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FINANCIAL STATEMENT

ANALYSIS
Teaching Note – March 7, 2018
This Teaching Note supplements textbook Chapter 14.

LEARNING OBJECTIVES CHAPTER OUTLINE


1. Master profit and loss statements 1. The Income Statement
2. Study a company’s sources and uses of funds 2. The Balance Sheet
3. Figure out where the money goes 3. The Cashflow Statement
4. Discover ratio analysis 4. Financial Ratios
5. Decompose a company’s return on equity 5. The DuPont Framework
6. Risk Analysis 6. Interpretation
7. Contrast time-series and cross-section values 7. Potential Problems
8. Summarize and reach conclusions 8. The Bottom Line

The goal of financial statement analysis is to identify financial strengths and weaknesses.

Investors, employees, lenders, suppliers, and the firm’s own managers use financial statements

to evaluate past performance, and, as a basis for projecting future performance. A company’s

financial statements play a key role in financial analysis because they furnish the input data

from which financial ratios are computed. But, the financial statements alone are insufficient for

a comprehensive financial analysis. The quality of the firm’s products, an assessment of the

firm’s management, a review of the firm’s competition, and a determination of where the firm’s

products are located in their product life cycle are examples of important factors not revealed in

the firm’s financial statements.

The income statement, balance sheet, and cash flow statement are the three financial statements

with which investors need to be familiar. We begin with the income statement.

1 THE INCOME STATEMENT


The income statement is sometimes called the income and expense statement, and the profit

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and loss statement (P&L). The income statement is an executive summary of all revenues

(sales) and expenses (costs) a firm experiences during a specified time span called the

accounting period. The following equation concisely summarizes the income statement.

Sales - Expenses = Income or Loss

Nearly every company publishes annual Income Statements, and many also publish quarterly

financial statements. Table 1 contains three annual income statements for a hypothetical

electronics manufacturer, it shows that the National Electronics Corporation (NEC) earned an

after-tax income of $2,800,000 from January 1 through December 31, 20X1.

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TABLE 1 - Three Annual Income Statements for NEC
National Electronics Corporation (NEC), in thousands of US dollars
For the periods from January 1 to December 31, 20X1, and 20X2 and 20X3
Row Item 20X1 20X2 20X3
I1 Sales $20,000 $22,000 $24,000
I2 Less: Returns & Allowances ($1,000) ($1,100) ($1,200)
I3 Net Sales $19,000 $20,900 $22,800

I4 Beginning Inventory $1,400 $1,500 $1,600


I5 Plus: Purchases & freight in $6,500 $6,600 $6,700
I6 Net Purchases $7,900 $8,100 $8,300
I7 Less: Ending Inventory ($1,500) ($1,600) ($1,700)
I8 Cost of raw materials $6,400 $6,500 $6,600
I9 Plus: Labor expense $3,500 $4,000 $4,500
I10 Cost Of Goods Sold (COGS) $9,900 $10,500 $11,100

I11 Gross Profit (Gross Income) $9,100 $10,400 $11,700


I12 Less: Operating expenses:
I13 Marketing expenses ($2,700) ($2,800) ($2,900)
I14 Depreciation ($700) ($800) ($900)
I15 Pension expenses ($100) ($200) ($300)
I16 Other expenses ($400) ($500) ($600)
I17 Amortization of goodwill ($100) ($100) ($100)
I18 Contingent liabilities ($200) ($300) ($400)
I19 Salaries ($500) ($600) ($700)
I20 Bonuses ($200) ($300) ($400)
I21 Less: Total Operating Expenses ($4,900) ($5,600) ($6,300)
I22 Operating income, Operating profit, or,
Earnings Before Interest & Tax (EBIT)1 $4,200 $4,800 $5,400
I23 Less: Interest expense ($700) ($800) ($900)
I24 Income (Loss) before taxes $3,500 $4,000 $4,500
I25 Less: Federal taxes (20%) ($700) ($800) ($900)
I26 Net income (loss) $2,800 $3,200 $3,600

1
Operating income can be used as a synonym for EBIT and for operating profit if the firm has
no non-operating income, which is common. If a firm has any non-operating income, defining
EBIT is slightly more complicated. A simple definition of EBIT that is undisputable is: EBIT =
Net income + all taxes paid + all interest paid.

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1A Cost of Goods Sold

Cost of goods sold (COGS on line I10 of Table 1) is what NEC spent on raw materials and

labor to produce its products. The COGS statement in Table 2 dissects COGS into smaller

components that permit a closer look at the firm’s manufacturing process.

TABLE 2 Cost of Goods Sold (COGS) For NEC’s Income Statement


Row Item 20X1 20X2 20X3
I4 Beginning Inventory $1,400 $1,500 $1,600
I5 Plus: Purchases & freight in $6,500 $6,600 $6,700
I6 Net Purchases $7,900 $8,100 $8,300
I7 Less: Ending Inventory ($1,500) ($1,600) ($1,700)
I8 Cost of raw materials $6,400 $6,500 $6,600
I9 Plus: Labor expense $3,500 $4,000 $4,500
I10 Cost Of Goods Sold (COGS) $9,900 $10,500 $11,100

Some firms’ Income Statements merely list COGS as the single line entry shown on line I10 of

Table 1 and omit the details shown in Table 2. In these cases the determination of COGS shown

in Table 2 is usually shown in a supporting financial statement that provides details omitted from

the Income Statement.

1B Common‐Size Income Statement

Table 3 is called a common-size income statement because the firm’s sales revenues are

treated as a common denominator for every other item in that income statement. In other words,

each year’s net sales revenue equals 100 percent and all other items in that accoun ting

period are stated as a percentage of net sales. Converting all income statement items to a

percent of sales facilitates comparing income statements from different years (called time-series

analysis) and from different corporations (called cross-sectional analysis).

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Time-series and cross-sectional comparisons can be insightful. For instance, lines IC8 and

IC9 of the common-size income statement in Table 3 show that NEC’s production process spends

considerably more on raw materials than on labor. This might be because NEC’s managers

choose to buy components from sub-contractors rather than manufacture these “building blocks”

internally.

