Financial Statement AnalysisFor Better Decision Making

Course Outline• Nature and Purpose of Financial Statement Analysis

• Users and Limitations of Financial Statement Analysis

• Methods of Financial Statement Analysis

• Nature and Importance of Ratio Analysis

• Classification of Accounting Ratios

Course Objectives• To know the major objectives of FS Analysis and its importance for the company.

• To learn the limitations and the parties interested in using FS Analysis.

• To recognize the different methods in performing FS Analysis.

• To appreciate Ratio Analysis as a tool for evaluating financial position and performance of a company.

• To be able to classify and know the use of the accounting ratios

Course Expectations

• To learn and acquire knowledge what FS Analysis is, its objectives and importance in making company plans and decisions.

• To know the different users of FS Analysis, when this should be used, and how it can influence the users.

• To be able to identify the three (3) methods of performing FS Analysis

• To know the nature and definition of Ratio Analysis, how it is presented, its importance and advantages.

• To determine the four (4) classifications of Accounting Ratios and be able to calculate and analyze them.

Introduction of Financial Statement Analysis

Definition of Financial Statement Analysis

Financial Statement Analysis is the process of reviewing and evaluating a company's financial statements (such as the balance sheet or profit and loss statement), thereby gaining an understanding of the financial health of the company and enabling more effective decision making.

Objectives of Financial Statement Analysis

1. Assessment of Past Performance

2. Assessment of Current Position

3. Prediction of Profitability and Growth Prospects

4. Prediction of Bankruptcy and Failure

5. Assessment of the Operational Efficiency

Importance of Financial Statement Analysis

1. Holding of ShareProvides meaningful information for shareholder decisions

2. Decisions and PlansProvides meaningful information for the company’s management in making decisions

3. Extension of CreditProvides information to creditors for decisions on granting loans and demanding levels of interest

4. Investment DecisionProvides information for investors whether to invest in a company or not

Limitations of Financial Statement Analysis1. Mislead the User

Accuracy depends on the accuracy of FS, thus information gathered by the user might not be accurate

2. Not Useful for PlanningFS prepared are from historical data, thus no guarantee that previous company situation would still prevail

3. Qualitative AspectsOnly produces quantitative information; qualitative aspects are overseen

4. Comparison Not PossibleComparison of FS Analysis in different time frame cannot be done due to inflation distortion

5. Wrong Judgment Biased attitude of the user leads to wrong judgment and conclusion

Users of Financial Statement Analysis1. Shareholders

To know the profitability and safety of their investments

2. Investors and LendersTo know the solvency of the firm

3. CreditorsTo know the short-term liquidity of the firm

4. ManagementTo measure the effectiveness of their policies and decisions

5. GovernmentTo determine the amount of tax liability of the firm

Methods of Financial Statement Analysis

Methods of Financial Statement Analysis1. Financial Ratio Analysis

It is the analysis of the interrelationship between two financial figures.

2. Horizontal and Vertical AnalysisHorizontal analysis analyzes the trend of the financial ratios of the company over the years, while vertical analysis analyzes a financial statement, where each line item on a financial statement is listed as a percentage of another item.

3. Comparative Financial StatementsIt is an analysis of financial statements of the two or more companies of similar types and/or of a company to the industry as a whole.

Financial Ratio Analysis

Definition of Ratio Analysis

Ratio Analysis is the process of

- determining and interpreting numerical relationship between figures of financial statements.

- presenting the quantitative relationship between two accounting figures to evaluate the strengths and weakness of a business.

Steps in Performing Ratio Analysis

1.

• Relevant data selection from the financial statements related to the objectives of the analysis

2.

• Calculation of required ratios from the data and presenting them either in pure ratio form or in percentage

3.• Interpretation of the ratios

Importance and Advantages of Ratio Analysis

1. Analyzing Financial Statements

2. Judging Efficiency

3. Locating Weaknesses

4. Formulating Plans

5. Comparing Performance

Presentation of Ratio Analysis1. Ratio Method

Ratio method shows the relationship between two figures in ratio or proportion. It is expressed by simple division of one item by another e.g. 2.5:1, 0.5:1 and so on.

