Analysis of Financial Statements

Timothy R. Mayes, Ph.D.

FIN 3300: Chapter 3

 Common-size Income Statements

 A common-size Elvis Products International

Common-size Income Statement
income statement For the Year Ended Dec. 31, 1997 ($ 000's)
restates all expenses as 1997% 1997 1996% 1996
Sales 100.00% 3900.00 100.00% 3500.00
a percentage of sales Cost of Goods Sold 83.33% 3250.00 81.83% 2864.00
Gross Profit 16.67% 650.00 18.17% 636.00
 This allows the analyst Selling and G&A Expenses 8.47% 330.30 6.86% 240.00
to quickly and easily Fixed Expenses 2.56% 100.00 2.86% 100.00
Depreciation Expense 0.51% 20.00 0.54% 18.90
see which expenses EBIT 5.12% 199.70 7.92% 277.10

have increased or Interest Expense

Earnings Before Taxes
1.95%
3.17%
76.00
123.70
1.79%
6.13%
62.50
214.60
decreased relative to Taxes @ 40% 1.27% 49.48 2.45% 85.84
Net Income 1.90% 74.22 3.68% 128.76
sales
 Common-size Balance Sheets
Elvis Products International
Common-size Balance Sheet
As of Dec. 31, 1997 ($ 000's)
 A common-size Assets
Cash and Equivalents
1997%
3.03%
1997
50.00
1996%
3.92%
1996
57.60
balance sheet restates Accounts Receivable
Inventory
24.35%
50.76%
402.00 23.91%
838.00 48.69%
351.20
715.20
all assets and liabilities Total Current Assets 78.14% 1290.00 76.53% 1124.00
Plant & Equipment 31.92% 527.00 33.43% 491.00
as a percentage of total Accumulated Depreciation 10.07% 166.20 9.95% 146.20

assets Net Fixed Assets

Total Assets
21.86% 360.80 23.47% 344.80
100.00% 1650.80 100.00% 1468.80

 This allows the analyst Liabilities and Owner's Equity

Accounts Payable 10.61% 175.20 9.91% 145.60
to quickly and easily Short-term Notes Payable 13.63% 225.00 13.62% 200.00
Other Current Liabilities 8.48% 140.00 9.26% 136.00
see which accounts Total Current Liabilities 32.72% 540.20 32.79% 481.60
Long-term Debt 25.72% 424.61 22.02% 323.43
have increased or Total Liabilities 58.45% 964.81 54.81% 805.03

decreased relative to Common Stock

Retained Earnings
27.87%
13.69%
460.00
225.99
31.32%
13.87%
460.00
203.77
total assets Total Shareholder's Equity 41.55% 685.99
Total Liabilities and Owner's Equity 100.00% 1650.80
45.19% 663.77
100.00% 1468.80
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
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
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
 The Current Ratio

For EPI the current ratio in 1997 is:

 The Quick Ratio

For EPI the quick ratio in 1997 is:

 The Cash Ratio

For EPI the cash ratio in 1997 is:

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

1
 The Inventory Turnover Ratio

For EPI the inventory turnover ratio in 1997 is:

1
 The A/R Turnover Ratio

For EPI the accounts receivable turnover ratio in 1997 is:

1
 The Average Collection Period

For EPI the average collection period in 1997 is:

1
 The Fixed Asset Turnover Ratio

For EPI the fixed asset turnover ratio in 1997 is:

1
 The Total Asset Turnover Ratio

For EPI the total asset turnover ratio in 1997 is:

1
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

1
 The Total Debt Ratio

For EPI the total debt ratio in 1997 is:

1
 The Long-term Debt Ratio

For EPI the long-term debt ratio in 1997 is:

1
 The Debt to Equity Ratio

For EPI the debt to equity ratio in 1997 is:

1
 The Long-term Debt to Equity Ratio

For EPI the long-term debt to equity ratio in 1997 is:

2
Coverage Ratios

 Coverage ratios indicate the firm’s ability to

pay certain expenses:
• Times Interest Earned Ratio
• Cash Coverage Ratio

2
 The Times Interest Earned Ratio

For EPI the times interest earned ratio in 1997 is:

2
 The Cash Coverage Ratio

For EPI the cash coverage ratio in 1997 is:

2
The Fixed Charge Coverage Ratio

EBIT + Le a s e P a yme nts

Fixe d Ch a rg e Cove ra ge =
S F P a yme nts
Int. Exp.+Le a s e P a yme nts +
(1- t )

 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.

2
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

2
 The Gross Profit Margin

For EPI the gross profit margin in 1997 is:

2
 The Operating Profit Margin

For EPI the operating profit margin in 1997 is:

2
 The Net Profit Margin

For EPI the net profit margin in 1997 is:

2
 The Return on Total Assets

For EPI the return on total assets in 1997 is:

2
 The Return on Equity

For EPI the return on equity in 1997 is:

3
 The Return on Common Equity

For EPI the return on common equity in 1997 is:

3
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

3
The Price/Earnings Ratio

3
The Price/Book Ratio

3
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

3
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)

3
Trend Analysis of Ratios

 Trend analysis involves the

examination of ratios over
EPI Current Ratio Trend
time
 The analyst tries to 2.40
2.39
x
x
determine if the ratio is 2.38 x

Curre nt Ratio
2.37 x
changing in a favorable, or 2.36 x
2.35 x
unfavorable, direction 2.34 x
2.33 x
 The chart shows EPI’s 2.32 x
2.31 x
current ratio for two years 2.30 x

(we really need more data) 1996 1997

Ye ar

3
Comparing to Industry Averages
Industry
Ratio 1997 1997 1996
Liquidity Ratios
Current 2.70 x 2.39 x 2.33 x
Quick 1.00 x 0.84 x 0.85 x
 Industry average ratios Efficiency Ratios
Inventory Turnover 7.00 x 3.88 x 4.00 x
provide a benchmark A/R Turnover
Average Collection Period
10.70 x
33.64
9.70 x
37.11
9.97 x
36.12
for comparison Fixed Asset Turnover
Total Asset Turnover
11.20 x
2.60 x
10.81 x
2.36 x
10.15 x
2.38 x
Leverage Ratios
 We assume that if a Total Debt Ratio 50.00% 58.45% 54.81%
Long-term Debt Ratio 20.00% 25.72% 22.02%
ratio is too far from the LTD to Total Capitalization
Debt to Equity
28.57%
1.00 x
38.23%
1.41 x
32.76%
1.21 x
average something is LTD to Equity 40.00%
Coverage Ratios
61.90% 48.73%

wrong Times Interest Earned 2.50 x

Profitabilty Ratios
2.63 x 4.43 x

Gross Profit Margin 17.50% 16.67% 18.17%

 Industry ratios are Operating Profit Margin 6.25% 5.12% 7.92%
Net Profit Margin 3.50% 1.90% 3.68%
available from Robert Return on Total Assets
Return on Equity
9.10%
18.20%
4.50%
10.82%
8.77%
19.40%
Morris Associates and Payout Ratio
Other Ratios
70.06%

Standard & Poor’s Plowback (Retention) Ratio

Internal Growth Rate
29.94%
1.36%
Sustainable Growth Rate 3.35%
Capital Intensity Ratio 38.46% 42.33% 41.97%
3
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