how well the firm has adjusted its financial mix. Comparison of these ra-
tios (allowing for the fact that one is an after-tax return) indicates some-
thing about the profitability—but not much about the risk of the firm’s use
of leverage.
EBIT to Interest Charges (Times Interest Earned—TIE) This ratio is ob-
tained by dividing the firm’s annual interest charges into its earnings before
interest and taxes (EBIT).^4 The size of the ratio obtained indicates some-
thing of the safety of the long-term debt component of the firm’s financing.
Standard & Poor’s Corporation makes extensive use of the times interest
earned ratio in ranking debt with respect to possible default. The opera-
tional safety of long-term debt affects the short-term creditors and working
capital management indirectly. If the coverage is good, the firm may safely
operate on a relatively smaller net working capital margin. A poor or er-
ratic coverage may cast doubt on what otherwise appears to be an ade-
quate current position.
We calculate these eight ratios and the general analysis ratios for JNJ
for selected years during the 1970–2003 period, using the WRDS database,
and will discuss the implications of these ratios later in the chapter when
we compare them to their respective sector and group medians.
Financial Ratios and the Perceived Financial Health of Firms
Financial analysis often combines the information of several ratios to gain
insight into a picture of the firm’s health. In this chapter, we examine two
composite measures of the firm’s health, the DuPont system rate of return,
dating back to the early twentieth century, and the Altman Z bankruptcy
prediction model, created in 1968. The DuPont system, or measure, di-
vides net operating income by sales and multiplies the result by the ratio of
sales to investment, producing a return on investment (ROI).
Stockholders should invest in firms with higher ROIs, and manage-
ment could seek to maximize the DuPont ROI to maximize its stock price.
The DuPont analysis uses information inherent in its return on sales and
sales turnover ratios.
Pierre DuPont and Donald Brown, a DuPont Corporation employee,
NOI
SalesSales
Investment×=ROI