Chapter 4 Analyzing Financial Statements

Learning Objectives
1. Explain the three perspectives from which financial statements can be viewed. 2. Describe common-size financial statements, explain why they are used, and be able to prepare and use them to analyze the historical performance of a firm. 3. Discuss how financial ratios facilitate financial analysis, and be able to compute and use them to analyze a firms performance. 4. Describe the DuPont system of analysis and be able to use it to evaluate a firms performance and identify corrective actions that may be necessary. 5. Explain what benchmarks are, describe how they are prepared, and discuss why they are important in financial statement analysis. 6. Identify the major limitations in using financial statement analysis

I.
4.1

Chapter Outline
Background for Financial Statement Analysis

Students sometimes get the impression that accounting data is useless because care must be used when interpreting some of the results. They sometimes ask why we bother with financial statement analysis at all. Robert Higgins provides a good answer to this question: objectively determinable current values of many assets do not exist. Faced with a tradeoff between relevant, but subjective current values, and irrelevant, but objective historical costs, accountants have opted for irrelevant, but objective historical costs. This means that it is the users responsibility to make adjustments. Financial statement information is often our ONLY source of information. Consequently, we use the information we have and make adjustments where appropriate. A. Stockholders Perspective Shareholders focus centers on the value of the stock they hold. Their interest in the financial statement is to gauge the cash flows that the firm will generate from operations,

 B.

This allows them to determine the firms profitability, their return for that period, and the dividend they are likely to receive.

Managers Perspective On one hand, managements interest in the firms financial statement is similar to that of shareholders. A good performance by the firm will keep the management in the firm, while a poor performance can cost them their jobs. In addition, management gets feedback on their investing, financing, and working capital decisions by identifying trends in the various accounts that are reported in the financial statements. Creditors Perspective Creditors or lenders are primarily concerned about getting their loans repaid and receiving interest payments on time. Their focus is on: Amount of debt the firm has. Firms ability to meet short-term obligations. Firms ability to generate sufficient cash flows to meet all legal obligations first and still have sufficient cash flows to meet debt repayment and interest payments. Guidelines for Financial Statement Analysis Identify whose perspective you are using to analyze a firmmanagement, shareholder, or creditor. Use only audited financial statements if possible. Perform analysis over a three- to five-year periodtrend analysis. Compare the firms performance to its direct competitorsthat is, firms that are similar in size and offer similar products. Perform a benchmark analysis. This involves comparing it to one or more of the most relevant competitorsAmerican Air with Delta or United Airlines.

C.

D.

Things to consider concerning financial ratios: -What aspects of the firm are we attempting to analyze? -What information goes into computing a particular ratio and how does that information relate to the aspect of the firm being analyzed? -What is the unit of measurement (times, days, percent)? -What are the benchmarks used for comparison? What makes a ratio good or bad? In discussing the nature of financial statement analysis, realize that it is a means to an end, rather than an end in itself. That is, financial ratios uncover areas of interest that a good analyst will use to determine what needs to be investigated further.

4.2

Common-Size Financial Statements A common-sized balance is created by dividing each asset or liability by a base number like total assets or sales. Such common-size or standardized financial statements allow one to compare firms that are different in size. A. Common-Size Balance Sheets Each asset and liability item on the balance sheet is standardized by dividing it by total assets, This results in these accounts being represented as percentages of total assets.

B.

Common-Size Income Statements Each income statement item is standardized by dividing it by the dollar amount of sales. Each income statement item is now indicated as a percentage of sales.

4.3 Financial Statement Analysis A. Overview A ratio is computed by dividing one balance sheet or income statement item by another. A variety of ratios can be computed to focus on specialized aspects of the firms performance. The choice of the scale determines the story that can be garnered from the ratio. Different ratios can be calculated based on the type of firm being analyzed or the kind of analysis being performed. Ratios may be computed to measure liquidity, efficiency, leverage, profitability, or market-value performance. Liquidity Ratios Liquidity ratios measure the ability of the firm to meet short-term obligations with short-term assets without putting the firm in financial trouble. There are two commonly used ratios to measure liquiditycurrent ratio and quick ratio. Current ratio is calculated by dividing the current assets by current liabilities.

