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Chapter 11
Financial Analysis: Evaluation of Corporate Performance
Associated Press
Learning Objectives
A�er studying this chapter, you should be able to:
Explain who a corpora�on's stakeholders are and how they each
evaluate performance.
Describe various sources of financial informa�on used in
financial analysis, and the characteris�cs of these
sources.
Perform financial statement analysis, including analysis of trend

and common size financial statements and ra�os.
Show how ra�os are related to stock performance.
Analyze methods used to evaluate the performance of
management.
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The evalua�on of corporate performance is an important
skill for managers, investors, and even customers
and employees. Such analysis is the topic of Chapter 11.
A range of financial indicators can be used to assess
business performance.
Evalua�on can be made by comparing current performance
with past
performance. It can also be made by comparing one
businesses
performance with another. In this chapter, we will explore
methods for
analyzing business performance.
Ch. 11 Introduction
Figure 11.0: Chapter 11 in focus
Evalua�on of corporate performance is an important skill
for managers, investors, and even customers and

employees. This chapter covers financial
statement analysis, par�cularly ra�o analysis, as well as
other methods of evalua�ng corporate performance. We
aim to give you an apprecia�on for the
complexi�es facing financial analysts and a sense of how
judgment and logic play into evalua�ng a firm's results.
Good financial analysis is like good
detec�ve work on a complex case: Solu�ons are seldom
obvious; rather, we solve the case by evalua�ng the
evidence, logically interpre�ng clues, and
eventually assembling a clear picture of what has
transpired. Understanding what has happened in a
business's financial past can help us understand what is
likely to happen in its future. Good analysis provides a
useful tool for evalua�ng past performance and planning
for the future.
How Can Business Performance be Evaluated?
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As company stakeholders, consumers play an important
role in
establishing the welfare of a corpora�on. For example,
much of
Apple's success can be a�ributed to its loyal customers.

Imaginechina/Associated Press
11.1 Stakeholders and Evaluating Corporate Performance
How do we determine if a corpora�on is doing well, and
what is meant by doing well? The
answers depend on who is asking the ques�ons. If
stockholders pose the queries, then doing
well probably refers to the stock's price performance. As
residual claimants, stockholders want
to see high returns in comparison to their risk exposure.
On the other hand, bondholders,
bankers, and other fixed claimants are more interested in
the likelihood of bankruptcy. They
are most concerned with being paid as promised.
Employees (including managers) are
interested in keeping their jobs and improving their
salaries. Thus, this set of individuals will
base doing well on the incen�ve systems that reward their
performance. Because fixed
claimants, residual claimants, and employees all have
different criteria for evalua�ng
performance, the analysis used by each group varies. We
largely confine our a�en�on to the
financial stakeholders (the financial claimants) and,
therefore, focus on the analysis of
corporate financial performance. As residual claimants, the
key financial stakeholders
(stockholders) have a keen interest in the performance of
the company from virtually all
perspec�ves, including the risk of bonds, the sa�sfac�on
of customers, and even the
performance of compe�tors.
In addi�on to financial claimants, other groups of

interested par�es have their own agendas.
Consumers, for example, may judge a manufacturer's
performance based on product reliability. A community in
which a business is located may be
concerned with the environmental impact of the factory's
waste emissions. Such groups are referred to as
stakeholders because each has a stake or interest
in some aspect of corporate performance.
Now that we have discussed who is concerned with a
company's performance, we can move on to the different
sources used by financial claimants to
conduct analysis.
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11.2 Information Sources and Their Characteristics
Like a detec�ve, an analyst must know where to look for
evidence. This sec�on presents a sample of informa�on
sources generally available to the analyst.
Accounting Statements
All publicly traded firms and many privately held firms
have an accountant prepare financial statements on a
regular basis. Detailed financial data are
included in the company's annual report, which includes

the firm's balance sheet as of the end of its fiscal year,
its income statement, statement of cash
flows, wri�en statements by management, and notes to the
statement. Large, publicly traded firms also complete 10-K
reports, which are filed with the
Securi�es and Exchange Commission (SEC). 10-Ks provide
even more detailed financial data, o�en broken down by
divisions or subsidiaries. These reports
are freely available for all publicly traded firms on the
EDGAR database maintained by the SEC. A link to this
site is provided in the Web Resources at the
end of the chapter.
Firms whose statements are externally audited and
compiled according to generally accepted accoun�ng
principles are providing independently verified
informa�on to interested par�es. GAAP ensures that, to
the greatest degree possible, standard accoun�ng methods
are consistently applied, enabling one
firm's numbers to be compared to another firm's, and this
year's results to be compared to last year's. Because of
these repor�ng standards, accoun�ng
statements have tradi�onally been the founda�on on which
financial analysis is built.
Included at the end of the annual report is an auditors'
statement, which is highly important to the analyst. This
statement, known as an unqualified
opinion, confirms that the informa�on provided is
representa�ve of the firm's ac�vi�es for the period. The
following is an example of an unqualified
auditor's opinion:
We have examined the consolidated balance sheets of the
Company and Subsidiaries as of December 31, 2010, and
the related consolidated

statements of income, stockholders' equity, and changes in
financial posi�on for the period. Our examina�ons were
made in accordance with
generally accepted audi�ng standards and, accordingly,
included such tests of the accoun�ng records and such
other audi�ng procedures as
we considered necessary in the circumstances.
In our opinion, these financial statements present fairly
the consolidated financial posi�on of the Company and
Subsidiaries as of December
31, 2010, and the consolidated results of their opera�ons
and changes in their financial posi�on for the period in
conformity with generally
accepted accoun�ng principles applied on a consistent
basis. (AICPA, 1988)
On the other hand, a qualified opinion serves as a red
flag for the analyst, signaling that something fishy may be
going on. There are several reasons why a
firm's auditor will render a qualified opinion. For example,
inadequate disclosure of informa�on would prompt the
following qualified opinion:
The Company declined to present a statement of cash
flows for the years ended December 31, 2010 and 2011.
Presenta�on of such a
statement summarizing the Company's opera�ng, inves�ng,
and financing ac�vi�es is required by generally accepted
accoun�ng principles.
(AICPA, 1988)
And an unjus�fied change in accoun�ng procedures would
result in the following qualified opinion:
As disclosed in Note X to the financial statements, in

2011 the Company adopted the first-in, first-out method of
accoun�ng for its
inventories; it previously used the last-in, first-out method.
Although use of the first-in, first-out method is in
conformity with generally
accepted accoun�ng principles, in our opinion the
Company has not provided reasonable jus�fica�on for
making this change, as required by
generally accepted accoun�ng principles. (AICPA, 1988)
Any qualified opinion is a warning sign and should make
the analyst search for the cause.
Small businesses o�en have accoun�ng statements
prepared on an unaudited basis. Unaudited financial
statements are based on the numbers supplied to
the accountant by management. Thus, if management says
the firm holds a $100,000 receivable from a customer,
that number is simply reported on the
balance sheet without the accountant actually confirming
the claim's accuracy. Data on unaudited statements has not
been independently verified,
therefore, analysts put less faith in these than audited
statements.
Despite their reliability and comparability, audited financial
statements do have several weaknesses. First, GAAP allows
some flexibility on the method used
in compiling data. For example, firms may choose the
type of deprecia�on method they use for certain assets.
They may also choose different methods for
valuing inventory, such a last-in, first-out (LIFO) and
first-in, first-out (FIFO). Two firms, iden�cal in all other
respects, could report drama�cally different
results if they used different accoun�ng methods. We
provide a moderate example of this difference in Table

11.1. Note that the firms have different
opera�ng incomes, even though the cash flows for the
two firms are iden�cal.
Table 11.1: LIFO versus FIFO
Date Ac�vity Cash flow
October 1 Purchase 100 widgets at $2 each $200
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December 1 Purchase 100 widgets at $3 each $300 ou�low
December 30 Sell 100 widgets at $6 each $600 inflow
Data Firm A (using LIFO) Firm B (using FIFO)
Sales $600 $600
Cost of goods sold –$300 –$200
Opera�ng income $300 $400
Cash inflow $600 $600
Cash ou�low –$500 –$500
Cash flow $100 $100

