Principles of Managerial Finance

Sixteenth Edition

Chapter 2 & 3

Understanding Financial
Statements &
Financial Statement
Analysis

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Chapter Outline
2.1 Mandatory Financial Reports of Public Companies

2.2 Firms’ Disclosure of Financial Information

2.2.1 The Income Statement

2.2.2 The Balance Sheet

2.2.3 The Statement of Cash Flows

2.2.4 The Statement of Retained Earnings

2.3 Financial Statement Analysis

2.4 Chapter Quiz

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Learning Goals
LG 1 Review the contents of a company’s financial statements.

LG 2 Understand who uses financial ratios and how they use them.

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

LG 4 Discuss the relationship between debt and financial leverage, as well as

the ratios used to analyze a firm’s debt.

LG 5 Use ratios to analyze a firm’s profitability and its market value.

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2.2 Firms’ Disclosure of Financial Information

How can we Assess the

Health of a Business?

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2.1 Mandatory Financial Reports of Public Companies
• Generally Accepted Accounting Principles (GAAP)
– Authorized by the Financial Accounting Standards Board (FASB)

• Sarbanes-Oxley Act of 2002

– In 2002, Congress passed the Sarbanes-Oxley Act (S O X)
– While S O X contains many provisions, the overall intent of the legislation was to improve the accuracy of information given to
both boards and to shareholders
– SOX attempted to achieve this goal in three ways:
1. Overhauling incentives and independence in the auditing process
2. ​Stiffening penalties for providing false information
3. ​Forcing companies to validate their internal financial control processes

• Form 10-K
– Annual report filed with the SEC that contains the company’s audited financial statements in great detail as well
as other information about the business, such as financial health, business strategy and risk profile.

• Annual Report
– Report that companies provide prior to the annual stockholders’ meeting containing basic financial
information as well as promotional materials designed to appeal to current and prospective investors.

• The Letter to Stockholders

– The first element of the annual stockholders’ report and the primary communication from management.
– Describes the events managers believe had the greatest effect on the firm during the year and typically
discusses management philosophy, corporate governance issues, strategies and plans for the coming year.
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2.2 Firms’ Disclosure of Financial Information

What are financial statements?

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2.2 Firms’ Disclosure of Financial Information

Historical Overview

• After the Stock Market Crash of 1929 ad

in the middle of Great depression,
Congress passed the Securities Act of
1933 and the Securities Exchange Act of
1934 that created the Securities and
Exchange Commission. This commission
requires publicly listed companies to
report financial information, including
financial statements each quarter of the
year. (www.sec.gov)

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2.2.1 The Income Statement

Personal Finance Example

Jan and Jon Smith, a mid-30s married couple with no children, prepared a personal income and expense statement, which
is similar to a corporate income statement. A condensed version of their income and expense statement follows.

During the year, the Smiths had total income of $91,815

and total expenses of $88,140, which left them with a cash
surplus of $3,675. They can save and invest the surplus.
Notice that the $3,675 represents just about 4% of the
Smiths’ total income. Most financial advisors would suggest
a much higher savings rate, so Jan and Jon may want to take
a hard look at their budget to see where they can cut
expenses.
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2.2.1 The Income Statement

What are in the Income (Profit or Loss) Statement?

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2.2.1 The Income Statement

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2.2.1 The Income Statement

• Earnings Calculations
– Gross Profit
▪ Revenues (Net Sales ) - Cost of Sales = Gross Profit

– Operating Income
▪ Gross Profit-Operating Expenses = Operating Income

– Earnings Before Interest and Taxes (E B IT)

▪ Operating Income +/-Other Income = Earnings Before Interest and Taxes

– Pretax and Net Income

▪ EBIT +/-Interest Income (Expense ) = Pretax Income

▪ Pretax Income-Taxes = Net Income

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Global Corporation’s Income Statement Sheet for 2022 and 2023

Global Corporation
Income Statement
Year ended December 31 (in $ millions)
2023 2022
Net sales 186.7 176.1
Cost of sales Minus 153.4 Minus 147.3
Gross Profit 33.3 28.8
Selling, general, and administrative expenses Minus 13.5 Minus 13
Research and development Minus 8.2 Minus 7.6
Depreciation and amortization Minus 1.2 Minus 1.1
Operating Income 10.4 7.1
Other income Blank Blank
Earnings Before Interest and Taxes (EBIT) 10.4 7.1
Interest income (expense) Minus 7.7 Minus 4.6
Pretax Income 2.7 2.5
Taxes Minus 0.7 Minus 0.6
Net Income 2.0 1.9

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2.2.2 The Balance Sheet

• Also called “Statement of Financial Position”

• Lists the firm’s assets and liabilities
• Provides a snapshot of the firm’s financial position
at a given point in time

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 2.2.2 The Balance Sheet
Legend:
Assets: The Left-Hand Side of the Balance Sheet

Current assets. Assets that the firm expects to convert to cash in 12 months or less. Examples
include cash, accounts receivable, inventories, and other current assets.

