1. CHAPTER 4 Analysis of Financial Statements
Ratio Analysis
Du Pont system <- learn this
Effects of improving ratios
Limitations of ratio analysis
Qualitative factors

2. Why are ratios useful? Ratios
Standardize numbers
Facilitate comparisons
Ratios highlight weaknesses and strengths.
Ratio comparisons should be
Made through time - Trend analysis
Compare competitors - Peer or Industry analysis

3. What are the five major categories of ratios, and what questions do they answer?
Liquidity: Can we make required payments?
Asset Management: right amount of assets vs. sales?
Debt Management: 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: How do investors value the business as reflected in P/E and Mkt/B ratios?

4. Balance Sheet: Assets Cash A/R Inventories Total Current Assets
Fixed Assets
Less: Accum Dep.
Net FA
Total Assets
2004 80
315
415
810
870
1,680
2005 10
375
615
1,000
2,000

5. Balance sheet: Liabilities and Equity
Accts payable
Notes payable
Accruals
Total CL
Long-term debt
Total Liabilities
Common stock
Retained earnings
Total Equity
Total L & E
2005 60
110
140
310
750
1,060
130
810
940
2,000
2004 30 60
130
220
580
800
750
880
1,680

6. Income statement Sales COGS EBITDA Depr. & Amort. EBIT Interest Exp.
EBT
Taxes
Net income
2005
3,000
2,616
384
100
284 88
196 78
118
2004
2,850
2,497
353 90
263 60
203 81
122

7. Income statement Per Share Common Stk Price Earnings / share
Dividends / share
Book Value / Share
Cash Flow /share
2005
23.00
2.35
1.15
18.80
4.35
2004
26.00
2.44
1.06
17.60
4.24

8. Liquidity Ratios

9. Liquidity Ratios Measure company ability to pay bills
Quick Ratio = Current Assets - Inventories
Current Liabilities

10. Management Ratios
Measure manager performance

11. Inventory Turnover Ratio

12. Days Sales Outstanding

13. Fixed Assets Turnover

14. Total Assets Turnover

15. DEBT MANAGEMENT RATIOS

16. Total Debt to Total Assets

17. Time Interest Earned Ratio

18. EBITDA Coverage Ratio EBITDA Coverage = EBITDA + Lease Payments _
Interest + Principal Pymt + Lease Pymt

19. PROFITABILITY RATIOS

20. Profit Margin
Profit Margin on Sales
= Net Income _
Sales

21. Return on Assts Return on Total Assets (ROA) = Net Income _

22. Basic Earning Power
B E P = EBIT _
Total Assets

23. Return on Common Equity
Return on Equity
R O E = Net Income _
Common Equity

24. Market Value Ratios

25. Price / Earnings Ratio
PE = Price per Share _
Earnings per Share

26. Price / Cash Flow Price/Cash Flow = Price per share _
Cash Flow per Share

27. Market / Book Book Value per share
= Common Equity _ Shares Outstanding
Market/Book
= Market Price per Share _
Book Value per Share

28. TREND ANALYSIS
Compare OVER TIME
Are ratios improving
Or deteriorating

29. DuPont Equation Return on Assets ROE = Net Income _
Measure of success
ROE = Net Income _
Stock Holder Equity

30. The Du Pont system

31. The Du Pont system

32. Potential uses of freed up cash
Repurchase stock
Expand business
Reduce debt
All these actions would likely improve the stock price.

33. Potential problems and limitations of financial ratio analysis
Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions.
Example
General Electric Businesses
Elevators
Air-conditioners
Jet Engines
Lends Money

34. Potential problems and limitations of financial ratio analysis
“Average” performance is not necessarily good, perhaps the firm should aim higher.

35. Potential problems and limitations of financial ratio analysis
Seasonal factors can distort ratios.

36. Potential problems and limitations of financial ratio analysis
“Window dressing” techniques can make statements and ratios look better.

37. Potential problems and limitations of financial ratio analysis
Comparison with industry averages difficult.
“Average” is not necessarily good.
Seasonal factors can distort ratios.
“Window dressing”

38. More issues regarding ratios
Different operating and accounting practices can distort comparisons.
Sometimes it is hard to tell if a ratio is “good” or “bad”.
Difficult to tell whether a company is in strong or weak position.

39. Qualitative factors to be considered when evaluating a company’s future financial performance
Are the firm’s revenues tied to one key customer, product, or supplier?
What percentage of the firm’s business is generated overseas?
Competition
Future prospects
Legal and regulatory environment