A B C D E F

1 Tool Kit Chapter 3 9/11/2017

2
3 Analysis of Financial Statements
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5
Financial statements are analyzed by calculating certain key ratios and then comparing them with the
6 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.
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8
9 3-1 Financial Analysis
10
11 Input Data:
12 2016 2015
13 Year-end common stock price $27.00 $40.00
14 Year-end shares outstanding (in millions) 50 50
15 Tax rate 40% 40%
16 After-tax cost of capital 11.0% 10.5%
17 Lease payments $28 $28
18 Required sinking fund payments $20 $20
19
20 Figure 3-1
21 MicroDrive Inc. Balance Sheets and Income Statements for Years Ending December 31
22 (Millions of Dollars, Except for Per Share Data)
23 Balance Sheets 2016 2015
24 Assets
25 Cash and equivalents $ 50 $ 60
26 Short-term investments - 40
27 Accounts receivable 500 380
28 Inventories 1,000 820
29 Total current assets $ 1,550 $ 1,300
30 Net plant and equipment 2,000 1,700
31 Total assets $ 3,550 $ 3,000
32
33 Liabilities and Equity
34 Accounts payable $ 200 $ 190
35 Notes payable 280 130
36 Accruals 300 280
37 Total current liabilities $ 780 $ 600
38 Long-term bonds 1,200 1,000
39 Total liabilities $ 1,980 $ 1,600
40 Preferred stock (400,000 shares) 100 100
41 Common stock (50,000,000 shares) 500 500
42 Retained earnings 970 800
43 Total common equity $ 1,470 $ 1,300
44 Total liabilities and equity $ 3,550 $ 3,000
45
46 Income Statements 2016 2015
47 Net sales $ 5,000 $ 4,760
48 Costs of goods sold except depreciation 3,800 3,560
49 Depreciation 200 170
50 Other operating expenses 500 480
51 Earnings before interest and taxes (EBIT) $ 500 $ 550
52 Less interest 120 100
 A B C D E F
53 Pre-tax earnings $ 380 $ 450
54 Taxes (40%) 152 180
55 Net income before preferred dividends $ 228 $ 270
56 Preferred dividends 8 8
57 Net income available to common stockholders $ 220 $ 262
58 Other Data
59 Common dividends $50 $48
60 Addition to retained earnings $170 $214
61 Lease payments $28 $28
62 Bonds' required sinking fund payments $20 $20
63 Common stock price per share $27 $40
64
 A B C D E F
65
66 Calculated Data: Operating Performance and Cash Flows
67 2016 2015
68 Net operating working capital (NOWC) = $1,050 $790
69 Total net operating capital = $3,050 $2,490
70 Net operating profit after taxes (NOPAT) = $300 $330
71 Operating profitability (OP) ratio = NOPAT/Sales = 6.00% 6.93%
Capital requirement(CR) ratio = (Total net operating capital/Sales) =
72 61.00% 52.31%
Return on invested capital (ROIC) = NOPAT/Total net operating capital =
73 9.8% 13.3%
Free cash flow (FCF) = NOPAT − Net investment in operating capital =
74 -$260 N/A
75 Net cash flow = Net income + Depreciation = $ 420 $432
Earnings before interest, taxes, depreciation & amortization (EBITDA) = EBIT +
76 Depreciation & amortization =
$700 $720
77 Market capitalization (# shares x price per share) $1,350 $2,000
78
79 Calculated Data: Per-share Information
80 2016 2015
81 Earnings per share (EPS) $4.40 $5.24
82 Dividends per share (DPS) $1.00 $0.96
83 Book value per share (BVPS) $29.40 $26.00
84 Cash flow per share (CFPS) $8.40 $8.64
85 EDITDA per share $14.00 $14.40
86 Free cash flow per share (FCFPS) -$5.20 N/A
87
88 3-2 Liquidity Ratios Industry
89 2016 2015 Average
90 Liquidity ratios
91 Current Ratio = CA/CL 2.0 2.2 2.2
92 Quick Ratio = (CA - Inventories)/CL 0.7 0.8 0.8
93
94 3-3 Asset Management Ratios Industry
95 2016 2015 Average
96 Asset Management ratios
97 Total Asset Turnover = Sales/TA 1.4 1.6 1.8
98 Fixed Asset Turnover = Sales/Fixed assets 2.5 2.8 3.0
99 Days Sales Outstanding = Accounts receivable/Daily sales 36.5 29.1 30.0
100 Inventory Turnover = COGS/Inventories 4.0 4.5 5.0
101
102 3-4 Debt Management Ratios Industry
103 2016 2015 Average
104 Debt Management ratios
105 Debt Ratio = Debt-to-Assets Ratio = Total debt/TA 41.7% 37.7% 25.0%
106 Debt-to-Equity Ratio = Total debt/Total common equity 1.01 0.87 0.46
107 Market Debt Ratio = Total debt/(Total debt + Market Cap) 52.3% 36.1% 20.0%
108 Liabilities-to-Assets Ratio = TL/TA 55.8% 53.3% 45.0%
109 Times Interest Earned = EBIT/Interest expense 4.2 5.5 10.0

