Fundamentals of Corporate Finance

Fifth Edition, International Adaptation

Robert Parrino, Ph.D.; David S. Kidwell, Ph.D.;
Thomas W. Bates, Ph.D.; Stuart Gillan, Ph.D.

Chapter 4

Analyzing Financial Statements

Copyright ©2022 John Wiley & Sons, Inc.
Chapter 4: Analyzing Financial
Statements

Copyright ©2022 John Wiley & Sons, Inc. 2

Learning Objectives (1 of 2)

1. Explain the four perspectives from which financial

statements can be viewed
2. Describe common-size financial statements, explain
why they are used, and be able to prepare and use them
to analyze the historical performance of a firm
3. Discuss how financial ratios facilitate financial
analysis and be able to compute and use them to
analyze a firm’s performance

Copyright ©2022 John Wiley & Sons, Inc. 3

Learning Objectives (2 of 2)

4. Describe the DuPont system of analysis and be able to

use it to evaluate a firm’s performance and identify
corrective actions that may be necessary
5. Explain what benchmarks are, describe how they are
prepared, and discuss why they are important in
financial statement analysis
6. Identify the major limitations in using financial
statement analysis

Copyright ©2022 John Wiley & Sons, Inc. 4

4.1 Background for Financial Statement Analysis
LEARNING OBJECTIVE
Explain the four perspectives from which financial statements
can be viewed
• Background for Financial Statement Analysis
• Perspectives on Financial Statement Analysis
o Stockholders
o Managers
o Creditors and
o Other stakeholders
• Guidelines for Financial Statement Analysis
o Trend analysis
o Benchmark

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Background for Financial Statement
Analysis
• The typical financial statement analysis involves the
use of financial statements to analyze a company’s
performance and assess its strengths and weaknesses
• There are four basic and different perspectives that are
necessary when analyzing financial statements
• The section introduces some helpful guidelines for
financial statement analysis

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Perspectives on Financial Statement
Analysis
• Stockholders focus on net cash flows, risk, rate of return, and
the market value of the firm’s stock
• Managers focus on rate of return, efficient use of assets,
controlling costs, increasing net cash flows, increasing the
market value of the firm’s stock, and job security
• Creditors focus on the predictability of revenues and expenses,
the ability to meet short-term obligations, the ability to make
loan payments as scheduled and avoidance of changes in risk
• Other stakeholders, including suppliers and employees, who
also have claims on the firm’s cash flows, have similar interests.

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Guidelines for Financial Statement
Analysis
• Understand which perspective: stockholder, manager,
creditor, or other stakeholders
• Use audited financial statements
• Use 3 to 5 years of statements to enable trend analysis
• Benchmark to competitors of similar size with similar
products and services

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4.2 Common-Size Financial Statements
LEARNING OBJECTIVE
Describe common-size financial statements, explain why
they are used, and be able to prepare and use them to
analyze the historical performance of the firm

• Common-Size Financial Statements

• Common-Size Balance Sheets
• Common-Size Income Statements

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Common-Size Financial Statements

• Common-size financial statements show the dollar

amount of each item as a percentage of a reference
value
o Common-size balance sheet use total assets as the
reference value; each item is expressed as a percentage
of total assets
o Common-size income statement use net sales as the
reference value; each item is expressed as a percentage
of net sales

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Common-Size Balance Sheet

• The Common-Size Balance Sheet standardizes the

amount in a balance sheet account by converting the
dollar value of each item to its percentage of total
assets
o Dollar values on a regular balance sheet provide
information on the number of dollars associated with a
balance sheet account
o Percentage values on a common-size balance sheet
provide information on the relative size or importance
of the dollars associated with a balance sheet account
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Exhibit 4.1 Common-Size Balance Sheets
for Diaz Manufacturing on December 31
($ millions)
2020 2020 2019 2019 2018 2018
% of % of % of
Assets Assets Assets
Assets
Cash and marketable securities $ 288.5 15.3 $ 16.6 1.1 $ 8.2 0.6
Accounts receivable 306.2 16.2 268.8 18.0 271.5 19.4
Inventories 423.8 22.4 372.7 24.9 400.0 28.6
Other current assets 21.3 1.1 29.9 2.0 24.8 1.8
Total current assets $1,039.8 55.0 $ 688.0 46.1 $ 704.5 50.4
Plant and equipment (net) 399.4 21.1 394.2 26.4 419.6 30.0
Goodwill and other assets 450.0 23.8 411.6 27.6 273.9 19.6
Total assets $1,889.2 100.0 $1,493.8 100.0 $1,398.0 100.0

