FINANCIAL STATEMENT ANALYSIS
Financial analysis is first covered followed by long-term financial planning, and
finally, working capital management and short-term financing. Up until now, the
management of short-term assets and short-term financing has not received much
attention. Working capital greases the skids for the efficient utilization of capital
assets that produce value. Too little working capital (current assets) and production
and sales are hindered; too much working capital and the rate of return on capital
diminishes. Working capital is justified as long as the incremental rate of return of
an added dollar invested in working capital exceeds the opportunity cost of capital.
We start our planning section with a chapter on financial statement analysis. This
chapter categorizes the scope of financial ratio analysis into five areas: (1) leverage,
(2) liquidity, (3) efficiency or turnover, (4) profitability, and (5) market value. Several
ratios are covered for each area, including an explanation of why the ratio is a good
proxy for the concept
11. FINANCIAL RATIOS
A. Financial ratios are used to summarize financial information about a company.
Information from the income statement, a listing of revenue, expenses, and
profits over a period of time, and the balance sheet, a listing of assets, liabilities,
and net worth at a point in time, are used to calculate financial ratios related to the
performance and risk level of a business.
B. A balance sheet and income statement are often calculated as common-size
statements by dividing the balance sheet ledger items by total assets, and income
statement items by total revenue.
C. Five types of risk-return areas are studied in this chapter, using financial
ratios as proxies to measure each risk.
Leverage Ratios
A. The use of fixed cost financing, either debt or preferred stock, is called
financial leverage. Financial leverage presents a risk-return opportunity.
Shareholders may magnify their earnings, or returns, by the use of fixed cost
financing but, on the other hand, debt is a fixed cost, contractual commitment to
pay regardless of the asset earning rate.
B. Creditors, owners, and suppliers are interested in the extent to which a firm
has used debt financing because the more debt a company has, everything else
being equal, the greater the chance it will not be able to pay the interest and repay
the debt.
C. Leverage ratios are two types: balance sheet ratios comparing leverage capital to
total capital or total assets, and coverage ratios that measure the earnings or cash-
flow times coverage of fixed cost obligations.
D. The analyst must decide what to consider as debt, or fixed cost financing. This
would include capital leases and may also include operating leases, especially when
they involve significant amounts of money. Wherever a reference is made to debt,
think of fixed cost financing.
E. The long-term debt ratio measures the proportion of the capital structure or
total capitalization that is made up of debt and lease obligations:
Long-term debt ratio = long term debt
Long term debt + Equity
The higher is the ratio, the greater the use of financial leverage, posing an
increased risk-return situation for investors.
F. No standard definition of "long-term debt" exists. Generally, one looks for
interest-bearing obligations that must be repaid. Often the current portion of long-
term debt is included as part of
long-term debt. Capital leases (on-balance sheet financing), operating leases (off-
balance sheet financing) and other debt equivalents can be included, especially if
the amounts owed are material. Preferred shares are also long-term fixed
obligations and may be included with long-term debt.
G. The debt-to-equity ratio measures the amount of long-term debt to equity or
the amount of leverage capital in relation to the equity cushion under the debt:
Debt-equity ratio = long term debt + value of leases
Equity
H. The total debt ratio measures total liabilities, current and long-term, relative to
total assets or the proportion of assets financed by debt:
Total debt ratio = Total Liabilities
Total Assets
I. A coverage ratio, such as the times interest earned ratio, measures an
amount available relative to amount owed. How many times is the obligation
covered?
Times interest earned = EBIT
Interest Expense
J. The cash coverage ratio broadens the numerator to cash flow from operations
relative to the interest expenses:
Cash coverage ratio = EBIT + Depreciation
Interest Expense
K. Fixed charge coverage ratios are even broader. One may include principal
payments necessary per period, on a before-tax basis, in the denominator to assess
the ability of operating earnings to cover the total debt obligation of principal and
interest. Other obligations that may be useful to include are dividend payments on
preferred equity and any sinking fund obligations. Remember, though, these are all
paid out of after-tax cash flow and should be converted to a before-tax amount by
dividing by (1 – tax rate).
Liquidity Ratios
A. Liquidity ratios attempt to measure the ability to pay obligations such as
current liabilities and assess the pool of assets available to cover the obligations.
Liquidity is the ability of an asset to be converted to cash quickly at low cost.
