Chapter 3

WORKING WITH FINANCIAL STATEMENT

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 Standardized Financial Statements

making comparisons COMMON-SIZE STATEMENTS

• differences in size • each item on the balance sheet as a

percentage of assets
• currency differences
• each item on the income statement as a
percentage of sales

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Common-Size Balance Sheets

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Common-Size Balance Sheets

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Common-Size Income Statements

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COMMON–BASE YEAR FINANCIAL STATEMENTS: TREND ANALYSIS

• choose a base year

• express each item relative to the base amount
• i.e: If we pick 2011 as our base year, then we would set inventory
equal to 1.00 for that year.
• inventory rose from $393 (2011) to $422 (2012)
• inventory relative to the base year as $422/393 = 1.07

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COMBINED COMMON-SIZE AND BASE
YEAR ANALYSIS

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 Financial Statement Analysis

• Investors often use accounting statements

to:
– Compare the firm with itself by analyzing how
the firm has changed over time
– Compare the firm to other similar firms using a
common set of financial ratios

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 Why are ratios useful?

• Ratios standardize numbers and facilitate

comparisons.
• Ratios are used to highlight weaknesses
and strengths.
• Ratio comparisons should be made through
time and with competitors.
– Trend analysis.
– Peer (or industry) analysis.

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Why are ratios useful?

• Ratio analysis is not merely the calculation

of a given ratio.
• to answer such questions as “Is it too high
or too low?” and “Is it good or bad?”
• Two types of ratio comparisons can be
made: cross-sectional and time-series.

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Cross-sectional & time series analysis
❖ Cross-sectional analysis

o involves the comparison of different firms’ financial ratios at

the same point in time.

o called benchmarking, has become very popular.

o comparison to industry averages

❖ Time-series analysis
o evaluates performance over time.
o Developing trends can be seen by using multiyear
comparisons.

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Combined analysis

• A combined view makes it possible to assess

the trend in the behavior of the ratio in
relation to the trend for the industry.

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Note to financial analysis

❑Ratios with large deviations from the norm

only indicate symptoms of a problem.
❑A single ratio does not generally provide
sufficient information
❑The ratios being compared should be
calculated using financial statements dated
at the same point in time during the year

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Note to financial analysis

❑ preferable to use audited financial statements

for ratio analysis.
❑ The financial data being compared should have
been developed in the same way (differing
accounting treatments)
❑ Results can be distorted by inflation, which can
cause the book values of inventory and
depreciable assets to differ greatly from their
true (replacement) values.

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Implications

1. How is it computed?
2. What is it intended to measure, and why
might we be interested?
3. What is the unit of measurement?
4. What might a high or low value tell us?
How might such values be misleading?
5. How could this measure be improved?

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 Five Major Categories of Ratios

1. Liquidity: Can we make required payments?

2. Asset management: right amount of assets
vs. sales?
3. Debt management: Right mix of debt and
equity?
4. Profitability: Do sales prices exceed unit
costs, and are sales high enough as
reflected in PM, ROE, and ROA?
5. Market value: Do investors like what they
see as reflected in P/E and M/B ratios?

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 1.Current Ratio and Quick Ratio

Current assets
Current ratio =
Current liabilitie s

the higher the current ratio, the more liquid the firm
is considered to be.

(Current assets − Inventories )

Quick ratio =
Current liabilitie s

A quick ratio of 1.0 or greater is occasionally recommended,

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2.Asset management
– Inventory Days and Inventory Turnover
• Inventory Days is the number of days’ cost of goods
sold represented by inventory
• Inventory Turnover tells how efficiently a company
turns its inventory into sales

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2.Asset management

Asset Efficiency

Total Asset Turnover

Fixed Asset Turnover

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2.Asset management

• Working Capital Ratios

– Accounts Receivable Days
• The firm’s accounts receivable in terms of the number
of days’ worth of sales that it represents

Accounts Receivable
Accounts Receivable Days =
Average Daily Sales

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3.Debt management
• Interest Coverage Ratios
– Also known as times interest earned (TIE)
– Assesses how easily a firm is able to cover its
interest payments

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3.Leverage Ratios

❖Debt-Equity Ratio
• The debt-equity ratio is a common ratio used to assess
a firm’s leverage

Total Debt
Debt-Equity Ratio =
Total Equity

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4.Profitability Ratios

❖Net Profit Margin

• The fraction of each dollar in revenues that is available
to equity holders after the firm pays interest and taxes

Net Income
Net Profit Margin =
Sales

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4.Profitability Ratios

• Operating Returns
– Return on Equity

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4.Profitability Ratios

• Operating Returns
– Return on Assets
• Evaluating the firm’s return on investment by
comparing its income to its assets

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5.Market Ratios

– Analysts and investors use a number of ratios to

gauge the market value of the firm
– The most important is the firm’s price-earnings
ratio (P/E)

