1. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt 5 C H A P T E R FIVE Financial Analysis Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc. 2000

2. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt 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. T 3-1 Classification System

3. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt B. Asset utilization ratios. 4. Receivable turnover. 5. Average collection period. 6. Inventory turnover. 7. Fixed asset turnover. 8. Total asset turnover. T 3-1 Classification System

4. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt 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. T 3-1 Classification System

5. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt SAXTON COMPANY Income Statement For the Year Ended December 31, 2001 Sales (all on credit)$ 4,000,000 Cost of goods sold3,000,000 Gross Profit1,000,000 Selling and administrative expense*450,000 Operating profit550,000 Interest expense50,000 Extraordinary loss200,000 Net income before taxes300,000 Taxes (33%)100,000 Net income$ 200,000 * Includes $50,000 in lease payments. T 3-2 Table 3-1a Financial Statement for Ratio Analysis

6. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Balance Sheet As of December 31, 2001 Assets Cash$ 30,000 Marketable securities50,000 Accounts receivable350,000 Inventory370,000 Total current assets800,000 Net plant and equipment800,000 Total assets$1,600,000 Liabilities and Stockholders’ Equity Accounts payable$ 50,000 Notes payable250,000 Total current liabilities300,000 Long-term liabilities300,000 Total liabilities600,000 Common stock400,000 Retained earnings600,000 Total liabilities and stockholders’ equity$1,600,000 T 3-2 Table 3-1b Financial Statement for Ratio Analysis

7. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Saxton Company Industry Average 1. Profit margin = = 5%6.7% 2. Return on assets (investment) = a. = 12.5% 10% 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 Net income Sales Total assets  $200,000 $1,600,000 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 T 3-3 Profitability Ratios

8. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt    Figure 3-1 DuPont analysis Net Income Sales Total Assets Profit Margin Asset Turnover Total Debt Total Assets Return on Assets Financing Plan Return on Equity Return on Assets  (1 - Debt/Assets) =  T 3-4

9. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Saxton Company Industry Average 4. Receivables turnover = = 11.410 times 5. Average collection period = = 32 36 days 6. Inventory turnover = = 10.87 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 T 3-6 Asset Utilization Ratios

10. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Asset Utilization Ratios Saxton Company Industry Average 7. Fixed asset turnover = = 55.4 times 8. Total asset turnover = = 2.5 1.5 times Sales Fixed assets $4,000,000 $800,000 Sales Total assets $4,000,000 $1,600,000 T 3-6

11. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Liquidity Ratios Saxton Company Industry Average 9. Current ratio = = 2.672.1 10. Quick ratio = = 1.43 1.0 Current assets Current liabilities $800,000 $300,000 Current assets – Inventory Current liabilities $430,000 $300,000 T 3-7

12. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Debt Utilization Ratios Saxton Company Industry Average 11. Debt to total asets = = 37.5%33% 12. Times interest earned = = 11 7 times 13. Fixed charge coverage = = 65.5 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 T 3-8

13. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Saxton Industry Company AverageConclusion A. Profitability 1.Profit Margin ……………… 5.0%6.7%Below average 2.Return on Assets …………..12.5%10.0%Above average due to high turnover 3.Return on Equity ………….. 20.0%15.0%Good due to ratios 2 and 10 B. Asset Utilization 4.Receivables turnover …….11.410.0Good 5.Average collection period….32.036.0Good 6.Inventory turnover ………...10.87.0Good 7.Fixed asset turnover ……….5.05.4Below average 8.Total asset turnover ……….2.51.5Good C. Liquidity 9.Current ratio ………………2.672.1Good 10.Quick Ratio ………………..1.431.0Good D. Debt Utilization 11.Debt to total assets ………..37.5%33.0%Slightly more debt 12.Times interest earned …….11.07.0Good 13.Fixed charge coverage …...6.05.5Good T 3-9 Table 3-3 Ratio Analysis

14. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Figure 3-2 Trend analysis A. Profit Margin Percent 75317531 1985 1987 1989 1991 1993 1995 1997 Industry Saxton T 3-10

15. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt B. Total asset turnover 3.5X 3.0X 2.5X 2.0X 1.5X 1.0X.5X 1985 1987 1989 1991 1993 1995 1997 Industry Saxton T 3-10 Figure 3-2 Trend Analysis

16. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Income Statement For the Year 2001 High Reported Conservative Income A B Sales............ $4,000,000 $4,200,000 Cost of goods sold........ 3,000,000 2,700,000 Gross profit.......... 1,000,000 1,500,000 Selling and administrative expense... 450,000 450,000 Operating profit........ 550,000 1,050,000 Interest expense........ 50,000 50,000 Extraordinary loss....... 100,000 — Net income before taxes...... 400,000 1,000,000 Taxes (30%)......... 120,000 300,000 Net income.......... 280,000 700,000 Extraordinary loss (net of tax).... — 70,000 Net income transferred to retained earnings $ 280,000 $ 630,000 T 3-13 Table 3-8

17. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Chapter 3 - OutlineLT 3-1 Financial Analysis 4 Categories of Financial Ratios Importance of Ratios Inflation and its Impact on Profits

18. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Financial Analysis and RatiosLT 3-2 What is financial analysis? Evaluating a firm’s financial performance Analyzing ratios or numerical calculations Comparing a company to its industry

19. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt 4 Categories of RatiosLT 3-3 Profitability Ratios Asset Utilization Ratios Liquidity Ratios Debt Utilization Ratios

20. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Profitability RatiosLT 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. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Asset Utilization RatiosLT 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. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Profitability and Turnover RatiosLT 3-6 Remember : Return on X = Net Income / X X Turnover = Sales / X

23. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Liquidity RatiosLT 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. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Debt Utilization RatiosLT 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. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Importance of RatiosLT 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. th 9 ©The McGraw-Hill Companies, Inc. 2000 Foundations of Financial Management E D I T I O N N I N T H Irwin/McGraw-Hill Block Hirt Inflation’s Impact on ProfitsLT 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