Addi�onally, management has some la�tude in the �ming
of its expense and revenue recogni�on and in ordering
inventory. For example, near the end of
the fiscal year, management may choose to let inventory
stocks run low. This lowers the inventory account balance
on the year-end balance sheet, infla�ng
the inventory turnover ra�o, which measures how fast
inventory is typically sold by the firm. This strategy
could cosme�cally alter ra�os, making them look
be�er than they actually are. The prac�ce of
manipula�ng accounts so they appear more favorable is
known as window dressing.
Field Trip: Window Dressing
Window dressing manipulates accoun�ng data and misleads
stakeholders regarding a firm's financial standing. In
November of 2012, Hewle� Packard
was forced to write off more than $8 billion, as a result
of what they considered to be accoun�ng
misrepresenta�ons on the part of a company they
acquired in 2011 (Worthen, 2012).
Listen to this news broadcast discussing HP's allega�ons
and subsequent inves�ga�on:
h�p://www.npr.org/2012/11/28/166054180/hp-mired-in-
messy-allega�ons
(h�p://www.npr.org/2012/11/28/166054180/hp-mired-in-messy-
allega�ons)
Reflec�on Ques�ons
1. Who do you think should be held responsible for HP's
mul�billion dollar losses?
2. Should HP have inves�gated Autonomy's accoun�ng data

more closely, or should Autonomy have been more forthcoming
with its financial situa�on?
A third shortcoming of accoun�ng data is its focus on
profit (as opposed to cash flow) and book values (as
opposed to market values). The differences
between these—and how they affect the appearance of
firm value—were discussed earlier. Recall that in Chapter
1 we highlighted the difference between
the financial balance sheet and the accoun�ng balance
sheet, and that in Chapter 5 we covered the importance of
cash and how accoun�ng profits may be
restated as cash flows. It is important to have a firm
grasp of that material as you a�empt to analyze financial
data.
A fourth weakness of audited financial statements is that
accoun�ng results are purely historical in nature. In many
cases, good historical results do not
necessarily translate into good future results. A firm that
makes large profits o�en en�ces compe�tors to join the
market. For example, Research in Mo�on,
the maker of the BlackBerry, made over $380 million in
profit in 2006. By 2012, this pioneer in the industry was
struggling to survive, in part because a
number of compe�ng smart phones entered the market.
For planning purposes, it would be foolish to count on
extraordinary profits con�nuing simply
because they have been consistently achieved in the past.
Likewise, dismal past performance does not always mean
the future will also be bleak. General
Motors, for example, was saved from bankruptcy in 2008,
but regained profitability by 2012.
The last weakness of accoun�ng data is that it reports
results in only one dimension: profitability. A firm that

maximizes profits (or even cash flows) without
regard to risk may be unwi�ngly lowering shareholder's
wealth. Unsustainable strategies for increasing profits may
work in the short run, but the risks will
eventually catch up and cause a collapse. This type of
system was certainly at work in the subprime lending
bubble that collapsed in 2007 and 2008. Thus,
higher profits (be�er accoun�ng-based results) do not
necessarily translate into greater wealth crea�on, which
should be management's ul�mate goal.
Table 11.2 summarizes the strengths and weaknesses of
accoun�ng statements.
Table 11.2: Strengths and weaknesses of accoun�ng
statements
Strengths Weaknesses
Independently audited GAAP statements provide some
assurance of
reliability and comparability, lowering informa�on
asymmetry.
Differences in accoun�ng methods may lower
comparability of results.
Statements are widely available. Window dressing may
lower reliability of data.
Accoun�ng statements do not focus on cash flows, nor
do they report
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They are purely historical in nature.
Risk is not considered in report of performance.
Market Data
The second important informa�on source used by financial
claimants to analyze performance is market data. As its
name implies, market data are the data
generated in a marketplace, such as the New York Stock
Exchange or the Chicago Mercan�le Exchange. Here, we
will discuss two types of market data: stock
market performance (measured by stock returns) and
product market performance (measured by market share).
Because it is generated by millions of
market par�cipants, market-based data are less subject to
manipula�on (window dressing) than accoun�ng data are.
Although it has been accomplished,
managers have a difficult �me misleading millions of
investors in the stock market or millions of consumers in
product markets.
Stock Returns
Early on, we iden�fied shareholder wealth maximiza�on
as the corpora�on's ul�mate objec�ve. This goal leads us
directly to the necessity of evalua�ng

share price changes or stock returns. Stock returns
measure changes in shareholder wealth. Returns are
available in many formats. For example, The Center
for Research in Security Prices (CRSP), developed by the
University of Chicago, offers a data set of daily security
returns decades long; it covers thousands of
publicly traded firms. Returns may also be calculated by
gathering share price and dividend informa�on from
sources like Yahoo! and Google. Recall that
prices and dividends for any period may be converted into
a periodic return using the following formula:
Stock prices and returns are also useful to the analyst
because they are forward-looking and implicitly consider
risk. Recall that two shortcomings of
accoun�ng statements are (1) their historical nature and
(2) the fact that they don't incorporate risk. Stock prices
(and therefore returns) do not suffer from
these faults because they are forward-looking; that is, they
include the present value of future expected dividends.
Examine once again the stock valua�on
formula first presented in Chapter 5:
Investors' required return, r, is dependent on the riskiness
of the firm's future cash flows, as discussed in Chapter 6.
Therefore, when today's price changes,
it is responding to changes in expected return requirements
(which can be caused by a perceived change in risk) and
to changes in expected dividends.
However, using stock returns to e valuate corporate
performance also has a shortcoming. We may observe a
decline in share price, signaling poor
performance, but it is impossible to know why the price
declined without more informa�on. Did price decline
because the overall market declined? If so,

this is outside the firm's ability to control. Or was the
decline a signal of lower expected dividends and/or higher
risk? Fortunately, there is a way to
dis�nguish the por�on of a stock's return caused by a
market-wide movement from the part with a firm-specific
cause. This is achieved by subtrac�ng the
market's return from the stock's return. What is le� is
known as the stock's abnormal return (AR), or market-
adjusted return, for the period. The AR is the
firm-specific part of the period's return, which has been
isolated from the part of the return a�ributed to the
general market trend. For example, let's say
XYZ, Inc. had a good year last year according to its
CEO; its stock increased in value by 15%. You probe a
bit more and find that the overall stock market
(measured by the S&P 500) had a 20% return last year.
By subtrac�ng the market's return from the firm's return,
we determine that XYZ's market-adjusted
return last year was 25% (AR = 15% − 20% = −5%).
Thus, the firm actually underperformed the market, and its
firm-specific return was nega�ve. Now, let's
suppose the nega�ve AR is caused by lower expected
dividends. The analyst must s�ll determine the reasons
dividends are expected to decrease. Searching
out these causes requires analysis of other informa�on,
including accoun�ng-based data. Did sales decline? Did
costs increase? Was there a lawsuit? The
analyst must gather much more informa�on before an
accurate analysis can be drawn up.
The financial balance sheet model of the corpora�on
iden�fies two markets cri�cal to the success of a
business: financial and product markets. Financial
markets are the source of the external capital the
corpora�on needs in order to fund its investment projects.
As we have shown, stock returns measure the

success of the firm in these markets. Next, we discuss
how to measure a firm's performance in product and
service markets: by analyzing market share.
Market Share
A firm's products compete within the product and service
market arenas, which provide the cash that flows back
to claimants. Ul�mately, the risks and returns to which
claimants are exposed are determined by the success or
failure of the firm's output in the product market. One
method of gauging this success is through the calcula�on
of a product's market share. Here, the demand for the
product is reflected. Addi�onally, product pricing
strategies, product differen�a�on, quality, reliability,
service, delivery, brand-name recogni�on, and other
a�ributes are collec�vely judged by consumers in
comparison to compe�ng products of other firms.
Market share is calculated by dividing the firm's product
sales by the total sales of all products perceived to be
similar and compe�ng for the same consumer purchases.
A declining market share indicates that compe�tors are
taking business away from the firm. Lower profits may
result if sales decline, if prices are lowered in order to
recapture market share, or if marke�ng expenses increase
to promote greater demand.
Hand in hand with market share informa�on is the size
of the market. If, over �me, total industry sales within a
market are flat or trending downward, the company must
implement a strategy that addresses the problem.
Similarly, a growing market calls for a plan to meet
poten�ally high growth. Firms in shrinking markets are
challenged to gain a greater share in a smaller market.
Such firms may a�empt to develop new products that

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Understanding market share includes
knowledge of market size. When the
market for horse drawn carriages began
to shrink due to the popularity of cars,
manufacturers followed the market.
Marka/SuperStock
capitalize on company strengths to replace current products
that may be headed toward obsolescence. A good
example is the horse-drawn carriage manufacturers at the
turn of the century. Seeing demand for carriages
decline, firms such as Fischer Body (now a division of
General Motors) entered automobile body manufacturing.
More recently, IBM switched strategic direc�on from
manufacturing computer hardware to informa�on services
because they saw computers becoming an almost
commodity-like product with wafer-thin product margins.
Market size and share informa�on are available from
several sources. Government and industry publica�ons are
widely available online and through libraries, in addi�on
to informa�on services such as Compustat and Standard &
Poor's. The poten�al size of a market,
for example, may be determined using the Census of

