Financial Analysis

Overview

1.Why Do We Analyze Financial Statements

2.Common Size Statements – Standardizing
Financial Information
3.Using Financial Ratios
4.Selecting a Performance Benchmark
5.The Limitations of Ratio Analysis
 Learning Objectives

1. Explain what we can learn by analyzing a firm’s

financial statements.
2. Use common size financial statements as a tool of
financial analysis.
3. Calculate and use a comprehensive set of
financial ratios to evaluate a company’s
performance.
4. Select an appropriate benchmark for use in
performing a financial ratio analysis.
5. Describe the limitations of financial ratio analysis.
 Principles Used in
this Chapter
 Principle 1: Money has a Time Value.
 Financial statements typically ignore time value of money. Thus, financial
managers and accountants may view financial statements very differently.
 Principle 2: There Is a Risk-Return Tradeoff.
 Financial statement analysis can yield important information about the
strengths and weaknesses of a firm’s financial condition. The analysts can
use such information to infer the risk-return tradeoff in a firm.
 Principle 3: Cash Flows Are the Source of Value.
 An important use of a firm’s financial statements involves analyzing past
performance as a tool for predicting future cash flows.
 Principle 4: Market Prices Reflect Information.
 Financial statement analysis requires gathering information about a firm’s
financial condition, which is important to the valuation of the firm.

Market Capitalisation = Share price X No. of shares

Share price = EPS X PER EPS – Profit per share PER – Earning multiple
 Relevant Principles

• Principle 7: Agency relationships, managers

won’t work for the owners unless its in their
best interest to do so.
• Principle 5: Competitive markets make it hard
to find exceptionally profitable investments.
• Principle 1: The risk-return trade-off – we
won’t take more risk unless we expect higher
returns.
 Why Analyze Financial
Statements?
 An internal financial analysis might be done:
 To evaluate the performance of employees and determine their pay raises
and bonuses.
 To compare the financial performance of the firm’s different divisions.
 To prepare financial projections, such as those associated with the launch
of a new product.
 To evaluate the firm’s financial performance in light of its competitors and
determine how the firm might improve its operations.
 A variety of firms and individuals that have an economic interest might also
undertake an external financial analysis:
 Banks and other lenders deciding whether to loan money to the firm.
 Suppliers who are considering whether to grant credit to the firm.
 Credit-rating agencies trying to determine the firm’s creditworthiness.
 Professional analysts who work for investment companies considering
investing in the firm or advising others about investing.
 Individual investors deciding whether to invest in the firm.
 Common Size Statements

A common size financial statement is a

standardized version of a financial statement in
which all entries are presented in percentages.
A common size financial statement helps to compare
entries in a firm’s financial statements, even if the
firms are not of equal size.
How to prepare a common size financial statement?
For a common size income statement, divide each entry
in the income statement by the company’s sales.
For a common size balance sheet, divide each entry in
the balance sheet by the firm’s total assets.

7
8
9
4 Key Questions to Answer with Ratio
Analysis
• How liquid is the firm?
• Is management generating adequate
operating profits on the firm’s assets?
• How is the firm financing its assets?
• Are the stockholders receiving an adequate
return on their investment?
 How liquid is the firm?
• Measuring Liquidity Approach 1: comparing
liquid assets to short-term debt.

• Current Ratio = Current Assets/Current

Liabilities 2:1
• Acid-test Ratio = (Current Assets –
Inventory)/Current Liabilities 1:1
 How liquid is the firm?
• Measuring Liquidity Approach 2: How easily can
other current assets be converted into cash.
– Average Collection Period = Accounts Receivable/Daily
(Credit) Sales
• Accounts Receivable/(Sales/365)
– Accounts Receivable Turnover = (Credit) Sales/Accounts
Receivable
– Inventory Turnover = Cost of Goods Sold/Inventory
 Kmart and Wal-Mart’s Liquidity
Ratios
Question 1: How Liquid is the Firm?
Kmart
Approach 1: 2001 2000 1999 1998 1997
Current Ratio 2.01 2.00 2.12 2.28 2.15
Acid-test (Quick) Ratio 0.32 0.26 0.35 0.34 0.38
Approach 2:
Average Collection Period 0 0 0 0 0
Accounts Receivable Turnover #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!
Inventory Turnover 4.63 3.96 4.03 3.95 3.84

Question 1: How Liquid is the Firm?

