Chapter 5: Analyzing and Interpreting Financial Statements (pg 219)

Introduction: (pg 220)

 Financial statement analysis identifies relationships between numbers within the financial
statements and trends in these relationships from one period to the next
 Assessing the Business Environment:
o Factors of interest include: Life cycle, outputs, customers, competition, inputs, labor,
technology, capital, political

Vertical and Horizontal Analysis: (pg 221)

 Vertical analysis is a method that attempts to overcome this obstacle by restating financial
statement information in ration (or percentage) form.
o Express components of the income statement as a percent of net sales
o Express components of the balance sheet as a percent of total assets
 Common-size financial statements – facilitates comparisons across companies of different sizes
as well as comparisons of accounts within a set of financial statements
o Horizontal analysis – examines changes in financial data across time
o The amount of change for a given y ear is computed by subtracting the amount for the
prior year from the amount for the current year

Return on Investment (pg 225)

 Return on Equity (ROE)

o The primary summary measure of company performance as is defined as:
 ROE = Net income / Average stockholders’ equity
o Companies can use debt to increase their return on equity, but too much debt increases
risk as the failure to make required debt payments is likely to yield many legal
consequences, including bankruptcy
 Return on Assets (ROA)
o Measures the return earned on each dollar that the firm invests in assets
o ROA is defined as:
 ROA = Earnings without interest expense (EWI) / Average total assets
o Denominator: Add the beginning and ending balances in total assets and then divide by
two
 Average total assets = (Beginning total assets + Ending total assets) / 2
o Numerator: EWI = Net income + [Interest expense x (1 – Statutory tax rate)]
 Return on Financial Leverage (ROFL)
o Financial leverage refers to the effect that liabilities (including debt financing) have on
ROE
o Return on financial leverage (ROFL) is defined as:
 ROFL = ROE – ROA
 Disaggregating ROA (pg 228)
o ROA can be restated as the product of two ratios – profit margin and asset turnover – by
simultaneously multiplying and dividing ROA by sales revenue:
  ROA = (Earnings without interest expense / Average total assets) = [(Earnings
without interest expense / Sales revenue) x (Sales revenue / Average total
assets)]

 Asset turnover (AT) ratio reveals insights into a company’s productivity and
efficiency
 Measures the level of sales generated by each dollar that a company
invests in assets
 A high asset turnover ratio suggests that assets are being used
efficiently so, all other things being equal, a high asset turnover ratio is
preferable

o Further Disaggregation of Profit Margin and Asset Turnover

 To disaggregate profit margin (PM), we examine gross profit on products sold
and individual expense accounts that contribute to the total cost of operations
 The key ratios include the gross profit margin and expense-to-sales ratio
 Gross profit margin (GPM) is defined as:
 Gross profit margin (GPM) = (Sales revenue – Cost of goods sold) / Sales
revenue
 Expense-to-sales (ETS) ratio measures the percentage of each sales dollar that
goes to cover a specific expense item and is computed by dividing the expense
by sales revenue
 To disaggregate asset turnover (AT), we examine individual asset accounts and
compare them to sales or cost of goods sold, focusing on three specific turnover
ratios:
 Accounts receivable turnover (ART)
 Inventory turnover (INVT)
 Property, plant, and equipment turnover (PPET)
 Accounts receivable turnover (ART) is defined as follows:
 Accounts receivable turnover (ART) = Sales revenue / Average accounts
receivable
 Measures how many times receivables have been turned (collected)
during the period
  More turns indicate that accounts receivables are being collected more
quickly, while low turnover often indicates difficulty with a company’s
credit policies
 Inventory turnover (INVT) is defined as:
 Inventory turnover (INVT) = Cost of goods sold / Average inventory
 Measures the number of times during a period that total inventory is
turned (sold)
 A high INVT indicates that inventory is managed efficiently
 A variation of this measure is days-inventory = 365/INVT
 Property, plant, and equipment turnover (PPET) measures the sales revenue
produced for each dollar invested in PP&E.
 It is computed as the ratio of sales to average PP&E assets:
o Property, plant, and equipment turnover (PPET) = Sales revenue
/ Average PP&E
 Provides insights into asset utilization and how efficiently a company
operates given its production technology

Liquidity and Solvency (pg 233)

 The increase in ROE due to the use of debt is called return on financial leverage (ROFL)
 Covenants – restrictions that help safeguard debtholders in the face of increased risk
 Default risk – the risk that the company will be unable to repay debt when it comes due
 Liquid analysis – the analysis of available cash
 Solvency analysis – the analysis of the company’s ability to generate sufficient cash in the future
 Liquidity Analysis:
o Liquidity refers to cash availability: how many cash a company has, and how much it can
raise on short notice
o The most common ratios used to assess the degree of liquidity are the current ratio and
the quick ratio:
 Current ratio:
 Current assets are those assets that a company expects to convert into
cash within this next operating cycle, which is typically a year
 Current liabilities are those liabilities that come due within the next year
 Excess of current assets over current liabilities (Current assets – Current
liabilities) is known as net working capital or simply, working capital
 Current ratio expresses working capital as a ratio and is computed as
follows:
o Current ratio (CR) = Current assets / Current liabilities
 A current ratio greater than 1.0 implies a positive working capital
 Quick ratio:
 A variant of the current ratio
 Focuses on quick assets, which are those assets likely to be converted to
cash within a relatively short period of time, usually less than 90 days
 Quick assets include cash, short-term securities, and accounts
receivable; they exclude inventories and prepaid assets
 The quick ratio is defined as follows:
o Quick ratio (QR) = (Cash + Short-term securities + Accounts
receivable) / Current liabilities
 Operating Cash Flow to Current Liabilities:
 The operating cash flow to current liabilities (OCFCL) ratio is defined as
follows:
o Operating cash flow to current liabilities (OCFCL) = Cash flow
from operations / Average current liabilities
 Cash Burn Rate:
 Is used when a company’s free cash flow (cash from operations minus
net investments in property, plant, and equipment) is negative
o Solvency Analysis:
 Solvency refers to a company’s ability to meet its debt obligations, including
both periodic interest payments and the repayment of the principal amount
borrowed
 There are two general approaches to measuring solvency:
 Using balance sheet data and assessing the proportion of capital raised
from creditors
 Using income statement data and assessing the profit generated
relative to debt payment obligations
 Debt-to-Equity
 Debt-to-equity ratio = Total liabilities / Total stockholders’ equity
 A higher ratio indicates less solvency, and more risk
 Times Interest Earned
 Compares profit to liabilities
  This approach assesses how much operating profit is available to cover
debt obligations
 Time interest earned = Earnings before interest expense and taxes /
Interest expense
 Limitations of Ratio Analysis (pg 239)
o The quality of financial statement analysis depends on the quality of financial
information
o GAPP Limitations: Several limitations in GAAP can distort financial ratios Limitations
include:
 Measurability
 Non-capitalized costs
 Historical costs
o Company Changes
o Conglomerate Effects
o Means to an End