Chapter 3 Financial Analysis

Classification System PPT 3-1 We will separate 13 significant ratios into four primary categories. 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. 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.

PPT 3-2 TABLE 3-1 Financial statement for ratio analysis

Return on assets (investment) Profitability Ratios PPT 3-3 Saxton Company Industry Average 1. Profit margin = = 5% 6.7% 2. Return on assets (investment) = a. = 12.5% 10% b. 5%  2.5 = 12.5% 6.7%  1.5 = 10% 3. Return on equity = a. = 20% 15% b. = 20% = 15% Net income sales $200,000 $4,000,000 Net income Total assets $200,000 $1,600,000 Net income Sales Sales Total assets  Net income Stockholders’ equity $200,000 $1,000,000 Return on assets (investment) (1 – Debt/Assets) 0.125 1 – 0.375 0.10 1 – 0.33

PPT 3-4 FIGURE 3-1 Du Pont analysis

PPT 3-5 TABLE 3-2 Return of Wal-Mart versus May Department Stores using the Du Pont method of analysis, 2002

Asset Utilization Ratios PPT 3-6 Saxton Company Industry Average 4. Receivables turnover = = 11.4 10 times 5. Average collection period = = 32 36 days 6. Inventory turnover = = 10.8 7 times Sales (credit) Receivables $4,000,000 $350,000 Accounts receivable Average daily credit sales $350,000 $11,111 Sales Inventory $4,000,000 $370,000

Asset Utilization Ratios PPT 3-6 Saxton Company Industry Average 7. Fixed asset turnover = = 5 5.4 times 8. Total asset turnover = = 2.5 1.5 times Sales Fixed assets $4,000,000 $800,000 Sales Total assets $4,000,000 $1,600,000

Current assets − Inventory Liquidity Ratios PPT 3-7 Saxton Company Industry Average 9. Current ratio = = 2.67 2.1 10. Quick ratio = = 1.43 1.0 Current assets Current liabilities $800,000 $300,000 Current assets − Inventory Current liabilities $430,000 $300,000

Debt Utilization Ratios PPT 3-8 Saxton Company Industry Average 11. Debt to total asets = = 37.5% 33% 12. Times interest earned = = 11 7 times 13. Fixed charge coverage = = 6 5.5 times Total debt Total assets $600,000 $1,600,000 Income before interest and taxes Interest $550,000 $50,000 Income before fixed charges and taxes Fixed charges $600,000 $100,000

TABLE 3-3 Ratio analysis PPT 3-9

PPT 3-10 FIGURE 3-2 Trend analysis

PPT 3-11 TABLE 3-4 Trend analysis in the computer industry

PPT 3-12 TABLE 3-7 Comparison of replacement cost accounting and historical cost accounting

PPT 3-13 TABLE 3-8

Chapter 3 - Outline LT 3-1 Financial Analysis 4 Categories of Financial Ratios Importance of Ratios Inflation and its Impact on Profits

Financial Analysis and Ratios LT 3-2 What is financial analysis? Evaluating a firm’s financial performance Analyzing ratios or numerical calculations Comparing a company to its industry

4 Categories of Ratios LT 3-3 Profitability Ratios Asset Utilization Ratios Liquidity Ratios Debt Utilization Ratios

Profitability Ratios LT 3-4 Show how profitable a company is. The ratios express: — Profit Margin or Return on Sales (%) — Return on Assets or Return on Investment (%) — Return on Equity (%)

Asset Utilization Ratios LT 3-5 Show how effectively a company uses its assets. The ratios express: — Receivables Turnover (times) — Average Collection Period (days) — Inventory Turnover (times) — Fixed Asset Turnover (times) — Total Asset Turnover (times)

Profitability and Turnover Ratios LT 3-6 Remember: Return on X = Net Income / X X Turnover = Sales / X

Liquidity Ratios LT 3-7 Show how liquid a company is or how much $ it has to meet S/T needs. The ratios express: —Current Ratio (times) —Quick Ratio or Acid-Test Ratio (times)

Debt Utilization Ratios LT 3-8 Show how well a company is managing or using debt. The ratios express: —Debt-to-Total Assets (%) —Times Interest Earned (times) —Fixed Charge Coverage (times) (Fixed Charges = lease payments, i expense)

Importance of Ratios LT 3-9 Which ratio is most important? It depends on your perspective. Suppliers and banks (lenders) are most interested in liquidity ratios. Stockholders are most interested in profitability ratios. A long-run trend analysis over a 5-10 year period is usually performed by an analyst.

Inflation’s Impact on Profits LT 3-10 FIFO (First-In, First-Out) Inventory: —Lowers COGS —Raises Profits LIFO (Last-In, First-Out) Inventory: —Raises COGS —Lowers Profits