Key Concepts and Skills

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Key Concepts and Skills

After studying this chapter, you should be

able to:

– Standardize financial statements for

comparison purposes.

– Compute and, more importantly, interpret

some common ratios.

– Assess the determinants of a firm’s

profitability and growth.

– Identify and explain some of the problems and

pitfalls in financial statement analysis.

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Chapter Outline

3.1 Standardized Financial Statements

3.2 Ratio Analysis

3.3 The DuPont Identity

3.4 Internal and Sustainable Growth

3.5 Using Financial Statement Information

consent of McGraw-Hill Education.

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Standardized Financial Statements

• Common-Size Balance Sheets

– All accounts = percent of total assets (%TA)

• Common-Size Income Statements

– All line items = percent of sales or revenue

(%SLS)

• Standardized statements are useful for:

– Comparing financial information year-to-year

– Comparing companies of different sizes,

particularly within the same industry

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Prufrock Corporation

Balance Sheets: Table 3.1

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Prufrock Corporation

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Prufrock Corporation

Income Statement: Table 3.3

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Prufrock Corporation

Common-Size Income Statement: Table 3.4

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Ratio Analysis

• Allow for better comparison through

time or between companies

• Used both internally and externally

• For each ratio, ask yourself:

– What the ratio is trying to measure

– Why that information is important

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Categories of Financial Ratios

• Liquidity ratios or Short-term solvency

• Financial leverage ratios or Long-term

solvency ratios

• Asset management or Turnover ratios

• Profitability ratios

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Table 3.5

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Liquidity Ratios

• Current Ratio = CA / CL

– 708 / 548 = 1.29 times

• Quick Ratio = (CA – Inventory) / CL

– “Acid Test”

– (708-422) / 548 = 0.52 times

• Cash Ratio = Cash / CL

– 98/ 548 = .18 times

Liabilities & Owners Equity Sales $ 2,361

Current Liabilities COGS $ 1,344

98

$ Accounts Payable $ 344 Depreciation $ 276 188

$ Notes Payable $ 204 EBIT $ 741

422

$ Total $ 548 Interest $ 141

708

$ Long term debt $ 457 Taxable Income $ 600

Owners' Equity Taxes (21%) $ 126

Common Stock and paid in surplus$ 510 Net Income $ 474 Retained Earnings $ 2,115

2,922

$ Total $ 2,625 Dividends $ 158

3,630

$ Total Liabilties & Owners' Equity $ 3,630 Addition to RE $ 316

PRUFROCK Balance Sheet - 2019

PRUFROCK Income Statement - 2019

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Financial Leverage Ratios (1 of 2)

• Total Debt Ratio = (TA – TE) / TA

– (3,630 – 2,625) / 3, = 0.28 times

• Debt/Equity = TD / TE

– (0.28 / 0.72) = 0.38 times

• Equity Multiplier = TA/TE = 1 + D/E

– ($1 / 0.72) = (1 + 0.38) = 1.38

Liabilities & Owners Equity Sales $ 2,361

Current Liabilities COGS $ 1,344

98

$ Notes Payable $ 204 EBIT $ 741

422

$ Total $ 548 Interest $ 141

708

$ Long term debt $ 457 Taxable Income $ 600

Owners' Equity Taxes (21%) $ 126

Common Stock and paid in surplus$ 510 Net Income $ 474 Retained Earnings $ 2,115

2,922

$ Total $ 2,625 Dividends $ 158

3,630

$ Total Liabilties & Owners' Equity $ 3,630 Addition to RE $ 316

Balance Sheet - 2019 Income Statement - 2019

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Financial Leverage Ratios (2 of 2)

• Times Interest Earned = EBIT / Interest

– 741 / 141 = 5.26 times

• Cash Coverage = (EBIT + Depreciation) / Interest

– (741 + 276) / 141 = 7.21 times

Sales

$

2,361

COGS

$

1,344

Depreciation

$

276 EBIT

$

741 Interest

$

141 Taxable Income

$

600 Taxes (21%)

$

126 Net Income

$

474 Dividends

$

158 Addition to RE

$

474 Income Statement - 2019

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Asset Management:

Inventory Ratios

• Inventory Turnover = COGS / Inventory

– 1,344 / 422 = 3.18 times

• Days’ Sales in Inventory = 365 / Inventory Turnover

– 365 / 3.2 = 114.61 days

Current Ratio 1.29 Inventory Turnover 3.18 Quick Ratio 0.52 Days' Sales in Inventory 114.61 days Cash Ratio 0.18 Receivables Turnover 12.56

Days' Sales in Receivables 29.06 days

Financial Leverage Ratios Total Asset Turnover 0.65 Total Debt Ratio 0.28 Profitability Measures

Debt to Equity 0.38 Profit Margin 20.08% Equity Multiplier 1.38 ROA 13.06% ROE 18.06% Times Interest Earned 5.26 Market Value Measures

Cash Coverage 7.21 Market Price $ 115 Shares Outstanding 33 million EPS 14.36

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Asset Management:

Receivables Ratios

• Receivables Turnover = Sales / AR

– 2,361 / 188 = 12.56 times

• Days’ Sales in Receivables = 365 / Receivables Turnover

– 365 / 12.56 = 29.06 days

ASSETS Liabilities & Owners Equity Sales $ 2,361 Current Assets Current Liabilities COGS $ 1,344 Cash $ 98 Accounts Payable $ 344 Depreciation $ 276 Accounts Receivable $ 188 Notes Payable $ 204 EBIT $ 741 Inventory $ 422 Total $ 548 Interest $ 141 Total $ 708 Long term debt $ 457 Taxable Income $ 600 Owners' Equity Taxes (21%) $ 126 Common Stock and paid in surplus$ 510 Net Income $ 474 Fixed Assets Retained Earnings $ 2,115

Net Plant & Equipment $ 2,922 Total $ 2,625 Dividends $ 158 Total Asets $ 3,630 Total Liabilties & Owners' Equity $ 3,630 Addition to RE $ 316 Balance Sheet - 2019 Income Statement - 2019

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Asset Management:

Payables

Ratios

• Payables Turnover = COGS / AP

– 1,344 / 344 = 3.91 times

• Days’ Costs in Payables = 365 / Payables Turnover

– 365 / 3.91 = 93.42 days

ASSETS Liabilities & Owners Equity Sales $ 2,361

Current Assets Current Liabilities COGS $ 1,344

Cash $ 98 Accounts Payable $ 344 Depreciation $ 276 Accounts Receivable $ 188 Notes Payable $ 204 EBIT $ 741 Inventory $ 422 Total $ 548 Interest $ 141 Total $ 708 Long term debt $ 457 Taxable Income $ 600 Owners' Equity Taxes $ 126 Common Stock and paid in surplus$ 510 Net Income $ 474 Fixed Assets Retained Earnings $ 2,115

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Asset Management:

Asset Turnover Ratios

• Total Asset Turnover = Sales / Total Assets

– 2,361 / 3,630 = 0.66 times

• Capital Intensity Ratio = 1/TAT

– 1 / 0.65 = 1.54

Cash $ 98 Accounts Payable $ 344 Depreciation $ 276 Accounts Receivable $ 188 Notes Payable $ 204 EBIT $ 741 Inventory $ 422 Total $ 548 Interest $ 141 Total $ 708 Long term debt $ 457 Taxable Income $ 600 Owners' Equity Taxes (21%) $ 126 Common Stock and paid in surplus$ 510 Net Income $ 474 Fixed Assets Retained Earnings $ 2,115

