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Chapter

McGraw-Hill/IrwinCopyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Analysis

3

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3-2

Chapter Outline

Ratio analysis and its importance

Use of ratio for measurements

The DuPont system of analysis Trend analysis

Evaluation of reported income to identify

distortion

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3-4

Ratios and their Classification

A. Profitability ratios1. Profit margin

2. Return on assets (investment)

3. Return on equity

B. Asset utilization ratios4. Receivable turnover

5. Average collection period6. Inventory turnover

7. Fixed asset turnover

8. Total asset turnover

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3-5

Ratios and their Classification

(contd)

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

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3-6

Types of Ratios

Profitability ratios

Measurement of the firms ability to earn anadequate return on:

Sales

Assets

Invested capital

Asset utilization ratios Measures the speed at which the firm is turning

over accounts receivable

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Types of Ratios (contd)

Liquidity ratios

Emphasizes the firms ability to pay off short-term obligations as and when due

Debt utilization ratios

Estimates the overall debt position of the firm

Evaluates in the light of asset base and earning

power

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Financial Statement

for Ratio Analysis

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Profitability Ratios

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DuPont System of Analysis

A satisfactory return on assets might bederived through:

A high profit margin

A rapid turnover of assets (generating moresales per dollar of its assets)

Or both

Return on assets (investment) = Profit margin Asset

turnover

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DuPont System of Analysis (contd)

A satisfactory return on equity might bederived 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)

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DuPont Analysis

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Return of Wal-Mart versus Macys using

the Du Pont method of analysis, 2007

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Asset Utilization Ratios

These ratios relate the balance sheet to theincome statement

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Asset Utilization Ratios (contd)

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Liquidity Ratios

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Debt Utilization Ratios

Measures the prudence of the debtmanagement policies of the firm

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Debt Utilization Ratios (contd)

Fixed charge coverage measures the firmsability to meet the fixed obligations

Interest payments alone are not considered

Income before interest and taxes..$550,000

Lease payments $50,000

Income before fixed charges and taxes$600,000

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Ratio Analysis

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3-20

Trend Analysis

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Liquidity and Efficiency

3-21

Current Ratio =Current Assets

Current Liabilities

Acid - test Ratio =Cash + Marketable Securities + AR

Current Liabilities

Accounts Receivable Turnover = Net SalesAccounts Receivable

Inventory Turnover =Cost of Goods Sold

Inventory

Total Asset Turnover =

Net Sales

Total Assets

Average Collection Period =360

AR Turnover

Net Sales

ARx 360

Day's Sales in Inventory =360

Inventory Turnover

Net Sales

Inventory

x 360

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Solvency

3-22

Debt Ratio =Total Liabilities

Total Assets

Equity Ratio =

Equity

Total Assets

Debt - to - Equity =Total Liabilities

Total Equity

Times Interest Earned=Interest Expens

EBIT

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Profitability

3-23

Profit Margin Ratio =Net Income

Sales

Gross Margin Ratio =Gross Profit

Sales

Return on Total Assets =Net Income

Sales

Return on Equity =Net Income

Stockholders' Equity

Earnings Per Share =Net Income

Number of Shares Outstanding Common Stoc

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Market Prospects

3-24

Price Earnings Ratio =Market Price Per Shar

Earnings Per Share

Dividend Yield =Dividend Per Share

Market Price Per Share

Dividend Payout =Total Dividends

Income

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Exercises

3-26

Pages: 84 and 85Numbers: 33 and 34

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3-27

Trend Analysis

in the Computer Industry

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3-28

Impact of Inflation

on Financial Analysis

Inflation

Revenue is stated in current dollars

Plant, equipment, or inventory may have been

purchased at lower price levels

Profits may be more a function of increasingprices than due to good performance

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Comparison of Replacement and

Historical Cost Accounting

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Comparison of Replacement and

Historical Cost Accounting (contd)

Replacement cost reduces income butincreases assets

An increase lowers the debt-to-assets ratio

A decrease indicates decrease in the financialleverage of the firm

A declining income results in a decreased ability

to cover interest costs

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Impact of Disinflation

on Financial Analysis

Disinflation

Financial assets such as stocks and bonds havethe potential to do well encouraging investors

Tangible assets do not have the potential

Deflation

Actual reduction of prices affecting everybody

due to bankruptcies and declining profits

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Other Elements of Distortion

in Reported Income

Effect of changing prices

Reporting of revenues

Treatment of nonrecurring items Tax write-off policies

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Income Statements

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Explanation of Discrepancies

(contd)

Sales

Firm may defer recognition until each payment isreceived or full recognition at earliest possible

date Cost of goods sold

Use of different accounting principles LIFO

versus FIFO

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Explanation of Discrepancies

(contd)

Extraordinary gains/losses

Inclusion of events in computing current incomeor leaving them out

Net income Use of different methods of financial reporting