Chapter (2)

Chapter (2)Chapter (2)

Financial Statement and Financial Statement and AnalysisAnalysis

The Stockholders’ Report &The Stockholders’ Report &Understanding The Four Key Understanding The Four Key

Financial StatementsFinancial Statements•• The guidelines used to prepare and maintain financialThe guidelines used to prepare and maintain financial

records and reports are known as records and reports are known as generally acceptedgenerally acceptedaccounting principles (GAAP)accounting principles (GAAP)..

• • GAAP is authorized by the GAAP is authorized by the Financial AccountingFinancial AccountingStandards Board (FASB)Standards Board (FASB). It is an accounting . It is an accounting profession’s rule-setting body.profession’s rule-setting body.

•• The The Sarbanes-Oxley Act of 2002Sarbanes-Oxley Act of 2002, passed to eliminate, passed to eliminatethe many disclosure and conflict of interest problems ofthe many disclosure and conflict of interest problems ofcorporations, established the Public Companycorporations, established the Public CompanyAccounting Oversight Board (PCAOB), which is aAccounting Oversight Board (PCAOB), which is anot-for-profit corporation that overseas auditors.not-for-profit corporation that overseas auditors.

The Stockholders’ ReportThe Stockholders’ Report

• • The PCAOB is charged with protecting the interests of The PCAOB is charged with protecting the interests of investors and furthering the public interest in the investors and furthering the public interest in the preparation of informative, fair, preparation of informative, fair, and independent audit and independent audit reports.reports.

• • Public corporations with more than $5 million in assets Public corporations with more than $5 million in assets and more than 500 stockholders are required by the and more than 500 stockholders are required by the SEC (Securities & Exchange CommissionSEC (Securities & Exchange Commission – federal – federal regulatory body governs sale & listing of securities) to regulatory body governs sale & listing of securities) to provide their stockholders with an provide their stockholders with an annual stockholders’ annual stockholders’ report (report (which summarizes & documents the firm’s which summarizes & documents the firm’s financial activities during the past yearfinancial activities during the past year))..

The Letter to StockholdersThe Letter to Stockholders

is the primary communication from is the primary communication from management, it discusses management, it discusses management philosophy, strategies, management philosophy, strategies, and actions and plans for the coming and actions and plans for the coming year.year.

The Four Key Financial The Four Key Financial StatementsStatements::

• • The Income StatementThe Income Statement

• • The Balance SheetThe Balance Sheet

• • Statement of Retained EarningsStatement of Retained Earnings

• • Statement of Cash FlowsStatement of Cash Flows

The Income StatementThe Income Statement

** The income statement provides a financialThe income statement provides a financialsummary of a company’s operating resultssummary of a company’s operating resultsduring a specified period (fiscal year).during a specified period (fiscal year).

• • Although they are prepared annually forAlthough they are prepared annually forreporting purposes, they are generallyreporting purposes, they are generallycomputed monthly by management andcomputed monthly by management andquarterly for tax purposesquarterly for tax purposes

** Look at table 2.1 (page 48)Look at table 2.1 (page 48)

The Income Statement (cont.)The Income Statement (cont.)

Operating Profit is often called Earnings Before Operating Profit is often called Earnings Before Interest and Taxes (EBIT)Interest and Taxes (EBIT)

Net Profits = EarningsNet Profits = Earnings

Interest expense = Financial costInterest expense = Financial cost

Depreciation expense can be, and frequently is, Depreciation expense can be, and frequently is, included in manufacturing costs (cost of goods included in manufacturing costs (cost of goods sold) to calculate gross profits. Depreciation is sold) to calculate gross profits. Depreciation is shown as an expense in this text to isolate its shown as an expense in this text to isolate its effect on cash flows.effect on cash flows.

The Income Statement (cont.)The Income Statement (cont.)

EPS (Earnings Per Share)EPS (Earnings Per Share) represents the No. represents the No. of dollars earned during the period on behalf of of dollars earned during the period on behalf of each outstanding share of common stock each outstanding share of common stock (earnings available for com. stocks / No. of (earnings available for com. stocks / No. of shares of com. Stocks)shares of com. Stocks)

DPS (Dividend Per Share)DPS (Dividend Per Share) represents the dollar represents the dollar amount of cash distributed during the period on amount of cash distributed during the period on behalf of each outstanding share of com. stock behalf of each outstanding share of com. stock (actual cash distributed / No. of shares of com. (actual cash distributed / No. of shares of com. Stocks)Stocks)

The Balance SheetThe Balance Sheet

The balance sheet presents a summary ofThe balance sheet presents a summary of

a firm’s financial position at a given pointa firm’s financial position at a given point

in time.in time.

•• Assets indicate what the firm owns, Assets indicate what the firm owns, against financing (what it owes) or equity against financing (what it owes) or equity which represents the owners’ investment, which represents the owners’ investment, and liabilities indicate what the firm has and liabilities indicate what the firm has borrowed (debt).borrowed (debt).

The Balance Sheet (cont.)The Balance Sheet (cont.)

