1. © 2005 Pearson Education Canada Inc. 3-1 Chapter Three Financial Statement Analysis Principles of Corporate Finance Canadian Edition Lawrence J. Gitman and Sean Hennessey

2. © 2005 Pearson Education Canada Inc. 3-2 Learning Goals LG 1 – Introduce financial ratio analysis, three types of ratio comparisons, and four categories of ratios. LG 2 – Analyze liquidity and effectiveness at managing inventory, accounts receivable, accounts payable, fixed and total assets. LG 3 – Discuss financial leverage, ratios used to assess how assets were financed, and ability to cover financing charges.

3. © 2005 Pearson Education Canada Inc. 3-3 Learning Goals (continued) LG 4 – Evaluate profitability using common-size analysis, and relative to sales, total assets, common equity, and common share price. LG 5 – Explore link between various categories of ratios, liquidity and activity ratios, leverage, and profitability ratios. LG 6 – Use DuPont system and summary of financial ratios to perform complete ratio analysis, with caution.

4. © 2005 Pearson Education Canada Inc. 3-4 Using Financial Ratios Financial Ratios are measures of relative values of key financial information. Ratio Analysis involves methods of calculating and interpreting financial ratios to assess the firm’s performance. Ratios are measured as (1) percentages; (2) times or multiples; and (3) number of days.

5. © 2005 Pearson Education Canada Inc. 3-5 Parties interested in Ratios Ratios are of interest as key indicators of financial health to: –shareholders, –creditors, –management, and –prospective investors. Ratio analysis directs attention to potential areas of concern, but are not conclusive evidence of problems.

6. © 2005 Pearson Education Canada Inc. 3-6 Types of Ratio Comparisons Cross-Sectional Analysis involves the comparison of different firms at the same time. –Benchmarking firm performance against industry averages is very popular. Time-Series Analysis evaluates performance over time, allowing for comparisons of current and past ratio values. Combined Analysis mixes both features of Cross-Sectional and Time Series Analysis.

7. © 2005 Pearson Education Canada Inc. 3-7 Categories of Financial Ratios Ratios are grouped into four basic categories: –liquidity ratios, –activity ratios, –leverage ratios, and –profitability ratios.

8. © 2005 Pearson Education Canada Inc. 3-8 Analyzing Liquidity Liquidity refers to the firm’s ability to satisfy its short-term obligations as they come due. Three areas are of particular concern: –Net Working Capital, –The Current Ratio, and –The Quick (Acid-Test) Ratio.

9. © 2005 Pearson Education Canada Inc. 3-9 Net Working Capital This measure of liquidity is simply a measure of current assets minus liabilities. Net Working Capital = Current Assets – Current Liabilities

10. © 2005 Pearson Education Canada Inc. 3-10 Current Ratio Commonly used, the Current Ratio measures the ability to meet short-term obligations. Current Ratio = Current Assets/Current Liabilities

11. © 2005 Pearson Education Canada Inc. 3-11 Quick (Acid Test) Ratio The Quick Ratio focuses on only the most liquid of the firm’s current assets: cash, marketable securities, and accounts receivable. Quick Ratio = Cash+Marketable Securities+Accounts Receivable Current Liabilities

12. © 2005 Pearson Education Canada Inc. 3-12 Analyzing Activity Activity Ratios measure the effectiveness of managing accounts receivable, inventory, accounts payable, fixed assets, and total assets. There are Activity Ratios for each of these management issues.

13. © 2005 Pearson Education Canada Inc. 3-13 Average Age of Inventory This ratio measures the effective management of inventory in terms of number of days inventory is held. Average Age of Inventory = Inventory Daily COGS Where Daily COGS equals the daily value of the Cost of Goods Sold.

14. © 2005 Pearson Education Canada Inc. 3-14 Average Collection Period Useful for evaluating credit and collections policies of the firm, this ratio is also measured in days. Average Collection Period = Accounts Receivable Average Sales Per Day

15. © 2005 Pearson Education Canada Inc. 3-15 Average Payment Period This ratio evaluates the speed of satisfying the Accounts Payable for the firm. Average Payment Period = Accounts Payable Average Purchase Per Day

16. © 2005 Pearson Education Canada Inc. 3-16 Fixed and Total Asset Turnover These ratios evaluate the use of Fixed and Total Assets to generate Sales. Fixed Asset Turnover = Sales Net Fixed Assets Total Asset Turnover = Sales Total Assets

17. © 2005 Pearson Education Canada Inc. 3-17 Analyzing Leverage Leverage measures the amounts of borrowed money being used by the firm. Leverage Ratios are classified as either –Capitalization Ratios, focusing on how investments are financed; or –Coverage Ratios, focusing on the ability to service the firm’s sources of financing.

18. © 2005 Pearson Education Canada Inc. 3-18 Debt Ratio The Debt Ratio measures the proportion of total assets financed by creditors. Debt Ratio = Total Liabilities/Total Assets The Preferred Equity Ratio shows only that portion of total assets financed by preferred shareholders. The Common Equity Ratio shows only that portion of total assets financed by common shareholders.

19. © 2005 Pearson Education Canada Inc. 3-19 Debt/Equity Ratio The popularly mentioned Debt/Equity Ratio measures the proportion of long-term debt to common equity of the firm. Debt/Equity Ratio = Long-Term Debt Common Equity

20. © 2005 Pearson Education Canada Inc. 3-20 Times Interest Earned Ratio Also called the Interest Coverage Ratio, measures the ability to make contractual interest payments. Times Interest Earned = EBIT Interest Recall that EBIT stands for Earnings Before Interest and Taxes.

