1
CHAPTER 3
Analysis of Financial Statements
Dr. Omar Al Nasser
FINC 6352
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Topics in Chapter 3
Ratio analysis
Du Pont system
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Why are ratios useful?
Standardize numbers; facilitate comparisons
Used to highlight weaknesses and strengths
From an investor’s standpoint:
The real value of financial statements lies in the
fact that they can be used to predict future
earnings, dividends, and free cash flow.
From management standpoint:
Financial statements is useful to anticipate future
conditions and as a starting point for planning
actions that will improve the firm’s future
performance.
4
Income Statement
2007
2008E
Sales
5,834,400
7,035,600
COGS
4,980,000
5,800,000
Other expenses
720,000
612,960
Deprec.
116,960
120,000
Tot. op. costs
5,816,960
6,532,960
EBIT
17,440
502,640
Int. expense
176,000
80,000
EBT
(158,560)
422,640
Taxes (40%)
(63,424)
169,056
Net income
(95,136)
253,584
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Balance Sheets: Assets
2007
2008E
Cash
7,282
14,000
S

T invest.
20,000
71,632
AR
632,160
878,000
Inventories
1,287,360
1,716,480
Total CA
1,946,802
2,680,112
Net FA
939,790
836,840
Total assets
2,886,592
3,516,952
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Liabilities & Equity
2007
2008E
Accts. payable
324,000
359,800
Notes payable
720,000
300,000
Accruals
284,960
380,000
Total CL
1,328,960
1,039,800
Long

term debt
1,000,000
500,000
Common stock
460,000
1,680,936
Ret. earnings
97,632
296,216
Total equity
557,632
1,977,152
Total L&E
2,886,592
3,516,952
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Other Data
2007
2008E
Stock price
$6.00
$12.17
# of shares
100,000
250,000
EPS

$0.95
$1.01
DPS
$0.11
$0.22
Book val. per
share
$5.58
$7.91
Lease payments
$40,000
$40,000
Tax rate
0.4
0.4
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What are the five major categories of
ratios?
Liquidity:
Can the company makes the required
payments for short

term creditors/suppliers and
bankers?
Asset management:
Do we have the right amount
of assets for the level of sales?
Debt management:
Do we have the right mix of
debt and equity?
9
What are the five major categories of
ratios?
Profitability:
Do sales prices exceed unit costs?
Shed light upon the overall effectiveness of
management regarding the returns generated on
sales and investment.
Market value:
What investors think about the
company’s past performance and future prospects?
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Liquidity Ratios
Provides information on a company’s
ability to meet its short

term obligations.
A liquid asset is one that be easily
converted to cash without significant loss
of its original value.
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Liquidity Ratios
Current Ratio
Is calculated by dividing current assets by
current liabilities.
Indicated the extent to which CL are covered
by assets expected to be converted into cash
in the near future
Current ratio
= Current assets / Current liabilities
= $
2680
/ $
1040
=
2.58
times
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Liquidity Ratios
Quick Ratio
Is calculated by deducting inventories from current
assets and dividing the results by current
liabilities.
Quick ratio
= (CA
–
Inventories) / CL
= ($
2
,
680
–
$
1
,
716
) / $
1
,
040
=
0.93
x
13
Asset Management Ratios
A set of ratios that measures how well a firm
is managing its asset.
Inventory Turnover Ratio
:
Is the ratio of total sales to inventory. This ratio
indicates how many times inventory is created and
sold during the period.
times
10
.
4
1716
7036
Inventory
Sales
Turnover
Inventory
14
This ratio is calculated by dividing AR by average
sales per day.
It indicates the average length of time the firm
must wait after making a sale before it receives
cash.
DSO
= Receivables / Avg sales per day
= Receivables / (Annual sales/
365
)
= $
878
/ ($
7
,
036
/
365
)
=
45.6
days
DSO: average number of days
from sale until cash received.
15
Asset Management Ratios
Fixed Assets Turnover Ratio
Is the ratio of sales to fixed assets.
This ratio indicates the ability of the company’s
management to put the fixed assets to work in order
to generate sales.
FA turnover = Sales / Net fixed assets
= $
7
,
036
/ $
837
=
8.41
x
If the ratio is close to the industry average, this
indicates that the company is using its fixed assets as
effectively as other companies in the industry.
16
Asset Management Ratios
Total Assets Turnover Ratio
Is the ratio of sales to total assets. This ratio
indicates the extent that the investment in total
assets results in sales.
TA turnover = Sales / Total assets
= $
7
,
036
/ $
3
,
517
=
2.00
x
If this ratio is below its industry average, it may indicate
that the company is not generating enough sales given
its total assets. Sales should be increased or assets
should be sold.
17
Debt Management Ratios
Measure the extent to which a firm relies on
debt financing (financial leverage).
Debt Ratio:
The ratio of total debt to total assets. It measures the
percentage of funds provided by creditors.
%
8
.
43
3517
500
1040
Assets
Total
debt
Total
Ratio
Debt
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Times Interest Earned ratio.
Is computed by dividing earnings before interest and
taxes by interest charges.
It measures the ability of the firm to meet its annual
interest payments.
We use earnings before interest and taxes, rather than
net income, because interest is paid with pre