Current assets and current liabilities are short-Current assets and current liabilities are short-term and expected to be converted into cash term and expected to be converted into cash received (assets) or paid (liabilities)received (assets) or paid (liabilities)

All other assets and liabilities, along with All other assets and liabilities, along with stockholders’ equity, have an infinite life and stockholders’ equity, have an infinite life and considered long-term (fixed)considered long-term (fixed)

Marketable Securities are highly liquid short-Marketable Securities are highly liquid short-term investments and viewed as a form of cash term investments and viewed as a form of cash (near cash)(near cash)


Accounts receivable represent the total monies Accounts receivable represent the total monies owed by the firm by its customers on credit sales owed by the firm by its customers on credit sales made to them.made to them.Inventories include raw materials and partially Inventories include raw materials and partially finished/finished goods.finished/finished goods.Gross fixed assets is the original cost of all long-Gross fixed assets is the original cost of all long-term assets owned by the firmterm assets owned by the firmNet fixed assets is the difference between the Net fixed assets is the difference between the gross fixed assets and accumulated depreciationgross fixed assets and accumulated depreciationThe net value of fixed assets called book valueThe net value of fixed assets called book value


Accounts payables is amounts owed for Accounts payables is amounts owed for credit purchases by the firmcredit purchases by the firmNotes Payable is outstanding short-term Notes Payable is outstanding short-term loans (from commercial banks)loans (from commercial banks)Accruals is amounts owed for services for Accruals is amounts owed for services for which a bill may not be received (taxes which a bill may not be received (taxes due the gov. & wages due employees)due the gov. & wages due employees)Long-term debt represents debt for which Long-term debt represents debt for which payment is not due in current year.payment is not due in current year.


Preferred stock entry shows the historical proceeds from Preferred stock entry shows the historical proceeds from the sale of preferred stockthe sale of preferred stockThe common stock entry is the par value of common The common stock entry is the par value of common stockstockPaid-in-capital in excess of parPaid-in-capital in excess of par is the amount of is the amount of proceeds in excess of the par value received from the proceeds in excess of the par value received from the original sale of common stock.original sale of common stock.The sum of the common stock & paid-in capital accounts The sum of the common stock & paid-in capital accounts divided by No. of shares outstanding represents divided by No. of shares outstanding represents the the original price per shareoriginal price per share Retained earnings (not cash) represent the cumulative Retained earnings (not cash) represent the cumulative total of all earnings, net of dividends, that have been total of all earnings, net of dividends, that have been retained & re-invested in the firm since its inceptionretained & re-invested in the firm since its inception

Statement of Retained EarningsStatement of Retained Earnings

•• The statement of retained earningsThe statement of retained earnings

reconciles the net income earned andreconciles the net income earned and

any cash dividends paid during the year, any cash dividends paid during the year, with the change in retained earnings with the change in retained earnings during the yearduring the year

Before going onBefore going on

we should know what is Statement of we should know what is Statement of Stockholders’ EquityStockholders’ Equity

It shows all equity account transactions It shows all equity account transactions that occurred during a given yearthat occurred during a given year

Statement of Retained EarningsStatement of Retained Earningsfor the Year Ended 31 December 2007for the Year Ended 31 December 2007

- Retained earnings balance (Jan 1, 2007)Retained earnings balance (Jan 1, 2007) $1,012$1,012- Plus: net profit after taxes (for 2007)Plus: net profit after taxes (for 2007) $ 231$ 231- Less: Cash dividends (paid during 2007)Less: Cash dividends (paid during 2007)

- Preferred stock- Preferred stock ($10)($10)- Common stock- Common stock (($98)$98)

Total dividends paidTotal dividends paid (($ 108)$ 108)- Retained earnings balance (Dec, 31 2007)- Retained earnings balance (Dec, 31 2007) $1,135$1,135

==========

Statement of Cash FlowsStatement of Cash Flows

•• The The statement of cash flows statement of cash flows provides aprovides asummary of the cash flows over the periodsummary of the cash flows over the periodof concern, typically the year just ended.of concern, typically the year just ended.

•• This statement not only provides insightThis statement not only provides insightinto a company’s investment, financinginto a company’s investment, financingand operating activities, but also tiesand operating activities, but also tiestogether the income statement andtogether the income statement andprevious and current balance sheetsprevious and current balance sheets

Notes to the Financial Notes to the Financial Statements – FYI onlyStatements – FYI only

it provides detailed information on the it provides detailed information on the accounting policies, procedures, accounting policies, procedures, calculations, and transactions underlying calculations, and transactions underlying entries in the financial statementsentries in the financial statements

In Practice box (page 53) discusses some In Practice box (page 53) discusses some common corporate accounting misdeeds common corporate accounting misdeeds and their potential impact on investorsand their potential impact on investors

International Financial International Financial StatementsStatements

Current Rate (translation) Method is a Current Rate (translation) Method is a technique under which all assets and technique under which all assets and liabilities are converted into dollar values liabilities are converted into dollar values using the exchange rate prevailing at the using the exchange rate prevailing at the fiscal year ending date (the current rate)fiscal year ending date (the current rate)

Income statement items are treated Income statement items are treated similarly.similarly.

Using Financial RatiosUsing Financial RatiosInterested PartiesInterested Parties

Interested Parties need to have Interested Parties need to have relative relative measuresmeasures of the company’s operating of the company’s operating efficiency.efficiency.RelativeRelative is the key word as the analysis of is the key word as the analysis of financial statement is based on the use of financial statement is based on the use of Ratios or Relative ValuesRatios or Relative ValuesThe basic inputs to ratio analysis are the The basic inputs to ratio analysis are the firm’s income statement and the balance firm’s income statement and the balance sheet.sheet.

Using Financial RatiosUsing Financial RatiosInterested Parties (cont.)Interested Parties (cont.)

Ratio analysis involves methods ofRatio analysis involves methods of

calculating and interpreting financial ratioscalculating and interpreting financial ratios

to assess a firm’s financial conditionto assess a firm’s financial condition

and performance.and performance.

• • It is of interest to shareholders, creditors,It is of interest to shareholders, creditors,

and the firm’s own management.and the firm’s own management.

