Chapter 3

Financial
Statements
and Ratio
Analysis

Copyright © 2012 Pearson Prentice Hall.

All rights reserved.
 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 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.

© 2012 Pearson Prentice Hall. All rights reserved. 3-2

 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?

© 2012 Pearson Prentice Hall. All rights reserved. 3-3

 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?

© 2012 Pearson Prentice Hall. All rights reserved. 3-4

 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.

© 2012 Pearson Prentice Hall. All rights reserved. 3-5

 Table 3.1 Bartlett Company
Income Statements ($000)

© 2012 Pearson Prentice Hall. All rights reserved. 3-6

 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).

© 2012 Pearson Prentice Hall. All rights reserved. 3-7

 Table 3.2a Bartlett Company
Balance Sheets ($000)

© 2012 Pearson Prentice Hall. All rights reserved. 3-8

 Table 3.2b Bartlett Company
Balance Sheets ($000)

© 2012 Pearson Prentice Hall. All rights reserved. 3-9

 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.

© 2012 Pearson Prentice Hall. All rights reserved. 3-10

 Table 3.3 Bartlett Company Statement of
Retained Earnings ($000) for the Year Ended
December 31, 2012

© 2012 Pearson Prentice Hall. All rights reserved. 3-11

 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.

© 2012 Pearson Prentice Hall. All rights reserved. 3-12

 Table 3.4 Bartlett Company Statement of
Cash Flows ($000) for the Year Ended
December 31, 2012

© 2012 Pearson Prentice Hall. All rights reserved. 3-13

 Using Financial Ratios:
Interested Parties
• Ratio analysis involves methods of calculating and interpreting
financial ratios to analyze and monitor the firm’s performance.
• 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.

© 2012 Pearson Prentice Hall. All rights reserved. 3-14

 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.

© 2012 Pearson Prentice Hall. All rights reserved. 3-15

 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.

© 2012 Pearson Prentice Hall. All rights reserved. 3-16

 Figure 3.1 Combined Analysis

© 2012 Pearson Prentice Hall. All rights reserved. 3-17

 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.

© 2012 Pearson Prentice Hall. All rights reserved. 3-18

 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.

© 2012 Pearson Prentice Hall. All rights reserved. 3-19

Liquidity Ratio (cont.)

Current assets 1,223,000

Current ratio = = = 1.97
Current liabilities 620,000

Current assets - Inventory 1,223,000 – 289,000

Quick ratio = = = 1.51
Current liabilities 620,000
Activity Ratio

Cost of goods sold 2,088,000

Inventory turnover = = = 7.2
Inventory 289,000

365 365
Average age of inventory = = = 50.7 days
Inventory turnover 7.2
 Using Financial Ratios:
Types of Ratio Comparisons (cont.)
Caldwell Manufacturing’s calculated inventory turnover for
2012 and the average inventory turnover were as follows:

Inventory turnover, 2012

Caldwell Manufacturing 14.8
Industry average 9.7

© 2012 Pearson Prentice Hall. All rights reserved. 3-22

Activity Ratio (cont.)

Accounts receivable
Average collection period =
Average sales per day

Accounts receivable
Average collection period =
Annual sales
365

503,000
Average collection period = = 59.7
3,074,000
365
Activity Ratio (cont.)

Accounts payable
Average payment period =
Average purchases per day

Accounts payable
Average payment period =
Annual purchases
365

382,000
Average payment period = = 95.4
0.7 x 2,088,000
365
Activity Ratio (cont.)

Sales 3,074,000
Total asset turnover = = = 0.85
Total assets 3,597,000
Debt Ratio

Total liabilities 1,643,000

Debt ratio = = = 45.7%
Total assets 3,597,000

EBIT 418,000
Times interest earned ratio = = = 4.5
Interest 93,000
Debt Ratio (cont.)

EBIT + Lease payment

Fixed interest coverage ratio =
Interest + Lease payments + 1/(1 – T) x {Principal payment + Preferred stock dividends}

418,000 + 35,000
Fixed interest coverage ratio =
93,000 + 35,000 + 1/(1 - 0.29) x{71,000 + 10,000}

453,000
Fixed interest coverage ratio = = 1.9
242,000
Profitability Ratio

Gross profit 986,000

Gross profit margin = = = 32.1%
Sales 3,074,000

Operating profit 418,000

Operating profit margin = = = 13.6%
Sales 3,074,000

Net profit 221,000

Net profit margin = = = 7.2%
Sales 3,074,000
Profitability Ratio (cont.)

Earnings available for common stockholders 221,000

Earning per share (EPS) = = = $2.90
Number of common stock outstanding 76,262

Earnings available for common stockholders 221,000

Return on total assets (ROA) = = = 6.1%
Total assets 3,597,000

Earnings available for common stockholders 221,000

Return on common equity (ROE) = = = 12.6%
Total assets 1,754,000
 Ratio Analysis (cont.)

Market Ratios

where,

© 2012 Pearson Prentice Hall. All rights reserved. 3-30

 Ratio Analysis (cont.)

Substituting the appropriate values for Bartlett Company from its

2012 balance sheet, we get:

Substituting Bartlett Company’s end of 2012 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

© 2012 Pearson Prentice Hall. All rights reserved. 3-31

 Table 3.8a Summary of
Bartlett Company Ratios

© 2012 Pearson Prentice Hall. All rights reserved. 3-32

 Table 3.8b Summary of
Bartlett Company Ratios

© 2012 Pearson Prentice Hall. All rights reserved. 3-33

 Table 3.5 Financial Ratios for Select Firms
and Their Industry Median Values

© 2012 Pearson Prentice Hall. All rights reserved. 3-34

 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?

© 2012 Pearson Prentice Hall. All rights reserved. 3-35

 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.

© 2012 Pearson Prentice Hall. All rights reserved. 3-36

 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.

© 2012 Pearson Prentice Hall. All rights reserved. 3-37

 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.

© 2012 Pearson Prentice Hall. All rights reserved. 3-38

 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,

© 2012 Pearson Prentice Hall. All rights reserved. 3-39

 DuPont System of Analysis
(cont.)
When the 2012 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%

© 2012 Pearson Prentice Hall. All rights reserved. 3-40

 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,

© 2012 Pearson Prentice Hall. All rights reserved. 3-41

 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 2.06
($3,597,000 total assets ÷ $1,754,000 common stock equity)
into the modified DuPont formula yields:
ROE = 6.1%  2.06 = 12.6%

© 2012 Pearson Prentice Hall. All rights reserved. 3-42

 Table 3.7 Bartlett Company
Common-Size Income Statements

© 2012 Pearson Prentice Hall. All rights reserved. 3-43

 Figure 3.2
DuPont System of Analysis

© 2012 Pearson Prentice Hall. All rights reserved. 3-44

 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%.

© 2012 Pearson Prentice Hall. All rights reserved. 3-45

 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.

© 2012 Pearson Prentice Hall. All rights reserved. 3-46