Statements. viewpoints PART TWO

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76

3

Analyzing Financial

Statements

viewpoints

Business Application

The managers of DPH Tree Farm, Inc., have released public statements that the firm’s performance surpasses that of other firms in the industry. They cite the firm’s liquidity and asset management positions as particularly strong. DPH’s superior performance in these areas has resulted in superior overall returns for their stockholders. What are the key financial ratios that DPH Tree Farm, Inc., needs to calculate and evaluate in order to justify these statements? (See solution on p. 99)

Personal Application

Chris Ryan is looking to invest in DPH Tree Farm, Inc. Chris has the most recent set of financial statements from DPH Tree Farm’s annual report but is not sure how to evaluate them or measure the firm’s performance relative to other firms in the industry. What are the financial ratios with which Chris should measure the performance of DPH Tree Farm, Inc.? How can Chris use these ratios to evaluate the firm’s performance? (See solution on p. 99)

So how can these financial ratios work in your life?

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77 LG3-1 Calculate and interpret major liquidity ratios.

LG3-2 Calculate and interpret major asset management ratios. LG3-3 Calculate and interpret major debt ratios.

LG3-4 Calculate and interpret major profitability ratios. LG3-5 Calculate and interpret major market value ratios. LG3-6 Appreciate how various ratios relate to one another.

LG3-7 Understand the differences between time series and cross-sectional ratio analysis.

LG3-8 Explain cautions that should be taken when examining financial ratios.

Learning Goals

W

e reviewed the major financial statements in Chapter 2. These financial statements provide

information on a firm’s financial position at a point in time or its operations over some past period of time. But these financial statements’ real value lies in the fact that managers, inves-tors, and analysts can use the information the statements contain to analyze the current financial perfor-mance or condition of the firm. More importantly, managers can use this information to plan changes that will improve the firm’s future performance and, ultimately, its market value. Managers, investors, and analysts universally use ratios to evaluate financial statements. Ratio analysis involves calculating and analyzing financial ratios to assess a firm’s performance and to identify actions that could improve firm performance. The most frequently used ratios fall into five groups: (1) liquidity ratios, (2) asset management ratios, (3) debt management ratios, (4) profitability ratios, and (5) market value ratios. Each of the five groups focuses on a specific area of the financial statements that managers, investors, and analysts assess.

In this chapter, we review these ratios, describe what each ratio means, and identify the general trend (higher or lower) that managers and investment analysts look for in each ratio. Note as we review the ratios that the number calculated for a ratio is not always good or bad and that extreme values (either high or low) can be a bad sign for a firm. We will discuss how a ratio that seems too good can actually be bad for a company. We will also see how ratios interrelate—how a change in one ratio may affect the value of sev-eral ratios. It is often hard to make sense of a set of performance ratios. Thus, when managers or investors review a firm’s financial position through ratio analysis, they often start by evaluating trends in the firm’s financial ratios over time and by comparing their firm’s ratios with that of other firms in the same industry. Finally, we discuss cautions that you should take when using ratio analysis to evaluate firm performance. As we go through the chapter, we show sample ratio analysis using the financial statements for DPH Tree Farm, Inc., listed in Tables 2.1 and 2.2.

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LG3-1

Calculating Liquidity Ratios

Use the balance sheet (Table 2.1) and income statement (Table 2.2) for DPH Tree Farm, Inc., to

calculate the firm’s 2015 values for the liquidity ratios.

For interactive versions of this example visit

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EXAMPLE

3-1

78 part two Financial Statements

3.1 ∙

Liquidity Ratios

As we stated in Chapter 2, firms need cash and other liquid assets (or current assets) to pay their bills (or current liabilities) as they come due. Liquidity ratios measure the relationship between a firm’s liquid (or current) assets and its cur-rent liabilities. The three most commonly used liquidity ratios are the curcur-rent ratio, the quick (or acid-test) ratio, and the cash ratio.

Current ratio 5 Current assets

Current liabilities (3-1)

The broadest liquidity measure, the current ratio, measures the dollars of current assets available to pay each dollar of current liabilities.

Quick ratio (acid-test ratio) 5 Current assets 2 Inventory

Inventories are generally the least liquid of a firm’s current assets. Further, inventory is the current asset for which book values are the least reliable mea-sures of market value. In practical terms, what this means is that if the firm must sell inventory to pay upcoming bills, the firm will most likely have to discount inventory items in order to liquidate them, and therefore, they are the current assets on which losses are most likely to occur. Therefore, the quick (or acid-test) ratio measures a firm’s ability to pay off short-term obligations without relying on inventory sales. The quick ratio measures the dollars of more liquid assets (cash and marketable securities and accounts receivable) available to pay each dollar of current liabilities.

Cash ratio 5 Cash and marketable securities

If the firm sells accounts receivable to pay upcoming bills, the firm must often discount the accounts receivable to sell them—the assets once again bring less than their book value. Therefore, the cash ratio measures a firm’s ability to pay short-term obligations with its available cash and marketable securities.

Of course, liquidity on the balance sheet is important. The more liquid assets a firm holds, the less likely the firm is to experience financial distress. Thus, the higher the liquidity ratios, the less liquidity risk a firm has. But as with every-thing else in business, high liquidity represents a painful trade-off for the firm. Liquid assets generate little, if any, profits for the firm. In contrast, fixed assets are illiquid, but generate revenue for the firm. Thus, extremely high levels of liquidity guard against liquidity crises, but at the cost of lower returns on assets. High liquidity levels may actually show bad or indecisive firm management. Thus, in deciding the appropriate level of current assets to hold on the balance sheet, managers must consider the trade-off between the advantages of being liquid versus the disadvantages of reduced profits. Note that a company with very predictable cash flows can maintain low levels of liquidity without incur-ring much liquidity risk.

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liquidity ratios

Measure the relation between a firm’s liquid (or current) assets and its cur-rent liabilities.

ratio analysis

The process of calculating and analyzing financial ratios to assess the firm’s performance and to identify actions needed to improve firm performance.

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SOLUTION:

The liquidity ratios for DPH Tree Farm, Inc., are calculated as follows. The industry average is reported alongside each ratio.

Current ratio 5$205m

$120m51.71 times Industry average 5 1.50 times

Quick ratio (acid-test ratio) 5$205m 2 $111m

$120m 50.78 times Industry average 5 0.50 times

Cash ratio 5 $24m

All three liquidity ratios show that DPH Tree Farm, Inc., has more liquidity on its balance sheet than the industry average (we discuss the process used to develop an industry average in section 3.8). Thus, DPH Tree Farm has more cash and other liquid assets (or current assets) available to pay its bills (or current liabilities) as they come due than does the average firm in the tree farm industry.

