l Explain why ratio analysis is usually the first step in the analysis of a company’s financial
statements.
l List the five groups of ratios, specify which ratios belong in each group, and explain what
information each group gives us about the firm’s financial position.
l State what trend analysis is, and why it is important.
l Describe how the Du Pont equation is used, and how it may be modified to include the
effect of financial leverage.
l Explain “benchmarking” and its purpose.
l List several limitations of ratio analysis.
l Identify some of the problems with ROE that can arise when firms use it as a sole
measure of performance.
l Identify some of the qualitative factors that must be considered when evaluating a
company’s financial performance.
OVERVIEW
Financial analysis is designed to determine the relative strengths and weaknesses of a
company. Investors need this information to estimate both future cash flows from the firm
and the riskiness of those cash flows. Financial managers need the information provided
by analysis both to evaluate the firm’s past performance and to map future plans.
Financial analysis concentrates on financial statement analysis, which highlights the key
aspects of a firm’s operations.
Financial statement analysis involves a study of the relationships between income
statement and balance sheet accounts, how these relationships change over time (trend
analysis), and how a particular firm compares with other firms in its industry
(bench-marking). Although financial analysis has limitations, when used with care and
judgment, it can provide some very useful insights into a company’s operations.
OUTLINE
Financial statements are used to help predict the firm’s future earnings and dividends.
From an investor’s standpoint, predicting the future is what financial statement analysis is
all about. From management’s standpoint, financial statement analysis is useful both to
help anticipate future conditions and, more important, as a starting point for planning
actions that will influence the future course of events.
n Financial ratios are designed to help one evaluate a firm’s financial statements.
The burden of debt, and the company’s ability to repay, can be best evaluated (1) by
comparing the company’s debt to its assets and (2) by comparing the interest it must pay to
the income it has available for payment of interest. Such comparisons are made by ratio
analysis.
A liquid asset is an asset that can be converted to cash quickly without having to reduce the
asset’s price very much. Liquidity ratios are used to measure a firm’s ability to meet its
current obligations as they come due.
n One of the most commonly used liquidity ratios is the current ratio.
The current ratio measures the extent to which current liabilities are covered by current
assets.
It is determined by dividing current assets by current liabilities.
It is the most commonly used measure of short-term solvency.
Asset management ratios measure how effectively a firm is managing its assets and
whether the level of those assets is properly related to the level of operations as measured
by sales.
n The inventory turnover ratio is defined as sales divided by inventories.
It is often necessary to use average inventories rather than year-end inventories, especially
if a firm’s business is highly seasonal, or if there has been a strong upward or downward
sales trend during the year.
n Days sales outstanding (DSO), also called the “average collection period” (ACP), is
used to appraise accounts receivable, and it is calculated by dividing accounts receivable
by average daily sales to find the number of days’ sales tied up in receivables.
The DSO represents the average length of time that the firm must wait after making a sale
before receiving cash.
The DSO can also be evaluated by comparison with the terms on which the firm sells its
goods.
If the trend in DSO over the past few years has been rising, but the credit policy has not
been changed, this would be strong evidence that steps should be taken to expedite the
collection of accounts receivable.
n The fixed assets turnover ratio is the ratio of sales to net fixed assets.
It measures how effectively the firm uses its plant and equipment.
A potential problem can exist when interpreting the fixed assets turnover ratio of a firm
with older, lower-cost fixed assets compared to one with recently acquired, higher-cost
fixed assets. Financial analysts recognize that a problem exists and deal with it
judgmentally.
n The total assets turnover ratio is calculated by dividing sales by total assets.
It measures the utilization, or turnover, of all the firm’s assets.
Debt management ratios measure the extent to which a firm is using debt financing, or
financial leverage, and the degree of safety afforded to creditors.
n Financial leverage has three important implications: (1) By raising funds through debt,
stockholders can maintain control of a firm while limiting their investment. (2) Creditors
look to the equity, or owner-supplied funds, to provide a margin of safety, so if the
stockholders have provided only a small proportion of the total financing, the firm’s risks
are borne mainly by its creditors. (3) If the firm earns more on investments financed with
borrowed funds than it pays in interest, the return on the owners’ capital is magnified, or
“leveraged.”
Firms with relatively high debt ratios have higher expected returns when the economy is
normal, but they are exposed to risk of loss when the economy goes into a recession.
Firms with low debt ratios are less risky, but also forgo the opportunity to leverage up their
return on equity.
Decisions about the use of debt require firms to balance higher expected returns against
increased risk.
n Analysts use two procedures to examine the firm’s debt: (1) They check the balance
sheet to determine the extent to which borrowed funds have been used to finance assets,
and
(2) they review the income statement to see the extent to which fixed charges are covered
by operating profits.
n The debt ratio, or ratio of total debt to total assets, measures the percentage of funds
provided by creditors. Total debt includes both current liabilities and long-term debt.
The lower the ratio, the greater the protection afforded creditors in the event of liquidation.
Stockholders, on the other hand, may want more leverage because it magnifies expected
earnings.
A debt ratio that exceeds the industry average raises a red flag and may make it costly for a
firm to borrow additional funds without first raising more equity capital.
n The times-interest-earned (TIE) ratio is determined by dividing earnings before interest
and taxes (EBIT) by the interest charges.
The TIE measures the extent to which operating income can decline before the firm is
unable to meet its annual interest costs.
Note that EBIT, rather than net income, is used in the numerator. Because interest is paid
with pre-tax dollars, the firm’s ability to pay current interest is not affected by taxes.
This ratio has two shortcomings: (1) Interest is not the only fixed financial charge.
(2) EBIT does not represent all the cash flow available to service debt, especially if a firm
has high depreciation and/or amortization charges.
n To account for the deficiencies of the TIE ratio, bankers and others have developed the
EBITDA coverage ratio. It is calculated as EBITDA plus lease payments divided by the
sum of interest, principal repayments, and lease payments.
The EBITDA coverage ratio is most useful for relatively short-term lenders such as banks,
which rarely make loans (except real estate-backed loans) for longer than about five years.
Over a relatively short period, depreciation-generated funds can be used to service debt.
Over a longer time, depreciation-generated funds must be reinvested to maintain the plant
and equipment or else the company cannot remain in business.
Banks and other relatively short-term lenders focus on the EDITDA coverage ratio,
whereas long-term bondholders focus on the TIE ratio.
Profitability ratios show the combined effects of liquidity, asset management, and debt on
operating results.
n The profit margin on sales is calculated by dividing net income by sales.
It gives the profit per dollar of sales.
n The basic earning power (BEP) ratio is calculated by dividing earnings before interest
and taxes (EBIT) by total assets.
It shows the raw earning power of the firm’s assets, before the influence of taxes and
leverage.
It is useful for comparing firms with different tax situations and different degrees of
financial leverage.
n The return on total assets (ROA) is the ratio of net income to total assets.
It measures the return on all the firm’s assets after interest and taxes.
n The return on common equity (ROE) measures the rate of return on the stockholders’
investment.
It is equal to net income divided by common equity. Stockholders invest to get a return on
their money, and this ratio tells how well they are doing in an accounting sense.
Market value ratios relate the firm’s stock price to its earnings, cash flow, and book value
per share, and thus give management an indication of what investors think of the
company’s past performance and future prospects. If the liquidity, asset management, debt