2. Rate MethodThis method shows relationship in rate or times, like 2 times or 4 times and so on.

3. Percentage MethodThe relationship between two figures can be presented in percentage like 20%, 30% and so on.

Classification of Accounting Ratios1. Liquidity Measurement Ratios

2. Profitability Indicator Ratios

3. Debt Ratios

4. Operating Performance Ratios

5. Cash Flow Indicator Ratios

6. Investment Valuation Ratios

Liquidity Measurement Ratios• To measure a company’s ability to pay off its short-term debt obligations

• Done by comparing a company’s most liquid-assets to its short-term liabilities

1. Current Ratio

2. Quick Ratio

3. Cash Ratio

4. Cash Conversion Cycle

Liquidity: Current RatioTo ascertain whether a company's short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes).

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑹𝒂𝒕𝒊𝒐 =𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

The higher the current ratio, the better.

Liquidity: Quick Ratio• A liquidity indicator that further refines the current ratio by measuring the

amount of the most liquid current assets there are to cover current liabilities.

• Excludes inventory and other current assets

𝑸𝒖𝒊𝒄𝒌 𝑹𝒂𝒕𝒊𝒐

=𝑪𝒂𝒔𝒉 & 𝑬𝒒𝒖𝒊𝒗𝒂𝒍𝒆𝒏𝒕𝒔 + 𝑺𝒉𝒐𝒓𝒕 𝑻𝒆𝒓𝒎 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕𝒔 + 𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

Liquidity: Cash Ratio• Further refines both the current ratio and the quick ratio by measuring the amount

of cash, cash equivalents or invested funds there are in current assets to cover current liabilities.

• The most stringent and conservative of the three short-term liquidity ratios (current, quick and cash)

𝑪𝒂𝒔𝒉 𝑹𝒂𝒕𝒊𝒐 =𝑪𝒂𝒔𝒉 + 𝑬𝒒𝒖𝒊𝒗𝒂𝒍𝒆𝒏𝒕𝒔 + 𝑰𝒏𝒗𝒆𝒔𝒕𝒆𝒅 𝑭𝒖𝒏𝒅𝒔

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

Liquidity: Cash Conversion Cycle• Expresses the length of time (in days) that a company uses to sell inventory, collect receivables and

pay its accounts payable.

• Measures the number of days a company's cash is tied up in the production and sales process of its operations and the benefit it gets from payment terms from its creditors.

𝑪𝒂𝒔𝒉 𝑪𝒐𝒏𝒗𝒆𝒓𝒔𝒊𝒐𝒏 𝑪𝒚𝒄𝒍𝒆 = 𝑫𝑰𝑶 + 𝑫𝑺𝑶 − 𝑫𝑷𝑶

Where:

𝐷𝐼𝑂 (𝐷𝑎𝑦𝑠 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔) =𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠365

𝐷𝑆𝑂 𝐷𝑎𝑦𝑠 𝑆𝑎𝑙𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 =𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠365

𝐷𝑃𝑂 𝐷𝑎𝑦𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 =𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠365

Exercise No. 1 (Liquidity Measurement Ratios)

Compute the following: (Refer to the financial statements in the previous slide)

1. Current Ratio2. Quick Ratio3. Cash Ratio4. Cash Conversion Cycle

Profitability Indicator Ratios• How well the company utilized its resources in generating profit and

shareholder value.

1. Profit Margin Analysis

2. Effective Tax Rate

3. Return On Assets

4. Return On Equity

5. Return On Capital Employed

Profitability: Profit Margin Analysis• In the income statement, there are four levels of profit or profit margins -

gross profit, operating profit, pretax profit and net profit. • It is the amount of profit (at the gross, operating, pretax or net income level)

generated by the company as a percent of the sales generated.