TABLE 3 - Three Annual Common-Size Income Statements


National Electronics Corporation
For the periods from January 1 to December 31 of 20X1, 20X2 and 20X3
Row Item 20X1 20X2 20X3
IC1 Sales 105.3% 105.3% 105.3%
IC2 Less: Returns & Allowances -5.3% -5.3% -5.3%
IC3 Net Sales 100.0% 100.0% 100.0%

IC4 Beginning Inventory 7.4% 7.2% 7.0%


IC5 Plus: Purchases & freight in 34.2% 31.6% 29.4%
IC6 Net Purchases 41.6% 38.8% 36.4%
IC7 Less: Ending Inventory -7.9% -7.7% -7.5%
IC8 Cost of raw materials 33.7% 31.1% 28.9%
IC9 Plus: Labor expense 18.4% 19.1% 19.7%
IC10 Cost Of Goods Sold (COGS) 52.1% 50.2% 48.7%

IC11 Gross Profit (Gross Income) 47.9% 49.8% 51.3%


IC12 Less: Operating expenses:
IC13 Marketing expenses -14.2% -13.4% -12.7%
IC14 Depreciation -3.7% -3.8% -3.9%
IC15 Pension expenses -0.5% -1.0% -1.3%
IC16 Other expenses -2.1% -2.4% -2.6%
IC17 Amortization of goodwill -0.5% -0.5% -0.4%
IC18 Contingent liabilities -1.1% -1.4% -1.8%
IC19 Salaries -2.6% -2.9% -3.1%
IC20 Bonuses -1.1% -1.4% -1.8%
IC21 Total Operating Expenses -25.8% -26.8% -27.6%
IC22 Net operating income (NOI), or,
Earnings before interest & taxes (EBIT) 22.1% 23.0% 23.7%
IC23 Less: Interest expense -3.7% -3.8% -3.9%
IC24 Income (Loss) before taxes 18.4% 19.1% 19.7%
IC25 Less: Federal taxes (20%) -3.7% -3.8% -3.9%
IC26 Net income (loss) 14.7% 15.3% 15.8%

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Subtracting the cost of goods sold (COGS) from sales yields the NEC’s gross profit. Gross

profit is a gross measure, not a net measure, of profitability because operating expenses have

not yet been deducted. Total operating expenses on line I21 of Table 1 and line IC21 of Table

3 equals the sum of assorted indirect costs like executive salaries, advertising expenses, pension

expenses, and other outlays that did not contribute directly to producing the firm’s products. A

company’s net operating income (NOI) on lines I22 and IC22 of Tables 1 and 3 is computed

by deducting all indirect costs from the firm’s gross profit. A corporation’s NOI is sometimes

referred to as its earnings before interest and taxes, or EBIT.

A corporation’s income statement summarizes inflows and outflows that produce the firm’s sales

revenue. However, cash payments to pay off a maturing bond issue, for example, is not

included in a corporation’s income statement. Financial cashflows are summarized in the firm’s

cashflow statement, this financial statement is discussed later in this chapter. Financial

cashflows are not included in the corporation’s income statement because they are not incurred

directly in the production and sale of the company’s products. Unlike the income statement, a

corporation’s balance sheet reports no cashflows.

2 THE BALANCE SHEET


Some people say the income statement is like a moving picture show that covers one

accounting period in a firm’s life. In contrast, the balance sheet is like a still photo of a

company’s sources and uses of funds. Stated differently, the balance sheet lists the company’s

assets, liabilities and owners equity that existed at one instant in time. A firm may prepare a

balance sheet and income statement monthly, each quarter, or annually. Table 4 shows the

balance sheet for the National Electronics Corporation at the end of three of the corporation’s

fiscal years, December 31, 20X1, 20X2, and 20X3.

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TABLE 4 Three Balance Sheets, thousands of US$
National Electronics Corporation, December 31, 20X1, 20X2, and 20X3
Row Assets (Uses of funds) 20X1 20X2 20X3
A1 Cash + Cash Equivalents $1,500 $1,900 $2,300
A2 Accounts receivable $4,000 $5,000 $6,000
A3 Inventories $1,500 $1,600 $1,700
A4 Other current assets $3,000 $3,500 $4,000
A5 Total current assets $10,000 $12,000 $14,000
A6 Investments:
A7 Property, plant, equipment, net $11,000 $13,000 $15,000
A8 Goodwill $2,000 $2,000 $2,000
A9 Total long-term assets $13,000 $15,000 $17,000
A10 Total Assets (TA) $23,000 $27,000 $31,000

Row Liabilities (Sources of funds) 20X1 20X2 20X3


L1 Accounts payable $2,000 $2,500 $3,000
L2 Notes payable $400 $500 $600
L3 Income taxes payable $600 $700 $800
L4 Total Current Liabilities $3,000 $3,700 $4,400
L5 Long-Term Bond Issue (15 yrs) $8,000 $9,000 $10,000
L6 Long-term Bank Loan (3 yrs) $5,000 $6,000 $7,000
L7 Total long-term liabilities $13,000 $15,000 $17,000
L8 Total liabilities $16,000 $18,700 $21,400

Row Net Worth (Sources of funds) 20X1 20X2 20X3


E1 Common stock, par zero,
900,000 shares outstanding $0 $0 $0
E2 Paid in surplus $4,000 $3,200 $2,100
E3 Retained earnings $3,500 $5,600 $8,000
E4 Less: Treasury stock owned ($500) ($500) ($500)
E5 Shareholders' equity (net worth) $7,000 $8,300 $9,600
E6 Total liabilities and equity $23,000 $27,000 $31,000

The balance sheet in Table 4 may be converted into a common-sized balance sheet by dividing

each item in Table 4 by the value of the firm’s total assets to create Table 5. Converting all

items in a balance sheet to percentages facilitates comparing income statements from different

years and from different corporations. For instance, lines LC8 and EC5 in Table 5 indicate

that NEC borrows about 70 percent of the funds spent to buy assets, while the stockholders

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provide the other 30 percent. Since 70 percent is more borrowing than most corporations

undertake, this s u g g e s t s that NEC is managed aggressively and is more likely to get into

financial difficulties than companies with more equity and less debt.