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Common-Size Balance Sheets for Diaz
Manufacturing on December 31 ($ millions)
Liabilities and Stockholders’ Equity:
Accounts payable and accruals $ 349.3 18.5 $ 325.0 21.8 $ 395.0 28.3
Notes payable 10.5 0.6 4.2 0.3 14.5 1.0
Accrued income taxes 18.0 1.0 16.8 1.1 12.4 0.9
Total current liabilities $ 377.8 20.0 $ 346.0 23.2 $ 421.9 30.2
Long-term debt 574.0 30.4 305.6 20.5 295.6 21.1
Total liabilities $ 951.8 50.4 $ 651.6 43.6 $ 717.5 51.3
Common stock (54,566,054 shares) 0.5 0.0 0.5 0.0 0.5 0.0
Additional paid-in capital 892.4 47.2 892.4 59.7 892.4 63.8
Retained earnings 67.8 3.6 (50.7) (3.4) (155.8) (11.1)
Less: Treasury stock (23.3) (1.2) – – (56.6) (4.0)
Total stockholders’ equity $ 937.4 49.6 $ 842.2 56.4 $ 680.5 48.7
Total liabilities and equity $1,889.2 100.0 $1,493.8 100.0 $1,398.0 100.0

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Common-Size Income Statement
• The most useful way to prepare a common size income
statement is to express each account as a percentage of
net sales
• Each expense is interpreted as the cost incurred to
generate $1 in sales

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Common-Size Income Statements for
Diaz Manufacturing for Fiscal Years
Ending December 31 ($ millions) (1 of 2)
2020 2020 2019 2019 2018 2018
% of % of % of
Net Net Net
Sales Sales Sales
Net sales $1,563.7 100.0 $1,386.7 100.0 $1,475.1 100.0
Cost of goods sold 1,081.1 69.1 974.8 70.3 1,076.3 73.0
Selling and administrative expenses 231.1 14.8 197.4 14.2 205.7 13.9
Earnings before interest, taxes,
depreciation, and amortization
(EBITDA) $ 251.5 16.1 $ 214.5 15.5 $ 193.1 13.1
Depreciation 83.1 5.3 75.3 5.4 71.2 4.8
Earnings before interest and taxes $ 168.4 10.8 $ 139.2 10.0 $ 121.9 8.3
(EBIT)

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Common-Size Income Statements for
Diaz Manufacturing for Fiscal Years
Ending December 31 ($ millions) (2 of 2)
Interest expense 5.6 0.4 18.0 1.3 27.8 1.9
Earnings before taxes (EBT) $ 162.8 10.4 $ 121.2 8.7 $ 94.1 6.4
Taxes 44.3 2.8 16.1 1.2 27.9 1.9
Net income $ 118.5 7.6 $ 105.1 7.6 $ 66.2 4.5
Dividends – – –
Addition to retained earnings $ 118.5 $105.1 $66.2

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4.3 Financial Ratios and Firm Performance
LEARNING OBJECTIVE
Discuss how financial ratios facilitate financial analysis and be able
to compute and use them to analyze a firm’s performance

• Financial Ratios and Firm Performance

• Why Ratios Are Better Measures
• Short-Term Liquidity Ratios
• Efficiency Ratios
• Leverage Ratios
• Profitability Ratios
• Market-Value Indicators
• Concluding Comments on Ratios
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Financial Ratios and Firm
Performance
• Other specialized financial ratios help analysts
interpret the myriad of numbers in financial
statements.
• Financial ratios can be used to measure a firm’s
o liquidity
o efficiency
o leverage
o profitability and
o market value
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Why Ratios Are Better Measures

