OUTLINE

Part 1

The major financial

statements

Part 2

Profitability Measures

Part 3

Ratio Analysis

Part 4

Comparability Problems

The major financial statements

1. The Income Statement : a summary of the profitability of

the firm over a period of time

2. The balance sheet : a snapshot of the financial

condition of the firm at a particular time.

3. The statement of cash flows : a financial statement

showing a firms cash receipts and cash payments during

a specified period.

Profitability Measures
ROE, ROA
0 ROA = EBIT/Total Assets
0 ROE = Net Profits/Common Equity

Financial leverage affects earnings for firms owners

ROE = (1 Tax rate)[ROA + (ROA Interest rate)*Debt/Equity]
Explanation:
0 ROA = Interest rate or Debt = 0 ROE = (1 Tax rate)*ROA

0 ROA > Interest rate ROE increases surplus earning for equity

owners

Profitability measures
0 High Debt/Equity ratio Higher possible earnings for

firms owners
0 Also, higher risk

0 ROE = (1 Tax rate)[ROA + (ROA Interest rate)*Debt/Equity]

0 Example:
0 Somdett equity = $60 mil
0 Somdetts after-tax profits = 0.6(EBIT - $3.2 mil)

Profitability measures
Using debt makes ROE more sensitive to the
business cycle, although EBIT of 2 companies are
the same.

5 factors of ROE decomposition

ROE =

Net Profit

Pretax Profit

EBIT

Sales
Assets

Assets

Pretax Profit

EBIT

Sales

Equity

(1)

(2)

(3)

(4)

(5)

Tax Burden
ratio

Interest
Burden ratio

Profit
margin

Total
asset
turnover

Leverage
ratio

Factors (1), (3), (4) are not affected by firms capital structure while
factors (2), (5) are.

Factors that are independent from firms

financial leverage
1. Profit Margin: EBIT/Sales
0 Measures how much out of every dollar of sales a company
actually keeps in earnings.
0 The higher the profit margin, the better companys ability to
control its costs.

2. Total Assets Turnover: Sales/Assets:

0 Measures a firms efficiency at using its assets in generating

sales or revenue the higher the number the better.

0 The lower the profit margin (factor 3), the higher ATO and
vice versa.

Factors that are independent from firms

financial leverage
3. Tax burden ration: Net profit/Pretax Profit
0 Is the proportion of the firms profits retained after paying

income taxes.
0 Reflect governments tax code and policies pursued by the
firm in trying to minimize its tax burden.

Factors that are affected

by firms capital structure
1. Interest burden (IB) ratio: Pretax profit/EBIT:
0 Pretax profit = EBIT Interest expense
0 The higher the degree of financial structure, the lower the IB

ratio
0 IB ratio =< 1

2. Financial leverage: Assets/Equity

0 Assets/Equity = (Equity + Debt)/Equity = 1 + Debt/Equity
0 Helps boost ROE only if ROA is greater than the interest rate

on the firms debt.

Relationships summary
0 ROE = Tax burden x Interest burden x Profit margin x

Turnover x Leverage
0 ROA = Profit margin x Turnover
0 Compounded leverage factor = Interest burden x Leverage

ROE = Tax burden x ROA x Compounded leverage factor

Liquidity Ratios
Tell us how easily a company can pay its debts (so that the
company doesnt get eaten up by banks or creditors)

Current Ratios
Quick Ratios
Cash Ratios.

Current Ratio
Company A has:
0 $1,000 in current assets
Current assets? Current liabilities?
(cash,account receivables
and inventories)
-> Convertible to cash within the next 12 0 $800 in current liabilities
months!
Current Ratio ?

Current Ratio =

What does 1.25 mean?

$1000
=
$800

= 1.25

Current Ratio
What does 1.25 mean?
Indicate that the company will not have any trouble paying its debt
for the next 12 months. The current assets are more than the current
liabilities for the next 12 months. (25% more)

1. If current ratio is higher than 1, Why is this good?

Its good for creditors (ex. banks which loan them money which
need to be paid back within the next 12 months)
If the current ratio is less than 1, that means negative net worth
in capital. The company is in trouble. Theres not enough current
assets to pay for current liabilities.

2. If current ratio is higher than 1. Why is this bad?

It may indicate inefficiency in using short-term assets

Quick Ratio
A better measure of liquidity than the
current ratio for firms whose inventory is
not readily convertible to cash

Quick Ratio =

Company A has:
0 $1,000 in current assets
(cash,account receivables and
inventories)
0 $800 in current liabilities
0 $100 of current assets is
inventory
Quick Ratio ?

$1000 $100
= 1.125
$800

Similar to Current Ratio, but whats the benefit of

subtracting inventory?

Quick Ratio
Whats the benefit of subtracting inventory?
1. Often considered less liquid than other current assets; not
as easily converted to cash

2. Could be lost , outdated or damaged

Quick Ratio
A better measure of liquidity than the
current ratio for firms whose inventory is
not readily convertible to cash

Quick Ratio =

What does 1.125 mean?

