Chapter 13

Financial Analysis & Ratios

Comparative Analysis

There are three types of comparisons to provide decision usefulness of financial information:

• Intra-company basis

• Inter-company basis

• Industry averages

Comparative Analysis

• Intra-company basis – comparisons within the company.

• Inter-company basis – comparisons with other companies.

• Industry averages – comparisons with other companies in the same industry.

Financial Statement AnalysisThree basic tools are used in financial statement analysis :

1. Horizontal analysis

2. Vertical analysis

3. Ratio analysis

Horizontal Analysis

• Is a technique for evaluating a series of financial statement data over a period of time.

• Did an increase or decrease take place?

– Pages 613 - 614

Horizontal Analysis

P1 – P0 P0

$245 – $281 = (12.81)%

$281The amount of cash for Lowe’s decreased approximately 12.81%

from fiscal 2007 to 2008.

Vertical Analysis• Expresses each item in a financial statement as a

percent of a base amount.

• Total Assets is the base amount on a Balance Sheet.

• Common-size balance sheet

• Net Sales is the base amount on an Income Statement.

• Common-size income statement

Pages 615 - 616

Ratio AnalysisFive types:

Liquidity ratios

Solvency ratios

Turnover ratios

Profitability ratios

Market value ratios

Liquidity Ratios

Measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash.

WHO CARES?Short-term creditors such as bankers and suppliers

Current Ratio

Indicates short-term debt-paying ability

Current AssetsCurrent Liabilities

Acid-Test Ratio

Indicates immediate short-term debt-paying ability

Current Assets - Inventory Current Liabilities

Cash Ratio

Indicates short-term debt-paying ability (cash basis)

_ Cash _Current Liabilities

Solvency Ratios

Measure the ability of the enterprise to survive over a long period of time

WHO CARES?Long-term creditors and stockholders

Debt to Assets Ratio

Indicates % of total assets provided by creditors

Total Liabilities

Total Assets

Times Interest Earned Ratio

Indicates company’s ability to meet interest payments as they come due

_ EBIT _

Interest Expense

Cash Debt Coverage Ratio

Indicates long-term debt-paying ability (cash basis)

Cash provided by operations Average total liabilities

Turnover Ratios

Measure how efficiently, or intensively, a firm uses its assets to generate sales

.

WHO CARES?

Short-term creditors such as bankers and suppliers

Inventory Turnover Ratio

Indicates liquidity of inventory

Cost of Goods SoldInventory

Average Days in Inventory

Indicates liquidity of inventory and inventory management

365 days

Inventory Turnover Ratio

Receivables Turnover Ratio

Indicates liquidity of receivables

Net SalesAccounts Receivable

Average Collection Period

Indicates liquidity of receivables and collection success

365 daysReceivables Turnover

Asset Turnover Ratio

Indicates how efficiently assets are used to generate sales

Net Sales

Total Assets

Profitability Ratios

Measure the income or operating success of an enterprise for a given period of time

WHO CARES? Everybody

WHY? A company’s income affects: its ability to obtain debt and equity financingits liquidity positionits ability to grow

Profit Margin Ratio

Indicates net income generated by each dollar of sales

Net IncomeNet Sales

Return On Assets

Reveals the amount of net income generated by each dollar invested

Net IncomeAverage Total Assets

Return on Equity

Indicates profitability of common

stockholders’ investment

Net IncomeAverage Total Equity

Market Value Ratios

Deals with market value of stock.

.

WHO CARES?Stockholder’s

Earnings Per Share (EPS)

Indicates net income earned on each share of common stock sales

Net IncomeShares Outstanding

Price Earnings Ratio

Indicates relationship between market price per share and earnings per share

Stock PriceEarnings Per Share

Payout Ratio

Indicates % of earnings distributed in the form of cash dividends

DividendsNet Income

Retention Ratio

Indicates % of earnings plowed back into the corporation.

Addition to Retained EarningsNet Income

Limitations Of Financial Analysis

• Horizontal, vertical, and ratio analysis are frequently used in making significant business decisions.

• One should be aware of the limitations of these tools and the financial statements.