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Chapter

3. Chapter. Financial Analysis. Chapter 3 - Outline. Financial Analysis 4 Categories of Financial Ratios Importance of Ratios Inflation and its Impact on Profits. What is financial analysis?. Evaluating a firm’s financial performance Analyzing ratios or numerical calculations

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  1. 3 Chapter Financial Analysis

  2. Chapter 3 - Outline • Financial Analysis • 4 Categories of Financial Ratios • Importance of Ratios • Inflation and its Impact on Profits

  3. What is financial analysis? • Evaluating a firm’s financial performance • Analyzing ratios or numerical calculations • Comparing a company to its industry

  4. 4 Categories of Ratios • Profitability Ratios—ability of the firm to earn an adequate return and control costs. • Asset Utilization Ratios—How efficiently the firm’s assets are being utilized. • Liquidity Ratios—focus on short term risk management. • Debt Utilization Ratios—focus on the capital structure and long-term risk management.

  5. Classification System PPT 3-1 • We will separate 13 significant ratios into four primary categories. • A. Profitability Ratios. • 1. Profit margin. • 2. Return on assets (investment). • 3. Return on equity. • B. Asset utilization ratios. • 4. Receivable turnover. • 5. Average collection period. • 6. Inventory turnover. • 7. Fixed 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.

  6. PPT 3-2

  7. Profitability Ratios show how profitable a company is.

  8. Profitability ratios express: • Profit Margin or Return on Sales (%)—what fraction of sales goes to the “bottom line.” • Return on Assets or Return on Investment (%)—what percent are we earning on the assets we have invested in the firm. • Return on Equity (%)—probably of most interest to shareholders

  9. $200,000 $4,000,000 Net income sales Net income Total assets $200,000 $1,600,000 Net income Sales Sales Total assets Net income Stockholders’ equity $200,000 $1,000,000 Return on assets (investment) (1 – Debt/Assets) 0.125 1 – 0.375 0.10 1 – 0.33 T 3-3 Profitability Ratios—Page 58 • Saxton Company Industry Average • 1. Profit margin = = 5% 6.7% • 2. Return on assets (investment) = • a. = 12.5% 10% • b. 5%  2.5 = 12.5% 6.7%  1.5 = 10% • 3. Return on equity = • a. = 20% 15% • b. = 20% = 15% 

  10. T 3-4 Figure 3-1DuPont analysis—Page 60 Net Income  Profit Margin Return on Assets  Sales  Asset Turnover Return on Equity Total Assets Return on Assets  (1 - Debt/Assets) = Total Debt Financing Plan  Total Assets

  11. Table 3-2 (Page 58) illustrates a very important point • IN ORDER TO PROPERLY INTERPRET A RATIO, WE MUST KNOW WHAT THE COMPANY IS TRYING TO ACCOMPLISH. • Ratios are a diagnostic tool that tells us whether we are properly executing our plan.

  12. PPT 3-5

  13. Asset Utilization Ratios show how effectively a company uses its assets.

  14. Asset Utilization ratios express: • Receivables Turnover (times)—In a 360 day year, how many times do our receivables turn over in terms of sales. • Average Collection Period (days)—the inverse of receivables turnover. • Inventory Turnover (times)—how many times must we replenish inventory to achieve this level of sales—often, COGS is used instead of sales. • Fixed Asset Turnover (times)—how many times would our fixed assets turnover to represent this level of sales. • Total Asset Turnover (times)—this is a combination of the above ratios.

  15. Sales (credit) Receivables $4,000,000 $350,000 $350,000 $11,111 Sales Inventory $4,000,000 $370,000 T 3-6 Asset Utilization Ratios—Page 60-61 Saxton Company Industry Average 4. Receivables turnover = = 11.4 10 times 5. Average collection period = = 32 36 days 6. Inventory turnover = = 10.8 7 times Accounts receivable Average daily credit sales

  16. Sales Fixed assets $4,000,000 $800,000 Sales Total assets $4,000,000 $1,600,000 T 3-6 Asset Utilization Ratios—Page 61 Saxton Company Industry Average 7. Fixed asset turnover = = 5 5.4 times 8. Total asset turnover = = 2.5 1.5 times

  17. Profitability and Turnover Ratios • Remember: • Return on X = Net Income / X • X Turnover = Sales / X

  18. Liquidity Ratios show how liquid a company is or how much $ it has to meet S/T needs.

  19. Liquidity ratios express: • Current Ratio (times)—how many times our current assets, if liquidated, pay our current liabilities? • Quick Ratio or Acid-Test Ratio (times) –excluding inventory, how many times will our current assets, if liquidated, cover our current liabilities?

