Finance Chapter 3 Analysis of financial statements

Financial statement analysis  Financial ratios  Show the strengths and weaknesses of a company when compared to other companies in the same industry  Is the company improving or not?  A starting point to help predict future conditions and planning appropriate actions  Types of ratios  Liquidity – assets that can be quickly converted to cash  Asset management  Debt management  Profitability  Market value

Liquidity & Asset Ratios  Liquidity ratios – current ratio  Current ratio = current assets/current liabilities  Asset management ratios  Inventory turnover ration = sales/inventories  Days sales outstanding = receivables/average sales per day  How many days it must wait to receive cash  Fixed assets turnover ratio = sales/net fixed assets  Effective use of plant and equipment  Total assets turnover ration = sales/total assets

Debt management ratios  Financial leveraging – use of debt financing  Ratios reveal:  The extent the firm is financed with debt  Likelihood of default (inability to pay debts)  Debt ratio  Times-interest-earned ratio  EBITDA coverage ration

Debt management ratios: Financial leverage  Using debt for financing (raising capital) - implications: 1. Stockholders maintain control of debt while limiting their investment 2. Creditors look to equity – the higher the proportion of capital provided by stockholders, the less risk to creditors 3. If income from borrowed funds investment exceeds interest paid on loans, the return on owners’ capital is magnified, or “leveraged”

Debt management ratios  Debt ratio = total debt/total assets  Ability to pay interest: times-interest-earned ratio  TIE = EBIT/interest charges  EBITDA coverage ratio = EBITDA + lease payments/interest + principal payments + lease payments

Profitability ratios  A group of ratios showing combined effects of liquidity, asset management, and debt on operating results  Profit margin on sales = net income/sales  Basic earning power (BEP)  BEP = EBIT/total assets  Return on total assets (ROA)  ROA = net income/total assets  Price/Earnings ratio (P/E) – the price per share to earnings per share  P/E = price per share/earnings per share  Market/Book ratio (M/B) – the ratio of a stock’s market price to its book value  Book value = common equity/shares outstanding  M/B = market price per share/book value per share

Financial statement analysis  Other analysis include:  Trend analysis  Extended Du Pont equation – rate of return on equity  Benchmarking  Economic Value Added (EVA) – accounts for the cost of equity as well as debt