Module 3

Analysis of Financial Statements

Module Overview

Modules 1 and 2 deal mostly with theoritical concepts of Finance and Financial Management.
In Module 3, you will be dealing with another concep that is very vital in making financial decisions.
Specifically, you will be learning how to analyze Financial Statements as basis and guidance in
decision making. There are several techniques in Financial Statement Analysis but the most common is
by way of Ratio Analysis.

Module Objectives/Outcomes

At the end of this module, the students are expected to:

 Illustrate ratio analysis;

 Appraise each ratio’s relationship with balance sheet and income statement ;
 Evaluate why return on equity (ROE) is the key ratio under management’s control, how the
ratios affect ROE and explain the use of DuPont equation to see how ROE can be improved;
and
 Relate ratios of different firms and analyze a given firms ratios over time.

Lessons in this Module

This module contains the following topics:

 Lesson 1: Financial Statements
 Lesson 2: Ratio Analysis
 Lesson 3: Trend Analysis and the DuPont Equation
 Financial Statements

Introduction

Since you have successfuly accomplished Module 2, you are now ready to take your course to
another level. This time you will have Analysis of Financial Statements. Lesson of Module 3 will discuss
about Financial Statements. You will basically get acquainted with the basic financial statements in
preparation for the succeeding lessons.

Activity

1. What comes to your mind when you hear the term Financial Statements?

Your answer:
Financial statement is basically the report cards for organizations. They recount the story, in
numbers, about the monetary soundness of the business.

Analysis

1. Do you think financial statements are important in making financial decisions? Elaborate.

Your answer:
Yes, it is, indeed, the key to successful business operations. Without proper administration of
finance, no business enterprise can reach its full potentials for growth and success. Money is to an
enterprise.

Financial management is all about planning investment, funding the investment, monitoring
expenses against budget and managing gains from the investments. Financial management means
management of all matters related to an organization’s finances.

Abstraction

Definition and Purpose of Financial Statements

Financial statements are written records that convey the business activities and the financial
performance of a company. As per International Accounting Standards, general purpose financial
statements are those intended to serve users who are not in a position to require financial reports
tailored to their particular information needs. The objective of general purpose financial statements is to
provide information about the financial position, financial performance, and cash flows of an entity that
is useful to a wide range of users in making economic decisions. To meet that objective, financial
statements provide information about an entity's:
  Assets
 Liabilities
 Equity
 Income and Expenses
 Contributions by and distributions to owners (in their capacity as owners)
 Cash flows

These information, along with other information in the notes, assists users of financial statements in
predicting the entity's future cash flows and, in particular, their timing and certainty.

Components of Financial Statements

 a statement of financial position (balance sheet) at the end of the period

 a statement of financial performance (Income Statement) for the period
 a statement of changes in equity for the period
 a statement of cash flows for the period
 notes, comprising a summary of significant accounting policies and other explanatory notes

Statement of Financial Position (Balance Sheet)

Statement of Financial Position, also known as the Balance Sheet, presents the financial
position of an entity at a given date. It is comprised of three main components: assets, liabilities and
equity.

Assets are resources with economic value that the entity controls with the expectation that it
will provide a future benefit. Assets can be categorized as current and non-current.

Current assets are short-term economic resources which economic benefits are expected to
flow to the entity within its normal operating cycle. Current assets include Cash and Cash Equivalents,
Trade and Other Receivable, Inventory, and Prepaid Expenses.

Non-current assets are resources which economic benefits are expected to extend beyond the
entity’s normal operating cycle. Examples are Property, Plant and Equipment, Intangible Assets, Long-
term Investments.

Liabilities are financial obligations of an entity as a result of past transaction and events that will
result to expected ouflow of economic benefits when settled. Liabilities are settled over time through the
transfer of economic benefits including money, goods, or services. Liabilities are also categorized as
current and non-current.

Current Libilities are obligations that are expected to be settled within the company’s operating
cycle.These include Trade and Other Payables, Accrued Expenses, and Shor-term Borrowings .

