MODULE 2

Financial Statements and Ratio

Analysis
Learning Outcomes

1 Review the contents of the stockholders’ report and

the procedures for consolidating international
financial statements.

2 Identify who uses financial ratios and how.

3 Use ratios to analyze a firm’s liquidity and activity.

Learning Goals (cont.)

4 Discuss the relationship between debt and financial

leverage and the ratios used to analyze a firm’s
debt.

5 Use ratios to analyze a firm’s profitability and its

market value.

6 Use a summary of financial ratios and the DuPont

system of analysis to perform a complete ratio
analysis.
The Stockholders’ Report

• Generally accepted accounting principles

(GAAP) are the practice and procedure guidelines
used to prepare and maintain financial records and
reports; authorized by the Financial Accounting
Standards Board (FASB).
The Stockholders’ Report (cont.)

• The Sarbanes-Oxley Act of 2002, passed to

eliminate the many disclosure and conflict of
interest problems of corporations, established the
Public Company Accounting Oversight Board
(PCAOB), which is a not-for-profit corporation that
overseas auditors.
• The PCAOB is charged with protecting the interests
of investors and furthering the public interest in the
preparation of informative, fair, and independent
audit reports.
Global Focus

• More Countries Adopt International Financial

Reporting Standards
– International Financial Reporting Standards (IFRS) are
established by the International Accounting Standards
Board (IASB).
– More than 80 countries now require listed firms to comply
with IFRS, and dozens more permit or require firms to
follow IFRS to some degree.
– In the United States, public companies are required to
report financial results using GAAP, which requires more
detail than IFRS.
• What costs and benefits might be associated with a
switch to IFRS in the United States?
Focus on Ethics

• Take Earnings Reports at Face Value

– Near the end of each quarter, many companies unveil their
quarterly performance.
– Firms that beat analyst estimates often see their share
prices jump, while those that miss estimates by even a
small amount, tend to suffer price declines.
– The practice of manipulating earnings in order to mislead
investors is known as earnings management.
• Why might financial managers be tempted to
manage earnings?
• Is it unethical for managers to manage earnings if
they disclose their activities to investors?
The Four Key Financial Statements: The
Income Statement
• The income statement provides a financial
summary of a company’s operating results during a
specified period.
• Although they are prepared quarterly for reporting
purposes, they are generally computed monthly by
management and quarterly for tax purposes.
Table 3.1 Bartlett Company Income
Statements ($000)
Personal Finance Example
The Four Key Financial Statements: The
Balance Sheet
• The balance sheet presents a summary of a firm’s
financial position at a given point in time.
• The statement balances the firm’s assets (what it
owns) against its financing, which can be either
debt (what it owes) or equity (what was provided
by owners).
Table 3.2 Bartlett Company Balance
Sheets ($000)
Table 3.2 Bartlett Company Balance
Sheets ($000) (cont.)
Personal Finance Example
The Four Key Financial Statements:
Statement of Retained Earnings
• The statement of retained earnings reconciles
the net income earned during a given year, and any
cash dividends paid, with the change in retained
earnings between the start and the end of that
year.
Table 3.3 Bartlett Company Statement of
Retained Earnings ($000) for the Year
Ended December 31, 2015
The Four Key Financial Statements:
Statement of Cash Flows
• The statement of cash flows provides a summary
of the firm’s operating, investment, and financing
cash flows and reconciles them with changes in its
cash and marketable securities during the period.
• This statement not only provides insight into a
company’s investment, financing and operating
activities, but also ties together the income
statement and previous and current balance sheets.
Table 3.4 Bartlett Company Statement of Cash
Flows ($000) for the Year Ended December 31,
2015
Consolidating International Financial
Statements
• FASB 52 mandates that U.S.-based companies
translate their foreign-currency-denominated assets
and liabilities into dollars, for consolidation with the
parent company’s financial statements. This is done
by using the current rate (translation) method.
• The current rate (translation) method is a
technique used by U.S.-based companies to
translate their foreign-currency-denominated assets
and liabilities into dollars, for consolidation with the
parent company’s financial statements, using the
year-end (current) exchange rate.
• Income statement items (revenues and expenses)
are usually treated similarly.
Consolidating International Financial
Statements (cont.)
• Equity accounts, on the other hand, are translated
into dollars by using the exchange rate that
prevailed when the parent’s equity investment was
made (the historical rate).
• Retained earnings are adjusted to reflect each
year’s operating profits (or losses).
Using Financial Ratios:
Interested Parties
• Ratio analysis involves methods of calculating and
interpreting financial ratios to analyze and monitor
the firm’s performance.
• Interested parties:
• Current and prospective shareholders are interested in the
firm’s current and future level of risk and return, which
directly affect share price.
• Creditors are interested in the short-term liquidity of the
company and its ability to make interest and principal
payments.
• Management is concerned with all aspects of the firm’s
financial situation, and it attempts to produce financial
ratios that will be considered favorable by both owners and
creditors.
Using Financial Ratios:
Types of Ratio Comparisons
• Cross-sectional analysis is the comparison of
different firms’ financial ratios at the same point in
time; involves comparing the firm’s ratios to those
of other firms in its industry or to industry averages
• Benchmarking is a type of cross-sectional analysis
in which the firm’s ratio values are compared to
those of a key competitor or group of competitors
that it wishes to emulate.
• Comparison to industry averages is also popular, as
in the following example.
Using Financial Ratios:
Types of Ratio Comparisons (cont.)
• Caldwell Manufacturing’s calculated inventory
turnover for 2015 and the average inventory
turnover were as follows:

Inventory turnover, 2015

Caldwell Manufacturing 14.8
Industry average 9.7
Table 3.5 Financial Ratios for Select Firms
and Their Industry Median Values
Using Financial Ratios: Types of Ratio
Comparisons (cont.)
• Time-series analysis is the evaluation of the
firm’s financial performance over time using
financial ratio analysis
• Comparison of current to past performance, using
ratios, enables analysts to assess the firm’s
progress.
• Developing trends can be seen by using multiyear
comparisons.
• The most informative approach to ratio analysis
combines cross-sectional and time-series analyses.
Figure 3.1 Combined Analysis
Using Financial Ratios: Cautions about
Using Ratio Analysis
1. Ratios that reveal large deviations from the norm
merely indicate the possibility of a problem.
2. A single ratio does not generally provide sufficient
information from which to judge the overall
performance of the firm.
3. The ratios being compared should be calculated
using financial statements dated at the same point
in time during the year.
4. It is preferable to use audited financial statements.
5. The financial data being compared should have
been developed in the same way.
6. Results can be distorted by inflation.
Ratio Analysis Example

• We will illustrate the use of financial ratios for

analyzing financial statements using the Bartlett
Company Income Statements and Balance Sheets
presented earlier in Tables 3.1 and 3.2.
Liquidity Ratios

The current ratio measures the ability of the firm

to meet its short-term obligations.

Current ratio = Current assets ÷ Current liabilities

The current ratio for Bartlett Company in 2015 is:

$1,223,000 ÷ $620,000 = 1.97

Matter of Fact

Determinants of Liquidity Needs

– Large enterprises generally have well established
relationships with banks that can provide lines of credit and
other short-term loan products in the event that the firm
has a need for liquidity.
– Smaller firms may not have the same access to credit, and
therefore they tend to operate with more liquidity.
Personal Finance Example

• The personal liquidity ratio is calculated by dividing

total liquid assets by total current debt. It indicates
the percent of annual debt obligations that an
individual can meet using current liquid assets.
• Calculate Jan and Jon Smith’s liquidity ratio for
calendar year 2015:
Liquidity ratio = ($2,225/$21,539) = 0.1033, or 10.3%
• That ratio indicates that the Smiths can cover only
about 10 percent of their existing 1-year debt
obligations with their current liquid assets.
Liquidity Ratios (cont.)

The quick (acid-test) ratio excludes inventory,

which is generally the least liquid current asset.