Using Financial RatiosUsing Financial RatiosInterested Parties (cont.)Interested Parties (cont.)

ShareholdersShareholders are interested in the firm’s current are interested in the firm’s current and future level of risk and return as this affects and future level of risk and return as this affects the share pricethe share price

CreditorsCreditors are interested in liquidity of the firm are interested in liquidity of the firm and its ability to make interest & principal and its ability to make interest & principal payments in addition to its profitability (i.e. payments in addition to its profitability (i.e. healthy)healthy)

ManagementManagement is concerned with all aspects and is concerned with all aspects and attempts to produce financial ratios favourable attempts to produce financial ratios favourable by both owners and creditors.by both owners and creditors.

Using Financial Ratios:Using Financial Ratios:Types of Ratio ComparisonsTypes of Ratio Comparisons

• • Cross-sectional analysisCross-sectional analysis

– – Used to compare different firms at the Used to compare different firms at the same point in timesame point in time

• • Trend or time-series analysisTrend or time-series analysis

– – Used to evaluate a firm’s performanceUsed to evaluate a firm’s performance

over timeover time

Using Financial RatiosUsing Financial RatiosCross-Sectional AnalysisCross-Sectional Analysis

Analysts are interested in how well a firm has Analysts are interested in how well a firm has performed in relation to other firms in its industry performed in relation to other firms in its industry ‘Benchmarking’ – this is one type!‘Benchmarking’ – this is one type!

Another type: Comparison to Industry AveragesAnother type: Comparison to Industry Averages

Many mistakenly believe that as long as the firm Many mistakenly believe that as long as the firm being analyzed has a value “better than” the being analyzed has a value “better than” the industry average, it can be viewed favourably.industry average, it can be viewed favourably.

However, this ‘better than average’ viewpoint However, this ‘better than average’ viewpoint can be misleading!can be misleading!

Using Financial RatiosUsing Financial Ratios Cross-Sectional Analysis Cross-Sectional Analysis

Example: Inventory Turnover Ratio (P.55)Example: Inventory Turnover Ratio (P.55)Higher values are preferred as it reflects the Higher values are preferred as it reflects the speed with which the firm moves its inventory speed with which the firm moves its inventory from raw materials thru’ produc. into finished from raw materials thru’ produc. into finished goods to the consumergoods to the consumerThe Caldwell Manufacturing turnover was 14.8 The Caldwell Manufacturing turnover was 14.8 better than the industry average (9.7)better than the industry average (9.7)High turnover means low levels of inventories in High turnover means low levels of inventories in warehouse which hindered the firm’s ability to warehouse which hindered the firm’s ability to meet demand & resulted in lost salesmeet demand & resulted in lost sales

Using Financial RatiosUsing Financial Ratios Time-Series Analysis Time-Series Analysis

It evaluates performance over timeIt evaluates performance over time

Developing trends can be seen by using Developing trends can be seen by using multi-year comparisons.multi-year comparisons.

Any changes may be symptomatic of Any changes may be symptomatic of major problemsmajor problems

Using Financial RatiosUsing Financial RatiosCombined AnalysisCombined Analysis

The most informative approach to ratio The most informative approach to ratio analysis combines cross-sectional and analysis combines cross-sectional and time-series analyses.time-series analyses.

It assess the trend in the behavior of the It assess the trend in the behavior of the ratio in relation to the trend for the industry ratio in relation to the trend for the industry

Figure 2.1 (Page 57) depicts the average Figure 2.1 (Page 57) depicts the average collection period ratio of Bartlett Company, collection period ratio of Bartlett Company, over the years 2003-2006over the years 2003-2006



The figure discloses:The figure discloses:

(1)(1) Bartlett’s effectiveness in collecting its Bartlett’s effectiveness in collecting its receivables is poor in comparison to the receivables is poor in comparison to the industry, and industry, and

(2)(2) Bartlett’s trend is towards longer Bartlett’s trend is towards longer collection periodscollection periods

Recommendation:Recommendation: Bartlett needs to shorten Bartlett needs to shorten its collection periodits collection period

Using Financial RatiosCautions 4 Doing Ratio Analysis

Ratios that reveal large deviation from the NORM merely indicate symptoms of a problem. Add. analysis is needed to isolate the causes of the problem. Ratio Analysis directs attention to potential areas of concern; it does not provide conclusive evidence as to the existence of a problem.Ratios must be considered together; a single ratio by itself means relatively little & cannot judge the overall performanceFinancial statements that are being compared should be dated at the same point in time (e.g. seasonal impact)Use audited financial statements when possible.The financial data being compared should have been developed in the same way (e.g. depreciation & inventory).Be wary of inflation distortions (older assets appear more efficient and profitable than new assets)

Categories of Financial RatiosCategories of Financial Ratios

5 basic categories5 basic categories

(1)(1) Liquidity Ratios}Liquidity Ratios}

(2)(2) Activity Ratios}Activity Ratios}

(3)(3) Debt Ratios} (the 3 ratios measure risk)Debt Ratios} (the 3 ratios measure risk)

(4)(4) Profitability Ratios (measure return)Profitability Ratios (measure return)

(5)(5) Market Ratios (capture risk and return)Market Ratios (capture risk and return)

Ratio AnalysisRatio Analysis

First: Liquidity Ratios: The liquidity of a firm is measured by its ability

to satisfy its short-term obligations as they come due. It refers to the solvency of the firm

These ratios provide signs of cash flow problems & impending business failure.