TABLE 5 Common-Sized Balance Sheet


National Electronics Corporation
December 31, 20X1, 20X2, and 20X3 (Percentages rounded to the nearest tenth)
Row Assets (Uses of funds) 20X1 20X2 20X3
AC1 Cash + Cash Equivalents 6.5% 7.0% 7.4%
AC2 Accounts receivable 17.4% 18.5% 19.4%
AC3 Inventories 6.5% 5.9% 5.5%
AC4 Other current assets 13.0% 13.0% 12.9%
AC5 Total current assets 43.5% 44.4% 45.2%
AC6 Investments:
AC7 Property, plant, equipment, net 47.8% 48.1% 48.4%
AC8 Goodwill 8.7% 7.4% 6.5%
AC9 Total long-term assets 56.5% 55.6% 54.8%
AC10 Total Assets (TA) 100.0% 100.0% 100.0%

Row Liabilities (Sources of funds) 20X1 20X2 20X3


LC1 Accounts payable 8.7% 9.3% 9.7%
LC2 Notes payable 1.7% 1.9% 1.9%
LC3 Income taxes payable 2.6% 2.6% 2.6%
LC4 Total Current Liabilities 13.0% 13.7% 14.2%
LC5 Long-Term Bond Issue (15 yrs) 34.8% 33.3% 32.3%
LC6 Long-term Bank Loan (3 yrs) 21.7% 22.2% 22.6%
LC7 Total long-term liabilities 56.5% 55.6% 54.8%
LC8 Total liabilities 69.6% 69.3% 69.0%

Row Net Worth (Sources of funds) 20X1 20X2 20X3


EC1 Common stock, par zero, 900k sh. 0.0% 0.0% 0.0%
EC2 Paid in surplus 17.4% 11.9% 6.8%
EC3 Retained earnings 15.2% 20.7% 25.8%
EC4 Less: Treasury stock owned -2.2% -1.9% -1.6%
EC5 Shareholders' equity (net worth) 30.4% 30.7% 31.0%
EC6 Total liabilities and equity 100.0% 100.0% 100.0%

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3 THE CASHFLOW STATEMENT
Monies taken in and paid out by a company are called cash inflows and cash outflows,

respectively. International Accounting Standard 7 stipulates that Cashflow Statements should

show how cash changes in the Balance Sheet and cashflows from operations affect the

company’s overall cash position. Cashflow Statements have several uses.

1. They provide information about a firm’s solvency, liquidity, and its ability to
handle specific cashflows.

2. They supply facts that can be used to evaluate the company’s assets, liabilities,
and equity.

3. They reveal data about cash inflows and outflows not found in the Balance Sheet
and Income Statement.

4. They furnish insights about the amount, timing, and probability of future cashflows.

The Cashflow Statement is a standard periodic financial statement that should accompany the

Balance Sheet and Income Statement. It eliminates some hypothetical cashflows that

accompany certain accounting conventions. For example, depreciation reduces the book values

of assets with usage or with the passage of time. Cashflows from depreciation come from

income tax reductions, not from earnings. The cashflows from depreciating assets (line C3) are

more visible in the Cashflow Statement than in other financial statements.

A Cashflow Statement breaks down a company’s cash inflows and outflows into three categories:

operating, investing, and financing activities. Table 6 contains three annual Cashflow Statements

for NEC.

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TABLE 6 Three Annual Cash Flow Statements for NEC
National Electronics Corporation (NEC) (000 omitted)
For years ending on December 31, 20X1, 20X2, &
20X3
Row Period Ending December 31 20X1 20X2 20X3
C1 Net Income (I26) $2,800 $3,200 $3,600

C2 Operating Activities, Cashflows provided by or used in:


C3 Depreciation (I14) ($700) ($800) ($900)
C4 Amortization of goodwill (I17) ($100) ($100) ($100)
C5 Decrease (Increase) in Accts. Receiv. (A2) ($1,000) ($1,000) ($1,000)
C6 Decr. (Incr.) in Inventory (I10 - I7) ($100) ($100) ($100)
C7 Incr. (Decr.) in Other Operating Activities $0 $0 $0
C8 Net Cashflow from Operating Activities $2,500 $2,900 $3,500

C9 Investing Activities, Cashflows provided by or used in:


C10 Capital Expenditures (A7) ($2,000) ($2,000) ($2,000)
C11 Other cashflows from Investing Activities ($1,200) ($1,000) ($800)
C12 Net cashflow from Investing Activities ($3,200) ($3,000) ($2,800)

C13 Financing Activities, Cashflows provided by or used in:


C14 Increase (Decrease) in LT Liabilities (L7) $2,000 $2,000 $2,000
C15 Less: Cash dividends paid ($1,000) ($1,100) ($1,200)
C16 Net cashflow from Financing Activities $1,000 $900 $800

C17 Net Increase or Decrease in Cash:


C18 Net Increase (Decrease) in Cash $300 $800 $1,500

4 FINANCIAL RATIOS
This section shows how data from financial statements are used to compute financial ratios.

4A Solvency (or Liquidity) Ratios

Solvency ratios, or liquidity ratios, measure a firm’s ability to meet its short-term financial

obligations. For example, if a firm’s Current Ratio equals two or better, and, if its Quick Ratio

equals one or more, the firm is probably solvent. The high solvency ratio values in Table 7 indicate

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that NEC is accumulating abnormal liquidity. T he Balance Sheets in Tables 4 and 5 also reveal

that NEC is holding more cash each year. Being insolvent should be avoided because it

would embarrass the firm and reduce the firm’s future credit worthiness. But, cash is a non-

earning asset and, therefore, carrying excessive cash is also undesirable. Perhaps NEC is

hoarding cash, for example, to finance the acquisition of new assets. If so, these p l a n n e d

acquisitions should be acknowledged in a footnote attached to NEC’s financial

statements. Or, NEC’s management might prefer to keep its strategic plans secret. A financial

analyst should be curious and investigate to discover the reason for NEC’s rapidly growing cash

holdings.

Table 7 Solvency (Liquidity) Ratios from NEC’s Financial Statements

Name of Ratio in words Source Symbols 20X1 20x2 20x3


Ratio
Current Current assets A5 in Table 4
3.33 3.24 3.18
ratio, S1 Current liabilities L4 in Table 4
Quick ratio, Current assets less Inventory A5-A3 in Table 4
2.83 2.81 2.8
S2 Current liabilities L4 in Table 4

Most of the following financial ratios have descriptive names that provide guidance about how

to calculate the ratio. To provide additional assistance, the alpha-numeric symbols

a c c o m p a n y i n g t h e ratios refer to line numbers o f t h e s o u r c e i t e m s in NEC's

financial statements.

4B Turnover Ratios

Turnover ratios are also called efficiency ratios or activity ratios, they measure particular

business activities within a firm. The idea underlying all turnover ratios is that inactive assets

may be non-earning assets. Once non-earning assets have been pinpointed, actions can be taken

to employ or eliminate them.

