Chapter 4 Table 4.

1 Observations Measuring the Overall Liquidity of a Firm

Financial Analysis— Sizing up Firm Performance\ • Table 4.1 created by dividing each entry in the The Overall liquidity is analyzed by comparing the
income statement of Table 3.1 by firm sales for firm’s current assets to the firm’s current liabilities.
Learning Objectives (1 of 2) 2016. Two ratios used to analyze overall liquidity are:
1. Explain what we can learn by analyzing a firm’s – Cost of goods sold make up 75% of the firm’s 1. Current Ratio
financial statements. sales resulting in a gross profit of 25%. 2. Acid-Test (or Quick) Ratio
2. Use common size financial statements as a tool – Selling expenses account for about 3% of sales.
of financial analysis. – Income taxes account for 4.1% of the firm’ssales.
Current Ratio (1 of 2)
3. Calculate and use a comprehensive set of – After all expenses, the firm generates net income
• Current Ratio: Current Ratio compares a firm’s
financial ratios to evaluate a company’s of 7.6% of firm’s sales.
current (liquid) assets to its current (short-term)
performance. liabilities.
4. Select an appropriate benchmark for use in Table 4.2 H. J. Boswell, Inc. (1 of 2)
performing a financial ratio analysis. Common-Size Balance Sheets, December 31, 2015 and Current Ratio = Current Assets_
5. Describe the limitations of financial ratio Current Liabilities
analysis.
• What is the current ratio for 2016 for Boswell?
Principles Used in this Chapter Current Ratio = $643.5m ÷ $288.0m
• Principle 3: Cash Flows Are the Source of Value. = 2.23 times
• Principle 4: Market Prices Reflect Information. • The firm had $2.23 in current assets for every $1 it
• Principle 5: Individuals Respond to Incentives. owed in current liability. It is better than peer group
average of $1.80.
4.1 WHY DO WE ANALYZE FINANCIAL
STATEMENTS? Acid—Test (Quick) Ratio (1 of 2)
• Acid-Test (Quick) Ratio excludes the inventory
from current assets as inventory may not be
Why Do We Analyze Financial very liquid.
Statements? Internal Financial Analysis
• An internal financial analysis might be done:
– To evaluate the performance of employees Acid-Test = Current Assets - Inventory
– To compare the performance of firm’s different (or Quick) Ratio Current Liabilities

divisions • What is the quick ratio for Boswell?

– To prepare financial projections • Acid Test (or Quick) Ratio
– To evaluate the firm’s financial performance in = ($643.5m−$378m) ÷ ($288.0m) = 0.92 times
light of its competitors’ performance 2016 • The firm has only $0.92 in current assets (less
inventory) to cover $1 in current liabilities. This
• External financial analysis to determine the credit Table 4.2 Observations ratio is worse than peer average of $0.94
worthiness or investment attractiveness is done • Table 4.2 created by dividing each entry in the
by: balance sheet of Table 3.2 (in chapter 3) by total Measuring the Liquidity of Individual
– Banks and other lenders assets. Asset Categories
– Suppliers – Total current assets increased by 5.6% in 2016 • We can also measure the liquidity of the firm by
– Credit-rating agencies while total current liabilities declined by 2%. examining the liquidity of accounts receivable
– Professional analysts – Long-term debt account for 39.2% of firm’s and inventories to see how long it takes the firm to
– Individual investors assets, showing a decline of 1.7%. convert its accounts receivables and inventories into
– Retained earnings increased by 5.8%. cash.
4.2 COMMON SIZE STATEMENTS:
STANDARDIZING FINANCIAL INFORMATION 4.3 USING FINANCIAL RATIOS Average Collection Period (1 of 2)
Average Collection Period measures the number of
Common Size Statements: Standardizing Using Financial Ratios (1 of 2) days it takes the firm to collects its receivables.
Financial Information • Financial ratios provide a second method for
• A common size financial statement is a standardizing the financial information on the
standardized version of a financial statement in income statement and balance sheet.
which all entries are presented in percentages. • A ratio by itself may have no meaning. Hence, a
• It helps to compare a firm’s financial statements given ratio is generally compared to: (a) ratios
with those of other firms, even if the other firms • What is the average collection period for Boswell,
are not of equal size. Inc. for 2016?
• Daily Credit Sales
= $2,700m ÷ 365 days = $7.40 million
Preparing Common Size Statements • Average Collection Period
• How to prepare a common size financial = $162m 􀃗 $7.40 = 21.9 days
statement?
– For a common size income statement, divide
each entry in the income statement by sales. Accounts Receivable Turnover Ratio (1 of 2)
– For a common size balance sheet, divide Accounts Receivable Turnover Ratio measures how
each entry in the balance sheet by total assets. many times receivables are “rolled over” during a
from previous years; or (b) ratios of other firms in year.
the same industry.
Accounts Receivable Turnover =
LIQUIDITY RATIOS Annual Credit Sales
Accounts Receivable
• Liquidity ratios address a basic question: How
liquid is the firm? • What is the accounts receivable turnover ratio
• A firm is financially liquid if it is able to pay its bills for Boswell, Inc. for 2016?
on time. We can analyze a firm’s liquidity from two • Accounts Receivable Turnover
complementary perspectives: = $2,700 million ÷ $162million = 16.67 times
– measuring overall liquidity of a firm, and – The firm’s accounts receivable were turning
– measuring the liquidity of individual asset over at 16.67 times per year. This is higher
Table 4.1 H. J. Boswell, Inc. categories. than peer group average of 14.60 times.
Common-Size Income Statement for the Year Ended

