© 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca College Revised by PChua References: Block et al Gitman et al

© 2003 McGraw-Hill Ryerson Limited Chapter 3 - Outline  What is Financial Analysis?  Uses of Ratio Analysis  Approaches to Ratio Analysis  4 Categories of Financial Ratios  Profitability Ratios (including Dupont Analysis)  Asset Utilization Ratios  Liquidity Ratios  Debt Utilization Ratios  Importance of Ratios  Final Notes on Using Financial Ratios  Summary and Conclusions PPT 3-2

© 2003 McGraw-Hill Ryerson Limited Financial Analysis  Financial Analysis is performed using Ratio Analysis  Ratio Analysis involves the method of calculating and interpreting financial ratios to assess the firm’s performance  A ratio is a numerator divided by a denominator; can be a percentage, times(x) or days  Ratio Analysis uses Income and Balance Sheet Statements for input PPT 3-3

© 2003 McGraw-Hill Ryerson Limited Uses of Financial Ratio Analysis  To decide whether to invest in a firm  To determine whether to lend funds to a firm  To plan for the future direction of a firm  To conduct routine financial analysis of a firm

© 2003 McGraw-Hill Ryerson Limited Approaches to Ratio Analysis  Cross-Sectional Analysis  Trend analysis  Combined Analysis  Common-size statements PPT 3-4

© 2003 McGraw-Hill Ryerson Limited 4 Categories of Ratios  Profitability Ratios  Asset Utilization Ratios  Liquidity Ratios  Debt Utilization Ratios PPT 3-5

© 2003 McGraw-Hill Ryerson Limited Sources of Published Ratios  D & B’s Industry Norms and key Business Ratios  Canada Company Handbook  Statistics Canada’s Financial Indicators for Canadian Business  

© 2003 McGraw-Hill Ryerson Limited Classification system for ratios(a) A. Profitability Ratios 1.Profit margin (Return on Sales) 2.Return on assets (ROA) 3.Return on equity (ROE) B. Asset Utilization Ratios 4a. Receivable turnover 4b. Average collection period (days sales outstanding) 5a. Inventory turnover 5b. Inventory holding period 6a. Accounts payable turnover 6b. Accounts payable period PPT 3-6

© 2003 McGraw-Hill Ryerson Limited Four categories of financial ratios (b) B. Asset Utilization Ratios (cont’d) 7.Capital 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 PPT 3-7

© 2003 McGraw-Hill Ryerson Limited Other Useful Ratios P/E Ratio = Market Share Price Earnings per share (EPS) MV to BV = Market Value of Share Book Value per share  Way of measuring desirability of a stock.  Influenced by earnings and sales growth of the firm, risk (debt-equity structure), quality of management, dividend policy, among others.  Indicates Expectations as to the company’s future performance.

© 2003 McGraw-Hill Ryerson Limited Which ratios are most important? It depends on its use  Shareholders are most interested in profitability ratios  Suppliers and banks (lenders) are most interested in liquidity ratios  Long-term creditors concentrate on debt utilization ratios  The effective utilization of assets is management’s responsibility PPT 3-8

© 2003 McGraw-Hill Ryerson Limited PPT 3-9 Table 3-1a Financial statements for ratio analysis

© 2003 McGraw-Hill Ryerson Limited Balance Sheet As of December 31, 2002 Assets Cash$ 30,000 Marketable securities50,000 Accounts receivable350,000 Inventory370,000 Total current assets800,000 Net plant and equipment800,000 Total assets$1,600,000 Liabilities and Shareholders' Equity Accounts payable$ 50,000 Notes payable250,000 Total current liabilities300,000 Long-term liabilities300,000 Total liabilities600,000 Common stock400,000 Retained earnings600,000 Total liabilities and shareholders' equity$1,600,000 PPT 3-10 Table 3-1b Financial statements for ratio analysis

