Ratio Analysis ii P a g e Contents .docx

Ratio Analysis
ii | P a g e
Contents
Introduction
...............................................................................................
..................................... 1
The Ratios
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........................................ 2
Profitability Sustainability
Ratios...................................................................... ...............
...... 2
Operational Efficiency Ratios
...............................................................................................
. 5
Liquidity Ratios
.................................................................................. .............
........................... 7
Leverage Ratios

...............................................................................................
......................... 9
Other Ratios
...............................................................................................
............................ 10
Ratio Analysis
1 | P a g e
Introduction
A sustainable business and mission requires effective planning
and financial
management. Ratio analysis is a useful management tool that
will improve your
understanding of financial results and trends over time, and
provide key indicators of
organizational performance. Managers will use ratio analysis
to pinpoint strengths
and weaknesses from which strategies and initiatives can be
formed. Funders may use
ratio analysis to measure your results against other
organizations or make judgments

concerning management effectiveness and mission impact
For ratios to be useful and meaningful, they must be:
o Calculated using reliable, accurate financial information (does
your financial
information reflect your true cost picture?)
o Calculated consistently from period to period
o Used in comparison to internal benchmarks and goals
o Used in comparison to other companies in your industry
o Viewed both at a single point in time and as an indication of
broad trends and
issues over time
o Carefully interpreted in the proper context, considering there
are many other
important factors and indicators involved in assessing
performance.
Ratios can be divided into four major categories:
o Profitability Sustainability
o Operational Efficiency
o Liquidity
o Leverage (Funding – Debt, Equity, Grants)

The ratios presented below represent some of the standard ratios
used in business
practice and are provided as guidelines. Not all these ratios
will provide the
information you need to support your particular decisions and
strategies. You can also
develop your own ratios and indicators based on what you
consider important and
meaningful to your organization and stakeholders.
Ratio Analysis
2 | P a g e
The Ratios
Profitability Sustainability Ratios
How well is our business performing over a specific period, will
your social enterprise
have the financial resources to continue serving its constituents
tomorrow as well as

today?
Ratio What does it tell you?
Sales Growth =
Current Period – Previous Period Sales
Previous Period Sales
Percentage increase (decrease) in sales
between two time periods.
If overall costs and inflation are increasing, then
you should see a corresponding increase in
sales. If not, then may need to adjust pricing
policy to keep up with costs.
Reliance on Revenue Source =
Revenue Source
Total Revenue
Measures the composition of an organization’s
revenue sources (examples are sales,
contributions, grants).
The nature and risk of each revenue source

should be analyzed. Is it recurring, is your
market share growing, is there a long term
relationship or contract, is there a risk that
certain grants or contracts will not be renewed,
is there adequate diversity of revenue sources?
Organizations can use this indicator to
determine long and short-term trends in line with
strategic funding goals (for example, move
towards self-sufficiency and decreasing reliance
on external funding).
Ratio Analysis
3 | P a g e
Profitability Sustainability Ratios continued
Operating Self-Sufficiency =
Business Revenue
Total Expenses
Measures the degree to which the
organization’s expenses are covered by its

core business and is able to function
independent of grant support.
For the purpose of this calculation, business
revenue should exclude any non-operating
revenues or contributions. Total expenses
should include all expenses (operating and
non-operating) including social costs.
A ratio of 1 means you do not depend on
grant revenue or other funding.
Gross Profit Margin =
Gross Profit
Total Sales
How much profit is earned on your products
without considering indirect costs.
Is your gross profit margin improving? Small
changes in gross margin can significantly affect
profitability. Is there enough gross profit to
cover your indirect costs. Is there a positive
gross margin on all products?
Net Profit Margin =
Net Profit

Sales
How much money are you making per every $
of sales. This ratio measures your ability to
cover all operating costs including indirect costs
SGA to Sales =
Indirect Costs (sales, general, admin)
Sales
Percentage of indirect costs to sales.
Look for a steady or decreasing ratio which
means you are controlling overhead
Ratio Analysis
4 | P a g e
Profitability Sustainability Ratios continued
Return on Assets =

Net Profit
Average Total Assets
Measures your ability to turn assets into profit.
This is a very useful measure of comparison
within an industry.
A low ratio compared to industry may mean
that your competitors have found a way to
operate more efficiently. After tax interest
expense can be added back to numerator
since ROA measures profitability on all assets
whether or not they are financed by equity or
debt
Return on Equity =
Net Profit
Average Shareholder Equity
Rate of return on investment by shareholders.
This is one of the most important ratios to
investors. Are you making enough profit to
compensate for the risk of being in business?
How does this return compare to less risky

investments like bonds?
Ratio Analysis
5 | P a g e
Operational Efficiency Ratios
How efficiently are you utilizing your assets and managing your
liabilities? These
ratios are used to compare performance over multiple periods.
Ratio What does it tell you
Operating Expense Ratio =
Operating Expenses
Total Revenue
Compares expenses to revenue.
A decreasing ratio is considered desirable
since it generally indicates increased efficiency.

Accounts Receivable Turnover =
Net Sales
Average Accounts Receivable
Days in Accounts Receivable =
Average Accounts Receivable
Sales x 365
Number of times trade receivables turnover
during the year.
The higher the turnover, the shorter the time
between sales and collecting cash.
What are your customer payment habits
compared to your payment terms. You may
need to step up your collection practices or
tighten your credit policies.
These ratios are only useful if majority of sales
are credit (not cash) sales.
Inventory Turnover =

Cost of Sales
Average Inventory
Days in Inventory =
Average Inventory
Cost of Sales x 365
The number of times you turn inventory over
into sales during the year or how many days it
takes to sell inventory.
This is a good indication of production and
purchasing efficiency. A high ratio indicates
inventory is selling quickly and that little unused
inventory is being stored (or could also mean
inventory shortage). If the ratio is low, it
suggests overstocking, obsolete inventory or
selling issues.
Ratio Analysis
6 | P a g e
Operational Efficiency Ratios Continued

Accounts Payable Turnover =
Cost of Sales
Average Accounts Payable
Days in Accounts Payable =
Average Accounts Payable
Cost of Sales x 365
The number of times trade payables turn over
during the year.
The higher the turnover, the shorter the period
between purchases and payment. A high
turnover may indicate unfavourable supplier
repayment terms. A low turnover may be a
sign of cash flow problems.
Compare your days in accounts payable to
supplier terms of repayment.
Total Asset Turnover =
Revenue

Average Total Assets
Fixed Asset Turnover =
Revenue
Average Fixed Assets
How efficiently your business generates sales
on each dollar of assets.
An increasing ratio indicates you are using your
assets more productively.
Ratio Analysis
7 | P a g e
Liquidity Ratios
Does your enterprise have enough cash on an ongoing basis to
meet its operational
obligations? This is an important indication of financial health.

Current Ratio =
Current Assets
Current Liabilities
(also known as Working Capital Ratio)
Measures your ability to meet short term
obligations with short term assets., a useful
indicator of cash flow in the near future.
A social enterprise needs to ensure that it can
pay its salaries, bills and expenses on time.
Failure to pay loans on time may limit your
future access to credit and therefore your
ability to leverage operations and growth.
A ratio less that 1 may indicate liquidity issues.
A very high current ratio may mean there is
excess cash that should possibly be invested
elsewhere in the business or that there is too
much inventory. Most believe that a ratio
between 1.2 and 2.0 is sufficient.
The one problem with the current ratio is that it
does not take into account the timing of cash
flows. For example, you may have to pay
most of your short term obligations in the next
week though inventory on hand will not be sold
for another three weeks or account receivable
collections are slow.

Ratio Analysis
8 | P a g e
Liquidity Ratios Continued
Quick Ratio =
Cash +AR + Marketable Securities
Current Liabilities
A more stringent liquidity test that indicates if a
firm has enough short-term assets (without
selling inventory) to cover its immediate
liabilities.
This is often referred to as the “acid test”
because it only looks at the company’s most
liquid assets only (excludes inventory) that can
be quickly converted to cash).
A ratio of 1:1 means that a social enterprise
can pay its bills without having to sell inventory.

Working Capital =
Current Assets – Current Liabilities
WC is a measure of cash flow and should
always be a positive number. It measures the
amount of capital invested in resources that are
subject to quick turnover. Lenders often use this
number to evaluate your ability to weather
hard times. Many lenders will require that a
certain level of WC be maintained.
Adequacy of Resources =
Cash + Marketable Securities + Accounts
Receivable
Monthly Expenses
Determines the number of months you could
operate without further funds received (burn
rate)

Ratio Analysis
9 | P a g e
Leverage Ratios
To what degree does an enterprise utilize borrowed money and
what is its level of
risk? Lenders often use this information to determine a
business’s ability to repay debt.
Debt to Equity =
Short Term Debt + Long Term Debt
Total Equity (including grants)
Compares capital invested by
owners/funders (including grants) and
funds provided by lenders.
Lenders have priority over equity
investors on an enterprise’s assets.
Lenders want to see that there is some

cushion to draw upon in case of financial
difificulty. The more equity there is, the
more likely a lender will be repaid. Most
lenders impose limits on the debt/equity
ratio, commonly 2:1 for small business
loans.
Too much debt can put your business at
risk, but too little debt may limit your
potential. Owners want to get some
leverage on their investment to boost
profits. This has to be balanced with the
ability to service debt.
Interest Coverage =
EBITDA
Interest Expense
Measures your ability to meet interest
payment obligations with business income.
Ratios close to 1 indicates company
having difficulty generating enough cash
flow to pay interest on its debt. Ideally,
a ratio should be over 1.5

Ratio Analysis
10 | P a g e
Other Ratios
You may want to develop your own customized ratios to
communicate results that are
specific and important to your organization. Here are some
examples.
Operating Self-Sufficiency =
Sales Revenue
Total Costs (Operating and Social Costs)
% Staffing Costs spent on Target Group =
Target Staff Costs
Total Staffing Costs
Social Costs per Employee =
Total Social Costs
Number of Target Employees
% Social Costs covered by Grants =

