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BAF 313: Financial Management

Week 3: Lesson 3.1 – Financial Ratios

Learning Outcomes:
a. Explain what we can learn by analyzing a firm’s financial statements.
b. Use common size financial statements as a tool of financial analysis.
c. Calculate and use a comprehensive set of financial ratios to evaluate a
company’s performance.
d. Select an appropriate benchmark for use in performing a financial ratio analysis.
e. Describe the limitations of financial ratio analysis.

Topic Outline

Financial statements analysis involves the process of extracting information from a firm’s
financial statements in order to evaluate the firm’s financial performance. Analyzing past
performance of a firm is a valuable tool in predicting future performance and cash flows.
Financial analysis is important to a variety of constituencies, including managers,
lenders, suppliers, credit-rating agencies, and investors.

There is a number of key types of statements and measures that are valuable in
performing a financial analysis.
• Common-size statements standardize financial statements to allow for
comparison.
• Financial ratios are developed to assess a firm’s liquidity, leverage, asset
management efficiency, profitability, and market performance.
• The DuPont Method provides a way of analyzing the relationship among a
number of key ratios and identifying key factors that affect firm performance.
• Two main types of benchmarks are used in analyzing a firm’s financial
performance: trend analysis and peer group comparisons.

Why Do We Analyze Financial Statements?

A. A firm’s financial statements can be analyzed internally (by employees,
managers) and externally (by bankers, investors, customers, and other
interested parties).
An internal financial analysis might be done:
– To evaluate the performance of employees and determine their pay
raises and bonuses.
– To compare the financial performance of the firm’s different divisions.
– To prepare financial projections, such as those associated with the launch
of a new product.
– To evaluate the firm’s financial performance in light of its competitors and
determine how the firm might improve its operations.

B. Financial analysis is performed by external parties to assess a firm’s

credit standing and to provide input for investment decisions.
A variety of firms and individuals that have an economic interest might also
undertake an external financial analysis:
a. Banks and other lenders deciding whether to loan money to the firm.
b. Suppliers who are considering whether to grant credit to the firm.
c. Credit-rating agencies trying to determine the firm’s creditworthiness.
d. Professional analysts who work for investment companies considering
investing in the firm or advising others about investing.
e. Individual investors deciding whether to invest in the firm.
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Common Size Statements: Standardizing Financial Information

A common size financial statement is a standardized version of a financial
statement in which all entries are presented in percentages.
A common-size balance sheet expresses all entries on a balance sheet as a
percent of total assets.

A common size financial statement helps to compare entries in a firm’s financial

statements, even if the firms are not of equal size.

How to prepare a common size financial statement?

- For a common size income statement, divide each entry in the income
statement by the company’s sales.
- For a common size balance sheet, divide each entry in the balance sheet by
the firm’s total assets.

ILLUSTRATIONS:
Illustration #1 - Income Statement of Boss, Inc. for the Year Ending December 31,
2021

Sales P2,700,000
Cost of Goods Sold ( 2,025,000)
Gross Profits P 675,000
Operating Expenses:
Selling Expenses (P90,000)
General & Admin Expenses ( 67,500)
Depreciation & Amortization (135,000)
Total Operating Expenses (292,500)
Operating Income (EBIT) P382,500
Interest Expense ( 67,500)
Earnings Before Taxes P315,000
Income Tax ( 110,250)
Net Income P204,750
Additional information:
Dividends paid to stockholders during 2020 P45,000
Number of common shares outstanding 90,000

Earnings per share (P204,750/90,000 shares) P 2.28

Dividends per share (P45,000/90,000 shares) P .50

• We can use the income statement to determine the earnings per share (EPS) and
dividends per share.
• EPS = Net income ÷ Number of shares outstanding
• DPS = Dividends ÷ Number of shares outstanding
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Common Size Income Statement of Boss, Inc. for Year Ending December 31, 2021:

Sales 100%
Cost of Goods Sold (75%)
Gross Profits 25%
Operating Expenses:
Selling Expenses (3.3%)
General & Admin Expenses (2.5%)
Depreciation & Amortization (5.0%)
Total Operating Expenses 10.8%
Operating Income (EBIT) 14.2%
Interest Expense (2.5%)
Earnings Before Taxes 11.7%
Income Tax (4.1%)
Net Income 7.6%

This common size income statement for year ending December 31, 2021 was prepared
by dividing each entry in the income statement by the firm sales for 2021.
– Cost of goods sold make up 75% of the firm’s sales resulting in a gross profit of 25%.
– Selling expenses account for about 3.3% of sales. Income taxes account for 4.1% of
the firm’s sales.
– After accounting for all expenses, the firm generates net income of 7.6% of firm’s
sales.