Non-current Liabilities are obligations whose settlement will extend beyond the company’s
operating cycle. Examples are Loans Payable, Mortgage Payable and other Long-term Borrowings.
 Shareholders’ (Stockholders’) Equity represents the difference between the entity’s total assets
and total liabilities. These represents the amount of the entity’s resources that is attributable to the
entity’s owners. This include accounts such as Ordinary Share Capital, Preferred Chare Capital, Share
Premium, and Retained Earnings.
The Basic Accounting Equation is: Asset= Liabilities + Equity

The table below shows details of the Statement of Financial Position

Statement of Financial Performance (Income Statement)

Statement of Financial Performance, also known as the Income Statement, presents the
financial performance of an entity for a given period. It also known as the profit and loss statement for it
shows the entity’s net income or loss. The details of the entity’s revenues (income) and expenses are
presented in this statement.

Revenue is the gross inflow of economic benefits (cash, receivables, other assets) arising from
the ordinary operating activities of an entity ( such as sales of goods, sales of services, interest,
royalties, and dividends).

An expense is the cost of operations that a company incurs to generate revenue. Examples are
Cost of Sales/Cost of Goods Sold, Salaries Expenses, Utilities Expenses and Depreciation Expenses .

Statement of Cash Flow

 Cash Flow Statement is a report that shows how things that affect the balance sheet and
income statement affect the firm’s cash flows. It shows the cash inflows and outflows of the company’s
operation. Simply stated, the statement of cash flow just presents that details of the company’s
transactions or activities that affect its CASH which can be categorized as operating, investing and
financiang actvities
Cash Flow from Operating Activities indicates the amount of money a company brings in from
its ongoing, regular business activities, such as manufacturing and selling goods or providing a service
to customers. Examples are:
 Cash receipts from the sale of  Cash payments of fines
goods and services  Cash payments to settle
 Cash receipts from the lawsuits
collection of receivables  Cash payments of taxes
 Cash receipts from lawsuit  Cash refunds to customers
settlements  Cash payments to settle asset
 Cash receipts from the retirement obligations
settlement of insurance claims  Cash payments of interest to
 Cash receipts from supplier creditors
refunds  Cash payments of
 Cash receipts from licensees contributions
 Cash payments to employees
 Cash payments to suppliers

Cash Flow from Investing Activities is one of the sections on the cash flow statement that
reports how much cash has been generated or spent from various investment-related activities in a
specific period. Investing activities include purchases of physical assets, investments in securities, or
the sale of securities or assets. Examples are:

 Purchase of fixed  Sale of investment

assets/property, plant and instruments, such as stocks
equipment and bonds
 Sale of fixed assets  Lending of money (non-
 Purchase of investment lending entities)
instruments, such as stocks  Collection of loans
and bonds  Proceeds of insurance
settlements related to
damaged fixed assets

Cash Flow from Financing Activities s a section of a company’s cash flow statement, which
shows the net flows of cash that are used to fund the company. Financing activities include transactions
involving debt, equity, and dividends. It provides investors with insight into a company’s financial
strength and how well a company's capital structure is managed. Examples are:

o Sale of stock/shares o Repayment of debt

o Repurchase of company stock o Payment of dividends
o Issuance of debt securities,
such as bonds

Statement of Changes in Shareholders’ Equity

 Statement of Changes in Shareholders’ Equity details the change in shareholders’ equity over
an accounting period by presenting the movement in reserves comprising the shareholders’ equity.
Movement in shareholders’ equity over an accounting period comprises the following elements:

 Net profit or loss during the accounting  Gains and losses recognized directly in
period attributable to shareholders equity
 Increase or decrease in share capital  Effect of changes in accounting
reserves policies
 Dividend payments to shareholders  Effect of correction of prior period error

Notes to Financial Statements

Notes to Financial Statements are supplementary notes that include explanations of various
activities, additional detail on some accounts, and other items as mandated by the applicable
accounting framework and standards.

Application

What component of financial statements are you going to look into when you want informations
pertianing to the following:

Balance Sheet 1. Details or disaggregation of the line item “Cash and Cash Equivalents”
Income Statement 2. Total Revenue of an entity
Balance Sheet 3. Total current assets of an entity
Cash Flow Statement 4. how much of the total cash inflow pertains to the operation
Balance Sheet 5. The company’s total retained earnings

Assessment

Matching type. Match Column A with Column B. Write your answers in the space provided.

