Fundamentals of Corporate Finance: Second Canadian Edition

17-1
Fundamentals
of Corporate
Finance
Second Canadian Edition
prepared by:
Carol Edwards
BA, MBA, CFA
Instructor, Finance
British Columbia Institute of Technology
copyright © 2003 McGraw Hill Ryerson Limited

17-2
Chapter 17
Financial Statement Analysis
Chapter Outline
 Financial Ratios
 The DuPont System
 Analysis of the Statement of Cash Flows
 Using Financial Ratios
 Measuring Company Performance
 The Role of Financial Ratios

17-3
Financial Ratios
• Introduction
 Public companies have a variety of
stakeholders:
 Shareholders,bondholders, bankers,
suppliers, employees, managers, etc.
 These stakeholders need to monitor how
well their interests are being served.
 They do so by analyzing the company’s
periodic financial statements.
17-4
Financial Ratios
• Introduction
 Analysts use financial ratios to
summarize large volumes of accounting
information.
 This allows them to assess the firm’s
overall performance and its current
financial standing.
 It also allows them to compare firm
performance.

17-5
Financial Ratios
• Introduction
 You will discover that many of the ratios
described in this chapter may be defined
in several different ways.
 Thereis no law stating how they should be
defined.
 Thus, you should never accept a ratio at
face value without understanding exactly
how it was calculated!
17-6
Financial Ratios
• Introduction
 This chapter will describe four types of
financial ratios:
1. Leverage ratios – show how heavily a
company is in debt.
2. Liquidity ratios – measure how easily a
firm can lay its hands on cash.
3. Efficiency or Turnover Ratios – measure
how productively a firm is using its assets.
4. Profitability Ratios – measure the firm’s
return on its investments.
17-7
Financial Ratios
• Warning!
 Before diving into the numbers, make
sure you do your homework first!
 You cannot understand a business simply by
reading its financial statements and
calculating a few numbers.
 You need to start by researching the industry,
and the firm itself, so that you can put the
results of your calculations into perspective.

17-8
Financial Ratios
• Income Statement
 The Income Statement summarizes the
firm’s revenues and expenses and shows
the difference between the two,which is
the firm’s profit.
 You can see the Income Statement for Le
Château (LC) in Table 17.1 on page 506

of your text.

17-9
Financial Ratios
• Income Statement
 Notice that 2000 was a poor year for LC.
 Can you see why it incurred losses?
 It is easier to see how a firm is performing if
you look at the common-size income
statement.
 This is an income statement which presents each of
the items as a percentage of revenues.
 A common-size income statement for LC is
shown in Table 17.2 on page 508.
17-10
Financial Ratios
• Balance Sheet
 A balance sheet is a financial statement that
shows the value of the firm’s assets and
liabilities at a particular time.
 Remember, a balance sheet shows assets at
book value, not market value!
 LC’s Balance Sheet is in Table 17.2 on page
509.
A common-size balance sheet, which shows
each of the items as a percent of total assets
may be seen in Table 17.4 on page 510.
17-11
Financial Ratios
• Leverage Ratios
 Leverage ratios show how much financial
leverage a firm is carrying.
 Financial leverage adds risk to the firm.
 That is, the higher the level of debt in the
firm, the greater the uncertainty about what
earnings (and eps) will be.
 Also the risk of default increases.
 There are several different types of

leverage ratios.
17-12
Financial Ratios
• Leverage Ratios
LT Debt + Value of Leases
Long Term Debt Ratio =
LT Debt + Value of Leases + Equity
LT Debt + Value of Leases

Debt-Equity Ratio =
Equity
Total Liabilities
Total Debt Ratio =
Total Assets

17-13
Financial Ratios
• Leverage Ratios
 The higher the leverage ratio, the greater
the financial leverage and the higher the
level of risk in a firm’s capital structure.
 Notice that these measures:
 Make use of book value not market value.
 Take account only of long-term debt.