Similar to Problems 3-1, 3-2, self-test problem 1

chapter 3 Analyzing Financial Statements 79

3.2 ∙

Asset Management Ratios

Asset management ratios measure how efficiently a firm uses its assets (inven-tory, accounts receivable, and fixed assets), as well as how efficiently the firm manages its accounts payable. The specific ratios allow managers and investors to evaluate whether a firm is holding a reasonable amount of each type of asset and whether management uses each type of asset to effectively generate sales. The most frequently used asset management ratios are listed in the following sections, grouped by type of asset.

Inventory Management

As they decide the optimal inventory level to hold on the balance sheet, manag-ers must consider the trade-off between the advantages of holding sufficient lev-els of inventory to keep the production process going versus the costs of holding large amounts of inventory. Two frequently used ratios are the inventory turn-over and days’ sales in inventory.

Inventory turnover 5Sales or cost of goods sold

Inventory (3-4)

The inventory turnover measures the number of dollars of sales produced per dollar of inventory. Cost of goods sold is used in the numerator when managers

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asset management ratios

Measure how efficiently a firm uses its assets (inven-tory, accounts receivable, and fixed assets), as well as its accounts payable.

T I M E O U T

3-1 What are the three major liquidity ratios used in evaluating financial statements? 3-2 How do the three major liquidity ratios used in evaluating financial statements

differ?

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want to emphasize that inventory is listed on the balance sheet at cost, that is, the cost of sales generated per dollar of inventory.

Days' sales in inventory 5 Inventory 3 365 days

Sales or cost of goods sold

5 365 days

Inventory turnover (3-5)

The days’ sales in inventory ratio measures the number of days that inventory is held before the final product is sold.

In general, a firm wants to produce a high level of sales per dollar of inventory; that is, it wants to turn inventory over (from raw materials to finished goods to sold goods) as quickly as possible. A high level of sales per dollar of inventory implies reduced warehousing, monitoring, insurance, and any other costs of ser-vicing the inventory. So, a high inventory turnover ratio or a low days’ sales in inventory is generally a sign of good management.

However, if the inventory turnover ratio is extremely high and the days’ sales in inventory is extremely low, the firm may not be holding sufficient inventory to pre-vent running out (or stocking out) of the raw materials needed to keep the produc-tion process going. Thus, producproduc-tion and sales stop, which wastes the firm’s fixed resources. So, extremely high levels for the inventory turnover ratio and low levels for the days’ sales in inventory ratio may actually be a sign of bad firm or produc-tion management. Note that companies with very good supply chain relaproduc-tions can maintain lower levels of inventory without incurring as much risk of stockouts.

Accounts Receivable Management

As they decide what level of accounts receivable to hold on the firm’s balance sheet, managers must consider the trade-off between the advantages of increased sales by offering customers better terms versus the disadvantages of financing large amounts of accounts receivable. Two ratios used here are the accounts receivable turnover and average collection period.

Accounts receivable turnover 5 Credit sales

Accounts receivable (3-6)

The accounts receivable turnover measures the number of dollars of sales pro-duced per dollar of accounts receivable.

Average collection period (ACP) 5Accounts receivable 3 365 days

Credit sales

5 365 days

Accounts receivable turnover (3-7)

The average collection period (ACP) measures the number of days accounts receivable are held before the firm collects cash from the sale. This ratio is also sometimes termed the days’ sales outstanding (DSO).

In general, a firm wants to produce a high level of sales per dollar of accounts receivable; that is, it wants to collect its accounts receivable as quickly as possible to reduce any cost of financing accounts receivable, including interest expense on liabilities used to finance accounts receivable and defaults associated with accounts receivable. In general, a high accounts receivable turnover or a low ACP is a sign of good management, which is well aware of financing costs and cus-tomer remittance habits.

However, if the accounts receivable turnover is extremely high and the ACP is extremely low, the firm’s accounts receivable policy may be so strict that

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customers prefer to do business with competing firms. Firms offer accounts receivable terms as an incentive to get customers to buy products from their firm rather than a competing firm. By offering customers the accounts receivable privilege, management allows them to buy (more) now and pay later. Without this incentive, customers may choose to buy the goods from the firm’s competi-tors who offer better credit terms. So extremely high accounts receivable turn-over levels and low ACP levels may be a sign of bad firm management.

Accounts Payable Management

As they decide the accounts payable level to hold on the balance sheet, managers must consider the trade-off between maximizing the use of free financing that raw material suppliers offer versus the risk of losing the opportunity to buy on account. Two ratios commonly used are the accounts payable turnover and aver-age payment period.

Accounts payable turnover 5 Cost of goods sold

Accounts payable (3-8)

The accounts payable turnover ratio measures the dollar cost of goods sold per dollar of accounts payable.

Average payment period (APP) 5Accounts payable 3 365 days

Cost of goods sold

5 365 days

Accounts payable turnover (3-9)

The average payment period (APP) measures the number of days that the firm holds accounts payable before it has to extend cash to pay for its purchases.

In general, a firm wants to pay for its purchases as slowly as possible. The slower the firm pays for its supply purchases, the longer it can avoid obtain-ing other costly sources of financobtain-ing such as notes payable or long-term debt. Thus, a low accounts payable turnover or a high APP is generally a sign of good management.

However, if the accounts payable turnover is extremely low and the APP is extremely high, the firm may be abusing the credit terms that its raw materials suppliers offer. At some point, the firm’s suppliers may revoke its ability to buy raw materials on account and the firm will lose this source of free financing. If this situation is developing, extremely low levels for the accounts receivable turnover and high levels for the APP may point to bad firm management.

Fixed Asset and Working Capital Management

Two ratios that summarize the efficiency in a firm’s overall asset management are the fixed asset turnover and sales to working capital ratios.

Fixed asset turnover 5 Sales

Net fixed assets (3-10)

The fixed asset turnover ratio measures the number of dollars of sales produced per dollar of net fixed assets.

Sales to working capital 5 Sales

Working capital (3-11)

Similarly, the sales to working capital ratio measures the number of dollars of sales produced per dollar of net working capital (current assets minus current liabilities).

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EXAMPLE

3-2

_LG3-2

Calculating Asset Management Ratios

calculate the firm’s 2015 values for the asset management ratios.

www.mhhe.com/can3e

In general, the higher the level of sales per dollar of fixed assets and work-ing capital, the more efficiently the firm is bework-ing run. Thus, high fixed asset turnover and sales to working capital ratios are generally signs of good man-agement. However, if either the fixed asset turnover or sales to working capital ratio is extremely high, the firm may be close to its maximum production capac-ity. If capacity is hit, the firm cannot increase production or sales. Accordingly, extremely high fixed asset turnover and sales to working capital ratio levels may actually indicate bad firm management if managers have allowed the company to approach maximum capacity without making any accommodations for growth.