• Cash. Every firm must have some cash on hand at all times because cash expenditures can
sometimes exceed cash receipts.

• Accounts receivable. The amounts owed to the firm by its customers who purchased on
credit.

Inventory. Raw materials that the firm utilizes to build its products, partially completed items or
work in process, and finished goods held by the firm for eventual sale.

Other current assets. All current assets that do not fall into one of the named categories (cash,
accounts receivable, and so forth). Prepaid expenses (prepayments for insurance premiums, for
example) are a common example of an asset in this catch-all category.

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 2.2.2 The Balance Sheet
Gross plant and equipment. The sum of the original acquisition prices of plant and equipment still owned
by the firm.

Accumulated depreciation. The sum of all the depreciation expenses charged against the prior year’s
revenues for fixed assets that the firm still owns.

Net plant and equipment. The depreciated value of the firm’s plant and equipment.

Liabilities and stockholders’ equity: The Right-Hand Side of the Balance Sheet

Current liabilities. Liabilities that are due and payable within a period of 12 months or less. Examples
include the firm’s accounts payable, accrued expenses, and short-term notes.

Accounts payable. The credit suppliers extended to the firm when it purchased items for its inventories.

Accrued expenses. Liabilities that were incurred in the firm’s operations but not yet paid. For example, the
company’s employees might have done work for which they will not be paid until the following week or
month. The wages owed by the firm to its employees are recorded as accrued wages.

Short-term notes. Debts created by borrowing from a bank or other lending source that must be repaid in
12 months or less.

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Assets: The Left-Hand Side of the Balance Sheet
• The left-hand side of the balance sheet lists the firm’s assets, which are categorized into current and fixed assets.

Liabilities and Stockholders’ Equity

This side of the balance sheet indicates how the firm finances its assets.

• Current liabilities represent the amount that the firm owes to creditors that must be repaid within a period of 12 months or
less such as accounts payable, notes payable.

Long-term liabilities Long-term debt. All firm debts that are due and payable more than 12 months in the future. A 25-year
mortgage loan used to purchase land or buildings is an example of a long-term liability. If the firm has issued bonds, the
portion of those bonds that is not due and payable in the coming 12 months is also included in long-term debt.

• Common stockholders’ equity. Common stockholders are the residual owners of a business. They receive whatever
income is left over after the firm has paid all of its expenses. In the event the firm is liquidated, the common stockholders
receive only what is left over—but never lose more than they invested—after the firm’s other financial obligations have
been paid.

• The stockholder’s equity includes the following: Par value of common stock + Paid in Capital
+ Retained Earnings.

We can also express stockholders’ equity as follows:

Stockholders' Equity = Total Assets – Total Liabilities

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 Personal Finance Example (BS)
The following personal balance sheet for Jan and Jon Smith—the couple introduced earlier, who are
married, in their mid-30s, and have no children—is similar to a corporate balance sheet.

The Smiths have total assets of

$227,175 and total liabilities of
$153,900. Personal net worth
(N/W) is a “plug figure”—the
difference between total assets
and total liabilities—which in the
case of Jan and Jon Smith is
Assets Liabilities and Net Worth $73,275.
Mutual funds 1,500 Auto loans 14,250
Retirement funds, IRA 2,000 Education loan 13,800
Total investments $ 5,750 Personal loan 4,000
Real estate $180,000 Furniture loan 800
Cars 34,000 Total long-term liabilities $152,850
Household furnishings 3,700 Total liabilities $153,900
Jewelry and artwork 1,500 Net worth (N/W) 73,275
Total personal property $219,200 Total liabilities and net worth $227,175

Total assets $227,175

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2.2.2 The Balance Sheet

• Current Assets
Cash and other marketable securities
Short-term, low-risk investments
Easily sold and converted to cash
Accounts receivable
Amounts owed to the firm by
customers who have purchased
on credit
Inventories
Raw materials, work-in-progress
and finished goods
Other current assets
Catch all category that includes
items such as prepaid expenses

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2.2.2 The Balance Sheet

• Long-Term Assets
– Assets that produce tangible benefits for more than one year
– Recorded value reduced through a yearly deduction called depreciation according to a schedule
that depends on an asset’s life span
▪ Depreciation is not an actual cash expense, but a way of recognizing that fixed assets wear
out and become less valuable as they get older

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2.2.2 The Balance Sheet

• Liabilities
– Current Liabilities
▪ Accounts payable
– The amounts owed to supplier's purchases
made on credit
▪ Notes payable and short-term debt
– Loans to be repaid in the next year
▪ Accrual items
– Items such as salary or taxes that are owed
but have not yet been paid.

