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CHAPTER 4 Financial Statement
Analysis Tools
In previous chapters we have seen how the firm’s basic financial statements are constructed. In this chapter we will see how financial analysts can use the information contained in the income statement and balance sheet for various purposes. Many tools are available for use when evaluating a company, but some of the most valuable are financial ratios. Ratios are an analyst’s microscope; they allow us to get a better view of the firm’s financial health than just looking at the raw financial statements. A ratio is simply a comparison of two numbers by division. We could also compare numbers by subtraction, but a ratio is superior in most cases because it is a measure of relative size. Relative measures
After studying this chapter, you should be able to:
1. Describe the purpose of financial ratios and who uses them. 2. Define the five major categories of ratios (liquidity, efficiency, leverage, coverage, and profitability). 3. Calculate the common ratios for any firm by using income statement and balance sheet data. 4. Use financial ratios to assess a firm’s past performance, identify its current problems, and suggest strategies for dealing with these problems. 5. Calculate the economic profit earned by a firm.
CHAPTER 4: Financial Statement Analysis Tools
are more easily compared to previous time periods or other firms than changes in dollar amounts. Ratios are useful to both internal and external analysts of the firm. For internal purposes, ratios can be useful in planning for the future, setting goals, and evaluating the performance of managers. External analysts use ratios to decide whether or not to grant credit, to monitor financial performance, to forecast financial performance, and to decide whether to invest in the company. We will look at many different ratios, but you should be aware that these are, of necessity, only a sampling of the ratios that might be useful. Furthermore, different analysts may calculate ratios slightly differently, so you will need to know exactly how the ratios are calculated in a given situation. The keys to understanding ratio analysis are experience and an analytical mind. We will divide our discussion of the ratios into five categories based on the information provided:
1. Liquidity ratios describe the ability of a firm to meets its short-term obligations. They compare current assets to current liabilities. 2. Efficiency ratios describe how well the firm is using its investment in various types of assets to produce sales. They may also be called asset management ratios. 3. Leverage ratios reveal the degree to which debt has been used to finance the firm’s asset purchases. These ratios are also known as debt management ratios. 4. Coverage ratios are similar to liquidity ratios in that they describe the ability of a firm to pay certain expenses. 5. Profitability ratios provide indications of how profitable a firm has been over a period of time. Before we begin the discussion of individual financial ratios, open your Elvis Products International workbook from Chapter 2 and add a new worksheet named “Ratios.”
Liquidity Ratios
The term “liquidity” refers to the speed with which an asset can be converted into cash without large discounts to its value. Some assets, such as accounts receivable, can easily be converted into cash with only small discounts. Other assets, such as buildings, can be converted into cash very quickly only if large price concessions are given. We therefore say that accounts receivable are more liquid than buildings.
CHAPTER 4: Financial Statement Analysis Tools
EXHIBIT 4-
RATIO WORKSHEET FOR EPI
Notice that we have applied a custom number format (see page 51 to refresh your memory) to the result in B5. In this case, the custom format is 0.00”x”. Any text that you include in quotes will be shown along with the number. However, the presence of the text in the display does not affect the fact that it is still a number and may be used for calculations. As an experiment, in B6 enter the formula: =B5*2. The result will be 4.78 just as if we had not applied the custom format. Now, in B7 type: 2.39x and then copy the formula from B6 to B8. You will get a #VALUE error because the value in B7 is a text string, not a number. This is one of the great advantages to custom number formatting: We can have both text and numbers in a cell and still use the number for calculations. Delete B6:B8 so that we can use the cells in the next section.
The Quick Ratio
Inventories are often the least liquid of the firm’s current assets.^1 For this reason, many believe that a better measure of liquidity can be obtained by excluding inventories. The result is known as the quick ratio (sometimes called the acid-test ratio) and is calculated as:
(4-2)
For EPI in 2011 the quick ratio is:
Notice that the quick ratio will always be less than the current ratio. This is by design. However, a quick ratio that is too low relative to the current ratio may indicate that
- That is why you so often see 50% off sales when firms are going out of business.
