M04 Titman 2544318 11 FinMgt C04

Chapter 4
Financial Analysis:
Sizing up Firm
Performance
Copyright 2011 Pearson Prentice Hall. All rights reserved.
Slide Contents
Learning Objectives
Principles Used 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
4-2
Slide Contents (cont.)

5. The Limitations of Ratio Analysis
Key Terms
4-3
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.
4-4
Learning Objectives (cont.)
Select an appropriate benchmark for use

in performing a financial ratio analysis.
Describe the limitations of financial ratio
analysis.
4-5

Principle 1: Money has a Time Value.
Financial statements typically ignore time value
of money. Thus financial managers and
accountants may view financial statements
very differently.
4-6

(cont.)
Principle 2: There Is a Risk-Return
Tradeoff.
Financial statement analysis can yield
important information about the strengths and
weaknesses of a firms financial condition. The
analysts can use such information to infer the
risk-return tradeoff in a firm.
4-7

(cont.)
Principle 3: Cash Flows Are the Source of
Value.
An important use of a firms financial
statements involves analyzing past
performance as a tool for predicting future cash
flows.
4-8

(cont.)
Principle 4: Market Prices Reflect
Information.
Financial statement analysis requires gathering
information about a firms financial condition,
which is important to the valuation of the firm.
4-9
4.1 Why Do We
Analyze Financial
Statements?
Why Do We Analyze Financial

Statements?
A firms financial statements can be
analyzed internally (by employees,
managers) and externally (by bankers,
investors, customers, and other interested
parties).
4-11

Statements? (cont.)
An internal financial analysis might be done:
To evaluate the performance of employees and
determine their pay raises and bonuses.
To compare the financial performance of the firms
different divisions.
To prepare financial projections, such as those associated
with the launch of a new product.
To evaluate the firms financial performance in light of its
competitors and determine how the firm might improve
its operations.
4-12

Statements? (cont.)
A variety of firms and individuals that have
an economic interest might also undertake
an external financial analysis:
Banks and other lenders deciding whether to
loan money to the firm.
Suppliers who are considering whether to grant
credit to the firm.
Credit-rating agencies trying to determine the
firms creditworthiness.
4-13

Statements? (cont.)
Professional analysts who work for
investment companies considering
investing in the firm or advising others
about investing.
Individual investors deciding whether to
invest in the firm.
4-14
4.2 Common Size

Statements
Standardizing
Financial
Information
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.
A common size financial statement helps
to compare entries in a firms financial
statements, even if the firms are not of
equal size.
4-16
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 the
companys sales.
For a common size balance sheet, divide each
entry in the balance sheet by the firms total
assets.
4-17
Common Size Income Statement

(H. J. Boswell, Inc.)
4-18
Table 4-1 Observations

Table 4-1 is created by dividing each entry in the
income statement found in Table 3-1 by firm sales
for 2010.
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 accounting for all expenses, the firm generates net
income of 7.6% of firms sales.
4-19
Common Size
Balance Sheet
(H. J. Boswell,
Inc.)
4-20
Table 4-2 Observations

Table 4-2 is created by dividing each entry
in the balance sheet found in Table 3-2 by
total assets for the year.
Total current assets increased by 5.6% in 2010
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% in 2010.
4-21
4.3 Using
Financial Ratios
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 compared to: (a) ratios from
previous years; or (b) ratios of other firms in the
same industry.
If the differences in the ratios are significant,
more in-depth analysis must be done.
4-23
Using Financial Ratios (cont.)

Question
1. How liquid is the firm?
Will it be able to pay its
bills as they become due?
2. How has the firm financed
the purchase of its assets?
3. How efficient has the
firms management been in
utilizing it assets to
generate sales?
Category of Ratios Used

Liquidity ratios
Capital structure ratios
Asset management efficiency
ratios
4. Has the firm earned

adequate returns on its
investments?
Profitability ratios
5. Are the firms managers

creating value for
shareholders?
Market value ratios
4-24
Liquidity Ratios
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:
Overall or general firm liquidity
Liquidity of specific current asset accounts
4-26
Liquidity Ratios (cont.)