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Table 8 Turnover Ratios for NEC
Name of Ratio in words Source Symbols 20X1 20x2 20x3
Ratio
Receivable Annual credit sales I3 in Table 1
4.74 4.18 3.8
turnover, T1 Accounts receivable A2 in Table 4
Collection Accounts receivable A2 in Table 4 76.84 87.32 96.05
period, T2 Average day's sales (I3 in Table 1)/365 days days days days
Inventory Annual sales (at cost) I10 in Table 1
6.60 6.56 6.53
turnover, T3 Average inventory (at cost) A3 in Table 4
Asset Annual net sales I3 in Table 1
0.83 0.77 0.74
turnover, T4 Total assets A10 in Table 4
Equity Annual net sales I3 in Table 1
2.71 2.52 2.38
turnover, T5 Equity E5 in Table 4

EXAMPLE: Establishing Inventory Turnover Guidelines

If a liquor distiller had an inventory turnover of two times per year, the company must be
producing the product so hastily that it might be unfit or unsafe. Alternatively, if the firm is in the
fresh vegetable business, inventory that is (12 months divided by 2 turns equals) six months old is
garbage. An electronics industry average inventory turnover would make an appropriate yardstick
for interpreting NEC's inventory turnover.*

Footnote *: An entire book on financial statement analysis would delve deeper than this chapter’s
review. For example, an in-depth inventory analysis might break total inventory down into raw
materials inventory, finished goods inventory, other components that might be appropriate, and,
each different type of inventory could be analyzed separately.

Chapter 4 - Analysis of Financial Statements - Jack Clark Francis - Page 12


EXAMPLE: Establishing Financial Ratio Guidelines for National Electronics Corporation
NEC’s increasing collection period of 76 to 96 days would be considered very slow if it extended
credit terms of 2/15, net 30.* Or, if NEC were in the fresh vegetables business, 76-96 days
would be too long to let customers' bills go unpaid. It would be more appropriate for retail
buyers of perishable vegetables to pay cash for their purchases, so accounts receivable would be
near zero. The length of the optimal collection period depends on the terms of credit, product
being sold, and competitors' credit terms. To keep from offending credit customers, the manager
of accounts receivable at NEC should find out what credit terms competitors are granting to their
customers when establishing NEC’s credit policies.

Footnote * A c c o u n t p a y a b l e t erms of “2/15, net 30” mean that customers purchasing


goods on credit are invited by the supplier to take a 2% cash discount if the customer pays for
the goods within 15 days after delivery. If the 2% cash discount is not taken within 15 days, NEC
expects full payment within 30 days.

4C Coverage Ratios

Coverage ratios measure the extent to which a firm's earnings are able to cover interest

expense and repay debt. The values of NEC’s Times-Interest-Earned ratios and Cashflow to

Long-Term-Debt ratios in Table 9 indicate that NEC is easily able to pay the interest on its

debts.

Table 9 Coverage Ratios (CRs) from NEC’s Financial Statements


Name of Ratio Ratio in words Source Symbols 20X1 20x2 20x3
Times-interest- Annual operating income I22 in Table 1
6.00 6.00 6.00
earned, CR1 Annual interest payment I23 in Table 1
EBIT + deprec. + amortiz.
Cashflow to long- I22+I14+I17 in Table 1
Long-term debt interest 63% 63% 64%
term-debt, CR2 L5 in Table 4
payment

Chapter 4 - Analysis of Financial Statements - Jack Clark Francis - Page 13


4D Measuring Cashflows

Three quantities from a firm’s Income and Expense Statement can be combined to determine its

cashflow; EBIT, depreciation, and amortization.

∙ EBIT: As mentioned above, a firm's normal operating income (NOI) before taxes is

sometimes called its earnings before interest and taxes (EBIT). Using the item numbers in

Table 1, NEC’s annual EBIT is shown item I22.

Depreciation and Amortization: Depreciation is a business expense that accounts for fair

wear and tear on plant and equipment. Amortization is similar business expense that allows

for obsolescence in i n t a n gi b l e a s s e t s l i k e computer programs, patents, and goodwill.

Even though no cash outlays actually occur, generally accepted accounting principles (GAAP)

stipulate that any deductions for depreciation or amortization expense be deducted in the

firm’s i n c o m e a n d e x p e n s e statement. Depreciation and amortization are

d e d u c t i o n s that reduce the firm’s taxable income. These tax savings generate cash flows

that can be either spent or saved. NEC's depreciation and amortization may be found in lines

I14 and I17 of Table 1. Similar deductions may be found in lines C3 and C4 of Table 6.

4E Leverage Ratios

Leverage ratios measure the extent to which a firm has been financed by creditors. Borrowing

increases what is called financial risk, default risk, credit risk, or bankruptcy risk. NEC

uses a substantial amount of borrowed funds, as evidenced by the values in Table 10. But,

NEC employs a slightly smaller proportion of debt than some other electronic firms.

Chapter 4 - Analysis of Financial Statements - Jack Clark Francis - Page 14


Table 10 Leverage Ratios with values from NEC
Name of Ratio Ratio in words Source Symbols 20X1 20x2 20x3
Total debt to total Total debt L8 in Table 4
69.6% 69.3% 69.0%
asset, L1 Total assets A10 in Table 4
Total debt to equity, Total debt L8 in Table 4
228.6% 225.3% 222.9%
L2 Equity E5 in Table 4
Long-term debt to Long-term debt L7 in Table 4
185.7% 180.7% 177.1%
equity, L3 Equity E5 in Table 4
Long-term debt to Long-term debt L7 in Table 4
65.0% 64.4% 63.9%
capitalization, L4 Capitalization L7+E5 in Table 4
Equity to total assets, Equity E5 in Table 4
30.4% 30.7% 31.0%
L5 Total Assets A10 in Table 4

4F Profitability Ratios

Profitability ratios measure the productivity of money invested in a firm. NEC is a profitable

firm. The trend in its profit margins is upward, while the trend in its return on assets and

return on equity is slightly downward. As mentioned above, the lack of growth in all of

NEC’s profit ratios might be attributed to its increasingly large holdings of liquid assets that are

non-earning assets. If NEC’s managers plan to acquire a competitor, for example, that planned

acquisition could explain NEC’s large accumulation of liquid assets. Clever financial analysts

and shrewd investors will try to discover and anticipate such developments before they become

public information.

