Analysis of Financial
Statements
Days sales outstanding = receivables
Why are ratios useful annual sales/365
● Standardize numbers and facilitate Fixed assets turnover ratio = sales
comparisons net fixed assets
● Highlight weaknesses and strengths Total assets turnover ratio = sales
● Comparisons should be made total assets
through time and with competitors
Debt management ratio: A set of ratios
Five categories of ratios that measure how effectively a firm
1. Liquidity ratios manages its debt.
- firm’s ability to pay off debts that are
maturing within a year Total debt to total capital = total debt
2. Asset management ratios total debt + total equity
- how efficiently a firm is using assets TIE ratio = EBIT
3. Debt management ratios interest charges
- how the firm has financed its assets
and the ability to pay long-term debt Profitability ratio: Reflect the net result
4. Profitability ratios of all of the firm’s financing policies and
- how profitably the firm is operating operating decisions.
and utilizing its assets
5. Market value ratios Operating margin = EBIT
- What investors think about the firm sales
and its future prospects Profit margin = net income
sales
Liquidity ratios: Will the firm be able to Return on total assets = net income
pay off its debts as they come due? total assets
Return on common equity = net income
Current ratio = current assets common equity
current liabilities Return on invested capital = EBIT(1-T)
Quick ratio = current assets - inventories debt + equity
current liabilities BEP ratio = EBIT
total assets
Asset management ratio: Does the
amount of each type of asset seem Market value ratio: Ratios that relate the
reasonable, too high, or too low in view firm’s stock price to its earnings and
of current and projected sales? book value per share.
Inventory turnover ratio = sales P/E ratio = price per share
inventories earnings per share
Book value per share = common equity
shares outstanding
M/B ratio = market price per share
book value per share
EBITDA = market value of equity + market
value of total debt + market value of other
financial claims - cash and equivalents
The DuPont Equation
Profit margin
● tells us how much the firm earns on
its sales
● depends primarily on costs and
sales prices—if a firm can command
a premium price and hold down its
costs, its profit margin will be high,
which will help its ROE
Total assets turnover
● a “multiplier” that tells us how many
times the profit margin is earned
each year
Equity multiplier
● adjustment factor
Potential Misuses of ROE
1. ROE does not consider risk
2. ROE does not consider the amount
of invested capital
3. A focus on ROE can cause
managers to turn down profitable
projects
Cost of Capital 2. Estimate the stock’s beta coefficient,
bi, and use it as an index of the
stock’s risk. The i signifies the ith
company’s beta.
3. Estimate the market risk premium.
Recall that the market risk premium
is the difference between the return
that investors require on an average
stock and the risk-free rate.
Cost of Debt 4. Substitute the preceding values in
- 𝑟𝑑(1 − 𝑇) the CAPM equation to estimate the
required rate of return on the stock
- Calculated because we are
in question
interested in maximizing the value
of the firm’s stock, and the stock
𝑅𝑠 = 𝑟𝑅𝐹 + (𝑅𝑃𝑀)𝑏𝑖
price depends on after-tax cash
flows = 𝑟𝑅𝐹 + (𝑟𝑚 − 𝑟𝑅𝐹)𝑏𝑖
Cost of Preferred Stock Bond-Yield-Plus-Risk Premium Approach
𝐷𝑝
- 𝑟𝑝 = 𝑃𝑝
𝑅𝑆 = 𝐵𝑜𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 + 𝑅𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
- Preferred dividend / current price of
preferred stock
Dividend-Yield-Plus Growth Rate or DCF
Cost of Retained Earnings
𝐷1 𝐷2
- Required rate of return 𝑃𝑜 = 1 + 2 …
(1+𝑟𝑠) (1+𝑟𝑠)
= 𝑅𝑠 = 𝑟𝑅𝐹 + 𝑅𝑃
- Expected rate of return If the growth is constant use:
- = 𝐷1/𝑃𝑜 + 𝑔 = 𝑟𝑠
𝐷1
- Retained earnings have an 𝑃𝑜 = 𝑟𝑠 − 𝑔
opportunity cost
- The managers, who work for the 𝐷1
stockholders, can either pay out 𝑟𝑠 = 𝑃0
+ 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑎𝑠 𝑝𝑟𝑜𝑗𝑒𝑐𝑡𝑒𝑑 𝑏𝑦 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦 𝑎𝑛𝑎𝑙𝑦𝑠𝑡𝑠
earnings in the form of dividends or
retain earnings for reinvestment in
the business
CAPM Approach
1. Estimate the risk free rate We
generally use the 10-year Treasury
bond rate as the measure of the
risk-free rate, but some analysts use
the short- term Treasury bill rate.
Cost of retained earnings
Ke = (D1/P0) + GR
Cost of new ordinary shares
Kn = (D1/(P0x(1-FC)) + GR
How to convert D0 to D1:
D1 = (D0 x (1 + growth rate))
Capital Budgeting
Payback period
= original investment / annual cash
flows
Accept if payback period is lower than
maximum allowable payback period; Reject
if otherwise
Accounting rate of return
= average income / original investment
Accept if higher than required rate of return
or cost of capital; Reject if otherwise
Net Present Value
PV of cash flow xxx
Less: PV of investment (xxx)
Net present value xxx
Accept if positive or zero; Reject if otherwise
Discounted payback period
= same as payback period but divide
(1+discount rate)^period to cash flow
Additional Funds Needed
