1. Ch3. Analysis of Financial Statement

2. 1. Why we need ratios? Specialized information Comparison Issue
Predicting future performance
5 types of financial ratios (handout)
Liquidity ratios
Asset management ratios
Debt management ratios
Profitability ratios
Market value ratios

3. Goals
To calculate financial ratios
To understand how to use them

6. [3] Debt management ratio
Debt ratio =
total liabilities/total assets
Debt to equity ratio = Total liabilities/(Total asset – total liabilities). But it ignore the market value.
Market debt ratio = Total liabilities / (Total liabilities + market value of equity).
Time-interest-earned (TIE) =
Earnings before interest and taxes (EBIT)/Interest charges. But it ignores lease payment related to bankruptcy. Lease payment was deducted when EBIT is calculated.

7. EBITDA coverage ratio = (EBITDA+ Lease payment) / (Interest + Principal payments + Lease payment). It is useful for short term lenders to evaluate financial status of firms with large amount of depreciation and amortization.
Equity Multiplier=Total asset/ common equity

8. 4) Profitability ratios
Net profit margin = Net income / Sales
Operating margin = Operating Income (EBIT)/Sales
Gross profit margin
= (Sale – COGS)/Sales
Return on Total Assets (ROA) = Net income / Total assets

9. Basic Earning power (BEP) ratio = EBIT/ Total assets
Return on common equity = ROE
=Net income /common equity
Return on total assets = ROA
=Net income /total assets

10. 5) Market value ratio
Price/ Earnings ratio = price / earnings per share.
Price / Cash flow ratio = price / cash flow per share.
Book value per share = common equity / shares outstanding.
Market / book ratio = market price per share / book value per share.

11. PEG ratio = PE ratio/Earnigs growth rate (%)
- The lower PEG, the more undervalued
Tobin’s Q ratio= Market value of assets/replacement cost of assets
- similar to Market to Book ratio
- higher Tobin’s Q, the higher growth opportunities.
Enterprise value –EBITDA ratio = Enterprise value / EBITDA

12. 2. Trend analysis:
An analysis of a firm’s financial ratios over time – plotting ratios over time periods
It is used to estimate the likelihood of improvement or deterioration in its financial condition
3. Du Pont Analysis:
Decomposing the ROA and ROE

13. ROA
= Net income / Total assets
= Net Income/Sales * Sales/Total assets
= Profit margin * Total asset turnover
If a company has only equity without any liability, ROA =ROE

14. ROE
= Net Income /Common Equity
= Net Income/Total Assets*Total asset/Common Equity
= Net Income/Sales * Sales/Total Assets * Total assets/Common equity
=Profit margin * Total asset turnover*Equity multiplier
Here Equity multiplier will increase with debts

15. 4. Benchmarking:
The process of comparing a particular company with a group of benchmark companies
The bench mark companies can be leading companies, peer groups or competitors in the industry
Comparative ratios are available from a number of sources, including value lines

16. 5. Limits of ratio analysis
Ratio analysis is more useful for small, narrowly focused firms than for large, multidivisional ones
For high level performance, it is better to focus on the industry leaders’ ratios
Seasonal factors: impacts on the inventory turnover ratio. Using monthly averages for inventory can minimize this problem
Window dressing: making financial statements look better than they really are

17. Different accounting practices: FIFO &LIFO or Depreciation methods
It is difficult to generalize whether a particular ratio is good or bad.
6. Problems with ROE
Some problems raises if ROE is used as only sole measure of performance

18. (1) ROE doesn’t consider risks
(2) ROE doesn’t consider amounts of invested capital