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5 Financial Analysis FIVE C H A P T E R Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc. 2000
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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.
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Classification System
B. Asset utilization ratios. 4. Receivable turnover. 5. Average collection period. 6. Inventory turnover. 7. Fixed asset turnover. 8. Total asset turnover.
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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.
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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.
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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
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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
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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
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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
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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
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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
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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
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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
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Figure 3-2 Trend analysis
A. Profit Margin Percent 7 5 3 1 Industry Saxton
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Figure 3-2 Trend Analysis
B. Total asset turnover 3.5X 3.0X 2.5X 2.0X 1.5X 1.0X .5X Saxton Industry
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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
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Chapter 3 - Outline LT 3-1 Financial Analysis
4 Categories of Financial Ratios Importance of Ratios Inflation and its Impact on Profits
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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
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4 Categories of Ratios LT 3-3
Profitability Ratios Asset Utilization Ratios Liquidity Ratios Debt Utilization Ratios
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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 (%)
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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)
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Profitability and Turnover Ratios LT 3-6
Remember: Return on X = Net Income / X X Turnover = Sales / X
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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)
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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)
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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.
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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
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