The quick ratio for Bartlett Company in 2015 is:

Matter of Fact

The importance of inventories:

– From Table 3.5:

Company Current ratio Quick ratio

Dell 1.3 1.2
Home Depot 1.3 0.4
Lowes 1.3 0.2

– All three firms have current ratios of 1.3. However, the

quick ratios for Home Depot and Lowes are dramatically
lower than their current ratios, but for Dell the two ratios
are nearly the same. Why?
Activity Ratios

Inventory turnover measures the activity, or liquidity,

of a firm’s inventory.

Inventory turnover = Cost of goods sold ÷ Inventory

Applying this relationship to Bartlett Company in 2015

yields:

$2,088,000 ÷ $289,000 = 7.2

Activity Ratios (cont.)

The average age of inventory is the average

number of days’ sales in inventory.

Average Age of Inventory = 365 ÷ Inventory turnover

For Bartlett Company, the average age of inventory in 2015

is:

365 ÷ 7.2 = 50.7 days

Activity Ratios (cont.)

The average collection period is the average

amount of time needed to collect accounts receivable.

– The average collection period for Bartlett Company in 2015

is:
Matter of Fact

Who Gets Credit?

– Notice in Table 3.5 the vast differences across industries in
the average collection periods.
– Companies in the building materials, grocery, and
merchandise store industries collect in just a few days,
whereas firms in the computer industry take roughly two
months to collect on their sales.
– The difference is primarily due to the fact that these
industries serve very different customers.
Activity Ratios (cont.)

The average payment period is the average amount

of time needed to pay accounts payable.

– If we assume that Bartlett Company’s purchases equaled

70 percent of its cost of goods sold in 2015, its average
payment period is:
Activity Ratios (cont.)

Total asset turnover indicates the efficiency with

which the firm uses its assets to generate sales.

– Total asset turnover = Sales ÷ Total assets

The value of Bartlett Company’s total asset turnover in

2015 is:

$3,074,000 ÷ $3,597,000 = 0.85

Matter of Fact

Sell It Fast
– Observe in Table 3.5 that the grocery business turns over
assets faster than any of the other industries listed.
– That makes sense because inventory is among the most
valuable assets held by these firms, and grocery stores
have to sell baked goods, dairy products, and produce
quickly or throw them away when they spoil.
– On average, a grocery stores has to replace its entire
inventory in just a few days or weeks, and that contributes
to the rapid turnover of the firms total assets.
Example 3.5

• Patty Akers in incorporating her new business. She

needs an initial investment of $50,000. She is
considering a no-debt plan, under which she would
invest the full amount without borrowing. The
second option, the debt plan, involves investing
$25,000 and balancing the remainder at 12%.
• Patty expects $30,000 in sales and $18,000 in
operating expenses and has a tax rate of 40%.
Table 3.6 Financial Statements Associated with
Patty’s Alternatives
Debt Ratios

The debt ratio measures the proportion of total

assets financed by the firm’s creditors.

Debt ratio = Total liabilities ÷ Total assets

The debt ratio for Bartlett Company in 2015 is

$1,643,000 ÷ $3,597,000 = 0.457 = 45.7%

Debt Ratios (cont.)

The debt-to-equity ratio measures the relative

proportion of total liabilities and common stock equity
used to finance the firm’s total assets.

Debt to equity = Total liabilities ÷ Common stock equity

The debt-to-equity ratio for Bartlett Company in 2015 is

$1,643,000 ÷ $1,754,000 = 0.937 = 93.7%

Debt Ratios (cont.)

The times interest earned ratio measures the

firm’s ability to make contractual interest payments;
sometimes called the interest coverage ratio.
Times interest earned ratio = EBIT ÷ taxes

The figure for earnings before interest and taxes (EBIT) is

the same as that for operating profits shown in the income
statement.

Applying this ratio to Bartlett Company yields the following

2015 value:

$418,000 ÷ $93,000 = 4.49

Debt Ratios (cont.)

