FINANCIAL RATIOS IN

AUDIT REPORT

CLIENTS INDUSTRY AND

PERFORMANCE MEASUREMENT

Financial statements a reminder

Financial ratio analysis

The different types of ratios

Time-series and cross-sectional analysis

Integrating ratios: the DuPont system

2

Industry and the external

environment
There
are risks associated with certain
industries; there are risks associated to all
clients in certain industries. Additionally,
there are varying accounting requirements
that the auditor must take into account in
assessing whether or not to serve a
particular client. The auditor must also
consider the external environment in which
a
company
operates--the
economic
situation, regulatory requirements, and
other factors.
3

Business operations and

processes

The auditor must strive to understand how the

business works--how revenue is generated, how the
company is financed, who the customers are, etc. A
company tour is a step toward getting some
familiarity, particularly if questions can be directed
to some of the employees. Additionally, identifying
transactions with related parties is a necessary step
in understanding the business, and may involve
examination of SEC filings, conversations with
management, and reading through stockholder
lists. The Sarbanes-Oxley Act prohibits related party
personal loans to executives; the auditor should be
on the lookout for such illegal loans.
4

Management and
governance

The auditor should become familiar with the

company's organization chart, as well as the
corporate charter and bylaws. The SEC
requires public companies to establish a code
of ethics; assuming such a code exists, it
should be reviewed by the auditor for any
changes or waivers taking place.Corporate
minutes taken at board meetings or
stockholders' meetings should be reviewed by
the auditor, to determine if actions required
of management have been executed.
5

Client objectives and strategies.

Measurement and performance

Auditors should be aware of client objectives

related to reliability of financial reporting,
effectiveness and efficiency of operations,
and compliance with laws and regulations.
Various contracts, debts, pension plans,
leases, and other legal documents should be
reviewed with the purpose of evaluating the
client's legal compliance.
The auditor should be knowledgeable
regarding the client's performance measures
by making those same calculations.
6

Bartlett Company Balance

Sheet
As of December 31 - $ in thousands
Assets
Current assets
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets
Gross fixed assets (at cost)
Land and buildings
Machinery and equipment
Furniture and fixtures
Vehicles
Other (includes financial leases)
Total gross fixed assets (at cost)
Less: Accumulated depreciation
Net fixed assets
TOTAL ASSETS

2003

2002

Changes

363
68
503
289
1,223

288
51
365
300
1,004

75
17
138
-11
219

2,072
1,866
358
275
98
4,669
2,295
2,374

1,903
1,693
316
314
96
4,322
2,056
2,266

169
173
42
-39
2
347
239
108

3,597

3,270

327
7

Bartlett Company Balance

As of December 31 - $ in thousands
Sheet
2003
2002 Changes
Liabilities and stockholders' equity
Current liabilities
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt (includes financial leases)
TOTAL LIABILITIES
Stockholders' equity
Preferred stock - cumulative 5%, $100 at par, 2,000 shares
authorized and issued
Common stock - $2.50 par, 100,000 shares authorized, shares
issued and outstanding in 2003: 76,262; in 2002: 76,244
Paid-in capital in excess of par on common stock
Retained earnings
Total stockholders' equity
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY

382
79
159
620
1,023
1,643

270
99
114
483
967
1,450

112
-20
45
137
56
193

200

200

191
428
1,135
1,954
3,597

190
418
1,012
1,820
3,270

1
10
123
134
327
8

Bartlett Company Income

Statement
As of December 31 - $ in thousands
Sales revenue
Less: Cost of goods sold
Gross profit
Less: Operating expenses
Selling expenss
General and administrative expenses
Lease expense
Depreciation expense
Total operating expenses
Operating profits (EBIT)
Less: Interest expense
Net profits before taxes (EBT)
Less: Taxes
Net profits after taxes (EAT)
Less: Preferred stock dividends
Earnings available to common stockholders

