Analysis of Financial Statements

1
Analysis of Financial Statements

• Timothy R. Mayes, Ph.D.
• FIN 3300 Chapter 3

2
Common-size Income Statements

• A common-size income statement restates all
  expenses as a percentage of sales
• This allows the analyst to quickly and easily see
  which expenses have increased or decreased
  relative to sales

3
Common-size Balance Sheets

• A common-size balance sheet restates all assets
  and liabilities as a percentage of total assets
• This allows the analyst to quickly and easily see
  which accounts have increased or decreased
  relative to total assets

4
Financial Ratios

• Financial ratios are the analysts microscope
  they allow us to get a better view of the firms
  financial health than just looking at the raw
  financial statements
• Ratios are used by both internal and external
  analysts
• Internal uses
• planning
• evaluation of management
• External uses
• credit granting
• performance monitoring
• investment decisions

5
Categories of Financial Ratios

• Financial ratios are often divided into
  categories based on the information that they
  provide
• Liquidity
• Efficiency
• Leverage
• Coverage
• Profitability
• Market valuation

6
Liquidity Ratios

• Liquidity refers to the speed with which an
  asset can be converted to cash
• Liquidity ratios describe the ability of a firm
  to meet its current obligations
• There are three common liquidity ratios
• The Current Ratio
• The Quick Ratio
• The Cash Ratio

7
The Current Ratio
For EPI the current ratio in 1997 is
8
The Quick Ratio
For EPI the quick ratio in 1997 is
9
The Cash Ratio
For EPI the cash ratio in 1997 is
10
Efficiency Ratios

• The efficiency ratios (A.K.A. assets utilization
  ratios) describe how well a firm is using its
  investment in various asset classes
• Inventory Turnover Ratio
• Accounts Receivable Turnover Ratio
• Average Collection Period
• Fixed Asset Turnover Ratio
• Total Asset Turnover Ratio

11
The Inventory Turnover Ratio
For EPI the inventory turnover ratio in 1997 is
12
The A/R Turnover Ratio
For EPI the accounts receivable turnover ratio in
1997 is
13
The Average Collection Period
For EPI the average collection period in 1997 is
14
The Fixed Asset Turnover Ratio
For EPI the fixed asset turnover ratio in 1997 is
15
The Total Asset Turnover Ratio
For EPI the total asset turnover ratio in 1997 is
16
Leverage Ratios

• Leverage ratios describe the amount of debt that
  the firm has used to finance its investments in
  assets
• Total Debt Ratio
• Long-term Debt Ratio
• Debt to Equity
• Long-term Debt to Equity

17
The Total Debt Ratio
For EPI the total debt ratio in 1997 is
18
The Long-term Debt Ratio
For EPI the long-term debt ratio in 1997 is
19
The Debt to Equity Ratio
For EPI the debt to equity ratio in 1997 is
20
The Long-term Debt to Equity Ratio
For EPI the long-term debt to equity ratio in
1997 is
21
Coverage Ratios

• Coverage ratios indicate the firms ability to
  pay certain expenses
• Times Interest Earned Ratio
• Cash Coverage Ratio

22
The Times Interest Earned Ratio
For EPI the times interest earned ratio in 1997
is
23
The Cash Coverage Ratio
For EPI the cash coverage ratio in 1997 is
24
The Fixed Charge Coverage Ratio

• Note SF Payments are Sinking Fund payments which
  are not tax deductible. Therefore, we must
  divide them by (1-t) to find out how much we need
  before taxes to meet this after-tax expense.
  Also, you must include preferred dividends in
  this number.

25
Profitability Ratios

• Profitability ratios provide a measure of the
  returns that a firm is generating
• Gross Profit Margin
• Operating Profit Margin
• Net Profit Margin
• Return on Total Assets
• Return on Equity
• Return on Common Equity

26
The Gross Profit Margin
For EPI the gross profit margin in 1997 is
27
The Operating Profit Margin
For EPI the operating profit margin in 1997 is
28
The Net Profit Margin
For EPI the net profit margin in 1997 is
29
The Return on Total Assets
For EPI the return on total assets in 1997 is
30
The Return on Equity
For EPI the return on equity in 1997 is
31
The Return on Common Equity
For EPI the return on common equity in 1997 is
32
Market Valuation Ratios

• The market valuation ratios provide an indication
  of the relative under- or over-pricing of a
  firms stock
• Price/Earnings Ratio
• Price/Book Ratio

33
The Price/Earnings Ratio
34
The Price/Book Ratio
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Rules for Memorizing Ratios

• There can be an infinite number of financial
  ratios, but knowing a few basic rules will help
  you to memorize the formulas The basic rule is
  that the name tells you how to calculate the
  ratio.
• Any margin ratio is something divided by sales
• Any turnover ratio is sales (or a variation of
  sales) divided by something
• Any return on ratio is net income (or a
  variation of net income) divided by something

36
Using Financial Ratios

• Calculating ratios is pointless unless you know
  how to use them
• The most basic rule is a single ratio provides
  very little information and may be misleading
• With that in mind, there are at least 4 uses of
  ratios
• Trend analysis (internal and external)
• Comparison to industry averages (internal and
  external)
• Setting and evaluating company goals (internal)
• Restrictive debt covenants (external)

37
Trend Analysis of Ratios

• Trend analysis involves the examination of ratios
  over time
• The analyst tries to determine if the ratio is
  changing in a favorable, or unfavorable,
  direction
• The chart shows EPIs current ratio for two years
  (we really need more data)

38
Comparing to Industry Averages

• Industry average ratios provide a benchmark for
  comparison
• We assume that if a ratio is too far from the
  average something is wrong
• Industry ratios are available from Robert Morris
  Associates and Standard Poors

39
Company Goals and Debt Covenants

• Company goals are often stated in terms of
  financial ratios
• For example, it is common for management to set
  goals regarding the firms ROE
• Debt covenants often contain restrictions on
  certain ratios
• For example, a borrower might be required to
  maintain a debt to equity ratio of less than 1.0
  and a current ratio greater than 2.0