1. Copyright © 2006 McGraw Hill Ryerson Limited17-1 prepared by: Sujata Madan McGill University Fundamentals of Corporate Finance Third Canadian Edition

2. Copyright © 2006 McGraw Hill Ryerson Limited17-2 Chapter 17 Financial Statement Analysis Financial Ratios The DuPont System Analysis of the Statement of Cash Flows Using Financial Ratios Measuring Company Performance The Role of Financial Ratios

3. Copyright © 2006 McGraw Hill Ryerson Limited17-3 Financial Ratios Introduction  This chapter will describe: 1. Leverage ratios – show how heavily a company is in debt. 2. Liquidity ratios – measure how easily a firm can lay its hands on cash. 3. Efficiency or Turnover Ratios – measure how productively a firm is using its assets. 4. Profitability Ratios – measure the firm’s return on its investments.

4. Copyright © 2006 McGraw Hill Ryerson Limited17-4 Financial Ratios Leverage Ratios  Leverage ratios show how much financial leverage a firm is carrying.  Financial leverage adds risk to the firm.

5. Copyright © 2006 McGraw Hill Ryerson Limited17-5 LT Debt + Value of Leases Financial Ratios Leverage Ratios Long Term Debt Ratio = LT Debt + Value of Leases + Equity LT Debt + Value of Leases Debt-Equity Ratio = Equity Total Liabilities Total Debt Ratio = Total Assets

6. Copyright © 2006 McGraw Hill Ryerson Limited17-6 EBIT Financial Ratios Leverage Ratios Times Interest Earned (TIE) = Interest Payments EBIT + Depreciation & Amortization Cash Coverage Ratio = Interest Payments EBIT + Depreciation & Amortization Fixed Charge Coverage Ratio = Interest Pymts+(Current Debt Repymt+Current Lease Obligations) (1 - Tax Rate)

7. Copyright © 2006 McGraw Hill Ryerson Limited17-7 Financial Ratios Liquidity Ratios  Liquidity Ratios measure how much of the company’s assets are liquid.  Liquid refers to an asset which can be converted to cash quickly and at low cost.

8. Copyright © 2006 McGraw Hill Ryerson Limited17-8 Current Assets – Current Liabilities Financial Ratios Liquidity Ratios Net Working Capital = Net Working Capital Net Working Capital as a % of Total Assets Total Assets =

9. Copyright © 2006 McGraw Hill Ryerson Limited17-9 Financial Ratios Liquidity Ratios Current Assets Current Ratio = Current Liabilities Cash + Marketable Securities + Receivables Quick Ratio = Current Liabilities

10. Copyright © 2006 McGraw Hill Ryerson Limited17-10 Financial Ratios Efficiency Ratios Sales Asset Turnover Ratio Average Total Assets Sales Fixed Asset Turnover Ratio = Average Fixed Assets =

11. Copyright © 2006 McGraw Hill Ryerson Limited17-11 Financial Ratios Efficiency Ratios Average Receivables Average Collection Period Average Daily Sales Cost of Goods Sold Inventory Turnover Ratio = Average Inventory = Inventory Days’ Sales in Inventories = Cost of Goods Sold/365

12. Copyright © 2006 McGraw Hill Ryerson Limited17-12 Financial Ratios Profitability Ratios  One group, called profit margins, look at profits or earnings as a fraction of sales.  The other group, called return ratios, measure profits earned as a fraction of the assets used.

13. Copyright © 2006 McGraw Hill Ryerson Limited17-13 Financial Ratios Profitability Ratios – Profit Margins Sales – Cost of Goods Sold Gross Profit Margin Sales EBIT – Taxes Operating Profit Margin = Sales = Net Income Net Profit Margin = Sales Net Income + Interest Sales or

14. Copyright © 2006 McGraw Hill Ryerson Limited17-14 Financial Ratios Profitability Ratios – Return Ratios Net Income + Interest Return on Assets (ROA) Average Total Assets = Return on Equity = Net Income Average Equity

15. Copyright © 2006 McGraw Hill Ryerson Limited17-15 Earnings Financial Ratios Profitability Ratios Dividends Payout Ratio Earnings = Plowback Ratio = Earnings - Dividends 1 – Payout Ratio = Earnings - Dividends Growth in Equity from Plowback Earnings = = Plowback x ROE

16. Copyright © 2006 McGraw Hill Ryerson Limited17-16 The DuPont System DuPont System - ROA  Some profitability and efficiency measures can be linked in useful ways. Net Income + Interest ROA = Assets Sales = Assets Asset TurnoverProfit Margin Net Income + Interest Sales x

17. Copyright © 2006 McGraw Hill Ryerson Limited17-17 The DuPont System DuPont System - ROE Net Income ROE = Equity Sales = Assets Asset Turnover Profit Margin Net Income+Interest Sales  Assets Equity  Net Income Net Income+Interest  Debt Burden Leverage

18. Copyright © 2006 McGraw Hill Ryerson Limited17-18 Analysis of the Statement of Cash Flows  Analysis of the Statement of Cash Flows can tell you a lot about the financial health of a firm.  By contrast, the Income Statement gives a better sense of the long-run profitability of the firm.

19. Copyright © 2006 McGraw Hill Ryerson Limited17-19 Using Financial Ratios Choosing a Benchmark  Once financial ratios have been calculated for a firm, they need to be compared to a benchmark.  The benchmark could be:  The firm’s performance in prior years.  Another firm’s performance.

20. Copyright © 2006 McGraw Hill Ryerson Limited17-20 Using Financial Ratios Financial Ratios for Selected Industry Groups, 2004

21. Copyright © 2006 McGraw Hill Ryerson Limited17-21 Measuring Company Performance MVA and EVA  Market Value Added is the difference between the market value of a firm’s equity and its book value.  Economic Value Added (EVA or Residual Income) measures the net profit of a firm after deducting the cost of the capital employed.

22. Copyright © 2006 McGraw Hill Ryerson Limited17-22 Measuring Company Performance EVA  EVA or residual income is a better measure of company performance than accounting profits.  EVA recognizes that companies need to cover their cost of capital before they can add value.  Residual income = After-tax operating profit - cost of capital x invested capital

23. Copyright © 2006 McGraw Hill Ryerson Limited17-23 The Role of Financial Ratios Helping Financial Managers Make Decisions  Ratios can help you understand, and improve, your company’s financial health by making sure that its leverage, liquidity, efficiency and profitability are kept at optimal levels.

24. Copyright © 2006 McGraw Hill Ryerson Limited17-24 Summary of Chapter 17  As a financial manager, you will be responsible for analyzing your company’s financial statements.  You will be looking at its income statement, balance sheet and statement of cash flows.  You will use financial ratios to summarize the firm’s leverage, liquidity, profitability and efficiency.

25. Copyright © 2006 McGraw Hill Ryerson Limited17-25 Summary of Chapter 17  The DuPont System provides a useful way to link ratios to explain the firm’s return on assets and equity.  ROE is a function of the firm’s leverage ratio, asset turnover, profit margin and debt burden.  ROA is a function of asset turnover and profit margin.

26. Copyright © 2006 McGraw Hill Ryerson Limited17-26 Summary of Chapter 17  Financial ratios need a benchmark for comparison. You can compare ratios with the company’s ratios in prior years and/or with the ratios of other firms in the same business.  Other measures, such as Market Value Added (MVA) and Economic Value Added (EVA) are available to help you assess a firm’s performance.