Note a word of caution here. The age of a firm’s fixed assets will affect the fixed asset turnover ratio level. A firm with older fixed assets, listed on its balance sheet at historical cost, will tend to have a higher fixed asset turnover ratio than will a firm that has just replaced its fixed assets and lists them on its balance sheet at a (most likely) higher value. Accordingly, the firm with newer fixed assets would have a lower fixed asset turnover ratio. But this is because it has updated its fixed assets, while the other firm has not. It is not correct to conclude that the firm with new assets is underperforming relative to the firm with older fixed assets listed on its balance sheet. Similarly, for firms that are in an expansion phase, a lower fixed asset turnover is actually a good sign. It is not correct to conclude that a firm with expanding assets is underperforming relative to a firm with no growth.

Total Asset Management

The final two asset management ratios put it all together. They are the total asset turnover and capital intensity ratios.

Total asset turnover 5 Sales

Total assets (3-12)

The total asset turnover ratio measures the number of dollars of sales produced per dollar of total assets.

Capital intensity 5 Total assets

Sales (3-13)

Similarly, the capital intensity ratio measures the dollars of total assets needed to produce a dollar of sales.

In general, a well-managed firm produces many dollars of sales per dollar of total assets, or uses few dollars of assets per dollar of sales. Thus, in general, the higher the total asset turnover and lower the capital intensity ratio, the more effi-cient the overall asset management of the firm will be. However, if the total asset turnover is extremely high and the capital intensity ratio is extremely low, the firm may actually have an asset management problem. As described above, inventory stockouts, capacity problems, or tight account receivables policies can all lead to a high total asset turnover and may actually be signs of poor firm management.

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SOLUTION:

We calculate the asset management ratios for DPH Tree Farm, Inc., as follows. The industry average is reported alongside each ratio.

i. Inventory turnover 5$315m

$111m 52.84 times Industry average52.15 times

ii. Days' sales in inventory 5$111m 3 365 days

$315m 5

365 days

2.84 times 5129 days Industry average 5 170 days

iii. Accounts receivable turnover 5$315m

iv. Average collection period 5$70m 3 365 days

$315m 5

365 days

4.50 times581 days Industry average 5 95 days

v. Accounts payable turnover 5$133m

vi. Average payment period 5$55m 3 365 days

$133m 5

365 days

2.42 times5151 days Industry average 5 102 days

vii. Fixed asset turnover 5$315m

viii. Sales to working capital 5 $315m

$205m 2 $120m53.71 times Industry average 5 3.20 times

ix. Total assets turnover 5$315m

x. Capital intensity 5$570m

In all cases, asset management ratios show that DPH Tree Farm, Inc., is outperforming the industry average. The firm is turning over its inventory faster than the average firm in the tree farm industry, thus producing more dollars of sales per dollar of inventory. It is also collecting its accounts receivable faster and paying its accounts payable slower than the average firm. Further, DPH Tree Farm is producing more sales per dollar of fixed assets, working capital, and total assets than the average firm in the industry.

T I M E O U T

3-4 What are the major asset management ratios?

3-5 Does a firm generally want to have high or low values for each of these ratios? 3-6 Explain why many of these ratios are mirror images of one another.

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3.3 ∙

Debt Management Ratios

As we discussed in Chapter 2, financial leverage refers to the extent to which the firm uses debt securities in its capital structure. The more debt a firm uses as a percentage of its total assets, the greater is its financial leverage. Debt

management ratios measure the extent to which the firm uses debt (or

finan-cial leverage) versus equity to finance its assets as well as how well the firm can pay off its debt. The specific ratios allow managers and investors to evaluate whether a firm is financing its assets with a reasonable amount of debt versus equity financing, as well as whether the firm is generating sufficient earnings or cash to make the promised payments on its debt. The most commonly used debt management ratios are listed in the following sections.

Debt versus Equity Financing

Managers’ choice of capital structure —the amount of debt versus equity to issue—affects the firm’s viability as a long-term entity. In deciding the level of debt versus equity financing to hold on the balance sheet, managers must con-sider the trade-off between maximizing cash flows to the firm’s stockholders ver-sus the risk of being unable to make promised debt payments. Ratios that are commonly used are the debt ratio, debt-to-equity, and equity multiplier.

Debt ratio 5 Total debt

The debt ratio measures the percentage of total assets financed with debt.

Debt-to-equity 5 Total debt

Total equity (3-15)

The debt-to-equity ratio measures the dollars of debt financing used for every dollar of equity financing.

Equity multiplier 5 Total assets

Total equity or

Total assets

Common stockholders’ equity (3-16)

The equity multiplier ratio measures the dollars of assets on the balance sheet for every dollar of equity (or just common stockholders’ equity) financing.

As you might suspect, all three measures are related. 1 Specifically,

Debt ratio 5 1 2 1

Equity multiplier5

1

(1/Debt-to-equity) 1 1

Debt-to-equity 5 1

(1/Debt ratio) 2 15Equity multiplier 2 1

Equity multiplier 5 1

1 2 Debt ratio 5Debt-to-equity 1 1

So, the lower the debt, debt-to-equity, or equity multiplier, the less debt and more equity the firm uses to finance its assets (i.e., the bigger the firm’s equity cushion). When a firm issues debt to finance its assets, it gives the debt holders first claim to a fixed amount of its cash flows. Stockholders are entitled to any residual

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debt management ratios

Measure the extent to which the firm uses debt (or financial leverage) versus equity to finance its assets as well as how well the firm can pay off its debt.

capital structure

The amount of debt versus equity held on the balance sheet.

1_{To see this remember the balance sheet identity is Assets (A) 5 Debt (D) 1 Equity (E). Dividing}

each side of this equation by assets, we get A/A 5 D/A 1 E/A. Rearranging this equation, D/A 5 A/A 2 E/A 5 1 2 E/A 5 1 2 [1/(A/E)]. Also, D/A 5 (A 2 E)/A 5 1/[A/(A 2 E)] 5 1/ [(A 2 E 1 E)/(A 2 E)] 5 1/[(E/(A 2 E) 1 (A 2 E)/(A 2 E)] 5 1/[E/D 1 1] 5 1/[1/(D/E) 1 1]. Dividing each side of the balance sheet identity equation by equity, we get A/E 5 D/E 1 E/E, or A/E 5 D/E 1 1. Also, rearranging this equation, D/E 5 A/E 2 1.

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cash flows—those left after debt holders are paid. When a firm does well, finan-cial leverage increases the reward to shareholders since the amount of cash flows promised to debt holders is constant and capped. So when firms do well, finan-cial leverage creates more cash flows to share with stockholders—it magnifies the return to the stockholders of the firm (recall Example 2-5). This magnification is one reason that stockholders encourage the use of debt financing.

However, financial leverage also increases the firm’s potential for financial dis-tress and even failure. If the firm has a bad year and cannot make promised debt payments, debt holders can force the firm into bankruptcy. Thus, a firm’s current and potential debt holders (and even stockholders) look at equity financing as a safety cushion that can absorb fluctuations in the firm’s earnings and asset values and guarantee debt service payments. Clearly, the larger the fluctuations or vari-ability of a firm’s cash flows, the greater the need for an equity cushion.