Quick Ratio Current Assets^ – Inventories Current Liabilities
Quick Ratio 1,290.00^ – 836.
= ------------------------------------------- =0.84 times
Efficiency Ratios
inventories are higher than they should be. As we will see later, this can only be determined by comparing the ratio to previous periods or to other companies in the same industry.
We can calculate EPI’s 2011 quick ratio in B6 with the formula: =('Balance Sheet'!B8-'Balance Sheet'!B7)/'Balance Sheet'!B17. Copying this formula to C6 reveals that the 2010 quick ratio was 0.85. Be sure to remember to enter a label in column A for all of the ratios.
Efficiency Ratios
Efficiency ratios, also called asset management ratios, provide information about how well the company is using its assets to generate sales. For example, if two firms have the same level of sales, but one has a lower investment in inventories, we would say that the firm with lower inventories is more efficient with respect to its inventory management.
There are many different types of efficiency ratios that could be defined. However, we will illustrate five of the most common.
Inventory Turnover Ratio
The inventory turnover ratio measures the number of dollars of sales that are generated per dollar of inventory. It can also be interpreted as the number of times that a firm replaces its inventories during a year. It is calculated as:
(4-3)
Note that it is also common to use sales in the numerator. Because the only difference between sales and cost of goods sold is a markup (i.e., profit margin), this causes no problems. In addition, you will frequently see the average level of inventories throughout the year in the denominator. Whenever using ratios, you need to be aware of the method of calculation to be sure that you are comparing “apples to apples.”
For 2011, EPI’s inventory turnover ratio was:
meaning that EPI replaced its inventories about 3.89 times during the year. Alternatively, we could say that EPI generated $3.89 in sales for each dollar invested in inventories. Both interpretations are valid, though the latter is probably more generally useful.
Inventory Turnover Ratio Cost of Goods Sold Inventory
Inventory Turnover Ratio 3,250.
= --------------------- =3.89 times
Efficiency Ratios
Note that the denominator is simply credit sales per day.^2 In 2011, it took EPI an average of 37.59 days to collect on their credit sales:
We can calculate the 2011 average collection period in B10 with the formula: ='Balance Sheet'!B6/('Income Statement'!B5/360). Copy this to C10 to find that in 2010 the average collection period was 36.84 days, which was slightly better than in 2011.
Note that this ratio actually provides us with the same information as the accounts receivable turnover ratio. In fact, it can easily be demonstrated by simple algebraic manipulation:
Or alternatively:
Because the average collection period is (in a sense) the inverse of the accounts receivable turnover ratio, it should be apparent that the inverse criteria apply to judging this ratio. In other words, lower is usually better, but too low may indicate lost sales.
Many firms offer a discount for fast payment in order to get customers to pay more quickly. For example, the credit terms on an invoice might specify 2/10n30, which means that there is a 2% discount for paying within 10 days otherwise the entire balance is due in 30 days. Such a discount is very attractive for customers, but whether it makes sense for a particular firm is for them to decide. Remember that accounts receivable represents short-term loans made to customers, and those funds have an opportunity cost. Regardless, offering a discount will almost certainly reduce the average collection period and increase the accounts receivable turnover.
Fixed Asset Turnover Ratio
The fixed asset turnover ratio describes the dollar amount of sales that are generated by each dollar invested in fixed assets. It is given by:
- The use of a 360-day year dates back to the days before computers. It was derived by assuming that there are 12 months, each with 30 days (known as a “Banker’s Year”). You may also use 365 days; the difference is irrelevant as long as you are consistent.
Average Collection Period 402. 3,850.00 ⁄ 360
= ---------------------------------- =37.59 days
Accounts Receivable Turnover Ratio 360 Average Collection Period
Average Collection Period 360 Accounts Receivable Turnover Ratio
CHAPTER 4: Financial Statement Analysis Tools
(4-6)
For EPI, the 2011 fixed asset turnover is:
So, EPI generated $10.67 in revenue for each dollar invested in fixed assets. In your “Ratios” worksheet, entering: ='Income Statement'!B5/'Balance Sheet'!B into B11 will confirm that the fixed asset turnover was 10.67 times in 2011. Again, copy this formula to C11 to get the 2010 ratio.
