Finance Chapter+3

7/27/2019 Finance Chapter+3

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2004 Pearson Education Canada Inc. 3-1

Chapter Three

Financial Statement AnalysisPrinciples of Manager ial F inance

First Canadian EditionLawrence J. Gitman and Sean Hennessey


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Learning Goals

LG1Introduce financial ratio analysis, three types of

ratio comparisons, and four categories of ratios.

LG2Analyze liquidity and effectiveness at managinginventory, accounts receivable, accounts

payable, fixed and total assets.

LG3Discuss financial leverage, ratios used to assess

how assets were financed, and ability to cover

financing charges.


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Learning Goals (continued)

LG4Evaluate profitability using common-size

analysis, and relative to sales, total assets,

common equity, and common share price.

LG5Explore link between various categories of

ratios, liquidity and activity ratios, leverage,

and profitability ratios.

LG6Use DuPont system and summary of financialratios to perform complete ratio analysis, with

caution.


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Using Financial Ratios

Financial Ratios are measures of relative

values of key financial information.

Ratio Analysis involves methods of calculatingand interpreting financial ratios to assess the

firms performance.

Ratios are measured as (1) percentages; (2)times or multiples; and (3) number of days.


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Parties interested in Ratios

Ratios are of interest as key indicators offinancial health to:

shareholders,

creditors,

management, and

prospective investors.

Ratio analysis directs attention to potentialareas of concern, but are not conclusiveevidence of problems.


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Types of Ratio Comparisons

Cross-Sectional Analysis involves thecomparison of different firms at the same time.

Benchmarking firm performance against industryaverages is very popular.

Time-Series Analysis evaluates performanceover time, allowing for comparisons of current

and past ratio values. Combined Analysis mixes both features of

Cross-Sectional and Time Series Analysis.


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Categories of Financial Ratios

Ratios are grouped into four basic

categories:

liquidity ratios,

activity ratios,

leverage ratios, and

profitability ratios.


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Analyzing Liquidity

Liquidity refers to the firms 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.


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Net Working Capital

This measure of liquidity is simply a measure of

current assets minus liabilities.

Net Working Capital = Current AssetsCurrent Liabilities


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Current Ratio

Commonly used, the Current Ratio measures the

ability to meet short-term obligations.

Current Ratio = Current Assets/Current Liabilities


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Quick (Acid Test) Ratio

The Quick Ration focuses on only the most

liquid of the firms current assets: cash,

marketable securities, and accounts receivable.

Quick Ratio =

Cash+Marketable Securities+Accounts Receivable

Current Liabilities


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Analyzing Activity

Activity Ratios measure the effectiveness of

managing accounts receivable, inventory,

accounts payable, fixed assets, and totalassets.

There are Activity Ratios for each of these

management issues.


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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.


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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


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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


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Fixed and Total Asset Turnover

These ratios evaluate the use of Fixed and

Total Assets to generate Sales.

Fixed Asset Turnover = SalesNet Fixed Assets

Total Asset Turnover = SalesTotal Assets


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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 toservice the firms sources of financing.


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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 thatportion of total assets financed by common

shareholders.


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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


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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.


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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.


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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.


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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 eachsales 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.


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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


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Return on Equity (ROE)

Measures the return earned on the owners

investment in the firm.

ROE = Earnings Available for Common Shareholders

Common Equity


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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


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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


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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.


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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 firms health. Two popular approaches are:

The DuPont System of Analysis, and

A summary analysis of all key ratios.


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DuPont System of Analysis

Developed by the DuPont Corporation.

The DuPont System merges Income

Statement and Balance Sheet into twosummary measures of profitability: ROA

and ROE.


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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 SalesSales Total Assets


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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


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Summarizing All Ratios

Simply preparing a table of the ratios from the

four key categories (liquidity, activity,

leverage, and profitability) over a multi-yearperiod allows for a quick and comprehensive

review of the firms performance.

T bl 3 7 S f B l tt


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Ratio 2000 2001 2002 Industry Ave.

2002

Net Working

Capital

$583,000 $521,000 $603,000 $427,000

Current Ratio 2.04 2.08 1.97 2.05

Quick Ratio 1.32 1.46 1.51 1.43

Table 3.7 Summary of Barlett

Company Liquidity Ratios

T bl 3 7 S f B l tt


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Ratio 2000 2001 2002 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 76.9days 82.3days 95.4days 67.4 days

Total Asset

Turnover0.94 0.79 0.85 0.75


Company Activity Ratios

T bl 3 7 S f B l tt


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Debt Ratio 36.8% 44.3% 45.7% 40.0%

Debt/EquityRatio

43.5% 59.7% 58.3% 47.4%

Times Interest

Earned5.6 3.3 4.5 4.3

Fixed ChargeCoverage

2.4 1.4 1.9 1.5


Company Leverage Ratios

T bl 3 7 S f B l tt


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Gross Margin 31.4% 33.3% 32.1% 30.0%

Operating Margin 14.6% 11.8% 13.6% 11.0%

Profit Margin 8.8% 5.8% 7.5% 6.4%

ROA 8.3% 4.5% 6.4% 4.8%

ROE 14.1% 8.5% 12.6% 8.0%

EPS $3.26 $1.81 $2.90 $2.26

P/E Ratio 10.5 10.0 11.1 12.5


Company Profitability Ratios


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Cautions about Ratio Analysis

A single ratio does not provide sufficientinformation to judge overall performance.

Financial statement comparisons should be datedat the same point during the year.

Audited Financial statements should be used forcalculating ratios.

Data being compared should use the sameaccounting rules applied.

Time series comparisons of ratios may bedistorted by inflation.

It is difficult to define categorically what a goodor bad ratio value should be.

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