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Forecasting 1

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forecasting 1

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Chapter 3 Slide Contents

Understanding Financial Statements, • Learning Objectives

Taxes, and 1. An Overview of the Firm’s Financial Statements
Cash Flows 2. The Income Statement
3. Corporate Taxes
4. The Balance Sheet
5. The Cash Flow Statement
• Principles Applied in This Chapter
• Key Terms

Learning Objectives Learning Objectives (cont.)

1. Describe the content of the four basic 4. Use the balance sheet to describe a firm’s
financial statements and discuss the investments in assets and the way it has
importance of financial statement analysis financed them.
to the financial manager. 5. Identify the sources and uses of cash for a
2. Evaluate firm profitability using the income firm using the firm’s cash flow statement.
statement.
3. Estimate a firm’s tax liability using the
corporate tax schedule and distinguish
between the average and marginal tax
rate.

Principles Used in This Chapter

• Principle 1: Money Has a Time Value.

• Principle 3: Cash Flows Are the Source of
Value. 3.1 AN OVERVIEW OF THE
• Principle 4: Market Prices Reflect FIRM’S FINANCIAL
Information. STATEMENTS
• Principle 5: Individuals Respond to
Incentives.

1
Basic Financial Statements Basic Financial Statements (cont.)

The accounting and financial regulatory 1. Income Statement: An income statement

authorities mandate the following four types provides the following information for a
of financial statements: specific period of time (for example, a full
1. Income statement year or quarterly):
2. Balance sheet • Revenue earned,
• Expenses incurred, and
3. Cash flow statement
• Profit earned.
4. Statement of shareholder’s equity

Basic Financial Statements (cont.) Basic Financial Statements (cont.)

2. Balance sheet: Balance sheet contains 3. Cash flow statement: It reports cash
information on a specific date (for example, received and cash spent by the firm over a
as of December 31, 2013) of the following: period of time.
• Assets (everything of value the company owns),
• Liabilities (the firm’s debts), and
• Shareholders’ equity (the money invested by the 4. Statement of shareholder’s equity: It
company owners). provides a detailed account of the firm’s
activities in the following accounts:
Common stock & Preferred stock account,
Retained earnings account, and Changes to
owners’ equity.

Why Study Financial Statements?

Why Study Financial Statements?
(cont.)

Analyzing a firm’s financial statement can help • This chapter discusses the distinction
managers carry out three important tasks: between the earnings numbers that the
1. Assess current performance, firm’s accountants calculate and the amount
2. Monitor and control operations, and of cash that a firm generates.
3. Plan and forecast future performance.
• It is possible for a firm to report positive
accounting earnings while generating
negative cash flows (and vice versa).

2
What are the Accounting Principles Used
to Prepare Financial Statements?

• Accountants use the following three

fundamental principles when preparing
financial statements: 3.2 THE INCOME STATEMENT
1. The revenue recognition principle,
2. The matching principle, and
3. The historical cost principle.

An Income Statement An Income Statement (cont.)

An income statement (also called a profit and An income statement will contain the
loss statement) measures the amount of following:
profits generated by a firm over a given time 1. Revenues
period (usually a year or a quarter). It can be 2. Expenses
expressed as follows:
– Cost of goods sold, Selling expenses, General
and administrative expense, depreciation &
Revenues (or Sales) – Expenses = Profits amortization expense, Interest expense, and
Income tax expense
3. Net Income
– Difference between Revenue and all expenses

Evaluating a Firm’s per Share

Table 3.1 H. J. Boswell, Inc.
Earnings (EPS) and Dividends

• Per Share earnings = company’s net income

divided by the number of common shares
outstanding.

• Dividends per share = total dividends paid

divided by the number of common shares
outstanding.

3
Evaluating a Firm’s EPS and Connecting the Income Statement
Dividends (for Boswell, Table 3.1) and the Balance Sheet

• Earnings per share = $204.75m ÷ 90m • What can the firm do with the net income?:
= $2.28 per share Pay dividends to shareholders, and/or
Reinvest in the firm
• Dividends per share = $45m ÷ 90m
= $0.50 per share – Boswell, Inc. earned net income of $204.75
million, of which $45 million was distributed in
dividends and $159.75 million was retained and
reinvested in the firm.

Interpreting Firm Profitability using Interpreting Firm Profitability using

the Income Statement the Income Statement (cont.)

From H.J. Boswell Inc.’s income statement 1. The gross profit margin (GPM)
(Table 3-1) we observe that firm has been = gross profits ÷ sales
profitable. We can identify three different = $675 million ÷ $2,700 million
measures of profit or income: = 25%
1. The gross Profit margin is 25% ($675 million) – GPM indicates the firm’s “mark-up” on its cost of
2. The operating profit margin is only 14.2% ($382.5 goods sold per dollar of sales. The markup
million)
percentage equals gross profit divided by cost of
3. The net profit margin is only 7.6% ($204.75 million)
goods sold (=$675m ÷ $2.025m = 33.3%)

Interpreting Firm Profitability using Interpreting Firm Profitability using

the Income Statement (cont.) the Income Statement (cont.)

2. The operating profit margin 3. The net profit margin

= net operating income ÷ sales = net profits ÷ sales
= $382.5 million ÷ $2,700 million = $204.75 million ÷ $2,700 million
= 14.17% = 7.6%

– The operating profit margin is equal to the ratio – Net profit margin indicates the percentage of
of net operating income or EBIT divided by revenues left over after all expenses (including
firm’s sales. interest and taxes) have been considered.