Chapter 4 - Analysis of Financial Statements - Jack Clark Francis - Page 15


Table 11 Profitability Ratios from NEC’s Financial Statements
Name of Ratio Ratio in words Source Symbols 20X1 20x2 20x3
Gross profit margin, Gross profit I11 in Table 1
47.9% 49.8% 51.3%
R1 Net Sales I3 in Table 1
Net profit margin, Net profit I26 in Table 1
14.7% 15.3% 15.8%
R2 Net Sales I3 in Table 1
Return on asset Net income I26 in Table 1
12.2% 11.9% 11.6%
(ROA), R3 Total assets A10 in Table 4
Return on equity Net income I26 in Table 1
40.0% 38.6% 37.5%
(ROE), R4 Equity E5 in Table 4
LT capital's pretax Interest+pre-tax Earnings I23+I22 in Tab.1
17.5% 17.2% 16.9%
rate of return, R5 Capitalization L7+E5 in Tab.4

EXAMPLE: Profit Margins

NEC’s net profit margins of 15% would be far too low for an upscale retail establishments like
Tiffany’s Jewelry Store in New York City or Harrods Department Store in London (where Her
Majesty shops). These luxurious stores have expensive displays and polished clerks. In
contrast, most U.S. supermarket chains have low net profit margins of one to two percent,
because they operate low cost mass merchandising operations. Different industries have
different profit margins.

4G Per Share Data

Balance sheet data can be used to derive per share common stock measurements used by security

analysts. More specifically, the number of shares of common stock outstanding in line E1 of

Table 4 is used to compute several of the per share financial ratios in Table 12. For example,

NEC’s book value per share in line P2 of Table 12 is computed by dividing NEC’s shareholder’s

equity from line E5 of Table 4 by the number of common stock shares outstanding in line P1 of

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Table 12. Earnings per share (P3 in Table 12) are determined by dividing the corporation’s total

earnings (net income) from line I26 of Table 1 by the number of common stock shares

outstanding. And, NECs cash dividends per share (P4 in Table 12) are determined by dividing the

corporation’s total cash dividend payment from line C16 of Table 6 by the number of common

stock shares outstanding.

Table 12 - Per Share Data for NEC’s Common Stock


Name of Ratio in words Source Symbols 20X1 20x2 20x3
Ratioof
Shares Number of common stock
E1 in Table 4 900,000 900,000 900,000
stock, P1 shares outstanding
Book value Net worth of the corporation
E5 in Table 4
per share, No. of common shares $7.78 $9.22 $10.67
E1 in Table 4
P2 outstanding
Earnings After tax net income
I26 in Table 1
per share, No. of common shares $3.11 $3.56 $4.00
E1 in Table 4
P31 outstanding
Cash Total corporate dividend
C16 in Table 6
dividend per No. of common shares $1.11 $1.22 $1.33
E1 in Table 4
share, P4 outstanding
Payout Cash dividends per share P3 in Table 6
35.7% 34.4% 33.3%
ratio, P5 Earnings per share (EPS) P2 in Table 6
Retention Retained earnings I26-C16 in Table 6
64.3% 65.6% 66.7%
rate, P6 After tax net income I26 in Table 1
Market Market determined P per
Author’s estimate3 $65.00 $60.00 $55.00
price, P7 share of out. common stock
Price-
Market price per share, P P7 in Table 12 20.89 16.88 13.75
earnings
Earnings per share (EPS) P3 in Table 12 times times times
ratio, P8

5 THE DUPONT FRAMEWORK

The DuPont Corporation is credited with developing an insightful way to analyze a firm’s return on

equity (ROE). ROE (Eqn.R4 from Table 11) can be decomposed into the equity turnover ratio

(Eqn.T5 from Table 8) and the net profit margin (Eqn.R2 from Table 11), as shown in Eqn.(1).

Chapter 4 - Analysis of Financial Statements - Jack Clark Francis - Page 17


𝑵𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆 𝑺𝒂𝒍𝒆𝒔 𝑵𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆 𝑬𝒒𝒖𝒊𝒕𝒚 𝑵𝒆𝒕 𝒑𝒓𝒐𝒇𝒊𝒕
𝑹𝑶𝑬 = = 𝑬𝒒𝒖𝒊𝒕𝒚 𝒙 =( )𝒙( ) (1)
𝑬𝒒𝒖𝒊𝒕𝒚 𝑺𝒂𝒍𝒆𝒔 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝒎𝒂𝒓𝒈𝒊𝒏

The algebra below reveals that the equity turnover ratio can be derived from two component ratios.

 Equity  Sales Sales Total assets  Total asset   Financial 


  =   =     
 turnover  EQ Total assets EQ  turnover   leverage ratio  (2)

Equity turnover Eqn.(2) can be substituted into ROE Eqn.(1) to obtain Eqn.(3). Table 13 shows

Eqn.(3) computed with three years of NEC’s financial statement data. The numerical analysis in

Table 13 shows that NEC’s declining ROE ratios result from declining asset turnover that occurs

while the firm’s financial leverage remains constant and its net profit margin creeps up slightly.

Essentially, NEC’s ROE is declining because it accumulated more assets than it needs; this finding

is supported by its declining return on assets (ROA) ratio - - see ratio R3 in Table 11.

𝑺𝒂𝒍𝒆𝒔 𝑻𝑨 𝑵𝑰 𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕 𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝑵𝒆𝒕 𝒑𝒓𝒐𝒇𝒊𝒕


𝑹𝑶𝑬 = 𝒙 𝒙 =( )𝒙( )𝒙( ) (𝟑)
𝑻𝑨 𝑬𝑸 𝑺𝒂𝒍𝒆𝒔 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝒍𝒆𝒗𝒆𝒓𝒂𝒈𝒆 𝒓𝒂𝒕𝒊𝒐 𝒎𝒂𝒓𝒈𝒊𝒏

TABLE 13 Three-part Decomposition of NEC’s ROE, Using Eqn.(3)


Column (1) Column (2) Column (3) Column (4)
(Asset turnover) (Leverage ratio) (Net profit margin) (Return on equity)
Year Sales/Total Assets Total Assets/Equity Net Income/Sales ROE
20X1 0.826 3.286 0.147 0.4
20X2 0.774 3.253 0.153 0.386
20X3 0.735 3.229 0.158 0.375

Analysis of growth. The rate of price appreciation in a corporation's common stock depends on

several factors. If we simplify things by ignoring external borrowing, any corporate growth that

occurs must be financed from the firm’s retained earnings. First, the retention ratio (RR) measures

the fraction of a company’s net income that is retained and invested internally.

Retention Ratio (RR) = (Retained earnings)/(Net income)

Second, the growth rate also depends on the return on equity (ROE), as shown in Eqn.(4).

