Ch. 4 –Analysis of Financial Statements
SALESSALES
- - EXPENSESEXPENSES
= PROFIT= PROFIT
Income Statement
SALESSALES
- - EXPENSESEXPENSES
= PROFIT= PROFIT
Income Statement
Revenue
Income Statement
SALESSALES
- - EXPENSESEXPENSES
= PROFIT= PROFIT
Income Statement
SALESSALES
- - EXPENSESEXPENSES
= PROFIT= PROFIT
•Cost of Goods Sold Cost of Goods Sold
Income Statement
SALESSALES
- - EXPENSESEXPENSES
= PROFIT= PROFIT
•Cost of Goods SoldCost of Goods Sold•Operating Expenses Operating Expenses
Income Statement
SALESSALES
- - EXPENSESEXPENSES
= PROFIT= PROFIT
•Cost of Goods SoldCost of Goods Sold•Operating ExpensesOperating Expenses (marketing, administrative)(marketing, administrative)
Income Statement
SALESSALES
- - EXPENSESEXPENSES
= PROFIT= PROFIT
•Cost of Goods SoldCost of Goods Sold•Operating ExpensesOperating Expenses (marketing, administrative)(marketing, administrative)•Financing CostsFinancing Costs
Income Statement
SALESSALES
- - EXPENSESEXPENSES
= PROFIT= PROFIT
•Cost of Goods SoldCost of Goods Sold•Operating ExpensesOperating Expenses (marketing, administrative)(marketing, administrative)•Financing CostsFinancing Costs•TaxesTaxes
SALESSALES
- - Cost of Goods SoldCost of Goods Sold
GROSS PROFITGROSS PROFIT
- - Operating ExpensesOperating Expenses
OPERATING INCOME (EBIT)OPERATING INCOME (EBIT)
- - Interest ExpenseInterest Expense
EARNINGS BEFORE TAXES (EBT)EARNINGS BEFORE TAXES (EBT)
- - Income TaxesIncome Taxes
NET INCOMENET INCOME
- - Preferred Stock DividendsPreferred Stock Dividends
- - NET INCOME AVAILABLENET INCOME AVAILABLE
TO COMMON STOCKHOLDERSTO COMMON STOCKHOLDERS
Income Statement
SALESSALES
- - Cost of Goods SoldCost of Goods Sold
GROSS PROFITGROSS PROFIT
- - Operating ExpensesOperating Expenses
OPERATING INCOMEOPERATING INCOME (EBIT)(EBIT)
- - Interest ExpenseInterest Expense
EARNINGS BEFORE TAXES (EBT)EARNINGS BEFORE TAXES (EBT)
- - Income TaxesIncome Taxes
NET INCOMENET INCOME
- - Preferred Stock DividendsPreferred Stock Dividends
- - NET INCOME AVAILABLENET INCOME AVAILABLE
TO COMMON STOCKHOLDERSTO COMMON STOCKHOLDERS
Income Statement
SALESSALES
- - Cost of Goods SoldCost of Goods Sold
GROSS PROFITGROSS PROFIT
- - Operating ExpensesOperating Expenses
OPERATING INCOME (EBIT)OPERATING INCOME (EBIT)
- - Interest ExpenseInterest Expense
EARNINGS BEFORE TAXES (EBT)EARNINGS BEFORE TAXES (EBT)
- - Income TaxesIncome Taxes
NET INCOMENET INCOME
- - Preferred Stock DividendsPreferred Stock Dividends
- NET INCOME AVAILABLE- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERSTO COMMON STOCKHOLDERS
Income Statement
Balance Sheet
Total Assets =Total Assets =
OutstandingOutstanding
DebtDebt
++
Shareholders’Shareholders’
EquityEquity
Balance Sheet
Balance SheetAssetsAssets
Balance SheetAssetsAssets Liabilities (Debt) & EquityLiabilities (Debt) & Equity
Balance SheetAssetsAssets Liabilities (Debt) & EquityLiabilities (Debt) & Equity
Current AssetsCurrent Assets CashCash
Marketable SecuritiesMarketable Securities
Accounts ReceivableAccounts Receivable
InventoriesInventories
Prepaid ExpensesPrepaid Expenses
Fixed AssetsFixed Assets Machinery & EquipmentMachinery & Equipment
Buildings and LandBuildings and Land
Other AssetsOther AssetsInvestments & patentsInvestments & patents
Current LiabilitiesCurrent Liabilities Accounts PayableAccounts Payable
Accrued ExpensesAccrued Expenses
Short-term notesShort-term notes
Long-Term LiabilitiesLong-Term LiabilitiesLong-term notes Long-term notes
MortgagesMortgages
EquityEquityPreferred Stock Preferred Stock
Common Stock (Par value)Common Stock (Par value)
Paid in CapitalPaid in Capital
Retained EarningsRetained Earnings
Financial Statement Analysis
Are our decisions maximizing Are our decisions maximizing shareholder wealth?shareholder wealth?
