Chapter

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Analysis

3

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Chapter Outline

Ratio analysis and its importance.

Use of ratio for measurements.

The Du Pont system of analysis (skip).

Trend analysis

Evaluation of reported income to identify distortion.

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Ratio Analysis

Financial ratios

Used to weigh and evaluate the operating performance of a firm.

Used to compare performance record as against other firms in the industry.

Analyzing ratios and numerical calculations.

Such data is provided by various organizations.

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Ratios and their Classification

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.

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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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Types of Ratios

Profitability ratios

Measurement of the firms ability to earn an adequate 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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Du Pont System of Analysis

A satisfactory return on assets might be derived through:

A high profit margin

A rapid turnover of assets (generating more sales per dollar of its assets)

Or both

Return of assets (investment) =

(Profit margin) X (Asset turnover)

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Du Pont System of Analysis (contd)

A satisfactory return on equity might be derived through:

A high return on total assets;

A generous utilization of debt;

Or a combination of both.

Return on equity = Return on assets (investments)

[1 (Debt/ Assets)]

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Du Pont Analysis

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Examples for Analysis using the Du

Pont System

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Asset Utilization Ratios

These ratios relate the balance sheet to the income 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 debt management policies of the firm.

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Debt Utilization Ratios (contd)

Fixed charge coverage measures the firms ability 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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Summary of Ratio Analysis

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Trend Analysis

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Trend Analysis in the Computer

Industry

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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 increasing prices 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 costs - reduces income but increases assets.

An increase lowers the debt-to-assets ratio.

A decrease indicates a decrease in the financial leverage 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 have the potentials 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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Explanation of Discrepancies

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Explanation of Discrepancies

(contd)

Sales

Use of defer recognition until each payment is received or full recognition at the 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 when computing current income or leaving them out.

Net income

Use of different methods of financial reporting.

Discussion Questions and Problems

Discussion Questions

Question 1, and 3 page 69

Problems

Problem 17 page 72

Problem 28 page 77

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