Financial Statement Analysis/Ratio
Week-8
| 2 Understand the purpose of basic financial statements and their contents. Explain why financial statement analysis is important to the firm and to outside suppliers of capital. Define, calculate, and categorize (according to liquidity, financial leverage, coverage, activity, and profitability) the major financial ratios and understand what they can tell us about the firm. Define, calculate, and discuss a firm’s operating cycle and cash cycle. Use ratios to analyze a firm’s health and then recommend reasonable alternative courses of action to improve the health of the firm. Analyze a firm’s return on investment (i.e., “earning power”) and return on equity using a DuPont approach. Understand the limitations of financial ratio analysis. Use trend analysis, common-size analysis, and index analysis to gain additional insights into a firm’s performance. |
| After studying Chapter 6, you should be able to: |
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| 3 How financial ratio analysis helps managers assess the firm’s health. Compute profitability, liquidity, debt, asset activity, and market value ratios. Compare financial information over time and amongcompanies. Chapter 5 2 Gallagher 6e: © Textbook Media Press |
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| 4 Financial managers use ratios to interpret the raw numbers on financial statements. Relative measures allow comparison over time and to other firms. Ratios are used by financial managers, other business managers, creditors, and investors. Chapter 5 3 Gallagher 6e: © Textbook Media Press |
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| 5 Five Categories of Ratios Profitability ratios Liquidity ratios Debt ratios Asset activity ratios Market value ratios Link to Financial Research Chapter 5 4 Gallagher 6e: © Textbook Media Press |
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| 6 Profitability Ratios Measure the overall effectiveness of the firm’s management. Chapter 5 5 Gallagher 6e: © Textbook Media Press |
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| 7 Profitability Ratios Gross Profit Gross Profit Margin = Sales How effective is the firm at generating revenue sold? in excess of its cost of goods Chapter 5 6 Gallagher 6e: © Textbook Media Press |
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8
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| Excalibur Corporation Balance Sheet |
| Excalibur Corporation Total Owners’ Equity $1,700 Total Liabilities and Income Statement |
$1,450
Cost of Goods Sold 875
Depreciation 200
Net Income $162
39.7
7
Cash $175
Accounts Receivable 430
Inventories 625
Current Assets $1,230
Plant & Equipment $2,500
Less:Acc. Depr. (1,200)
Net Fixed Assets $1,300
Total Assets $2,530
Accounts Payable $115
S-T Notes Payable 115
Current Liabilities $230
Bonds $600
Owner’s Equity
Common Stock $300
Capital in Excess of Par 600
Retained Earnings 800
Owners Equity $2,530
Sales
Gross
Gross Profit
Profit =
Sales
Margin
$575
Gross Profit Margin = $1,450 =
Gross Profit $575
Operating Expenses 45
Net Operating Income $330
Interest Expense 60
Income Before Taxes $270
Taxes (40%) 108
Common Dividends Paid 100
Addition to Retained Earnings $62
| 9 Profitability Ratios Operating Income Operating Profit Margin = Sales How effective of production is the firm low? in keeping costs Chapter 5 8 Gallagher 6e: © Textbook Media Press |
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| 10 Excalibur Corporation Operating Income 9 Income Statement Sales $330 gin = $1,450 = 22.8% |
| Excalibur Corporation Balance Sheet |
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$1,450
Common Dividends Paid 100
Cash $175
Accounts Receivable 430
Inventories 625
Current Assets $1,230
Plant & Equipment $2,500
Less:Acc. Depr. (1,200)
Net Fixed Assets $1,300
Total Assets $2,530
Accounts Payable $115
S-T Notes Payable 115
Current Liabilities $230
Long-term Debt $600
Owner’s Equity