110 EBITDA Coverage Ratio =

(EBIT + Depreciation + Lease pmt)
(Interest + Principal pmt + Lease pmt) 4.3 5.1 12.0
111
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112 3-5 Profitability Ratios Industry
113 2016 2015 Average
114 Profitability ratios
115 Profit Margin = Net income/Sales 4.4% 5.5% 6.2%
116 Basic Earning Power = EBIT/TA 14.1% 18.3% 20.2%
117 Return on Assets = Net income/TA 6.2% 8.7% 11.0%
118 Return on Equity = Net income/Total common equity 15.0% 20.2% 19.0%
119
120 3-6 Market Value Ratios Industry
121 2016 2015 Average
122 Market Value ratios
123 Price-to Earnings Ratio = Price/(Net income/# shares) 6.1 7.6 10.5

124 Price-to-Cash Flow Ratio =

Price
(Net income + Depreciation)/# shares 3.2 4.6 6.3

125 Price-to-EBITDA Ratio =

Price
(EBIT + Depreciation)/# shares 1.9 2.8 4.0
126 Market-to-Book Ratio = Price/(Total common equity/#shares) 0.9 1.5 1.8
127 Market-to-Book Ratio = (Price x #shares)/(Total common equity 0.9 1.5 1.8
128
129 3-7 Trend Analysis, Common Size Analysis, and Percentage Change Analysis
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131 TREND ANALYSIS
Trend analysis allows you to see how a firm's results are changing over time. For instance, a firm's ROE may be slightly below
132 the benchmark, but if it has been steadily rising over the past four years, that should be seen as a good sign.
133
A trend analysis and graph have been constructed on this data regarding MicroDrive's ROE over the past 5 years.
134 (MicroDrive and indusry average data for earlier years has been provided.)