17-14
Financial Ratios
• Leverage Ratios
EBIT
Times Interest Earned (TIE) =
Interest Payments
EBIT + Depreciation & Amortization

Cash Coverage Ratio =
Interest Payments
Fixed Charge Coverage Ratio =

EBIT + Depreciation & Amortization
Interest Pymts+(Current Debt Repymt+Current Lease Obligations)
(1 - Tax Rate)
17-15
Financial Ratios
• Leverage Ratios
 The TIE Ratio is a measure of the firm’s ability
to cover its interest payments with its earnings.
 Banks prefer to lend to firms with high TIE ratios
(earnings are far in excess of interest payments).
 The Cash Coverage Ratio recognizes that we
subtract depreciation and amortization when
calculating earnings.
 However, no cash goes out the door for these
expenses.
 This ratio asks if earnings plus non-cash charges
are sufficient to cover the interest payments.
17-16
Financial Ratios
• Leverage Ratios
 Interest is not the only cost a firm will have to
meet.
 There are also principal repayments on the debt and
preferred dividends.
 The Fixed Charge Coverage Ratio measures
the ability of the firm to cover its fixed charges
with its earnings.
 Since these payments are nontax-deductible
payments, you must convert them to a before-tax
basis by dividing by (1 – Corporate Tax Rate).

17-17
Financial Ratios
• Liquidity Ratios
 If you are making a short-term loan to a
company, you are not interested in their
leverage ratio, but in their ability to come-
up with the cash to repay you.
 Liquidity Ratios measure how much of
the company’s assets are liquid.
 Liquid
refers to an asset which can be
converted to cash quickly and at low cost.

17-18
Financial Ratios
Net Working Capital = Current Assets – Current Liabilities
Net Working Capital as a Net Working Capital

% of Total Assets =
Total Assets
Current Assets
Current Ratio =
Current Liabilities
Cash + Marketable Securities + Receivables

Quick Ratio* =
Current Liabilities
* Also known as the Acid Test Ratio
17-19
Financial Ratios
 Net Working Capital roughly measures
a company’s potential reservoir of cash.
 Usually it is positive; however, it can be
negative.
 Net Working Capital is often expressed as a
percentage of Total Assets.
 The Current Ratio and Quick Ratio
roughly measure a firm’s ability to cover
its liabilities with its most liquid assets.
17-20
Financial Ratios
 The Quick Ratio is a more stringent
measure of liquidity than the Current
Ratio.
 Itexcludes the inventory and prepaids from
the calculation.
 These components of the Balance Sheet are
generally the least liquid assets.

17-21
Financial Ratios
• Efficiency Ratios
Sales
Asset Turnover Ratio =
Average Total Assets
Sales
Fixed Asset Turnover Ratio =
Average Fixed Assets

17-22
Financial Ratios
 These ratios measure how efficiently the
firm is using its assets.
 Notice that since the assets are likely to
change over the year, we use an average
of the assets at the beginning and end of
the year.
 Averages are often used when a flow figure
(Annual Sales) is compared to a snapshot
figure (Total Assets).
17-23
Financial Ratios
 The Asset Turnover Ratio and Fixed Asset
Turnover Ratio indicate how hard the firm’s
assets are being used.
 For example, for LC, each $1 of assets is
generating $2.36 of sales, while each $1 of fixed
assets is generating $4.43 of sales.
 Note that a high ratio compared with other firms
may indicate that a firm is working close to
capacity.
 It could be difficult to generate further business
without additional investment.
17-24
Financial Ratios
• Profitability Ratios
Profitability ratios focus on the firm’s earnings,
giving an indication of its performance.
One group, called profit margins, look at
profits or earnings as a fraction of sales.
The other group, called return ratios,
measure profits earned as a fraction of the
assets used.
The definition of profits, or earnings, depends
on the ratio being used.

