3
Financial
Analysis
Prepared by:
Michel Paquet
SAIT Polytechnic
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©2009 McGraw-Hill Ryerson Limited
Chapter 3 - Outline
•
•
•
•
•
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What is Financial Analysis?
4 Categories of Financial Ratios
Techniques of Ratio Analysis
Distortion in Financial Reporting
Summary and Conclusions
©2009 McGraw-Hill Ryerson Limited
Learning Objectives
1. Calculate 13 financial ratios that measure
profitability, asset utilization, liquidity and debt
utilization. (LO1)
2. Assess a company’s source of profitability
using the DuPont system of analysis. (LO2)
3. Examine the ratios in comparison to industry
averages. (LO3)
4. Examine the ratios and company performance
by means of trend analysis. (LO4)
5. Identify sources of distortion in reported
income.
(LO5)
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©2009 McGraw-Hill Ryerson Limited
LO1
What is Financial Analysis?
• Evaluating a firm’s financial performance
• Calculating ratios to reveal relationships
between different accounts of financial
statements
• Linking ratios to reveal the factors
determining a firm’s profitability and value
• Financial analysis may not answer
questions, but leads to further inquiry
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LO1
Classification System of Financial
Ratios
A.
B.
C.
D.
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Profitability Ratios
Asset Utilization Ratios
Liquidity Ratios
Debt Utilization Ratios
©2009 McGraw-Hill Ryerson Limited
LO1
A. Profitability Ratios
Show how profitable a company is
The ratios are:
1. Profit margin
2. Return on assets (ROA) (investment)
3. Return on equity (ROE) (common
shareholders)
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©2009 McGraw-Hill Ryerson Limited
LO1
B. Asset Utilization Ratios
Show how effectively a company uses its
assets
The ratios are:
4a. Receivable turnover
4b. Average collection period (days sales outstanding)
5a. Inventory turnover
5b. Inventory holding period
6a. Accounts payable turnover
6b. Accounts payable period
7. Capital asset turnover
8. Total asset turnover
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LO1
C. Liquidity Ratios
Show how liquid a company is or
how much cash it has to meet
short-term needs.
The ratios are:
9. Current Ratio
10. Quick Ratio
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LO1
D. Debt Utilization Ratios
Show how well a company is
managing or using debt
The ratios are
11. Debt to total assets
12. Times interest earned
13. Fixed charge coverage
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LO2
Which ratio(s) is/are most
important?
It depends on your perspective
• Suppliers and banks (short-term creditors) are
most interested in liquidity ratios
• Shareholders are most interested in profitability
ratios
• Long-term creditors concentrate on debt utilization
ratios
• The effective utilization of assets is management’s
responsibility
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©2009 McGraw-Hill Ryerson Limited
LO1
Table 3-1a
Financial statements for ratio analysis
SAXTON COMPANY
Income Statement
For the Year 2009
Sales (all on credit) . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . .
Gross profit . . . . . . . . . . . . . . . . . . .
Selling and administrative expense* . . . . . . . . .
Operating profit . . . . . . . . . . . . . . . . .
Interest expense
. . . . . . . . . . . . . . . .
Extraordinary loss . . . . . . . . . . . . . . . .
Net income before taxes . . . . . . . . . . . . . .
Taxes (50%) . . . . . . . . . . . . .
. .
. .
. .
. .
. .
. .
. .
. .
. .
Net income . . . . . . . . . . . . . . . . . . . . .
$ 4,000,000
3,000,000
1,000,000
450,000
550,000
50,000
100,000
400,000
200,000
$ 200,000
* Includes $50,000 in lease payments.
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LO1
Table 3-1b
Financial statements for ratio analysis
Balance Sheet
As of December 31, 2009
Assets
Cash
Marketable securities
Accounts receivable
Inventory
Total current assets
Net plant and equipment
Total assets
Liabilities and Shareholders' Equity
Accounts payable
Notes payable
Total current liabilities
Long-term liabilities
Total liabilities
Common stock
Retained earnings
Total liabilities and shareholders' equity
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$
30,000
50,000
350,000
370,000
800,000
800,000
$1,600,000
$
50,000
250,000
300,000
300,000
600,000
400,000
600,000
$1,600,000
©2009 McGraw-Hill Ryerson Limited
LO1
Profitability ratios(a)
Saxton Company
$200,000 = 5%
$4,000,000
3-1. Profit margin = Net income
Sales
Industry Average
6.5%
3-2. Return on assets (ROA) (investment) =
$200,000
$1,600,000
a.