Wal-Mart
Approach 1: 2001 2000 1999 1998 1997
Current Ratio 0.92 0.94 1.26 1.34 1.64
Acid-test (Quick) Ratio 0.18 0.18 0.24 0.20 0.19
Approach 2:
Average Collection Period 3.34 2.93 2.93 2.99 2.90
Accounts Receivable Turnover 109.33 124.39 124.52 122.23 125.65
Inventory Turnover 7.01 6.55 6.37 5.66 5.25
 Is management generating adequate
operating profits on the firm’s assets?

• Operating Return on Investment (OIROI)

– Operating Income/Total Assets, also:
– Operating Profit Margin x Total Asset Turnover
• Operating Profit Margin = Operating Income/Sales
– Operating Income = Pre-Tax Income plus interest expense, or
Pre-tax income minus interest, non-op
• Total Asset Turnover = Sales/Total Assets
– Affected by Accounts Receivable Turnover, Inventory Turnover,
Fixed Asset Turnover
– Fixed Asset Turnover = Sales/Net Fixed Assets; Net Fixed Assets =
Property, Plant, Equip, NET
 Kmart & Wal-Mart’s Operating
Profitability Ratios
Question 2: Is Management Generating Adequate Operating Profits on the Firm's Assets?
Kmart
2001 2000 1999 1998 1997
OIROI Component 1: Oper Profit Margin -0.1% 3.6% 3.2% 2.4% 2.5%
OIROI Component 2 : Total Asset Turnover 2.53 2.38 2.38 2.37 2.20
Oper. Income Return On Investmt (OIROI) -0.3% 8.6% 7.7% 5.8% 5.5%
Accounts Receivable Turnover #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!
Inventory Turnover 4.63 3.96 4.03 3.95 3.84
Fixed Asset Turvover 5.65 5.60 5.69 5.88 5.48

Question 2: Is Management Generating Adequate Operating Profits on the Firm's Assets?

Wal-Mart
2001 2000 1999 1998 1997
OIROI Component 1: Oper Profit Margin 5.9% 6.1% 5.8% 5.5% 5.4%
OIROI Component 2 : Total Asset Turnover 2.474 2.371 2.784 2.629 2.681
Oper. Income Return On Investmt (OIROI) 14.7% 14.4% 16.2% 14.3% 14.4%
Accounts Receivable Turnover 109.33 124.39 124.52 122.23 125.65
Inventory Turnover 7.01 6.55 6.37 5.66 5.25
Fixed Asset Turvover 4.72 4.64 5.36 5.05 5.22
How is the firm financing its assets?
• Debt Ratio = Total Liabilities/Total Assets
• Times-Interest-Earned = Operating
Income/Interest Expense
– Operating Income = Pre-Tax Income plus interest
expense, or Pre-tax income minus interest, non-op
(int exp for Kmart)
 Kmart & Wal-Mart’s Financing Ratios

Question 3: How is the Firm Financing Its Assets?

Kmart
2001 2000 1999 1998 1997
Debt Ratio 58.4% 58.3% 57.8% 52.7% 57.5%
Times-Interest-Earned Ratio -0.16 4.64 3.72 2.15 1.73

Question 3: How is the Firm Financing Its Assets?

Wal-Mart
2001 2000 1999 1998 1997
Debt Ratio 59.9% 63.3% 57.8% 59.2% 56.7%
Times-Interest-Earned Ratio 8.36 9.89 10.19 8.29 6.77
 Are the stockholders receiving an adequate
return on their investment?

• Return On Common Equity

– Net Income Available to Common
Stockholders(including EI&DO)/Total Common
Equity
– Total Common Equity = Total Shareholders’ Equity
– Preferred Stock
Kmart & Wal-Mart’s Return on Equity

Question 4: Are the Owners Receiving an Adequate Return on Their Investment?