Chapter 4 - Analysis of Financial Statements - Jack Clark Francis - Page 18


𝑮𝒓𝒐𝒘𝒕𝒉 𝑹𝒆𝒕𝒂𝒊𝒏𝒆𝒅 𝒆𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝑹𝒆𝒕𝒂𝒊𝒏𝒆𝒅 𝒆𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝑵𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆
( )= = 𝒙 = 𝑹𝑹 𝒙 𝑹𝑶𝑬 (4)
𝒓𝒂𝒕𝒆, g 𝑬𝒒𝒖𝒊𝒕𝒚 𝑵𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆 𝑬𝒒𝒖𝒊𝒕𝒚

Further Analysis of Growth. Substituting the three-part ROE ratio of Eqn.(3) into growth rate,

Eqn.(4), results in the more definitive growth rate formula in Eqn.(5).

𝑹𝒆𝒕𝒂𝒊𝒏𝒆𝒅 𝒆𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝑺𝒂𝒍𝒆𝒔 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 𝑵𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆


𝑮𝒓𝒐𝒘𝒕𝒉 𝒓𝒂𝒕𝒆 = 𝒙 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 𝒙 𝒙 (5)
𝑵𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆 𝑬𝒒𝒖𝒊𝒕𝒚 𝑺𝒂𝒍𝒆𝒔

𝑹𝒆𝒕𝒆𝒏𝒕𝒊𝒐𝒏 𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕 𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝑵𝒆𝒕 𝒑𝒓𝒐𝒇𝒊𝒕


=( )𝒙( )𝒙( )𝒙( )
𝒓𝒂𝒕𝒊𝒐 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝒍𝒆𝒗𝒆𝒓𝒂𝒈𝒆 𝒓𝒂𝒕𝒊𝒐 𝒎𝒂𝒓𝒈𝒊𝒏

If a company borrowed significant amounts, Eqns.(4) and (5) must be supplemented to include

borrowing.

6 INTERPRETION

Business analysts use more than just financial ratios.

Analyzing Different Types of Risk. In addition to the factors shown in Eqn.(5), a firm’s growth

rate is related to its riskiness. If all other factors remain unchanged, when a firm becomes riskier the

market value of its securities falls, as illustrated in Eqn.(6) below.

𝐴 𝑓𝑖𝑟𝑚′ 𝑠 𝐵𝑎𝑛𝑘𝑠 𝑎𝑛𝑑 𝑜𝑡ℎ𝑒𝑟 𝑖𝑛𝑣𝑒𝑠𝑡𝑜𝑟𝑠 𝑆𝑡𝑜𝑐𝑘 𝑎𝑛𝑑 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒𝑠 𝑑𝑟𝑜𝑝
( 𝑟𝑖𝑠𝑘𝑖𝑛𝑒𝑠𝑠 ) → (𝑟𝑒𝑞𝑢𝑖𝑟𝑒 ℎ𝑖𝑔ℎ𝑒𝑟 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑠) → (𝑤ℎ𝑒𝑛 𝑡ℎ𝑒 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑓𝑖𝑟𝑚′ 𝑠) (6)
𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠 𝑡𝑜 𝑚𝑎𝑘𝑒 𝑟𝑖𝑠𝑘𝑖𝑒𝑟 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑟𝑖𝑠𝑒𝑠.

In contrast to the increasing risk in Eqn.(6), if all other factors are held constant, reducing risk leads

to a lower interest rates, a reduced cost of capital for the borrower, and that causes higher market

prices for the borrower’s stock and bonds. Because of the inverse relationship between risk and

security prices, wealth-maximizing investors need to assess the riskiness of their investments. To

supplement the information from financial ratios, risk can also be measured in terms of the

variability of dollar sales, variability of unit sales, variability of units produced, variability of net

income, or by the variability of other metrics. The coefficient of variation is a useful tool for

computations involving dollar amounts.

Chapter 4 - Analysis of Financial Statements - Jack Clark Francis - Page 19


The Coefficient of Variation (CV). Variability of dollar sales, units sold, units produced, dollars

of profit, or other variables can be analyzed with the coefficient of variation (CV).

𝐶𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 𝑜𝑓 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑋


( ) = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑋 (7)
𝑣𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑋

The standard deviation of X in the numerator of the CV is rescaled (normalized, standardized) by

dividing it by the average value of X. The CV that results is an index number that measures

variability relative to the average value. Like all index numbers, the CV is dimensionless because it

is not measured in dollars, percentages, pounds, miles, or any other standard unit of measure. Not

having a size dimension is a quality that facilitates comparing the riskiness of different things, for

example, the riskiness of IBM’s huge net income and the riskiness of the much smaller net income

from Moe’s Software Shop.

Different Risk Measures: Business firms are exposed to different types of risk. A firm’s business

risk is determined by the volatility of its operating income. Purchasing power risk comes from

inflation. Foreign exchange risk arises when foreign exchange rates fluctuate. The financial risks

a firm undertakes can be measured with the coverage ratios and the leverage ratios from Tables 9

and 10. Financial ratios and CV variations can be compared with other statistics to analyze risk.

Cross-Sectional Analysis. Financial analysts routinely use two different approaches to interpreting

financial statements. First, competing firms are compared. A firm's financial ratios can be compared

to other firm's ratios or industry average ratios. Making different cross-sectional comparisons can

reveal strengths and/or weaknesses in one firm relative to competing firms. Standard & Poors,

Moodys, Fitch, Value Line, Yahoo.com, Bloomberg, and other financial information providers

purvey historical financial statements from competing companies to expedite cross-sectional

Chapter 4 - Analysis of Financial Statements - Jack Clark Francis - Page 20


comparisons.

Time-Series Analysis. The second approach to interpreting financial statements focuses on a firm's

own ratios from previous years. Time-series analysis of financial data from a single firm can

highlight trends or changes. Many of the tables in this chapter provide three year examples of time-

series financial data for NEC to help the financial analyst discover trends and relationships.

7 POTENTIAL PROBLEMS WITH FINANCIAL ANALYSIS


Sometimes it is difficult to find meaningful financial statements that are defined consistently

through time.

7A Inflationary Distortions

Inflation distorts financial statements and financial ratios. For example, if several consecutive years

of financial statements from a single corporation are compared, the comparison can be clouded by

inflating prices. Inflation can be a particular problem with the balance sheet, where some fixed

assets are reported at their historical cost. Historical costs can become irrelevant and even

misleading after a few years of inflation. Furthermore, some generally accepted accounting

procedures (GAAP) mandate depreciating a fixed asset while its market value might actually be

appreciating. In countries that with serious inflation problems, accountants and financial analysts

find it necessary to make explicit inflation-adjustments to make a firm’s financial statements from

successive years comparable.

