Week 6

Financial Statement Analysis

Tools
Timothy R. Mayes, Ph.D.
Metropolitan State University of Denver

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Analysis Tools Covered this week

• this week we will see:

• How to calculate many financial ratios
• How to use financial ratios to make predictions about potential
bankruptcy
• How to calculate the economic profit (as opposed to net income)
that a firm earned in a period

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Financial Ratios

• Financial ratios are simply comparisons of two financial statement

items
• These comparisons help us to draw conclusions about the financial health of
the firm that aren’t immediately obvious by looking at the raw values (e.g.,
net income may be positive, but what matters is how large it is relative to
sales, assets, or equity)
• We will calculate five categories of ratios:
• Liquidity ratios
• Efficiency ratios
• Leverage ratios
• Coverage ratios
• Profitability ratios
© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Liquidity Ratios

• Liquidity ratios describe the ability of a firm to meets its short-term obligations
by comparing current assets to current liabilities
• Current assets will be converted to cash which will then be used to retire current
liabilities

Current Assets
Current Ratio 
Current Liabilities
Current Assets  Inventories
Quick Ratio 
Current Liabilities
• For both of these ratios, higher values are indicative of a higher probability of being able
to pay off short-term debts

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Liquidity Ratios

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Efficiency Ratios

• Efficiency ratios, also called asset management ratios, provide information about how
well the company is using its assets to generate sales

Cost of GoodsSold
Inventory Turnover 
Inventory
Credit Sales
Accounts Receivable Turnover 
Accounts Receivable
Accounts Receivable
Average Collection Period 
Credit Sales  360
Sales
Fixed Asset Turnover 
Net Fixed Assets
Sales
Total Asset Turnover 
Total Assets
© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Efficiency Ratios – Inventory Turnover

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Efficiency Ratios – Receivables and payables

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Efficiency Ratios – Fixed Assets Turnover

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Leverage Ratios

• Leverage ratios describe the degree to which the firm uses debt in its capital structure

Total Liabilities
Total Debt Ratio 
Total Assets
Long-term Debt
Long-term Debt Ratio 
Total Assets
Long-term Debt
LTD to Total Capitalization 
Long  term Debt  Total Equity
Total Liabilities
Debt to Equity 
Total Equity
Long-term Debt
LTD to Equity 
Total Equity

• Generally, lower leverage ratios are preferred though a reasonable amount of debt is
usually considered to be a good thing
© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Liquidity Ratios – Debt to Equtiy

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Coverage Ratios

• Coverage ratios describe the quantity of funds available to “cover” certain expenses,
particularly interest expense (though this is not the only one)

EBIT
Times Interest Earned 
Interest Expense
EBIT  Noncash Expenses
Cash Coverage Ratio 
Interest Expense

• We generally prefer higher coverage ratios as that indicates a level of debt that is easy for
the firm to service
© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Coverage Ratios

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Profitability Ratios

• Profitability ratios measure how profitable a firm is relative to sales, total assets, or equity

Gross Profit
Gross Profit Margin 
Sales
Net Operating Profit
Operating Profit Margin 
Sales
Net Income
Net Profit Margin 
Sales
Net Income
Return on Assets  ROA  
Total Assets
Net Income
Return on Equity  ROE  
Total Equity
Net Income
Return on Common Equity 
Common Equity
• Without exception, higher profitability ratios are preferred over lower ones
© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Profitability Ratios

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Using Financial Ratios

• Financial ratios can be analyzed in three ways:

• Trend Analysis
• Comparing to Industry Averages
• Compared to Company Goals and Debt Covenants
• Additionally, ratios can be used in valuation
analysis and for financial distress prediction

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Comparing Industry Trends

When looking at year over year financials, it doesn't always give you a clear picture.

You need to compare industry averages

Are published by Risk Management Association and Standard and Poor’s

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Open week 7 – Financial Ratios Exercise Data

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 IF Function

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
IF Using Excel

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
IF Using Excel

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 IF Using Excel – In Class Exercise

• Open If Function Exercise in D2L

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Week 6 Assignments

Week 6 Assignment – submit to drop box

Week 6 Quiz

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
DuPont Analysis

• DuPont analysis refers to a method of decomposing the return on equity into its
components to better understand the ROE and why it may have changed (or why it
is different than that of some other firm)

• There are two versions of DuPont analysis:

Net Income Sales Total Assets

DuPont ROE   
Sales Total Assets Total Equity

EBIT EBT Net Income Sales Total Assets

Extended DuPont ROE     
Sales EBIT EBT Total Assets Total Equity

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Using Financial Ratios

• Financial ratios can be analyzed in three ways:

• Trend Analysis
• Comparing to Industry Averages
• Compared to Company Goals and Debt Covenants

• Additionally, ratios can be used in valuation analysis and

for financial distress prediction

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Financial Distress Prediction
(Z-Scores)
• In 1968, Edward Altman first used discriminant analysis to
classify firms into one of three categories: bankruptcy
predicted, possible bankruptcy, and no financial distress
• Today, this model would be considered to be a “machine learning”
model alongside other classification methods (e.g., k-means or support
vector machines)
• We covered two Z-Score models:
• The Original Z-Score Model
• The Z-Score Model for Private Firms

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Original Z-Score Model

• The original Z-Score model was for publicly traded firms:

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Z-Score Model for Private Firms

• Altman also estimated a model for privately held firms to allow for
the fact that you cannot calculate the market value of equity for a
private firm
• This model is very similar, but the coefficients changed (note that X 4
has been redefined):

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Financial Distress Prediction
(Z-Scores)
• Altman reports the model is 80-90% accurate if we use a cut off
point of 2.675.
Group 1: Z<1.81(1.21) = Bankruptcy predicted within one year
Group 2: 1.81<Z<2.675 (1.23<Z<2.90) = Financial distress, possible
bankruptcy
Group 3: z>2.675 (>2.90) = No financial distress predicted

© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.