CHAPTER 17: FINANCIAL STATEMENT AND RATIO ANALYSIS

A. OVERVIEW

Definition: A ratio is simply a numerator divided by a denominator

• Percentage (e.g. earnings as a % of sales revenue)
• Times (e.g. asset as xx times of debt)
• Number of days for certain activities to be completed (e.g. inventory to be sold)

Definition: Ratio analysis refers to methods of calculating and interpreting financial ratios to assess a
firm’s performance

Question: Why is ratio analysis useful?

• Provide details for financial planning
• Put details into perspective
• Manage expectations (creditors and investors)

Types of ratio comparisons:

• Cross-sectional analysis
• Time-series analysis
• Combined (mixed)

Cross-sectional: Compares different firms’ financial ratios at the same time

– Benchmarking: relative to other firm(s) or the industrial average; check for deviations
– Caution: Large deviations as symptoms but inconclusive
– Example: Interested in average age of inventory
• What might have caused the firm to have an AAI so much lower than the industrial
average? Is it an indicator of “good” performance?

Avg. age of inventory,

2003 (AAI)
Caldwell manufacturing 24.7 days

Industry average 43.3 days

Time-series: Evaluate a firm’s financial performance over time

– Establish trends to assess the firm’s performance over time

Combined / mixed:
– Use both cross-sectional and time-series

Types of financial ratios:

1. Liquidity
2. Activity
3. Leverage
4. Profitability

Note: When commenting on the performance of a firm, be sure to

• organize your ideas by these four types of ratios
• compare these ratios of the firm over time
• compare with the industrial averages
B. ANALYZING LIQUIDITY

Definition: Liquidity measures a firm’s ability to satisfy its short-term obligations as they come due
• Can the firm pay its bills?

Types of ratios used for analyzing liquidity (See Tables 3.3 and 3.4 for examples):
1. Net working capital (not a ratio)
2. Current ratio
3. Quick ratio (acid test)

1. NET WORKING CAPITAL: Dollar amount of current assets exceeds / falls short of current liabilities

Net working capital = Current assets – current liabilities

Example: Net working capital = $1,223,000-$620,000 = $603,000

Interpretation: Current assets exceed current liabilities by $603,000 at the end of 2002.
• Working capital: usually refers to current assets only
• Cash component: does not earn a return! So, too large a number does not necessarily imply a
“good” performance

Note: Not a useful measure for comparing among firms. Why?

• Nature of activities is different
• Size of operation is different
2. CURRENT RATIO: Size of current assets relative to current liabilities

Current ratio = Current asset / Current liabilities

Example: Current ratio = $1,223,000/$620,000 = 1.97

Interpretation: For each dollar the firm owes (short-term liabilities), the firm has $1.97 in its asset.

Rule of thumb: current ratio=2, but if cash flow is predictable, a lower current ratio is acceptable

Twist: % of current assets that can be reduced such that the firm can still cover its short-term
obligations as they come due

Example: (1-1/1.97) * 100% = 49.24

Interpretation: The firm can reduce its current asset by 49.24% and still be able to meet its short-term
obligations

Question: What would be the net working capital when current ratio=1?

3. QUICK RATIO (ACID-TEST): Size of most liquid current assets relative to current liabilities

Quick ratio = (Cash + marketable securities + accounts receivable) / Current liabilities

Note: Inventories excluded

• Inventories generally take longer to sell, often at discounted prices
• Inventories may be accounts receivable before they can be turned into cash

Example: Quick ratio = ($363,000 + $68,000 + $503,000) / $620,000 = 1.51

Rule of thumb: quick ratio=1

Note: Quick ratio vs. current ratio: depends on how liquid are the inventories

Final remarks
• Higher ratios Æ firm is in a more liquid position
• Trade-off between liquidity (risk) and profitability
– Higher ratio Æ lower current liabilities, less costly than long-term financing (lower risk)
– Higher ratio Æ larger current assets, less profitable than fixed assets (lower return

C. ANALYZING ACTIVITY
Definition: Activity ratios measure the firm’s effectiveness at managing accounts receivable, inventory,
accounts payable, fixed assets, and total assets