Total Asset Turnover Ratio
Like the other ratios discussed in this section, the total asset turnover ratio describes how efficiently the firm is using all of its assets to generate sales. In this case, we look at the firm’s total asset investment:
(4-7)
In 2011, EPI generated $2.33 in sales for each dollar invested in total assets:
This ratio can be calculated in B12 on your worksheet with: ='Income Statement'!B5/'Balance Sheet'!B12. After copying this formula to C12, you should see that the 2010 value was 2.34, essentially the same as 2011. We can interpret the asset turnover ratios as follows: Higher turnover ratios indicate more efficient usage of the assets and are therefore preferred to lower ratios. However, you should be aware that some industries will naturally have lower turnover ratios than others. For example, a consulting business will almost surely have a very small investment in fixed assets and therefore a high fixed asset turnover ratio. On the other hand, an electric utility will have a large investment in fixed assets and a low fixed asset turnover ratio. This does not mean, necessarily, that the utility company is more poorly managed than the consulting firm. Rather, each is simply responding to the demands of their very different industries.
Fixed Asset Turnover Sales Net Fixed Assets
Fixed Asset Turnover 3,850.
= --------------------- =10.67 times
Total Asset Turnover Sales Total Assets
Total Asset Turnover 3,850. 1,650.
= --------------------- =2.33 times
CHAPTER 4: Financial Statement Analysis Tools
deductibility of interest can increase the wealth of the firm’s shareholders. We will examine several ratios that help to determine the amount of debt that a firm is using. How much is too much depends on the nature of the business.
The Total Debt Ratio
The total debt ratio measures the total amount of debt (long-term and short-term) that the firm uses to finance its assets:
(4-8)
Calculating the total debt ratio for EPI, we find that debt financing makes up about 58.45% of the firm’s capital structure:
The formula to calculate the total debt ratio in B14 is: ='Balance Sheet'!B19/ 'Balance Sheet'!B12. The result for 2011 is 58.45%, which is higher than the 54.81% in 2010.
The Long-Term Debt Ratio
Many analysts believe that it is more useful to focus on just the long-term debt (LTD) instead of total debt. The long-term debt ratio is the same as the total debt ratio, except that the numerator includes only long-term debt:
(4-9)
EPI’s long-term debt ratio is:
In B15, the formula to calculate the long-term debt ratio for 2011 is: ='Balance Sheet'!B18/'Balance Sheet'!B12. Copying this formula to C15 reveals that in 2010 the ratio was only 22.02%. Obviously, EPI has increased its long-term debt at a faster rate than it has added assets.
Total Debt Ratio Total Liabilities Total Assets
-------------------------------------- Total Assets^ – Total Equity Total Assets
Total Debt Ratio 964. 1,650.
Long-Term Debt Ratio Long-Term Debt Total Assets
Long-Term Debt Ratio 424. 1,650.
Leverage Ratios
The Long-Term Debt to Total Capitalization Ratio
Similar to the previous two ratios, the long-term debt to total capitalization ratio tells us the percentage of long-term sources of capital that is provided by long-term debt (LTD). It is calculated by:
(4-10)
For EPI, we have:
Because EPI has no preferred equity, its total capitalization consists of long-term debt and common equity. Note that common equity is the total of common stock and retained earnings. We can calculate this ratio in B16 of the worksheet with: ='Balance Sheet'!B18/('Balance Sheet'!B18+'Balance Sheet'!B22). In 2010 this ratio was only 32.76%.
The Debt to Equity Ratio
The debt to equity ratio provides exactly the same information as the total debt ratio, but in a slightly different form that some analysts prefer:
(4-11)
For EPI, the debt to equity ratio is:
In B17, this is calculated as: ='Balance Sheet'!B19/'Balance Sheet'!B22. Copy this to C17 to find that the debt to equity ratio in 2010 was 1.21 times.
