5. GIT - Principles of Managerial Finance (13th Edition). Cap.3 (Pág.85-90 )

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Why This Chapter Matters to You

In your professional lifeACCOUNTING You need to understand the stockholders’ report andpreparation of the four key financial statements; how firms consolidateinternational financial statements; and how to calculate and interpretfinancial ratios for decision making.

INFORMATION SYSTEMS You need to understand what data areincluded in the firm’s financial statements to design systems that willsupply such data to those who prepare the statements and to those inthe firm who use the data for ratio calculations.

MANAGEMENT You need to understand what parties are interested inthe stockholders’ report and why; how the financial statements will beanalyzed by those both inside and outside the firm to assess variousaspects of performance; the caution that should be exercised in usingfinancial ratio analysis; and how the financial statements affect thevalue of the firm.

MARKETING You need to understand the effects your decisions willhave on the financial statements, particularly the income statement andthe statement of cash flows, and how analysis of ratios, especially

those involving sales figures, will affect the firm’s decisions about levelsof inventory, credit policies, and pricing decisions.

OPERATIONS You need to understand how the costs of operations arereflected in the firm’s financial statements and how analysis of ratios,particularly those involving assets, cost of goods sold, or inventory,may affect requests for new equipment or facilities.

A routine step in personal financialplanning is to prepare and analyze

personal financial statements, so that you can monitor progress toward your financial goals. Also, you need to understand and analyze corpo-rate financial statements to build and monitor your investment portfolio.

In your personal life

Learning Goals

Review the contents of thestockholders’ report and theprocedures for consolidatinginternational financial statements.

Understand who uses financial

ratios and how.Use ratios to analyze a firm’sliquidity and activity.

Discuss the relationship betweendebt and financial leverage andthe ratios used to analyze a firm’sdebt.

Use ratios to analyze a firm’sprofitability and its market value.

Use a summary of financial ratiosand the DuPont system of analysisto perform a complete ratioanalysis.

LG 6

LG 5

LG 4

LG 3

LG 2

LG 1

3Financial Statements

and Ratio Analysis

56



CHAPTER 3 Financial Statements and Ratio Analysis 85

Profitability

Bartlett’s profitability relative to sales in 2012 was better than the average com-pany in the industry, although it did not match the firm’s 2010 performance.Although the gross profit margin was better in 2011 and 2012 than in 2010,

higher levels of operating and interest expenses in 2011 and 2012 appear to havecaused the 2012 net profit margin to fall below that of 2010. However, BartlettCompany’s 2012 net profit margin is quite favorable when compared to theindustry average.

The firm’s earnings per share, return on total assets, and return on commonequity behaved much as its net profit margin did over the 2010–2012 period.Bartlett appears to have experienced either a sizable drop in sales between 2010and 2011 or a rapid expansion in assets during that period. The exceptionallyhigh 2012 level of return on common equity suggests that the firm is performingquite well. The firm’s above-average returns—net profit margin, EPS, ROA, andROE—may be attributable to the fact that it is more risky than average. A lookat market ratios is helpful in assessing risk.

Market

Investors have greater confidence in the firm in 2012 than in the prior 2 years, asreflected in the price/earnings (P/E) ratio of 11.1. However, this ratio is below theindustry average. The P/E ratio suggests that the firm’s risk has declined butremains above that of the average firm in its industry. The firm’s market/book(M/B) ratio has increased over the 2010–2012 period, and in 2012 it exceeds theindustry average. This implies that investors are optimistic about the firm’s futureperformance. The P/E and M/B ratios reflect the firm’s increased profitabilityover the 2010–2012 period: Investors expect to earn high future returns as com-pensation for the firm’s above-average risk.

In summary, the firm appears to be growing and has recently undergone anexpansion in assets, financed primarily through the use of debt. The 2011–2012period seems to reflect a phase of adjustment and recovery from the rapid growthin assets. Bartlett’s sales, profits, and other performance factors seem to be growingwith the increase in the size of the operation. In addition, the market response tothese accomplishments appears to have been positive. In short, the firm seems tohave done well in 2012.

DUPONT SYSTEM OF ANALYSIS

The DuPont system of analysis is used to dissect the firm’s financial statementsand to assess its financial condition. It merges the income statement and balancesheet into two summary measures of profitability, return on total assets (ROA)and return on common equity (ROE). Figure 3.2 (see page 88) depicts the basicDuPont system with Bartlett Company’s 2012 monetary and ratio values. Theupper portion of the chart summarizes the income statement activities; the lowerportion summarizes the balance sheet activities.

