FIN 303 Financial Management (Fall 2016)

Instructor: Dr. Chang

Chapter 4 Financial Statements Analysis

Lecture Outline

Perspectives on Financial Statement Analysis

1. Stockholders perspective
2. Managers perspective
3. Creditors perspective

Two Types of Analysis

1. Trend analysis (also called time-series analysis)
(a) Evaluate performance over time.
(b) Compare its ratio values to its past performance.
2. Benchmark analysis (also called cross-sectional analysis)
(a) Benchmarking is the term used to describe this cross-sectional comparison with competitor firms.
(b) Benchmark is a standard, used for comparison. For example, the Nasdaq may be used as a
benchmark against which the performance of a technology stock is compared.
(c) Two types of benchmarking:
(1) Peer Group Analysis:
(2) Industry Analysis:

Using Financial Ratios / Ratio Analysis

1.
2.
3.
4.
5.
6.

Analyze and monitor the firms performance.

Based on the use of ratios or relative values.
Basic inputs: the firms Income Statement and Balance Sheet.
Relative measures of the firms performance.
More important is the interpretation of the ratio value.
Two basic questions:
(a) Is it too high or too low?
(b) Is it good or bad?

Cautions about using Ratio Analysis

1. Large deviations from the norm merely indicate symptoms of a problem.
2. A single ratio does not generally provide sufficient information to judge the overall
performance of the firm.
3. Use financial statements dated at the same point in time.
4. Use audited financial statements.
5. Use same accounting treatments.
6. Results can be distorted by inflation.

Five Categories of Financial Ratios

1. Liquidity ratios
2. Efficiency ratios
3. Leverage ratios
4. Profitability ratios
5. Market ratios

Liquidity Ratios
1. Measure a firms ability to satisfy its ___________-term obligations (or bills) as they come
due.
(a) Liquidity ratios are concerned with the firms ability to pay its current bills (or short-term
liabilities) without putting the firm in financial difficulty.
(b) Liquidity ratios provide early signs of cash flow problems and impending business failure.
(c) These ratios are also known as short-term solvency ratios.
2. Two measures of liquidity:
Current ratio =

(a) Current Ratio (CR):

Current assets (CA)

Current liabilities (CL)

(b) Quick Ratio (often referred to as acid-test ratio):

Quick ratio =

CA- Inventory
CL

3. The higher a firms liquidity ratio, the more ______________ the firm.
(a) Suppose a firms current ratio changed from 1.4 times in the previous year to 1.6 times this year.
This means that the firms liquidity is improved.
(b) The quick ratio is similar to the current ratio except that it excludes inventory.
4. A values acceptability depends on the industry in which the firm operates.

Efficiency Ratios
1. Measure how efficiently a firm uses its assets to generate sales.
e.g., inventory, A/R, and A/P
2. The higher the ratio, the more _____________ the firm.
3. Measures:
=

(a) Inventory Turnover

COGS
Inventory
=

(b) Days sales in inventory

365
Inventory turnover (days)

(c) A/R Turnover =

Net Sales
A /R

(d) Days Sales Outstanding (DSO) =

(e) Total Asset (TA) Turnover =

(f) Fixed Asset Turnover =

365 days
(days)
A /R turnover

Net Saless
TA

Net
Net Saless
Assets

4. Mr. Jakob is studying Gateway Corp. that has an inventory turnover ratio of 5. Can you tell
him how long it takes for this firm to turn over its inventory on average (i.e., the firm's days'
sales in inventory)?

Leverage (also called Financial Leverage) 101

1. The term leverage refers to the use of _____________ in an investors investment (or in a
firms capital structure).
(a) The degree to which an investor (or business) is utilizing _____________ money.
(b) The debt position of an investor (or a firm) indicates the amount of _____________________
money that has been used to generate profits.
(c) Leverage measures the extent to which an investor (or a firm) uses debt rather than
____________ financing.
2. The use of leverage is a double-edged sword. That is, using leverage __________________the
realized return.
(a) Debt is one type of fixed-cost financing.
(b) Debt increases the returns to stockholders during good times & reduces the returns during bad times.
3. The more debt an investor (or a firm) uses, the higher his (or its) financial leverage, and the
greater his (or its) risk of default.
(a) The default risk is the risk that an investor (or a firm) will not be able to pay its debt as it comes
due.
(b) Investors (or companies) that are highly leveraged may be at risk of bankruptcy if they are
unable to make payments on their debt; they may also be unable to find new lenders in the
future.

Leverage Ratios
1. Indicate the firms ability to meet its __________-term financial obligations, such as interest
payments on debt and lease payments.
2. The ratios are also called ___________-term solvency ratios.
3. Debt ratios:
3

(a) Total Debt Ratio =

Total Liabilities TAEquity

=
Total Assets
TA

(b) Debt-to-Equity ratio =

Total Liabilities
Equity

(c) Long-term Debt-to-Equity ratio =

(d) Equity multiplier =

Debt
Equity

TA
Equity

4. Based on the balance sheet identity, debt ratios, debt-to-equity ratios, and equity multipliers
are convertible.
TL Equity( Debtequity ratio) ( Debtequity ratio)
=
=
=
TA
TA
(TL+ Equity )/Equity
Debt Equity ratio
1+(DebtEquity ratio)