Supplement to liquidity ratios: focus on the composition of current assets

Four ratios:
1. Average age of inventory
2. Average collection period
3. Average payment period
4. Fixed and total asset turnover
1. AVERAGE AGE OF INVENTORY
• Average time inventory is held by the firm (unsold)

Average age of inventory = Inventory / daily cost of goods sold (COGS)

= Inventory / (COGS/365)

Example: Average age of inventory = $289,000 / ($2,088,000 / 365 days) = 50.7 days

Interpretation: The firm takes, on average, 50.7 days to sell an “average” item of its inventory

Note: Importance of benchmarking against other firms in the same industry

• Too high: Risk of not being able to sell inventory
• Too low: Under-investment in inventory

2. AVERAGE COLLECTION PERIOD

• Average time taken to collect accounts receivable

Avg. collection period = Accts rec’ble / avg. daily sales

= Accts rec’ble / (Annual sales/365)

Example: Avg. collection period = $503,000 / ($3,074,000 / 365 days) = 59.7 days

Interpretation: The firm takes, on average, 59.7 days to collect accounts receivable

Note: Important to compare with terms of credit

3. AVERAGE PAYMENT PERIOD

• Average time taken to pay its purchases

Avg. payment period = Accts payable / avg. daily purchase

= Accts payable / (% COGS/365)

Example: Suppose the firm purchases 70% of its COGS. Avg. payment period = $382,000 /
(0.7*$2,088,000 / 365 days) = 95.4 days

Interpretation: The firm takes, on average, 95.4 days to pay

Note: Important to compare with terms of credit given by creditors

4. FIXED AND TOTAL ASSET TURNOVER
• Efficiency with which the firm uses its net fixed assets to generate sales

Fixed asset turnover = Sales / Net fixed assets

Total asset turnover = Sales / Total assets

Example:
Fixed asset turnover = $3,074,000 / $2,374,000 = 1.29
Total asset turnover = $3,074,000 / $3,597,000 = 0.85

Interpretation: Every dollar of fixed asset generates $1.29 sales; every dollar of asset (total) generates
$0.85 sales

Question: High fixed asset turnover and low total asset turnover Æ low fixed-to-current assets. Why?

D. ANALYZING LEVERAGE
Definition: Amount of debt used in an attempt to maximize shareholders’ wealth

Two types:
– Capitalization ratios: How a firm has financed its investment
• Debt ratio
• Debt/Equity ratio

– Coverage ratios: Assess the firm’s ability to service the source of financing (payment debt,
interest, leases, dividend payments i.e., fixed financial charges)
• Times interest earned ratio
• Fixed-charge coverage ratio

Capitalization ratios
1. DEBT RATIO
• Proportion of total assets financed by creditors

Debt ratio = Total liabilities / Total assets

Example: Debt ratio = $1,643,000 / $3,597,000 = 0.457 (45.7%)

Interpretation: 45.7% of assets have been financed by debt

Related ratios:
– Preferred equity ratio
– Common equity ratio

1b. PREFERRED EQUITY RATIO

• Proportion of total assets financed by preferred shareholders

Preferred equity ratio = Preferred shares / Total assets

Example Preferred equity ratio = $200,000 / $3,597,000 = 0.056 (5.6%)

1c. COMMON EQUITY RATIO

• Proportion of total assets financed by common shareholders

Common equity ratio = Common shares / Total assets

Example Common equity ratio = $1,754,000 / $3,597,000 = 0.488 (48.8%)

Note: Common equity includes retained earnings

Note: Debt ratio + preferred equity ratio + common equity ratio = 100%. Why?

