LN04Titman 449327 12 LN04

Chapter 4
Financial
Analysis
Sizing up Firm
Performance
Slide Contents
Learning Objectives
Principles Applied in this Chapter
1. Why Do We Analyze Financial Statements
2. Common Size Statements Standardizing
Financial Information
3. Using Financial Ratios
4. Selecting a Performance Benchmark
5. Limitations of Ratio Analysis
Key Terms
Copyright 2014 Pearson Education, Inc. All rights reserved.
4-2
Learning Objectives
1. Explain what we can learn by analyzing a
firms financial statements.
2. Use common size financial statements as a
tool of financial analysis.
3. Calculate and use a comprehensive set of
financial ratios to evaluate a companys
performance.
4-3
Learning Objectives (cont.)

4. Select an appropriate benchmark for use in
performing a financial ratio analysis.
5. Describe the limitations of financial ratio
analysis.
4-4
Principles Used in this Chapter

Principle 3: Cash Flows Are the Source of
Value.
Principle 4: Market Prices Reflect
Information.
Principle 5: Individuals Respond to
Incentives.
4-5
4.1 WHY DO WE ANALYZE

FINANCIAL STATEMENTS?
4-6
Why Do We Analyze Financial

Statements?
An internal financial analysis might be done:
To evaluate the performance of employees
To compare the performance of different
divisions
To prepare financial projections
To evaluate the firms financial performance in
light of its competitors performance
4-7
Why Do We Analyze Financial

Statements? (cont.)
External financial analysis is done by:
Banks and other lenders

Suppliers
Credit-rating agencies
Professional analysts
Individual investors
4-8
4.2 COMMON SIZE

STATEMENTS:
STANDARDIZING FINANCIAL
INFORMATION
4-9
Common Size Statements:

Standardizing Financial Information
A common size financial statement is a
standardized version of a financial
statement in which all entries are presented
in percentages.
It helps to compare a firms financial
statements with those of other firms, even if
the other firms are not of equal size.
4-10
Common Size Statements: Standardizing

Financial Information (cont.)
How to prepare a common size financial
statement?
For a common size income statement, divide
each entry in the income statement by sales.
For a common size balance sheet, divide each
entry in the balance sheet by total assets.
4-11
Table 4.1 H. J. Boswell, Inc.
4-12
Table 4.1 Observations

Table 4-1 created by dividing each entry in
the income statement of Table 3.1 by firm
sales for 2013.
Cost of goods sold make up 75% of the firms
sales resulting in a gross profit of 25%.
Selling expenses account for about 3% of sales.
Income taxes account for 4.1% of the firms
sales.
After all expenses, the firm generates net income
of 7.6% of firms sales.
4-13
Table 4.2 H. J.
Boswell, Inc.
4-14
Table 4.2 Observations

Table 4.2 created by dividing each entry in
the balance sheet of Table 3.2 by total
assets.
Total current assets increased by 5.6% in 2013
while total current liabilities declined by 2%.
Long-term debt account for 39.2% of firms
assets, showing a decline of 1.7%.
Retained earnings increased by 5.8% .
4-15
4.3 USING FINANCIAL

RATIOS
4-16
Using Financial Ratios

Financial ratios provide a second method
for standardizing the financial information
on the income statement and balance sheet.
A ratio by itself may have no meaning.
Hence, a given ratio is generally compared
to: (a) ratios from previous years; or (b)
ratios of other firms in the same industry.
4-17
Using Financial Ratios (cont.)
4-18
LIQUIDITY RATIOS
4-19
Liquidity Ratios
Liquidity ratios address a basic question:
How liquid is the firm?
A firm is financially liquid if it is able to pay
its bills on time. We can analyze a firms
liquidity from two perspectives (see next
slide).
4-20
Liquidity Ratios (cont.)

1. Overall liquidity - analyzed by comparing
the firms current assets to the firms
current liabilities.
2. Liquidity of specific assets - analyzed by
examining the timeliness in which the
firms liquid assets (accounts receivable
and inventories) are converted into cash.
4-21
Liquidity Ratios: Current Ratio

The overall liquidity of a firm is analyzed by
computing the current ratio and acid-test
ratio. Current Ratio: Current Ratio
compares a firms current (liquid) assets to
its current (short-term) liabilities.
4-22
Liquidity Ratios: Current Ratio

(cont.)
What is the current ratio for 2012 for
Boswell?
Current Ratio = $477 292.5 = 1.63
times
The firm had $1.63 in current assets for
every $1 it owed in current liability.
4-23
Liquidity Ratios: Quick Ratio