Common Stock $300
Capital in Excess of Par 600
Retained Earnings 800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity $2,530
Sales
Cost of Goods Sold 875
Gross Profit $575
Operating Expenses 45
Depreciation 200
Operating
Profit =
Margin
Oper. Profit MarOperating Income $330
Interest Expense 60
Income Before Taxes $270
Taxes (40%) 108
Net Income $162
Addition to Retained Earnings $62
| 11 Profitability Ratios Net Income Net Profit Margin = Sales How much net profit is being generated from each dollar of sales? Chapter 5 10 Gallagher 6e: © Textbook Media Press |
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| 12 Excalibur Corporation $1,450 Cost of Goods Sold 875 Net Income Profit = Addition to Retained Earnings $62 11 Income Statement Sales Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Margin Sales $162 Net Profit Margin = $1,450 = 11.2% Net Income $162 Common Dividends Paid 100 |
| Excalibur Corporation Balance Sheet Assets Liabilities |
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Cash $175
Accounts Receivable 430
Inventories 625
Current Assets $1,230
Plant & Equipment $2,500
Less:Acc. Depr. (1,200)
Net Fixed Assets $1,300
Total Assets $2,530
Accounts Payable $115
S-T Notes Payable 115
Current Liabilities $230
Long-term Debt $600
Owner’s Equity
Common Stock $300
Capital in Excess of Par 600
Retained Earnings 800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity $2,530
| 13 Profitability Ratios Net Income Return on Assets = Total Assets How effectively is the firm generating net income from its assets ? Chapter 5 12 Gallagher 6e: © Textbook Media Press |
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| 14 n 13 Addition to Retained Earnings $62 |
| Excalibur Corporation Balance Sheet Assets Liabilities |
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ratio$1,450
=
Assets Total Assets
ROA = = 6.4%
$2,530
Cash $
Accounts Receivable
Inventories
Current Assets $1,
Plant & Equipment $2,
Less:Acc. Depr. (1,
Net Fixed Assets $1,
175
430
625
Accounts Payable $115
S-T Notes Payable 115
Current Liabilities $230
Long-term debt $600
Owner’s Equity
Common Stock $300
Capital in Excess of Par 600
Retained Earnings 800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity $2,530
230
500
200)
300
Total Assets $2,530
Income Statement
Excalibur Corpo
Sales
Cost of Goods Sold 875
Gross Profit $575
Operating Expenses 45
Depreciation 200
Operating Income $330
Interest Expense 60
Income Before Taxes $270
Taxes (40) 108
Net Income% $162
Common Dividends Paid 100
Return on Net Income
$162
| 15 Profitability Ratios Net Income Return on Equity = Common Equity How well is the firm generating return its equity providers? to Chapter 5 14 Gallagher 6e: © Textbook Media Press |
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| 16 15 |
| Excalibur Corporation Balance Sheet Assets Liabilities |
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$1,450
Cost of Goods Sold 875
Common Equity
Addition to Retained Earnings $62
Cash $
Accounts Receivable
Inventories
Current Assets $1,
Plant & Equipment $2,
Less:Acc. Depr. (1,
Net Fixed Assets $1,
Total Assets $2,
175
430
625
Accounts Payable $115
S-T Notes Payable 115
Current Liabilities $230
Long-term Debt $600
Owner’s Equity
Common Stock $300
Capital in Excess of Par 600
Retained Earnings 800
230
500
200)
300
530
Income Statement
Excalibur Corporation
Total Owners’ Equity $1,700
Total Liabilities and
Sales Owners Equity $2,530
Gross Profit $575
Operating Expenses 45
Depreciation 200
Operating Income $330
Interest Expense 60
Income Before Taxes $270
Taxes (40%) 108
Return on Equity = Net Income
$162
ROE =
$1,700 = 9.53%
Net Income $162
Common Dividends Paid 100
| 17 Liquidity Ratios Measure the ability of the firm to meet its short-term financial obligations. Current Assets Current Ratio = Current Liabilities Are there sufficient current assets to pay off current liabilities? What is the cushion of safety? Chapter 5 16 Gallagher 6e: © Textbook Media Press |