Coverage Ratios

Three additional debt management ratios are the times interest earned, fixed-charge coverage, and cash coverage ratios. These ratios are different measures of a firm’s ability to meet its debt obligations.

Times interest earned 5 EBIT

Interest (3-17)

The times interest earned ratio measures the number of dollars of operating earnings available to meet each dollar of interest obligations on the firm’s debt.

Fixed-charge coverage 5Earnings available to meet fixed charges

Fixed charges (3-18)

The fixed-charge coverage ratio measures the number of dollars of operating earnings available to meet the firm’s interest obligations and other fixed charges.

Cash coverage 5 EBIT 1 Depreciation

Fixed charges (3-19)

The cash coverage ratio measures the number of dollars of operating cash avail-able to meet each dollar of interest and other fixed charges that the firm owes.

With the help of the times interest earned, fixed-charge coverage, and cash coverage ratios, managers, investors, and analysts can determine whether a firm has taken on a debt burden that is too large. These ratios measure the dollars available to meet debt and other fixed-charge obligations. A value of one for these ratios means that $1 of earnings or cash is available to meet each dollar of interest or fixed-charge obligations. A value of less (greater) than one means that the firm has less (more) than $1 of earnings or cash available to pay each

dol-lar of interest or fixed-charge obligations. 2 Further, the higher the times interest

earned, fixed-charge coverage, and cash coverage ratios, the more equity and less debt the firm uses to finance its assets. Thus, low levels of debt will lead to a dilu-tion of the return to stockholders due to increased use of equity as well as to not taking advantage of the tax deductibility of interest expense.

2_{The fixed-charge and cash coverage ratios can be tailored to a particular firm’s situation,}

depending on what really constitutes fixed charges that must be paid. One version of it follows: (EBIT 1 Lease payments)/[Interest 1 Lease payments 1 Sinking fund/(1 2 t )], where t is the firm’s marginal tax rate. Here, it is assumed that sinking fund payments must be made. They are adjusted by the division of (1 2 t ) into a before-tax cash outflow so they can be added to other before-tax cash outflows.

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EXAMPLE

3-3

Calculating Debt Management Ratios

calculate the firm’s 2015 values for the debt management ratios.

SOLUTION:

The debt management ratios for DPH Tree Farm, Inc., are calculated as follows. The industry average is reported alongside each ratio.

i. Debt ratio 5$120m 1 $195m

$570m 555.26% Industry average 5 68.50%

ii. Debt-to-equity 5$120m 1 $195m

iii. Equity multiplier 5$570m

or $570m

$255m 2 $5m52.28 times Industry average 5 4.14 times

iv. Times interest earned 5 $152m

v. Fixed-charge coverage 5$152m

vi. Cash coverage 5$152m 1 $13m

In all cases, debt management ratios show that DPH Tree Farm, Inc., holds less debt on its balance sheet than the average firm in the tree farm industry. Further, the firm has more dollars of operating earnings and cash available to meet each dollar of interest obligations (there are no other fixed charges listed on DPH Tree Farm’s income statement) on the firm’s debt. This lack of financial leverage decreases the firm’s potential for financial distress and even failure, but may also decrease equity shareholders’ chance for magnified earnings. If the firm has a bad year, it has promised relatively few payments to debt holders. Thus, the risk of bankruptcy is small. However, when DPH Tree Farm, Inc., does well, the low level of financial leverage dilutes the return to the stockholders of the firm. This dilution of profit is likely to upset common stockholders of the firm. Similar to Problems 3-5, 3-6, self-test problem 1

LG3-3

www.mhhe.com/can3e

T I M E O U T

3-7 What are the major debt management ratios?

3-8 Does a firm generally want to have high or low values for each of these ratios? 3-9 What is the trade-off between using too much financial leverage and not using

enough leverage? Who is likely to complain the most in each case?

3.4 ∙

Profitability Ratios

The liquidity, asset management, and debt management ratios examined so far allow for an isolated or narrow look at a firm’s performance. Profitability ratios show the combined effects of liquidity, asset management, and debt manage-ment on the overall operating results of the firm. Profitability ratios are among profitability ratios

Ratios that show the com-bined effect of liquidity, asset management, and debt management on the firm’s overall operating results.

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the most watched and best known of the financial ratios. Indeed, firm values (or stock prices) react quickly to unexpected changes in these ratios. The most com-monly used profitability ratios are listed below.

Gross profit margin 5Sales 2 Cost of goods sold

Sales (3-20)

The gross profit margin is the percent of sales left after costs of goods sold are deducted.

Operating profit margin 5 EBIT

Sales (3-21)

The operating profit margin is the percent of sales left after all operating expenses are deducted.

Profit margin 5Net income available to common stockholders

Sales (3-22)

The profit margin is the percentage of sales left after all firm expenses are deducted. Thus, this ratio provides the net profit margin of the firm, as opposed to the gross profit or operating profit margin.

Basic earnings power (BEP) 5 EBIT

The basic earnings power ratio measures the operating return on the firm’s assets, regardless of financial leverage and taxes. This ratio measures the operat-ing profit (EBIT) earned per dollar of assets on the firm’s balance sheet.

Return on assets (ROA) 5Net income available to common stockholders

Total assets _(3-24)

Return on assets (ROA) measures the overall return on the firm’s assets, includ-ing financial leverage and taxes. This ratio is the net income earned per dollar of assets on the firm’s balance sheet.

Return on equity (ROE) 5Net income available to common stockholders

Common stockholders’ equity _(3-25)

Return on equity (ROE) measures the return on the common stockholders’ investment in the assets of the firm. ROE is the net income earned per dollar of common stockholders’ equity. The value of a firm’s ROE is affected not only by net income, but also by the amount of financial leverage or debt that firm uses. As stated previously, financial leverage magnifies the return to the stockholders of the firm. However, financial leverage also increases the firm’s potential for financial distress and even failure. Generally, a high ROE is considered to be a positive sign of firm performance. However, if performance comes from a high degree of financial leverage, a high ROE can indicate a firm with an unaccept-ably high level of bankruptcy risk as well.

Dividend payout 5 Common stock dividends

Net income available to common stockholders (3-26)

Finally, the dividend payout ratio is the percentage of net income available to common stockholders that the firm actually pays as cash to these investors.

For all but the dividend payout, the higher the value of the ratio, the higher the profitability of the firm. But just as has been the case previously in this chapter, high profitability ratio levels may result from poor management in other areas

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EXAMPLE

3-4

www.mhhe.com/can3e

Calculating Profitability Ratios

Use the balance sheet (Table 2.1) and income statement (Table 2.2) for DPH Tree Farm, Inc., to calculate the firm’s 2015 values for the profitability ratios.