𝑮𝒓𝒐𝒔𝒔 𝑷𝒓𝒐𝒇𝒊𝒕 𝑴𝒂𝒓𝒈𝒊𝒏 =𝑮𝒓𝒐𝒔𝒔 𝑷𝒓𝒐𝒇𝒊𝒕

𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔

𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑷𝒓𝒐𝒇𝒊𝒕 𝑴𝒂𝒓𝒈𝒊𝒏 =𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑷𝒓𝒐𝒇𝒊𝒕

𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔

𝑷𝒓𝒆𝒕𝒂𝒙 𝑷𝒓𝒐𝒇𝒊𝒕 𝑴𝒂𝒓𝒈𝒊𝒏 =𝑷𝒓𝒆𝒕𝒂𝒙 𝑷𝒓𝒐𝒇𝒊𝒕

𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔

𝑵𝒆𝒕 𝑷𝒓𝒐𝒇𝒊𝒕 𝑴𝒂𝒓𝒈𝒊𝒏 =𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆

𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔

Profitability: Effective Tax Rate• This ratio is a measurement of a company's tax rate, which is calculated by

comparing its income tax expense to its pretax income.

• The variances in this percentage can have a material effect on the net-income figure.

𝑬𝒇𝒇𝒆𝒄𝒕𝒊𝒗𝒆 𝑻𝒂𝒙 𝑹𝒂𝒕𝒆 =𝑰𝒏𝒄𝒐𝒎𝒆 𝑻𝒂𝒙 𝑬𝒙𝒑𝒆𝒏𝒔𝒆

𝑷𝒓𝒆𝒕𝒂𝒙 𝑰𝒏𝒄𝒐𝒎𝒆

Profitability: Return On Assets• Indicates how profitable a company is relative to its total assets

• Illustrates how well management is employing the company's total assets to make a profit

• The higher the return, the more efficient management is in utilizing its asset base

𝑹𝒆𝒕𝒖𝒓𝒏 𝑶𝒏 𝑨𝒔𝒔𝒆𝒕𝒔 =𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔

As a rule of thumb, investment professionals like to see a company's ROA come in at no less than 5%.

Profitability: Return On Equity• Indicates how profitable a company is by comparing its net income to its

average shareholders' equity

• Measures how much the shareholders earned for their investment in the company

• The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investors

𝑹𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝑬𝒒𝒖𝒊𝒕𝒚 =𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔′𝑬𝒒𝒖𝒊𝒕𝒚

Profitability: Return on Capital Employed• Complements the return on equity (ROE) ratio by adding a company's debt

liabilities, or funded debt, to equity to reflect a company's total "capital employed"

• To gain a better understanding of a company's ability to generate returns from its available capital base

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑 =𝐸𝐵𝐼𝑇

𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑Where:

Capital Employed = Average Debt Liabilities + Average Shareholders’ Equity

An ROCE ratio, as a very general rule of thumb, should be at or above a company's average borrowing rate.

Exercise No. 2 (Profitability Indicator Ratios)

Compute for the following: (refer to the financial statement in the previous slide)

1. Gross Profit Margin

2. Operating Profit Margin

3. Pretax Profit Margin

4. Net Profit Margin

5. Effective Tax Rate

6. Return on Assets

7. Return on Equity

8. Return on Capital Employed

Debt Ratios• Debt ratios can be used to determine the overall level of financial risk a company

and its shareholders face.

• In general, the greater the amount of debt held by a company the greater the

financial risk of bankruptcy.

1. Debt Ratio

2. Debt-Equity Ratio

3. Capitalization Ratio

4. Interest Coverage Ratio

5. Cash Flow to Debt Ratio

Debt: Debt Ratio

• Compares a company's total debt to its total assets, which is used to gain a general idea as to the amount of leverage being used by a company

• The lower the percentage, the less leverage a company is using and the stronger its equity position

𝑫𝒆𝒃𝒕 𝑹𝒂𝒕𝒊𝒐 =𝑻𝒐𝒕𝒂𝒍 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔

In general, the higher the ratio, the more risk that company is considered to have taken on.

