For this Distingiushed Scholar Project, your assignment is to research Starbucks.

For this Distingiushed Scholar Project, your assignment is to research Starbucks. Once you have found the financial statements, you will calculate the past three year’s worth of financial ratios found on page 119 of the textbook. You will need to calculate all of the Liquidity and Asset Management ratios, Total debt to total assets ratio, all of the Profitability ratios, the P/E and M/B ratio. The assignment to research is Starbucks. Go to bottom of page to Table 4-2 which is Allied Food Products: Summary of Financial Ratios (Millions of Dollars) this will give you a idea for the question that is ask above. CHA P TER4 CHA P TER4 ANALYSIS OF FINANCIAL STATEMENTS1 Enron, WorldCom Lessons Learned from Enron and WorldCom In early 2001, Enron appeared to be on top of the world. The high-flying energy firm had a market capitalization of $60 billion, and its stock was trading at $80 a share. Wall Street analysts were touting its innovations and management success and strongly recommending the stock. Less than a year later, Enron had declared bankruptcy, its stock was basically worthless, and investors had lost billions of dollars. This dramatic and sudden collapse left many wondering how so much value could be destroyed in such a short period of time.
I do need it today by 9pm EST, if not, I have to find someone else. Thanks
For this Distingiushed Scholar Project, your assignment is to research Starbucks. Once you have found the financial statements, you will calculate the past three year’s worth of financial ratios found on page 119 of the textbook. You will need to calculate all of the Liquidity and Asset Management ratios, Total debt to total assets ratio, all of the Profitability ratios, the P/E and M/B ratio.
The assignment to research is Starbucks.
Go to bottom of page to Table 4-2 which is Allied Food Products: Summary of Financial Ratios (Millions of Dollars) this will give you a idea for the question that is ask above.
CHA P TER4
CHA P TER4
ANALYSIS OF FINANCIAL
STATEMENTS1
Enron, WorldCom
Lessons Learned from Enron and WorldCom
In early 2001, Enron appeared to be on top of the world. The high-flying energy
firm had a market capitalization of $60 billion, and its stock was trading at $80 a
share. Wall Street analysts were touting its innovations and management success
and strongly recommending the stock. Less than a year later, Enron had
declared bankruptcy, its stock was basically worthless, and investors had lost billions
of dollars. This dramatic and sudden collapse left many wondering how so
much value could be destroyed in such a short period of time.
While Enron’s stock fell steadily throughout the first part of 2001, most
analysts voiced no concerns. The general consensus was that it was simply
caught up in a sell-off that was affecting the entire stock market and that its
long-run prospects remained strong. However, a hint of trouble came when
Enron’s CEO, Jeffrey Skilling, unexpectedly resigned in August 2001; he was
replaced by its chairman and previous CEO, Ken Lay. By the end of August, its
stock had fallen to $35 a share. Two months later, Enron stunned the financial
markets by announcing a $638 million loss, along with a $1.2 billion write-down
in its book value equity. The write-down, which turned out to be grossly inadequate,
stemmed primarily from losses realized on a series of partnerships set up
by its CFO, Andrew Fastow. Shortly thereafter, it was revealed that Enron had
1 We have covered this chapter both early in the course and toward the end. Early coverage gives
students an overview of how financial decisions affect financial statements and results, and thus of
what financial management is all about. If it is covered later, after coverage of bond and stock valuation,
risk analysis, capital budgeting, capital structure, and working capital management, students
can better understand the logic of the ratios and see how they are used for different purposes.
Depending on students’ backgrounds, instructors may want to cover the chapter early or late.
© AP PHOTO/RON EDMONDS
Chapter 4 Analysis of Financial Statements
guaranteed the partnerships’ debt, so its true liabilities were far higher than the
financial statements indicated. These revelations destroyed Enron’s credibility,
caused its customers to flee, and led directly to its bankruptcy.
Not surprisingly, Enron’s investors and employees were enraged to learn
that its senior executives had received $750 million in salaries, bonuses, and
profits from stock options for good performance in the same year before the
company went bankrupt. During that year, senior executives were bailing out of
the stock as fast as they could, even as they put out misleading statements
touting the stock to their employees and outside investors. Fastow has since
pleaded guilty to fraud and is cooperating with authorities in the cases against
his former bosses, Lay and Skilling, who have been indicted for their roles in
Enron’s collapse and await trial.
After Enron declared bankruptcy, critics turned their attention to the company’s
auditor, Arthur Andersen, and to certain Wall Street analysts who had
blindly recommended the stock over the years. Critics contended that the auditors
and analysts neglected their responsibilities because of conflicts of interest.
Andersen partners looked the other way because they didn’t want to compromise
their lucrative consulting contracts with Enron, and the analysts kept recommending
the stock because they wanted to help the investment banking
side of their firms get more Enron business.
As if the Enron debacle was not enough, in June 2002 it was learned that
WorldCom, an even larger company, had “cooked its books” and inflated its
profits and cash flows by more than $11 billion. Shortly thereafter, WorldCom
collapsed, with many more billions of investor losses and thousands unemployed.
Enron had set up complicated partnerships to deceive investors, but
WorldCom simply lied, reporting normal operating costs as capital expenditures
and thus boosting its reported profits. Interestingly, Enron and WorldCom used
the same auditing firm, Arthur Andersen, which was itself put out of business,
causing about 70,000 employees to lose their jobs. It is also interesting to note
that Citigroup’s investment banking subsidiary, Salomon Smith Barney, earned
many millions in fees from WorldCom, and that Salomon’s lead telecom analyst,
Jack Grubman, who helped bring in this business, did not downgrade World-
Com to a sell until the very day the fraud was announced. At that point the
stock was selling for less than a dollar, down from a high of $64.50.
The Enron and WorldCom collapses caused investors throughout the world
to wonder if these companies’ misdeeds were isolated situations or were symptomatic
of undiscovered problems lurking in many other companies. Those
fears led to a broad decline in stock prices, and President Bush expressed
outrage at executives whose actions were imperiling our financial markets and
economic system. In response to these and other abuses, Congress passed the
Sarbanes-Oxley Act of 2002. One of its provisions requires the CEO and the
CFO to sign a statement certifying that the “financial statements and disclosures
fairly represent, in all material respects, the operations and financial condition”
of the company. This will make it easier to haul off in handcuffs a CEO or
CFO who has misled investors.
Financial statements have undoubtedly improved in the last few years, and
they now provide a wealth of good information that can be used by managers,
investors, lenders, customers, suppliers, and regulators. As you will see in this
chapter, a careful analysis of a company’s statements can highlight its strengths
and shortcomings. Also, as you will see, financial analysis can be used to predict
how such strategic decisions as the sale of a division, a change in credit or
inventory policy, or a plant expansion will affect a firm’s future performance.
102
Part 2 Fundamental Concepts in Financial Management
Putting Things In PerspectivePutting Things In Perspective
The primary goal of financial management is to maximize shareholders’
wealth over the long run, not to maximize accounting measures such as net
income or EPS. However, accounting data influence stock prices, and these
data can be used to understand why a company is performing the way it is
and to forecast where it is heading. Chapter 3 described the key financial
statements and showed how they change as a firm’s operations undergo
change. Now, in Chapter 4, we show how the statements are used by managers
to improve performance; by lenders to evaluate the likelihood of collecting
on loans; and by stockholders to forecast earnings, dividends, and
stock prices.
If management is to maximize a firm’s value, it must take advantage of
the firm’s strengths and correct its weaknesses. Financial analysis involves
(1) comparing the firm’s performance to other firms, especially those in the
same industry, and (2) evaluating trends in the firm’s financial position over
time. These studies help management identify deficiencies and then take
corrective actions. We focus here on how financial managers and investors
evaluate firms’ financial positions. Then, in later chapters, we examine the
types of actions management can take to improve future performance and
thus increase the firm’s stock price.
The most important ratio is the ROE, or return on equity, which is net
income to common stockholders divided by total stockholders’ equity.
Stockholders obviously want to earn a high rate of return on their invested
capital, and the ROE tells them the rate they are earning. If the ROE is
high, then the stock price will also tend to be high, and actions that
increase ROE are likely to increase the stock price. The other ratios provide
information about how well such assets as inventory, accounts receivable,
and fixed assets are managed, and about how the firm is financed. As we
will see, these factors all affect the ROE, and management uses the other
ratios primarily to help develop plans to improve the average ROE over the
long run.
4.1 RATIO ANALYSIS
Financial statements report both a firm’s position at a point in time and its operations
over some past period. However, their real value lies in the fact that they
can be used to help predict future earnings and dividends. From an investor’s
standpoint, predicting the future is what financial statement analysis is all about,
while from management’s standpoint, financial statement analysis is useful both to
help anticipate future conditions and, more important, as a starting point for planning
actions that will improve future performance.
Chapter 4 Analysis of Financial Statements
Financial ratios are designed to help one evaluate a financial statement. For
example, Firm A might have debt of $5,248,760 and interest charges of $419,900,
while Firm B might have debt of $52,647,980 and interest charges of $3,948,600.
Which company is stronger? The burden of these debts, and the companies’ ability
to repay them, can best be evaluated (1) by comparing each firm’s debt to its
assets and (2) by comparing the interest it must pay to the income it has available
for payment of interest. Such comparisons involve ratio analysis.
In the paragraphs that follow, we will calculate Allied Food Products’ financial
ratios for 2005, using data from the balance sheets and income statements
given in Tables 3-1 and 3-2. We will also evaluate the ratios relative to the industry
averages.2 Note that the dollar amounts in the ratio calculations are generally
in millions.
4.2 LIQUIDITY RATIOS
A liquid asset is one that trades in an active market and hence can be quickly
converted to cash at the going market price, and a firm’s “liquidity position”
deals with this question: Will the firm be able to pay off its debts as they come
due in the coming year? As shown in Table 3-1 in Chapter 3, Allied has $310 million
of debt that must be paid off within the coming year. Will it have trouble
meeting those obligations? A full liquidity analysis requires the use of cash
budgets, but by relating cash and other current assets to current liabilities, ratio
analysis provides a quick, easy-to-use measure of liquidity. Two of the most
commonly used liquidity ratios are discussed here.
Current Ratio
The primary liquidity ratio is the current ratio, which is calculated by dividing
current assets by current liabilities:
Current assets
Current ratio
Current liabilities
$1,000
3.2
$310
Industry average  4.2
Current assets include cash, marketable securities, accounts receivable, and
inventories. Allied’s current liabilities consist of accounts payable, short-term
notes payable, current maturities of long-term debt, accrued taxes, and accrued
wages.
If a company is getting into financial difficulty, it begins paying its bills
(accounts payable) more slowly, borrowing from its bank, and so on, all of which
increase current liabilities. If current liabilities are rising faster than current
assets, the current ratio will fall, and this is a sign of possible trouble. Allied’s
current ratio of 3.2 is well below the industry average, 4.2, so its liquidity position
is rather weak. Still, since its current assets are supposed to be converted to
2 In addition to the ratios discussed in this section, financial analysts sometimes employ a tool
known as common size analysis. To form a common size balance sheet, simply divide each asset and
liability item by total assets and then express the results as percentages. The resultant percentage
statement can be compared with statements of larger or smaller firms, or with those of the same
firm over time. To form a common size income statement, divide each income statement item by
sales. With a spreadsheet, which most analysts use, this is trivially easy.
Liquid Asset
An asset that can be
converted to cash
quickly without having
to reduce the asset’s
price very much.
Liquidity Ratios
Ratios that show the
relationship of a firm’s
cash and other current
assets to its current
liabilities.
Current Ratio
This ratio is calculated
by dividing current
assets by current
liabilities. It indicates
the extent to which
current liabilities are
covered by those
assets expected to be
converted to cash in
the near future.
Part 2 Fundamental Concepts in Financial Management
Quick (Acid Test)
Ratio
This ratio is calculated
by deducting inventories
from current assets
and then dividing the
remainder by current
liabilities.
Asset Management
Ratios
A set of ratios that
measure how
effectively a firm is
managing its assets.
cash within a year, it is likely that they could be liquidated at close to their
stated value. With a current ratio of 3.2, Allied could liquidate current assets at
only 31 percent of book value and still pay off current creditors in full.3
Although industry average figures are discussed later in some detail, note
that an industry average is not a magic number that all firms should strive to
maintain—in fact, some very well-managed firms may be above the average
while other good firms are below it. However, if a firm’s ratios are far removed
from the averages for its industry, an analyst should be concerned about why
this variance occurs. Thus, a deviation from the industry average should signal
the analyst (or management) to check further.
Quick, or Acid Test, Ratio
The second most used liquidity ratio is the quick, or acid test, ratio, which is
calculated by deducting inventories from current assets and then dividing the
remainder by current liabilities:
Current assets  Inventories
Quick, or acid test, ratio
Current liabilities
$385
1.2
$310
Industry average  2.2
Inventories are typically the least liquid of a firm’s current assets, hence they are
the assets on which losses are most likely to occur in the event of liquidation.
Therefore, this measure of a firm’s ability to pay off short-term obligations without
relying on the sale of inventories is important.
The industry average quick ratio is 2.2, so Allied’s 1.2 ratio is quite low in
comparison with other firms in its industry. Still, if the accounts receivable can
be collected, the company can pay off its current liabilities without having to liquidate
its inventories.
What are some characteristics of a liquid asset? Give some examples.
What two ratios are used to analyze a firm’s liquidity position?
Write out their equations.
Why is the current ratio the most commonly used measure of short-
term solvency?
Which current asset is typically the least liquid?
A company has current liabilities of $500 million, and its current ratio
is 2.0. What is its level of current assets? ($1,000 million) If this firm’s
quick ratio is 1.6, how much inventory does it have? ($200 million)
4.3 ASSET MANAGEMENT RATIOS
A second group of ratios, the asset management ratios, measures how effectively
the firm is managing its assets. These ratios answer this question: Does the
amount of each type of asset seem reasonable, too high, or too low in view of
3 1/3.2  0.31, or 31%. Note also that 0.31($1,000)  $310, the current liabilities balance.
Chapter 4 Analysis of Financial Statements
current and projected sales? When they acquire assets, Allied and other companies
must obtain capital from banks or other sources. If a firm has too many
assets, its cost of capital will be too high and its profits will be depressed. On the
other hand, if assets are too low, profitable sales will be lost. The asset management
ratios described in this section are important.
Inventory Turnover Ratio
“Turnover ratios” are ratios where sales are divided by some asset, and as
the name implies, they show how many times the item is “turned over” during
the year. Thus, the inventory turnover ratio is defined as sales divided by
inventories:
Sales
Inventory turnover ratio
Inventories
$3,000
4.9
$615
Industry average  10.9
As a rough approximation, each item of Allied’s inventory is sold out and
restocked, or “turned over,” 4.9 times per year. “Turnover” is a term that originated
many years ago with the old Yankee peddler, who would load up his
wagon with goods, then go off on his route to peddle his wares. The merchandise
was called “working capital” because it was what he actually sold, or
“turned over,” to produce his profits, whereas his “turnover” was the number of
trips he took each year. Annual sales divided by inventory equaled turnover, or
trips per year. If he made 10 trips per year, stocked 100 pans, and made a gross
profit of $5 per pan, his annual gross profit would be (100)($5)(10)  $5,000. If
he went faster and made 20 trips per year, his gross profit would double, other
things held constant. So, his turnover directly affected his profits.
Allied’s turnover of 4.9 is much lower than the industry average of 10.9.
This suggests that it is holding too much inventory. Excess inventory is, of
course, unproductive and represents an investment with a low or zero rate of
return. Allied’s low inventory turnover ratio also makes us question the current
ratio. With such a low turnover, the firm may be holding obsolete goods not
worth their stated value.4
Note that sales occur over the entire year, whereas the inventory figure is for
one point in time. For this reason, it might be better to use an average inventory
measure.5 If the business is highly seasonal, or if there has been a strong upward
or downward sales trend during the year, it is especially useful to make an
adjustment. To maintain comparability with industry averages, however, we did
not use the average inventory figure.
4 A problem arises when calculating and analyzing the inventory turnover ratio. Sales are stated at
market prices, so if inventories are carried at cost, as they generally are, the calculated turnover
overstates the true turnover ratio. Therefore, it might be more appropriate to use cost of goods sold
in place of sales in the formula’s numerator. However, some established compilers of financial ratio
statistics such as Dun & Bradstreet use the ratio of sales to inventories carried at cost. To have a figure
that can be compared with those published by Dun & Bradstreet and similar organizations, it is
necessary to measure inventory turnover with sales in the numerator, as we do here.
5 Preferably, the average inventory value should be calculated by summing the monthly figures during
the year and dividing by 12. If monthly data are not available, the beginning and ending figures
can be added and then divided by 2. Both methods adjust for growth but not for seasonal effects.
Inventory Turnover
Ratio
This ratio is calculated
by dividing sales by
inventories.
Part 2 Fundamental Concepts in Financial Management
Days Sales
Outstanding (DSO)
This ratio is calculated
by dividing accounts
receivable by average
sales per day; it indicates
the average
length of time the
firm must wait after
making a sale before
it receives cash.
Fixed Assets Turnover
Ratio
The ratio of sales to
net fixed assets.
Days Sales Outstanding
Days sales outstanding (DSO), also called the “average collection period”
(ACP), is used to appraise accounts receivable, and it is calculated by dividing
accounts receivable by average daily sales to find how many days’ sales are tied
up in receivables. Thus, the DSO represents the average length of time that the
firm must wait after making a sale before receiving cash. Allied has 46 days sales
outstanding, well above the 36-day industry average:
Days
Receivables Receivables
DSO  sales
Average sales per day Annual sales>
365
outstanding
$375 $375
45.625 days ˜
46 days
$3,000>
365 $8.2192
Industry average  36 days
Note that in this calculation we used a 365-day year. Some analysts use a 360day
year; on this basis Allied’s DSO would have been slightly lower, 45 days.6
The DSO can also be evaluated by comparing it with the terms on which the
firm sells its goods. For example, Allied’s sales terms call for payment within 30
days, so the fact that 46 days’ sales, not 30 days’, are outstanding indicates that
customers, on the average, are not paying their bills on time. This deprives the
company of funds that could be used to reduce bank loans or some other type of
costly capital. Moreover, with a high average DSO, it is likely that a number of
customers are paying very late, and those customers may well be in financial
trouble, in which case Allied may never be able to collect the receivable.7 Therefore,
if the trend in DSO over the past few years has been rising, but the credit
policy has not been changed, this would be strong evidence that steps should be
taken to expedite the collection of accounts receivable.
Fixed Assets Turnover Ratio
The fixed assets turnover ratio measures how effectively the firm uses its plant
and equipment. It is the ratio of sales to net fixed assets:
Sales
Fixed assets turnover ratio
Net fixed assets
$3,000
3.0
$1,000
Industry average  2.8
6 It would be somewhat better to use average receivables, either an average of the monthly figures or
(Beginning receivables  Ending receivables)/2  ($315  $375)/2  $345 in the formula. Had
average annual receivables been used, Allied’s DSO on a 365-day basis would have been
$345/$8.2192  41.975 days, or approximately 42 days. The 42-day figure is a more accurate one,
but our interest is in comparisons, and because the industry average was based on year-end receivables,
the 46-day number is better for our purposes. The DSO is discussed further in Part 6.
7 For example, if further analysis along the lines suggested in Part 6 indicated that 85 percent of the
customers pay in 30 days, then for the DSO to average 46 days, the remaining 15 percent must be
paying on average in 136.67 days. Paying that late suggests financial difficulties. In Part 6 we also
discuss refinements into this analysis, but a DSO of 46 days would alert a good analyst of the need
to dig deeper.
Chapter 4 Analysis of Financial Statements
Allied’s ratio of 3.0 times is slightly above the 2.8 industry average, indicating
that it is using its fixed assets at least as intensively as other firms in the industry.
Therefore, Allied seems to have about the right amount of fixed assets relative
to its sales.
