1. ©2009 McGraw-Hill Ryerson Limited 1 of 33 3 3 Financial Analysis ©2009 McGraw-Hill Ryerson Limited Prepared by: Michel Paquet SAIT Polytechnic

2. ©2009 McGraw-Hill Ryerson Limited 2 of 33 Chapter 3 - Outline What is Financial Analysis? 4 Categories of Financial Ratios Techniques of Ratio Analysis Distortion in Financial Reporting Summary and Conclusions

3. ©2009 McGraw-Hill Ryerson Limited 3 of 33 Learning Objectives 1.Calculate 13 financial ratios that measure profitability, asset utilization, liquidity and debt utilization. (LO1) 2.Assess a company’s source of profitability using the DuPont system of analysis. (LO2) 3.Examine the ratios in comparison to industry averages. (LO3) 4.Examine the ratios and company performance by means of trend analysis. (LO4) 5.Identify sources of distortion in reported income. (LO5)

4. ©2009 McGraw-Hill Ryerson Limited 4 of 33 What is Financial Analysis? Evaluating a firm’s financial performance Calculating ratios to reveal relationships between different accounts of financial statements Linking ratios to reveal the factors determining a firm’s profitability and value Financial analysis may not answer questions, but leads to further inquiry LO1

5. ©2009 McGraw-Hill Ryerson Limited 5 of 33 Classification System of Financial Ratios A. Profitability Ratios B. Asset Utilization Ratios C. Liquidity Ratios D. Debt Utilization Ratios LO1

6. ©2009 McGraw-Hill Ryerson Limited 6 of 33 A. Profitability Ratios Show how profitable a company is The ratios are: 1.Profit margin 2.Return on assets (ROA) (investment) 3.Return on equity (ROE) (common shareholders) LO1

7. ©2009 McGraw-Hill Ryerson Limited 7 of 33 B. Asset Utilization Ratios Show how effectively a company uses its assets The ratios are: 4a. Receivable turnover 4b. Average collection period (days sales outstanding) 5a. Inventory turnover 5b. Inventory holding period 6a. Accounts payable turnover 6b. Accounts payable period 7. Capital asset turnover 8. Total asset turnover LO1

8. ©2009 McGraw-Hill Ryerson Limited 8 of 33 C. Liquidity Ratios Show how liquid a company is or how much cash it has to meet short-term needs. The ratios are: 9. Current Ratio 10. Quick Ratio LO1

9. ©2009 McGraw-Hill Ryerson Limited 9 of 33 D. Debt Utilization Ratios Show how well a company is managing or using debt The ratios are 11. Debt to total assets 12. Times interest earned 13. Fixed charge coverage LO1

10. ©2009 McGraw-Hill Ryerson Limited 10 of 33 Which ratio(s) is/are most important? It depends on your perspective Suppliers and banks (short-term creditors) are most interested in liquidity ratios Shareholders are most interested in profitability ratios Long-term creditors concentrate on debt utilization ratios The effective utilization of assets is management’s responsibility LO2

11. ©2009 McGraw-Hill Ryerson Limited 11 of 33 Table 3-1a Financial statements for ratio analysis LO1

12. ©2009 McGraw-Hill Ryerson Limited 12 of 33 Balance Sheet As of December 31, 2009 Assets Cash$ 30,000 Marketable securities50,000 Accounts receivable350,000 Inventory370,000 Total current assets800,000 Net plant and equipment800,000 Total assets$1,600,000 Liabilities and Shareholders' Equity Accounts payable$ 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 shareholders' equity$1,600,000 Table 3-1b Financial statements for ratio analysis LO1

13. ©2009 McGraw-Hill Ryerson Limited 13 of 33 Saxton Company Industry Average 3-1. Profit margin = = 5% 6.5% 3-2. Return on assets (ROA) (investment) = a. = 12.5% 10% b. 5% x 2.5 = 12.5% 6.5% x 1.5 = 10% Net income Sales $200,000 $4,000,000 Net income Total assets Net income Sales Total assets  $200,000 $1,600,000 Profitability ratios(a) LO1

