Financial Statements

and Ratio Analysis

1. Understand who uses financial ratios, and how.
2. Use ratios to analyze a firm’s liquidity and activity.
3. Discuss the relationship between debt and financial
leverage and the ratios used to analyze a firm’s debt.
4. Use ratios to analyze a firm’s profitability and market
value.
5. Use a summary of financial ratios and the DuPont
system of analysis to perform a complete ratio
analysis.
6. Understand limitations of financial ratio analysis.
 A popular way to analyze financial statements is by
computing ratios. A ratio is a relationship between two
numbers, e.g. If ratio of A:B = 30:10==> A is 3 times B.

 A ratio by itself may have no meaning.

Hence, a given ratio is compared to:
 (a) ratios from previous years – internal time series
analysis

 (b) ratios of other firms/leaders in the same

industry – external cross-sectional analysis
 Uses of Financial Ratios: Within the Firm

 Identify deficiencies in a firm’s performance and take corrective

action.
 Evaluate employee performance and determine incentive
compensation.
 Compare the financial performance of different divisions
within the firm.
 Prepare, at both firm and division levels, financial projections.
 Understand the financial performance of the firm’s competitors.
 Evaluate the financial condition of a major supplier.
 Uses of Financial Ratios: Outside the Firm
 Lenders in deciding whether or not to make a loan to a
company.
 Credit-rating agencies in determining a firm’s credit
worthiness.

 Investors (shareholders and bondholders) in deciding

whether or not to invest in a company.

 Major suppliers in deciding whether or not to grant

credit terms to a company.
 The Four Key Financial Statements

 Income Statement
 Provides a financial summary of the firm’s

operating results during a specified period

 Dividends Per Share

 The dollar amount of cash distributed

during the period on behalf of each

outstanding share of common stock
 Bartlett Company Income Statements
($000) (1/2)
For the years ended December 31
2019 2018
Sales revenue $ 3,074 $ 2,567
Less: Cost of goods sold 2,088 1,711
Gross profits $ 986 $ 856
Less: Operating expenses
Selling expense $ 100 $ 108
General and administrative expenses 194 187
Other operating expenses 35 35
Depreciation expense 239 223
Total operating expense $ 568 $ 553
Operating profits $ 418 $ 303
 Bartlett Company Income Statements
($000) (2/2)
For the years ended December 31
2019 2018
Less: Interest expense 93 91
Net profits before taxes $ 325 $ 212
Less: Taxes 94 64
Net profits after taxes $ 231 $ 148
Less: Preferred stock dividends 10 10
Earnings available for common stockholders $ 221 $ 138
Earnings per share (EPS)a $ 2.90 $ 1.81
Dividend per share (DPS)b $ 1.29 $ 0.75
aCalculated by dividing the earnings available for common stockholders by the number of shares of common stock
outstanding: 76,262 in 2019 and 76,244 in 2018. Earnings per share in 2019: $221,000 ÷ 76,262 = $2.90; in 2018:
$138,000 ÷ 76,244 = $1.81.
bCalculated by dividing the dollar amount of dividends paid to common stockholders by the number of shares of common

stock outstanding. Dividends per share in 2019: $98,000 ÷ 76,262 = $1.29; in 2018: $57,183 ÷ 76,244 = $0.75.
 The Four Key Financial Statements
 Balance Sheet
 Summary statement of the firm’s financial position at a

given point in time

 Current Assets

 Short-term assets, expected to be converted into

cash within 1 year

 Current Liabilities

 Short-term liabilities, expected to be paid within 1

year
 Long-Term Debt

 Debt for which payment is not due in the current year

 The Four Key Financial Statements

 Balance Sheet
 Paid-in-Capital in Excess of Par

 The amount of proceeds in excess of the par value

received from the original sale of common stock

 Statement of Stockholders’ Equity

 Shows all equity account transactions that occurred

during a given year

 Bartlett Company Balance Sheets
($000) (1/2) December 31

Assets 2019 2018

Cash $ 363 $ 288
Marketable securities 68 51
Accounts receivable 503 365
Inventories 289 300
Total current assets $ 1,223 $ 1,004
Land and buildings $ 2,072 $ 1,903
Machinery and equipment 1,866 1,693
Furniture and fixtures 358 316
Vehicles 275 314
Other (includes financial leases) 98 96
Total gross fixed assets (at cost) $ 4,669 $ 4,322
Less: Accumulated depreciation 2,295 2,056
Net fixed assets $ 2,374 $ 2,266
Total assets $ 3,597 $ 3,270
 Bartlett Company Balance Sheets
($000) (2/2) December 31iiiiiiiiiiii

