805 Chapter 03

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©The McGraw-Hill Companies, Inc. 2000

Foundations of FinancialManagement

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Financial Analysis

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Chapter 3 - Outline

• Financial Analysis

• 4 Categories of Financial Ratios

•

Importance of Ratios• Inflation and its Impact on Profits

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What is financial analysis?

• Evaluating a firm’s financial

performance• Analyzing ratios or numerical

calculations

• Comparing a company to its industry

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4 Categories of Ratios

• Profitabi l i ty Ratios — ability of the firm to

earn an adequate return and control costs.

• Asset Uti l ization Ratios — How efficiently the

firm’s assets are being utilized.

• L iquidity Ratios — focus on short term risk

management.

• Debt Uti l ization Ratios — focus on the capital

structure and long-term risk management.

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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.

Classification SystemPPT 3-1

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PPT 3-2

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Profitability Ratios show how profitable a company is.

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Profitability ratios express:

• Profit Margin or Return on Sales (%) — what

fraction of sales goes to the ―bottom line.‖

• Return on Assets or Return on I nvestment

(%) — what percent are we earning on the

assets we have invested in the firm.

• Return on Equi ty (%) — probably of most

interest to shareholders

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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%

Net income

sales

$200,000

$4,000,000

Net income

Total assets

Net income

Sales

Sales

Total assets

$200,000

$1,600,000

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

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Figure 3-1DuPont analysis — Page 60

Net Income

Sales

Total Assets

Profit Margin

AssetTurnover

Total Debt

Total Assets

Return on

Assets

FinancingPlan

Return onEquityReturn on Assets

(1 - Debt/Assets)=

T 3-4

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Table 3-2 (Page 58) illustrates a very

important pointIN ORDER TO PROPERLY

INTERPRET A RATIO, WE MUST

KNOW WHAT THE COMPANY IS

TRYING TO ACCOMPLISH.

Ratios are a diagnostic tool that tells uswhether we are properly executing our

plan.

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PPT 3-5

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Asset Utilization Ratiosshow how effectively acompany uses its assets.

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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 Per iod (days) — the inverse of

receivables turnover.

– I nventory Turnover (times) — how many times must we

replenish inventory to achieve this level of sales — often,

COGS is used instead of sales.

– F ixed Asset Turnover (times) — how many times wouldour fixed assets turnover to represent this level of sales.

– Total Asset Turnover (times) — this is a combination of

the above ratios.

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4. Receivables turnover =

= 11.4 10 times

5. Average collection period =

= 32 36 days

6. Inventory turnover =

= 10.8 7 times

Sales (credit)

Receivables

$4,000,000

$350,000

Accounts receivable

Average daily credit sales

$350,000

$11,111

Sales

Inventory

$4,000,000

$370,000

T 3-6

Asset Utilization Ratios — Page 60-61

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Asset Utilization Ratios — Page 61


7. Fixed asset turnover =

= 5 5.4 times

8. Total asset turnover =

= 2.5 1.5 times

Sales

Fixed assets

$4,000,000

$800,000

Sales

Total assets

$4,000,000

$1,600,000

T 3-6

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Profitability and Turnover Ratios

Remember:

Return on X = Net Income / X

X Turnover = Sales / X

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Liquidity Ratios show

how liquid a companyis or how much $ it has

to meet S/T needs.

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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?


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Liquidity Ratios — Page 61Saxton Company Industry Average

9. Current ratio =

= 2.67 2.1

10. Quick ratio =

= 1.43 1.0

Current assets

Current liabilities

$800,000

$300,000

Current assets – Inventory

Current liabilities

$430,000

$300,000

T 3-7


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Debt UtilizationRatios show howwell a company ismanaging or usingdebt.


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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 ofsafety — 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)


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Debt Utilization Ratios — Page 62


11. Debt to total asets =

= 37.5% 33%

12. Times interest earned =

= 11 7 times

13. Fixed charge coverage =

= 6 5.5 times

Total debt

Total assets$600,000

$1,600,000

Income beforeinterest and taxes

Interest

$550,000

$50,000

Income beforefixed charges and taxes

Fixed charges$600,000

$100,000

T 3-8


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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 5-10year period is usually performed by an

analyst.


