FIN 365 Business Finance

Topic 4: Analysis of Financial Statements

Larry Schrenk, Instructor
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Todays Outline
1.
2.
3.
4.

Project and Exam

The Ratios
DuPont Equation
Uses of Ratios

.Website:
D&B Key Business Ratios
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1. Course Project
Financial Analysis
Calculate Ratios
See Example for Specific Ratios

Perspective: Equity Investor

Analysis

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Three Traditional Ratios (Only)

One Custom Ratio
Use D&B Key Business Ratios
One Page

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1. Exam 1
Schedule
Next Class: Exam 1 Review (9/9)
Following Class: Exam 1 (9/12)

Format
10 short answer; 5 calculations
Only calculator
Coverage: Topics 1-4
Required ratios on Exam 1 Review Sheet
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2. The Ratios

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My Principles
1.
2.
3.
4.
5.
6.
7.

Consider the Perspective

Toolbox Approach
Annualization
Anomalies/Accounting Numbers
Red Flags
Customized Ratios
No Rules

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Classification
A. Short-Term Solvency (Liquidity). attempt to
measure the ability of a firm to meet its shortterm financial obligations
B. Long-Term Solvency (Leverage)
C. Efficiency. How efficient are we using the money
D. Profitability.
E. Market Value.
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A. Short-Term Solvency

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Short-Term Solvency: Analysis

Form
Measure of Short-Term C ash Inflow
Measure of Short-Term C ash Outflow

Purpose
Short-Term Liquidity
Can the Firm Meet Current Obligations?

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Short-Term Solvency: The Ratios

Cash Ratio

C ash
C urrent Liabilities
Quick Ratio. Cash and accounts receivable.

C urrent Assets - Inventory

C urrent Liabilities
Current Ratio. Cash, accounts receivable, and
inventory
C urrent Assets

C urrent Liabilities
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Liquidity Ratio Analysis

LiquidityAbility to Convert Assets to
Cash with Significant Loss of Value
Differing Time Horizons for Liquidity
Cash Ratio??? Immediately
Quick Ratio??? Depends on the firm .
Roughly less than three months
Current Ratio??? Depends on the firm

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A Custom Ratio Example

A New Coverage Ratio
C ash
Interest

Application? Can I Pay Interest?

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B. Long-Term Solvency

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Long-Term Solvency
Measures of the Long-Term Viability
of the Firm
Two Metrics
Degree of Leverage. How much debt. Means
Debt level
Coverage. Am I able to make my debt
payments.
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Long-Term Solvency:
Degree of Leverage Analysis

Form
Measure of Debt
Measure Asset Base

Purpose
Long-Term Liquidity
Is the Total Amount of Debt Reasonable?
Can the Firm Remain Solvent?
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Long-Term Solvency:
Degree of Leverage Ratios. Amount of total
debt. Same ratios but in different form.

Total Debt Ratio

Total Assets - Total Equity

Total Assets
Debt/Equity Ratio

Total Debt
Total Equity
Equity Multiplier

Total Assets
Total Equity
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T-P-S
Which of the following statements
is true?
1. From the total debt ratio, I can calculate
the debt/equity ratio?
2. From the debt/equity ratio, I can calculate
the equity multiplier?
3. From the equity multiplier, I can calculate
the total debt ratio?
4. All the above.
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Long-Term Solvency:
Coverage Analysis

Form
Measure of Short-Term C ash Inflow
Interest Payment

Purpose
Short-Term Liquidity
Can the Firm Service its Long-Term
Obligations?
Is Bankruptcy a Concern?
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Long-Term Solvency:
Coverage Ratios

Times Interest Earned (TIE)

EBIT
Interest

Cash Coverage. Depreciation is

not a cash flow.
EBIT + Depreciation
Interest
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C. Efficiency

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Efficiency: Analysis
Form
Sales (or other Benchmark)
Balance Sheet Asset

Purpose
How Efficiently does the Firm Use the
Value Invested in each Asset?
Balance Sheet Assets as Portfolio
Liquidity-Return Trade-Off

Turnover versus Days Sales

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Turnover Analysis
Sales as Goal
Total Asset Turnover RatioSales versus
a Dollar Spend on Total Assets

Example
Total Asset Turnover Ratio = 5x
$1.00 in Assets Generates $5.00 in Sales
on Average.
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Efficiency: The Inventory Ratios

Inventory Turnover
C OGS
Inventory

Days Sales in Inventory

365
Inventory Turnover
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Efficiency:
The Receivables Ratios

Receivables Turnover
Sales
Accounts Receivable

Days Sales in Receivables

365
Receivables Turnover
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Efficiency: The Asset Ratios

Total Asset Turnover
Sales
Total Assets

Fixed Asset Turnover

Sales
Fixed Assets
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Customized Efficiency
Ratios
Denominator
Any Balance Sheet Asset

Numerator
Any Firm Goal

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D. Profitability

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Profitability: Analysis
Form
Earnings C ash Flow
Asset Benchmark

Purpose
Is the Firm Generating Reasonable
Earnings Relative to
Total Assets
Equity

NOTE: Accounting Measures

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Profitability: The Ratios

Profit Margin

Net Income
Sales
Return on Assets (ROA)

Net Income
Total Assets
Return on Equity (ROE)

Net Income
Total Equity
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T-S-P
You are considering investing in the
bonds of a firm. Which ratio is the
most important for your decision:
1.
2.
3.
4.

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Current Ratio
Long-Term Debt Ratio
TIE Ratio
Cash Coverage Ratio

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E. Market Values

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Market Value: Analysis

No Common Form
No Common Purpose
Commonality: Market Data

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Market Value: Analysis

PE Ratio. Is the price of the share
over the earnings of the company
(on a per share basis).
Price per Share
Earnings per Share

Market-to-Book Ratio

Market Value per Share

Book Value per Share

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3. DuPont Equations

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DuPont Equations:
Analysis
Decomposition
Analysis, Not Calculation. Used
to analyze, decompose a
problem

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The DuPont Equation

Net Income
ROE =
Total Equity
Net Income
Sales
Total Assets
=

Sales
Total Assets Total Equity
=

Profit
Margin

Total Assets
Turnover

Profitability Effeciency
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Equity
Multiplier

Leverage
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Extending the DuPont Equation

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4. Using Ratios
Comparisons
Time-Trend Analysis. Look at how a specific
ratio has changed over time for a firm.
Firms Performance over Time

Peer Group Analysis.

Similar Companies or Industry Analysis
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Some Cautions
No Underlying Theory
Diversified Firms
Globalization. As firms are globalized and
compare with foreign markets more difficult
ratio analysis will be.
Varying Accounting Procedures. IFRS vs. GAAP
Different Fiscal Years
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