Assets 2019 2018

Liabilities and Stockholders’
Equity

Accounts payable $ 382 $ 270

Notes payable 79 99
Accruals 159 114
Total current liabilities $ 620 $ 483
Long-term debt (includes financial leases) 1,023 967
Total liabilities $ 1,643 $ 1,450
Preferred stock: cumulative 5%, $100 par, 2,000 shares authorized $ 200 $ 200
and issued
Common stock: $2.50 par, 100,000 shares authorized, shares issued 191 191
and outstanding in 2019: 76,262; in 2018: 76,244
Paid-in capital in excess of par on common stock 428 417
Retained earnings 1,135 1,012
Total stockholders’ equity $ 1,954 $ 1,820
Total liabilities and stockholders’ equity $ 3,597 $ 3,270
 The Four Key Financial Statements

 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
 Bartlett Company Statement of Retained
Earnings ($000) for the Year Ended
December 31, 2019

Retained earnings balance (January 1, 2019) $1,012

Plus: Net profits after taxes (for 2019) 231
Less: Cash dividends (paid during 2019)
Preferred stock 10
Common stock 98
Total dividends paid $ 108
Retained earnings balance (December 31, 2019) $1,135
 The Four Key Financial Statements

 Statement of Cash Flows

 Provides a summary of the firm’s operating,

investment, and financing cash flows and

reconciles them with changes in its cash and
marketable securities during the period
 Bartlett Company Statement of Cash
Flows ($000) for the Year Ended
December 31, 2019 (1/2)
Cash Flow from Operating Activities
Net profits after taxes $ 231
Depreciation 239
Increase in accounts receivable −138a
Decrease in inventories 11
Increase in accounts payable 112
Increase in accruals 45
Cash provided by operating activities $ 500
Cash Flow from Investment Activities
Increase in gross fixed assets −347
Change in equity investments in otherfirms 0
Cash provided by investment activities −$ 347
 Bartlett Company Statement of Cash
Flows ($000) for the Year Ended
December 31, 2019 (2/2)
Cash Flow from Financing Activities
Decrease in notes payable −20
Increase in long-term debts 56
Changes in stockholders’ equityb 11
Dividends paid − 108
Cash provided by financing activities −$ 61
Net increase in cash and marketablesecurities $ 92
a As is customary, parentheses are used to denote a negative number,
which in this case is a cash outflow.
b Retained earnings are excluded here because their change is actually

reflected in the combination of the “net

profits after taxes” and “dividends paid” entries.
 Analyzing Financial Performance: 5 Key Qs
1. How liquid is the firm?
2. Is management generating adequate operating
profits on the firm’s assets?
3. How is the firm financing its assets?
4. Is management providing a good return on the
capital provided by the shareholders?
5. Is the management team creating shareholder
value?
 How Liquid Is a Firm?

 Liquidity measures the firm’s ability to pay its bills

on time.
 It indicates the ease with which non-cash assets
can be converted to cash, and also the ratio of
non-cash assets to current liabilities.
 How Liquid Is a Firm?

 Liquidity is measured by two approaches:

 Comparing the firm’s current assets and current
liabilities
 Examining the firm’s ability to convert accounts
receivables and inventory into cash on a timely
basis
 Measuring Liquidity: Approach 1

 Compare a firm’s current assets with current

liabilities

 Current Ratio
 Acid Test or Quick Ratio
 Current Ratio

 Compares cash and current assets that should be

converted into cash during the year with the liabilities that
should be paid within the year
 Formula: = Current assets/Current liabilities

Davies Example: = $143M / $64M = 1.67

Davies has $2.23 in current assets for every $1 in current

liabilities. The average is higher than the peer group’s
ratio of 1.80.
 Acid Test or Quick Ratio
 Compares cash and current assets (minus inventory) that
should be converted into cash during the year with the
liabilities that should be paid within the year.

 Formula: = Cash and accounts receivable/Current liabilities

Davies Example: = ($20M + $36M) / $64M = 0.88

Davies has 88 cents in quick assets for every $1 in current

liabilities.
Davies is less liquid compared to its peers that have 94
cents for every $1 in current liabilities.
 Measuring Liquidity: Approach 2

 Measures a firm’s ability to convert accounts receivable

and inventory into cash

 Average Collection Period

 Accounts Receivable Turnover

 Inventory Turnover

 Cash Conversion Cycle

 Average Collection Period
 How long does it take to collect the firm’s receivables?