Converting an asset into cash occurs in one of two ways: sell the asset, hoping it
has reasonable liquidity, or in the case of a financial asset, like accounts receivable
or Treasury bill, maturity brings cash. Working capital circulates from inventory to
accounts receivable to cash, etc. Accounting value estimates of liquid assets are
reasonable estimates of their value.
B. Current assets (the pool of circulating cash assets available to be allocated to
pay bills) minus current liabilities (the pool of obligations the business must pay in
the near future) is an analytical amount called net working capital (NWC). NWC is a
rough measure of the current assets left over if the current liabilities were paid. The
NWC to total assets ratio estimates the proportion of assets in net current assets,
another name for NWC:
Net working capital/total asset ratio = Net Working Capital
Total Assests
C. The current ratio is the classic liquidity ratio, but is merely a variation of the
idea above—what pool of circulating assets is available relative to the pool of
current obligations:
Current ratio = Current Assest
Current Liabilities
D. Continuing the theme of assets available to pay obligations, the quick or acid-
test ratio eliminates inventories, the least liquid current asset, from current assets:
Quick ratio = cash + marketable securities + accounts receivable
Current Liabilities
E. The cash ratio eliminates inventories and accounts receivable from current
assets to review the cash assets relative to the current liabilities:
Cash ratio = Cash + Marketable Securities
Current Liabilities
F. The interval measure of liquidity measures the firm’s pool of liquid, quick
assets relative to the daily expenditures from operations and gives an estimate of
the number of days’ obligations that are circulating in the quick assets. The more
days, the greater the ability to meet obligations:
Interval measure = cash + marketable securities + accounts receivable
Average daily expenses from
operations
The denominator represents annual cash (not depreciation) expenses divided by
365.
Efficiency Ratios
A. Another area of financial analysis, efficiency ratios, measures how effectively
the business is using its assets. “Using” relates to liquidity or profitability or
performance. The numerators used in efficiency ratios are activity-based items,
such as sales, cost of sales, etc., while the denominators are generally some
balance sheet amount. Turnover ratios are often converted to a time-line focus by
dividing turnover ratios into 365 days.
B. In a typical efficiency ratio, "flow" data from the income statement is
measured against a "stock" (snapshot) data from the balance sheet, creating the
possibility of distortion from timing differences. For example, a rapidly growing
company's total assets at the end of the year will likely be substantially larger than
its assets at the start of the year. If sales are measured over the entire year, then
the end-of-year assets will be "too" high. Analysts deal with this problem several
ways. One way is to use average assets (average of the assets at the end of the
current year and the assets at the end of the previous year), rather than end-of-year
assets. A second way is to change the sales measure to cover a period closer to
end of the year, say take 12 times the sales during the last month of the year. This
won't work if the company's sales are markedly seasonal. For the purpose of making
the presentation simple, we have chosen to define the activity ratios using end-of-
year balance sheet items. Instructors may wish to define the ratios using averages
balance sheet items.
C. The asset turnover ratio measures the sales activity derived from total
assets, or the revenue generated per dollar of total assets. The asset turnover is
also an important component of asset profitability studied later, measuring the
revenue per dollar invested:
Asset turnover ratio = Sales
Total Assets
Sales, a measure of activity, may be compared to a variety of balance sheet
accounts (e.g. fixed assets, net working capital, shareholders’ equity, etc.) to
measure the revenue-generating efficiency of the account.
D. The asset turnover ratio based on average total assets (average of total
assets at the end of the current year and the total assets at the end of the previous
year) is
Asset turnover ratio = Sales
Average Total Assets
E. The inventory turnover ratio, using the cost of goods sold representing the
cumulative amount of inventory sold in a period as the numerator and end of year
inventory as the denominator, measures the number of times the value of inventory
turns over in a period:
Inventory turnover = Cost of Good Sold
Inventory
The inventory turnover may be converted to a time line concept, the number of day
sales in inventories, by finding the reciprocal (1/x) of the inventory turnover times
365 or:
Days’ sales in inventories = Inventory
Cost of Good Sold/365
= 1 x 365
Inventory Turnover
F. The average collection period applies the same concept above to accounts
receivable. The average collection period is the estimated number of days it takes
to collect accounts receivable:
Average collection period = receivables
Average Days Sales
= Receivables
Sales/365
The more days’ sales outstanding, the greater amount of capital is tied up in
accounts receivable relative to sales.