Potential problems may arise when interpreting the fixed assets turnover
ratio. Recall that fixed assets are shown on the balance sheet at their historical
costs, less depreciation. Inflation has caused the value of many assets that were
purchased in the past to be seriously understated. Therefore, if we compared an
old firm that had acquired many of its fixed assets years ago at low prices with a
new company with similar operations that had acquired its fixed assets only
recently, we would probably find that the old firm had the higher fixed assets
turnover ratio. However, this would be more reflective of when the assets were
acquired than of inefficiency on the part of the new firm. The accounting profession
is trying to develop procedures for making financial statements reflect
current values rather than historical values, which would help us make better
comparisons. However, at the moment the problem still exists, so financial analysts
must recognize that a problem exists and deal with it judgmentally. In
Allied’s case, the issue is not serious because all firms in the industry have been
expanding at about the same rate, hence the balance sheets of the comparison
firms are reasonably comparable.8
Total Assets Turnover Ratio
The final asset management ratio, the total assets turnover ratio, measures the
turnover of all the firm’s assets, and it is calculated by dividing sales by total assets:
Sales
Total assets turnover ratio
Total assets
$3,000
1.5
$2,000
Industry average  1.8
Allied’s ratio is somewhat below the industry average, indicating that it is not
generating enough sales given its total assets. Sales should be increased, some
assets should be disposed of, or a combination of these steps should be taken.
Identify four ratios that are used to measure how effectively a firm
manages its assets, and write out their equations.
If one firm is growing rapidly and another is not, how might this
distort a comparison of their inventory turnover ratios?
If you wanted to evaluate a firm’s DSO, with what would you compare
it?
What potential problem might arise when comparing different firms’
fixed assets turnover ratios?
A firm has annual sales of $100 million, $20 million of inventory,
and $30 million of accounts receivable. What is its inventory
turnover ratio? (5) What is its DSO based on a 365-day year?
(109.5 days)
Total Assets Turnover
Ratio
This ratio is calculated
by dividing sales by
total assets.
8 See FASB #89, Financial Reporting and Changing Prices (December 1986), for a discussion of the
effects of inflation on financial statements. The report’s age indicates how difficult the problem is.
Part 2 Fundamental Concepts in Financial Management
4.4 DEBT MANAGEMENT RATIOS
Financial Leverage
The use of debt
financing.
The extent to which a firm uses debt financing, or financial leverage, has three
important implications: (1) By raising funds through debt, stockholders can control
a firm with a limited amount of equity investment. (2) Creditors look to the
equity, or owner-supplied funds, to provide a margin of safety, so the higher the
proportion of the total capital provided by stockholders, the less the risk faced
by creditors. (3) If the firm earns more on its assets than the interest rate it pays
on debt, then using debt “leverages,” or magnifies, the return on equity, ROE.
Table 4-1 illustrates both the potential benefits and risks resulting from the
use of debt.9 Here we analyze two companies that are identical except for how
they are financed. Firm U (for “Unleveraged”) has no debt and thus 100 percent
common equity, whereas Firm L (for “Leveraged”) is financed with half debt at a
10 percent interest rate and half equity. Both companies have $100 of assets.
Their sales will range from $150 down to $75, depending on business conditions,
with an expected level of $100. Some of their operating costs (rent, the president’s
salary, and so on) are fixed and will be there regardless of the level of
sales, while other costs (some labor costs, materials, and so forth) will vary with
sales.10 When we deduct total operating costs from sales revenues, we are left
with operating income, or earnings before interest and taxes (EBIT).
Notice in the table that everything is the same for the leveraged and
unleveraged firms down through operating income—thus, they have the same
EBIT under the three states of the economy. However, things then begin to differ.
Firm U has no debt so it pays no interest, and its taxable income is the same as
its operating income, and it then pays a 40 percent state and federal tax to get to
its net income, which is $27 under good conditions and $0 under bad conditions.
When net income is divided by common equity, we get the ROE, which ranges
from 27 percent to 0 percent for Firm U.
Firm L has the same EBIT under each condition, but it uses $50 of debt with
a 10 percent interest rate, so it has $5 of interest charges regardless of business
conditions. This amount is deducted from EBIT to get to taxable income, taxes
are then taken out, and the result is net income, which ranges from $24 to $5,
depending on conditions.11 At first blush it looks like Firm U is better off under
all conditions, but this is not correct—we need to consider how much the two
firms’ stockholders have invested. Firm L’s stockholders have put up only $50,
so when that investment is divided into net income, we see that their ROE under
good conditions is a whopping 48 percent (versus 27 percent for U) and is 12
percent (versus 9 percent for U) under expected conditions. However, L’s ROE
falls to 10 percent under bad conditions, which means that it would go bankrupt
if those conditions last for several years.
There are two reasons for the leveraging effect: (1) Because interest is
deductible, the use of debt lowers the tax bill and leaves more of the firm’s operating
income available to its investors. (2) If operating income as a percentage of
9 We discuss ROE in more depth later in the chapter, and we examine the effects of leverage in
detail in the chapter on capital structure.
10 The financial statements do not show the breakdown between fixed and variable operating costs,
but companies can and do make this breakdown for internal purposes. Of course, the distinction is
not always clear, because what’s a fixed cost in the very short run can become a variable cost over a
longer time horizon. It’s interesting to note that companies are moving toward making more of their
costs variable, using such techniques as increasing bonuses rather than base salaries, switching to
profit-sharing plans rather than fixed-pension plans, and outsourcing various parts and materials.
11 As we discussed in the last chapter, firms can carry losses back or forward for several years.
Therefore, if Firm L had profits and thus paid taxes in recent prior years, it could carry its loss
under bad conditions back and receive a credit (a check from the government). In Table 4-1 we
assume that the firm cannot use the carry-back/carry-forward provision.
Chapter 4 Analysis of Financial Statements
TABLE 4-1 Effects of Financial Leverage on Stockholder Returns
FIRM U [UNLEVERAGED (NO DEBT)]
Current assets $ 50 Debt $ 0
Fixed assets 50 Common equity 100
Total assets $100 Total liabilities and equity $100
BUSINESS CONDITIONS
Good Expected Bad
Sales revenues $150.0 $100.0 $75.0
Operating costs Fixed 45.0 45.0 45.0
Variable 60.0 40.0 30.0
Total operating costs 105.0 85.0 75.0
Operating income (EBIT) $ 45.0 $ 15.0 $ 0.0
Interest (Rate = 10%) 0.0 0.0 0.0
Earnings before taxes (EBT) $ 45.0 $ 15.0 $ 0.0
Taxes (Rate = 40%) 18.0 6.0 0.0
Net income (NI) $ 27.0 $ 9.0 $ 0.0
ROEU 27.0% 9.0% 0.0%
FIRM L [LEVERAGED (SOME DEBT)]
Current assets $ 50 Debt $ 50
Fixed assets 50 Common equity 50
Total assets $100 Total liabilities and equity $100
BUSINESS CONDITIONS
Good Expected Bad
Sales revenues $150.0 $100.0 $75.0
Operating costs Fixed 45.0 45.0 45.0
Variable 60.0 40.0 30.0
Total operating costs 105.0 85.0 75.0
Operating income (EBIT) $ 45.0 $ 15.0 $ 0.0
Interest (Rate = 10%) 5.0 5.0 5.0
Earnings before taxes (EBT) $ 40.0 $ 10.0 $ 5.0
Taxes (Rate = 40%) 16.0 4.0 0.0
Net income (NI) $ 24.0 $ 6.0 $ 5.0
ROEL 48.0% 12.0% 10.0%
assets exceeds the interest rate on debt, as it generally is expected to do, then a
company can use debt to acquire assets, pay the interest on the debt, and have
something left over as a “bonus” for its stockholders. Under the expected conditions,
our hypothetical firms expect to earn 15 percent on assets versus a 10 percent
cost of debt, and this, combined with the tax benefit of debt, pushes Firm
L’s expected rate of return on equity up far above that of Firm U.
We see, then, that firms with relatively high debt ratios have higher expected
returns when the economy is normal, but they are exposed to risk of loss when
the economy enters a recession. Therefore, decisions about the use of debt require
firms to balance higher expected returns against increased risk. Determining the
optimal amount of debt is a complicated process, and we defer a discussion of
Part 2 Fundamental Concepts in Financial Management
Debt Ratio
The ratio of total debt
to total assets.
Times-Interest-Earned
(TIE) Ratio
The ratio of earnings
before interest and
taxes (EBIT) to interest
charges; a measure of
the firm’s ability to
meet its annual interest
payments.
that subject to a later chapter on capital structure. For now, we simply look at
two procedures analysts use to examine the firm’s debt: (1) They check the balance
sheet to determine the proportion of total funds represented by debt, and
(2) they review the income statement to see the extent to which fixed charges are
covered by operating profits.
Total Debt to Total Assets
The ratio of total debt to total assets, generally called the debt ratio, measures
the percentage of funds provided by creditors:
Total debt
Debt ratio
Total assets
$310  $750 $1,060
53.0%
$2,000 $2,000
Industry average  40.0%
Total debt includes all current liabilities and long-term debt. Creditors prefer
low debt ratios because the lower the ratio, the greater the cushion against creditors’
losses in the event of liquidation. Stockholders, on the other hand, may
want more leverage because it can magnify expected earnings.
Allied’s debt ratio is 53.0 percent, which means that its creditors have
supplied more than half the total financing. As we will discuss in the capital
structure chapter, a number of factors affect a company’s optimal debt ratio. Nevertheless,
the fact that Allied’s debt ratio exceeds the industry average raises a red
flag, and this will make it relatively costly for Allied to borrow additional funds
without first raising more equity. Creditors will be reluctant to lend the firm more
money, and management would probably be subjecting the firm to the risk of
bankruptcy if it sought to borrow a substantial amount of additional funds.12
Times-Interest-Earned Ratio
The times-interest-earned (TIE) ratio is determined by dividing earnings before
interest and taxes (EBIT in Table 3-2) by the interest charges:
EBIT
Times-interest-earned (TIE) ratio
Interest charges
$283.8
3.2
$88
Industry average  6.0
The TIE ratio measures the extent to which operating income can decline before
the firm is unable to meet its annual interest costs. Failure to pay interest will
bring legal action by the firm’s creditors and probably result in bankruptcy. Note
that earnings before interest and taxes, rather than net income, is used in the
numerator. Because interest is paid with pre-tax dollars, the firm’s ability to pay
current interest is not affected by taxes.
12 The ratio of debt to equity is also used in financial analysis. The debt-to-assets (D/A) and debt-toequity
(D/E) ratios are simply transformations of each other:
D>
AD>
E
D/E = and D/A =
1  D>
A1  D>
E
Chapter 4 Analysis of Financial Statements
Allied’s interest is covered 3.2 times. The industry average is 6 times, so
Allied is covering its interest charges by a relatively low margin of safety. Thus,
the TIE ratio reinforces the primary conclusion from our analysis of the debt
ratio, namely, that Allied would face difficulties if it attempted to borrow additional
funds.
EBITDA Coverage Ratio
The TIE ratio is useful for assessing the ability to meet interest charges on debt,
but it has two shortcomings: (1) Interest is not the only fixed financial charge—
companies must also retire debt on a fixed schedule, and many firms also lease
assets and thus must make lease payments. If they fail to repay debt or meet
lease payments, they can be forced into bankruptcy. (2) EBIT does not represent
all the cash flow available to service debt, especially if a firm has high depreciation
and/or amortization charges. To account for these deficiencies, bankers and
others also use the EBITDA coverage ratio, which shows all of the cash flow
available for payments in the numerator and all of the required financial payments
in the denominator. This ratio is defined as follows:13
EBITDA  Lease payments
EBITDA
coverage ratio
Interest  Principal payments  Lease payments
$383.8  $28 $411.8
3.0
$88  $20  $28 $136
Industry average  4.3
Regarding the numerator, Allied had EBITDA of $383.8 million, consisting of
$283.8 million of operating income (EBIT) and $100 million of depreciation.
However, $28 million of lease payments were deducted when we calculated
EBITDA, yet that $28 million was available to meet financial charges. Therefore,
we must add it back to EBITDA, giving a total of $411.8 million that is available
for fixed financial charges.14 Fixed financial charges consisted of $88 million of
interest, $20 million of sinking fund payments, and $28 million of lease payments,
for a total of $136 million.15 Therefore, Allied covered its fixed financial
charges by 3.0 times. However, if operating income declines, the coverage will
fall, and operating income certainly can decline. As Allied’s ratio is well below
the industry average, we again see that the company has a relatively high level
of debt.
13 Different analysts define the EBITDA coverage ratio in different ways. For example, some would
omit the lease payment information, and others would “gross up” principal payments by dividing
them by (1  T) because these payments are not tax deductions, hence must be made with after-tax
cash flows. We included lease payments because, for many firms, they are quite important, and failing
to make them can lead to bankruptcy just as surely as can failure to make payments on “regular”
debt. We did not gross up principal payments because, if a company is in financial difficulty, its
tax rate will probably be zero, hence the gross up is not necessary whenever the ratio is really
important.
14 Lease payments are included in the numerator because, unlike interest, they were deducted when
EBITDA was calculated. We want to find all the funds that were available to service fixed charges,
so lease payments must be added to the EBIT and DA to find the funds that could be used to service
debt and meet lease payments.
15 A sinking fund is a required annual payment designed to reduce the balance of a bond or preferred
stock issue. A sinking fund payment is like the principal repayment portion of the payment
on an amortized loan, but sinking funds are used for publicly traded bond issues, whereas amortization
payments are used for bank loans and other private loans.
EBITDA Coverage
Ratio
A ratio whose numerator
includes all cash
flows available to meet
fixed financial charges
and whose denominator
includes all fixed
financial charges.
Part 2 Fundamental Concepts in Financial Management
Profitability Ratios
A group of ratios that
show the combined
effects of liquidity,
asset management,
and debt on operating
results.
Profit Margin on Sales
This ratio measures net
income per dollar of
sales; it is calculated by
dividing net income by
sales.
The EBITDA coverage ratio is most useful for relatively short-term lenders
such as banks, which rarely make loans (except real estate–backed loans) for
longer than about five years. Over a relatively short period, depreciation-
generated funds can be used to service debt. Over a longer time, those funds
must be reinvested to maintain the plant and equipment or else the company
cannot remain in business. Therefore, banks and other relatively short-term
lenders focus on the EBITDA coverage ratio, whereas long-term bondholders
focus on the TIE ratio.
What are three important implications of financial leverage?
How does the use of financial leverage affect stockholders’ control
position?
How does the U.S. tax structure influence a firm’s willingness to
finance with debt?
How does the decision to use debt involve a risk-versus-return
trade-off?
Explain the following statement: “Analysts look at both balance
sheet and income statement ratios when appraising a firm’s financial
condition.”
Name three ratios that are used to measure financial leverage, and
write out their equations.
A company has EBITDA of $500 million, interest payments of $50
million, lease payments of $40 million, and required principal
payments (due this year) of $30 million. What is its EBITDA coverage
ratio? (4.5)
4.5 PROFITABILITY RATIOS
Accounting statements reflect things that happened in the past, but they also
give us clues about what’s really important—what’s likely to happen in the
future. The liquidity, asset management, and debt ratios covered thus far tell us
something about the firm’s policies and operations. Now we turn to the
profitability ratios, which reflect the net result of all of the financing policies
and operating decisions.
Profit Margin on Sales
The profit margin on sales, calculated by dividing net income by sales, gives the
profit per dollar of sales:
Net income
Profit margin on sales
Sales
$117.5
3.9%
$3,000
Industry average  5.0%
Allied’s profit margin is below the industry average of 5 percent. This sub-par
result occurs because costs are too high. High costs, in turn, generally occur
because of inefficient operations. However, Allied’s low profit margin is also a
Chapter 4 Analysis of Financial Statements
GLOBAL PERSPECTIVES
GLOBAL PERSPECTIVESGLOBAL PERSPECTIVES
Global Accounting Standards:
Can One Size Fit All?
These days you must be a good financial detective
to analyze financial statements, especially if the
company operates overseas. Despite attempts to standardize
accounting practices, there are still many differences
in financial reporting in different countries that
create headaches for investors making cross-border
company comparisons. However, as businesses become
more global and more foreign companies list
on U.S. stock exchanges, accountants and regulators
are realizing the need for a global convergence of
accounting standards. As a result, the writing is on
the wall regarding accounting standards, and differences
are disappearing.
The effort to internationalize accounting standards
began in 1973 with the formation of the International
Accounting Standards Committee. However, in 1998 it
became apparent that a full-time rule-making body
with global representation was necessary, so the International
Accounting Standards Board (IASB), with
members representing nine major countries, was
established. The IASB was charged with the responsibility
for creating a set of International Financial
Reporting Standards (IFRS) for European Union (EU)
companies by January 1, 2005, when more than 7,000
publicly listed European companies were supposed to
conform to these standards. In contrast, only 350 European
companies were using international standards as
of 2003. A number of other countries, including Australia
and other Pacific Rim countries, South Africa,
Canada, Russia, Japan, and China are interested in
adopting IFRS.
A survey of senior executives from 85 financial
institutions worldwide found that 92 percent of those
responding favored a single set of international stan
dards but only 55 percent thought universal adoption
was achievable. Obviously, the globalization of accounting
standards is a huge endeavor—one that will
involve compromises between the IASB and FASB.
Part of the problem is that U.S. GAAP takes a rules-
based approach, while the IASB insists on using a
principles-based approach. With a rules-based system,
companies can tell whether or not they are in
compliance, but they can also develop ways to get
around a rule and thus subvert its intent. With a principles-
based system, there is greater uncertainty
about whether certain border-line procedures will be
allowed, but such a system makes it easier to prosecute
on the basis of intent.
A global accounting structure would enable
investors and practitioners around the world to read
and understand financial reports produced anywhere
in the world. In addition, it would enhance all companies’
access to all capital markets, which would
improve investor diversification, reduce risk, and
lower the cost of capital. However, it remains to be
seen whether the IASB’s lofty goal can be achieved.
Sources: “All Accountants Soon May Speak the Same Language,”
The Wall Street Journal, August 29, 1995, p. A15;
Jim Cole, “Global Standards Loom for Accounting,” East
Bay Business Times, November 12, 2001; “Accountants
Struggle to Reconcile Rules,” BestWire, April 28, 2003;
“For and Against; Standards Need Time to Work,” Accountancy
Age, June 5, 2003, p. 16; Larry Schlesinger, “Overview;
Bringing about a New Dawn,” Accountancy Age, September
4, 2003, p. 18; Cassell Bryan-Low, “Deals & Deal Makers:
Accounting Changes Are in Store,” The Wall Street
Journal, September 10, 2003, p. C4; and Fay Hansen, “Get
Ready for New Global Accounting Standards,” January
2004, www.BusinessFinanceMag.com.
result of its heavy use of debt. Recall that net income is income after interest.
Therefore, if two firms have identical operations in the sense that their sales,
operating costs, and EBIT are the same, but if one firm uses more debt than the
other, it will have higher interest charges. Those interest charges will pull net
income down, and as sales are constant, the result will be a relatively low profit
margin. In this situation, the low profit margin would indicate a difference in
financing strategies, not an operating problem. Thus, the firm with the low
profit margin might end up with a higher rate of return on its stockholders’
investment due to its use of financial leverage.
Note too that while a high return on sales is good, other things held constant,
other things may not be held constant—we must also be concerned with
turnover. If a firm sets a very high price on its products, it may get a high return
on each sale but not make many sales. That might result in a high profit margin
but still not be optimal because total sales are low.
Part 2 Fundamental Concepts in Financial Management
Return on Total
Assets (ROA)
The ratio of the net
income to total assets.
Basic Earning Power
(BEP) Ratio
This ratio indicates the
ability of the firm’s
assets to generate
operating income; calculated
by dividing
EBIT by total assets.
We will see exactly how profit margins, the use of debt, and turnover interact
to affect overall stockholder returns shortly, when we examine the Du Pont
equation.
