1. Financial Analysis 3
Chapter

2. Chapter 3 - Outline What is Financial Analysis?
4 Categories of Financial Ratios
Profitability Ratios
Asset Utilization Ratios
Liquidity Ratios
Debt Utilization Ratios
Distortion in Financial Reporting
Summary and Conclusions

3. Financial Analysis What is financial analysis?
Evaluating a firm’s financial performance
Ratios are calculated by dividing one value on financial statements by another related value
A long-run trend analysis over a number of years shows changes over time
Ratios, trends and other calculations are used to interpret and compare the financial performance of a company to its industry and to its past results
Financial analysis may not answer questions, but leads to further inquiry

4. 4 Categories of Ratios Profitability Ratios Asset Utilization Ratios
Liquidity Ratios
Debt Utilization Ratios

5. Classification system for ratios
A. Profitability Ratios
1. Profit margin
2. Return on assets (ROA) (investment)
3. Return on equity (ROE) (common shareholders)
B. Asset Utilization Ratios
4. Receivable turnover
5. Average collection period (days sales outstanding)
6. Inventory turnover
7. Fixed Asset Turnover
8. Total Asset Turnover

6. Four categories of financial ratios
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

7. 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
Long-term creditors concentrate on debt utilization ratios
The effective utilization of assets is management’s responsibility

8. Financial statements for ratio analysis

9. Financial statements for ratio analysis
Balance Sheet As of December 31, 2002
Assets
Cash $ ,000
Marketable securities 50,000
Accounts receivable 350,000
Inventory 370,000
Total current assets 800,000
Net plant and equipment 800,000
Total assets $1,600,000
Liabilities and Shareholders' Equity
Accounts payable $ ,000
Notes payable 250,000
Total current liabilities 300,000
Long-term liabilities 300,000
Total liabilities 600,000
Common stock 400,000
Retained earnings 600,000
Total liabilities and shareholders' equity $1,600,000

10. Profitability Ratios
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 Assets
Net Income
Sales
Net Income
Total Assets
Net Income
Total Owner’s Equity
Return on Equity

11. Profitability ratios Saxton Company Industry Average = 12.5% 10%
1. Profit margin = = 5% %
measures how much out of every dollar of sales a company actually keeps in earnings.
A low profit margin indicates a low margin of safety: higher risk that a decline in sales will erase
profits and result in a net loss, or a negative margin.
Profit margin is an indicator of a company's pricing strategies and how well it controls costs.
2. Return on assets (ROA) (investment) =
= 12.5% 10%
An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how
efficient management is at using its assets to generate earnings.
Net income
Sales
$200,000
$4,000,000
Net income
Total assets
$200,000
$1,600,000

12. Profitability ratios Saxton Company Industry Average = 20% 15%
3. Return on equity (ROE) =
= 20% %
Return on equity (ROE) measures the rate of return for ownership interest (shareholders’ equity). It measures the efficiency of a firm at generating profits from each unit of shareholder equity. ROE shows how well a company uses investments to generate earnings growth.
ROEs 15-20% are generally considered good.
Net income
Shareholders’ equity
$200,000
$1,000,000

13. Asset Utilization Ratios
Measure how efficiently the company uses its assets to generate sales.
Sales (credit)
Accounts Receivable
Capital Asset Turnover
Cost of Goods Sold
Inventory
Receivable
Turnover
Inventory Turnover
Sales
Capital Assets

14. Average daily credit sales*
Receivables Turnover
Saxton Company Industry Average
4. Receivables turnover =
= times
5. Average collection period =
= days
Explanation: Saxton collects its receivables faster than the industry; which is shown by the receivables turnover of 11.4 times versus 10 times for the industry, and, in daily terms, by the average collection period of 32 days, which is 4days faster than the industry norms.
*Average daily credit sales = annual credit sales / 365 days
Sales (credit)
Receivables
$4,000,000
$350,000
Accounts receivable
Average daily credit sales*
$350,000
$10,959

15. Receivables Turnover
Accounts receivable turnover is the number of times per year that a business collects its average accounts receivable. The ratio is intended to evaluate the ability of a company to efficiently collect funds in a timely manner.
A high turnover ratio indicates an aggressive collections department. 
It is also quite likely that a low turnover level indicates an excessive amount of bad debt.

16. Asset utilization ratios(a)
Saxton Company Industry Average
6. Inventory turnover =
Sales = times
Inventory
Explanation: shows how many times a company's inventory is sold and replaced over a period. Low ratio figure implies poor sales and existence of excess inventory. Higher is better, because it implies strong and faster sales of inventory.
This ratio tells us that Saxton generates more sales per dollar of inventory than the average company in the industry, and we can assume the firm uses very efficient inventory-ordering and cost-control method.
$4,000,000
$370,000

17. Asset utilization ratios(c)
Saxton Company Industry Average
7. Fixed asset turnover =
= times
8. Total asset turnover =
= times
Sales
Fixed assets
$4,000,000
$800,000
Sales
Total assets
$4,000,000
$1,600,000
This ratios measure how effectively the firm is using its fixed and total assets in generating revenues.
The firm maintains a slightly lower ratio of sales to fixed assets (plant and equipment) than does the industry. This is relatively a minor consideration in relation to rapid movement of inventory and accounts receivables. Again, the rapid turnover of total assets is much higher than the industry average.