Profitability Ratios
A. Profitability refers to some measure of profit relative to revenue or an amount
invested. A profit margin is the ratio of some measure of profits or earnings to sales
and tells how much was earned per dollar of revenue. Profit or return ratios
compares some measure of profit to an amount invested.
B. There are as many definitions of profit margin as there are ways to measure
profit. We look at a few of the more commonly used margins.
C. A commonly used definition of the net profit margin is net income/sales. It
measures the proportion of revenues that finds its way to shareholders' net income.
D. The net profit margin is affected by the firm's capital structure. A company
with a lot of debt will tend to have a higher net profit margin than one with little
debt even when their operating performance is similar. The net profit margin is not
useful to compare operating performance of companies with different capital
structures.
E. The operating profit margin is a more appropriate measure of operating
performance than the net profit margin. It is the ratio of net income and interest to
sales, capturing payments to both lenders and shareholders. The operating profit
margin is less affected by the capital structure choice of the company
operating profit margin = Net Income + Interest
Sales
F. An equivalent expression for operating profit margin can be found by
rearranging the expression for net income. From the income statement we see that
net income = EBIT - taxes - interest
This allows us to write:
net income + interest = EBIT - taxes
Thus the operating profit margin can be expressed as:
operating profit margin = EBIT-Taxes
Sales
EBIT - taxes is often referred to as operating profit.
G. A word of warning: if the company has other income or losses that are not
directly related to operating activities, these will be added or subtracted to
determine to net income. In this case, operating profit (EBIT-taxes) will not add up to
net income + interest.
H. A commonly used performance ratio is the return on total assets, ROA.
Return on assets, ROA = Net Income
Total Assets
I. The return on assets is affected by the firm's financing choice as well as its
operating decisions. By including interest with net income, the operating return on
assets can be found:
Operating return on assets = Net Income + Interest
Total Assets
J. The operating return on assets ROA is still not fully adjusted for differences in
capital structure. To make a fairer comparison of the overall operating performance
of two companies that happen to have different capital structures, it is necessary to
remove the tax shield benefit. Recall that interest payments are tax deductible,
whereas dividends are not. A company with more debt has higher interest payments
and enjoys a greater tax benefit. To focus exclusively on the operating performance
of a company, remove the benefit from the financing decision by subtracting the
interest tax shield, or tax rate × interest payment:
Adjusted operating return on assets = net income + interest – interest tax
shield
Total
Assets
K. The return on invested capital, ROIC, is a refinement of the operating return
on assets. The main difference is the denominator: in the operating return on
assets, profit is measure relative to total assets which equals total liabilities plus
shareholders’ equity. In the ROIC, only invested capital, debt plus preferred equity
plus common equity, is put into the denominator. This focuses on the profit relative
to funds that have been invested by suppliers of capital:
Return on invested capital, ROIC = Net Income + interest
Short and long term debt +
preferred and common equity
Again, to completely remove the impact of borrowing, the interest tax shield
must be removed. This gives the following adjusted ROIC:
Return on invested capital, ROIC = Net Income + interest – interest tax
shield
Short and long term debt +
preferred and common equity
L. The return on equity, ROE measures the profitability of the common
shareholder’s equity or return per dollar of invested equity capital:
Return on equity, ROE = net income
Equity
If the company has preferred dividends, the ratio can be redefined as earnings
available for common shareholders, net income less any preferred dividends, to
common equity.
M. The proportion of earnings (or net income) that is paid out as dividends is
called the payout ratio:
Payout ratio = Dividends
Earnings
The complement of the payout ratio is the plowback ratio studied earlier, or the
proportion of earnings retained in the period:
Plowback ratio = 1 - payout ratio
= Earnings - Dividends
Earnings
= Earnings retained in period
Earnings
N. The plowback ratio times the return on equity (ROE) is an estimate of the
growth rate in common equity from internally generated earnings, or the
sustainable growth rate in assets that the business can support from internal
earnings without changing the total debt/total asset ratio:
Growth in equity from plowback = Earnings retained in period
Equity
= Earnings retained in period x
earnings
Earnings
equity
= plowback ratio × ROE
11.2 THE DUPONT SYSTEM
The DuPont System is a process of analyzing component ratios, (also called
decomposition) of the ROA and ROE to explain their level or changes.
