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3-1 CHAPTER 3 Analysis of Financial Statements
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3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

Dec 19, 2015

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Page 1: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

3-1

CHAPTER 3Analysis of Financial Statements

Page 2: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

3-2

4-1 Ration Analysis Ratios standardize numbers and

facilitate comparisons. Ratios are used to highlight

weaknesses and strengths.

Page 3: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

3-3

4-1 Ration Analysis Liquidity: Can we make required

payments? Asset management: right amount of

assets vs. sales? Debt management: Right mix of debt and

equity? Profitability: Do sales prices exceed unit

costs, and are sales high enough as reflected in PM, ROE, and ROA?

Market value: Do investors like what they see as reflected in P/E and M/B ratios?

Page 4: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4.2 Liquidity Ratios The liquidity ratios help answer this

question: Will the firm be able to pay off its debts as they come due and thus remain a viable organization? If the answer is no, liquidity must be the first order of business.

A liquid asset is one that trades in an active market and thus can be quickly converted to cash at the going market price

Page 5: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

3-5

4-2a Current Ratio The primary liquidity ratio is the current

ratio, which is calculated by dividing current assets by current liabilities

Page 6: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-2b Quick, or Acid Test, Ratio The second liquidity ratio is the

quick, or acid test, ratio, which is calculated by deducting inventories from current assets and then dividing the remainder by current liabilities:

Page 7: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

3-7

4-3 Asset Management Ratios The second group of ratios, the

asset management ratios, measure how effectively the firm is managing its assets. These ratios answer this question: Does the amount of each type of asset seem reasonable, too high, or too low in view of current and projected sales?

Page 8: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

3-8

4-3a Inventory Turnover Ratio “Turnover ratios” divide sales by

some asset: Sales/Various assets. As the name implies, these ratios show how many times the particular asset is “turned over” during the year. Here is the inventory turnover ratio:

Page 9: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-3b Days Sales Outstanding Accounts receivable are evaluated by

the days sales outstanding (DSO) ratio, also called the average collection period (ACP).5 It is calculated by dividing accounts receivable by the average daily sales to find how many days’ sales are tied up in receivables.

Page 10: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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DSO is the average number of days after making a sale before receiving cash.

DSO = Receivables / Average sales per day

= Receivables / Sales/365

Page 11: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

3-11

4-3c Fixed Asset Turnover Ratio The fixed assets turnover ratio, which

is the ratio of sales to net fixed assets, measures how effectively the firm uses its plant and equipment:

Page 12: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

3-12

4-4 Debt Management Ratio The use of debt will increase, or

“leverage up,” a firm’s ROE if the firm earns more on its assets than the interest rate it pays on debt. However, debt exposes the firm to more risk than if it financed only with equity.

Page 13: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

3-13

4-4 Debt Management Ratio

Page 14: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

3-14

4-4 Debt Management Ratio

Table below illustrates the potential benefits and risks associated with debt. Here we analyze two companies that are identical except for how they are financed.Firm U (for Unleveraged) has no debt; thus, it uses 100% common equity. Firm L (for Leveraged) obtained 50% of its capital as debt at an interest rate of 10%. Both firms have $100 of assets, and their sales are expected to range from a high of $150 down to $75 depending on business conditions. Some of their operating costs(e.g., rent and the president’s salary) are fixed and will be the same regardless of the level of sales, while other costs (e.g., manufacturing labor and materials costs)vary with sales

Page 15: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-4a Total Debt to Total Assets The ratio of total debt to total

assets, generally called the debt ratio, measures the percentage of funds provided by creditors:

Page 16: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-4b Times-Interest-Earned Ratio The times-interest-earned (TIE)

ratio is determined by dividing earnings before interest and taxes by the interest charges:

Page 17: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

3-17

4-5 Profitability Ratios Profitability Ratios is a group of

ratios that show the combined effects

of liquidity, asset management, and debt on operating results.

Page 18: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

3-18

4-5a Operating Margin The operating margin, calculated

by dividing operating income (EBIT) by sales, gives the operating profit per dollar of sales:

Page 19: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

3-19

4-5b Profit Margin The profit margin, also

sometimes called the net profit margin, is calculated by dividing net income by sales:

Page 20: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-5c Return on Total Assets Net income divided by total assets gives

us the return on total assets (ROA):

Page 21: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-5e Basic Earning Power(BEP) Ratio Basic Earning Power(BEP) Ratio

This ratio indicates the ability of the firm’s assets to generate operating income; it is calculated by dividing EBIT by total assets.

