1 Chapter 03 Analyzing Financial Statements McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Introduction Financial Statement Use – Analyze firm performance – Plan changes to improve performance Ratio Analysis – Used to assess firm’s performance 3-2

Five Groups of Financial Ratios Liquidity Asset management Debt management Profitability Market value 3-3

Ratios Used to Make Comparisons Trend – Comparison to the same firm over time Competitors – Comparison to other firms in the same industry 3-4

Liquidity Ratios Relationship between firm’s liquid (current) assets and current liabilities – Commonly-used liquidity ratios Current ratio Quick (or acid-test) ratio Cash ratio 3-5

Current Ratio Broadest liquidity measure Measures current assets available to pay current liabilities 3-6

Quick Ratio Excludes inventory in numerator Measures ability to pay short-term obligations without inventory sales 3-7

Cash Ratio Measures ability to pay short-term obligations with available cash and marketable securities 3-8

Asset Management Ratios Measure efficiency of firm’s asset use – Inventory – Accounts receivable – Fixed assets – Accounts payable management 3-9

Inventory Management Inventory Turnover Ratio – Dollar of sales produced per dollar of inventory – Often uses cost of goods sold instead of sales because inventory is listed on the balance sheet at cost 3-10

Inventory Management Days’ Sales in Inventory Ratio – Measures average number of days inventory held 3-11

Accounts Receivable Management The Average Collection Period (ACP) Ratio – Measures number of days accounts receivable held until collected 3-12

Accounts Receivable Management The Accounts Receivable Turnover Ratio – Measures dollars of sales produced per dollar of accounts receivable 3-13

Accounts Payable Management The Average Payment Period (APP) Ratio – Measures the number of days accounts payable held before extending cash to pay for raw materials 3-14

Accounts Payable Management Accounts Payable Turnover Ratio – Measures dollar of COGS per dollar of accounts payable. 3-15

Fixed Asset and Working Capital Management The Fixed Asset Turnover Ratio – Measures dollars of sales produced per dollar of fixed assets 3-16

Fixed Asset and Working Capital Management Sales to Working Capital Ratio – Measures dollar of sales produced per dollar of working capital (Current assets minus current liabilities) 3-17

Total Asset Management Total Asset Turnover Ratio – Measures dollars of sales produced per dollar of total assets 3-18

Total Asset Management Capital Intensity Ratio – Measures dollars of total assets needed to produce a dollar of sales 3-19

Debt Management Ratios Measure how much debt (financial leverage) versus equity a firm uses to finance assets Two major ratio types – Measure debt amount – Measure firm’s ability to service debt 3-20

Three related measures – Debt Ratio – Debt-to-Equity Ratio – Equity Multiplier Ratio Debt vs. Equity Financing 3-21

Debt vs. Equity Financing Debt Ratio – Measures percentage of total assets financed with debt 3-22

Debt vs. Equity Financing Debt-to-Equity Ratio — Measures dollars of debt financing for every dollar of equity financing 3-23

Equity Multiplier Ratio – Measures the dollars of assets on balance sheet for every dollar of equity financing Debt vs. Equity Financing 3-24

Coverage Ratios Times Interest Earned Ratio – Measures operating earnings dollars available to meet interest obligations 3-25

Coverage Ratios The Fixed-Charge Coverage Ratio – Measures operating earnings available for interest and other fixed charges 3-26

Cash Coverage Ratio – Measures operating cash available to meet interest and other fixed charges – Indicates if debt burden is too large Coverage Ratios 3-27

Profitability Ratios Show the combined effect of liquidity, asset management and debt management on firm’s operating results Closely monitored by investors – Stock prices react very quickly to unexpected changes in these ratios 3-28

Percent of sales left after all firm expenses are paid Profit Margin 3-29

Basic Earnings Power Ratio Measures the EBIT earned per dollar of assets on the balance sheet Represents operating return on assets irrespective of financial leverage and taxes 3-30

Return on Assets (ROA) Measures overall return on firm’s assets inclusive of leverage and taxes 3-31

Measures return on common stockholders’ investment – Affected by net income and amount of financial leverage – High ROE is usually a positive sign, unless driven by excessively high leverage Return on Equity (ROE) 3-32

Dividend Payout Ratio Measures fraction of earnings paid out to common stockholders as dividends 3-33

Market Value Ratios Market prices of publicly traded firms incorporate risk – Ratios that incorporate stock market values are important Market values reflect what investors think of the company’s future performance and risk 3-34

Price-Earnings Ratio Best known and most often quoted figure – Measures price investors will pay per dollar of earnings – High PE ratio usually indicates projected growth – Drives stock classification as growth or value 3-35

DuPont Analysis Uses Balance Sheet and Income Statements – Breaks ROA and ROE into components to explain why the ratios are low or high 3-36

DuPont Analysis 3-37

Other Ratios Spreading the Financial Statement – Divide balance sheet amounts by total assets – Divide all income statement amounts by net sales 3-38

Other Ratios Internal Growth Rate Sustainable Growth Rate Time Series Cross-Sectional Analysis 3-39