Illustration #2:
Balance Sheet of Boss, Inc. as of December 31, 2021:
2020 2021
Assets
Cash P 94.50 P 90.00
Accounts Receivable 139.50 162.00
Inventory 229.50 378.00
Other Current Assets 13.50 13.50
Total Current Assets 477.00 643.50
Gross Plant and Equipment 1,669.50 1,845.00
Accumulated Depreciation (382.50) (517.50)
Net Plant and Equipment 1,287.00 1,327.50
Total Assets P 1,764.00 P 1,971.00
Liabilities & Owners’ Equity
Accounts Payable P 184.50 P 189.00
Accrued Expenses 45.00 45.00
Short-term Notes 63.00 54.00
Total Current Liabilities P 292.50 P 288.00
Long-term Debt 720.00 771.75
Total Liabilities P 1,012.50 P 1,059.75
Stockholders’ Equity
Common Stock-par value 45.00 45.00
Paid-in Capital 324.00 324.00
Retained Earnings 382.50 542.25
Total Stockholders’ Equity P 751.50 P 911.25
Total Liabilities & Stockholders’ Equity P 1,764.00 P 1,971.00
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Common Size Balance Sheet of Boss, Inc. as of December 31, 2021:

2020 2021 Change

Assets % % %
Cash 5.4 4.6 (0.8)
Accounts Receivable 7.9 8.2 0.3
Inventory 13.0 19.2 6.2
Other Current Assets 0.8 .7 (0.1)
Total Current Assets 27.1 32.6 5.6
Gross Plant and Equipment 94.6 93.6 (1.0)
Accumulated Depreciation (21.7) (26.3) (4.6)
Net Plant and Equipment 72.9 67.4 (5.6)
Total Assets 100% 100% 0.0%
Liabilities & Owners’ Equity
Accounts Payable 10.5 9.6 (0.9)
Accrued Expenses 2.6 2.3 (0.3)
Short-term Notes 3.6 2.7 (0.8)
Total Current Liabilities 16.6 14.6 (2.0)
Long-term Debt 40.8 39.2 (1.7)
Total Liabilities 57.4 53.8 (3.6)
Stockholders’ Equity
Common Stock-par value 2.6 2.3 (0.3)
Paid-in Capital 18.4 16.4 (1.9)
Retained Earnings 21.7 27.5 5.8
Total Stockholders’ Equity 42.6 46.2 3.6
Total Liabilities & Stockholders’ Equity 100% 100% 0.0%

This common size balance sheet was prepared by dividing each entry in the balance
sheet by the total assets for the year.
– Total current assets increased by 5.6% in 2021 while total current liabilities
declined by 2%.
– Long-term debt account for 39.2% of firm’s assets, showing a decline of 1.7%.
– Retained earnings increased by 5.8% in 2021.

Using Financial Ratios

Financial ratios provide a second method for standardizing the financial information on
the income statement and balance sheet.

A ratio by itself may have no meaning. Hence, a given ratio is compared to: (a) ratios
from previous years; or (b) ratios of other firms in the same industry (peer).

If the differences in the ratios are significant, more in-depth analysis must be done.
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Which category of ratios will be used for certain questions?

Question Category of Ratios Used

1. How liquid is the firm? Will it be able to pay its bills Liquidity ratios
as they become due?

2. How has the firm financed the purchase of its Capital structure ratios
assets?

3. How efficient has the firm’s management been in Asset management

utilizing it assets to generate sales? efficiency ratios

4. Has the firm earned adequate returns on its Profitability ratios

investments?

5. Are the firm’s managers creating value for Market value ratios
shareholders?

1. Liquidity ratios assess a firm’s ability to pay its bills as they come due.
Liquidity ratios address a basic question: How liquid is the firm?

A firm is financially liquid if it is able to pay its bills on time. We can analyze a firm’s
liquidity from two perspectives:

a. Overall or general firm liquidity is analyzed by comparing the firm’s current

assets to the firm’s current liabilities

Current Ratio: Current Ratio compares a firm’s current (liquid) assets to its current
(short-term) liabilities.

Current Ratio = Current Assets

Current Liabilities

Acid-Test (Quick) Ratio. This ratio excludes the inventory from current assets as
inventory may not always be very liquid.

Acid-Test Ratio or Quick Ratio = Current Assets – Inventory

Current Liabilities
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Computations from the given Balance Sheet of Boss, Inc.