Overall liquidity is analyzed by comparing
the firms current assets to the firms
current liabilities.
Liquidity of specific assets is analyzed by
examining the timeliness in which the
firms primary liquid assets accounts
receivable and inventories are converted
into cash.
4-27
Liquidity Ratios: Current Ratio

The overall liquidity of a firm is analyzed
by computing the current ratio and acidtest ratio.
Current Ratio: Current Ratio compares a
firms current (liquid) assets to its current
(short-term) liabilities.
4-28

(cont.)
The text computes the current ratio for
H.J. Boswell, Inc. for 2010.
What is the current ratio for 2009?
4-29

(cont.)
Current Ratio = $477 292.5 = 1.63

times
The firm had $1.63 in current assets for
every $1 it owed in current liability. The
current ratio improved in 2010 to 2.23
times as the current assets increased
significantly in 2010.
4-30
Liquidity Ratios: Quick Ratio

The overall liquidity of a firm is also
analyzed by computing the Acid-Test
(Quick) Ratio. This ratio excludes the
inventory from current assets as inventory
may not always be very liquid.
4-31

(cont.)
The text computes the quick ratio for H.J.
Boswell, Inc. for 2010.
What is the quick ratio for 2009?
4-32

(cont.)
Quick Ratio = ($477-$299.50) ($292.50)

= 0.63 times
The firm is clearly less liquid using quick ratio as
the firm has only $0.63 in current assets (less
inventory) to cover $1 in current liabilities. The
quick ratio improved in 2010 to 0.94 times largely
due to an increase in current assets.
4-33
Liquidity Ratios:
Individual Asset Categories
We can also measure the liquidity of the
firm by examining the liquidity of individual
current asset accounts, including
accounts receivable and inventories.
We can assess the liquidity of the firm by
measuring how long it takes the firm to
convert its accounts receivables and
inventories into cash.
4-34
Liquidity Ratios: Accounts Receivable

Average Collection Period measures the
number of days it takes the firm to collects
its receivables.
4-35

(cont.)
The text computes the average collection
period for H.J. Boswell, Inc. for 2010.
What will be the average collection period
for 2009 if we assume that the annual
credit sales were $2,500 million in 2009?
4-36

(cont.)
Daily Credit Sales
= $2,500 million 365 days = $6.85 million
Average Collection Period

= Accounts Receivable Daily Credit
Sales
= $139.5m $6.85m = 20.37 days
The firm collects its accounts receivable in
20.37 days.
4-37
Liquidity Ratios: Accounts

Receivable Turnover Ratio
Accounts Receivable Turnover Ratio
measures how many times accounts
receivable are rolled over during a year.
4-38

Receivable Turnover Ratio (cont.)
The text computes the accounts receivable
turnover ratio for H.J. Boswell, Inc. for
2010.
What will be the accounts receivable
turnover ratio for 2009 if we assume that
the annual credit sales were $2,500 million
in 2009?
4-39

Receivable Turnover Ratio (cont.)
Accounts Receivable Turnover

= $2,500 million $139.50
= 17.92 times
The firms accounts receivable were
turning over at 17.92 times per year.
4-40
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.
4-41
Liquidity Ratios:
Inventory Turnover Ratio (cont.)
The text computes the inventory turnover
ratio for H.J. Boswell, Inc. for 2010.
What will be the inventory turnover ratio
for 2009 if we assume that the cost of
goods sold were $1,980 million in 2009?
4-42
Liquidity Ratios:
Inventory Turnover Ratio (cont.)
Inventory Turnover Ratio

= $1,980 $229.50
= 8.63 times
The firm turned over its inventory 8.63
times per year.
4-43
Liquidity Ratios:
Days Sales in Inventory
We can express the inventory turnover ratio in
terms of the number of days the inventory sits
unsold on the firms shelves.
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.
4-44
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.
4-45
Checkpoint 4.1
Evaluating Dell Computer Corporations (DELL) Liquidity
You work for a small company that manufactures a new memory
storage device. Computer giant Dell has offered to put the new device
in their laptops if your firm will extend them credit terms that allow
them 90 days to pay. Since your company does not have many cash
resources, your boss has asked that you look into Dells liquidity and
analyze its ability to pay their bills on time using the following
accounting information for Dell and two other computer firms (figures
in thousands of dollars):
4-46
Checkpoint 4.1
4-47
Checkpoint 4.1
4-48
Checkpoint 4.1
4-49
Checkpoint 4.1: Check Yourself