135
136 ROE
137 MicroDrive Industry
138 2012 15.0% 14.0%
139 2013 18.0% 15.0%
140 2014 21.0% 18.0%
141 2015 20.2% 17.0%
142 2016 15.0% 19.0%
143
144 Figure 3-2
145 MicroDrive, Inc.: Return on Common Equity
146
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148 ROE
149 (%)
150 22.0%
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152 20.0%
153 18.0%
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155 16.0%
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
2012 2013 2014 2015 2016
 ROE
(%)
22.0%
20.0%
18.0%
A
16.0% B C D E F
156
14.0%
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158 12.0%
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160 10.0%
161 8.0%
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163 6.0%
164 4.0%
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166 2.0%
167 0.0%
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2012 2013 2014 2015 2016
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 A B C D E F
172 COMMON SIZE ANALYSIS
173 In common size income statements, all items for a year are divided by the sales for that year.
174
175 Figure 3-3
MicroDrive Inc.: Common Size Income Statements
176
177 Industry
178 Composite MicroDrive
179 2016 2016 2015
180 Net sales 100.0% 100.0% 100.0%
181 Costs of goods sold except depreciation 75.5% 76.0% 74.8%
182 Depreciation 3.0% 4.0% 3.6%
183 Other operating expenses 10.0% 10.0% 10.1%
184 Earnings before interest and taxes (EBIT) 11.5% 10.0% 11.6%
185 Less interest 1.2% 2.4% 2.1%
186 Pre-tax earnings 10.4% 7.6% 9.5%
187 Taxes (40%) 4.1% 3.0% 3.8%
188 Net income before preferred dividends 6.2% 4.6% 5.7%
189 Preferred dividends 0.0% 0.2% 0.2%
190 Net income available to common stockholders 6.2% 4.4% 5.5%
191
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193 In common sheets, all items for a year are divided by the total assets for that year.
194
195 Figure 3-4
196 MicroDrive Inc.: Common Size Balance Sheets
197 Industry
198 Composite MicroDrive
199 2016 2016 2015
200 Assets
201 Cash and equivalents 1.8% 1.4% 2.0%
202 Short-term investments 0.0% 0.0% 1.3%
203 Accounts receivable 14.0% 14.1% 12.7%
204 Inventories 26.3% 28.2% 27.3%
205 Total current assets 42.1% 43.7% 43.3%
206 Net plant and equipment 57.9% 56.3% 56.7%
207 Total assets 100.0% 100.0% 100.0%
208
209 Liabilities and Equity
210 Accounts payable 7.0% 5.6% 6.3%
211 Notes payable 0.0% 7.9% 4.3%
212 Accruals 12.3% 8.5% 9.3%
213 Total current liabilities 19.3% 22.0% 20.0%
214 Long-term bonds 25.4% 33.8% 33.3%
215 Total liabilities 44.7% 55.8% 53.3%
216 Preferred stock 0.0% 2.8% 3.3%
217 Total common equity 55.3% 41.4% 43.3%
218 Total liabilities and equity 100.0% 100.0% 100.0%
219
220
221 PERCENT CHANGE ANALYSIS
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 A B C D E F
223 In percent change analysis, all items are divided by the that item's value in the beginning, or base, year.
224
225 Figure 3-5
226 MicroDrive Inc.: Income Statement Percent Change Analysis
227 Base year = 2015 Percent
228 Change in
229 2016
230 Net sales 5.0%
231 Costs of goods sold except depreciation 6.7%
232 Depreciation 17.6%
233 Other operating expenses 4.2%
234 Earnings before interest and taxes (EBIT) (9.1%)
235 Less interest 20.0%
236 Pre-tax earnings (15.6%)
237 Taxes (40%) (15.6%)
238 Net income before preferred dividends (15.6%)
239 Preferred dividends 0.0%
240 Net income available to common stockholders (16.0%)
241
242
243
244
245 MicroDrive, Inc.: Balance Sheet Percent Change Analysis (not in textbook)
Percent
246 Base year = 2015 Change in
247 2016
248 Assets
249 Cash and equivalents (16.7%)
250 Short-term investments (100.0%)
251 Accounts receivable 31.6%
252 Inventories 22.0%
253 Total current assets 19.2%
254 Net plant and equipment 17.6%
255 Total assets 18.3%
256
257 Liabilities and Equity
258 Accounts payable 5.3%
259 Notes payable 115.4%
260 Accruals 7.1%
261 Total current liabilities 30.0%
262 Long-term bonds 20.0%
263 Total liabilities 23.8%
264 Preferred stock (400,000 shares) 0.0%
265 Common stock (50,000,000 shares) 0.0%
266 Retained earnings 21.3%
267 Total common equity 13.1%
268 Total liabilities and equity 18.3%
269
270
271 3-8 DuPont Analysis
Profit margin TA Equity
272 ROE = x turnover x multiplier
273 MicroDrive 2016 15.0% 4.40% 1.41 2.415
274 MicroDrive 2015 20.2% 5.50% 1.59 2.308
 A B C D E F
275 Industry Average 20.3% 6.20% 1.80 1.818
276
277 Suppose MicroDrive can improve its total asset turnover ratio.
278
279 Improved TA turover ratio = 1.8
280
281 Profit margin TA Equity
ROE = x turnover x multiplier
282 19.1% 4.40% 1.80 2.415
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For instance, a firm's ROE may be slightly below
132
hould be seen as a good sign.
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oDrive's ROE over the past 5 years.
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SECTION 3-2
SOLUTIONS TO SELF-TEST

Morris Corporation has the following information on its balance sheets: Cash = $40, accounts receivable = $30,
inventories = $100, net fixed asset = $500, accounts payable = $20, accruals = $10, short-term debt (matures in less
than a year) = $25, long-term debt = $200, and total common equity = $415. What is its current ratio? Its quick
ratio?