18. Liquidity Ratios
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
Current Assets-Inventory
Current Liabilities

19. Current assets – Inventory
Liquidity ratios
Saxton Company Industry Average
9. Current ratio = =
Current assets
Current liabilities
$800,000
$300,000
10. Quick ratio =
Current assets – Inventory
Current liabilities
$430,000
$300,000 =
Measures how much current asset and cash equivalent the company is carrying to meet its current liabilities/obligations.
The firm’s liquidity ratios are very good compare to the industry average. However, further analysis might call for a cash budget to determine if the firm can meet each maturing obligation as it comes due.

20. Liquidity ratios (current ratio)
 Acceptable current ratios vary from industry to industry and are generally between 1.5 and 3 for healthy businesses. If a company's current ratio is in this range, then it generally indicates good short-term financial strength.
 If current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations.
 If the current ratio is too high, then the company may not be efficiently using its current assets or its short-term financing facilities. This may also indicate problems in working capital management.

21. Liquidity ratios (quick ratio)
In finance, the Acid-test or quick ratio or liquid ratio measures the ability of a company to use its near cash or quick assets to extinguish or retire its  current liabilities immediately. Quick assets include those current assets that presumably can be quickly converted to cash at close to their book values. A company with a quick ratio of less than 1 cannot currently fully pay back its current liabilities.

22. Debt Utilization Ratios
Measure the company’s ability to pay long-term debts
The higher the ratio, the less risk of insolvency
Fixed Charge
Coverage
Times Interest
Earned
Operating Income
“Fixed” Charges
Operating Income
Interest Expense
Debt
Total Assets
Debt-to-Total Assets Ratio

23. Debt utilization ratios
Saxton Company Industry Average
11. Debt to total assets =
= 37.5% 33%
12. Times interest earned =
= times
13. Fixed charge coverage =
= 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

24. Debt Utilization Ratios
The debt to total assets ratio is an indicator of financial leverage. It tells you the percentage of total assets that were financed by creditors, liabilities, debt. 
Times interest earned (TIE) or interest coverage ratio is a measure of a company's ability to honor its debt payments.
The fixed charge coverage ratio measures a firm's ability to pay all of its fixed charges or expenses with its income before interest and income taxes. The fixed charge coverage ratio is basically an expanded version of the times interest earned ratio or the times interest coverage ratio.

25. Debt utilization ratios: Implications for Saxton
Debt to total asset is slightly higher than the industry average, but well within the prudence range of 50% or less.
Times interest earned indicates the number of times that EBIT covers the interest obligation. The higher the ratio, the stronger is the interest paying ability of the firm.
Fixed charge coverage measures the firm’s ability to meet all fixed obligations rather than interest alone.
“Income before fixed charges and taxes” = EBIT + other fixed charges (e.g. Lease payment)
Ratios for times interest earned and fixed charge coverage show that the Saxton Company debt is being well managed compared to the debt management of other firms in the industry.

26. Ratio analysis Saxton Industry Company Average Conclusion
A. Profitability
1. Profit margin……………… % % Below average
2. Return on assets………..… % % Above average due to high turnover
3. Return on equity………… % % Good due to ratios 2 and 11
B. Asset Utilization
4. Receivables turnover …… Good
5. Average collection period… Good
6. Inventory turnover ……… Good
7. Fixed asset turnover …… Below average
8. Total asset turnover ……… Good

27. Ratio analysis Saxton Industry Company Average Conclusion C. Liquidity
9. Current ratio ……………… Good
10. Quick ratio ……………… Good
D. Debt Utilization
11. Debt to total assets ……… % % Slightly more debt
12. Times interest earned …… Good
13. Fixed charge coverage …… Good

28. Trend Analysis A. Profit Margin Percent Industry 7 5 Saxton 3 1
Industry
Saxton

29. Trend Analysis B. Total asset turnover 3.5X 3.0X 2.5X 2.0X 1.5X Saxton
Industry

30. 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

31. Income Statements

32. Explanation of Discrepancies
Sales
Firm may defer recognition until each payment is received or full recognition at earliest possible date
Cost of goods sold
Use of different accounting principles – LIFO versus FIFO
Extraordinary gains/losses
Inclusion of events in computing current income or leaving them out
Net income
Use of different methods of financial reporting

33. Chapter 03: Discussion Question
1. If we divide users of ratios into short-term lenders, long-term lenders, and stockholders, in which ratios would each group be most interested, and for what reasons?
Short-term lenders–liquidity ratios because their concern is with the firm’s ability to pay short-term obligations as they come due.
Long-term lenders–leverage ratios because they are concerned with the relationship of debt to total assets. They also will examine profitability to insure that interest payments can be made.
Stockholders–profitability ratios, with secondary consideration given to debt utilization, liquidity, and other ratios. Since stockholders are the ultimate owners of the firm, they are primarily concerned with profits or the return on their investment.

34. Chapter 03: Discussion Question
2. If the accounts receivable turnover ratio is decreasing, what will be happening to the average collection period?
If the accounts receivable turnover ratio is decreasing, accounts receivable will be on the books for a longer period of time. This means the average collection period will be increasing.

35. Chapter 03: Discussion Question
3. Why is trend analysis helpful in analyzing ratios?
Trend analysis allows us to compare the present with the past and evaluate our progress through time. A profit margin of 5 percent may be particularly impressive if it has been running only 3 percent in the last ten years. Trend analysis must also be compared to industry patterns of change.

36. Summary and Conclusions
Financial analysis involves evaluating and comparing financial performance
Basic tools for financial analysis include financial ratios and trend analysis