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Analysis of Financial Statements Chapter 4

Analysis of Financial Statements Chapter 4. Financial Ratios DuPont Analysis Limitations and Cautions. Financial Analysis Overview. Managers and Investors are continuously analyzing company performance:

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Analysis of Financial Statements Chapter 4

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  1. Analysis of Financial StatementsChapter 4 Financial Ratios DuPont Analysis Limitations and Cautions Chapter 2

  2. Financial Analysis Overview • Managers and Investors are continuously analyzing company performance: • Managers: compensation is driven by performance in areas of profitability and asset management. • Investors: wealth is affected by company performance. • Managers are primarily interested in 4 areas: • Liquidity Management • Asset Management • Debt Management • Profitability Management Chapter 2

  3. More on Financial Analysis • Comparing [current to past] performance • Where have we improved? • Where do we need to improve? • How do we compare to the best run companies in our industry? [benchmarking] • Key Problem Areas • Cost Management - key to profitability • Asset Management – “right-sizing” Chapter 2

  4. More on Financial Analysis • Why is Benchmarking Important? • Key to planning and strategy formulation. • Setting performance standards and goals for improvement. • Lets the personnel people know where they have to go to recruit top performers. Chapter 2

  5. Liquidity Management • Liquidity ratios measure the company's ability to pay their bills: Accounts Payable, Notes Payable, Accrued Expense • Current Ratio: $ in current assets per dollar of current liabilities. • Quick Ratio: $ in quick assets per dollar of current liabilities. (Inventory - low liquidity) • Desirable trends: depends on working capital strategy and market volatility. Chapter 2

  6. Asset Management • Asset utilization ratios measure the efficiency of asset management. • Inventory Turnover: increasing is good • Days Sales Outstanding: decreasing is good • Fixed Assets Turnover: increasing is good • Total Assets Turnover: increasing is good Chapter 2

  7. Debt Management • The extent to which assets and operating expenses are financed by borrowing money. • Debt Ratio: stable over time, decreasing is good • Times Interest Earned: increasing is good • Fixed Charge Coverage: increasing good • Many financial theorists favor borrowing • Method for increasing return on equity • Less expensive than equity Chapter 2

  8. Profitability Management • Profits result when a firm’s expenses are less than its revenues. • Profitability is a proxy measure for the firm’s ability to control costs. • Gross Profit Margin (GPM) – direct costs • Operating Profit Margin (OPM) – all operating costs • Net Profit Margin (NPM) – how much to bottom line • Return on Total Assets (ROA) – overall return • Return on Common Equity (ROE) – stockholders Chapter 2

  9. Market Value Ratios • Investors are continually appraising corporate performance. The Price / Earnings ratio is a very good proxy for how favorably or unfavorably investors judge performance. • High growth, high profitability - HIGH P/E • low growth, poor profitability - LOW P/E • Other Measures or Ratios • Book Value per Share • Market to Book Ratio Chapter 2

  10. Trend Analysis • Trend analysis answers two very important questions: 1. How has the company done over the last x years in a particular area. 2. How does the company’s trend compare to the industry average? Industry benchmark? Chapter 2

  11. Trend Analysis Example Chapter 2

  12. Trend Analysis Chapter 2

  13. DuPont System of Financial Analysis • DuPont System: a set of interrelated financial ratios used to measure operating performance. • ROE = ROA x (Total Assets/ Common Equity) • ROA = NPM * TATO • EQTY MULT = TOTAL ASSETS / COM EQTY • TATO = Net Sales / Total Assets • ROE = NPM * TATO * EQTY. MULT. Chapter 2

  14. DuPont System Chapter 2

  15. Limitations of Ratio Analysis1 • Industry averages affected by the presence of heterogeneity between firms in a given SIC. • Multiple lines of business in different market sectors, domestic & international. • Inflation Effects; • Mostly on balance sheet and income statement amounts. • Ratios are largely unaffected by inflation. Chapter 2

  16. Limitations of Ratio Analysis2 • Accounting numbers always subject to window dressing. • Although all US firms subject to GAAP, practices vary from firm to firm. • Ratio magnitudes not absolute; a good ratio in one environment can be bad in another. • Firms can have a mix of good and bad ratios making an overall rating difficult. Chapter 2

  17. Homework Assignment • Self-Test: ST-2 • Questions: 4-2, 4-6, 4-10, 4-11 (parts a, b, f, h, m, q) • Problems: 4-1, 4-6, 4-18, 4-21 Chapter 2

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