14. ©2009 McGraw-Hill Ryerson Limited 14 of 33 Saxton Company Industry Average 3-3. Return on equity (ROE) = a. = 20% 15% b. Equity multiplier = = 1.6 = 1.5 c. ROA × Equity multiplier = 0.125 × 1.60 = 20% 0.10 × 1.50 = 15% Total assets Equity $1,600,000 $1,000,000 Net income Shareholders’ equity $200,000 $1,000,000 Profitability ratios(b) 1 0.6667 LO1/LO2

15. ©2009 McGraw-Hill Ryerson Limited 15 of 33 DuPont Analysis Reveals the relationships between profitability ratios and asset utilization ratios and debt utilization ratios Decomposes a firm’s profitability into several determining factors ROA= Net Income Assets = Net Income x Assets Sales Profit MarginAsset Turnover LO2

16. ©2009 McGraw-Hill Ryerson Limited 16 of 33 DuPont Analysis ROE = Net Income Equity = Net IncomeSalesAssets EquitySalesAssets x x Profit Margin Asset TurnoverEquity Multiplier LO2

17. ©2009 McGraw-Hill Ryerson Limited 17 of 33    Figure 3-1 DuPont analysis Net income Sales Total assets Profit margin Asset turnover Total assets Equity Return on assets Financing plan (Equity multiplier) Return on Equity =  LO2 

18. ©2009 McGraw-Hill Ryerson Limited 18 of 33 Profit Asset Return on Equity Return Company Margin X Turnover = Assets X Multiplier = on Equity CP Rail 20.09% 0.3522 7.07%2.45 17.33% CN Rail 27.32 0.3366 9.202.31 21.24 Loblaw 1.12 2.15 2.412.47 5.95 Cdn Tire4.80 1.28 6.202.18 13.50 LO2 Applying DuPont Analysis on the Rails

19. ©2009 McGraw-Hill Ryerson Limited 19 of 33 Saxton Company Industry Average 3-4a. Receivables turnover = = 11.410 times 3-4b. Average collection period = = 32 36 days 3-5a. Inventory turnover = Cost of Goods Sold = 8.17 times Inventory Sales (credit) Receivables $4,000,000 $350,000 Accounts receivable Average daily credit sales $350,000 $10,959 $3,000,000 $370,000 Asset utilization ratios(a) LO1/LO3

20. ©2009 McGraw-Hill Ryerson Limited 20 of 33 Saxton Company Industry Average 3-5b. Inventory holding period = = 4552 days 3-6a. Accounts payable turnover = = 60.0 12 times 3-6b. Accounts payable period = Accounts payable = 6 30 days Average daily purchases (COGS) Inventory Average daily COGS $370,000 $8,219 Cost of goods sold Accounts payable $3,000,000 $50,000 $8,219 Asset utilization ratios(b) LO1/LO3

21. ©2009 McGraw-Hill Ryerson Limited 21 of 33 Asset utilization ratios(c) Saxton Company Industry Average 3-7. Capital asset turnover = = 5.05.4 times 3-8. Total asset turnover = = 2.5 1.5 times Sales Capital assets $4,000,000 $800,000 Sales Total assets $4,000,000 $1,600,000 LO1/LO3

22. ©2009 McGraw-Hill Ryerson Limited 22 of 33 Liquidity ratios Saxton Company Industry Average 3-9. Current ratio = = 2.672.1 3-10. Quick ratio = = 1.43 1.0 Current assets Current liabilities $800,000 $300,000 Current assets – Inventory Current liabilities $430,000 $300,000 LO1/LO3

23. ©2009 McGraw-Hill Ryerson Limited 23 of 33 Debt utilization ratios Saxton Company Industry Average 3-11. Debt to total assets = = 37.5%33% 3-12. Times interest earned = = 11 7 times 3-13. 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 LO1/LO3

