Copyright © 2006 McGraw Hill Ryerson Limited17-1 prepared by: Sujata Madan McGill University Fundamentals of Corporate Finance Third Canadian Edition.

Copyright © 2006 McGraw Hill Ryerson Limited 17-1

prepared by:Sujata Madan

McGill University

Fundamentals

of Corporate

Finance

Third Canadian Edition


Chapter 17 Financial Statement Analysis Financial Ratios

The DuPont System

Analysis of the Statement of Cash Flows

Using Financial Ratios

Measuring Company Performance

The Role of Financial Ratios


Financial Ratios Introduction

This chapter will describe:

1. Leverage ratios – show how heavily a company is in debt.

2. Liquidity ratios – measure how easily a firm can lay its hands on cash.

3. Efficiency or Turnover Ratios – measure how productively a firm is using its assets.

4. Profitability Ratios – measure the firm’s return on its investments.


Financial RatiosLeverage Ratios

Leverage ratios show how much financial leverage a firm is carrying. Financial leverage adds risk to the firm.


LT Debt + Value of Leases

Financial Ratios Leverage Ratios

Long Term Debt Ratio = LT Debt + Value of Leases + Equity

LT Debt + Value of LeasesDebt-Equity Ratio =

Equity

Total LiabilitiesTotal Debt Ratio =

Total Assets


EBIT

Financial Ratios Leverage Ratios

Times Interest Earned (TIE) = Interest Payments

EBIT + Depreciation & AmortizationCash Coverage Ratio =

Interest Payments

EBIT + Depreciation & Amortization

Fixed Charge Coverage Ratio =

Interest Pymts+(Current Debt Repymt+Current Lease Obligations)

(1 - Tax Rate)


Financial Ratios Liquidity Ratios

Liquidity Ratios measure how much of the company’s assets are liquid.

Liquid refers to an asset which can be converted to cash quickly and at low cost.


Current Assets – Current Liabilities


Net Working Capital =

Net Working CapitalNet Working Capital as a % of Total Assets

Total Assets=



Current AssetsCurrent Ratio =

Current Liabilities

Cash + Marketable Securities + ReceivablesQuick Ratio =

Current Liabilities


Financial Ratios Efficiency Ratios

SalesAsset Turnover Ratio

Average Total Assets

SalesFixed Asset Turnover Ratio =

Average Fixed Assets

=


Financial Ratios Efficiency Ratios

Average ReceivablesAverage Collection Period Average Daily Sales

Cost of Goods SoldInventory Turnover Ratio =

Average Inventory

=

InventoryDays’ Sales in Inventories =

Cost of Goods Sold/365


Financial RatiosProfitability Ratios

One group, called profit margins, look at profits or earnings as a fraction of sales.

The other group, called return ratios, measure profits earned as a fraction of the assets used.


Financial Ratios Profitability Ratios – Profit Margins

Sales – Cost of Goods SoldGross Profit MarginSales

EBIT – TaxesOperating Profit Margin =

Sales

=

Net IncomeNet Profit Margin =

Sales

Net Income + Interest

Salesor


Financial Ratios Profitability Ratios – Return Ratios

Net Income + InterestReturn on Assets (ROA)Average Total Assets

=

Return on Equity =Net Income

Average Equity


Earnings

Financial Ratios Profitability Ratios

DividendsPayout Ratio

Earnings=

Plowback Ratio = Earnings - Dividends

1 – Payout Ratio =

Earnings - DividendsGrowth in Equity from Plowback

Earnings=

= Plowback x ROE


The DuPont System DuPont System - ROA

Some profitability and efficiency measures can be linked in useful ways.

Net Income + InterestROA =

Assets

Sales =

Assets

Asset Turnover Profit Margin

Net Income + Interest

Sales x


The DuPont System DuPont System - ROE

Net IncomeROE =

Equity

Sales =

Assets

Asset Turnover Profit Margin

Net Income+Interest

Sales

Assets

Equity

Net Income

Net Income+Interest

Debt BurdenLeverage


Analysis of the Statement of Cash Flows

Analysis of the Statement of Cash Flows can tell you a lot about the financial health of a firm.

By contrast, the Income Statement gives a better sense of the long-run profitability of the firm.


Using Financial Ratios

Choosing a Benchmark Once financial ratios have been calculated for a

firm, they need to be compared to a benchmark.

The benchmark could be: The firm’s performance in prior years. Another firm’s performance.


Using Financial Ratios Financial Ratios for Selected Industry Groups, 2004


Measuring Company PerformanceMVA and EVA

Market Value Added is the difference between the market value of a firm’s equity and its book value.

Economic Value Added (EVA or Residual Income) measures the net profit of a firm after deducting the cost of the capital employed.


Measuring Company PerformanceEVA

EVA or residual income is a better measure of company performance than accounting profits.

EVA recognizes that companies need to cover their cost of capital before they can add value.

Residual income = After-tax operating profit - cost of capital x invested capital


The Role of Financial Ratios Helping Financial Managers Make

Decisions Ratios can help you understand, and improve,

your company’s financial health by making sure that its leverage, liquidity, efficiency and profitability are kept at optimal levels.


Summary of Chapter 17 As a financial manager, you will be responsible

for analyzing your company’s financial statements.

You will be looking at its income statement, balance sheet and statement of cash flows.

You will use financial ratios to summarize the firm’s leverage, liquidity, profitability and efficiency.


Summary of Chapter 17 The DuPont System provides a useful way to link

ratios to explain the firm’s return on assets and equity.

ROE is a function of the firm’s leverage ratio, asset turnover, profit margin and debt burden.

ROA is a function of asset turnover and profit margin.


Summary of Chapter 17 Financial ratios need a benchmark for

comparison. You can compare ratios with the company’s ratios in prior years and/or with the ratios of other firms in the same business.

Other measures, such as Market Value Added (MVA) and Economic Value Added (EVA) are available to help you assess a firm’s performance.

Copyright © 2006 McGraw Hill Ryerson Limited17-1 prepared by: Sujata Madan McGill University Fundamentals of Corporate Finance Third Canadian Edition.

Documents

turnover ratios

return ratios

assets roaaverage total

equity ratio

companys assets

total assetstotal assets

financial leverage

average fixed assets