FMGT 3550 – FDA

Financial Statements analysis – Chapter 3

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1. Financial analysis using financial ratios

1.1 Five main ratio categories

 Liquidity ratios Measure a firm’s ability to fulfill its short-term financial obligations.

 Asset management ratios Measure how effectively management uses its assets for a given
level
of sales.

 Debt Management ratios Measure how much debt financing (financial leverage) a company
uses relative to its assets and operations.

 Profitability ratios Measure a firm’s ability to generate profits from its assets and
operations.

 Market value ratios Reflect investors’ assessment of the company’s performance, value
as
well as the management ability to maximize the firm’s value.

In what follows we will use MicroDrive Inc. numbers (textbook’s example – Chapter 3).
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MicroDrive Inc. Balance Sheet as at December 31st, (in millions of dollars)

2022 2021 2022 2021

Cash and equivalents $10 $15 Accounts payable $60 $30

Short-term 65 Notes payable 110 60

investments
Accruals 140 130

Accounts Receivable 375 315 Total Current 310 220

Liabilities
Inventories 615 415 Long-term bonds 754 580

Total Current Assets 1,000 810 Total liabilities 1,064 800

Net fixed assets 1,000 870 Preferred stock 40 40

(400,000 shares)
Common stock 130 130
(50,000,000 shares)
Retained Earnings 766 710

Total equity 896 840

Total Assets $2,000 $1,680 Total Liab. and SE $2,000 $1,680

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MicroDrive Inc. Income statement for year ended Dec.31 st (million $) 2022 2021
Net sales $3,000 $2,850
Cost of good sold (including lease payments) 2,100 2,000
Note: Depreciation and amortization 100 90

Other operating expenses 516.2 497

Earnings Before Interest and Taxes EBIT (operating income) 283.8 263
Interest expense 88 60
Earnings before tax (EBT) 195.8 203
Taxes (40%) 78.3 81.2
Net Income 117.5 121.8
Preferred shares dividend 4 4
Net Income Available to Common Shareholders (NIATCS) $113.5 $117.8

Additional information 2022 2021

Lease payments (million per year) $28 $28
Bonds sinking funds payments (million per year) $20 $20
Common stock price $23 $26
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1.2 Liquidity Ratios
Firms normally pay off short-term liabilities by using cash or converting current assets to cash, it is useful to
compare the proportions (or ratio) of current assets to current liabilities.

Current Ratio = Current Assets / Current Liabilities = $1,000 / $310 = 3.2 times (Industry average 4.2 x)

Quick Ratio = (Current Assets – Inventories) / Current Liabilities = (1,000 – 615)/310 = $385 / $310
= 1.2 x (Industry average 2.1 x)

Q. Think about an industry where the current ratio’s value is very close to the quick ratio’s value?
Why is it so?

A low current ratio compared to the industry average suggests possible liquidity issues. Short-term
lenders such as banks and suppliers normally prefer high liquidity ratios.

A high current ratio compared to the industry average suggests that too much capital may be tied up in
assets (such as cash, receivables, and inventory) that do not earn a return.

The quick ratio is a stronger liquidity measure as inventories are normally the least liquid current assets.
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1.3 Asset Management Ratios
Inventory turnover ratio shows how quickly a firm sells its inventory.
Inventory Turnover ratio = COGS / Inventories = $2,200* / $615 = 3.6 x (Industry average 8 x)
 A ratio, which is significantly lower than the industry average suggests that too much capital may be
tied up into inventory. The firm’s profitability is reduced.

 A ratio, which is significantly higher than the industry average suggests the company may not carry
enough inventories on hand and may be missing some sales due to stock outs.

 Some analysts calculate inventory ratios using sales rather than Cost of Goods Sold.

* 2,200 = COGS except depreciation + depreciation = 2,100 + 100

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1.3 Asset Management Ratios
Days sales outstanding (DSO) ratio (also called “Average Collection Period”), calculates the number of
days of sales that are tied up in receivables.