– Long-Term Liabilities
▪ Long-term debt
– A loan or debt obligation maturing in more
than a year

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2.2.2 The Balance Sheet

• Stockholders’ Equity

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2.2.2 The Balance Sheet

Global Corporation Balance Sheet for 2022 and 2023 ($ millions)

Assets 2022 2023 Liabilities and Stockholders’ Equity 2022 2023

Current Liabilities blank blank

Current Assets blank Blank

Accounts payable 29.2 26.5

Cash 23.2 20.5 Notes payable/short-term debt 5.5 3.2
Accounts receivable 18.5 13.2 Total current liabilities 34.7 29.7
Long-Term Liabilities blank blank

Inventories 15.3 14.3

Long-term debt 113.2 78.0
Total current assets 57.0 48.0 Total long-term liabilities 113.2 78.0
Total Liabilities 147.9 107.7
Long-Term Assets blank blank

Stockholders’ Equity Blank Blank

Net property, plant, Common stock and paid-in surplus 8.0 8.0
113.1 80.9
and equipment Retained earnings 14.2 13.2
Total long-term assets 113.1 80.9 Total Stockholders’ Equity 22.2 21.2

Total Assets 170.1 128.9 Total Liabilities and Stockholders’ Equity 170.1 128.9

Assets = Liabilities + Stockholders’ Equity

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2.2.2 The Balance Sheet
Balance Sheets ($ millions), December 31, 2022, and 2023
Blank Blank Blank Blank

Assets Liabilities and

Stockholders’ Equity
Blank

2022 2023 2022 2023

Cash $ 94.50 $ 90.00 Accounts payable $ 184.50 $ 189.00
Accounts 139.50 162.00 Accrued expenses 45.00 45.00
Receivable
Inventory 229.50 378.00 Short-term notes 63.00 54.00
Other current assets 13.50 13.50 Total current liabilities $ 292.50 $ 288.00
Total current assets $ 477.00 $ 643.50 Long-term debt 720.00 771.75
Gross plant and 1,669.50 1,845.00 Total liabilities $1,012.50 $1,059.75
equipment Blank Blank

Less accumulated (382.50) (517.50) Common stockholders’ equity

depreciation
Net plant and $1,287.00 $1,327.50 Common stock-par value 45.00 45.00
equipment
Total assets $1,764.00 $1,971.00 Paid-in capital 324.00 324.00
Blank Blank Blank

Retained earnings 382.50 542.25

Blank Blank Blank

Total common stockholders’ $ 751.50 $ 911.25

equity
Blank Blank Blank

Total liabilities and $1,764.00 $1,971.00

stockholders’ equity

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 2.2.2 The Balance Sheet
H. J. Boswell, Inc., Balance Sheets and Balance Sheet Changes
Blank 2015 2016 Change Blank 2015 2016 Change

Accounts payable $ 184.50 $ 189.00 $ 4.50

Cash $ 94.50 $ 90.00 $ (4.50)
Accrued expenses 45.00 45.00 0.00
Accounts receivable 139.50 162.00 22.50
Short-term notes 63.00 54.00 (9.00)

Inventory 229.50 378.00 148.50 Total current liabilities $ 292.50 $ 288.00 $ (4.50)

Other current assets 13.50 13.50 0.00 Long-term debt 720.00 771.75 51.75

Total liabilities $1,012.50 $1,059.75 $ 47.25

Total current assets $ 477.00 $ 643.50 $166.50
Common stockholders’ equity Blank Blank Blank
Gross plant and equipment 1,669.50 1,845.00 175.50
Common stock—par value 45.00 45.00 0.00
Less accumulated (382.50) (517.50) (135.00) Paid-in capital 324.00 324.00 324.00
depreciation
Retained earnings 382.50 542.25 159.75
Net plant and $1,287.00 $1,327.50 $ 40.50
equipment Total Common Stockholders’ Equity $ 751.50 $ 911.25 $159.75

Total Assets $1,764.00 $1,971.00 $207.00 Total Liabilities and Stockholders’ $1,764.00 $1,971.00 $207.00
Equity

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2.2.3 The Statement of Cash Flows

– How much cash the firm has generated

– How that cash has been allocated

• Cash is important because it is needed to pay bills

and maintain operations and is the source of any
return of investment for investors

• The statement of cash flows is divided into

three sections which roughly correspond to the
three major jobs of the financial manager:
1. Operating activities
2. Investment activities
3. Financing activities

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2.2.3 The Statement of Cash Flows

Statement of Cash Flows

Operating Investing Financing
CASH Activities Activities Activities
INFLOWS

CASH
OUTFLOWS

Operating Investing Financing

Activities Activities Activities
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 2.2.3 The Statement of Cash Flows

• Operating activities represent the company’s core

business, including sales and expenses.
• Investing activities include the cash flows that arise out
of the purchase and sale of long-term assets such as plant
and equipment.
• Financing activities represent changes in the firm’s use
of debt and equity such as issue of new shares, the
repurchase of outstanding shares, and the payment of
dividends.