Kmart
2001 2000 1999 1998 1997
Return on Common Equity -3.8% 6.4% 8.7% 4.6% -4.3%
Question 4: Are the Owners Receiving an Adequate Return on Their Investment?
Wal-Mart
2001 2000 1999 1998 1997
Return on Common Equity 20.1% 20.8% 21.0% 19.1% 17.8%
 DuPont Analysis of Return on
Common Equity (ROE)
• Breaks down company performance into operational and
financing components.
• ROE = (Net Profit Margin x Total Asset Turnover)/(1-Debt
Ratio), where
– Net Profit Margin = Net Income(available to common
stockholders including EI&DO)/Sales
– Total Asset Turnover = Sales/Total Assets
– Debt Ratio = Total Liabilities/Total Assets
• Net Profit Margin x Total Asset Turnover = Return on
Assets, which are the operating components.
• 1/(1-Debt Ratio) = measures impact of financial leverage
 How does Leverage work?

• Suppose we have an all equity-financed

firm worth $100,000. Its earnings this
year total $15,000.

ROE =
(ignore taxes for this example)
 How does Leverage work?

• Suppose we have an all equity-financed

firm worth $100,000. Its earnings this
year total $15,000.

ROE = 15,000 =15%

100,00
0
 How does Leverage work?

• Suppose the same $100,000 firm is

financed with half equity, and half 8% debt
(bonds). Earnings are still $15,000.

ROE =
 How does Leverage work?

• Suppose the same $100,000 firm is

financed with half equity, and half 8% debt
(bonds). Earnings are still $15,000.
ROE = 15,000 -=4,000
50,000
 How does Leverage work?

• Suppose the same $100,000 firm is

financed with half equity, and half 8% debt
(bonds). Earnings are still $15,000.
ROE = 15,000 -=4,000
22%
50,000
 Kmart & Wal-Mart’s DuPont Analysis

Kmart
ROE Components: 2001 2000 1999 1998 1997
Net Profit Margin -0.6% 1.1% 1.5% 0.8% -0.7%
Total Asset Turnover 2.53 2.38 2.38 2.37 2.20
Return on Assets -1.6% 2.7% 3.7% 1.8% -1.5%
1 - Debt Ratio 0.42 0.42 0.42 0.47 0.43
Return On Equity -3.8% 6.4% 8.7% 3.9% -3.6%

Wal-Mart
ROE Components: 2001 2000 1999 1998 1997
Net Profit Margin 3.3% 3.2% 3.2% 3.0% 2.9%
Total Asset Turnover 2.47 2.37 2.78 2.63 2.68
Return on Assets 8.1% 7.6% 8.9% 7.8% 7.7%
1 - Debt Ratio 0.40 0.37 0.42 0.41 0.43
Return On Equity 20.1% 20.8% 21.0% 19.1% 17.8%
 Caveats of Ratio Analysis
• Different Accounting Practices.
• Sometimes hard to pick an industry for
comparison.
• Seasonality in Operations.
 Using Financial Ratios
 Financial ratios provide a second method for standardizing
the financial information on the income statement and
balance sheet.
 A ratio by itself may have no meaning. Hence, a given ratio is
compared to:
a) ratios from previous years – time series analysis;
or
b) ratios of other firms in the same industry – cross-
sectional analysis.
 If the differences in the ratios are significant, more in-depth
analysis must be done.
 Financial Ratios

Question Category of Ratios Used

1. How liquid is the firm? Will it be Liquidity ratios
able to pay its bills as they
become due?
2. How has the firm financed the Capital structure ratios
purchase of its assets?
3. How efficient has the firm’s Asset management efficiency
management been in utilizing it ratios
assets to generate sales?
4. Has the firm earned adequate Profitability ratios
returns on its investments?
5. Are the firm’s managers creating Market value ratios
value for shareholders?
 Can a Firm Have Too Much Liquidity?

