Analysis of Financial Statements
After reading this chapter, students should be able to:
; Explain why ratio analysis is usually the first step in the analysis of a company’s financial statements.
; List the five groups of ratios, specify which ratios belong in each group, and explain what information each
group gives us about the firm’s financial position.
; State what trend analysis is, and why it is important.
; Describe how the basic Du Pont equation is used, and how it may be modified to form the extended Du
Pont equation, which includes the effect of financial leverage.
; Explain ―benchmarking‖ and its purpose.
; List several limitations of ratio analysis.
; Identify some of the problems with ROE that can arise when firms use it as a sole measure of
; Identify some of the qualitative factors that must be considered when evaluating a company’s financial
Chapter 4: Analysis of Financial Statements Learning Objectives 73
Chapter 4 shows how financial statements are analyzed to determine firms’ strengths and weaknesses. On
the basis of this information, management can take actions to exploit strengths and correct weaknesses.
At Florida, we find a significant difference in preparation between our accounting and non-accounting students. The accountants are relatively familiar with financial statements, and they have covered in depth in their financial accounting course many of the ratios discussed in Chapter 4. We pitch our lectures to the non-accountants, which means concentrating on the use of statements and ratios, and the ―big picture,‖ rather
than on details such as seasonal adjustments and the effects of different accounting procedures. Details are important, but so are general principles, and there are courses other than the introductory finance course where details can be addressed.
What we cover, and the way we cover it, can be seen by scanning the slides and Integrated Case solution for Chapter 4, which appears at the end of this chapter solution. For other suggestions about the lecture, please see the ―Lecture Suggestions‖ in Chapter 2, where we describe how we conduct our classes.
DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods)
74 Lecture Suggestions Chapter 4: Analysis of Financial Statements
Answers to End-of-Chapter Questions
4-1 The emphasis of the various types of analysts is by no means uniform nor should it be. Management
is interested in all types of ratios for two reasons. First, the ratios point out weaknesses that should
be strengthened; second, management recognizes that the other parties are interested in all the
ratios and that financial appearances must be kept up if the firm is to be regarded highly by creditors
and equity investors. Equity investors (stockholders) are interested primarily in profitability, but they
examine the other ratios to get information on the riskiness of equity commitments. Long-term
creditors are more interested in the debt, TIE, and EBITDA coverage ratios, as well as the profitability
ratios. Short-term creditors emphasize liquidity and look most carefully at the current ratio.
4-2 The inventory turnover ratio is important to a grocery store because of the much larger inventory
required and because some of that inventory is perishable. An insurance company would have no
inventory to speak of since its line of business is selling insurance policies or other similar financial
products—contracts written on paper and entered into between the company and the insured. This
question demonstrates that the student should not take a routine approach to financial analysis but
rather should examine the business that he or she is analyzing.
4-3 Given that sales have not changed, a decrease in the total assets turnover means that the company’s
assets have increased. Also, the fact that the fixed assets turnover ratio remained constant implies
that the company increased its current assets. Since the company’s current ratio increased, and yet,
its cash and equivalents and DSO are unchanged means that the company has increased its
4-4 Differences in the amounts of assets necessary to generate a dollar of sales cause asset turnover
ratios to vary among industries. For example, a steel company needs a greater number of dollars in
assets to produce a dollar in sales than does a grocery store chain. Also, profit margins and turnover
ratios may vary due to differences in the amount of expenses incurred to produce sales. For example,
one would expect a grocery store chain to spend more per dollar of sales than does a steel company.
Often, a large turnover will be associated with a low profit margin, and vice versa.
4-5 Inflation will cause earnings to increase, even if there is no increase in sales volume. Yet, the book
value of the assets that produced the sales and the annual depreciation expense remain at historic
values and do not reflect the actual cost of replacing those assets. Thus, ratios that compare current
flows with historic values become distorted over time. For example, ROA will increase even though
those assets are generating the same sales volume.
When comparing different companies, the age of the assets will greatly affect the ratios.