December 31, 2016

Inventory Turnover Ratio Debt Ratio Step 4: Analyze
Debt ratio measures the proportion of the firm’s • We observe that a drop in net operating income
Inventory turnover ratio measures how many assets that were financed using current plus longterm leads to a significant drop in times interest earned
times the company turns over its inventory during liabilities. ratio for both the firms. Should creditors be
the year. Shorter inventory cycles lead to greater worried by this drop? The drop in earnings would
liquidity because the items in inventory are Debt Ratio = Total Liabilities be bad for Home Depot but devastating for
converted to cash more quickly. Total Assets Lowe’s.

Inventory Turnover = Cost of Goods Sold • What is the debt ratio for H.J. Boswell, Inc.? ASSET MANAGEMENT EFFICIENCY RATIOS
Inventories • Debt Ratio Asset management efficiency ratios measure a firm’s
= $1,059.75 million ÷ $1,971 million = 53.80% effectiveness in utilizing its assets to generate sales.
– The firm financed 53.80% of its assets with These ratios are commonly referred to as turnover
• What is the inventory turnover ratio for H. J.
debt. This ratio is significantly higher than the ratios as they reflect the number of times a particular
Boswell, Inc.?
peer group average of 35%. asset account balance turns over during the year.
• Inventory Turnover Ratio
= $2,025m ÷ $378m = 5.36 times
– The firm turned over its inventory 5.36 times Times Interest Earned Ratio Total Asset Turnover Ratio
per year. This ratio is slower than peer group Times Interest Earned Ratio measures the ability of • Total Asset Turnover Ratio represents the
average of 7.0 times. the firm to service its debt or repay the interest on amount of sales generated per dollar invested in
debt. the firm’s assets.
Days’ Sales in Inventory
• Days’ Sales in Inventory Times Interest = Net Operating Income or EBIT
= 365÷ inventory turnover ratio Earned Interest Expense
= 365 ÷ 5.36 = 68 days
• The firm, on average, holds it inventory for • What is the times interest earned ratio for H.J.
about 68 days. Boswell, Inc. for 2016? Fixed Asset Turnover Ratio
• Times Interest Earned • Fixed asset turnover ratio measures firm’s
Can a Firm Have Too Much Liquidity? = $382.5m ÷ $67.5m = 5.67 times efficiency in utilizing its fixed assets (such as
• A high investment in liquid assets will enable the – The firm can pay its interest expense 5.67
firm to repay its current liabilities in a timely times or interest used 1/5.67th or 17.7% of its
manner. operating income, which means its operating
• However, an excessive investments in liquid earnings could shrink by 82.3% and it could
assets can prove to be costly as liquid assets still pay its interest expense.
(such as cash) generate minimal return. property, plant and equipment).
CHECKPOINT 4.2: CHECK YOURSELF
CHECKPOINT 4.1: CHECK YOURSELF Comparing the Financing Decisions of HD and Asset Management Efficiency Ratios:
Evaluating Hewlett Packard’s Liquidity LOWES Summary
If HP’s management were able to increase its What would be Home Depot’s times interest earned The following grid summarizes the efficiency of
inventory turnover ratio to 30 times a year while ratio if interest payments remained the same, but net Boswell’s management in utilizing its assets to
holding firm sales constant, how much this reduce the operating income dropped by 80% to only $2.354 generate sales. Overall, the managers utilized the
firm’s investment in inventory? billion? Similarly if Lowes’ net operating income
dropped by 80%, what would its times interest earned
Step 1: Picture the Problem ratio be?
• The inventory turnover ratio will measure how
many days items remain in inventory before being Step 1: Picture the Problem (1 of 2)