17-25
Financial Ratios
• Profitability Ratios – Profit Margins
Sales – Cost of Goods Sold
Gross Profit Margin =
Sales
EBIT – Taxes
Operating Profit Margin* =
Sales
Net Income Net Income + Interest

Net Profit Margin = or
Sales Sales`
* Also known as Basic Earning Power

17-26
Financial Ratios
• ProfitabilityRatios – Profit Margins
Other things held constant, a firm would prefer
high profit margins.
 However, there is a conflict between high prices
and high turnover.
 Think of, for example, Walmart’s margins as
compared to those of Holt Renfrew.
 Both are profitable, but use different strategies:
 Holt Renfrew has a high margin strategy, but
with lower lower sales or turnover.
 Walmart has low margins, but compensates with
higher volume or turnover.
17-27
Financial Ratios
• Profitability Ratios – Return Ratios
Net Income + Interest
Return on Assets (ROA) =
Net Income + Interest - Interest Tax Shields
Adjusted ROA =
Return on Net Income + Interest - Interest Tax Shields
Invested =
Average Total Debt + Preferred &
Capital Common Equity
Net Income
Return on Equity =
Average Equity
17-28
Financial Ratios
 The Payout Ratio measures the proportion of
earnings which are paid out as dividends.
 The Plowback Ratio shows the percentage of
earnings which are retained in the business.
Dividends
Payout Ratio =
Earnings
Earnings - Dividends
Plowback Ratio = 1 – Payout Ratio =
Earnings
17-29
Financial Ratios
 If you multiply the Plowback Ratio by the
Return on Equity, you can calculate how fast
shareholders’ equity is growing as a result of
plowing back part of earnings every year.
Earnings - Dividends
Growth in Equity from Plowback =
Earnings
Earnings - Dividends Earnings

= x = Plowback x ROE
Earnings Equity
17-30
Financial Ratios
• DuPont System - ROA
 Some profitability and efficiency measures can be
linked in useful ways.
 These relationships are referred to as the DuPont
System, in recognition of the company which
popularized them.
Net Income + Interest
ROA =
Assets
Sales Net Income + Interest
= x
Assets Sales
Asset Turnover x Profit Margin
17-31
Financial Ratios
• DuPont System – Margin vs Turnover
 All firms would like to earn a high ROA, but
their ability to do so is limited by competition.
 In general, most firms must make a trade-off
between turnover and margin.
 To get high turnover, prices generally have to
be low, meaning low margins as well.
(Walmart’s strategy.)
 To have high margins, prices generally have to
be high as well, which reduces the firm’s
turnover. (Holt Renfrew’s strategy.)
17-32
Financial Ratios
• DuPont System – Margin vs Turnover
 For example, fast-food chains tend to have low
margins, which they offset by high turnover.
 Hotels tend to have low turnover, but they offset
it with high margins.
 The result: both can have identical ROA’s while
their margins and turnover ratios are entirely
different:
Asset Turnover x Profit Margin = ROA
Fast Food 2.0 x 5% = 10%
Hotels 0.5 x 20% = 10%
17-33
Financial Ratios
• DuPont System - ROE
 We can also break down the ROE into its
component parts:
Net Income
ROE =
Equity
Assets Sales Net Income+Interest Net Income

= x x x
Equity Assets Sales Net Income+Interest
Leverage Asset Turnover Profit Margin Debt Burden

17-34
Financial Ratios
• Analysis of the Statement of Cash Flows
 The Cash Flow Statement tracks the cash
coming into and flowing out of a corporation
over a specific time period.
 Analysis of this statement can tell you a lot
about the financial health of a firm.
 By contrast, the Income Statement gives a
better sense of the long-run profitability of the
firm.
 But its focus on accruals means a healthy looking
income statement can miss a current cash crunch.
17-35
Financial Ratios
• Analysis of the Statement of Cash Flows
 You can see a Statement of Cash Flows for LC in
Table 17.7 on page 523 of your text.
 In Chapter 2, you learned how to calculate the
Free Cash Flow from the firm by rearranging the
statement of cash flows:
Cash Flow from Operating Activities

- Cash Flow from Investing Activities
= Cash Flows from Assets
(Free Cash Flows)
17-36
Using Financial Ratios

• Finance in Action
 Companies have considerable discretion in
calculating profits.
 They also have a great deal of leeway in
deciding what to record on the Balance Sheet.
 Thus, when you calculate financial ratios, you
need to look below the surface and understand
the some of the pitfalls of accounting data.
 Check the Finance in Action boxes on pages
526 and 527 of your text.