• Financial ratios establish a common reference point

across firms, even though the numerical value of the
reference point will differ from firm-to-firm
o Ratios make it easier to compare the performance of
large firms to that of small firms
o Ratios make it easier to compare the current and
historical performance of a single firm as the firm
changes over time (trend analysis)

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Short-Term Liquidity Ratios

• Liquidity ratios indicate a firm’s ability to pay short-term

obligations with short-term assets without endangering the firm.
In general, higher ratios are a favorable indicator
Equation 4.1

Equation 4.2

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Efficiency Ratios (1 of 2)
• Efficiency ratios indicate a firm’s ability to use assets to produce
sales. These are also called asset turnover ratios. In general,
higher numbers are a favorable indicator. For days sales in
inventory, however, a lower number is favorable.
Equation 4.3

Equation 4.4

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Efficiency Ratios (2 of 2)
Equation 4.5

Equation 4.6

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Asset Turnover Ratios
Equation 4.7

Equation 4.8

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Leverage Ratios
• Financial leverage ratios indicate whether a firm is using the
appropriate amount of debt financing. In general, higher debt ratios
indicate greater potential return and greater bankruptcy risk.
Equation 4.9

Equation 4.10

Equation 4.11

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Coverage Ratios

• For the following ratios, a higher number generally

indicates less bankruptcy risk and (possibly) lower
potential return
Equation 4.12

Equation 4.13

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Profitability Ratios (1 of 2)
• Profitability ratios indicate whether a firm is generating
adequate profit from its assets. In general, higher ratios
indicate better performance.
Equation 4.14

Equation 4.15

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Profitability Ratios (2 of 2)

Equation 4.16

Equation 4.17

Equation 4.18

Equation 4.19

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Market-Value Indicators
• Market-value ratios indicate how the market is valuing the firm’s
equity. Higher ratios indicate greater shareholder wealth.

Equation 4.20

Equation 4.21

Equation 4.22

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Exhibit 4.3: Ratios for Time-Trend
Analysis for Diaz Manufacturing for
Fiscal Years Ending December 31
Financial Ratio 2020 2019 2018
Liquidity Ratios:
Current ratio 2.75 1.99 1.67
Quick ratio 1.63 0.91 0.72
Efficiency Ratios:
Inventory turnover 2.55 2.62 2.69
Days’ sales in inventory 143.14 139.31 135.69
Accounts receivable turnover 5.11 5.16 5.43
Days’ sales outstanding 71.43 70.74 67.22

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Ratios for Time-Trend Analysis for
Diaz Manufacturing for Fiscal Years
Ending December 31 (1 of 2)
Financial Ratio 2020 2019 2018
Total asset turnover 0.83 0.93 1.06
Fixed asset turnover 3.92 3.52 3.52
Leverage Ratios:
Total debt ratio 0.50 0.44 0.51
Debt-to-equity ratio 1.02 0.77 1.05
Equity multiplier 2.02 1.77 2.05
Times interest earned 30.07 7.73 4.38
Cash coverage 44.91 11.92 6.95
Profitability Ratios:
Gross profit margin 30.86% 29.70% 27.04%
Operating profit margin 10.77% 10.04% 8.26%

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Ratios for Time-Trend Analysis for
Diaz Manufacturing for Fiscal Years
Ending December 31 (2 of 2)
Financial Ratio 2020 2019 2018
Net profit margin 7.58% 7.58% 4.49%
EBIT return on assets 8.91% 9.32% 8.72%
Return on assets 6.27% 7.04% 4.74%
Return on equity 12.64% 12.48% 9.73%
Market-Value Indicators:
Price-earnings ratio 22.40 18.43 14.29
Earnings per share $2.17 $1.93 $1.21
Market-to-book ratio 2.83 1.63 1.39

Note: Numbers may not add up because of rounding.