SOLUTION:

The profitability ratios for DPH Tree Farm, Inc., are calculated as follows. The industry average is reported along-side each ratio.

i. Gross profit margin 5$182m

$315m557.78% Industry average 5 56.65%

ii. Operating profit margin 5$152m

iii. Profit margin 5 $80m

iv. Basic earnings power (BEP) 5$152m

v. Return on assets (ROA) 5 $80m

vi. Return on equity (ROE) 5 $80m

$40m 1 $210m532.00% Industry average 5 38.00%

vii. Dividend payout 5$25m

These ratios show that DPH Tree Farm, Inc., is more profitable than the average firm in the tree farm industry. The profit margin, gross profit margin, operating profit margin, BEP, and ROA are all higher than industry figures. Despite this, the ROE for DPH Tree Farm is much lower than the industry average. DPH’s low debt level and high equity level relative to the industry is the main reason for DPH’s strong figures relative to the industry. As we mentioned above, DPH’s managerial decisions about capital structure dilute its returns, which will likely upset its common stockholders. To counteract common stockholders’ discontent, DPH Tree Farm pays out a slightly larger percentage of its income to its common stockholders as cash dividends. Of course, this slightly high dividend payout ratio means that DPH Tree Farm retains less of its profits to reinvest into the busi-ness. A profitable firm that retains its earnings increases its equity capital level as well as its own value. Similar to Problems 3-7, 3-8, self-test problem 1

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of the firm as much as superior financial management. A high profit (and gross profit or operating profit) margin means that the firm has low expenses rela-tive to sales. The BEP reflects how much the firm’s assets earn from operations, regardless of financial leverage and taxes. It follows logically that managers, investors, and analysts find BEP a useful ratio when they compare firms that differ in financial leverage and taxes. In contrast, ROA measures the firm’s over-all performance. It shows how the firm’s assets generate a return that includes financial leverage and tax decisions made by management.

ROE measures the return on common stockholders’ investment. Since man-agers seek to maximize common stock price, manman-agers, investors, and analysts monitor ROE above all other ratios. The dividend payout ratio measures how much of the profit the firm retains versus how much it pays out to common stockholders as dividends. The lower the dividend payout ratio, the more profits the firm retains for future growth or other projects. A profitable firm that retains its earnings increases its level of equity capital as well as its own value.

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3.5 ∙

Market Value Ratios

As noted, ROE is a most important financial statement ratio for managers and investors to monitor. Generally, a high ROE is considered to be a positive sign of firm performance. However, if a high ROE results from a highly leveraged posi-tion, it can signal a firm with a high level of bankruptcy risk. While ROE does not directly incorporate this risk, for publicly traded firms, market prices of the firm’s stock do. (We look at stock valuation in Chapter 8.) Since the firm’s stock-holders earn their returns primarily from the firm’s stock market value, ratios that incorporate stock market values are equally, and arguably more, important than other financial statement ratios.

The final group of ratios is market value ratios. Market value ratios relate a firm’s stock price to its earnings and its book value. For publicly traded firms, market value ratios measure what investors think of the company’s future per-formance and risk.

Market-to-book ratio 5Market price per share

Book value per share (3-27)

The market-to-book ratio measures the amount that investors will pay for the firm’s stock per dollar of equity used to finance the firm’s assets. Book value per share is an accounting-based number reflecting the firm’s assets’ historical costs, and hence historical value. The market-to-book ratio compares the market (current) value of the firm’s equity to its historical cost. In general, the higher the market-to-book ratio, the better the firm. If liquidity, asset management, debt management, and accounting profitability are good for a firm, then the market-to-book ratio will be high. A market-to-book ratio greater than one (or 100 percent) means that stockholders will pay a premium over book value for their equity investment in the firm.

Price-earnings (PE) ratio 5 Market price per share

Earnings per share (3-28)

One of the best known and most often quoted figures, the price-earnings (or PE) ratio measures how much investors are willing to pay for each dollar the firm earns per share of its stock. PE ratios are often quoted in multiples—the number of dollars per share—that fund managers, investors, and analysts compare within industry classes. Managers and investors often use PE ratios to evaluate the rela-tive financial performance of the firm’s stock. Generally, the higher the PE ratio, the better the firm’s performance. Analysts and investors, as well as managers, expect companies with high PE ratios to experience future growth, to have rapid future dividend increases, or both, because retained earnings will support the company’s goals. However, for value-seeking investors, high-PE firms indicate expensive companies. Further, higher PE ratios carry greater risk because inves-tors are willing to pay higher prices today for a stock in anticipation of higher earnings in the future. These earnings may or may not materialize. Low-PE firms

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market value ratios

Ratios that relate a firm’s stock price to its earnings and book value.

T I M E O U T

3-10 What are the major profitability ratios?

3-11 Does a firm generally want to have high or low values for each of these ratios? 3-12 What are the trade-offs to having especially high or low values for ROE?

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are generally companies with little expected growth or low earnings. However, note that earnings depend on many factors (such as financial leverage or taxes) that have nothing to do directly with firm operations.

EXAMPLE

3-5

www.mhhe.com/can3e

Calculating Market Value Ratios

calculate the firm’s 2015 values for the market value ratios.

SOLUTION:

The market value ratios for DPH Tree Farm, Inc., are calculated as follows. The industry average is reported alongside each ratio.

i. Market-to-book ratio 5$17.25

$12.5051.38 times Industry average 5 2.15 times

ii. Price-earnings (PE) ratio 5$17.25_$4.00 54.31 times Industry average 5 6.25 times

These ratios show that DPH Tree Farm’s investors will not pay as much for a share of DPH’s stock per dol-lar of book value and earnings as the average for the industry. DPH’s low leverage level and high reliance on equity relative to the industry are likely the main reason for investors’ disinterest. As mentioned previously, DPH’s seemingly intentional return dilution will likely upset the firm’s common stockholders. Accordingly, stock-holders lower the amount they are willing to invest per dollar of book value and EPS.

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DuPont system of analysis

An analytical method that uses the balance sheet and income statement to break the ROA and ROE ratios into component pieces.

3.6 ∙

DuPont Analysis

Table 3.1 (on page 92) lists the ratios we discuss, their values for DPH Tree Farm, Inc., as of 2015, and the corresponding values for the tree farm industry. The value of each ratio for DPH Tree Farm is highlighted in green if it is generally stronger than the industry and is highlighted in red if it is generally a nega-tive sign for the firm. As we noted in this chapter’s introduction, many of the ratios we have discussed thus far are interrelated. So a change in one ratio may well affect the value of several ratios. Often these interrelations can help evalu-ate firm performance. Managers and investors often perform a detailed analysis

of ROA (return on assets) and ROE (return on equity) using the DuPont

system of analysis . Popularized by the DuPont Corporation, the DuPont

sys-tem of analysis uses the balance sheet and income stasys-tement to break the ROA

and ROE ratios into component pieces.

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T I M E O U T

3-13 What are the major market value ratios?