17-37
Using Financial Ratios

• Choosing a Benchmark
 Once you select and calculate the important
ratios for a firm, you must still find some way to
judge whether the results are high or low.
 Do this by comparing them to a benchmark.
 The simplest comparison is to the firm’s
performance in prior years.
 But you can also compare the numbers to those
calculated for another firm(s).
 When making your comparisons, don’t forget to
dig behind the numbers!
17-38
Measuring Company Performance

• MVA and EVA
 Market Value Added is the difference between
the market value of a firm’s equity and its book
value.
A table which ranks MVA for a number of large
Canadian companies is published by Stern Stewart.
 You can see a sample of this data (plus EVA) in
Table 17.10 on page 530 of your text.
 Economic Value Added (EVA or Residual
Income) measures the net profit of a firm after
deducting the cost of the capital employed.

17-39
Measuring Company Performance

• EVA
 EVA or residual income is a better measure of
company performance than accounting profits.
 Profits are calculated after deducting all costs
except the cost of capital.
 EVA recognizes that companies need to cover
their cost of capital before they can add value.
 If a plant or division is not earning a positive
EVA, the financial managers are likely to face
some pointed questions about whether assets
could be better employed elsewhere.
17-40
The Role of Financial Ratios

• Helping
Financial Managers Make
Decisions
 Whenever financial managers discuss the state
of business, you can bet that ratios will enter
into the discussion.
 Ratios can help you understand, and improve,
your company’s financial health by making
sure that its leverage, liquidity, efficiency and
profitability are kept at optimal levels.

17-41
Summary of Chapter 17
 As a financial manager, you will be responsible
for analyzing your company’s financial
statements.
 You will be looking at its income statement,
balance sheet and statement of cash flows.
 You will use financial ratios to summarize the
firm’s leverage, liquidity, profitability and
efficiency.
 You may combine these measures with other
data to measure the esteem in which investors
hold your company and its performance.
17-42
 The DuPont System provides a useful way to
link ratios to explain the firm’s return on assets
and equity.
 ROE is a function of the firm’s leverage ratio, asset
turnover, profit margin and debt burden.
 ROA is a function of asset turnover and profit
margin.
 Financial ratios will rarely be useful if applied
mechanically.
 You need an understanding of the business and
good judgment to make good decisions using
ratios.
17-43
 You need a benchmark for assessing a ratio.
 Typically you compare ratios with the company’s
ratios in prior years and/or with the ratios of
other firms in the same business.
 Other measures, such as Market Value Added
(MVA) and Economic Value Added (EVA) are
available to help you assess a firm’s
performance.
 Managers of divisions or plants are often judged
and rewarded by their business’s EVA.

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17-1

copyright © 2003 McGraw Hill Ryerson Limited

copyright © 2003 McGraw Hill Ryerson Limited

copyright © 2003 McGraw Hill Ryerson Limited

copyright © 2003 McGraw Hill Ryerson Limited

Château (LC) in Table 17.1 on page 506

copyright © 2003 McGraw Hill Ryerson Limited

 There are several different types of

LT Debt + Value of Leases

copyright © 2003 McGraw Hill Ryerson Limited

copyright © 2003 McGraw Hill Ryerson Limited

EBIT + Depreciation & Amortization

Fixed Charge Coverage Ratio =

copyright © 2003 McGraw Hill Ryerson Limited

copyright © 2003 McGraw Hill Ryerson Limited

Net Working Capital as a Net Working Capital

Cash + Marketable Securities + Receivables

copyright © 2003 McGraw Hill Ryerson Limited

copyright © 2003 McGraw Hill Ryerson Limited

copyright © 2003 McGraw Hill Ryerson Limited

Net Income Net Income + Interest

* Also known as Basic Earning Power

Earnings - Dividends Earnings

Assets Sales Net Income+Interest Net Income

Leverage Asset Turnover Profit Margin Debt Burden

Cash Flow from Operating Activities

Using Financial Ratios

copyright © 2003 McGraw Hill Ryerson Limited

Using Financial Ratios

Measuring Company Performance

copyright © 2003 McGraw Hill Ryerson Limited

Measuring Company Performance

The Role of Financial Ratios

copyright © 2003 McGraw Hill Ryerson Limited

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