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| 18 Excalibur Corporation Assets Liabilities Current Assets Current Ratio = Current Liabilities $1,230 Current Ratio = $230 = 5.35x Chapter 5 17 Gallagher 6e: © Textbook Media Press |
| Balance Sheet |
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$230
Cash $175
Accounts Receivable 430
Inventories 625
Accounts Payable $115
S-T Notes Payable 115
Current Liabilities
Current Assets $1,230 Long-term Debt $600
Owner’s Equity
Common Stock $300
Capital in Excess of Par 600
Retained Earnings 800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity $2,530
Plant & Equipment $2,500
Less:Acc. Depr. (1,200)
Net Fixed Assets $1,300
Total Assets $2,530
| 19 id Liquidity Ratios Measure the ability of the firm to meet its short-term financial obligations. Ac Test Ratio = Current Assets – Inventory Current Liabilities What happens to the firm’s ability to repay current liabilities after what is usually the least liquid of the current assets is subtracted? Chapter 5 18 Gallagher 6e: © Textbook Media Press |
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| 20 Acid-Test Ratio = Current Assets – Inventory Current Liabilities $1,230 -$625 Acid-Test Ratio = = 2.63x $230 Chapter 5 19 Gallagher 6e: © Textbook Media Press |
| Excalibur Corporation Balance Sheet Assets Liabilities |
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Cash $175 Accounts Payable $115
Accounts Receivable 430 S-T Notes Payable 115
Inventories 625 Current Liabilities $230
Current Assets $1,230 Long-term Debt $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock $300
Net Fixed Assets $1,300 Capital in Excess of Par 600
Total Assets $2,530 Retained Earnings 800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity $2,530
| 21 Debt Ratios Measure the relative size of the firm’s debt load and the firm’s debt. abilityto pay off the Chapter 5 20 Gallagher 6e: © Textbook Media Press |
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| 22 Debt Ratios What proportion of the financed with debt? firm’s assets is Chapter 5 21 Gallagher 6e: © Textbook Media Press |
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Total Debt
Debt Ratio =
Total Assets
23
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| Excalibur Corporation Balance Sheet Assets Liabilities |
| Total Assets $2,530 h ounts entori rr ant ss F otal Debt Ratio = Total Debt Debt Ratio = $230 + $600 = 33% Chapter 5 |
Excalibur Corporation
$1,450
Cost of Goods Sold 875
22
Cas$175
AccReceivable 430
Inves 625
Cuent Assets $1,230
Pl& Equipment $2,500
Le:Acc. Depr. (1,200)
Net ixed Assets $1,300
Accounts Payable $115
S-T Notes Payable 115
Current Liabilities $230
Long-term Debt $600
Owner’s Equity
Common Stock $300
Capital in Excess of Par 600
Retained Earnings 800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity $2,530
TAssets $2,530
Income Statement
Sales
Gross Profit $575
Operating Expenses 45
Depreciation 200
Operating Income $330
Interest Expense 60
Income Before Taxes $270
Taxes (40%) 108
Net Income $162
Common Dividends Paid 100
Addition to Retained Earnings $62
| 24 Debt Ratios Debt to Total Debt Equity Ratio = Common Equity What is the proportion of debt relative equity financing for the firm? to Chapter 5 23 Gallagher 6e: © Textbook Media Press |
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25
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| Excalibur Corporation Balance Sheet Assets Liabilities |
| Equity Ratio = Common Equity $1,700 h ounts entori rr ant ss F otal Debt to Total Debt D/E = $230 + $600 = 48.8% |
$1,450
Cost of Goods Sold 875
24
Cas$175
AccReceivable 430
Inves 625
Cuent Assets $1,230
Pl& Equipment $2,500
Le:Acc. Depr. (1,200)
Net ixed Assets $1,300
TAssets $2,530
Accounts Payable $115
S-T Notes Payable 115
Current Liabilities $230
Long-term Debt $600
Owner’s Equity
Common Stock $300
Capital in Excess of Par 600
Retained Earnings 800
Income Statement Total Owners’ Equity $1,700
