Transcript Block Hirt Short

Chapter
3
Financial Analysis
Prepared by:
Terry Fegarty
Seneca College
Revised by PChua
References:
Block et al
Gitman et al
McGraw-Hill Ryerson
2003 McGraw-Hill
RyersonLimited
Limited
©2003©McGraw-Hill
Ryerson
Chapter 3 - Outline
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PPT 3-2
What is Financial Analysis?
Uses of Ratio Analysis
Approaches to Ratio Analysis
4 Categories of Financial Ratios
Profitability Ratios (including Dupont Analysis)
Asset Utilization Ratios
Liquidity Ratios
Debt Utilization Ratios
Importance of Ratios
Final Notes on Using Financial Ratios
Summary and Conclusions
© 2003 McGraw-Hill Ryerson Limited
PPT 3-3
Financial Analysis
Financial Analysis is performed using Ratio Analysis
 Ratio Analysis involves the method of calculating and
interpreting financial ratios to assess the firm’s
performance
 A ratio is a numerator divided by a denominator; can be
a percentage, times(x) or days
 Ratio Analysis uses Income and Balance Sheet
Statements for input

© 2003 McGraw-Hill Ryerson Limited
Uses of Financial Ratio Analysis

To decide whether to invest in a firm

To determine whether to lend funds to a firm

To plan for the future direction of a firm

To conduct routine financial analysis of a firm
© 2003 McGraw-Hill Ryerson Limited
PPT 3-4
Approaches to Ratio Analysis
 Cross-Sectional Analysis
 Trend
analysis
 Combined Analysis
 Common-size statements
© 2003 McGraw-Hill Ryerson Limited
PPT 3-5
4 Categories of Ratios
Profitability
Asset
Utilization Ratios
Liquidity
Debt
Ratios
Ratios
Utilization Ratios
© 2003 McGraw-Hill Ryerson Limited
Sources of Published Ratios
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D & B’s Industry Norms and key Business Ratios
Canada Company Handbook
Statistics Canada’s Financial Indicators for
Canadian Business
www.globeinvestor.com
www.nasdaq-canada.com
© 2003 McGraw-Hill Ryerson Limited
PPT 3-6
Classification system for ratios(a)
A. Profitability Ratios
1. Profit margin (Return on Sales)
2. Return on assets (ROA)
3. Return on equity (ROE)
B. Asset Utilization Ratios
4a.
4b.
5a.
5b.
6a.
6b.
Receivable turnover
Average collection period (days sales outstanding)
Inventory turnover
Inventory holding period
Accounts payable turnover
Accounts payable period
© 2003 McGraw-Hill Ryerson Limited
PPT 3-7
Four categories of financial ratios (b)
B. Asset Utilization Ratios (cont’d)
7. Capital 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
© 2003 McGraw-Hill Ryerson Limited
Other Useful Ratios
P/E Ratio =
Market Share Price
Earnings per share (EPS)
MV to BV =
Market Value of Share
Book Value per share

Way of measuring desirability of a stock.

Influenced by earnings and sales growth of the firm, risk (debt-equity
structure), quality of management, dividend policy, among others.
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Indicates Expectations as to the company’s future performance.
© 2003 McGraw-Hill Ryerson Limited
Which ratios are most important?
PPT 3-8
It depends on its use
 Shareholders are most interested in profitability
ratios
 Suppliers and banks (lenders) are most interested
in liquidity ratios
 Long-term creditors concentrate on debt utilization
ratios
 The effective utilization of assets is management’s
responsibility
© 2003 McGraw-Hill Ryerson Limited
PPT 3-9
Table 3-1a
Financial statements for ratio analysis
SAXTON COMPANY
Income Statement
For the Year 2002
Sales (all on credit) . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . .
Gross profit . . . . . . . . . . . . . . . . . . .
Selling and administrative expense* . . . . . . . . .
Operating profit . . . . . . . . . . . . . . . . .
Interest expense
. . . . . . . . . . . . . . . .
Extraordinary loss . . . . . . . . . . . . . . . .
Net income before taxes . . . . . . . . . . . . . .
Taxes (50%) . . . . . . . . . . . . . . .
. .
. .
. .
. .
. .
. .
. .
. .
Net income . . . . . . . . . . . . . . . . . . . . .
$ 4,000,000
3,000,000
1,000,000
450,000
550,000
50,000
100,000
400,000
200,000
$ 200,000
* Includes $50,000 in lease payments.
© 2003 McGraw-Hill Ryerson Limited
PPT 3-10
Table 3-1b
Financial statements for ratio analysis
Balance Sheet
As of December 31, 2002
Assets
Cash
Marketable securities
Accounts receivable
Inventory
Total current assets
Net plant and equipment
Total assets
Liabilities and Shareholders' Equity
Accounts payable
Notes payable
Total current liabilities
Long-term liabilities
Total liabilities
Common stock
Retained earnings
Total liabilities and shareholders' equity
$
30,000
50,000
350,000
370,000
800,000
800,000
$1,600,000
$
50,000
250,000
300,000
300,000
600,000
400,000
600,000
$1,600,000
© 2003 McGraw-Hill Ryerson Limited
PPT 3-11
Profitability Ratios
 Measure
overall company profitability for potential
investors (income to investment base)
 The higher the ratio, the more profitable the firm
Return on Sales
Return on Assets
Net Income
Net Income
Sales
Total Assets
Net Income
Total Owner’s Equity
Return on Equity
© 2003 McGraw-Hill Ryerson Limited
PPT 3-12
Profitability ratios(a)
Saxton Company
3-1. Profit margin = Net income
Sales
$200,000 = 5%
$4,000,000
Industry Average
6.5%
3-2. Return on assets (ROA) (investment) =
a.
b.
Net income
Total assets
Sales
Net income 
Total assets
Sales
$200,000 = 12.5%
$1,600,000
5%  2.5 = 12.5%
10%
6.5%  1.5 = 10%
© 2003 McGraw-Hill Ryerson Limited
PPT 3-13
Profitability ratios(b)
Saxton Company
Industry Average
3-3. Return on equity (ROE) =
a.
Net income
Shareholders’ equity
$200,000 = 20%
$1,000,000
Total assets $1,600,000
b. Equity multiplier =
$1,000,000
Equity
c. ROA × Equity multiplier =
= 1.6
0.125 × 1.60 = 20%
15%
1
0.6667
=1.5
0.10 × 1.50 = 15%
© 2003 McGraw-Hill Ryerson Limited
PPT 3-14
Figure 3-1
Du Pont analysis
Net income