(a) Debt ratio =

(b) Debt-to-Equity ratio =

Total Liabilities
=
Equity

(c) Equity multiplier (or leverage) =

TL/TA
=
(TATL)/TA

Debt ratio
1Debt ratio

TA
TL+ Equity
TL
=
=
+1= Debt-to-equity ratio +1
Equity
Equity
Equity

(d) Assume Kristine is researching a firm with a debt ratio of 0.6. She is currently taking FIN 303
financial management at CSUN. Can you help her figure out the firms debt-to-equity ratio and
equity multiplier?
5. Coverage Ratios:

EBIT
(a) Interest Coverage Ratio (or Times Interest Earned Ratio) = Interest expense
(b) Cash Coverage =

EBITDA
EBIT + Dep
=
Interest expense Interest expense

Common-Size Financial Statements

Exhibit 4.1 (p 86)

1. Each number is expressed as a percentage of a base number.

2. Scaling: Dividing numbers by a common base to form a ratio is called scaling.
3. Common-size analysis is used in financial analysis to compare companies of different sizes or
compare a company with itself over time.
4. Also called standardized financial statements.
4

Profitability Ratios
1. Common-Size Income Statements
Exhibit 4.2 Common-size income statements (p. 88)

(a) Gross profit margin =

Gross profit Net salesCOGS

=
Net sales
Net sales

(b) Operating profit margin =

(c) (Net) profit margin =

Operating profit
EBIT
=
Net sales
Net sales

Net income EBT Taxes

=
Net sales
Net sales

2. Return on assets (ROA)

EBIT SalesOperating exp
=
(a) EROA (EBIT Return on Assets) =
TA
TA
(b) ROA =

SalesOperating expInterest Tax

=
Total Assets
TA

3. Return on common equity (ROE) =

Total Equity

Market Ratios
1. Assess the owners appraisal of share value.
2. The higher the ratio, the greater the investors __________ about the firms expected future
performance.
3. Price/Earnings (P/E) ratio:
Market Price per share of CommonStock
P/E ratio =
EPS

Earnings per share (EPS) =

Shares outstanding

(a)

It measures the amount that investors are willing to pay for each dollar of a firms earnings.

(b)

It reflects all future cash flows from earnings, and the especially high P/E ratio can indicate that
investors expect the firms earnings to grow in the future.

4. Market/book (M/B) ratio:

M/B ratio =

Market Price per share of CommonStock

Book value per share of Common Stock

DuPont System of Analysis

1. A diagnostic tool that uses financial ratios to evaluate a companys financial health.
(a) Used to identify the primary driver(s) behind an increase or a decrease in the ROA (or ROE).

(b)
(c)
2.
(a)
(b)
(c)

Decomposing the ROA (or ROE) into its components allows analysts to identify adverse
impacts on the ROA (or ROE) and to predict future trends.
This analysis highlights expense control, asset utilization, and debt utilization.

Two basic components of the ROA:

ROA = __________ = __________________ __________________
What are the primary factors that drive a firms ROA?
Assume you are studying a firm with the following financial data: NI = $5,807, Sales = $31,944,
Total assets = $40,510. Whats its ROA? Whats its NPM? Whats its asset turnover?

3. Two basic strategies to earn a higher ROA.

FIN 303: Exhibit 4.4 (p. 105)

(a) To maximize a firm's ROA, management can focus more on achieving high profit margins or on
achieving high asset turnover.
(b) High-end retailers like Polo Ralph Lauren and Nordstrom focus more on achieving high profit
margins, while grocery and discount stores like Whole Foods Market and Wal-Mart tend to focus
more on achieving high asset turnover because competition limits their ability to achieve very high
profit margins.
4. A further breakdown of the four components of the ROA:
Net Sales
EBIT
EBT
Net Sales

(a) ROA =
Net Sales
TA
Net Sales EBIT EBT
TA

(b) ROA can also depend on the product of four variables: (1) operating profit margin, (2) interest
burden, (3) tax burden, and (4) asset turnover.
6

5. Two basic components of the ROE:

(a) ROE = __________ = __________________ __________________
(b) What are the primary factors that drive a firms ROE?
6. You can get a further breakdown of the components that make up the ROE, when using the
components of the ROA.
(a) ROE can also depend on the product of three variables: (1) net profit margin, (2) asset turnover,
and (3) leverage.
(b) ROE = [Operating profit margin Interest burden Tax burden Asset turnover] Leverage
7. Suppose Miguel is looking at a firm with the NPM of 5%. The firms TA turnover is 1.5
times, and its financial leverage ratio is 1.2. Whats the firms ROA and ROE?
8. Think about this question Why do banks have a low ROA (relative to other industries) but
a high ROE?

Objectives
1.
2.
3.
4.

Trend analysis vs benchmark analysis

Liquidity ratios, efficiency ratios, leverage ratios, profitability ratios, market ratios
Total debt ratio, debt-to-equity ratio, and equity multiplier (or leverage)
DuPont system of analysis

Assigned end-of-chapter questions

o Self-study problems
o Questions and Problems: 4.5, 4.7, 4.9, 4.12, 4.15, 4.19, 4.22, 4.29, 4.35, 4.37

[END]
Seize every moment to accumulate merits and build up virtues.
The first exam covers chapters 1 to 4.
The first four quizzes are due before you take the first exam next week.
Cheers,
Dr. Chang