Days Sales Outstanding = Receivables / Annual daily Sales

= $375 / ($3,000/365) = 45.6 days (46 days) with industry average 36 days

If in this example the company’s payment terms are 30 days. According to our DSO’s calculation, on
average, customers are paying late. What could be possible explanations for such a poor
performance?
Answer:
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Average payables period (APP) ratio shows how quickly a company pays off its suppliers.
Average Payables Period = Payables / Average daily operating cost
= $60 / ($2,616.2* / 365) = 8.4 days or 8 days (Industry average 9 days)
*Operating Cost = 2,200 – 100 + 516.2

 “Cost of goods sold” can also be used in place of “Annual operating costs”
For exam purpose we will ALWAYS use COGS ($2,200 in this example).

 In our example, an APP significantly over 9 days would suggest that the company experiences
liquidity issues. Late payments will lead suppliers to adopt a tighter policy (asking for faster
payments or cash).

 In our example, if the APP is much lower than 9 days, financial analysts and investors will ask why
MicroDrive doesn’t take full advantage of the trade credit.
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Fixed asset turnover ratio measures how well the company uses its plant and equipment in relation to
its sales.
Fixed Asset Turnover = Sales / Net Fixed Assets = $3,000 / $1,000 = 3 x (Industry average 3 x)

A low fixed asset turnover ratio in comparison to the industry average might suggest that the firm does
not use it fixed assets effectively (too much fixed assets vs. sales level).

A ratio significantly higher than the industry average may suggest that the assets are undervalued
(remember that assets are normally recorded at historical costs and depreciated over time).

Total asset turnover ratio measures how well the company uses all of its assets to generate sales.
Total Asset Turnover = Sales / Total Assets
= $3,000 / $2,000 = 1.5 x (Industry average 1.8 x)
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1.4 Debt Management Ratios

The Debt ratio (Debt-to-Assets ratio) measures the proportion of funds provided by all interest paying
debt (current and long-term).
Debt ratio = (Notes payable + Long-term bonds) / Total Assets
= ($110 + $754) / $2,000 = $1,064 / $2,000 = 43.2% (Industry average 30%)
Long-term creditors (lenders) prefer lower debt ratios, since this provides the lenders a greater cushion
in the event of bankruptcy and liquidation.

The Debt-to-equity ratio measures the mix of interest-bearing debt and equity in a firm’s capital
structure.

Debt – to – Equity = Total debt / Total equity = ($110 + $754) / $936 = 0.92 (industry average 0.43)

The higher a firm’ debt management ratio (in comparison to the industry average), the higher the firm’s
financial risk. Can you think about a type of industry which can NOT use much debt financing
due to the nature of its operations (business risk)?
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1.4 Debt Management Ratios - continued
Times-interest-earned (TIE) ratio measures the proportion of EBIT available to cover the interest
payments a company must make.
Times – Interest – Earned = EBIT / Interest expenses = $283.8 / $88 = 3.2 x (Industry average 6 x)
Since interest payments are normally made from EBIT (operating income), the greater the TIE ratio, the
easier it should be for the firm to meet its upcoming interest payments. From the lenders’ perspective,
normally, a high TIE suggests a low default risk.

What is the main weakness of this ratio?

EBITDA Coverage ratio measures the proportion of EBITDA available to cover the interest payments a
company must make. Why use EBITDA instead of EBIT?

EBITDA Coverage ratio

= (EBITDA + Lease payments) / (Interest + Principal repayments + Lease payments)

= (383.8 + 28) / (88 + 20 + 28) = 3 times (Industry average 4.3 times)

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1.5 Profitability ratios

Net Profit margin (also called return on sales) measures the proportion of net income relative to sales.
Net Profit margin = Net Income Available To Common Shareholders / Sales
= $113.5 / $3,000 = 3.8% (Industry average 5%)
A low profit margin compared to the industry may suggest that costs are too high, usually resulting from
inefficient operations and/or heavy use of debt. Or, it could suggest that selling prices are too low.