Acid-Test (Quick) Ratio excludes the
inventory from current assets as inventory
may not be very liquid.
4-24
Liquidity Ratios: Quick Ratio

(cont.)
What is the quick ratio for Boswell for 2012?
Quick Ratio
= ($477-$229.50) ($292.50) = 0.84 times
The firm has only $0.84 in current assets

(less inventory) to cover $1 in current
liabilities.
4-25
Liquidity Ratios:
Individual Asset Categories
We can also measure the liquidity of the firm
by examining the liquidity of accounts
receivable and inventories to see how long
it takes the firm to convert its accounts
receivables and inventories into cash.
4-26
Liquidity Ratios: Accounts

Receivable
Average Collection Period measures the
number of days it takes the firm to collects its
receivables.
4-27

Receivable (cont.)
What will be the average collection period
for Boswell, Inc. for 2012 if we assume that
the annual credit sales were $2,500 million?
Daily Credit Sales
= $2,500 365 days = $6.85 million
Average Collection Period

= $139.5m $6.85m = 20.37 days
4-28

Receivable Turnover Ratio
Accounts Receivable Turnover Ratio
measures how many times receivables are
rolled over during a year.
4-29

Receivable Turnover Ratio (cont.)
What will be the accounts receivable
turnover ratio for Boswell, Inc. for 2012 if
we assume that the annual credit sales were
$2,500 million?
Accounts Receivable Turnover
= $2,500 million $139.50 = 17.92 times
The firms accounts receivable were turning over
at 17.92 times per year.
4-30
Liquidity Ratios:
Inventory Turnover Ratio
Inventory turnover ratio measures how many
times the company turns over its inventory during the
year. Shorter inventory cycles lead to greater liquidity
since the items in inventory are converted to cash
more quickly.
4-31
Liquidity Ratios:
Inventory Turnover Ratio (cont.)
What will be the inventory turnover ratio for
2012 for Boswell, Inc. if we assume that the
cost of goods sold were $1,980 million in
2012?
Inventory Turnover Ratio
= $1,980 $229.50 = 8.63 times
The firm turned over its inventory 8.63 times per
year.
4-32
Liquidity Ratios:
Days Sales in Inventory
Days Sales in Inventory
= 365 inventory turnover ratio
= 365 8.63 = 42.29 days
The firm, on average, holds it inventory for

about 42 days.
4-33
Can a Firm Have Too Much Liquidity?

A high investment in liquid assets will
enable the firm to repay its current liabilities
in a timely manner.
However, an excessive investments in liquid
assets can prove to be costly as liquid
assets (such as cash) generate minimal
return.
4-34
CHECKPOINT 4.1:
CHECK YOURSELF
Evaluating Dells Liquidity
Why do you think HPs inventory
turnover ratio is so much lower than
Dells inventory turnover ratio?
4-35
Step 1: Picture the Problem

The inventory turnover ratio will measure
how many days items remain in inventory
before being sold.
Inventory turnover ratio is important as it
has implications for cash flows and
profitability of a firm.
4-36
Step 2: Decide on a Solution

Strategy
Step 3: Solve
We will use the following equation to
compute the Inventory Turnover (IT) ratio
IT ratio = Cost of Goods Sold Inventories
Inventory Turnover Ratio for HP

= $97,529,000 7,490,000 = 13.02
4-37
Step 4: Analyze
HPs inventory turnover ratio indicates that
the inventory at HP remains on shelf for
(365 13.02) days or 28.03 days. This is
much higher than Dell that has an inventory
turnover ratio of 34.37 or shelf life of only
10.61 days.
The significant difference must be
investigated further as the two firms are in
the same industry.
4-38
Step 4: Analyze (cont.)

There are two reasons why HP has a lower
turnover of inventories relative to Dell:
HP sells computers out of inventory of computers
while Dell builds computers only when orders are
received.
HP carries more parts inventory on hand than
does Dell.
4-39
CAPITAL STRUCTURE RATIOS
4-40
Capital Structure Ratios

Capital structure refers to the way a firm
finances its assets. Capital structure ratios
address the important question: How has the
firm financed the purchase of its assets?
4-41
Capital Structure Ratios (cont.)

