1. Corporate Finance: Financial Statement Analysis
Professor Scott Hoover
Business Administration 221

2. What questions are important in assessing the health of a firm?
Can the firm meet its debt obligations?
How well are assets being managed?
How risky is the firm?
How profitable is the firm?
What does the market think of the firm?
 Ratio Analysis: interpretation of accounting and market information to assess the health of companies.

3. Why do we use ratios?
We must consider things on a relative basis, not an absolute one.
e.g.: If one company has earnings of $2,000,000 and another of $1,000,000, which is better?
We can’t say because one company may be considerably bigger than the other.
We evaluate a company by comparing it to its peers.
To adjust for differences in size, etc., we use ratios.
Note that there are no hard-and-fast rules here. We can and should be creative and create our own ratios to investigate potential problems or identify strengths.

4. The DuPont Relationship
We begin any analysis by examining the factors that contribute to the ROE. Why?
DuPont: ROE  NI / E = (NI / S)  (S / TA)  (TA / E ) = profit margin  asset turnover  leverage multiplier
Note that ROE = ROA  (TA / E )
leverage multiplier = TA / E = 1 / (1 – D/TA)

5. The DuPont approach is nice because it divides the firm into three tasks
expense management (measured by the profit margin)
asset management (measured by asset turnover)
debt management (measured by the debt ratio or leverage multiplier)
The DuPont Method
layered approach
examine the three components
identify possible weaknesses and strengths
dig deeper to find more specific causes
dig deeper to identify possible corrective action, etc.

6. factors of the profit margin
sales
cost of goods sold
selling, general, and administrative costs
research and development expense
depreciation
interest
taxes
other expenses

7. factors of the asset turnover
sales
current assets
cash
receivables
inventory
fixed assets
property
plant
equipment
factors of the leverage multiplier
current liabilities
long-term liabilities
shareholder's equity

8. Ratios Liquidity Ratios
current ratio  current assets / current liabilities = CA/CL
higher current ratio  greater ability to cover short-term debt obligations
current ratio “too high”  firm may be holding too much cash, etc. That money might be invested to earn a higher rate of return.
acid test ratio (aka, quick ratio)  (CA - inventory)/CL
higher quick ratio  the greater is the ability to cover short-term debt obligations without selling off inventory.
As before, if the quick ratio is too high, the firm may be wasting money.

9. Activity (Asset Management) Ratios
total asset turnover  sales / total assets = S/TA
higher asset turnover  more effective use of assets.
BUT…may imply that the company has old assets.
inventory turnover  cost of goods sold / inventory
higher inventory turnover  more effective use of inventory.
We sometimes use inventory turnover in days  inventory / (COGS/n)
n is the number of days in the reporting period.
fixed-asset turnover  sales / net property, plant and equipment
higher fixed asset turnover  more effective use of fixed assets.

10. days sales in cash  (cash + marketable securities) / (sales/n)
collection period  receivables / credit sales per day = receivables / (credit sales/n)
higher collection period  lower “quality” of sales
Note that we often do not have “credit sales,” so we proxy by using actual sales
days sales in cash  (cash + marketable securities) / (sales/n)
higher days sales in cash  greater ability to handle unexpected short-term needs.
BUT…lower return due to uninvested capital
payables period  payables / (credit purchases/n)
higher payables period  lesser need for short-term capital
Note that we often do not have “credit purchases,” so we proxy by using actual cost of goods sold

11. Payables Period
Collection Period
Goods Acquired
Goods Paid For
Goods Sold
Money Received For Goods
Inventory Turnover in Days
The time between paying for goods and receiving money for them is ITD+CP-PP
The greater is this number, the greater the opportunity cost because the company’s money is tied up rather than being invested.

12. Debt Management Ratios
debt ratio  total debt / total assets
Note that we prefer to use the market value of equity in the calculation: DR = debt/(debt+MV(equity)
example: $100 initial investment in a project that pays off $120, all equity firm
return to shareholders is 20%
example: same, but 50% debt (6% interest), 50% equity:
$50  1.06 = $53 goes to debtholders
$67 left for shareholders  ($67-$50) / $50 = 34%
Other benefits of higher debt
greater control (less shares outstanding)
interest tax deduction
Drawbacks of higher debt
greater risk of bankruptcy
must appease debtholders

13. times-interest earned  EBIT / interest expense
higher times-interest-earned ratio  the higher the profits beyond what is necessary to pay debtholders.
BUT… a firm with too little debt may have a high TIE  we must be cautious in interpreting the ratio.
current ratio
quick ratio

14. Profitability Ratios gross margin  (sales – COGS)/sales
higher gross margin  efficient control of costs or efficient generation of sales
net profit margin  net profits after taxes (net income) / sales  NI / S
higher net profit margin  higher fraction of revenues kept as profits.
return on equity (ROE)  NI / E
higher ROE  more profitable use of firm equity.
A profitable high-debt firm will tend to have a high ROE (since equity is low), so we must be cautious in interpreting the ratio.