Return on Total Assets
The ratio of net income to total assets measures the return on total assets (ROA)
after interest and taxes:
Net income
Return on total assets  ROA
Total assets
$117.5
5.9%
$2,000
Industry average  9.0%
Allied’s 5.9 percent return is well below the 9 percent industry average. This is
not good, but a low return on assets is not necessarily bad—it could result from
a conscious decision to use a lot of debt, in which case high interest expenses
will cause net income to be relatively low. Debt is part of the reason for Allied’s
low ROA. Never forget—you must look at a number of ratios, see what each
suggests, and then look at the overall situation when you judge the performance
of a company and try to figure out what it should do to improve.
Basic Earning Power (BEP) Ratio
The basic earning power (BEP) ratio is calculated by dividing earnings before
interest and taxes (EBIT) by total assets:
EBIT
Basic earning power (BEP) ratio
Total assets
$283.8
14.2%
$2,000
Industry average  18.0%
This ratio shows the raw earning power of the firm’s assets, before the influence
of taxes and leverage, and it is useful when comparing firms with different
degrees of financial leverage and tax situations. Because of its low turnover
ratios and poor profit margin on sales, Allied is not earning as high a return on
assets as the average food-processing company.16
16 A related ratio is the return on investors’ capital, defined as follows:
Net income  Interest
Return on investors’ capital
Debt  Equity
The numerator shows the dollar returns to investors, the denominator shows the money investors
have put up, and the ratio itself shows the rate of return on all investors’ capital. This ratio is especially
important in regulated industries such as electric utilities, where regulators are concerned
about companies’ using their monopoly power to earn excessive returns on investors’ capital. In
fact, regulators try to set electric rates at levels that will force the return on investors’ capital to
equal a company’s cost of capital as defined in Chapter 10.
Chapter 4 Analysis of Financial Statements
Return on Common Equity
The “bottom-line” accounting ratio is the return on common equity (ROE),
found as follows:
Net income
Return on common equity  ROE
Common equity
$117.5
12.5%
$940
Industry average  15.0%
Stockholders expect to earn a return on their money, and this ratio tells how well
they are doing in an accounting sense. Allied’s 12.5 percent return is below the
15 percent industry average, but not as far below as the return on total assets.
This somewhat better ROE is due to the company’s greater use of debt, a point
that we discussed earlier in the chapter.
Identify four profitability ratios, and write out their equations.
Why is the basic earning power ratio useful?
Why does the use of debt lower the ROA?
What does ROE measure? Since interest expense lowers profits and
thus the ROA, does using debt necessarily lower the ROE? Explain.
A company has $20 billion of sales and $1 billion of net income. Its
total assets are $10 billion, financed half by debt and half by common
equity. What is its profit margin? (5%) What is its ROA? (10%)
What is its ROE? (20%) Would ROA increase if the firm used less
leverage? (yes) Would ROE increase? (no)
4.6 MARKET VALUE RATIOS
The ROE reflects the effects of all the other ratios and is the best single measure
of performance in an accounting sense. Investors obviously like to see a high
ROE, and high ROEs are generally positively correlated with high stock prices.
However, other things come into play. As we saw earlier, financial leverage generally
increases the ROE but leverage also increases the firm’s risk, which
investors dislike. So, if a high ROE is achieved by the use of a very large amount
of debt, the stock price might well be lower than it would be with less debt and
a lower ROE. Similarly, investors are interested in growth, and if the current
ROE was achieved by holding back on research and development costs, which
will constrain future growth, this will not be regarded favorably.
This takes us to a final group of ratios, the market value ratios, which relate
the firm’s stock price to its earnings, cash flow, and book value per share. These
ratios give management an indication of what investors think of the company’s
risk and future prospects. If the liquidity, asset management, debt management,
and profitability ratios all look good, and if these conditions have been stable
over time, then the market value ratios will be high, the stock price will probably
be as high as can be expected, and management has been doing a good job
and should be rewarded. Otherwise, changes might be needed.
Return on Common
Equity (ROE)
The ratio of net income
to common equity;
measures the rate of
return on common
stockholders’ investment.
Market Value Ratios
A set of ratios that
relate the firm’s stock
price to its earnings,
cash flow, and book
value per share.
Part 2 Fundamental Concepts in Financial Management
Price/Earnings (P/E)
Ratio
The ratio of the price
per share to earnings
per share; shows the
dollar amount investors
will pay for $1 of
current earnings.
Price/Cash Flow Ratio
The ratio of price per
share divided by cash
flow per share; shows
the dollar amount
investors will pay for $1
of cash flow.
Price/Earnings Ratio
The price/earnings (P/E) ratio shows how much investors are willing to pay per
dollar of reported profits. Allied’s stock sells for $23, so with an EPS of $2.35 its
P/E ratio is 9.8:
Price per share
Price>earnings 1P>E2 ratio
Earnings per share
$23.00
9.8
$2.35
Industry average  11.3
As we will see in Chapter 9, P/E ratios are higher for firms with strong growth
prospects and relatively little risk. Allied’s P/E ratio is below the average for
other food processors, so this suggests that the company is regarded as being
somewhat riskier than most, as having poor growth prospects, or both.
Price/Cash Flow Ratio
In some industries, stock price is tied more closely to cash flow rather than net
income. Consequently, investors often look at the price/cash flow ratio:
Price per share
Price>cash flow
Cash flow per share
$23.00
5.3
$4.35
Industry average  5.4
The calculation for cash flow per share was discussed in Chapter 3, but to
refresh your memory, it is equal to net income plus depreciation and amortization
divided by common shares outstanding. Allied’s price/cash flow ratio is
slightly below the industry average, once again suggesting that its growth
prospects are below average, its risk is above average, or both.
Note that for some purposes analysts look at multiples beyond just the
price/earnings and the price/cash flow ratios. For example, depending on the
industry, analysts may look at price/sales, price/customers, or price/(EBITDA
per share). Ultimately, though, value depends on earnings and cash flows, so if
these “exotic” ratios do not forecast future levels of EPS and cash flow, they may
turn out to be misleading.17
Market/Book Ratio
The ratio of a stock’s market price to its book value gives another indication of
how investors regard the company. Companies that are well regarded by
investors—which means companies with safe and growing earnings and cash
17 During the “Internet bubble” of the late 1990s and early 2000s, some Internet companies were
valued by multiplying the number of “hits” to a Web site times some sort of multiple. If those hits
translated to sales and profits, this procedure would have made sense, but generally they did not,
and the result was a vast overvaluation of stocks and a subsequent huge crash. Keep your eye on
earnings and cash flows.
Chapter 4 Analysis of Financial Statements
flows—sell at higher multiples of book value than those with low returns. First,
we find Allied’s book value per share:
Common equity
Book value per share
Shares outstanding
$940
$18.80
50
Then we divide the market price per share by the book value per share to get the
market/book (M/B) ratio, which for Allied is 1.2 times:
Market price per share
Market>
book ratio  M>
B
Book value per share
$23.00
1.2
$18.80
Industry average  1.7
Investors are willing to pay less for a dollar of Allied’s book value than for
one of an average food-processing company. This is consistent with our other
findings.
In today’s market (September 2005), the average Standard & Poor’s (S&P)
500 company had a market/book ratio of about 2.87.18 Because M/B ratios typically
exceed 1.0, this means that investors are willing to pay more for stocks than
their accounting book values. This situation occurs primarily because asset values,
as reported by accountants on corporate balance sheets, do not reflect either
inflation or “goodwill.” Thus, assets purchased years ago at preinflation prices
are carried at their original costs, even though inflation might have caused their
actual values to rise substantially, and successful going concerns have a value
greater than their historical costs.
If a company earns a low rate of return on its assets, then its M/B ratio will
be relatively low versus an average company. Some airlines, which have not
fared well in recent years, sell at M/B ratios well below 1.0, while very successful
firms such as Microsoft achieve high rates of return on their assets, resulting
in market values far in excess of their book values. In September 2005
Microsoft’s book value per share was about $4.49 versus a market price of
$26.28, so its market/book ratio was $26.28/$4.49  5.9 times.
Describe three ratios that relate a firm’s stock price to its earnings,
cash flow, and book value per share, and write out their equations.
How do these market value ratios reflect investor’s opinions about a
stock’s risk and expected future growth?
What does the price/earnings (P/E) ratio show? If one firm’s P/E
ratio is lower than that of another, what are some factors that might
explain the difference?
How is book value per share calculated? Explain how inflation and
“goodwill” built up over time could cause book values to deviate
from market values.
Market/Book (M/B)
Ratio
The ratio of a stock’s
market price to its
book value.
18 This was obtained from the key ratios section shown in http://moneycentral.msn.com.
Part 2 Fundamental Concepts in Financial Management
Trend Analysis
An analysis of a firm’s
financial ratios over
time; used to estimate
the likelihood of
improvement or deterioration
in its financial
condition.
Basic Du Pont
Equation
A formula that shows
that the rate of return
on assets can be found
as the product of the
profit margin times the
total assets turnover.
4.7 TREND ANALYSIS
It is important to analyze trends in ratios as well as their absolute levels, for
trends give clues as to whether a firm’s financial condition is likely to improve
or to deteriorate. To do a trend analysis, simply plot a ratio over time, as shown
in Figure 4-1. This graph shows that Allied’s rate of return on common equity
has been declining since 2002, even though the industry average has been relatively
stable. All the other ratios could be analyzed similarly.
How is a trend analysis done?
What important information does a trend analysis provide?
4.8 TYING THE RATIOS TOGETHER:
THE DU PONT EQUATIONS
Table 4-2 summarizes Allied’s ratios. The profit margin times the total assets
turnover is called the basic Du Pont equation, and it gives the rate of return on
assets (ROA):
ROA  Profit margin Total assets turnover
Net income Sales
(4-1)
Sales Total assets
3.9%  1.5  5.9%
Allied made 3.9 percent, or 3.9 cents, on each dollar of sales, and assets were
“turned over” 1.5 times during the year. Therefore, the company earned a return
of 5.9 percent on its assets.
FIGURE 4-1 Rate of Return on Common Equity, 2001–2005
ROE
(%)
16
14
12
10
Industry
Allied
2001 2002 2003 2004 2005
Chapter 4 Analysis of Financial Statements
TABLE 4-2 Allied Food Products: Summary
of Financial Ratios (Millions of Dollars)
Ratio Formula Calculation Ratio
Industry
Average Comment
Liquidity
Current
Quick
C
3.24.2Poor
1.22.2Poor$385
$310
urrent assets  Inventories
Current liabilities
$1,000
$310
Current assets
Current liabilities
Asset Management
Inventory turnover
Sales
Inventories
4.910.9Poor$3,000
$615
Days sales outstanding (DSO)
Receivables
Annual sales>
365
46 days 36 days Poor$375
$8.2192
Fixed assets turnover
Sales
Net fixed assets
3.02.8OK$3,000
$1,000
Total assets turnover
Sales
Total assets
1.51.8
$3,000
$2,000
Somewhat low
Debt Management
Total debt $1,060
Total debt to total assets 53.0% 40.0% High (risky)
Total assets $2,000
Times-interest-Earnings before interest and taxes 1
EBIT2
$283.8
3.26.0Low (risky)
earned 1
TIE2
Interest charges $88
EBITDA  Lease payments
$411.8
EBITDA coverage 3.04.3Low (risky)
Interest  Principal payments  Lease payments $136
Profitability
Net income
Profit margin on sales
Sales
Return on total Net income
assets 1
ROA2
Total assets
Basic earning Earnings before interest and taxes 1
EBIT2
power 1
BEP2
Total assets
Return on common Net income
equity 1
ROE2
Common equity
$117.5
3.9% 5.0% Poor
$3,000
$117.5
5.9% 9.0% Poor
$2,000
$283.8
14.2% 18.0% Poor
$2,000
$117.5
12.5% 15.0% Poor
$940
Market Value
Price/earnings (P/E)
Price per share
Earnings per share
$23.00
$2.35
9.811.3Low
Price/cash flow
Price per share
Cash flow per share
$23.00
$4.35
5.35.4Low
Market/book (M/B)
Market price per share
Book value per share
$23.00
$18.80
1.21.7Low
Part 2 Fundamental Concepts in Financial Management
If the company were financed only with common equity, the rate of return
on assets (ROA) and the return on equity (ROE) would be the same because
total assets would equal common equity:
Net income Net income
ROA   ROE
Total assets Common equity
This equality holds if and only if the company uses no debt. Allied does use
debt, so its common equity is less than its total assets. Therefore, the return to
the common stockholders (ROE) must be greater than the ROA of 5.9 percent.
Specifically, to go from the rate of return on assets (ROA) to the return on equity
(ROE) we multiply by the equity multiplier, which is the ratio of total assets to
common equity:
Total assets
Equity multiplier
Common equity
Firms that use large amounts of debt (more leverage) will necessarily have a
high equity multiplier—the greater the debt, the less the equity, hence the higher
the equity multiplier. For example, if a firm has $1,000 of assets and finances
with $800, or 80 percent debt, then its equity will be $200 and its equity multiplier
will be $1,000/$200  5. Had it used only $200 of debt, its equity would
have been $800, and its equity multiplier would have been only $1,000/$800
1.25.19
Allied’s return on equity (ROE) depends on its ROA and its use of
leverage:20
ROE  ROA Equity multiplier (4-2)
Net income Total assets
Total assets Common equity
5.9% $2,000/$940
5.9% 2.13
12.5%
When they are combined, Equations 4-1 and 4-2 form the extended Du Pont
equation, which shows how the profit margin, the total assets turnover ratio, and
the equity multiplier combine to determine the ROE:
ROE  (Profit margin)(Total assets turnover)(Equity multiplier)
Net income Sales Total assets
(4-3)
Sales Total assets Common equity
19 Expressed algebraically,
DA  EAE 1
Debt ratio   1
A A A A Equity multiplier
Here D is debt, E is equity, A is total assets, and A/E is the equi

CHA P TER4
CHA P TER4
ANALYSIS OF FINANCIAL
STATEMENTS1
Enron, WorldCom
Lessons Learned from Enron and WorldCom
In early 2001, Enron appeared to be on top of the world. The high-flying energy
firm had a market capitalization of $60 billion, and its stock was trading at $80 a
share. Wall Street analysts were touting its innovations and management success
and strongly recommending the stock. Less than a year later, Enron had
declared bankruptcy, its stock was basically worthless, and investors had lost billions
of dollars. This dramatic and sudden collapse left many wondering how so
much value could be destroyed in such a short period of time.
While Enron’s stock fell steadily throughout the first part of 2001, most
analysts voiced no concerns. The general consensus was that it was simply
caught up in a sell-off that was affecting the entire stock market and that its
long-run prospects remained strong. However, a hint of trouble came when
Enron’s CEO, Jeffrey Skilling, unexpectedly resigned in August 2001; he was
replaced by its chairman and previous CEO, Ken Lay. By the end of August, its
stock had fallen to $35 a share. Two months later, Enron stunned the financial
markets by announcing a $638 million loss, along with a $1.2 billion write-down
in its book value equity. The write-down, which turned out to be grossly inadequate,
stemmed primarily from losses realized on a series of partnerships set up
by its CFO, Andrew Fastow. Shortly thereafter, it was revealed that Enron had
1 We have covered this chapter both early in the course and toward the end. Early coverage gives
students an overview of how financial decisions affect financial statements and results, and thus of
what financial management is all about. If it is covered later, after coverage of bond and stock valuation,
risk analysis, capital budgeting, capital structure, and working capital management, students
can better understand the logic of the ratios and see how they are used for different purposes.
Depending on students’ backgrounds, instructors may want to cover the chapter early or late.
© AP PHOTO/RON EDMONDS
Chapter 4 Analysis of Financial Statements
guaranteed the partnerships’ debt, so its true liabilities were far higher than the
financial statements indicated. These revelations destroyed Enron’s credibility,
caused its customers to flee, and led directly to its bankruptcy.
Not surprisingly, Enron’s investors and employees were enraged to learn
that its senior executives had received $750 million in salaries, bonuses, and
profits from stock options for good performance in the same year before the
company went bankrupt. During that year, senior executives were bailing out of
the stock as fast as they could, even as they put out misleading statements
touting the stock to their employees and outside investors. Fastow has since
pleaded guilty to fraud and is cooperating with authorities in the cases against
his former bosses, Lay and Skilling, who have been indicted for their roles in
Enron’s collapse and await trial.
After Enron declared bankruptcy, critics turned their attention to the company’s
auditor, Arthur Andersen, and to certain Wall Street analysts who had
blindly recommended the stock over the years. Critics contended that the auditors
and analysts neglected their responsibilities because of conflicts of interest.
Andersen partners looked the other way because they didn’t want to compromise
their lucrative consulting contracts with Enron, and the analysts kept recommending
the stock because they wanted to help the investment banking
side of their firms get more Enron business.
As if the Enron debacle was not enough, in June 2002 it was learned that
WorldCom, an even larger company, had “cooked its books” and inflated its
profits and cash flows by more than $11 billion. Shortly thereafter, WorldCom
collapsed, with many more billions of investor losses and thousands unemployed.
Enron had set up complicated partnerships to deceive investors, but
WorldCom simply lied, reporting normal operating costs as capital expenditures
and thus boosting its reported profits. Interestingly, Enron and WorldCom used
the same auditing firm, Arthur Andersen, which was itself put out of business,
causing about 70,000 employees to lose their jobs. It is also interesting to note
that Citigroup’s investment banking subsidiary, Salomon Smith Barney, earned
many millions in fees from WorldCom, and that Salomon’s lead telecom analyst,
Jack Grubman, who helped bring in this business, did not downgrade World-
Com to a sell until the very day the fraud was announced. At that point the
stock was selling for less than a dollar, down from a high of $64.50.
The Enron and WorldCom collapses caused investors throughout the world
to wonder if these companies’ misdeeds were isolated situations or were symptomatic
of undiscovered problems lurking in many other companies. Those
fears led to a broad decline in stock prices, and President Bush expressed
outrage at executives whose actions were imperiling our financial markets and
economic system. In response to these and other abuses, Congress passed the
Sarbanes-Oxley Act of 2002. One of its provisions requires the CEO and the
CFO to sign a statement certifying that the “financial statements and disclosures
fairly represent, in all material respects, the operations and financial condition”
of the company. This will make it easier to haul off in handcuffs a CEO or
CFO who has misled investors.
Financial statements have undoubtedly improved in the last few years, and
they now provide a wealth of good information that can be used by managers,
investors, lenders, customers, suppliers, and regulators. As you will see in this
chapter, a careful analysis of a company’s statements can highlight its strengths
and shortcomings. Also, as you will see, financial analysis can be used to predict
how such strategic decisions as the sale of a division, a change in credit or
inventory policy, or a plant expansion will affect a firm’s future performance.
102
Part 2 Fundamental Concepts in Financial Management
Putting Things In PerspectivePutting Things In Perspective
The primary goal of financial management is to maximize shareholders’
wealth over the long run, not to maximize accounting measures such as net
income or EPS. However, accounting data influence stock prices, and these
data can be used to understand why a company is performing the way it is
and to forecast where it is heading. Chapter 3 described the key financial
statements and showed how they change as a firm’s operations undergo
change. Now, in Chapter 4, we show how the statements are used by managers
to improve performance; by lenders to evaluate the likelihood of collecting
on loans; and by stockholders to forecast earnings, dividends, and
stock prices.
If management is to maximize a firm’s value, it must take advantage of
the firm’s strengths and correct its weaknesses. Financial analysis involves
(1) comparing the firm’s performance to other firms, especially those in the
same industry, and (2) evaluating trends in the firm’s financial position over
time. These studies help management identify deficiencies and then take
corrective actions. We focus here on how financial managers and investors
evaluate firms’ financial positions. Then, in later chapters, we examine the
types of actions management can take to improve future performance and
thus increase the firm’s stock price.
The most important ratio is the ROE, or return on equity, which is net
income to common stockholders divided by total stockholders’ equity.
Stockholders obviously want to earn a high rate of return on their invested
capital, and the ROE tells them the rate they are earning. If the ROE is
high, then the stock price will also tend to be high, and actions that
increase ROE are likely to increase the stock price. The other ratios provide
information about how well such assets as inventory, accounts receivable,
and fixed assets are managed, and about how the firm is financed. As we
will see, these factors all affect the ROE, and management uses the other
ratios primarily to help develop plans to improve the average ROE over the
long run.
