CH 03

FINANCIAL
MANAGEMENT
THEORY &
PRACTICE
ADAPTED FOR THE CANADIAN THIRD

EDITION BY:
JIMMY WANG
LAURENTIAN
UNIVERSITY
CHAPTER 3
ANALYSIS OF FINANCIAL
STATEMENTS
CHAPTER 3 OUTLINE
3-1. Financial Analysis

3-2. Liquidity Ratios
3-3. Asset Management Ratios
3-4. Debt Management Ratios
3-5. Profitability Ratios
3-6. Market Value Ratios
Copyright 2017 by Nelson Education Ltd. 3-3

CHAPTER 3 OUTLINE (contd)
3-7. Trend Analysis, Common Size Analysis,

and Percent Change Analysis
3-8. Tying the Ratios Together: The DuPont
Equation
3-9. Comparative Ratios and Benchmarking
3-10. Uses and Limitations of Ratio Analysis

3-1. Financial Analysis
Individual numbers in a firms financial
statements do not mean much if looked at
independently.
Ratios are calculated to reveal relationships
between different numbers and to extract
important information.
Ratios also remove the size factor between
different firms and make comparison of
them meaningful ($5 million of net income
for $50 million vs. $100 million of sales).

3-1. Income Statement
Net sales
Costs of goods sold except depreciation
Depreciation and amortization
Other operating expenses
EBIT
Int. expense
EBT
Taxes (40%)
Net income
Preferred dividends
Net income available to shareholders (NI)
3-1. Balance Sheets: Assets
Cash
S-T invest.
AR
Inventories
Total CA
Net FA
Total assets

3-1. Balance Sheets: Liabilities and
Equity
Accts. payable
Notes payable
Accruals
Total CL
Long-term bonds
Total liabilities
Pref. stock (400,000 shares)
Com. stock (50,000,000 shares)
Ret. earnings
Total common equity
Total L&E

3-1. Other Data
Stock price
# of shares
EPS
DPS
CFPS
BVPS
Lease payments
Tax rate

3-1. Why Are Ratios Useful?
Standardize numbers and facilitate
comparisons both between firms and
over time
Used to highlight weaknesses and strengths

3-1. Who Is Using Ratios?
Investors: Predicting the future
Management: Evaluating current situation and
planning to improve the firms future
performance

3-1. Five Major Categories of Ratios
Liquidity: Can we make required payments as
they fall due?
Asset management: Do we have the right amount
of assets for the level of sales?
Debt management: Do we have the right mix of
debt and equity?
Profitability: Do sales prices exceed unit costs,
and are sales high enough as reflected in PM,
ROE, and ROA?
Market value: Do investors like what they see as
reflected in P/E and M/B ratios?
3-2. Liquidity Ratios
Provide a quick, easy-to-use measure of
liquidity
Two commonly used ratios:
Current ratio (CR): Measures the ability to
meet short-term obligations
Quick, or acid test, ratio (QR): Measures the
ability to pay off short-term obligations
without relying on the sale of inventories

3-2. Current and Quick Ratios
CR16 = CA = $1,000 = 3.2

CL $310
QR16 = CA Inv.
CL
= $1,000 $615 = 1.2

$310

3-2. Comments on CR and QR
2016 2015 Industry
CR 3.2 3.7 4.2
QR 1.2 1.8 2.1
It is expected to worsen and is still below the

industry average.
Liquidity position is weak.
Shareholders may not want a high CR.

3-3. Asset Management Ratios
Measure how effectively the firm is managing
its assets
Answer the question: Does the firm have the
right amount of each type of assets in view of
sales levels?
Can be calculated for different types of assets:
inventories, A/R, A/P, fixed assets, and total
assets

3-3. Evaluating Inventories:
Inventory Turnover Ratio
Inv. turnover =COGS
Inventories
= $2,200= 3.60
$615
2016 2015 Ind.

Inv. t. 3.6 5.04 8.0

3-3. Comments on Inventory
Turnover
Inventory turnover is below industry average.
Firm might have old inventory, or its control
might be poor.
True turnover will be overstated when sales
are stated at market prices, but inventories are
recorded at historical cost.
This ratio may be distorted by seasonal
factors.

3-3. Evaluating Receivables:
The Days Sales Outstanding (DSO)
DSO = Receivables
Average sales per day
$375
= Receivables = $3,000/365
Sales/365
= 45.6 days 46 days

3-3. Appraisal of DSO
Also called the average collection period
(ACP), indicates the average length of time for
the firm to wait after making a sale before
receiving cash
Firm collects too slowly, and situation is
getting worse: poor credit policy
2016 2015 Ind.
DSO 46 40 36

3-3. Evaluating Payables:
Average Payables Period (APP)
Payables
APP
Avg.OperatingCostPerDay
Payables
AnnualOperatingCost / 365
$60 $60
APP 8.4days 8days
$2,616.2 365 $7.1677

3-3. APP: Interpretation
With an industry average of 9 days, the firm is
doing fine with sufficient cash flow to pay bills
on time.
If APP is significantly longer than the credit
term provided, the firm will be at risk of losing
those credit terms.
If APP is lower than the credit terms offered,
the firm has not taken advantage of the free
financing from suppliers.