24. ©2009 McGraw-Hill Ryerson Limited 24 of 33 Saxton Industry Company AverageComparison A. Profitability 1.Profit margin……………… 5.0% 6.5%Below average 2.Return on assets………..…. 12.5% 10% Above average due to high 8 3.Return on equity…………. 20% 15% Good due to ratios 2 and 11 B. Asset Utilization 4a.Receivables turnover ……... 11.4 10.0 Good 4b.Average collection period…. 32.0 36.0 Good 5a.Inventory turnover ………... 8.1 7.0 Good 5b.Inventory holding period...... 45 52 Good 6a.Accounts payable turnover... 60 12 Good 6b.Accounts payable period...... 6 30 Good 7.Capital asset turnover ……. 5.0 5.4 Below average 8.Total asset turnover ………. 2.5 1.5 Good Table 3-2a Ratio analysis(a) LO3

25. ©2009 McGraw-Hill Ryerson Limited 25 of 33 Saxton Industry Company AverageComparison 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%Slightly more debt 12.Times interest earned ……. 117Good 13.Fixed charge coverage ……. 65.5Good Table 3-2b Ratio analysis(b) LO3

26. ©2009 McGraw-Hill Ryerson Limited 26 of 33 Techniques of Ratio Analysis 1.DuPont Analysis 2.Comparative Analysis 3.Trend Analysis 4.Common-Size Statements LO1/LO2/LO3/LO4

27. ©2009 McGraw-Hill Ryerson Limited 27 of 33 Comparative vs. Trend Analysis Ratios on their own do not mean a lot Comparing a company’s ratios to those of its industry or its competitors is comparative analysis and may reveal what ratios are out of line with certain standards Comparing the same company’s ratios over a number of years is trend analysis and may reveal whether ratios are improving or worsening LO3/LO4

28. ©2009 McGraw-Hill Ryerson Limited 28 of 33 Table 3-3 Trend analysis of competitors 2000 2001 2002 2003 2004 2005 2006 2007 0.7918.00.8119.8 0.6013.80.7416.4 0.5613.40.7615.5 0.7116.40.7316.8 0.8718.10.6615.7 0.8114.50.7217.1 0.8317.70.8821.4 0.5813.90.9022.1 Return on Assets Return on Equity Royal Bank Bank of Montreal Return on Assets Return on Equity LO4 Source: Bank of Montreal annual reports www.bmo.com Royal Bank of Canada annual reports www.rbc.com

29. ©2009 McGraw-Hill Ryerson Limited 29 of 33 FIGURE 3-2 Trend analysis LO4

30. ©2009 McGraw-Hill Ryerson Limited 30 of 33 Distortion in Financial Reporting Historical-based accounting in an environment of changing prices may distort financial results: -- immediate effect of price changes on revenues versus delayed impact on asset values Accrual-based accounting allows certain leeway in matching the revenues and expenses -- cost of goods sold (LIFO vs. FIFO) -- asset write-downs -- net income LO5

31. ©2009 McGraw-Hill Ryerson Limited 31 of 33 Income Statement For the Year 2009 High Reported Conservative Income (A) (B) Sales............ $4,000,000 $4,200,000 Cost of goods sold....... 3,000,000 2,400,000 Gross profit.......... 1,000,000 1,800,000 Selling and administrative expense.. 450,000 450,000 Operating profit........ 550,000 1,350,000 Interest expense........ 50,000 50,000 Net income before taxes..... 500,000 1,300,000 Taxes (40%)......... 200,000 520,000 Net income.......... 300,000 780,000 Extraordinary loss (net of tax)... 60,000 — Net income transferred to retained earnings $ 240,000 $ 780,000 Table 3-7 Income Statement Illustration of different income reporting methods LO5

32. ©2009 McGraw-Hill Ryerson Limited 32 of 33 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 LO5

33. ©2009 McGraw-Hill Ryerson Limited 33 of 33 Summary and Conclusions Financial ratios cover 4 areas of management: profitability, asset utilization, liquidity and debt utilization. The DuPont system of analysis tells us that the profit margin, asset turnover, and debt usage each contributes to return on equity. Ratios should be compared to industry average (comparative analysis) as well as historical data (trend analysis). What ratios do is to suggest aspects requiring further exploration. It is the manager/analyst’s job to answer the questions revealed by ratios. Analysts should also be aware of the distortion in financial reporting.