COLUMN A COLUMN B
D 1. Basic Accounting Equation a. Salaries of Office Staff
H 2. Balance Sheet b. Current Asset
I 3. Profit/Net Income c. Cash flow from Operating Activities
J 4. Accounting Policies can be seen d. A=L+E
A 5. Payment of Employees Salaries e. Property, Plant and Equipment
B 6. Prepaid Rent f. Liabilities
F 7. Obligations g. Notes to Financial Statements
C 8. Cash Flow Statement h. Financial Position
E 9. Non-current Asset i. Revenue is greater than Expenses
G10. Expense j. Cash inflows and Cash ouflows
 Excellent! You have just finished Lesson 1.
Take some rest and get ready for Lesson 2.

Ratio Analysis

Introduction

Congratulations for doing a great job in Lesson 1. You are now in Lesson 2 of Module 3. In this
lesson, you will get to deal with the details contained in the basic financial statements. These details will
be used in analyzing a certain entity’s liquidity, profitability and other factors that are important in
decision making. You will be doing this using Ratio Analysis.

Activity

Express the following ratios in percentage and fractional forms:

Example: 4:8 Answer: 1/3:2/3 and 33%:67%

1. 2:3 Answer: __2/5:3/5______ and __40%:60%______

2. 15:30 Answer: __1/3:2/3______ and __33%:67%______
3. 4:6 Answer: __2/5:3/5______ and __40%:60%_______

Analysis

1. How do you think are ratios useful in Financial Statement Analysis?

Your answer:
Financial Ratios is useful tool that help entrepreneurs and investors and look at monetary
connections between the records on the association's budget reports. They are one apparatus that
makes monetary investigation conceivable over a company's set of experiences, an industry, or a
business area.

Abstraction
 The ratio analysis is the most powerful tool of financial statement analysis. Ratio simply means
one number expressed in terms of another. Ratios can be found out by dividing one number by another
number. Ratios show how one number is related to another.

Categories of Financial Ratios

1. Liquidity ratios, which give us an idea of the firm’s ability to pay off debts that are maturing
within a year.
2. Asset management ratios, which give us an idea of how efficiently the firm is using its assets.
3. Debt management ratios, which give us an idea of how the firm has financed its assets as well
as the firm’s ability to repay its long-term debt.
4. Profitability ratios, which give us an idea of how profitably the firm is operating and utilizing its
assets.
5. Market value ratios, which bring in the stock price and give us an idea of what investors think
about the firm and its future prospects.
Consider the following illustrations for the discussion in the proceeding pages.

ABC Company
Statement of Financial Positions
As of December 31, 2008 and 2007
 ABC Company
Statement of Financial Performance
For the Year Ended December 31, 2008 and 2007

ABC Company
Statement of Stockholders’ Equity
For the Year Ended December 31, 2008
 ABC Company
Statement of Cash Flows
For the Year Ended December 31, 2008

Liquidity Ratios

Liquidity ratios measure the short-term solvency of financial position of a firm. These ratios are
calculated to comment upon the short-term paying capacity of a concern or the firm’s ability to meet its
current obligations.

The liquidity ratios help answer this question: Will the firm be able to pay off its debts as they
come due and thus remain a viable organization? If the answer is no, liquidity must be the first order of
business. A liquid asset is one that trades in an active market and thus can be quickly converted to
cash at the going market price.
 a. Current Ratio- this ratio is a general and quick measure of liquidity of a firm.it is an index of
the firm’s financial stability, technical solvency and strength of working capital. This ratio is
calculated by dividing current assets by current liabilities. It indicates the extent to which
current liabilities are covered by those assets expected to be converted to cash in the near
future.