We will want to answer We will want to answer questions about the firm’squestions about the firm’s
LiquidityLiquidity Efficient use of AssetsEfficient use of Assets Leverage (financing)Leverage (financing) ProfitabilityProfitability
We will want to answer We will want to answer questions about the firm’squestions about the firm’s
LiquidityLiquidity Efficient use of AssetsEfficient use of Assets Leverage (financing)Leverage (financing) ProfitabilityProfitability
Financial Ratios
Tools that help us determine the Tools that help us determine the financial health of a company.financial health of a company.
We can compare a company’s We can compare a company’s financial ratios with its ratios in financial ratios with its ratios in previous years previous years (trend analysis)(trend analysis)..
We can compare a company’s We can compare a company’s financial ratios with those of its financial ratios with those of its industry.industry.
Example:CyberDragon Corporation
CyberDragon’s Balance Sheet ($000)
Assets:Assets: Liabilities & Equity:Liabilities & Equity: CashCash $2,540$2,540 Accounts payableAccounts payable 9,7219,721
Marketable securitiesMarketable securities 1,8001,800 Notes payable Notes payable 8,5008,500
Accounts receivableAccounts receivable 18,32018,320 Accrued taxes payableAccrued taxes payable 3,2003,200
InventoriesInventories 27,53027,530 Other current liabilitiesOther current liabilities 4,1024,102
Total current assetsTotal current assets 50,19050,190 Total current liabilitiesTotal current liabilities 25,52325,523
Plant and equipmentPlant and equipment 43,10043,100 Long-term debt (bonds)Long-term debt (bonds) 22,00022,000
less accum deprec.less accum deprec. 11,40011,400 Total liabilitiesTotal liabilities 47,52347,523
Net plant & equip.Net plant & equip. 31,70031,700 Common stock ($10 par)Common stock ($10 par) 13,00013,000
Total assetsTotal assets 81,89081,890 Paid in capital Paid in capital 10,00010,000
Retained earningsRetained earnings 11,36711,367
Total stockholders' equity Total stockholders' equity 34,36734,367
Total liabilities & equityTotal liabilities & equity 81,89081,890
Sales (all credit)Sales (all credit) $112,760$112,760
Cost of goods soldCost of goods sold (85,300)(85,300)
Gross profitGross profit 31,50031,500
Operating expenses:Operating expenses:
SellingSelling (6,540)(6,540)
General & administrativeGeneral & administrative (9,400)(9,400)
Total operating expensesTotal operating expenses (15,940)(15,940)
Earnings before interest and taxes (EBIT)Earnings before interest and taxes (EBIT) 11,52011,520
Interest charges:Interest charges:
Interest on bank notes:Interest on bank notes: (850)(850)
Interest on bonds:Interest on bonds: (2,310)(2,310)
Total interest chargesTotal interest charges ((3,160)3,160)
Earnings before taxes (EBT)Earnings before taxes (EBT) 8,6008,600
TaxesTaxes (3,344) (3,344)
Net IncomeNet Income 5,0165,016
CyberDragon’s Income Statement
CyberDragonOther Information
Dividends paid on common stockDividends paid on common stock$2,800$2,800
Earnings retained in the firmEarnings retained in the firm 2,2162,216
Shares outstanding (000)Shares outstanding (000) 1,3001,300
Market price per shareMarket price per share 2020
Book value per shareBook value per share 26.4426.44
Earnings per shareEarnings per share 3.863.86
Dividends per shareDividends per share 2.152.15
1. Liquidity Ratios
Do we have enough liquid assets Do we have enough liquid assets to meet approaching obligations?to meet approaching obligations?
What is CyberDragon’s Current Ratio?
What is CyberDragon’s Current Ratio?
50,19025,523 = 1.97
What is CyberDragon’s Current Ratio?
If the average current ratio for the If the average current ratio for the industry is industry is 2.42.4, is this good or not?, is this good or not?
50,19025,523 = 1.97
What is the firm’s Acid Test Ratio?
What is the firm’s Acid Test Ratio?
50,190 - 27,53025,523 = .89
What is the firm’s Acid Test Ratio?
Suppose the industry average is Suppose the industry average is .92.92..What does this tell us?What does this tell us?
50,190 - 27,53025,523 = .89
What is the firm’s Average Collection Period?
