Analyzing and Interpreting

Financial Statements
Module 4
 Learning Objectives
1. Compute return on equity (ROE) and disaggregate it into
components of operating and nonoperating returns.
2. Disaggregate operating return (RNOA) into components of
profitability and asset turnover
3. Explain nonoperting return and compute it from return on
equity and the operating return
4. Compute and interpret measures of liquidity and
solvency.
5. Describe and illustrate traditional DuPont disaggregation
of ROE.

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 Analysis Structure

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 Return on Equity
Return on equity (ROE) is computed as:

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 Operating Return (RNOA)

The income statement reflects operating activities through

revenues, costs of goods sold (COGS), selling, general and
administrative expenses (SG&A) and other expenses.
Net operating assets typically include current assets other
than cash and marketable securities (cash is typically
comprised mostly of short-term investments, called cash
equivalents) and noncurrent assets like PPE, less current
liabilities other than short-term debt, and less long-term
operating liabilities like pension obligations and deferred
taxes.

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 Operating Items in the Income
Statement

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 Walmarts Operating Items

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Computing Tax on Operating Profit

For Walmart:

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 Net Operating Assets (NOA)

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 For
Walmart

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 Walmart: NOA

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 Walmart: RNOA and ROE

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 Key Definitions

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 Disaggregation of RNOA

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 Walmart: NOPM

This result means that for each dollar of sales at

Walmart, the company earns just over 4 profit
after all operating expenses and tax.
As a reference, the median NOPM for all publicly
traded firms is about 8.

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 Walmart: NOAT

This result means that for each dollar of net

operating assets, Walmart realizes $3.73 in sales.
As a reference, the median for all publicly traded
companies is $1.30.

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 Nonoperating Return Component of
ROE
Assume that a company has $1,000 in average
assets for the current year in which it earns a
20% RNOA. It finances those assets entirely with
equity investment (no debt).
Its ROE is computed as follows:

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 Effect of Financial Leverage
Assume that this company now borrows $500 at
7% interest and uses those funds to acquire
additional assets yielding the same operating
return.
Its net operating assets for the year now total
$1,500 and its profit is $265.

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Effect of Financial Leverage on ROE
The company has increased its profit from $200 to
$265 by using debt. This results in an increase in
ROE to 26.5% ($265/$1,000).
The reason for the increased ROE is that the
company borrowed $500 at 7% and invested those
funds in assets earning 20%.
The difference of 13%, or $65, accrues to
shareholders.

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 GAAP Limitations of Ratio Analysis
1. Measurability Financial statements reflect what can be reliably measured.
This results in nonrecognition of certain assets, often internally developed
assets, the very assets that are most likely to confer a competitive
advantage and create value. Examples are brand name, a superior
management team, employee skills, and a reliable supply chain.
2. Non-capitalized costs Related to the concept of measurability is the
expensing of costs relating to assets that cannot be identified with enough
precision to warrant capitalization. Examples are brand equity costs from
advertising and other promotional activities, and research and
development costs relating to future products.
3. Historical costs Assets and liabilities are usually recorded at original
acquisition or issuance costs. Subsequent increases in value are not
recorded until realized, and declines in value are only recognized if deemed
permanent.
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 Liquidity Analysis
Liquidity ratios relate current assets to current liabilities
to determine if a company is likely able to meet current
financial obligations.
Higher ratio is generally better, but not too high to
suggest inefficient use of assets.
Composition of current assets is important in analyzing
liquidity.
Current Ratio = Current Assets
Current Liabilities
Quick Ratio = Cash + Marketable Securities + A/R
Current Liabilities
 Solvency Analysis
Used to determine if company will be able to pay long-term
debt obligations, both interest and principal, when they
become due.
Using balance sheet data, compare amount of capital raised
from debt (creditors) vs. equity (owners). Higher ratio
indicates less solvency; greater risk of default.
Liabilities to Equity Ratio = Total Liabilities
Stockholders Equity
Using income statement data, relate operating profit to
interest expense. Higher ratio indicates higher solvency; less
risk of default.
Times Interest Earned = Earnings Before Interest and Taxes
Interest Expense