Grant Income
Total Social Costs
Financial ratio analysis
A reading prepared by Pamela Peterson Drake
O U T L I N E
1. Introduction
2. Liquidity ratios
3. Profitability ratios and activity ratios
4. Financial leverage ratios
5. Shareholder ratios
1. Introduction
As a manager, you may want to reward employees based on
their performance. How do you know
how well they have done? How can you determine what
departments or divisions have performed
well? As a lender, how do decide the borrower will be able to
pay back as promised? As a manager of
a corporation how do you know when existing capacity will be
exceeded and enlarged capacity will be
needed? As an investor, how do you predict how well the
securities of one company will perform

relative to that of another? How can you tell whether one
security is riskier than another? We can
address all of these questions through financial analysis.
Financial analysis is the selection, evaluation, and
interpretation of financial data, along with other
pertinent information, to assist in investment and financial
decision-making. Financial analysis may be
used internally to evaluate issues such as employee
performance, the efficiency of operations, and
credit policies, and externally to evaluate potential investments
and the credit-worthiness of
borrowers, among other things.
The analyst draws the financial data needed in financial analysis
from many sources. The primary
source is the data provided by the company itself in its annual
report and required disclosures. The
annual report comprises the income statement, the balance
sheet, and the statement of cash flows,
as well as footnotes to these statements. Certain businesses are
required by securities laws to
disclose additional information.
Besides information that companies are required to disclose
through financial statements, other
information is readily available for financial analysis. For
example, information such as the market
prices of securities of publicly-traded corporations can be found
in the financial press and the
electronic media daily. Similarly, information on stock price
indices for industries and for the market
as a whole is available in the financial press.
Another source of information is economic data, such as the
Gross Domestic Product and Consumer

Price Index, which may be useful in assessing the recent
performance or future prospects of a
company or industry. Suppose you are evaluating a company
that owns a chain of retail outlets.
What information do you need to judge the company's
performance and financial condition? You
need financial data, but it doesn't tell the whole story. You also
need information on consumer
Financial ratios, a reading prepared by Pamela Peterson Drake 1
spending, producer prices, consumer prices, and the
competition. This is economic data that is
readily available from government and private sources.
Besides financial statement data, market data, and economic
data, in financial analysis you also need
to examine events that may help explain the company's present
condition and may have a bearing on
its future prospects. For example, did the company recently
incur some extraordinary losses? Is the
company developing a new product? Or acquiring another
company? Is the company regulated?
Current events can provide information that may be
incorporated in financial analysis.
The financial analyst must select the pertinent information,
analyze it, and interpret the analysis,
enabling judgments on the current and future financial condition
and operating performance of the
company. In this reading, we introduce you to financial ratios --
the tool of financial analysis. In
financial ratio analysis we select the relevant information --
primarily the financial statement data --

and evaluate it. We show how to incorporate market data and
economic data in the analysis and
interpretation of financial ratios. And we show how to interpret
financial ratio analysis, warning you
of the pitfalls that occur when it's not used properly.
We use Microsoft Corporation's 2004 financial statements for
illustration purposes throughout this
reading. You can obtain the 2004 and any other year's
statements directly from Microsoft. Be sure to
save these statements for future reference.
Classification of ratios
A ratio is a mathematical relation between one quantity and
another. Suppose you have 200 apples
and 100 oranges. The ratio of apples to oranges is 200 / 100,
which we can more conveniently
express as 2:1 or 2. A financial ratio is a comparison between
one bit of financial information and
another. Consider the ratio of current assets to current
liabilities, which we refer to as the current
ratio. This ratio is a comparison between assets that can be
readily turned into cash -- current assets
-- and the obligations that are due in the near future -- current
liabilities. A current ratio of 2:1 or 2
means that we have twice as much in current assets as we need
to satisfy obligations due in the near
future.
Ratios can be classified according to the way they are
constructed and their general characteristics.
By construction, ratios can be classified as a coverage ratio, a
return ratio, a turnover ratio, or a
component percentage:

1. A coverage ratio is a measure of a company's ability to
satisfy (meet) particular obligations.
2. A return ratio is a measure of the net benefit, relative to the
resources expended.
3. A turnover ratio is a measure of the gross benefit, relative to
the resources expended.
4. A component percentage is the ratio of a component of an
item to the item.
When we assess a company's operating performance, we want to
know if it is applying its assets in
an efficient and profitable manner. When we assess a company's
financial condition, we want to
know if it is able to meet its financial obligations.
There are six aspects of operating performance and financial
condition we can evaluate from financial
ratios:
1. A liquidity ratio provides information on a company's ability
to meet its short−term,
immediate obligations.
2. A profitability ratio provides information on the amount of
income from each dollar of
sales.
http://www.microsoft.com/msft/ar.mspx
3. An activity ratio relates information on a company's ability to

manage its resources (that is,
its assets) efficiently.
4. A financial leverage ratio provides information on the degree
of a company's fixed
financing obligations and its ability to satisfy these financing
obligations.
5. A shareholder ratio describes the company's financial
condition in terms of amounts per
share of stock.
6. A return on investment ratio provides information on the
amount of profit, relative to the
assets employed to produce that profit.
We cover each type of ratio, providing examples of ratios that
fall into each of these classifications.
2. Liquidity Ratios
Liquidity reflects the ability of a company to meet its short-
term obligations using assets that are
most readily converted into cash. Assets that may be converted
into cash in a short period of time
are referred to as liquid assets; they are listed in financial
statements as current assets. Current
assets are often referred to as working capital because these
assets represent the resources needed
for the day-to-day operations of the company's long-term,
capital investments. Current assets are
used to satisfy short-term obligations, or current liabilities. The
amount by which current assets
exceed current liabilities is referred to as the net working
capital.1
The role of the operating cycle

How much liquidity a company needs depends on its operating
cycle. The operating cycle is the
duration between the time cash is invested in goods and services
to the time that investment
produces cash. For example, a company that produces and sells
goods has an operating cycle
comprising four phases:
(1) purchase raw material and produce goods, investing in
inventory;
(2) sell goods, generating sales, which may or may not be for
cash;
(3) extend credit, creating accounts receivables, and
(4) collect accounts receivables, generating cash.
The operating cycle is the length of time it takes to convert an
investment of cash in inventory
back into cash (through collections of sales). The net operating
cycle is the length of time it takes to
convert an investment of cash in inventory and back into cash
considering that some purchases are
made on credit.
The number of days a company ties up funds in inventory is
determine by:
(1) the total amount of money represented in inventory, and
(2) the average day's cost of goods sold.
The current investment in inventory -- that is, the money "tied
up" in inventory -- is the ending

balance of inventory on the balance sheet. The average day's
cost of goods sold is the cost of goods
1 You will see reference to the net working capital (i.e., current
assets – current liabilities) as simply working
capital, which may be confusing. Always check the definition
for the particular usage because both are common
uses of the term working capital.
sold on an average day in the year, which can be estimated by
dividing the cost of goods sold found
on the income statement by the number of days in the year.
We compute the number of days of inventory by calculating the
ratio of the amount of inventory on
hand (in dollars) to the average day's Cost of Goods Sold (in
dollars per day):
365 / sold goods ofCost
Inventory
sold goods ofcost sday' Average
Inventory
inventory days ofNumber ==
If the ending inventory is representative of the inventory
throughout the year, the number of days
inventory tells us the time it takes to convert the investment in
inventory into sold goods. Why worry
about whether the year-end inventory is representative of

inventory at any day throughout the year?
Well, if inventory at the end of the fiscal year-end is lower than
on any other day of the year, we
have understated the
number of days of
inventory.
Indeed, in practice most
companies try to choose
fiscal year-ends that
coincide with the slow
period of their business.
That means the ending
balance of inventory would
be lower than the typical
daily inventory of the year.
We could, for example,
look at quarterly financial
statements and take
averages of quarterly
inventory balances to get
a better idea of the typical
inventory. However, here
for simplicity in this and
other ratios, we will make
a note of this problem and
deal with it later in the
discussion of financial
ratios.
We can extend the same
logic for calculating the
number of days between a
sale -- when an account
receivable is created -- to
the time it is collected in

cash. If the ending
balance of receivables at
the end of the year is
representative of the
receivables on any day throughout the year, then it takes, on
average, approximately the "number of
days credit" to collect the accounts receivable, or the number of
days receivables:
Try it!
Wal-Mart Stores, Inc., had cost of revenue of $219,793 million
for the fiscal
year ended January 31, 2005. It had an inventory balance of
$29,447 million
at the end of this fiscal year. Using the quarterly information,
Wal-Mart’s
average inventory balance during the fiscal year is $29,769.25:
Inventory balance, in millions
$28,320 $27,963
$33,347
$29,447
$24,000
$26,000
$28,000
$30,000
$32,000

$34,000
April July October January
Source: Wal-Mart Stores 10-K and 10-Q filings
Based on this information, what is Wal-Mart’s inventory
turnover for fiscal year
2004 (ending January 31, 2005)?
Solution
:
Using the fiscal year end balance of inventory:
= =
$29,447 $29, 447
Number of days inventory = 48.9 days
$219,793/365 $602.173
Using the average of the quarterly balances:

= =
$29,769.25 $29, 769.25
$219,793/365 $602.173
In other words, it takes Wal-Mart approximately 50 days to sell
its
merchandise from the time it acquires it.
= =
Accounts receivable Accounts receivable
Number of days receivables
Average day's sales on credit Sales on credit / 365
What does the operating cycle have to do with liquidity? The
longer the operating cycle, the more

current assets needed (relative to current liabilities) because it
takes longer to convert inventories
and receivables into cash. In other words, the longer the
operating cycle, the more net working
capital required.
We also need to look at the liabilities on the balance sheet to
see how long it takes a company to pay
its short-term obligations. We can apply the same logic to
accounts payable as we did to accounts
receivable and inventories. How long does it take a company, on
average, to go from creating a
payable (buying on credit) to paying for it in cash?
= =
Accounts payable Accounts payable
Number of days payables
Average day's purchases Purchases / 365
First, we need to determine the amount of an average day's
purchases on credit. If we assume all
purchases are made on credit, then the total purchases for the
year would be the Cost of Goods Sold,

less any amounts included in this Cost of Goods Sold that are
not purchases.2
The operating cycle tells us how long it takes to convert an
investment in cash back into cash (by
way of inventory and accounts receivable):
Number of days Number of days
Operating cycle
of inventory of receivables
= +
The number of days of purchases tells us how long it takes use
to pay on purchases made to create
the inventory. If we put these two pieces of information
together, we can see how long, on net, we
tie up cash. The difference between the operating cycle and the
number of days of payables is the
net operating cycle:
Net operating cycle = Operating Cycle - Number of days of
purchases
or, substituting for the operating cycle,

purchases of
days ofNumber
sreceivable of
daysofNumber
inventory of
daysofNumber
cycle operatingNet −+=
The net
operating cycle
therefore tells
us how long it
takes for the
company to get
cash back from
its investment
in inventory
and accounts
receivable,
considering that
purchases may be made on credit. By not paying for purchases

immediately (that is, using trade
credit), the company reduces its liquidity needs. Therefore, the
longer the net operating cycle, the
greater the company’s need for liquidity.
Microsoft's Number of Days Receivables
2004:
Average day's receivables = $36,835 million / 365 = $100.9178
million
Number of days receivables = $5,890 million / $100.9178
million = 58.3643 days
Now try it for 2005 using the 2005 data from Microsoft’s
financial statements.
Answer: 65.9400 days
Source of data: Income Statement and Balance Sheet, Microsoft
Corporation Annual Report 2005
2 For example, depreciation is included in the Cost of Goods

Sold, yet it not a purchase. However, as a quite
proxy for purchases, we can use the accounting relationship:
beginning inventory + purchases = COGS + ending
inventory.
Measures of liquidity
Liquidity ratios provide a measure of a company’s ability to
generate cash to meet its immediate
needs. There are three commonly used liquidity ratios:
1. The current ratio is the ratio of current assets to current
liabilities; Indicates a company's
ability to satisfy its current liabilities with its current assets:
sliabilitieCurrent
assetsCurrent
ratioCurrent =
2. The quick ratio is the ratio of quick assets (generally current

assets less inventory) to
current liabilities; Indicates a company's ability to satisfy
current liabilities with its most
liquid assets
sliabilitieCurrent
Inventory - assetsCurrent
ratio Quick =
3. The net working capital to sales ratio is the ratio of net
working capital (current assets
minus current liabilities) to sales; Indicates a company's liquid
assets (after meeting
short−term obligations) relative to its need for liquidity
(represented by sales)
Sales
sliabilitieCurrent - assetsCurrent
ratio sales to capital workingNet =
Generally, the larger these liquidity ratios, the better the ability
of the company to satisfy its
immediate obligations. Is there a magic number that defines

good or bad? Not really.
Consider the current ratio. A large amount of current assets
relative to current liabilities provides
assurance that the company will be able to satisfy its immediate
obligations. However, if there are
more current assets than the company needs to provide this
assurance, the company may be
investing too heavily in these non- or low-earning assets and
therefore not putting the assets to the
most productive use.
Another consideration is the
operating cycle. A company
with a long operating cycle
may have more need to
liquid assets than a
company with a short
operating cycle. That’s
because a long operating
cycle indicate that money is
tied up in inventory (and then receivables) for a longer length of
time.

Microsoft Liquidity Ratios -- 2004
Current ratio = $70,566 million / $14,696 million = 4.8017
Quick ratio = ($70,566-421) / $14,696 = 4.7731
Net working capital-to-sales = ($70,566-14,969) / $36,835 =
1.5515
Source of data: Balance Sheet and Income Statement, Microsoft
Corporation Annual
Report 2005
3. Profitability ratios
Profitability ratios (also referred to as profit margin ratios)
compare components of income with sales.
They give us an idea of what makes up a company's income and
are usually expressed as a portion
of each dollar of sales. The profit margin ratios we discuss here
differ only by the numerator. It's in
the numerator that we reflect and thus evaluate performance for

different aspects of the business:
The gross profit margin is the ratio of gross income or profit to
sales. This ratio indicates how
much of every dollar of sales is left after costs of goods sold:
Gross income
Gross profit margin
Sales
=
The operating profit margin is the
ratio of operating profit (a.k.a. EBIT,
operating income, income before
interest and taxes) to sales. This is a
ratio that indicates how much of each
dollar of sales is left over after operating
expenses:
Microsoft's 1998 Profit Margins
Gross profit margin = ($14,484 - 1,197)/$14,484 = 91.736%
Operating profit margin = $6,414 / $14,484 = 44.283%

Net profit margin = $4,490 / $14,484 = 31%
Source of data: Microsoft Corporation Annual Report 1998
___
Microsoft's 2004 Profit Margins
Gross profit margin = ($36,835 – 6,716)/$36,835 = 81.767%
Operating profit margin = $9,034 / $36,835 = 24.526%
Net profit margin = $8,168 / $36,835 = 22.175%
Source of data: Income Statement, Microsoft Corporation
Annual Report
2005
Operating income
Operating profit margin =
Sales
The net profit margin is the ratio of
net income (a.k.a. net profit) to sales,

and indicates how much of each dollar
of sales is left over after all expenses:
Net income
Net profit margin
Sales
= .
4. Activity ratios
Activity ratios are measures of how well assets are used.
Activity ratios -- which are, for the most
part, turnover ratios -- can be used to evaluate the benefits
produced by specific assets, such as
inventory or accounts receivable. Or they can be use to evaluate
the benefits produced by all a
company's assets collectively.
These measures help us gauge how effectively the company is at
putting its investment to work. A
company will invest in assets – e.g., inventory or plant and
equipment – and then use these assets to
generate revenues. The greater the turnover, the more
effectively the company is at producing a
benefit from its investment in assets.

The most common turnover ratios are the following:
1. Inventory turnover is the ratio of cost of goods sold to
inventory. This ratio indicates how
many times inventory is created and sold during the period:
Inventory
sold goods ofCost
turnover Inventory =
2. Accounts receivable turnover is the ratio of net credit sales to
accounts receivable. This
ratio indicates how many times in the period credit sales have
been created and collected on:
receivable Accounts
credit on Sales
turnover receivable Accounts =

3. Total asset turnover is the ratio of sales to total assets. This
ratio indicates the extent that
the investment in total assets results in sales.
assets Total
Sales
turnover asset Total =
4. Fixed asset turnover is the ratio of sales to fixed assets. This
ratio indicates the ability of
the company’s management to put the fixed assets to work to
generate sales:
assets Fixed
Sales
turnover asset Fixed =
Microsoft’s Activity Ratios – 2004
Accounts receivable turnover = $36,835 / $5,890 = 6.2538 times
Total asset turnover = $36,835 / $92,389 = 0.3987 times

Source of data: Income Statement and Balance Sheet, Microsoft
Corporation Annual
Report 2005
Turnovers and numbers of days
You may have noticed that there is a relation between the
measures of the operating cycle and
activity ratios. This is because they use the same information
and look at this information from
different angles. Consider the number of days inventory and the
inventory turnover:
=
Inventory
Number of days inventory
Average day's cost of goods sold
Inventory
sold goods ofCost

turnover Inventory =
The number of days inventory is how long the inventory stays
with the company, whereas the
inventory turnover is the number of times that the inventory
comes and leaves – the complete cycle
– within a period. So if the number of days inventory is 30 days,
this means that the turnover within
the year is 365 / 30 = 12.167 times. In other words,
= =
365 365 Cost of goods sold
Inventory turnover =
InventoryNumber of days inventory Inventory
Cost of goods sold / 365
Try it!

Wal-Mart Stores, Inc., had cost of revenue of $219,793 million
for the fiscal year ended January 31, 2005. It
had an inventory balance of $29,447 million at the end of this
fiscal year.
Source: Wal-Mart Stores 10-K
Wal-Mart’s number of days inventory for fiscal year 2004
(ending January 31, 2005) is
= =
$29,447 $29, 447
$219,793/365 $602.173
Wal-Mart’s inventory turnover is:
=
$219,793
Inventory turnover = 7.464 times
$29,447

And the number of days and turnover are related as follows:
Inventory turnover = 365 / 48.9 = 7.464 times
Number of days inventory = 365 / 7.464 = 48.9 days
5. Financial leverage ratios
A company can finance its assets either with equity or debt.
Financing through debt involves risk
because debt legally obligates the company to pay interest and
to repay the principal as promised.
Equity financing does not obligate the company to pay anything
-- dividends are paid at the
discretion of the board of directors. There is always some risk,
which we refer to as business risk,
inherent in any operating segment of a business. But how a
company chooses to finance its
operations -- the particular mix of debt and equity -- may add
financial risk on top of business risk
Financial risk is the extent that debt financing is used relative
to equity.
Financial leverage ratios are used to assess how much financial

risk the company has taken on. There
are two types of financial leverage ratios: component
percentages and coverage ratios. Component
percentages compare a company's debt with either its total
capital (debt plus equity) or its equity
capital. Coverage ratios reflect a company's ability to satisfy
fixed obligations, such as interest,
principal repayment, or lease payments.
Component-percentage financial leverage ratios
The component-percentage financial leverage ratios convey how
reliant a company is on debt
financing. These ratios compare the amount of debt to either the
total capital of the company or to
the equity capital.
1. The total debt to assets ratio indicates the proportion of
assets that are financed with
debt (both short−term and long−term debt):
assets Total
debt Total
ratio assets todebt Total =

Remember from your study of accounting that total assets are
equal to the sum of total debt
and equity. This is the familiar accounting identity: assets =
liabilities + equity.
2. The long−term debt to assets ratio indicates the proportion of
the company's assets that
are financed with long−term debt.
assets Total
debt term-Long
ratio assets todebt term-Long =
3. The debt to equity ratio (a.k.a. debt-equity ratio) indicates
the relative uses of debt and
equity as sources of capital to finance the company's assets,
evaluated using book values of
the capital sources:

equity rs'shareholde Total
debt Total
ratioequity todebt Total =
One problem (as we shall see)
with looking at risk through a
financial ratio that uses the book
value of equity (the stock) is that
most often there is little relation
between the book value and its
market value. The book value of
equity consists of:
• the proceeds to the
company of all the stock
issued since it was first
incorporated, less any
treasury stock (stock
repurchased by the
company); and
• the accumulation of all
the earnings of the

company, less any
dividends, since it was
first incorporated.
Let's look at an example of the
book value vs. market value of
equity. IBM was incorporated in
1911. So its book value of equity
represents the sum of all its stock
issued and all its earnings, less all dividends paid since 1911.
As of the end of 2003, IBM's book value
of equity was approximately $28 billion and its market value of
equity was approximately $162 billion.
The book value understates its market value by over $130
billion. The book value generally does not
give a true picture of the investment of shareholders in the
company because:
Note that the debt-equity ratio is related to the debt-to-total
assets
ratio because they are both measures of the company’s capital
structure. The capital structure is the mix of debt and equity
that
the company uses to finance its assets.