B.

Current assets Current ratio = Current liabilites

It tells how many dollars of current assets the firm has per dollar of current liabilities. The higher the number, the more liquid the firm and the better its ability to pay its short-term bills. Quick ratio or acid-test ratio is calculated by dividing the most liquid of current assets by current liabilities. Inventory that is not very liquid is subtracted from total current assets to determine the most liquid assets.

Current assets - Inventory Quick ratio = Current liabilities

It tells us how many dollars of liquid assets the firm has per dollar of current liabilities. The higher the number, the more liquid the firm and the better its ability to pay its short-term bills. Quick ratios will tend to be much smaller than current ratios for manufacturing firms or other industries that have a lot of inventory, while service firms that tend not to carry too much inventory will see no significant difference between the two.

C.

Efficiency Ratios This set of ratios, sometimes called asset turnover ratios, measures the efficiency with which a firms management uses the assets to generate sales. While management can use these ratios to identify areas of inefficiency that require improvement, creditors can use some of these ratios to determine the speed with which inventory can be converted to receivables, which can then be converted to cash and help the firm to meet its debt obligations. These efficiency ratios focus on inventory, receivables, and the use of fixed and total assets. Inventory turnover ratio is calculated by dividing the cost of goods sold by inventory.

Cost of goods sold Inventory turnover ratio = Inventory

Year-end inventory can be used or, if a firm experiences significant changes in the inventory level during the year, the average inventory level can be used. It measures how many times the inventory is turned over into saleable products. The more times a firm can turn over the inventory, the better. Too high a turnover or too low a turnover could be a warning sign. Another ratio that builds on the inventory turnover ratio is the days sales in inventory.

365 days Days' sales in inventory = Inventory turnover

It measures the number of days the firm takes to turn over the inventory. The smaller the number, the faster the firm is turning over its inventory and the more efficient it is. Accounts receivables turnover ratio measures how quickly the firm collects on its credit sales.

Accounts receivables turnover =

Net sales Accounts receivables

The higher the frequency of turnover, the quicker it is converting its credit sales into cash flows. Another measure of the firms efficiency in this regard is Days Sales Outstanding.

365 days DSO = Accounts receivables turnover

It measures in days the time the firm takes to convert its receivables into cash. The fewer the days it takes the firm to collect on its receivables, the more efficient the firm is. Recognize, however, that an overzealous credit department may turn off the firms customers. Total asset turnover ratio measures the level of sales a firm is able to generate per dollar of total assets.

Net sales Total asset turnover = Total assets

The higher the total asset turnover, the more efficiently management is using total assets. Fixed asset turnover ratio measures the level of sales a firm is able to generate per dollar of fixed assets.

Fixed asset turnover =

Net sales Net fixed assets

The higher the fixed asset turnover, the more efficiently management is using its plant and equipment. This ratio is more significant for equipment-intensive manufacturing industry firms, while the total assets turnover ratio is more relevant for service industry firms.

D.

Leverage Ratios The ability of a firm and its owners to use their equity to generate borrowed funds is reflected in the leverage ratios. Financial leverage refers to the use of long-term debt in a firms capital structure. The use of debt increases shareholders returns thanks to the tax benefits provided by the interest payments on debt. Two sets of ratios can be used to analyze leveragedebt ratios that quantify the use of debt in the capital structure and coverage ratios that measure the ability of the firm to meet its debt obligations. The first ratio, total debt ratio, is calculated by dividing total debt by total assets.

Total debt Total debt ratio = Total assets

Total debt includes short-term and long-term debt. The higher the amount of debt, the higher the firms leverage, and the more risky it is. The second leverage ratio is debt-to-equity ratio.