7B Defining Accounting Income

The generally accepted accounting principles (GAAP) used to define a firm's income are not always

defined in extremely narrow and precise terms. Whether the firm's accountants use straight-line or

accelerated depreciation, LIFO or FIFO or some other inventory valuation technique, and whether

sales are recognized as occurring when the order is signed by the customer or when the customer

Chapter 4 - Analysis of Financial Statements - Jack Clark Francis - Page 21


makes the final payment, are all important accounting decisions that modify a company's financial

statements and its taxable income.

7C Consolidated Financial Statements

Subsidiary corporations must be accounted for on the balance sheet of the parent corporation. For

instance, the Coca-Cola Company (NYSE ticker symbol KO) is a parent company that owns (i) the

well-known red and white Coca-Cola trademark and (ii) the secret recipes for the syrups used to

manufacture its soft drinks. (iii) A KO division named the Bottling Investment Group (BIG) owns

billions of dollars’ worth of interests in bottling subsidiaries like Coca-Cola Enterprises (NYSE

ticker symbol CCE) and other bottling subsidiaries around the globe. KO exercises more than a

modest ownership control in these bottling subsidiaries. Some financial analysts argue that KO

should fully disclose all information about all the bottling affiliates over which it exercises

significant controls in its consolidated balance sheet. Such a consolidation would increase KO's

total assets, reduce its return on assets (ROA) and reveal debts of the subsidiaries that were

previously out-of-sight. KO has not violated any generally accepted accounting principles or done

anything illegal. But, some accountants argue that KO’s consolidated balance sheet is unethical

because it reports KO’s subsidiary interests in bottling companies with less than total transparency.

7D Buying Goodwill In A Merger

The purchase of one company by another can create problems when their financial statements are

consolidated. An intangible asset called "goodwill" often appears on the consolidated balance sheet

of the acquiring firm to reflect the difference between the purchase price and the book value of a

subsidiary. Since it is intangible, the true value of goodwill is difficult to assess. For example, in

August 2011 Google purchased Motorola for $12.5 billion. Then, Google sold Motorola for $2.9

billion to Lenovo in 2014. But, Google retained several billion of dollars’ worth of Motorola’s

patents. As a result of these transactions, Google’s accountants reported billions of dollars’ worth of

Chapter 4 - Analysis of Financial Statements - Jack Clark Francis - Page 22


“goodwill” on Google’s balance sheet. These accountants explained that the “goodwill” on

Google’s balance sheet would be amortized away as the Motorola patents expired and became

worthless. Such vague explanations force security analysts to do forensic accounting work.

7E Historical Cost Versus Fair Market Value

During the peak of sub-prime mortgage crisis, 2007-2008, many commercial banks owned stocks,

bonds, real estate, and other assets that collapsed in value. If banks carried these assets on their

financial statements at the assets’ historical costs, the banks were able to meet the legal reserve

requirements that banking laws and the government’s bank examiners required. But, if these banks

carried the assets on their financial statements at their much lower fair (market determined)

values, the banks would have been bankrupt. Citibank, J. P. Morgan Chase, Merrill Lynch,

Goldman Sachs, and some other large banks provide examples of the banks that were determined to

be too big to fail. As a result, after the sub-prime mortgage crisis, a number of large banks were

under great pressure from the nation’s bank regulators to retain most of their earnings internally to

replenish their capital and avoid bankruptcy. Some of these troubled banks asked their bank

examiners if they could switch from fair value accounting to historic book value accounting rather

than endure the costly process of replenishing their capital accounts to meet the reserve

requirements that were based on fair (market) value accounting procedures. In the final analysis, the

bank examiners compromised and required the troubled banks use fair value accounting for many

categories of assets but also permitted some asset categories to be valued at their historical costs.

7F Corporate Fraud

Enron Corporation was a Houston, Texas energy-trading company and public utility that became

embroiled in one of the biggest accounting frauds in U.S. history. Enron’s common stock reached a

high of $90 per share in mid-2000, before it plummeted to $0.30 when the fraud was uncovered in

October 2001. Most of Enron’s employees were surprised to read in the newspapers that their

Chapter 4 - Analysis of Financial Statements - Jack Clark Francis - Page 23


employer had been “cooking the books” to improve its financial statements. The corporation filed

for bankruptcy in December 2001. The resulting scandals shocked investors and regulators and

made them more aware that some large and respected companies might not be publishing truthful

financial statements. Some of Enron’s high ranking executives went to jail for years. To protect

investors from corporate fraud in the future, and to improve investors’ confidence, Congress

enacted a corporate ethics law called the Sarbanes-Oxley Act of 2002. While the Enron case is

worse than most other cases of fraud, it is not as rare as we might like.2 Companies that generate

their earnings through shadowy financial accounting are said to have low quality earnings.

8 - THE BOTTOM LINE


Financial statement analysis tools introduced in this chapter provide the opportunity to exploit the

richness of the information contained in many financial statements while understanding the

limitations of that information. Financial analysis can reduce the analyst’s uncertainty and give the

analyst the confidence needed to make good buy and sell recommendations.

Skeptics sometimes ask if financial statement data are able to explain changes in the price of a

common stock. The answer is yes, thousands of professional security analysts earn their livings by,

in part, studying financial statements. When a corporation announces its latest earnings per share to

the public, if the earnings rise (fall), stock prices usually rise (fall) too. Financial research also

shows that increases in a corporation’s size, riskiness, and financial leverage tend to reduce the

price of its stock. Conversely, researchers report that increases in a firm’s earnings and its growth

rate cause increased stock price. As long as no inside information is used, a clever financial analyst

2
For an empirical study over 2,000 cases of “cooking the books” see Simi Kedia, Kevon Koh,
Shicaram Rajgopal, “Evidence on Contagion in Earnings Management,” Accounting Review,
November 2015.

Chapter 4 - Analysis of Financial Statements - Jack Clark Francis - Page 24


can supplement his or her salary by trading on valuable information they may discover.

REFERENCES

Leopold A. Bernstein and John J. Wild, Analysis of Financial Statements, Fifth Edition, McGraw-

Hill, 1999, New York, NY.

Stephen H. Penman, Financial Statement Analysis and Security Valuation, Fifth Edition, Richard D.

Irwin, Burr Ridge, Illinois, 2012.