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2.2.3 The Statement of Cash Flows

Evaluating the Cash Flow Statement

The statement can be used to answer a number of important

questions such as:
– How much cash did the firm generate from its operations?
– How much did the firm invest in plant and equipment?
– Did the firm raise additional funds, and if so, how much and from what
sources?

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2.2.3 The Statement of Cash Flows

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Global Corporation’s Statement of Cash Flows for 2022 and 2023
Year ended December 31 (in $ millions)

2022 2023
Operating activities
Net income 2.0 1.9
Depreciation and amortization 1.2 1.1
Accounts receivable (5.5) (0.3)
Accounts payable 2.7 (0.5)
Inventory (1.0) (1.0)
Cash from operating activities (0.6) 1.2
Investment activities
Capital expenditures (33.4) (4.0)
Acquisitions and other investing activity
Cash from investing activities (33.4) (4.0)
Financing activities
Dividends paid (1.0) (1.0)
Sale or purchase of stock
Increase in short-term borrowing 2.3 3.0
Increase in long-term borrowing 35.2 2.5
Cash from financing activities 36.5 4.5
Change in cash and cash equivalents 2.5 1.7

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 2.2.3 The Statement of Cash Flows

Ending Cash Balance for 2015 Blank Blank $94.50 Financing activities Blank Blank Blank
(Beginning Cash Balance for 2016)

Operating activities Blank Blank Blank Decrease in short-term notes (9.00) Blank Blank

Net income $204.75 Blank Blank

Increase in long-term debt 51.75 Blank Blank
Increase in accounts receivable (22.50) Blank Blank

Increase in inventory (148.50) Blank Blank Cash dividends paid to shareholders $ Blank Blank
(45.00)
No change in other current assets 0.00 Blank Blank
Cash flow from financing Blank (2.25) Blank
Depreciation expense 135.00 Blank Blank activities
Increase in accounts payable 4.50 Blank Blank Increase (decrease) in cash during Blank Blank $ (4.50)
the year
No change in accrued expenses 0.00 Blank Blank
Ending cash balance for 2016 Blank Blank $90.00
Cash flow from operating Blank $ 173.25 Blank
activities
Investing activities Blank Blank Blank

Purchases of plant and equipment (175.50) Blank Blank

Cash flow from investing Blank (175.50) Blank

activities

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2.2.3 The Statement of Cash Flows
• Operating Activity
– Use the following guidelines to adjust for changes in working capital:
▪ Accounts receivable:
– Adjust the cash flows by deducting the increases in accounts receivable
– This increase represents additional lending by the firm to its customers and it
reduces the cash available to the firm
▪ Accounts payable:
– Similarly, we add increases in accounts payable
– Accounts payable represents borrowing by the firm from its suppliers
– This borrowing increases the cash available to the firm
▪ Inventory:
– Finally, we deduct increases to inventory
– Increases to inventory are not recorded as an expense and do not contribute to net
income
– However, the cost of increasing inventory is a cash expense for the firm and must
be deducted
– We also add depreciation to net income, since it is not a cash outflow

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2.2.3 The Statement of Cash Flows

• Investment Activity
– Subtract the actual capital expenditure that the
firm made
– Also deduct other assets purchased or
investments made by the firm, such as
acquisitions

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2.2.3 The Statement of Cash Flows

• Financing Activity
– The last section of the statement of cash flows
shows the cash flows from financing activities
▪ Dividends paid
▪ Cash received from sale of stock or spent
repurchasing its own stock
▪ Changes to short-term and long-term borrowing

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2.2.3 The Statement of Cash Flows

• The last line of the Statement of Cash Flows

combines the cash flows from these three
activities to calculate the overall change in the
firm’s cash balance over the time period of
the statement

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2.2.4 Statement of Retained Earnings

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2.3 Financial Statement Analysis

• Investors often use accounting statements to:

– Compare the firm with itself by analyzing how the firm has changed over time
– Compare the firm to other similar firms using a common set of financial ratios

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Why Analyze Financial Statements? Internal Financial Analysis
2.3 Financial Statement Analysis

An internal financial analysis might be done:

– To evaluate the performance of employees to determine
incentives
– To compare the financial performance of firm’s different
divisions
– To prepare financial projections
– To evaluate the firm’s financial performance relative to its
competitors’ performance

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2.3 Financial Statement Analysis
Why Analyze Financial Statements? Internal Financial Analysis
External financial analysis to determine the credit worthiness
or investment attractiveness is done by:
– Banks and other lenders
– Suppliers
– Credit-rating agencies
– Professional analysts
– Individual investors

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2.3 Financial Statement Analysis
Using Financial Ratios
Financial ratios provide a second method for standardizing and analyzing the financial
information on the income statement and balance sheet around five fundamental categories of
issues.