Two Basic measures of liquidity are:

(1) Current Ratio

(2) Quick (acid-test) Ratio


Current RatioCurrent Ratio = = Current Assets Current Assets = = $1,223 $1,223 = 1.97= 1.97Current Liabilities $620Current Liabilities $620

Notes:Notes:- The higher the current ratio, the more liquid the firm The higher the current ratio, the more liquid the firm

is consideredis considered- A current ratio of 2.0 is occasionally cited as A current ratio of 2.0 is occasionally cited as

acceptableacceptable- But! A value’s acceptability depends on the industry But! A value’s acceptability depends on the industry

in which the firm operates in which the firm operates - Current ratio of 1.0 is acceptable for a public utilityCurrent ratio of 1.0 is acceptable for a public utility- Thus the rule is: The more predictable a firm’s cash Thus the rule is: The more predictable a firm’s cash

flows, the lower the acceptable current ratio.flows, the lower the acceptable current ratio.


Quick RatioQuick Ratio = = Current Assets – InventoryCurrent Assets – Inventory = = $1,223 - $289$1,223 - $289 = 1.51 = 1.51 Current LiabilitiesCurrent Liabilities $620 $620

Notes:Notes:- It is similar to current ratio but it excludes the inventory, It is similar to current ratio but it excludes the inventory,

the least liquid current assetsthe least liquid current assets- Low liquidity of inventory results from (a) cannot be Low liquidity of inventory results from (a) cannot be

easily sold - partially completed (b) inventory sold on easily sold - partially completed (b) inventory sold on credit becomes account receivables before converted credit becomes account receivables before converted into cashinto cash

- A quick ratio of 1.0 or greater is occasionally A quick ratio of 1.0 or greater is occasionally recommended but depends on the industry.recommended but depends on the industry.

- If inventory is easily to get liquid, the current ratio is If inventory is easily to get liquid, the current ratio is preferred measure of overall liquidity.preferred measure of overall liquidity.


Quick Ratio, sometimes, is defined as:Quick Ratio, sometimes, is defined as:

= = cash + market. securities + a/c receivablescash + market. securities + a/c receivables

current liabilitiescurrent liabilities

Financial Ratio AnalysisFinancial Ratio AnalysisIndustry Average Ratios (2003) for selected lines of Industry Average Ratios (2003) for selected lines of business by SIC (Standard Industrial Classification)business by SIC (Standard Industrial Classification)


Second: Activity Ratios:Second: Activity Ratios: measure the speed with which various accounts measure the speed with which various accounts

are converted into sales or cash – inflows or are converted into sales or cash – inflows or outflowsoutflows

Liquidity measures are inadequate because Liquidity measures are inadequate because differences in the composition of a firm’s current differences in the composition of a firm’s current assets/liabilities & would affect its ‘true’ liquidityassets/liabilities & would affect its ‘true’ liquidity

So we need to assess the activity (liquidity) of So we need to assess the activity (liquidity) of specific current accountsspecific current accounts


Four Basic measures of Activity:Four Basic measures of Activity:

(1) Inventory Turnover(1) Inventory Turnover

(2) Average Collection Period (a/c (2) Average Collection Period (a/c receivables)receivables)

(3)(3) Average Payment Period (a/c Average Payment Period (a/c payables)payables)

(4) Total Asset Turnover(4) Total Asset Turnover


Inventory Turnover:Inventory Turnover:measures the activity (or liquidity) of a firm’s measures the activity (or liquidity) of a firm’s inventory.inventory.

Inventory turnover = Inventory turnover = Cost of goods soldCost of goods sold InventoryInventory

Inventory turnover = Inventory turnover = $2,088,000$2,088,000 = 7.2 = 7.2 $289,000$289,000


An inventory turnover of 20.0 is acceptable for grocery An inventory turnover of 20.0 is acceptable for grocery store, whereas a common inventory turnover for an store, whereas a common inventory turnover for an aircraft manufacturer is 4.0aircraft manufacturer is 4.0Inventory turnover can be converted into an Inventory turnover can be converted into an average average age of inventoryage of inventory

Average Age of Inventory = Average Age of Inventory = 365365 Inventory TurnoverInventory Turnover

Inv Turnover = Inv Turnover = 365 365 = 50.7 (average No. of days’ sales) = 50.7 (average No. of days’ sales) 7.27.2


Average Collection Period (Average Collection Period (or the or the average age of accounts receivable):average age of accounts receivable):

Sometimes called ‘Days’ Sales Sometimes called ‘Days’ Sales Outstanding – DSO’Outstanding – DSO’

IIt measures and evaluates the credit and t measures and evaluates the credit and collection policies.collection policies.


Average Collection Period:Average Collection Period:

= = Accounts Receivables Accounts Receivables = = A/C receivables A/C receivables Average Sales per day* Average Sales per day* Annual SalesAnnual Sales

365365= = $503,000 $503,000 = = $503,000$503,000 = 59.7 days = 59.7 days $3,074,000$3,074,000 $8,422 $8,422 365365* The formula as presented assumes, for simplicity, * The formula as presented assumes, for simplicity, that all that all

sales are made on a credit basissales are made on a credit basis. If this is not the case, . If this is not the case, average credit sales per day should be substituted for average credit sales per day should be substituted for average sales per day.average sales per day.