3-14 Does a firm generally want to have high or low values for each of these ratios? 3-15 Discuss the price-earnings ratio and explain why it assumes particular importance

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The basic DuPont equation looks at ROA as the product of the profit margin and the total asset turnover ratios:

ROA 5 Profit margin 3 Total asset turnover

Net income available to common stockholders

Total assets 5

Sales 3

Sales

The basic DuPont equation looks at the firm’s overall profitability as a func-tion of the profit the firm earns per dollar of sales (operating efficiency) and the dollar of sales produced per dollar of assets on the balance sheet (efficiency in asset use). With this tool, managers can see the reason for any changes in ROA in more detail. For example, if ROA increases, the DuPont equation may show that the net profit margin was constant, but the total asset turnover (efficiency in using assets) increased, or that total asset turnover remained constant, but profit margins (operating efficiency) increased. Managers can identify the reasons for an ROA change more specifically by using the ratios described above to further break down operating efficiency and efficiency in asset use.

Next, the DuPont system looks at ROE as the product of ROA and the equity multiplier.

ROE 5 ROA 3 Equity multiplier

Common stockholders’ equity 5 ROA 3

Total assets

Common stockholders’ equity

(3-30)

Notice that this version of the equity multiplier uses the return to common stock-holders (the firm’s owners) only. So the DuPont equity multiplier uses common stockholders’ equity only, rather than total equity (which includes preferred stock).

Taking this breakdown one step further, the DuPont system breaks ROE into the product of the profit margin, the total asset turnover, and the equity multiplier.

ROE 5 Profit margin 3 Total asset turnover 3 Equity multiplier

5

Net income available to common stockholders Sales 3 Sales Total assets 3 Total assets Common stockholders’ equity (3-31)

This presentation of ROE allows managers, analysts, and investors to look at the return on equity as a function of the net profit margin (profit per dollar of sales from the income statement), the total asset turnover (efficiency in the use of assets from the balance sheet), and the equity multiplier (financial leverage from the balance sheet). Again, we can break these components down to iden-tify possible causes for a ROE change more specifically. Figure 3.1 illustrates the DuPont system of analysis breakdown of ROA and ROE. The figure highlights how many of the ratios discussed in this chapter are linked.

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ROE

ROA

Profit margin

Gross profit margin Liquidity ratios

Asset management ratios Operating profit margin

Basic earnings power

Cost of goods sold to sales

Interest expense to sales

Taxes to sales

Total asset turnover

Equity multiplier

figure 3.1

DuPont System Analysis Breakdown of ROA and ROE

table 3.1 Summary of Ratios and Their Values for DPH Tree Farm, Inc., and the Tree Farm Industry

Ratio Value for DPH Tree

Farm, Inc.

Value for the Tree Farm Industry

Liquidity ratios:

Current ratio 5 Current assets Current liabilities

1.71 times 1.50 times

Quick ratio (acid-test ratio) 5Current assets 2 Inventory Current liabilities

Cash ratio 5Cash and marketable securities Current liabilities

Asset management ratios:

Inventory turnover 5Sales or cost of goods sold Inventory

Days’ sales in inventory 5 Inventory 3 365 days Sales or cost of goods sold

129 days 170 days

Accounts receivable turnover 5 Credit sales Accounts receivable

Average collection period 5Accounts receivable 3 365 days Credit sales

81 days 95 days

Accounts payable turnover 5Cost of goods sold Accounts payable

Average payment period (APP) 5Accounts payable 3 365 days Cost of goods sold

151 days 102 days

Fixed asset turnover 5 Sales Net fixed assets

Sales to working capital 5 Sales Working capital

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EXAMPLE

3-6

Application of DuPont Analysis

Use the balance sheet (Table 2.1) and income statement (Table 2.2) for DPH Tree Farm, Inc.,

to calculate the firm’s 2015 values for the ROA and ROE DuPont equations.

SOLUTION:

The ROA and ROE DuPont equations for DPH Tree Farm, Inc., are calculated as follows. The industry average is reported below each ratio.

www.mhhe.com/can3e LG3-6

Ratio Value for DPH Tree

Farm, Inc.

Value for the Tree Farm Industry Total assets turnover 5 Sales

Total assets

Capital intensity 5Total assets Sales

Debt management ratios:

Debt ratio 5 Total debt Total assets

55.26% 68.50%

Debt-to-equity 5 Total debt Total equity

Equity multiplier 5Total assets Total equity

or Total assets

Times interest earned 5 EBIT Interest

Fixed-charge coverage 5Earnings available to meet fixed charges

Fixed charges

Cash coverage 5EBIT 1 Depreciation Fixed charges

Profitability ratios:

Gross profit margin 5Sales 2 Cost of goods sold

Sales

57.78% 56.65%

Operating profit margin 5 EBIT Sales

48.25% 46.88%

Profit margin 5Net income available to common stockholders

Sales

25.40% 23.25%

Basic earnings power 5 EBIT Total assets

26.67% 22.85%

Return on assets 5Net income available to common stockholders

Total assets

14.04% 9.30%

Return on equity 5Net income available to common stockholders Common stockholders’ equity

32.00% 38.00%

Dividend payout 5 Common stock dividends

31.25% 30.90%

Market value ratios:

Market-to-book ratio 5Market price per share Book value per share

Price-earnings ratio 5Market price per share Earnings per share

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94 part two Financial Statements i.

ROA 5 Profit margin 3 Total asset turnover

14.04% 5 25.39683% 3 0.55263 times

Industry average: 9.30% 5 23.25% 3 0.40 times

Total assets 5

Net income available to common stockholders Sales 3 Sales Total assets $80m $570m 5 $80m $315m 3 $315m $570m ii.

ROE 5Profit margin 3 Total asset turnover 3 Equity multiplier

32.00% 5 25.39683% 3 0.55263 times 3 2.28 times

Industry average: 38.50% 5 23.25% 3 0.40 times 3 4.13978 times

Net income available Net income available

to common stockholders

Common stockholders’ equity 5

to common stockholders

Sales 3

Sales

Total assets 3

Total assets Common stockholders’ equity $80m $40m 1 $210m 5 $80m $315m 3 $315m $570m 3 $570m $40m 1 $210m

As we saw with profitability ratios, DPH Tree Farm, Inc., is more profitable than the average firm in the tree farm industry when it comes to overall efficiency expressed as return on assets, or ROA. The DuPont equation highlights that this superior performance comes from both profit margin (operating efficiency) and total asset turnover (efficiency in asset use). Despite this, the ROE for DPH Tree Farm lags the average indus-try ROE. The DuPont equation highlights that this inferior performance is due solely to the low level of debt and high level of equity used by DPH Tree Farm relative to the industry.

Similar to Problems 3-11, 3-12

T I M E O U T

3-16 What are the DuPont ROA and ROE equations?

3-17 How do each of these equations help to explain firm performance and pinpoint areas for improvement?