Calculate HPs inventory turnover ratio. Why do you
think this ratio is so much lower than Dells
inventory turnover ratio?
4-50
Step 1: Picture the Problem

One of the indicators of liquidity of the firm
is the inventory turnover ratio. This 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.
4-51
Step 2: Decide on a Solution

Strategy
We will use the inventory turnover ratio to
determine HPs inventory turnover ratio.
This will give us clues about inventory
practices at HP.
We will use the following equation to
compute the Inventory Turnover (IT) ratio
IT ratio = Cost of Goods Sold Inventories
4-52
Step 3: Solve
Inventory Turnover Ratio for HP
= Cost of Goods Sold Inventories
= $69,178,000 7,750,000
= 8.93
4-53
Step 4: Analyze
HPs inventory turnover ratio indicates that
the inventory at HP remains on shelf for
(365 8.93) days or 40.87 days. This is
much higher than Dell that has an
inventory turnover ratio of 79.79 or shelf
life of only 4.57 days.
The significant difference must be
investigated further as the two firms are in
the same industry.
4-54
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
4-55
Capital Structure
Ratios
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?
We will use two ratios, debt ratio and
times interest earned ratio, to answer
the question.
4-57
Capital Structure Ratios (cont.)

Debt ratio measures the proportion of the
firms assets that are financed by
borrowing or debt financing.
4-58

The text computes the debt ratio for H.J.
What will be the debt ratio for 2009?
4-59
Debt Ratio
= $1,012.50 million $1,764 million
= 57.40%
The firm financed 57.39% of its assets

with debt.
4-60

Times Interest Earned Ratio measures
the ability of the firm to service its debt or
repay the interest on debt.
We use EBIT or operating income as interest

expense is paid before a firm pays its taxes.
4-61

The text computes the times interest
earned ratio for H.J. Boswell, Inc. for
2010.
What will be the times interest earned
ratio for 2009 if we assume interest
expense of $65 million and EBIT of $350
million?
4-62
Times Interest Earned

= $350 million $65 million = 5.38
times
Thus the firm can pay its total interest expense
5.38 times or interest consumed 1/5.38th or
18.58% of its EBIT. Thus, even if the EBIT shrinks
by 81.42% (100-18.58), the firm will be able to
pay its interest expense.
4-63
Checkpoint 4.2
Comparing the Financing Decisions of Home Depot (HD) and
Lowes Corporation (LOW)
You inherited a small sum of money from your grandparents and currently have
it in a savings account at your local bank. After enrolling in your first finance
class in business school you have decided that you would like to begin investing
your money in the common stock of a few companies. The first investment you
are considering is stock in either Home Depot or Lowes. Both firms operate
chains of home improvement stores throughout the United States and other
parts of the world.
In your finance class you learned that an important determinant of the risk of
investing in a firms stock is driven by the firms capital structure, or how it has
financed its assets. In particular, the more money the firm borrows, the greater
is the risk that the firm may become insolvent and bankrupt. Consequently, the
first thing you want to do before investing in either companys stock is to
compare how they financed their investments. Just how much debt financing
have the two firms used?
4-64
Checkpoint 4.2
4-65
Checkpoint 4.2
4-66
Checkpoint 4.2
4-67

What would be Home Depots times interest earned ratio if
interest payments remained the same, but net operating
income dropped by 80% to only $1.9346 billion? Similarly if
Lowes net operating income dropped by 80%, what would its
times interest earned ratio be?
4-68

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.
4-69
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
4-70

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
4-71
Step 3: Solve
Times Interest Earned (TIE)
= EBIT Interest Expense
TIE (Home Depot)

= $1.9346 billion $0.392 billion = 4.94
times
TIE (Lowes)
= $1.03 billion $0.154 billion = 6.69 times
4-72
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.
The times interest earned ratio drops from 24.68
to 4.94 for Home Depot and from 33.45 to 6.69
for Lowes.
Should creditors be worried by this drop?
4-73
Step 4: Analyze (cont.)