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Profitability Ratios

• Profit Margin = NI / Sales

– 474 / 2,361 = 20.08%

• Return on Assets (ROA) = NI / TA

– 474 / 3,630 = 13.06%

• Return on Equity (ROE) = NI / TE

– 474 / 2,625 = 18.06%

Cash $ 98 Accounts Payable $ 344 Depreciation $ 276 Accounts Receivable $ 188 Notes Payable $ 204 EBIT $ 741 Inventory $ 422 Total $ 548 Interest $ 141 Total $ 708 Long term debt $ 457 Taxable Income $ 600 Owners' Equity Taxes (21%) $ 126 Common Stock and paid in surplus$ 510 Net Income $ 474 Fixed Assets Retained Earnings $ 2,115

Net Plant & Equipment $ 2,922 Total $ 2,625 Dividends $ 158 Total Asets $ 3,630 Total Liabilties & Owners' Equity $ 3,630 Addition to RE $ 316

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Market Value Ratios

• Market Price = $115 per share = PPS

• Shares outstanding = 33 million

• Earnings per Share = EPS = 474 / 33 = $14.36

• PE ratio = PPS / EPS

– $115 / $14.36 = 8.01 times

• Price/Sales ratio = PPS/Sales per share

– $115 / ($2,361 / 33) = 1.61 times

• Market-to-book ratio = PPS / Book value per share

– Book value per share = Total Equity/shares outstanding

= $2,625 / 33 = $79.55

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Market Value Ratios

EBITDA Ratio

• Enterprise value = Total market value of the stock

+ Book value of all liabilities

– Cash

– ($115 x 33) + (3,630 – 2,625) – (98) = 4,702

• EBITDA ratio = Enterprise value / EBITDA

– EBITDA = EBIT + Depreciation & Amortization

= (741 + 276) = 1,017

– EBITDA ratio = (4,702 / 1,017) = 4.62 times

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Prufrock Ratios

Liquidity Ratios Asset Management Ratios

Current Ratio 1.29 Inventory Turnover 3.18 Quick Ratio 0.52 Days' Sales in Inventory 114.61 days Cash Ratio 0.18 Receivables Turnover 12.56

Days' Sales in Receivables 29.06 days

Financial Leverage Ratios Total Asset Turnover 0.65

Total Debt Ratio 0.28 Profitability Measures

Debt to Equity 0.38 Profit Margin 20.08% Equity Multiplier 1.38 ROA 13.06%

ROE 18.06%

Times Interest Earned 5.26 Market Value Measures

Cash Coverage 7.21 Market Price $ 115 Shares Outstanding 33 million

EPS $14.36

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Table 3.6: Lowe’s versus Home

Depot

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The DuPont Identity

• ROE = NI / TE = Basic Formula

**• ROE = PM * TAT * EM = DuPont Identity**

– PM

= Net Income / Sales

– TAT

= Sales / Total Assets

– EM

= Total Assets / Total Equity

TE

NI

TE

TA

Sales

NI

ROE

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Using the DuPont Identity

**• ROE = PM * TAT * EM**

– Profit margin

• Measures firm’s operating efficiency

• How well does it control costs

– Total asset turnover

• Measures the firm’s asset use efficiency

• How well does it manage its assets

– Equity multiplier

• Measures the firm’s financial leverage

• EM = TA / TE = 1 + D/E ratio

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Prufrock’s DuPont Identity

• **ROE = PM * TAT * EM**

– PM = 20.08%

– TAT = 0.65

– EM = 1.38

• ROE = 0.2008 x 0.65 x 1.38

= 18.06%

Asset Management Ratios

Inventory Turnover 3.18 Days' Sales in Inventory 114.61 days Receivables Turnover 12.56 Days' Sales in Receivables 29.06 days Total Asset Turnover 0.65

Profitability Measures

Profit Margin 20.08%

ROA 13.06%

ROE 18.06%

Market Value Measures

Market Price $ 115 Shares Outstanding 33 million

EPS $ 14.36

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Internal & Sustainable Growth

Payout & Retention Ratios (1 of 3)

• Dividend payout ratio (“1 – b”) = DPS / EPS

= Cash dividends / Net income

• Retention ratio (“b”) = (EPS – DPS) / EPS

= (Addition to Retained Earnings) / Net income

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Internal & Sustainable Growth