Debt: Debt-Equity RatioThis is a measurement of how much suppliers, lenders, creditors and obligors have committed to the company versus what the shareholders have committed.

𝑫𝒆𝒃𝒕 𝒕𝒐 𝑬𝒒𝒖𝒊𝒕𝒚 𝑹𝒂𝒕𝒊𝒐 =𝑻𝒐𝒕𝒂𝒍 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔′𝑬𝒒𝒖𝒊𝒕𝒚

Similar to the debt ratio, a lower the percentage means that a company is using less leverage and has a stronger equity position.

Debt: Capitalization Ratio• Measures the debt component of a company's capital structure, or

capitalization (i.e., the sum of long-term debt liabilities and shareholders' equity) to support a company's operations and growth

𝑪𝒂𝒑𝒊𝒕𝒂𝒍𝒊𝒛𝒂𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒊𝒐 =𝑳𝒐𝒏𝒈 𝑻𝒆𝒓𝒎𝑫𝒆𝒃𝒕

𝑳𝒐𝒏𝒈 𝑻𝒆𝒓𝒎𝑫𝒆𝒃𝒕 + 𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔′𝑬𝒒𝒖𝒊𝒕𝒚

A low level of debt and a healthy proportion of equity in a company's capital structure is an indication of financial fitness.

Debt: Interest Coverage Ratio• Used to determine how easily a company can pay interest expenses on outstanding

debt

• The lower the ratio, the more the company is burdened by debt expense

𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑪𝒐𝒗𝒆𝒓𝒂𝒈𝒆 𝑹𝒂𝒕𝒊𝒐 =𝑬𝑩𝑰𝑻

𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑬𝒙𝒑𝒆𝒏𝒔𝒆

Debt: Cash Flow to Debt Ratio• Provides an indication of a company's ability to cover total debt with its yearly cash flow from

operations

• The higher the percentage ratio, the better the company's ability to carry its total debt

𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘 𝒕𝒐 𝑫𝒆𝒃𝒕 =𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘

𝑻𝒐𝒕𝒂𝒍 𝑫𝒆𝒃𝒕

Exercise No. 3 (Debt Ratios)Compute for the following:

1. Debt Ratio

2. Debt-Equity Ratio

3. Capitalization Ratio

4. Interest Coverage Ratio

5. Cash Flow to Debt Ratio

Operating Performance Ratios• Look at how well a company turns its assets into revenue as well as how

efficiently a company converts its sales into cash

• Look at how efficiently and effectively a company is using its resources to generate sales and increase shareholder value

1. Fixed Asset Turnover

2. Sales per Employee

3. Operating Cycle (refer to Cash Conversion Cycle)

Operating: Fixed Asset Turnover• A rough measure of the productivity of a company's fixed assets (property,

plant and equipment or PP&E) with respect to generating sales

• Reflects a company's efficiency in managing these significant assets

• The higher the yearly turnover rate, the better

𝑭𝒊𝒙𝒆𝒅 𝑨𝒔𝒔𝒆𝒕 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 =𝑹𝒆𝒗𝒆𝒏𝒖𝒆

𝑷𝒓𝒐𝒑𝒆𝒓𝒕𝒚, 𝑷𝒍𝒂𝒏𝒕 𝒂𝒏𝒅 𝑬𝒒𝒖𝒊𝒑𝒎𝒆𝒏𝒕

Operating: Sales Per Employee• A gauge of personnel productivity, and measures the amount of dollar sales, or

revenue, generated per employee

• The higher the peso figure, the better

• Labor-intensive businesses (ex. mass market retailers) will be less productive in this metric than a high-tech, high product-value manufacturer