Manufacturers, published by the U.S. Department of
Commerce, or a private source such as the
"Survey of Buying Power," published in Sales and
Marke�ng Management.
Opinions of Other Analysts
In addi�on to performing their own research, analysts can
supplement their analysis of a firm's performance with the
opinions of other analysts. Many large
firms are closely followed by securi�es analysts, and an
en�re industry exists to publish analysts' opinions and
forecasts of firm performance. The best
known of these publishers are Moody's, Standard & Poor's,
Fitch, Morningstar, and Value Line, all of which are
available online for a fee. Almost any library
carries one or more of these company's publica�ons.
Another source is brokerage firms, which o�en make their
analysts' reports available to investors.
Moody's, Fitch, and Standard & Poor's are best known as
bond-ra�ng agencies. These agencies base their ra�ngs on
the likelihood (in their opinion) that a
bond will default and on the protec�on afforded to the
claimant by the bond contract should default occur. Table
11.3 shows the major ra�ng categories
used by Moody's and Standard & Poor's. Naturally, the
higher the ra�ng is, the lower investors' required return
on the bonds will be and the lower the cost
of debt for the company. AAA or Aaa bonds, for
example, will have lower yields to maturity than BB or
Ba bonds.
Table 11.3: Standard & Poor's and Moody's bond ra�ng
categories

Agency Very High Quality High Quality Specula�ve Very
Poor
Standard & Poor's AAA AA A BBB BB B CCC D
Moody's Aaa Aa A Baa Ba B Caa C
Value Line is another ra�ng agency available to analysts.
Their weekly publica�on, The Value Line Investment
Survey, analyzes more than 1,700 stocks. They
rate equi�es for future price apprecia�on poten�al
(�meliness) and rela�ve riskiness (safety), and provide
explicit es�mates of future dividends, dividend
growth, sales, and earnings, among other forecasts. Stocks
are categorized by industry, and the publica�on includes
some discussion of each firm's prospects
and challenges as well as brief industry analysis.
Addi�onally, they also provide some historical data and
calculate several ra�os per�nent to analysis. See the
Web Resources at the end of this chapter for links to
Value Line's main site and a sample Value Line
investment survey.
Similar to Value Line, Morningstar also provides
informa�on on equi�es, dividends, and stocks. The agency
is also well known for its analysis of mutual
funds. See the Web Resources at the end of this chapter
for more informa�on on Morningstar.
We must keep in mind that, if markets are efficient, the
informa�on included in reports by Moody's or Value Line
is already included in the market price of
a firm's bonds and stock. Addi�onally, these ra�ngs and
opinions represent those of only one or a small handful
of analysts. However, when we analyze the
financial performance of a firm, these sources provide

useful data about the company in ques�on and the
industry of interest. To be sure, the opinions of
major ra�ng agencies certainly ma�er to the management
of companies whose securi�es they follow. Moreover,
opinions of other analysts serve as a
benchmark with which our own conclusions may be
compared.
Comparative Data
Numbers, by themselves, don't necessarily inform us of
much. If I caught a fish weighing five pounds, that may
be a big fish, if it is a trout, but it may be a
li�le fish if it is a tuna. To have meaning, numbers need
to be compared to some benchmark or target.
Suppose your employer's sales increased 10% last year. Is
this unexpectedly high or disappoin�ng? To answer that
ques�on, you must compare the result to
three pieces of data:
1. historical results,
2. your compe�tors' results,
3. your firm's targeted sales.
We will look specifically at historical results and your
compe�tors' results in this discussion of compara�ve data.
Let's consider the first piece of data. Historical results are
readily available in a firm's annual reports. In fact, annual
reports include data from several years
for just this purpose. If, in the last five years, sales had
increased by a minimum of 15% per year, then a 10%
increase for this year could be disappoin�ng.
On the other hand, if 10% were the largest increase in a
decade, it might indicate outstanding performance. The

historical record provides the analyst with a
clue.
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Coke's archrival, Pepsi, leads the way in offering healthy
alterna�ves such as
water and juice to their original soda line. Pepsi's
marke�ng strategy is
trouncing Coke in the marketplace. While Coke and Pepsi
are not technically
compara�ve companies, it is hard to separate their
products. Do you think
it is s�ll worthwhile, from a business analy�cal
standpoint, to compare the
two companies?
Coca-Cola and PepsiCo may seem like comparable
companies, but a
significant por�on of Pepsi's profits stem from Frito Lay.
Can you
think of be�er comparisons for the two companies?
Associated Press
To examine the second piece of data, look for comparable
firms that are compe�tors in the same product market.

Ideally, comparables would be about the
same size and have the same product mix as the firm
you're analyzing. If comparable firms had increases that
averaged 20%, your firm's 10% increase may
look rather dismal. Of course, if comparables showed no
sales growth, then your firm looks like a superstar.
You may have difficulty loca�ng comparables. Diversified
firms may not fit neatly into an
industry classifica�on. You may think, for example, that
Coca-Cola and PepsiCo are natural
comparables, but if you inves�gate, you will find that
PepsiCo owns Frito-Lay and the Quaker
Oats Company, among other snack food companies (see
h�p://www.pepsico.com/
(h�p://www.pepsico.com/) ). Surprisingly, snack foods
generate most of PepsiCo's sales and
profits, differen�a�ng its product line from Coca-Cola's.
Thus, the two companies are not as
comparable as one might assume.
Coke vs. Pepsi
For firms that do fit into an industry classifica�on, there
are publica�ons that produce industry average ra�os for
comparison purposes. Among the most
widely available industry averages are those published by
Dun & Bradstreet, Risk Management Associa�on, and the
annual surveys appearing in Forbes and
Business Week. Value Line, as previously men�oned,
classifies firms by industry and can be another useful
source for comparables data.
Print and Digital Media

We have already men�oned two sources of informa�on
that are not quan�ta�ve in nature: annual reports and
published analysts opinions. However,
analysts must look beyond the numbers when evalua�ng a
company's performance. The press offers a wealth of
valuable informa�on—both online and in
print—that may be useful to the analyst.
Why should we consider informa�on available through the
media when performing financial analysis? When you
analyze quan�ta�ve data like ra�os and
growth rates, you may be tempted to evaluate performance
using numbers alone. This level of analysis does not
understand the cause of performance. For
instance, concluding that share price declined because
earnings were lower is not very useful; we don't know
why earnings were lower. If we take the
quan�ta�ve analysis a step further and discover that
earnings were lower because sales were down, then we've
added to our knowledge, but we s�ll have
not reached a level of understanding that is useful to
decision making. What a manager or a claimant needs to
know is why sales were down. Did theProcessing math: 0%
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,sec11.5,ch11concl… 10/26
company lose market share because a compe�tor
introduced a superior product or lowered prices? Were
sales down because the overall market shrank?

Was there a recession last year that caused consumers to
cut back their overall spending? Maybe bad press caused
sales to decline, or maybe it was a result
of internal problems at the company. A strike may have
hurt produc�on, or a key salesperson may have re�red.
There is a myriad of possibili�es, and it is
the analyst's job to find the correct one. Ra�os are useful
because they raise red flags, causing analysts to focus
their a�en�on in the correct places, but
numbers don't always tell the complete story. Publica�ons
devoted to business and economics, such as The Wall
Street Journal, Barron's, Financial Times,
Forbes, and Fortune are just a few resources that analysts
can turn to for addi�onal (non data-driven) informa�on
crucial to the analysis of a company's
performance.
In addi�on to these print sources, numerous sources are
available online. Virtually all of the informa�on sources
listed here, from The Wall Street Journal to
the Risk Management Associa�on, maintain their own
sites. You can find a corpora�on's website by using a
search engine, and you can access financial
statements by looking at a corpora�on's filings with the
Securi�es and Exchange Commission—including their
annual reports, proxy statements, and 10-Ks.
The SEC makes these available on its EDGAR database.
In addi�on to these sources, general news about
companies is provided online by television networks
such as ABC, CNN, and CBS, and by newspapers such as
the New York Times. Business-specific news sources
include Bloomberg, CNBC, and Britain's
Financial Times, which is similar to The Wall Street
Journal but with a more interna�onal perspec�ve. Another
useful site is Financial Web, managed by Dr.
James Graven. Finally, securi�es exchanges that manage

their own sites include the NYSE and NASDAQ. See the
Web Resources at the end of this chapter
for more informa�on on online resources.
As you can see, evalua�ng corporate performance requires
a significant amount of research. No single source
provides all the pieces of the puzzle, yet each
makes a contribu�on toward understanding the full picture.
Next, we examine how analysts take their gathered
informa�on and apply it to financial
statement analysis.
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These figures show the company's income statements and
balance sheets from 2009–2011.
11.3 Financial Statement Analysis
In the previous sec�on we examined different sources
analysts use to gather informa�on when evalua�ng
corporate performance. In this sec�on, we will
discuss how that informa�on is applied to analyzing
financial statements. Let's start by looking at an example.
Shingard, Inc. manufactures plas�c shin guards used
primarily by soccer players. Figures 11.1 and 11.2 show
the firm's income statements and balance