2003
3,074
2,088
986

2002
2,574
1,711
863

100
194
35
239
568
418
93
325
94
231
10
221

108
187
35
223
553
310
91
219
64
155
10
145

Change
500
377
123
0
-8
7
0
16
15
108
2
106
31
75
0
75
9

Bartlett Co. Statement of retained

earnings, 2003
Retained earnings balance (Jan 1, 2003)
Plus: Net profits after taxes (for 2003)
Less: Cash dividends (paid in 2003)
Dividends for preferred stock
Dividends for common stock
Total dividends paid
Retained earnings balance (Dec 2003)

1,012
231
10
98
108
1,135

10

Bartlett Co. Statement of cash flows,

Cash Flow from Operating Activities
2003
Net profits after taxes
Depreciation expense
Change in accounts receivable
Change in inventories
Change in accounts payable
Change in accruals
Cash provided by operating activities

231
239
-138
11
112
45
500

Cash Flow from Investment Activities

Change in gross fixed assets
Change in business interests
Cash provided by investment activities

-347
0
-347

Cash Flow from Financing Activities

Changes in notes payable
Changes in long-term debt
Changes in stockholders' equity
Dividends paid
Cash provided by financing activities

Net increase in cash and marketable securities

-20
56
11
-108
-61

92

11

Financial analysis/ratios
objectives

Ratio analysis involves methods of calculating

and interpreting financial ratios to analyze and
monitor the firms performance
Basic inputs: income statement and balance
sheet
Interested parties:

Shareholders risk and return characteristics of

the firm
Creditors short-term liquidity & company
ability to make interest and principal payments
Management all aspects of firms financial
situation
12

Financial ratios comparisons

Cross-sectional
analysis

involves
comparison of different firms financial ratios at
the same point in time

It is important to understand how the firm has

performed in relation to other firms in its industry

Frequently, a firm will be compared to a key

competitor in industry benchmarking

Time-series analysis evaluates performance

over time and enables assessing the firms
progress

Combined analysis the most informative

approach to ratio analysis
13

Financial ratios

Liquidity ratios measure the firms ability to

satisfy short-term obligations as they come
due
Leverage (financing) ratios measure the
firms ability to pay its long-term debt
Efficiency (activity) ratios measure the
speed with which various accounts are
converted into sales or cash
Profitability ratios shows the firms ability to
generate income from its assets
Market ratios give insight into how well
investors in the market value the firm
14

C
u
r
e
n
t
a
s
e
rF
to
iC
C
u
e
n
a
o
=
l
i
b
1
,
2
3
F
rQ
lru
o
B
a
t
e

C
u
r
e
n
t
r
a
i
o

1
.
9
7
6
0
s
e
I
n
v
e
t
o
r
y
iFo
c
k
o
=
C
u
r
n
t
l
i
a
b
s
1
,
2
3
8
9
B
ts
lrh
a
e

Q
i
c
k
a
o

1
.
5
6
0
C
a
s
h

M
e
e
c
u
r
i
t
iB
o
=
u
r
n
t
l
i
a
b
s
3
6

8
a
tle

C
a
s
h
rtio

.2

0
6
9
0
Liquidity ratios

15

L
o
n
g
t
e
r
m
d
b
t

V
a
l
u
e
o
f
l
a
s
e
tD
D
re
e
iF
b
a
o
=
+

E
q
u
i
t
y
1
,
0
2
3
lb
F
B
t
e

D
b
a
i
o

0
.
3
4

9
5
4
L
n
g
t
e
r
m
d
e
b
t
+
V
a
l
u
e
o
f
l
a
s
e
to
iT
iriB
q
u
y
r
a
o
=
E
q
i
y
1
,
0
2
3
tm
lF
e

D
e
b
q
u
i
y
a
o

0
.
5
2
9
5
4
I1
i8
E
B
T
+
D
e
p
r
c
a
t
o
n
e
so
n
rB
ta
rl
s
e
a
n
d
(E
T
I
)4
=
t
n
s
2
3
9