tax dollars,
so the firm’s ability to pay its interest payments is not
affected by taxes.
TIE
= EBIT / Interest expense
= $
502.6
/ $
80
=
6.3
x
The higher the ratio, the greater the company's ability to
make its interest payments or take on more debt.
Debt Management Ratios
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Profitability Ratios
Profitability Ratios
show the combined effects of
liquidity, asset management, and debt
management on operating results.
Profit margin on sales:
Net profit margin shows how much net profit is
derived from every dollar of total sales.
It indicates how well the business has managed its
operating expenses.
Profit margin= Net income / Sales
= $
253.6
/ $
7
,
036
=
3.6
%
If the industry average is
5
%, this may indicates
that the cost is too high which may be a results of
inefficient operations
.
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Profitability Ratios
Basic Earning Power (BEP) Ratio:
It compares earnings apart from the influence of
taxes or financial leverage, to the assets of the
company.
BEP
= EBIT / Total assets
= $
502.6
/ $
3517
=
14.3
%
If the industry average is
18.0
%, this indicates that
the company is not earning as high return on assets
as the average companies in its industry.
21
Profitability Ratios
Return on Equity:
Is computed by dividing net income available to
common stockholders by common equity.
It measure the rate of return on common stockholders
investment. Higher return will results in happy
common stockholders.
ROE
= Net income / Total common equity
= $
253.6
/ $
1977
=
12.8
%
22
Profitability Ratios
Return on Assets:
This evaluates how well the company employs its
assets to generate a return.
High return ratio indicates good use of assets
ROA
= Net income / Total assets
= $
253.6
/ $
3517
=
7.2
%
If the industry average is
11.0
%, this indicate that
the company’s
7.2
% return is well below the industry
average for the following reasons:
The company’s low basic earning power, and
High interest costs resulting from its above

average use of
debt. Both of which cause its NI to be relatively low.
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Market Value Ratios
It relate the firm’s stock price to its earnings, cash
flow, and book value per share.
These ratios give management an indication of
what investors think of the company risk and
future performance.
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Price/Earning Ratio (P/E ratio)
The ratio of the price per share to earnings per share.
It is a useful indicator of what premium or discount
investors are prepared to pay or receive for the
investment.
The higher the price in relation to earnings, the higher the
P/E ratio which indicates the higher the premium an
investor is prepared to pay for the share.
P/E
= Price / Earnings per share
= $
12.17
/ $
1.01
=
12.0
x
If the P/E ratio is below the industry average, this
indicates that the company is riskier than other companies
or have poor growth prospects.
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Price/Cash flow Ratio
A measure of the market's expectations of a firm's
future financial health. It is calculated by dividing the
price per share by cash flow per share.
Cash flow per share is equal to net income plus
depreciation and amortization divided by common
shares outstanding.
P/CF
= Price / Cash flow per share
= $
12.17
/ [($
253.6
+$
120.0
)
÷
250
]
=
8.17
x
This indicate that the company’s stock was trading at
8.17

times the company's cash flow of $
1.49
per share.
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Market/Book Ratio
Is the ratio of the current share price to the book value
per share. It measures how much a company worth at
present
.
Com. equity
Shares out.
BVPS
=
= = $
7.91
.
$
1
,
977
250
Mkt. price per share
Book value per share
M/B
=
= =
1.54
x.
$
12.17
$
7.91
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The Du Pont Equation
In ratio analysis, managers often need a framework
that ties together a firm’s profitability, its asset
usage efficiency, and its use of debt.
The basic Du Pont Equation shows that the ROA
can be found as the product of the profit margin
times the total assets turnover.
ROA = Profit Margin x Total assets turnover
= NI / sales x Sales / TA
ROA= Net income / Total asset
= $
253.6
/ $
3517
=
7.2
%
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Extended DuPont Equation:
Breaking down Return On Equity
ROE
equity
Common
income
Net
Assets
Total
income
Net
ROA
If the company were financed only with common
equity, ROA and ROE would be the same because
TA would equal common equity.
The equality holds if and only if the company uses
no debt.
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Extended DuPont Equation:
Breaking down Return On Equity
multiplier
Equity
turnover
assets
Total
margin
Profit
ROE
Equity
Assets
X
Assets
Sales
X
Sales
NI
ROE
=
3.6
% x
2
x
1.8
=
13.0
%
However, the Dupont system, shows how profit
margin, total asset turnover, and the use of debt
interact to determine the return on equity.
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