21. © 2005 Pearson Education Canada Inc. 3-21 Fixed-Charge Coverage Ratio This ratio measures the ability to meet all fixed financial payments. EBIT + Lease Payments Interest + Lease Payments + ((1-T)*(Principal + Dividends)) Where T is the corporate tax rate.

22. © 2005 Pearson Education Canada Inc. 3-22 Analyzing Profitability There are many measures of the bottom- line, the profitability of the firm. Four main measures examined here are: –Common-Size Income Statements, –Return on Total Assets, –Return on Equity, and –Price/Earnings Ratio.

23. © 2005 Pearson Education Canada Inc. 3-23 Common Size Income Statements Gross Margin measures the percentage of each sales dollar after direct cost of goods have been paid. Operating Margin measures the percentage of each sales dollar after all expenses associated with producing, selling, and operating the company have bee deducted (EBIT). Profit Margin measures the percentage of each sales dollar after all expenses, including interest and taxes, have been paid.

24. © 2005 Pearson Education Canada Inc. 3-24 Return on Total Assets (ROA) Also called Return On Investment, measures the overall effectiveness in generating profits with available assets. ROA = Net Income After Taxes Total Assets

25. © 2005 Pearson Education Canada Inc. 3-25 Return on Equity (ROE) Measures the return earned on the owners’ investment in the firm. ROE = Earnings Available for Common Shareholders Common Equity

26. © 2005 Pearson Education Canada Inc. 3-26 Earnings per Share (EPS) Represents the number of dollars earned on behalf of each outstanding common share. EPS = Earnings Available for Common Shareholders Number of Common Shares Outstanding

27. © 2005 Pearson Education Canada Inc. 3-27 Price/Earnings (P/E) Ratio This commonly used ratio is more an appraisal of share value than directly of profitability. P/E Ratio = Market Price Per Common Share Earnings Per Share

28. © 2005 Pearson Education Canada Inc. 3-28 Leverage and Profitability Leverage is the advantage gained by using a lever. In finance, debt financing is the financial lever. Financial leverage allows the firm to acquire assets beyond those available through pure equity financing arrangements.

29. © 2005 Pearson Education Canada Inc. 3-29 Complete Ratio Analysis Investors and Analysts want to get a global view of the various ratios in order to make their overall assessment of a firm’s health. Two popular approaches are: –The DuPont System of Analysis, and –A summary analysis of all key ratios.

30. © 2005 Pearson Education Canada Inc. 3-30 DuPont System of Analysis Developed by the DuPont Corporation. The DuPont System merges Income Statement and Balance Sheet into two summary measures of profitability: ROA and ROE.

31. © 2005 Pearson Education Canada Inc. 3-31 DuPont Formula The DuPont Formula links the Profit Margin with Total Asset Turnover, as their underlying formulas will summarize Return on Assets. ROA = Profit Margin  Total Asset Turnover Since, ROA = Net Income After Taxes  Sales Sales Total Assets

32. © 2005 Pearson Education Canada Inc. 3-32 Modified DuPont Formula The Financial Leverage Multiplier (FLM) is the ratio of Total Assets to Shareholders’ Equity. The FLM transforms ROA into ROE. ROE = ROA  FLM Since, ROE = Net Income After Taxes  Total Assets Total Assets Shareholders’ Equity

33. © 2005 Pearson Education Canada Inc. 3-33 Summarizing All Ratios Simply preparing a table of the ratios from the four key categories (liquidity, activity, leverage, and profitability) over a multi-year period allows for a quick and comprehensive review of the firm’s performance.

34. © 2005 Pearson Education Canada Inc. 3-34 Ratio200020012002 Industry Ave. 2002 Net Working Capital $583,000$521,000$603,000$427,000 Current Ratio2.042.081.972.05 Quick Ratio1.321.461.511.43 Table 3.7 Summary of Barlett Company Liquidity Ratios

35. © 2005 Pearson Education Canada Inc. 3-35 Ratio200020012002 Industry Ave. 2002 Ave. Age Inventory 71.6 days 64 days 50.7 days 55.3 days Ave. Collection Period 44.5 days 51.9 days 59.7 days 44.9 days Ave. Payment Period 76.9 days 82.3 days 95.4 days 67.4 days Total Asset Turnover 0.940.790.850.75 Table 3.7 Summary of Barlett Company Activity Ratios

36. © 2005 Pearson Education Canada Inc. 3-36 Ratio200020012002 Industry Ave. 2002 Debt Ratio36.8%44.3%45.7%40.0% Debt/Equity Ratio 43.5%59.7%58.3%47.4% Times Interest Earned 5.63.34.54.3 Fixed Charge Coverage 2.41.41.91.5 Table 3.7 Summary of Barlett Company Leverage Ratios

37. © 2005 Pearson Education Canada Inc. 3-37 Ratio200020012002 Industry Ave. 2002 Gross Margin31.4%33.3%32.1%30.0% Operating Margin14.6%11.8%13.6%11.0% Profit Margin8.8%5.8%7.5%6.4% ROA8.3%4.5%6.4%4.8% ROE14.1%8.5%12.6%8.0% EPS$3.26$1.81$2.90$2.26 P/E Ratio10.510.011.112.5 Table 3.7 Summary of Barlett Company Profitability Ratios

38. © 2005 Pearson Education Canada Inc. 3-38 Cautions about Ratio Analysis A single ratio does not provide sufficient information to judge overall performance. Financial statement comparisons should be dated at the same point during the year. Audited Financial statements should be used for calculating ratios. Data being compared should use the same accounting rules applied. Time series comparisons of ratios may be distorted by inflation. It is difficult to define categorically what a good or bad ratio value should be.