The ratio is still reasonably safe.
For example, for Home Depot, it indicates
that the firm can pay its interest expense
4.94 times out of its EBIT. Thus, even if
the EBIT shrank further by 79.75% (11/4.94 = 1-.2025 or 79.75%), it can still
pay its interest expense.
4-74
Asset
Management
Efficiency Ratios
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.
4-76

(cont.)
Total Asset Turnover Ratio represents
the amount of sales generated per dollar
invested in firms assets.
4-77

(cont.)
The text computes the total asset turnover
What will be the total asset turnover ratio
for 2009 if we assume the total sales in
2009 were $2,500 million?
4-78

(cont.)
Total Asset Turnover

= $2,500 million $1,764 million = 1.42 times
Thus the firm generated $1.42 in sales per

dollar of assets in 2009.
4-79

(cont.)
Fixed asset turnover ratio measures
firms efficiency in utilizing its fixed assets
(such as property, plant and equipment).
4-80

(cont.)
The text computes the fixed asset turnover
What will be the fixed asset turnover ratio
for 2009 if we assume sales of $2,500
million for 2009?
4-81

(cont.)
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.
4-82

(cont.)
We could similarly compute the turnover
ratio for other assets.
We had earlier computed the receivables
turnover and inventory turnover, which
measured firm effectiveness in managing
its investments in accounts receivables and
inventories.
4-83

(cont.)
For Boswell, 2010
Total Asset Turnover
= Sales Total Assets
= $2,700m $1,971m =
1.37
Fixed Asset Turnover
Equipment
= Sales Net Plant and

= $2,700m $1,327.5m = 2.03
4-84

(cont.)
For Boswell, 2010
Receivables Turnover
= Credit Sales Accounts Receivable
= $2,700m $162m = 16.67 times
Inventory Turnover
= Cost of Goods Sold Inventories
= $2,025m $378m = 3.36 times
4-85

(cont.)
The following grid summarizes the efficiency
of Boswells management in utilizing its
assets to generate sales in 2010.
Turnover
Ratio
Boswell
Total
Assets
1.37
1.15
Good
Fixed
Assets
2.03
1.75
Good
Receivable
s
16.67
14.60
Good
Inventory
5.36
7.0
Poor
Peer Group Assessment
4-86
Profitability
Ratios
Profitability Ratios
Profitability ratios address a very
fundamental question: Has the firm earned
adequate returns on its investments?
We answer this question by analyzing the
firms profit margin, which predict the
ability of the firm to control its expenses,
and the firms rate of return on
investments.
4-88
Profitability Ratios (cont.)

Two fundamental determinants of firms
profitability and returns on investments
are the following:
Cost Control
Is the firm controlling costs and earning reasonable
profit margin?
Efficiency of asset utilization

Is the firm efficiently utilizing the assets to generate
sales?
4-89

Gross profit margin shows how well the
firms management controls its expenses
to generate profits.
4-90

The text computes the gross profit margin
What will be the gross profit margin ratio
for 2009 if we assume sales of $2,500
million and gross profit of $650 million for
2009?
4-91
Gross Profit Margin

= $650 million $2,500 million = 26%
The firm spent $0.74 for cost of goods sold

for each dollar of sales. Thus, $0.26 out of
each dollar of sales goes to gross profits.
4-92

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 thus
also indicates how well the firm is
managing its income statement.
4-93

The text computes the operating profit
margin ratio for H.J. Boswell, Inc. for
2010.
What will be the operating profit margin
ratio for 2009 if we assume sales of
$2,500 million and net operating income
of $350 million for 2009?
4-94
Operating Profit Margin

= $350 million $2,500 million = 14%
Thus the firm generates $0.14 in operating
profit for each dollar of sales.
4-95

Net Profit Margin measures how much
income is generated from each dollar of
sales after adjusting for all expenses
(including income taxes).
4-96

The text computes the net profit margin
What will be the net profit margin ratio for
2009 if we assume sales of $2,500 million
and net income of $217.75 million for
2009?
4-97
Net Profit Margin

= $217.75 million $2,500 million = 8.71%
The firm generated $0.087 for each dollar

of sales after all expenses (including
income taxes) were accounted for.
4-98

Operating Return on Assets ratio is the
summary measure of operating
profitability, which takes into account both
the managements success in controlling
expenses, contributing to profit margins,
and its efficient use of assets to generate
sales.
4-99

The text computes the operating return on
assets ratio for H.J. Boswell, Inc. for 2010.
What will be the operating return on assets
ratio for 2009 if we assume EBIT or net
operating income of $350 million for 2009?
4-100
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.
4-101