On the average, it takes 59.7 days to On the average, it takes 59.7 days to collect an account receivablecollect an account receivableIt is meaningful only in relation to the firm’s It is meaningful only in relation to the firm’s credit termscredit termsIf the firm extends 30-day credit terms to If the firm extends 30-day credit terms to customers , ACP of 59.7 days indicates a customers , ACP of 59.7 days indicates a poorly managed credit/collection Dept.poorly managed credit/collection Dept.If it is 60-day credit terms, then 59.7-day If it is 60-day credit terms, then 59.7-day ACP is quite acceptable ACP is quite acceptable


Average Payment Period (or average age of Average Payment Period (or average age of accounts payable):accounts payable):

= = Accounts Payable Accounts Payable = = Accounts Payable Accounts Payable Average purchase per day Average purchase per day Annual purchase Annual purchase 365365

Notes: Notes: 1)1) Annual purchases are not available in published financial statementAnnual purchases are not available in published financial statement2)2) Therefore, purchases are estimated as a given percentage of cost Therefore, purchases are estimated as a given percentage of cost

of goods sold (assumed 70% of good sold)of goods sold (assumed 70% of good sold)3)3) Technically, annual credit purchases – rather than annual Technically, annual credit purchases – rather than annual

purchases (for simplicity) – should be used in calculating the ratio. purchases (for simplicity) – should be used in calculating the ratio. But this refinement is ignored.But this refinement is ignored.


Average Payment Period:Average Payment Period:= = $382,000 $382,000 = = $382,000 $382,000 = 95.4 days = 95.4 days 70% X $2,088,00070% X $2,088,000 $4,004 $4,004

365365• Again, the resulted figure should be read in line with the Again, the resulted figure should be read in line with the

average credit terms extended to the firm by other average credit terms extended to the firm by other firms/suppliers.firms/suppliers.

• By 30-day credit terms, the firm considered a low credit By 30-day credit terms, the firm considered a low credit ratingrating

• Prospective lenders & suppliers are interested in the Prospective lenders & suppliers are interested in the firm’s bill-paying patterns.firm’s bill-paying patterns.


Total Asset Turnover: Total Asset Turnover: indicates the efficiency with indicates the efficiency with which the firm uses its assets to generate saleswhich the firm uses its assets to generate salesManagement is interested in this measure Management is interested in this measure as it indicates as it indicates whether the firm’s operation have been financially whether the firm’s operation have been financially efficient.efficient.

= = Sales Sales = = $3,074,000$3,074,000 = 0.85 = 0.85 Total assets $3,597,000Total assets $3,597,000

• The company’s turnover is 0.85 times per yearThe company’s turnover is 0.85 times per year• The higher a firm’s total asset turnover, the more efficiently its The higher a firm’s total asset turnover, the more efficiently its

assets have been used.assets have been used.


Third: Debt Ratios:Third: Debt Ratios:The debt position points at the amount of other The debt position points at the amount of other peoples’ money being used to generate profitspeoples’ money being used to generate profits

The more debt a firm has, the greater its risk of The more debt a firm has, the greater its risk of being unable to meet its contractual debt being unable to meet its contractual debt payments and becoming bankrupt.payments and becoming bankrupt.

Creditors, current and prospective shareholders, Creditors, current and prospective shareholders, lenders, and management are also concerned lenders, and management are also concerned about the firm indebtedness.about the firm indebtedness.


The more debt a firm uses in relation to its The more debt a firm uses in relation to its total assets , the greater its total assets , the greater its financial financial leverageleverageFinancial LeverageFinancial Leverage is the magnification of is the magnification of risk and return introduced thru’ the use of risk and return introduced thru’ the use of fixed-cost financing (e.g. debt & preferred fixed-cost financing (e.g. debt & preferred stocks)stocks)& the more fixed-cost debt a firm uses, the & the more fixed-cost debt a firm uses, the greater will be its expected risk & returngreater will be its expected risk & return

Ratio Analysis – Debt RatiosRatio Analysis – Debt Ratios

The example in page 63, table 2.6 shows The example in page 63, table 2.6 shows that with increased debt comes greater that with increased debt comes greater risk as well as higher potential returnrisk as well as higher potential return

Therefore, the greater the financial Therefore, the greater the financial leverage, the greater the potential risk and leverage, the greater the potential risk and returnreturn

Ratio Analysis – Debt RatiosRatio Analysis – Debt Ratios

There R 2 general types of debt measures:There R 2 general types of debt measures:(1)(1) the Degree of Indebtedness:the Degree of Indebtedness: measures the measures the

amount of debt relative to other significant amount of debt relative to other significant balance sheet amountsbalance sheet amounts(popular measure is Debt Ratio which (popular measure is Debt Ratio which measures the proportion of total assets measures the proportion of total assets financed by the firm’s creditors )financed by the firm’s creditors )

(2) (2) the Ability to Service Debtsthe Ability to Service Debts: reflects a firm’s : reflects a firm’s ability to make the payments required on a ability to make the payments required on a scheduled basis over the life of a debt.scheduled basis over the life of a debt.(Popular measure is Coverage Ratios)(Popular measure is Coverage Ratios)

Ratio Analysis – Debt RatiosRatio Analysis – Debt RatiosNotes:Notes:

(1)(1) Coverage ratios measure the firm’s ability to pay Coverage ratios measure the firm’s ability to pay certain fixed charges.certain fixed charges.