7
.0
6
Leverage ratios

16

S
a
l
e
s
lFo
T
o
t
a
s
e
t
u
r
n
o
v
e
r
=
T
o
t
t
3
,
0
7
4
rF
B
a
e

T
o
a
l
s
e
t
u
n
o
v
e
r

0
.
8
5
5
9
C
o
s
t
f
g
o
d
s
o
l
IF
to
n
v
e
o
r
y
u
n
o
v
e
r
=
I
n
v
e
t
r
y
2
,
0
8
o
rrB
B
la
a
Itle

t
y
u
r

7
.
2
9
3
6
5
i
p
d
IIn
n
v
e
t
o
y
u
o
v
e
3
6
5
v
e
to
ry
p
id
7
..25

0
d
a
y
s

Efficiency ratios and operating

cycleof total assets
Efficiency

Efficiency of current assets OPERATING CYCLE

Finding the inventory period

17

S
a
l
e
s
A
/
R
t
u
r
n
o
v
e
=
A
/
R
3
,
0
7
4
F
o
r
B
a
t
l
e

6
.
1
5
6
R
c
i
v
a
b
l
e
s
p
r
i
o
d
=
A
/
R
t
u
r
n
o
v
e
3
lO
F
o
r
B
a
t
e

R
c
v
a
b
l
e
s
p
r
i
o
d

5
9
.
7
4
d
a
y
s
.
1
iForBatn
p
e
cl
g
yO
ep=
Iranigctolyp
i50.59.74v1ble0.2p
e
o
d

R
e
c
r9aioysd

Efficiency ratios and operating

cycle

Finding
period

the

accounts

receivable

(collection)

18

C
o
s
t
f
g
o
d
s
o
l
/C
A
P
t
u
r
n
o
v
e
=
A
/
P
2
,
0
8
lF
F
o
r
B
a

A
/
P
u
r
n
v
e

5
.
4
7
3
6
5
P
y
b
e
s
p
i
o
d
=
A
/
P
t
u
r
n
o
v
e
ro
lra
F
o
B
a
t

P
a
y
b
l
e
s
p
i
d

6
.
7
3
d
a
y
s
.
4
7
sBh
ctley
e
=
rCashcya
O
p
tlen
l10.2e
g
c
y
-96P
a
l.734e
y
b
r.56daio
p
d
ys
Efficiency ratios and operating
cycle

Finding the payables period

19

Operating cycle

20

A few considerations on operating

cycle

The longer the production process, the longer

the inventory period
The longer it takes customers to pay their bills,
the longer the accounts receivable period
The longer the accounts payable period, the
shorter the cash cycle
the cash conversion cycle is not given to a
large extent it is under managements control
balance between the costs and benefits of
maintaining high current assets
21

S
a
l
e
s
C
O
G
S
G
r
o
s
p
fi
t
m
a
r
g
i
n
=
3
,
0
7
4
2
,
0
8
F
o
rF
tN
lo
B
a
e

G
r
o
s
p
fi
t
m
a
r
g
i
n

0
.
3
2
8
o
r
3
2
.
0
8
%
O
p
e
r
a
t
i
n
g
p
r
o
fi
t
s
ie
O
p
e
a
t
n
g
r
o
m
=
S
l
s
4
1
8
rB
tF
a
lp
iro

O
p
e
a
t
n
g
p
r
o
fi
t
m
a
r
g
i
n

0
.
1
3
6
o
r
1
3
.
6
0
%
3
,
0
7
E
s
v
l
b
e
t
o
c
m
n
s
h
a
e
l
d
r
s
rB
fi
m
a
g
=
S
a
l
s
1
tle

N
e
tp
ro
fi
m
a
rg
in
2
0
.7
1
9
o
r7
.1
9
%

3
,0
7
4

Profitability ratios

22

E
a
r
n
i
g
s
a
v
i
l
b
e
t
o
c
m
o
n
s
h
a
r
e
o
l
d
r
s
E
a
rn
iP
ra
g
s
p
e
h
a
e
(
E
P
S
)

N
u
m
r
f
s
h
a
r
u
t
d
i
g
2
1
,
0
F
o
r
B
a
t
l
e

E
P
S

$
2
.
9
0
7
6
D
i
v
d
e
n
s
t
o
c
m
o
n
s
h
a
r
e
o
l
d
r
s
y
tFrB
o
u
a
ile
=
rt
E
a
iP
n
ly
g
a
b
e
m
h
e
9
8
o
u
tr2
.14