Current Ratio = Total Current Assets / Total Current Liabilities

= 1,000 / 310
= 3.2x

b. Quick or Acid Test Ratio- measures the firm’s capacity to pay off current obligations
immediately and is more rigorous test of liquidity than the current ratio. It is more rigorous
test of liquidity than the current ratio because it eliminates inventories and prepaid
expenses as a part of current assets. This ratio is calculated by total quick assets by total
current liabilities. (Note: Total Quick Asset = Total Current Asset – Inventory – Prepaid
Expenses)

Quick Ratio = Total Quick Assets / Total Current Liabilities

= 385 / 310
= 2.2x

Asset Management Ratios

The asset management ratios measure how effectively the firm is managing its assets. These
ratios answer this question: Does the amount of each type of asset seem reasonable, too high, or too
low in view of current and projected sales? These ratios are important because when companies
acquire assets, they must obtain capital from banks or other sources and capital is expensive.
Therefore, if a company has too many assets, its cost of capital will be too high, which will depress its
profits. On the other hand, if its assets are too low, profitable sales will be lost.

a. Inventory Turnover Ratio- this ratio is calculated by dividing Cost of Goods Sold by
inventories. As the name implies, this ratio shows how many times the particular asset
(inventory) is “turned over” during the year. ( Note: If Cost of Goods Sold is not available,
use Net Sales as numerator instead)

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

= 3,000 / ((615+415) / 2)
= 5.8x
Note: Average Inventory is equal to the sum of Beginning and Ending Inventory divided by 2.

b. Days Sales Outstanding- Accounts receivable are evaluated by the days sales outstanding
(DSO) ratio, also called the average collection period (ACP).5 It is calculated by dividing
accounts receivable by the average daily sales to find how many days’ sales are tied up in
receivables. Thus, the DSO represents the average length of time the firm must wait after
making a sale before receiving cash.

Days Sales Outstanding = Average Accounts Receivable / Average Daily Sales

= ((375 + 315) / 2) / (3,000 / 365)
 = 41.98 or 42 Days

c. Fixed Assets Turnover Ratio- is an efficiency ratio that measures how well a company uses
its fixed assets to generate sales. It is calculated by dividing net sales by the net of its
property, plant, and equipment (fixed assets).

Fixed Assets Turnover Ratio = Net Sales / Average Fixed Assets

= 3,000 / ((1,000+870) / 2)
= 3.2x

d. Total Asset Turnover Ratio- measures the turnover of all of the firm’s assets. The asset
turnover ratio can be used as an indicator of the efficiency with which a company is using
its assets to generate revenue.

Total Assets Turnover Ratio = Net Sales / Average Total Assets

= 3,000 / ((2,000+1,680) / 2)
= 1.63x

Debt Management Ratios

The use of debt will increase, or “leverage up,” a firm’s ROE if the firm earns more on its assets
than the interest rate it pays on debt. However, debt exposes the firm to more risk than if it financed
only with equity. As such, it is important that the entity plays well in managing its debt and in achieve
the best structure in terms of asset financing.

Debt Management Ratios is a set of ratios that measure how effectively a firm manages its
debt.

a. Total Debt to Total Asset Ratio- is a leverage ratio that defines the total amount of debt
relative to assets owned by a company. Using this metric, analysts can compare one
company's leverage with that of other companies in the same industry. This information
can reflect how financially stable a company is. The higher the ratio, the higher the degree
of leverage (DoL) and, consequently, the higher the risk of investing in that company.

Total Debt to Total Asset Ratio = Total Liabilities / Total Asset

= 1,060 / 2,000
= 53%

b. Times-Interest-Earned- measures the extent to which operating income can decline before
the firm is unable to meet its annual interest costs. Failure to pay interest will bring legal
action by the firm’s creditors and probably result in bankruptcy. Note that earnings before
interest and taxes, rather than net income, is used in the numerator. Because interest is
paid with pretax earnings, the firm’s ability to pay current interest is not affected by taxes.

Times-Interest-Earned Ratio = EBIT / Interest Expense

= 283.6 / 88
= 3.2x
 c. Debt to Equity Ratio- is used to evaluate a company's financial leverage. The D/E ratio is
an important metric used in corporate finance. It is a measure of the degree to which a
company is financing its operations through debt versus wholly-owned funds. More
specifically, it reflects the ability of shareholder equity to cover all outstanding debts in the
event of a business downturn. The debt-to-equity (D/E) ratio is calculated by dividing a
company’s total liabilities by its shareholder equity.