Companies with assets that were purchased earlier will reflect lower asset values than those that
purchased assets later at inflated prices. Two firms with similar physical assets and sales could have
significantly different ROAs. Under inflation, ratios will also reflect differences in the way firms treat
inventories. As can be seen, inflation affects both income statement and balance sheet items.
4-6 ROE, using the extended Du Pont equation, is the return on assets multiplied by the equity multiplier.
The equity multiplier, defined as total assets divided by common equity, is a measure of debt
utilization; the more debt a firm uses, the lower its equity, and the higher the equity multiplier. Thus,
using more debt will increase the equity multiplier, resulting in a higher ROE.
Chapter 4: Analysis of Financial Statements Answers and Solutions 75
4-7 a. Cash, receivables, and inventories, as well as current liabilities, vary over the year for firms with
seasonal sales patterns. Therefore, those ratios that examine balance sheet figures will vary
unless averages (monthly ones are best) are used.
b. Common equity is determined at a point in time, say December 31, 2005. Profits are earned over
time, say during 2005. If a firm is growing rapidly, year-end equity will be much larger than
beginning-of-year equity, so the calculated rate of return on equity will be different depending on
whether end-of-year, beginning-of-year, or average common equity is used as the denominator.
Average common equity is conceptually the best figure to use. In public utility rate cases, people
are reported to have deliberately used end-of-year or beginning-of-year equity to make returns
on equity appear excessive or inadequate. Similar problems can arise when a firm is being
4-8 Firms within the same industry may employ different accounting techniques that make it difficult to compare financial ratios. More fundamentally, comparisons may be misleading if firms in the same industry differ in their other investments. For example, comparing Pepsico and Coca-Cola may be misleading because apart from their soft drink business, Pepsi also owns other businesses, such as Frito-Lay.
4-9 The three components of the extended Du Pont equation are profit margin, assets turnover, and the equity multiplier. One would not expect the three components of the discount merchandiser and high-end merchandiser to be the same even though their ROEs are identical. The discount merchandiser’s profit margin would be lower than the high-end merchandiser, while the assets
turnover would be higher for the discount merchandiser than for the high-end merchandiser.
4-10 Total Current Effect on
Current Assets Ratio Net Income
a. Cash is acquired through issuance of additional
common stock. + + 0
b. Merchandise is sold for cash. + + +
c. Federal income tax due for the previous year is paid. – + 0
d. A fixed asset is sold for less than book value. + + –
e. A fixed asset is sold for more than book value. + + +
f. Merchandise is sold on credit. + + +
g. Payment is made to trade creditors for previous purchases. – + 0
h. A cash dividend is declared and paid. – – 0
i. Cash is obtained through short-term bank loans. + – 0
j. Short-term notes receivable are sold at a discount. – – –
k. Marketable securities are sold below cost. – – –
l. Advances are made to employees. 0 0 0
m. Current operating expenses are paid. – – –
n. Short-term promissory notes are issued to trade creditors
in exchange for past due accounts payable. 0 0 0
o. 10-year notes are issued to pay off accounts payable. 0 + 0
76 Answers and Solutions Chapter 4: Analysis of Financial Statements
Total Current Effect on
Current Assets Ratio Net Income p. A fully depreciated asset is retired. 0 0 0 q. Accounts receivable are collected. 0 0 0 r. Equipment is purchased with short-term notes. 0 – 0 s. Merchandise is purchased on credit. + – 0 t. The estimated taxes payable are increased. 0 – –
Chapter 4: Analysis of Financial Statements Answers and Solutions 77
Solutions of End-of-Chapter Problems
4-1 DSO = 40 days; S = $7,300,000; AR = ?
ARDSO = S
AR 40 = $7,300,000/365
40 = AR/$20,000
AR = $800,000.
4-2 A/E = 2.4; D/A = ?
，，(：D1(： = 1 - A(：A(：E；；
D1，， = 1 - (：A2.4；；
D = 0.5833 = 58.33%.A
4-3 ROA = 10%; PM = 2%; ROE = 15%; S/TA = ?; TA/E = ?