Debt ratio measures the proportion of the
firms assets that are financed by borrowing
or debt financing.
4-42

What is the debt ratio for H.J. Boswell, Inc.
for 2012?
Debt Ratio
= $1,012.50 million $1,764 million = 57.40%
The firm financed 57.39% of its assets with debt.
4-43

Times Interest Earned Ratio measures
the ability of the firm to service its debt or
repay the interest on debt.
4-44

What will be the times interest earned ratio
for Boswell for 2012 if we assume interest
expense of $65 million and EBIT of $350
million?
Times Interest Earned
= $350m $65m = 5.38 times
The firm can pay its interest expense 5.38 times
or interest used 1/5.38th or 18.58% of its EBIT.
4-45
4-46
CHECKPOINT 4.2:
CHECK YOURSELF
Comparing the Financing Decisions
of HD and LOW
What would be Home Depots times interest earned ratio if
interest payments remained the same, but net operating
income dropped by 80% to only $1.332 billion? Similarly
if Lowes net operating income dropped by 80%, what
would its times interest earned ratio be?
4-47

Times interest earned ratio is an important
ratio for firms that use debt financing. It
measures the firms ability to service its
debt.
The ratio requires comparing net operating
income or EBIT with Interest expense. Both
items are found on the income statement.
4-48
Step 1: Picture the Problem (cont.)

Picture an Income Statement
Sales
Less: Cost of Good Sold

Equals: Gross Profit
Less: Operating Expenses
Equals: Net Operating Income (EBIT)
Less: Interest Expense
Equals: Earnings before Taxes
Less: Taxes
Equals Net Income
EBIT
Interest
Expense
4-49

Strategy
Here we are considering the impact of a
drop in EBIT on the times interest earned
ratio of Home Depot and Lowes. We will use
the following ratio to measure the times
interest earned (TIE) ratio.
TIE = EBIT Interest Expense
4-50
Step 3: Solve
TIE (Home Depot)
= $1.332 billion $0.606 billion = 2.20 times
TIE (Lowes)
= $0.655 billion $0.371 billion = 1.77 times
4-51
Step 4: Analyze
We observe that a drop in net operating
income leads to a significant drop in times
interest earned ratio for both the firms.
Should creditors be worried by this drop?
The ratio is still reasonably safe. For
example, for Home Depot, even if the EBIT
shrank further by 55.55% (1-1/2.20 ), it
can still pay its interest expense.
4-52
ASSET MANAGEMENT
EFFICIENCY RATIOS
4-53
Asset Management Efficiency Ratios

Asset management efficiency ratios
measure a firms effectiveness in utilizing its
assets to generate sales.
They are commonly referred to as turnover
ratios as they reflect the number of times a
particular asset account balance turns over
during a year.
4-54

(cont.)
Total Asset Turnover Ratio represents
the amount of sales generated per dollar
invested in firms assets.
4-55

(cont.)
What will be the total asset turnover ratio for
Boswell, Inc. for 2012 if we assume total sales
to be $2,500 million?
Total Asset Turnover
= $2,500 million $1,764 million = 1.42 times
The firm generated $1.42 in sales per dollar of
assets in 2012.
4-56

(cont.)
Fixed asset turnover ratio measures
firms efficiency in utilizing its fixed assets
(such as property, plant and equipment).
4-57

(cont.)
What will be the fixed asset turnover ratio for
Boswell for 2012 if we assume sales of $2,500
million for 2012?
Fixed Asset Turnover
= $2,500 million $1,287 million = 1.94 times
The firm generated $1.94 in sales per dollar
invested in plant and equipment.
4-58

(cont.)
The following grid summarizes the efficiency
of Boswells management in utilizing its assets
to generate sales in 2013.
4-59
PROFITABILITY RATIOS
4-60
Profitability Ratios
Profitability ratios address a very
fundamental question: Has the firm earned
adequate returns on its investments?
4-61
Profitability Ratios (cont.)

Two fundamental determinants of firms
profitability and returns on investments:
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?
4-62
Cost Control: Is the Firm Earning

Reasonable Profit Margins?
Gross profit margin shows how well the
firms management controls its expenses to
generate profits.
4-63

Reasonable Profit Margins? (cont.)
What will be the gross profit margin ratio for
2012 for Boswell if we assume sales of $2,500
million and gross profit of $650 million?
Gross Profit Margin
= $650 million $2,500 million = 26%
The firm spent $0.74 for cost of goods sold and
thus $0.26 out of each dollar of sales went
towards gross profits.
4-64

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.
4-65

What will be the operating profit margin ratio
for Boswell for 2012 if we assume sales of
$2,500 million and net operating income of
$350 million?
Operating Profit Margin
= $350 million $2,500 million = 14%
The firm generates $0.14 in operating profit for
each dollar of sales.
4-66

Net Profit Margin measures how much
income is generated from each dollar of sales
after adjusting for all expenses (including
income taxes).
4-67

What will be the net profit margin ratio for
2012 if we assume sales of $2,500 million and
net income of $217.75 million?
Net Profit Margin
= $217.75 million $2,500 million = 8.71%
The firm generated $0.087 for each dollar of
sales after all expenses were accounted for.
4-68
Return on Invested Capital

Operating Return on Assets ratio is the
summary measure of operating profitability. It
takes into account the managements success
in controlling expenses and its efficient use of
assets.
4-69
Profitability Ratios (cont.)