Company A has:
0 $1,000 in current assets
(cash,account receivables and
inventories)
0 $800 in current liabilities
0 $100 of current assets is
inventory
Quick Ratio ?

$1000 $100
= 1.125
$800

Quick Ratio
What does 1.125 mean?
Indicates that the company will not have any trouble paying its debt for the
next 12 months. The quick assets are more than the current liabilities for
the next 12 months

HIGH quick ratio good or bad?

LOW quick ratio good or bad?

Cash Ratio
Company A has:
0 $200 in Cash and Marketable
securities
0 $800 in current liabilities
Quick Ratio ?

Cash Ratio =

$200
$800

= 0.25

What does our 0.25 Cash Ratio mean?

Indicates that the company will not have any trouble paying 25% of
its debt for the next 12 months.

Turnover and Other Asset Utilization Ratios

Asset Turnover
Ratio

Indicates how successful a

firm is in utilizing its assets in
generation of sales revenue

For subcategories
of assets

Fixed Asset
Turnover

Inventory
Turnover

Turnover and Other Asset Utilization Ratios

Total Asset
Turnover Ratio

Fixed Asset
Turnover

Inventory
Turnover

Turnover and Other Asset Utilization Ratios

Table 14.8 (Page 452)
Compute:
0 Total assets Turnover.
0 Fixed assets Turnover.
0 Inventory Turnover.

Market Price Ratios

Company A has:
0 Stock market price = $100
0 Last years earning per
share = $10
Price-earnings ratios? (P/E)

Price-earnings ratio (P/E)

A valuation ratio of a company's
current share price compared to its
per-share earnings.

P/E=

$100
$10

What does this mean?

Company As stock is selling for 10X its
earnings

= 10

Price-earnings ratio (P/E)

Good or Bad?
1. Low P/E
0 A low P/E can be good, because it means the stock is
selling for cheap, and stock is good value for investors
0 A low P/E is can be bad, because Why is it selling
cheap?

Price-earnings ratio (P/E)

Good or Bad?
2. High P/E
0 A high P/E can be bad, because its expensive and not good
value for investors.
0 A high P/E can be good, because Why are people willing
to buy it expensive?

Comparability problems
0 A major problem in the use of data obtained from a firms

financial statement

0 It is necessary for the security analyst to adjust accounting

earnings and financial ratios to a uniform standard before

attempting to compare financial results across firms

1. Inventory Valuation
0 2 ways to value inventories: LIFO and FIFO

LIFO
The last-in first out accounting
method of valuing inventories.
The last goods produced are
considered the first ones to be
sold.

FIFO
The first-in first- out
accounting method of valuing
inventories.
The units used up or sold are
the ones that were added to
inventory first, and goods sold
should be valued at original
cost

0 LIFO is preferred over FIFO because it uses up-to-date

prices to evaluate the cost of goods sold

0 Disadvantages : LIFO accounting includes balance sheet

distortions when it values investment in inventories at

original cost

2. Depreciation
0 In economic definition: depreciation is the amount of a

firms operating cash flow that must be reinvested in the

firm to sustain its real cash flow at the current level

0 In accounting definition : accounting depreciation is the

amount of the original acquisition cost of an asset that is

allocated to each accounting

0 The simplest and most commonly used method of

depreciation is the straight line method or straight line

accelerated depreciation method.
Depreciation Expense = (Total Acquisition Cost Salvage
Value) / Useful Life
Example : an equipment worth $1m
an estimated life :5 years
salvage value :$100,000
Depreciation expense ?

Accelerated Depreciation Method:

0 this method allows companies to write off more of their assets in

the earlier years and less in the later years

0 The common method of accelerated depreciation is called the
double declining balance (DDB) method.

DDB in year 1 =Depreciation Base * (2 * 100% / Useful Life of Asset

in Years)
DDB in year 2 and beyond = 2/n * (Asset Value on Balance Sheet)
Example : an equipment worth $1m
an estimated life :5 years
salvage value :$100,000
Depreciation expense over 5 years?

The major problem related to depreciation is caused by

inflation.
Measured depreciation in periods of inflation is
understated relative to replacement cost, and real economic
income is corresponding overstated.

Inflation and Interest expense

0 The relationship between real and nominal interest rates

can be described in the equation:

(1+r)(1+i)=(1+R)
where r is the real interest rate, i is the inflation rate, and R
is the nominal interest rate.
0 Nominal interest rate includes an inflation premium that

compensates the lender for inflation-reduced erosion in

the real value of principal

Fair value accounting

0 Fair value accounting : use of current market values rather

than historic cost in the firms financial statements.

0 Potential problem:

0 Fair value accounting relies too heavily on estimates->

introduce considerable noise in firms accounts and induce

great profit volatility
0 subjective valuations may offer management a tempting tool to
manipulate earnings or the apparent financial condition of the
firm at opportune time.