CHAPTER 3

Analysis of Financial
Statements

3-1
Balance Sheet: Assets
2003E 2002
Cash 85,632 7,282
A/R 878,000 632,160
Inventories 1,716,480 1,287,360
Total CA 2,680,112 1,926,802
Gross FA 1,197,160 1,202,950
Less: Dep. 380,120 263,160
Net FA 817,040 939,790
Total Assets 3,497,152 2,866,592
3-2
Balance sheet:
Liabilities and Equity
2003E 2002
Accts payable 436,800 524,160
Notes payable 300,000 636,808
Accruals 408,000 489,600
Total CL 1,144,800 1,650,568
Long-term debt 400,000 723,432
Common stock 1,721,176 460,000
Retained earnings 231,176 32,592
Total Equity 1,952,352 492,592
Total L & E
3,497,152 2,866,592
3-3
Income statement
2003E 2002
Sales 7,035,600 6,034,000
COGS 5,875,992 5,528,000
Other expenses 550,000 519,988
EBITDA 609,608 (13,988)
Depr. & Amort. 116,960 116,960
EBIT 492,648 (130,948)
Interest Exp. 70,008 136,012
EBT 422,640 (266,960)
Taxes 169,056 (106,784)
Net income 253,584 (160,176)
3-4
Other data
2003E 2002
No. of shares 250,000 100,000
EPS $1.014 -$1.602
DPS $0.220 $0.110
Stock price $12.17 $2.25

3-5
Why are ratios useful?
 Ratios standardize numbers and
facilitate comparisons.
 Ratios are used to highlight
weaknesses and strengths.

3-6
What are the five major categories of
ratios, and what questions do they
answer?
 Liquidity: Can we make required payments?
 Asset management: right amount of assets
vs. sales?
 Debt management: Right mix of debt and
equity?
 Profitability: Do sales prices exceed unit
costs, and are sales high enough as
reflected in PM, ROE, and ROA?
 Market value: Do investors like what they
see as reflected in P/E and M/B ratios?

3-7
 Calculate the forecasted current
ratio for 2003 & 2002.

Current ratio = Current assets / Current

liabilities
= $2,680,112 / $1,144,800
= 2.34 times or, 2.34 : 1

2002 = ???

3-8
 Calculate the Quick ratio or, Acid
Test for 2003 & 2002.

Quick ratio = (Current assets – Inventory) /

Current liabilities
= ($2,680,112 - 1,716,480)/
$1,144,800
= 0.84 times or, 0.84 : 1

2002 = ???

3-9
Comments on current & Quick
ratio
2003 2002 2001 Ind.
Current
2.34x 1.17x 2.30x 2.70x
ratio
Quick 1.11x
0.84x 0.39x 0.30x
ratio
 Expected to improve but still below the
industry average.
 Liquidity position is weak.
3-10
 What is the inventory turnover
vs. the industry average?
Inv. turnover = Sales / Inventories
= $7,035600 / $1,716,480
= 4.10x

2003 2002 2001 Ind.

Inventory
4.1x ??? 4.8x 6.1x
Turnover
3-11
Comments on
Inventory Turnover
 Inventory turnover is below industry
average.
 The company might have old
inventory, or its control might be poor.
 No improvement is currently
forecasted.

3-12
Fixed asset and total asset turnover
ratios vs. the industry average

FA turnover = Sales / Net fixed assets

= $7,036 / $817 = 8.61x

TA turnover = Sales / Total assets

= $7,036 / $3,497 = 2.01x

3-13
Evaluating the FA turnover and
TA turnover ratios
2003 2002 2001 Ind.
FA TO 8.6x ??? 10.0x 7.0x
TA TO 2.0x ??? 2.3x 2.6x
 FA turnover projected to exceed the industry
average.
 TA turnover below the industry average.
Caused by excessive currents assets (A/R
and Inv).
3-14
 Evaluating the Average Collection
period and Average payment period

DSO = Receivables / Annual sales/365

= $8,78,000 / 7,035,600/365
= 46 days
Average payment period
= Payables / Annual purchases/365
= $ 1,144,800/ $5,875,992/365
= 71 days
3-15
 Calculate the debt ratio and TIE ratios.