Profit margin
Sales


Asset
turnover
Return on
assets
 =
Total assets
Return on
Equity
Total assets

Financing plan
(Equity multiplier)
Equity
© 2003 McGraw-Hill Ryerson Limited
PPT 3-16
Asset Utilization Ratios
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Measure how efficiently the company uses its assets to
generate sales
The higher the ratio, the greater the company’s efficiency
Sales
Accounts Receivable
Receivable
Turnover
Capital Asset
Turnover
Inventory
Turnover
Sales
Capital Assets
Cost of Goods Sold
Inventory
© 2003 McGraw-Hill Ryerson Limited
PPT 3-17
Asset utilization ratios(a)
Saxton Company
Industry Average
3-4a. Receivables turnover =
Sales (credit)
Receivables
$4,000,000
$350,000
= 11.4
10 times
3-4b. Average collection period =
Accounts receivable
Average daily credit sales
3-5a. Inventory turnover =
Cost of Goods Sold
Inventory
$350,000
$10,959
= 32
36 days
$3,000,000
$370,000
= 8.1
7 times
© 2003 McGraw-Hill Ryerson Limited
PPT 3-18
Asset utilization ratios(b)
Saxton Company
Industry Average
3-5b. Inventory holding period =
Inventory
Average daily COGS
$370,000
$8,219
= 45
52 days
3-6a. Accounts payable turnover =
Cost of goods sold
Accounts payable
3-6b. Accounts payable period =
Accounts payable
Average daily purchases
(COGS)
$3,000,000
$50,000
$50,000
$8,219
= 60.0
=6
12 times
30 days
© 2003 McGraw-Hill Ryerson Limited
PPT 3-19
Asset utilization ratios(c)
Saxton Company
Industry Average
3-7. Capital asset turnover =
Sales
Capital assets
$4,000,000
= 5.0
$800,000
5.4 times
3-8. Total asset turnover =
Sales
Total assets
$4,000,000
= 2.5
$1,600,000
1.5 times
© 2003 McGraw-Hill Ryerson Limited
PPT 3-21
Liquidity Ratios
 Measure
the company’s liquidity (its ability to pay
short-term debts)
 The higher the ratio, the lower the risk of inability
to pay
Current Ratio
Current Assets
Current Liabilities
Quick Ratio
“Quick” Assets
Current Liabilities
© 2003 McGraw-Hill Ryerson Limited
PPT 3-22
Liquidity ratios
Saxton Company
Industry Average
3-9. Current ratio =
Current assets
Current liabilities
3-10. Quick ratio =
Current assets – Inventory
Current liabilities
$800,000
$300,000
= 2.67
2.1
$430,000
= 1.43
$300,000
1.0
© 2003 McGraw-Hill Ryerson Limited
PPT 3-23
Debt Utilization Ratios
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Measure the company’s ability to pay long-term debts
The higher the ratio, the less risk of insolvency
Fixed Charge
Coverage
Times Interest
Earned
Operating Income
“Fixed” Charges
Operating Income
Interest Expense
Debt
Total Assets
Debt-to-Total Assets Ratio
© 2003 McGraw-Hill Ryerson Limited
PPT 3-24
Debt utilization ratios
Saxton Company
Industry Average
3-11. Debt to total assets =
Total debt
Total assets
$600,000
$1,600,000
= 37.5%
33%
3-12. Times interest earned =
Income before
interest and taxes
Interest
$550,000
$50,000
= 11
3-13. Fixed charge coverage =
Income before
fixed charges and taxes
Fixed charges
$600,000
$100,000
=6
7 times
5.5 times
© 2003 McGraw-Hill Ryerson Limited
PPT 3-25
Table 3-2a
Ratio analysis(a)
Saxton
Company
Industry
Average
1. Profit margin………………
2. Return on assets………..….
5%
12.5%
6.5%
10%
3. Return on equity………….
20%
15%
11.4
32.0
8.1
45
60.0
6
5.0
2.5
10.0
36.0
7.0
52
12
30
5.4
1.5
Conclusion
A. Profitability
Below average
Above average due
to high turnover
Good due to
ratios 2 and 11
B. Asset Utilization
4a. Receivables turnover ……...
4b. Average collection period….