Let’s use short-hand notation to demonstrate this relationship.
Let D
represent total debt and E represent equity. Therefore, total
assets
are equal to D+E.
If a company has a debt-equity ratio of 0.25, this means that is
debt-
to-asset ratio is 0.2. We calculate it by using the ratio
relationships
and Algebra:
D/E = 0.25
D = 0.25 E
Substituting 0.25 E for D in the debt-to-assets ratio D/(D+E):
D/(D+E) = 0.25 E / (0.25 E + E) = 0.25 E / 1.25 E = 0.2
In other words, a debt-equity ratio of 0.25 is equivalent to a
debt-to-
assets ratio of 0.2
This is a handy device: if you are given a debt-equity ratio and

need
the debt-assets ratio, simply:
D/(D+E) = (D/E) / (1 + D/E)
Why do we bother to show this? Because many financial
analysts
discuss or report a company’s debt-equity ratio and you are left
on
your own to determine what this means in terms of the
proportion of
debt in the company’s capital structure.
• earnings are recorded according to accounting principles,
which may not reflect the true
economics of transactions, and
• due to inflation, the dollars from earnings and proceeds from
stock issued in the past do not
reflect today's values.
The market value, on the other hand, is the value of equity as
perceived by investors. It is what
investors are willing to pay, its worth. So why bother with the
book value of equity? For two reasons:

first, it is easier to obtain the book value than the market value
of a company's securities, and
second, many financial services report ratios using the book
value, rather than the market value.
We may use the market value of equity in the denominator,
replacing the book value of equity. To do
this, we need to know the current number of shares outstanding
and the current market price per
share of stock and multiply to get the market value of equity.
Financial ratios, a reading prepared by Pamela Peterson Drake
10
Coverage financial leverage ratios
In addition to the leverage ratios that use information about how
debt is related to either assets or
equity, there are a number of financial leverage ratios that
capture the ability of the company to
satisfy its debt obligations. There are many ratios that
accomplish this, but the two most common
ratios are the times interest coverage ratio and the fixed charge

coverage ratio.
The times-interest-coverage ratio, also referred to as the interest
coverage ratio, compares the
earnings available to meet the interest obligation with the
interest obligation:
Interest
taxes andinterest before Earnings
ratio coverage-interest-Times =
The fixed charge coverage ratio expands on the obligations
covered and can be specified to include
any fixed charges, such as lease payments and preferred
dividends. For example, to gauge a
company’s ability to cover its interest and lease payments, you
could use the following ratio:
payment Lease Interest
payment Lease taxes andinterest before Earnings
ratio coverage charge- Fixed
+

+
=
Coverage ratios are often used in debt covenants to help protect
the creditors.
Microsoft’s Financial Leverage Ratios – 2004
Total debt to total assets = ($94,368 - 74,825) / $94,368 =
0.20709 or 20.709%
Debt to equity ratio = ($94,368 - 74,825) / $74,825 = 0.26118 or
26.118%
Source of data: Balance sheet, Microsoft Corporation Annual
Report 2005
6. Shareholder ratios
The ratios we have explained to this point deal with the
performance and financial condition of the
company. These ratios provide information for managers (who
are interested in evaluating the
performance of the company) and for creditors (who are
interested in the company's ability to pay its

obligations). We will now take a look at ratios that focus on the
interests of the owners -- shareholder
ratios. These ratios translate the overall results of operations so
that they can be compared in terms
of a share of stock:
Earnings per share (EPS) is the amount of income earned during
a period per share of common
stock.
goutstandin shares ofNumber
rsshareholde to available incomeNet
shareper Earnings =
As we learned earlier in the study of Financial Statement
Information, two numbers of earnings per
share are currently disclosed in financial reports: basic and
diluted. These numbers differ with respect
to the definition of available net income and the number of
shares outstanding. Basic earnings per
share are computed using reported earnings and the average
number of shares outstanding.
Diluted earnings per share are computed assuming that all
potentially dilutive securities are

issued. That means we look at a “worst case” scenario in terms
of the dilution of earnings from
factors such as executive stock options, convertible bonds,
convertible preferred stock, and warrants.
Suppose a company has convertible securities outstanding, such
as convertible bonds. In calculating
diluted earnings per share, we consider what would happen to
both earnings and the number of
11
shares outstanding if these bonds were converted into common
shares. This is a “What if?” scenario:
what if all the bonds are converted into stock this period. To
carry out this “What if?” we calculate
earnings considering that the company does not have to pay the
interest on the bonds that period
(which increases the numerator of earnings per share), but we
also add to the denominator the
number of shares that would be issued if
these bonds were converted into shares.3

Another source of dilution is executive
stock options. Suppose a company has 1
million shares of stock outstanding, but
has also given its executives stock options
that would result in 0.5 million new shares
issued if they chose to exercise these
options. This would not affect the
numerator of the earnings per share, but
would change the denominator to 1.5
million shares. If the company had
earnings of $5 million, its basic earnings
per share would be $5 million / 1 million
shares = $5.00 per share and its diluted
earnings per share would be $5 million /
1.5 million shares = $3.33 per share.
What’s a convertible security?
A convertible security is a security – debt or equity – that
gives the investor the option to convert—that is, exchange –
the security into another security (typically, common stock).
Convertible bonds and convertible preferred stocks are
common.

Suppose you buy a convertible bond with a face value of
$1,000 that is convertible into 100 shares of stock. This
means that you own the bond and receive interest, but you
have the option to exchange it for 100 shares of stock. You
can hold the bond until it matures, collecting interest
meanwhile and then receiving the face value at maturity, or
you can exchange it for the 100 shares of stock at any time.
Your choice. Once you convert your bond into stock,
however, you no longer receive any interest on the bond.
Some issuers will limit conversion such that the bond cannot
be converted for a fixed number of years from issuance.
As an example, consider Yahoo!'s earnings per share reported in
their 2004 annual report:
Item 2003 2004
Basic EPS $0.19 $0.62
Diluted EPS $0.18 $0.58
The difference between the basic and diluted earnings per share
in Yahoo!'s case is attributable to its
extensive use of stock options in compensation programs.

Book value equity per share is the amount of the book value
(a.k.a. carrying value) of common
equity per share of common stock, calculated by dividing the
book value of shareholders’ equity by
the number of shares of stock outstanding. As we discussed
earlier, the book value of equity may
differ from the market value of equity. The market value per
share, if available, is a much better
indicator of the investment of shareholders in the company.
The price−earnings ratio (P/E or PE ratio) is the ratio of the
price per share of common stock to
the earnings per share of common stock:
Market price per share
Price-earnings ratio =
Earnings per share
Though earnings per share are reported in the income statement,
the market price per share of stock
is not reported in the financial statements and must be obtained
from financial news sources. The

3 A “catch” is that diluted earnings per share can never be
reported to be greater than basic earnings per share.
In some cases (when a company has many convertible securities
outstanding), we may calculate a diluted
earnings per share greater than basic earnings per share, but in
this case we cannot report diluted earnings per
share because it would be anti-dilutive.
12
P/E ratio is sometimes used as a proxy for investors' assessment
of the company's ability to generate
cash flows in the future. Historically, P/E ratios for U.S.
companies tend to fall in the 10-25 range, but
in recent periods (e.g., 2000-2001) P/E ratios have reached
much higher. Examples of P/E ratios (P/E
ratios at the end of 2004): 4
Company
Ticker

symbol
P/E ratio
Amazon.com AMZN 57
Time Warner Inc. TWX 29
IBM IBM 21
Coca-Cola KO 22
Microsoft MSFT 36
Yahoo! YHOO 98
3M Co. MMM 23
General Electric GE 24
We are often interested in the returns to shareholders in the
form of cash dividends. Cash
dividends are payments made by the company directly to its
owners. There is no requirement that
a company pay dividends to its shareholders, but many
companies pay regular quarterly or annual
dividends to the owners. The decision to pay a dividend is
made by the company’s board of
directors. Note that not all companies pay dividends.
Dividends per share (DPS) is the dollar amount of cash
dividends paid during a period, per share

of common stock:
Dividends paid to shareholders
Dividends per share
Number of shares outstanding
=
The dividend payout ratio is the ratio of cash dividends paid to
earnings for a period:
Dividends
Dividend payout ratio =
Earnings
The complement to the dividend payout ratio is the retention
ratio or the plowback ratio:
Earnings - Dividends
Retention ratio =
Earnings

We can also convey information about dividends in the form of
a yield, in which we compare the
dividends per share with the market price per share:
Dividends per share
Dividend yield =
Market price per share
The dividend yield is the return to shareholders measured in
terms of the dividends paid during the
period.
We often describe a company's dividend policy in terms of its
dividend per share, its dividend payout
ratio, or its dividend yield. Some companies' dividends appear
to follow a pattern of constant or
4 Source: Yahoo! Finance