Debt to Equity Ratio = Total Liabilities / Total Debt

= 1,060/940
= 1.13x

Profitability Ratios

Profitability ratios are a class of financial metrics that are used to assess a business's ability to
generate earnings relative to its revenue, operating costs, balance sheet assets, or shareholders' equity
over time, using data from a specific point in time. They show how efficiently a company generates
profit and value for shareholders.

a. Operating Margin- is a profitability ratio that shows how much profit a company makes from
its core operations in relation to the total revenues it brings in. It helps investors understand
how a business makes money; if it is generating income primarily from core operations, or
other means, such as investments. This ratio measures operating income, or EBIT, per
dollar of sales; it is calculated by dividing operating income by sales.

Operating Margin = Operating Income (or EBIT) / Sales

= 283.8 / 3,000
= 9.5%

b. Profit Margin- is one of the commonly used profitability ratios to gauge the degree to which
a company or a business activity makes money. It represents what percentage of sales has
turned into profits. Simply put, the percentage figure indicates how many cents of profit the
business has generated for each dollar of sale. This ratio measures net income per dollar
of sales and is calculated by dividing net income by sales.

Profit Margin = Net Income (or Profit) / Sales

= 117.5 / 3,000
= 3.92%

c. Return on Total Assets- is considered to be an indicator of how effectively a company is

using its assets to generate earnings. The ratio of the net income to average total assets.

Return on Total Assets = Net Income / Average Total Assets

= 117.5 / ((2,000+1,680) / 2)
= 6.4%

d. Return on Equity- measures how the profitability of a corporation in relation to stockholders’

equity. Return on equity (ROE) is a measure of financial performance calculated by
dividing net income by shareholders' equity. Because shareholders' equity is equal to a
company’s assets minus its debt, ROE is considered the return on net assets.
 Return on Equity = Net Income / Average Total Equity
= 117.5 / ((940+880) / 2)
= 12.9%

Market Value Ratios

Market value ratios are used to evaluate the current share price of a company's stock. These
ratios are employed by current and potential investors to determine whether a company's shares are
over-priced or under-priced.

The market value ratios are used in three primary ways: (1) by investors when they are
deciding to buy or sell a stock, (2) by investment bankers when they are setting the share price for a
new stock issue (an IPO), and (3) by firms when they are deciding how much to offer for another firm in
a potential merger.

a. Price/Earnings Ratio- The price-to-earnings ratio (P/E ratio) is the ratio for valuing a
company that measures its current share price relative to its per-share earnings (EPS). It is
used by investors and analysts to determine the relative value of a company's shares in an
apples-to-apples comparison. It can also be used to compare a company against its own
historical record or to compare aggregate markets against one another or over time.

Price/Earnings Ratio= Price per share / Earnings per Share

= 23.06 / 2.35
= 9.8x
(Note: Price per share is assumed)

b. Market / Book Ratio- The ratio of a stock’s market price to its book value gives another
indication of how investors regard the company. Companies that are well regarded by
investors—which means low risk and high growth—have high M/B ratios.

Market / Book Ratio = Market Price per Share / Book Value per Share
= 23.06 / 18.80
= 1.2x

Book Value per Share = Total Common Equity / Total Outstanding Shares

Application

Instruction: Consider the following data and compute for the required ratios.
1. Current Ratio = Total Current Assets / Total Current Liabilities
= 655,000 / 330,000
= 1.9x

2. Quick Ratio = Total Quick Assets / Total Current Liabilities

 = (655,000 – 241,500) / 330,000
= 413,500 / 330,000
= 1.2x

3. Days Sales Outstanding = Average Accounts Receivable / Average Daily Sales

= 336,000 / (1,607,500/365)
= 336,500 / 4,404
= 76.29 or 76 days

4. Inventory Turnover = Cost of Goods Sale / Average Inventory

= 1,392,500 / 241,500
= 5.7x

5. Total Assets Turnover = Net Sales / Average Total Assets

= 1,392,500 / 947,500
= 1.4x

6. Profit Margin = Net Income (profit) / Sales

= 27,300 / 1,607,500
= 1.69 % or 1.7 %

7. ROA = Net Income / Average Total Assets

= 27,300 / 947,500
= 2.88% or 2.9%

8. ROE = Net Income / Average Total Equity

= 27,300 / 361, 000
= 7.5 %

9. Total Debt to Total Assets = Total Liabilities/ Total Assets

= 586,500 / 947,500
= 61.89%

Assessment

Instruction: Solve for all the missing values (blank).