Net income
Total assets
b.
Net income 
Sales
Sales
Total assets
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= 12.5%
5% x 2.5 = 12.5%
10%
6.5% x 1.5 = 10%
©2009 McGraw-Hill Ryerson Limited
LO1/LO2
Profitability ratios(b)
Saxton Company
Industry Average
3-3. Return on equity (ROE) =
a.
Net income
Shareholders’ equity
$200,000
$1,000,000
Total assets $1,600,000
b. Equity multiplier =
$1,000,000
Equity
c. ROA × Equity multiplier =
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= 20%
= 1.6
0.125 × 1.60 = 20%
15%
1
0.6667 = 1.5
0.10 × 1.50 = 15%
©2009 McGraw-Hill Ryerson Limited
LO2
DuPont Analysis
• Reveals the relationships between profitability ratios
and asset utilization ratios and debt utilization ratios
• Decomposes a firm’s profitability into several
determining factors
ROA =
=
Net Income
Assets
Net Income
x
Sales
Profit Margin
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Sales
Assets
Asset Turnover
©2009 McGraw-Hill Ryerson Limited
LO2
DuPont Analysis
ROE
Net Income
=
Equity
=
Net Income x Sales
Sales
Assets
x Assets
Equity
Profit Margin Asset Turnover
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Equity Multiplier
©2009 McGraw-Hill Ryerson Limited
LO2
Figure 3-1
DuPont analysis
Net income

Profit margin
Sales


Asset
turnover
Return on
assets
 =
Total assets
Return on
Equity
Total assets

Financing plan
(Equity multiplier)
Equity
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©2009 McGraw-Hill Ryerson Limited
LO2
Applying DuPont Analysis on the Rails
Profit
Company Margin
X
Asset
Return on
Equity
Return
Turnover = Assets
X Multiplier = on Equity
CP Rail
20.09%
0.3522
7.07%
2.45
17.33%
CN Rail
27.32
0.3366
9.20
2.31
21.24
Loblaw
1.12
2.15
2.41
2.47
5.95
Cdn Tire
4.80
1.28
6.20
2.18
13.50
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LO1/LO3
Asset utilization ratios(a)
Saxton Company
Industry Average
3-4a. Receivables turnover =
Sales (credit)
Receivables
$4,000,000
$350,000
= 11.4
10 times
3-4b. Average collection period =
Accounts receivable
Average daily credit sales
3-5a. Inventory turnover =
Cost of Goods Sold
Inventory
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$350,000
$10,959
= 32
36 days
$3,000,000 = 8.1
$370,000
7 times
©2009 McGraw-Hill Ryerson Limited
LO1/LO3
Asset utilization ratios(b)
Saxton Company
Industry Average
3-5b. Inventory holding period =
Inventory
Average daily COGS
$370,000
$8,219
= 45
52 days
3-6a. Accounts payable turnover =
Cost of goods sold
Accounts payable
3-6b. Accounts payable period =
Accounts payable
Average daily purchases
(COGS)
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$3,000,000 = 60.0
$50,000
$50,000
$8,219
= 6
12 times
30 days
©2009 McGraw-Hill Ryerson Limited
LO1/LO3
Asset utilization ratios(c)
Saxton Company
Industry Average
3-7. Capital asset turnover =
Sales
Capital assets
$4,000,000
= 5.0
$800,000
5.4 times
$4,000,000 = 2.5
$1,600,000
1.5 times
3-8. Total asset turnover =
Sales
Total assets
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LO1/LO3
Liquidity ratios
Saxton Company
Industry Average
3-9. Current ratio =
Current assets
Current liabilities
$800,000
= 2.67
$300,000
2.1
$430,000 = 1.43
$300,000
1.0
3-10. Quick ratio =
Current assets – Inventory
Current liabilities
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LO1/LO3
Debt utilization ratios
Saxton Company
Industry Average
3-11. Debt to total assets =
Total debt
Total assets
$600,000 = 37.5%
$1,600,000
33%
3-12. Times interest earned =
Income before
interest and taxes
Interest
$550,000 = 11
$50,000
7 times
$600,000
= 6
$100,000
5.5 times
3-13. Fixed charge coverage =
Income before
fixed charges and taxes
Fixed charges
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LO3
Table 3-2a
Ratio analysis(a)
Saxton
Company
A. Profitability
1. Profit margin………………
2. Return on assets………..….
3. Return on equity………….
B. Asset Utilization
4a. Receivables turnover ……...