𝑺𝒂𝒍𝒆𝒔 𝑷𝒆𝒓 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒆 =𝑺𝒂𝒍𝒆𝒔

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒆𝒔

Exercise No. 4 (Operating Performance Ratios) Compute for the following:

1. Fixed Asset Turnover

2. Sales/Revenue per Employee (ABC has 150 employees)

Cash Flow Indicator Ratios• Look at cash flow indicators, which focus on the cash being generated in terms of how much is

being generated and the safety net that it provides to the company

• Use cash flow compared to other metrics to determine how much cash generated from sales, generated free and clear cash, and the generated cash to pay obligations

1. Operating Cash Flow/Sales Ratio

2. Free Cash Flow/Operating Cash Ratio

3. Cash Flow Coverage Ratio

4. Dividend Payout Ratio

Cash Flow: Operating Cash Flow/Sales Ratio• Indicates the ability of a company to generate cash from its sales

• Shows the ability of a company to turn its sales into cash

• The higher this ratio is the better it is for the company

𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘 𝒕𝒐 𝑺𝒂𝒍𝒆𝒔 =𝑶𝑪𝑭

𝑺𝒂𝒍𝒆𝒔

Cash Flow: Free Cash Flow/Operating Cash Ratio• Measures the relationship between free cash flow and operating cash flow

• FCF is OCF minus capital expenditures -- an essential outflow of funds to maintain a company's competitiveness and efficiency

• The higher the percentage of FCF embedded in a company's OCF, the greater the financial strength of the company

𝑭𝑪𝑭 𝒕𝒐 𝑶𝑪𝑭 =𝑶𝑪𝑭 − 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆𝒔

𝑶𝑪𝑭

Cash Flow: Cash Flow Coverage Ratio• Measures the ability of the company's operating cash flow to meet its obligations -

including its liabilities or ongoing concern costs

• The larger the OCF coverage, the greater the company's ability to meet its obligations more cash flow to expand its business, withstand hard times, and be burden-free from debt servicing and credit restrictions

𝑺𝒉𝒐𝒓𝒕 𝑻𝒆𝒓𝒎 𝑫𝒆𝒃𝒕 𝑪𝒐𝒗𝒆𝒓𝒂𝒈𝒆 =𝑶𝑪𝑭

𝑺𝒉𝒐𝒓𝒕 𝑻𝒆𝒓𝒎 𝑫𝒆𝒃𝒕

𝑪𝒂𝒑𝑬𝒙 𝑪𝒐𝒗𝒆𝒓𝒂𝒈𝒆 =𝑶𝑪𝑭

𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆𝒔

Cash Flow: Dividend Payout Ratio• Identifies the percentage of earnings (net income) per common share allocated to paying cash

dividends to shareholders

• Indicator of how well earnings support the dividend payment

𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝑷𝒂𝒚𝒐𝒖𝒕 =𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔 𝒑𝒆𝒓 𝑪𝒐𝒎𝒎𝒐𝒏 𝑺𝒉𝒂𝒓𝒆

𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒑𝒆𝒓 𝑺𝒉𝒂𝒓𝒆

Exercise No. 5 Cash Flow Indicator Ratios Compute for the following:

Assume

No dividends given during the year

Operating Cash Flow = Net Income + Depreciation and Amortization

1. Operating Cash Flow/Sales Ratio

2. Free Cash Flow/Operating Cash Flow Ratio

3. Cash Flow Coverage Ratio

4. Dividend Payout Ratio

Decoding DuPont Analysis

DuPont Analysis is an expression which breaks Return on Equity (ROE) into three parts.