DuPont Formula

The DuPont system first brings together the net profit margin, which measuresthe firm’s profitability on sales, with its total asset turnover, which indicates how

DuPont system of analysisSystem used to dissect thefirm’s financial statements andto assess its financial condition.



S u m m

a r y o f B a r t l e t t C o m p a n y R a t i o s ( 2 0 1 0 –

2 0 1 2 ,

I n c l u d i n g 2 0 1 2 I n d u s t r y A v e r a g e s )

E v a l u a

t i o n

d

I n d u s t r y

C r o s s -

Y e a r

A v e r a g e

S e c t i o n a l

T i m e - S e r i e s

R a t i o

F o r m u

l a

2 0 1 0 a

2

0 1 1 b

2 0 1 2 b

2 0 1 2 c

2 0 1 2

2 0 1 0 – 2

0 1 2

O v e r a

l l

L i q u

i d i t y

C u r r e n t r a t i o

2 . 0

4

2

. 0 8

1 . 9

7

2 . 0

5

O K

O K

O K

Q u i c k ( a c i d - t e s t ) r a t i o

1 . 3

2

1

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1

1 . 4

3

O K

G o o d

G o o d

A c t i v

i t y

I n v e n t o r y t u r n o v e r

5 . 1

5

. 7

7 . 2

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G o o d

G o o d

G o o d

A v e r a g e c o l l e c t i o n p e r

i o d

4 3 . 9

d a y s

5 1

. 2 d a y s

5 9 . 7

d a y s

4 4 . 3

d a y s

P o o r

P o o r

P o o r

A v e r a g e p a y m e n t p e r i o d

7 5 . 8

d a y s

8 1

. 2 d a y s

9 5 . 4

d a y s

6 6 . 5

d a y s

P o o r

P o o r

P o o r

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

0 . 9

4

0

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0 . 8

5

0 . 7

5

O K

O K

O K

D e b

t

D e b t r a t i o

3 6 . 8

%

4 4

. 3 %

4 5 . 7

%

4 0 . 0

%

O K

O K

O K

T i m e s i n t e r e s t e a r n e d

r a t i o

5 . 6

3

. 3

4 . 5

4 . 3

G o o d

O K

O K

F i x e d - p a y m e n t c o v e r a

g e r a t i o

2 . 4

1

. 4

1 . 9

1 . 5

G o o d

O K

G o o d

P r o

f i t a b i l i t y

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

3 1 . 4

%

3 3

. 3 %

3 2 . 1

%

3 0 . 0

%

O K

O K

O K

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

i n

1 4 . 6

%

1 1

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1 3 . 6

%

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O K

G o o d

N e t p r o f i t m a r g i n

8 . 2

%

5

. 4 %

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%

6 . 2

%

G o o d

O K

G o o d

E a r n i n g s a v a i l a b l e f o r c o m m o n

s t o c k h o l d e r s

S a l e s

O p e r a t i n g p r o f i t s

S a l e s

G r o s s p r o f i t s

S a l e s

E a r n i n g s b e f o r e i n t e r e s t a n d t

a x e s +

L e a s e p a y m e n t s

I n t . +

L e a s e p a y . +

5 ( P r i n . + P

r e f . d i v . ) *

3 1 > ( 1 -

T ) 4 6

E a r n i n g s b e f o r e i n t e r e s t a n d t a x

e s

I n t e r e s t

T o t a l l i a b i l i t i e s

T o t a l a s s e t s

S a l e s


A c c o u n t s p a y a b l e

A v e r a g e p u r c h a s e s p e r d a y

A c c o u n t s r e c e i v a b l e

A v e r a g e s a l e s p e r d a y

C o s t o f g o o d s s o l d

I n v e n t o r y

C u r r e n t a s s e t s -

I n v e n t o r y

C u r r e n t l i a b i l i t i e s

C u r r e n t a s s e t s

C u r r e n t l i a b i l i t i e s

T A B L E

3 .