 Cash 27,000 Accounts payable 90,000

Accounts receivable 45,000 Long-term debt 60,000

Inventories 90,000 Common stock 52,500

Fixed assets 138,000 Retained earnings 97,500

Total assets 300,000 Total liabilities and 300,000

equity
Sales 450,000 Cost of goods sold 337,500

Solutions:

Debt Ratio = total liabilities/total assets

SO% = x/300
x= 3000,000 (SO%)
x= 150,000

Total Asset Turnover= Sales/total assets

1.5 = x/300,000
x= 300,000 x 1.5
x= 450,000
DSO = Receivables/annual sale/ 36.5

36.5 = x/450,00/36.5
36.5 = x/1232.87

x = 1232.87 (36.5)
x = 44,999.75 or 45,000

Gross Profit Margin on Sales = Sales-COGS/sales

0.25 = 450, 000-x/450,000

450,000 – x = 450,000 (0.25)
-x = 112,500 – 450,000
-x/1 = -337,500/1
X= 337,500

Inventory Turnover Ratio = Sales/Inventories

5 = 450,00/x
5(x) = 450,000
5x/5 =450,00/5
X=90,000

Current ratio = Current Assets/Current liabilities

1.8 = x/90,00
x= 90,000 (1.8)
x=162,000

Wooooooooaaah! Guess
you’ve drained your energy, haven’t you?
But you did well and congratulations for
that. For now, take some rest and prepare
for the Lesson 3.
 Trend Analysis and the DuPont Equation

Introduction

It’s now time for Lesson 3. In here, you will be learning about Trend Analysis and DuPont
Equation. This is another concept in analyzing financial statements data so that financial decisions can
be derived. I hope you are still purposely driven and inspired to learn.

Activity

1. Discuss your idea about Trend Analysis.

Your answer:
Trend Analysis is an analysis of a company's monetary proportions after some time. It is
imperative to investigate patterns in proportions just as their outright levels, for patterns give hints
concerning whether a company's monetary condition is probably going to improve or to weaken. trend
examination is useful on the grounds that moving with patterns, and not against them, will prompt
benefit for a speculator.

Analysis

1. How do you think is trend analysis important in making investment decisions?

Your answer:
Trend analysis is significant inside the exchange and cash related divisions. trend analysis is
every now and again used to make projections and evaluations of monetary well-being. Monetary
examiners take a gander at the past presentation of their organization, alongside the current monetary
conditions, to decide how their organization will act later.
Abstraction

Trend Analysis is an analysis of a firm’s financial ratios over time. It is important to analyze
trends in ratios as well as their absolute levels, for trends give clues as to whether a firm’s financial
condition is likely to improve or to deteriorate. To do a trend analysis, simply plot a ratio over time.

The figure below shows an example in of a Trend Analysis with respect to a Company’s Return
on Equity (ROE) overtime.
 You can see in the illustration that the Company’s ROE has increased in 2005 and is above the
Industry’s average for years 2004 and 2005. However, beginning 2006 up to 2008, the firm’s ROE has
been declining and has started to drop below the industry average.
The above-mentioned analysis is very important in making investments decisions. Examples
are:
 Whether you will invest in the said Company
 Whether you will put up your own Company and join the same
industry

The DuPont Equation is a useful technique used to decompose the different drivers of return on
equity (ROE). The decomposition of ROE allows investors to focus on the key metrics of financial
performance individually to identify strengths and weaknesses.
There are three major financial metrics that drive return on equity (ROE): operating efficiency,
asset use efficiency and financial leverage. Operating efficiency is represented by net profit margin or
net income divided by total sales or revenue. Asset use efficiency is measured by the asset turnover
ratio. Leverage is measured by the equity multiplier, which is equal to average assets divided by
average equity. Thus, a DuPont Equation is a formula that shows that the rate of return on equity can
be found as the product of profit margin, total assets turnover, and the equity multiplier. It shows the
relationships among asset management, debt management, and profitability ratios.
The DuPont Equation:

ROE = (Profit Margin) x (Total Asset Turnover) x (Equity Multiplier)

= (Net Income / Sales) x (Net Sales / Average Total Assets) x ( Ave. Total Asset / Ave. Equity)
 To continue the illustration in Lesson 2, the DuPont Equation can be computed as follows:

ROE = (117.5 / 3,000) x [3,000 / {(2,000+1,680) / 2}] x [{(2,000+1,680) / 2} / {(940+880) / 2}]

= 3.92% x 1.63 x 2.02
= 12.9%
As you can see, the DuPont Equation shows the same ROE as computed in Lesson 2.

