Chapter 4

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Chapter 4Analysis of Financial Statements

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Ratio Analysis Notes• When analyzing a firm, we compare

financial ratios rather than dollar figures to diminish the effects of differences in size (i.e., scale effects).

• Industry averages are arithmetic medians, rather than means, to remove the distorting effects of outlier values.

3Liquidity Ratios(MicroDrive p.124)

• Liquidity ratios measure the ability of to pay short-term debts.

• What is the current ratio for our firm?

• If the industry norm is 4.2, this is a(n) unfavorable comparison.

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• What is the quick ratio for our firm?


• While the current ratio assumes that all current assets will be converted into cash within a year, the quick ratio assumes that inventories are illiquid.

5Asset Management Ratios• Asset management ratios measure

how efficiently management is using its resources. These ratios are also known as efficiency or activity ratios.

• What is the inventory turnover ratio?


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• What is the fixed assets turnover ratio for our firm?

• If the industry norm is 3.0, this is a(n) favorable comparison.

• Caution: If the fixed assets are older than average, this will cause the FA Turnover ratio to be artificially high.

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• What is the total assets turnover ratio for our firm?


• Caution: If current assets are excessive, this will cause the TA Turn ratio to be artificially low.

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• What is the days sales outstanding (DSO) for our firm? (also known as the average collection period)

• If the industry norm is 36 days, this is a(n) unfavorable comparison.

• Caution: If a company has excess

inventories, it might be influenced to offer more lenient credit terms.

9Debt Management Ratios

• Debt management ratios measure the company’s use of outside (i.e., nonequity) financing. (also known as leverage ratios)

• What is the debt ratio for our firm?

• If the industry norm is 40%, this is a(n) unfavorable comparison.

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• What is the times interest earned (TIE) ratio for our firm?


• Note that the debt ratio focus is on the volume of debt, while the TIE focus is on ability to pay.

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• What is the EBITDA coverage ratio for our firm?

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• If the industry norm is 4.3, this is a(n) unfavorable comparison.• Like the TIE ratio, the EBITDA coverage

ratio measures ability to pay, but the EBITDA coverage ratio assumes that more categories of fixed payments must be met (not just interest expense)• The EBITDA coverage ratio also

assumes that payments are made out of cash profit, rather than book profit.

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Profitability Ratios

• Profitability ratios measure the overall performance of management. (also known as the bottom line)

• The profit margin measures profit per dollar of sales, and is:

• If the industry norm is 5.0%, this is a(n) unfavorable comparison.

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• The basic earning power ratio focus is on profit before financing costs, and is:


• Note: EBIT is also known as operating profit.

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• What is the return on total assets ratio (ROA) for our firm?


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• What is the return on equity ratio (ROE) for our firm?

• If the industry norm is 15.0%, this is a(n) unfavorable comparison?

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Market Value Ratios

• Market value ratios measure the market’s perception of the quality of the firm.

• What is the price earnings ratio (P/E) for our firm?


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• Caution: If a firm’s profitability is low, it will cause the P/E ratio to be artificially high.

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• What is the price to cash flow ratio (P/CF) for our firm?


• Caution: If a firm is undergoing rapid expansion, its high depreciation charges will cause the P/CF ratio to be artificially low.

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• What is the market to book ratio (M/B) for our firm?


• Note: Of the three market value ratios, the M/B is least subject to distortion.

21Methods of Comparisons

• Comparing a firm’s ratios to its industry averages is called cross-sectional analysis or benchmarking.

• Observing how a firm’s ratios change over time is called time series analysis or trend analysis.

• A third approach is comparison to another firm of comparable size in the same industry.

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Du Pont Analysis• The Du Pont analysis refers to two

formulas that show how selected ratios are linked to each other.

• What are its components?

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•What are the Du Pont values for our firm?

• The analysis indicates that insufficient volume is our firm’s greatest weakness, followed by cost control.

24A broader example of how ratios are inter-connected

• What would be our revised balance sheet if we reduce DSO to 36 days, and use the additional cash to reduce short-term debt?

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• The excess cash was used to reduce debt. It also could have been used to:- increase dividends- repurchase stock (tax treatment)- expand business (future profit)

• Note: Inventories also too high. If inventories are reduced, cash balances will increase. (Same effect as reducing receivables.)

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Limitations of Ratio Analysis

• Ratio comparisons are less valid if your firm or the industry average firm operate in multiple industries.

• The industry average may not be a(n) optimal goal.

• Balance sheet values are based on historical costs and may not reflect market values.

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• Ratio comparisons may be less valid if your company’s fiscal year and the fiscal year for the industry average firm are different.

• Management has considerable latitude in its ability to manipulate reported profits in the short-run.

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• Ratio comparisons in seasonal industries may be more distorted by the fact that the firms tend to close their books during the least active part of the season, when working capital items are typically lower.

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• Variations in how the cost of items sold are recognized may further distort ratio comparisons. • In an inflationary environment,

companies that use FIFO (rather than LIFO) will report a lower cost of goods sold and a higher reported profit.

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• There is typically a trade-off between risk and return. While a high current ratio reflects greater liquidity, it also tends to result in lower profitability.

• Profitability ratios are measures of book profit, and do not reflect the effect on shareholder wealth. A firm’s profits could be above average, and the stock price still fall if the reported profits are less than the market was expecting.

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Independent Reading• What is the difference between the

IASB and the FASB? (p. 131)• What are a common-size balance sheet

and a common-size income statement? (p. 137-139)• Is a company in a safer if (p.144-145):

- the bulk of its revenues are tied to one customer or many customers?- it has a larger % of its business generated overseas or domestically?

Chapter 4

Economy & Finance

Transcript of Chapter 4