3-3. Fixed Assets and Total Assets
Turnover Ratios
Fixed assets Sales
=
turnover Net fixed assets
= $3,000 = 3.0
$1,000
Total assets Sales
=
turnover Total assets
= $3,000 = 1.5
$2,000

3-3. Fixed Assets and Total Assets
Turnover Ratios
FA turnover is equal to the industry average, suggesting that
the firm has about the right amount of fixed assets in relation
to other firms.
Note the different accounting policies in recording fixed assets
when comparing two firms FA ratios.
TA turnover not up to industry average is caused by excessive
current assets (A/R and inventory).
2016 2015 Ind.
FA TO 3.0 3.3 3.0
TA TO 1.5 1.7 1.8

Measure the extent to which a firm uses debt
financing or financial leverage
For shareholders, high debt ratios enable
them to maintain control and earn more on
investments.
For creditors, low debt ratios provide a margin
of safety.

3-4. (Total) Debt and
Times-Interest-Earned (Tie) Ratios
Total debt
Debt (D/A) ratio = Total assets
$110 + $754
= $2,000 = 43.2%
EBIT
TIE =
Int. expense
= $283.8 = 3.2
$88

3-4. EBITDA Coverage (EC) Ratio
EBITDA + Lease payments

Interest Lease
expense+ pmt.+ Loan pmt.
= ($283.8 + $100) + $28 = 3.0

$88 + $28 + $20

vs. Industry Averages
2016 2015 Ind.
D/A 43.2% 38.1% 30.0%
TIE 3.2 4.4 6.0
EC 3.0 0.8 4.3
Creditors provide more funds, further increasing D/A ratio
above industry average.
Higher debt worsens its ability to pay interest expenses.
The firm seems to use the lease as an alternative to debt.

3-5. Profitability Ratios
Show the combined effects of liquidity, asset
management, and debt on operating results
Profitability is the net result of a number of
policies (including accounting) and decisions.

3-5. Net Profit Margin (PM)
NI $113.5
PM = Sales = $3,000 = 3.8%
2016 2015 Ind.

PM 3.8% 4.1% 5.0%
PM was very bad in 2016 because of

high costs. It resulted from inefficient
operations or heavy use of debt.

3-5. Operating and Gross Profit Margin
Ratios
Can be calculated to identify the source of a low
net profit margin
Operating profit margin = EBIT/Sales
This ratio identifies how a firm is performing
before the impact of interest expenses is
considered.
Gross profit margin = Gross profit/Sales
Gross margin = Sales Cost of goods sold
This ratio identifies the gross profit per dollar of
sales before deducting any other expenses.

3-5. Basic Earning Power (BEP)
EBIT
BEP =
Total assets
= $283.8 = 14.2%
$2,000

3-5. Basic Earning Power vs.
Industry Average
BEP removes the effect of taxes and financial
leverage; useful for comparison
BEP is below average probably due to the low
turnover ratios and low profit margin on sales.
Room for improvement
2016 2015 Ind.

BEP 14.2% 15.7% 17.2%

3-5. Return on Assets (ROA) and
Return on Equity (ROE)
NI
ROA =
Total assets
= $113.5 = 5.7%
$2,000

3-5. Return on Assets (ROA) and
Return on Equity (ROE)
NI
ROE = Common equity
= $113.5 = 12.7%
$896

3-5. ROA and ROE vs. Industry
Averages
20162015 Ind.
ROA 5.7% 7.0% 9.0%
ROE 12.7% 14.0% 15.0%
Both below average and worsening

3-5. Effects of Debt on ROA and
ROE
ROA is lowered by debt: Interest expense
lowers net income, which also lowers ROA.
However, the use of debt lowers equity, and if
equity is lowered more than net income, ROE
would increase.

3-6. Market Value Ratios
Relate the firms stock price to its earnings,
cash flow, and book value per share
Measure the firms stock value in terms of its
competitors

3-6. Price/Earnings (P/E) Ratio
Price = $23.00
NI $113.5m
EPS =Shares out = 50m = $2.27
Price per share $23.00

P/E = EPS = $2.27 = 10.1

3-6. Price/Cash Flow (P/CF) Ratio
NI + Depr.
CF per share = Shares out.
$113.5 + $100.0
= 50 = $4.27
Price per share

P/CF = Cash flow per share
= $23.00 = 5.4
$4.27
3-6. Market/Book (M/B) Ratio
Total Com. equity

BVPS = Shares out.
$896m
= 50m = $17.92
Mkt. price per share
M/B = Book value per share
$23.00
= $17.92 = 1.3

3-6. Interpreting Market Value
Ratios
P/E: How much investors will pay for $1 of
earnings. Higher is better.
M/B: How much paid for $1 of book value.
Higher is better.
P/E and M/B are high if ROE is high, risk is low.
P/CF: How much paid for $1 of cash flow.
Higher is better.

3-6. Comparison with Industry
Averages
2016 2015 Ind.