Excalibur Corporation Total Liabilities and
Sales Owners Equity $2,530
Gross Profit $575
Operating Expenses 45
Depreciation 200
Operating Income $330
Interest Expense 60
Income Before Taxes $270
Taxes (40%) 108
Net Income $162
Common Dividends Paid 100
Addition to Retained Earnings $62
| 26 Debt Ratios Times Interest Earned Ratio = Operating Income Interest Expense What is the firm’s ability to repay interest payments from its operating income? Chapter 5 25 Gallagher 6e: © Textbook Media Press |
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| 27 = Interest Expense 26 Operating Income $330 = $60 = 5.50x |
| Excalibur Corporation Balance Sheet Assets Liabilities |
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Excalibur Corporation
Interest Net Income
Common Dividends Paid
$162
100
Cash $175
Accounts Receivable 430
Inventories 625
Current Assets $1,230
Plant & Equipment $2,500
Less:Acc. Depr. (1,200)
Net Fixed Assets $1,300
Total Assets $2,530
Accounts Payable $115
S-T Notes Payable 115
Current Liabilities $230
Long-term Debt $600
Owner’s Equity
Common Stock $300
Capital in Excess of Par 600
Retained Earnings 800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity $2,530
Income Statement
Sales $
Cost of Goods Sold
1,450
875
Gross Profit $575
Operating Expenses 45
Depreciation 200
Times
Earned Ratio
TIE Ratio Operating Income $330
Interest Expense 60
Income Before Taxes $270
Taxes (40%) 108
Addition to Retained Earnings $62
| 28 Asset Activity Ratios Help assess how effectively the firm is using assetsto generate sales. Chapter 5 27 Gallagher 6e: © Textbook Media Press |
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| 29 Asset Activity Ratios Accounts Receivable Average Collection Period = Avg. Daily Credit Sales How long does it take for the firm on average to collect customers? its credit sales from Chapter 5 28 Gallagher 6e: © Textbook Media Press |
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| 30 29 Days in a year |
| Excalibur Corporation Balance Sheet Assets Liabilities |
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Current Assets $1,230
Less:Acc. Depr. (1,200)
Excalibur Corporation
$1,450
Cost of Goods Sold 875
Accounts Receivable
Collection =
= 108.24 days
Cash $175 Accounts Payable $115
S-T Notes Payable 115
Current Liabilities $230
Bonds $600
Owner’s Equity
Common Stock $300
Capital in Excess of Par 600
Retained Earnings 800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity $2,530
Accounts Receivable 430
Inventories 625
Plant & Equipment $2,500
Net Fixed Assets $1,300
Total Assets $2,530
Income Statement
Sales
Gross Profit $575
Operating Expenses 45
Depreciation 200
Operating Income $330
Interest Expense 60
Income Before Taxes $270
Taxes (40%) 108
Net Income $162
Common Dividends Paid 100
Addition to Retained Earnings $62
Average
Period Avg. Daily Credit Sales
ACP = $430
$1,450/365
| 31 Asset Activity Ratios Sales Inventory Turnover Ratio = Inventory Is inventory efficiently translating into sales for the firm? Chapter 5 30 Gallagher 6e: © Textbook Media Press |
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| 32 = 2.3x 31 |
| Excalibur Corporation Balance Sheet Assets Liabilities |
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Excalibur Corporation
$1,450
Cost of Goods Sold 875
Turnover =
Inventory Turnover = $625
Cash $175
Accounts Receivable 430
Accounts Payable $115
S-T Notes Payable 115
Current Liabilities $230
Long-term Debt $600
Owner’s Equity
Common Stock $300
Capital in Excess of Par 600
Retained Earnings 800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity $2,530
Inventories 625
Current Assets $1,230
Plant & Equipment $2,500
Less:Acc. Depr. (1,200)
Net Fixed Assets $1,300
Total Assets $2,530
Income Statement
Sales
Gross Profit $575
Operating Expenses 45
Depreciation 200
Operating Income $330
Interest Expense 60
Income Before Taxes $270
Taxes (40%) 108
Net Income $162
Common Dividends Paid 100
