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Financial Analysis

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  1. Financial Analysis Chapter 4

  2. Overview of Financial Analysis First order of business is to SPECIFY THE OBJECTIVES OF THE ANALYSIS Remember -- the identity of the user helps define what information is needed

  3. Potential Financial Statement Users: • Creditors • Investors • Managers • What types of questions do each of these users seek answers to?

  4. Creditors • Why does the firm want/need to borrow funds? • What is the firm’s capital structure? How leveraged are they? • How will they pay it back? What kind of cash flows are being generated by operations?

  5. Investors • How has the firm performed/what are future expectations? • How much RISK is inherent in the capital structure? • What are the expected returns from the firm? • What is firm’s competitive position?

  6. Managers • Need all info creditors and investors need PLUS: • What operating areas have contributed to success and which have not? • What are strengths/weaknesses of company’s financial position? • What changes are indicated to improve future performance?

  7. Caution!!! • Keep in mind: management PREPARES financial statements • Analyst should be alert to potential for management to influence reporting to make data more “appealing” • May want to supplement analysis with information apart from Annual Report prepared by management

  8. Where to look for data... • Financial statements (and notes) • Annual Report • 10K and 10Q reports filed with SEC (EDGAR) • Computerized data bases • Info on industry norms/ratios • Info on particular companies/industries/mutual funds • Websites

  9. Basic Tools • Common size financial statements • Financial ratios • Trend analysis • Industry comparisons

  10. Common Sizing

  11. Common Sizing

  12. Common Sizing

  13. Common Size Statements • Common size income statement • expresses each income statement category as a percentage of sales • Common size balance sheet • expresses each item on balance sheet as a percentage of total assets

  14. Comparisons/benchmarking

  15. Explain how big the sun is relative to the Earth using data below. • Diameter • Earth 12,756 KM • Sun 1,392,000 KM • Mass • Earth 1 • Sun 330,000

  16. How big is Antares (one of the largest stars in our galaxy)?

  17. Ratio Analysis • Profitability ratios • Liquidity ratios • Leverage (solvency) ratios • Efficiency ratios • Market-value ratios Five Categories of Ratios

  18. Ratio Analysis • Measure the overall effectiveness of the firm’s management. Profitability Ratios

  19. Gross Profit Sales Gross Profit Margin = Ratio Analysis Profitability Ratios How effective is the firm at generating revenue in excess of its cost of goods sold?

  20. Gross Profit = Margin Gross Profit Sales $575 $1,450 Gross Profit Margin = = 39.7% Balance Sheet Excalibur Corporation Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Net Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  21. Operating Profit = Margin Operating Income Sales $330 $1,450 Oper. Profit Margin = = 22.8% Balance Sheet Excalibur Corporation Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  22. Ratio Analysis Profitability Ratios Note: Net Income equals Earnings Available to CS when there is no preferred stock. Net Income Sales Net Profit Margin or Profit Margin = How much net profit is being generated from each dollar of sales?

  23. Net Profit = Margin Net Income Sales $162 $1,450 Net Profit Margin = = 11.2% Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  24. Net Income Total Assets Return on Assets = Ratio Analysis Profitability Ratios How effectively is the firm generating net income from its assets ?

  25. Net Income Total Assets Return on Assets = $162 $2,530 = 6.4% ROA = Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40) 108 Net Income% $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  26. Ratio Analysis Profitability Ratios Net Income Equity Return on Equity = How well is the firm generating return to its equity providers?

  27. Net Income Equity Return on Equity = $162 $1,700 ROE = = 9.53% Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  28. Current Assets Current Liabilities Current Ratio = Ratio Analysis • Measure the ability of the firm to meet its short-term financial obligations. Liquidity Ratios Are there sufficient current assets to pay off current liabilities? What is the cushion of safety?

  29. Current Assets Current Liabilities Current Ratio = $1,230 $230 Current Ratio = = 5.35x Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530

  30. Current Assets - Inventory Current Liabilities Quick Ratio = Ratio Analysis • Measure the ability of the firm to meet its short-term financial obligations. Liquidity Ratios What happens to the firm’s ability to repay current liabilities after what is usually the least liquid of the current assets is subtracted?

  31. Current Assets - Inventory Current Liabilities Quick Ratio = $1,230 -$625 $230 Acid-Test Ratio = = 2.63x Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530

  32. Ratio Analysis • Measure the relative size of the firm’s debt load and the firm’s ability to pay off the debt. Leverage Ratios

  33. Total Debt Total Assets Debt Ratio = Ratio Analysis Debt Ratios What proportion of the firm’s assets is financed with debt?

  34. Total Debt Total Assets Debt Ratio = $230 + $600 $2,530 Debt Ratio = = 33% Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  35. Operating Income Interest Expense Times Interest Earned Ratio = Ratio Analysis Debt Ratios What is the firm’s ability to repay interest payments from its operating income?

  36. Times Interest = Earned Ratio Operating Income Interest Expense $330 $60 TIE Ratio = = 5.50x Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  37. Total Assets Total Equity Equity Multiplier = Ratio Analysis Debt Ratios What is the firm’s investment in assets relative to it’s equity?

  38. Equity Multiplier = Total Assets Total Equity $2,530 $1,700 EqMult= = 1.49x Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  39. Ratio Analysis • Help assess how effectively the firm is using assets to generate sales. Efficiency Ratios

  40. Ratio Analysis Efficiency Ratios Accounts Receivable Avg. Daily Sales DSO – Days Sales Out. or Average Collection Period = How long does it take for the firm on average to collect its credit sales from customers?

  41. Average Collection = Period Accounts Receivable Avg. Daily Sales $430 $1,450/365 DSO = = 108 days Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62 Days in a year

  42. COGS Inventory Inventory Turnover Ratio = Ratio Analysis Efficiency Ratios Is inventory efficiently translating into sales for the firm?

  43. Inventory Turnover = Ratio COGS Inventory $875 $625 Inventory Turnover = = 1.4x Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  44. Sales Net Fixed Assets Fixed Asset Turnover Ratio = Ratio Analysis Efficiency Ratios How effective is the firm in using its fixed assets to help generate sales?

  45. Fixed Asset Turnover = Ratio Sales Net Fixed Assets $1,450 $1,300 Fixed Asset Turnover = = 1.12x Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 Common Dividends Paid 100 Addition to Retained Earnings $62

  46. Sales Total Assets Total Asset Turnover Ratio = Ratio Analysis Efficiency Ratios How effective is the firm in using its overall assets to generate sales?