost of goods sold
Inventory turnover =
Inventory

Average Age of Inventory = 365 Inventory turnover

Tells how quickly inventory is turned over, or sold
Will vary greatly depending on industry

30

Average Collection Period or Days

Sales Outstanding

Tells how long in takes to collect AR

Useful for evaluating firms credit and collection policies

31

Matter of Fact
Who gets credit?
Notice in Table 3.5 the vast differences across industries in the
average collection periods.
Companies in the building materials, grocery, and merchandise
store industries collect in just a few days, whereas firms in the
computer industry take roughly two months to collect on their
sales.
The difference is primarily due to the fact that these industries
serve very different customers.

2012 Pearson Prentice Hall. All rights reserved.

3-32

Average Payment Period

Annual purchases have to be estimated

We assume they are equal to COGS X .70
Tells how long it takes firm to pay it bills

33

Fixed Assets Turnover Ratio

Fixed assets turnover

Sales
Net fixed assets

Measures the efficiency with which the firm has been using its fixed, or
earning, assets to generate sales (higher the better)
Firms with newer (more expensive and less accumulated depreciation)
fixed assets tend to have a lower ratio

34

Total Assets Turnover Ratio

Total assets turnover

Sales
=
Total assets

Measures the efficiency with which the firm uses all of its assets to
generate sales (higher the better)
Good place to look for signs of agency problem

35

Matter of Fact
Sell it fast
Observe in Table 3.5 that the grocery business turns over assets
faster than any of the other industries listed.
That makes sense because inventory is among the most
valuable assets held by these firms, and grocery stores have to
sell baked goods, dairy products, and produce quickly or throw
them away when they spoil.
On average, a grocery stores has to replace its entire inventory
in just a few days or weeks, and that contributes to the rapid
turnover of the firms total assets.

2012 Pearson Prentice Hall. All rights reserved.

3-36

Debt Management Ratios

Greater the debt level the greater the
financial leverage
What is financial leverage?

Debt Ratio
Times-Interest-Earned Ratio
Fixed Charge Coverage Ratio

37

Debt Ratio

Debt ratio = Total liabilities Total assets

Measures the proportion of total assets financed by the firms creditors

The higher the ratio the more financial leverage is utilized

38

Times-Interest-Earned Ratio

Times interest earned ratio = EBIT Interest

Measures the firms ability to meet contractual interest payments (higher

typically better)

39

Fixed Charge Coverage Ratio

FCC

Interest
charges

EBIT Lease payments

Lease Sinking fund payment

payments
1 Tax rate

Measures the firms ability to meet all fixed payment obligations (typically
higher is better)
Will not have to calculate on test

40

Profitability Ratios

Gross Profit Margin

Operating Profit Margin
Net Profit Margin
Return on Total Assets (ROA)
Return on Common Equity (ROE)

41

Gross Profit Margin Ratio

Gross Profit
Gross Profit Margin =
Sales
Measures the percentage of each sales dollar remaining after the COGS has
been paid

42

Operating Profit Margin Ratio

Operating Profit Margin

Operating Profit
Sales

Operating profit also known as EBIT

Measures the percentage of each sales dollar remaining after everything but
interest and taxes has been paid

43

Net Profit Margin Ratio

Net Profit Margin = Earnings Available for Common Stockholders
Sales

Measures the percentage of each sales dollar remaining after all expenses
have been deducted
Earnings available for common stockholders same as net profit if
company has no preferred stock

44

Return on Total Assets

Earnings Available for Common Stockholders

ROA =
Total assets

Measures the effectiveness of management in generating profits with its

available assets
Generally the higher the better

45

Return on Common Equity

ROE =

Earnings Available for Common Stockholders

Common equity

Measures the return on the owners investment in the firm

Closely monitored by investors (higher the better)
Does not represent an individual stockholders actual return

46

Market Value Ratios

Earnings Per Share
Price/Earnings Ratio
Market/Book Ratio

47

Earnings Per Share

Earnings Per Share =

Earnings Available for Common Stockholders

# of Common Shares Outstanding

Represents the net profit per share of outstanding common stock

Simply another way to look at firms profitability

48

Price/Earnings Ratio

P/E Ratio

Market Price Per Share

Earnings Per Share

Measures the amount investors are willing to pay for each dollar of the firms
earnings
The higher the ratio the more confidence investors have in the future
performance of the company

49

Market/Book Ratio
Market/Book Ratio

Book value per share =

Market price per share

Book value per share
Common Stock Equity

# of Common Shares Outstanding

Companies with relatively high rates of return generally sell at

higher multiples of book value than those with low returns
Gives an indication of what investors are willing to pay for one
dollar of the firms value on the balance sheet (book value)

50

Table 3.8a Summary of

Bartlett Company Ratios

2012 Pearson Prentice Hall. All rights reserved.

3-51

Table 3.8b Summary of

Bartlett Company Ratios

2012 Pearson Prentice Hall. All rights reserved.

3-52

DuPont Equation Overview

Merges the income statement and balance sheet
into two summary measures of profitability: ROA
and ROE
Proves useful for quick estimates of the impact that
operating changes have on returns

53