Chapter 3 Financial Analysis

Chapter 3 - Outline Financial Analysis 4 Categories of Financial Ratios Importance of Ratios Inflation 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

Asset Utilization Ratios Liquidity Ratios Debt Utilization Ratios 4 Categories of Ratios Profitability Ratios Asset Utilization Ratios Liquidity Ratios Debt 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 3-1 Financial statement for 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 (%)

Return on assets (investment) Profitability Ratios Saxton 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 income sales $200,000 $4,000,000 Net income Total assets $200,000 $1,600,000 Net income Sales Sales Total assets  Net income Stockholders’ equity $200,000 $1,000,000 Return on assets (investment) (1 – Debt/Assets) 0.125 1 – 0.375 0.10 1 – 0.33

FIGURE 3-1 Du 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)

Asset Utilization Ratios 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 receivable Average daily credit sales $350,000 $11,111 Sales Inventory $4,000,000 $370,000

Asset Utilization Ratios Saxton Company Industry Average 7. Fixed asset turnover = = 5 5.4 times 8. Total asset turnover = = 2.5 1.5 times Sales Fixed assets $4,000,000 $800,000 Sales Total 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)

Current assets − Inventory Liquidity Ratios Saxton Company Industry Average 9. Current ratio = = 2.67 2.1 10. Quick ratio = = 1.43 1.0 Current assets Current liabilities $800,000 $300,000 Current assets − Inventory Current 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 Ratios Saxton 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 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

TABLE 3-3 Ratio analysis

FIGURE 3-2 Trend analysis

Trend Analysis in the Computer Industry

TABLE 3-7 Comparison of replacement cost accounting and historical cost accounting

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

Which ratio is most important? 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.