Analysis of Financial

Statements

Tools:

Common-Size Financial Statements

Indexed Financial Statements
Financial Ratios

Return on Equity (ROE)

Ratio

Equals: Net Income/Shareholders

Equity
Measures the efficiency with which a
company employs owners capital
Gives the bang per buck
Ametek 2001 ROE: 66.1 / 335.1 =
19.7%

The Du Pont Equation:

3 Determinants of ROE
Net Income
ROE
Shareholders ' Equity
Net Income Sales
Assets

x
x
Sales
Assets Shareholde rs ' Equity

Resource
Operating
Profitability Utilization
Efficiency

Leverage
Usage

A Road Map for Ratio

Analysis
ROE

Profit
Margin
Gross Margin
Tax Rate
Percentage
Income
Statement

Asset
Turnover

Financial
Leverage

Days Sales in Cash

Collection Period
Inventory Turnover
Fixed Asset Turnover
Payables Period
Percentage Balance
Sheet

Debt to Asset
TIE
Times Burden
Coverage
Current Ratio
Acid Test Ratio

Profit Margin Ratio

Equals: Net Income / Sales

Measures the fraction of each dollar of
sales that trickles down to profit.
Reflects the companys pricing strategy
and ability to control operating costs.
Ameteks 2001 PM: 66.1 / 1019.3 = 6.5%
Variant : Gross Profit Margin Ratio (GPM)

Asset Turnover

Equals: Sales / Total Assets

Measure of asset intensity
Dependent on the nature of
companys products, its competitive
strategy and management diligence
and creativity
Ameteks 2001 Asset Turnover:
1019.3 / 1029.3 = 1.0

Why Compare Asset to

Sales?

Assets (specially the current

type) will move with sales the
ratio corrects for changes in sales
and allows one to evaluate how
well management used the
resources available.

Standard Control Ratio

Related to Asset Turnover

Inventory Turnover:
CGS / Ending Inventory
(Variant : Days Inventory = Number of Days in
A Year / Inventory Turnover)

Collection Period:
A/R / Credit Sales per Day
(Variant : A/R Turnover = Credit Sales / A/R)

Standard Control Ratio

Related to Asset Turnover

Days Sales in Cash:

Cash and Securities / Sales per Day
Payables Period:
A/P / Credit Purchases per Day
(this is a control ratio for liability, if credit purchases is
unkown, CGS can be used in its place)

Fixed Asset Turnover:

Sales / Net Property, Plant and Equip.
(a measure of capital intensity, important for firms that rely on
large investments in long-lived assets to produce their goods)

Return on Assets (ROA)

Equal: Net Income / Assets

Or: Profit Margin x Asset Turnover
Measures the efficiency with which a
company allocates and manages its
resources, or profit as a % of money
provided by owners and creditors.
Ameteks 2001 ROA: 66.1 /
1029.3=6.4%

Financial Leverage

The extent to which debt financing

is used in a business.
Not necessarily that the higher it is
the better. Need to balance it with
the risks associated with the usage
of debt.
ROA and financial leverage tend to
be inversely related.

Debt Ratios

Debt to asset ratio:

Total Liabilities / Total Assets
Debt to equity ratio:
Total Liabilities / Shareholders Equity

Note: These ratios can be used to assess if the

company has over-borrowed however it should be
kept in mind that the financial burden a company
faces by using debt financing ultimately depends
not on the size of its liabilities relative to assets or
to equity but on its ability to meet the annual cash
payments the debt requires.

Coverage Ratios

Address weakness of debt ratios.

Measures income available for debt
service. (Can the business pay its way?)

EBIT
Times Interest Earned
Interest Expense
EBIT
Times Burden Covered
Pr incipal Re payment
Interest

Tax
Rate

Ameteks 2001 TIE: 112.3/27.9 = 4

TBC: 112.3 / [27.9+1.3/(1- {18.3/84.4})] = 3.8

Liquidity Ratios

Liquidity of assets is a determinant of a

companys debt capacity.
These are crude measures of liquidity: (1)
rolling over some current liabilities involves
no insolvency risk provided the company is
at least marginally profitable (2) unless
company intends to go out of business,
most of cash generated by liquidating
current assets cannot be used to reduce
liabilities because it must be plowed back
into the business

Liquidity Rations
Current Assets
Current Ratio
Current Liabilities
Current Assets Inventory
Acid Test
Current Assets
Current Liabilities

Ameteks 2001 Current Ratio: 379.3 / 336.2 =

1.1

Acid Test: (379.3-152.5) / 336.2 = 0.7

Three Deficiencies of ROE

(if used as the main financial
yardstick)
The Timing Problem: ROE is backward

looking and single year- focused

The Risk Problem: ROE says nothing
about the risk a company has taken to
generate it
The Value Problem: ROE measures
return on shareholders investment
using book value of shareholders equity
not the market value

Using Ratios: Some

Guidelines

One or even several ratios by itself or

themselves might not yield important
insights about a corporation but
combined with other knowledge of a
companys management and
economic circumstances, it can tell a
very revealing story (think of ratios
as clues in a detective story).

Using Ratios: Some

Guidelines

Ratios has no single correct value.

A high current ratio maybe a
positive sign for a short-term
creditor but might not be viewed
similarly by management as it
might indicate too liberal credit
terms or too much inventory.

Using Ratios: Some

Guidelines

Comparing a companys ratios to

industry ratios provides a useful feel
for how the company measures up to
its competitors, provided you bear in
mind that company-specific differences
can result in entirely justifiable
deviations from industry norms.
(More given in your handouts.)