5a. Inventory turnover ………...
5b. Inventory holding period......
6a. Accounts payable turnover...
6b. Accounts payable period......
7. Capital asset turnover …….
8. Total asset turnover ……….
Good
Good
Good
Good
Good
Good
Below average
Good
© 2003 McGraw-Hill Ryerson Limited
PPT 3-26
Table 3-2b
Ratio analysis(b)
Saxton
Company
Industry
Average
2.67
1.43
2.1
1.0
Good
Good
37.5%
11
6
33%
7
5.5
Slightly more debt
Good
Good
Conclusion
C. Liquidity
9. Current ratio ………………
10. Quick ratio ………………..
D. Debt Utilization
11. Debt to total assets ………..
12. Times interest earned …….
13. Fixed charge coverage …….
© 2003 McGraw-Hill Ryerson Limited
PPT 3-27
Figure 3-2a
Trend analysis
A. Profit Margin
Percent
7
Saxton
5
3
1
1990
1992
1994
1996
1998
2000
2002
© 2003 McGraw-Hill Ryerson Limited
PPT 3-27
Figure 3-2a
Combined analysis
A. Profit Margin
Percent
Industry
7
Saxton
5
3
1
1990
1992
1994
1996
1998
2000
2002
© 2003 McGraw-Hill Ryerson Limited
PPT 3-28
Figure 3-2b
Trend Analysis
B. Total asset turnover
3.5X
3.0X
2.5X
Saxton
2.0X
1.5X
1.0X
.5X
1990
1992
1994
1996
1998
2000
2002
© 2003 McGraw-Hill Ryerson Limited
PPT 3-28
Figure 3-2b
Combined Analysis
B. Total asset turnover
3.5X
3.0X
2.5X
Saxton
2.0X
1.5X
Industry
1.0X
.5X
1990
1992
1994
1996
1998
2000
2002
© 2003 McGraw-Hill Ryerson Limited
PPT 3-29
Table 3-3
Trend analysis of competitors
Bank of Montreal
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
Royal Bank
Return on
Assets
Return on
Equity
Return on
Assets
Return on
Equity
0.61
0.63
0.68
0.68
0.74
0.66
0.59
0.61
0.79
0.60
14.1
14.1
14.9
15.4
17.0
17.1
15.2
14.1
18.0
13.8
0.08
0.21
0.70
0.69
0.70
0.70
0.70
0.65
0.81
0.74
<0.3>
2.4
16.8
16.6
17.6
9.3
18.4
15.6
19.8
16.4
Source: Annual reports
www.bmo.com
www.rbc.com
Symbol: BMO
Symbol: RY
© 2003 McGraw-Hill Ryerson Limited
Inflation and it’s Impact on Profits
PPT 3-31
FIFO (First-In, First-Out) Inventory:
Lowers COGS (Cost of Goods Sold)
 Raises Profits
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LIFO (Last-In, First-Out) Inventory:
Raises COGS
 Lowers Profits
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© 2003 McGraw-Hill Ryerson Limited
Notes on the Use of Ratio Analysis
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Ratio analysis may not answer questions, but leads to further
inquiry and help you ask the right questions
It may merely direct attention to potential areas of concern; it does
not provide evidence as to the existence of a problem
Ratios that deviate from the norm are only symptoms of the
problem; further analysis is required to isolate the cause of the
problem.
A single ratio does not provide sufficient information to judge overall
performance.
Be aware that data being compared may not use the same accounting
rules applied.
Time series comparisons of ratios may be distorted by inflation.
It is difficult to define categorically what a good or bad ratio value should
be.
Requires a large dose of good judgment
Ratio analysis will rarely be useful if practiced mechanically
© 2003 McGraw-Hill Ryerson Limited
PPT 3-32
Summary and Conclusions
Financial
analysis involves
evaluating and comparing financial
performance
Basic
tools for financial analysis
include financial ratios, trend
analysis and cross-sectional analysis
Financial
analysis is somewhat
hindered by limitations in financial
reporting, but can suggest aspects
requiring further exploration
© 2003 McGraw-Hill Ryerson Limited