sold. Inventory turnover ratio is important as it has • Times interest earned ratio is an important ratio for firm’s total investment in assets efficiently.
implications for cash flows and profitability of a firm. firms that use debt financing. It measures the
• Changes in inventory turnover ratio will impact the firm’s ability to service its debt.
firm’s investment in inventory. • The ratio requires comparing net operating PROFITABILITY RATIOS
income or EBIT with Interest expense. Both items
are found on the income statement. Profitability ratios address a very fundamental
Step 2: Decide on a Solution Strategy
question: Has the firm earned adequate returns on its
• We will use the Inventory Turnover (IT) ratio to
investments?
compute the investment in inventory. Picture an Income Statement
IT ratio = Cost of Goods Sold ÷ Inventories – Sales EBIT
We are given the inventories and IT ratio. § Less: Cost of Good Sold Two fundamental determinants of firm’s profitability
§ Equals: Gross Profit and returns on investments are the following:
Step 3: Solve § Less: Operating Expenses • Cost Control – How well has the firm controlled
• Inventory Turnover Ratio for HP § Equals: Net Operating Income (EBIT) its costs relative to each dollar of firm sales?
= $78,596m ÷ Inventory = 30 § Less: Interest Expense • Efficiency of asset utilization – How effective
• Solving for the revised inventory level we get § Equals: Earnings before Taxes is the firm in using the assets to generate sales?
$78,596 million /30 = $2,619.87 million. § Less: Taxes INTEREST
§ Equals Net Income EXPENSE Cost Control: Is the Firm Earning
S Reasonable Profit Margins?
Step 2: Decide on a Solution Strategy Gross profit margin shows how well the firm’s
Step 4: Analyze
• Here we are considering the impact of a drop in management controls its expenses to generate
• Reducing the firm’s inventory turnover ratio has a
operating income on the times interest earned profits.
major impact on the level of investment in
inventory. With inventory turnover ratio of 30, ratio of Home Depot and Lowes. We will use the
investment in inventory drops significantly from following ratio to measure the times interest Gross Profit = Gross Profits
$4,288 million to $2,619.87 million. earned (TIE) ratio. Interest expense is assumed to Margin Sales
remain the same.
• TIE = EBIT ÷ Interest Expense Cost Control: Gross Profit Margin
CAPITAL STRUCTURE RATIOS
What is the gross profit margin ratio for 2016 for H.J.
Capital structure refers to the way a firm finances its
Step 3: Solve Boswell, Inc.?
assets using a combination of debt and equity.
• TIE (Home Depot) • Gross Profit Margin
Capital structure ratios address the important question:
= $2.354 billion ÷ $0.919 billion = 2.56 times = $675 million ÷ $2,700 million = 25%
How has the firm financed the purchase of its assets?
• TIE (Lowes) – The firm spent $0.75 for cost of goods sold
To address this issue, we use two types of capital
= $0.509 billion ÷$1.873 billion = .271 times and thus $0.25 out of each dollar of sales
structure ratios: the debt ratio, and the times interest
went towards gross profits.
earned ratio.
Cost Control: Operating Profit Margin Panel B. Analyzing the Determinants of the Total Is the Firm Providing a Reasonable Return
Asset Turnover Ratio on the Owner’s Investment? (2 of 2)
Operating Profit Margin measures how much What is the ROE ratio for H. J. Boswell, Inc.?
profit is generated from each dollar of sales after • ROE = $204.75 million ÷ $911.25 million =
accounting for both costs of goods sold and 22.5%
operating expenses. It also indicates how well the – Thus the shareholders earned 22.5% on
firm is managing its income statement. their investments. This is higher than peer
average of 18%