  20. Current assets Current liabilities Current assets – Inventory Current liabilities T 3-7 Liquidity Ratios—Page 61 Saxton Company Industry Average 9. Current ratio = = 2.67 2.1 10. Quick ratio = = 1.43 1.0 $800,000 $300,000 $430,000 $300,000

  21. Debt Utilization Ratios show how well a company is managing or using debt.

  22. Debt utilization ratios express: • Debt-to-Total Assets (%)—debt as a percent of total assets—what part of assets is financed with long-term debt. • Times Interest Earned (times)—a measure of safety—how many times will our EBIT cover interest expenses? • Fixed Charge Coverage (times)—income before fixed charges and taxes divided by fixed charges • (Fixed Charges = lease payments, i expense)

  23. Total debt Total assets Income before interest and taxes Interest Income before fixed charges and taxes Fixed charges T 3-8 Debt Utilization Ratios—Page 62 Saxton Company Industry Average 11. Debt to total asets = = 37.5% 33% 12. Times interest earned = = 11 7 times 13. Fixed charge coverage = = 6 5.5 times $600,000 $1,600,000 $550,000 $50,000 $600,000 $100,000

  24. Which ratio is most important? • It depends on your perspective. • Suppliers and banks (lenders) are most interested in liquidity ratios. • Stockholders are most interested in profitability ratios. • A long-run trend analysis over a 5-10 year period is usually performed by an analyst.

  25. T 3-9 Table 3-3--Ratio Analysis—Page 62 • Saxton Industry • Company Average Conclusion • A. Profitability • 1. Profit Margin ……………… 5.0% 6.7% Below average • 2. Return on Assets ………….. 12.5% 10.0% Above average due to high turnover • 3. Return on Equity ………….. 20.0% 15.0% Good due to ratios 2 and 10 • B. Asset Utilization • 4. Receivables turnover ……. 11.4 10.0 Good • 5. Average collection period…. 32.0 36.0 Good • 6. Inventory turnover ………... 10.8 7.0 Good • 7. Fixed asset turnover ………. 5.0 5.4 Below average • 8. Total asset turnover ………. 2.5 1.5 Good • C. Liquidity • 9. Current ratio ……………… 2.67 2.1 Good • 10. Quick Ratio ……………….. 1.43 1.0 Good • D. Debt Utilization • 11. Debt to total assets ……….. 37.5% 33.0% Slightly more debt • 12. Times interest earned ……. 11.0 7.0 Good • 13. Fixed charge coverage …... 6.0 5.5 Good

  26. Interpreting ratios

  27. Understand the strategic plan of the firm before you begin.

  28. Compare the ratios of other, similar firms at a given point in time. • Do NOT assume that if your firm is different, it is necessarily bad. • Be sure you compensate for firm size and other differences.

  29. Perform a trend analysis (over time) to spot trends—good or bad.

  30. Don’t jump to conclusions—ratios are only a starting point—you must figure out WHY the ratio is what it is—remember Wal Mart and Dillards

  31. Bigger isn’t necessarily always better—or worse.

  32. When in doubt, talk to management—ask questions and study the industry.

  33. A. Profit Margin Percent Industry 7 5 3 1 Saxton 1985 1987 1989 1991 1993 1995 1997 T 3-10 Figure 3-2Trend analysis—Page 64

  34. T 3-10 Figure 3-2Trend Analysis—Page 64 B. Total asset turnover 3.5X 3.0X 2.5X 2.0X 1.5X 1.0X .5X Saxton Industry 1985 1987 1989 1991 1993 1995 1997

  35. Table 3-4 (next) shows how intense competition in the computer industry has caused return to decline over time.

  36. Impact of inflation on Financial Analysis

  37. Because accountants use historical cost as a basis for certain expenses, expenses do not keep up with revenue on the income statement.

  38. The result of accountants using historical costs is that revenue can increase, even though no change has really occurred in the underlying business.

  39. The next example illustrates how use of historical cost accounting can distort results.

  40. Stein company (Table 3-5 and Table 3-6 combined)—Page 65

  41. The effect of Inflation on financial numbers

  42. Table 3-7 (Page 66) shows selected financial data for 10 Chemical companies and 8 Drug companies.

  43. T 3-12 Table 3-7 / Comparison of replacement cost accounting and historical cost accounting—Page 66 • 10 Chemical 8 Drug Companies Companies • Replacement Historical Replacement Historical Cost Cost Cost Cost • Increase in assets. . . . . . . . 28.4% -- 15.4% -- • Decrease in net incomebefore taxes . . . . . . . . . 45.8% -- 19.3% -- • Return on assets . . . . . . . . 2.8% 6.2% 8.3% 11.4% • Return on equity. . . . . . . . 4.9% 13.5% 12.8% 19.6% • Debt-to-assets ratio. . . . . . 34.3% 43.8% 30.3% 35.2% • Interest coverage ratio (times interest earned) 7.1 8.4 15.4 16.7

  44. The column labeled Replacement cost shows what the numbers would be if inflation were properly considered.

  45. The column labeled historical cost shows what the numbers actually were.

  46. Replacement cost: • Reduces income • Increases assets • Debt-to-asset ratio is lowered since debt does not inflate. • Declining income causes interest coverage ratio to decline. • Return on assets drops because assets increase while net income drops.

  47. Disinflationary Effect

  48. Disinflation means expensive inventory is charged against softening sales.

  49. Cyclical industries are most susceptible to sudden declines in earnings as business slows (disinflation).

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