13
constantly growing dividends per share. And some companies'
dividends appear to be a constant
percentage of earnings.
Summary
You’ve been introduced to a few of the financial ratios that a
financial analyst has in his or her toolkit.
There are hundreds of ratios that can be formed using available
financial statement data. The ratios
selected for analysis depend on the type of analysis (e.g., credit
worthiness) and the type of
company. You’ll see in the next reading how to use these ratios
to get an understanding of a
company’s condition and performance.
14
1. IntroductionClassification of ratios2. Liquidity RatiosThe
role of the operating cycleMeasures of liquidity3. Profitability
ratios4. Activity ratiosTurnovers and numbers of days5.
Financial leverage ratiosComponent-percentage financial

leverage ratiosCoverage financial leverage ratios6. Shareholder
ratiosSummary
Ratios - 1
RATIO ANALYSIS-OVERVIEW
Ratios:
1. Provide a method of standardization
2. More important - provide a profile of firm’s economic
characteristics and
competitive strategies.
• Although extremely valuable as analytical tools, financial
ratios also have
limitations. They can serve as screening devices , indicate
areas of
potential strength or weakness, and reveal matters that need
further

investigation.
• Should be used in combinations with other elements of
financial
analysis.
• There is no one definitive set of key ratios; there is no
uniform definition
for all ratios; and there is no standard that should be met for
each ratio.
• There are no "rules of thumb" that apply to the interpretation
of financial
ratios.
Caveats:
• economic assumptions - linearity assumption
• benchmark
• manipulation - timing
accounting methods
• negative numbers

Ratios - 2
Common Size Financial Statements
Differences in firm size may confound cross sectional and time
series
analyses. To overcome this problem, common size statements
are used.
A common size balance sheet expresses each item on the
balance
sheet as a percentage of total assets
A common size income statement expresses each income
statement
category as a percentage of total sales revenues
1 2 3 4
Sales $ 101,840 $ 109,876 $ 115,609 $ 126,974
COGS $ 78,417 $ 83,506 $ 85,551 $ 93,326
SG&A $ 20,368 $ 24,722 $ 27,168 $ 31,109

PROFIT $ 3,055 $ 1,648 $ 2,890 $ 2,539
1 2 3 4
Sales 100.0% 100.0% 100.0% 100.0%
COGS 77.0% 76.0% 74.0% 73.5%
SG&A 20.0% 22.5% 23.5% 24.5%
PROFIT 3.00% 1.50% 2.50% 2.00%
1 2 3 4
Sales 100% 108% 114% 125%
COGS 100% 106% 109% 119%
SG&A 100% 121% 133% 153%
PROFIT 100% 54% 95% 83%

Problem 4-8
C
B
C
i
R
I
O
G
L
I
I
T
T
D
O

L
O
E
T
R
C
O
R
A
O
N
I
o
A
A. Aerospace D. Computer Software G. Consumer Finance
B. Airline E. Consumer Foods H. Newspaper Publishing
C. Chemicals & Drugs F. Department Stores I. Electric Utility
Ratios - 3

ommon size statements
alance Sheet
Company 1 2 3 4 5 6 7 8 9
ash and short-term
nvestments 2 % 13 % 37 % 1 % 1 % 3 % 1 % 22 % 6 %
eceivables 17 8 22 28 23 5 11 16
8
nventory 15 52 15 23 14 2 2 -
5
ther current assets 6 - 5 1 4 2 2
1 -
Current assets 40 % 73 % 79 % 53 % 42 % 12 % 16 % 39 %
19 %
ross property 86 40 26 44 63 112 65
1 106
ess: Accumulated
depreciation (50) (19) (8) (15) (23) (45) (28) -
(34)
Net property 36 % 21 % 18 % 29 % 40 % 67 % 37 % 1 % 72
%

nvestments 3 1 - - 3 14 16 55
-
ntangibles and other 21 5 3 18 15 7
31 5 9
otal assets 100 % 100 % 100 % 100 % 100 % 100 % 100 % 100
% 100 %
rade payables 11 21 22 13 26 7 11
- 20
ebt payable 4 - 3 6 4 6 2 46
4
ther current liabilities 9 43 - - 1 4
1 16 8
Current liabilities 24 % 64 % 25 % 19 % 31 % 17 % 14 % 62
% 32 %
ong-term debt 20 5 12 27 23 34 24
27 21
ther liabilities 16 - 1 21 16 12 13
5 12
Total liabilities 60 % 69 % 38 % 67 % 70 % 63 % 51 % 94 %
65 %

quity 40 31 62 33 30 37 49 6 35
otal liabilities & equity 100 % 100 % 100 % 100 % 100 % 100
% 100 % 100 % 100 %
Income statement
Company 1 2 3 4 5 6 7 8 9
evenues 100 % 100 % 100 % 100 % 100 % 100 % 100 % 100 %
100 %
ost of goods sold 58 81 58 63 52 - 59
- -
perating expenses 21 7 24 28 33 84 29
55 91
esearch % development 7 5 9 - 1 -
- - -
dvertising 3 - 3 2 5 - - -
2
perating income 11 % 7 % 6 % 7 % 9 % 16 % 12 % 45 % 7 %
et interest expense 1 (1) - 2 2 6 3
41 1
ncome from continuing
perations before tax 10 % 8 % 6 % 5 % 7 % 10 % 9 % 4 % 6 %

sset turnover ratio 0.96 1.12 0.94 1.38 1.82 0.45 0.96 0.15 0.96
Ratios - 4
Four categories of ratios to be covered are:
1 . Activity ratios - the liquidity of specific assets and the
efficiency of
managing assets
2. Liquidity ratios - firm's ability to meet cash needs as they
arise;
3. Debt and Solvency ratios - the extent of a firm's financing
with
debt relative to equity and its ability to cover fixed charges; and
4. Profitability ratios - the overall performance of the firm and
its
efficiency in managing investment (assets, equity, capital)
These categories are not distinct as we shall see
activity -------> liquidity

activity ---------> profitability
solvency <------> profitability
Ratios - 5
A. ACTIVITY RATIOS: ASSET MANAGEMENT &
EFFICIENCY
1. Short-term (operating) activity ratios:
Inventory Turnover Ratio (COGS)/(Average inventory)
Measures the efficiency of the firm in managing and selling
inventory.
Inventory does not languish on shelves. High ratio represent
fewer
funds tied up in inventories -- efficient management. High
inventory
can also represent understocking and lost orders. Low turnover
can
also represent legitimate reasons such as preparing for a strike,
increased demand, etc. Ratio depends on industry -perishable
goods

etc.)
Average # of days inventory in stock = 365 / (Inventory
Turnover Ratio)
Receivable Turnover Ratio Sales/(Average receivable)
How many times receivables are turned into cash Relatively low
turnover may
indicate inefficiency, cutback in demand, or earnings
manipulations.
Average # of days receivable are outstanding = 365/(Receivable
Turnover)
(When available, the figure for credit sales can be substituted
for net sales
since credit sales produce the receivables.)
Provides information about the firm's credit policy. Should be
compared with the firm's stated policy (i.e., if firm policy is 30
days and
average collection period is 60 days, company is not stringent in
collection effort.)
High/low relative to the industry should be examined (i.e., low

might
indicate loss sales to competitors).
Low turnover ratios may imply
• firm’s income overstated
• future production cutbacks
• future liquidity problems
Ratios - 6
2. Long-term (investment) activity ratios:
Fixed Assets Turnover Ratio = Sales/ Average fixed assets
Total Assets Turnover Ratio = Sales/ Average total assets
As an alternative, one can use Plant-Asset Turnover Ratio
(Revenues/Average plant assets). Plant-Asset Turnover is a
measure of the
relation between sales and investments in long-lived assets.
When the asset turnover ratios are low, relative to the industry
or historical

record, either the investment in assets is too heavy and/or sales
are sluggish.
There may, however, be plausible explanations: the firm may
have taken an
extensive plant modernization.
Ratios - 7
B. LIQUIDITY RATIOS: SHORT TERM SOLVENCY
These ratios measure short term solvency -- the ability of the
firm to
meet its debt requirements as they come due.
Length of the Cash Cycle - Net Trade Cycle
The Length of cash cycle (i.e., the number of- days a company's
cash is tied
up by its current operating cycle) for a merchandise company is
calculated as
follows:

Operating cycle
(1) the number of days inventory is in stock [365/inventory
turnover]
PLUS
(2) the of days receivable are outstanding [365/Receivable
turnover]
MINUS
(3) the # of days accounts payable are outstanding (365 Average
accounts
payable)/Purchases].
where purchases are approximated by:
COGS plus ending inventories less beginning inventories.
Please note that for a manufacturing company, the length of the
cash cycle
must also consider the time that money is tied up by production.
(Box 3-1)

Ratios - 8
Current Ratio Current assets / Current liabilities
Quick Ratio Cash + Marketable securities + Receivable
Current liabilities
Cash Ratio = Cash + Marketable securities
Current liabilities
Cash Flow From Operations Ratio = CFO / Current liabilities
Defensive Interval =
365 x Cash + Marketable Securities + Accounts Receivable
Projected Expenditures
Ratios - 9
C. DEBT & SOLVENCY RATIOS:
DEBT FINANCING AND COVERAGE
• The use of debt involves risk because debt carries. fixed

commitment
(interest charges & principal repayment).
• While debt implies risk, it also introduces the potential for
increased
benefits to the firm's owners (leverage effect illustrated below).
• There are other fixed commitments, such as lease payments,
that are
similar to debt and should be considered
Debt-Capital Ratio = Debt/(Debt + Equity)
Debt - Assets Ratio = Debt/Total assets
Debt-Equity Ratio = Debt/Shareholders' equity
Debt can include trade debt -- usually it does not
Coverage Ratios [Can also be calculated on cash basis]
Times interest earned = Operating profit(EBIT) /interest
expense
Fixed charge coverage Operating profit + Lease payments
Interest expense + Lease payments

