Chapter 2: Financial Statements
and Ratio Analysis
financial
information is used to assist
investment and financial decision making
Helps managers with efficiency analysis and
identification of problem areas within the
firm
Helps managers
• identify strengths
• Identify weaknesses
Useful
for credit managers evaluating loan
requests and investors considering security
purchases
Cross Sectional Analysis
• Comparison of one firm to other similar firms
Sources of cross sectional information
include:
• Value Line
• Risk Management Association
• Dun and Bradstreet
Time Series Analysis
• Evaluation of a firm’s financial performance over
time, utilizing financial ratio analysis
Profitability
ratios Unit 2
Liquidity ratios Unit 2
Activity ratios Unit 2
Financing ratios Unit 3
Market ratios Unit 3
Profitability
ratios relate to profit margins
and the earnings of the firm
Measure
how effectively the firm uses its
resources to generate income
Provide
analysts and managers with
additional information on firm
performance
Return on Equity (ROE)
• Tells what the firm earns on every dollar of equity
Return on Assets (ROA)
• Measures profit per dollar of assets
Gross Profit Margin
• The gross profit earned on each dollar of sales
Operating Profit Margin
• Measures only profits earned on operations
Net Profit Margin
• Percentage of each sales dollar that remains after all
costs have been deducted
What is the Return on Assets (ROA) if net
income was $55,000, total assets are
$115,000, EBIT was $100,000, and equity is
$75,000?
ROA= net income after tax/total assets
55,000/115,000= 47.8%
What is the Return on Equity if net income
was $55,000, total assets are $115,000, EBIT
was $100,000, and equity is $75,000?
ROE= net income after tax/stockholder
equity
55,000/75,000=73.3%
If net income was $10,000, interest
expense was $4,000, and taxes were
$1,000, what is the operating profit margin
if sales were $50,000?
Operating profit margin= operating
profit/sales
(10,000+4,000+1,000)/50,000=30%
Operating profit is the earnings before
interest and taxes
Measure
the degree to which a firm is
leveraged
Debt ratio
• Proportion of assets financed by debt
Debt equity ratio
• Shows the relationship between the suppliers of long
-term debt and equity
Times interest earned ratio (TIE ratio)
• Measures the firm’s ability to meet its interest
payments
What is a firm’s times interest earned if it
posts revenues of $200,000, taxes of
$35,000, expenses of $100,000, and interest
of $30,000?
TIE= EBIT/Interest
(200,000-100,000)/30,000=3.3 times
EBIT is revenues minus expenses. You do
not need to incorporate the taxes and
interest into the calculation of EBIT on this
one.
Based
on the firm’s security price
Earning per share (EPS)
• Reports the net income per share of common
stock
Price
earnings (PE)
• The amount investors are willing to pay for $1 of
income by the firm
Market
to book
• Measures how the market values the firm
If a firm has $100,000 shares of common
stock outstanding and has just recorded a
$45,000 profit, what is its PE ratio if its
current share price is $35?
PE Ratio= market price of common
stock/EPS
35/(45,000/100,000)=78
Financial
statements that have every line
converted into a ratio by dividing income
statement data by total sales and balance
sheet data by total assets
Specialized
type of ratio analysis in which
the denominator of every ratio is total
assets or total sales
Makes
benchmarking easier
The
financial analysis of a firm should
include the following steps • Analyze the economy in which the firm operates
• Analyze the industry in which the firm operates
• Analyze the competitors that currently challenge
the firm
• Analyze the strengths and weaknesses of the
firm, using common-sized statements and ratios
Ratio
interaction
• The effect one ratio has on another
• Ex: If sales fall, inventory turnover will also fall if
inventory is constant
Reading
between the lines
• Ratios do not often tell the whole story
• Ratios will provide flags that analysts must
investigate to find the truth
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