sheets for the years 2009, 2010, and 2011. These two
figures provide the informa�on we will use to demonstrate
techniques used to analyze financial
statements, including the calcula�on of trend and common
size statements in the following sec�on of the chapter.
Figure 11.1: Shingard, Inc. income statements, 2009–2011 (in
000s)
Figure 11.2: Shingard, Inc. balance sheets, 2009–2011 (in 000s)
Trend Statements
Analysts use trend statements to uncover evidence of
pa�erns in the data. They are constructed by taking a
beginning year's account balance as a
benchmark year. Each account for subsequent years is then
divided by the benchmark year's balance. Thus, all
accounts are re-expressed in a trend
statement as a mul�ple of the beginning year's balance.
Table 11.4 shows the balances of the revenue and cost of
goods sold (COGS) accounts for Shingard
and their trend statement values.
Table 11.4: Balances of revenue and COGS for Shingard,
Inc.
Dollar Values 2009 2010 2011
Revenue $52,846 $50,280 $57,394Processing math: 0%
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What do trend statements help companies determine?
Trend statements provide the clues
necessary to explain corporate
performance. By inves�ga�ng Shingard,
Inc.'s trend statement, the analyst would
discover that the World Cup may have
impacted sales.
Comstock/Thinkstock
Calcula�ng the trend values $52,846 $50,280 $57,394
Beginning year's balance $52,846 $52,846 $52,846
Trend values 1.000 0.951 1.086
Dollar values 2009 2010 2011
COGS $23,781 $23,632 $29,271
Calcula�ng the trend values $23,781 $23,632 $29,271
Beginning year's balance $23,781 $23,781 $23,781
Trend values 1.000 0.994 1.231
Next, Figure 11.3 shows abbreviated trend income and
balance sheets for Shingard. The most striking features of
the trend statements for Shingard are that (1) net income
was down in 2010 and made a drama�c recovery in

2011; (2) total assets were actually smaller at the end of
2011 than they were at the end of 2009; and (3) total
equity was more than 50% higher in 2011 than in 2009.
Closer inves�ga�on of the trend statements and the
underlying accoun�ng statements reveals that net income
was down in 2010 because of lower sales. The recovery
in 2011 was driven by higher sales and control of selling,
general, and administra�ve expenses. The la�er factor
was vital because it offset higher COGS in the same year.
Total assets declined slightly as deprecia�on expense
outstripped the increase in current asset accounts. And the
total equity increase was fueled by 2011's outstanding
earnings, which led to a large increase in retained
earnings. This internal capital replaced external long-term
debt
in the firm's capital structure.
Figure 11.3: Trend analysis and trend balance sheet for
Shingard, Inc., 2009–2011
It is apparent from the trend statements that something
unusual took place in 2011. Sales and profits were up
drama�cally. Remember that numbers do not
explain things; they simply provide clues. If we were to
inves�gate further by carefully reading 2011's annual
report or perhaps some industry literature for
that year, we would discover that the World Cup for
soccer was played during the summer of 2010, perhaps
genera�ng some interest in the sport and
s�mula�ng sales in 2011. This comes closer to explaining
2011's outstanding results, but keep in mind that the trend
statement highlighted that year's
drama�c turnaround, pu�ng us on the correct
inves�ga�ve path.

Common Size Statements
Common size statements are another tool used to analyze
financial statements. These statements allow analysts to
compare the rela�ve composi�on of a
company's accounts over �me. Each year's common size
income statement is found by dividing each account by
that year's revenue. Common size balance
sheets are constructed by dividing each account by that
year's total assets. For example, the common size COGS
for Shingard for 2010 is $23,632/$50,280 =
0.470 and the common size Inventory account for 2010
would equal 0.477. Figure 11.4 shows abbreviated common
size income and balance sheet
statements.
Figure 11.4: Shingard, Inc. common size income statement and
balance sheet,
selected accounts: 2009–2011
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What does comparing these common size income
statements and balance sheets offer to companies? What
can they determine from this informa�on?
Focusing our a�en�on on the contrast between the 2009

and 2010 common size statements, we see two glaring
changes. First, COGS sharply increased as a
propor�on of revenue, while selling, general, and
administra�ve expense decreased.
To explain this, we would need to deconstruct COGS:
Was the increase due to labor costs or raw materials? If
labor caused the increase, was the rise due to
a renego�ated union contract? Or was management paying
over�me to meet increased demand (rather than hiring
more employees)? As analysts, we need
to look beyond the numbers. The decrease in selling,
general, and administra�ve expense may be an inten�onal
cost-cu�ng act on management's part as a
response to the increased COGS. Perhaps management
canceled an adver�sing campaign, cut excess expenses in
the central office, or began to pay sales
people on salary rather than by commission. We need to
look beyond the accoun�ng numbers to find how and why
SG&A declined.
The second drama�c change takes place in the common
size balance sheet long-term debt and total equity
accounts. Clearly, retained earnings have been
used to pay down debt balances. Thus, Shingard is using
less financial leverage. However, there is a troubling
aspect to this use of retained earnings: Recall
that, from the trend balance sheet (Figure 11.3), total
assets were shrinking over the period. Thus, management
has apparently chosen to pay off debt
rather than reinvest in new equipment or other assets.
This could lead to trouble if the equipment begins to
break down. A second concern is the signaling
content of lower leverage (recall Chapter 9). Perhaps
shareholders will believe that management is concerned
that the firm's future cash flows cannot

support the previous level of debt. If, for example, you
served on Shingard's board of directors, you would require
some explana�on to convince you that
paying off debt is a wise move on management's part.
Ratio Analysis
We will not burden you with in-depth coverage of ra�os'
mechanics. Like the skilled detec�ve who leaves the DNA
tes�ng to the crime lab, we will leave the
calcula�on of ra�os to the calculator. Figure 11.5 shows
the most common financial ra�os calculated from
Shingard's 2011 accoun�ng statements. Carefully
review each ra�o, paying par�cular a�en�on the
calcula�on and how it relates to the ra�o's use.
Figure 11.5: Financial ra�os for Shingard, Inc. for 2011
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This figure shows the most common financial ra�os from
Shingard's account statements from 2011.
What we're most interested in is understanding what clues
to look for, where to look for them, and how to interpret
them once they have been found. Just
as a school for detec�ves cannot cover every crime or

review all poten�al pieces of evidence, neither can we
cover all scenarios an analyst may encounter.
Rather, the detec�ve school tries to cover major types of
crime in the hope that the ability to analyze one case
will carry over to other new and different
cases. In that spirit, we are going to present some
scenarios that commonly occur in business and analyze
how these events are manifested in the firm's
ra�os and financial statements.
Scenario 1: Increasing Leverage and Return on Equity (ROE)
In the first scenario, we examine the rela�onship between
borrowing and one of the most important ra�os, return on
equity (ROE = Net income/Total
Equity). Suppose a corpora�on decides to raise capital by
borrowing. Whether this decision to "lever-up" will have a
posi�ve or a nega�ve impact on the
firm's ROE depends on the interest charged by the lender
and the firm's earning power (EP = EBIT/Total assets). If
the firm's earning power is less than the
interest rate, then ROE will fall, and vice versa.
If EP > i, ROE increases with leverage. If EP < i, ROE
decreases with leverage.
Figure 11.6 shows two firms of equal size, with equal
debt ra�os, being charged the same interest rate. The one
difference between these two companies is
a drama�c gap in earning power. Note what happens to
their respec�ve ROEs as their debt ra�os change.
Figure 11.6: Illustra�on of earning power, leverage, and ROE
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What happens to their respec�ve ROEs when the
companies' debt ra�o changes?
The March 2011 tsunami in Japan affected
businesses all over the world, as
companies were relying on parts
manufactured in Japan. Do you think just-
in-�me inventory plans need backups?
Associated Press
Scenario 2: Just-in-Time Inventory
Let's consider another scenario, concerning just-in-�me
inventory. Just-in-�me inventory systems deliver inventory
directly to the assembly line as needed,
rather than the tradi�onal method of being stockpiled in a
warehouse. Thus, materials are delivered just in �me for
their use in the manufacturing process,
rather than being stored onsite. This is a very efficient
system because less capital is invested in inventory,
making it available for other projects or uses.
Furthermore, less warehouse space is needed to stockpile
inventory, and less labor is required to store and retrieve
it when needed. Considering these
characteris�cs of just-in-�me systems, let's see what

efficiency ra�os from Figure 11.1 would be impacted if a
manufacturer successfully implemented this
inventory system. Inventory turnover would certainly
increase because less inventory would be kept on hand,
which lowers the denominator in the ra�o.
Asset turnover would also increase as total assets decline,
due to lower inventory and warehouse requirements,
lowering the ra�o's denominator.
If just-in-�me inventory improves these efficiency ra�os,
why don't all manufacturers adopt the system? The answer
lies in the just-in-�me inventory system's poten�al for
risk. The manufacturer becomes extremely dependent on its
suppliers, and on its ability to accurately gauge and �me
demand for the finished product. If the supplier cannot
meet delivery schedules, or if the manufacturer
inaccurately gauges its own material requirements,
produc�on
schedules may be missed. Missed deadlines would likely
result in loss of sales. If the company needs to meet
higher
than an�cipated material needs, raw materials would have
to be rushed to the assembly line at a high cost in order
to meet promised delivery dates. So, although the
inventory turnover ra�o may be improved, it is also
likely that
sales would decline and profit margins shrink. For some
companies, these risks may outweigh the benefits of
implemen�ng such a system.
At the extreme end of just-in-�me inventory risk is
disrup�on caused by a catastrophe. Such an event
occurred on
March 11, 2011, when a giant earthquake and tsunami hit
Japan. The crisis caused widespread disrup�on in
manufacturing with the effects being felt almost