Debt ratio = Total debt / Total assets

= ($1,145 + $400) / $3,497 =
44.2%

TIE = EBIT / Interest expense

= $492.6 / $70 = 7.0x

3-16
 How do the debt management ratios
compare with industry averages?

2003 2002 2001 Ind.

D/A 44.2% ??? 54.8% 50.0%
TIE 7.0x ??? 4.3x 6.2x

 What can we tell about D/A and TIE by

comparing with the industry average?

3-17
 Profitability ratios: Profit margin

Profit margin = Net income / Sales

= $253.6 / $7,036 = 3.6%

3-18
 Appraising profitability with the profit
margin

2003 2002 2001 Ind.

PM 3.6% ??? 2.6% 3.5%

 Profit margin was very bad in 2002, but is projected to

exceed the industry average in 2003.

3-19
Profitability ratios:
Return on assets and Return on equity

ROA = Net income / Total assets

= $253.6 / $3,497 = 7.3%

ROE = Net income / Total common

equity
= $253.6 / $1,952 = 13.0%

3-20
Appraising profitability with the return
on assets and return on equity
2003 2002 2001 Ind.
ROA 7.3% -5.6% 6.0% 9.1%
ROE 13.0% -32.5% 13.3% 18.2%

 Both ratios rebounded from the previous year,

but are still below the industry average. More
improvement is needed.
 Wide variations in ROE illustrate the effect that
leverage can have on profitability.
3-21
 Calculate the Price/Earnings, and
Market/Book ratios.

P/E = Price / Earnings per share

= $12.17 / $1.014 = 12.0x

3-22
 Calculate the Price/Earnings, and
Market/Book ratios.

M/B = Mkt price per share / Book value per

share
= $12.17 / ($1,952 / 250) = 1.56x
2003 2002 2001 Ind.
P/E 12.0x -1.4x 9.7x 14.2x
M/B 1.56x 0.5x 1.3x 2.4x

3-23
Analyzing the market value ratios

 P/E: How much investors are willing to pay

for $1 of earnings.
 M/B: How much investors are willing to
pay for $1 of book value equity.
 For each ratio, the higher the number, the
better.

3-24
 Extended DuPont equation:
Breaking down Return on equity

ROE = (Profit margin) x (TA turnover) x (Equity multiplier)

= 3.6% x 2 x 1.8
= 13.0%

PM TA TO EM ROE
2001 2.6% 2.3 2.2 13.3%
2002 -2.7% 2.1 5.8 -32.5%
2003E 3.6% 2.0 1.8 13.0%
Ind. 3.5% 2.6 2.0 18.2%
3-25
 The Du Pont system
Also can be expressed as:
ROE = (NI/Sales) x (Sales/TA) x (TA/Equity)
 Focuses on:

 Expense control (PM)

 Asset utilization (TATO)

 Debt utilization (Eq. Mult.)

 Shows how these factors combine to

determine ROE.
3-26
 Trend analysis
 Analyzes a firm’s
financial ratios over
time
 Can be used to
estimate the likelihood
of improvement or
deterioration in
financial condition.

3-27
Potential problems and limitations
of financial ratio analysis
 Comparison with industry averages is
difficult for a conglomerate firm that
operates in many different divisions.
 “Average” performance is not necessarily
good, perhaps the firm should aim
higher.
 Seasonal factors can distort ratios.

3-28
More issues regarding ratios
 Different operating and accounting
practices can distort comparisons.
 Sometimes it is hard to tell if a ratio is
“good” or “bad”.
 Difficult to tell whether a company is,
on balance, in strong or weak position.

3-29
Qualitative factors to be considered
when evaluating a company’s future
financial performance
 Are the firm’s revenues tied to 1 key
customer, product, or supplier?
 What percentage of the firm’s business
is generated overseas?
 Competition
 Future prospects
 Legal and regulatory environment
3-30