© 2003 McGraw-Hill Ryerson Limited  Measure overall company profitability for potential investors (income to investment base)  The higher the ratio, the more profitable the firm Return on Sales Return on Equity Return on Assets Net Income Sales Net Income Total Owner’s Equity Net Income Total Assets Profitability Ratios PPT 3-11

© 2003 McGraw-Hill Ryerson Limited Saxton Company Industry Average 3-1. Profit margin = = 5% 6.5% 3-2. Return on assets (ROA) (investment) = a. = 12.5% 10% b. 5%  2.5 = 12.5% 6.5%  1.5 = 10% Net income Sales $200,000 $4,000,000 Net income Total assets Net income Sales Total assets  $200,000 $1,600,000 PPT 3-12 Profitability ratios(a)

© 2003 McGraw-Hill Ryerson Limited Saxton Company Industry Average 3-3. Return on equity (ROE) = a. = 20% 15% b. Equity multiplier = = 1.6=1.5 c. ROA × Equity multiplier = × 1.60 = 20% 0.10 × 1.50 = 15% Total assets Equity $1,600,000 $1,000,000 Net income Shareholders’ equity $200,000 $1,000,000 PPT 3-13 Profitability ratios(b)

© 2003 McGraw-Hill Ryerson Limited    Figure 3-1 Du Pont analysis Net income Sales Total assets Profit margin Asset turnover Total assets Equity Return on assets Financing plan (Equity multiplier) Return on Equity =  PPT 3-14 

© 2003 McGraw-Hill Ryerson Limited  Measure how efficiently the company uses its assets to generate sales  The higher the ratio, the greater the company’s efficiency Sales Accounts Receivable Asset Utilization Ratios Cost of Goods Sold Inventory Inventory Turnover Capital Asset Turnover ReceivableTurnover Sales Capital Assets PPT 3-16

© 2003 McGraw-Hill Ryerson Limited Saxton Company Industry Average 3-4a. Receivables turnover = = times 3-4b. Average collection period = = days 3-5a. Inventory turnover = Cost of Goods Sold = 8.17 times Inventory Sales (credit) Receivables $4,000,000 $350,000 Accounts receivable Average daily credit sales $350,000 $10,959 $3,000,000 $370,000 PPT 3-17 Asset utilization ratios(a)

© 2003 McGraw-Hill Ryerson Limited Saxton Company Industry Average 3-5b. Inventory holding period = = 4552 days 3-6a. Accounts payable turnover = = times 3-6b. Accounts payable period = Accounts payable = 630 days Average daily purchases (COGS) Inventory Average daily COGS $370,000 $8,219 Cost of goods sold Accounts payable $3,000,000 $50,000 $8,219 PPT 3-18 Asset utilization ratios(b)

© 2003 McGraw-Hill Ryerson Limited Asset utilization ratios(c) Saxton Company Industry Average 3-7. Capital asset turnover = = times 3-8. Total asset turnover = = times Sales Capital assets $4,000,000 $800,000 Sales Total assets $4,000,000 $1,600,000 PPT 3-19

© 2003 McGraw-Hill Ryerson Limited  Measure the company’s liquidity (its ability to pay short-term debts)  The higher the ratio, the lower the risk of inability to pay Current Ratio Quick Ratio Current Assets Current Liabilities “Quick” Assets Current Liabilities Liquidity Ratios PPT 3-21

© 2003 McGraw-Hill Ryerson Limited Liquidity ratios Saxton Company Industry Average 3-9. Current ratio = = Quick ratio = = Current assets Current liabilities $800,000 $300,000 Current assets – Inventory Current liabilities $430,000 $300,000 PPT 3-22

© 2003 McGraw-Hill Ryerson Limited  Measure the company’s ability to pay long-term debts  The higher the ratio, the less risk of insolvency Debt Total Assets Debt Utilization Ratios Debt-to-Total Assets Ratio Debt-to-Total Assets Ratio Times Interest Earned Earned Operating Income Interest Expense Fixed Charge Coverage Coverage Operating Income “Fixed” Charges PPT 3-23

