Analyzing Financial Statements

Chapter 3

ACT3211 FINANCIAL MANAGEMENT

Chapter 3 Learning Goals

LG1:

Calculate and interpret major liquidity ratios

LG2:

Calculate and interpret major asset management ratios

LG3:

Calculate and interpret major debt ratios

LG4:

Calculate and interpret major profitability ratios

LG5:

Calculate and interpret major market value ratios

LG6:

Appreciate how various ratios relate to one another

LG7:

Discuss the differences between time series and cross-sectional ratio

analysis and decide which is most appropriate given an analytical
situation

LG8:

Explain cautions that should be taken when examining financial ratios

and financial information in general

ACT3211 FINANCIAL MANAGEMENT

Introduction
The real value of financial statements lies in
the fact that managers, investors, and analysts
can use the information in the statements to:
Analyze firm performance
Plan changes to improve performance

Ratio Analysis
Calculating and analyzing financial ratios to assess
a firms performance
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 Ratios fall into five groups:

Liquidity ratios
Asset management ratios
Debt management ratios
Profitability ratios
Market value ratios

After managers, analysts, or investors calculate a firms

ratios they make two comparisons:
Trend comparison to the same firm over time
Competitors comparison to other firms in the same industry

We will use the financial statements for DPH Tree Farm to

illustrate the use of ratios

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Table
3-1

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Liquidity Ratios
Liquidity ratios provide an indication of the
ability of the firm to meet its obligations as
they come due
The three most common liquidity ratios are
the current ratio, the quick (or acid-test) ratio,
and the cash ratio

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 The broadest liquidity measure is the current ratio,

which measures the dollars of current assets available
to pay each dollar of current liabilities
Current Ratio = CA / CL

Inventory is the least liquid of the current assets, and is

the current asset for which book values are the least
reliable measure of market value. The quick, or acidtest ratio excludes inventory in the numerator, and
measures the firms ability to pay off short-term
obligations without relying on inventory sales:
Quick Ratio = (CA Inventory) / CL

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 The cash ratio measures a firms ability to pay

short-term obligations with its available cash and
marketable securities
Cash Ratio = Cash / CL

The liquidity ratios for DPH Tree Farm are:

Current Ratio = CA / CL
Current Ratio = 205 / 120
Current Ratio = 1.71 times
The industry average current ratio is 1.50
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Quick Ratio = (CA Inventory) / CL

Quick Ratio = (205 111) / 120
Quick Ratio = 0.78 times
The industry average quick ratio is 0.50
Cash Ratio = Cash / CL
Cash Ratio = 24 / 120
Cash Ratio = 0.20 times
The industry average cash ratio is 0.15
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 Based on all three measures, DPH has more

liquidity on its balance sheet than the industry
average
The more liquid assets a firm holds, the more likely
the firm can pay its bills, so it has less liquidity risk.
However, liquid assets do not generate profits for
the firm
Managers must consider the tradeoff of lower
liquidity risk versus the disadvantages of reduced
profits
Note that a firm with very predictable cash flows can
safely maintain lower levels of liquidity

ACT3211 FINANCIAL MANAGEMENT

Asset Management Ratios

Asset management ratios measure how
efficiently a firm uses its assets
Many of these ratios are focused on a specific
asset, such as inventory or accounts receivable

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 Inventory Management
The inventory turnover ratio measures the
dollars of sales produced per dollar of
inventory. Often this ratio uses cost of goods
sold in the numerator rather than sales since
inventory is listed on the balance sheet at cost
Inventory Turnover = Sales / Inventory
or
Inventory Turnover = Cost of Goods Sold /
Inventory
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 The days sales in inventory ratio measures the average number of

days that inventory is held
Days Sales in Inventory = Inventory x 365 / Sales or COGS

Firms want to turn inventory over as quickly as possible to reduce

costs associated with warehousing, monitoring, insurance
A high inventory turnover ratio and a low days sales in inventory
ratio indicate good management

However, if inventory is too low then the firm risks losing sales or
running out of raw materials, so there is a tradeoff between
sufficient levels of inventory versus the costs of holding too much
Note that companies with good supply chain relations can
maintain lower inventory levels