TABLE OF CONTENTS - CHAPTER 4 – FINANCIAL STATEMENT ANALYSIS

1 THE INCOME STATEMENT ........................................................................................................ 1


TABLE 1 - Three Annual Income Statements for NEC ............................................................ 3
1A Cost of Goods Sold .................................................................................................................. 4
TABLE 2 Cost of Goods Sold (COGS) For NEC’s Income Statement .................................... 4
1B Common‐Size Income Statement........................................................................................... 4
TABLE 3 - Three Annual Common-Size Income Statements .................................................. 5
2 THE BALANCE SHEET ........................................................................................................... 6
TABLE 4 Three Balance Sheets, thousands of US$ .................................................................. 7
TABLE 5 Common-Sized Balance Sheet.................................................................................... 8
3 THE CASHFLOW STATEMENT .................................................................................................. 9
TABLE 6 Three Annual Cash Flow Statements for NEC ...................................................... 10
4 FINANCIAL RATIOS ................................................................................................................ 10
4A Solvency (or Liquidity) Ratios ........................................................................................... 10
Table 7 Solvency (Liquidity) Ratios from NEC’s Financial Statements .................................. 11
4B Turnover Ratios .................................................................................................................... 11
Table 8 Turnover Ratios for NEC........................................................................................... 12
Table 9 Coverage Ratios (CRs) from NEC’s Financial Statements ....................................... 13
4D Measuring Cashflows ........................................................................................................... 14
4E Leverage Ratios ..................................................................................................................... 14
Table 10 Leverage Ratios with values from NEC .................................................................. 15
4F Profitability Ratios ................................................................................................................ 15
Table 11 Profitability Ratios from NEC’s Financial Statements ........................................... 16
4G Per Share Data ...................................................................................................................... 16
Table 12 - Per Share Data for NEC’s Common Stock ............................................................ 17

Chapter 4 - Analysis of Financial Statements - Jack Clark Francis - Page 25


5 THE DUPONT FRAMEWORK .................................................................................................. 17
𝑹𝑶𝑬 = 𝑵𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆𝑬𝒒𝒖𝒊𝒕𝒚 = 𝑺𝒂𝒍𝒆𝒔𝑬𝒒𝒖𝒊𝒕𝒚𝒙𝑵𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆𝑺𝒂𝒍𝒆𝒔 =
𝑬𝒒𝒖𝒊𝒕𝒚𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓𝒙𝑵𝒆𝒕 𝒑𝒓𝒐𝒇𝒊𝒕𝒎𝒂𝒓𝒈𝒊𝒏 (1) ....................................................................... 18
 Equity  Sales Sales Total assets  Total asset   Financial 
  =   =     
 turnover  EQ Total assets EQ  turnover   leverage ratio  (2) ......... 18
𝑹𝑶𝑬 = 𝑺𝒂𝒍𝒆𝒔𝑻𝑨𝒙𝑻𝑨𝑬𝑸𝒙𝑵𝑰𝑺𝒂𝒍𝒆𝒔 =
𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓𝒙𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍𝒍𝒆𝒗𝒆𝒓𝒂𝒈𝒆 𝒓𝒂𝒕𝒊𝒐𝒙𝑵𝒆𝒕 𝒑𝒓𝒐𝒇𝒊𝒕𝒎𝒂𝒓𝒈𝒊𝒏(𝟑) ................. 18
TABLE 13 Three-part Decomposition of NEC’s ROE, Using Eqn.(3)................................. 18
𝑮𝒓𝒐𝒘𝒕𝒉𝒓𝒂𝒕𝒆, g = 𝑹𝒆𝒕𝒂𝒊𝒏𝒆𝒅 𝒆𝒂𝒓𝒏𝒊𝒏𝒈𝒔𝑬𝒒𝒖𝒊𝒕𝒚 =
𝑹𝒆𝒕𝒂𝒊𝒏𝒆𝒅 𝒆𝒂𝒓𝒏𝒊𝒏𝒈𝒔𝑵𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆 𝒙 𝑵𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆𝑬𝒒𝒖𝒊𝒕𝒚 = 𝑹𝑹 𝒙 𝑹𝑶𝑬 (4) ................... 19
𝑮𝒓𝒐𝒘𝒕𝒉 𝒓𝒂𝒕𝒆 =
𝑹𝒆𝒕𝒂𝒊𝒏𝒆𝒅 𝒆𝒂𝒓𝒏𝒊𝒏𝒈𝒔𝑵𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆𝒙𝑺𝒂𝒍𝒆𝒔𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔𝒙𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔𝑬𝒒𝒖𝒊𝒕𝒚𝒙𝑵𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆𝑺𝒂𝒍𝒆𝒔
(5).................................................................................................................................................. 19
6 INTERPRETION......................................................................................................................... 19
𝐴 𝑓𝑖𝑟𝑚′𝑠𝑟𝑖𝑠𝑘𝑖𝑛𝑒𝑠𝑠𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠 →
𝐵𝑎𝑛𝑘𝑠 &𝑎𝑛𝑑 𝑜𝑡ℎ𝑒𝑟 𝑖𝑛𝑣𝑒𝑠𝑡𝑜𝑟𝑠𝑟𝑒𝑞𝑢𝑖𝑟𝑒 ℎ𝑖𝑔ℎ𝑒𝑟 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑠𝑡𝑜 𝑚𝑎𝑘𝑒 𝑟𝑖𝑠𝑘𝑖𝑒𝑟 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 →
𝑆𝑡𝑜𝑐𝑘 𝑎𝑛𝑑 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒𝑠 𝑑𝑟𝑜𝑝𝑤ℎ𝑒𝑛 𝑡ℎ𝑒 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑓𝑖𝑟𝑚′𝑠𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑟𝑖𝑠𝑒𝑠. (6) ..... 19
𝐶𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 𝑜𝑓 𝑣𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑋 = 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑋𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑋
(7).................................................................................................................................................. 20
7 POTENTIAL PROBLEMS WITH FINANCIAL ANALYSIS .................................................. 21
7A Inflationary Distortions ........................................................................................................ 21
7B Defining Accounting Income .............................................................................................. 21
7C Consolidated Financial Statements ..................................................................................... 22
7D Buying Goodwill In A Merger ............................................................................................. 22
7E Historical Cost Versus Fair Market Value ....................................................................... 23
7F Corporate Fraud ................................................................................................................. 23
8 - THE BOTTOM LINE ................................................................................................................. 24
REFERENCES ................................................................................................................................. 25
TABLE OF CONTENTS - CHAPTER 4 – FINANCIAL STATEMENT ANALYSIS .................. 25

Chapter 4 - Analysis of Financial Statements - Jack Clark Francis - Page 26