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CHAPTER 13: Analysis of Financial Statements. Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis Qualitative factors. Income Statement. Balance Sheets: Assets. Balance Sheets: Liabilities & Equity. Other Data. Why are ratios useful?.

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CHAPTER 13: Analysis of Financial Statements

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Chapter 13 analysis of financial statements

CHAPTER 13: Analysis of Financial Statements

  • Ratio analysis

  • Du Pont system

  • Effects of improving ratios

  • Limitations of ratio analysis

  • Qualitative factors

Income statement

Income Statement

Balance sheets assets

Balance Sheets: Assets

Balance sheets liabilities equity

Balance Sheets: Liabilities & Equity

Other data

Other Data

Why are ratios useful

Why are ratios useful?

  • Standardize numbers; facilitate comparisons

  • Used to highlight weaknesses and strengths

Five major categories of ratios

Five Major Categories of Ratios

  • Liquidity: Can we make required payments as they fall due?

  • Asset management: Do we have the right amount of assets for the level of sales?


Ratio categories continued

Ratio Categories (Continued)

  • Debt management: Do we have the right mix of debt and equity?

  • Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA?

  • Market value: Do investors like what they see as reflected in P/E and M/B ratios?

Forecasted current and quick ratios for 2005





CR05 = = = 2.58x.

CA - Inv.


QR05 =

$2,680 - $1,716


= = 0.93x.

Forecasted Current and Quick Ratios for 2005.

Comments on cr and qr

Comments on CR and QR

  • Expected to improve but still below the industry average.

  • Liquidity position is weak.

Inventory turnover ratio vs industry average



Inv. turnover=

= = 4.10x.




Inv. T.4.1x4.5x4.8x6.1x

Inventory Turnover Ratio vs. Industry Average

Comments on inventory turnover

Comments on Inventory Turnover

  • Inventory turnover is below industry average.

  • Firm might have old inventory, or its control might be poor.

  • No improvement is currently forecasted.

Dso average number of days from sale until cash received


Average sales per day


= =

= 45.5 days.





DSO: average number of days from sale until cash received.

Appraisal of dso



Appraisal of DSO

  • Firm collects too slowly, and situation is getting worse.

  • Poor credit policy.

Fixed assets and total assets turnover ratios

Fixed assets



Net fixed assets


= = 8.41x.



Total assets



Total assets


= = 2.00x.



Fixed Assets and Total AssetsTurnover Ratios


Fixed assets and total assets turnover ratios1

Fixed Assets and Total AssetsTurnover Ratios

  • FA turnover is expected to exceed industry average. Good.

  • TA turnover not up to industry average. Caused by excessive current assets (A/R and inventory).

Calculate the debt tie and ebitda coverage ratios

Total liabilities

Total assets

Debt ratio=

= = 43.8%.

$1,040 + $500



Int. expense


= = 6.3x.



Calculate the debt, TIE, and EBITDA coverage ratios.


Ebitda coverage ec

EBIT + Depr. & Amort. + Lease payments

Interest Lease

expense pmt.

= = 5.5x.

+ + Loan pmt.

$502.6 + $120 + $40

$80 + $40 + $0

EBITDA Coverage (EC)

Debt management ratios vs industry averages

2005E 2004 2003 Ind.




Debt Management Ratios vs. Industry Averages

Recapitalization improved situation, but lease payments drag down EC.

Profit margin pm





PM = = = 3.6%.



Profit Margin (PM)

Very bad in 2004, but projected to

meet industry average in 2005. Looking good.

Basic earning power bep


Total assets


= = 14.3%.




Basic Earning Power (BEP)

Basic earning power vs industry average



Basic Earning Power vs. Industry Average

  • BEP removes effect of taxes and financial leverage. Useful for comparison.

  • Projected to be below average.

  • Room for improvement.

Return on assets roa and return on equity roe


Total assets





= 7.2%.


Common Equity





= 12.8%.