8

86



E v a

l u a

t i o n

d

I n d u s t r y

C r o s s -

Y e a r

A v e r a g e

S e c t i o n a

l

T i m e - S e r i e s

R a t i o

F o r m u

l a

2 0 1 0 a

2

0 1 1 b

2 0 1 2 b

2 0 1 2 c

2 0 1 2

2 0 1 0 – 2

0 1 2

O v e r a l l

P r o

f i t a b i l i t y ( c o n

t . )

E a r n i n g s p e r s h a r e ( E P

S )

$ 3 . 2

6

$ 1

. 8 1

$ 2 . 9

0

$ 2 . 2

6

G o o d

O K

G o o d

R e t u r n o n t o t a l a s s e t s

( R O A )

7 . 8

%

4

. 2 %

6 . 1

%

4 . 6

%

G o o d

O K

G o o d

R e t u r n o n c o m m o n e q

u i t y

( R O E )

1 3 . 7

%

8 . 5

%

1 2 . 6

%

8 . 5

%

G o o d

O K

G o o d

M a r k e t

P r i c e / e a r n i n g s ( P / E ) r a

t i o

1 0 . 5

1 0

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1 1 . 1

1 2 . 5

O K

O K

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t i o

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O K

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O K

a C a l c u l a t e d f r o m d a t a n o

t i n c l u d e d i n t h i s c h a p t e r .

b C a l c u l a t e d b y u s i n g t h e f i n a n c i a l s t a t e m e n t s p r e s e n t e d i n T a b l e s 3 . 1 a n d 3 . 2 .

c O b t a i n e d f r o m s o u r c e s n

o t i n c l u d e d i n t h i s c h a p t e r .

d S u b j e c t i v e a s s e s s m e n t s b

a s e d o n d a t a p r o v i d e d .

e T h e m a r k e t p r i c e p e r s h a r e a t t h e e n d o f 2 0 1 1 w a s $ 1 8 . 0 6 .

M a r k e t p r i c e p e r s h a r e o f c o m m

o n s t o c k

B o o k v a l u e p e r s h a r e o f c o m m o n s t o c k

M a r k e t p r i c e p e r s h a r e o f c o m m

o n s t o c k

E a r n i n g s p e r s h a r e

E a r n i n g s a v a i l a b l e f o r c o m m o n

s t o c k h o l d e r s

C o m m o n s t o c k e q u i t y

E a r n i n g s a v a i l a b l e f o r c o m m o n s t o c k h o l d e r s


E a r n i n g s a v a i l a b l e f o r c o m m o n s t o c k h o l d e r s

N u m b e r o f s h a r e s o f c o m m o n s t o c k o u t s t a n d i n g

87



88 PART 2 Financial Tools

Sales$3,074,000

minus

Cost of Goods Sold$2,088,000

minus

divided by

OperatingExpenses$568,000 I n

c o m e

S t a t e m e n t

minusInterest Expense$93,000

minus

Taxes$94,000

minus

Preferred Stock

Dividends$10,000

Earnings Available

for CommonStockholders$221,000 Net Profit

Margin7.2%

Sales$3,074,000

divided by

multipliedby

multipliedby

Sales$3,074,000

Total Asset Turnover

0.85

Common Stock Equity

$1,754,000

Total Assets$3,597,000

Return onCommon

Equity (ROE)12.6%

plusdivided by

TotalLiabilities

$1,643,000 FinancialLeverage

Multiplier (FLM)2.06

Return onTotal Assets

(ROA)6.1%

Total Liabilitiesand Stockholders’

Equity = Total Assets

$3,597,000

Stockholders’Equity

$1,954,000

Current Assets

$1,223,000

plus

Net Fixed Assets

$2,374,000

Current Liabilities$620,000

plus

Long-TermDebt

$1,023,000

B a l a n c e

S h e e t

FIGURE 3.2

DuPont System of AnalysisThe DuPont system of analysis with application to Bartlett Company (2012)



efficiently the firm has used its assets to generate sales. In the DuPont formula,the product of these two ratios results in the return on total assets (ROA):

Substituting the appropriate formulas into the equation and simplifying results inthe formula given earlier,

When the 2012 values of the net profit margin and total asset turnover forBartlett Company, calculated earlier, are substituted into the DuPont formula, theresult is

This value is the same as that calculated directly in an earlier section (page 81).

The DuPont formula enables the firm to break down its return into profit-on-sales and efficiency-of-asset-use components. Typically, a firm with a low netprofit margin has a high total asset turnover, which results in a reasonably goodreturn on total assets. Often, the opposite situation exists.

Modified DuPont Formula

The second step in the DuPont system employs the modified DuPont formula.This formula relates the firm’s return on total assets (ROA) to its return oncommon equity (ROE). The latter is calculated by multiplying the return on totalassets (ROA) by the financial leverage multiplier (FLM), which is the ratio of total assets to common stock equity:

Substituting the appropriate formulas into the equation and simplifying results inthe formula given earlier,

Use of the financial leverage multiplier (FLM) to convert the ROA into theROE reflects the impact of financial leverage on owners’ return. Substituting thevalues for Bartlett Company’s ROA of 6.1 percent, calculated earlier, andBartlett’s FLM of 2.06 ($3,597,000 total assets $1,754,000 common stockequity) into the modified DuPont formula yields

The 12.6 percent ROE calculated by using the modified DuPont formula is thesame as that calculated directly (page 82).

