Financial Analysis 3
Chapter
McGraw -Hill/Irwin Copyright ©2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
• Ratio analysis and its importance.
• Use of ratio for measurements.
• The Du Pont system of analysis.
• Trend analysis.
• Evaluation of reported income to identify distortion.
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Financial Ratios
• Accounting data stated in relative terms
3-3
Financial Ratios
• Financial ratios help us identify some of the financial strengths and weaknesses of a company.
– Trends across time
– Comparisons with other firms ’ ratios
3-4
Financial Ratios
• We could use ratios to answer the following important questions about a firm’s operations.
– How liquid is a firm?
– Is management generating adequate operating profits on the firm’s assets?
– How is the firm financing its assets?
– Is management providing a good return on the capital provided by the shareholder?
3-5
Ratio Analysis
• Financial ratios
– Used to weigh and evaluate the operating performance of a firm.
– Used to compare performance record as against other firms in the industry.
– Analyzing ratios and numerical calculations.
– Such data is provided by various organizations.
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1

Ratios and their Classification
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.
3-7
Ratios and their Classification
(cont’d)
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.
3-8
Types of Ratios
• Profitability ratios
– Measurement of the firm’s ability to earn an adequate return on:
• Sales
• Assets
• Invested capital
• Asset utilization ratios
– Measures the speed at which the firm is turning over accounts receivable.
3-9
Types of Ratios (cont’d)
• Liquidity ratios
– Emphasizes the firm’s ability to pay off shortterm obligations as and when due.
• Debt utilization ratios
– Estimates the overall debt position of the firm.
– Evaluates in the light of asset base and earning power.
3-10
Financial Statement for Ratio
Analysis
Profitability Ratios
A1
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Du Pont System of Analysis
• A satisfactory return on assets might be derived through:
– A high profit margin
– A rapid turnover of assets (generating more sales per dollar of its assets)
– Or both
Return of assets (investment) =
(Profit margin) X (Asset turnover)
3-13
Du Pont System of Analysis (cont’d)
• A satisfactory return on equity might be derived through:
– A high return on total assets;
– A generous utilization of debt;
– Or a combination of both.
Return on equity = Return on assets (investments)
[1 – (Debt/ Assets)]
3-14
Du Pont Analysis
Examples for Analysis using the Du
Pont System
Asset Utilization Ratios
A2
• These ratios relate the balance sheet to the income statement.
3-15
Asset Utilization Ratios (cont’d)
A3
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3

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Liquidity Ratios
A4
Debt Utilization Ratios
A5
• Measures the prudence of the debt management policies of the firm.
3-19
Debt Utilization Ratios (cont’d)
• Fixed charge coverage measures the firm’s ability to meet the fixed obligations.
• Interest payments alone are not considered.
Income before interest and taxes………………..$550,000
Lease payments…………………………………… $50,000
Income before fixed charges and taxes…………$600,000
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Limitations of Ratio Analysis
• Difficulty in identifying industry categories or finding peers
• Published peer group or industry averages are only approximations
• Accounting practices differ among firms
• Financial ratios can be too high or too low
• Industry averages may not provide a desirable target ratio or norm
• Use of average account balances to offset effects of seasonality
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Summary of Ratio Analysis
Trend Analysis
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Trend Analysis in the Computer
Industry
3-25
Impact of Inflation on Financial
Analysis
• Inflation
– Revenue is stated in current dollars.
– Plant, equipment, or inventory may have been purchased at lower price levels.
– Profits may be more a function of increasing prices than due to good performance.
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Comparison of Replacement and
Historical Cost Accounting
3-27
Comparison of Replacement and
Historical Cost Accounting (cont’d)
• Replacement costs - reduces income but increases assets.
– An increase lowers the debt-to-assets ratio.
– A decrease indicates a decrease in the financial leverage of the firm.
– A declining income results in a decreased ability to cover interest costs.
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Impact of Disinflation on Financial
Analysis
• Disinflation
– Financial assets such as stocks and bonds have the potentials to do well – encouraging investors.
– Tangible assets do not have the potential.
• Deflation
– Actual reduction of prices affecting everybody due to bankruptcies and declining profits.
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Other Elements of Distortion in
Reported Income
• Effect of changing prices.
• Reporting of revenues.
• Treatment of nonrecurring items.
• Tax write-off policies.
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5

Explanation of Discrepancies
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Explanation of Discrepancies
(cont’d)
• Sales
– Use of defer recognition until each payment is received or full recognition at the earliest possible date.
• Cost of goods sold
– Use of different accounting principles - LIFO versus FIFO.
3-32
Explanation of Discrepancies
(cont’d)
• Extraordinary gains/ losses
– Inclusion of events when computing current income or leaving them out.
• Net income
– Use of different methods of financial reporting.
3-33
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