Return on Assets (ROA)and Return on Equity (ROE)


Roa and roe vs industry averages

ROA and ROE vs. Industry Averages

2005E 2004 2003 Ind.



Both below average but improving.

Effects of debt on roa and roe

Effects of Debt on ROA and ROE

  • ROA is lowered by debt--interest expense lowers net income, which also lowers ROA.

  • However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase.

Calculate and appraise the p e p cf and m b ratios

Price = $12.17.

EPS = = = $1.01.

P/E = = = 12x.


Shares out.



Price per share




Calculate and appraise theP/E, P/CF, and M/B ratios.

Industry p e ratios

Industry P/E Ratios

Market based ratios

NI + Depr.

Shares out.

CF per share=

= = $1.49.

$253.6 + $120.0


Price per share

Cash flow per share

P/CF =

= = 8.2x.



Market Based Ratios

Market based ratios continued

Com. equity

Shares out.


= = $7.91.



Mkt. price per share

Book value per share


= = 1.54x.



Market Based Ratios (Continued)

Comparison with industry averages

Comparison with Industry Averages

2005E 2004 2003 Ind.




P/E: How much investors will pay for $1 of earnings. Higher is better.

M/B: How much paid for $1 of book value. Higher is better.

P/E and M/B are high if ROE is high, risk is low.

Common size balance sheets divide all items by total assets

Common Size Balance Sheets:Divide all items by Total Assets

Divide all items by total liabilities equity

Divide all items by Total Liabilities & Equity

Analysis of common size balance sheets

Analysis of Common Size Balance Sheets

  • Computron has higher proportion of inventory and current assets than Industry.

  • Computron now has more equity (which means LESS debt) than Industry.

  • Computron has more short-term debt than industry, but less long-term debt than industry.

Common size income statement divide all items by sales

Common Size Income Statement:Divide all items by Sales

Analysis of common size income statements

Analysis of Common Size Income Statements

  • Computron has lower COGS (86.7) than industry (84.5), but higher other expenses. Result is that Computron has similar EBIT (7.1) as industry.

Percentage change analysis change from first year 2003

Percentage Change Analysis: % Change from First Year (2003)

Analysis of percent change income statement

Analysis of Percent Change Income Statement

  • We see that 2005 sales grew 105% from 2003, and that NI grew 188% from 2003.

  • So Computron has become more profitable.

Percentage change balance sheets assets

Percentage Change Balance Sheets: Assets

Percentage change balance sheets liabilities equity

Percentage Change Balance Sheets: Liabilities & Equity

Analysis of percent change balance sheets

Analysis of Percent Change Balance Sheets

  • We see that total assets grew at a rate of 139%, while sales grew at a rate of only 105%. So asset utilization remains a problem.

Explain the du pont system

Explain the Du Pont System

  • The Du Pont system focuses on:

    • Expense control (PM)

    • Asset utilization (TATO)

    • Debt utilization (EM)

  • It shows how these factors combine to determine the ROE.

The du pont system

( )( )( ) = ROE
















The Du Pont System

20032.6% x 2.3x2.2=13.2%




Potential problems and limitations of ratio analysis

Potential Problems and Limitations of Ratio Analysis?

  • Comparison with industry averages is difficult if the firm operates many different divisions.

  • “Average” performance is not necessarily good.

  • Seasonal factors can distort ratios


Problems and limitations continued

Problems and Limitations (Continued)

  • Window dressing techniques can make statements and ratios look better.

  • Different accounting and operating practices can distort comparisons.

  • Sometimes it is difficult to tell if a ratio value is “good” or “bad.”

  • Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition.


Qualitative factors

Qualitative Factors

  • Are the company’s revenues tied to a single customer?

  • To what extent are the company’s revenues tied to a single product?

  • To what extent does the company rely on a single supplier?


Qualitative factors continued

Qualitative Factors (Continued)

  • What percentage of the company’s business is generated overseas?

  • What is the competitive situation?

  • What does the future have in store?

  • What is the company’s legal and regulatory environment?

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