Addition to Retained Earnings $62
Inventory Sales
Ratio Inventory
$1450
| 33 Asset Activity Ratios Sales Fixed Asset Turnover Ratio = Net Fixed Assets How effective is the firm in using assets to help generate sales? its fixed Chapter 5 32 Gallagher 6e: © Textbook Media Press |
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| 34 33 |
| Excalibur Corporation Balance Sheet Assets Liabilities |
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Excalibur Corporation
$1,450
Cost of Goods Sold 875
Sales
Turnover =
Fixed Asset Turnover = = 1.12x
$1,300
Cash $175
Accounts Receivable 430
Inventories 625
Current Assets $1,230
Plant & Equipment $2,500
Less:Acc. Depr. (1,200)
Accounts Payable $115
S-T Notes Payable 115
Current Liabilities $230
Long-term Debt $600
Owner’s Equity
Common Stock $300
Capital in Excess of Par 600
Retained Earnings 800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity $2,530
Net Fixed Assets $1,300
Total Assets $2,530
Income Statement
Sales
Gross Profit $575
Operating Expenses 45
Depreciation 200
Operating Income $330
Interest Expense 60
Income Before Taxes $270
Taxes (40%) 108
Net Income $162
Common Dividends Paid 100
Addition to Retained Earnings $62
Fixed Asset
Ratio Net Fixed Assets
$1,450
| 35 Asset Activity Ratios Sales Total Asset Turnover Ratio = Total Assets How effective is the firm in using its overall assets to generate sales? Chapter 5 34 Gallagher 6e: © Textbook Media Press |
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| 36 = 0.57x 35 |
| Excalibur Corporation Balance Sheet Assets Liabilities |
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Excalibur Corporation
$1,450
Cost of Goods Sold 875
Turnover =
Total Assets
Total Asset Turnover = $2,530
Cash $175
Accounts Receivable 430
Inventories 625
Current Assets $1,230
Plant & Equipment $2,500
Less:Acc. Depr. (1,200)
Net Fixed Assets $1,300
Accounts Payable $115
S-T Notes Payable 115
Current Liabilities $230
Long-term Debt $600
Owner’s Equity
Common Stock $300
Capital in Excess of Par 600
Retained Earnings 800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity $2,530
Total Assets $2,530
Income Statement
Sales
Gross Profit $575
Operating Expenses 45
Depreciation 200
Operating Income $330
Interest Expense 60
Income Before Taxes $270
Taxes (40%) 108
Net Income $162
Common Dividends Paid 100
Addition to Retained Earnings $62
Total Asset Sales
Ratio
$1,450
| 37 Market Value Ratios Market Price per Share Price to Earnings Ratio = Earnings per Share How much are investors willing to pay per dollar of earnings of the firm? (Indicator of investor’s attitudes toward future prospects of the firm and of the firm’s risk.) Chapter 5 36 |
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| 38 37 100 shares |
| Excalibur Corporation Additional Info: Balance Sheet Assets Liabilities |
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S-T Notes Payable 115
Long-term Debt $600
Common Stock $300
Excalibur Corporation
1,450
Cost of Goods Sold 875
Ratio EPS
Addition to Retained Earnings $62
$20.00 per
share
Cash $175
Accounts Receivable 430
Inventories 625
Current Assets $1,230
Plant & Equipment $2,500
Less:Acc. Depr. (1,200)
Net Fixed Assets $1,300
Total Assets $2,530
Accounts Payable $115
Current Liabilities $230
Owner’s Equity
Capital in Excess of Par 600
Retained Earnings 800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity $2,530
Income Statement
Sales $
Gross Profit $575
Operating Expenses 45
Depreciation 200
Operating Income $330
Interest Expense 60
Income Before Taxes $270
Taxes (40%) 108
P/E
= MarketPrice/Share
P/E ratio = $20.00 = 12.35x
$162/100
Net Income $162
Common Dividends Paid 100
| 39 Market Value Ratios Market to Book Ratio = Market Price per Share Book Value per Share How much are investors willing to pay per dollar of book value? Chapter 5 38 |
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40
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Excalibur Corporation
Current Liabilities $230