Total debt Debt to equity ratio = Total equity

It measures the amount of debt per dollar of equity.

Debt to equity ratio Debt ratio = 1+ Debt to equity ratio

Equity multiplier = 1 + debt to equity ratio
The third leverage ratio is called the equity multiplier or leverage multiplier.

Equity multiplier = Total assets Total equity

It tells us the amount of assets that the firm has for every dollar of equity. It serves as the best measure of the firms ability to leverage shareholders equity with borrowed funds. Of the coverage ratios, the first one is times interest earned.

EBIT TIE = Interest expense

It measures the number of dollars in operating earnings the firm generates per dollar of interest expense. The higher the number, the greater the ability of the firm to meet its interest obligations. The second ratio is the cash coverage ratio.

EBIT + Depreciation Cash coverage ratio = Interest expense

E. It measures the amount of cash a firm has to meet its interest payments. Profitability Ratios These ratios measure the financial performance of the firm. Gross profit margin measures the amount of gross profit generated per dollar of net sales, while operating profit margin measures the amount of operating profit generated by the firm for each dollar of net sales. Net profit margin measures the amount of net income after taxes generated by the firm for each dollar of net sales.

Gross profit margin =

Net sales - Cost of goods sold Net sales

Operating profit margin

Net sales Net profit margin = Net income Net sales

In each case, the higher the ratio, the more profitable the firm. While management and creditors are likely to focus on these profitability measures, shareholders are likely to concentrate on two others. The return on assets (ROA) ratio measures the amount of net income per dollar of total assets.

EBIT

ROA = Net income Total assets

A variation of this ratio, called the EBIT return on assets, is a powerful measure of return because it tells us how efficiently management utilized the assets under

their command, independent of financing decisions and taxes. This measures the amount of EBIT per dollar of total assets. The return on equity (ROE) ratio measures the dollar amount of net income per dollar of shareholder s equity.

ROE = Net income Total equity

F. For a firm with no debt ROA = ROE; for firms with leverage ROE > ROA (assuming that ROA is positive). Market-Value Indicators The ratios that follow tell us how the market views the companys liquidity, efficiency, leverage, and profitability. The earnings per share (EPS) ratio measures the income after taxes generated by the firm for each share outstanding.

Net income EPS = Shares outstanding

The price-earnings (P/E) ratio ties the firms earnings per share to price per share.

Price per share P/E ratio = EPS

The P/E ratio reflects investors expectations that the firms earnings will grow in the future. The price used to calculate a P/E ratio is usually the most recent price. The earnings figure used is the most recently available, although this figure may be out of date and may not necessarily reflect the current position of the company. This is often referred to as a trailing P/E, because it involves taking earnings from the last four quarters; the 'forward P/E' (or current price compared to estimated earnings going forward twelve months) is also used. The P/E ratio of a company is a significant focus for management in many

companies and industries. This is because management is primarily paid with their company's stock (a form of payment that is supposed to align the interests of management with the interests of other stock holders), in order to increase the stock price. The stock price can increase in one of two ways: either through improved earnings or through an improved multiple that the market assigns to those earnings. Price-sales ratio = price per share / sales per share A stock's capitalization divided by its sales over the trailing 12 months. The value is the same whether the calculation is done for the whole company or on a pershare basis. A low price to sales ratio (for example, below 1.0) is usually thought to be a better investment since the investor is paying less for each unit of sales. However, sales don't reveal the whole picture, since the company might be unprofitable. Because of the limitations, price to sales ratio are usually used only for unprofitable companies, since such companies don't have a price/earnings ratio (P/E ratio).
http://stocks.about.com/od/evaluatingstocks/a/ps.htm http://www.fool.com/investing/high-growth/2006/04/10/foolish-fundamentals-thepricetosales-ratio.aspx

4.4 The DuPont System: A Diagnostic Tool A. An Overview The DuPont system is a set of related ratios that links the balance sheet and the income statement. It is used as a diagnostic tool to evaluate a firms financial health. Both management and shareholders can use this tool to understand the factors that drive a firms ROE. It is based on two equations that relate a firms ROA and ROE.