A high investment in liquid assets will enable

the firm to repay its current liabilities in a
timely manner.
However, an excessive investments in liquid
assets can prove to be costly as liquid assets
(such as cash) generate minimal return.
 Checkpoint 1
Evaluating Dell Computer Corporation’s (DELL) Liquidity
You work for a small company that manufactures a new memory storage
device. Computer giant Dell has offered to put the new device in their laptops
if your firm will extend them credit terms that allow them 90 days to pay.
Since your company does not have many cash resources, your boss has asked
that you look into Dell’s liquidity and analyze its ability to pay their bills on
time using the following accounting information for Dell and two other
computer firms (figures in thousands of dollars):
 Checkpoint 1

Compute and compare the current ratio, quick ratio,

accounts receivable turnover ratio and inventory
turnover ratio.
Average collection period on accounts receivable and
days’ sales in inventory are simply inverse of the
corresponding turnover ratios (multiplied by 365 to
convert fraction of a year into number of days)
Checkpoint 1
 Checkpoint 1: Check Yourself

Calculate HP’s inventory turnover ratio and days’ sales in

inventory. Why do you think this ratio is so much lower than
Dell’s inventory turnover ratio?
 Analysis
In 2009, the inventory turnover ratio is 11.29 for HP,
much slower compared to 47.71 for Dell.
Days’s sales in inventory is (365/11.29)=32.33 days
for HP while only (365/47.71)=7.65 days for Dell.
There are two reasons why HP has a lower turnover
of inventories relative to Dell:
HP sells computers out of inventory of computers while
Dell builds computers only when orders are received.
HP carries more parts inventory on hand than does Dell.
 II. Capital Structure Ratios

Capital structure refers to the way a firm

finances its assets.
Capital structure ratios address the
important question: How has the firm
financed the purchase of its assets?
We will use two ratios, [1] debt ratio and [2]
times interest earned ratio, to answer the
question.
 [1] Debt Ratio
Debt ratio measures the proportion of the firm’s assets
that are financed by borrowing or debt financing.

Example: H.J. Boswell, Inc.,.

2009: $1012.50/$1764.00=57.40%
2010: $1059.75/$1971.00 =53.77%
The firm financed 57.40% of its assets with debt in 2009;
53.77% in 2010.
The debt ratios can be directly read from the total liabilities
in the common size statement.
 [2] Times Interest Earned Ratio
Times Interest Earned Ratio (interest coverage
ratio) measures the ability of the firm to service
its debt or repay the interest on debt.

Example: H.J. Boswell, Inc.,.

2010: $382.50/$67.50 =5.67 times
The firm can pay its total interest expense 5.67 times
or interest consumed 1/5.67th or 17.65% of its EBIT.
Thus, even if the EBIT shrinks by 82.35% (100-17.65),
the firm will still be able to pay its interest expense.
 Checkpoint 2
Comparing the Financing Decisions of Home Depot (HD) and Lowes Corporation
(LOW)
You inherited a small sum of money from your grandparents and currently have it in a savings
account at your local bank. After enrolling in your first finance class in business school you have
decided that you would like to begin investing your money in the common stock of a few
companies. The first investment you are considering is stock in either Home Depot or Lowes. Both
firms operate chains of home improvement stores throughout the United States and other parts
of the world.
In your finance class you learned that an important determinant of the risk of investing in a firm’s
stock is driven by the firm’s capital structure, or how it has financed its assets. In particular, the
more money the firm borrows, the greater is the risk that the firm may become insolvent and
bankrupt. Consequently, the first thing you want to do before investing in either company’s stock
is to compare how they financed their investments. Just how much debt financing have the two
firms used?
 Checkpoint 2: Check Yourself

What would be Home Depot’s times interest earned ratio if interest payments
remained the same, but net operating income dropped by 80% to only
$1.9346 billion? Similarly if Lowes’ net operating income dropped by 80%,
what would its times interest earned ratio be?
Solution: Times Interest Earned (TIE) = EBIT ÷ Interest Expense
TIE (Home Depot) = [$9.637*(1-80%) billon]/$0.392 billion
= $1.9346 ÷ $0.392 = 4.94 times
TIE (Lowes) = [$5.52*(1-80%) billion]/$0.154 billion
= $1.03 billion÷$0.154 billion = 6.69 times
III. Asset Management Efficiency Ratios

Asset management efficiency ratios measure

a firm’s effectiveness in utilizing its assets to
generate sales.
They are commonly referred to as turnover
ratios as they reflect the number of times a
particular asset account balance turns over
during a year.
 Asset Management Efficiency Ratios

①Total Asset Turnover Ratio represents the

amount of sales generated per dollar
invested in firm’s assets.

