Slide Contents Learning Objectives Principles Used in this Chapter Why Do We Analyze Financial Statements Common Size Statements – Standardizing Financial Information Using Financial Ratios Selecting a Performance Benchmark
Slide Contents (cont.) The Limitations of Ratio Analysis Key Terms
Learning Objectives Explain what we can learn by analyzing a firm’s financial statements. Use common size financial statements as a tool of financial analysis. Calculate and use a comprehensive set of financial ratios to evaluate a company’s performance.
Learning Objectives (cont.) Select an appropriate benchmark for use in performing a financial ratio analysis. Describe the limitations of financial ratio analysis.
Principles Used in this Chapter Principle 1: Money has a Time Value. Financial statements typically ignore time value of money. Thus financial managers and accountants may view financial statements very differently.
Principles Used in this Chapter (cont.) Principle 2: There Is a Risk-Return Tradeoff. Financial statement analysis can yield important information about the strengths and weaknesses of a firm’s financial condition. The analysts can use such information to infer the risk-return tradeoff in a firm.
Principles Used in this Chapter (cont.) Principle 3: Cash Flows Are the Source of Value. An important use of a firm’s financial statements involves analyzing past performance as a tool for predicting future cash flows.
Principles Used in this Chapter (cont.) Principle 4: Market Prices Reflect Information. Financial statement analysis requires gathering information about a firm’s financial condition, which is important to the valuation of the firm.
Why Do We Analyze Financial Statements? A firm’s financial statements can be analyzed internally (by employees, managers) and externally (by bankers, investors, customers, and other interested parties).
Why Do We Analyze Financial Statements? (cont.) An internal financial analysis might be done: To evaluate the performance of employees and determine their pay raises and bonuses. To compare the financial performance of the firm’s different divisions. To prepare financial projections, such as those associated with the launch of a new product. To evaluate the firm’s financial performance in light of its competitors and determine how the firm might improve its operations.
Why Do We Analyze Financial Statements? (cont.) A variety of firms and individuals that have an economic interest might also undertake an external financial analysis: Banks and other lenders deciding whether to loan money to the firm. Suppliers who are considering whether to grant credit to the firm. Credit-rating agencies trying to determine the firm’s creditworthiness.
Why Do We Analyze Financial Statements? (cont.) Professional analysts who work for investment companies considering investing in the firm or advising others about investing. Individual investors deciding whether to invest in the firm.
Common Size Statements – Standardizing Financial Information A common size financial statement is a standardized version of a financial statement in which all entries are presented in percentages. A common size financial statement helps to compare entries in a firm’s financial statements, even if the firms are not of equal size.
Common Size Statements – Standardizing Financial Information (cont.) How to prepare a common size financial statement? For a common size income statement, divide each entry in the income statement by the company’s sales. For a common size balance sheet, divide each entry in the balance sheet by the firm’s total assets.
Table 4-1 Observations Table 4-1 is created by dividing each entry in the income statement found in Table 3-1 by firm sales for 2010. Cost of goods sold make up 75% of the firm’s sales resulting in a gross profit of 25%. Selling expenses account for about 3% of sales. Income taxes account for 4.1% of the firm’s sales. After accounting for all expenses, the firm generates net income of 7.6% of firm’s sales.
Table 4-2 Observations Table 4-2 is created by dividing each entry in the balance sheet found in Table 3-2 by total assets for the year. Total current assets increased by 5.6% in 2010 while total current liabilities declined by 2%. Long-term debt account for 39.2% of firm’s assets, showing a decline of 1.7%. Retained earnings increased by 5.8% in 2010.
Using Financial Ratios Financial ratios provide a second method for standardizing the financial information on the income statement and balance sheet. A ratio by itself may have no meaning. Hence, a given ratio is compared to: (a) ratios from previous years; or (b) ratios of other firms in the same industry. If the differences in the ratios are significant, more in-depth analysis must be done.
Liquidity Ratios Liquidity ratios address a basic question: How liquid is the firm? A firm is financially liquid if it is able to pay its bills on time. We can analyze a firm’s liquidity from two perspectives: Overall or general firm liquidity Liquidity of specific current asset accounts
Liquidity Ratios (cont.) Overall liquidity is analyzed by comparing the firm’s current assets to the firm’s current liabilities. Liquidity of specific assets is analyzed by examining the timeliness in which the firm’s primary liquid assets – accounts receivable and inventories – are converted into cash.
Liquidity Ratios: Current Ratio The overall liquidity of a firm is analyzed by computing the current ratio and acid-test ratio. Current Ratio: Current Ratio compares a firm’s current (liquid) assets to its current (short-term) liabilities.