• Current Ratio =

• Quick Ratio =

b. Liquidity of specific current asset accounts is analyzed by examining the

timeliness in which the firm’s primary liquid assets – accounts receivable and
inventories – are converted into cash.

We can assess the liquidity of the firm by measuring how long it takes the firm to
convert its accounts receivables and inventories into cash.

Several ratios assess the liquidity of specific asset categories. These include:
Average Collection Period measures the number of days it takes the firm to
collects its receivables.

Average Collection Period = Accounts Receivable = Accounts Receivable

Annual Credit Sales/365 days Daily Credit Sales

What will be the average collection period of Boss, Inc. for 2020 if we assume
that the annual credit sales were P2,500 million in 2020?

Accounts Receivable Turnover Ratio measures how many times accounts

receivables are “rolled over” during a year.

Accounts Receivable Turnover = Annual Credit Sales

Accounts Receivable

Inventory Turnover Ratio measures how many times the company turns over
its inventory during the year. Shorter inventory cycles lead to greater
liquidity since the items in inventory are converted to cash more quickly.

Inventory Turnover = Cost of Goods Sold

Inventories
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What will be the inventory turnover ratio for 2020 if we assume that the cost of
goods sold were P1,980 million in 2020?

We can express the inventory turnover ratio in terms of the number of days the
inventory sits unsold on the firm’s shelves.
Days’ Sales in Inventory
= 365÷ inventory turnover ratio
= 365 ÷ 8.63 = 42.29 days
The firm, on average, holds it inventory for about 42 days.

Can a Firm Have Too Much Liquidity?

A high investment in liquid assets will enable the firm to repay its current liabilities
in a timely manner.
However, an excessive investment in liquid assets can prove to be costly as
liquid assets (such as cash) generate minimal return.

2. Capital Structure Ratios refer to the way a firm finances its assets or indicate how
the firm has financed the purchase of its assets using debt and equity funds.

Capital structure ratios address the important question: How has the firm financed
the purchase of its assets?
We will use two ratios, debt ratio and times interest earned ratio, to answer the
question.
Debt Ratio measures the percentage of the firm’s assets that were financed using
current plus long-term liabilities.
Debt Ratio = Total Liabilities
Total Assets
What will be the debt ratio for 2020 of Boss, Inc.?

Times Interest Earned Ratio measures the ability of the firm to service its debt or
repay the interest on debt.
– We use EBIT or operating income as interest expense is paid before a
firm pays its taxes.

What will be the times interest earned ratio for 2020 if we assume interest expense
of P65 million and EBIT of P350 million?

3. Asset Management Efficiency Ratios analyze how efficient the firm’s management
has been in utilizing its assets to generate sales. They are commonly referred to as
turnover ratios as they reflect the number of times a particular asset account
balance turns over during a year.
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Total Asset Turnover Ratio represents the amount of sales generated per
peso invested in the firm’s assets.

Total Asset Turnover = Sales

Total Sales

= P2,700m = 1.37 times

P1,971

What will be the total asset turnover ratio for 2020 if we assume the total sales
in 2020 were P2,500 million?

Fixed Asset Turnover Ratios measures the amount of sales generated per
peso invested in the firm’s fixed assets or measures firm’s efficiency in utilizing
its fixed assets (such as property, plant and equipment).

Fixed Asset Turnover = Sales

Net Plant & Equipment

What will be the fixed asset turnover ratio for 2020 if we assume sales of P2,500
million for 2020?

• We could similarly compute the turnover ratio for other assets.

We had earlier computed the receivables turnover and inventory turnover, which
measured firm effectiveness in managing its investments in accounts receivables
and inventories.

Sample Assessment of company’s performance:

Turnover Ratio Boss, Inc. Peer Group Assessment
(Other companies in
the same Industry)

Total Assets 1.37 1.15 Good

Fixed Assets 2.03 1.75 Good

Receivables 16.67 14.60 Good

Inventory 5.36 7.0 Poor

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4. Profitability Ratios determine if the firm has earned adequate returns on its
investments. They address a very fundamental question: Has the firm earned
adequate returns on its investments?

We answer this question by analyzing the firm’s profit margin, which predict the
ability of the firm to control its expenses, and the firm’s rate of return on
investments.

Two fundamental determinants of firm’s profitability and returns on investments are

the following:
– Cost Control
• Is the firm controlling costs and earning reasonable profit margin?
– Efficiency of asset utilization
• Is the firm efficiently utilizing the assets to generate sales?