The fixed-payment coverage ratio measures the

firm’s ability to meet all fixed-payment obligations.
Fixed-Payment coverage Ratio (FPCR)

Applying the formula to Bartlett Company’s 2015 data

yields:
Table 3.7 Bartlett Company
Common-Size Income Statements
Profitability Ratios

Gross profit margin measures the percentage of

each sales dollar remaining after the firm has paid for
its goods.

Bartlett Company’s gross profit margin for 2015 is:

Profitabiity Ratios (cont.)

Operating profit margin measures the percentage

of each sales dollar remaining after all costs and
expenses other than interest, taxes, and preferred
stock dividends are deducted.

Operating profit margin = Operating profits ÷ sales

Bartlett Company’s operating profit margin for 2015 is:

$418,000 ÷ $3,074,000 = 13.6%

Profitability Ratios (cont.)

Net profit margin measures the percentage of each

sales dollar remaining after all costs and expenses,
including interest, taxes, and preferred stock
dividends, have been deducted.

Net profit margin = Earnings available for common

stockholders ÷ Sales

Bartlett Company’s net profit margin for 2015 is:

$221,000 ÷ $3,074,000 = 0.072 = 7.2%

Profitability Ratios (cont.)

Earnings per share represents the number of

dollars earned during the period on the behalf of each
outstanding share of common stock.

Bartlett Company’s earnings per share (EPS) in 2015 is:

$221,000 ÷ 76,262 = $2.90

Profitability Ratios (cont.)

The return on total assets measures the overall

effectiveness of management in generating profits
with its available assets.

Return on total assets (ROA) = Earnings available for

common stockholders ÷ Total assets

Bartlett Company’s return on total assets in 2015 is:

$221,000 ÷ $3,597,000 = 0.061 = 6.1%

Profitability Ratios (cont.)

The return on equity measures the return earned on

common stockholders’ investment in the firm.

Return on Equity (ROE) = Earnings available for common

stockholders ÷ Common stock equity

This ratio for Bartlett Company in 2015 is:

$221,000 ÷ $1,754,000 = 0.126 = 12.6%

Market Ratios

The price/earnings (P/E) ratio measures the

amount that investors are willing to pay for each
dollar of a firm’s earnings.

Price Earnings (P/E) Ratio = Market price per share of

common stock ÷ Earnings per share

If Bartlett Company’s common stock at the end of 2015 was

selling at $32.25, using the EPS of $2.90, the P/E ratio at
year-end 2015 is:

$32.25 ÷ $2.90 = 11.12

Market Ratios (cont.)

The market/book (M/B) ratio provides an

assessment of how investors view the firm’s
performance.

where,
Market Ratios (cont.)

• Substituting the appropriate values for Bartlett

Company from its 2015 balance sheet, we get:

• Substituting Bartlett Company’s end of 2015

common stock price of $32.25 and its $23.00 book
value per share of common stock (calculated
above) into the M/B ratio formula, we get:

$32.25 ÷ $23.00 = 1.40

Table 3.8 Summary of Bartlett Company Ratios
(2010–2015, Including 2015 Industry Averages)
Table 3.8 Summary of Bartlett Company Ratios
(2010–2015, Including 2015 Industry Averages)
(Cont.)
DuPont System of Analysis

• The DuPont system of analysis is used to dissect

the firm’s financial statements and to assess its
financial condition.
• It merges the income statement and balance sheet
into two summary measures of profitability.
• The Modified DuPont Formula relates the firm’s ROA
to its ROE using the financial leverage multiplier
(FLM), which is the ratio of total assets to common
stock equity:
• ROA and ROE as shown in the series of equations
on the following slide.
DuPont System of Analysis

• The DuPont system first brings together the net

profit margin, which measures the firm’s
profitability on sales, with its total asset turnover,
which indicates how efficiently the firm has used its
assets to generate sales.
ROA = Net profit margin  Total asset turnover
• Substituting the appropriate formulas into the
equation and simplifying results in the formula
given earlier,
DuPont System of Analysis (cont.)