Payout & Retention Ratios (2 of 3)

• Dividend payout ratio (“1 – b”) =

– Cash dividends / Net income (DIV / NI)

– 158 / 474 = 33.3%

Liabilities & Owners Equity Sales $ 2,361 Current Liabilities COGS $ 1,344 98

$ Notes Payable $ 204 EBIT $ 741 422

$ Total $ 548 Interest $ 141 708

$ Long term debt $ 457 Taxable Income $ 600 Owners' Equity Taxes (21%) $ 126 Common Stock and paid in surplus$ 510 Net Income $ 474 Retained Earnings $ 2,115

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Internal & Sustainable Growth

Payout & Retention Ratios (3 of 3)

• Retention ratio (“b”) = (NI – DIV) / NI

– Addition to Retained Earnings / Net income

– $316 / 474 = 66.7%

ASSETS Liabilities & Owners Equity Sales $ 2,311 Current Assets Current Liabilities COGS $ 1,344 Cash $ 98 Accounts Payable $ 344 Depreciation $ 276 Accounts Receivable $ 188 Notes Payable $ 204 EBIT $ 691 Inventory $ 422 Total $ 548 Interest $ 141 Total $ 708 Long term debt $ 457 Taxable Income $ 550 Owners' Equity Taxes $ 126 Common Stock and paid in surplus$ 510 Net Income $ 424 Fixed Assets Retained Earnings $ 2,115

Net Plant & Equipment $ 2,922 Total $ 2,625 Dividends $ 158 Total Asets $ 3,630 Total Liabilties & Owners' Equity $ 3,630 Addition to RE $ 316 Balance Sheet -2019 Income Statement - 2019

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The Internal Growth Rate

How much the firm can grow assets using

retained earnings as the only source of

financing?

Internal Growth Rate = ROA x b

1 - ROA x b

= .1306 x .667

1 - .1306 x .667

= 9.54%

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The Sustainable Growth Rate

How much the firm can grow by using

internally generated funds and issuing debt to

maintain a constant debt ratio?

Sustainable Growth Rate = ROE x b

1 - ROE x b

= .1806 x .667

1 - .1806 x .667

= 13.69%

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Determinants of Growth

• Profit margin – operating efficiency

• Total asset turnover – asset use

efficiency

• Financial leverage – choice of optimal

debt ratio

• Dividend policy – choice of how much

to pay to shareholders versus

reinvesting in the firm

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Table 3.7: Amazon versus

Alibaba

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Why Evaluate Financial

Statements?

• Internal uses

– Performance evaluation – compensation and

comparison between divisions

– Planning for the future – guide in estimating future

cash flows

• External uses

– Creditors

– Suppliers

– Customers

– Stockholders

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Benchmarking

• Ratios need to be compared to something

• Time-Trend Analysis

– How the firm’s performance is changing

through time

– Internal and external uses

• Peer Group Analysis

– Compare to similar companies or within

industries

– SIC and NAICS

codes (NAICS codes can be found

at

this link

)

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Problems with Financial Analysis

• Conglomerates

– No readily available comparables

• Global competitors

• Different accounting procedures

• Different fiscal year ends

• Differences in capital structure

• Seasonal variations and one-time events

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Example: Work the Web

• The Internet makes ratio analysis much easier

than it has been in the past

• Click on

this link

to go to

www.reuters.com

– Choose a company and enter its ticker symbol

– Click on “Financial Results” and “Key Ratios” to

compare the firm to its industry and the S&P 500 for

various ratio categories

– Change the ratio category using the links to the left of

the chart.

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Quick Quiz

• How do you standardize balance sheets and

income statements?

– Why is standardization useful?

(Slide 3.4)

• What are the major categories of ratios and how

do you compute specific ratios within each

category?

(Slide 3.11)

• What are the major determinants of a firm’s

growth potential?

(Slide 3.32)

• What are some of the problems associated with

financial statement analysis?

(Slide 3.36)

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