• Created by DuPont Corporation to break down ROE into a more complex equation and show the causes of shifts in the ratio

3-Step DuPont Analysis: 𝑹𝑶𝑬 = 𝑵𝒆𝒕 𝑷𝒓𝒐𝒇𝒊𝒕 𝑴𝒂𝒓𝒈𝒊𝒏 × 𝑨𝒔𝒔𝒆𝒕 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 × 𝑬𝒒𝒖𝒊𝒕𝒚 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓

5-Step DuPont Analysis: 𝑹𝑶𝑬= 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑷𝒓𝒐𝒇𝒊𝒕 𝑴𝒂𝒓𝒈𝒊𝒏 × 𝑨𝒔𝒔𝒆𝒕 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 − 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑬𝒙𝒑𝒆𝒏𝒔𝒆 𝑹𝒂𝒕𝒆× 𝑬𝒒𝒖𝒊𝒕𝒚 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 × 𝑻𝒂𝒙 𝑹𝒆𝒕𝒆𝒏𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒆

The Three-Step DuPont

𝑹𝑶𝑬 = 𝑵𝒆𝒕 𝑷𝒓𝒐𝒇𝒊𝒕 𝑴𝒂𝒓𝒈𝒊𝒏 × 𝑨𝒔𝒔𝒆𝒕 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 × 𝑬𝒒𝒖𝒊𝒕𝒚 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓

𝑹𝑶𝑬 = (𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆

𝑺𝒂𝒍𝒆𝒔) × (

𝑺𝒂𝒍𝒆𝒔

𝑨𝒔𝒔𝒆𝒕𝒔) × (

𝑨𝒔𝒔𝒆𝒕𝒔

𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔′𝑬𝒒𝒖𝒊𝒕𝒚)

• If ROE ↑ due to ↑ in Net Profit Margin and/or Asset Turnover, it is a good sign.

• If ROE ↑ due to ↑ in Equity Multiplier, it is riskier for the company because it is

already overleveraged.

The Five-Step DuPont

• Also called extended DuPont Equation, breaks down net profit margin further

• It shows that increases in leverage don't always indicate an increase in ROE

𝑹𝑶𝑬 =𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆

𝑺𝒂𝒍𝒆𝒔×

𝑺𝒂𝒍𝒆𝒔

𝑨𝒔𝒔𝒆𝒕𝒔×

𝑨𝒔𝒔𝒆𝒕𝒔

𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔′𝑬𝒒𝒖𝒊𝒕𝒚

𝑹𝑶𝑬 =𝑬𝑩𝑻

𝑺𝒂𝒍𝒆𝒔×

𝑺𝒂𝒍𝒆𝒔

𝑨𝒔𝒔𝒆𝒕𝒔×

𝑨𝒔𝒔𝒆𝒕𝒔

𝑬𝒒𝒖𝒊𝒕𝒚× 𝟏 − 𝑻𝒂𝒙 𝑹𝒂𝒕𝒆

𝑹𝑶𝑬 =𝑬𝑩𝑰𝑻

𝑺𝒂𝒍𝒆𝒔×

𝑺𝒂𝒍𝒆𝒔

𝑨𝒔𝒔𝒆𝒕𝒔−

𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕

𝑨𝒔𝒔𝒆𝒕𝒔×

𝑨𝒔𝒔𝒆𝒕𝒔

𝑬𝒒𝒖𝒊𝒕𝒚× 𝟏 − 𝑻𝒂𝒙 𝑹𝒂𝒕𝒆

The Bottom Line

• If a company's ROE is lower than its peers, the three- or five-step identities can help show where the company is lagging.

• It can also shed light on how a company is lifting or propping up its ROE.

• DuPont analysis helps significantly broaden understanding of ROE.

Horizontal and Vertical Analysis

Horizontal Analysis

• Is the comparison of historical financial information over a series of reporting periods, or of the ratios derived from this financial information

• When conducting a horizontal analysis, it is useful to conduct the analysis for all of the financial statements at the same time, so that you can see the complete impact of operational results on a company's financial condition over the review period.

