Financial Analysis Chapter 3. Chapter 3 - Outline Financial Analysis 4 Categories of Financial Ratios Importance of Ratios Inflation and its Impact on.

Financial Analysis

Chapter 3

Chapter 3 - Outline

Financial Analysis 4 Categories of Financial Ratios

Importance of RatiosInflation and its Impact on Profits

Financial Analysis and Ratios

What is financial analysis?

Evaluating a firm’s financial performance

Analyzing ratios or numerical calculations

Comparing a company to its industry

4 Categories of Ratios

Profitability RatiosAsset Utilization RatiosLiquidity RatiosDebt Utilization Ratios

Classification System

We will separate 13 significant ratios into four primary categories.

A. Profitability Ratios.1. Profit margin.

2. Return on assets (investment).

3. Return on equity.

B. Asset utilization ratios.4. Receivable turnover.

5. Average collection period.

6. Inventory turnover.

7. Fixed asset turnover.

8. Total asset turnover.

C. Liquidity ratios.9. Current ratio.

10. Quick ratio.

D. Debt utilization ratios.11. Debt to total assets.

12. Times interest earned.

13. Fixed charge coverage.

TABLE 3-1Financial statementfor ratio analysis

Profitability Ratios

Show how profitable a company is.

The ratios express:— Profit Margin or Return on Sales (%)

— Return on Assets or Return on Investment (%)

— Return on Equity (%)

Profitability RatiosSaxton Company Industry

Average

1. Profit margin = = 5% 6.7%

2. Return on assets (investment) =

a. = 12.5% 10%

b. 5% 2.5 = 12.5% 6.7% 1.5 = 10%

3. Return on equity =

a. = 20% 15%

b. = 20% = 15%

Net incomesales

$200,000$4,000,000

Net incomeTotal assets

Net incomeSales

SalesTotal assets

$200,000$1,600,000

Net incomeStockholders’ equity

$200,000$1,000,000

Return on assets (investment)(1 – Debt/Assets)

0.1251 – 0.375

0.101 – 0.33

FIGURE 3-1Du Pont analysis

Return of Wal-Mart versus Macy’s using the Du Pont method of analysis, 2007

Asset Utilization Ratios

Show how effectively a company uses its assets.

The ratios express:— Receivables Turnover (times)— Average Collection Period (days)— Inventory Turnover (times)— Fixed Asset Turnover (times)— Total Asset Turnover (times)

Saxton Company Industry Average

4. Receivables turnover =

= 11.4 10 times

5. Average collection period =

= 32 36 days

6. Inventory turnover =

= 10.8 7 times

Sales (credit)Receivables

$4,000,000$350,000

Accounts receivableAverage daily credit sales

$350,000$11,111

SalesInventory

$4,000,000$370,000

Asset Utilization Ratios

Asset Utilization Ratios

Saxton Company Industry Average

7. Fixed asset turnover =

= 5 5.4 times

8. Total asset turnover =

= 2.5 1.5 times

SalesFixed assets

$4,000,000$800,000

SalesTotal assets

$4,000,000$1,600,000

Profitability and Turnover Ratios

Remember:Return on X = Net Income / X

X Turnover = Sales / X

Liquidity Ratios

Show how liquid a company is or how much $ it has to meet S/T needs.

The ratios express:—Current Ratio (times)—Quick Ratio or Acid-Test Ratio (times)

Liquidity Ratios

Saxton Company Industry Average

9. Current ratio =

= 2.672.1

10. Quick ratio =

= 1.43 1.0

Current assetsCurrent liabilities

$800,000$300,000

Current assets − InventoryCurrent liabilities

$430,000$300,000

Debt Utilization Ratios

Show how well a company is managing or using debt.

The ratios express:—Debt-to-Total Assets (%)—Times Interest Earned (times)—Fixed Charge Coverage (times)

(Fixed Charges = lease payments, i expense)

Debt Utilization RatiosSaxton Company Industry

Average

11. Debt to total asets =

= 37.5% 33%

12. Times interest earned =

= 11 7 times

13. Fixed charge coverage =

= 6 5.5 times

Total debtTotal assets

$600,000$1,600,000

Income before interest and taxes

Interest$550,000$50,000

Income before fixed charges and taxes

Fixed charges$600,000$100,000

TABLE 3-3Ratio analysis

FIGURE 3-2Trend analysis

1-21

Trend Analysis in the Computer Industry

TABLE 3-7Comparison of replacementcost accounting and historicalcost accounting

Inflation’s Impact on ProfitsFIFO (First-In, First-Out) Inventory:—Lowers COGS—Raises Profits

LIFO (Last-In, First-Out) Inventory:—Raises COGS—Lowers Profits

Importance of Ratios

Which ratio is most important?It depends on your perspective.Suppliers and banks (lenders) are most

interested in liquidity ratios.Stockholders are most interested in

profitability ratios.A long-run trend analysis over a 5-10

year period is usually performed by an analyst.