 Formula: Accounts receivable/(Annual credit sales/365)

Davies Example:

= $36M / ($600M/365)= 21.9 days

 Davies is faster than peers (25 days) in collecting the

accounts receivable.
 Inventory Turnover
 How many times is inventory rolled over per year?

 Formula: = Cost of goods sold/Inventory

Davies Example

= $460M / $84M = 5.48 times

 # of days = 365/Inventory turnover = 365/5.48 = 67 days

 Thus Davies carries the inventory for longer time than its
competitors (Competitors = 365/7 = 52 days).
 Overtrading: a situation where a firm experiences
liquidity problem due to its trading beyond capital
resources available to it. Usually has low liquidity ratios
(current ratio and acid test ratio) and abnormally high
turnover ratios (A/R turnover ratio, inventory turnover ratio
and total asset turnover ratio).

 Overcapitalization: a situation where a firm has excess

capital, under-utilized probably due to lack of attractive
investment opportunities. Usually has high liquidity ratios
(current ratio and acid test ratio) and abnormally low
turnover ratios (A/R turnover ratio, inventory turnover
ratio and total asset turnover ratio).
 Davies vs. Peer Group: Question #1
Summary

Ratio Davies Peers

Current Ratio 1.67 1.80

Quick Ratio .88 .94

Avg. Collection Period 21.9 25

Inventory Turnover 5.48 (67) 7 (52)
(days in inventory)
 Are the Firms’ Managers Generating
Adequate Operating Profits on the
Firm’s Assets?

 This question focuses on the profitability of the assets

in which the firm has invested. We will consider the
following ratios to answer the question:
 Operating Return on Assets
 Operating Profit Margin
 Total Asset Turnover
 Fixed Asset Turnover
 Operating Return on Assets

 Indicates level of operating profits relative to the

firm’s total assets

 Formula: = Operating return/Total assets

Davies Example
= $75M / $438M = .171 or 17.1%

 Thus managers are generating 17.1 cents of

operating profit for every $1 of assets (Peer Group
average = 17.8)
 Dis-aggregation of Operating Return
on Assets
 Operating return on assets
= operating profits/total assets
= operating profit/sales X sales/assets
= operating profit margin X total asset turnover
 Managing Operations: Operating Profit
Margin

 Examines how effective the company is in managing its

cost of goods sold and operating expenses that determine
the operating profit.

 Formula: = Operating profit/Sales

Davies Example

=$75M / $600M = .125 or 12.5%

 Davies managers are not as good as peers in managing

the cost of goods sold and operating expenses, as the
average for Peers is higher at 15.5%
 Managing Assets: Total Asset Turnover

 How efficiently a firm is using its assets in generating sales

 Formula: = Sales/Total assets

Davies Example

= $600M / $538M = 1.37X

 Davies is generating $1.37 in sales for every $1 invested in

assets, which is higher than the Peers average of $1.15.
 Managing Assets: Fixed Asset Turnover

 Examines efficiency in generating sales from investment

in “fixed assets”
 Formula: = Sales/Fixed assets
Davies Example
= $600M / $295M= 2.03X
 Davies generates $2.03 in sales for every $1 invested in
fixed assets (Peer Group average = $1.75)
Davies vs. Peer Group: Question #2
Summary

Ratio Davies Peer

Operating 17.1% 17.8%
Return on
Assets
Operating 12.5% 15.5%
Profit Margin
Total Asset 1.37x 1.15x
Turnover
Fixed Asset 2.03x 1.75x
Turnover
 How Is the Firm Financing Its Assets?

 Here we examine the question: Does the firm

finance its assets by debt or equity or both?
We use the following two ratios to answer the
question:
 Debt Ratio
 Times Interest Earned
 Debt Ratio

 This ratio indicates the percentage of the firm’s assets that

are financed by debt (implying the balance is financed by
equity).
 Formula: Total debt/Total assets

Davies Example
= $235M / $438M = .54 or 54%

 Davies finances 54% of firm’s assets by debt and 46% by

equity.This ratio is higher than Peers average of 35%.
 Times Interest Earned

 This ratio indicates the amount of operating income

available to service interest payments
 Formula: = Operating income/Interest
 Davies Example
=$75M / $15M = 5.0X
 Davies operating income are 5 times the annual interest
expense or 20% of the operating profits goes towards
servicing the debt.
Davies vs. Peer Group: Question #3
Summary

Ratio Davies Peers

Debt Ratio 54% 35%

Times 5X 7X
Interest
Earned
 Are the Firm’s Managers Providing a
Good Return on the Capital Provided by
the Shareholders?