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Saxton IndustryCompany Average ConclusionA. Profitability

1. Profit Margin ……………… 5.0% 6.7% Below average2. Return on Assets ………….. 12.5% 10.0% Above average due

to high turnover3. Return on Equity ………….. 20.0% 15.0% Good due to

ratios 2 and 10B. Asset Utilization

4. Receivables turnover ……. 11.4 10.0 Good5. Average collection period…. 32.0 36.0 Good6. Inventory turnover ………... 10.8 7.0 Good7. Fixed asset turnover ………. 5.0 5.4 Below average

8. Total asset turnover ………. 2.5 1.5 GoodC. Liquidity 9. Current ratio ……………… 2.67 2.1 Good

10. Quick Ratio ……………….. 1.43 1.0 Good

D. Debt Utilization11. Debt to total assets ……….. 37.5% 33.0% Slightly more debt12. Times interest earned ……. 11.0 7.0 Good

13. Fixed charge coverage …... 6.0 5.5 Good

T 3-9

Table 3-3--Ratio Analysis — Page 62


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Interpreting ratios


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Understand the

strategic plan of thefirm before you

begin.


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Compare the ratios of other,similar firms at a given point intime.

• Do NOT assume that if yourfirm is different, it is necessarily

bad.• Be sure you compensate for

firm size and other differences.

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Perform a trend

analysis (over time)to spot trends — good

or bad.

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Don’t jump toconclusions — ratios are onlya starting point — you mustfigure out WHY the ratio iswhat it is — remember Wal

Mart and Dillards

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Bigger isn’t

necessarilyalways better —

or worse.

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When in doubt, talk

to management — askquestions and study

the industry.

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Figure 3-2Trend analysis — Page 64

A. Profit Margin

Percent

7

5

3

1

1985 1987 1989 1991 1993 1995 1997

Industry

Saxton

T 3-10

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B. Total asset turnover

3.5X

3.0X

2.5X

2.0X

1.5X

1.0X

.5X

1985 1987 1989 1991 1993 1995 1997

Industry

Saxton

T 3-10

Figure 3-2Trend Analysis — Page 64

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Table 3-4 (next) showshow intense competitionin the computer industryhas caused return to

decline over time.

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Impact of

inflation onFinancial

Analysis

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Because accountants

use historical cost as abasis for certain

expenses, expenses donot keep up with

revenue on the incomestatement.

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The result of accountantsusing historical costs is thatrevenue can increase, eventhough no change has reallyoccurred in the underlying

business.

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The next exampleillustrates how use of

historical costaccounting can distort

results.

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Stein company (Table 3-5 andTable 3-6 combined) — Page 65

STEIN CORPORATION

Net Income for 1999 Net Income for 2000

Sales $200 (100 units at $2) $220 (100 units at $2.20)Cost of Goods Sold 100 100Gross profit 100 120Selling and admin. exp. 20 (10% of sales) 22 (10% of sales)Depreciation (historical) 10 10Operating profit (EBIT) 70 88

Taxes (40%( 28 35Aftertax income $42 $53

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The effect of Inflationon financial numbers

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Table 3-7 (Page 66)shows selectedfinancial data for 10Chemical companies

and 8 Drugcompanies.

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10 Chemical 8 DrugCompanies Companies

Replacement Historical Replacement HistoricalCost 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

T 3 12

Table 3-7 / Comparison of replacement costaccounting and historical cost accounting — Page 66

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The column labeledReplacement cost

shows what thenumbers would be if

inflation wereproperly considered.

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The columnlabeled historical

cost shows whatthe numbersactually were.

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Replacement cost:

• Reduces income

• Increases assets

•

Debt-to-asset ratio is lowered sincedebt does not inflate.

• Declining income causes interest

coverage ratio to decline.

• Return on assets drops because assets

increase while net income drops.

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Disinflationary Effect

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Disinflationmeans expensiveinventory is

charged againstsoftening sales.

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Cyclical industries are

most susceptible tosudden declines inearnings as business

slows (disinflation).

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Disinflation meansfinancial assets

will appear moreattractive asinvestments.

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Disinflation meansbankruptcies can

increase.

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None of theseeffects of

disinflation occurswith any degree ofregularity.

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Elements ofdistortion in

reported income(other than

disinflation)

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The Table 3-8 — Page 68 — shows two pictures of the samecompany and how they varydepending on which accounting

conventions are used.

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Here is why the aggressive income ishigher:

• Company B used aggressive revenue

recognition (booking installment sales

immediately, etc.)

• Company B is using FIFO, matching cheapcosts with current revenue.

• Company B chose not to recognize the

extraordinary (nonrecurring) loss on thestatement until AFTER net-income is

computed.

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Financial analysts spendlots of time and effortundoing what companies

and accountants do, sothat similar companies

can be accuratelycompared.

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PPT 3-13

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Inflation’s Impact on Profits

• FIFO (First-In, First-Out) Inventory:

– Lowers COGS

–

Raises Profits• LIFO (Last-In, First-Out) Inventory:

– Raises COGS

– Lowers Profits

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805 Chapter 03

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