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CHAPTER 4 Analysis of Financial Statements

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1 CHAPTER 4 Analysis of Financial Statements
Ratio Analysis Du Pont system <- learn this Effects of improving ratios Limitations of ratio analysis Qualitative factors

2 Why are ratios useful? Ratios
Standardize numbers Facilitate comparisons Ratios highlight weaknesses and strengths. Ratio comparisons should be Made through time - Trend analysis Compare competitors - Peer or Industry analysis

3 What are the five major categories of ratios, and what questions do they answer?
Liquidity: Can we make required payments? Asset Management: right amount of assets vs. sales? Debt Management: Mix of debt and equity? Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? Market Value: How do investors value the business as reflected in P/E and Mkt/B ratios?

4 Balance Sheet: Assets Cash A/R Inventories Total Current Assets
Fixed Assets Less: Accum Dep. Net FA Total Assets 2004 80 315 415 810 870 1,680 2005 10 375 615 1,000 2,000

5 Balance sheet: Liabilities and Equity
Accts payable Notes payable Accruals Total CL Long-term debt Total Liabilities Common stock Retained earnings Total Equity Total L & E 2005 60 110 140 310 750 1,060 130 810 940 2,000 2004 30 60 130 220 580 800 750 880 1,680

6 Income statement Sales COGS EBITDA Depr. & Amort. EBIT Interest Exp.
EBT Taxes Net income 2005 3,000 2,616 384 100 284 88 196 78 118 2004 2,850 2,497 353 90 263 60 203 81 122

7 Income statement Per Share Common Stk Price Earnings / share
Dividends / share Book Value / Share Cash Flow /share 2005 23.00 2.35 1.15 18.80 4.35 2004 26.00 2.44 1.06 17.60 4.24

8 Liquidity Ratios

9 Liquidity Ratios Measure company ability to pay bills
Quick Ratio = Current Assets - Inventories Current Liabilities

10 Management Ratios Measure manager performance

11 Inventory Turnover Ratio

12 Days Sales Outstanding

13 Fixed Assets Turnover

14 Total Assets Turnover


16 Total Debt to Total Assets

17 Time Interest Earned Ratio

18 EBITDA Coverage Ratio EBITDA Coverage = EBITDA + Lease Payments _
Interest + Principal Pymt + Lease Pymt


20 Profit Margin Profit Margin on Sales = Net Income _ Sales

21 Return on Assts Return on Total Assets (ROA) = Net Income _

22 Basic Earning Power B E P = EBIT _ Total Assets

23 Return on Common Equity
Return on Equity R O E = Net Income _ Common Equity

24 Market Value Ratios

25 Price / Earnings Ratio PE = Price per Share _ Earnings per Share

26 Price / Cash Flow Price/Cash Flow = Price per share _
Cash Flow per Share

27 Market / Book Book Value per share
= Common Equity _ Shares Outstanding Market/Book = Market Price per Share _ Book Value per Share

28 TREND ANALYSIS Compare OVER TIME Are ratios improving Or deteriorating

29 DuPont Equation Return on Assets ROE = Net Income _
Measure of success ROE = Net Income _ Stock Holder Equity

30 The Du Pont system

31 The Du Pont system

32 Potential uses of freed up cash
Repurchase stock Expand business Reduce debt All these actions would likely improve the stock price.

33 Potential problems and limitations of financial ratio analysis
Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions. Example General Electric Businesses Elevators Air-conditioners Jet Engines Lends Money

34 Potential problems and limitations of financial ratio analysis
“Average” performance is not necessarily good, perhaps the firm should aim higher.

35 Potential problems and limitations of financial ratio analysis
Seasonal factors can distort ratios.

36 Potential problems and limitations of financial ratio analysis
“Window dressing” techniques can make statements and ratios look better.

37 Potential problems and limitations of financial ratio analysis
Comparison with industry averages difficult. “Average” is not necessarily good. Seasonal factors can distort ratios. “Window dressing”

38 More issues regarding ratios
Different operating and accounting practices can distort comparisons. Sometimes it is hard to tell if a ratio is “good” or “bad”. Difficult to tell whether a company is in strong or weak position.

39 Qualitative factors to be considered when evaluating a company’s future financial performance
Are the firm’s revenues tied to one key customer, product, or supplier? What percentage of the firm’s business is generated overseas? Competition Future prospects Legal and regulatory environment

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