Mod 3 Financial Statement Analysis

Common size balance sheet

Compute all accounts as a percentage of total assets

Common size income statement

Compute all accounts as a percentage of total revenue

Liquidity ratios

Ability to pay short term obligations

• current ratio

• Quick ratio

• Cash ratio

• Operating cash flow ratio

Current ratio

Current assets / Current liabilities

The higher, the ratio, the more favorable, the liquidity

Quick ratio (Acid test ratio)

(Cash + Marketable securities + Accounts receivable) / Current liabilities

This ratio is more useful when inventory percentage is high

Cash ratio

Cash and cash equivalent / Current liabilities

Considered the most conservative liquidity ratio

Used more often to evaluate a company in financial distress because at that time It is very hard for that company to convert accounts receivables and inventory into cash in a short period of time.

Trade-off with having high amounts of cash

Creditors like to see high amounts of cash, but cash and near cash have lower returns compared to other assets

Operating cash flow ratio

Cash flow from operations / Current liabilities

• current ratio

• Quick ratio

• Cash ratio

• Operating cash flow ratio

Lenders often look at these metrics during the loan approval process

Solvency ratios (Leverage ratios)

• Total debt ratio

• Equity multiplier

• Interest coverage ratio

Total debt ratio

(Total assets - Total stockholders equity) / Total assets

In some versions, the total debt does not include certain items such as accounts, payable, and accrued expenses. Must investigate whether to use the broad version of debt or the narrow version.

Equity multiplier

Total assets / Total stockholders equity

This formula indicates how much equity financing a company uses

Benefits of using debt

• Interest tax shield - help a company lower its taxes because interest payments are tax deductible

• Boost returns for existing shareholders

The cost of debt financing is usually

Lower than equity financing

Interest coverage ratio

EBIT / Interest expense

Tell us how easily a company can pay its interest expenses with its earnings

The interest coverage ratio should be at least 1.5

Asset turnover ratios

• Inventory turnover

• Days sales in inventory

• Total asset turnover

Inventory turnover

Cost of good sold / Inventory

Which inventory to be used?

• Beginning inventory

• Ending inventory

• Average in inventory

Normally retailers favor

High inventory turnover because holding inventory incurs high holding costs such as storage costs, Insurance, and Opportunity cost.

A low inventory turnover may reflect weak sales or too much inventory

Days sales in inventory (DSI)

365 days / Inventory Turnover

It measures the average time a company can turn its inventory into sales.

If the DSI is short, that means the company can turn its inventory into cash quickly. The inventory is more liquid.

Total asset turnover

Total revenues / Total assets

The higher the ratio, the more efficient a company is at turning its assets into revenues

Profitability Ratios

• Gross profit margin

• Net profit margin

• Return on assets (ROA)

• Return on equity (ROE)

• The Dupont identity

Gross profit margin

Gross profit / Total revenues

Or

Total revenues - Cost of good sold / Total revenues

Net profit margin

Net income / Total revenue

Is the most widely used metric of profitability.

When the net profit margin is high we know the company is good generating profits from its sales and controlling its costs.

Return on assets (ROA)

Net income / Total assets

Return on equity (ROE)

Net Income / Total Equity

As long as a firm has debt

ROE will always be higher than ROA

The DuPont Identity

ROE = Net Profit Margin * Total Assets Turnover * Equity Multiplier

How to Improve Net Profit Margin

• increasing prices

• reduce costs

Market Value Ratios

• Price to earnings (P/E) Ratio

• Market capitalization

P/E Ratio

Current Share Price / Earnings per share

Tells us how much investors are willing to pay for each dollar of current earnings

When the firms earnings are negative you can no longer use the P/E ratio because it no longer makes any sense

Market Capitalization (market cap)

= current price per share * shares outstanding

Large Cap Firm

Market Cap > $10billion

Mid-cap

$2B - $10B

Small Cap

$300M - $2B

T/F No matter the circumstances, EBIT can never be the same as operating income

False: EBIT can be the same as operating income when there is no other income

Suppose you invested $10,000 with an interest rate of 6%, What is the principal payment after one year?

$10,000

The principal payment is the initial $10,000 that was used to invest

Asset Coverage Ratio Explained

The asset coverage ratio is a financial metric that tells you how well a company can repay its debts using its tangible assets—especially if earnings fall short. It’s a way to assess a company’s solvency and risk profile, particularly from the perspective of lenders and investors.