4
Interpreting Firm Profitability using
GAAP and Earnings Management
the Income Statement (cont.)

By monitoring any changes in these margins • While the firms must adhere to GAAP, there
and comparing these margins to those of is considerable room for managers to
similar businesses, we can dissect and identify actively influence the firm’s reported
a firm’s performance and identify expenses earnings.
that are out of line.
• Managers have an incentive to tamper with
earnings as their pay depends upon it and
because investors pay close attention to
earnings announcements.

GAAP and Earnings Management

An audit by an independent accounting firm

serves as a check and balance to control
management’s incentive to disguise the firm’s CHECKPOINT 3.1:
financial condition. CHECK YOURSELF

Constructing an Income Statement

Reconstruct the firm’s income statement
assuming the firm is able to cut its cost of
goods sold by 10% and that the firm pays
taxes at a 40% rate. What is the firm’s net
income and earnings per share?
Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-27 Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-28

Step 1: Picture the Problem Step 1: Picture the Problem (cont.)

• The income statement can be expressed as Revenues

follows: Less: Cost of goods sold

Equals Gross
Revenues – Expenses = Net Income profit
Less: Operating expenses
Equals: net

• We are given information on revenues and Less: Interest expense

Operating income

expenses (cost of goods sold, operating Equals: earnings

expenses, interest expense and income Before taxes

taxes) to fill the template given on next Less: Income taxes

Equals:
slide. NET INCOME

5
Step 2: Decide on a Solution
Step 3: Solve
Strategy

• Given the account balances, constructing Revenues = $14,549,000,000

the income statement will entail substituting Less: Cost of goods sold
= $8,347,500,000
the appropriate balances into the template Equals: profit
=$6,201,500,000
of step 1. Less: Operating/other expenses
=$3,841,000,000
Equals: net
Operating income
=$2,370,500,000
Less: Interest expense
=$74,000,000
Equals: earnings
Before taxes
=$2,291,500,000
Less: Income taxes (40%)
=$916,600,000
Equals:
NET INCOME
=$1,374,900,000

Step 3: Solve (cont.) Step 4: Analyze

Earnings per share: The firm is profitable since it earned net

= net income ÷ number of shares income of $1,374,900,000. The shareholders
were able be earn $1.96 per share.
= $1,374,900,000 ÷ 716,296,296
= $1.92

Corporate Taxes

A firm’s income tax liability is based on its

taxable income and the tax rates on corporate
3.3 CORPORATE TAXES income.

6
Computing Taxable Income Marginal and Average Tax Rates

The table reveals the following: • Marginal tax rate is the tax rate that the
company will pay on its next dollar of
– Tax rates range from 15% to 39% taxable income.

– Tax rates are progressive i.e. corporations with • Average tax rate is total taxes paid
higher profits tend to pay more taxes. divided by the taxable income.

Marginal and Average Tax Rates Marginal and Average Tax Rates

Example: What is the average and marginal • Average tax rate

tax liability for a firm reporting $100,000 as – = Total tax liability ÷ Total taxable income
taxable income. – = $22,250 ÷ $100,000
– = 22.25%
• Marginal tax rate
– = 39% as the firm will have to pay 39% on its
next dollar of taxable income i.e. if its taxable
income increases from $100,000 to $100,001.

Dividend Exclusion for Corporate Dividend Exclusion for Corporate

Shareholders Shareholders

The dividend received by corporate Example What will be the taxable income if
stockholders are partially exempt from firm A receives $100,000 in dividends from
taxation. The rationale is to avoid double firm B.
taxation at the corporate level. The
percentage of exempt taxes is based on the
degree of ownership of the firm.

7
The Balance Sheet

The balance sheet provides a snapshot of the

firm’s financial position on a specific date. It
3.4 THE BALANCE SHEET is defined by the following equation:

Total Assets = Total Liabilities + Total

Shareholders Equity

The Balance Sheet (cont.) The Balance Sheet (cont.)

• Total liabilities represent the total amount • In general, GAAP requires that the firm
of money the firm owes its creditors report assets using the historical costs.
• Total shareholders’ equity refers to the
difference in the value of the firm’s total • Cash and assets held for sale (such as
assets and the firm’s total liabilities. marketable securities) are an exception to
• Total assets, sum of total shareholders’ the rule. These assets are reported using
equity and total liabilities, represents the the lower of their cost or current market
resources owned by the firm. value.

The Balance Sheet (cont.) Table 3.2 H. J. Boswell, Inc.

Assets whose value is expected to decline

over time (such as equipment) is reported as
“net equipment”(equal to historical cost less
the accumulated depreciation). Net value
(also known as accounting or book value)
could be significantly different from the
market value of the asset.

8
Table 3.2 H. J. Boswell, Inc. (cont.) Figure 3.1 The Balance Sheet

The Balance Sheet (cont.) The Balance Sheet (cont.)

The balance sheet includes the following main • Current assets consists of firm’s cash plus
components: other assets the firm expects to convert to
1.Assets – It includes current assets and fixed cash within 12 months or less, such as
assets. receivables and inventory.
2.Liabilities and Stockholders’ Equity – It
indicates how the firm finances its assets. It • Fixed assets are assets that the firm does
includes current liabilities, long-term liabilities, not expect to sell within one year. For
and owner’s equity. example, plant and equipment, land.

The Balance Sheet (cont.) The Balance Sheet (cont.)

