3 Financial Analysis Chapter Mc GrawHillIrwin Copyright 2008

3 Financial Analysis Chapter Mc. Graw-Hill/Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Chapter Outline • • • Ratio analysis and its importance. Use of ratio for measurements. The Du Pont system of analysis. Trend analysis. Evaluation of reported income to identify distortion. 2

Ratio Analysis • Financial ratios – Used to weigh and evaluate the operating performance of a firm. – Used to compare performance record as against other firms in the industry. – Analyzing ratios and numerical calculations. – Such data is provided by various organizations. 3

Ratios and their Classification A. Profitability ratios 1. Profit margin. 2. Return on assets (investment). 3. Return on equity. B. Asset utilization ratios 4. 5. 6. 7. 8. Receivable turnover. Average collection period. Inventory turnover. Fixed asset turnover. Total asset turnover. 4

Ratios and their Classification (cont’d) C. Liquidity ratios 9. Current ratio. 10. Quick ratio. Debt utilization ratios 11. Debt to total assets. 12. Times interest earned. 13. Fixed charge coverage. 5

Types of Ratios • Profitability ratios – Measurement of the firm’s ability to earn an adequate return on: • Sales • Assets • Invested capital • Asset utilization ratios – Measures the speed at which the firm is turning over accounts receivable. 6

Types of Ratios (cont’d) • Liquidity ratios – Emphasizes the firm’s ability to pay off shortterm obligations as and when due. • Debt utilization ratios – Estimates the overall debt position of the firm. – Evaluates in the light of asset base and earning power. 7

Financial Statement for Ratio Analysis 8

Profitability Ratios 9

Du Pont System of Analysis • A satisfactory return on assets might be derived through: – A high profit margin – A rapid turnover of assets (generating more sales per dollar of its assets) – Or both Return of assets (investment) = (Profit margin) X (Asset turnover) 10

Du Pont 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 (investments) [1 – (Debt/ Assets)] 11

Du Pont Analysis 12

Examples for Analysis using the Du Pont System 13

Asset Utilization Ratios • These ratios relate the balance sheet to the income statement. 14

Asset Utilization Ratios (cont’d) 15

Liquidity Ratios 16

Debt Utilization Ratios • Measures the prudence of the debt management policies of the firm. 17

Debt Utilization Ratios (cont’d) • Fixed charge coverage measures the firm’s ability to meet the fixed obligations. • Interest payments alone are not considered. Income before interest and taxes………………. . $550, 000 Lease payments………………… $50, 000 Income before fixed charges and taxes…………$600, 000 18

Summary of Ratio Analysis 19

Trend Analysis 20

Trend Analysis in the Computer Industry 21

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 due to good performance. 22

Comparison of Replacement and Historical Cost Accounting 23

Comparison of Replacement and Historical Cost Accounting (cont’d) • Replacement costs - reduces income but increases assets. – An increase lowers the debt-to-assets ratio. – A decrease indicates a decrease in the financial leverage of the firm. – A declining income results in a decreased ability to cover interest costs. 24

Impact of Disinflation on Financial Analysis • Disinflation – Financial assets such as stocks and bonds have the potentials to do well – encouraging investors. – Tangible assets do not have the potential. • Deflation – Actual reduction of prices affecting everybody due to bankruptcies and declining profits. 25

Other Elements of Distortion in Reported Income • • Effect of changing prices. Reporting of revenues. Treatment of nonrecurring items. Tax write-off policies. 26

Explanation of Discrepancies 27

Explanation of Discrepancies (cont’d) • Sales – Use of defer recognition until each payment is received or full recognition at the earliest possible date. • Cost of goods sold – Use of different accounting principles - LIFO versus FIFO. 28

Explanation of Discrepancies (cont’d) • Extraordinary gains/ losses – Inclusion of events when computing current income or leaving them out. • Net income – Use of different methods of financial reporting. 29