Applying the DuPont System

The advantage of the DuPont system is that it allows the firm to break its return onequity into a profit-on-sales component (net profit margin), an efficiency-of-asset-use component (total asset turnover), and a use-of-financial-leverage component

ROE = 6.1% * 2.06 = 12.6%

,

ROE =

Earnings available forcommon stockholders

Total assets *

Total assets

Common stock equity =


Common stock equity

ROE = ROA * FLM

ROA = 7.2% * 0.85 = 6.1%

ROA =


Sales *

Sales

Total assets =


Total assets

ROA = Net profit margin * Total asset turnover

CHAPTER 3 Financial Statements and Ratio Analysis 89

DuPont formulaMultiplies the firm’s net profit margin by its total asset turnover to calculate the firm’s

return on total assets (ROA).

Matter of fact

Dissecting ROA

Return to Table 3.5, andexamine the total asset

turnover figures for Dell andThe Home Depot. Both firmsturn their assets 1.6 times per year. Now look at the returnon assets column. Dell’s ROA is 4.3 percent, but The Home

Depot’s is significantly higher at 6.5 percent. If the two firmsare equal in terms of the effi-ciency with which they manage their assets (that is,equal asset turns), why is TheHome Depot more profitablerelative to assets? The answer lies in the DuPont formula.Notice that Home Depot’s net profit margin is 4.0 percent compared to Dell’s 2.7 percent.That drives the superior ROA

figures for The Home Depot.

modified DuPont formulaRelates the firm’s return on total assets (ROA) to its return oncommon equity (ROE) using thefinancial leverage multiplier (FLM).

financial leverage multiplier(FLM)The ratio of the firm’s totalassets to its common stock equity.



(financial leverage multiplier). The total return to owners therefore can be ana-lyzed in these important dimensions.

The use of the DuPont system of analysis as a diagnostic tool is best explainedusing Figure 3.2. Beginning with the rightmost value—the ROE—the financial

analyst moves to the left, dissecting and analyzing the inputs to the formula to iso-late the probable cause of the resulting above-average (or below-average) value.

For the sake of demonstration, let’s ignore all industry average data in Table 3.8and assume that Bartlett’s ROE of 12.6% is actually below the industry average.Moving to the left in Figure 3.2, we would examine the inputs to the ROE—theROA and the FLM—relative to the industry averages. Let’s assume that the FLMis in line with the industry average, but the ROA is below the industry average.Moving farther to the left, we examine the two inputs to the ROA—the net profitmargin and total asset turnover. Assume that the net profit margin is in line withthe industry average, but the total asset turnover is below the industry average.Moving still farther to the left, we find that whereas the firm’s sales are consistent

with the industry value, Bartlett’s total assets have grown significantly during thepast year. Looking farther to the left, we would review the firm’s activity ratios forcurrent assets. Let’s say that whereas the firm’s inventory turnover is in line with theindustry average, its average collection period is well above the industry average.

We can readily trace the possible problem back to its cause: Bartlett’s lowROE is primarily the consequence of slow collections of accounts receivable,which resulted in high levels of receivables and therefore high levels of totalassets. The high total assets slowed Bartlett’s total asset turnover, driving downits ROA, which then drove down its ROE. By using the DuPont system of analysis to dissect Bartlett’s overall returns as measured by its ROE, we foundthat slow collections of receivables caused the below-industry-average ROE.Clearly, the firm needs to better manage its credit operations.

6 REVIEW QUESTIONS

3–18 Financial ratio analysis is often divided into five areas: liquidity, activity,debt, profitability, and market ratios. Differentiate each of these areas of analysis from the others. Which is of the greatest concern to creditors?

3–19 Describe how you would use a large number of ratios to perform a com-plete ratio analysis of the firm.

3–20 What three areas of analysis are combined in the modified DuPont for-mula? Explain how the DuPont system of analysis is used to dissect thefirm’s results and isolate their causes.

Example 3.6 3

90 PART 2 Financial Tools

Summary

FOCUS ON VALUE

Financial managers review and analyze the firm’s financial statements periodi-cally, both to uncover developing problems and to assess the firm’s progresstoward achieving its goals. These actions are aimed at preserving and creatingvalue for the firm’s owners. Financial ratios enable financial managers to mon-itor the pulse of the firm and its progress toward its strategic goals. Although

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