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 Accounts Receivable Management

The Average Collection Period (ACP) measures
the number of days that accounts receivable
are held until they are collected
Average collection period (ACP) = Accounts receivable x 365 / Credit sales

The Accounts Receivable Turnover ratio

measures the dollars of sales produced per
dollar of accounts receivable
Accounts receivables turnover = Credit Sales / Accounts Receivable

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 Firms want to produce a high level of sales

per dollar of accounts receivable, and turn
accounts receivable into cash as quickly as
possible
A high accounts receivable turnover ratio and a
low average collection period are indicators of
good receivables management
If these ratios are too good, it may indicate that
credit terms are so strict that the firm may be
losing sales
Managers must consider the tradeoff between
increasing sales through credit terms versus the
cost of high accounts receivable
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 Accounts Payable
The Average Payment Period (APP) measures the
number of days that the firm holds accounts payable
before it has to extend the cash to pay for raw
materials
Average payment period (APP) = Accounts payable x 365 / COGS

The Accounts Payable Turnover ratio measures the

dollar COGS per dollar of accounts receivable
Accounts payable turnover = COGS / Accounts payable
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 Firms want to pay for purchases as slowly as

possible
Accounts payable represent a form of financing
from suppliers
The more the accounts payable, the less the firm
will need other costly sources of financing such as
notes payable or long-term debt.
A high APP and a low accounts payable turnover
ratio is generally a sign of good management
If these indicators are too good it may indicate that
the firm is abusing their credit terms and jeopardizing
their relationship with suppliers

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 Fixed Asset and Working Capital Management

The Fixed Asset Turnover ratio measures the number
of dollars of sales produced per dollar of fixed assets
Fixed asset turnover ratio = Sales / Fixed assets

The Sales to Working Capital ratio measures the

dollars of sales produced per dollar of net working
capital (NWC = current assets current liabilities)
Sales to Working Capital ratio = Sales / Working capital

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 The higher the level of sales produced per dollar of

fixed assets or working capital, the more efficiently
the firm is being run.
High fixed asset turnover ratios and sales to
working capital ratios are signs of good
management
If these ratios are too high the firm may be close to
maximum capacity and may indicate that
management has not made accommodations for
growth

Caution: the age of a firms fixed assets will affect

the fixed asset turnover ratio. A firm with newer
(more expensive) fixed assets may appear to have
a lower turnover ratio.
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 Total Asset Management

The Total Asset Turnover ratio measures the
dollars of sales produced per dollar of total assets
Total assets turnover ratio = Sales / Total assets
The Capital Intensity ratio is simply the inverse of
the total assets turnover ratio and measures the
dollars of total assets needed to produce a dollar
of sales
Capital intensity ratio = Total assets / Sales

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 These ratios provide an indication of how

efficiently assets are being utilized
If the ratios are too good however it may
indicate that the firm is in danger of inventory
stockouts, capacity problems, or excessively
tight credit terms which might indicate poor
management

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Asset Management Ratios for

DPH Tree Farm
Asset Management Ratio

Industry Average

Inventory Turnover = Sales / Inventory

Inventory Turnover = 315/ 111
Inventory Turnover = 2.84 times

2.15 times

Days Sales in Inventory = Inventory x 365 / Sales

Days Sales in Inventory = 111 x 365 / 315
Days Sales in Inventory = 129 days

1.70 days

Average collection period (ACP) = Accounts receivable x 365 /

Credit sales
ACP = 70 x 365 / 315
ACP = 81 days

95 days

Accounts receivables turnover = Credit Sales / Accounts

Receivable
Accounts receivables turnover = 315 / 70
Accounts receivables turnover = 4.50 times

3.84 times

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Average payment period (APP) = Accounts payable x 365 / COGS

APP = 55 x 365 / 150
APP = 134 days

102 days

Accounts payable turnover = COGS / Accounts payable

Accounts payable turnover = 150 / 55
Accounts payable turnover = 2.73 times

3.55 times

Fixed asset turnover ratio = Sales / Fixed assets

Fixed asset turnover ratio = 315 / 315
Fixed asset turnover ratio = 1.0

0.85 times

Sales to Working Capital ratio = Sales / Working capital

Sales to Working Capital ratio = 315 / 205-120
Sales to Working Capital ratio = 3.71 times