4.1 RATIO ANALYSIS
Financial statements report both a firm’s position at a point in time and its operations
over some past period. However, their real value lies in the fact that they
can be used to help predict future earnings and dividends. From an investor’s
standpoint, predicting the future is what financial statement analysis is all about,
while from management’s standpoint, financial statement analysis is useful both to
help anticipate future conditions and, more important, as a starting point for planning
actions that will improve future performance.
Chapter 4 Analysis of Financial Statements
Financial ratios are designed to help one evaluate a financial statement. For
example, Firm A might have debt of $5,248,760 and interest charges of $419,900,
while Firm B might have debt of $52,647,980 and interest charges of $3,948,600.
Which company is stronger? The burden of these debts, and the companies’ ability
to repay them, can best be evaluated (1) by comparing each firm’s debt to its
assets and (2) by comparing the interest it must pay to the income it has available
for payment of interest. Such comparisons involve ratio analysis.
In the paragraphs that follow, we will calculate Allied Food Products’ financial
ratios for 2005, using data from the balance sheets and income statements
given in Tables 3-1 and 3-2. We will also evaluate the ratios relative to the industry
averages.2 Note that the dollar amounts in the ratio calculations are generally
in millions.
4.2 LIQUIDITY RATIOS
A liquid asset is one that trades in an active market and hence can be quickly
converted to cash at the going market price, and a firm’s “liquidity position”
deals with this question: Will the firm be able to pay off its debts as they come
due in the coming year? As shown in Table 3-1 in Chapter 3, Allied has $310 million
of debt that must be paid off within the coming year. Will it have trouble
meeting those obligations? A full liquidity analysis requires the use of cash
budgets, but by relating cash and other current assets to current liabilities, ratio
analysis provides a quick, easy-to-use measure of liquidity. Two of the most
commonly used liquidity ratios are discussed here.
Current Ratio
The primary liquidity ratio is the current ratio, which is calculated by dividing
current assets by current liabilities:
Current assets
Current ratio
Current liabilities
$1,000
3.2
$310
Industry average 4.2
Current assets include cash, marketable securities, accounts receivable, and
inventories. Allied’s current liabilities consist of accounts payable, short-term
notes payable, current maturities of long-term debt, accrued taxes, and accrued
wages.
If a company is getting into financial difficulty, it begins paying its bills
(accounts payable) more slowly, borrowing from its bank, and so on, all of which
increase current liabilities. If current liabilities are rising faster than current
assets, the current ratio will fall, and this is a sign of possible trouble. Allied’s
current ratio of 3.2 is well below the industry average, 4.2, so its liquidity position
is rather weak. Still, since its current assets are supposed to be converted to
2 In addition to the ratios discussed in this section, financial analysts sometimes employ a tool
known as common size analysis. To form a common size balance sheet, simply divide each asset and
liability item by total assets and then express the results as percentages. The resultant percentage
statement can be compared with statements of larger or smaller firms, or with those of the same
firm over time. To form a common size income statement, divide each income statement item by
sales. With a spreadsheet, which most analysts use, this is trivially easy.
Liquid Asset
An asset that can be
converted to cash
quickly without having
to reduce the asset’s
price very much.
Liquidity Ratios
Ratios that show the
relationship of a firm’s
cash and other current
assets to its current
liabilities.
Current Ratio
This ratio is calculated
by dividing current
assets by current
liabilities. It indicates
the extent to which
current liabilities are
covered by those
assets expected to be
converted to cash in
the near future.
Part 2 Fundamental Concepts in Financial Management
Quick (Acid Test)
Ratio
This ratio is calculated
by deducting inventories
from current assets
and then dividing the
remainder by current
liabilities.
Asset Management
Ratios
A set of ratios that
measure how
effectively a firm is
managing its assets.
cash within a year, it is likely that they could be liquidated at close to their
stated value. With a current ratio of 3.2, Allied could liquidate current assets at
only 31 percent of book value and still pay off current creditors in full.3
Although industry average figures are discussed later in some detail, note
that an industry average is not a magic number that all firms should strive to
maintain—in fact, some very well-managed firms may be above the average
while other good firms are below it. However, if a firm’s ratios are far removed
from the averages for its industry, an analyst should be concerned about why
this variance occurs. Thus, a deviation from the industry average should signal
the analyst (or management) to check further.
Quick, or Acid Test, Ratio
The second most used liquidity ratio is the quick, or acid test, ratio, which is
calculated by deducting inventories from current assets and then dividing the
remainder by current liabilities:
Current assets Inventories
Quick, or acid test, ratio
Current liabilities
$385
1.2
$310
Industry average 2.2
Inventories are typically the least liquid of a firm’s current assets, hence they are
the assets on which losses are most likely to occur in the event of liquidation.
Therefore, this measure of a firm’s ability to pay off short-term obligations without
relying on the sale of inventories is important.
The industry average quick ratio is 2.2, so Allied’s 1.2 ratio is quite low in
comparison with other firms in its industry. Still, if the accounts receivable can
be collected, the company can pay off its current liabilities without having to liquidate
its inventories.
What are some characteristics of a liquid asset? Give some examples.
What two ratios are used to analyze a firm’s liquidity position?
Write out their equations.
Why is the current ratio the most commonly used measure of short-
term solvency?
Which current asset is typically the least liquid?
A company has current liabilities of $500 million, and its current ratio
is 2.0. What is its level of current assets? ($1,000 million) If this firm’s
quick ratio is 1.6, how much inventory does it have? ($200 million)
4.3 ASSET MANAGEMENT RATIOS
A second group of ratios, the asset management ratios, measures how effectively
the firm is managing its assets. These ratios answer this question: Does the
amount of each type of asset seem reasonable, too high, or too low in view of
3 1/3.2 0.31, or 31%. Note also that 0.31($1,000) $310, the current liabilities balance.
Chapter 4 Analysis of Financial Statements
current and projected sales? When they acquire assets, Allied and other companies
must obtain capital from banks or other sources. If a firm has too many
assets, its cost of capital will be too high and its profits will be depressed. On the
other hand, if assets are too low, profitable sales will be lost. The asset management
ratios described in this section are important.
Inventory Turnover Ratio
“Turnover ratios” are ratios where sales are divided by some asset, and as
the name implies, they show how many times the item is “turned over” during
the year. Thus, the inventory turnover ratio is defined as sales divided by
inventories:
Sales
Inventory turnover ratio
Inventories
$3,000
4.9
$615
Industry average 10.9
As a rough approximation, each item of Allied’s inventory is sold out and
restocked, or “turned over,” 4.9 times per year. “Turnover” is a term that originated
many years ago with the old Yankee peddler, who would load up his
wagon with goods, then go off on his route to peddle his wares. The merchandise
was called “working capital” because it was what he actually sold, or
“turned over,” to produce his profits, whereas his “turnover” was the number of
trips he took each year. Annual sales divided by inventory equaled turnover, or
trips per year. If he made 10 trips per year, stocked 100 pans, and made a gross
profit of $5 per pan, his annual gross profit would be (100)($5)(10) $5,000. If
he went faster and made 20 trips per year, his gross profit would double, other
things held constant. So, his turnover directly affected his profits.
Allied’s turnover of 4.9 is much lower than the industry average of 10.9.
This suggests that it is holding too much inventory. Excess inventory is, of
course, unproductive and represents an investment with a low or zero rate of
return. Allied’s low inventory turnover ratio also makes us question the current
ratio. With such a low turnover, the firm may be holding obsolete goods not
worth their stated value.4
Note that sales occur over the entire year, whereas the inventory figure is for
one point in time. For this reason, it might be better to use an average inventory
measure.5 If the business is highly seasonal, or if there has been a strong upward
or downward sales trend during the year, it is especially useful to make an
adjustment. To maintain comparability with industry averages, however, we did
not use the average inventory figure.
4 A problem arises when calculating and analyzing the inventory turnover ratio. Sales are stated at
market prices, so if inventories are carried at cost, as they generally are, the calculated turnover
overstates the true turnover ratio. Therefore, it might be more appropriate to use cost of goods sold
in place of sales in the formula’s numerator. However, some established compilers of financial ratio
statistics such as Dun & Bradstreet use the ratio of sales to inventories carried at cost. To have a figure
that can be compared with those published by Dun & Bradstreet and similar organizations, it is
necessary to measure inventory turnover with sales in the numerator, as we do here.
5 Preferably, the average inventory value should be calculated by summing the monthly figures during
the year and dividing by 12. If monthly data are not available, the beginning and ending figures
can be added and then divided by 2. Both methods adjust for growth but not for seasonal effects.
Inventory Turnover
Ratio
This ratio is calculated
by dividing sales by
inventories.
Part 2 Fundamental Concepts in Financial Management
Days Sales
Outstanding (DSO)
This ratio is calculated
by dividing accounts
receivable by average
sales per day; it indicates
the average
length of time the
firm must wait after
making a sale before
it receives cash.
Fixed Assets Turnover
Ratio
The ratio of sales to
net fixed assets.
Days Sales Outstanding
Days sales outstanding (DSO), also called the “average collection period”
(ACP), is used to appraise accounts receivable, and it is calculated by dividing
accounts receivable by average daily sales to find how many days’ sales are tied
up in receivables. Thus, the DSO represents the average length of time that the
firm must wait after making a sale before receiving cash. Allied has 46 days sales
outstanding, well above the 36-day industry average:
Days
Receivables Receivables
DSO sales
Average sales per day Annual sales>
365
outstanding
$375 $375
45.625 days ˜
46 days
$3,000>
365 $8.2192
Industry average 36 days
Note that in this calculation we used a 365-day year. Some analysts use a 360day
year; on this basis Allied’s DSO would have been slightly lower, 45 days.6
The DSO can also be evaluated by comparing it with the terms on which the
firm sells its goods. For example, Allied’s sales terms call for payment within 30
days, so the fact that 46 days’ sales, not 30 days’, are outstanding indicates that
customers, on the average, are not paying their bills on time. This deprives the
company of funds that could be used to reduce bank loans or some other type of
costly capital. Moreover, with a high average DSO, it is likely that a number of
customers are paying very late, and those customers may well be in financial
trouble, in which case Allied may never be able to collect the receivable.7 Therefore,
if the trend in DSO over the past few years has been rising, but the credit
policy has not been changed, this would be strong evidence that steps should be
taken to expedite the collection of accounts receivable.
Fixed Assets Turnover Ratio
The fixed assets turnover ratio measures how effectively the firm uses its plant
and equipment. It is the ratio of sales to net fixed assets:
Sales
Fixed assets turnover ratio
Net fixed assets
$3,000
3.0
$1,000
Industry average 2.8
6 It would be somewhat better to use average receivables, either an average of the monthly figures or
(Beginning receivables Ending receivables)/2 ($315 $375)/2 $345 in the formula. Had
average annual receivables been used, Allied’s DSO on a 365-day basis would have been
$345/$8.2192 41.975 days, or approximately 42 days. The 42-day figure is a more accurate one,
but our interest is in comparisons, and because the industry average was based on year-end receivables,
the 46-day number is better for our purposes. The DSO is discussed further in Part 6.
7 For example, if further analysis along the lines suggested in Part 6 indicated that 85 percent of the
customers pay in 30 days, then for the DSO to average 46 days, the remaining 15 percent must be
paying on average in 136.67 days. Paying that late suggests financial difficulties. In Part 6 we also
discuss refinements into this analysis, but a DSO of 46 days would alert a good analyst of the need
to dig deeper.
Chapter 4 Analysis of Financial Statements
Allied’s ratio of 3.0 times is slightly above the 2.8 industry average, indicating
that it is using its fixed assets at least as intensively as other firms in the industry.
Therefore, Allied seems to have about the right amount of fixed assets relative
to its sales.
Potential problems may arise when interpreting the fixed assets turnover
ratio. Recall that fixed assets are shown on the balance sheet at their historical
costs, less depreciation. Inflation has caused the value of many assets that were
purchased in the past to be seriously understated. Therefore, if we compared an
old firm that had acquired many of its fixed assets years ago at low prices with a
new company with similar operations that had acquired its fixed assets only
recently, we would probably find that the old firm had the higher fixed assets
turnover ratio. However, this would be more reflective of when the assets were
acquired than of inefficiency on the part of the new firm. The accounting profession
is trying to develop procedures for making financial statements reflect
current values rather than historical values, which would help us make better
comparisons. However, at the moment the problem still exists, so financial analysts
must recognize that a problem exists and deal with it judgmentally. In
Allied’s case, the issue is not serious because all firms in the industry have been
expanding at about the same rate, hence the balance sheets of the comparison
firms are reasonably comparable.8
Total Assets Turnover Ratio
The final asset management ratio, the total assets turnover ratio, measures the
turnover of all the firm’s assets, and it is calculated by dividing sales by total assets:
Sales
Total assets turnover ratio
Total assets
$3,000
1.5
$2,000
Industry average 1.8
Allied’s ratio is somewhat below the industry average, indicating that it is not
generating enough sales given its total assets. Sales should be increased, some
assets should be disposed of, or a combination of these steps should be taken.
Identify four ratios that are used to measure how effectively a firm
manages its assets, and write out their equations.
If one firm is growing rapidly and another is not, how might this
distort a comparison of their inventory turnover ratios?
If you wanted to evaluate a firm’s DSO, with what would you compare
it?
What potential problem might arise when comparing different firms’
fixed assets turnover ratios?
A firm has annual sales of $100 million, $20 million of inventory,
and $30 million of accounts receivable. What is its inventory
turnover ratio? (5) What is its DSO based on a 365-day year?
(109.5 days)
Total Assets Turnover
Ratio
This ratio is calculated
by dividing sales by
total assets.
8 See FASB #89, Financial Reporting and Changing Prices (December 1986), for a discussion of the
effects of inflation on financial statements. The report’s age indicates how difficult the problem is.
Part 2 Fundamental Concepts in Financial Management
4.4 DEBT MANAGEMENT RATIOS
Financial Leverage
The use of debt
financing.
The extent to which a firm uses debt financing, or financial leverage, has three
important implications: (1) By raising funds through debt, stockholders can control
a firm with a limited amount of equity investment. (2) Creditors look to the
equity, or owner-supplied funds, to provide a margin of safety, so the higher the
proportion of the total capital provided by stockholders, the less the risk faced
by creditors. (3) If the firm earns more on its assets than the interest rate it pays
on debt, then using debt “leverages,” or magnifies, the return on equity, ROE.
Table 4-1 illustrates both the potential benefits and risks resulting from the
use of debt.9 Here we analyze two companies that are identical except for how
they are financed. Firm U (for “Unleveraged”) has no debt and thus 100 percent
common equity, whereas Firm L (for “Leveraged”) is financed with half debt at a
10 percent interest rate and half equity. Both companies have $100 of assets.
Their sales will range from $150 down to $75, depending on business conditions,
with an expected level of $100. Some of their operating costs (rent, the president’s
salary, and so on) are fixed and will be there regardless of the level of
sales, while other costs (some labor costs, materials, and so forth) will vary with
sales.10 When we deduct total operating costs from sales revenues, we are left
with operating income, or earnings before interest and taxes (EBIT).
Notice in the table that everything is the same for the leveraged and
unleveraged firms down through operating income—thus, they have the same
EBIT under the three states of the economy. However, things then begin to differ.
Firm U has no debt so it pays no interest, and its taxable income is the same as
its operating income, and it then pays a 40 percent state and federal tax to get to
its net income, which is $27 under good conditions and $0 under bad conditions.
When net income is divided by common equity, we get the ROE, which ranges
from 27 percent to 0 percent for Firm U.
Firm L has the same EBIT under each condition, but it uses $50 of debt with
a 10 percent interest rate, so it has $5 of interest charges regardless of business
conditions. This amount is deducted from EBIT to get to taxable income, taxes
are then taken out, and the result is net income, which ranges from $24 to $5,
depending on conditions.11 At first blush it looks like Firm U is better off under
all conditions, but this is not correct—we need to consider how much the two
firms’ stockholders have invested. Firm L’s stockholders have put up only $50,
so when that investment is divided into net income, we see that their ROE under
good conditions is a whopping 48 percent (versus 27 percent for U) and is 12
percent (versus 9 percent for U) under expected conditions. However, L’s ROE
falls to 10 percent under bad conditions, which means that it would go bankrupt
if those conditions last for several years.
There are two reasons for the leveraging effect: (1) Because interest is
deductible, the use of debt lowers the tax bill and leaves more of the firm’s operating
income available to its investors. (2) If operating income as a percentage of
9 We discuss ROE in more depth later in the chapter, and we examine the effects of leverage in
detail in the chapter on capital structure.
10 The financial statements do not show the breakdown between fixed and variable operating costs,
but companies can and do make this breakdown for internal purposes. Of course, the distinction is
not always clear, because what’s a fixed cost in the very short run can become a variable cost over a
longer time horizon. It’s interesting to note that companies are moving toward making more of their
costs variable, using such techniques as increasing bonuses rather than base salaries, switching to
profit-sharing plans rather than fixed-pension plans, and outsourcing various parts and materials.
11 As we discussed in the last chapter, firms can carry losses back or forward for several years.
Therefore, if Firm L had profits and thus paid taxes in recent prior years, it could carry its loss
under bad conditions back and receive a credit (a check from the government). In Table 4-1 we
assume that the firm cannot use the carry-back/carry-forward provision.
Chapter 4 Analysis of Financial Statements
TABLE 4-1 Effects of Financial Leverage on Stockholder Returns
FIRM U [UNLEVERAGED (NO DEBT)]
Current assets $ 50 Debt $ 0
Fixed assets 50 Common equity 100
Total assets $100 Total liabilities and equity $100
BUSINESS CONDITIONS
Good Expected Bad
Sales revenues $150.0 $100.0 $75.0
Operating costs Fixed 45.0 45.0 45.0
Variable 60.0 40.0 30.0
Total operating costs 105.0 85.0 75.0
Operating income (EBIT) $ 45.0 $ 15.0 $ 0.0
Interest (Rate = 10%) 0.0 0.0 0.0
Earnings before taxes (EBT) $ 45.0 $ 15.0 $ 0.0
Taxes (Rate = 40%) 18.0 6.0 0.0
Net income (NI) $ 27.0 $ 9.0 $ 0.0
ROEU 27.0% 9.0% 0.0%
FIRM L [LEVERAGED (SOME DEBT)]
Current assets $ 50 Debt $ 50
Fixed assets 50 Common equity 50
Total assets $100 Total liabilities and equity $100
BUSINESS CONDITIONS
Good Expected Bad
Sales revenues $150.0 $100.0 $75.0
Operating costs Fixed 45.0 45.0 45.0
Variable 60.0 40.0 30.0
Total operating costs 105.0 85.0 75.0
Operating income (EBIT) $ 45.0 $ 15.0 $ 0.0
Interest (Rate = 10%) 5.0 5.0 5.0
Earnings before taxes (EBT) $ 40.0 $ 10.0 $ 5.0
Taxes (Rate = 40%) 16.0 4.0 0.0
Net income (NI) $ 24.0 $ 6.0 $ 5.0
ROEL 48.0% 12.0% 10.0%
assets exceeds the interest rate on debt, as it generally is expected to do, then a
company can use debt to acquire assets, pay the interest on the debt, and have
something left over as a “bonus” for its stockholders. Under the expected conditions,
our hypothetical firms expect to earn 15 percent on assets versus a 10 percent
cost of debt, and this, combined with the tax benefit of debt, pushes Firm
L’s expected rate of return on equity up far above that of Firm U.
We see, then, that firms with relatively high debt ratios have higher expected
returns when the economy is normal, but they are exposed to risk of loss when
the economy enters a recession. Therefore, decisions about the use of debt require
firms to balance higher expected returns against increased risk. Determining the
optimal amount of debt is a complicated process, and we defer a discussion of
Part 2 Fundamental Concepts in Financial Management
Debt Ratio
The ratio of total debt
to total assets.