Note: Lease payments are added to numerator because they were
deducted in order to arrive at operating profits.
Capital Expenditure ratio = CFO/Capital expenditures
CFO-debt = CFO/debt
Debt covenants: It is important to examine the proximity to a
technical
violation for two reasons:
(1) it implies potential costs of renegotiation; and
(2) it implies potential earnings management.
Ratios - 10
D. PROFITABILITY RATIOS: OVERALL EFFICIENCY &
PERFORMANCE
Gross Profit Margin = Gross profit/Sales
Measures the ability of the firm to control costs of inventories
and/or
manufacturing cost and to pass along price increases through

sales to
customers.
Operating Profit Margin = Operating profit/Sales
Measure of overall operating efficiency.
Net Profit Margin = (Net Earnings)/Sales
Measure of overall profitability after all items included
(revenues,
expenses, tax, interest, etc.). The profit margin ratio is a
measure of a
firm's ability to control the level of expenses relative to
revenues
generated.
ROI measures
Rate of return on assets (ROA) =
Net income + Interest expense (net of income tax savings)
Average total assets
By adding back interest expense, we actually measure the rate
of return on
assets as if the firm is fully financed with equity. This ratio

provides a
performance measure that is independent of the financing of the
firm's
assets.
Rate of Return on Common Shareholders' Equity (ROE) =
Net income
Average common equity
Disaggregation of ROA/ROE
To simplify matters, we first illustrate ROA on a pre-tax basis.
ROA = EBIT
Assets
= EBIT x Sales
Sales Assets
= Profitability x Activity
Similarly for ROE we find
ROE = EBT

Equity
= EBT x Sales x Assets
Sales Assets Equity
= Profitability x Activity x Solvency
___________ ________ ________
Common Size Inventory T/O Debt/Equity
I/S Components A/R T/O Debt/Assets
Fixed Asset T/O
ON AN AFTER-TAX BASIS
THREE COMPONENT DISAGGREGATION OF ROE
ROE = Net Income
Equity
= Net Income x Sales x Assets
Sales Assets Equity
FIVE COMPONENT DISAGGREGATION OF ROE
ROE = Net Income

Equity
= EBIT x EBT x Net Income x Sales x Assets
Sales EBIT EBT Assets Equity
Operations x Financing x Taxes
Ratios - 11
Additional insights into the relationship of ROE & ROA
Note the in the three way disaggregation of ROE, the first two
components are ROA
calculated on an after interest basis
We can express ROE in terms of ROA directly as (again using
pre-tax numbers to
simplify matters)
ROE = EBIT - Interest x Assets
Assets Equity
= [ROA - Interest ] x Assets
Assets Equity

This term with some manipulation can be converted to*
ROE = ROA + (ROA - Cost of Debt) x [Debt /
Equity]
Leveraging is only profitable if the return on assets is greater
than the cost of debt
_________
* An obvious parallel to this equation for ROE (return on
equity)
ROE = ROA + (ROA - Cost of Debt) x [Debt /
Equity]
is the equation for the beta of a firm (βe)
β β β βe = ββββa + (
ββββa - ββββd ) x [Debt / Equity]
where βa and βd are the unlevered beta and the beta of debt
respectively.
Ratios - 12

Ratios - 13
Problem 4-16 -- Errata
1985 1986 1987 1988 1989 1990
Sales 287.48 295.32 685.36 757.38 790.97 864.60
EBIT 12.57 16.84 56.36 70.68 70.97 74.06
Interest 9.41 9.51 25.51 24.67 17.96 11.44
EBT 3.16 7.33 30.85 46.01 53.01 62.62
Taxes 0.53 3.03 13.18 18.85 20.40 24.31
Net income 2.63 4.30 17.67 27.16 32.61 38.31
Tax rate 16.8% 41.3% 42.7% 41.0% 38.5% 38.8%
Assets 114.09 327.19 380.87 401.11 378.92 407.47
Liabilities &
Equity
Current debt 2.88 18.09 28.33 33.23 26.93 23.86
Trade liabilities 53.77 90.73 105.35 103.16 109.43 122.67
Current liabilities 56.65 108.82 133.68 136.39 136.36 146.53
Long term debt 51.50 191.59 178.76 135.18 74.79 48.34
Other 1.32 0.62 5.51 7.90 11.52 13.82

Total liabilities 109.47 301.03 317.95 279.47 222.67 208.69
Equity 4.62 26.16 62.92 121.64 156.25 198.78
Total lblty & equity 114.09 327.19 380.87 401.11 378.92
407.47
Chapter4/11/10Chapter 3. Tool Kit for Analysis of Financial
Statements Financial statements are analyzed by calculating
certain key ratios and then comparing them with the ratios of
other firms and by examining the trends in ratios over time. We
can also combine ratios to make the analysis more revealing,
one below are exceptionally useful for this type of analysis.
RATIO ANALYSIS (Section 3.1)Input Data:20102009Year-end
common stock price$23.00$26.00Year-end shares outstanding
(in millions)5050Tax rate40%40%After-tax cost of
capital11.0%10.8%Lease payments$28$28Required sinking fund
payments$20$20Balance Sheets(in millions of
dollars)Assets20102009Cash and equivalents$10$15Short-term
investments$0$65Accounts
receivable$375$315Inventories$615$415 Total current
assets$1,000$810Net plant and equipment$1,000$870Total
assets$2,000$1,680Liabilities and equityAccounts
payable$60$30Notes payable$110$60Accruals$140$130 Total
current liabilities$310$220Long-term bonds$754$580 Total
liabilities$1,064$800Preferred stock (400,000

shares)$40$40Common stock (50,000,000
shares)$130$130Retained earnings$766$710Total common
equity$896$840Total liabilities and equity$2,000$1,680Income
Statements(in millions of dollars)20102009Net
sales$3,000.0$2,850.0 Operating
costs$2,616.2$2,497.0Earnings before interest, taxes, depr. &
amort. (EBITDA)$383.8$353.0 Depreciation$100.0$90.0
Amortization$0.0$0.0 Depreciation and
amortization$100.0$90.0Earnings before interest and taxes
(EBIT)$283.8$263.0 Less interest $88.0$60.0Earnings before
taxes (EBT)$195.8$203.0 Taxes (40%)$78.3$81.2Net income
before preferred dividends$117.5$121.8 Preferred
dividends$4.0$4.0Net income available to common
stockholders$113.5$117.8Common
dividends$57.5$53.0Addition to retained
earnings$56.0$64.8Calculated Data: Operating Performance
and Cash Flows20102009Net operating working capital
(NOWC)$800.0$585.0Total operating
capital$1,800.0$1,455.0Net Operating Profit After Taxes
(NOPAT)$170.3$157.8Net Cash Flow (Net income +
Depreciation)$213.5$207.8Operating Cash Flow
(OCF)$270.3$247.8Free Cash Flow
(FCF)($174.7)N/ACalculated Data: Per-share
Information20102009Earnings per share
(EPS)$2.27$2.36Dividends per share (DPS)$1.15$1.06Book

value per share (BVPS)$17.92$16.80Cash flow per share
(CFPS)$4.27$4.16Free cash flow per share
(FCFPS)($3.49)N/ALIQUIDITY RATIOS (Section
3.2)Industry20102009AverageLiquidity ratios Current
Ratio3.233.684.2 Quick Ratio1.241.802.1ASSET
MANAGEMENT RATIOS (Section
3.3)Industry20102009AverageAsset Management ratios
Inventory Turnover4.886.879 Days Sales Outstanding45.640.34
Christopher Buzzard: To calculate the DSO ratio, a 365-day
accounting year was used.36 Fixed Asset Turnover3.003.283
Total Asset Turnover1.501.701.8DEBT MANAGEMENT
RATIOS (Section 3.4)Industry20102009AverageDebt
Management ratios Debt Ratio53.20%47.62%40.00% Debt-to-
Equity Ratio1.140.910.67 Market Debt Ratio48.06%38.10%N/A
Times Interest Earned3.234.386 EBITDA Coverage Ratio3.03
Brigham: (EBITDA + Lease Payments) / (Interest + Loan
Payments + Lease Payments)
3.538PROFITABILITY RATIOS (Section
3.5)Industry20102009AverageProfitability ratios Profit
Margin3.78%4.13%5.00% Basic Earning
Power14.19%15.65%17.20% Return on
Assets5.67%7.01%9.00% Return on
Equity12.67%14.02%15.00%MARKET VALUE RATIOS

(Section 3.6)Industry20102009AverageMarket Value ratios
Price-to Earnings Ratio10.1311.0412.5 Price-to-Cash Flow
Ratio5.396.26
Christopher Buzzard: P/CF ratio is calculated by dividing the
price by the net cash flow per share.
Brigham: (EBITDA + Lease Payments) / (Interest + Loan
Payments + Lease Payments)
Christopher Buzzard: To calculate the DSO ratio, a 365-day
accounting year was used.6.8 Price-to-EBITDA3.003.684.6
Market-to-Book Ratio1.281.551.7TREND ANALYSIS,
COMMON SIZE ANALYSIS, AND PERCENT CHANGE
ANALYSIS (Section 3.7)TREND ANALYSISTrend analysis
allows you to see how a firm's results are changing over time.
For instance, a firm's ROE may be slightly below the
benchmark, but if it has been steadily rising over the past four
years, that should be seen as a good sign.A trend analysis and
graph have been constructed on this data regarding
MicroDrive's ROE over the past 5 years. (MicroDrive and
indusry average data for earlier years has been
provided.)ROEMicroDriveIndustry200614.0%13.2%200716.1%
15.0%200814.8%16.0%200914.0%16.2%201012.7%15.0%Figur

e 3-1 Rate of Return on Common EquityCOMMON SIZE
ANALYSISIn common size income statements, all items for a
year are divided by the sales for that year.Figure 3-2 Common
Size Income StatementsIndustry
CompositeMicroDrive201020102009Net
sales100.0%100.0%100.0% Operating
costs87.6%87.2%87.6%Earnings before interest, taxes, depr. &
amort. (EBITDA)12.4%12.8%12.4% Depreciation and
amortization2.8%3.3%3.2%Earnings before interest and taxes
(EBIT)9.6%9.5%9.2% Less interest 1.3%2.9%2.1%Earnings
before taxes (EBT)8.3%6.5%7.1% Taxes
(40%)3.3%2.6%2.8%Net income before preferred
dividends5.0%3.9%4.3% Preferred
dividends0.0%0.1%0.1%Net income available to common
stockholders (profit margin)5.0%3.8%4.1%In common sheets,
all items for a year are divided by the total assets for that
year.Figure 3-3 Common Size Balance SheetsIndustry
CompositeMicroDrive201020102009AssetsCash and
equivalents1.0%0.5%0.9%Short-term
investments2.2%0.0%3.9%Accounts
receivable17.8%18.8%18.8%Inventories19.8%30.8%24.7%
Total current assets40.8%50.0%48.2%Net plant and
equipment59.2%50.0%51.8%Total
assets100.0%100.0%100.0%Liabilities and equityAccounts
payable1.8%3.0%1.8%Notes