When the 2015 values of the net profit margin and

total asset turnover for Bartlett Company, calculated
earlier, are substituted into the DuPont formula, the
result is:

ROA = 7.2%  0.85 = 6.1%

DuPont System of Analysis:
Modified DuPont Formula
• The modified DuPont Formula relates the firm’s
return on total assets to its return on common
equity. The latter is calculated by multiplying the
return on total assets (ROA) by the financial
leverage multiplier (FLM), which is the ratio of
total assets to common stock equity:
ROE = ROA  FLM
• Substituting the appropriate formulas into the
equation and simplifying results in the formula
given earlier,
DuPont System of Analysis:
Modified DuPont Formula (cont.)
Substituting the values for Bartlett Company’s ROA of
6.1 percent, calculated earlier, and Bartlett’s FLM of
2.051 ($3,597,000 total assets ÷ $1,754,000
common stock equity) into the modified DuPont
formula yields:
ROE = 6.1%  2.051 = 12.5%
Figure 3.2
DuPont System of Analysis
Matter of Fact

• Dissecting ROA
– Return to Table 3.5 and examine the total asset turnover
figures for Dell and Home Depot.
– Both firms turn their assets 1.6 times per year.
– Dell’s ROA is 4.3%, but Home Depot’s is significantly
higher at 6.5%. Why?
– The answer lies in the DuPont formula.
– Notice that Home Depot’s net profit margin is 4.0%
compared to Dell’s 2.7%.
Review of Learning Goals

LG1 Review the contents of the stockholders’ report and the

procedures for consolidating international financial
statements.
The annual stockholders’ report, which publicly owned corporations
must provide to stockholders, documents the firm’s financial
activities of the past year. It includes the letter to stockholders and
various subjective and factual information. It also contains four key
financial statements: the income statement, the balance sheet, the
statement of stockholders’ equity (or its abbreviated form, the
statement of retained earnings), and the statement of cash flows.
Notes describing the technical aspects of the financial statements
follow. Financial statements of companies that have operations
whose cash flows are denominated in one or more foreign
currencies must be translated into dollars in accordance with FASB
Standard No. 52.
Review of Learning Goals (cont.)

LG2 Identify who uses financial ratios and how.

Ratio analysis enables stockholders, lenders, and the firm’s
managers to evaluate the firm’s financial performance. It can be
performed on a cross-sectional or a time-series basis.
Benchmarking is a popular type of cross-sectional analysis. Users of
ratios should understand the cautions that apply to their use.
LG3 Use ratios to analyze a firm’s liquidity and activity.
Liquidity, or the ability of the firm to pay its bills as they come due,
can be measured by the current ratio and the quick (acid-test) ratio.
Activity ratios measure the speed with which accounts are
converted into sales or cash—inflows or outflows. The activity of
inventory can be measured by its turnover, that of accounts
receivable by the average collection period and that of accounts
payable by the average payment period. Total asset turnover
measures the efficiency with which the firm uses its assets to
generate sales.
Review of Learning Goals (cont.)

LG4 Discuss the relationship between debt and financial leverage

and the ratios used to analyze a firm’s debt.
The more debt a firm uses, the greater its financial leverage, which
magnifies both risk and return. A common measure of indebtedness
is the debt ratio. The ability to pay fixed charges can be measured
by times interest earned and fixed-payment coverage ratios.
LG5 Use ratios to analyze a firm’s profitability and its market
value.
The common-size income statement, which shows all items as a
percentage of sales, can be used to determine gross profit margin,
operating profit margin, and net profit margin. Other measures of
profitability include earnings per share, return on total assets, and
return on common equity. Market ratios include the price/earnings
ratio and the market/book ratio.
Review of Learning Goals (cont.)

LG6 Use a summary of financial ratios and the DuPont

system of analysis to perform a complete ratio
analysis.
A summary of all ratios can be used to perform a complete
ratio analysis using cross-sectional and time-series analysis.
The DuPont system of analysis is a diagnostic tool used to
find the key areas responsible for the firm’s financial
performance. It enables the firm to break the return on
common equity into three components: profit on sales,
efficiency of asset use, and use of financial leverage.