1. 3 Chapter Financial Analysis McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. Financial Statement for Ratio Analysis

10. Profitability Ratios

11. 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

12. 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)

13. DuPont Analysis

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

15. 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.

16. Asset Utilization Ratios (cont’d)

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

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

19. 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

20. Ratio Analysis

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

22. Trend Analysis in the Computer Industry

23. 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

24. 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.”

25. 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

26. 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

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

28. Income Statements

29. 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.

30. 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