Liquidity Ratios: Current Ratio (cont.) The text computes the current ratio for H.J. Boswell, Inc. for 2010. What is the current ratio for 2009?
Liquidity Ratios: Current Ratio (cont.) Current Ratio = $477 ÷ 292.5 = 1.63 times The firm had $1.63 in current assets for every $1 it owed in current liability. The current ratio improved in 2010 to 2.23 times as the current assets increased significantly in 2010.
Liquidity Ratios: Quick Ratio The overall liquidity of a firm is also analyzed by computing the Acid-Test (Quick) Ratio. This ratio excludes the inventory from current assets as inventory may not always be very liquid.
Liquidity Ratios: Quick Ratio(cont.) The text computes the quick ratio for H.J. Boswell, Inc. for 2010. What is the quick ratio for 2009?
Liquidity Ratios: Quick Ratio(cont.) Quick Ratio = ($477-$299.50) ÷ ($292.50) = 0.63 times The firm is clearly less liquid using quick ratio as the firm has only $0.63 in current assets (less inventory) to cover $1 in current liabilities. The quick ratio improved in 2010 to 0.94 times largely due to an increase in current assets.
Liquidity Ratios: Individual Asset Categories We can also measure the liquidity of the firm by examining the liquidity of individual current asset accounts, including accounts receivable and inventories. We can assess the liquidity of the firm by measuring how long it takes the firm to convert its accounts receivables and inventories into cash.
Liquidity Ratios: Accounts Receivable Average Collection Period measures the number of days it takes the firm to collects its receivables.
Liquidity Ratios: Accounts Receivable (cont.) The text computes the average collection period for H.J. Boswell, Inc. for 2010. What will be the average collection period for 2009 if we assume that the annual credit sales were $2,500 million in 2009?
Liquidity Ratios: Accounts Receivable (cont.) Daily Credit Sales = $2,500 million ÷ 365 days = $6.85 million Average Collection Period = Accounts Receivable ÷ Daily Credit Sales = $139.5m ÷ $6.85m = 20.37 days The firm collects its accounts receivable in 20.37 days.
Liquidity Ratios: Accounts Receivable Turnover Ratio Accounts Receivable Turnover Ratio measures how many times accounts receivable are “rolled over” during a year.
Liquidity Ratios: Accounts Receivable Turnover Ratio (cont.) The text computes the accounts receivable turnover ratio for H.J. Boswell, Inc. for 2010. What will be the accounts receivable turnover ratio for 2009 if we assume that the annual credit sales were $2,500 million in 2009?
Liquidity Ratios: Accounts Receivable Turnover Ratio (cont.) Accounts Receivable Turnover = $2,500 million ÷ $139.50 = 17.92 times The firm’s accounts receivable were turning over at 17.92 times per year.
Liquidity Ratios: Inventory Turnover Ratio Inventory turnover ratio measures how many times the company turns over its inventory during the year. Shorter inventory cycles lead to greater liquidity since the items in inventory are converted to cash more quickly.
Liquidity Ratios: Inventory Turnover Ratio (cont.) The text computes the inventory turnover ratio for H.J. Boswell, Inc. for 2010. What will be the inventory turnover ratio for 2009 if we assume that the cost of goods sold were $1,980 million in 2009?
Liquidity Ratios: Inventory Turnover Ratio (cont.) Inventory Turnover Ratio = $1,980 ÷ $229.50 = 8.63 times The firm turned over its inventory 8.63 times per year.
Liquidity Ratios: Days’ Sales in Inventory We can express the inventory turnover ratio in terms of the number of days the inventory sits unsold on the firm’s shelves. Days’ Sales in Inventory = 365÷ inventory turnover ratio = 365 ÷ 8.63 = 42.29 days The firm, on average, holds it inventory for about 42 days.
Can a Firm Have Too Much Liquidity? A high investment in liquid assets will enable the firm to repay its current liabilities in a timely manner. However, an excessive investments in liquid assets can prove to be costly as liquid assets (such as cash) generate minimal return.
Checkpoint 4.1 Evaluating Dell Computer Corporation’s (DELL) Liquidity You work for a small company that manufactures a new memory storage device. Computer giant Dell has offered to put the new device in their laptops if your firm will extend them credit terms that allow them 90 days to pay. Since your company does not have many cash resources, your boss has asked that you look into Dell’s liquidity and analyze its ability to pay their bills on time using the following accounting information for Dell and two other computer firms (figures in thousands of dollars):
Checkpoint 4.1: Check Yourself Calculate HP’s inventory turnover ratio. Why do you think this ratio is so much lower than Dell’s inventory turnover ratio?