B.

The ROA Equation Return on assets, which is Net income / Total assets, can be broken down into two componentsprofit margin and total assets turnover ratio. See Equation 4.18.

ROA =

Net income Net sales

Net sales Total assets

= Profit margin Total assets turnover

C. The net profit margin measures managements ability to generate sales and efficiently manage the firms operating expenses; overall, this is a measure of operating efficiency. Total asset turnover looks at how efficiently management uses the assets under its commandthat is, how much output can be generated with a given asset base. Thus, asset turnover is a measure of asset use efficiency. The ROA equation says that if management wants to increase the firms ROA, it can increase the profit margin, asset turnover, or both. By the same token, management can examine a poor ROA and determine whether operating efficiency is the problem or asset use efficiency problem.

The ROE Equation This equation is simply a restatement of Equation 4.19. Reorganization of the terms allows ROE to be restated as a product of the ROA and the equity multiplier.

ROE = Net income = Net income Total assets Total equity Total assets Total equity = ROA Equity multiplier
D. ROE is determined by the firms ROA and its use of leverage. A firm with a small ROA can magnify it by using a higher leverage to get a higher ROE.

The DuPont Equation Substituting the ROA into the ROE equations gives us the DuPont equation as shown in Equations 4.23 and 4.24.

ROE = Net profit margin x Total asset turnover x Equity multiplier ROE = Net income/Net sales x Net sales/Total assets x Total assets/Total equity

The DuPont equation shows that a firms ROE is determined by three factors: (1) net profit margin, which measures the firms operating efficiency, (2) total asset turnover, which measures the firms asset use efficiency, and (3) the equity multiplier, which measures the firms financial leverage. Analyzing a firms financial performance will allow one to identify where the inefficiencies are and where the strengths are. If operational efficiency is the area of weakness, then it calls for a closer look at the firms income statement items. If asset turnover or leverage is the problem area, then the focus shifts to the balance sheet.

You can click below for an excel version of a DuPont Chart: http://investment-db.com/ARTICLES/DupontCalc.xls E. ROE as a Goal The issue of whether maximizing ROE is equivalent to maximizing shareholders wealth is something to be discussed. Those who do not agree that they are the same identify three key weaknesses. The first weakness with ROE is that it is based on after-tax earnings, not cash flows. Next, ROE does not consider risk.

Third, ROE ignores the size of the initial investment as well as future cash flows. Those who believe that they are consistent propose that: ROE allows management to break down the performance and identify areas of strengths and weaknesses. ROE is highly correlated with shareholder wealth maximization.

4.5 Selecting a Benchmark A. A ratio analysis becomes relevant only if it can be compared against a benchmark. Financial managers can create a benchmark for comparison in three ways: through trend analysis, industry average analysis, and peer group analysis. Trend Analysis This benchmark is based on a firms historical performance. It allows management to examine each ratio over time and determine whether the trend is good or bad for the firm. Industry Analysis Industry analysis is another way of developing a benchmark. Firms in the same industry are grouped by size, sales, and product lines to establish benchmark ratios.

B.

 C.

One way of identifying industry groups is the Standard Industrial Classification (SIC) System.

Peer Group Analysis Instead of selecting an entire industry, management may choose to identify a set of firms that are similar in size or sales, or who compete in the same market. The average ratios of this peer group would then be used as the benchmark. Depending on the industry, peer groups can be as small as three or four firms.

4.6.

