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  1. 1. Analysis of Financial Statements Timothy R. Mayes, Ph.D. FIN 3300: Chapter 3
  2. 2. Common-size Income Statements <ul><li>A common-size income statement restates all expenses as a percentage of sales </li></ul><ul><li>This allows the analyst to quickly and easily see which expenses have increased or decreased relative to sales </li></ul>
  3. 3. Common-size Balance Sheets <ul><li>A common-size balance sheet restates all assets and liabilities as a percentage of total assets </li></ul><ul><li>This allows the analyst to quickly and easily see which accounts have increased or decreased relative to total assets </li></ul>
  4. 4. Financial Ratios <ul><li>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 </li></ul><ul><li>Ratios are used by both internal and external analysts </li></ul><ul><ul><li>Internal uses </li></ul></ul><ul><ul><ul><li>planning </li></ul></ul></ul><ul><ul><ul><li>evaluation of management </li></ul></ul></ul><ul><ul><li>External uses </li></ul></ul><ul><ul><ul><li>credit granting </li></ul></ul></ul><ul><ul><ul><li>performance monitoring </li></ul></ul></ul><ul><ul><ul><li>investment decisions </li></ul></ul></ul>
  5. 5. Categories of Financial Ratios <ul><li>Financial ratios are often divided into categories based on the information that they provide: </li></ul><ul><ul><li>Liquidity </li></ul></ul><ul><ul><li>Efficiency </li></ul></ul><ul><ul><li>Leverage </li></ul></ul><ul><ul><li>Coverage </li></ul></ul><ul><ul><li>Profitability </li></ul></ul><ul><ul><li>Market valuation </li></ul></ul>
  6. 6. Liquidity Ratios <ul><li>‘Liquidity’ refers to the speed with which an asset can be converted to cash </li></ul><ul><li>Liquidity ratios describe the ability of a firm to meet its current obligations </li></ul><ul><li>There are three common liquidity ratios: </li></ul><ul><ul><li>The Current Ratio </li></ul></ul><ul><ul><li>The Quick Ratio </li></ul></ul><ul><ul><li>The Cash Ratio </li></ul></ul>
  7. 7. The Current Ratio For EPI the current ratio in 1997 is:
  8. 8. The Quick Ratio For EPI the quick ratio in 1997 is:
  9. 9. The Cash Ratio For EPI the cash ratio in 1997 is:
  10. 10. Efficiency Ratios <ul><li>The efficiency ratios (A.K.A. assets utilization ratios) describe how well a firm is using its investment in various asset classes: </li></ul><ul><ul><li>Inventory Turnover Ratio </li></ul></ul><ul><ul><li>Accounts Receivable Turnover Ratio </li></ul></ul><ul><ul><li>Average Collection Period </li></ul></ul><ul><ul><li>Fixed Asset Turnover Ratio </li></ul></ul><ul><ul><li>Total Asset Turnover Ratio </li></ul></ul>
  11. 11. The Inventory Turnover Ratio For EPI the inventory turnover ratio in 1997 is:
  12. 12. The A/R Turnover Ratio For EPI the accounts receivable turnover ratio in 1997 is:
  13. 13. The Average Collection Period For EPI the average collection period in 1997 is:
  14. 14. The Fixed Asset Turnover Ratio For EPI the fixed asset turnover ratio in 1997 is:
  15. 15. The Total Asset Turnover Ratio For EPI the total asset turnover ratio in 1997 is:
  16. 16. Leverage Ratios <ul><li>Leverage ratios describe the amount of debt that the firm has used to finance its investments in assets: </li></ul><ul><ul><li>Total Debt Ratio </li></ul></ul><ul><ul><li>Long-term Debt Ratio </li></ul></ul><ul><ul><li>Debt to Equity </li></ul></ul><ul><ul><li>Long-term Debt to Equity </li></ul></ul>
  17. 17. The Total Debt Ratio For EPI the total debt ratio in 1997 is:
  18. 18. The Long-term Debt Ratio For EPI the long-term debt ratio in 1997 is:
  19. 19. The Debt to Equity Ratio For EPI the debt to equity ratio in 1997 is:
  20. 20. The Long-term Debt to Equity Ratio For EPI the long-term debt to equity ratio in 1997 is:
  21. 21. Coverage Ratios <ul><li>Coverage ratios indicate the firm’s ability to pay certain expenses: </li></ul><ul><ul><li>Times Interest Earned Ratio </li></ul></ul><ul><ul><li>Cash Coverage Ratio </li></ul></ul>
  22. 22. The Times Interest Earned Ratio For EPI the times interest earned ratio in 1997 is:
  23. 23. The Cash Coverage Ratio For EPI the cash coverage ratio in 1997 is:
  24. 24. The Fixed Charge Coverage Ratio <ul><li>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. </li></ul>
  25. 25. Profitability Ratios <ul><li>Profitability ratios provide a measure of the returns that a firm is generating: </li></ul><ul><ul><li>Gross Profit Margin </li></ul></ul><ul><ul><li>Operating Profit Margin </li></ul></ul><ul><ul><li>Net Profit Margin </li></ul></ul><ul><ul><li>Return on Total Assets </li></ul></ul><ul><ul><li>Return on Equity </li></ul></ul><ul><ul><li>Return on Common Equity </li></ul></ul>
  26. 26. The Gross Profit Margin For EPI the gross profit margin in 1997 is:
  27. 27. The Operating Profit Margin For EPI the operating profit margin in 1997 is:
  28. 28. The Net Profit Margin For EPI the net profit margin in 1997 is:
  29. 29. The Return on Total Assets For EPI the return on total assets in 1997 is:
  30. 30. The Return on Equity For EPI the return on equity in 1997 is:
  31. 31. The Return on Common Equity For EPI the return on common equity in 1997 is:
  32. 32. Market Valuation Ratios <ul><li>The market valuation ratios provide an indication of the relative under- or over-pricing of a firm’s stock: </li></ul><ul><ul><li>Price/Earnings Ratio </li></ul></ul><ul><ul><li>Price/Book Ratio </li></ul></ul>
  33. 33. The Price/Earnings Ratio
  34. 34. The Price/Book Ratio
  35. 35. Rules for Memorizing Ratios <ul><li>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. </li></ul><ul><ul><li>Any ‘ margin ’ ratio is something divided by sales </li></ul></ul><ul><ul><li>Any ‘ turnover ’ ratio is sales (or a variation of sales) divided by something </li></ul></ul><ul><ul><li>Any ‘ return on ’ ratio is net income (or a variation of net income) divided by something </li></ul></ul>
  36. 36. Using Financial Ratios <ul><li>Calculating ratios is pointless unless you know how to use them </li></ul><ul><li>The most basic rule is: a single ratio provides very little information and may be misleading </li></ul><ul><li>With that in mind, there are at least 4 uses of ratios: </li></ul><ul><ul><li>Trend analysis (internal and external) </li></ul></ul><ul><ul><li>Comparison to industry averages (internal and external) </li></ul></ul><ul><ul><li>Setting and evaluating company goals (internal) </li></ul></ul><ul><ul><li>Restrictive debt covenants (external) </li></ul></ul>
  37. 37. Trend Analysis of Ratios <ul><li>Trend analysis involves the examination of ratios over time </li></ul><ul><li>The analyst tries to determine if the ratio is changing in a favorable, or unfavorable, direction </li></ul><ul><li>The chart shows EPI’s current ratio for two years (we really need more data) </li></ul>
  38. 38. Comparing to Industry Averages <ul><li>Industry average ratios provide a benchmark for comparison </li></ul><ul><li>We assume that if a ratio is too far from the average something is wrong </li></ul><ul><li>Industry ratios are available from Robert Morris Associates and Standard & Poor’s </li></ul>
  39. 39. Company Goals and Debt Covenants <ul><li>Company goals are often stated in terms of financial ratios </li></ul><ul><ul><li>For example, it is common for management to set goals regarding the firm’s ROE </li></ul></ul><ul><li>Debt covenants often contain restrictions on certain ratios </li></ul><ul><ul><li>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 </li></ul></ul>

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