Market Capitalization Share Price

P / E Ratio = =
Net Income Earnings per Share

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5.Market Ratios

– PE Ratio
• P/E ratios can vary widely across industries and tend to
be higher for industries with higher growth rates
• It is the ratio of the firm’s P/E to its expected earnings
growth rate
• The higher the P/E ratio, the higher the price relative to
growth, so some investors avoid companies with P/E
ratios over 1

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6.The DuPont Identity
• The DuPont Identity
– This expression says that ROE can be thought of
as net income per dollar of sales (profit margin)
times the amount of sales per dollar of equity

 Net Income  Sales   Net Income  Sales 

ROE =   =   
 Total Equity  Sales   Sales  Total Equity 

 Net Income  Sales  Total Assets   Net Income  Sales  Total Assets 
ROE =    =    
 Sales  Total Equity  Total Assets   Sales  Total Assets  Total Equity 

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Example 1 DuPont Analysis

Problem:
• The following table contains information about Wal-Mart
(WMT) and Nordstrom (JWN)
• Compute their respective ROEs and then determine how
much Wal-Mart would need to increase its profit margin in
order to match Nordstrom’s ROE

Profit Asset Equity

Margin Turnover Multiplier
Wal-Mart 3.6% 2.3 2.7
Nordstrom 6.1% 1.5 4.2

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Example 1 DuPont Analysis (cont’d)

Execute:
• Using the DuPont Identity, we have:
– ROEWMT = 3.6% x 2.3 x 2.7 = 22.3%
– ROEJWN = 6.1% x 1.5 x 4.2 = 38.4%
• we can solve for the margin that Wal-Mart needs to achieve
Nordstrom’s ROE:
– 38.4% = Margin x 2.3 x 2.7
– Margin = 38.4% / 6.21 = 6.2%

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Example 1 DuPont Analysis (cont’d)

Evaluate:
• Wal-Mart would have to increase its profit margin from 3.6%
to 6.2% in order to match Nordstrom’s ROE
• It would be able to achieve Nordstrom’s ROE even with
around the same profit margin as Nordstrom (6.2% vs.
6.1%) because of its higher turnover

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Example 2 DuPont Analysis

Problem:
• Compute ROEs and then determine how much General Mills
would need to increase its equity multiplier in order to match
Campbell’s ROE

Profit Asset Equity

Margin Turnover Multiplier
Campbell’s 5.7% 0.97 6.84
General Mills 10.4% 0.78 2.97

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Example 2 DuPont Analysis (cont’d)

Execute:
• Using the DuPont Identity, we have:
– ROECPB = 5.7% x 0.97 x 6.84 = 37.6%
– ROEGIS = 10.4% x 0.78 x 2.97 = 24.3%
• we can solve for the equity multiplier that General Mills needs
to achieve Campbell’s ROE:
– 37.6% = 10.4% x 0.78 x Equity Multiplier
– Equity Multiplier = 37.6% / 8.2% = 4.59

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Example 2 DuPont Analysis (cont’d)

Evaluate:
• General Mills would have to increase its equity multiplier from
2.97 to 4.59 in order to match Campbell’s ROE
• This large increase in equity multiplier is required because of
its lower asset turnover (0.78 vs. 0.97) (lower efficiency),
despite its higher profit margin (10.4% vs. 5.7%)

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Example 3 DuPont Analysis

Problem:
• Compute ROEs and then determine how much General Mills
would need to increase its asset turnover in order to match
Campbell’s ROE

Profit Asset Equity

Margin Turnover Multiplier
Campbell’s 5.7% 0.97 6.84
General Mills 10.4% 0.78 2.97

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Example 3 DuPont Analysis (cont’d)

Execute:
• Using the DuPont Identity, we have:
– ROECPB = 5.7% x 0.97 x 6.84 = 37.6%
– ROEGIS = 10.4% x 0.78 x 2.97 = 24.3%
• Now, using Campbell’s ROE, but General Mills’ profit margin
and asset turnover, we can solve for the equity multiplier that
General Mills needs to achieve Campbell’s ROE:
– 37.6% = 10.4% x Asset Turnover x 2.97
– Asset Turnover = 37.6% / 31.0% = 1.22

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Example 3 DuPont Analysis (cont’d)

Evaluate:
• General Mills would have to increase its asset turnover from
0.78 to 1.22 in order to match Campbell’s ROE
• This large increase in asset turnover is required because of its
lower equity multiplier (2.97 vs. 6.84) (lower leverage),
despite its higher profit margin (10.4% vs. 5.7%)

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Table 1 Summary of Key
Financial Ratios

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Table 1 A
Summary of Key
Financial Ratios
(cont.)

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Chapter Quiz

• What is the role of an auditor?

• What is depreciation designed to capture?
• What does a high debt-to-equity ratio tell
you?
• What do a firm’s earnings tell you?
• How do you use the price-earnings (P/E)
ratio to gauge the market value of a firm?

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Chapter Quiz

• Why does a firm’s net income not

correspond to cash earned?
• What information do the notes to financial
statements provide?
• What is the Sarbanes-Oxley Act?

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