• Current liabilities represent the amount • The stockholder’s equity includes the
that the firm owes to creditors that must be following: Par value of common stock + Paid
repaid within a period of 12 months or less in Capital + Retained Earnings.
such as accounts payable, notes payable.
• We can also express stockholders’ equity as
• Long-term liabilities refer to debt with follows:
maturities longer than a year such as bank Shareholders' equity = Total Assets – Total Liabilities
loans, bonds.

9
Firm Liquidity and Net Working Firm Liquidity and Net Working
Capital Capital (cont.)

Liquidity generally refers to the firm’s ability • If a firm’s net working capital is significantly
to covert its current assets into cash so that it positive, it is in a good position to pay its
can pay its current liabilities on time. We can debts on time and is consequently very
thus measure a firm’s liquidity by computing liquid.
its net working capital (equal to current
assets less current liabilities). • Lenders consider the net working capital as
an important indicator of firm’s ability to
repay its loans.

Step 1: Picture the Problem

• The firm’s balance sheet can be expressed

as follows:
CHECKPOINT 3.2: Total Shareholders’ Equity +
CHECK YOURSELF Total Liabilities
Constructing a Balance Sheet = Total Assets
Reconstruct the Gap’s balance sheet to
reflect the repayment of $1 billion in short-
term debt using a like amount of the firm’s
cash. What is the balance for total assets
and current liabilities?

Step 2: Decide on a Solution

Step 1: Picture the Problem (cont.)
Strategy
Current Assets Current Liabilities
Cash
Accounts Receivable
Accounts payable
Short-term debt
We are given the account balances so in order
Inventories
Other current assets
Other current liabilities to construct the balance sheet we need to
Total current assets Total current liabilities substitute the appropriate balances into the
Long-term (fixed) assets Long-term Liabilities template developed in step 1.
Gross PPE Long-term debt
Less: Accumulated depreciation
Net property, plant and equip. Owner’s Equity
Par value of common stock
Other long-term assets Paid-in-capital
Retained earnings
Total long-term assets Total equity

Total Assets Total Liabilities and

Owners’ equity

10
Step 3: Solve Step 4: Analyze

Cash 885,000,000 Current 1,128,000,000 We can make the following observations from
Inventories liabilities
Other current 1,615,000,000 Gap’s Balance sheet:
assets 809,000,000
– The total assets of $6,422,000,000 is financed
Total current 3,309,000,000 Total current 1,128,000,000
assets liabilities
by a combination of current liabilities, long-term
Net Property, 2,523,000,000 Long-term 2,539,000,000
liabilities and owner’s equity. Owner’s equity
Plant and liabilities accounts for $2,755,000,000 of the total.
equipment
– The firm has a healthy net working capital of
Other long-term 590,000,000 Common Equity 2,755,000,000
$2,181,000,000.
assets
Total Assets $6,422,000,00 Total Liabilities $6,422,000,00
0 and Equity 0

Debt and Equity Financing Debt versus Equity

The right-hand side of the balance sheet • Payment: Payment for debt holders is
reveals the following two sources of money generally fixed (in the form of interest);
used to finance the purchase of the firm’s Payment for equity holders (dividends) is
assets listed on the left-hand side of the not fixed nor guaranteed.
balance sheet. • Seniority: Debt holders are paid before
– Borrowings (debt financing) equity holders in the event of bankruptcy.
– firms owners (equity financing) • Maturity: Debt matures after a fixed period
while equity securities do not mature.

Book Values, Historical Costs, and

Market Values

Book values (based on historical cost)

reported in the balance sheet can differ from
market values. 3.5 THE CASH FLOW
The gap is likely to be higher for fixed assets STATEMENT
relative to current assets for two reasons:

11
The Cash Flow Statement Sources and Uses of Cash

The Cash Flow Statement is used by firms • A source of cash is any activity that brings
to explain changes in their cash balances over cash into the firm. For example, sale of
a period of time by identifying all of the equipment.
sources and uses of cash for the period
spanned by the statement. • A use of cash is any activity that causes
cash to leave the firm. For example,
payment of taxes.

Table 3-3 H. J.
Cash Flow Analysis (cont.)
Boswell, Inc.,
Balance Sheets
and Balance Why did the cash balance decline by $4.50m?.
Sheet Changes See table 3.1 and table below:

Sources of Cash Uses of Cash

Increase in Accounts Increase in Accounts
Payable = $4.50 Receivable $22.50

Increase in long-term debt Increase in inventory =

=$51.75 $148.50
Increase in retained Increase in net plant and
earnings = $159.75 equipment = $40.50

Decrease in short-term
notes = $9
Total Sources of cash = Total Uses of cash =
$216.00 $220.50

Cash Flow Analysis (cont.) Cash Flow Analysis Summary

An analysis of H.J. Boswell’s operations Sources of Cash Uses of Cash

reveals the following: Decrease in an asset Increase in an asset
– The firm used more cash than it generated, account account
resulting in a deficit of $4.5 million
Increase in a liability Decrease in a liability
– The main source of cash flow was retained account account
earnings ($159.75m) and long-term debt
Increase in an Decrease in an
($51.75m)
owner’s equity owners’ equity
– The largest use of cash was for acquiring account account
inventory at $148.5 million.

12
Cash Flow Statement Cash Flow Statement (cont.)

The basic format for a cash flow statement is • Operating activities represent the company’s
as follows: core business, including sales and expenses.
Beginning Cash Balance
Plus: Cash Flow from Operating • Investing activities include the cash flows
Activities that arise out of the purchase and sale of
Plus: Cash Flow from Investing long-term assets such as plant and
Activities equipment.
Plus: Cash Flow from Financing
Activities
Equals: Ending Cash Balance
Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-73 Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-74

Cash Flow Statement (cont.) Table 3-4 H. J. Boswell, Inc.

