Chapter 4: Analysis of Financial Statements
Learning Objectives
47
Chapter 4
Analysis of Financial Statements
Learning Objectives
After reading this chapter, students should be able to:
◆ Explain what ratio analysis is.
◆ List the five groups of ratios and identify, calculate, and interpret the key ratios in each group.
◆ Discuss each ratio’s relationship to the balance sheet and income statement.
◆ Discuss why return on equity (ROE) is the key ratio under management’s control and how the other
ratios impact ROE, and explain how to use the DuPont equation for improving ROE.
◆ Compare a firm’s ratios with those of other firms (benchmarking) and analyze a given firm’s ratios
over time (trend analysis).
◆ Discuss the tendency of ratios to fluctuate over time (which may or may not be problematic); explain
how they can be influenced by accounting practices as well as other factors; and explain why they
must be used with care.
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Lecture Suggestions
Chapter 4: Analysis of Financial Statements
Lecture Suggestions
Chapter 4 shows how financial statements are analyzed to determine the firm’ strengths and weaknesses.
On the basis of this information, management can take actions to exploit the firm’s strengths and correct
its weaknesses.
At Florida, we find a significant difference in preparation between our accounting and non-
accounting students. The accountants are relatively familiar with financial statements, and they have
covered in depth in their financial accounting course many of the ratios discussed in Chapter 4. We pitch
our lectures to the non-accountants, which means concentrating on the use of statements and ratios, and
the “big picture,” rather than on details such as seasonal adjustments and the effects of different
accounting procedures. Details are important, but so are general principles, and there are courses other
than the introductory finance course where details can be addressed.
What we cover, and the way we cover it, can be seen by scanning the slides and Integrated Case
solution for Chapter 4, which appears at the end of this chapter’s solutions. For other suggestions about
the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our
classes.
DAYS ON CHAPTER: 4 OF 56 DAYS (50-minute periods)
Chapter 4: Analysis of Financial Statements
Answers and Solutions
49
Answers to End-of–Chapter Questions
4-1 The emphasis of the various types of analysts is by no means uniform nor should it be.
Management is interested in all types of ratios for two reasons. First, the ratios point out
4-2 The inventory turnover ratio is important to a grocery store because of the much larger inventory
required and because some of that inventory is perishable. An insurance company would have
4-3 Given that sales have not changed, a decrease in the total assets turnover means that the
4-4 Differences in the amounts of assets necessary to generate a dollar of sales cause asset turnover
ratios to vary among industries. For example, a steel company needs a greater number of
4-5 Inflation will cause earnings to increase, even if there is no increase in sales volume. Yet, the
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Answers and Solutions
Chapter 4: Analysis of Financial Statements
4-6 ROE is calculated as the return on assets multiplied by the equity multiplier. The equity
4-7 a. Cash, receivables, and inventories, as well as current liabilities, vary over the year for firms
vary unless averages (monthly ones are best) are used.
b. Common equity is determined at a point in time, say December 31, 2015. Profits are earned
4-8 Firms within the same industry may employ different accounting techniques that make it difficult
4-9 The three components of the DuPont equation are profit margin, assets turnover, and the equity
4-10 A review of Yahoo! Finance on 09/22/14 showed that the trailing twelve-month P/E ratio for
4-12 Total Current Effect on
Current Assets Ratio Net Income
a. Cash is acquired through issuance of additional
common stock. + + 0
Chapter 4: Analysis of Financial Statements
Answers and Solutions
51
Total Current Effect on
Current Assets Ratio Net Income
f. Merchandise is sold on credit. + + +
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Answers and Solutions
Chapter 4: Analysis of Financial Statements
Solutions of End-of–Chapter Problems
4-1 DSO = 40 days; S = $7,300,000; AR = ?
4-2 Since the firm’s M/B ratio = 1, then its total market value of equity is equal to its book value of equity.
4-3 ROA = 10%; PM = 2%; ROE = 15%; S/TA = ?; TA/E = ?
Chapter 4: Analysis of Financial Statements
Answers and Solutions
53
4-5 EPS = $2.00; BVPS = $20; M/B = 1.2; P/E = ?
4-6 NI/S = 2%; TA/E = 2.0; Sales = $100,000,000; Assets = $50,000,000; ROE = ?
4-7 Given: Net income = $25,000; Common equity = $250,000
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Answers and Solutions
Chapter 4: Analysis of Financial Statements
4-8 Step 1: Calculate total assets from information given.
4-9
Calculate BEP:
Calculate ROE:
We need to determine common equity from total assets calculated above and the accounts
payable and accrual balance given in the problem.
Chapter 4: Analysis of Financial Statements
Answers and Solutions
55
4-10 Stockholders’ equity = $3,750,000,000; M/B = 1.9; P = ?
4-11 We are given ROA = 3% and Sales/Total assets = 1.5.
From the DuPont equation:
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Answers and Solutions
Chapter 4: Analysis of Financial Statements
4-12 TA = $12,000,000,000; T = 40%; EBIT/TA = 15%; ROA = 5%; TIE = ?
4-13
Calculate TIE:
4-14 ROE = Profit margin TA turnover Equity multiplier
Chapter 4: Analysis of Financial Statements
Answers and Solutions
57
Now we need to determine the inputs for the DuPont equation from the data that were given.
On the left we set up an income statement, and we substitute values on the right:
4-15 Currently, ROE is ROE1 = $15,000/$200,000 = 7.5%.
4-16 Known data:
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Answers and Solutions
Chapter 4: Analysis of Financial Statements
No Debt Debt = 50%
EBIT $200,000 $200,000
4-17 Statement a is correct. Refer to the solution setup for Problem 4-16 and think about it this way:
4-18 TA = $5,000,000,000; T = 40%; EBIT/TA = 10%; ROA = 5%; TIE ?
Chapter 4: Analysis of Financial Statements
Answers and Solutions
59
4-19 Present current ratio =
$525,000
$1,312,500
= 2.5.
4-20 Step 1: Solve for current annual sales using the DSO equation:
55 = $750,000/(Sales/365)
55Sales = $273,750,000
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Answers and Solutions
Chapter 4: Analysis of Financial Statements
4-23 a. (Dollar amounts in thousands.)
Industry
Firm Average
c. The firm’s days sales outstanding ratio is more than twice as long as the industry average,
4-24 a. Industry
Firm Average
Current ratio
=
sliabilitieC urrent
assetsCurrent
=
85$
$303
=
3.56
3
=
=
=
7
5
=
=
=
=
=
$795
=
5.41
6
1.77
3
=
=
=
3.40%
3.00%
=
=
=
6.00%
9.00%
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Answers and Solutions
Chapter 4: Analysis of Financial Statements
b. ROE = Profit margin Total assets turnover Equity multiplier
incomeNet
Sales
assets Total
d. The comparison of inventory turnover ratios shows that other firms in the industry seem to
be getting along with about half as much inventory per unit of sales as the firm. In addition,