Owner’s Equity
Capital in Excess of Par 600
$1,450
Cost of Goods Sold 875
to =
| Common Equity/ # shares $1,700/100 Market Price/Share M/B = $20.00 = 1.18x |
| Additional Info: 100 shares $20.00 per share Income Statement Excalibur Corporation |
39
Balance Sheet
Assets Liabilities
Cash $175
Accounts Receivable 430
Inventories 625
Current Assets $1,230
Plant & Equipment $2,500
Less:Acc. Depr. (1,200)
Net Fixed Assets $1,300
Total Assets $2,530
Accounts Payable $115
S-T Notes Payable 115
Long-term Debt $600
Common Stock $300
Retained Earnings 800
Total Owners’ Equity $1,700
Total Liabilities and
Sales Owners Equity $2,530
Gross Profit $575
Operating Expenses 45
Depreciation 200
Operating Income $330
Interest Expense 60
Income Before Taxes $270
Taxes (40%) 108
Net Income $162
Common Dividends Paid 100
Addition to Retained Earnings $62
Book
| 41 EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is often of great interest to financial analysts although FASB does not require that this number be reported. It measures the amount of cash thrown off from the operations of the company. Chapter 5 40 |
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| 42 Profitability Excalibur is good at keeping operating costs down, but not as good at total costs. ROA and ROE are low mainly due to productivity problems. Chapter 5 41 Gross Profit Margin 38% 39.7% Operating Profit Margin 20% 22.8% Net Profit Margin 12% 11.2% Return on Assets 9.0% 6.4% Return on Equity 13.4% 9.5% Ratio Industry Excalibur |
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| 43 Summary of Excalibur Corporation Ratios Liquidity Looking at the current ratio it appears that Excalibur is more liquid than the industry…. however when looking at Acid Test (a better measure) they are not as liquid indicating that inventory levels are probably too high. Chapter 5 42 Current Ratio 5.00x 5.35x Acid-Test Ratio 3.00x 2.63x Ratio Industry Excalibur |
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| 44 Debt While the debt ratio is close to the industry average, Excalibur is not able to cover interest payments as easily as the industry. This indicates Excalibur may have too much debt relative to what they can realistically afford. 43 Chapter 5 Debt Ratio 35% 33% Times Interest Earned 7.00x 5.50x Debt to Equity 49% 48% Ratio Industry Excalibur |
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| 45 Asset Activity Collection policies need examining, as Excalibur is slower than average at collecting receivables. Inventories are being sold more slowly than the industry average, again indicating inventories that are too high. Excalibur is very efficient at converting Fixed Assets to Sales (fixed assets are productive). However, overall assets are not productive indicating CurrentAssets (e.g. inventories) are not as productive as for the industry. 44 Chapter 5 Avg. Collection Period 90 days 108 days Inventory Turnover 3.00x 2.32x Fixed Asset Turnover 1.00x 1.12x Total Asset Turnover 0.75x .57x Ratio Industry Excalibur |
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| 46 Market Value Excalibur’s Investors are not willing to pay as much per dollar of earnings or per dollar of book value as they are for shares in other firms in the industry. This signals that they consider the firm’s prospects to be worse than the average. However, the firm is still selling for more than its accounting book value. Chapter 5 45 Price Earnings 18.0 12.35 Market to Book 2.5 1.18 Ratio Industry Excalibur |
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| 47 EVA is the amount of profit earned after all costs have been subtracted, including the cost of the funds used for the investmen t. of Link to Stern Stewart & Co. EVA Chapter 5 46 |
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| 48 MVA is the market value of the firm, debt plus equity, minus the total amount of capital invested in the firm. Chapter 5 47 |
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