Horizontal Analysis of the Income Statement

20X1 20X2 Variance ($) Variance (%)

Sales $1,000,000 $1,500,000 $500,00050%

Cost of goods sold 400,000 600,000 (200,000)50%

Gross margin 600,000 900,000 300,00050%

Salaries and wages 250,000 375,000 (125,000)50%

Office rent 50,000 80,000 (30,000)60%

Supplies 10,000 20,000 (10,000)100%

Utilities 20,000 30,000 (10,000)50%

Other expenses 90,000 110,000 (20,000)22%

Total expenses 420,000 615,000 (195,000)46%

Net profit $180,000 $285,000 $105,00058%

Horizontal Analysis of the Balance Sheet

20X1 20X2 Variance ($) Variance (%)Cash $100,000 80,000 $(20,000) -20%Accounts receivable 350,000 525,000 175,000 50%Inventory 150,000 275,000 125,000 83%

Total current assets 600,000 880,000 280,000 47%

Fixed assets 400,000 800,000 400,000 100%Total assets $1,000,000 $1,680,000 $680,000 68%

Accounts payable $180,000 $300,000 $120,000 67%Accrued liabilities 70,000 120,000 50,000 71%

Total current liabilities 250,000 420,000 170,000 68%

Notes payable 300,000 525,000 225,000 75%Total liabilities 550,000 945,000 395,000 72%

Capital stock 200,000 200,000 0 0%Retained earnings 250,000 535,000 285,000 114%

Total equity 450,000 735,000 285,000 63%

Total liabilities and equity $1,000,000 $1,680,000 $680,000 68%

Vertical Analysis

• Vertical analysis or Common Size Analysis is the proportional analysis of a financial statement, where each line item on a financial statement is listed as a percentage of another item.

• Every line item on an income statement is stated as a percentage of gross sales, while every line item on a balance sheet is stated as a percentage of total assets.

• The most common use of vertical analysis is within a financial statement for a single time period, so that you can see the relative proportions of account balances.

Vertical Analysis on the Income Statement

$ Totals Percent

Sales $1,000,000 100%

Cost of goods sold 400,000 40%

Gross margin 600,000 60%

Salaries and wages 250,000 25%

Office rent 50,000 5%

Supplies 10,000 1%

Utilities 20,000 2%

Other expenses 90,000 9%

Total expenses 420,000 42%

Net profit 180,000 18%

Vertical Analysis of the Balance Sheet

$ Totals PercentCash $100,000 10%Accounts receivable 350,000 35%Inventory 150,000 15%