A ratio by itself may have no meaning. Hence, a given ratio is generally compared to: (a) ratios
from previous years (trend analysis); or (b) ratios of other firms in the same industry (peer
comparison analysis).
Category of Ratios Used to Address the
Question
Question

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

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

3. How efficient has the firm’s management been in utilizing its assets to generate
Asset management efficiency ratios
sales?

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

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

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2.3 Financial Statement Analysis

• Ratio Analysis
– A method for evaluating financial
performance on a relative basis.
– Required inputs come from the firm’s
income statement and balance sheet

• Interested Parties
– Shareholders
– Creditors
– Management

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2.3 Financial Statement Analysis
1. Liquidity Ratios

• Liquidity ratios address a basic question: Can a firm pay its bills on time?

• A firm is financially liquid if it is able to pay its bills on time. We can analyze a firm’s liquidity
from two complementary perspectives:
– measuring the overall liquidity of a firm, and
– measuring the liquidity of individual asset categories.

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2.3 Financial Statement Analysis
1. Liquidity Ratios

• Current Ratio
Current Ratio: Current Ratio compares a firm’s current (liquid) assets to its current (short-
term) liabilities.
Current Assets
Current Ratio =
Current Liabilities
What is the current ratio for 2023 for Boswell?

Current Ratio = $643.5m ÷ $288.0m = 2.23 times

The firm had $2.23 in current assets for every $1 it owed in current liability. It is better than
peer group average of $1.80.

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2.3 Financial Statement Analysis
1. Liquidity Ratios

• Acid-Test (Quick) Ratio

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

Acid-Test Current Assets − Inventory

=
(or Quick) Ratio Current Liabilities

What is the quick ratio for Boswell?

Acid-Test (or Quick) Ratio

= ($643.5m − $378m) ÷ ($288.0m) = 0.92 times

The firm has only $0.92 in current assets (less inventory) to cover $1 in current liabilities. This ratio is worse
than peer average of $0.94

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2.3 Financial Statement Analysis
1. Liquidity Ratios

• Cash Ratio
Cash
Cash Ratio=
Current Liabilities

• Cash Ratio = Cash / CL

• 98 / 540 = .18 times

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2.3 Financial Statement Analysis
2. Capital Structure Ratios/ Leverage Ratios

Capital structure refers to the way a firm finances its assets

using a combination of debt and equity.

Capital structure ratios address the important question: How

has the firm financed the purchase of its assets? To address
this issue, we use two types of capital structure ratios: the
debt ratio, and the times interest earned ratio.

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2.3 Financial Statement Analysis
2. Capital Structure Ratios/ Leverage Ratios Example of Debt-Equity Ratio Calculation
ABC Company has the following financial details:
– Debt-Equity Ratio
•Total Liabilities: $500,000
▪ •Shareholders' Equity: $250,000
The debt-equity ratio is a common ratio used to assess a firm’s leverage
▪ This ratio can be calculated using book or market values Formula:
Debt-Equity Ratio = Total Liabilities / Shareholders’ Equity
Total Debt
Debt-Equity Ratio = Calculation:
Total Equity Debt-Equity Ratio = 500,000/250,000 = 2.

Interpretation:
•The ratio of 2.0 means that for every $1 of equity, ABC
Company has $2 in debt.

– Debt-to-Capital Ratio
▪ The debt-to-capital ratio calculates the fraction of the firm financed by debt:
▪ This ratio can also be calculated using book or market values

Total Debt
Debt-to-Capital Ratio =
Total Equity + Total Debt

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2.3 Financial Statement Analysis
2. Capital Structure Ratios/ Leverage Ratios

– Net Debt
▪ While leverage increases risk to equity holders, firms may also hold cash reserves in
order to reduce risk
▪ Another useful measure is net debt

Net Debt =Total Debt-Excess Cash and Short-Term Invesments

- Debt to Assets Ratio

Debt-to-Assets Ratio = Total Debt / Total Assets

- Assets to Equity Ratio

Asset-to-Equity Ratio = Total Assets / Total Equity

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2.3 Financial Statement Analysis
3. Profitability Ratios

Profitability ratios address a very fundamental question: Has the firm earned
adequate returns on its investments?

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

are the following:

Cost Control—How well has the firm controlled its costs relative to each dollar of firm sales?