payable4.4%5.5%3.6%Accruals3.6%7.0%7.7% Total current
liabilities9.8%15.5%13.1%Long-term bonds30.2%37.7%34.5%
Total liabilities40.0%53.2%47.6%Preferred
stock0.0%2.0%2.4%Total common
equity60.0%44.8%50.0%Total liabilities and
equity100.0%100.0%100.0%PERCENT CHANGE ANALYSISIn
percent change analysis, all items are divided by the that item's
value in the beginning, or base, year.Figure 3-4 Income
Statement Percent Change AnalysisBase year =2009Percent
Change in2010Net sales5.3% Operating costs4.8%Earnings
before interest, taxes, depr. & amort. (EBITDA)8.7%
Depreciation and amortization11.1%Earnings before interest
and taxes (EBIT)7.9% Less interest 46.7%Earnings before
taxes (EBT)(3.5%) Taxes (40%)(3.5%)Net income before
preferred dividends(3.5%) Preferred dividends0.0%Net income
available to common stockholders(3.7%)Balance Sheet Percent
Change Analysis (not in textbook)Base year =2009Percent
Change in2010AssetsCash and equivalents-33.3%Short-term
investments-100.0%Accounts receivable19.0%Inventories48.2%
Total current assets23.5%Net plant and equipment14.9%Total
assets19.0%Liabilities and equityAccounts payable100.0%Notes
payable83.3%Accruals7.7% Total current
liabilities40.9%Long-term bonds30.0% Total
liabilities33.0%Preferred stock (400,000 shares)0.0%Common
stock (50,000,000 shares)0.0%Retained earnings7.9%Total

common equity6.7%Total liabilities and equity19.0%DU PONT
ANALYSIS (Section 3.8) ROE =(Profit margin)(TA
turnover)(Equity
Multiplier)MicroDrive201012.67%3.78%1.502.23MicroDrive
200914.02%4.13%1.702.00Industry
Average15.00%5.00%1.801.67
MicroDrive
200620072008200920100.140000000000000010.1610.14800000
0000000020.140238095238095250.12665178571428584Industry
200620072008200920100.132000000000000010.150.160.16200
0000000000010.15
ROE
(%)
3.2SECTION 3.2SOLUTIONS TO SELF-TESTA company has
current liabilities of $800 million, and its current ratio is 2.5.
What is its level of current assets? If this firm’s quick ratio is
2, how much inventory does it have?Current liabilities
($M)$800Current ratio2.5Current assets ($M)$2,000Current
liabilities ($M)$800Current ratio2.5Quick ratio2.0Curr assets -
Inv ($M)$1,600Inventories ($M)$400

3.3SECTION 3.3SOLUTIONS TO SELF-TEST QUESTIONSA
firm has annual sales of $200 million, $40 million of inventory,
and $60 million of accounts receivable. What is its inventory
turnover ratio? Annual Sales ($M)$200Inventory
($M)$40Accounts receivable ($M)$60Inventory
turnover5.0Annual Sales ($M)$200Inventory ($M)$40Accounts
receivable ($M)$60Days sales outstanding109.5
3.4SECTION 3.4SOLUTIONS TO SELF-TESTA company has
EBITDA of $600 million, interest payments of $60 million,
lease payments of $40 million, and required principal payments
(due this year) of $30 million. What is its EBITDA coverage
ratio?EBITDA ($M)$600Interest payments$60Lease
payments$40Principal payments$30EBITDA coverage4.9
3.5SECTION 3.5SOLUTIONS TO SELF-TEST A company has
$200 billion of sales and $10 billion of net income. Its total
assets are $100 billion, financed half by debt and half by
common equity. What is its profit margin? What is its ROA?
What is its ROE? Sales ($B)$200Net income ($B)$10Total
assets ($B)$100Debt ratio50%Profit margin5.00%Sales
($B)$200Net income ($B)$10Total assets ($B)$100Debt
ratio50%ROA10.00%Sales ($B)$200Net income ($B)$10Total
assets ($B)$100Debt ratio50%ROE20.00%
3.6SECTION 3.6SOLUTIONS TO SELF-TEST A company has
$6 billion of net income, $2 billion of depreciation and
amortization, $80 billion of common equity, and one billion

shares of stock. If its stock price is $96 per share, what is its
price/earnings ratio? Its price/cash flow ratio? Its market/book
ratio? Net income ($B)$6Amortization and depreciation
($B)$2Common equity$80Number of shares ($B)1Stock price
per share$96Earnings per share$6P/E ratio16.00Cash
flow$8.00Cash flow per share8.00Price/cash flow12.00Book
value per share80.00Market/Book1.20
3.8SECTION 3.8SOLUTIONS TO SELF-TEST A company has a
profit margin of 6%, a total asset turnover ratio of 2, and an
equity multiplier of 1.5. What is its ROE?Profit
margin6.0%Total asset turnover2.0Equity
multiplier1.5ROE18.0%
Overview
� Ratios facilitate comparison of:
� One company over time
� One company versus other companies
1

� Ratios are used by:
� Lenders to determine creditworthiness
� Stockholders to estimate future cash flows and
risk
� Managers to identify areas of weakness and
strength
Income Statement
2010 2011E
Sales $5,834,400 $7,035,600
COGS 4,980,000 5,800,000
Other expenses 720,000 612,960
2
Other expenses 720,000 612,960

Deprec. 116,960 120,000
Tot. op. costs 5,816,960 6,532,960
EBIT 17,440 502,640
Int. expense 176,000 80,000
EBT (158,560) 422,640
Taxes (40%) (63,424) 169,056
Net income ($ 95,136) $ 253,584
Balance Sheets: Assets
2010 2011E
Cash $ 7,282 $ 14,000
S-T invest. 20,000 71,632

3
S-T invest. 20,000 71,632
AR 632,160 878,000
Inventories 1,287,360 1,716,480
Total CA 1,946,802 2,680,112
Net FA 939,790 836,840
Total assets $2,886,592 $3,516,952
Balance Sheets: Liabilities &
Equity
2010 2011E
Accts. payable $ 324,000 $ 359,800
Notes payable 720,000 300,000

4
Accruals 284,960 380,000
Total CL 1,328,960 1,039,800
Long-term debt 1,000,000 500,000
Common stock 460,000 1,680,936
Ret. earnings 97,632 296,216
Total equity 557,632 1,977,152
Total L&E $2,886,592 $3,516,952
Other Data
2010 2011E
Stock price $6.00 $12.17
# of shares 100,000 250,000

5
# of shares 100,000 250,000
EPS -$0.95 $1.01
DPS $0.11 $0.22
Book val. per sh. $5.58 $7.91
Lease payments $40,000 $40,000
Tax rate 0.4 0.4
Liquidity Ratios
� Can the company meet its short-term
obligations using the resources it
currently has on hand?
6

currently has on hand?
Forecasted Current and Quick
Ratios for 2011.
CR10 = = = 2.58.
CA
CL
$2,680
$1,040
7
QR10 =
= = 0.93.
CL
$2,680 - $1,716
$1,040

CA - Inv.
CL
Comments on CR and QR
2011E 2010 2009 Ind.
CR 2.58 1.46 2.3 2.7
QR 0.93 0.5 0.8 1.0
8
QR 0.93 0.5 0.8 1.0
� Expected to improve but still below the
industry average.
� Liquidity position is weak.
Asset Management Ratios

� How efficiently does the firm use its
assets?
� How much does the firm have tied up in
9
� How much does the firm have tied up in
assets for each dollar of sales?
Inventory Turnover Ratio vs.
Industry Average
Inv. turnover =
Sales
Inventories
$7,036
10

= = 4.10.
$7,036
$1,716
2011E 2010 2009 Ind.
Inv. T. 4.1 4.5 4.8 6.1
Comments on Inventory
Turnover
� Inventory turnover is below industry
average.
� Firm might have old inventory, or its
11
� Firm might have old inventory, or its
control might be poor.
� No improvement is currently forecasted.

DSO = Receivables
Average sales per day
DSO: average number of days
from sale until cash received.
12
= =
= 45.5 days.
$878
$7,036/365
Receivables
Sales/365
Appraisal of DSO
� Firm collects too slowly, and situation is

getting worse.
� Poor credit policy.
13
� Poor credit policy.
2011 2010 2009 Ind.
DSO 45.5 39.5 37.4 32.0
Fixed assets
turnover
Sales
Net fixed assets
=
Fixed Assets and Total Assets
Turnover Ratios

14
Total assets
turnover
=
= = 2.00.
Sales
Total assets
$7,036
$3,517
= = 8.41.
$7,036
$837
(More…)
Fixed Assets and Total Assets
Turnover Ratios

� FA turnover is expected to exceed industry average.
Good.
� TA turnover not up to industry average. Caused by
excessive current assets (A/R and inventory).
15
excessive current assets (A/R and inventory).
2011E 2010 2009 Ind.
FA TO 8.4 6.2 10.0 7.0
TA TO 2.0 2.0 2.3 2.5
Debt Management Ratios
� Does the company have too much
debt?
� Can the company’s earnings meet its

16
� Can the company’s earnings meet its
debt servicing requirements?
Total liabilities
Total assets
Debt ratio =
$1,040 + $500
Calculate the debt, TIE, and
EBITDA coverage ratios.
17
= = 43.8%.
$1,040 + $500
$3,517

EBIT
Int. expense
TIE =
= = 6.3.
$502.6
$80 (More…)
EBIT + Depr. & Amort. + Lease payments
EBITDA Coverage (EC)
18
= = 5.5.
EBIT + Depr. & Amort. + Lease payments
Interest Lease
expense pmt. + + Loan pmt.
$502.6 + $120 + $40

$80 + $40 + $0
2011E 2010 2009 Ind.
D/A 43.8% 80.7% 54.8% 50.0%
Debt Management Ratios vs.
Industry Averages
19
Recapitalization improved situation, but
lease payments drag down EC.
D/A 43.8% 80.7% 54.8% 50.0%
TIE 6.3 0.1 3.3 6.2
EC 5.5 0.8 2.6 8.0
Profitability Ratios

� What is the company’s rate of return
on:
� Sales?
20
� Sales?
� Assets?
Profit Margins
PM = = = 3.6%.
NI
Sales
$253.6
$7,036
Net profit margin (PM):

21
PM = = = 3.6%.
Sales $7,036
OM = = = 7.1%.
EBIT
Sales
$503
$7,036
Operating profit margin (OM):
(More…)
Sales − COGS
Sales
Profit Margins (Continued)
GPM = =

Gross profit margin (GPM):
$7,036 − $5,800
$7,036
22
Sales
GPM = =
GPM = = 17.6%.
$1,236
$7,036
$7,036 − $5,800
$7,036
2011E 2010 2009 Ind.
PM 3.6% -1.6% 2.6% 3.6%
Profit Margins vs. Industry
Averages

23
Very bad in 2010, but projected to
meet or exceed industry average in
2011.
PM 3.6% -1.6% 2.6% 3.6%
OPM 7.1 0.3 6.1 7.1
GPM 17.6 14.6 16.6 15.5
BEP =
EBIT
Total assets
Basic Earning Power (BEP)
24
= = 14.3%.

