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Topic 13 Financial Statement Analysis 1
Topic 13 Financial Statement Analysis 1
OVERVIEW
Financial analysis is the process of examining a company’s performance in the context of its industry and economic
environment in order to arrive at a decision or recommendation.
Often, the decisions and recommendations addressed by financial analysts pertain to providing capital to companies—
specifically, whether to invest in the company’s debt or equity securities and at what price.
Overall, a central focus of financial analysis is evaluating the company’s ability to earn a return on its capital that is at
least equal to the cost of that capital, to profitably grow its operations, and to generate enough cash to meet obligations
and pursue opportunities.
Common-Size Analysis
Common-size analysis involves expressing financial data, including entire financial statements, in relation to a single
financial statement item, or base. Items used most frequently as the bases are total assets or revenue. In essence,
common-size analysis creates a ratio between every financial statement item and the base item.
LIQUIDITY RATIOS
Liquidity – A firm’s ability to satisfy its short-term obligations as they come due.
3. Cash ratio
Cash ratio = Cash + Short-term marketable investments ÷ Current Liabilities
The cash ratio normally represents a reliable measure of an entity’s liquidity in a crisis situation.
SOLVENCY RATIOS
Solvency – refers to a company’s ability to fulfill its long-term debt obligations. Assessment of a company’s ability to pay
its long-term obligations (i.e., to make interest and principal payments) generally includes an in-depth analysis of the
components of its financial structure.
2. Debt-to-capital ratio
Debt-to-capital ratio = Total debt ÷ (Total debt + Total shareholders’ equity)
The debt-to-capital ratio measures the percentage of a company’s capital (debt plus equity)
represented by debt. As with the previous ratio, a higher ratio generally means higher financial risk and thus
indicates weaker solvency.
3. Debt-to-equity ratio
Debt-to-equity ratio = Total debt ÷ Total shareholders’ equity
The debt-to-equity ratio measures the amount of debt capital relative to equity capital. Interpretation is
similar to the preceding two ratios (i.e., a higher ratio indicates weaker solvency).
5. Interest coverage
Interest coverage = EBIT ÷ Interest Payments
This ratio measures the number of times a company’s EBIT could cover its interest payments. Thus, it
is sometimes referred to as “times interest earned.” A higher interest coverage ratio indicates stronger
solvency, offering greater assurance that the company can service its debt (i.e., bank debt, bonds, notes) from
operating earnings.
Activity ratios are also known as asset utilization ratios or operating efficiency ratios.
This category is intended to measure how well a company manages various activities, particularly how efficiently it
manages its various assets. Activity ratios are analyzed as indicators of ongoing operational performance—how
effectively assets are used by a company.
3. Receivables turnover
Receivables turnover = Revenue ÷ Inventory turnover (Average Receivables)
This provides us the number of times Accounts Receivables (Credit Sales) is converted into Cash
Sales. Although limiting the numerator to sales made on credit in the receivables turnover would be more
appropriate, credit sales information is not always available to analysts; therefore, revenue as reported in the
income statement is generally used as an approximation. A relatively high receivables turnover ratio (and
commensurately low DSO) might indicate highly efficient credit and collection. A relatively low receivables
turnover ratio would typically raise questions about the efficiency of the company’s credit and collections
procedures
5. Payables turnover
Payables turnover = Purchases ÷ Average trade payables
The payables turnover ratio measures how many times per year the company theoretically pays off all its
creditors. For purposes of calculating these ratios, an implicit assumption is that the company makes all its
purchases using credit. If the amount of purchases is not directly available, it can be computed as cost of
goods sold plus ending inventory less beginning inventory. A payables turnover ratio that is high (low days
payable) relative to the industry could indicate that the company is not making full use of available credit
facilities. An excessively low turnover ratio (high days payable) could indicate trouble making payments on
time, or alternatively, exploitation of lenient supplier terms.
PROFITABILITY RATIOS
Profitability - reflects a company’s competitive position in the market, and by extension, the quality of its management.
3. Pre-tax Margin
Pre-tax Margin = EBT (earnings before tax but after interest) ÷ Revenue
The pretax margin reflects the effects on profitability of leverage and other (non-operating) income and
expenses. If a company’s pretax margin is increasing primarily as a result of increasing amounts of non-
operating income, the analyst should evaluate whether this increase reflects a deliberate change in a
company’s business focus and, therefore, the likelihood that the increase will continue.
VALUATION RATIOS
Valuation ratios - measure the quantity of an asset or flow (e.g., earnings) associated with ownership of a specified
claim (e.g., a share or ownership of the enterprise). Analysts are interested in valuing a security to assess its merits for
inclusion or retention in a portfolio.
ROE measures the return a company generates on its equity capital. Thus, to understand what drives a company’s ROE,
a useful technique is to decompose ROE into its component parts. (Decomposition of ROE is sometimes referred to as
DuPont analysis because it was developed originally at that company.) Decomposing ROE involves expressing the basic
ratio (i.e., net income divided by average shareholders’ equity) as the product of component ratios.
Decomposing ROE is useful in determining the reasons for changes in ROE over time for a given company and for
differences in ROE for different companies in a given time period. The information gained can also be used by
management to determine which areas they should focus on to improve ROE.
The decomposition of ROE makes use of simple algebra and illustrates the relationship between ROE and ROA.