Financing activities represent changes in the

firm’s use of debt and equity such as issue of
new shares, the repurchase of outstanding
shares, and the payment of dividends.

Quality of Earnings: Evaluating Cash

Evaluating the Cash Flow Statement
Flow from Operations

The statement can be used to answer a Since reported earnings can sometimes be
number of important questions such as: misleading, we can combine information from
– How much cash did the firm generate from its the firm’s income statement and the
operations? statement of cash flows to evaluate the
– How much did the firm invest in plant and quality of firm’s reported earnings.
equipment?
– Did the firm raise additional funds, and if so, how
much and from what sources?
– Is the firm able to generate positive cash flows?

13
Quality of Earnings: Evaluating Cash Quality of Earnings: Evaluating Cash
Flow from Operations (cont.) Flow from Operations (cont.)

• A ratio of 1.00 indicates very high quality of • The quality of earnings ratio for Boswell for
earnings and that the firm’s operating cash 2013 = $173.25m ÷ $ 204.75m = 84.6%
flows and net income are in sync with each
other. • Boswell’s ratio was only 84.6% due to more
credit sales than it collected, increase in
• A low ratio indicates firm’s reliance on non- inventories, non-cash depreciation expense,
operating sources of cash to generate net and increased reliance on accounts payable.
income that may not be sustainable.

Sustainable Capital Expenditures: Sustainable Capital Expenditures:

Evaluating Investment Activities Evaluating Investment Activities (cont.)

This ratio calculates the extent to which • For Boswell, the capital acquisition ratio is:
the firm’s operating cash flows can pay for = $157.75m ÷ $159.5m = 98.9%
capital expenditures. Higher ratio will
mean less dependence on capital markets • Boswell was, on average, able to finance
for financing. 98.9% of its new expenditures out of the
firm’s current-year operations.

Step 1: Picture the Problem

• The cash flow statement identifies the net

sources and uses of cash for a specific
CHECKPOINT 3.3: period of time into 3 groups: operating
CHECK YOURSELF activities, investing activities, and financing
activities.
Interpreting the Statement of Cash Flows
Go to http:finance.google.com/finance and get the • Here we have to compare the cash flow
cash flow statements for the most recent four-year from operating activities and investment
period for Exco Resources (XCO). How does their cash activities in 2012 for Exco Resources (XCO).
from investing activities compare to their cash flow
from operating activities in 2012.
Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-83 Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-84

14
Step 2: Decide on a Solution
Step 3: Solve
Strategy

We can compare the cash flow from operating Cash flow from operating activities
activities and cash flow from investing EXCO had a positive cash flow from operating
activities by retrieving the cash flow activities of $514.78 million in 2012. In 2011,
statement from the cash flow from operating activities was much
lower at $428.54 million. The primary
http://finance.google.com/finance
contributors to the operating cash flows were
adjustments to net income.

Step 3: Solve (cont.) Step 4: Analyze

Cash flow from investing activities: • The cash flow statement for 2012 depicts a
Cash flow from investing activities were profitable firm with positive cash flow from
($426.09) million in 2012. EXCO had invested operations that have been steadily
heavily in capital expenditures with a total increasing since 2010. In 2010, cash flow
expense of $536.92 million.
from operations were only $339.92 million.

• The firm has been aggressively investing in

fixed assets. However, it has dropped
significantly compared to 2011 ($1,041
million).

Key Terms Key Terms (cont.)

• Accounts receivable • Cost of goods sold

• Accounts payable • Current assets
• Accumulated depreciation • Current liabilities
• Average tax rate • Depreciation expense
• Balance sheet • Dividends per share
• Cash flow from operations • Earnings before interest and taxes (EBIT)
• Cash flow statement • Earnings per share

15
Key Terms (cont.) Key Terms (cont.)

• Fixed assets • Marginal tax rate

• Gross plant and equipment • Market value
• Gross profit margin • Net operating income
• Income statement • Net income
• Inventories • Net plant and equipment
• Liquidity • Net profit margin
• Long-term debt • Net working capital
• Notes payable

Key Terms (cont.) Key Terms (cont.)

• Operating profit margin • Source of cash

• Paid-in capital • Stockholders’ equity
• Par value • Taxable income
• Profits • Total assets
• Quality of earnings ratio • Total liabilities
• Retained earnings • Total shareholders’ equity
• Revenues • Treasury stock
• Uses of cash

Chapter 4 Slide Contents

• Financial • Learning Objectives

Analysis— • Principles Applied in this Chapter
Sizing up Firm Performance 1. Why Do We Analyze Financial Statements
2. Common Size Statements – Standardizing
Financial Information
3. Using Financial Ratios
4. Selecting a Performance Benchmark
5. Limitations of Ratio Analysis
• Key Terms

16
Learning Objectives Learning Objectives (cont.)

1. Explain what we can learn by analyzing a 4. Select an appropriate benchmark for use in
firm’s financial statements. performing a financial ratio analysis.
2. Use common size financial statements as a 5. Describe the limitations of financial ratio
tool of financial analysis. analysis.
3. Calculate and use a comprehensive set of
financial ratios to evaluate a company’s
performance.