Decomposing the OROA ratio: We can use the
following equation to decompose the OROA ratio
that allows us to analyze the firms ability to
control costs and utilize its investments in assets
efficiently.
4-102
4-103
Figure 4-1 Observations

Firms OROA (operating return on assets) is better
than its peers. Thus the firm earned more net
operating income per dollar invested in assets.
Firms OPM (operating profit margin) is lower
than its peers. Thus the firm retained a lower
percentage of its sales in net operating income.
Firms TATO (total asset turnover ratio) is higher
than its peers. Thus the firm generated more
sales from its assets.
4-104
Figure 4-1 Recommendations

The firm has two opportunities to improve
its profitability:
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.
4-105
Checkpoint 4.3
Evaluating the Operating Return on Assets Ratio for
Home Depot (HD) and Lowes (LOW)
In Checkpoint 4.2 we evaluated how much debt financing Home Depot
and Lowes used. We continue our analysis by evaluating the operating
return on assets (OROA) earned by the two firms. Calculate the net
operating income each firm earned during 2007 relative to the total
assets of each firm using the information found below:
4-106
Checkpoint 4.3
4-107
Checkpoint 4.3
4-108
Checkpoint 4.3
4-109

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?
4-110

The operating return on assets ratio for a
firm is determined by two factors: cost
control and efficiency of asset utilization. It
is expressed by equation 4-13a. Here the
focus is on asset utilization i.e.
improvement in total asset turnover ratio.
4-111

Strategy
We will analyze the impact on operating
return on assets of improvement on the
total asset turnover ratio by using the
following equation:
Operating Return on Assets (OROA)
= Total Asset Turnover Operating Profit
Margin
4-112
Step 3: Solve
Operating Return on Assets (OROA)
= Total Asset Turnover Operating Profit
Margin
Before = 1.74 10.65% = 18.53%

Now
= 2.5 10.65% = 26.63%
4-113
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.
4-114
Is the Firm Providing a Reasonable

Return on the Owners Investment?
A firms net income consists of earnings
that is available for distribution to the
firms shareholders. Return on Equity
ratio measures the accounting return on
the common stockholders investment.
4-115
Is the Firm Providing a Reasonable Return on

the Owners Investment (cont.)
The text computes the return on equity

What will be the return on equity ratio for
2009 if we assume net income of $217.75
million for 2009?
4-116
Is the Firm Providing a Reasonable Return on

the Owners Investment (cont.)
Return on Equity
= $217.75 million $751.50 million =
28.98%
Thus the shareholders earned 28.97% on their investments.
Note common equity includes both common stock plus the
firms retained earnings.
4-117
Using the DuPont Method for

Decomposing the ROE ratio
DuPont method analyzes the firms ROE by
decomposing it into three parts: profitability,
efficiency and an equity multiplier.
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.
4-118

Decomposing the ROE ratio (cont.)
ROE = Profitability Efficiency Equity Multiplier
ROE = Net Profit Margin Total Asset

Turnover Ratio 1/(1-debt ratio)
4-119

The following table shows why Boswells
return on equity was higher than its peers.
Return
on
Equity
Net
Profit
Margin
H. J.
Boswell,
Inc.
22.5%
7.6%
1.37
2.16
Peer
Group
18.0%
10.2%
1.15
1.54
Total
Equity
Asset
Multipli
Turnover
er
4-120

The table suggests that Boswell had a
higher ROE as it was able to generate
more sales from its assets (1.37 versus
1.15 for peers) and used more leverage
(2.16 versus 1.54).
Note use of financial leverage may not
always generate value for shareholders.
Impact of financial leverage is discussed in
detail in chapter 15.
4-121
Using the
DuPont
Method for
Decomposing
the ROE ratio
(cont.)
4-122
Market Value
Ratios
Market Value Ratios

Market value ratios address the
question, how are the firms shares valued
in the stock market?
Two market value ratios are:
Price-Earnings Ratio
Market-to-Book Ratio
4-124
Market Value Ratios (cont.)