P/E 10.1 11.0 12.5
P/CF 5.4 6.3 6.8
M/B 1.3 1.1 1.7

3-7. Common Size Balance Sheets:
Divide All Items by Total Assets
Assets 2016 2015 Ind.
Cash 0.5% 0.9% 1.0%
ST inv. 0.0% 3.9% 2.2%
AR 18.8% 18.8% 17.8%
Invent. 30.8% 24.7% 19.8%
Total CA 50.0% 48.2% 40.8%
Net FA 50.0% 51.8% 59.2%
TA 100.0% 100.0% 100.0%

3-7. Divide All Items by Total
Liabilities and Equity
Assets 2016 2015 Ind.
AP 3.0% 1.8% 1.8%
Notes pay. 5.5% 3.6% 4.4%
Accruals 7.0% 7.7% 3.6%
Total CL 15.5% 13.1% 9.8%
LT bonds 37.7% 34.5% 30.2%
Total liabilities 53.2% 47.6% 40.0%
Pref. stock 2.0% 2.4% 0.0%
Total com. eq. 44.8% 50.0% 60.0%
Total L&E 100.0% 100.0% 100.0%

3-7. Analysis of Common Size
Balance Sheets
The company has a higher proportion of
inventory and current assets than industry.
The company has less equity (which means
more debt) than industry.
The company now has zero short-term debt
but more long-term debt than industry.

3-7. Common Size Income Statement:
Divide All Items by Sales

3-7. Analysis of Common Size
Income Statements
The company has lower COGS (70.0) than
industry (77.6), but slightly higher
depreciation and amortization and other
operating expenses. The result is that the
company has similar EBIT. However, the high
interest expense lowers the EBT (6.5)
compared to industry (8.3).

3-7. Income Statement Percentage Change
Analysis: Percent Change from Base Year

3-7. Analysis of Percent Change Income
Statement
We see that 2016 sales grew 5.3% from 2015,
and that NI fell 3.7% from 2015. So the
company has become less profitable.
The analysis reveals whether the firms
condition has been improving or deteriorating
over time.
Similar analysis can be performed on the
balance sheet. The extreme growth in
inventories (48.2%) should be of great
concern.

3-8. Tying the Ratios Together:
The DuPont Equation
The DuPont equation focuses on:
expense control (PM)
asset utilization (TATO)
debt utilization (EM)
It shows how these factors combine to
determine the ROE.
It also provides a quick and dirty estimate of
the impact of operating changes on returns
(see Chapter 5).
3-8. The DuPont Equation
( Profit
margin )( TA
turnover )( Equity
multiplier = ROE )
NI Sales TA
Sales TA CE = ROE

3-8. The DuPont Equation (contd)
NI Sales TA
= ROE
Sales TA CE
2016: 3.8%1.5 2.23 =12.7%
Alternatively,
ROE = ROA Equity multiplier
= 5.7% ($2,000/$896) = 12.7%

3-9. Comparative Ratios and
Benchmarking
Ratio analysis involves comparing a firms
ratios with industry average figures.
Managers can also use a technique called
benchmarkingcomparing the firms ratios
with those of a smaller set of leading
companies in its industry.
Comparative ratios are available from various
sources including FPinfomart.

3-9. Comparative Ratios for
TransCanada

3-10. Uses and Limitations of Ratio
Analysis
Comparison with industry averages is difficult
if the firm operates many different divisions.
Average performance is not necessarily
good.
Seasonal factors and inflation can distort
ratios.
Window dressing techniques can make
statements and ratios look better.

3-10. Uses and Limitations (contd)
Different accounting and operating practices
can distort comparisons.
Sometimes it is difficult to tell if a ratio value is
good or bad.
To sum up, ratio analysis can provide useful
insights into a firms operations only when
used intelligently and with good judgment.

Summary
A discussion of techniques used by investors and
managers to analyze financial statements
Various ratios calculated to evaluate a firms
liquidity, asset and debt management,
profitability, and market value
Ratios organized as trend analysis and
benchmarking
DuPont system used to show the relationship
between ratios and to analyze ways of improving
performance

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FINANCIAL

ADAPTED FOR THE CANADIAN THIRD

3-1. Financial Analysis

Copyright 2017 by Nelson Education Ltd. 3-3

3-7. Trend Analysis, Common Size Analysis,

Copyright 2017 by Nelson Education Ltd. 3-4

Copyright 2017 by Nelson Education Ltd. 3-6

Copyright 2017 by Nelson Education Ltd. 3-8

Copyright 2017 by Nelson Education Ltd. 3-9

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Copyright 2017 by Nelson Education Ltd. 3-14

CR16 = CA = $1,000 = 3.2

= $1,000 $615 = 1.2

Copyright 2017 by Nelson Education Ltd. 3-15

It is expected to worsen and is still below the

Copyright 2017 by Nelson Education Ltd. 3-16

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2016 2015 Ind.

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EBITDA + Lease payments

= ($283.8 + $100) + $28 = 3.0

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2016 2015 Ind.

PM was very bad in 2016 because of

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2016 2015 Ind.

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Both below average and worsening

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Price per share $23.00

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Price per share

Total Com. equity

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2016 2015 Ind.

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