Using Financial Ratios Limitations of ratio analysis include the following: It depends on accounting data based on historical costs. There is no theoretical backing in making judgments based on financial statement and ratio analysis. When doing industry or peer group analysis, you are often confronted with large, diversified firms that do not fit into any one SIC code. Trend analysis could be distorted by financial statements affected by inflation.

Chapter 4 Sample Questions Multiple Choice Identify the choice that best completes the statement or answers the question. 1. Liquidity ratio: Bathez Corp. has receivables of $334,227, inventory of $451,000, cash of $73,913, and accounts payables of $469,553. What is the firm's current ratio? a. 1.83 b. 0.73 c. 1.67 d. None of the above 2. Liquidity ratio: Zidane Enterprises has a current ratio of 1.53, current liabilities of $206,938, and inventory of $161,412. What is the firm's quick ratio? a. 0.92 b. 0.75 c. 2.31 d. 0.65 3. Efficiency ratio: Jason Traders has sales of $624,081, a gross profit margin of 36.1 percent, and inventory of $243,392. What is the company's inventory turnover ratio? a. 1.92 times b. 2.56 times c. 2.18 times d. 1.64 times 4. Efficiency ratio: Gateway Corp. has an inventory turnover ratio of 5.6. What is the firm's days' sales in inventory? a. 65.2 days b. 64.3 days c. 61.7 days d. 57.9 days 5. Efficiency ratio: Ellicott City Manufacturers, Inc., has sales of $6,344,210, and a gross profit margin of 67.3 percent. What is the firm's cost of goods sold? a. $2,074,557 b. $2,745,640 c. $274,560 d. None of the above

6. Coverage ratios: Fahr Company had depreciation expenses of $630,715, interest expenses of $112,078, and an EBIT of $1,542,833 for the year ended June 30, 2006. What are the times interest earned and cash coverage ratios for this company? a. 19.4 times; 12.7 times b. 17.3 time; 11.4 times c. 13.8 times; 19.4 times d. None of the above 7. Leverage ratio: Your firm has an equity multiplier of 2.47. What is its debt-to-equity ratio? a. 0.60 b. 1.47 c. 1.74 d. 0 8. Market-value ratio: RTR Corp. has reported a net income of $1,526,990 for the year. The company's share price is $56.26, and the company has 348,685 shares outstanding. Compute the firm's price-earnings ratio. a. 11.69 times b. 10.92 times c. 12.85 times d. 10.41 times 9. Profitability ratio: Juventus Corp has total assets of $2,977,397, total debt of $982,541, and net sales of $4,466,096. Their net profit margin for the year is 6.55 percent. What is Juventus's ROA? a. 9.83% b. 9.24% c. 8.55% d. 6.19% 10. DuPont equation: Andrade Corp has debt of $2,834,950, total assets of $5,178,235, sales of $8,234,121, and net income of $812,355. What is the firm's return on equity? a. 7.1% b. 34.7% c. 28.1% d. 43.2%

Answer Section MULTIPLE CHOICE 1. ANS: A Current assets = $73,913 + $451,000 +$334,227 = $859,140 Current liabilities = $469,553

PTS: 1 2. ANS: B Current ratio = 1.53; Current liabilities = $206,938; Inventory = $161,412

PTS: 1

MSC: JDK

3. ANS: D Sales = $624,081; Gross profit margin = 36.1%; Inventory = $243,392

PTS: 1 4. ANS: A

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5. ANS: A

PTS: 1 6. ANS: C Depreciation = $630,715 Interest expenses = $112,078 EDIT= $1,542,833

PTS: 1 7. ANS: B Equity multiplier = 1 + Debt to equity Debt to equity = Equity multiplier 1 = 2.47 1 = 1.47 PTS: 1 8. ANS: C

PTS: 1

MSC: JDK

9. ANS: A Total assets = $2,977,397; Total debt = $982,541; Sales = $4,466,096; Net profit margin = 6.55%

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PTS: 1 10. ANS: B

MSC: JDK

Feedback:

PTS: 1

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