0
34
.3
%
Profitability ratios

23

rR
iR
iO
lO
E
a
n
g
s
a
v
b
e
t
o
c
m
o
n
s
h
a
r
e
o
l
d
r
s
A
=
T
a
l
s
e
t
2
1
F
o
rF
t=
lo
B
a
e

R
O
A

0
.
6
1
4
o
r
6
.
1
4
%
3
,
5
9
7
E
irB
ia
n
ltle
g
s
a
v
b
e
f
o
r
c
m
n
s
h
a
e
l
d
r
s
C
o
l
m
n
s
h
a
d
e
r
'
q
u
i
t
y
1
R
O
E
2
.,7

0
1
2
6
o
r
1
2
.
6
0
%
5
4
Profitability ratios

24

P
r
i
c
e
p
r
s
h
a
e
o
f
c
m
o
n
s
t
c
k
/ForM
rBaa
P
trtklee
E
it-
a
(o
o
)M
P
E
R
=
E
n
i
g
p
r
s
h
a
e
3
2
.
5
rab
trketk
F
B
loie
a

P
R

1
.
3
9
0
ro
ib=
c
e
p
r
s
h
a
e
o
f
c
m
o
n
s
t
c
k
lkratio(1,7543
B
o
k
v
r02./5
u
p
s
h
a
e
.7
3
2
5

1
.
4
0
6
,2)
Market ratios

25

iR
E
a
r
n
g
s
a
v
i
l
b
e
t
o
c
m
o
n
s
t
c
k
h
o
l
d
e
r
s
O
A
=
T
a
l
s
e
t
l
S
e
E
r
n
g
v
i
b
m
n
t
c
k
h
o
l
d
e
r
s
x
T
o
tF
a
to
s
S
a
l
e
s
rB
atle
R
O
A
0
.8
5
71
8
%
6
.1
4
%
The DuPont system

Assets
Assets turnover ratio

Net profit margin

26

iR
E
a
r
n
g
s
a
v
i
l
b
e
t
o
c
m
o
n
s
t
c
k
h
o
l
d
e
r
s
O
=
S
h
r
l
d
r
s
'
e
q
u
i
y

a
l
S
a
e
s
tF
T
o
t
e
s
ro
h
'B
d
r
q
u
i
t
y
,3
2
1
0
3
,
0
7
4
0
3
,
5
9
7
0
a
tle

R
O
E

7
4
5
9
1
4
.8
%
.8
2
.
2
.6
%
The DuPont system

Net profit margin

Assets turnover ratio

Leverage ratio

27

Time-series and cross-sectional analysis for

Bartlett
2003
2002 Industry average
2003
1. Liquidity

1. Current ratio
2. Quick ratio
3. Cash ratio

2. Efficiency 1. Inventory turnover

2. Days in inventory
3. Average collection period
4. Total assets turnover
3. Leverage

1. Debt ratio
2. Debt-to-equity ratio
3. Times interest earned

4. Profitablity 1. Gross profit margin

2. Operating profit margin
3. Net profit margin
4. Earnings per share
5. Payout ratio
6. ROA
7. ROE
5. Market

1. PER
2. Market to book ratio

1.97
1.51
0.70

2.08
1.46
0.70

2.05
1.43
0.71

7.22
50.52
59.73
0.85

5.70
64.00
51.76
0.79

6.60
55.30
42.75
0.75

34.36% 34.70%
52.35% 53.13%
7.06
5.86

32.46%
48.06%
6.25

32.08% 33.53%
13.60% 12.04%
7.18% 5.65%
2.89
1.91
0.44
0.42
6.14% 4.45%
12.59% 8.98%

30.00%
11.00%
6.20%
2.26
0.41
4.60%
8.50%

11.14
1.40

9.46
0.85

12.50
1.30

28

Problems of financial statements

analysis

The need for theory

Conglomerates

There is no compelling rationale for use of

financial statement to make judgment about
value and risk
Which ratios matter most?
What is the right value for the ratio?
Not identified in a single industry or sector
Hard to find comparables

Global reach

Comparability of financial statements between

countries is problematic
29