Total current assets 600,000 60%

Fixed assets 400,000 40%Total assets $1,000,000 100%

Accounts payable $180,000 18%Accrued liabilities 70,000 7%

Total current liabilities 250,000 25%

Notes payable 300,000 30%Total liabilities 550,000 55%

Capital stock 200,000 20%Retained earnings 250,000 25%

Total equity 450,000 45%Total liabilities and equity $1,000,000 100%

Peer Group Financial Statement AnalysisUse of Ratio Analysis

2012 Company Financial Ratios

Company Names ABC DEF GHI Industry Average

LIQUIDITY RATIOS

Current Ratio 1.07 1.37 2.05 1.49

Quick Ratio 0.89 0.91 0.82 0.88

ASSET MANAGEMENT

Inventory Turnover Ratio 3.16 1.30 0.50 1.65

Days Sales Outstanding 449 121 334 301.25

Fixed Assets Turnover 0.71 0.30 0.37 0.46

Total Assets Turnover 0.27 0.17 0.14 0.19

DEBT MANAGEMENT

Total Debt to Total Assets 50% 0.46 44% 0.47

Payment Deferral Period 423 182 415 340.02

PROFITABILITY

Profit Margin on Sales 23% 29% 29% 0.27

Basic Earning Power 6% 7% 5% 0.06

Return on Total Assets 6% 5% 4% 0.05

Return on Equity 12% 9% 7% 0.10

MARKET VALUE

Price-Earnings Ratio 1.89 4.35 7.14 4.46

Earnings Per Share 0.53 0.23 0.14 0.30

Inventory Conversion Period 164 545 1583 763.88

Receivables Collection Period 449 121 334 301.25

Payables Deferral Period 423 182 415 340.02

Cash Conversion Cycle 190 484 1502 725.12

Peer Group Financial Statement AnalysisUse of Trend Analysis

Percentage Growth

CONSOLIDATED STATEMENTS OF INCOME ABC DEF GHI Industry Average

2012 2011 2012 2011 2012 2011 2012 2011

REVENUE 33% 77% 13% -5% 22% 11% 23% 28%

COSTS OF REAL ESTATE SOLD 40% 92% 22% -17% 33% 35% 32% 37%

GROSS PROFIT 24% 60% 7% 6% -130% -107% -33% -14%

OPERATING EXPENSES 55% 76% 3% 10% 18% -7% 25% 26%

OTHER INCOME (EXPENSE) -6974% -102% 70% -3% -15% 13% -2306% -31%

INCOME BEFORE INCOME TAX 20% 31% 5% 5% 17% -1% 14% 12%

PROVISION FOR (BENEFIT FROM) INCOME TAX -603% -112% 17% 6% 16% -3% -190% -36%

NET INCOME 17% 38% 2% 4% 17% 0% 12% 14%

Percentage Growth

CONSOLIDATED STATEMENTS OF FINANCIAL POSITION ABC DEF GHI Industry Average

2012 2011 2012 2011 2012 2011 2012 2011

CURRENT ASSETS 57% 32% 43% 19% 29% 8% 43% 20%

NON-CURRENT ASSETS 43% 18% 33% 17% 18% 11% 31% 15%

TOTAL ASSETS 49% 23% 37% 18% 20% 10% 35% 17%

LIABILITIES 116% 3% 112% 60% 46% 22% 92% 28%

SHAREHOLDERS' EQUITY 13% 38% 5% 6% 5% 5% 8% 16%

TOTAL LIABILITIES AND EQUITY 49% 23% 37% 18% 20% 10% 35% 17%

Peer Group Financial Statement AnalysisUse of Common Size Analysis

Percentage of Revenue

CONSOLIDATED STATEMENTS OF INCOME ABC DEF GHI Industry Average

2012 2011 2012 2011 2012 2011 2012 2011

REVENUE 100% 100% 100% 100% 100% 100% 100% 100%

COSTS OF REAL ESTATE SOLD 63% 60% 46% 43% 46% 42% 51% 48%

GROSS PROFIT 37% 40% 54% 57% 54% 58% 49% 52%

OPERATING EXPENSES 17% 14% 15% 15% 20% 22% 17% 17%

OTHER INCOME (EXPENSE) 3% 0% 0% 0% 0% 0% 1% 0%

INCOME BEFORE INCOME TAX 23% 26% 39% 43% 34% 36% 32% 35%

PROVISION FOR (BENEFIT FROM) INCOME TAX 0% 0% 10% 10% 5% 6% 5% 5%

NET INCOME 24% 26% 50% 53% 40% 42% 38% 40%

Percentage of Total Assets

CONSOLIDATED STATEMENTS OF FINANCIAL POSITION ABC DEF GHI Industry Average

2012 2011 2012 2011 2012 2011 2012 2011

CURRENT ASSETS 44% 42% 38% 37% 19% 18% 34% 32%

NON-CURRENT ASSETS 56% 58% 62% 63% 81% 82% 66% 68%

TOTAL ASSETS 100% 100% 100% 100% 100% 100% 100% 100%

LIABILITIES 50% 34% 46% 29% 44% 36% 47% 33%

SHAREHOLDERS' EQUITY 50% 66% 54% 71% 56% 64% 53% 67%

TOTAL LIABILITIES AND EQUITY 100% 100% 100% 100% 100% 100% 100% 100%