What is the firm’s Average Collection Period?
18,320112,760/365 = 59.3 days
What is the firm’s Average Collection Period?
If the industry average is If the industry average is 47 days47 days, , what does this tell us?what does this tell us?
18,320112,760/365 = 59.3 days
2. Operating Efficiency Ratios
Measure how efficiently the Measure how efficiently the firm’s assets generate operating firm’s assets generate operating profits.profits.
What is the firm’s Operating Income Return on Investment (OIROI)?
What is the firm’s Operating Income Return on Investment (OIROI)?
11,52081,890
= 14.07%
•Slightly below the industry Slightly below the industry average of average of 15%15%. .
What is the firm’s Operating Income Return on Investment (OIROI)?
11,52081,890
= 14.07%
•Slightly below the industry Slightly below the industry average of average of 15%15%. .
•The OIROI reflects product The OIROI reflects product pricing and the firm’s ability to pricing and the firm’s ability to
keep costs down.keep costs down.
What is the firm’s Operating Income Return on Investment (OIROI)?
11,52081,890
= 14.07%
What is their Operating Profit Margin?
What is their Operating Profit Margin?
11,520112,760 = 10.22%
What is their Operating Profit Margin?
•This is below the industry average of This is below the industry average of 12%12%..
11,520112,760 = 10.22%
What is their Total Asset Turnover?
What is their Total Asset Turnover?
112,76081,890 = 1.38 times
What is their Total Asset Turnover?
The industry average is The industry average is 1.82 times1.82 times. . The firm needs to figure out how to The firm needs to figure out how to squeeze more sales dollars out of its squeeze more sales dollars out of its
assets.assets.
112,76081,890 = 1.38 times
What is the firm’s Accounts Receivable Turnover?
What is the firm’s Accounts Receivable Turnover?
112,76018,320 = 6.16 times
What is the firm’s Accounts Receivable Turnover?
CyberDragon turns their A/R over CyberDragon turns their A/R over 6.166.16 times per year. The industry averagetimes per year. The industry average
is is 8.28.2 times. Is this efficient? times. Is this efficient?
112,76018,320 = 6.16 times
What is the firm’s Inventory Turnover?
What is the firm’s Inventory Turnover?
85,30027,530 = 3.10 times
What is the firm’s Inventory Turnover?
CyberDragon turns their inventory CyberDragon turns their inventory over 3.1 times per year. over 3.1 times per year.
The industry average is The industry average is 3.93.9 times. times. Is this efficient?Is this efficient?
85,30027,530 = 3.10 times
Low inventory turnover:
The firm may have too much The firm may have too much
inventory, which is expensive inventory, which is expensive
because:because:
Inventory takes up costly Inventory takes up costly
warehouse space.warehouse space.
Some items may become spoiled Some items may become spoiled
or obsolete.or obsolete.
What is the firm’s Fixed Asset Turnover?
What is the firm’s Fixed Asset Turnover?
112,76031,700 = 3.56 times
What is the firm’s Fixed Asset Turnover?
If the industry average is If the industry average is 4.64.6 times, what times, whatdoes this tell us about CyberDragon?does this tell us about CyberDragon?
112,76031,700 = 3.56 times
3. Leverage Ratios(financing decisions)
Measure the Measure the impact of using debt impact of using debt capitalcapital to finance assets. to finance assets.
Firms use debt to lever (increase) Firms use debt to lever (increase) returns on common equity.returns on common equity.
How does Leverage work?
Suppose we have an all equity-Suppose we have an all equity-financed firm worth $100,000. Its financed firm worth $100,000. Its earnings this year total $15,000.earnings this year total $15,000.
ROE =ROE =
(ignore taxes for this example)(ignore taxes for this example)
How does Leverage work?
Suppose we have an all equity-Suppose we have an all equity-financed firm worth $100,000. Its financed firm worth $100,000. Its earnings this year total $15,000.earnings this year total $15,000.
ROE = = 15%ROE = = 15%15,000100,000
How does Leverage work?
Suppose the same $100,000 firm is Suppose the same $100,000 firm is financed with half equity, and half financed with half equity, and half 8% debt (bonds). Earnings are still 8% debt (bonds). Earnings are still $15,000.$15,000.
ROE =ROE =
How does Leverage work?
Suppose the same $100,000 firm is Suppose the same $100,000 firm is financed with half equity, and half financed with half equity, and half 8% debt (bonds). Earnings are still 8% debt (bonds). Earnings are still $15,000.$15,000.
ROE =ROE = ==15,000 - 4,00050,000
How does Leverage work?