To see that the total debt ratio and the debt to equity ratio provide the same information, realize that:
(4-12)
but from rearranging equation (4-8) we know that:
LTD to Total Capitalization LTD LTD + Preferred Equity +Common Equity
LTD to Total Capitalization 424. 424.61 +685.
Debt to Equity Total Debt Total Equity
Debt to Equity 964.
= ---------------- =1.41 times
Total Debt Total Equity
------------------------------ Total Debt Total Assets
----------------------------- Total Assets Total Equity
= ×------------------------------
Coverage Ratios
EXHIBIT 4-
EPI’S FINANCIAL RATIOS WITH THE LEVERAGE RATIOS
The Times Interest Earned Ratio
The times interest earned ratio measures the ability of the firm to pay its interest obligations by comparing earnings before interest and taxes (EBIT) to interest expense:
(4-16)
For EPI in 2011 the times interest earned ratio is:
In your worksheet, the times interest earned ratio can be calculated in B20 with the formula: ='Income Statement'!B11/'Income Statement'!B12. Copy the formula to C20 and notice that this ratio has declined rather precipitously from 3.35 in 2010.
Times Interest Earned EBIT Interest Expense
Times Interest Earned 149.
= ---------------- =1.97 times
CHAPTER 4: Financial Statement Analysis Tools
The Cash Coverage Ratio
EBIT does not really reflect the cash that is available to pay the firm’s interest expense. That is because a noncash expense (depreciation) has been subtracted in the calculation of EBIT. To correct for this deficiency, some analysts like to use the cash coverage ratio instead of times interest earned. The cash coverage ratio is calculated as:
(4-17)
The calculation for EPI in 2011 is:
Note that the cash coverage ratio will always be higher than the times interest earned ratio. The difference depends on the amount of depreciation expense and therefore the amount and age of fixed assets. The cash coverage ratio can be calculated in cell B21 of your “Ratios” worksheet with: =('Income Statement'!B11+'Income Statement'!B10)/'Income Statement'!B12. In 2010, the ratio was 3.65.
Profitability Ratios
Investors, and therefore managers, are particularly interested in the profitability of the firms that they own. As we’ll see, there are many ways to measure profits. Profitability ratios provide an easy way to compare profits to earlier periods or to other firms. Furthermore, by simultaneously examining the first three profitability ratios, an analyst can discover categories of expenses that may be out of line. Profitability ratios are the easiest of all the ratios to analyze. Without exception, high ratios are preferred. However, the definition of high depends on the industry in which the firm operates. Generally, firms in mature industries with lots of competition will have lower profitability measures than firms in faster growing industries with less competition. For example, grocery stores will have lower profit margins than computer software companies. In the grocery business, a net profit margin of 3% would be considered quite good. That same margin would be abysmal in the software business, where 15% or higher is common.
Cash Coverage Ratio EBIT^ +Noncash Expenses Interest Expense
Cash Coverage Ratio 149.70^ +20.
= ------------------------------------ =2.23 times
CHAPTER 4: Financial Statement Analysis Tools
(4-20)
The net profit margin for EPI in 2011 is:
which can be calculated on your worksheet in B25 with: ='Income Statement'!B15/ 'Income Statement'!B5. This is lower than the 2.56% in 2010. If you take a look at the common-size income statement (Exhibit 2-5, page 56), you can see that profitability has declined because cost of goods sold, SG&A expense, and interest expense have risen more quickly than sales. Taken together, the three profit margin ratios that we have examined show a company that may be losing control over its costs. Of course, high expenses mean lower returns for investors, and we’ll see this confirmed by the next three profitability ratios.
Return on Total Assets
The total assets of a firm are the investment that the shareholders have made. Much like you might be interested in the returns generated by your investments, analysts are often interested in the return that a firm is able to get from its investments. The return on total assets is:
(4-21)
In 2011, EPI earned about 2.68% on its assets:
For 2011, we can calculate the return on total assets in cell B26 with the formula: ='Income Stat ement'!B15/'Balance Sheet'!B12. Notice that this is more than 50% lower than the 5.99% recorded in 2010. Obviously, EPI’s total assets increased in 2011 at a faster rate than its net income (which actually declined).