Times-Interest-Earned
(TIE) Ratio
The ratio of earnings
before interest and
taxes (EBIT) to interest
charges; a measure of
the firm’s ability to
meet its annual interest
payments.
that subject to a later chapter on capital structure. For now, we simply look at
two procedures analysts use to examine the firm’s debt: (1) They check the balance
sheet to determine the proportion of total funds represented by debt, and
(2) they review the income statement to see the extent to which fixed charges are
covered by operating profits.
Total Debt to Total Assets
The ratio of total debt to total assets, generally called the debt ratio, measures
the percentage of funds provided by creditors:
Total debt
Debt ratio
Total assets
$310 $750 $1,060
53.0%
$2,000 $2,000
Industry average 40.0%
Total debt includes all current liabilities and long-term debt. Creditors prefer
low debt ratios because the lower the ratio, the greater the cushion against creditors’
losses in the event of liquidation. Stockholders, on the other hand, may
want more leverage because it can magnify expected earnings.
Allied’s debt ratio is 53.0 percent, which means that its creditors have
supplied more than half the total financing. As we will discuss in the capital
structure chapter, a number of factors affect a company’s optimal debt ratio. Nevertheless,
the fact that Allied’s debt ratio exceeds the industry average raises a red
flag, and this will make it relatively costly for Allied to borrow additional funds
without first raising more equity. Creditors will be reluctant to lend the firm more
money, and management would probably be subjecting the firm to the risk of
bankruptcy if it sought to borrow a substantial amount of additional funds.12
Times-Interest-Earned Ratio
The times-interest-earned (TIE) ratio is determined by dividing earnings before
interest and taxes (EBIT in Table 3-2) by the interest charges:
EBIT
Times-interest-earned (TIE) ratio
Interest charges
$283.8
3.2
$88
Industry average 6.0
The TIE ratio measures the extent to which operating income can decline before
the firm is unable to meet its annual interest costs. Failure to pay interest will
bring legal action by the firm’s creditors and probably result in bankruptcy. Note
that earnings before interest and taxes, rather than net income, is used in the
numerator. Because interest is paid with pre-tax dollars, the firm’s ability to pay
current interest is not affected by taxes.
12 The ratio of debt to equity is also used in financial analysis. The debt-to-assets (D/A) and debt-toequity
(D/E) ratios are simply transformations of each other:
D>
AD>
E
D/E = and D/A =
1 D>
A1 D>
E
Chapter 4 Analysis of Financial Statements
Allied’s interest is covered 3.2 times. The industry average is 6 times, so
Allied is covering its interest charges by a relatively low margin of safety. Thus,
the TIE ratio reinforces the primary conclusion from our analysis of the debt
ratio, namely, that Allied would face difficulties if it attempted to borrow additional
funds.
EBITDA Coverage Ratio
The TIE ratio is useful for assessing the ability to meet interest charges on debt,
but it has two shortcomings: (1) Interest is not the only fixed financial charge—
companies must also retire debt on a fixed schedule, and many firms also lease
assets and thus must make lease payments. If they fail to repay debt or meet
lease payments, they can be forced into bankruptcy. (2) EBIT does not represent
all the cash flow available to service debt, especially if a firm has high depreciation
and/or amortization charges. To account for these deficiencies, bankers and
others also use the EBITDA coverage ratio, which shows all of the cash flow
available for payments in the numerator and all of the required financial payments
in the denominator. This ratio is defined as follows:13
EBITDA Lease payments
EBITDA
coverage ratio
Interest Principal payments Lease payments
$383.8 $28 $411.8
3.0
$88 $20 $28 $136
Industry average 4.3
Regarding the numerator, Allied had EBITDA of $383.8 million, consisting of
$283.8 million of operating income (EBIT) and $100 million of depreciation.
However, $28 million of lease payments were deducted when we calculated
EBITDA, yet that $28 million was available to meet financial charges. Therefore,
we must add it back to EBITDA, giving a total of $411.8 million that is available
for fixed financial charges.14 Fixed financial charges consisted of $88 million of
interest, $20 million of sinking fund payments, and $28 million of lease payments,
for a total of $136 million.15 Therefore, Allied covered its fixed financial
charges by 3.0 times. However, if operating income declines, the coverage will
fall, and operating income certainly can decline. As Allied’s ratio is well below
the industry average, we again see that the company has a relatively high level
of debt.
13 Different analysts define the EBITDA coverage ratio in different ways. For example, some would
omit the lease payment information, and others would “gross up” principal payments by dividing
them by (1 T) because these payments are not tax deductions, hence must be made with after-tax
cash flows. We included lease payments because, for many firms, they are quite important, and failing
to make them can lead to bankruptcy just as surely as can failure to make payments on “regular”
debt. We did not gross up principal payments because, if a company is in financial difficulty, its
tax rate will probably be zero, hence the gross up is not necessary whenever the ratio is really
important.
14 Lease payments are included in the numerator because, unlike interest, they were deducted when
EBITDA was calculated. We want to find all the funds that were available to service fixed charges,
so lease payments must be added to the EBIT and DA to find the funds that could be used to service
debt and meet lease payments.
15 A sinking fund is a required annual payment designed to reduce the balance of a bond or preferred
stock issue. A sinking fund payment is like the principal repayment portion of the payment
on an amortized loan, but sinking funds are used for publicly traded bond issues, whereas amortization
payments are used for bank loans and other private loans.
EBITDA Coverage
Ratio
A ratio whose numerator
includes all cash
flows available to meet
fixed financial charges
and whose denominator
includes all fixed
financial charges.
Part 2 Fundamental Concepts in Financial Management
Profitability Ratios
A group of ratios that
show the combined
effects of liquidity,
asset management,
and debt on operating
results.
Profit Margin on Sales
This ratio measures net
income per dollar of
sales; it is calculated by
dividing net income by
sales.
The EBITDA coverage ratio is most useful for relatively short-term lenders
such as banks, which rarely make loans (except real estate–backed loans) for
longer than about five years. Over a relatively short period, depreciation-
generated funds can be used to service debt. Over a longer time, those funds
must be reinvested to maintain the plant and equipment or else the company
cannot remain in business. Therefore, banks and other relatively short-term
lenders focus on the EBITDA coverage ratio, whereas long-term bondholders
focus on the TIE ratio.
What are three important implications of financial leverage?
How does the use of financial leverage affect stockholders’ control
position?
How does the U.S. tax structure influence a firm’s willingness to
finance with debt?
How does the decision to use debt involve a risk-versus-return
trade-off?
Explain the following statement: “Analysts look at both balance
sheet and income statement ratios when appraising a firm’s financial
condition.”
Name three ratios that are used to measure financial leverage, and
write out their equations.
A company has EBITDA of $500 million, interest payments of $50
million, lease payments of $40 million, and required principal
payments (due this year) of $30 million. What is its EBITDA coverage
ratio? (4.5)
4.5 PROFITABILITY RATIOS
Accounting statements reflect things that happened in the past, but they also
give us clues about what’s really important—what’s likely to happen in the
future. The liquidity, asset management, and debt ratios covered thus far tell us
something about the firm’s policies and operations. Now we turn to the
profitability ratios, which reflect the net result of all of the financing policies
and operating decisions.
Profit Margin on Sales
The profit margin on sales, calculated by dividing net income by sales, gives the
profit per dollar of sales:
Net income
Profit margin on sales
Sales
$117.5
3.9%
$3,000
Industry average 5.0%
Allied’s profit margin is below the industry average of 5 percent. This sub-par
result occurs because costs are too high. High costs, in turn, generally occur
because of inefficient operations. However, Allied’s low profit margin is also a
Chapter 4 Analysis of Financial Statements
GLOBAL PERSPECTIVES
GLOBAL PERSPECTIVESGLOBAL PERSPECTIVES
Global Accounting Standards:
Can One Size Fit All?
These days you must be a good financial detective
to analyze financial statements, especially if the
company operates overseas. Despite attempts to standardize
accounting practices, there are still many differences
in financial reporting in different countries that
create headaches for investors making cross-border
company comparisons. However, as businesses become
more global and more foreign companies list
on U.S. stock exchanges, accountants and regulators
are realizing the need for a global convergence of
accounting standards. As a result, the writing is on
the wall regarding accounting standards, and differences
are disappearing.
The effort to internationalize accounting standards
began in 1973 with the formation of the International
Accounting Standards Committee. However, in 1998 it
became apparent that a full-time rule-making body
with global representation was necessary, so the International
Accounting Standards Board (IASB), with
members representing nine major countries, was
established. The IASB was charged with the responsibility
for creating a set of International Financial
Reporting Standards (IFRS) for European Union (EU)
companies by January 1, 2005, when more than 7,000
publicly listed European companies were supposed to
conform to these standards. In contrast, only 350 European
companies were using international standards as
of 2003. A number of other countries, including Australia
and other Pacific Rim countries, South Africa,
Canada, Russia, Japan, and China are interested in
adopting IFRS.
A survey of senior executives from 85 financial
institutions worldwide found that 92 percent of those
responding favored a single set of international stan
dards but only 55 percent thought universal adoption
was achievable. Obviously, the globalization of accounting
standards is a huge endeavor—one that will
involve compromises between the IASB and FASB.
Part of the problem is that U.S. GAAP takes a rules-
based approach, while the IASB insists on using a
principles-based approach. With a rules-based system,
companies can tell whether or not they are in
compliance, but they can also develop ways to get
around a rule and thus subvert its intent. With a principles-
based system, there is greater uncertainty
about whether certain border-line procedures will be
allowed, but such a system makes it easier to prosecute
on the basis of intent.
A global accounting structure would enable
investors and practitioners around the world to read
and understand financial reports produced anywhere
in the world. In addition, it would enhance all companies’
access to all capital markets, which would
improve investor diversification, reduce risk, and
lower the cost of capital. However, it remains to be
seen whether the IASB’s lofty goal can be achieved.
Sources: “All Accountants Soon May Speak the Same Language,”
The Wall Street Journal, August 29, 1995, p. A15;
Jim Cole, “Global Standards Loom for Accounting,” East
Bay Business Times, November 12, 2001; “Accountants
Struggle to Reconcile Rules,” BestWire, April 28, 2003;
“For and Against; Standards Need Time to Work,” Accountancy
Age, June 5, 2003, p. 16; Larry Schlesinger, “Overview;
Bringing about a New Dawn,” Accountancy Age, September
4, 2003, p. 18; Cassell Bryan-Low, “Deals & Deal Makers:
Accounting Changes Are in Store,” The Wall Street
Journal, September 10, 2003, p. C4; and Fay Hansen, “Get
Ready for New Global Accounting Standards,” January
2004, www.BusinessFinanceMag.com.
result of its heavy use of debt. Recall that net income is income after interest.
Therefore, if two firms have identical operations in the sense that their sales,
operating costs, and EBIT are the same, but if one firm uses more debt than the
other, it will have higher interest charges. Those interest charges will pull net
income down, and as sales are constant, the result will be a relatively low profit
margin. In this situation, the low profit margin would indicate a difference in
financing strategies, not an operating problem. Thus, the firm with the low
profit margin might end up with a higher rate of return on its stockholders’
investment due to its use of financial leverage.
Note too that while a high return on sales is good, other things held constant,
other things may not be held constant—we must also be concerned with
turnover. If a firm sets a very high price on its products, it may get a high return
on each sale but not make many sales. That might result in a high profit margin
but still not be optimal because total sales are low.
Part 2 Fundamental Concepts in Financial Management
Return on Total
Assets (ROA)
The ratio of the net
income to total assets.
Basic Earning Power
(BEP) Ratio
This ratio indicates the
ability of the firm’s
assets to generate
operating income; calculated
by dividing
EBIT by total assets.
We will see exactly how profit margins, the use of debt, and turnover interact
to affect overall stockholder returns shortly, when we examine the Du Pont
equation.
Return on Total Assets
The ratio of net income to total assets measures the return on total assets (ROA)
after interest and taxes:
Net income
Return on total assets ROA
Total assets
$117.5
5.9%
$2,000
Industry average 9.0%
Allied’s 5.9 percent return is well below the 9 percent industry average. This is
not good, but a low return on assets is not necessarily bad—it could result from
a conscious decision to use a lot of debt, in which case high interest expenses
will cause net income to be relatively low. Debt is part of the reason for Allied’s
low ROA. Never forget—you must look at a number of ratios, see what each
suggests, and then look at the overall situation when you judge the performance
of a company and try to figure out what it should do to improve.
Basic Earning Power (BEP) Ratio
The basic earning power (BEP) ratio is calculated by dividing earnings before
interest and taxes (EBIT) by total assets:
EBIT
Basic earning power (BEP) ratio
Total assets
$283.8
14.2%
$2,000
Industry average 18.0%
This ratio shows the raw earning power of the firm’s assets, before the influence
of taxes and leverage, and it is useful when comparing firms with different
degrees of financial leverage and tax situations. Because of its low turnover
ratios and poor profit margin on sales, Allied is not earning as high a return on
assets as the average food-processing company.16
16 A related ratio is the return on investors’ capital, defined as follows:
Net income Interest
Return on investors’ capital
Debt Equity
The numerator shows the dollar returns to investors, the denominator shows the money investors
have put up, and the ratio itself shows the rate of return on all investors’ capital. This ratio is especially
important in regulated industries such as electric utilities, where regulators are concerned
about companies’ using their monopoly power to earn excessive returns on investors’ capital. In
fact, regulators try to set electric rates at levels that will force the return on investors’ capital to
equal a company’s cost of capital as defined in Chapter 10.
Chapter 4 Analysis of Financial Statements
Return on Common Equity
The “bottom-line” accounting ratio is the return on common equity (ROE),
found as follows:
Net income
Return on common equity ROE
Common equity
$117.5
12.5%
$940
Industry average 15.0%
Stockholders expect to earn a return on their money, and this ratio tells how well
they are doing in an accounting sense. Allied’s 12.5 percent return is below the
15 percent industry average, but not as far below as the return on total assets.
This somewhat better ROE is due to the company’s greater use of debt, a point
that we discussed earlier in the chapter.
Identify four profitability ratios, and write out their equations.
Why is the basic earning power ratio useful?
Why does the use of debt lower the ROA?
What does ROE measure? Since interest expense lowers profits and
thus the ROA, does using debt necessarily lower the ROE? Explain.
A company has $20 billion of sales and $1 billion of net income. Its
total assets are $10 billion, financed half by debt and half by common
equity. What is its profit margin? (5%) What is its ROA? (10%)
What is its ROE? (20%) Would ROA increase if the firm used less
leverage? (yes) Would ROE increase? (no)
4.6 MARKET VALUE RATIOS
The ROE reflects the effects of all the other ratios and is the best single measure
of performance in an accounting sense. Investors obviously like to see a high
ROE, and high ROEs are generally positively correlated with high stock prices.
However, other things come into play. As we saw earlier, financial leverage generally
increases the ROE but leverage also increases the firm’s risk, which
investors dislike. So, if a high ROE is achieved by the use of a very large amount
of debt, the stock price might well be lower than it would be with less debt and
a lower ROE. Similarly, investors are interested in growth, and if the current
ROE was achieved by holding back on research and development costs, which
will constrain future growth, this will not be regarded favorably.
This takes us to a final group of ratios, the market value ratios, which relate
the firm’s stock price to its earnings, cash flow, and book value per share. These
ratios give management an indication of what investors think of the company’s
risk and future prospects. If the liquidity, asset management, debt management,
and profitability ratios all look good, and if these conditions have been stable
over time, then the market value ratios will be high, the stock price will probably
be as high as can be expected, and management has been doing a good job
and should be rewarded. Otherwise, changes might be needed.
Return on Common
Equity (ROE)
The ratio of net income
to common equity;
measures the rate of
return on common
stockholders’ investment.
Market Value Ratios
A set of ratios that
relate the firm’s stock
price to its earnings,
cash flow, and book
value per share.
Part 2 Fundamental Concepts in Financial Management
Price/Earnings (P/E)
Ratio
The ratio of the price
per share to earnings
per share; shows the
dollar amount investors
will pay for $1 of
current earnings.
Price/Cash Flow Ratio
The ratio of price per
share divided by cash
flow per share; shows
the dollar amount
investors will pay for $1
of cash flow.
Price/Earnings Ratio
The price/earnings (P/E) ratio shows how much investors are willing to pay per
dollar of reported profits. Allied’s stock sells for $23, so with an EPS of $2.35 its
P/E ratio is 9.8:
Price per share
Price>earnings 1P>E2 ratio
Earnings per share
$23.00
9.8
$2.35
Industry average 11.3
As we will see in Chapter 9, P/E ratios are higher for firms with strong growth
prospects and relatively little risk. Allied’s P/E ratio is below the average for
other food processors, so this suggests that the company is regarded as being
somewhat riskier than most, as having poor growth prospects, or both.
Price/Cash Flow Ratio
In some industries, stock price is tied more closely to cash flow rather than net
income. Consequently, investors often look at the price/cash flow ratio:
Price per share
Price>cash flow
Cash flow per share
$23.00
5.3
$4.35
Industry average 5.4
The calculation for cash flow per share was discussed in Chapter 3, but to
refresh your memory, it is equal to net income plus depreciation and amortization
divided by common shares outstanding. Allied’s price/cash flow ratio is
slightly below the industry average, once again suggesting that its growth
prospects are below average, its risk is above average, or both.
Note that for some purposes analysts look at multiples beyond just the
price/earnings and the price/cash flow ratios. For example, depending on the
industry, analysts may look at price/sales, price/customers, or price/(EBITDA
per share). Ultimately, though, value depends on earnings and cash flows, so if
these “exotic” ratios do not forecast future levels of EPS and cash flow, they may
turn out to be misleading.17
Market/Book Ratio
The ratio of a stock’s market price to its book value gives another indication of
how investors regard the company. Companies that are well regarded by
investors—which means companies with safe and growing earnings and cash
17 During the “Internet bubble” of the late 1990s and early 2000s, some Internet companies were
valued by multiplying the number of “hits” to a Web site times some sort of multiple. If those hits
translated to sales and profits, this procedure would have made sense, but generally they did not,
and the result was a vast overvaluation of stocks and a subsequent huge crash. Keep your eye on
earnings and cash flows.
Chapter 4 Analysis of Financial Statements
flows—sell at higher multiples of book value than those with low returns. First,
we find Allied’s book value per share:
Common equity
Book value per share
Shares outstanding
$940
$18.80
50
Then we divide the market price per share by the book value per share to get the
market/book (M/B) ratio, which for Allied is 1.2 times:
Market price per share
Market>
book ratio M>
B
Book value per share
$23.00
1.2
$18.80
Industry average 1.7
Investors are willing to pay less for a dollar of Allied’s book value than for
one of an average food-processing company. This is consistent with our other
findings.
In today’s market (September 2005), the average Standard & Poor’s (S&P)
500 company had a market/book ratio of about 2.87.18 Because M/B ratios typically
exceed 1.0, this means that investors are willing to pay more for stocks than
their accounting book values. This situation occurs primarily because asset values,
as reported by accountants on corporate balance sheets, do not reflect either
inflation or “goodwill.” Thus, assets purchased years ago at preinflation prices
are carried at their original costs, even though inflation might have caused their
actual values to rise substantially, and successful going concerns have a value
greater than their historical costs.
If a company earns a low rate of return on its assets, then its M/B ratio will
be relatively low versus an average company. Some airlines, which have not
fared well in recent years, sell at M/B ratios well below 1.0, while very successful
firms such as Microsoft achieve high rates of return on their assets, resulting
in market values far in excess of their book values. In September 2005
Microsoft’s book value per share was about $4.49 versus a market price of
$26.28, so its market/book ratio was $26.28/$4.49 5.9 times.
Describe three ratios that relate a firm’s stock price to its earnings,
cash flow, and book value per share, and write out their equations.
How do these market value ratios reflect investor’s opinions about a
stock’s risk and expected future growth?
What does the price/earnings (P/E) ratio show? If one firm’s P/E
ratio is lower than that of another, what are some factors that might
explain the difference?
How is book value per share calculated? Explain how inflation and
“goodwill” built up over time could cause book values to deviate
from market values.
Market/Book (M/B)
Ratio
The ratio of a stock’s
market price to its
book value.