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Concluding Comments on Ratios

• The group of ratios presented in this chapter is a fair

representation of the ratios needed to analyze the
performance of a business
• When using ratios, it is important that you ask
yourself, “What does this ratio mean, and what is it
measuring?”
• Good ratios should make good economic sense when
you look at them

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4.4 The Dupont System: A Diagnostic Tool
LEARNING OBJECTIVE
Describe the Dupont system of analysis and be able to use it to
evaluate a firm’s performance and identify corrective actions that
may be necessary

• The Dupont System: A Diagnostic Tool

• An Overview of the DuPont System
• The ROA Equation
• The ROE Equation
• The DuPont Equation
• Applying the DuPont System
• Is Maximizing ROE an Appropriate Goal?
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The Dupont System: A Diagnostic
Tool
• Fortunately, some enterprising financial managers at
the DuPont Company developed a system that ties
together some of the most important financial ratios
and provides a systematic approach to financial ratio
analysis

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An Overview of the DuPont System

• Diagnostic tool for evaluating a firm’s financial health

• Uses related ratios that link the balance sheet and
income statement
• Based on two equations that connect a firm’s ROA and
ROE
• Used by management and shareholders to understand
factors that drive ROE

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The ROA Equation
Equation 4.18

Equation 4.23

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Two Basic Strategies to Earn a Higher
ROAa
Exhibit 4.4 To maximize a firm’s R O A, management can focus more on achieving high
profit margins or on achieving high asset turnover. High-end retailers like Tiff any & Co.
and Burberry Group plc focus more on achieving high profit margins. In contrast, grocery
and discount stores like Whole Foods Market and Walmart tend to focus more on
achieving high asset turnover because competition limits their ability to achieve very high
profit margins.
Company Asset Turnover × Profit Margin (%) = ROA (%)
High Profit Margin:
Tiffany & Co. 0.80 11.30 9.04
Burberry Group plc 1.09 12.33 13.44
High Turnover:
Whole Foods Market 2.48 3.22 7.99
Walmart Stores 2.42 3.05 7.38
a
Ratios are calculated using financial results for the fiscal year ending closest to December 2015.

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The ROE Equation
Return on equity = Return on assets × Equity multiplier

Equation 4.24

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The DuPont Equation

Equation 4.25

Equation 4.26

Equations 4.25 and 4.26 show that ROE is driven by

profitability, operating efficiency, and amount of
leverage (debt)
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Applying the DuPont System
• The DuPont equation tells us that a firm’s ROE is
determined by three factors:
1. net profit margin, which measures the firm’s operating
efficiency and how it manages its interest expense and
taxes
2. total asset turnover, which measures the efficiency with
which the firm’s assets are utilized
3. the equity multiplier, which measures the firm’s use of
financial leverage
• The DuPont system of analysis is a useful tool to help
identify problem areas within a firm
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Exhibit 4.5: Relations in the DuPont
System of Analysis for Diaz
Manufacturing in 2020 ($ millions)

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Is Maximizing ROE an Appropriate
Goal?
• Is maximizing the value of ROE, as suggested by the DuPont
system equivalent to maximizing share price?
• The short answer is that the two goals are not equivalent.
• A major shortcoming of ROE is that it does not directly consider
cash flow. ROE considers earnings, but earnings are not the
same as future cash flows
• ROE does not consider risk
• ROE does not consider the size of the initial investment or the
size of future cash payments
• Despite of these shortcomings, ROE analysis is widely used in
business as a measure of operating performance
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4.5 Selecting a Benchmark
LEARNING OBJECTIVE
Explain what benchmarks are, describe how they are prepared, and
discuss why they are important in financial statement analysis

• Selecting a Benchmark
• Trend Analysis
• Industry Analysis
• Peer Group Analysis

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Selecting a Benchmark
• How do you judge whether a ratio value is too high or
too low?
• Is the value good or bad?
• The starting point for making these judgments is
selecting an appropriate benchmark—a standard that
will be the basis for meaningful comparisons
• Financial managers can gather appropriate benchmark
data in three ways: through trend, industry, and peer
group analysis

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Trend Analysis
• A ratio or ratio analysis is relevant only when
compared to an appropriate benchmark
• Trend Analysis – comparison to the firm’s historical
performance