immediately by firms with just-in-�me inventory systems
in place.
The risks of such disasters are great enough in some
regions that planning groups are formed to develop
con�ngency plans for addressing such events, like the
Cascadia Region Earthquake Workgroup (CREW). CREW
has
even prepared a study �tled, "Just-In-Time Inventory:
Effects on Earthquake Recovery," demonstra�ng the
seriousness with which this risk is taken on the Pacific
Coast. A link to this study can be found in the Web
Resources
at the end of this chapter.
Scenario 3: Working Capital Analysis
This scenario will help you understand working capital.
Here is some informa�on about a large U.S. company that
will help hone your financial analysis skills. We won't
name the company yet, so you can focus on the financial
data.
Here are facts from a Wall Street Journal ar�cle
supplemented with data from the company's annual report.
Sales growth during 2011 was less than 1%. The
company held just 13 days of inventory (compared to 7.5
days on average for its industry). Its Accounts Payable to
suppliers was over 100 days (compared
to 37 days on average for its industry), and its Accounts
Receivable was 58 days (compared to 45 days on average
for its industry) (Winkler, 2012).
This isn't much informa�on but try to infer something
about the financial health of this company. We might
begin by simply comparing the company to its
industry. It has about 70% more inventory than other

companies in its industry and does not pay its bills nearly
as quickly, nor does it collect its credit sales
as quickly. All of these indicators suggest poor working
capital management.
But using industry averages as benchmarks assumes that
the average firm in an industry is an outstanding
performer that should be emulated. By defini�on,
the average firm is . . . well, average. Let us consider
the working capital metrics for our mystery company in a
different light. The company buys enough
inventory for 13 days of sales (more on this later); it
then makes a sale and collects cash for the sale 58 days
later. This means that there is a 71-day gap
between the �me inventory arrives at the company and
when it finally turns into cash. On the other side of the
ledger, it is able to postpone paying its
suppliers for 100 days. By combining these numbers (100
– 71) we see that the company has 29 days of free cash
to use before it pays its suppliers. Think
about this. The company gets to use cash at no cost for
one month. This is free financing! From this perspec�ve,
the firm's managers are incredibly clever.Processing math:
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The company we have been considering is Dell. The Wall
Street Journal ar�cle is somewhat cau�onary, warning that
this interest-free cash machine is

slowing down as sales slow. Despite this, the lesson
remains clear: Averages are average, and it is important
to look at a company from several perspec�ves.
Scenario 4: Corporate Bond Ra�ngs and Financial Ra�os
The last scenario we cover relates to corporate bond
ra�ngs and financial ra�os. Recall from earlier in this
chapter that three companies rate bonds:
Standard & Poor's, Moody's, and Fitch. As discussed, bond
ra�ngs serve as risk indicators, and investors depend on
them when se�ng their required rate of
return from inves�ng in a bond.
The ra�ng process usually begins with a thorough
financial ra�o analysis. Ra�ng analysts then consider the
prospects for the industry and the company
being rated within that industry, (e.g., How will
compe��on affect the company? Are the company's
primary markets growing?). In this scenario, we focus
on the ra�o analysis component of the bond-ra�ng
process.
Table 11.10 shows the medians for eight different
financial ra�os and six different bond ra�ngs. Recall that
Aaa-Aa through Caa-C are Moody's bond ra�ng
categories from the highest to the very lowest (See Table
11.3), which correspond to S&P ra�ngs of AAA-AA
through CCC-C. The IG column is for Investment
Grade, Aaa through Baa3 (or in S&P symbols: AAA
through BB+). The IG column on the far right of Table
11.10 is for Investment Grade, Aaa through Baa3
(or in S&P symbols: AAA through BB1).The SG acronym
stands for Specula�ve Grade and is everything below
Investment Grade. This breakdown is important
because some investors, for example bank trust

departments, can only invest in IG bonds, or have a strict
limit on how much they will invest in SG bonds.
The numbers
shown are medians rather than means or averages. Because
the median is not sensi�ve
to extreme values, it o�en provides a be�er measure of
central tendency than the mean.
Table 11.11 lists Moody's defini�on of these financial
metrics.
Table 11.10: Aggregate metrics by ra�ng category
Median Median
Aaa-Aa A Baa Ba B Caa-C IG SG
Interest coverage 16.0 8.6 5.4 3.7 1.9 0.7 6.5 2.1
Asset coverage 3.7 2.4 2.3 2.0 1.3 1.0 2.4 1.4
Leverage 31.6% 41.7% 44.8% 49.8% 68.7% 92.2% 43.6%
66.8%
Cash flow/Debt 52.4% 32.6% 25.8% 21.6% 12.1% 6.4% 28.4%
12.7%
Return on assets 11.6% 7.5% 5.3% 4.4% 1.7% -2.1% 6.3%
1.9%
Profit 11.8% 9.0% 6.7% 5.0% 2.0% -2.6% 7.8% 2.1%
Liquidity 7.8% 4.7% 4.0% 4.3% 39% 3.3% 4.6% 3.9%
Revenue stability 7.2 7.3 6.1 5.2 6.1 7.3 6.6 5.9
Source: Moody's ra�ngs and financial database as of July

1, 2006
For all of the listed metrics (except Leverage) larger
numbers are be�er than smaller numbers. That is, a
company with higher Interest Coverage, higher Cash
Flow-to-Debt, Profit, and so on is superior to similar
companies with lower ra�os. This is apparent in Table
11.10, with the highest numbers for listed ra�os
(except Leverage) associated with the highest rated bonds
(Aaa-Aa), declining steadily to the Caa-C rated bonds
(with the excep�on of Revenue stability for
the lowest rated bonds).
The defini�ons that Moody's uses to compute its ra�os
(shown in Table 11.11) are very similar to those
introduced earlier in this chapter. You will no�ce a
few slight varia�ons, but overall the ra�os a�empt to
measure the same characteris�cs.
Table 11.11: Moody's ra�os defined
Ra�o Defini�on
Interest coverage
(EBIT − Interest capitalized + (1/3) * Rental
expense)/(Interest expense + (1/3) * Rental expense +
Preferred
dividends/0.65)
Asset coverage (Total assets − Goodwill − Intangibles) /
Total debt
Leverage (Total debt + 8 * Rental expense)/(Total debt +
8 * Rental expense + Deferred taxes + Minority interest
+ Total
equity)

Cash flow/Debt Net a�er-tax income before X-items +
Deprecia�ons − Dividends)/(Total debt - 8 * Rental
expense)
Return on assets Net a�er-tax income before X-items/2
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Profit Net a�er-tax income before X-items/Net sales
Liquidity Cash & market securi�es/Total assets
Revenue stability 5 year average net sales/5 year standard
devia�on net sales
Source: Mertz & Cantor (2006).
Now that you have a be�er understanding of bond ra�ngs
and financial ra�os, we can apply the Moody's ra�o
analysis to an actual company, by es�ma�ng
the bond ra�ng for Sears (Ticker: SHLD) in the Applying
Finance feature. We will be using data from 2010 and
2011.
Applying Finance: Moody's Ra�o Analysis
Tables 11.12 and 11.13 show four years of income
statements and balance sheets for Sears. Other informa�on

you will need to construct the ra�os for
Sears bond ra�ng es�ma�on are: Revenue (2008) $49,867.
Table 11.12: Sears Holdings Corpora�on income
statements, 2008–2011
In millions of USD (except
for per share items)
52 weeks ending January
28, 2012
29, 2011
30, 2010
31, 2009
Revenue 41,567.00 42,664.00 43,360.00 46,770.00
Total revenue 41,567.00 42,664.00 43,360.00 46,770.00
Cost of revenue, total 30,966.00 31,000.00 31,374.00
34,118.00
Gross Profit 10,601.00 11,664.00 11,986.00 12,652.00
Selling, general &
administra�ve expenses,
total
10,664.00 10,425.00 10,499.00 11,060.00

Deprecia�on/amor�za�on 853.00 869.00 894.00 981.00
Unusual expense (income) 585.00 –67.00 –74.00 309.00
Total opera�ng expense 43,068.00 42,227.00 42,693.00
46,468.00
Opera�ng income –1,501.00 437.00 667.00 302.00
Other, net –2.00 –14.00 –61.00 108.00
Income before tax –1,751.00 162.00 391.00 184.00
Income a�er tax –3,120.00 135.00 280.00 99.00
Minority interest 7.00 –17.00 –62.00 –46.00
Net income before extra
items
–3,113.00 118.00 218.00 53.00
Net income –3,140.00 129.00 235.00 53.00
Income Available to
Common Excl. Extra Items
–3,113.00 118.00 218.00 53.00
Income Available to
Common Incl. Extra Items
–3,140.00 129.00 235.00 53.00
Diluted Weighted Average
Shares