Price-Earnings (PE) Ratio indicates how
much investors are currently willing to pay
for $1 of reported earnings.
4-125

The text computes the PE ratio for H.J.
What will be the PE ratio for 2009 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?
4-126
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.
4-127

Market-to-Book Ratio measures the
relationship between the market value and
the accumulated investment in the firms
equity.
4-128

The text computes the market-to-book
What will be the market-to-book ratio for
2009 given that the current market price
of the stock is $22 and the firm has 90
million shares outstanding?
4-129

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
4-130
Checkpoint 4.4
Comparing the Valuation of Dell (DELL) to Apple (APPL)
Using Market Value Ratios
The following information on Dell and Apple was gathered on April 9, 2010:
4-131
Checkpoint 4.4
4-132
Checkpoint 4.4
4-133

What price per share for Dell would it take to
increase the firms price-to-earnings ratio to the
level of Apple?
4-134

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
4-135

Strategy
We need to determine the price per share
that will make PE ratio of Dell equal to the
PE ratio of Apple. PE ratio of Dell has to
increase from 11.04 to 18.20.
PE ratio = Price per share Earnings per
share
==> 18.20 =
?
1.14
4-136
Step 3: Solve
PE ratio = Price per share Earnings per
share
18.20 = Price per share $1.14
Price per share = 18.20 1.14 = $20.75
4-137
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 $12.54 to
$20.75.
4-138
Summing up the Financial Analysis

of H. J. Boswell, Inc.
Liquidity: With the exception of inventory
turnover ratio, liquidity ratios were
adequate to good. The next step will be to
see how inventory management can be
improved.
Financial Leverage: The firm uses more
debt than its peers, which exposes the firm
to a higher degree of financial risk or
potential default on its debt in the future.
4-139
Summing up the Financial Analysis

of H. J. Boswell, Inc. (cont.)
Profitability: H.J. Boswell had favorable net
operating income despite lower profit
margins, largely due to its higher asset
turnover ratio. The return on equity was
also higher than the peer group due to use
of more debt.
Market Value Ratios: These ratios suggest
that the market is pleased with the firm as
indicated by higher stock valuations.
4-140
4.4 Selecting a
Performance
Benchmark
Selecting a Performance Benchmark

There are two types of benchmarks that
are commonly used:
Trend Analysis involves comparing a firms
financial statements over time.
Peer Group Comparisons involves comparing
the subject firms financial statements with
those of similar, or peer firms. The
benchmark for peer groups typically consists of
firms from the same industry or industry
average financial ratios.
4-142
Trend Analysis
4-143
Financial Analysis of the Gap, Inc., June

2009
4-144
4.5 The
Limitations of
Ratio Analysis
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.
4-146
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. We need to
analyze the numbers in order to fully understand
the ratios.
7. The results of financial analysis are dependent
on the quality of the financial statements.
4-147
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
4-148
Key Terms (cont.)
Debt ratio
DuPont method
Equity Multiplier
Earnings per share (EPS)
Financial leverage
Fixed asset turnover ratio
Inventory turnover ratio
4-149
Key terms (cont.)
Liquidity ratios
Market-to-book ratio
Market value ratios
Notes payable
Operating return on assets
Price-earnings ratio
4-150
Key terms (cont.)
Return on assets (ROA)

Return on equity (ROE)
Times interest earned
Total asset turnover ratio
Trend analysis
4-151

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Chapter 4

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Slide Contents (cont.)

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Learning Objectives (cont.)

Select an appropriate benchmark for use

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Principles Used in this Chapter

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Principles Used in this Chapter

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Principles Used in this Chapter

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Principles Used in this Chapter

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Why Do We Analyze Financial

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Why Do We Analyze Financial

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Why Do We Analyze Financial

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Why Do We Analyze Financial

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4.2 Common Size

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Common Size Statements Standardizing

Common Size Statements Standardizing

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Common Size Income Statement

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Table 4-1 Observations

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Table 4-2 Observations

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Using Financial Ratios

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Using Financial Ratios (cont.)

Category of Ratios Used

4. Has the firm earned

5. Are the firms managers

Market value ratios

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Liquidity Ratios (cont.)

Liquidity Ratios: Current Ratio

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Liquidity Ratios: Current Ratio

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Liquidity Ratios: Current Ratio

Current Ratio = $477 292.5 = 1.63

Liquidity Ratios: Quick Ratio

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Liquidity Ratios: Quick Ratio

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Liquidity Ratios: Quick Ratio

Quick Ratio = ($477-$299.50) ($292.50)