Principles Used in this Chapter

• Principle 3: Cash Flows Are the Source of

Value.
• Principle 4: Market Prices Reflect 4.1 WHY DO WE ANALYZE
Information. FINANCIAL STATEMENTS?
• Principle 5: Individuals Respond to
Incentives.

Why Do We Analyze Financial Why Do We Analyze Financial

Statements? Statements? (cont.)

• An internal financial analysis might be done: • External financial analysis is done by:
– To evaluate the performance of employees – Banks and other lenders
– To compare the performance of different – Suppliers
divisions – Credit-rating agencies
– To prepare financial projections – Professional analysts
– To evaluate the firm’s financial performance in – Individual investors
light of its competitors’ performance

17
Common Size Statements:
Standardizing Financial Information

• A common size financial statement is a

standardized version of a financial
4.2 COMMON SIZE statement in which all entries are presented
STATEMENTS: in percentages.
STANDARDIZING FINANCIAL
INFORMATION • It helps to compare a firm’s financial
statements with those of other firms, even if
the other firms are not of equal size.

Common Size Statements: Standardizing

Financial Information (cont.)
Table 4.1 H. J. Boswell, Inc.

• How to prepare a common size financial

statement?
– For a common size income statement, divide
each entry in the income statement by sales.
– For a common size balance sheet, divide each
entry in the balance sheet by total assets.

Table 4.1 Observations Table 4.2 H. J.

Boswell, Inc.
• Table 4-1 created by dividing each entry in
the income statement of Table 3.1 by firm
sales for 2013.
– Cost of goods sold make up 75% of the firm’s
sales resulting in a gross profit of 25%.
– Selling expenses account for about 3% of sales.
– Income taxes account for 4.1% of the firm’s
sales.
– After all expenses, the firm generates net income
of 7.6% of firm’s sales.

18
Table 4.2 Observations

• Table 4.2 created by dividing each entry in

the balance sheet of Table 3.2 by total
assets. 4.3 USING FINANCIAL
– Total current assets increased by 5.6% in 2013 RATIOS
while total current liabilities declined by 2%.
– Long-term debt account for 39.2% of firm’s
assets, showing a decline of 1.7%.
– Retained earnings increased by 5.8% .

Using Financial Ratios Using Financial Ratios (cont.)

• Financial ratios provide a second method

for standardizing the financial information
on the income statement and balance sheet.

• A ratio by itself may have no meaning.

Hence, a given ratio is generally compared
to: (a) ratios from previous years; or (b)
ratios of other firms in the same industry.

Liquidity Ratios

• Liquidity ratios address a basic question:

How liquid is the firm?
LIQUIDITY RATIOS
• A firm is financially liquid if it is able to pay
its bills on time. We can analyze a firm’s
liquidity from two perspectives (see next
slide).

19
Liquidity Ratios (cont.) Liquidity Ratios: Current Ratio

1. Overall liquidity - analyzed by comparing • The overall liquidity of a firm is analyzed by

the firm’s current assets to the firm’s computing the current ratio and acid-test
current liabilities. ratio. Current Ratio: Current Ratio
2. Liquidity of specific assets - analyzed by compares a firm’s current (liquid) assets to
examining the timeliness in which the its current (short-term) liabilities.
firm’s liquid assets (accounts receivable
and inventories) are converted into cash.

Liquidity Ratios: Current Ratio

Liquidity Ratios: Quick Ratio
(cont.)

• What is the current ratio for 2012 for • Acid-Test (Quick) Ratio excludes the
Boswell? inventory from current assets as inventory
may not be very liquid.
Current Ratio = $477 ÷ 292.5 = 1.63
times

• The firm had $1.63 in current assets for

every $1 it owed in current liability.

Liquidity Ratios: Quick Ratio Liquidity Ratios:

(cont.) Individual Asset Categories

• What is the quick ratio for Boswell for 2012? We can also measure the liquidity of the firm
by examining the liquidity of accounts
• Quick Ratio receivable and inventories to see how long
it takes the firm to convert its accounts
= ($477-$229.50) ÷ ($292.50) = 0.84 times
receivables and inventories into cash.

• The firm has only $0.84 in current assets

(less inventory) to cover $1 in current
liabilities.

20
Liquidity Ratios: Accounts Liquidity Ratios: Accounts
Receivable Receivable (cont.)

Average Collection Period measures the • What will be the average collection period
number of days it takes the firm to collects its for Boswell, Inc. for 2012 if we assume that
receivables. the annual credit sales were $2,500 million?
• Daily Credit Sales
= $2,500 ÷ 365 days = $6.85 million
• Average Collection Period
= $139.5m ÷ $6.85m = 20.37 days

Liquidity Ratios: Accounts Liquidity Ratios: Accounts

Receivable Turnover Ratio Receivable Turnover Ratio (cont.)

Accounts Receivable Turnover Ratio • What will be the accounts receivable

measures how many times receivables are turnover ratio for Boswell, Inc. for 2012 if
“rolled over” during a year. we assume that the annual credit sales were
$2,500 million?

• Accounts Receivable Turnover

= $2,500 million ÷ $139.50 = 17.92 times
– The firm’s accounts receivable were turning over
at 17.92 times per year.

Liquidity Ratios: Liquidity Ratios:

Inventory Turnover Ratio Inventory Turnover Ratio (cont.)
Inventory turnover ratio measures how many • What will be the inventory turnover ratio for
times the company turns over its inventory during the 2012 for Boswell, Inc. if we assume that the
year. Shorter inventory cycles lead to greater liquidity
cost of goods sold were $1,980 million in
since the items in inventory are converted to cash
more quickly. 2012?