4b.Average collection period….
5a. Inventory turnover ………...
5b.Inventory holding period......
6a. Accounts payable turnover...
6b.Accounts payable period......
7. Capital asset turnover …….
8. Total asset turnover ……….
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5.0%
12.5%
20%
11.4
32.0
8.1
45
60
6
5.0
2.5
Industry
Average
Comparison
6.5%
Below average
10% Above average due to high 8
15% Good due to ratios 2 and 11
10.0
36.0
7.0
52
12
30
5.4
1.5
Good
Good
Good
Good
Good
Good
Below average
Good
©2009 McGraw-Hill Ryerson Limited
LO3
Table 3-2b
Ratio analysis(b)
Saxton
Company
Industry
Average
Comparison
C. Liquidity
9. Current ratio ……………… 2.67
10. Quick ratio ……………….. 1.43
2.1
1.0
Good
Good
D. Debt Utilization
11. Debt to total assets ……….. 37.5%
12. Times interest earned ……. 11
13. Fixed charge coverage ……. 6
33%
7
5.5
Slightly more debt
Good
Good
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LO1/LO2/LO3/LO4
Techniques of Ratio Analysis
1.
2.
3.
4.
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DuPont Analysis
Comparative Analysis
Trend Analysis
Common-Size Statements
©2009 McGraw-Hill Ryerson Limited
LO3/LO4
Comparative vs. Trend Analysis
• Ratios on their own do not mean a lot
• Comparing a company’s ratios to those of
its industry or its competitors is
comparative analysis and may reveal what
ratios are out of line with certain standards
• Comparing the same company’s ratios
over a number of years is trend analysis
and may reveal whether ratios are
improving or worsening
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LO4
Table 3-3
Trend analysis of competitors
Bank of Montreal
Return on
Assets
2000
2001
2002
2003
2004
2005
2006
2007
0.79
0.60
0.56
0.71
0.87
0.81
0.83
0.58
Return on
Equity
18.0
13.8
13.4
16.4
18.1
14.5
17.7
13.9
Royal Bank
Return on
Assets
0.81
0.74
0.76
0.73
0.66
0.72
0.88
0.90
Return on
Equity
19.8
16.4
15.5
16.8
15.7
17.1
21.4
22.1
Source: Bank of Montreal annual reports www.bmo.com
Royal Bank of Canada annual reports www.rbc.com
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LO4
FIGURE 3-2
Trend analysis
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LO5
Distortion in Financial Reporting
• Historical-based accounting in an environment of
changing prices may distort financial results:
-- immediate effect of price changes on revenues versus
delayed impact on asset values
• Accrual-based accounting allows certain leeway in
matching the revenues and expenses
-- cost of goods sold (LIFO vs. FIFO)
-- asset write-downs
-- net income
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Income Statement
Illustration of different income reporting
methods
Income Statement
Table 3-7
LO5
For the Year 2009
Conservative
(A)
Sales . . . . . . . . . . . .
$4,000,000
Cost of goods sold
. . . . . . .
3,000,000
Gross profit . . . . . . . . . .
1,000,000
Selling and administrative expense . .
450,000
Operating profit . . . . . . . .
550,000
Interest expense . . . . . . . .
50,000
Net income before taxes
. . . . .
500,000
Taxes (40%) . . . . . . . . .
200,000
Net income . . . . . . . . . .
300,000
Extraordinary loss (net of tax)
. . .
60,000
Net income transferred to retained earnings $ 240,000
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High Reported
Income
(B)
$4,200,000
2,400,000
1,800,000
450,000
1,350,000
50,000
1,300,000
520,000
780,000
—
$ 780,000
©2009 McGraw-Hill Ryerson Limited
LO5
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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Summary and Conclusions
• Financial ratios cover 4 areas of management:
profitability, asset utilization, liquidity and debt utilization.
• The DuPont system of analysis tells us that the profit
margin, asset turnover, and debt usage each contributes
to return on equity.
• Ratios should be compared to industry average
(comparative analysis) as well as historical data (trend
analysis).
• What ratios do is to suggest aspects requiring further
exploration. It is the manager/analyst’s job to answer the
questions revealed by ratios.
• Analysts should also be aware of the distortion in
financial reporting.
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