(2)(2) The term (service) refers to the repayment of the The term (service) refers to the repayment of the principal amount plus the payment of the interest; principal amount plus the payment of the interest; therefore when a firm services its debts, it fulfils its therefore when a firm services its debts, it fulfils its obligation (amortization)obligation (amortization)

(3)(3) Higher coverage ratios are favourable, but too high Higher coverage ratios are favourable, but too high ratio (above the industry norms) may result in ratio (above the industry norms) may result in unnecessarily low risk and returnunnecessarily low risk and return

(4)(4) So, the lower the firm’s coverage ratios, the less it is So, the lower the firm’s coverage ratios, the less it is able to pay fixed obligations (creditors may seek able to pay fixed obligations (creditors may seek repayment and force the firm into bankruptcy)repayment and force the firm into bankruptcy)

Ratio Analysis – Debt RatiosRatio Analysis – Debt RatiosDegree of IndebtednessDegree of Indebtedness

Debt Ratio = Debt Ratio = Total LiabilitiesTotal Liabilities = = $1,643$1,643 Total Assets $3,597Total Assets $3,597• The debt ratio for Bartlett is 0.457 = 45.7%The debt ratio for Bartlett is 0.457 = 45.7%• The company has financed 50% of its The company has financed 50% of its

assets by debtassets by debt• Thus, the higher this ratio, the greater the Thus, the higher this ratio, the greater the

firm’s degree of indebtedness and the firm’s degree of indebtedness and the more financial leverage it has (& the more financial leverage it has (& the greater its expected return & risk)greater its expected return & risk)

Ratio Analysis – Ability to Ratio Analysis – Ability to Service DebtsService Debts (coverage ratios) (coverage ratios)

2 types of coverage ratios:2 types of coverage ratios:(1)(1) Times Interest Earned Ratio (Interest Times Interest Earned Ratio (Interest

Coverage Ratio):Coverage Ratio): measures the firm’s ability measures the firm’s ability to make contractual interest payments. The to make contractual interest payments. The higher its value, the better able to fulfil its higher its value, the better able to fulfil its obligationsobligations

= = EBIT (or operating profits) EBIT (or operating profits)= = $418,000$418,000 Interest Interest $93,000 $93,000• Times interest earned ratio = 4.5Times interest earned ratio = 4.5• This rate is acceptable (at least 3.0 and This rate is acceptable (at least 3.0 and

preferable closer to 5.0 is often recommended)preferable closer to 5.0 is often recommended)

(2) Fixed-Payment Coverage Ratio: (2) Fixed-Payment Coverage Ratio: measures the firm’s ability to meet all measures the firm’s ability to meet all fixed-payment obligations, such as loan fixed-payment obligations, such as loan interest and principal, lease payment & interest and principal, lease payment & preferred stock dividends. preferred stock dividends.

• The higher this value, the better!The higher this value, the better!• The lower the ratio, the greater the risk to The lower the ratio, the greater the risk to

both lenders and owners both lenders and owners • & the greater the ratio, the lower the risk& the greater the ratio, the lower the risk



Fixed-payment coverage ratioFixed-payment coverage ratio

= = EBIT + Lease Payment EBIT + Lease Payment = =

Interest + Lease Pays. + {(Principal Pays. + Interest + Lease Pays. + {(Principal Pays. + Preferred stock dividends) X [1/(1 – Preferred stock dividends) X [1/(1 – T)]}T)]}

= = 418,000 + 35,000 418,000 + 35,000 = =

93,000 + 35,000 + {(71,000 + 10,000) X [1/(1 – 0.29)]}93,000 + 35,000 + {(71,000 + 10,000) X [1/(1 – 0.29)]}

= = 453,000 453,000 = 1.9 (almost 2)= 1.9 (almost 2)

242,000242,000


Notes:Notes:(1)(1) T is the corporate tax applicable to the firm’s T is the corporate tax applicable to the firm’s

income.income.(2)(2) The term 1/1(1-T) is included to adjust the The term 1/1(1-T) is included to adjust the

after-tax principal & preferred stock dividend after-tax principal & preferred stock dividend payments back to a before-tax equivalentpayments back to a before-tax equivalent

(3)(3) The earnings available (almost 2) are nearly The earnings available (almost 2) are nearly twice as large as its fixed-payments twice as large as its fixed-payments obligations; thus the firm is safely able to meet obligations; thus the firm is safely able to meet the latter (obligations)the latter (obligations)


Forth: Profitability Ratio:Forth: Profitability Ratio:

Measures of profitability enable the analyst Measures of profitability enable the analyst to evaluate the firm’s profits with respect to a to evaluate the firm’s profits with respect to a given level of sales, assets, or the owners’ given level of sales, assets, or the owners’ investment.investment.

The The Common-Size Income StatementCommon-Size Income Statement is an is an interesting tool for evaluating profitability in interesting tool for evaluating profitability in relation to sales (Table 2.7 – Page 66)relation to sales (Table 2.7 – Page 66)

Ratio Analysis Ratio Analysis Common-Size Income StatementCommon-Size Income Statement

This statement is sometimes called a This statement is sometimes called a ‘‘Percent Income StatementPercent Income Statement’. The same ’. The same treatment is often applied to the firm’s treatment is often applied to the firm’s balance sheet to evaluate changes in the balance sheet to evaluate changes in the asset and financial structures of the firmasset and financial structures of the firm

These statements can be used as an These statements can be used as an alternative or supplement to liquidity, alternative or supplement to liquidity, activity, and debt-ratio analysisactivity, and debt-ratio analysis

Ratio Analysis – Profitability RatiosRatio Analysis – Profitability Ratios

The following 3 ratios of profitability can The following 3 ratios of profitability can be read directly from the common-size be read directly from the common-size income statement:income statement:

(1)(1) The gross profit marginThe gross profit margin

(2)(2) The operating profit marginThe operating profit margin

(3)(3) The net profit marginThe net profit margin


Gross Profit Margin:Gross Profit Margin: measures the measures the percentage of each sales dollar remaining percentage of each sales dollar remaining after the firm has paid for its goodsafter the firm has paid for its goods

The higher the GPM, the better!The higher the GPM, the better!