• Inventory Turnover Ratio

= $1,980 ÷ $229.50 = 8.63 times
– The firm turned over its inventory 8.63 times per
year.

21
Liquidity Ratios:
Can a Firm Have Too Much Liquidity?
Days’ Sales in Inventory

• Days’ Sales in Inventory • A high investment in liquid assets will

= 365÷ inventory turnover ratio enable the firm to repay its current liabilities
in a timely manner.
= 365 ÷ 8.63 = 42.29 days

• The firm, on average, holds it inventory for • However, an excessive investments in liquid
about 42 days. assets can prove to be costly as liquid
assets (such as cash) generate minimal
return.

Step 1: Picture the Problem

• The inventory turnover ratio will measure

how many days items remain in inventory
CHECKPOINT 4.1: before being sold.
CHECK YOURSELF
• Inventory turnover ratio is important as it
Evaluating Dell’s Liquidity has implications for cash flows and
profitability of a firm.
Why do you think HP’s inventory
turnover ratio is so much lower than
Dell’s inventory turnover ratio?

Step 2: Decide on a Solution

Strategy Step 4: Analyze
Step 3: Solve
• We will use the following equation to • HP’s inventory turnover ratio indicates that
compute the Inventory Turnover (IT) ratio the inventory at HP remains on shelf for
IT ratio = Cost of Goods Sold ÷ Inventories (365 ÷ 13.02) days or 28.03 days. This is
much higher than Dell that has an inventory
turnover ratio of 34.37 or shelf life of only
• Inventory Turnover Ratio for HP
10.61 days.
= $97,529,000 ÷ 7,490,000 = 13.02

• The significant difference must be

investigated further as the two firms are in
the same industry.

22
Step 4: Analyze (cont.)

There are two reasons why HP has a lower

turnover of inventories relative to Dell:
– HP sells computers out of inventory of computers CAPITAL STRUCTURE RATIOS
while Dell builds computers only when orders are
received.
– HP carries more parts inventory on hand than
does Dell.

Capital Structure Ratios Capital Structure Ratios (cont.)

Capital structure refers to the way a firm Debt ratio measures the proportion of the
finances its assets. Capital structure ratios firm’s assets that are financed by borrowing
address the important question: How has the or debt financing.
firm financed the purchase of its assets?

Capital Structure Ratios (cont.) Capital Structure Ratios (cont.)

• What is the debt ratio for H.J. Boswell, Inc. • Times Interest Earned Ratio measures
for 2012? the ability of the firm to service its debt or
repay the interest on debt.
• Debt Ratio
= $1,012.50 million ÷ $1,764 million = 57.40%

– The firm financed 57.39% of its assets with debt.

23
Capital Structure Ratios (cont.) Capital Structure Ratios (cont.)

• What will be the times interest earned ratio

for Boswell for 2012 if we assume interest
expense of $65 million and EBIT of $350
million?
• Times Interest Earned
= $350m ÷ $65m = 5.38 times
– The firm can pay its interest expense 5.38 times
or interest used 1/5.38th or 18.58% of its EBIT.

Step 1: Picture the Problem

• Times interest earned ratio is an important

ratio for firms that use debt financing. It
CHECKPOINT 4.2: measures the firm’s ability to service its
CHECK YOURSELF debt.

Comparing the Financing Decisions

• The ratio requires comparing net operating
of HD and LOW
What would be Home Depot’s times interest earned ratio if
income or EBIT with Interest expense. Both
interest payments remained the same, but net operating items are found on the income statement.
income dropped by 80% to only $1.332 billion? Similarly
if Lowes’ net operating income dropped by 80%, what
would its times interest earned ratio be?

Step 2: Decide on a Solution

Step 1: Picture the Problem (cont.)
Strategy

• Picture an Income Statement • Here we are considering the impact of a

– Sales
EBIT
drop in EBIT on the times interest earned
• Less: Cost of Good Sold ratio of Home Depot and Lowes. We will use
• Equals: Gross Profit the following ratio to measure the times
• Less: Operating Expenses
interest earned (TIE) ratio.
• Equals: Net Operating Income (EBIT)
Interest
• Less: Interest Expense
Expense
• Equals: Earnings before Taxes • TIE = EBIT ÷ Interest Expense
• Less: Taxes
• Equals Net Income

24
Step 3: Solve Step 4: Analyze

• TIE (Home Depot) • We observe that a drop in net operating

= $1.332 billion ÷ $0.606 billion = 2.20 times income leads to a significant drop in times
interest earned ratio for both the firms.
Should creditors be worried by this drop?
• TIE (Lowes)
= $0.655 billion ÷$0.371 billion = 1.77 times • The ratio is still reasonably safe. For
example, for Home Depot, even if the EBIT
shrank further by 55.55% (1-1/2.20 ), it
can still pay its interest expense.

Asset Management Efficiency Ratios

• Asset management efficiency ratios

measure a firm’s effectiveness in utilizing its
ASSET MANAGEMENT assets to generate sales.
EFFICIENCY RATIOS • They are commonly referred to as turnover
ratios as they reflect the number of times a
particular asset account balance turns over
during a year.

Asset Management Efficiency Ratios Asset Management Efficiency Ratios

(cont.) (cont.)

• Total Asset Turnover Ratio represents What will be the total asset turnover ratio for
the amount of sales generated per dollar Boswell, Inc. for 2012 if we assume total sales
invested in firm’s assets. to be $2,500 million?

