Chapter 3: Analysis of Financial Statements

Question 1

Explain why ratio analysis is usually the first step in the analysis of a company’s financial statements.

Answer 1

• Designed to extract important information that might not be obvious from just looking at a firm’s financial statements
• Compares line item data to show info about profitability, liquidity, etc.
• Compare with other companies in the industry to see financial standing

Question 2

List and explain the five groups of ratios and specify which ratios belong in each group.

Answer 2

• Profitability ratio: shows the combined effects of liquidity, asset management, and debt on operating AND financial results.
  o Net profit margin: net income available to common stockholders/sales
  o Basic earning power ratio: EBIT/ total assets
  o Return on total assets: net income available for stockholders/total assets
  o Return on common equity: net income available for stockholders/ common equity
• -Asset management ratios: measure how effectively a firm is managing its assets Also called efficiency ratios.
  o Total assets turnover ratio: sales/total assets
  o Fixed assets turnover ratio: sales/net fixed assets
  o Days sales outstanding (DSO)/ average collection period (ACP): receivables/(annual sales/365) – measures time it’ll take to receive cash.
  o Inventory turnover ratio: COGS/ inventories
• Liquidity ratio: shows the relationship of a firm’s cash and other current assets to its current liabilities
  o Current ratio: current assets/current liabilities
  o Quick ratio/acid test ratio: (current assets – inventories)/ current liabilities industry average is 1.0
• Debt/leverage ratio: identify a firm’s use of debt relative to equity and it ability to pay interest and principle.
  o Debt-to-assets ratio: total debt/total assets
  o Debt-to-equity ratio: total debt/ total common equity
  o Market debt ratio: total debt/ (total debt + market value of equity)
  o Liabilities to assets ratio: total liabilities/total assets
  o Equity multiplier ratio: total assets/ common equity
  o Times interest earned (TIE) ratio: EBIT/ interest expense
  o EBITDA coverage ratio: (EBITDA + lease payments) / (interest + principal payments + lease payments)
• Market ratio: ratio of the market value of total debt provided by an investor to the total market value of debt and equity. If market value of debt isn’t available, then analysts use book value.
  o Price/earnings ratio: price per share/earnings per share
  o Price/ FCF ratio: price per share/ FCF per share
  o Book value per share: total common equity/ shares outstanding
  o Market/book ratio: market price per share/ book value per share
  o Market capitalization: (price per share) (total # of shares)
  o Market/book ratio: market cap/total common equity

Question 3

For each ratio on the ratio table page, be able to calculate the ratio, explain what it measures, and state whether a firm is “BETTER” or “WORSE” than the trend or the industry numbers. In addition, you should think about strengths and potential weaknesses for each ratio.

Question 4

Understand how the Quick Ratio is different from the Current Ratio and why it may be more useful in some instances.

Answer 4

• Both ratios measure a company’s ability to generate enough cash to pay off all debts should they become due at once. Quick ratio subtracts inventories from the current assets.
  o Quick ratio only considers highly liquid assets/cash equivalents as part of the current assets because inventories are typically the least liquid and difficult to convert to cash and most sales are made on a credit basis.
  o Industry average is 1.0 – the higher the quick ratio the better the company’s liquidity position.

Question 5

Understand and know how to calculate a trend analysis, common-size analysis and percentage-change analysis and be able to interpret and explain how each type of analysis is useful. Be able to complete and interpret a common-size income statement and a common-size balance sheet.

Answer 5

• Trend analysis: analysis of a firm’s financial ratios over time. Used to estimate the likelihood of improvement/deterioration in its financial situation
• Common size analysis- all income statement items are divided by total assets. Common size income statement shows each item as a % of sales and common size balance sheet shows % of total assets.
  o Advantage is that it allows a comparison over time and across companies
• Percentage change analysis: shows how different items change over time. % changes for all income statement and balance sheet accounts are calculated relative to the items’ values in the base year.

Question 6

Explain each of these: benchmarking, trend analysis, cross-sectional analysis, and common-size analysis.

Answer 6

• Benchmarking: when a firm compares its ratios to other leading (benchmark) companies in the same industry.
• Trend analysis: analysis of a firm’s financial ratios over time. Used to estimate the likelihood of improvement/deterioration in its financial situation
• Cross-sectional analysis: compares many companies over a focused time period.
• Common-size analysis: all income statement items are divided by total assets.

Question 7

Describe the “pieces” of ROE and how they are used (Equation 3-25 and 3-36).

Answer 7

• Answers: how do managerial actions affecting a firm’s profitability, asset efficiency, and financial leverage interact to determine the ROE?
• Return on Equity= net income/shareholder equity  if the # goes up it’s good means the Rate of return on shareholders equity is rising.
• ROE = (net income/sales) x (sales/total assets) x (total assets/common equity)  ROE = (profit margin)(total assets turnover) (equity multiplier)
  o Measure of operating efficiency x asset use efficiency x financial leverage
  o 3 step ROE can show where the company is lagging

Question 8

Describe the “pieces” of ROA and how they are used (Equation 3-5 and 3-25).

Answer 8

• Indicates how profitable a company is in relation to its total assets. Used to see how efficiently a company uses its assets to generate a profit.  high # is good
• Can’t be used across industries

Question 9

Explain the importance of the “equity multiplier” and its impact on ROE.

Answer 9

• Reveals how much of the total assets are financed by shareholders’ equity.
• The ratio is a risk indicator used by investors to determine how leveraged the company is.
• High equity multiplier = high level of debt
• = total assets/common equity
• One of the 3 ratios for ROE  high equity multiple = higher ROE

Question 10

List and explain several limitations of ratio analysis.

Answer 10

• Inflation can distort firms balance sheets because reported values are often different than the true values
• Season effects can distort ratio analysis. At certain times of the year, a firm may have excessive inventories preparing for high demand so the inventory turnover ratio will be different.
• To set higher performance goals, its better to benchmark industry leader ratios instead of industry average ratios.

Question 11

Identify some of the qualitative factors that must be considered when evaluating a company’s financial performance and when using some specific ratios, as discussed in class.

Answer 11

• What % of the company’s business is generate overseas? Can be exposed to risk of political instability and currency exchange.
• How do legal and regulatory environments affect the company?
• What’s the likelihood of additional new competitors?