 Are the earnings available to shareholders attractive? This is

analyzed by computing the firm’s accounting return on
common stockholder’s investment or return on equity (ROE).

 Formula:= Net income/Common equity

 Note, common equity includes both common stock and

retained earnings
 Return on Equity (ROE)

Davies Example
ROE = $42M / $203M
= .207 or 20.7%

 Owners of Davies are receiving a higher return (20.7%)

compared to the Peer Group (18%).

 One of the reasons for higher ROE for Davies is the higher
debt used by Davies. Higher debt translates to higher ROE
under favorable business conditions.
Davies vs. Peer Group: Question #4
Summary

Ratio Davies Peers

Return on Equity 12.9% 12.0%
 Are the Firm’s Management Creating
Shareholder Value?

 We can use market value ratios to answer this

question:
 Price/Earnings ratio
 Price/Book ratio
 These ratios indicate what investors think of
management’s past performance and future
prospects.
 Price/Earnings Ratio

 Measures how much investors are willing to pay for $1

of reported earnings

 Formula: Price per share/Earnings per share

 Davies Example

=$32.00 / $2.10 = 15.24X

 Investors are willing to pay less for Davies for every dollar
of earnings compared to Peers ($15.24 for Davies versus
$19 for Peers)
 Price/Book Ratio

 Compares the market value of a share of stock to the book

value per share of the reported equity on the balance sheet.

 Formula: = Price per share/Equity book value per share

 Davies Example

= $32.00 / $10.15= 3.15X

 A ratio greater than 1 indicates that the shares are more

valuable than what the shareholders originally paid. However,
the ratio is lower than the S&P average of 3.70.
 Davies vs. S&P/Peer Group: Question #5
Summary

Ratio Davies
Price/Earnings 15.24X 19X
Ratio (Peers)

Price/Book Ratio 3.15X 3.7X

(S&P 500)
 The DuPont Model

Brings together:
 Profitability (net profit margin)

 Efficiency (total asset turnover)

 Leverage (equity multiplier or known as financial

leverage multiplier, i.e. 1 ÷ (1 – Debt Ratio) or

Total asset divided by Common equity)
 The DuPont Model

 The DuPont system of analysis is used to dissect the firm’s

financial statements and to assess its financial condition.
 It merges the income statement and balance sheet into two
summary measures of profitability.
 The Modified DuPont Formula relates the firm’s ROA to its
ROE using the financial leverage multiplier (FLM), which is
the ratio of total assets to common stock equity.
 Use of the FLM to convert ROA into ROE reflects the
impact of financial leverage on the ordinary shareholder’s
return.
 The DuPont Model

ROE = Net Profit  Total Asset  Financial

Margin Turnover Leverage
Multiplier

= Net Income  Sales  Total Asset

Sales Total Asset Common Equity
 The DuPont Model

ROE =
Net Profit
Margin x
Total Asset
Turnover / (1- Debt
Ratio )
Net Income Sales Total Debt
= Sales x Total Assets /(1- Total Assets )
5,016 112,760 47,523
= 112,760 x 81,890 / (1 - 81,890 )
= 14.6%
 The DuPont Model

 Can ROE improves when both net profit margin and total
asset turnover deteriorates? Yes, if Equity Multiplier rise,
where the firm reduces the use of equity or increases the
use of debt in its capital structure significantly. By using
more debt than equity, the firm enjoys cheaper cost of
financing.
 Limitations of Financial Ratio Analysis

1. Difficult to identify industry categories or comparable peers.

2. Published peer group or industry averages are only
approximations.
3. Industry averages may not provide a desirable target ratio
or norm.
4. Accounting practices differ widely among firms.
5. A high or low ratio does not automatically lead to a specific
favorable or unfavorable conclusion.
6. Seasons may bias the numbers in the financial statements.
 Lecture exercise
Complete the following balance sheet using the information given.
Round account balances to the nearest dollar.00
Balance Sheet Income Statement