Application
Doublewide Dealers has an ROA of 10%, a 2% profit margin, and an ROE of 15%.
Compute for the following:
 Total Asset Turnover
 Equity Multiplier

ROA = Net Income / Total Assets

Profit Margin = Net Income / Sales
Total asset turnover = Sales / Total Assets

TAT = ROA x (1 / profit margin)

TAT = 0.1 x (1/0.02)
TAT = 0.1 x 50
Total Assets Turnover = 5
ROE = Profit Margin x Total assets turnover x Equity multiplier
0.15 = 0.02 x 5 x EM
0.15 = 0.1 x EM
0.15 x 0.1 = Equity multiplier
EM = 0.015 x 100
Equity Multiplier = 1.5
Assessment

Ebersoll Mining has $6 million in sales, its ROE is 12%, and its total assets turnover is 3.2×.
The company is 50% equity financed. Compute for the Net Income.

Total Assets Turnover = Sales / Total Assets

3.2x = $6M / Total Assets
Total Assets = $6M / 3.2x
Total Assets = $ 1, 875, 000

Equity = 50% of Total Assets

= 0.5 x $ 1,875,000
Equity = $ 937, 500

ROE = Net Income / Total Equity

Net Income = ROE x Total Equity
= 12% x $937,500
Net Income = 0.12 x $937,500
Net Income = $12,500

Finally, you are done with Module 3. It was

tough, right? Congratulations for sustaining
thus far. Please make sure to review your
lessons to insure thorough understanding.
Module Summary

Key points covered in the module 3 include the following:

 Financial statements are written records that convey the business activities and the
financial performance of a company.
 The objective of general purpose financial statements is to provide information about
the financial position, financial performance, and cash flows of an entity that is useful to
a wide range of users in making economic decisions.
 Statement of Financial Position, also known as the Balance Sheet, presents the
financial position of an entity at a given date. It is comprised of three main components:
assets, liabilities and equity.
 Statement of Financial Performance, also known as the Income Statement, presents
the financial performance of an entity for a given period. It also known as the profit and
loss statement for it shows the entity’s net income or loss. The details of the entity’s
revenues (income) and expenses are presented in this statement.
 Cash Flow Statement is a report that shows how things that affect the balance sheet
and income statement affect the firm’s cash flows
 Statement of Changes in Shareholders’ Equity details the change in shareholders’
equity over an accounting period by presenting the movement in reserves comprising
the shareholders’ equity.
 Notes to Financial Statements are supplementary notes that include explanations of
various activities, additional detail on some accounts, and other items as mandated by
the applicable accounting framework and standards.
 The ratio analysis is the most powerful tool of financial statement analysis.
 Liquidity ratios, which give us an idea of the firm’s ability to pay off debts that are
maturing within a year.
 Asset management ratios, which give us an idea of how efficiently the firm is using its
assets.
 Debt management ratios, which give us an idea of how the firm has financed its assets
as well as the firm’s ability to repay its long-term debt.
 Profitability ratios, which give us an idea of how profitably the firm is operating and
utilizing its assets.
 Market value ratios, which bring in the stock price and give us an idea of what
investors think about the firm and its future prospects.
 Trend Analysis is an analysis of a firm’s financial ratios over time. It is important to
analyze trends in ratios as well as their absolute levels, for trends give clues as to
whether a firm’s financial condition is likely to improve or to deteriorate. To do a trend
analysis, simply plot a ratio over time.
 The DuPont Equation is a useful technique used to decompose the different drivers of
return on equity (ROE). The decomposition of ROE allows investors to focus on the
key metrics of financial performance individually to identify strengths and weaknesses.