= = Sales – Cost of goods sold Sales – Cost of goods sold = = Gross ProfitsGross Profits

SalesSales Sales Sales

= = $3,074,000 – $2,088,000$3,074,000 – $2,088,000 = = 32.1%32.1%

$3,074,000$3,074,000 (worse than 2005)(worse than 2005)


Operating Profit Margin: Operating Profit Margin: measures the measures the percentage of each sales dollar remaining percentage of each sales dollar remaining after all costs and expenses – other than after all costs and expenses – other than interest, taxes, and preferred stock interest, taxes, and preferred stock dividends – are collected. dividends – are collected. Higher is better!Higher is better!It represents the ‘pure profits’ earned on It represents the ‘pure profits’ earned on each sales dollareach sales dollar

= = Operating ProfitsOperating Profits = = $418,000 $418,000 = = 13.6% 13.6% SalesSales $3,074,000 (better) $3,074,000 (better)


Net Profit Margin: Net Profit Margin: measures the measures the percentage of each sales dollar remaining percentage of each sales dollar remaining after all costs and expenses, incl. interest, after all costs and expenses, incl. interest, taxes, and preferred stock dividends, have taxes, and preferred stock dividends, have been deducted. been deducted. The higher is better!The higher is better!

= = Earnings avail. for common stockholdersEarnings avail. for common stockholders

SalesSales


= = $221,000 $221,000 = 7.2% (the higher the better) = 7.2% (the higher the better)

$3,074,000$3,074,000

• ‘‘Good’ net profit margins differ across industriesGood’ net profit margins differ across industries• A net profit margin of 1% or less would not be A net profit margin of 1% or less would not be

unusual for grocery store, whereas net profit unusual for grocery store, whereas net profit margin of 10% would be low for a retail jewelry margin of 10% would be low for a retail jewelry store.store.


Earnings Per Share (EPS): Earnings Per Share (EPS): represents represents the dollar amount earned on behalf of the dollar amount earned on behalf of each outstanding share of common stockeach outstanding share of common stock= = Earnings avail. for com. stockholdersEarnings avail. for com. stockholders

No. of shares of com. stock outstandingNo. of shares of com. stock outstanding = = $221,000$221,000 = $2.90 = $2.90 76,26276,262* * EPS is watched by investing public & indicator EPS is watched by investing public & indicator

for corporate successfor corporate success


Return of Total Assets (ROA):Return of Total Assets (ROA): measures overall measures overall effectiveness of management in generating profits effectiveness of management in generating profits with its available assets. (called Return on with its available assets. (called Return on Investment – ROI). The higher the better!Investment – ROI). The higher the better!

= = Earnings avail. for com. stockholdersEarnings avail. for com. stockholders Total assetsTotal assets

= $221,000/$3,597,000 = 6.1%= $221,000/$3,597,000 = 6.1%

* Indicates the firm earned 6.1 cents on each dollar of asset * Indicates the firm earned 6.1 cents on each dollar of asset investment investment


Return on Common Equity (ROE): Return on Common Equity (ROE): measures return measures return earned on the common stockholders’ investment in the earned on the common stockholders’ investment in the firmfirm. T. The higher this return, the better off are the he higher this return, the better off are the owners!owners!

= = Earnings avail. for com. StockholdersEarnings avail. for com. Stockholders Common stock equityCommon stock equity

ROE = $221,000/$1,754,000 = 12.6%ROE = $221,000/$1,754,000 = 12.6%

* Indicates the firm earned 12.6 cents on each dollar of * Indicates the firm earned 12.6 cents on each dollar of common stock equity common stock equity


Fifth: Market Ratios: Fifth: Market Ratios: Give insight into Give insight into how well investors in the marketplace how well investors in the marketplace feel the firm is doing of risk & return.feel the firm is doing of risk & return.

Two popular Ratios:Two popular Ratios:

(1)(1) Price/Earnings (P/E) RatioPrice/Earnings (P/E) Ratio

(2)(2) Market/Book (M/B) RatioMarket/Book (M/B) Ratio

Ratio Analysis – Market RatiosRatio Analysis – Market Ratios

Price/Earnings (P/E) Ratio: Price/Earnings (P/E) Ratio: measures measures the amount that investor are willing to pay the amount that investor are willing to pay for each dollar of a firm’s earnings.for each dollar of a firm’s earnings.

The higher P/E ratio, the greater the The higher P/E ratio, the greater the investor confidence in the firm’s future investor confidence in the firm’s future performanceperformance

P/E = P/E = Market price per share of com. stockMarket price per share of com. stock

Earnings per shareEarnings per share


So, if Bartlett company’s common stock at So, if Bartlett company’s common stock at the end of year 2007 was selling at the end of year 2007 was selling at $32.25, using the EPS of $2.9, the P/E $32.25, using the EPS of $2.9, the P/E ratio at year-end = $32.25/$2.90 = 11.1ratio at year-end = $32.25/$2.90 = 11.1This tells us that investors were paying This tells us that investors were paying $11.1 for each $1 of earnings$11.1 for each $1 of earningsThe P/E ration is most informative when The P/E ration is most informative when applied in cross-sectional analysis using applied in cross-sectional analysis using the industry average.the industry average.


Market/Book (M/B) Ratio: Market/Book (M/B) Ratio: assesses how assesses how investors view the firm’s performanceinvestors view the firm’s performance

It relates the market value of the firm’s It relates the market value of the firm’s shares to their book – strict accounting – shares to their book – strict accounting – value.value.