What will be the operating return on assets
ratio for Boswell for 2012 if we assume EBIT
or net operating income of $350 million for
2012?
Operating Return on Assets
= $350 million $1,764 million = 19.84%
The firm generated $0.1984 of operating profits
for every $1 of its invested assets.
4-70
Decomposing the Operating Return

on Assets Ratio
4-71
Figure 4.1 Analyzing H. J. Boswell, Inc.s

Operating Return on Assets (OROA)
4-72
Figure 4-1 Observations

Firms OROA (operating return on assets) is
better than its peers.
Firms OPM (operating profit margin) is
lower than its peers.
Firms TATO (total asset turnover ratio) is
higher than that of its peers.
4-73
Figure 4-1 Recommendations

1. Reduce costs - The firm must investigate
the cost of goods sold and operating
expenses to see if there are opportunities
to reduce costs.
2. Reduce inventories The firm must
investigate if it can reduce the size of its
inventories.
4-74
CHECKPOINT 4.3:
CHECK YOURSELF
Evaluating the Operating Return on Assets
(OROA) for HD and LOW
If Home Depot were able to raise its total asset
turnover ratio to 2.5 while maintaining its current
operating profit margin, what would happen to its
operating return on assets?
4-75

The operating return on assets ratio for a
firm is determined by two factors: cost
control and asset utilization. Here the focus
is on asset utilization.
4-76

Strategy
We will analyze the impact on operating
return on assets of improvement on the total
asset turnover ratio by using the following
equation:
= Total Asset Turnover Operating Profit Margin
4-77
Step 3: Solve
= Total Asset Turnover Operating Profit
Margin
Before = 1.74 9.46% = 16.46%

Now
= 2.5 9.46% = 23.65%
4-78
Step 4: Analyze
An improvement in total asset turnover ratio
has a favorable impact on Home Depots
operating return on assets (OROA).
If Home Depot wants to increase its OROA
more, it should focus on cost control that
will help improve the net operating profit.
4-79
Is the Firm Providing a Reasonable

Return on the Owners Investment?
Return on Equity (ROE) ratio measures the
accounting return on the common
stockholders investment.
4-80
Is the Firm Providing a Reasonable Return

on the Owners Investment (cont.)
What will be the ROE ratio for Boswell for 2012
if we assume net income of $217.75 million?
ROE = $217.75m $751.50 mi = 28.98%
Thus the shareholders earned 28.97% on their
investments.
4-81
Using the DuPont Method for

Decomposing the ROE ratio
DuPont method analyzes the firms ROE
by decomposing it into three parts.
ROE = Profitability Efficiency Equity
Multiplier
Equity multiplier captures the effect of the

firms use of debt financing on its return on
equity. The equity multiplier increases in
value as the firm uses more debt.
4-82

Decomposing the ROE ratio (cont.)
ROE = Profitability Efficiency Equity
Multiplier
4-83

The following table shows why Boswells
return on equity was higher than its peers.
4-84

Figure 4.2
4-85
MARKET VALUE RATIOS
4-86
Market Value Ratios

Market value ratios address the question,
how are the firms shares valued in the stock
market?
4-87
Price-Earnings Ratio
Price-Earnings (PE) Ratio indicates how
much investors are currently willing to pay for
$1 of reported earnings.
4-88
Price-Earnings Ratio (cont.)

What will be the PE ratio for 2012 for Boswell,
Inc. if we assume the firms stock was selling
for $22 per share at a time when the firm
reported a net income of $217.75 million, and
the total number of common shares
outstanding are 90 million?
4-89
Market Value Ratios (cont.)