Suppose the same $100,000 firm is Suppose the same $100,000 firm is financed with half equity, and half financed with half equity, and half 8% debt (bonds). Earnings are still 8% debt (bonds). Earnings are still $15,000.$15,000.
ROE =ROE = = = 22%22%
15,000 - 4,00050,000
What is CyberDragon’s Debt Ratio?
What is CyberDragon’s Debt Ratio?
47,52381,890 = 58%
What is CyberDragon’s Debt Ratio?
If the industry average is If the industry average is 47%47%, what, whatdoes this tell us?does this tell us?
47,52381,890 = 58%
What is CyberDragon’s Debt Ratio?
47,52381,890 = 58%
If the industry average is If the industry average is 47%47%, what, whatdoes this tell us?does this tell us?
Can leverage make the firm Can leverage make the firm more more profitableprofitable??
Can leverage make the firm Can leverage make the firm riskierriskier??
What is the firm’s Times Interest Earned Ratio?
What is the firm’s Times Interest Earned Ratio?
11,5203,160 = 3.65 times
What is the firm’s Times Interest Earned Ratio?
The industry average is The industry average is 6.76.7 times. This times. This is further evidence that the firm usesis further evidence that the firm uses
more debt financing than average.more debt financing than average.
11,5203,160 = 3.65 times
4. Profitability
How well are the firm’s managers How well are the firm’s managers maximizing shareholder wealth?maximizing shareholder wealth?
What is CyberDragon’s Net Profit Margin?
5,016112760 = 4.45%
What is CyberDragon’sReturn on Equity (ROE)?
What is CyberDragon’sReturn on Equity (ROE)?
5,01534,367 = 14.6%
What is CyberDragon’sReturn on Equity (ROE)?
The industry average is The industry average is 17.54%17.54%..
5,01534,367 = 14.6%
What is CyberDragon’sReturn on Equity (ROE)?
5,01534,367 = 14.6%
The industry average is The industry average is 17.54%17.54%..Is this what we would expect, Is this what we would expect,
given the firm’s leverage?given the firm’s leverage?
Calculate the Price/Earnings, Price/Cash flow, and Market/Book ratios.
P/EP/E = Price / Earnings per share= Price / Earnings per share= 20/3.86 = 5.18= 20/3.86 = 5.18
P/E: How much investors are willing to pay for $1 of earnings.P/E: How much investors are willing to pay for $1 of earnings.
M/B = Market price / Book value per shareM/B = Market price / Book value per share= 20/26.44 = 0.76= 20/26.44 = 0.76
M/B: How much investors are willing to pay for $1 of book value equity.M/B: How much investors are willing to pay for $1 of book value equity.
The Du Pont system
)(TA/Equity (Sales/TA) (NI/Sales) ROE
multiplierEquity
turnoverassets Total margin
Profit ROE
= 4.45*1.38* 81890/34367 = 14.63%= 4.45*1.38* 81890/34367 = 14.63% Focuses on expense control (PM), asset utilization Focuses on expense control (PM), asset utilization
(TA TO), and debt utilization (Equity multiplier.)(TA TO), and debt utilization (Equity multiplier.)
Conclusion:
Even though CyberDragon has Even though CyberDragon has higher leverage than the industry higher leverage than the industry
average, they are average, they are much less much less efficientefficient, and therefore, less , and therefore, less
profitable.profitable.
Potential problems and limitations of financial ratio analysis
Comparison with industry averages is Comparison with industry averages is difficult for a conglomerate firm that difficult for a conglomerate firm that operates in many different divisions.operates in many different divisions.
““Average” performance is not necessarily Average” performance is not necessarily good, perhaps the firm should aim higher.good, perhaps the firm should aim higher.
Seasonal factors can distort ratios.Seasonal factors can distort ratios. ““Window dressing” techniques can make Window dressing” techniques can make
statements and ratios look better.statements and ratios look better.
More issues regarding ratios
Different operating and accounting Different operating and accounting practices can distort comparisons.practices can distort comparisons.
Sometimes it is hard to tell if a ratio is Sometimes it is hard to tell if a ratio is “good” or “bad”.“good” or “bad”.
Difficult to tell whether a company is, on Difficult to tell whether a company is, on balance, in strong or weak position.balance, in strong or weak position.
Qualitative factors to be considered when evaluating a company’s future financial performance Are the firm’s revenues tied to one key Are the firm’s revenues tied to one key
customer, product, or supplier?customer, product, or supplier? What percentage of the firm’s business is What percentage of the firm’s business is
generated overseas?generated overseas? CompetitionCompetition Future prospectsFuture prospects Legal and regulatory environmentLegal and regulatory environment