18 This was obtained from the key ratios section shown in http://moneycentral.msn.com.
Part 2 Fundamental Concepts in Financial Management
Trend Analysis
An analysis of a firm’s
financial ratios over
time; used to estimate
the likelihood of
improvement or deterioration
in its financial
condition.
Basic Du Pont
Equation
A formula that shows
that the rate of return
on assets can be found
as the product of the
profit margin times the
total assets turnover.
4.7 TREND ANALYSIS
It is important to analyze trends in ratios as well as their absolute levels, for
trends give clues as to whether a firm’s financial condition is likely to improve
or to deteriorate. To do a trend analysis, simply plot a ratio over time, as shown
in Figure 4-1. This graph shows that Allied’s rate of return on common equity
has been declining since 2002, even though the industry average has been relatively
stable. All the other ratios could be analyzed similarly.
How is a trend analysis done?
What important information does a trend analysis provide?
4.8 TYING THE RATIOS TOGETHER:
THE DU PONT EQUATIONS
Table 4-2 summarizes Allied’s ratios. The profit margin times the total assets
turnover is called the basic Du Pont equation, and it gives the rate of return on
assets (ROA):
ROA Profit margin Total assets turnover
Net income Sales
(4-1)
Sales Total assets
3.9% 1.5 5.9%
Allied made 3.9 percent, or 3.9 cents, on each dollar of sales, and assets were
“turned over” 1.5 times during the year. Therefore, the company earned a return
of 5.9 percent on its assets.
FIGURE 4-1 Rate of Return on Common Equity, 2001–2005
ROE
(%)
16
14
12
10
Industry
Allied
2001 2002 2003 2004 2005
Chapter 4 Analysis of Financial Statements
TABLE 4-2 Allied Food Products: Summary
of Financial Ratios (Millions of Dollars)
Ratio Formula Calculation Ratio
Industry
Average Comment
Liquidity
Current
Quick
C
3.2 4.2 Poor
1.2 2.2 Poor$385
$310
urrent assets Inventories
Current liabilities
$1,000
$310
Current assets
Current liabilities
Asset Management
Inventory turnover
Sales
Inventories
4.9 10.9 Poor$3,000
$615
Days sales outstanding (DSO)
Receivables
Annual sales>
365
46 days 36 days Poor$375
$8.2192
Fixed assets turnover
Sales
Net fixed assets
3.0 2.8 OK$3,000
$1,000
Total assets turnover
Sales
Total assets
1.5 1.8
$3,000
$2,000
Somewhat low
Debt Management
Total debt $1,060
Total debt to total assets 53.0% 40.0% High (risky)
Total assets $2,000
Times-interest-Earnings before interest and taxes 1
EBIT2
$283.8
3.2 6.0 Low (risky)
earned 1
TIE2
Interest charges $88
EBITDA Lease payments
$411.8
EBITDA coverage 3.0 4.3 Low (risky)
Interest Principal payments Lease payments $136
Profitability
Net income
Profit margin on sales
Sales
Return on total Net income
assets 1
ROA2
Total assets
Basic earning Earnings before interest and taxes 1
EBIT2
power 1
BEP2
Total assets
Return on common Net income
equity 1
ROE2
Common equity
$117.5
3.9% 5.0% Poor
$3,000
$117.5
5.9% 9.0% Poor
$2,000
$283.8
14.2% 18.0% Poor
$2,000
$117.5
12.5% 15.0% Poor
$940
Market Value
Price/earnings (P/E)
Price per share
Earnings per share
$23.00
$2.35
9.8 11.3 Low
Price/cash flow
Price per share
Cash flow per share
$23.00
$4.35
5.3 5.4 Low
Market/book (M/B)
Market price per share
Book value per share
$23.00
$18.80
1.2 1.7 Low
Part 2 Fundamental Concepts in Financial Management
If the company were financed only with common equity, the rate of return
on assets (ROA) and the return on equity (ROE) would be the same because
total assets would equal common equity:
Net income Net income
ROA ROE
Total assets Common equity
This equality holds if and only if the company uses no debt. Allied does use
debt, so its common equity is less than its total assets. Therefore, the return to
the common stockholders (ROE) must be greater than the ROA of 5.9 percent.
Specifically, to go from the rate of return on assets (ROA) to the return on equity
(ROE) we multiply by the equity multiplier, which is the ratio of total assets to
common equity:
Total assets
Equity multiplier
Common equity
Firms that use large amounts of debt (more leverage) will necessarily have a
high equity multiplier—the greater the debt, the less the equity, hence the higher
the equity multiplier. For example, if a firm has $1,000 of assets and finances
with $800, or 80 percent debt, then its equity will be $200 and its equity multiplier
will be $1,000/$200 5. Had it used only $200 of debt, its equity would
have been $800, and its equity multiplier would have been only $1,000/$800
1.25.19
Allied’s return on equity (ROE) depends on its ROA and its use of
leverage:20
ROE ROA Equity multiplier (4-2)
Net income Total assets
Total assets Common equity
5.9% $2,000/$940
5.9% 2.13
12.5%
When they are combined, Equations 4-1 and 4-2 form the extended Du Pont
equation, which shows how the profit margin, the total assets turnover ratio, and
the equity multiplier combine to determine the ROE:
ROE (Profit margin)(Total assets turnover)(Equity multiplier)
Net income Sales Total assets
(4-3)
Sales Total assets Common equity
19 Expressed algebraically,
DA EAE 1
Debt ratio 1
A A A A Equity multiplier
Here D is debt, E is equity, A is total assets, and A/E is the equity multiplier. This equation ignores
preferred stock.
20 Note that we could also find the ROE by “grossing up” the ROA, that is, by dividing the ROA by
the common equity fraction: ROE ROA/Equity fraction 5.9%/0.47 12.5%. The two procedures
are algebraically equivalent.
Chapter 4 Analysis of Financial Statements
For Allied, we have
ROE (3.9%)(1.5)(2.13)
12.5%
The 12.5 percent rate of return could, of course, be calculated directly: both Sales
and Total assets cancel, leaving Net income/Common equity $117.5/$940
12.5%. However, the extended Du Pont equation shows how the profit margin,
total assets turnover, and use of debt combine to determine the return on equity.
Allied’s management can use the extended Du Pont equation to analyze
ways of improving performance. Focusing on the profit margin, marketing people
can study the effects of raising sales prices (or lowering them to increase volume),
of moving into new products or markets with higher margins, and so on.
Cost accountants can study various expense items and, working with engineers,
purchasing agents, and other operating personnel, seek ways to hold down costs.
Regarding the “turnover” term, the financial staff, working with both production
and marketing people, can investigate ways to reduce the investment in various
types of assets. Finance people can also analyze the effects of alternative financing
strategies, seeking ways to hold down interest expense and the risk associated
with debt while still using leverage to increase the return on equity.
As a result of such an analysis, Ellen Jackson, Allied’s president, recently
announced a series of moves that are expected to cut operating costs by more
than 20 percent per year. Jackson and Allied’s other executives have a strong
incentive for improving its financial performance because their compensation is
based to a large extent on how well the company does. Its executives receive a
salary that is sufficient to cover their living costs, but their compensation package
also includes stock options that will be awarded if and only if Allied meets
or exceeds target levels for earnings and the stock price. These target levels are
based on its performance relative to other food companies. So, if it does well,
then Jackson and the other executives—and the stockholders—will also do well.
But if things deteriorate, Jackson could be looking for a new job.
Write out the equation for the basic Du Pont equation.
What is the equity multiplier?
How can management use the extended Du Pont equation to
analyze ways of improving the firm’s performance?
4.9 COMPARATIVE RATIOS
AND “BENCHMARKING”
Ratio analysis almost always involves comparisons—a company’s ratios are
compared with industry average figures. However, like most firms, Allied’s
managers go one step further—they also compare their ratios with those of leading
food companies. This technique is called benchmarking, and the companies
used for the comparison are called benchmark companies. Allied’s management
benchmarks against Campbell Soup, a leading manufacturer of canned soups;
Dean Foods, a processor of canned and frozen vegetables; Del Monte Foods, a
processor of fruits and vegetables; H. J. Heinz, which makes ketchup and other
products; Flowers Industries, a producer of bakery and snack-food goods; Sara
Lee, a manufacturer of baked goods; and Hershey Foods Corp., a producer of
A good site for comparative
ratios is http://
moneycentral.msn.com.
Here you can find stock
quotes, detailed company
reports, company ratios,
and comparative ratios.
Benchmarking
The process of comparing
a particular
company with a group
of “benchmark”
companies.
Part 2 Fundamental Concepts in Financial Management
chocolates, nonchocolate confectionary products, and pasta. Ratios are calculated
for each company, then listed in descending order as shown below for the profit
margin (the firms’ latest 12 months’ results reported by Yahoo!Finance as of September
15, 2005):
Company Profit Margin
Hershey Foods 11.9%
Campbell Soup 9.4
H. J. Heinz 7.9
Allied Food Products 3.9
Del Monte Foods 3.9
Sara Lee 3.7
Flowers Industries 3.6
Dean Foods 2.6
TABLE 4-3 Key Financial Ratios for Selected Industriesa
Total Days Return Return
Current Inventory Assets Debt Sales Profit on on
Industry Name Ratio Turnoverb Turnover Ratioc Outstandingd Margin Assets Equity
Aerospace/defense 1.1 9.3 0.9 70.8% 49.3 2.8% 2.6% 8.9%
Apparel stores 2.5 4.4 1.6 44.2 12.7 5.0 8.2 14.7
Auto manufacturing—major 1.8 8.2 0.6 85.3 202.8 2.6 1.6 10.9
Beverage (soft drink) 1.0 7.8 0.8 65.0 39.7 10.6 8.5 24.3
Education and training services 1.4 59.4 1.1 40.8 38.4 9.8 10.0 16.9
Electronics—diversified 2.6 4.7 0.7 39.4 70.2 5.7 4.0 6.6
Food processing 2.0 4.6 1.1 52.6 36.1 4.4 4.6 9.7
Food wholesalers 1.2 16.1 3.6 64.1 18.1 2.0 7.1 19.8
Grocery stores 1.1 11.0 2.4 73.9 9.1 0.5 1.2 4.6
Health services—specialized 1.5 27.5 1.6 57.2 47.4 4.3 6.5 15.2
Lodging 1.0 49.4 0.7 56.8 35.1 6.0 4.1 9.5
Metals and minerals—industrial 1.6 4.8 0.6 58.3 42.9 8.4 5.0 12.0
Newspapers 1.1 10.9 0.5 53.4 57.0 9.9 5.4 11.6
Paper and paper products 1.3 6.1 0.7 69.0 71.6 2.7 1.8 5.8
Railroad 0.8 13.2 0.4 64.8 29.2 8.7 3.1 8.8
Restaurant 0.9 30.3 1.1 55.1 11.2 5.7 6.2 13.8
Retail—department stores 1.7 3.6 1.3 65.5 32.6 3.8 4.8 13.9
Scientific and technical
instruments 2.6 3.2 0.8 41.1 76.0 5.4 4.3 7.3
Sporting goods 2.0 3.6 1.1 51.9 53.7 3.4 3.8 7.9
Steel and iron 1.7 5.2 1.0 61.9 46.2 3.9 3.7 9.7
Telecommunications equipment 2.2 7.7 0.7 50.0 86.9 0.2 0.2 0.4
Textile manufacturing 2.1 3.9 1.1 51.6 49.3 2.8 3.1 6.4
Tobacco (cigarettes) 1.1 3.4 0.8 77.6 32.3 6.2 5.0 22.3
Notes:
a The ratios presented are averages for each industry. Ratios for the individual companies are also available.
b The inventory turnover ratio in this table is calculated as the company’s latest 12 months of cost of sales divided by the average of
its inventory for the last quarter and the comparable year earlier quarter.
c The debt ratio in this table is calculated as 1 (ROA/ROE).
d The days sales outstanding ratio in this table was calculated as 365/Receivable turnover. The receivable turnover is calculated as the
company’s latest 12 months of sales divided by the average of its receivables for the last quarter and the comparable year earlier
quarter.
Source: Data obtained from the Key Ratios section, http://moneycentral.msn.com, February 25, 2005.
Chapter 4 Analysis of Financial Statements
Looking for Warning Signs
within the Financial Statements
Enron’s decline spurred a renewed interest in financial
accounting, and analysts now scour companies’
financial statements to see if trouble is lurking. This
renewed interest has led to a list of “red flags” to
consider when reviewing a company’s financial statements.
For example, after conferring with New York
University Accounting Professor Baruch Lev, Fortune
magazine’s Shawn Tully identified the following warning
signs:
•
Year after year, a company reports restructuring
charges and/or write-downs. This practice raises
concerns because companies can use write-
downs to mask operating expenses and thus
results in overstated earnings.
•
A company’s earnings have been propped up
through a series of acquisitions. Acquisitions can
increase earnings if the acquiring company has a
higher P/E than the acquired firm, but such
“growth” cannot be sustained over the long run.
•
A company depreciates its assets more slowly
than the industry average. Lower depreciation
boosts current earnings, but again, this cannot
be sustained because eventually depreciation
must be recognized.
•
A company routinely has high earnings but low
cash flow. As Tully points out, this warning sign
would have exposed Enron’s problems. In the
second quarter of 2001 (a few months before its
problems began to unfold), Enron reported earnings
of $423 million versus a cash flow of minus
$527 million.
Along similar lines, after consulting with various professionals,
Ellen Simon of the Newark Star Ledger
came up with her list of “red flags”:
•
You wouldn’t buy the stock at today’s price.
•
You don’t really understand the company’s financial
statements.
•
The company is in a business that lends itself to
“creative accounting.”
•
The company keeps taking nonrecurring
charges.
•
Accounts receivable and inventory are increasing
faster than sales revenue.
•
The company’s insiders are selling their stock.
•
The company is making aggressive acquisitions,
especially in unrelated fields.
There is some overlap between these two lists. Also,
none of these items automatically means there is
something wrong with the company—instead, the
items should be viewed as warning signs that cause
you to take a closer look at the company’s performance
before making an investment.
The benchmarking setup makes it easy for Allied’s management to see exactly
where it stands relative to the competition. As the data show, Allied is in the
middle of its benchmark group relative to its profit margin, so it has lots of room
for improvement. Other ratios are analyzed similarly.
Comparative ratios are available from a number of sources, including the
MSN Money Web site, http://moneycentral.msn.com. Table 4-3 presents a list of
key ratios for a variety of industries covered by this site. Useful ratios are also
compiled by Value Line Investment Survey, Dun and Bradstreet (D&B), and
Robert Morris Associates, which is the national association of bank loan officers.
Also, financial statement data for thousands of publicly owned corporations are
available on other Internet sites, and as brokerage houses, banks, and other
financial institutions have access to these data, security analysts can and do generate
comparative ratios tailored to their specific needs.
Each of the data-supplying organizations uses a somewhat different set of
ratios designed for its own purposes. For example, D&B deals mainly with small
firms, many of which are proprietorships, and it sells its services primarily to
banks and other lenders. Therefore, D&B is concerned largely with the creditor’s
viewpoint, and its ratios emphasize current assets and liabilities, not market
Part 2 Fundamental Concepts in Financial Management
To find quick information
about a company, link to
http://www.investor
.reuters.com. Here you
can find company profiles
and snapshots, stock price
quotes and share information,
key ratios, and comparative
ratios.
“Window Dressing”
Techniques
Techniques employed
by firms to make their
financial statements
look better than they
really are.
value ratios. So, when you select a comparative data source, you should be sure
that your emphasis is similar to that of the agency whose ratios you plan to use.
Additionally, there are often definitional differences in the ratios presented by
different sources, so before using a source, be sure to verify the exact definitions
of the ratios to ensure consistency with your own work.
Why is it useful to do comparative ratio analyses?
Differentiate between trend and comparative analyses.
What is benchmarking?
4.10 USES AND LIMITATIONS
OF RATIO ANALYSIS
As noted earlier, ratio analysis is used by three main groups: (1) managers, who
employ ratios to help analyze, control, and thus improve their firms’ operations;
(2) credit analysts, including bank loan officers and bond rating analysts, who
analyze ratios to help judge a company’s ability to pay its debts; and (3) stock
analysts, who are interested in a company’s efficiency, risk, and growth
prospects. In later chapters we will look more closely at the basic factors that
underlie each ratio, which will give you a better idea about how to interpret and
use ratios. Note, though, that while ratio analysis can provide useful information
concerning a company’s operations and financial condition, it does have
limitations that necessitate care and judgment. Some potential problems are
listed here:
1.
Many large firms operate different divisions in different industries, and for
such companies it is difficult to develop a meaningful set of industry averages.
Therefore, ratio analysis is more useful for small, narrowly focused
firms than for large, multidivisional ones.
2.
Most firms want to be better than average, so merely attaining average performance
is not necessarily good. As a target for high-level performance, it is
best to focus on the industry leaders’ ratios. Benchmarking helps in this
regard.
3.
Inflation has badly distorted many firms’ balance sheets—recorded values
are often substantially different from “true” values. Further, because inflation
affects both depreciation charges and inventory costs, profits are also
affected. Thus, a ratio analysis for one firm over time, or a comparative
analysis of firms of different ages, must be interpreted with judgment.
4.
Seasonal factors can also distort a ratio analysis. For example, the inventory
turnover ratio for a food processor will be radically different if the balance
sheet figure used for inventory is the one just before versus just after the close
of the canning season. This problem can be minimized by using monthly
averages for inventory (and receivables) when calculating turnover ratios.
5.
Firms can employ “window dressing” techniques to make their financial
statements look stronger. To illustrate, a Chicago builder borrowed on a two-
year basis on December 27, 2005, held the proceeds of the loan as cash for a
few days, and then paid off the loan ahead of time on January 2, 2006. This
improved his current and quick ratios, and made his year-end 2005 balance
sheet look good. However, the improvement was strictly window dressing; a
week later the balance sheet was back at the old level.
6.
Different accounting practices can distort comparisons. As noted earlier,
inventory valuation and depreciation methods can affect financial statements
Chapter 4 Analysis of Financial Statements
and thus distort comparisons among firms. Also, if one firm leases a substantial
amount of its productive equipment, then its assets may appear low relative
to sales because leased assets often do not appear on the balance sheet.
At the same time, the liability associated with the lease obligation may not
appear as debt. Therefore, leasing can artificially improve both the turnover
and the debt ratios. However, the accounting profession has taken steps to
reduce this problem.
7.
It is difficult to generalize about whether a particular ratio is “good” or
“bad.” For example, a high current ratio may indicate a strong liquidity position,
which is good, or excessive cash, which is bad (because excess cash in
the bank is a nonearning asset). Similarly, a high fixed assets turnover ratio
may indicate either that the firm uses its assets efficiently or that it is short of
cash and cannot afford to make needed investments.
8.
A firm may have some ratios that look “good” and others that look “bad,”
making it difficult to tell whether the company is, on balance, strong or
weak. However, statistical procedures can be used to analyze the net effects of
a set of ratios. Many banks and other lending organizations use such procedures
to analyze firms’ financial ratios, and then to classify them according
to their probability of getting into financial trouble.21
Ratio analysis is useful, but analysts should be aware of these problems and
make adjustments as necessary. Ratio analysis conducted in a mechanical,
unthinking manner is dangerous, but used intelligently and with good judgment,
it can provide useful insights into a firm’s operations. Your judgment in
interpreting a set of ratios is bound to be weak at this point, but it will improve
as you read the remaining chapters of this book.
List three types of users of ratio analysis. Would the different users
emphasize the same or different types of ratios? Explain.
List several potential problems with ratio analysis.
4.11 PROBLEMS WITH ROE
In Chapter 1 we said that managers should strive to maximize shareholder
wealth. If a firm takes steps to improve its ROE, does it mean that shareholder
wealth will also increase? Not necessarily, for despite its widespread use and the
fact that ROE and shareholder wealth are often highly correlated, serious problems
can arise if a firm uses ROE as its sole performance measure.
