Analysis of Financial Statements

Ratio Analysis
 Liquidity ratios: give us an idea of the firm’s
ability to pay off debts that are maturing within a
year.
 Asset management ratios: give us an idea of how
efficiently the firm is using its assets.
 Debt management ratios: give us an idea of how
the firm has financed its assets as well as the
firm’s ability to repay its long-term debt.

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Ratio Analysis, contd.
 Profitability ratios: give us an idea of how
profitably the firm is operating and utilizing its
assets.
 Market value ratios: bring in the stock price and
give us an idea of what investors think about the
firm and its future prospects.

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Liquidity Ratios

Current Assets: cash, marketable securities,

accounts receivable, inventories.

Current Liabilities: accounts payable, accrued

wages and taxes, short-term notes payable

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Liquidity Ratios, Current Ratio
 For Allied Food Products on December 2008

Industry average= 4.2

Allied liquidity position is somewhat weak  check
further.
A high current ratio may indicate too many old
accounts receivable, too much cash, receivables,
inventories …

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Liquidity Ratios, Quick or Acid Test

Measures the firm’s ability to pay off short-term

obligations without relying on the sale of
inventories.
For Allied, relatively low compared to the industry
average quick ratio of 2.2.

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Asset Management Ratios
 These ratios answer this question:
Does the amount of each type of asset seem
reasonable, too high, or too low in view of current
and projected sales?

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Asset Management Ratios,
Inventory Turnover Ratio

Shows how many times the particular asset is

“turned over” during the year.
For Allied, =4.9, compared to industry average of
10.9 shows that Allied is holding too much
inventory.
Sometimes average inventory measure is more
useful.

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Asset Management Ratios,
Days Sales Outstanding

DSO or average collection period (ACP) represents

the average length of time the firm must wait after
making a sale before receiving cash.
For Allied,
Allied credit policy calls for payment within 30
days!

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Asset Management Ratios,
Fixed Assets Turnover Ratio

Measures how effectively the firm uses its plant

and equipment.
For Allied, , which is slightly above the 2.8 industry
average, showing that it is using its fixed assets at
least as intensively as other firms in the industry.

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Asset Management Ratios,
Fixed Assets Turnover Ratio, Problem:

If we compare an old firm whose fixed assets have

been depreciated with a new company with similar
operations that acquired its fixed assets only
recently, the old firm will probably have the higher
fixed assets turnover ratio. However, this would be
more reflective of the age of the assets than of
inefficiency on the part of the new firm.

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Asset Management Ratios,
Total Assets Turnover Ratio

Measures the turnover of all of the firm’s assets.

For Allied, , compared to industry average of 1.8
indicates that it is not generating enough sales
given its total assets. Inventories should be
reduced and receivables collected faster.

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Debt Management Ratios
 The use of debt will increase, or leverage up, a
firm’s ROE if the firm earns more on its assets
than the interest rate it pays on debt.
 Debt exposes the firm to more risk than if it
financed only with equity.

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Debt Ratios, Total Debt to Total Capital

Measures the percentage of funds provided by debt

holders. Total Debt does not include operating
items like accruals and accounts payables.
For Allied, , compared to industry average of
36.8% it raises a red flag!

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Debt Ratios, Times-Interest-Earned Ratio

Measures the extent to which operating income

can decline before the firm is unable to meet its
annual interest costs.
For Allied, , compared to industry average of 6
shows that it is covering its interest charges by a
relatively low margin of safety.

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Profitability Ratios

A group of ratios that show the combined effects of

liquidity, asset management, and debt on
operating results.

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Profitability Ratios, Operating Margin

Gives the operating profit per dollar of sales.

For Allied, , which is below the industry average of
10%, consistent with the low inventory turnover
and high DSO ratios.

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Profitability Ratios, Profit Margin

Gives net income per dollar of sales.

For Allied, , quite below the industry average of
5%.
1. High operating costs, 2. Heavy use of debt

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Profitability Ratios, Return on Total Assets

For Allied, , below the 9% industry average.