②Fixed asset turnover ratio measures firm’s

efficiency in utilizing its fixed assets (such as
property, plant and equipment).
 Asset Management Efficiency Ratios
We could similarly compute the turnover ratio
for other assets.

We had earlier computed, similarly, the

receivables turnover against credit sales and
inventory turnover against costs of goods sold,
which measure firm effectiveness in managing
its investments in accounts receivables and
inventories.
 Asset Management Efficiency Ratios for
Boswell, Inc.
The following grid summarizes the efficiency
of Boswell’s management in utilizing its assets
to generate sales in 2010.
Turnover Boswell Peer Group Assessment
Ratio
Total Assets 1.37 1.15 Good
Fixed 2.03 1.75 Good
Assets
Receivables 16.67 14.60 Good
Inventory 5.36 7.0 Poor
 IV. Profitability Ratios
 Profitability ratios address a very fundamental question: Has the firm
earned adequate returns on its investments?
 We answer this question by analyzing the firm’s profit margin, which
predict the ability of the firm to control its expenses, and the firm’s rate of
return on investments.
 Two fundamental determinants of firm’s profitability and returns on
investments are the following:
 Cost Control
 Is the firm controlling costs and earning reasonable profit margin?
 Efficiency of asset utilization
 Is the firm efficiently utilizing the assets to generate sales?
 [i] Profit margins

①Gross profit margin = Gross profits/Sales. It shows how well the firm’s
management controls its expenses to generate profits.
②Operating profit margin=Operating income (EBIT)/Sales. It measures
how much profit is generated from each dollar of sales after accounting
for both costs of goods sold and operating expenses. It thus also
indicates how well the firm is managing its income statement.
③Net profit margin=Net income/Sales. It measures how much income is
generated from each dollar of sales after adjusting for all expenses
(including income taxes).
 They can be directly read from the common size income statement as
gross profit, EBIT, and net income.
 For Bosewell, they are 25%, 14.17%, and 7.58%, respectively.
 [ii] Returns on investments

①Operating Return on Assets = EBIT/Total Assets. It is the

summary measure of operating profitability, which takes into
account both the management’s success in controlling
expenses, contributing to profit margins, and its efficient use
of assets to generate sales.
A combination of operating profit margin and total asset turn over.
[=(EBIT/Sales)x(Sales/Total Assets)]
Bosewell 2010:
Operating return on assets=$382.50/$1971.00=19.41%.
Operating profit margin = $382.50/$2700=14.17%.
Total asset turnover = $2700/$1971=1.37.
Operating return on assets also =14.17%x1.37=19.41%.
Return on the Owner’s Investment

② Return on Equity (ROE) ratio measures the accounting

return on the common stockholders’ investment,
Return on equity =Net income/Common equity
 Bosewell 2010 Return on
equity=$204.75/$911.25=22.47%.
 Note common equity includes both common stock plus
the firm’s retained earnings.
Using the DuPont Method for Decomposing
the ROE ratio

 DuPont method analyzes the firm’s ROE by decomposing it into

three parts: profitability, efficiency and an equity multiplier.
ROE = Profitability × Efficiency × Equity Multiplier
= (Net Profit margin) x (Total Asset Turnover) x (Equity
Multiplier)
Equity multiplier =(Total Assets/Total Equity)=1/(1-
Debt ratio), captures the effect of the firm’s use of
debt financing on its return on equity. The equity
multiplier increases in value as the firm uses more
debt.
 Decomposing Bosewell’s ROE
 The following table shows why Boswell’s return on equity was higher than its
peers.

