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 analyst’s microscope; they allow us to get a better view of the firm’s 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 firm’s 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 firm’s stock:
Price/Earnings Ratio
Price/Book Ratio

33. The Price/Earnings Ratio

34. The Price/Book Ratio

35. 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 EPI’s 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 & Poor’s

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 firm’s 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