Using the DuPont Method for

Figure 4-1 Observations Decomposing the ROE ratio (1 of 4)
• Firm’s OROA (operating return on assets) is • DuPont method analyzes the firm’s ROE by
higher than that of its peers. decomposing it into three parts.
Cost Control: Net Profit Margin (1 of 2) – ROE = Profitability 􀂺 Efficiency 􀂺 Equity
• Firm’s OPM (operating profit margin) is lower
Net Profit Margin measures how much income is Multiplier
than that of its peers.
generated from each dollar of sales after adjusting for • Equity multiplier captures the effect of the firm’s
• Firm’s TATO (total asset turnover ratio) is
all expenses (including income taxes). use of debt financing on its return on equity.
higher than that of its peers.
The equity multiplier increases in value as the
Net Profit = Net Income firm uses more debt.
Figure 4-1 Recommendations
Margin Sales
1. Reduce costs - The firm must investigate the
cost of goods sold and operating expenses to
What is the net profit margin ratio for H. J. Boswell, see if there are opportunities to reduce costs.
Inc.? 2. Reduce inventories -The firm must investigate
• Net Profit Margin if it can reduce the size of its inventories.
= $204.75 million ÷ $2,700 million = 7.6%
– The firm generated $0.076 for each dollar of
CHECKPOINT 4.3: CHECK YOURSELF
sales after paying all of the firm’s expenses,
Evaluating the Operating Return on Assets
whereas the peer group firms earn $0.102. The following table shows why Boswell’s return on
(OROA) for HD and LOW
If Home Depot were able to raise its total asset
Return on Invested Capital turnover ratio to 2.5 while maintaining its current
Operating Return on Assets ratio is the summary operating profit margin, what would happen to its
measure of operating profitability. It takes into operating return on assets?
account both management’s success in controlling
expenses and its efficient use of assets.
Step 1: Picture the Problem
• The operating return on assets ratio for a firm is
Operating Return Net Operating Income or determined by two factors: cost control and
equity was higher than its peers.
on Assets (OROA) = EBIT______
Total Assets

Operating Return on Assets asset utilization. Here the focus is on asset

What will be the operating return on assets ratio for utilization.
H. J. Boswell, Inc. ?
• Operating Return on Assets Step 2: Decide on a Solution Strategy
= $382.5 million ÷$1,971 million = 19.4% We will analyze the impact on operating return on
– The firm generated $0.194 of operating profits assets of improvement on the total asset turnover
for every $1 of its invested assets, which is ratio by using the following equation:
higher than peer group average of $0.178. • Operating Return on Assets (OROA)

Decomposing the Operating Return on = Total Asset Turnover × Operating Profit Margin

Step 3: Solve Figure 4.2 Expanded DuPont Analysis for H. J.

• Operating Return on Assets (OROA) Boswell, Inc.
= Total Asset Turnover 􀂺 Operating Profit
Margin MARKET VALUE RATIOS
• Before = 2.08 ÷ 13.3% = 27.67% Market value ratios address the question, how are
• Now = 2.5 ÷ 13.3% = 33.25% the firm’s shares valued in the stock market?