3.7 ∙

Other Ratios

Spreading the Financial Statements

In addition to the many ratios listed, managers, analysts, and investors can also compute additional ratios by dividing all balance sheet amounts by total assets and all income statement amounts by net sales. These calculations, some-times called spreading the financial statements, yield what we call common-size

financial statements that correct for sizes. Year-to-year growth rates in common-size balance sheets and income statement balances provide useful ratios for identifying trends. They also allow for an easy comparison of balance sheets and income statements across firms in the industry. Common-size financial state-ments may provide quantitative clues about the direction that the firm (and per-haps the industry) is moving. They may thus provide roadmaps for managers’ next moves.

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common-size financial statements

Dividing all balance sheet amounts by total assets and all income statement amounts by net sales.

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Internal and Sustainable Growth Rates

Remember again that any firm manager’s job is to maximize the firm’s market value. The firm’s ROA and ROE can be used to evaluate the firm’s ability to grow and its market value to be maximized. Specifically, managers, analysts, and investors use these ratios to calculate two growth measures: the internal growth rate and the sustainable growth rate.

The internal growth rate is the growth rate a firm can sustain if it uses only internal financing—that is, retained earnings—to finance future growth. Math-ematically, the internal growth rate is:

Internal growth rate 5 ROA 3 RR

1 2 (ROA 3 RR) (3-32)

where RR is the firm’s earnings retention ratio. The retention ratio represents the portion of net income that the firm reinvests as retained earnings:

Retention ratio (RR) 5 Addition to retained earnings

Net income available to common stockholders (3-33)

Since a firm either pays its net income as dividends to its stockholders or rein-vests those funds as retained earnings, the dividend payout and the retention ratios must always add to one:

Retention ratio 5 1 2 Dividend payout ratio (3-34)

A problem arises when a firm relies only on internal financing to support asset growth: Through time, its debt ratio will fall because as asset values grow, total debt stays constant—only retained earnings finance asset growth. If total debt remains constant as assets grow, the debt ratio decreases. As we noted above, shareholders often become disgruntled if, as the firm grows, a decreasing debt ratio (increasing equity financing) dilutes their return. So as firms grow, managers must often try to maintain a debt ratio that they view as optimal. In this case, managers finance asset growth with new debt and retained earnings. The maximum growth rate that can be achieved this way is the sustainable

growth rate . Mathematically, the sustainable growth rate is:

Sustainable growth rate 5 ROE 3 RR

1 2 (ROE 3 RR) (3-35)

Maximizing the sustainable growth rate helps firm managers maximize firm value. When applying the DuPont ROE equation (3-31) here (i.e., ROE 5 Profit margin 3 Total asset turnover 3 Equity multiplier), notice that a firm’s sustain-able growth depends on four factors:

1. The profit margin (operating efficiency).

2. The total asset turnover (efficiency in asset use).

3. Financial leverage (the use of debt versus equity to finance assets). 4. Profit retention (reinvestment of net income into the firm rather than

paying it out as dividends).

Increasing any of these factors increases the firm’s sustainable growth rate and hence helps to maximize firm value. Managers, analysts, and investors will want to focus on these areas as they evaluate firm performance and market value.

internal growth rate

The growth rate a firm can sustain if it finances growth using only internal financ-ing, that is, retained earn-ings growth.

sustainable growth rate

The growth rate a firm can sustain if it finances growth using both debt and inter-nal financing such that the debt ratio remains constant.

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3.8 ∙

Time Series and Cross-Sectional Analysis

We have explored many ratios that allow managers and investors to examine firm performance. But to really analyze performance in a meaningful way, we must interpret our ratio results against some kind of standard or benchmark. To interpret financial ratios, managers, analysts, and investors use two major types of benchmarks: (1) performance of the firm over time ( time series analysis ) and (2) performance of the firm against one or more companies in the same industry ( cross-sectional analysis ).

Analyzing ratio trends over time, along with absolute ratio levels, gives man-agers, analysts, and investors information about whether a firm’s financial condi-tion is improving or deteriorating. For example, ratio analysis may reveal that the days’ sales in inventory is increasing. This suggests that inventories, relative to

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time series analysis

Analyzing firm performance by monitoring ratio trends.

cross-sectional analysis

Analyzing the performance of a firm against one or more companies in the same industry.

EXAMPLE

3-7

www.mhhe.com/can3e

Calculating Internal and Sustainable Growth Rates

Use the balance sheet (Table 2.1) and income statement (Table 2.2) for DPH Tree Farm, Inc.,

to calculate the firm’s 2015 internal and sustainable growth rates.

SOLUTION:

The internal and sustainable growth rates for DPH Tree Farm, Inc., are calculated as follows. The industry average is reported alongside each ratio.

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T I M E O U T

3-18 What does “spreading the financial statements” mean?

3-19 What are retention rates and internal and sustainable growth rates? 3-20 What factors enter into sustainable growth rates?

Retention rate (RR) 5$210m 2 $155m

$80m 50.6875 or 68.75%

Industry RR 5 1 2 Industry dividend payout ratio 51 2 0.3090 5 0.6910

i. Internal growth rate 5 0.1404 3 0.6875 1 2 (0.1404 3 0.6875) 5 0.1068 or 10.68%

Industry average internal growth rate 5 0.0930 3 0.6910 1 2 (0.0930 3 0.6910) 5 0.0687 or 6.87%

ii. Sustainable growth rate 5 0.3200 3 0.6875 1 2 (0.3200 3 0.6875) 5 0.2821 or 28.21% 5 0.3800 3 0.6910 1 2 (0.3800 3 0.6910)50.3561 or 35.61% Industry average sustainable growth rate

These ratios show that DPH Tree Farm, Inc., can grow faster than the industry if the firm uses only retained earnings to finance the growth. How-ever, if DPH grows while keeping the debt ratio constant (e.g., both debt and retained earnings are used to finance the growth), industry firms can grow much faster than DPH Tree Farm. Once again, DPH’s low debt level and high equity level relative to the industry creates this disparity. Therefore, DPH Tree Farm limits its growth as a result of its managerial decisions.

MATH COACH

When putting values into the equation, enter them in decimal format, not percentage format

CORRECT 1 2 (0.1404 3 0.6875) NOT CORRECT 1 2 (14.04 3 68.75)

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the sales they support, are not being used as well as they were in the past. If this increase is the result of a deliberate policy to increase inventories to offer custom-ers a wider choice and if it results in higher future sales volumes or increased margins that more than compensate for increased capital tied up in inventory, the increased relative size of the inventories is good for the firm. Managers and investors should be concerned, on the other hand, if increased inventories result from declining sales but steady purchases of supplies and production.