Look at a number of ratios, see what each suggest,
and then look at the overall situation when you
judge the performance of a company.

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Profitability Ratios, Return on Common Equity

The most important accounting ratio, measures the

rate of return on common stockholders’
investment.
For Allied,

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Profitability Ratios, Return on Invested Capital

Measures the total return that the company has

provided for its investors.
For Allied, < 10.8% (industry average)

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Profitability Ratios, Basic Earning Power Ratio

Shows the raw earning power of the firm’s assets

before the influence of taxes and debt. Useful
when comparing firms with different debt and tax
situations.
For Allied, . Low turnover ratios and poor profit
margin.

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Market Value Ratios

Ratios that relate the firm’s stock price to its

earnings and book value per share.
Used:
1. By investors deciding to buy or sell a stock

2. By investment bankers when they are setting

the share price for a new stock issue
3. By firms when they are deciding how much to
offer for another firm in a potential merger.

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Market Value Ratios, Price Earning Ratio

Shows how much investors are willing to pay per

dollar of reported profits.
For Allied, =9.8 (Industry average), the company
is regarded as being relatively risky, as having
poor growth prospects, or both.

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Market Value Ratios, Market/Book Ratio

Another indication of how investors regard the

company. Typically exceed 1.

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Market Value Ratios, Market/Book Ratio:
Example

For Allied,

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Market Value Ratios, Enterprise Value/EBITDA
Ratio
 the EV/EBITDA ratio looks at the relative market
value of all the company’s key financial claims.
One benefit of this approach is that unlike the
P/E ratio, the EV/EBITDA ratio is not heavily
influenced by the company’s debt and tax
situations.

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Market Value Ratios, Enterprise Value/EBITDA
Ratio, Example

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The DuPont Equation
 A formula that shows that the rate of return on
equity can be found as the product of profit
margin, total assets turnover, and the equity
multiplier.
 It shows the relationships among asset
management, debt management, and
profitability ratios.

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The DuPont equation helps us see why Allied’s ROE is only 12.5%
versus 15% for the industry

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Potential Misuses of ROE

1. ROE does not consider risk.

2. ROE does not consider the amount of invested
capital.
3. A focus on ROE can cause managers to turn
down profitable projects.
Contribution of a project to stock price= f(ROE,
Risk, Size)

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Benchmarking
 The process of comparing a particular company
with asset of benchmark companies.

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Trend Analysis

An analysis of a firm’s financial ratios over time;

used to estimate the likelihood of improvement or
deterioration in its financial condition.

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Uses of Ratios

Ratio Analysis is used by:

1. Managers: use ratios to help analyze, control,
improve their firms’ operations.
2. Credit Analysts: to help judge a company’s
ability to repay its debts.
3. Stock Analysts: interested in a company’s
efficiency, risk and growth prospects.

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Limitations of Ratios
1. For multidivisional companies it is difficult to
develop a meaningful set of industry averages.
2. Because of inflation which distorts the balance
sheets, ratio analysis for one firm over time or a
comparative analysis of firms of different ages
must be interpreted with care.
3. Seasonal factors can also distort a ratio
analysis.

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Limitations of Ratios, contd.

4. Firms can employ “window dressing” techniques

to improve their financial statements.
5. Different accounting practices can distort
comparisons.
6. It is difficult to generalize about whether a
particular ratio is “good” or “bad”.
7. Firms often have some ratios that look good and
others that look bad, making it difficult to judge.

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Looking Beyond the Numbers

1. Are the company’s revenues tied to one key

customer?
2. To what extent are the company’s revenues tied
to one key product?
3. To what extent does the company rely on a
single supplier?
4. What percentage of the company’s business is
generated overseas?

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Looking Beyond the Numbers

5. How much competition does the firm face?

6. Is it necessary for the company to continually
invest in research and development?
7. Are changes in laws and regulations likely to
have important implications for the firm?

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