Chapter 2: Financial Statement Analysis

Investors often use accounting statements to evaluate a firm in one of two ways:

  1. Compare the firm with itself by analyzing how the firm has changed over time.
  2. Compare the firm to other similar firms using a common set of financial ratios.

Profitability Ratios

Information used here comes from the income statement.

Gross Margin

Gross Margin=Gross ProfitSales\text{Gross Margin}=\frac{\text{Gross Profit}}{\text{Sales}}

This tells us a firm’s ability to sell a product for more than cost of producing it.

Operating Margin

Operating Margin=Operating IncomeSales\text{Operating Margin}=\frac{\text{Operating Income}}{\text{Sales}}

This reveals how much a company earns before interest and taxes from each dollar of sales. We can similarly compute a firm’s EBIT margin = (EBIT/Sales). By comparing operating or EBIT margins across firms within an industry, we can assess the relative efficiency of the firms’ operations.

Net Profit Margin

Net Profit Margin=Net IncomeSales\text{Net Profit Margin}=\frac{\text{Net Income}}{\text{Sales}}

The net profit margin shows the fraction of each dollar in revenues that is available to equity holders after the firm pays interest and taxes. Be careful when comparing net profit margins: While differences in net profit margins can be due to differences in efficiency, they can also result from differences in leverage, which determines the amount of interest expense, as well as differences in accounting assumptions.

Liquidity Ratios

Information used here comes from the balance sheet.

Current Ratio

Current Ratio=Current AssetsCurrent Liabilities\text{Current Ratio}=\frac{\text{Current Assets}}{\text{Current Liabilities}}

Used to assess whether the firm has sufficient working capital to meet its short-term needs.

Quick Ratio

A more stringent test of the firm’s liquidity is the quick ratio, which compares only cash and “near cash” assets, such as short-term investments and accounts receivable, to current liabilities.

Cash Ratio

Cash Ratio=CashCurrent Liabilities\text{Cash Ratio}=\frac{\text{Cash}}{\text{Current Liabilities}}

The most stringent liquidity ratio is to look at a firm’s cash position.

Working Capital Ratios

Accounts Receivable Days

Accounts Receivable Days=Accounts ReceivableAverage Daily Sales\text{Accounts Receivable Days}=\frac{\text{Accounts Receivable}}{\text{Average Daily Sales}}

To evaluate the speed at which a company turns sales into cash, firms compute the number of days’ worth of sales accounts receivable represents.

Accounts Payable Days

Accounts Payable Days=Accounts PayableAverage Daily Cost of Sales\text{Accounts Payable Days}=\frac{\text{Accounts Payable}}{\text{Average Daily Cost of Sales}}

The number of days’ worth of costs accounts payable represents.

Inventory Days

Inventory Days=InventoryAverage Daily Cost of Sales\text{Inventory Days}=\frac{\text{Inventory}}{\text{Average Daily Cost of Sales}}

The number of days’ worth of costs inventory represents.

Turnover Ratios

Inventory Turnover=Annual Cost of SalesInventory\text{Inventory Turnover}=\frac{\text{Annual Cost of Sales}}{\text{Inventory}}

The number of times average inventory is sold during the year. Similarly, accounts receivable turnover = (annual sales/accounts receivable) and accounts payable turnover = (annual cost of sales/accounts payable).

Interest Coverage Ratios

Lenders often assess a firm’s ability to meet its interest obligations by comparing its earnings with its interest expenses using an interest coverage ratio. One common ratio to consider is the firm’s EBIT as a multiple of its interest expenses. A high ratio indicates that the firm is earning much more than is necessary to meet its required interest payments.

EBITInterest Coverage\frac{\text{EBIT}}{\text{Interest Coverage}}

Depreciation and amortization expenses are deducted when computing EBIT, but they are not actually cash expenses for the firm. Consequently, financial analysts often compute a firm’s earnings before interest, taxes, depreciation, and amortization, or EBITDA, as a measure of the cash a firm generates from its operations and has available to make interest payments:

EBITDA=EBIT+Depreciation and Amortization\text{EBITDA}=\text{EBIT}+\text{Depreciation and Amortization}

EBITDAInterest Coverage\frac{\text{EBITDA}}{\text{Interest Coverage}}

Leverage Ratios

An important piece of information that we can learn from a firm’s balance sheet is the firm’s leverage, or the extent to which it relies on debt as a source of financing.

Debt-Equity Ratio

Debt-Equity Ratio=Total DebtTotal Equity\text{Debt-Equity Ratio}=\frac{\text{Total Debt}}{\text{Total Equity}}

We can calculate the debt–equity ratio using either book or market values for equity and debt. It is more informative to compare the firm’s debt to the market value of its equity.