Page 22: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-5e Return on Common Equity Return on Common Equity (ROE)

The ratio of net income to common equity; measures the rate of return on common stockholders’ investment.

Page 23: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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Effects of debt on ROA and ROE ROA is lowered by debt--interest

lowers NI, which also lowers ROA = NI/Assets.

But use of debt also lowers equity, hence debt could raise ROE = NI/Equity.

Page 24: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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Problems with ROE ROE and shareholder wealth are

correlated, but problems can arise when ROE is the sole measure of performance. ROE does not consider risk. ROE does not consider the amount of capital

invested. Might encourage managers to make

investment decisions that do not benefit shareholders.

ROE focuses only on return. A better measure is one that considers both risk and return.

Page 25: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-6 Market Value Ratios Market Value Ratios is ratios

that relate the firm’s stock price to its earnings and book value per share.

Page 26: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-6a Price/Earning Ratio The price/earnings (P/E) ratio

shows how much investors are willing to pay per dollar of reported profits. Allied’s stock sells for $23.06; so with an EPS of $2.35, its P/E ratio is 9.8×:

Page 27: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-6b Market/Book Ratio Market/Book (M/B) is the ratio of a

stock’s market price to its book value.

Page 28: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-7 Trend Analysis Trend Analysis is an analysis of a

firm’s financial ratios over time; used to estimate the likelihood of improvement or deterioration in its financial condition.

Page 29: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-7 Trend analysis Analyzes a firm’s

financial ratios over time

Can be used to estimate the likelihood of improvement or deterioration in financial condition.

Page 30: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-8 The DuPont Equation DuPont Equation is a formula that

shows that the rate of return on equity can be found as the product of profit margin, total assets turnover, and the equity multiplier. It shows the relationships among asset management, debt management, and profitability ratios.

Page 31: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-9 Ratio In Different Industries

Page 32: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-9 Ratio In Different Industries Table below provides a list of the ratios

for a number of different industries in early 2008. ROEs vary across industries, ranging from 45.7% for education and training services to 0.9% for newspapers. The education and training services industry has been positively impacted by enrollment growth of online operations in schools.

Page 33: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-9 Ratio In Different Industries

The newspaper industry has been in decline because the proportion of the population that reads newspapers has been in a long-term decline, which has a negative impact on the demand for newspaper advertising. Industry rankings change from year to year because firms and industries go through cycles of good and bad times. When times are good, companies often over-expand, which leads to hard times.

Page 34: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-10 Summary of Allied’s Ratios

Page 35: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-11 Benchmarking Benchmarking is the process of

comparing a particular company with a set of benchmark companies.

Page 36: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-12 Uses And Limitation Of Ratios that while ratio analysis can

provide useful information concerning a company’s operations and financial condition, it does have limitations.

Page 37: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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Potential problems and limitations of financial ratio analysis Comparison with industry averages is

difficult for a conglomerate firm that operates in many different divisions.

“Average” performance is not necessarily good, perhaps the firm should aim higher.

Seasonal factors can distort ratios. “Window dressing” techniques can

make statements and ratios look better.

Page 38: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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4-13 Potential Misuses Of ROE three problems are likely to arise if a firm

relies too heavily on ROE to measure performance.

First, ROE does not consider risk. Shareholders care about ROE, but they also care about risk.

Second, ROE does not consider the amount of invested capital.

Third, a focus on ROE can cause managers to turn down profitable projects.

Page 39: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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More issues regarding ratios Different operating and accounting

practices can distort comparisons. Sometimes it is hard to tell if a

ratio is “good” or “bad”. Difficult to tell whether a company

is, on balance, in strong or weak position.

Page 40: 3-1 CHAPTER 3 Analysis of Financial Statements. 3-2 4-1 Ration Analysis Ratios standardize numbers and facilitate comparisons. Ratios are used to highlight.

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Qualitative factors to be considered when evaluating a company’s future financial performance Are the firm’s revenues tied to 1 key

customer, product, or supplier? What percentage of the firm’s

business is generated overseas? Competition Future prospects Legal and regulatory environment