1. Chapter 3
Financial Analysis

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

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

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

5. 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.
B. Asset utilization ratios.
4. Receivable turnover.
5. Average collection period.
6. Inventory turnover.
7. Fixed asset turnover.
8. Total asset turnover.
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. TABLE 3-1
Financial statement for ratio analysis

7. Profitability Ratios 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 (%)

8. 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% %
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

9. FIGURE 3-1
Du Pont analysis

10. Return of Wal-Mart versus Macy’s using the Du Pont method of analysis, 2007

11. Asset Utilization Ratios
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)

12. 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

13. 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

14. Profitability and Turnover Ratios
Remember: Return on X = Net Income / X X Turnover = Sales / X

15. Liquidity Ratios
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)

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

17. Debt Utilization Ratios
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)

18. 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

19. TABLE 3-3
Ratio analysis

20. FIGURE 3-2
Trend analysis

21. Trend Analysis in the Computer Industry

22. TABLE 3-7
Comparison of replacement cost accounting and historical cost accounting

23. 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

24. Which ratio is most important?
Importance of Ratios
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.