Gross Profit Margin assesses the cost of goods sold and markups of the firm.
It shows how well the firm’s management controls its expenses to generate profits.
Gross Profit Margin = Gross Profit
Sales

• What will be the gross profit margin ratio for 2020 if we assume sales of P2,500
million and gross profit of P650 million for 2020?

Operating Profit Margin tells managers how much profit they generated from each
peso of sales after accounting for both costs of goods sold and operating expenses.
It thus also indicates how well the firm is managing its income statement.

Operating Profit Margin (OPM) = Net Operating Income or EBIT

Sales

• What will be the operating profit margin ratio for 2020 if we assume sales of
P2,500 million and net operating income of P350 million for 2020?

Net Profit Margin identifies how much of each peso of sales the firm has after
paying all of its expenses. It measures how much income is generated from each
peso of sales after adjusting for all expenses (including income taxes).
Net Profit Margin = Net Profit
Sales
• What will be the net profit margin ratio for 2020 if we assume sales of P2,500
million and net income of P217.75 million for 2020?

Operating Return on Assets Ratio considers management’s success in controlling

expenses and its efficient use of assets to generate firm sales. It measures how
much profit is generated from each peso of sales after accounting for both costs of
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goods sold and operating expenses. Thus, it also indicates how well the firm is
managing its income statement.

Operating Return on Assets (OROA) = Net Operating Income or EBIT

Total Assets
• What will be the operating return on assets ratio for 2020 if we assume EBIT or net
operating income of P350 million for 2020?

Decomposing the OROA ratio: We can use the following equation to

decompose the OROA ratio that allows us to analyze the firm’s ability to control
costs and utilize its investments in assets efficiently.

Is the Firm Providing a Reasonable Return on the Owner’s Investment?

A firm’s net income consists of earnings that is available for distribution to the firm’s
shareholders.
Return on Equity ratio measures the accounting return on the common stockholders’
investment. It determines the earnings available for distribution to the firm’s
shareholders.

Return on Equity = Net Income

Common Equity

• What will be the return on equity ratio for 2020 if we assume net income of
P217.75 million for 2020?
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The DuPont Method is a way to decompose Return on Assets and Return on Equity
into component parts. DuPont method analyzes the firm’s ROE by decomposing it
into three parts: profitability, efficiency and an equity multiplier.
ROE = Profitability × Efficiency × Equity Multiplier
ROE = Net Profit Margin × Total Asset Turnover Ratio × 1/(1-debt ratio)

Equity multiplier captures the effect of the firm’s use of debt financing on its return on
equity. The equity multiplier increases in value as the firm uses more debt.

5. Market Value Ratios examine how a firm’s shares are valued in the stock market.
They address the question, how are the firm’s shares valued in the stock market?
Two market value ratios are:
a. Price-Earnings Ratio
b. Market-to-Book Ratio

Price-Earnings Ratio indicates how much investors have been willing to pay for
Php1 of reported earnings.

Price Earnings Ratio = Market Price per Share

Earnings per share
• What will be the PE ratio for 2020 if we assume the firm’s stock was selling for P22
per share at a time when the firm reported a net income of P217.75 million, and
the total number of common shares outstanding are 90 million?

Market-to-Book Ratio measures the relationship between the market value and the
accumulated investment in the firm’s equity. It compares the market’s valuation of the
firm to the accumulated investment made by the shareholders in the firm.

Market-to-Book Ratio = Market Price per Share = Market Price per share
Book Value per Share (Common Stockholders’ Equity /
Common Shares Outstanding)
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• What will be the market-to-book ratio for 2020 given that the current market price of
the stock is P22 and the firm has 90 million shares outstanding?

Selecting a Performance Benchmark

A. Trend analysis compares a firm’s recent financial ratios with its past financial
ratios and provides insight into whether the firm is improving or deteriorating in
its financial performance over time.
B. Peer firm comparisons compare a firm’s performance to that of a relevant peer
group of firms. It involves comparing the subject firm’s financial statements with
those of similar, or “peer” firms. The benchmark for peer groups typically
consists of firms from the same industry or industry average financial ratios.

Limitations of Ratio Analysis

Financial analysts must be aware of a number of limitations in performing financial
analysis for a firm:
1. Picking an industry benchmark can sometimes be difficult.
2. Published peer-group or industry averages are not always representative of the
firm being analyzed.
3. An industry average is not necessarily a desirable target or norm.
4. Accounting practices differ widely among firms.
5. Many firms experience seasonal changes in their operations.
6. Financial ratios offer only clues. We need to analyze the numbers in order to fully
understand the ratios.
7. The results of financial analysis are dependent on the quality of the financial
statements.