•Total Asset Turnover

= $2,500 million ÷ $1,764 million = 1.42 times
– The firm generated $1.42 in sales per dollar of
assets in 2012.

25
Asset Management Efficiency Ratios Asset Management Efficiency Ratios
(cont.) (cont.)

• Fixed asset turnover ratio measures What will be the fixed asset turnover ratio for
firm’s efficiency in utilizing its fixed assets Boswell for 2012 if we assume sales of $2,500
(such as property, plant and equipment). million for 2012?

•Fixed Asset Turnover

= $2,500 million ÷ $1,287 million = 1.94 times
– The firm generated $1.94 in sales per dollar
invested in plant and equipment.

Asset Management Efficiency Ratios

(cont.)

The following grid summarizes the efficiency

of Boswell’s management in utilizing its assets
to generate sales in 2013. PROFITABILITY RATIOS

Profitability Ratios Profitability Ratios (cont.)

Profitability ratios address a very Two fundamental determinants of firm’s

fundamental question: Has the firm earned profitability and returns on investments:
adequate returns on its investments?
•Cost Control – How well has the firm
controlled its costs relative to each dollar of
firm sales?

•Efficiency of asset utilization – How

26
Cost Control: Is the Firm Earning Cost Control: Is the Firm Earning
Reasonable Profit Margins? Reasonable Profit Margins? (cont.)

Gross profit margin shows how well the What will be the gross profit margin ratio for
firm’s management controls its expenses to 2012 for Boswell if we assume sales of $2,500
generate profits. million and gross profit of $650 million?
•Gross Profit Margin
= $650 million ÷ $2,500 million = 26%
– The firm spent $0.74 for cost of goods sold and
thus $0.26 out of each dollar of sales went
towards gross profits.

Cost Control: Is the Firm Earning Cost Control: Is the Firm Earning
Reasonable Profit Margins? (cont.) Reasonable Profit Margins? (cont.)

Operating Profit Margin measures how What will be the operating profit margin ratio
much profit is generated from each dollar of for Boswell for 2012 if we assume sales of
sales after accounting for both costs of goods $2,500 million and net operating income of
sold and operating expenses. It also indicates $350 million?
how well the firm is managing its income
statement. •Operating Profit Margin
= $350 million ÷ $2,500 million = 14%
– The firm generates $0.14 in operating profit for
each dollar of sales.

Cost Control: Is the Firm Earning Cost Control: Is the Firm Earning
Reasonable Profit Margins? (cont.) Reasonable Profit Margins? (cont.)

Net Profit Margin measures how much What will be the net profit margin ratio for
income is generated from each dollar of sales 2012 if we assume sales of $2,500 million and
after adjusting for all expenses (including net income of $217.75 million?
income taxes).
•Net Profit Margin
= $217.75 million ÷ $2,500 million = 8.71%
– The firm generated $0.087 for each dollar of
sales after all expenses were accounted for.

27
Return on Invested Capital Profitability Ratios (cont.)

Operating Return on Assets ratio is the What will be the operating return on assets
summary measure of operating profitability. It ratio for Boswell for 2012 if we assume EBIT
takes into account the management’s success or net operating income of $350 million for
in controlling expenses and its efficient use of 2012?
assets.
•Operating Return on Assets
= $350 million ÷$1,764 million = 19.84%
– The firm generated $0.1984 of operating profits
for every $1 of its invested assets.

Decomposing the Operating Return Figure 4.1 Analyzing H. J. Boswell, Inc.’s

on Assets Ratio Operating Return on Assets (OROA)

Figure 4-1 Observations Figure 4-1 Recommendations

• Firm’s OROA (operating return on assets) is 1. Reduce costs - The firm must investigate
better than its peers. the cost of goods sold and operating
expenses to see if there are opportunities
• Firm’s OPM (operating profit margin) is to reduce costs.
lower than its peers.
2. Reduce inventories – The firm must
• Firm’s TATO (total asset turnover ratio) is investigate if it can reduce the size of its
higher than that of its peers. inventories.

28
Step 1: Picture the Problem

• The operating return on assets ratio for a

firm is determined by two factors: cost
CHECKPOINT 4.3: control and asset utilization. Here the focus
CHECK YOURSELF is on asset utilization.

Evaluating the Operating Return on Assets

(OROA) for HD and LOW
If Home Depot were able to raise its total asset
turnover ratio to 2.5 while maintaining its current
operating profit margin, what would happen to its
operating return on assets?

Step 2: Decide on a Solution

Step 3: Solve
Strategy

We will analyze the impact on operating • Operating Return on Assets (OROA)

return on assets of improvement on the total – = Total Asset Turnover × Operating Profit
asset turnover ratio by using the following Margin
equation:
• Before = 1.74 × 9.46% = 16.46%
•Operating Return on Assets (OROA)
= Total Asset Turnover × Operating Profit Margin • Now = 2.5 × 9.46% = 23.65%

Is the Firm Providing a Reasonable

Step 4: Analyze
Return on the Owner’s Investment?

• An improvement in total asset turnover ratio Return on Equity (ROE) ratio measures the
has a favorable impact on Home Depot’s accounting return on the common
operating return on assets (OROA). stockholders’ investment.

• If Home Depot wants to increase its OROA

more, it should focus on cost control that
will help improve the net operating profit.

29
Is the Firm Providing a Reasonable Return Using the DuPont Method for
on the Owner’s Investment (cont.) Decomposing the ROE ratio

What will be the ROE ratio for Boswell for 2012 • DuPont method analyzes the firm’s ROE
if we assume net income of $217.75 million? by decomposing it into three parts.