106.8 111.7 117.9 127
Diluted EPS Excluding
Extraordinary Items
–29.15 1.06 1.85 0.42
Dividends per Share—
Common Stock Primary
Issue
0.00 0.00 0.00 0.00
Diluted Normalized EPS –19.88 0.74 2.55 3.69
Source: Sears Holding Corpora�on (2011).Processing math:
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Table 11.13: Sears Holding Corpora�on's balance sheets,
2008–2011
In millions of USD (except
for per share items)
As of January 28, 2012 As of January 29, 2011 As of
January 30, 2010 As of January 31, 2009

Cash & equivalents 747.00 1,359.00 1,689.00 1,173.00
Cash and short-term
investments
747.00 1,359.00 1,689.00 1,173.00
Accounts receivable—
trade, net
695.00 689.00 652.00 839.00
Total receivables, net 695.00 689.00 652.00 839.00
Total inventory 8,407.00 8,951.00 8,705.00 8,795.00
Prepaid expenses 388.00 334.00 351.00 458.00
Other current assets, total 7.00 227.00 41.00 151.00
Total current assets 10,244.00 11,560.00 11,438.00 11,416.00
Property, plant &
equipment, total—gross
11,210.00 11,329.00 11,392.00 10,959.00
Accumulated deprecia�on,
total
–4,633.00 –4,227.00 –3,683.00 –2,868.00
Goodwill, net 841.00 1,392.00 1,392.00 1,392.00
Intangibles, net 2,937.00 2,993.00 3,208.00 3,283.00

Other long-term assets,
total
782.00 1,313.00 1,061.00 1,160.00
Total assets 21,381.00 24,360.00 24,808.00 25,342.00
Accounts payable 2,912.00 3,046.00 3,335.00 3,006.00
Accrued expenses 523.00 546.00 — 2,272.00
Notes payable/short-term
debt
1,175.00 360.00 325.00 442.00
Current port. of long term
debt/capital leases
230.00 489.00 482.00 345.00
Other current liabili�es,
total
4,372.00 4,202.00 4,644.00 2,447.00
Total current liabili�es 9,212.00 8,643.00 8,786.00 8,512.00
Long-term debt 2,088.00 2,344.00 1,698.00 2,132.00
Total long-term debt 2,088.00 2,344.00 1,698.00 2,132.00
Total debt 3,493.00 3,193.00 2,505.00 2,919.00
Deferred income tax 816.00 0.00 — —

Minority interest 60.00 103.00 339.00 319.00
Other liabili�es, total 4,924.00 4,759.00 4,889.00 4,999.00
Total liabili�es 17,100.00 15,849.00 15,712.00 15,962.00
Common stock, total 1.00 1.00 1.00 1.00
Addi�onal paid-in capital 10,005.00 10,185.00 10,465.00
10,441.00
Retained earnings
(accumulated deficit)
1,865.00 4,930.00 4,797.00 4,562.00
Treasury stock—common –5,981.00 –5,826.00 –5,446.00 –
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Other equity, total –1,604.00 –780.00 -–730.00 –615.00
Total equity 4,281.00 8,511.00 9,096.00 9,380.00
Total liabili�es &
shareholders' equity
21,381.00 24,360.00 24,808.00 25,342.00

Total common shares
outstanding
106.3 108.9 114.8 122.00
Source: Sears Holding Corpora�on (2011).
Addi�onal relevant informa�on is shown in Figure 11.7.
The figure combines Sears's interest expenses, rental
expenses, and deferred taxes for 2009–
2011. Interest expense is not broken out in the income
statements. As shown, the company did not report any
capitalized interest and did not pay any
dividends, either preferred or common.
Figure 11.7: Sears Holding Corpora�on's interest expense,
rental expense, and
deferred taxes, 2009–2011
Source: Sears Holding Corpora�on (2011).
Table 11.14 shows Sears's bond ra�ng financial ra�os
found using the defini�ons in Table 11.11. The pink
shaded cells indicate deteriora�on in a ra�o.
The Moody's le�er ra�ng is an es�mate based on the
medians shown in Table 11.10. The Revenue Stability
metric is based on four years of data instead
of the five Moody's uses, because that is what was
readily available.
Table 11.14: Sears Holding Corpora�on's bond ra�ng
financial ra�os, 2009–2011
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*Interest coverage: –2.118 1.289 1.746
Moody's Ra�ng C Caa B
• Asset coverage: 5.040 6.256 8.067
Moody's Ra�ng Aaa Aaa Aaa
• Leverage: 64.19% 53.53% 50.03%
Moody's Ra�ng B B Ba
• Cash flow/debt: –22.64% 10.29% 12.28%
Moody's Ra�ng C B B
• Return on assets: –3.41% 0.14% 0.28%
Moody's Ra�ng C Caa B
• Profit: –7.55% 0.30% 0.54%
Moody's Ra�ng C Caa Caa
• Liquidity: 3.49% 5.58% 6.81%
Moody's Ra�ng C Ba Baa
• Revenue stability: 13.134 Moody's Ra�ng Aaa

Moody's Ra�ng Aaa
Based on the informa�on from Table 11.14, es�ma�ng
the bond ra�ng for Sears's debt from 2009 to 2011
becomes a ma�er of judgment. One approach
is to use the same method used for compu�ng grade
point averages: give each ra�ng a numerical value, then
find the average of those values. There are
nine ra�ngs, so we assign Aaa a score of 9, Aa a score
of 8, and so on, un�l C receives a score of 1. We show
the results in Table 11.15.
Table 11.15: Es�ma�ng Sears's bond ra�ng using
financial ra�os, 2009–2011
2011 2010 2009
*Interest coverage: 1 3 4
• Asset coverage: 9 9 9
• Leverage: 4 4 5
• Cash flow/debt: 1 4 4
• Return on assets: 1 3 4
• Profit: 1 3 3
• Liquidity: 1 5 6
Average 2.6 4.4 5.0
Moody's Ra�ng Caa-Ca Ba-B Ba

These results show that Sears's ra�ng has deteriorated
from 2009 to 2011, dropping from almost investment grade
(Ba) down to specula�ve grade. In
fact, on January 4, 2012, The Wall Street Journal reported
that Moody's had downgraded Sears's ra�ng (Stynes,
2012).
The scenarios presented in this sec�on illustrate how
business's ac�ons may manifest themselves in financial
statements and ra�os. As pointed out earlier,
the endless possibili�es make an exhaus�ve study of
ra�o analysis impossible. However, it is a good habit
when you read the business news to imagine
some of the possible financial ramifica�ons of each news
item. Doing so will help you become an astute and
sophis�cated analyst.
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The DuPont System can be used to calculate return on
equity.
11.4 Stock Prices and Ratio Analysis
An analyst could easily get lost in examining ra�os and
lose track of financial management's primary objec�ve—
the maximiza�on of shareholders' wealth.
The manager and analyst must be concerned with how

ra�os can help to explain share price behavior. It's
important to know why the price is outperforming
compe�ng firms' prices or why the stock is
underperforming its peers. In this sec�on, we establish a
link between ra�os and the value of common stock
that will help us understand the performance of the
shares.
Let's begin by returning to the constant growth stock
valua�on formula. Although not all stocks have constantly
growing dividends, this formula is useful
because it illustrates the interplay between dividends, risk,
and growth that affects share price regardless of the stock
being analyzed. Recall that the
constant growth formula is
Now, let's examine the terms in the formula, star�ng with
the numerator.
First, D1, the dividend, is equal to net income �mes the
firm's payout ra�o:
Dividend = (Net income)(Payout)
Next, consider that net income is equal to sales �mes net
profit margin:
Dividend = (Net income)(Payout) = (Sales)(Net profit
margin)(Payout)
Because the dividend's value appears in the numerator of
the stock valua�on formula, we can determine that, all
else being equal, a higher dividend will
increase share price. Thus, increased sales will increase
share price, if sales can be increased without affec�ng

other factors. For example, if sales are
increased by lowering prices, then the net profit margin
may decline and share price may not increase. On the
other hand, if sales increase because of a
new, outstanding product that can be sold without cu�ng
the profit margin, then it is likely that share price will
go up according to the formula's predic�on.
Now let's consider the denominator (r – gn) of the
constant growth formula. No�ce that if the growth rate,
gn, increases, the value of the denominator in
the formula decreases, which will increase the frac�on's
value. Thus, increased growth leads to increased price (if
everything else is held constant). So what
increases growth? From a ra�o-analysis perspec�ve,
growth is a func�on of return on equity (ROE) and the
earnings reten�on rate (where the reten�on rate
is found by dividing retained earnings by net income). In
fact, the following iden�ty is called the sustainable growth
formula:
Growth = (ROE)(Reten�on rate)
Now, it is clear that ROE is a key driver of growth.
What, then, affects ROE? Here, a system of very
important rela�onships between ra�os called the DuPont
system (see Figure 11.8) becomes useful for analyzing
ROE. Note that ROE is shown to be a func�on of return
on assets (ROA) mul�plied by the leverage
ra�o (LEV). ROA is then shown to equal net profit
margin (NPM) �mes asset turnover.
Figure 11.8: The DuPont System