3.20 times

Total assets turnover ratio = Sales / Total assets

Total assets turnover ratio = 315 / 570
Total assets turnover ratio = 0.55 times

0.40 times

Capital intensity ratio = Total assets / Sales

Capital intensity ratio = 570 / 315
Capital intensity ratio = 1.81 times

2.50 times

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 In all cases DPH has better asset management

than the industry average
Produces more sales per dollar of inventory
Collects its accounts receivables faster
Pays its accounts payables slower
Produces more sales per dollar of fixed assets,
working capital, and total assets

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Debt Management Ratios

Debt management ratios measure the extent
to which the firm uses debt (financial
leverage) versus equity to finance its assets
There are two major types of debt
management ratios
Ratios that measure the amount of debt
Ratios that indicate the ability of the firm to
service its debt
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 Debt vs. Equity financing

The debt ratio measures the percentage of total
assets financed with debt.
Debt ratio = Total debt / Total assets

The debt-to-equity ratio measures the dollars of

debt financing used for every dollar of equity
financing.
Debt-to-equity ratio = Total debt / Total equity
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 The Equity Multiplier ratio measures the

dollars of assets on the balance sheet for
every dollar of equity financing
Equity multiplier ratio = Total assets / Total equity

All three of these measures are related:

Equity multiplier = 1 / (1 Debt ratio) = Debt-to-equity ratio +1

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 When a firm issues debt to finance its assets it gives

the debtholders first claim to a fixed amount of its cash
flows
Stockholders are entitled to any residual cash flows
When the firm does well, financial leverage increases
the return to stockholders since the cash flows
promised to debtholders is constant
Stockholders encourage the use of debt financing up to a
point

Financial leverage also increases the risk of financial

distress

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 Investors view equity financing as a safety

cushion that can absorb fluctuations in the firms
earnings and asset values
The larger the fluctuations or variability of a
firms cash flows the greater the need for an
equity cushion
In deciding the level of debt versus equity
financing managers must consider the trade-off
between maximizing cash flows to the firms
stockholders versus the risk of being unable to
make promised debt payments
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 Coverage Ratios
The Times Interest Earned ratio measures the number
of dollars of operating earnings available to meet each
dollar of interest obligations
Times interest earned = EBIT / Interest expense

The Fixed Charge Coverage ratio measures the

number of dollars of operating earnings available to
meet the firms interest and other fixed charges
Fixed charge coverage = Earnings available to meet fixed charges / Fixed
charges
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 The Cash Coverage ratio measures the number of

dollars of operating cash available to meet each
dollar of interest and other fixed charges
Cash coverage ratio = (EBIT + Depreciation) / Fixed
charges

These coverage measures can indicate

whether a firm has taken on a debt burden
that is too large
A value less than 1 means that the firm has
less than $1 of earnings or cash available to
pay each dollar of interest or fixed charges

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Example 3-3

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Profitability Ratios
These ratios show the combined effect of
liquidity, asset management, and debt
management on the overall operating results
of the firm
These ratios are closely monitored by
investors
Stock prices react very quickly to unexpected
changes in these ratios
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 The Profit Margin is the percent of sales left after all firm expenses
are paid
Profit margin = Net income available to common stockholders / Sales

The Basic Earnings Power ratio measures the EBIT earned per dollar
of assets on the balance sheet and represents the operating return
on the firms assets irrespective of financial leverage and taxes.
Basic earnings power ratio (BEP) = EBIT / Total assets

BEP is a useful ratio for comparing firms that differ in financial

leverage and taxes

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 The Return on Assets (ROA) measures the overall return on

the firms assets, inclusive of leverage and taxes
Return on Assets (ROA) = Net income available to common
stockholders / Total Assets

The Return on Equity (ROE) measures the return on

common stockholders investment
Return on Equity (ROE) = Net income available to common
stockholders / Common stockholders equity

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 ROE is affected by net income as well as the amount of

financial leverage
A high ROE is generally considered to be a positive sign
of firm performance
Unless it is driven by excessively high leverage