The ROA is comprised of the product of the net profit margin, what the firm earns on
every dollar of sales, times the asset turnover or the extent to which a business
utilizes its assets:
Return on assets, ROA = Net Income
Total Assets
= sales × Net Income
Total Assets sales
= total asset turnover × net profit margin
Both the profit margin and asset turnover can be broken down in subcomponents
(decomposed) to assess the cause of the level or changes in the ROA. The ability to
earn on assets is comprised of expense control per sales (net profit margin) and the
effective use of assets to generate revenue (asset turnover). A level of ROA can be
generated or changed by affecting the margin or turnover.
The ROE is comprised of the ROA times the leverage ratio, or the ROE is related to
the effective, profitable use of assets, the extent of financial leverage, and the level
of interest rates paid on debt:
ROE = Net Income
Equity
= Assets × Sales × Net Income =
Assets × ROA
Equity Assets Sales
Equity
= leverage ratio × asset turnover × net profit margin = leverage ratio
× ROA
Other Important Financial Ratios
a. Some important financial ratios combine accounting information with market
data.
b. The market-to-book ratio compares the market value of equity to its book value.
If managers are successful at creating value for shareholders, the ratio should be
greater than 1.
c. The price-earnings ratio, price per share divided by earnings per share, and the
dividend yield, current dividends divided by share price, are also measure of how
highly valued is the company.
11.3 ANALYSIS OF THE STATEMENT OF CASH FLOWS
A. The cash flow statement can be used to calculate cash flow from assets, or
free cash flow. Start with cash flow from operating activities and add to it cash flow
from investing activities (likely a negative number) to get cash flow from assets.
B. Cash flow from assets must also equal the distributions to bondholders and
shareholders plus any increase in cash.
C. Ratios based on information from the cash flow statement are used. For example,
the ratio of free operating cash flow to total debt is another type of coverage ratio.
11.4 USING FINANCIAL RATIOS
Accounting Principles and Financial Ratios
A. Generally acceptable accounting principles have considerable leeway in
accounting for asset and liability values and income, so that it is often difficult to
make an absolute comparison of company ratio with other companies or the
industry ratios.
B. Goodwill is difficult to assess. Some commitments to pay, such as pensions,
lease obligations, and guarantees, are not always shown as a liability. Often
important information can be found in the footnotes to the financial statement.
Choosing a Benchmark
A. Knowing reasonable ranges for the above ratios calculated requires practice.
Useful information can be found through comparison of the trends over time, and
with the ratios of another business in the same industry or with averages of ratios
for several companies.
B. Industry ratios are available from a number of sources. See Table 17.9. Caution
students that industry ratios can be very misleading for several reasons. First, the
definitions of the industry ratios may be different than the ratios you calculate.
Second, variations in accounting practices may result in major differences in the
financial data. Third, the companies may differ in size and also may not be in the
exact same lines of business. Use industry ratios with caution.
C. Differences from averages or earlier trends do not necessarily indicate the
company is in trouble, but provides a beginning for understanding why the
differences or changes occurred.
11.5 MEASURING COMPANY PERFORMANCE
A. Companies that earn positive NPVs on their investments most likely will have
generated market value added, the extent to which market value of equity exceeds
the book value of equity.
B. Market value company performance indicators include:
1. Market-to-book ratio
2. Market value added (P)
3. Return on assets (%)
4. Economic value added (EVA) (P)
C. Market value performance measures have two disadvantages:
1. They are based on expectations that positive NPV projects will continue to be
made.
2. Market value-based indicators are difficult to estimate for privately held
companies.
D. Residual income or economic value added is calculated as after-tax operating
profit minus the dollar cost of invested capital. To measure the dollar cost of
invested capital, multiply the dollar amount of invested capital and the cost of
capital (WACC or required rate of return on the invested capital):
Residual income = after-tax operating profit - cost of capital × invested capital
E. Residual income or EVA is a better measure of company profits than
accounting profit. Accounting profits do not recognize the cost of capital or the
minimum return necessary to return shareholders their opportunity rate of
return.
11.6 THE ROLE OF FINANCIAL RATIOS
A. Financial ratios often serve as:
1. Goals representing optimal financial condition or performance.
2. Benchmarking comparisons with competitors or higher valued similar
companies.
3. Minimums below which the company hesitates to venture.