Net Profit Margin Net Income Sales
Net Profit Margin 44. 3,850.
Return on Total Assets Net Income Total Assets
Return on Total Assets 44.
Profitability Ratios
Return on Equity
While total assets represent the total investment in the firm, the owners’ investment (common stock and retained earnings) usually represent only a portion of this amount (some is debt). For this reason, it is useful to calculate the rate of return on the shareholder’s invested funds. We can calculate the return on (total) equity as:
(4-22)
Note that if a firm uses no debt, then its return on equity will be the same as its return on assets. The more debt a firm uses, the higher its return on equity will be relative to its return on assets (see Du Pont Analysis on page 122).
In 2011, EPI’s return on equity was:
which can be calculated in B27 with: ='Income Statement'!B15/'Balance Sheet'!B22. Again, copying this formula to C27 reveals that this ratio has declined from 13.25% in 2010.
Return on Common Equity
For firms that have issued preferred stock in addition to common stock, it is often helpful to determine the rate of return on just the common stockholders’ investment:
(4-23)
Net income available to common is net income less preferred dividends. In the case of EPI, this ratio is the same as the return on equity because it has no preferred shareholders:
For EPI, the worksheet formula for the return on common equity is exactly the same as for the return on equity.
Return on Equity Net Income Total Equity
Return on Equity 44.
Return on Common Equity Net Income Available to Common Common Equity
Return on Common Equity 44.22^ –^0
Profitability Ratios
(4-28)
Or, to simplify it somewhat:
(4-29)
To prove this to yourself, in A30 enter the label: Du Pont ROE. Now, in B30 enter the formula: =(B25*B12)/(1-B14). The result will be 6.45% as we found earlier. Note that if a firm uses no debt then the denominator of equation (4-29) will be 1, and the ROE will be the same as the ROA.
Analysis of EPI’s Profitability Ratios
Obviously, EPI’s profitability has slipped rather dramatically in the past year. The sources of these declines can be seen most clearly if we look at all of EPI’s ratios. At this point, your worksheet should resemble the one in Exhibit 4-4.
The gross profit margin in 2011 is lower than in 2010, but not significantly (at least compared to the declines in the other ratios). The operating profit margin, however, is significantly lower in 2011 than in 2010. This indicates potential problems in controlling the firm’s operating expenses, particularly SG&A expenses. The other profitability ratios are lower than in 2010 partly because of the “trickle down” effect of the increase in operating expenses. However, they are also lower because EPI has taken on a lot of extra debt in 2011, resulting in interest expense increasing faster than sales. This can be confirmed by examining EPI’s common-size income statement (Exhibit 2-5, page 56).
Finally, the Du Pont analysis of the firm’s ROE has shown us that it could be improved by any of the following: (1) increasing the net profit margin; (2) increasing the total asset turnover; or (3) increasing the amount of debt relative to equity. Our ratio analysis has shown that operating expenses have grown considerably, leading to the decline in the net profit margin. Reducing these expenses should be the primary objective of management. Because the total asset turnover ratio is near the industry average, as we’ll soon see, it may be difficult to increase this ratio. However, the firm’s inventory turnover ratio is considerably below the industry average and inventory control may provide one method of improving the total asset turnover. An increase in debt is not called for because the firm already has somewhat more debt than the industry average.
ROE
Net Income Sales
---------------------------- Sales Total Assets
×-----------------------------
1 Total Debt Total Assets
ROE Net Profit Margin^ ×Total Asset Turnover 1 – Total Debt Ratio
CHAPTER 4: Financial Statement Analysis Tools
EXHIBIT 4-
COMPLETED RATIO WORKSHEET FOR EPI
Financial Distress Prediction
The last thing that any investor wants to do is to invest in a firm that is nearing a bankruptcy filing or about to suffer through a period of severe financial distress. Starting in the late 1960s and continuing today, scholars and credit analysts have spent considerable time and effort trying to develop models that could identify such companies in advance. The best- known of these models was created by Professor Edward Altman in 1968. We will discuss Altman’s original model and a later one developed for privately held companies.