Assets Ratio Step 4: Analyze Price—Earnings Ratio

• An improvement in total asset turnover ratio has a Price-Earnings (PE) Ratio indicates how much
favorable impact on Home Depot’s operating return investors have been willing to pay for $1 of reported
on assets (OROA). earnings.
Figure 4.1 Analyzing H. J. Boswell, Inc.’s Operating • If Home Depot wants to increase its OROA more, it
Return on Assets (OROA) (1 of 2) should focus on cost control that will help improve Market Price-Earning Ratio = Price per Share
Panel A. Decomposing the Operating Return on the net operating profit. Earnings per Share
Price-Earning Ratio = $32.00 = 14.07 times
Is the Firm Providing a Reasonable Return $2.28
on the Owner’s Investment? (1 of 2)
Return on Equity (ROE) ratio measures the
accounting return on the common
stockholders’investment.
Assets Ratio
Return on = __Net Income__
Equity Common Equity
Market—to—Book Ratio
Market-to-Book Ratio measures the relationship
between the market value and the accumulated
investment in the firm’s equity.
CHECKPOINT 4.4: CHECK YOURSELF Key Terms (1 of 4)
• Accounts receivable turnover ratio
Comparing the Valuation of APPL to MSFT Using Trend Analysis • Acid-test (quick) ratio
Market Value Ratios Comparing a firm’s recent financial ratios with the • Average collection period
What would be the price per share have to be for past financial ratios provides insight into whether
• Book value per share
• Capital structure
Apple to increase its PE ratio to that of Microsoft’s if the firm is improving or deteriorating over time. This • Current ratio
we assume Apple’s earnings remain the same as type of financial analysis is referred to as trend an • Days’ sales in inventory
reported above? alysis.
• Debt ratio
• DuPont method
• Equity Multiplier
• Earnings per share (EPS)
Step 1: Picture the Problem Figure 4-3 A Time—Series (Trend) Analysis of the Inventory Turnover • Financial leverage
Price-to-earnings (PE) ratio depends on earnings • Financial ratios
per share and price per share, pictured as follows: • Fixed asset turnover ratio
• Inventory turnover ratio
• Liquidity ratios
• Market-to-book ratio
• Market value ratios
• Notes payable
• Operating return on assets (OROA)
• Price-earnings (PE) ratio
• Return on equity
• Times interest earned
• Total asset turnover ratio (TATO)
• Trend analysis
Ratio: Home Depot Versus Lowe’s, 2001–2015

Step 2: Decide on a Solution Strategy

We need to determine the price per share that will
make PE ratio of Apple (10.39) equal to the PE ratio
of Microsoft (35.09).
Peer—Firm Comparisons
A peer firm is simply one that the analyst believes will
provide a relevant benchmark for the analysis at hand.
Peer groups often consist of firms from thesame
industry. Industry average financial ratios can be
obtained from a number of financial databases (such
Step 3: Solve as Compustat) and internet sources (such as yahoo
From Step 2, note that the PE ratio of Microsoft is finance and google finance).

Figure 4-4 Financial Analysis of the Gap, Inc., 2016

35.09.

Step 4: Analyze
• PE ratio allows us to compare two stocks with
different prices by standardizing the stock prices
by earnings.
• Microsoft has a much higher PE ratio. To reach
the same PE valuation, the stock price of Apple
will have to increase from $95.76 to $323.53. 4.5 LIMITATIONS OF RATIO ANALYSIS

4.4 SELECTING A PERFORMANCE Limitations of Ratio Analysis (1 of 2)

BENCHMARK 1. Picking an industry benchmark can sometimes
be difficult.
Selecting a Performance Benchmark 2. Published peer-group or industry averages are
There are two types of benchmarks that are not always representative of the firm being
commonly used to analyze a firm’s financial analyzed.
performance by means of its financial statements: 3. An industry average is not necessarily a
• Trend Analysis – compares a firm’s financial desirable target or norm.
statements over time (time-series comparisons). 4. Accounting practices differ widely among
• Peer Group Comparisons – compares the firms.
subject firm’s financial statements with “peer” 5. Many firms experience seasonal changes in
firms. their operations.
6. Financial ratios offer simply clues that can
suggest the need for further investigation.
7. The results of financial analysis are no better
than the quality of the financial statements.