Total assets
$502.6
$3,517
(More…)
Basic Earning Power vs.
Industry Average
� BEP removes effect of taxes and
financial leverage. Useful for
comparison.
25
comparison.
� Projected to be below average.
� Room for improvement.

2011E 2010 2009 Ind.
BEP 14.3% 0.6% 14.2% 17.8%
ROA =
NI
Total assets
Return on Assets (ROA)
and Return on Equity (ROE)
26
= = 7.2%.
Total assets
$253.6
$3,517
(More…)

ROE =
NI
Common Equity
Return on Assets (ROA)
and Return on Equity (ROE)
27
= = 12.8%.
Common Equity
$253.6
$1,977
(More…)
2011E 2010 2009 Ind.

ROA 7.2% -3.3% 6.0% 9.0%
ROA and ROE vs. Industry
Averages
28
ROA 7.2% -3.3% 6.0% 9.0%
ROE 12.8% -17.1% 13.3% 18.0%
Both below average but improving.
Effects of Debt on ROA and
ROE
� ROA is lowered by debt--interest
expense lowers net income, which also
lowers ROA.
29
lowers ROA.

� However, the use of debt lowers equity,
and if equity is lowered more than net
income, ROE would increase.
Market Value Ratios
� Market value ratios incorporate the:
� High current levels of earnings and cash
flow increase market value ratios
30
flow increase market value ratios
� High expected growth in earnings and cash
flow increases market value ratios
� High risk of expected growth in earnings
and cash flow decreases market value
ratios

Price = $12.17.
NI $253.6
Calculate and appraise the
P/E, P/CF, and M/B ratios.
31
EPS = = = $1.01.
P/E = = = 12.
NI
Shares out.
$253.6
250
Price per share
EPS
$12.17

$1.01
Industry P/E Ratios:
Industry Ticker* P/E
Banking STI 1.32
Software MSFT 6.14
32
Drug PFE 5.87
Electric Utilities DUK 10.14
Semiconductors INTC 4.01
Steel NUE 0.33
Tobacco MO 1.30
S&P 500 14.22

*Ticker is for typical firm in industry, but P/E ratio is for the
industry, not
the individual firm; www.investor.reuters.com, January 2009.
NI + Depr.
Shares out.
CF per share =
$253.6 + $120.0
Market Based Ratios
33
= = $1.49.
$253.6 + $120.0
250
Price per share
Cash flow per share

P/CF =
= = 8.2.$12.17
$1.49
Com. equity
Shares out.
BVPS =
Market Based Ratios
(Continued)
34
= = $7.91.
$1,977
250
Mkt. price per share
Book value per share
M/B =

= = 1.54.
$12.17
$7.91
Interpreting Market Based
Ratios
� P/E: How much investors will pay for $1
of earnings. Higher is better.
� M/B: How much paid for $1 of book
35
� M/B: How much paid for $1 of book
value. Higher is better.
� P/E and M/B are high if ROE is high,
risk is low.

2011E 2010 2009 Ind.
Comparison with Industry
Averages
36
2011E 2010 2009 Ind.
P/E 12.0 -6.3 9.7 14.2
P/CF 8.2 27.5 8.0 7.6
M/B 1.5 1.1 1.3 2.9
Common Size Balance Sheets:
Divide all items by Total Assets
Assets 2009 2010 2011E Ind.
Cash 0.6% 0.3% 0.4% 0.3%
ST Inv. 3.3% 0.7% 2.0% 0.3%

37
ST Inv. 3.3% 0.7% 2.0% 0.3%
AR 23.9% 21.9% 25.0% 22.4%
Invent. 48.7% 44.6% 48.8% 41.2%
Total CA 76.5% 67.4% 76.2% 64.1%
Net FA 23.5% 32.6% 23.8% 35.9%
TA 100.0% 100.0% 100.0% 100.0%
Divide all items by Total
Liabilities & Equity
Assets 2009 2010 2011E Ind.
AP 9.9% 11.2% 10.2% 11.9%
Notes pay. 13.6% 24.9% 8.5% 2.4%

38
Notes pay. 13.6% 24.9% 8.5% 2.4%
Accruals 9.3% 9.9% 10.8% 9.5%
Total CL 32.8% 46.0% 29.6% 23.7%
LT Debt 22.0% 34.6% 14.2% 26.3%
Total eq. 45.2% 19.3% 56.2% 50.0%
Total L&E 100.0% 100.0% 100.0% 100.0%
Analysis of Common Size
Balance Sheets
� Computron has higher proportion of
inventory and current assets than
Industry.
Computron now has more equity (which

39
� Computron now has more equity (which
means LESS debt) than Industry.
� Computron has more short-term debt
than industry, but less long-term debt
than industry.
Common Size Income Statement:
Divide all items by Sales
2009 2010 2011E Ind.
Sales 100.0% 100.0% 100.0% 100.0%
COGS 83.4% 85.4% 82.4% 84.5%
40
Other exp. 9.9% 12.3% 8.7% 4.4%

Depr. 0.6% 2.0% 1.7% 4.0%
EBIT 6.1% 0.3% 7.1% 7.1%
Int. Exp. 1.8% 3.0% 1.1% 1.1%
EBT 4.3% -2.7% 6.0% 5.9%
Taxes 1.7% -1.1% 2.4% 2.4%
NI 2.6% -1.6% 3.6% 3.6%
Analysis of Common Size
Income Statements
� Computron has lower COGS (86.7) than
industry (84.5), but higher other
expenses. Result is that Computron
41
expenses. Result is that Computron
has similar EBIT (7.1) as industry.

Percentage Change Analysis: %
Change from First Year (2009)
Income St. 2009 2010 2011E
Sales 0.0% 70.0% 105.0%
COGS 0.0% 73.9% 102.5%
42
Other exp. 0.0% 111.8% 80.3%
Depr. 0.0% 518.8% 534.9%
EBIT 0.0% -91.7% 140.4%
Int. Exp. 0.0% 181.6% 28.0%
EBT 0.0% -208.2% 188.3%
Taxes 0.0% -208.2% 188.3%

NI 0.0% -208.2% 188.3%
Analysis of Percent Change
Income Statement
� We see that 2011 sales grew 105%
from 2009, and that NI grew 188%
from 2009.
43
from 2009.
� So Computron has become more
profitable.
Percentage Change Balance
Sheets: Assets
Assets 2009 2010 2011E

Cash 0.0% -19.1% 55.6%
ST Invest. 0.0% -58.8% 47.4%
44
ST Invest. 0.0% -58.8% 47.4%
AR 0.0% 80.0% 150.0%
Invent. 0.0% 80.0% 140.0%
Total CA 0.0% 73.2% 138.4%
Net FA 0.0% 172.6% 142.7%
TA 0.0% 96.5% 139.4%
Percentage Change Balance
Sheets: Liabilities & Equity
Liab. & Eq. 2009 2010 2011E

AP 0.0% 122.5% 147.1%
45
Notes pay. 0.0% 260.0% 50.0%
Accruals 0.0% 109.5% 179.4%
Total CL 0.0% 175.9% 115.9%
LT Debt 0.0% 209.2% 54.6%
Total eq. 0.0% -16.0% 197.9%
Total L&E 0.0% 96.5% 139.4%
Analysis of Percent Change
Balance Sheets
� We see that total assets grew at a rate
of 139%, while sales grew at a rate of
only 105%. So asset utilization remains

46
only 105%. So asset utilization remains
a problem.
Explain the Du Pont System
� The Du Pont system focuses on:
� Expense control (PM)
� Asset utilization (TATO)
47
� Asset utilization (TATO)
� Debt utilization (EM)
� It shows how these factors combine to
determine the ROE.

( )( )( )Profit TA Equity
The Du Pont System
48
( )( )( ) = ROEProfitmargin
TA
turnover
Equity
multiplier
NI
Sales
Sales
TA
TA
CE

x x = ROE
NI
Sales
Sales
TA
TA
CE
x x = ROE
The Du Pont System
49
2008: 2.6% x 2.3 x 2.2 = 13.2%
2009: -1.6% x 2.0 x 5.2 = -16.6%
2010: 3.6% x 2.0 x 1.8 = 13.0%
Ind.: 3.6% x 2.5 x 2.0 = 18.0%
Sales TA CE

Potential Problems and
Limitations of Ratio Analysis
� Comparison with industry averages is
difficult if the firm operates many
different divisions.
Seasonal factors can distort ratios.
50
� Seasonal factors can distort ratios.
� Window dressing techniques can make
statements and ratios look better.
� Different accounting and operating
practices can distort comparisons.
Qualitative Factors

� There is greater risk if:
� revenues tied to a single customer
� revenues tied to a single product
reliance on a single supplier?
51
� reliance on a single supplier?
� High percentage of business is generated
overseas?
� What is the competitive situation?
� What products are in the pipeline?
� What are the legal and regulatory issues?

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