Cash Sales (All Credit) $16,000

Accounts receivable Cost of goods sold 11,000
Inventory Operating expenses 1,000
Net fixed assets Interest expense 200
Total assets $20,000 Taxes 1,000
Net income $2,800
Accounts payable
Short-term notes payable $1,000 Ratios:
Long-term debt Operating Profit Margin = 25%
Common stock $1,500 Return on Equity = 20%
Retained earnings Average Collection Period= 31.9375
Total Liabilities and equity Fixed Asset Turnover = 2
Inventory Turnover = 5
Current Ratio = 2
 Lecture exercise
1. Use the return on equity to calculate common equity: CE = $14,000
2. Retained earnings = common equity – common stock = $12,500
3. Use fixed asset turnover to calculate fixed assets: FA = $8,000
4. Total liabilities and equity = total assets = $20,000
5. Use the inventory turnover ratio to find inventory: INV = $2,200
6. Use average collection period to calculate accounts receivable: A/R
= $1,400
7. Plug cash = $8,400
8. Current assets = cash + accounts receivable + inventory = $12,000
9. Use the current ratio to solve for current liabilities: CL = $6,000
10.Accounts payable = current liabilities – short-term notes payable =
$5,000
11.Plug long-term debt = $0
 Lecture exercise
Complete the following balance sheet using the information given.
Round account balances to the nearest dollar.
Balance Sheet Income Statement

Cash Sales (All Credit) $20,000

Accounts receivable Cost of goods sold 10,000
Inventory Operating expenses 6,000
Net fixed assets Interest expense 100
Total assets Taxes 1,365
Net income $2,535
Accounts payable
Short-term notes payable $1,425 Ratios:
Long-term debt Profit Margin = 12.675
Common stock $5,000 Return on Equity = 15
Retained earnings Quick Ratio = 1.2
Total Liabilities and equity Return on Total Assets = 10
Fixed Asset Turnover = 1.6
Current Ratio = 2
Days Sales Outstanding= 45
 Lecture exercise

1.Solve for common equity using ROE: Common Equity = $16,900

2.Retained Earnings = Common Equity – Common Stock = $11,900
3.Solve for total assets using ROA: Total Assets = $25,350
4.Total Liabilities & Equity = Total Assets = $25,350
5.Solve for net fixed assets using fixed asset turnover: NFA = $12,500
6.Current Assets = Total Assets – Net Fixed Assets = $12,850
7.Solve for current liabilities using the current ratio: Current Liabilities = $6,425
8.Accounts Payable = Current Liabilities – Short-term Notes Payable = $5,000
9.Plug Long-term Debt: $2,025
10.Use the quick ratio to find inventory: Inventory = $5,140
11.Use the days sales outstanding ratio to find accounts receivable: AR = $2,466
12.Plug the cash figure: Cash = $5,244
Lecture exercise
Financial Data for Springfield Power Co. as of December
31, 2019:
Inventory $200,000
Long-term debt 300,000
Interest expense 15,000
Accumulated depreciation 440,000
Cash 260,000
Net sales (all credit) 1,500,000
Common stock 800,000
Accounts receivable 225,000
Operating expense (incl. depr. exp. and taxes) 525,000
Notes payable-current 180,000
Cost of goods sold 940,000
Plant and equipment 1,300,000
Accounts payable 160,000
Marketable securities 90,000
Accrued wages 65,000
Retained earnings 130,000
 Lecture exercise

Calculate the following ratios for the Springfield Power Co.

i. Current ratio
ii. Acid test ratio
iii. Average collection period
iv. Inventory turnover
v. Gross profit margin
vi. Operating profit margin
vii. Net profit margin
viii. Total asset turnover
ix. Times-interest-earned
 Lecture exercise
Current ratio = (200 + 260 + 225 + 90) / (180 + 160 + 65) = 1.91
Acid test ratio = (260 + 225 + 90) / (180 + 160 + 65) = 1.42
Average collection period = 225,000/(1,500,000/365 days) = 55
days
Inventory turnover = 940/200 = 4.7
Gross profit margin = (1,500,000 – 940,000) / 1,500,000 = 0.373
Operating profit margin = (1,500,000 – 940,000 – 525,000 ) /
1,500,000
= $35,000/$1,500,000 = 0.023
Net profit margin = (1,500,000 – 940,000 – 525,000 – 15,000) /
1,500,000 = $20,000/$1,500,000 = 0.013
Total asset turnover = $1,500,000/$1,635,000 = 0.917
Times-interest-earned = $35,000/$15,000 = 2.33 times