Return Net Total Equity

on Equity Profit Asset Multiplier
Margin Turnover
 The table H. J.
suggests 22.5%had a higher
that Boswell 7.6%ROE as it1.37
was able to 2.16
generate
more salesBoswell,
from its assets (1.37 versus 1.15 for peers) and used more leverage
(2.16 versus 1.54).
Inc.
Peer 18.0% 10.2% 1.15 1.54
Group
 Checkpoint 3
Evaluating the Operating Return on Assets Ratio for Home Depot (HD) and
Lowes (LOW)
In Checkpoint 4.2 we evaluated how much debt financing Home Depot and Lowes
used. We continue our analysis by evaluating the operating return on assets (OROA)
earned by the two firms. Calculate the net operating income each firm earned during
2007 relative to the total assets of each firm using the information :
Checkpoint 3
 Checkpoint 3: Check Yourself

If Home Depot were able to raise its total asset turnover ratio to
2.5 while maintaining its current operating profit margin, what
would happen to its operating return on assets?
 Solution
 The operating return on assets ratio for a firm is determined by two factors: cost
control and efficiency of asset utilization. It is expressed by equation 4-13a. Here the
focus is on asset utilization i.e. improvement in total asset turnover ratio.
 Operating Return on Assets (OROA)
= Total Asset Turnover × Operating Profit Margin
 Before = 1.74 × 10.65% = 18.53%
 Now = 2.5 × 10.65% = 26.63%
 An improvement in total asset turnover ratio has a favorable impact on Home Depot’s
operating return on assets (OROA).
 If Home Depot wants to increase its OROA more, it should focus on cost control that
will help improve the net operating profit.
 V. Market Value Ratios

Market value ratios address the question, how

are the firm’s shares valued in the stock market?
①Price-Earnings Ratio (PE ratio)=Market price per
share/earnings per share, indicates how much
investors are currently willing to pay for $1 of
reported earnings.
②Market-to-Book Ratio=Market price per share/book
value per share, measures the relation between the
market value and the accumulated investment in the
firm’s equity.
 Examples: Bosewell PE ratios
• Bosewell 2010:

 What will be the PE ratio for 2009 if we assume the firm’s stock was selling
for $22 per share at a time when the firm reported a net income of
$217.75 million, and the total number of common shares outstanding are
90 million?
 Earnings per hare (EPS)= $217.75 million ÷ 90 million = $2.42
 PE ratio = $22 ÷ $2.42 = 9.09
 The investors were willing to pay $9.09 for every dollar of earnings per
share that the firm generated.
 Bosewell market-to-book ratios
 2010:

 What will be the market-to-book ratio for 2009 given that the current
market price of the stock is $22 and the firm has 90 million shares
outstanding?
 Book Value per Share = 751.50 million ÷ 90 million = $8.35 per share
 Market-to-Book Ratio= $22 ÷ $8.35 = 2.63 times
 Checkpoint 4
Comparing the Valuation of Dell (DELL) to Apple
(APPL) Using Market Value Ratios
The following information on Dell and Apple was gathered on April 9, 2010:
Checkpoint 4
 Checkpoint 4.4: Check Yourself

What price per share for Dell would it take to increase the firm’s
price-to-earnings ratio to the level of Apple?
 Step 2: Decide on a Solution Strategy
 PE=Price/EPS  Price=PE x EPS

 Let PE=26.54 (Apple). EPS=0.73.

 Price=26.53x0.73=19.47.
 The price for Dell has to increase from 15.56
to 19.47 to match Apple’s PE ratio for the
same earnings per share.
Summing up the Financial Analysis of Boswell

 Liquidity: With the exception of inventory turnover ratio, liquidity

ratios were adequate to good. The next step will be to see how
inventory management can be improved.
 Financial Leverage: The firm uses more debt than its peers, which
exposes the firm to a higher degree of financial risk or potential
default on its debt in the future.
 Profitability: H.J. Boswell had favorable net operating income
despite lower profit margins, largely due to its higher asset
turnover ratio. The return on equity was also higher than the
peer group due to use of more debt.
 Market Value Ratios: These ratios suggest that the market is
pleased with the firm as indicated by higher stock valuations.
 Selecting a Performance Benchmark
There are two types of benchmarks that are
commonly used:
1. Trend Analysis – involves comparing a firm’s financial
statements over time (time series analysis).
2. Peer Group Comparisons – involves comparing the
subject firm’s financial statements with those of
similar, or “peer” firms. The benchmark for peer
groups typically consists of firms from the same
industry or industry average financial ratios. (Cross-
sectional analysis).
Trend Analysis
Financial Analysis of the Gap, Inc., June 2009
 EDWARD ALTMAN’S Z-SCORE

Edward Altman’s Z-Score

The Z-Score formula for predicting bankruptcy was published in 1968 by Edward
Altman , who was at the time, an Assistant Professor of Finance at New York
University. The formula may be used to predict the probability that a firm will go into
bankruptcy within two years. Z-Scores are used to predict corporate defaults and an
easy-to-calculate control measure for the financial distress status of companies in
academic studies. The Z-Score uses multiple corporate income and balance sheet
values to measure the financial health of a company.