© 2003 McGraw-Hill Ryerson Limited Debt utilization ratios Saxton Company Industry Average Debt to total assets = = 37.5%33% Times interest earned = = 11 7 times Fixed charge coverage = = 65.5 times Total debt Total 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 PPT 3-24

© 2003 McGraw-Hill Ryerson Limited Saxton Industry Company AverageConclusion A. Profitability 1.Profit margin……………… 5% 6.5%Below average 2.Return on assets………..…. 12.5% 10%Above average due to high turnover 3.Return on equity…………. 20% 15%Good due to ratios 2 and 11 B. Asset Utilization 4a.Receivables turnover …… Good 4b.Average collection period… Good 5a.Inventory turnover ……… Good 5b.Inventory holding period Good 6a.Accounts payable turnover Good 6b.Accounts payable period Good 7.Capital asset turnover …… Below average 8.Total asset turnover ……… Good PPT 3-25 Table 3-2a Ratio analysis(a)

© 2003 McGraw-Hill Ryerson Limited Saxton Industry Company AverageConclusion C. Liquidity 9.Current ratio ……………… Good 10.Quick ratio ……………… Good D. Debt Utilization 11.Debt to total assets ……… % 33%Slightly more debt 12.Times interest earned ……. 117Good 13.Fixed charge coverage ……. 65.5Good PPT 3-26 Table 3-2b Ratio analysis(b)

© 2003 McGraw-Hill Ryerson Limited Figure 3-2a Trend analysis A. Profit Margin Percent Saxton PPT 3-27

© 2003 McGraw-Hill Ryerson Limited Figure 3-2a Combined analysis A. Profit Margin Percent Industry Saxton PPT 3-27

© 2003 McGraw-Hill Ryerson Limited B. Total asset turnover 3.5X 3.0X 2.5X 2.0X 1.5X 1.0X.5X Saxton PPT 3-28 Figure 3-2b Trend Analysis

© 2003 McGraw-Hill Ryerson Limited B. Total asset turnover 3.5X 3.0X 2.5X 2.0X 1.5X 1.0X.5X Industry Saxton PPT 3-28 Figure 3-2b Combined Analysis

© 2003 McGraw-Hill Ryerson Limited Table 3-3 Trend analysis of competitors Return on Assets Return on Equity Royal Bank Bank of Montreal Return on Assets Return on Equity PPT 3-29 Source: Annual reportswww.bmo.comSymbol: BMO RY

© 2003 McGraw-Hill Ryerson Limited Inflation and it’s Impact on Profits FIFO (First-In, First-Out) Inventory:  Lowers COGS (Cost of Goods Sold)  Raises Profits LIFO (Last-In, First-Out) Inventory:  Raises COGS  Lowers Profits PPT 3-31

© 2003 McGraw-Hill Ryerson Limited Notes on the Use of Ratio Analysis  Ratio analysis may not answer questions, but leads to further inquiry and help you ask the right questions  It may merely direct attention to potential areas of concern; it does not provide evidence as to the existence of a problem  Ratios that deviate from the norm are only symptoms of the problem; further analysis is required to isolate the cause of the problem.  A single ratio does not provide sufficient information to judge overall performance.  Be aware that data being compared may not use the same accounting rules applied.  Time series comparisons of ratios may be distorted by inflation.  It is difficult to define categorically what a good or bad ratio value should be.  Requires a large dose of good judgment  Ratio analysis will rarely be useful if practiced mechanically

© 2003 McGraw-Hill Ryerson Limited Summary and Conclusions  Financial analysis involves evaluating and comparing financial performance  Basic tools for financial analysis include financial ratios, trend analysis and cross-sectional analysis  Financial analysis is somewhat hindered by limitations in financial reporting, but can suggest aspects requiring further exploration PPT 3-32