Earnings per share
= $217.75 million 90 million = $2.42
PE ratio =
$22 $2.42 = 9.09
The investors were willing to pay $9.09 for

every dollar of earnings per share that the
firm generated.
4-90

Market-to-Book Ratio measures the
relationship between the market value and
the accumulated investment in the firms
equity.
4-91

What will be the market-to-book ratio for
2012 for Boswell if the market price of the
stock is $22 and the firm has 90 million
shares outstanding?
4-92

Book Value per Share
= 751.50 million 90 million = $8.35 per
share
Market-to-Book Ratio
= Market price per share Book value per
share
= $22 $8.35
= 2.63 times
4-93
CHECKPOINT 4.4:
CHECK YOURSELF
Comparing the Valuation of DELL to
APPL Using Market Value Ratios
What price per share for Dell would it take
to increase the firms price-to-earnings
ratio to the level of Apple?
4-94

Price-to-earnings (PE) ratio depends on
earnings per share and price per share,
pictured as follows:
Price per share standardized by
EPS =
Net income number
Of shares outstanding
PE Ratio =
Price per share
Earnings per share
4-95

Strategy
We need to determine the price per share that
will make PE ratio of Dell (4.83) equal to the
PE ratio of Apple (13.22).
PE ratio = Price per share Earnings per
share
==> 13.22 = ?
2.01
Price per share = 13.22 2.01 = $26.57
4-96
Step 4: Analyze
PE ratio allows us to compare two stocks
with different prices by standardizing the
stock prices by earnings.
Apple has a much higher PE ratio. To reach
the same PE valuation, the stock price of
Dell will have to increase from $9.70 to
$26.57.
4-97
4.4 SELECTING A
PERFORMANCE BENCHMARK
4-98
Selecting a Performance Benchmark

There are two types of benchmarks that are
commonly used:
Trend Analysis compares a firms financial
statements over time (time-series comparisons).
Peer Group Comparisons compares the subject
firms financial statements with peer firms.
4-99
Trend Analysis
Comparing a firms 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.
4-100
Figure 4-3 A Time-Series (Trend) Analysis: Dells

Inventory Turnover Ratio Versus Hewlett
Packards: 19952011
4-101
Peer Firm Comparisons

Peer groups often consist of firms from the
same industry. Industry average financial
ratios can be obtained from a number of
financial databases and internet sources (such
as yahoo finance and google finance).
4-102
Figure 4-4 Financial Analysis of the

Gap, Inc., June 2009
4-103
4.5 LIMITATIONS OF RATIO

ANALYSIS
4-104
The Limitations of Ratio Analysis

1. Picking an industry benchmark can
sometimes be difficult.
2. Published peer-group or industry averages
are not always representative of the firm
being analyzed.
3. An industry average is not necessarily a
desirable target or norm.
4-105
The Limitations of Ratio Analysis

(cont.)
4. Accounting practices differ widely among
firms.
5. Many firms experience seasonal changes in
their operations.
6. Financial ratios offer only clues.
7. The results of financial analysis are no
better than the quality of the financial
statements.
4-106
Key Terms
Accounts receivable turnover ratio

Acid-test (quick) ratio
Average collection period
Book value per share
Capital structure
Current ratio
Days sales in inventory
4-107
Key Terms (cont.)
Debt ratio
DuPont method
Equity Multiplier
Earnings per share (EPS)
Financial leverage
Financial ratios
Fixed asset turnover ratio
Inventory turnover ratio
4-108
Key terms (cont.)
Liquidity ratios
Market-to-book ratio
Market value ratios
Notes payable
Operating return on assets (OROA)
Price-earnings (PE) ratio
4-109
Key terms (cont.)
Return on assets (ROA)

Return on equity (ROE)
Times interest earned
Total asset turnover ratio (TATO)
Trend analysis
4-110

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Chapter 4

Copyright 2014 Pearson Education, Inc. All rights reserved.

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Learning Objectives (cont.)

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Principles Used in this Chapter

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4.1 WHY DO WE ANALYZE

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Why Do We Analyze Financial

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Why Do We Analyze Financial

Banks and other lenders

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4.2 COMMON SIZE

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Common Size Statements:

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Common Size Statements: Standardizing

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Table 4.1 H. J. Boswell, Inc.

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Table 4.1 Observations

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Table 4.2 Observations

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4.3 USING FINANCIAL

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Using Financial Ratios

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Using Financial Ratios (cont.)

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Liquidity Ratios (cont.)

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Liquidity Ratios: Current Ratio

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Liquidity Ratios: Current Ratio

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Liquidity Ratios: Quick Ratio

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Liquidity Ratios: Quick Ratio

The firm has only $0.84 in current assets

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Liquidity Ratios: Accounts

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Liquidity Ratios: Accounts

Average Collection Period

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Liquidity Ratios: Accounts

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Liquidity Ratios: Accounts

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The firm, on average, holds it inventory for

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Can a Firm Have Too Much Liquidity?

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Step 1: Picture the Problem