Looking at one firm’s financial ratios, even through time, gives manag-ers, analysts, and investors only a limited picture of firm performance. Ratio analysis almost always includes a comparison of one firm’s ratios relative to the ratios of other firms in the industry, or sectional analysis. The key to cross-sectional analysis is identifying similar firms that compete in the same mar-kets, have similar asset sizes, and operate in a similar manner to the firm being analyzed. Since no two firms are identical, obtaining such a comparison group is no easy task. Thus, the choice of companies to use in cross-sectional analy-sis is at best subjective. Note that as we calculated the financial ratios for DPH Tree Farm, Inc., throughout the chapter, we compared them to the industry aver-age. Comparative ratios that can be used in cross-sectional analysis are available from many sources. For example, Value Line Investment Surveys, Robert Mor-ris Associates, Hoover’s Online (at www.hoovers.com ), and MSN Money website (at moneycentral.msn.com ) are examples of four major sources of financial ratios for numerous industries that operate within the United States and worldwide.

T I M E O U T

3-21 What is time series analysis of a firm’s operations? 3-22 What is cross-sectional analysis of a firm’s operations?

3-23 How do time series and cross-sectional analyses differ, and what information would you expect to gain from each?

3.9 ∙

Cautions in Using Ratios to Evaluate

Firm Performance

Financial statement analysis allows managers, analysts, and investors to bet-ter understand a firm’s performance. However, data from financial statements should not be received without certain cautions. These include:

1. Financial statement data are historical. Historical data may not reflect

future performance. While we can make projections using historical data, we must also remember that projections may be inaccurate if historical performance does not persist.

2. As we discussed in Chapter 2, firms use different accounting procedures.

For example, inventory methods can vary. One firm may use FIFO (first-in, first-out), transferring inventory at the first purchase price, while another uses LIFO (last-in, first-out), transferring inventory at the last purchase price. Likewise, the depreciation method used to value a firm’s fixed assets over time may vary across firms. One firm may use straight-line depre-ciation, while another may use an accelerated depreciation method (e.g., MACRS). Particularly, when reviewing cross-sectional ratios, differences in accounting rules can affect balance sheet values and financial ratios. It is important to know which accounting rules the firms under consideration

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are using before making any conclusions about their performance from ratio analysis.

3. Similarly, a firm’s cross-sectional competitors may often be located around

the world. Financial statements for firms based outside the United States do not necessarily conform to GAAP. Even beyond inventory pricing and depreciation methods, different accounting standards and procedures make it hard to compare financial statements and ratios of firms based in different countries.

4. Sales and expenses vary throughout the year. Managers, analysts, and

investors need to note the timing of these fund flows when perform-ing cross-sectional analysis. Otherwise they may draw conclusions from comparisons that are actually the result of seasonal cash flow differences. Similarly, firms end their fiscal years at different dates. For cross-sectional analysis, this complicates any comparison of balance sheets during the year. Likewise, one-time events, such as a merger, may affect a firm’s financial performance. Cross-sectional analysis involving these events can result in misleading conclusions.

5. Large firms often have multiple divisions or business units engaged in

different lines of business. In this case, it is difficult to truly compare a set of firms with which managers and investors can perform cross-sectional analysis.

6. Firms often window dress their financial statements to make annual

results look better. For example, to improve liquidity ratios calculated with year-end balance sheets, firms often delay payments for raw materi-als, equipment, loans, and so on to build up their liquid accounts and thus their liquidity ratios. If possible, it is often more accurate to use something other than year-end financial statements to conduct ratio analysis.

7. Individual analysts may calculate ratios in modified forms. For example,

one analyst may calculate ratios using year-end balance sheet data, while another may use the average of the beginning- and end-of-year balance sheet data. If the firm’s balance sheet has changed significantly during the year, this difference in the way the ratio is calculated can cause large varia-tions in ratio values for a given period of analysis and large variavaria-tions in any conclusions drawn from these ratios regarding the financial health of the firm.

Financial statement ratio analysis is a major part of evaluating a firm’s perfor-mance. If managers, analysts, or investors ignore the issues noted here, they may well draw faulty conclusions from their analysis. However, used intelligently and with good judgment, ratio analysis can provide useful information on a firm’s current position and hint at future performance.

T I M E O U T

3-24 What cautions should managers and investors take when using ratio analysis to evaluate a firm?

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Personal Application Solution

To evaluate DPH Tree Farm, Inc.’s, financial statements, Chris Ryan would want to perform ratio analysis in which she uses the financial statements to calculate the most commonly used ratios. These include liquidity ratios, asset management ratios, debt management ratios, profitability ratios, and market value ratios. The value of these ratios for DPH Tree Farms and the tree farming industry are presented in Table 3.1 . Chris might also want to spread the financial statements. These calculations yield common-size, easily compared financial statements that can be used to identify changes in corporate performance as well as how DPH Tree Farm compares to other firms in the industry. Having calculated these ratios, Chris can identify any interrelationships in the ratios by performing a detailed analysis of ROA and ROE using the DuPont system of analysis. A critical part of performance analysis lies in the interpretation of these numbers against some benchmark. To interpret the financial ratios, Chris will also want to evaluate the performance of the firm over time (time series analysis) and the performance of the firm against one or more companies in the same industry (cross-sectional analysis). Finally, Chris needs to exercise some cautions when reviewing data from financial statements. For example, the financial statement data are historical and may not be representative of future performance. Further, she needs to know what accounting rules DPH Tree Farm uses before making any comparisons or conclusions about its performance from ratio analysis. Finally, DPH Tree Farm’s managers may have window dressed their financial statements to make them look better.

viewpoints

REVISITED

Business Application Solution

The managers of DPH Tree Farm, Inc., have stated that its performance surpasses that of other firms in the industry. Particularly strong are the firm’s liquidity and asset management positions. The superior performance in these areas has resulted in superior overall returns for the stockholders of DPH Tree Farm, Inc., according to DPH management. Having analyzed the financial statements using ratio analysis, we could conclude that these statements are partially true. All three liquidity ratios show that DPH Tree Farm holds more liquidity on its balance sheet than the industry average. Thus, DPH Tree Farm has more cash and other liquid assets (or current assets) available to pay its bills (or current liabilities) as they come due than the average firm in the tree farm industry. In all cases, the asset management ratios show that DPH Tree Farm, Inc., is outperforming the industry average in its asset management. The firm is turning over its inventory faster than the average firm in the tree farm industry, thus producing more dollars of sales per dollar of inventory. It is also collecting its accounts receivable faster and paying its accounts payable slower than the average firm. Further, DPH Tree Farm is producing more sales per dollar of fixed assets, working capital, and total assets than the average firm in the industry. The profitability ratios show that DPH Tree Farm, Inc., is more profitable than the average firm in the tree farm industry. The profit margin, BEP, and ROA are all higher than the industry. Despite this, the ROE for DPH Tree Farm is much lower than the average for the industry.

What the managers do not state is that the debt management ratios show that DPH Tree Farm, Inc., holds less debt on its balance sheet than the average firm in the tree farm industry. This is a good sign in that this lack of financial leverage decreases the firm’s potential for financial distress and even failure. If the firm has a bad year, it has promised relatively few payments to debt holders. Thus, the risk of bankruptcy is small. Further, the firm has more dollars of operating earnings and cash available to meet each dollar of interest obligations on the firm’s debt.