Efficiency of asset utilization—How effective is the firm in using the assets to generate sales?

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 2.3 Financial Statement Analysis
3. Profitability Ratios

• Cost Control: Is the Firm Earning Reasonable Profit Margins?

Gross profit margin shows how well the firm’s management controls its expenses to generate profits.

Gross Profit Gross Profits

=
Margin Sales

What is the gross profit margin ratio for 2023 for H. J. Boswell, Inc.?

Gross Profit Margin

= $675 million ÷ $2,700 million = 25%
– The firm spent $0.75 for cost of goods sold and thus $0.25 out of each dollar of sales went towards gross
profits.

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 2.3 Financial Statement Analysis
3. Profitability Ratios

• Cost Control: Operating Profit Margin

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

Operating Profit Net Operating Income or EBIT $382.5 million

= = = 14.2%
Margin (OPM) Sales $2, 700 million
Peer-group operating profit margin = 15.5%

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 2.3 Financial Statement Analysis
3. Profitability Ratios
• Cost Control: Net Profit Margin

Net Profit Margin measures how much income is generated from each dollar of sales after
adjusting for all expenses (including income taxes).

Net Profit Net Income

=
Margin Sales
What is the net profit margin ratio for H. J. Boswell, Inc.?

Net Profit Margin

= $204.75 million ÷ $2,700 million = 7.6%
– The firm generated $0.076 for each dollar of sales after paying all of the firm’s expenses, whereas
the peer-group firms earn $0.102.

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 2.3 Financial Statement Analysis
3. Profitability Ratios

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

Return on Equity (ROE) ratio measures the accounting return on the common stockholders’ investment.

Return on Net Income

=
Equity Common Equity

What is the ROE ratio for H. J. Boswell, Inc.?

ROE = $204.75 million ÷ $911.25 million = 22.5%

– Thus, the shareholders earned 22.5% on their investments. This is higher than peer average of 18%

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2.3 Financial Statement Analysis
3. Profitability Ratios
• Operating Returns
– Return on Equity
▪ Evaluating the firm’s return on investment by comparing its income to its investment
Net Income
Return on Equity = Return on Equity (ROE) = Net Income / Total Equity
Book Value of Equity 363 / 2591 = 14.0%

This means that you generate 14 cents of income for every RM your company holds in assets.

– Return on Assets
• Evaluating the firm’s return on investment by comparing its income to its assets

Net Income Return on Assets (ROA) = Net Income / Total Assets

Return on Assets = 363 / 3588 = 10.1%
Total Assets
– Return on Invested Capital
• After-tax profit generated by the business, excluding interest, compared to capital raised that
has already been deployed
EBIT (1 - tax rate )
Return on Invested Capital =
Book Value of Equity + Net Debt

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 2.3 Financial Statement Analysis
4. Asset Management Efficiency Ratios

Asset management efficiency ratios measure a firm’s

effectiveness in utilizing its assets to generate sales. These
ratios are commonly referred to as turnover ratios as they
reflect the number of times a particular asset account
balance turns over during the year.

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 2.3 Financial Statement Analysis

4. Asset Management Efficiency Ratios

• Total Asset Turnover Ratio

Total Asset Turnover Ratio represents the amount of sales generated per dollar invested in
the firm’s assets.

Total Assets Sales $2, 700 million

= = = 1.37 times
Turnover Total Assets $1, 971 million
Peer-group total asset turnover = 1.15 times

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 2.3 Financial Statement Analysis

4. Asset Management Efficiency Ratios

Fixed Asset Turnover Ratio

Fixed asset turnover ratio measures firm’s efficiency in utilizing its fixed assets (such as
property, plant and equipment).

Fixed Asset Sales $2, 700 million

= = = 2.03 times
Turnover Net Plant and Equipment $1, 327 million
Peer-group fixed asset turnover = 1.75 times

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2.4 Selecting a Performance
Benchmark
There are two types of benchmarks that are commonly used
to analyze a firm’s financial performance by means of its
financial statements:

Trend Analysis—compares a firm’s financial statements

over time (time-series comparisons).
Peer Group Comparisons—compares the subject firm’s
financial statements with “peer” firms.

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Trend Analysis

Comparing a firm’s recent financial ratios with the past

financial ratios provides insight into whether the firm is
improving or deteriorating over time. This type of financial
analysis is referred to as trend analysis.

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Figure 4.3 A Time-Series (Trend) Analysis of the Inventory Turnover Ratio: Home
Depot Versus Lowe’s, 2001–2015

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Peer-Firm Comparisons

A peer firm is simply one that the analyst believes will

provide a relevant benchmark for the analysis at hand. Peer
groups often consist of firms from the same industry. Industry
average financial ratios can be obtained from a number of
financial databases (such as Compustat) and internet (such
as finance.yahoo.com and www.google.com/finance).