ROA = NI/A; PM = NI/S; ROE = NI/E.
ROA = PM ， S/TA
NI/A = NI/S ， S/TA
10% = 2% ， S/TA
S/TA = TATO = 5.
ROE = PM ， S/TA ， TA/E
NI/E = NI/S ， S/TA ， TA/E
15% = 2% ， 5 ， TA/E
15% = 10% ， TA/E
TA/E = EM = 1.5.
4-4 TA = $10,000,000,000; CL = $1,000,000,000; LT debt = $3,000,000,000; CE = $6,000,000,000;
Shares outstanding = 800,000,000; P = $32; M/B = ? 0
$6,000,000,000Book value = = $7.50. 800,000,000
$32.00M/B = = 4.2667. $7.50
78 Answers and Solutions Chapter 4: Analysis of Financial Statements
4-5 EPS = $2.00; CFPS = $300; P/CF = 8.0，; P/E = ?
P/CF = 8.0
P/$3.00 = 8.0
P = $24.00.
P/E = $24.00/$2.00 = 12.0，.
4-6 PM = 2%; EM = 2.0; Sales = $100,000,000; Assets = $50,000,000; ROE = ?
ROE = PM ， TATO ， EM
= NI/S ， S/TA ， A/E
= 2% ， $100,000,00/$50,000,000 ， 2
4-7 Step 1: Calculate total assets from information given.
Sales = $6 million.
3.2， = Sales/TA
$6,000,000 3.2， = Assets
Assets = $1,875,000.
Step 2: Calculate net income.
There is 50% debt and 50% equity, so Equity = $1,875,000 ， 0.5 = $937,500.
ROE = NI/S ， S/TA ， TA/E
0.12 = NI/$6,000,000 ， 3.2 ， $1,875,000/$937,500
6.4NI 0.12 = $6,000,000
$720,000 = 6.4NI
$112,500 = NI.
4-8 ROA = 8%; net income = $600,000; TA = ?
NIROA = TA
$600,000 8% = TA
TA = $7,500,000.
To calculate BEP, we still need EBIT. To calculate EBIT construct a partial income statement:
EBIT $1,148,077 ($225,000 + $923,077) Interest 225,000 (Given)
EBT $ 923,077 $600,000/0.65
Taxes (35%) 323,077
NI $ 600,000
Chapter 4: Analysis of Financial Statements Answers and Solutions 79
EBIT BEP = TA
$1,148,077 = $7,500,000
= 0.1531 = 15.31%.
4-9 Stockholders’ equity = $3,750,000,000; M/B = 1.9; P = ?
Total market value = $3,750,000,000(1.9) = $7,125,000,000. Market value per share = $7,125,000,000/50,000,000 = $142.50.
Stockholders’ equity = $3,750,000,000; Shares outstanding = 50,000,000; P = ?
Book value per share = $3,750,000,000/50,000,000 = $75. Market value per share = $75(1.9) = $142.50.
4-10 We are given ROA = 3% and Sales/Total assets = 1.5，.
From the basic Du Pont equation: ROA = Profit margin ， Total assets turnover
3% = Profit margin(1.5)
Profit margin = 3%/1.5 = 2%.
We can also calculate the company’s debt ratio in a similar manner, given the facts of the problem. We are given ROA(NI/A) and ROE(NI/E); if we use the reciprocal of ROE we have the following
ENIEDE = ， and = 1 ； , soAANIAA
E1 = 3% ， A0.05 E = 60% .A
D = 1 ； 0.60 = 0.40 = 40%.A
Alternatively, using the extended Du Pont equation:
ROE = ROA ， EM
5% = 3% ， EM
EM = 5%/3% = 5/3 = TA/E.
Take reciprocal: E/TA = 3/5 = 60%; therefore, D/A = 1 – 0.60 = 0.40 = 40%.
Thus, the firm’s profit margin = 2% and its debt ratio = 40%.