Expressing ROE as a product of only two of its components, we can write:
To separate the effects of taxes and interest, we can further decompose the net profit margin and write:
2. Present and prospective shareholders are mainly concerned with a firm's ________.
a. risk and return
b. profitability
c. leverage
d. liquidity
3. ________ analysis involves the comparison of different firms' financial ratios at the same point in time.
a. Time-series
b. Cross-sectional
c. Marginal
d. Technical
4. Which of the following is used to analyze a firm's financial performance over different years?
a. time-series analysis
b. break-even analysis
c. gap analysis
d. marginal analysis
7. An analyst should be careful when conducting ratio analysis to ensure that ________.
a. the overall performance of a firm is not judged on a single ratio
b. the role of inflation is ignored
c. ratios being compared should be calculated using financial statements dated at different points in time
during the year
d. different accounting procedures are used
9. A firm has a current ratio of 1. To increase that ratio the firm might ________.
a. develop a better inventory management system so the firm doesn't have to hold as many items in
inventory at one time
b. hold lower cash balances at the bank and increase holdings of interest-earning marketable securities
c. take out a long-term bank loan and simultaneously offer customers better credit terms, allowing them to
pay their bills more slowly
d. issue bonds and use the proceeds to purchase new equipment
11. The ________ measures the activity, or liquidity, of a firm's stock of goods.
a. average collection period
b. inventory turnover ratio
c. average payment period
d. total asset turnover ratio
13. A firm's total asset turnover increased from 0.75 to 0.90. Which of the following is true about the given data?
a. The firm is generating more dollars of sales per dollar of assets now than it was before.
b. The firm is generating fewer dollars of sales per dollar of assets now than it was before.
c. By cutting back on assets, the firm runs the risk of creating problems like inventory stockouts and
production delays.
d. The firm's stock price will go up because it is using asset more efficiently.
14. The higher, the value of the ________ ratio, the better able a firm is to fulfill its interest obligations.
a. dividend payout
b. average collection period
c. times interest earned
d. average payment period
15. Two frequently cited ratios of profitability that can be read directly from the common-size income statement are
________.
a. the earnings per share and the return on total assets
b. the gross profit margin and the earnings per share
c. the gross profit margin and the return on total assets
d. the gross profit margin and the net profit margin
FOR 16-30
Dana Dairy Products Key Ratios
Income Statement
Dana Dairy Products
For the Year Ended December 31, 2019
16. The current ratio for Dana Dairy Products in 2019 was ________. (See Table 3.2)
a. 1.58
b. 0.63
c. 1.10
d. 0.91
17. Since 2018, the liquidity of Dana Dairy Products ________. (See Table 3.2)
a. has deteriorated
b. has remained the same
c. has improved
d. is not determinable
18. The net working capital for Dana Dairy Products in 2019 was ________. (See Table 3.2)
a. $10,325
b. -$10,325
c. -$1,425
d. $14,250
19. The inventory turnover for Dana Dairy Products in 2019 was ________. (See Table 3.2)
a. 43
b. 5
c. 20
d. 25
20. The inventory management at Dana Dairy Products ________ since 2018. (See Table 3.2)
a. has deteriorated
b. has remained the same
c. has improved slightly
d. cannot be determined
21. The average collection period for Dana Dairy Products in 2019 was ________. (See Table 3.2)
a. 32.5 days
b. 11.8 days
c. 25.3 days
d. 35.9 days
22. If Dana Dairy Products has credit terms which specify that accounts receivable should be paid in 25 days, the
average collection period ________ since 2018. (See Table 3.2)
a. has deteriorated
b. has remained the same
c. has improved
d. cannot be determined
24. The debt ratio for Dana Dairy Products in 2019 was ________. (See Table 3.2)
a. 50 percent
b. 11 percent
c. 55 percent
d. 44 percent
25. Dana Dairy Products' gross profit margin was inferior to the industry standard. This may have resulted from
________. (See Table 3.2)
a. a high sales price
b. the high cost of goods sold
c. excessive selling and administrative expenses
d. excessive interest expense
26. The gross profit margin and net profit margin for Dana Dairy Products in 2019 were ________. (See Table 3.2)
a. 13 percent and 0.9 percent, respectively
b. 13 percent and 1.5 percent, respectively
c. 2 percent and 0.9 percent, respectively
d. 2 percent and 1.5 percent, respectively
27. The return on total assets for Dana Dairy Products for 2019 was ________. (See Table 3.2)
a. 0.9 percent
b. 5.5 percent
c. 25 percent
d. 2.5 percent
28. The return on equity for Dana Dairy Products for 2019 was ________. (See Table 3.2)
a. 0.6 percent
b. 5.6 percent
c. 0.9 percent
d. 50 percent
29. Using the modified DuPont formula allows the analyst to break Dana Dairy Products return on equity into 3
components: the net profit margin, the total asset turnover, and a measure of leverage (the financial leverage
multiplier). Which of the following mathematical expressions represents the modified DuPont formula relative
to Dana Dairy Products' 2019 performance? (See Table 3.2)
a. 5.6(ROE) = 2.5(ROA) × 2.22(Financial leverage multiplier)
b. 5.6(ROE) = 3.3(ROA) × 1.70(Financial leverage multiplier)
c. 4.0(ROE) = 2.5(ROA) × 2.00(Financial leverage multiplier)
d. 2.5(ROE) = 5.6(ROA) × 2.22(Financial leverage multiplier)
30. As the financial leverage multiplier increases, this may result in ________.
a. an increase in the net profit margin and return on investment, due to the decrease in interest expense as
debt decreases
b. an increase in the net profit margin and return on investment, due to the increase in interest expense as
debt increases
c. a decrease in the net profit margin and return on investment, due to the increase in interest expense as
debt increases
d. a decrease in the net profit margin and return on investment, due to the decrease in interest expense as
debt decreases
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