Return on assets (ROA) evaluates net income relative to the company’s total assets.
ROA = Net Income available to Common shareholders / Total Assets = $113.5 / $2,000 = 5.7%
(industry average 9%)
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1.5 Profitability ratios

Return on equity (ROE) evaluates how much net income is generated relative to the amount of equity that
investors’ have in the company.
ROE = Net Income available to Common shareholders / Common Equity = $113.5 / $896 = 12.7%
(Industry average 15%)

RETURN on INVESTED CAPITAL (ROIC) = NOPAT/TNOC = 170.28 / 1,800 = 9.46%

NOPAT (2022) = EBIT (1-T) = 283.8 (1- 0.40) = 170.28

Total Net Operating Capital (TNOC 2022) = NOWC + Operating LT assets

= 10 + 375 + 615 – 60 – 140 + 1,000 = 1,800
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1.6 Market Value Ratios
The price/earnings (P/E) ratio shows how much investors are willing to pay per dollar of reported (or
expected) net income.
Price Earnings Ratio = Price per share / Earnings per share
= $23 / $2.27 = 10.1 x (industry average 12.5 times)

P/E ratios are normally high for companies with high growth prospects, but lower for firms with low
growth prospects.

Canadian Tires (12.5x ) Industry average – broadline retail: 25.2x

Teck Resources (7.3x) - Industry average – Diversified metals and Mining: 9.5x Source: Capital iQ, July 2023
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1.6 Market Value Ratios

The market/book (M/B) ratio reflects investors’ perception of the firm’s ability to create or destroy value.

Book Value per share = Total Common equity / number of shares outstanding = $896 / 50 = $17.92

Market to Book Value = Market price per share / Book value per share = $23 / $17.92 = 1.3 x (Industry
av. 1.7 x)

Stocks of companies with high ROE and good growth prospects usually sell at higher multiples of
book value than lower return/growth companies.
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1.7 Trend Analysis
 Trends provide insights as to whether a company’s financials will likely improve or worsen.
 An example is plotting the ROE for MicroDrive and the industry average over a 5-year period to
identify any trends.
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1.8 Combining financial ratios – DuPont analysis
How can we use financial ratios to better understand where a firm’s financial performance is coming from?
ROA = Net Income / Total assets
ROA = (Net Income / Sales) x (Sales/Total assets) = Profit margin x Total Assets Turnover
For MicroDrive: ROA = 3.8% x 1.5 = 5.7%
ROE = Net Income / Common equity
= (Net Income / Sales) x (Sales/Total assets) X (Total assets / Common equity)
= Profit margin x Total Assets Turnover x Equity multiplier = ROA x Equity Multiplier

Where the equity multiplier reflects the firm’s capital structure (extent to which the firm relies on debt
financing vs. equity financing, referred to as financial leverage).
All other things being equal, the greater the equity multiplier (more financial leverage), the greater the
ROE.
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2. Uses and Limitations of Ratio Analysis
 Ratios are used by three main groups:
o Managers to help analyze, control and improve company operations.
o Credit analysts, working for banks and suppliers to assess a company’s ability to pay its debts.
o Stock analysts, who assess a company’s efficiency, risk and growth prospects.

 The following can limit ratio analysis’ usefulness:

o Inflation can distort balance sheet values
o Different accounting policies can make comparisons difficult
o May be difficult to interpret whether a ratio is “good” or “bad” (e.g., a high current ratio means strong
liquidity which is good but may also mean that the firm has too much money tied up in assets that
don’t earn a return). A ratio may look good for a bad reason and vice versa.
o Companies can “window dress” their financial statements. For instance, a company can borrow
(long term debt) just before year-end to improve its liquidity ratios and then repay early in the next
year.
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3. Common Size Analysis
Used to identify trends in financial statements by comparing a firm to itself across time, of comparing a
firm to its industry.
Common size income statement – calculated by dividing all income statement items by sales.
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Common size balance sheet – calculated by dividing all balance sheet items by total assets.