Cash $40
Accounts receivable $30
Inventories $100
Net fixed assets $500
Total $670
Accounts payable $20
Accruals $10
ST debt $25
LT debt $200
Total common equity $415
$670

Current assets $170

Current liabilities $55

Current ratio 3.1

Current assets − Inventories $70

Current liabilities $55

Quick ratio 1.3

A 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) $800

Current ratio 2.5

Current assets ($M) $2,000

Current liabilities ($M) $800

Current ratio 2.5
Quick ratio 2

Current assets - Inventories ($M) $1,600

Inventories ($M) $400
SECTION 3-3
SOLUTIONS TO SELF-TEST
Morris Corporation has the following information on its balance sheets: Cash = $40, accounts receivable = $30, inventories =
$100, net fixed asset = $500, accounts payable = $20, accruals = $10, short-term debt (matures in less than a year) = $25,
long-term debt = $200, and total common equity = $415. Its income statement reports: Sales = $820, costs of goods sold
(excluding depreciation) = $450, depreciation = $50, other operating expenses = $100, interest expense = $20, and tax rate =
40%. Calculate the following ratios: total assets turnover, fixed assets turnover, days sales outstanding (based on a 365 day
year), inventory turnover. Hint: This is the same company used in the previous Self-Test.

Cash $40
Accounts receivable $30
Inventories $100
Net fixed assets $500
Total assets $670
Accounts payable $20
Accruals $10
ST debt $25
LT debt $200
Total common equity $415
$670

Sales $820
COGS (excluding depreciation) $450
Depreciation $50
Other operating expenses $100
EBIT $220
Interest expense $20
Pre-tax earnings $200
Tax rate 40%
Tax expense $80
Net income $120
Days in year 365

Sales $820
Total assets $670

Total assets turnover 1.2

Sales $820
Fixed assets $500

Fixed assets turnover 1.6

Daily average sales $2.25

Accounts receivable $30

Days sales outstanding 13.4

COGS including depreciation $500

Inventories $100

Fixed assets turnover 5.0

A firm has $200 million annual sales, $180 million costs of goods sold, $40 million of inventory, and $60 million of accounts
receivable. What is its inventory turnover ratio?
Annual Sales ($M) $200
Costs of good sold ($M) $180
Inventory ($M) $40
Accounts receivable ($M) $60

Inventory turnover 4.5

Annual Sales ($M) $200

Inventory ($M) $40
Accounts receivable ($M) $60

Days sales outstanding 109.5

SECTION 3-4
SOLUTIONS TO SELF-TEST

Morris Corporation has the following information on its balance sheets: Cash = $40, accounts receivable = $30,
inventories = $100, net fixed asset = $500, accounts payable = $20, accruals = $10, short-term debt (matures in
less than a year) = $25, long-term debt = $200, and total common equity = $415. Its income statement reports:
Sales = $820, costs of goods sold (excluding depreciation) = $450, depreciation = $50, other operating expenses =
$100, interest expense = $20, and tax rate = 40%. Calculate the following ratios: total assets turnover, fixed
assets turnover, days sales outstanding (based on a 365 day year), inventory turnover. Hint: This is the same
company used in the previous Self-Test.

Cash $40
Accounts receivable $30
Inventories $100
Net fixed assets $500
Total assets $670
Accounts payable $20
Accruals $10
ST debt $25
LT debt $200
Total common equity $415
$670

Sales $820
COGS (excluding depreciation) $450
Depreciation $50
Other operating expenses $100
EBIT $220
Interest expense $20
Pre-tax earnings $200
Tax rate 40%
Tax expense $80
Net income $120
Days in year 365
Lease payments $0
Required principal payments $0

Total debt $225

Total assets $670

Debt-to-assets ratio 33.6%

Total debt $225

Total common equity $415

Debt-to-equity ratio 54.2%

Total liabilities $255

Total assets $670

Liabilities-to-assets ratio 38.1%

EBIT $220
Interest expense $20

Times-interest-earned ratio 11.0

Suppose the previous company has 100 shares of stock with a price of $15 per share. What is its market debt
ratio (assume the market value of debt is close to the book value)? How does this compare with the previously
calculated debt-to-assets ratio? Does the market debt ratio imply that the company is more or less risky than the
debt-to-assets ratio indicated?

Number of shares 100

Price per share $15

Total debt $225

Market value of equity $1,500

Market debt ratio 13.0%

Notice that the market debt ratio is much less than the debt ratio based on book values, implying that the firm is
less risky than indicated by the ratio based on book values.