The Dividend Payout Ratio measures the fraction of

earnings paid out to common stockholders as
dividends
Dividend payout ratio = Common stock dividends / Net
income available to common stockholders
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Example 3-4

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Market Value Ratios

While ROE is a very important financial statement ratio,
it doesnt specifically incorporate risk.
Market prices of publicly traded firms do incorporate
risk, and so ratios that incorporate stock market values
are important.
Market values reflect what investors think of the
companys future performance and risk

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 The Market-to-Book ratio measures the amount that

investors will pay for the firms stock per dollar of
equity used to finance the firms assets
Market-to-book ratio = Market price per share / Book value per share

Book value per share is an accounting-based number

reflecting historical costs
This ratio compares the market (current) value of the
firm's equity to their historical costs.
If liquidity, asset management, and accounting profitability
are good for a firm, then the market-to-book ratio will be
high
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 The Price-Earnings ratio is the best known and

most often quoted figure
Price-earnings ratio = Market price per share / Earnings per share

Measures how much investors are willing to pay for

each dollar of earnings
A high PE ratio is often an indication of anticipated
growth
Stocks are classified as growth stocks or value stocks based
on the PE ratio
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Example 3-5

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DuPont Analysis
DuPont analysis is a decomposition model
ROA and ROE can be broken down into
components in an effort to explain why
they may be low (or high).
The Basic DuPont equation
ROA
= Profit Margin x Total asset
turnover
=

NI
Sales

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Sales
TA

 The ROA depends on the firms profit margin

(which is an indicator of expense control) and
total asset turnover, an indicator of how
efficiently the firm manages its assets

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 The full DuPont formula looks at the

decomposition of ROE:
ROE = profit margin x total asset turnover x equity
multiplier

NI
ROE =Sales

Sales
X
TA

ACT3211 FINANCIAL MANAGEMENT

TA
CE

 The DuPont model focuses on

Expense control (PM)
Asset utilization (TATO)
Debt utilization (EM)
Notice that the first two terms in the ROE model
are the same as ROA, so:
ROE = ROA x equity multiplier

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Example 3-6

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Other Ratios
Spreading the Financial Statements
Managers, analysts, and investors often create
common size financial statements
Balance sheet items are divided by total assets
Income statement items are divided by sales

Common size statements are conducive to:

Identifying trends for the firm
Comparisons across firms in the industry

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 Internal and Sustainable Growth Rates

The internal growth rate measures the amount of
growth a firm can sustain if it uses only internal
financing (retained earnings)
Internal growth rate = (ROA x RR) / [(1-ROA) x RR]
where RR = retention ratio

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 If the firm uses retained earnings to support

asset growth, the firms capital structure will
change over time
More equity financing and decreasing debt ratio

To maintain the same capital structure

managers must use both debt and equity
financing to support asset growth

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 The sustainable growth rate measures the

amount of growth a firm can achieve using
internal equity and maintaining a constant
debt ratio:
Sustainable growth rate = (ROE x RR) / [(1-ROE) x RR]

Combining this with the DuPont equation, the

sustainable growth rate depends on four factors:
Profit margin (operating efficiency)
Total asset turnover (efficiency in asset use)
Financial leverage (using debt vs. equity to finance
assets)
Profit retention (reinvestment of NI rather paying
dividends)

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Example 3-7

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Time Series and Cross-Sectional

Analysis

To analyze ratios in a meaningful way they

must be compared to some benchmark
There are two types of benchmarks:
Performance of the firm over time (time
series analysis)
Performance of the firm against other
companies in the same industry (crosssectional analysis)
Comparative ratios for industries are available
from Value Line, Robert Morris Associates, Dun &
Bradstreet, Hoovers Online, and MSN Money
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Cautions in Using Ratios

1. Financial statement data are historical
2. Firms use different accounting procedures
E.g. LIFO/FIFO, depreciation methods

3. Sales and expenses may be seasonal

1. Some items may be unusually high or low at the close
of the fiscal year

4. Large firms have multiple lines of business

5. Firms can use window dressing to make
financial statement look better

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