First, ROE does not consider risk. While shareholders clearly care about
returns, they also care about risk. To illustrate this point, consider two divisions
within the same firm. Division S has stable cash flows and a predictable 15 percent
ROE. Division R, on the other hand, has a 16 percent expected ROE, but its cash
flows are quite risky, so the expected ROE may not materialize. If managers were
compensated solely on the basis of ROE, and if the expected ROEs were actually
achieved, then Division R’s manager would receive a higher bonus than S’s, even
though S might actually be creating more value for shareholders as a result of its
lower risk. Also, as we discussed earlier, financial leverage can increase expected
ROE but at the cost of higher risk, so raising ROE through greater use of leverage
may not be good.
21 The technique used is discriminant analysis. The seminal work on this subject was by Edward I.
Altman, “Financial Ratios, Discriminant Analysis, and the Prediction of Corporate Bankruptcy,”
Journal of Finance, September 1968, pp. 589–609.
Part 2 Fundamental Concepts in Financial Management
EVA and ROE
To better understand the idea behind EVA and how
it is connected to ROE, let’s look at Keller Electronics.
Keller has $100,000 in investor-supplied operating
capital, which, in turn, consists of $50,000 of
long-term debt and $50,000 of common equity. The
company has no preferred stock or notes payable.
The long-term debt has a 10 percent interest rate.
However, since the company is in the 40 percent tax
bracket and interest expense is tax deductible, the
after-tax cost of debt is only 6 percent. On the basis
of their assessment of the company’s risk, shareholders
require a 14 percent return. This 14 percent
return is what shareholders could expect to earn if
they were to take their money elsewhere and invest
in stocks that have the same risk as Keller. Keller’s
overall cost of capital is a weighted average of the
cost of debt and equity, and it is 10 percent, found
as 0.50(6%) 0.50(14%) 10%. The total dollar cost
of capital per year is 0.10($100,000) $10,000.
Now let’s look at Keller’s income statement. Its
operating income, EBIT, is $20,000, and its interest
expense is 0.10($50,000) $5,000. Therefore, its
taxable income is $20,000 $5,000 $15,000.
Taxes equal 40 percent of taxable income, or
0.4($15,000) $6,000, so the firm’s net income is
$9,000, and its return on equity, ROE, is
$9,000/$50,000 18%.
Now what is Keller’s EVA? The basic formula for
EVA is
EVA EBIT (1 Corporate tax rate) (Total
investor-supplied operating capital)
(After-tax percentage cost of capital)
$20,000(1 0.40) ($100,000)(0.10)
$2,000
This $2,000 EVA indicates that Keller provided its
shareholders with $2,000 more than they could have
earned elsewhere by investing in other stocks with the
same risk as Keller’s stock. To see where this $2,000
comes from, let’s trace what happens to the money:
•
The firm generates $20,000 in operating income.
•
$6,000 goes to the government to pay taxes,
leaving $14,000.
•
$5,000 goes to the bondholders in the form of
interest payments, thus leaving $9,000.
•
$7,000 is what Keller’s shareholders expected to
earn: (0.14)($50,000) $7,000. Note that this
$7,000 payment is not a requirement to stay in
business—companies can stay in business as
long as they pay their bills and their taxes. However,
this $7,000 is what shareholders expected
to earn, and it is the amount the firm must earn
if it is to avoid reducing shareholder wealth.
Second, ROE does not consider the amount of invested capital. To illustrate,
consider a large company that has $100 invested in Project A, which has an ROE
of 50 percent, and $1,000,000 invested in Project B, which has a 40 percent ROE.
The projects are equally risky, and the two returns are both well above the company’s
cost of the capital invested in the projects. In this example, Project A has a
higher ROE, but because it is so small, it does little to enhance shareholder
wealth. Project B, on the other hand, has the lower ROE, but it adds much more
to shareholder value.
Consider one last problem with ROE. Assume that you manage a division of
a large firm. The firm uses ROE as the sole performance measure, and it determines
bonuses on the basis of ROE. Toward the end of the year, your division’s
ROE is an impressive 45 percent. Now you have an opportunity to invest in a
large, low-risk project that has an estimated ROE of 35 percent, which is well
above the firm’s cost of capital. Even though this project is profitable, you might
be reluctant to make the investment because it would reduce your division’s
average ROE, and therefore reduce the size of your year-end bonus.
These three examples suggest that a project’s return must be combined with
its risk and size to determine its effect on shareholder value:
Chapter 4 Analysis of Financial Statements
•
What’s left over, the $2,000, is EVA. In this case,
Keller’s management created wealth because it
provided shareholders with a return greater than
what they presumably would have earned on
alternative investments with the same risk as
Keller’s stock.
Some Additional Points
•
In practice, it is often necessary to make several
adjustments in order to arrive at a “better” measure
of EVA. The adjustments deal with leased
assets, depreciation, and other accounting details.
•
Shareholders may not immediately receive the
$9,000 that Keller made for them this year (the
$7,000 that shareholders expected plus the
$2,000 of EVA). Keller can either pay its earnings
out as dividends or keep them in the firm as
retained earnings. In either event, the $9,000 is
shareholders’ money. The factors influencing the
dividend payout decision are discussed in the
chapter on dividend policy.
The Connection between ROE and EVA
EVA is different from the traditional accounting measure
of profit because EVA explicitly considers not
just the interest cost of debt but also the cost of
equity. Indeed, using the simple example above, we
could also express EVA as net income minus the dollar
cost of equity:
EVA Net Income [(Equity capital)
(Cost of equity capital)]
$9,000 [($50,000)(0.14)]
$2,000
Note that this is the same number we calculated
before when we used the other formula for calculating
EVA. Note also that the expression above could
be rewritten as follows:
EVA (Equity capital)[Net income/Equity capital
Cost of equity capital]
or simply as
EVA (Equity capital)(ROE Cost of equity capital)
This last expression implies that EVA depends on
three factors: rate of return, as reflected in ROE; risk,
which affects the cost of equity; and size, which is
measured by the equity employed. Recall that earlier
in this chapter we said that shareholder value
depends on risk, return, and capital invested. This
final equation illustrates this point.
Value f(ROE, Risk, Size)
ROE is only one dimension of the value equation, and because actions that
increase expected ROE may also affect the other two factors, steps designed to
increase expected ROE may in some cases be inconsistent with increasing shareholder
wealth. Note that we say “expected ROE,” not simply ROE. All management
decisions are designed to do something in the future, hence to affect future
outcomes.
With all this in mind, academics, practitioners, and consultants have developed
alternative measures that attempt to overcome ROE’s potential problems
when it is used to gauge performance. One such measure is Economic Value
Added (EVA), which was mentioned in Chapter 3 where we calculated EVA. For
a discussion of the connection between ROE and EVA, see the accompanying
box, “EVA and ROE.”
If a firm takes steps that increase its expected future ROE, does this
mean that shareholder wealth will also increase? Explain.
Part 2 Fundamental Concepts in Financial Management
4.12 LOOKING BEYOND THE NUMBERS
Hopefully, working through this chapter has increased your ability to understand
and interpret financial statements. This is critically important for anyone making
business decisions, evaluating performance, or forecasting likely future develop-
ments. Moreover, sound financial analysis involves more than just calculating
Students might want to
refer to AAII’s educational
Web site at http://www
.aaii.com. The site provides
information on
investing basics, financial
planning, portfolio management,
and the like, so
individuals can manage
their own assets more
effectively.
numbers—good analysis requires that certain qualitative factors be considered
when evaluating a company. These factors, as summarized by the American
Association of Individual Investors (AAII), include the following:
1.
Are the company’s revenues tied to one key customer? If so, the company’s
performance may decline dramatically if the customer goes elsewhere. On
the other hand, if the relationship is firmly entrenched, this might actually
stabilize sales.
2.
To what extent are the company’s revenues tied to one key product? Companies that
focus on a single product may be more efficient, but this lack of diversification
also increases risk. If revenues come from several different products, the overall
bottom line will be less affected by an event that leads to a drop in the
demand for one of the products.
3.
To what extent does the company rely on a single supplier? Depending on a single
supplier may lead to unanticipated shortages, which investors and potential
creditors should consider.
4.
What percentage of the company’s business is generated overseas? Companies with
a large percentage of overseas business are often able to realize higher
growth and larger profit margins. However, firms with large overseas operations
may be exposed to regional stability problems, and cash flows from
their various operations also depend on the values of different currencies.
5.
Competition. Increases in competition tend to lower prices and profit margins.
In forecasting future performance, it is important to assess both the likely
actions of the current competitors and the entry by new competitors.
6.
Future products. Is it necessary for the company to invest heavily in research
and development? If so, its future prospects will depend critically on the success
of new products in the pipeline. For example, the market’s assessment
of Boeing’s and Airbus’s future profits depends on how their next generations
of planes are shaping up. Likewise, investors in pharmaceutical companies
are interested in knowing whether the company has a strong pipeline of
potential blockbuster drugs, and that those products are doing well in the
required tests.
7.
Legal and regulatory environment. Changes in laws and regulations have
important implications for many industries. For example, when forecasting
the future of tobacco companies, it is crucial to factor in the effects of proposed
regulations and pending or likely lawsuits. Likewise, when assessing
banks, telecommunications firms, and electric utilities, analysts need to forecast
both the extent to which these industries will be regulated in the future
and the ability of individual firms to respond to changes in regulation.
What are some qualitative factors analysts should consider when
evaluating a company’s likely future financial performance?
Chapter 4 Analysis of Financial Statements
129
Tying It All TogetherTying It All Together
The primary purpose of this chapter was to discuss techniques investors
and managers use to analyze financial statements. The five main categories
of ratios were discussed using data for Allied Foods, and we explained how
trend analysis and benchmarking are used. It is important to realize ratio
analysis is useful, but it must be done intelligently and with good judgment
if it is to provide useful insights into firms’ operations.
SELF-TEST QUESTIONS AND PROBLEMS
(Solutions Appear in Appendix A)
ST-1
Key terms Define each of the following terms:
a.
Liquidity ratios: current ratio; quick ratio
b.
Asset management ratios: inventory turnover ratio; days sales outstanding (DSO);
fixed assets turnover ratio; total assets turnover ratio
c.
Financial leverage: debt ratio; times-interest-earned (TIE) ratio; EBITDA coverage
ratio
d.
Profitability ratios: profit margin on sales; basic earning power (BEP) ratio; return
on total assets (ROA); return on common equity (ROE)
e.
Market value ratios: price/earnings (P/E) ratio; price/cash flow ratio; market/
book (M/B) ratio
f.
Trend analysis; comparative ratio analysis; benchmarking
g.
Basic and extended Du Pont equations; book value per share
h.
“Window dressing”; seasonal effects on ratios
ST-2
Debt ratio Last year, K. Billingsworth & Co. had earnings per share of $4 and dividends
per share of $2. Total retained earnings increased by $12 million during the year, while
book value per share at year-end was $40. Billingsworth has no preferred stock, and
no new common stock was issued during the year. If its year-end total debt was $120
million, what was the company’s year-end debt/assets ratio?
ST-3
Ratio analysis The following data apply to A.L. Kaiser & Company (millions of dollars):
Cash and equivalents $100.00
Fixed assets $283.50
Sales $1,000.00
Net income $50.00
Current liabilities $105.50
Current ratio 3.0
DSOa 40.55 days
ROE 12%
a This calculation is based on a 365-day year.
Kaiser has no preferred stock—only common equity, current liabilities, and long-term
debt.
a.
Find Kaiser’s (1) accounts receivable, (2) current assets, (3) total assets, (4) ROA,
(5) common equity, (6) quick ratio, and (7) long-term debt.
Part 2 Fundamental Concepts in Financial Management
b.
In part a, you should have found Kaiser’s accounts receivable (A/R) $111.1
million. If Kaiser could reduce its DSO from 40.55 days to 30.4 days while holding
other things constant, how much cash would it generate? If this cash were used to
buy back common stock (at book value), thus reducing common equity, how would
this affect (1) the ROE, (2) the ROA, and (3) the total debt/total assets ratio?
QUESTIONS
4-1 Financial ratio analysis is conducted by four groups of analysts: short-term lenders, long-
term lenders, stockholders, and managers. What is the primary emphasis of each group,
and how would that affect the ratios they focus on?
4-2 Why would the inventory turnover ratio be more important for someone analyzing a
grocery store chain than an insurance company?
4-3 Over the past year, M. D. Ryngaert & Co. had an increase in its current ratio and a
decline in its total assets turnover ratio. However, the company’s sales, cash and equivalents,
DSO, and its fixed assets turnover ratio remained constant. What balance sheet
accounts must have changed to produce the indicated changes?
4-4 Profit margins and turnover ratios vary from one industry to another. What differences
would you expect to find between the turnover ratios, profit margins, and Du Pont
equations for a grocery chain and a steel company?
4-5 How does inflation distort ratio analysis comparisons, both for one company over time
(trend analysis) and when different companies are being compared? Are only balance
sheet items or both balance sheet and income statement items affected?
4-6 If a firm’s ROE is low and management wants to improve it, explain how using more
debt might help.
4-7 Give some examples that illustrate how (a) seasonal factors and (b) different growth
rates might distort a comparative ratio analysis. How might these problems be
alleviated?
4-8 Why is it sometimes misleading to compare a company’s financial ratios with those of
other firms that operate in the same industry?
4-9 Suppose you were comparing a discount merchandiser with a high-end merchandiser.
Suppose further that both companies had identical ROEs. If you applied the extended
Du Pont equation to both firms, would you expect the three components to be the same
for each company? If not, explain what balance sheet and income statement items might
lead to the component differences.
4-10 Indicate the effects of the transactions listed in the following table on total current assets,
current ratio, and net income. Use () to indicate an increase, () to indicate a decrease,
and (0) to indicate either no effect or an indeterminate effect. Be prepared to state any
necessary assumptions, and assume an initial current ratio of more than 1.0. (Note: A
good accounting background is necessary to answer some of these questions; if yours is
not strong, just answer the questions you can handle.)
Total Effect
Current Current on Net
Assets Ratio Income
a. Cash is acquired through issuance of additional
common stock. _____ _____ _____
b. Merchandise is sold for cash. _____ _____ _____
c.
d.
Federal income tax due for the previous year is paid.
A fixed asset is sold for less than book value.
_____
_____
_____
_____
_____
_____
e. A fixed asset is sold for more than book value. _____ _____ _____
f. Merchandise is sold on credit. _____ _____ _____
g.
h.
Payment is made to trade creditors for previous
purchases.
A cash dividend is declared and paid.
_____
_____
_____
_____
_____
_____
Chapter 4 Analysis of Financial Statements
Total Effect
Current Current on Net
Assets Ratio Income
Easy
Problems 1–6
4-1
4-2
4-3
4-4
Intermediate
Problems 7–19
4-5
4-6
4-7
4-8
4-9
4-10
4-11
i. Cash is obtained through short-term bank loans. _____ _____ _____
j. Short-term notes receivable are sold at a discount. _____ _____ _____
k. Marketable securities are sold below cost. _____ _____ _____
l. Advances are made to employees. _____ _____ _____
m. Current operating expenses are paid. _____ _____ _____
n. Short-term promissory notes are issued to trade
creditors in exchange for past due accounts payable. _____ _____ _____
o. Ten-year notes are issued to pay off accounts
payable. _____ _____ _____
p. A fully depreciated asset is retired. _____ _____ _____
q. Accounts receivable are collected. _____ _____ _____
r. Equipment is purchased with short-term notes. _____ _____ _____
s. Merchandise is purchased on credit. _____ _____ _____
t. The estimated taxes payable are increased. _____ _____ _____
PROBLEMS
Days sales outstanding Baker Brothers has a DSO of 40 days, and its annual sales are
$7,300,000. What is its accounts receivable balance? Assume it uses a 365-day year.
Debt ratio Bartley Barstools has an equity multiplier of 2.4, and its assets are financed
with some combination of long-term debt and common equity. What is its debt ratio?
Du Pont analysis Doublewide Dealers has an ROA of 10 percent, a 2 percent profit
margin, and an ROE of 15 percent. What is its total assets turnover? What is its equity
multiplier?
Market/book ratio Jaster Jets has $10 billion in total assets. Its balance sheet shows $1
billion in current liabilities, $3 billion in long-term debt, and $6 billion in common equity.
It has 800 million shares of common stock outstanding, and its stock price is $32 per
share. What is Jaster’s market/book ratio?
Price/earnings ratio A company has an EPS of $2.00, a cash flow per share of $3.00, and
a price/cash flow ratio of 8.0. What is its P/E ratio?
Du Pont and ROE A firm has a profit margin of 2 percent and an equity multiplier of
2.0. Its sales are $100 million and it has total assets of $50 million. What is its ROE?
Du Pont and net income Ebersoll Mining has $6 million in sales; its ROE is 12 percent;
and its total assets turnover is 3.2. The company is 50 percent equity financed. What is
its net income?
Basic earning power Duval Manufacturing recently reported the following information:
Net income $600,000
ROA 8%
Interest expense $225,000
Its tax rate is 35 percent. What is its basic earning power (BEP)?
M/B and share price You are given the following information: Stockholders’ equity
$3.75 billion; price/earnings ratio 3.5; common shares outstanding 50 million; and
market/book ratio 1.9. Calculate the price of a share of the company’s common stock.
Ratio calculations Assume you are given the following relationships for the Brauer Corp.:
Sales/total assets 1.5
Return on assets (ROA) 3%
Return on equity (ROE) 5%
Calculate Brauer’s profit margin and debt ratio.
EBITDA coverage ratio Willis Publishing has $30 billion in total assets. Its basic earning
power (BEP) ratio is 20 percent, and its times-interest-earned ratio is 8.0. Willis’ depreciation
and amortization expense totals $3.2 billion. It has $2 billion in lease payments, and
Part 2 Fundamental Concepts in Financial Management
Challenging
Problems 20–24
$1 billion must go toward principal payments on outstanding loans and long-term debt.
What is Willis’s EBITDA coverage ratio?
4-12 Ratio calculations Graser Trucking has $12 billion in assets, and its tax rate is 40 percent.
Its basic earning power (BEP) ratio is 15 percent, and its return on assets (ROA) is 5 percent.
What is its times-interest-earned (TIE) ratio?
4-13 Times-interest-earned ratio The H.R. Pickett Corp. has $500,000 of debt outstanding, and
it pays an annual interest rate of 10 percent. Its annual sales are $2 million, its average
tax rate is 30 percent, and its net profit margin on sales is 5 percent. What is its TIE ratio?
4-14 Return on equity Midwest Packaging’s ROE last year was only 3 percent, but its management
has developed a new operating plan that calls for a total debt ratio of 60 percent,
which will result in annual interest charges of $300,000. Management projects an
EBIT of $1,000,000 on sales of $10,000,000, and it expects to have a total assets turnover
ratio of 2.0. Under these conditions, the tax rate will be 34 percent. If the changes are
made, what will be its return on equity?
4-15 Return on equity and quick ratio Lloyd Inc. has sales of $200,000, a net income of
$15,000, and the following balance sheet:
Cash $ 10,000 Accounts payable $ 30,000
Receivables 50,000 Other current liabilities 20,000
Inventories 150,000 Long-term debt 50,000
Net fixed assets 90,000 Common equity 200,000
Total assets $300,000 Total liabilities and equity $300,000
The new owner thinks that inventories are excessive and can be lowered to the point
where the current ratio is equal to the industry average, 2.5, without affecting either
sales or net income. If inventories are sold off and not replaced thus reducing the current
ratio to 2.5, if the funds generated are used to reduce common equity (stock can be
repurchased at book value), and if no other changes occur, by how much will the ROE
change? What will be the firm’s new quick ratio?
4-16 Return on equity Central City Construction (CCC) needs $1 million of assets to get
started, and it expects to have a basic earning power ratio of 20 percent. CCC will own
no securities, so all of its income will be operating income. If it chooses to, CCC can
finance up to 50 percent of its assets with debt, which will have an 8 percent interest
rate. Assuming a 40 percent tax rate on all taxable income, what is the difference between
its expected ROE if CCC finances with 50 percent debt versus its expected ROE if it
finances entirely with common stock?