A 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) $600

Interest payments $60
Lease payments $40
Principal payments $30

EBITDA coverage 4.9

SECTION 3-5
SOLUTIONS TO SELF-TEST

Morris Corporation has the following information on its balance sheets: Cash = $40, accounts receivable = $30,
inventories = $100, net fixed asset = $500, accounts payable = $20, accruals = $10, short-term debt (matures in
less than a year) = $25, long-term debt = $200, and total common equity = $415. Its income statement reports:
Sales = $820, costs of goods sold (excluding depreciation) = $450, depreciation = $50, other operating expenses =
$100, interest expense = $20, and tax rate = 40%. Calculate the following ratios: total assets turnover, fixed
assets turnover, days sales outstanding (based on a 365 day year), inventory turnover. Hint: This is the same
company used in the previous Self-Test.

Cash $40
Accounts receivable $30
Inventories $100
Net fixed assets $500
Total assets $670
Accounts payable $20
Accruals $10
ST debt $25
LT debt $200
Total common equity $415
$670

Sales $820
COGS (excluding depreciation) $450
Depreciation $50
Other operating expenses $100
EBIT $220
Interest expense $20
Pre-tax earnings $200
Tax rate 40%
Tax expense $80
Net income $120

Net income $120

Sales $820

Net profit margin 14.6%

EBIT $220
Sales $820

Operating profit margin 26.8%

EBIT $220
Total assets $670

Basic earnings power ratio 32.8%

Net income $120

Total assets $670

Return on total assets 17.9%

Net income $120

Total common equity $415

Return on common equity 28.9%

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) $200

Net income ($B) $10
Total assets ($B) $100
Debt ratio 50%

Profit margin 5.00%

Sales ($B) $200

Net income ($B) $10
Total assets ($B) $100
Debt ratio 50%

ROA 10.00%

Sales ($B) $200

Net income ($B) $10
Total assets ($B) $100
Debt ratio 50%

ROE 20.00%
SECTION 3-6
SOLUTIONS 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) $6

Amortization and depreciation ($B) $2
Common equity $80
Number of shares ($B) 1
Stock price per share $96

Earnings per share $6

P/E ratio 16.00

Cash flow $8.00

Cash flow per share 8.00
Price/cash flow 12.00

Book value per share 80.00

Market/Book 1.20
SECTION 3-8
SOLUTIONS 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 margin 6.0%

Total asset turnover 2.0
Equity multiplier 1.5

ROE 18.0%
 9/11/2017
Mini Case Data
Input Data:
2014 2015 2016
Year-end common stock price $8.50 $6.00 $12.17
Year-end shares outstanding 100,000 100,000 250,000
Tax rate 40% 40% 40%
Lease payments $40,000 $40,000 $40,000

Balance Sheets

Assets 2014 2015 2016

Cash and equivalents $9,000 $7,282 $14,000
Short-term investments $48,600 $20,000 $71,632
Accounts receivable $351,200 $632,160 $878,000
Inventories $715,200 $1,287,360 $1,716,480
Total current assets $1,124,000 $1,946,802 $2,680,112
Gross Fixed Assets $491,000 $1,202,950 $1,220,000
Less Accumulated Dep. $146,200 $263,160 $383,160
Net Fixed Assets $344,800 $939,790 $836,840
Total Assets $1,468,800 $2,886,592 $3,516,952

Liabilities and Equity

Accounts payable $145,600 $324,000 $359,800
Notes payable $200,000 $720,000 $300,000
Accruals $136,000 $284,960 $380,000
Total current liabilities $481,600 $1,328,960 $1,039,800
Long-term bonds $323,432 $1,000,000 $500,000
Total liabilities $805,032 $2,328,960 $1,539,800
Common stock (100,000 shares) $460,000 $460,000 $1,680,936
Retained earnings $203,768 $97,632 $296,216
Total common equity $663,768 $557,632 $1,977,152
Total liabilities and equity $1,468,800 $2,886,592 $3,516,952

Income Statements

2014 2015 2016

Net sales $3,432,000 $5,834,400 $7,035,600
Costs of Goods Sold Except Depr. $2,864,000 $4,980,000 $5,800,000
Depreciation and amortization $18,900 $116,960 $120,000
Other Expenses $340,000 $720,000 $612,960
Total Operating Cost $3,222,900 $5,816,960 $6,532,960
Earnings before interest and taxes (EBIT) $209,100 $17,440 $502,640
Less interest $62,500 $176,000 $80,000
Pre-tax earnings $146,600 ($158,560) $422,640
Taxes (40%) $58,640 ($63,424) $169,056
Net Income before preferred dividends $87,960 ($95,136) $253,584
EPS $0.880 ($0.951) $1.014
DPS $0.220 $0.110 $0.220
Book Value Per Share $6.638 $5.576 $7.909