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1 Analysis of Financial Statements Timothy R. Mayes, Ph.D. FIN 3300: Chapter 3

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2 Common-size Income Statements v A common-size income statement restates all expenses as a percentage of sales v This allows the analyst to quickly and easily see which expenses have increased or decreased relative to sales

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3 Common-size Balance Sheets v A common-size balance sheet restates all assets and liabilities as a percentage of total assets v This allows the analyst to quickly and easily see which accounts have increased or decreased relative to total assets

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4 Financial Ratios v Financial ratios are the 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 v Ratios are used by both internal and external analysts Internal uses u planning u evaluation of management External uses u credit granting u performance monitoring u investment decisions

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5 Categories of Financial Ratios v Financial ratios are often divided into categories based on the information that they provide: Liquidity Efficiency Leverage Coverage Profitability Market valuation

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6 Liquidity Ratios v ‘Liquidity’ refers to the speed with which an asset can be converted to cash v Liquidity ratios describe the ability of a firm to meet its current obligations v There are three common liquidity ratios: The Current Ratio The Quick Ratio The Cash Ratio

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7 The Current Ratio For EPI the current ratio in 1997 is:

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8 The Quick Ratio For EPI the quick ratio in 1997 is:

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9 The Cash Ratio For EPI the cash ratio in 1997 is:

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10 Efficiency Ratios v The efficiency ratios (A.K.A. assets utilization ratios) describe how well a firm is using its investment in various asset classes: Inventory Turnover Ratio Accounts Receivable Turnover Ratio Average Collection Period Fixed Asset Turnover Ratio Total Asset Turnover Ratio

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11 The Inventory Turnover Ratio For EPI the inventory turnover ratio in 1997 is:

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12 The A/R Turnover Ratio For EPI the accounts receivable turnover ratio in 1997 is:

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13 The Average Collection Period For EPI the average collection period in 1997 is:

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14 The Fixed Asset Turnover Ratio For EPI the fixed asset turnover ratio in 1997 is:

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15 The Total Asset Turnover Ratio For EPI the total asset turnover ratio in 1997 is:

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16 Leverage Ratios v Leverage ratios describe the amount of debt that the firm has used to finance its investments in assets: Total Debt Ratio Long-term Debt Ratio Debt to Equity Long-term Debt to Equity

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17 The Total Debt Ratio For EPI the total debt ratio in 1997 is:

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18 The Long-term Debt Ratio For EPI the long-term debt ratio in 1997 is:

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19 The Debt to Equity Ratio For EPI the debt to equity ratio in 1997 is:

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20 The Long-term Debt to Equity Ratio For EPI the long-term debt to equity ratio in 1997 is:

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21 Coverage Ratios v Coverage ratios indicate the firm’s ability to pay certain expenses: Times Interest Earned Ratio Cash Coverage Ratio

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22 The Times Interest Earned Ratio For EPI the times interest earned ratio in 1997 is:

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23 The Cash Coverage Ratio For EPI the cash coverage ratio in 1997 is:

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24 The Fixed Charge Coverage Ratio v Note: SF Payments are Sinking Fund payments which are not tax deductible. Therefore, we must divide them by (1-t) to find out how much we need before taxes to meet this after-tax expense. Also, you must include preferred dividends in this number.

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25 Profitability Ratios v Profitability ratios provide a measure of the returns that a firm is generating: Gross Profit Margin Operating Profit Margin Net Profit Margin Return on Total Assets Return on Equity Return on Common Equity

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26 The Gross Profit Margin For EPI the gross profit margin in 1997 is:

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27 The Operating Profit Margin For EPI the operating profit margin in 1997 is:

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28 The Net Profit Margin For EPI the net profit margin in 1997 is:

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29 The Return on Total Assets For EPI the return on total assets in 1997 is:

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30 The Return on Equity For EPI the return on equity in 1997 is:

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31 The Return on Common Equity For EPI the return on common equity in 1997 is:

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32 Market Valuation Ratios v The market valuation ratios provide an indication of the relative under- or over- pricing of a firm’s stock: Price/Earnings Ratio Price/Book Ratio

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33 The Price/Earnings Ratio

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34 The Price/Book Ratio

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35 Rules for Memorizing Ratios v There can be an infinite number of financial ratios, but knowing a few basic rules will help you to memorize the formulas: The basic rule is that the name tells you how to calculate the ratio. Any ‘ margin ’ ratio is something divided by sales Any ‘ turnover ’ ratio is sales (or a variation of sales) divided by something Any ‘ return on ’ ratio is net income (or a variation of net income) divided by something

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36 Using Financial Ratios v Calculating ratios is pointless unless you know how to use them v The most basic rule is: a single ratio provides very little information and may be misleading v With that in mind, there are at least 4 uses of ratios: Trend analysis (internal and external) Comparison to industry averages (internal and external) Setting and evaluating company goals (internal) Restrictive debt covenants (external)

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37 Trend Analysis of Ratios v Trend analysis involves the examination of ratios over time v The analyst tries to determine if the ratio is changing in a favorable, or unfavorable, direction v The chart shows EPI’s current ratio for two years (we really need more data)

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38 Comparing to Industry Averages v Industry average ratios provide a benchmark for comparison v We assume that if a ratio is too far from the average something is wrong v Industry ratios are available from Robert Morris Associates and Standard & Poor’s

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39 Company Goals and Debt Covenants v Company goals are often stated in terms of financial ratios For example, it is common for management to set goals regarding the firm’s ROE v Debt covenants often contain restrictions on certain ratios For example, a borrower might be required to maintain a debt to equity ratio of less than 1.0 and a current ratio greater than 2.0

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