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 Chapter Quiz
• What is the role of an auditor?

• What is depreciation designed to capture?

• What does a high debt-to-equity ratio tell you?

• What do a firm’s earnings tell you?

• How do you use the price-earnings P/E ration to measure the market value of the firm?

• Why does a firm’s net income not correspond to cash earned?

• What information do the notes to financial statements provide?

• What is the Sarbanes-Oxley Act?

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 Chapter Quiz
INSTRUCTIONS
• Select TWO (2)latest annual report from established companies and listed on Bursa Malaysia.
• Conduct a cross Financial statement analysis (eg Shell vs Petronas)
• Calculate the respective ratio that you have learned throughout the course.
• Provide relevant analysis based on your findings in (a) and (b) with regards to the performance of the company.
• Conclude your findings including decision whether the company is worth investing as well as your recommendation

Required
(a) Calculate the following ratios for 2022:

• Current Ratio
• Quick Ratio
• Cash Ratio
• Debt to Equity Ratio
• Debt to Capital Ratio
• Gross Profit Ratio
• Net Profit Ratio
• Return on Asset
• Return on Equity
• Assets Turnover

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 Review of Learning Goals
• LG 1
– Review the contents of a company’s financial statements.
▪ Form 10-K, which publicly owned corporations must file with the SEC each year, documents the firm’s
financial activities of the past year.
▪ It includes information about the firm’s activities and strategies
▪ 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
– Review the contents of the stockholders’ report and the procedures for consolidating international financial
statements.
▪ 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 U.S. dollars in accordance with FASB Standard No. 52

• LG 2
– Understand who uses financial ratios and how they use them.
▪ 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

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Review of Learning Goals
• LG 3
– Use ratios to analyze a firm’s liquidity and activity.
▪ Analysts can assess a firm’s liquidity, or the ability of the firm to pay its bills as they come
due, by calculating the current ratio and the quick (acid-test) ratio
▪ Activity ratios measure the speed with which accounts are converted into sales or cash
▪ Analysts use the inventory turnover ratio, the accounts receivable collection period, and
the average payment period (for accounts payable) to assess the activity of those current
assets and liabilities
▪ Total asset turnover measures the efficiency with which the firm uses its assets to generate
sales

• LG 4
– Discuss the relationship between debt and financial leverage, as well as 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
▪ Financial debt ratios measure both the degree of indebtedness and the ability to service
debts
▪ A common measure of indebtedness is the debt ratio
▪ The times interest earned and fixed-payment coverage ratios measure the ability to pay
fixed charges
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 Review of Learning Goals
• LG 5
– Use ratios to analyze a firm’s profitability and its market value.
▪ The common-size income statement, which shows each item 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

• LG 6
– 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

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 Financial Ratios for Select Firms and Their Industry Average Values
Times
Average interest
Current Quick Inventory collection Total asset Debt-to- earned Net profit Return on Return on
ratio ratio turnover period (days) turnover Debt ratio equity ratio margin total assets common equity
Builders 1.6 0.9 9.1 35.0 2.4 0.8 2.9 35.5 3.0% 7.2% 31.2%
FirstSource
Home Depot 1.1 0.2 5.1 7.0 2.3 1.1 - 13.3 10.2% 23.5% -
Lowes 1.0 0.1 3.8 - 2.0 1.0 19.0 8.8 5.9% 11.8% 152.5%

Building 1.6 1.2 12.6 8.0 7.6 0.7 1.5 11.0 5.3% 28.8% 67.6%
Materials
Apple 1.6 1.4 36.5 52.0 0.7 0.7 2.8 20.5 21.5% 15.1% 55.5%

Cisco Systems 1.8 1.6 12.2 64.0 0.5 0.6 1.5 20.4 21.4% 10.7% 29.0%
IBM 1.0 0.9 24.3 129.0 0.6 0.9 6.3 8.6 12.2% 7.3% 49.7%