The DuPont system can be par�cularly useful for
analyzing price performance. Suppose, for example, you
are analyzing a company's stock that has lagged
behind its compe�tors' shares performance. You want to
know why. One approach is to analyze your firm's sales
growth compared to the compe�tors'
(remember sales is a factor in the top of the valua�on
formula). If lagging sales is the problem, then you may
want to analyze the reputa�on of the firm's
products, the products' pricing, or the effec�veness of the
company's marke�ng strategy. If sales performance is not
the root of the problem, perform a
DuPont analysis. Is ROE falling? Is it below compe�tors'
ROEs? If either is the case, the next step is to find out
why by analyzing asset turnover, net profit
margins, or leverage. Perhaps one of these ra�os holds
the key to the lagging stock price.
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Toys "R" Us is just one example of a corpora�on that
has
incorporated MVA and EVA into its financial strategy.
What are the
benefits of these techniques? What are the drawbacks?
age fotostock/SuperStock

11.5 Evaluating Management's Performance
The central issue in determining how well a firm is doing
is how much wealth has been created by the company's
projects. By inves�ng on behalf of
claimants, the firm strives to add value to the securi�es
purchased by these suppliers of capital. As we have seen,
the strategy for accomplishing this
objec�ve is to iden�fy and pursue posi�ve net present
value projects.
Economic value added (EVA), developed by Joel Stern and
Benne� Stewart, is a method for evalua�ng how effec�ve
management is at adding value to the
corpora�on. EVA can be thought of as a kind of
historical NPV analysis. Whereas tradi�onal NPV is done
when evalua�ng a poten�al future project, EVA
looks at past results to see whether the projects the
company has pursued are actually producing wealth in
excess of their cost. EVA subtracts the dollar
amount of the firm's cost of capital from its a�er-tax
opera�ng profits to arrive at the value added to the
corpora�on. For example, suppose a firm's cost of
capital is 12% and the company employs $50,000,000 in
assets. The dollar amount of the firm's cost of capital is
$6,000,000 annually (0.12 × $50 million). If
the company is able to produce a�er-tax opera�ng profits
of $9 million, its EVA is $3 million.
Note that a�er-tax opera�ng profit is essen�ally a�er-tax
cash flow before deprecia�on expense and any
distribu�ons to debt or equity holders. The cost of
capital includes in its calcula�on the cost of debt and the
cost of equity. Therefore, when the cost of capital is
subtracted from opera�ng cash flow, the

remaining cash (the EVA) is the cash flow that belongs
to equity holders a�er their return requirements have been
sa�sfied. Thus, EVA measures the
addi�onal wealth added to equity claims for the year; or
the extra profit earned by the company beyond that
necessary to finance the firm's opera�ons. A
corpora�on with posi�ve EVA is doing a good job of
inves�ng on behalf of its stockholders, while a
corpora�on with nega�ve EVA is actually destroying
wealth by inves�ng in projects whose value is less than
their cost.
One problem with EVA is that it measures only a single
year's opera�ng results. These could be affected, for
example, by a large financial commitment to
research and development that would produce no opera�ng
income for several years. Such a project would ini�ally
lower EVA because the dollar cost of
capital would reflect the new project and the opera�ng
cash flow realizes no project income during the product
development period.
Yet, such a project could have a posi�ve net present
value when the future cash flows are
considered.
To correct for this shortcoming, some firms and analysts
use a measure called market value
added (MVA). MVA is found by taking the market value
of the firm's claims (the market price
of the firm's securi�es, both equity and debt, �mes the
outstanding shares and bonds) and
subtrac�ng the book value of the liabili�es and equity. If
MVA is posi�ve, the firm has taken
the historical contribu�ons of the claimants (reflected in
book values) and increased their

worth (reflected in their higher market values). Because
market values incorporate investors'
expecta�ons about the firm's future cash flows, MVA
reflects the future benefits that a
project is expected to produce. Thus, MVA answers one
of the chief cri�cisms of EVA. Both
MVA and EVA have been adopted by many large
corpora�ons, including Coca-Cola and Toys
"R" Us, and show promise as tools for evalua�ng a
firm's—and management's—performance.
New financial analysis metrics are being developed every
year. For example, shareholder value
added (SVA) is closely related to EVA and MVA. Other
metrics may measure performance in
new and much different ways. For example, the "Balanced
Scorecard" a�empts to measure
performance for a wider perspec�ve than the tradi�onal
financial metrics.
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Ch. 11 Conclusion
Financial analysis is one of the most important tools
available to individuals with interest in a firm's financial
performance. This chapter has introduced
several sources of informa�on useful to the financial

analyst, and has provided an overview of the mechanics of
financial statement analysis. Most
importantly, the chapter has illustrated how analysis can
help lead the analyst toward the issues that may explain a
company's performance, which is crucial
to the firm's future success.
Throughout this text, we have considered how firms decide
which projects to pursue in their aim to increase
shareholder wealth. We have also examined
the factors that firms should consider when selec�ng
financing alterna�ves and dividend payment policy, as
well as the concepts that aid in the
development of such policy decisions. Addi�onally, we
have covered the tools used in mathema�cs of
discoun�ng, and theories such as the CAPM. Using
the financial balance sheet, these decisions have been
placed in the context of the firm's role as an investment
vehicle in the hope of providing a vision of
how these decisions fit into the process of wealth
building.
Students some�mes compartmentalize their educa�on;
meaning, they use the material from finance class only in
finance class, the material from marke�ng
only in marke�ng, and so on. In this text, we have tried
to show you how the concepts and tools typically
associated with finance actually apply to many
business areas. Just as the finance func�on relies on
marke�ng, accoun�ng, and other management areas, so
too does finance contribute to those other
fields. Good business decisions o�en require looking at a
problem a li�le differently or applying a slightly different
set of tools to the problem. We hope that
this textbook has given you some ideas on how financial
concepts and tools might be applied to a range of

problems, both within and without the
corpora�on.
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Ch. 11 Learning Resources
Key Ideas
In addi�on to the auditor's opinion, analysts should take a
careful look at the footnotes to a firm's financial statements.
These footnotes may reveal
important informa�on like pending lawsuits that may not be
reported elsewhere.
The ul�mate success or failure of a business is determined in
product and in capital markets. Therefore, it is impera�ve that
the evalua�on of firm
performance include the analysis of market data.
The corpora�on exists to benefit its owners, the shareholders.
Stock returns directly measure the benefits of ownership of a
for-profit corpora�on, while
market share measures what propor�on of sales a firm is
capturing in the market for its products.
The research of professional analysts can be a good source of
informa�on about a corpora�on or an industry. One should
keep in mind, however, that
these opinions are very subjec�ve so care should be taken if
you try to second-guess securi�es markets based on an analyst's

recommenda�on.
Raw data describing a company's performance is not very useful
without benchmarks with which it can be compared. Typically,
comparisons are made
with the firm's historical performance as well as to similar
firms.
Useful evalua�on of corporate performance uncovers the causes
of the firm's successes and shortcomings. This level of analysis
requires looking beyond
accoun�ng statements so that qualita�ve informa�on as well as
quan�ta�ve informa�on is considered.
Trend statements compare current levels of performance with
historical norms.
Common size statements compare the current composi�on of
accounts with historical benchmarks for account composi�on.
Financial ra�os are very useful in that they can help isolate the
performance of the firm in a specific area like inventory
management, and they are easily
compared to the firm's historical norms and to the industry.
EVA and MVA are closely linked to classical economic
principles and are gaining in popularity—two good reasons to
be aware of these performance
measures.
The DuPont system deconstructs ROE in an insigh�ul way,
helping to trace the cause of return on equity's performance.
Key Equa�ons
Cri�cal Thinking Ques�ons
1. We classified inventory turnover as an efficiency ra�o. In
what other classifica�on category do you think it could belong?
Why?
2. Under what circumstances do you think the current ra�o and
quick ra�o would give opposite signals of the liquidity of a
firm?