Debt-to-Capital Ratio

Debt-to-Capital Ratio=Total DebtTotal Equity+Total Debt\text{Debt-to-Capital Ratio}=\frac{\text{Total Debt}}{\text{Total Equity}+\text{Total Debt}}

This is the fraction of the firm financed by debt. This can be computed with book or market values.

Debt-to-Enterprise Value Ratio

While leverage increases the risk to the firm’s equity holders, firms may also hold cash reserves in order to reduce risk. Thus, another useful measure to consider is the firm’s net debt, or debt in excess of its cash reserves:

Net Debt=Total DebtExcess Cash & Short-Term Investments\text{Net Debt}=\text{Total Debt}-\text{Excess Cash \& Short-Term Investments}

We can use the concept of net debt to compute the firm’s debt-to-enterprise value ratio:

Equity Multipliers

A final measure of leverage is a firm’s equity multiplier, measured in book value terms.

Equity Multiplier=Total AssetsBook Value of Equity\text{Equity Multiplier}=\frac{\text{Total Assets}}{\text{Book Value of Equity}}

This measure captures the amplification of the firm’s accounting returns that results from leverage.

The market value equity multiplier, which is generally measured as the following, indicates the amplification of shareholders’ financial risk that results from leverage.

Market Value Equity Multiplier=Enterprise ValueMarket Value of Equity\text{Market Value Equity Multiplier}=\frac{\text{Enterprise Value}}{\text{Market Value of Equity}}

Valuation Ratios

Price-Earnings Ratio

P/E Ratio=Market CapitalizationNet Income=Share PriceEarnings per Share\text{P/E Ratio}=\frac{\text{Market Capitalization}}{\text{Net Income}}=\frac{\text{Share Price}}{\text{Earnings per Share}}

This tells how many times the earnings is a shareholder willing to pay for a share. This depends on the industry; faster growing industries tend to have higher P/E ratios, and vice versa. It also depends on risk; riskier firms have lower P/E ratios.

The P/E ratio is sensitive to the firm’s choice of leverage. It’s hard to use when comparing two firms with different leverages. We can avoid this by assessing the market value using valuation ratios based on the firm’s enterprise value. Common ratios include the ratio of enterprise value to revenue, or enterprise value to operating income, EBIT, or EBITDA. These ratios compare the value of the business to its sales, operating profits, or cash flow.

The P/E ratio, or ratios to EBIT or EBITDA, are not meaningful if the firm’s earnings are negative. In that case, it’s common to look at the firm’s enterprise value relative to sales. However, this is risky because earnings could be negative due to the underlying business model being fundamentally flawed.

Operating Returns

Return on Equity

Return on Equity=Net IncomeBook Value of Equity\text{Return on Equity}=\frac{\text{Net Income}}{\text{Book Value of Equity}}

The ROE provides a measure of the return that the firm has earned on its past investments. A high ROE may indicate the firm is able to find investment opportunities that are very profitable.

Return on Assets

Return on Assets=Net Income+Interest ExpenseBook Value of Assets\text{Return on Assets}=\frac{\text{Net Income}+\text{Interest Expense}}{\text{Book Value of Assets}}

ROA has the benefit that it is less sensitive to leverage than ROE. However, it is sensitive to working capital – for example, an equal increase in the firm’s receivables and payables will increase total assets and thus lower ROA.

Return on Invested Capital

To avoid the problem with the ROA, we can consider the firm’s return on invested capital (ROIC):

Return on Invested Capital=EBIT×(1tax rate)Book Value of Equity+Net Debt\text{Return on Invested Capital}=\frac{\text{EBIT}\times(1-\text{tax rate})}{\text{Book Value of Equity}+\text{Net Debt}}

The return on invested capital measures the after-tax profit generated by the business itself, excluding any interest expenses (or interest income), and compares it to the capital raised from equity and debt holders that has already been deployed (i.e., is not held as cash). Of the three measures of operating returns, ROIC is the most useful in assessing the performance of the underlying business.

The DuPont Identity

We can gain further insight into a firm’s ROE using a tool called the DuPont Identity, which expresses the ROE in terms of the firm’s profitability, asset efficiency, and leverage:

The first two terms together determine the firm’s return on assets. We compute ROE by multiplying by a measure of leverage called the equity multiplier, which indicates the value of assets held per dollar of shareholder equity. The greater the firm’s reliance on debt financing, the higher it will be.


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