2. DEBT / EQUITY RATIO

• Proportion of long-term debt to common equity

Debt / Equity ratio = Long-term debt / Common equity

Example Debt/Equity ratio = $1,023,000 / $1,754,000 = 0.583 (58.3%)

Interpretation: For every dollar of common equity financing, the firm uses $0.583 of long-term debt

Suggested maximum: 100%

Coverage ratios
1. TIMES INTEREST EARNED (INTEREST COVERAGE) RATIO
• Firm’s ability to pay contractual interest
• The higher is the ratio, the more capable is the firm to pay

Interest coverage ratio = Earnings before interest and taxes (EBIT) / Interest

Example Interest coverage ratio = $418,000 / $93,000 = 4.49

Interpretation: For every dollar of interest, the firm has $4.49 of operating earnings available to pay

Rule of thumb: 3 to 5
Twist: (1 - 1/interest coverage ratio)*100%

Example: (1-1/4.49)*100% = 78%

Interpretation: The firm can shrink its earnings by 78% and still be able to pay its contractual interest
payment

Question: Suppose a firm has times interest earned ratio of 28.63 but the industry’s average is 12.31.
Why might the company’s ratio be so much higher than the industry average?
• Little debt
• Lower risk (Æ financial leverage and lower return)

2. FIXED-CHARGE COVERAGE RATIO

• Firm’s ability to pay fixed charges
• The higher is the ratio, the more capable is the firm to pay
• 4 types of fixed financial charges
– Interest on debt
– Principal repayment on debt
– Lease payment
– Preferred-share dividend payments

Example A firm has EBIT: $418,000 with lease payments of $35,000 and interest payment of $93,000.
Principal payments are $71,000. Preferred share dividends are $10,000. Find fixed-charge coverage
ratio.

Interpretation: For every dollar of fixed financial charges, the firm has $1.87 available to make the
payment

Note: The lower the ratio, the higher the risk to lenders and owners (harder for firm to pay fixed
charges)

E. ANALYZING PROFITABILITY
• Concerned with evaluating a firm’s earnings with respect to a given level of sales / assets / owners’
investment or share value

1. Common-size income statements

2. Return on total assets (ROA)
3. Return on equity (ROE)
4. Earnings per share (EPS)
5. Price/Earning (P/E) ratio

1. COMMON-SIZE INCOME STATEMENT

• Express every item on the income statement as a % of sales
– Gross margin
– Operating margin
– Profit margin
 • Gross margin: % of each sales dollar remaining after the firm has paid the direct COGS
• Operating margin: % of each sales dollar remaining after the firm has paid all expenses
(excluding financing expenses and taxes)
• Profit margin: % of each sales dollar remaining after the firm has paid all expenses (including
interest and taxes)

2. RETURN OF TOTAL ASSETS (ROA)

• Return on investment (ROI)
• Effectiveness in generating profits with its available assets
• The higher the better

ROA = Net income after taxes / Total assets

Example ROI = $231,000 / $3,597,000 = 0.064 (6.4%)

Interpretation: For every $100 of assets, the firm has a return of $6.4.

3. RETURN ON EQUITY (ROE)

• Return on owners’ equity
• The higher the better

ROE = Earnings available for common shareholders / Common equity

Example: ROE = $221,000 / $1,754,000 = 0.126 (12.6%)

Interpretation: For every $100 of common equity financing, the firm generates $12.6.

4. EARNINGS PER SHARE (EPS)

• Dollar amount earned on behalf of each common share
• The higher the better
EPS = Earnings available for common shareholders / Number of common shares outstanding

Example: EPS = $221,000 / 76,262 = $2.90

Interpretation: Earnings are $2.90 per share

5. PRICE/EARNING (P/E) RATIO

• Amount investors are willing to pay for each dollar of earnings
• Indicates investors’ confidence

P/E = Market price per share / Earnings per share

Example: Suppose market price is $32.25 per share. P/E = $32.25 / $2.90 = $11.12 per share

Interpretation: Investors are paying $11.2 for each $1 of earnings for each share
F. COMPLETE RATIO ANALYSIS
1. DuPont System : Diagnostic
2. Summary analysis : Consider all aspects

1. DUPONT SYSTEM
• System used by management to dissect the firm’s financial statements and to assess the firm’s
financial conditions
• Merge income statement with balance sheet information
• Focus on
– ROA
– ROE

2. SUMMARY ANALYSIS
• Tabulate all ratios discussed earlier
– Liquidity
– Activity
– Leverage
– Profitability
• Combining cross-sectional with time-series analyses