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

2. 3-2 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

3. 3-3 Ratios and their Classification A.Profitability ratios: Show the combined effects of liquidity, asset management, and debt on operating results. 1. Profit margin 2. Return on assets (investment) 3. Return on equity

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

5. 3-5 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. 3-6 Types of Ratios Profitability 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. 3-7 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. 3-8 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. 3-9 Financial Statement for Ratio Analysis

10. 3-10 Profitability Ratios Profit margin= Net Income/ Sales Return on Assets (ROA)= Net Income / Total Assets Return on Equity (ROE) = Net Income / stock holders’ equity

11. 3-11 Profitability Ratios

12. 3-12 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

13. 3-13 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)

14. 3-14 DuPont Analysis

15. 3-15 Return of Wal-Mart versus Abercrombie using the Du Pont method of analysis, 2009

16. 3-16 Asset Utilization Ratios (cont’d)

17. 3-17 Liquidity Ratios These ratios determine if the firm can meet each maturing obligation as it comes due

18. 3-18 Debt Utilization Ratios Measures the prudence of the debt management policies of the firm

19. 3-19 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. 3-20 Ratio Analysis

21. 3-21 Income Statements

22. 3-22 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. –Varying treatment of R&D costs etc.