In its initial test, the Altman Z-Score was found to be 72% accurate in predicting
bankruptcy two years prior to the event. In a series of subsequent tests covering three
different time periods over the next 31 years (up until 1999), the model was found to
be approximately 80-90% accurate in predicting bankruptcy one year prior to the
event.

For more information, see http://en.wikipedia.org/wiki/Altman_Z-score.

• Original Z-Score Component Definitions
WC - Current asset – Current liabilities
T1 = Working Capital / Total Assets
RE - Accumulated profit
T2 = Retained Earnings / Total Assets
EBIT - Profit before interest and tax
T3 = EBIT / Total Assets
Share price X No. of shares
T4 = Market Value of Equity / Total Liabilities

T5 = Sales/ Total Assets

Z-Score estimated for Public Companies

Z-Score Bankruptcy Model

Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + 0.999T5

Zones of Discrimination

Z > 2.99 “Safe” Zones

1.8 < Z < 2.99 “Grey” Zones

Z < 1.80 “Distress” Zones

Z-Score estimated for Private Firms

Z-Score Bankruptcy Model

Z = 0.717T1 + 0.847T2 + 3.107T3 + 0.420T4 + 0.998T5

Zones of Discrimination

Z' > 2.9 “Safe” Zone

1.23 < Z' < 2. 9 “Grey” Zone

Z' < 1.23 “Distress” Zone

 Z-Score estimated for Non-Manufacturer Firms

Z-Score Bankruptcy Model

Z = 6.56T1 + 3.26T2 + 6.72T3 + 1.05T4

Zones of Discrimination

Z > 2.6 “Safe” Zone

1.1 < Z < 2. 6 “Grey” Zone

Z < 1.1 “Distress” Zone

 The Limitations of Ratio Analysis
1. Picking an industry benchmark can sometimes be
difficult.
2. Published peer-group or industry averages are
not always representative of the firm being
analyzed.
3. An industry average is not necessarily a desirable
target or norm.
4. Accounting practices differ widely among firms.
5. Many firms experience seasonal changes in their operations.
6. Financial ratios offer only clues. We need to analyze the numbers in order to
fully understand the ratios.
7. The results of financial analysis are dependent on the quality of the financial
statements.
 A summary of 17 ratios

I. Liquidity
① Current ratio
② Acid-test (quick) ratio
③ Accounts receivable turnover ratio
④ Average collection period on accounts receivable
⑤ Inventory turnover ratio
⑥ Days’ sales in inventory
II. Capital structure
① Debt ratio
② Times interest earned ratio (interest coverage ratio)
III. Asset management efficiency
① Total asset turnover ratio
② Fixed asset turnover ratio
IV. Profitability
① Gross/operating/net profit margin
② Operating return on assets (ROA)
③ Return on equity (ROE)
V. Market value
① Price to earnings ratio (PE)
② Market-to-book ratio
 Economic Value Added (EVA)

• Measures a firm’s economic profit, rather than

accounting profit
• Recognizes a cost of equity and a cost of debt
• EVA = (r-k) X C = ( 12% - 8% ) X 20,000,000
where:
r = Operating return on assets - ROA
k = Total cost of capital
C = Amount of capital (Total Assets) invested in the firm

Pearson Prentice Hall Foundations of Finance 4 - 77

 Limitations of Ratio Analysis

• Difficulty in identifying industry categories or finding peers

• Published peer group or industry averages are only
approximations
• Accounting practices differ among firms
• Financial ratios can be too high or too low
• Industry averages may not provide a desirable target ratio
or norm
• Use of average account balances to offset effects of
seasonality

Pearson Prentice Hall Foundations of Finance 4 - 78