4-17 Conceptual: Return on equity Which of the following statements is most correct? (Hint:
Work Problem 4-16 before answering 4-17, and consider the solution setup for 4-16, as
you think about 4-17.)
a.
b.
c.
d.
If a firm’s expected basic earning power (BEP) is constant for all of its assets and
exceeds the interest rate on its debt, then adding assets and financing them with
debt will raise the firm’s expected return on common equity (ROE).
The higher its tax rate, the lower a firm’s BEP ratio will be, other things held constant.
The higher the interest rate on its debt, the lower a firm’s BEP ratio will be, other
things held constant.
The higher its debt ratio, the lower a firm’s BEP ratio will be, other things held
constant.
e. Statement a is false, but statements b, c, and d are all true.
4-18 TIE ratio AEI Incorporated has $5 billion in assets, and its tax rate is 40 percent. Its basic
earning power (BEP) ratio is 10 percent, and its return on assets (ROA) is 5 percent.
What is AEI’s times-interest-earned (TIE) ratio?
4-19 Current ratio The Petry Company has $1,312,500 in current assets and $525,000 in current
liabilities. Its initial inventory level is $375,000, and it will raise funds as additional
notes payable and use them to increase inventory. How much can its short-term debt
(notes payable) increase without pushing its current ratio below 2.0?
4-20 DSO and accounts receivable Harrelson Inc. currently has $750,000 in accounts receivable,
and its days sales outstanding (DSO) is 55 days. It wants to reduce its DSO to 35
days by pressuring more of its customers to pay their bills on time. If this policy is
adopted the company’s average sales will fall by 15 percent. What will be the level of
accounts receivable following the change? Assume a 365-day year.
Chapter 4 Analysis of Financial Statements
4-21
P/E and stock price Fontaine Inc. recently reported net income of $2 million. It has
500,000 shares of common stock, which currently trades at $40 a share. Fontaine continues
to expand and anticipates that 1 year from now its net income will be $3.25 million. Over
the next year it also anticipates issuing an additional 150,000 shares of stock, so that 1
year from now it will have 650,000 shares of common stock. Assuming its price/earnings
ratio remains at its current level, what will be its stock price 1 year from now?
4-22
Balance sheet analysis Complete the balance sheet and sales information that follows
using the following financial data:
Debt ratio: 50%
Current ratio: 1.8
Total assets turnover: 1.5
Days sales outstanding: 36.5 daysa
Gross profit margin on sales: (Sales Cost of goods sold)/Sales 25%
Inventory turnover ratio: 5
a Calculation is based on a 365-day year.
Balance Sheet
Cash Accounts payable
Accounts receivable Long-term debt 60,000
Inventories Common stock
Fixed assets Retained earnings 97,500
Total assets $300,000 Total liabilities and equity
Sales Cost of goods sold
4-23
Ratio analysis Data for Barry Computer Co. and its industry averages follow.
a.
Calculate the indicated ratios for Barry.
b.
Construct the extended Du Pont equation for both Barry and the industry.
c.
Outline Barry’s strengths and weaknesses as revealed by your analysis.
d.
Suppose Barry had doubled its sales as well as its inventories, accounts receivable,
and common equity during 2005. How would that information affect the validity of
your ratio analysis? (Hint: Think about averages and the effects of rapid growth on
ratios if averages are not used. No calculations are needed.)
Barry Computer Company: Balance Sheet as of
December 31, 2005 (In Thousands)
Cash $ 77,500 Accounts payable $129,000
Receivables 336,000 Notes payable 84,000
Inventories 241,500 Other current liabilities 117,000
Total current assets $655,000 Total current liabilities $330,000
Long-term debt 256,500
Net fixed assets 292,500 Common equity 361,000
Total assets $947,500 Total liabilities and equity $947,500
Barry Computer Company: Income Statement for
Year Ended December 31, 2005 (In Thousands)
Sales
$1,607,500
Cost of goods sold
Materials $717,000
Labor 453,000
Heat, light, and power 68,000
Indirect labor 113,000
Depreciation 41,500 1,392,500
Gross profit $ 215,000
Selling expenses 115,000
General and administrative expenses 30,000
Earnings before interest and taxes (EBIT) $ 70,000
Interest expense 24,500
Earnings before taxes (EBT) $ 45,500
Federal and state income taxes (40 percent) 18,200
Net income
$ 27,300
Part 2 Fundamental Concepts in Financial Management
Ratio Barry Industry Average
4-24
Current _____ 2.0
Quick _____ 1.3
Days sales outstandinga _____ 35 days
Inventory turnover _____ 6.7
Total assets turnover _____ 3.0
Net profit margin _____ 1.2%
ROA _____ 3.6%
ROE _____ 9.0%
Total debt/total assets _____ 60.0%
a Calculation is based on a 365-day year.
Du Pont analysis A firm has been experiencing low profitability in recent years. Perform
an analysis of the firm’s financial position using the extended Du Pont equation. The
firm has no lease payments, but has a $2 million sinking fund payment on its debt. The
most recent industry average ratios and the firm’s financial statements are as follows:
Industry Average Ratios
Current ratio 2 Fixed assets turnover 6
Debt/total assets 30% Total assets turnover 3
Times interest earned 7 Profit margin on sales 3%
EBITDA coverage 9 Return on total assets 9%
Inventory turnover 10 Return on common equity 12.9%
Days sales outstandinga 24 days
a Calculation is based on a 365-day year.
Balance Sheet as of December 31, 2005 (Millions of Dollars)
Cash and equivalents $ 78 Accounts payable $ 45
Net receivables 66 Notes payable 45
Inventories 159 Other current liabilities 21
Total current assets $303 Total current liabilities $ 111
Long-term debt 24
Total liabilities $ 135
Gross fixed assets 225
Less depreciation 78 Common stock 114
Net fixed assets $147 Retained earnings 201
Total stockholders’ equity $ 315
Total assets $450 Total liabilities and equity $ 450
Income Statement for Year Ended December 31, 2005
(Millions of Dollars)
Net sales $795.0
Cost of goods sold 660.0
Gross profit $135.0
Selling expenses 73.5
EBITDA $ 61.5
Depreciation expense 12.0
Earnings before interest and taxes (EBIT) $ 49.5
Interest expense 4.5
Earnings before taxes (EBT) $ 45.0
Taxes (40%) 18.0
Net income $ 27.0
Chapter 4 Analysis of Financial Statements
a. Calculate those ratios that you think would be useful in this analysis.
b. Construct an extended Du Pont equation, and compare the company’s ratios to the
industry average ratios.
c. Do the balance sheet accounts or the income statement figures seem to be primarily
responsible for the low profits?
d. Which specific accounts seem to be most out of line relative to other firms in the
industry?
e. If the firm had a pronounced seasonal sales pattern, or if it grew rapidly during the
year, how might that affect the validity of your ratio analysis? How might you correct
for such potential problems?
COMPREHENSIVE/SPREADSHEET
PROBLEM
4-25
Ratio analysis The Corrigan Corporation’s 2004 and 2005 financial statements follow,
along with some industry average ratios.
a.
Assess Corrigan’s liquidity position, and determine how it compares with peers and
how the liquidity position has changed over time.
b.
Assess Corrigan’s asset management position, and determine how it compares with
peers and how its asset management efficiency has changed over time.
c.
Assess Corrigan’s debt management position, and determine how it compares with
peers and how its debt management has changed over time.
d.
Assess Corrigan’s profitability ratios, and determine how they compare with peers
and how the profitability position has changed over time.
e.
Assess Corrigan’s market value ratios, and determine how their valuation compares
with peers and how it has changed over time.
f.
Calculate Corrigan’s ROE, as well as the industry average ROE, using the extended
Du Pont equation. From this analysis, how does Corrigan’s financial position compare
with the industry average numbers?
g.
What do you think would happen to its ratios if the company initiated cost-cutting
measures that allowed it to hold lower levels of inventory and substantially
decreased the cost of goods sold? No calculations are necessary. Think about which
ratios would be affected by changes in these two accounts.
Corrigan Corporation: Balance Sheets as of December 31
2005
2004
Cash $ 72,000 $ 65,000
Accounts receivable 439,000 328,000
Inventories 894,000 813,000
Total current assets $1,405,000 $1,206,000
Land and building 238,000 271,000
Machinery 132,000 133,000
Other fixed assets 61,000 57,000
Total assets
$1,836,000 $1,667,000
Accounts and notes payable $ 432,000 $ 409,500
Accrued liabilities 170,000 162,000
Total current liabilities $ 602,000 $ 571,500
Long-term debt 404,290 258,898
Common stock 575,000 575,000
Retained earnings 254,710 261,602
Total liabilities and equity
$1,836,000 $1,667,000
Part 2 Fundamental Concepts in Financial Management
Corrigan Corporation: Income Statements for
Years Ending December 31
2005 2004
Sales $4,240,000 $3,635,000
Cost of goods sold 3,680,000 2,980,000
Gross operating profit $ 560,000 $ 655,000
General administrative and selling expenses 236,320 213,550
Depreciation 159,000 154,500
Miscellaneous 134,000 127,000
Earnings before taxes (EBT) $ 30,680 $ 159,950
Taxes (40%) 12,272 63,980
Net income $ 18,408 $ 95,970
Per-Share Data
2005 2004
EPS $0.80 $4.17
Cash dividends $1.10 $0.95
Market price (average) $12.34 $23.57
P/E ratio 15.4 5.65
Number of shares outstanding 23,000 23,000
Industry Financial Ratiosa
Current ratio 2.7
Inventory turnoverb 7.0
Days sales outstandingc 32 days
Fixed assets turnoverb 13.0
Total assets turnoverb 2.6
Return on assets 9.1%
Return on equity 18.2%
Debt ratio 50.0%
Profit margin on sales 3.5%
P/E ratio 6.0
Price/cash flow ratio 3.5
a Industry average ratios have been constant for the past 4 years.
b Based on year-end balance sheet figures.
c Calculation is based on a 365-day year.
Integrated Case
D’Leon Inc., Part II
4-26 Financial statement analysis Part I of this case, presented in Chapter 3, discussed the situation that D’Leon
Inc., a regional snack-foods producer, was in after an expansion program. D’Leon had increased plant capacity
and undertaken a major marketing campaign in an attempt to “go national.” Thus far, sales have not been
up to the forecasted level, costs have been higher than were projected, and a large loss occurred in 2005 rather
than the expected profit. As a result, its managers, directors, and investors are concerned about the firm’s
survival.
Donna Jamison was brought in as assistant to Fred Campo, D’Leon’s chairman, who had the task of getting
the company back into a sound financial position. D’Leon’s 2004 and 2005 balance sheets and income
statements, together with projections for 2006, are given in Tables IC4-1 and IC4-2. In addition, Table IC4-3
gives the company’s 2004 and 2005 financial ratios, together with industry average data. The 2006 projected
financial statement data represent Jamison’s and Campo’s best guess for 2006 results, assuming that some
new financing is arranged to get the company “over the hump.”
Chapter 4 Analysis of Financial Statements
Jamison examined monthly data for 2005 (not given in the case), and she detected an improving pattern
during the year. Monthly sales were rising, costs were falling, and large losses in the early months had turned
to a small profit by December. Thus, the annual data look somewhat worse than final monthly data. Also, it
appears to be taking longer for the advertising program to get the message across, for the new sales offices to
generate sales, and for the new manufacturing facilities to operate efficiently. In other words, the lags between
spending money and deriving benefits were longer than D’Leon’s managers had anticipated. For these reasons,
Jamison and Campo see hope for the company—provided it can survive in the short run.
Jamison must prepare an analysis of where the company is now, what it must do to regain its financial
health, and what actions should be taken. Your assignment is to help her answer the following questions. Provide
clear explanations, not yes or no answers.
a.
Why are ratios useful? What are the five major categories of ratios?
b.
Calculate D’Leon’s 2006 current and quick ratios based on the projected balance sheet and income statement
data. What can you say about the company’s liquidity positions in 2004, 2005, and as projected for
2006? We often think of ratios as being useful (1) to managers to help run the business, (2) to bankers for
credit analysis, and (3) to stockholders for stock valuation. Would these different types of analysts have
an equal interest in these liquidity ratios?
c.
Calculate the 2006 inventory turnover, days sales outstanding (DSO), fixed assets turnover, and total
assets turnover. How does D’Leon’s utilization of assets stack up against other firms in its industry?
d.
Calculate the 2006 debt, times-interest-earned, and EBITDA coverage ratios. How does D’Leon compare
with the industry with respect to financial leverage? What can you conclude from these ratios?
e.
Calculate the 2006 profit margin, basic earning power (BEP), return on assets (ROA), and return on equity
(ROE). What can you say about these ratios?
f.
Calculate the 2006 price/earnings ratio, price/cash flow ratio, and market/book ratio. Do these ratios
indicate that investors are expected to have a high or low opinion of the company?
g.
Use the extended Du Pont equation to provide a summary and overview of D’Leon’s financial condition
as projected for 2006. What are the firm’s major strengths and weaknesses?
h.
Use the following simplified 2006 balance sheet to show, in general terms, how an improvement in the
DSO would tend to affect the stock price. For example, if the company could improve its collection procedures
and thereby lower its DSO from 45.6 days to the 32-day industry average without affecting sales,
how would that change “ripple through” the financial statements (shown in thousands below) and influence
the stock price?
Accounts receivable
Other current assets
Net fixed assets
Total assets
$ 878
1,802
817
$3,497
Debt
Equity
Liabilities plus equity
$1,545
1,952
$3,497
i.
Does it appear that inventories could be adjusted, and, if so, how should that adjustment affect D’Leon’s
profitability and stock price?
j.
In 2005, the company paid its suppliers much later than the due dates, and it was not maintaining financial
ratios at levels called for in its bank loan agreements. Therefore, suppliers could cut the company off,
and its bank could refuse to renew the loan when it comes due in 90 days. On the basis of data provided,
would you, as a credit manager, continue to sell to D’Leon on credit? (You could demand cash on
delivery—that is, sell on terms of COD—but that might cause D’Leon to stop buying from your
company.) Similarly, if you were the bank loan officer, would you recommend renewing the loan or
demand its repayment? Would your actions be influenced if, in early 2006, D’Leon showed you its 2006
projections plus proof that it was going to raise more than $1.2 million of new equity?
k.
In hindsight, what should D’Leon have done back in 2004?
l.
What are some potential problems and limitations of financial ratio analysis?
m.
What are some qualitative factors analysts should consider when evaluating a company’s likely future
financial performance?
Part 2 Fundamental Concepts in Financial Management
TABLE IC4-1 Balance Sheets
2006E 2005
Assets
Cash $ 85,632 $ 7,282 $ 57,600
Accounts receivable 878,000 632,160 351,200
Inventories 1,716,480 1,287,360 715,200
Total current assets $2,680,112 $1,926,802 $1,124,000
Gross fixed assets 1,197,160 1,202,950 491,000
Less accumulated depreciation 380,120 263,160 146,200
Net fixed assets $ 817,040 $ 939,790 $ 344,800
Total assets $3,497,152 $2,866,592 $1,468,800
Liabilities and Equity
Accounts payable $ 436,800 $ 524,160 $ 145,600
Notes payable 300,000 636,808 200,000
Accruals 408,000 489,600 136,000
Total current liabilities $1,144,800 $1,650,568 $ 481,600
Long-term debt 400,000 723,432 323,432
Common stock 1,721,176 460,000 460,000
Retained earnings 231,176 32,592 203,768
Total equity $1,952,352 $ 492,592 $ 663,768
Total liabilities and equity $3,497,152 $2,866,592 $1,468,800
Note: “E” indicates estimated. The 2006 data are forecasts.
TABLE IC4-2 Income Statements
2006E 2005
Sales $7,035,600 $6,034,000 $3,432,000
Cost of goods sold 5,875,992 5,528,000 2,864,000
Other expenses 550,000 519,988 358,672
Total operating costs excluding
depreciation $6,425,992 $6,047,988 $3,222,672
EBITDA $ 609,608 ($ 13,988) $ 209,328
Depreciation 116,960 116,960 18,900
EBIT $ 492,648 ($ 130,948) $ 190,428
Interest expense 70,008 136,012 43,828
EBT $ 422,640 ($ 266,960) $ 146,600
Taxes (40%) 169,056 ( 106,784)a 58,640
Net income $ 253,584 ($ 160,176) $ 87,960
EPS $1.014 ($1.602) $0.880
DPS $0.220 $0.110 $0.220
Book value per share $7.809 $4.926 $6.638
Stock price $12.17 $2.25 $8.50
Shares outstanding 250,000 100,000 100,000
Tax rate 40.00% 40.00% 40.00%
Lease payments 40,000 40,000 40,000
Sinking fund payments 0 0 0
Note: “E” indicates estimated. The 2006 data are forecasts.
a The firm had sufficient taxable income in 2003 and 2004 to obtain its full tax refund in 2005.
Chapter 4 Analysis of Financial Statements
TABLE IC4-3 Ratio Analysis
2006E 2005 2004
Industry
Average
Current
Quick
Inventory turnover
Days sales outstanding (DSO)a
Fixed assets turnover
Total assets turnover
Debt ratio
TIE
EBITDA coverage
Profit margin
Basic earning power
ROA
ROE
Price/earnings
Price/cash flow
Market/book
Book value per share
1.2
0.4
4.7
38.2
6.4
2.1
82.8%
1.0
0.1
2.7%
4.6%
5.6%
32.5%
1.4
5.2
0.5
$4.93
2.3
0.8
4.8
37.4
10.0
2.3
54.8%
4.3
3.0
2.6%
13.0%
6.0%
13.3%
9.7
8.0
1.3
$6.64
2.7
1.0
6.1
32.0
7.0
2.6
50.0%
6.2
8.0
3.5%
19.1%
9.1%
18.2%
14.2
11.0
2.4
n.a.
Note: “E” indicates estimated. The 2006 data are forecasts.
a Calculation is based on a 365-day year.
Please go to the ThomsonNOW Web site to access the
Cyberproblems.
Part 2 Fundamental Concepts in Financial Management
Access the Thomson ONE problems though the ThomsonNOW Web site. Use the Thomson
ONE—Business School Edition online database to work this chapter’s questions.
Conducting a Financial Ratio Analysis on Ford Motor Company
In Chapter 3, we took a look at Starbucks’ financial statements. Now we use Thomson
One to analyze Ford Motor Company.
Enter Ford’s ticker symbol (F) and select “GO.” If we select the tab at the top labeled
“Financials,” we can find Ford’s key financial statements for the past several years. At the
“Financials” screen on the second line of tabs, select the “Fundamental Ratios” tab. If
you then select the SEC Database Ratios from the pull-down menu, you can select either
annual or quarterly ratios.
Under annual ratios, there is an in-depth summary of Ford’s various ratios over the
past 3 years. This information enables you to evaluate Ford’s performance over time for
each of the ratio categories that we mention in the text (liquidity, asset management,
debt management, profitability, and market-based ratios).
The text mentions that financial statement analysis has two major components: a
trend analysis, where we evaluate changes in the key ratios over time, and a peer analysis,
where we compare financial ratios with firms that are in the same industry and/or line
of business. We have already used Thomson One to conduct a trend analysis—next we
use this tool to conduct a peer analysis. If we click on the “Peers” tab (on the first line of
tabs) near the top of the screen, some summary financial information for Ford and a few
of its peers will be presented. If you click on the “Peer Sets” tab (second line of tabs),
you can modify the list of peer firms. The default setup is “Peers set by SIC Code.” To
obtain a comparison of many of the key ratios presented in the text, just click on “Financials”
(second line of tabs) and select “Key Financial Ratios” from the drop-down menu.
Discussion Questions
1.
What has happened to Ford’s liquidity position over the past 3 years? How does
Ford’s liquidity compare with its peers? (Hint: You may use both the peer key financial
ratios and liquidity comparison to answer this question.)
2.
Take a look at Ford’s inventory turnover ratio. How does this ratio compare with its
peers? Have there been any interesting changes over time in this measure? Do you
consider Ford’s inventory management to be a strength or a weakness?
3.
Construct a simple Du Pont analysis for Ford and its peers. What are Ford’s strengths
and weaknesses relative to its competitors?

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