15. The profitability ratios are often difficult to interpret. Why?
return on invested capital (ROIC) = EBIT(1-T) / (interest-bearing debt + equity).
higher ROIC  greater overall efficiency.
The profitability ratios are often difficult to interpret. Why?
incentives to make their taxable incomes low
incentives to make earnings appear high.
 We must always look at notes to the financial statements, new reports, etc. to see if any unusual accounting events are happening.
We can examine other measures of profitability such as EBITDA and free cash flow

16. Market Value Ratios
price to earnings  market share price / earnings per share
higher P/E ratio  better market opinion of the future prospects of the firm.
BUT…P/Es for firm’s with extremely low earnings can be misleading.
One rule of thumb: ignore P/E when profit margin is less than some arbitrary value (4% perhaps?)
Mathematically, it is more reasonable to look at E/P.

17. market to book  market value of equity / book value of equity
higher market to book ratio  better market opinion of the current state of the firm.
BUT…M/B may be high if assets are old.
M/B < 1 is a special case. Why?
Two main explanations:
1. Book value of assets (and hence book value of equity) is misleading
2. The company has a high risk of bankruptcy.

18. Other tools Common Size statements Indexed statements
express the balance sheet as a percentage of total assets
express the income statement as a percentage of sales
Indexed statements
express the financial statements from one period as a percentage of the previous period.

19. Difficulties with Financial Statement Analysis
The information we consider is always old.
We rely on book values, which can be quite misleading.
We are often forced to compare companies at different points in time.
Different accounting firms use different terminology, sometimes making it difficult to interpret the financial statements.
We must be careful in calculating industry averages.
Should we include negative ratios in averages?
Should we include outliers in averages (P/E very high for example)?
Firm managers may have incentives to mislead (agency problems).
Financial statements often do not have the level of detail necessary to fully evaluate problems.

20. Very Simple Example Ratio firm industry average current ratio 2.2 3.6
quick ratio
1.8
2.9
total asset turnover
2.1
fixed asset turnover
4.2 4
collection period
22 days
24 days
inventory turnover
10 days
9 days
payables period
18 days
17 days
debt ratio
40%
30%
TIE ratio
6.4 6
profit margin 9% 8%
ROA
16%
18%
ROE
26.5%
24.5%
P/E 16 15
market to book
2.4
2.3

21. Debt ratio: a bit higher than average.
ROE: looks okay
Debt ratio: a bit higher than average.
TIE is slightly above average
current ratio is below average but above 1.
quick ratio is below average but above 1.
conclusion: The firm did not have trouble covering its interest over the past year (TIE ok), but may struggle a bit over the coming year (CR and QR below average)
Profit margin: a bit above average.
Total asset turnover: nearly average.
Price to earnings and Market to book: look okay
No other ratios are significantly different from the industry average.
Overall conclusion: The firm (perhaps) has “a little” too much debt, but it is probably not a big deal.

22. Another Very Simple Example
ratio
firm
industry average
current ratio
3.2
3.6
quick ratio
1.4
2.9
total asset turnover
1.3
2.2
fixed asset turnover
4.2 4
collection period
22 days
24 days
inventory turnover
19 days
11 days
payables period
21 days
debt ratio
30%
TIE ratio
6.4 6
profit margin 9% 8%
ROA
12%
20%
ROE
16.7%
24%
P/E 16 15
market to book
1.2
2.3

23. Debt ratio: about average. Net profit margin: about average.
ROE: a bit low
Debt ratio: about average.
Net profit margin: about average.
Total asset turnover: significantly below average.
Fixed asset turnover: looks okay.
Inventory turnover in days: well above industry average.
Collection period: about average.
Current ratio: a bit low. Quick ratio: well under average.
Price to earnings: okay. This tells us that the current price is in line with last year's earnings.
Market to book: well under average.
Overall conclusion: The firm appears to have an inventory control problem (too much inventory on hand). The problem might be a serious one.

24. Final Comments
We should always consider the notes to the financial statements.
..give explanations for unusual items as well as notes that suggest an accounting explanation for a peculiarity.
We should always consider news stories, press releases, etc.
…often contain statements concerning the financial condition of the firm and comments on what to expect.
…give information on the firm since the date of the last financials.