3 Chapter Financial Analysis McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline Ratio analysis and its importance Use of ratios as measurement tool The DuPont system of analysis Trend analysis Evaluation of reported income to identify sources of distortion

Management Functions Management Functions are: 1) Planning 2) Organizing 3) Directing and Leading 4) Controlling In Finance controlling will be through Financial Analysis.

Financial analysis Types of Financial analysis: 1) Horizontal (Sources& Uses of Funds) 2) Vertical (Ratio Analysis) Sources of Data for ratio analysis will be from the Financial Statements (Balance sheet and Income statement).

Financial Statement Analysis Financial Statement Analysis is the Art of transforming Data from Financial Statements into Information that is useful for decision making.

Kinds of Comparison Kinds of Comparison are: - First : Internal comparison 1) Past comparison 2) Present comparison 3) Expected Future comparison - Second: External comparison 1) Similar firms comparison 2) Industry Average comparison

Ratio Analysis Financial ratios Used to weigh and evaluate the operating performance of a firm Numerical calculations and analyzing ratios Used to compare performance record as against similar firms in the industry Additional evaluation of company management, physical facilities and other factors Such data is provided by various organizations

Sources of Industry Average Ratios 1) Dun & Bradstreet 2) Prentice Hall 3) Almanac of Business & Industrial Financial Ratios 4) Various Trade Associations Note: The Industry Average Ratios should not be a target or goal, rather they provide a Guidelines to the companies.

Types of Ratios 1) Liquidity Ratios 2)Asset Utilization Ratios or Activity Ratios. 3) Debt Ratios 4) Profitability Ratios 5) Stock Ratios 6) Growth Ratios

Ratios and their Classification 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

Ratios and their Classification (cont’d) 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

Types of Ratios Profitability ratios Asset utilization ratios Measure the firm’s ability to earn adequate return on: Sales Assets Invested capital Asset utilization ratios Measure the speed at which the firm is turning over: Accounts receivable Inventory Long-term assets

Types of Ratios (cont’d) Liquidity ratios Emphasizes the firm’s ability to pay off short-term obligations as they come due Debt utilization ratios Estimates the overall debt position of the firm Evaluates in the light of asset base and earning power

Financial Statement for Ratio Analysis

Liquidity Ratios These ratios determine if the firm can meet each maturing obligation as it comes due

Asset Utilization Ratios These ratios relate the balance sheet (assets) to the income statement (sales) * *This ratio may also be computed by using “Cost of goods sold” in the numerator.

Asset Utilization Ratios (cont’d)

Debt Utilization Ratios Measures the prudence of the debt management policies of the firm

Debt Utilization Ratios (cont’d) Fixed charge coverage measures the firm’s ability to meet all fixed obligations rather than interest payments alone Income before interest and taxes………………..$550,000 Lease payments…………………………………… 50,000 Income before fixed charges and taxes…………$600,000

Profitability Ratios

DuPont System of Analysis A satisfactory return on assets might be derived through: a high profit margin, or a rapid turnover of assets (generating more sales per dollar of its assets) or a combination of both Return on assets (investment) = Profit margin × Asset turnover

DuPont System of Analysis (cont’d) A satisfactory return on equity might be derived through: a high return on total assets a generous utilization of debt or a combination of both Return on equity = Return on assets (investment) (1 – Debt/Assets)

DuPont Analysis

Return of Wal-Mart versus Abercrombie using the Du Pont method of analysis, 2009

Ratio Analysis

Importance of Ratios to Users of Financial Statements For potential investors/security analysts: Primary considerations – profitability ratios Secondary considerations – liquidity and debt utilization For banker or trade creditor – liquidity ratios For long-term creditors – debt utilization ratios and profitability ratios

Trend Analysis Gives a picture of performance over a number of years against industry averages

Trend Analysis in the Computer Industry

Impact of Inflation on Financial Analysis Revenue is stated in current dollars Plant, equipment, or inventory may have been purchased at lower price levels Profits may be more a function of increasing prices than of satisfactory performance Financial reports get distorted for no consideration of inflation factor, which in turn will affect the financial analysis

Comparison of Replacement and Historical Cost Accounting Jeff Garnett and Geoffrey A. Hirt, “Replacement Cost Data: A Study of the Chemical and Drug Industry for Years 1976 through 1978.”

Comparison of Replacement and Historical Cost Accounting (cont’d) Replacement cost – reduces income but increases assets an increase in assets lowers the debt-to-assets ratio a lower debt-to-assets ratio indicates decrease in the financial leverage of the firm a declining income results in a decreased ability to cover interest costs

Impact of Disinflation on Financial Analysis Disinflation – a situation of declining inflationary pressures Will not impair the purchasing power of the dollar Reduction in investors’ expectation of returns on financial assets Financial assets such as stocks and bonds have the potential to do well Deflation Actual reduction of prices affecting everybody due to bankruptcies and declining profits

Other Elements of Distortion in Reported Income Effect of changing prices Reporting of revenues Treatment of nonrecurring items Tax write-off policies

Income Statements

Explanation of Discrepancies Sales Firm may defer revenue recognition until each payment received or full recognition at earliest possible date Cost of goods sold Use of different accounting principles – LIFO versus FIFO Varying treatment of R&D costs etc.

Explanation of Discrepancies (cont’d) Extraordinary gains/losses Inclusion of extra-ordinary events in computing current income or leave them out Net income Use of different methods of financial reporting (inclusion / exclusion of extra-ordinary gains / losses) Each item in the financial statement analyzed rather accepting bottom-line figures