3. Industry averages are o�en used as benchmarks in ra�o
analysis. Jus�fy this prac�ce.
4. How do you think the average leverage ra�o in the banking
industry would compare to the average leverage ra�o among
computer manufacturers?
5. Suppose your father owns a stock that he feels has done very
well. "In fact," he says, "it went up 18% last year!" Do you
think that 18% was good
performance? How would you go about deciding whether 18%
was good, bad, or mediocre for the past 12 months?
6. Ar�s�c Designs, Inc. has a current ra�o of 3.0. What would
be the impact on the current ra�o if the company
a. used cash to pay off some current debt?
b. used cash to repurchase some outstanding shares of stock?
c. used cash to pay a dividend?
d. borrowed cash from a local bank to purchase a company-
owned automobile? The loan is short-term, due in six months.
e. borrowed short term and used the funds to increase
inventory?
Key Terms
Click on each key term to see the defini�on.
10-K reports
(h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�o
ns/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/b
ooks/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS65
SLIDE 1 OF 19
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ctions/front_matter/books/AUBUS650.13.1/sections/front_matte
r/books/AUBUS650.13.1/sections/front_matter/books/AUBUS65
0.13.1/sections/front_matter/books/AUBUS650.13.1/sections/fr
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Annual reports required by the U.S. Securi�es and
Exchange Commission, that give a comprehensive summary
of a public company's performance.
abnormal return (AR) or market-adjusted return
The firm-specific part of the period's return, which has
been isolated from the part of the return a�ributed to the
general market trend.
annual report
Detailed financial data, including the firm's balance sheet
as of the end of its fiscal year, its income statement,

statement of cash flows, wri�en statements
by management, and notes to the statement (which are
wri�en by the firm's accountant).
common size statements
Reports used by a company's analyst to compare the
rela�ve composi�on of the company's accounts over �me.
economic value added (EVA)
A method, developed by Joel Stern and Benne� Stewart,
for evalua�ng how effec�ve management is at adding
value to the corpora�on.
market share
The calcula�on derived by dividing a company's product
sales by the total sale of products perceived to be similar
and compe�ng for the same consumer
purchases.
market value added (MVA)

The market value of the firm's claims (the market price
of the firm's securi�es, both equity and debt, �mes the
outstanding shares and bonds) net of the
book value of the liabili�es and equity.
Securi�es and Exchange Commission (SEC)
Federal agency that holds primary responsibility for
enforcing the federal securi�es laws and regula�ng the
securi�es industry, the na�on's stock and op�ons
exchanges, and other electronic securi�es markets in the
United States.
stakeholders
Groups, such as stockholders, financial claimants,
employees, or community member, that have a stake or
interest in some aspect of corporate performance.
trend statements
Reports that give insights to a market sector's future
prospects of growth or decline.
window dressing

The prac�ce, by management, of manipula�ng accounts so
they appear more favorable on financial statements.
Web Resources
For free business sta�s�cs and financial ra�ons, visit:
h�p://www.bizstats.com (h�p://www.bizstats.com)
Moody's paper �tled "The Distribu�on of Common
Financial Ra�os by Ra�ng and Industry for North
American Non-Financial Corpora�ons: July 2006"
summarizes the financial ra�os associated with different
bond ra�ngs for about 20 U.S. industrial sectors. It also
aggregates data for all the industries,
providing a guide for how financial ra�os determine bond
ra�ngs for all companies:
h�p://www.moodys.com/sites/products/DefaultResearch/200570
0000436062.pdf
(h�p://www.moodys.com/sites/products/DefaultResearch/20057
00000436062.pdf)
Sears's Annual Reports can be downloaded from the
investor rela�ons segment of Sears's website at:
h�p://www.searsholdings.com/invest/financial_info.htm
(h�p://www.searsholdings.com/invest/financial_info.htm)
Visit the ValueLine website for a sample of a ra�ngs and
reports investment survey:
h�p://www.valueline.com/Tools/Sample_Reports.aspx
(h�p://www.valueline.com/Tools/Sample_Reports.aspx)
The Risk Management Associa�on website can be accessed
at: h�p://www.rmahq.org (h�p://www.rmahq.org)
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http://www.bizstats.com/
http://www.moodys.com/sites/products/DefaultResearch/200570
0000436062.pdf
http://www.searsholdings.com/invest/financial_info.htm
http://www.valueline.com/Tools/Sample_Reports.aspx
http://www.rmahq.org/
11/25/2019 Print
Britain's Financial Times can be accessed at:
h�p://www.�.com/world/uk (h�p://www.�.com/world/uk)

Dr. James Graven's Financial Web site can be accessed at:
h�p://www.finweb.com/ (h�p://www.finweb.com/)
The SEC's EDGAR site can be accessed at:
h�p://www.sec.gov/edgarhp.htm
(h�p://www.sec.gov/edgarhp.htm)
For more informa�on on Cascadia Region Earthquake
Workgroup's study, "Just-In-Time Inventory: Effects on
Earthquake Recovery," visit:
h�p://www.crew.org/sites/default/files/JITfinal032405.pdf
(h�p://www.crew.org/sites/default/files/JITfinal032405.pdf)
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http://www.ft.com/world/uk
http://www.finweb.com/
http://www.sec.gov/edgarhp.htm
http://www.crew.org/sites/default/files/JITfinal032405.pdf
Final Communication Paper
Directions:
1. Papers should be written using full, complete sentences and
in paragraph form.
2. Papers should be typed, double-spaced, and 4-6 pages in
length.
3. Be sure to use very specific examples to explain and
illustrate the claims you make. Do not simply offer vague
generalizations.
4. Papers will be graded according to the thoroughness of your
answer, the strength of your specific examples, and the accuracy
of your understanding of the communication concepts you
discuss.
Prompt:

This semester we learned that communication consists of
creating and responding to messages. In order to communicate
effectively with others, we need to develop skills that enable us
to impart, convey, and exchange information in a variety of
ways. In this class, we explored 5 different pathways of
communication: Professional Communication in Small Groups,
Public Discourse, Communication in Human Relationships,
Visual and Mediated Communication, and Communication in
Art and Culture.
Based on your knowledge and experience in these areas, in what
specific ways will each of these pathways help you become a
better or more effective communicator in the future? In other
words, how might you apply the skills that you learned in each
of these pathways in the future? When and how (under what
conditions or circumstances) might you find need to draw upon
these skills in your personal or professional life (either as the
sender of the message or the receiver/interpreter of the
message)? Be sure to include specific examples for each
pathway.
For example:
A pre-vet student one semester discussed how she could use
concepts from each of these pathways in her future career as a
veterinarian. She talked about how she could use her
understanding of group roles and work-related communication
styles from the Professional Communication in Small Groups
pathway to help her develop better working relationships with
her vet techs and kennel workers. She discussed how she could
make use of manipulative persuasion from the Public Discourse
pathway by putting up posters depicting the horrible things that
can happen if owners do not vaccinate their pets against disease
or give them heartworm preventatives. She explained how she
could use her expert power, which she learned in
Communication in Human Relationships, to encourage her
clients to agree to the various treatments she would suggest for

their cats or dogs. From the Visual and Mediated
pathway, she hypothesized that she could get together with a
group of other veterinarians to create a multi-media art
performance that would educate the public on how procedures
like ear-cropping, tail-docking, and declawing are actually
forms of mutilation. Finally, from the Art and Culture pathway,
she suggested that she could interview residents of long-term
care facilities who had been visited by therapy animals and find
out how these visits affected them. She would then be able to
turn their stories into an ethnographic performance.
This is just a brief example of one way you can approach this
paper. You can also apply the concepts to your personal life
instead of your professional life.
Please be aware that I have given you only a brief outline of her
paper. She went into more detail for each example. I have just
given you the gist of what she talked about.
Week 6 Discussions and Required Resources
Two-part assignment: All parts must be at least 200 words
unless otherwise noted. Please read all attachments and follow
ALL instructions.
Part 1: Comparing Financial Ratios
Go to MSN Money (Links to an external site.).
(http://investing.money.msn.com/investments/key-ratios) and
type in a ticker symbol for a company with the first letter of
your last name.

Next, complete the following:
1. On the company page that you selected click on the
“Analysis” tab. After doing so, scroll down the page until you
see the Financial ratios for the company and the industry.
2. There are several categories listed for ratios. Select one
“Financial Condition Ratio” and one “Management Efficiency
Ratio”.
3. Also on the company page, on the same ribbon that you found
the “Analysis” tab you will find the “Related” tab. Click on it
and select a competitive company within that industry and
compare those ratios to the ones you just found.
Examine your findings and determine whether your company
outperforms its competition based on financial ratios. Identify
where your firm seems to lag. Describe how your firm compares
with the industry and speculate as to why you believe your firm
is performing as it is.
Part 2: Potential Issues in Ratio Analysis
As your text describes, ratio analysis is a common technique in
financial analysis. One of your colleagues states that a
thorough ratio analysis is all that is needed in considering the
financial health of a company. Although you agree that ratio
analysis is a helpful guide, there may be some potential pitfalls
in ratio analysis.
Discuss at least three potential issues in utilizing ratio analysis
that you would share with your colleague. In addition, calculate
a liquidity, profitability, and efficiency ratio from your Week
Six company (Apple, Inc.) to demonstrate your observations.
Your post should be 200-words in length.

Required Resources
Text
Byrd, J., Hickman, K., & McPherson, M. (2013). Managerial
finance [Electronic version]. Retrieved from
https://content.ashford.edu/
· Chapter 11: Financial Analysis – Evaluation of Corporate
Performance
Website
Network Status - MSN Money (Links to an external site.).
(n.d.). Retrieved from
http://investing.money.msn.com/investments/key-ratios

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