80 Answers and Solutions Chapter 4: Analysis of Financial Statements
4-11 TA = $30,000,000,000; EBIT/TA = 20%; TIE = 8; DA = $3,200,000,000; Lease payments =
$2,000,000,000; Principal payments = $1,000,000,000; EBITDA coverage = ?
EBIT/$30,000,000,000 = 0.2
EBIT = $6,000,000,000.
8 = EBIT/INT
8 = $6,000,000,000/INT
INT = $750,000,000.
EBITDA = EBIT + DA
= $6,000,000,000 + $3,200,000,000
EBITDA ; Lease paymentsEBITDA coverage ratio = INT ; Princ. pmts ; Lease pmts
$9,200,000,000;$2,000,000,000 = $750,000,000;$1,000,000,000;$2,000,000,000
$11,200,000,000 = = 2.9867. $3,750,000,000
4-12 TA = $12,000,000,000; T = 40%; EBIT/TA = 15%; ROA = 5%; TIE = ?
EBIT = 0.15 $12,000,000,000
EBIT = $1,800,000,000.
NI = 0.05 $12,000,000,000
NI = $600,000,000.
Now use the income statement format to determine interest so you can calculate the firm’s TIE ratio.
INT = EBIT – EBT EBIT $1,800,000,000 See above. = $1,800,000,000 – $1,000,000,000 INT 800,000,000
EBT $1,000,000,000 EBT = $600,000,000/0.6 Taxes (40%) 400,000,000
NI $ 600,000,000 See above.
TIE = EBIT/INT
Chapter 4: Analysis of Financial Statements Answers and Solutions 81
4-13 TIE = EBIT/INT, so find EBIT and INT.
Interest = $500,000 ， 0.1 = $50,000.
Net income = $2,000,000 ， 0.05 = $100,000.
Pre-tax income (EBT) = $100,000/(1 – T) = $100,000/0.7 = $142,857.
EBIT = EBT + Interest = $142,857 + $50,000 = $192,857.
TIE = $192,857/$50,000 = 3.86，.
4-14 ROE = Profit margin ， TA turnover ， Equity multiplier
= NI/Sales ， Sales/TA ， TA/Equity.
Now we need to determine the inputs for the extended Du Pont equation from the data that were
given. On the left we set up an income statement, and we put numbers in it on the right:
Sales (given) $10,000,000
– Cost na
EBIT (given) $ 1,000,000
– INT (given) 300,000
EBT $ 700,000
– Taxes (34%) 238,000
NI $ 462,000
Now we can use some ratios to get some more data:
Total assets turnover = 2 = S/TA; TA = S/2 = $10,000,000/2 = $5,000,000.
D/A = 60%; so E/A = 40%; and, therefore,
Equity multiplier = TA/E = 1/(E/A) = 1/0.4 = 2.5.
Now we can complete the extended Du Pont equation to determine ROE: ROE = $462,000/$10,000,000 ， $10,000,000/$5,000,000 ， 2.5 = 0.231 = 23.1%.
4-15 Currently, ROE is ROE = $15,000/$200,000 = 7.5%. 1
The current ratio will be set such that 2.5 = CA/CL. CL is $50,000, and it will not change, so we
can solve to find the new level of current assets: CA = 2.5(CL) = 2.5($50,000) = $125,000. This is
the level of current assets that will produce a current ratio of 2.5，.
At present, current assets amount to $210,000, so they can be reduced by $210,000 – $125,000
= $85,000. If the $85,000 generated is used to retire common equity, then the new common equity
balance will be $200,000 – $85,000 = $115,000.
Assuming that net income is unchanged, the new ROE will be ROE = $15,000/$115,000 = 2
13.04%. Therefore, ROE will increase by 13.04% – 7.50% = 5.54%.
The new CA level is $125,000; CL remain at $50,000; and the new Inventory level = $150,000 –
$85,000 = $65,000. Thus, the new quick ratio is calculated as follows:
CA；Inv New quick ratio = CL
$125,000；$65,000 = $50,000
82 Answers and Solutions Chapter 4: Analysis of Financial Statements