Financial Analysis

3Chapter

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Chapter Outline

• Ratio analysis and its importance

• Use of ratios as measurement tool

• The DuPont system of analysis

• Trend analysis

• Evaluation of reported income to identify sources of distortion

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Ratio Analysis

• Financial ratios– Used to weigh and evaluate the operating

performance of a firm– Numerical calculations and analyzing ratios– Used to compare performance record as

against similar firms in the industry– Additional evaluation of company

management, physical facilities and other factors

– Such data is provided by various organizations

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Ratios and their Classification

A. Profitability ratios1. Profit margin2. Return on assets (investment)3. Return on equity

B. Asset utilization ratios4. Receivable turnover5. Average collection period6. Inventory turnover7. Fixed asset turnover8. Total asset turnover

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Ratios and their Classification (cont’d)

C. Liquidity ratios 9. Current ratio

10. Quick ratio

D. Debt utilization ratios11. Debt to total assets

12. Times interest earned

13. Fixed charge coverage

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Types of Ratios

• Profitability ratios– Measure the firm’s ability to earn adequate return on:

• Sales• Assets• Invested capital

• Asset utilization ratios– Measure the speed at which the firm is turning over:

• Accounts receivable• Inventory• Long-term assets

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Types of Ratios (cont’d)

• Liquidity ratios– Emphasizes the firm’s ability to pay off short-

term obligations as they come due

• Debt utilization ratios– Estimates the overall debt position of the firm– Evaluates in the light of asset base and

earning power

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Importance of Ratios to Users of Financial Statements

• For potential investors/security analysts:– Primary considerations – profitability ratios– Secondary considerations – liquidity and debt

utilization

• For banker or trade creditor – liquidity ratios

• For long-term creditors – debt utilization ratios and profitability ratios

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Financial Statement for Ratio Analysis

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Profitability Ratios

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DuPont System of Analysis

• A satisfactory return on assets might be derived through:– a high profit margin, or– a rapid turnover of assets (generating more

sales per dollar of its assets)– or a combination of both

Return on assets (investment) = Profit margin × Asset turnover

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DuPont System of Analysis (cont’d)

• A satisfactory return on equity might be derived through:– a high return on total assets – a generous utilization of debt– or a combination of both

Return on equity = Return on assets (investment)

(1 – Debt/Assets)

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DuPont Analysis

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Return of Wal-Mart versus Abercrombie using the Du Pont method of analysis, 2009

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Asset Utilization Ratios

• These ratios relate the balance sheet (assets) to the income statement (sales)

*

*This ratio may also be computed by using “Cost of goods sold” in the numerator.

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Asset Utilization Ratios (cont’d)

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Liquidity Ratios

• These ratios determine if the firm can meet

each maturing obligation as it comes due

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Debt Utilization Ratios

• Measures the prudence of the debt management policies of the firm

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Debt Utilization Ratios (cont’d)

• Fixed charge coverage measures the firm’s ability to meet all fixed obligations rather than interest payments aloneIncome before interest and taxes………………..$550,000

Lease payments…………………………………… 50,000

Income before fixed charges and taxes…………$600,000

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Ratio Analysis

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Trend Analysis

• Gives a picture of performance over a number of years against industry averages

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Trend Analysis in the Computer Industry

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Impact of Inflation on Financial Analysis

• Inflation– Revenue is stated in current dollars– Plant, equipment, or inventory may have been

purchased at lower price levels – Profits may be more a function of increasing

prices than of satisfactory performance

• Financial reports get distorted for no consideration of inflation factor, which in turn will affect the financial analysis

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Comparison of Replacement and Historical Cost Accounting

Jeff Garnett and Geoffrey A. Hirt, “Replacement Cost Data: A Study of the Chemical and Drug Industry for Years 1976 through 1978.”

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Comparison of Replacement and Historical Cost Accounting (cont’d)• Replacement cost – reduces income but

increases assets– an increase in assets lowers the debt-to-assets

ratio– a lower debt-to-assets ratio indicates decrease

in the financial leverage of the firm– a declining income results in a decreased

ability to cover interest costs

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Impact of Disinflation on Financial Analysis

• Disinflation – a situation of declining inflationary pressures– Will not impair the purchasing power of the

dollar– Reduction in investors’ expectation of returns

on financial assets– Financial assets such as stocks and bonds

have the potential to do well

• Deflation– Actual reduction of prices affecting everybody

due to bankruptcies and declining profits

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Other Elements of Distortion in Reported Income

• Effect of changing prices

• Reporting of revenues

• Treatment of nonrecurring items

• Tax write-off policies

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Income Statements

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Explanation of Discrepancies

• Sales– Firm may defer revenue recognition until each

payment received or full recognition at earliest possible date

• Cost of goods sold– Use of different accounting principles – LIFO

versus FIFO– Varying treatment of R&D costs etc.

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Explanation of Discrepancies (cont’d)

• Extraordinary gains/losses– Inclusion of extra-ordinary events in computing

current income or leave them out

• Net income– Use of different methods of financial reporting

(inclusion / exclusion of extra-ordinary gains / losses)

– Each item in the financial statement analyzed rather accepting bottom-line figures