Computers 2.0 1.1 14.6 17.0 2.9 0.6 1.0 3.4 3.1% 5.8% 7.2%

Chipotle 1.6 1.5 182.5 6.0 1.5 0.7 2.0 - 6.3% 9.5% 22.4%

Texas Roadhouse 0.6 0.5 91.3 13.0 1.6 0.5 1.1 - 6.3% 10.1% 18.4%

Wendy’s 1.6 1.2 365.0 27.0 0.4 0.9 8.7 2.4 8.0% 3.2% 23.5%

Eating and 0.6 0.4 121.7 3.0 3.6 0.8 1.3 3.4 2.6% 7.9% -12.3%

Drinking
Dilliard’s 2.0 0.4 2.8 3.0 1.9 0.5 1.0 3.9 1.8% 3.4% 6.7%

Nordstrom 0.9 0.3 - 4.0 1.8 0.8 8.0 3.8 3.2% 5.8% 53.6%

Target 0.9 0.3 6.1 2.1 1.8 0.7 2.6 9.8 4.2% 7.7% 27.7%

Walmart 0.8 0.2 8.9 4.0 2.3 0.7 1.9 9.9 2.8% 6.4% 18.5%

Merchandise 1.3 0.2 16.6 1.0 6.1 0.6 2.0 6.5 2.4% 15.1% 40.4%
Stores

All Industries 1.6 1.0 17.4 13.0 1.7 0.6 1.0 1.9 3.3% 2.4% 3.2%

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Copyright

This work is protected by United States copyright laws and

is provided solely for the use of instructors in teaching their
courses and assessing student learning. Dissemination or
sale of any part of this work (including on the World Wide
Web) will destroy the integrity of the work and is not
permitted. The work and materials from it should never be
made available to students except by instructors using the
accompanying text in their classes. All recipients of this
work are expected to abide by these restrictions and to
honor the intended pedagogical purposes and the needs of
other instructors who rely on these materials.

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2.3 Financial Statement Analysis
• Activity Ratios InventoryTurnover Ratio

cost of goods sold

• Inventory turnover ratio =
stocks

2,482,000
• Inventory turnover ratio = = 5.7 times
435,000
stocks
= 365 days
• Inventory turnover days = cost of goods sold

435,000
• Inventory turnover days = × 365 = 63.97 days
2,482,000

• Indicates the relative liquidity of stocks in a firm

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 2.3 Financial Statement Analysis
• Activity Ratios Accounts Receivables Turnover Ratio

• Indicates how long it takes for a firm to collect its receivables

Credit sales
• Accounts receivables turnover ratio =
Trade debtors
3,393,000
• Accounts receivables turnover ratio = 441,000 = 7.7 times

Trade debtors ×365 days

• Accounts receivables turnover days = Credit sales
441,000
3,393,000 ×365
• Accounts receivables turnover days =
= 47.44 days
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2.3 Financial Statement Analysis
• Activity Ratios Accounts Payable Turnover Ratio

• Indication of the extent of how quick the cash outflows are in a

firm
Credit purchases
• Accounts payables turnover ratio =
Trade creditors
2,482,000
• Accounts payables turnover ratio = 343,000 = 7.3 times
Accounts payables ×365 days
• Accounts payables turnover days = Credit purchases

343,000 ×365
• Accounts payables turnover days = 2,482,000 = 50.44
days
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3.2 Using Financial Ratios
• Types of Ratio Comparisons
– Time-Series Analysis
▪ Evaluation of the firm’s financial performance over time using financial
ratio analysis
– Combined Analysis
▪ Combines cross-sectional and time-series analyses

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Personal Finance Example
The personal liquidity ratio is calculated by dividing total liquid assets by total current debt.
It indicates the percentage of annual debt obligations that an individual can meet using
current liquid assets. The Smiths’ total liquid assets were $2,225. Their total current debts
are $18,080 (total current liabilities of $1,050 + mortgage payments of $11,500 + auto loan
payments of $4,280 + appliance and furniture payments of $1,250). Substituting these
values into the ratio formula, we get

Total liquid assets $2, 225

Liquidity ratio = = = 0.123, or 12.3%
Total current debts $18, 080

The ratio indicates that the Smiths can cover only about 12% of their existing one-year debt
obligations with their current liquid assets. Clearly, the Smiths plan to meet these debt
obligations from their income, but this ratio suggests that their liquid funds do not provide a
large cushion. As one of their goals, they should probably build up a larger fund of liquid
assets to meet unexpected expenses.

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 A Complete Ratio Analysis
• Summary of Target’s Financial Condition
– Liquidity
▪ Liquidity position was relatively stable over this period, with a slight increase in 2020
– Activity
▪ Target is managing its current assets and liabilities reasonably well
▪ Total asset turnover was rock steady from 2018 to 2020
– Debt
▪ Target’s indebtedness increased slightly from 2018 to 2019 before moving back a bit in 2020.
▪ Target is generating more than enough cash flow to cover its interest payments, though leverage does
increase its risk profile
– Profitability
▪ Target was profitable from 2018 to 2020 by all measures and was more profitable than Walmart.
▪ Compared to the industry average, it exceeded on some measures and trailed on others
– Market
▪ Both the P/E and M/B ratios rose sharply in 2020, largely reflecting an upswing in stock prices generally over
that period.
▪ Target’s P/E ratio was below that of the average stock, but that is not surprising given the company’s size and
the industry
– Overall, Target’s financial position was sound both in absolute terms and relative to its key competitors

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