•ROE = $217.75m ÷ $751.50 mi = 28.98% – ROE = Profitability × Efficiency × Equity

Multiplier

– Thus the shareholders earned 28.97% on their

investments. • Equity multiplier captures the effect of the
firm’s use of debt financing on its return on
equity. The equity multiplier increases in
value as the firm uses more debt.

Using the DuPont Method for Using the DuPont Method for
Decomposing the ROE ratio (cont.) Decomposing the ROE ratio (cont.)

ROE = Profitability × Efficiency × Equity The following table shows why Boswell’s
Multiplier return on equity was higher than its peers.

Using the DuPont Method for

Decomposing the ROE ratio (cont.)
Figure 4.2

MARKET VALUE RATIOS

30
Market Value Ratios Price-Earnings Ratio

Market value ratios address the question, Price-Earnings (PE) Ratio indicates how
how are the firm’s shares valued in the stock much investors are currently willing to pay for
market? $1 of reported earnings.

Price-Earnings Ratio (cont.) Market Value Ratios (cont.)

What will be the PE ratio for 2012 for Boswell, • Earnings per share
Inc. if we assume the firm’s stock was selling = $217.75 million ÷ 90 million = $2.42
for $22 per share at a time when the firm
reported a net income of $217.75 million, and • PE ratio = $22 ÷ $2.42 = 9.09
the total number of common shares
outstanding are 90 million?
• The investors were willing to pay $9.09 for
every dollar of earnings per share that the
firm generated.

Market Value Ratios (cont.) Market Value Ratios (cont.)

Market-to-Book Ratio measures the What will be the market-to-book ratio for
relationship between the market value and 2012 for Boswell if the market price of the
the accumulated investment in the firm’s stock is $22 and the firm has 90 million
equity. shares outstanding?

31
Market Value Ratios (cont.)

• Book Value per Share

– = 751.50 million ÷ 90 million = $8.35 per
share CHECKPOINT 4.4:
CHECK YOURSELF
• Market-to-Book Ratio
= Market price per share ÷ Book value per
Comparing the Valuation of DELL to
share
APPL Using Market Value Ratios
= $22 ÷ $8.35
What price per share for Dell would it take
= 2.63 times to increase the firm’s price-to-earnings
ratio to the level of Apple?
Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-187 Copyright ©2014 Pearson Education, Inc. All rights reserved. 3-188

Step 2: Decide on a Solution

Step 1: Picture the Problem
Strategy

Price-to-earnings (PE) ratio depends on We need to determine the price per share that
earnings per share and price per share, will make PE ratio of Dell (4.83) equal to the
pictured as follows: PE ratio of Apple (13.22).
Price per share standardized by
•PE ratio = Price per share ÷ Earnings per
share
EPS =
Net income ÷ number ==> 13.22 = ? ÷ 2.01
Of shares outstanding
PE Ratio = •Price per share = 13.22 × 2.01 = $26.57
Price per share ÷
Earnings per share

Step 4: Analyze

• PE ratio allows us to compare two stocks

with different prices by standardizing the
stock prices by earnings. 4.4 SELECTING A
PERFORMANCE BENCHMARK
• Apple has a much higher PE ratio. To reach
the same PE valuation, the stock price of
Dell will have to increase from $9.70 to
$26.57.

32
Selecting a Performance Benchmark Trend Analysis

• There are two types of benchmarks that are • Comparing a firm’s recent financial ratios
commonly used: with the past financial ratios provides insight
– Trend Analysis – compares a firm’s financial into whether the firm is improving or
statements over time (time-series comparisons). deteriorating over time. This type of
– Peer Group Comparisons – compares the subject financial analysis is referred to as trend
firm’s financial statements with “peer” firms. analysis.

Figure 4-3 A Time-Series (Trend) Analysis: Dell’s

Inventory Turnover Ratio Versus Hewlett Peer Firm Comparisons
Packard’s: 1995–2011

Peer groups often consist of firms from the

same industry. Industry average financial
ratios can be obtained from a number of
financial databases and internet sources (such
as yahoo finance and google finance).

Figure 4-4 Financial Analysis of the

Gap, Inc., June 2009

4.5 LIMITATIONS OF RATIO

ANALYSIS

33
The Limitations of Ratio Analysis
The Limitations of Ratio Analysis
(cont.)

1. Picking an industry benchmark can 4. Accounting practices differ widely among

sometimes be difficult. firms.
2. Published peer-group or industry averages 5. Many firms experience seasonal changes in
are not always representative of the firm their operations.
being analyzed. 6. Financial ratios offer only clues.
3. An industry average is not necessarily a 7. The results of financial analysis are no
desirable target or norm. better than the quality of the financial
statements.

Key Terms Key Terms (cont.)

• Accounts receivable turnover ratio • Debt ratio

• Acid-test (quick) ratio • DuPont method
• Average collection period • Equity Multiplier
• Book value per share • Earnings per share (EPS)
• Capital structure • Financial leverage
• Current ratio • Financial ratios
• Days’ sales in inventory • Fixed asset turnover ratio
• Inventory turnover ratio

Key terms (cont.) Key terms (cont.)

• Liquidity ratios • Return on assets (ROA)

• Market-to-book ratio • Return on equity (ROE)
• Market value ratios • Times interest earned
• Notes payable • Total asset turnover ratio (TATO)
• Operating return on assets (OROA) • Trend analysis
• Price-earnings (PE) ratio

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