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Industry Analysis
• A ratio or ratio analysis is relevant only when
compared to an appropriate benchmark
• Industry Analysis – comparison to the aggregate of
firms in the same industry
o Standard Industrial Classification (SIC) System
o North American Industry Classification System
(NAICS)

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Peer Group Analysis
o Peer Group Analysis – comparison to a select group of
firms in the same industry

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Exhibit 4.6 Peer Group Ratios for
Diaz Manufacturing
2020 2019 2018
Liquidity Ratios:
Current ratio 2.10 2.20 2.10
Quick ratio 1.50 1.60 1.50
Efficiency Ratios:
Inventory turnover 5.40 5.30 5.20
Days’ sales in inventory 67.59 68.87 70.19
Accounts receivable turnover 4.90 4.20 4.10
Days’ sales outstanding 76.70 89.80 90.00

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Peer Group Ratios for Diaz
Manufacturing (1 of 2)
2020 2019 2018
Total asset turnover 0.87 0.90 0.80
Fixed asset turnover 3.50 3.30 2.40
Leverage Ratios:
Total debt ratio 0.18 0.11 0.21
Debt-to-equity ratio 0.40 0.20 0.50
Equity multiplier 2.02 1.77 2.05
Times interest earned 7.00 5.60 1.60
Cash coverage 7.50 8.20 1.30
Profitability Ratios:
Gross profit margin 26.80% 24.10% 19.20%
Operating profit margin 12.00% 6.90% 2.70%

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Peer Group Ratios for Diaz
Manufacturing (2 of 2)
2020 2019 2018
Net profit margin 10.74% 3.30% 0.10%
Return on assets 9.34% 3.30% 0.80%
Return on equity 13.07% 7.00% 1.00%
Market-Value Indicators:
Price-earnings ratio 18.10 38.40 44.60
Earnings per share $1.65 $3.85 $3.78
Market-to-book ratio 2.84 1.82 1.64

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4.6 Using Financial Ratios
LEARNING OBJECTIVE
Identify major limitations in using financial statement analysis

• Using Financial Ratios

• Performance Analysis of Diaz Manufacturing
• Limitations of Financial Statement Analysis

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Using Financial Ratios

• In using financial ratios the most important tasks are to:

o Correctly interpret the ratio values
o make appropriate decisions based on this interpretation

• This section describes how to use financial ratios in

performance analysis

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Performance Analysis of Diaz
Manufacturing (1 of 2)
Exhibit 4.7 Peer Group Analysis for Diaz Manufacturing in 2020
Examining the differences between the ratios of a firm and its peer group is a
good way to spot areas that require further analysis.
(1) (2) (3)
Diaz Ratio Peer Group Ratio Difference
(Column 1 – Column 2)
DuPont Ratios:
Return on equity (%) 12.64 13.07 (0.43)
Return on assets (%) 6.27 9.34 (3.07)
Equity multiplier (%) 2.02 1.40 0.62
Net profit margin (%) 7.58 10.74 (3.16)
Total asset turnover 0.83 0.87 (0.04)

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Performance Analysis of Diaz
Manufacturing (2 of 2)
(1) (2) (3)
Diaz Ratio Peer Group Ratio Difference
(Column 1 – Column 2)
Asset Ratios:
Current ratio 2.75 2.10 0.65
Fixed asset turnover 3.92 3.50 0.42
Inventory turnover 2.55 5.40 (2.85)
Accounts receivable turnover 5.11 4.90 0.21
Profit Margins:
Gross profit margin (%) 30.86 26.80 4.06
Operating margin (%) 10.77 12.00 (1.23)
Net profit margin (%) 7.58 10.74 (3.16)

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Limitations of Financial Statement
Analysis
• Weaknesses of financial statement analysis:
o Not an exact science
o Relies on accounting data and historical costs
o Few guidelines or principles for determining whether a
ratio is “high” or “low,” or is a reason for confidence or
for concern

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Copyright

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Copyright ©2022 John Wiley & Sons, Inc. 56