1. Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Financial Analysis 3

2. 1-2 Chapter 3 - Outline Financial Analysis 4 Categories of Financial Ratios Importance of Ratios Distortion in Financial Reporting

3. 1-3 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 and to its past performance A long-run trend analysis over a 5-10 year period is usually performed by an analyst. Ratio analysis may not answer questions, but leads to further inquiry

4. 1-4 Tools of Financial Analysis Financial ratios Comparative financial statements Trend analysis Common-size statements PPT 3-4

5. 1-5 4 Categories of Ratios Profitability Ratios Asset Utilization Ratios Liquidity Ratios Debt Utilization Ratios PPT 3-5

6. 1-6 Classification system for ratios(a) A. Profitability Ratios 1.Profit margin 2.Return on assets (ROA) (investment) 3.Return on equity (ROE) (common shareholders) 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

7. 1-7 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

8. 1-8 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 (%)

9. 1-9 Asset Utilization Ratios Show how effectively a company uses its assets. The ratios express: –Receivables Turnover (times) –Average Collection Period (days) –Inventory Turnover (times) –Capital Asset Turnover (times) –Total Asset Turnover (times)

10. 1-10 Liquidity Ratios LT 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)

11. 1-11 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, interest expense)

12. 1-12 Importance of Ratios Which ratios are most important? It depends on your perspective. Suppliers and banks (lenders) are most interested in liquidity ratios. Shareholders are most interested in profitability ratios Bondholders concentrate on debt utilization ratios The effective utilization of assets is management ’ s responsibility

13. 1-13 SAXTON COMPANY Income Statement For the Year 2009 Sales (all on credit)..................$ 4,000,000 Cost of goods sold...................3,000,000 Gross profit.....................1,000,000 Selling and administrative expense*........... 450,000 Operating profit...................550,000 Interest expense...................50,000 Extraordinary loss..................100,000 Net income before taxes................400,000 Taxes (50%).....................200,000 Net income......................$ 200,000 * Includes $50,000 in lease payments. PPT 3-2 Financial statements for ratio analysis

14. 1-14 Balance Sheet As of December 31, 2009 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 3-2 Financial statements for ratio analysis

15. 1-15 Profitability Ratios

16. 1-16 DuPont System of Analysis A satisfactory return on assets might be derived through: –A high profit margin –A rapid turnover of assets (generating more sales per dollar of its assets) –Or both Return on assets (investment) = Profit margin × Asset turnover

17. 1-17 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)

18. 1-18 DuPont Analysis

19. 1-19 Return of Wal-Mart versus Macy’s using the Du Pont method of analysis, 2007

20. 1-20 Asset Utilization Ratios These ratios relate the balance sheet to the income statement

21. 1-21 Asset Utilization Ratios (cont’d)

22. 1-22 Liquidity Ratios

23. 1-23 Debt Utilization Ratios Measures the prudence of the debt management policies of the firm

24. 1-24 Debt Utilization Ratios (cont’d) Fixed charge coverage measures the firm’s ability to meet the fixed obligations Interest payments alone are not considered Income before interest and taxes………………..$550,000 Lease payments…………………………………… $50,000 Income before fixed charges and taxes…………$600,000

25. 1-25 Ratio Analysis

26. 1-26 Trend analysis A. Profit Margin Percent 75317531 1996 1998 2000 2002 2004 2006 2009 Industry Saxton PPT 3-10

27. 1-27 B. Total asset turnover 3.5X 3.0X 2.5X 2.0X 1.5X 1.0X.5X 1996 1998 2000 2002 2004 2006 2009 Industry Saxton PPT 3-10 Trend Analysis

28. 1-28 Trend Analysis in the Computer Industry

29. 1-29 Common-size financial statements (vertical analysis) 1. Express the items on the balance sheet as a percentage of total assets. 2. Presents the items on the income statement as a percentage of total sales.

30. 1-30 SAXTON COMPANY Income Statement For the Year 2009 Sales (all on credit).................100%($ 4,000,000) Cost of goods sold...................75% Gross profit.....................25% Selling and administrative expense*........... 11.25% Operating profit...................13.75% Interest expense...................1.25% Extraordinary loss..................2.5% Net income before taxes................10% Taxes (50%).....................5% Net income......................5% * Includes $50,000 in lease payments. Common size income statements

31. 1-31 Balance Sheet As of December 31, 2009 Assets Cash1.875% Marketable securities3.125% Accounts receivable21.875% Inventory23.20% Total current assets50% Net plant and equipment50% Total assets100%($1,600,000) Liabilities and Shareholders' Equity Accounts payable3.125% Notes payable15.625% Total current liabilities18.75% Long-term liabilities18.75% Total liabilities37.5% Common stock25% Retained earnings37.5% Total liabilities and shareholders' equity100% Common size balance sheet

32. 1-32 Impact of inflation and disinflation on financial analysis A. Impact on profits 1. FIFO inventory valuation during inflation periods “ understates ” cost of goods sold and causes “ inventory profits. ” 2.The use of replacement cost accounting reduces income and interest coverage during inflationary periods. 3. A leveling off of prices referred to as disinflation, may cause a reduction in profits.

33. 1-33 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

34. 1-34 Impact of inflation and disinflation on financial analysis B. Impact on asset value 1. Assets on the balance sheet are record at cost. 2.In inflationary periods, the replacement cost of long-term assets may greatly exceed the report values. 3. Cash flows from the amortization process may be insufficient to replace assets as they wear out. 4.The use of replacement accounting increase assets value during inflationary periods while lowers the debt to asset ratio but does not necessarily enhance the firm ’ s ability to service its debt.

35. 1-35 Comparison of Replacement and Historical Cost Accounting

36. 1-36 Impact of inflation and disinflation on financial analysis C. Raising capital 1. Investors generally require higher rates of return during periods of inflation. 2. Although earnings may drop because of disinflation,the declining rate of return demanded by investors may cause the value of a firm ’ s securities to increase. 3. The movement away from financial assets into tangible assets by investors during periods of inflation makes it difficult and more expensive for firms to raise capital. But during periods of disinflation enhance a firm ’ s ability to issue securities.

37. 1-37 Other Elements of distortion in Reported Income A. Recognition of revenue. - Firm may defer recognition until each payment is received or full recognition at earliest possible date B. Handling of expenses - LIFO, FIFO or average cost -Treatment of R&D C. Extraordinary gains or losses - Inclusion of events in computing current income or leaving them out

38. 1-38 Income Statements