1. 5 Financial Analysis FIVE C H A P T E R Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc. 2000

2. 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.

3. Classification System
B. Asset utilization ratios.
4. Receivable turnover.
5. Average collection period.
6. Inventory turnover.
7. Fixed asset turnover.
8. Total asset turnover.

4. Classification System
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.

5. Table 3-1a Financial Statement for Ratio Analysis
SAXTON COMPANY
Income Statement
For the Year Ended December 31, 2001
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 200,000
Net income before taxes 300,000
Taxes (33%) 100,000
Net income $ ,000
* Includes $50,000 in lease payments.

6. Table 3-1b Financial Statement for Ratio Analysis
Balance Sheet As of December 31, 2001
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 Stockholders’ 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 stockholders’ equity $1,600,000

7. Return on assets (investment)
Profitability Ratios
Saxton Company Industry Average
1. Profit margin = = 5% 6.7%
2. Return on assets (investment) =
a. = 12.5% %
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

8. Figure 3-1 DuPont analysis
Net Income 
Profit Margin
Return on
Assets
Sales  
Asset
Turnover
Total Assets
Return on
Equity
Return on Assets 
(1 - Debt/Assets) =
Total Debt 
Financing
Plan
Total Assets

9. Asset Utilization Ratios
Saxton Company Industry Average
4. Receivables turnover =
= times
5. Average collection period =
= days
6. Inventory turnover =
= 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

10. Asset Utilization Ratios
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

11. Current assets – Inventory
Liquidity Ratios
Saxton Company Industry Average
9. Current ratio = =
10. Quick ratio = =
Current assets
Current liabilities
$800,000
$300,000
Current assets – Inventory
Current liabilities
$430,000
$300,000

12. Debt Utilization Ratios
Saxton Company Industry Average
11. Debt to total asets =
= 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

13. Table 3-3 Ratio Analysis T 3-9 Saxton Industry
Company Average Conclusion
A. Profitability
1. Profit Margin ……………… 5.0% 6.7% Below average
2. Return on Assets ………… % 10.0% Above average due to high turnover
3. Return on Equity ………… % 15.0% Good due to ratios 2 and 10
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
C. Liquidity
9. Current ratio ……………… Good
10. Quick Ratio ……………… Good
D. Debt Utilization
11. Debt to total assets ……… % 33.0% Slightly more debt
12. Times interest earned …… Good
13. Fixed charge coverage … Good

14. Figure 3-2 Trend analysis
A. Profit Margin Percent 7 5 3 1
Industry
Saxton

15. Figure 3-2 Trend Analysis
B. Total asset turnover
3.5X
3.0X
2.5X
2.0X
1.5X
1.0X
.5X
Saxton
Industry

16. Table 3-8 T 3-13 Income Statement For the Year 2001 High Reported
Conservative Income
A B
Sales $ 4,000, $ 4,200,000
Cost of goods sold ,000, ,700,000
Gross profit ,000, ,500,000
Selling and administrative expense , ,000
Operating profit , ,050,000
Interest expense , ,000
Extraordinary loss , —
Net income before taxes , ,000,000
Taxes (30%) , ,000
Net income , ,000
Extraordinary loss (net of tax) — ,000
Net income transferred to retained earnings $ , $ 630,000

17. Chapter 3 - Outline LT 3-1 Financial Analysis
4 Categories of Financial Ratios
Importance of Ratios
Inflation and its Impact on Profits

18. Financial Analysis and Ratios LT 3-2
What is financial analysis?
Evaluating a firm’s financial performance
Analyzing ratios or numerical calculations
Comparing a company to its industry

19. 4 Categories of Ratios LT 3-3
Profitability Ratios
Asset Utilization Ratios
Liquidity Ratios
Debt Utilization Ratios

20. Profitability Ratios LT 3-4
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 (%)

21. Asset Utilization Ratios LT 3-5
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)

22. Profitability and Turnover Ratios LT 3-6
Remember:
Return on X = Net Income / X
X Turnover = Sales / X

23. Liquidity Ratios LT 3-7
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)

24. Debt Utilization Ratios LT 3-8
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)

25. Importance of Ratios LT 3-9
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.

26. Inflation’s Impact on Profits LT 3-10
FIFO (First-In, First-Out) Inventory:
Lowers COGS
Raises Profits
LIFO (Last-In, First-Out) Inventory:
Raises COGS
Lowers Profits
Provision policy
Depreciation policy
Accounting method