To calculate M/B ratio, we first need to find To calculate M/B ratio, we first need to find the book value per share of com. stock:the book value per share of com. stock:


BV/share = BV/share = Common Stock Equity Common Stock Equity = = No. of shares of com. stockNo. of shares of com. stock

BV/share = $1,754,000/76,262 = $23.00BV/share = $1,754,000/76,262 = $23.00Then:Then: MB ratio = MB ratio = Market price/share of com. StockMarket price/share of com. Stock = = $32$32 = $1.4 = $1.4

BV/share of com. StockBV/share of com. Stock $23 $23

• This MB ratio means that investors are paying $1.40 for This MB ratio means that investors are paying $1.40 for each $1.00 of book value of Bartlett company’s stock. each $1.00 of book value of Bartlett company’s stock.

• Most informative using cross-sectional analysis to Most informative using cross-sectional analysis to compare peer firms’ risk and returncompare peer firms’ risk and return

Ratio Analysis:Ratio Analysis:A complete Ratio AnalysisA complete Ratio Analysis

Analysts frequently wish to take an Analysts frequently wish to take an overall look at the firm’s financial overall look at the firm’s financial performance.performance.

2 approaches to a ‘complete ratio 2 approaches to a ‘complete ratio analysis’:analysis’:

(1)(1) Summarizing all ratiosSummarizing all ratios

(2)(2) DuPont system of analysisDuPont system of analysis

Ratio Analysis:Ratio Analysis:Summarizing All RatiosSummarizing All Ratios

See (table 2.8) in pages 72 and 73See (table 2.8) in pages 72 and 73In conclusion, the Bartlett firm shows growth and In conclusion, the Bartlett firm shows growth and expansion in assets, financed by Debts.expansion in assets, financed by Debts.The 2005-2006 period seems to reflect a phase The 2005-2006 period seems to reflect a phase of adjustment and recovery from the rapid of adjustment and recovery from the rapid growth in assetsgrowth in assetsIt’s sales, profits and others seem to be growing It’s sales, profits and others seem to be growing in line with the increase size of operationin line with the increase size of operationThe market response to these achievements The market response to these achievements seems to be positiveseems to be positive

Ratio Analysis:Ratio Analysis:DuPont System of AnalysisDuPont System of Analysis

This system is used to examine the firm’s This system is used to examine the firm’s financial statements and to assess its financial statements and to assess its financial status.financial status.

It merges the income statement and It merges the income statement and balance sheet into two summary balance sheet into two summary measures of profitability: ROA & ROE as measures of profitability: ROA & ROE as shown in the equation below and in figure shown in the equation below and in figure 2.2 (page 76) on the following slide:2.2 (page 76) on the following slide:


DuPont Formula:DuPont Formula: ROA = Net profit margin X Total asset turnoverROA = Net profit margin X Total asset turnover

Substituting the appropriate formulas into the Substituting the appropriate formulas into the equation and simplifying results given earlierequation and simplifying results given earlier

Earnings avail. for Earnings avail. for Earnings avail. for Earnings avail. for ROA = ROA = common stockholderscommon stockholders X X Sales Sales = = common stockholderscommon stockholders

SalesSales Total AssetsTotal Assets Total Assets Total Assets

ROA = 7.2% X 0.85 = 6.1% ROA = 7.2% X 0.85 = 6.1% (same value – see slide 66 or page 68)(same value – see slide 66 or page 68) (also, see slide Nos. 47 & 64 for info.)(also, see slide Nos. 47 & 64 for info.)

Conclusion:Conclusion: low net profit margin has a high total asset turnover,low net profit margin has a high total asset turnover, which results in a good return on total assets!!which results in a good return on total assets!!


Modified DuPont Formula:Modified DuPont Formula:This formula relates the firm’s ROA to its ROE This formula relates the firm’s ROA to its ROE using the using the financial leverage multiplier (FLM)financial leverage multiplier (FLM) which is the ratio of total assets to common which is the ratio of total assets to common stock equity:stock equity: ROE = ROA X FLMROE = ROA X FLMSubstituting the appropriate formulas into the Substituting the appropriate formulas into the equation and simplifying results in the formula given equation and simplifying results in the formula given earlier:earlier:

Earnings avail. forEarnings avail. for Earnings avail Earnings avail forfor ROA = ROA = common stockholderscommon stockholders X X Total assetsTotal assets = = common stockholdercommon stockholder

Total assetsTotal assets C Stock equity C Stock Equity C Stock equity C Stock Equity

Ratio Analysis:Ratio Analysis:DuPont System of AnalysisDuPont System of Analysis• Use of FLM to convert the ROA into the ROA reflects the Use of FLM to convert the ROA into the ROA reflects the

impact of financial leverage on owner’s returnimpact of financial leverage on owner’s return• ROE = 6.1% X 2.06 = 12.6% (ROE = 6.1% X 2.06 = 12.6% (see slide No. 67 or page 69) see slide No. 67 or page 69)

Advantage of Applying the DuPont System:Advantage of Applying the DuPont System:• It allows the firm to break its return on equity into a profit-It allows the firm to break its return on equity into a profit-

on-sales component (NPM), an efficiency-of-use on-sales component (NPM), an efficiency-of-use component (TAT), & a use-of-financial leverage component (TAT), & a use-of-financial leverage component (FLM)component (FLM)

• The use of DuPont System of analysis as a diagnostic The use of DuPont System of analysis as a diagnostic tool is best illustrated in figure 2.2 (page 76), to isolate tool is best illustrated in figure 2.2 (page 76), to isolate the probable cause of the resulting above-average (or the probable cause of the resulting above-average (or below-average) values.below-average) values.


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