9/16/2010
Ch.. 3
Ch
Analyzing Financial
Statements
korth
1
Preview



Introduce financial ratios
Examine how ratios are used to
evaluate the firm’s past
p
performance
Show how ratios are used to guide
& predict a firm’s future
performance
2
Financial Analysis

Without a systematic format, the
analysis of financial statements
would be very difficult.
korth
3
1
9/16/2010
Financial Statement Analysis

Evaluate a firm’s overall performance

Assess a firm’s (+) & (
(--)
korth
4
Whose Perspective?

Management

Stockholders & stock analysts

Creditors

Others: IRS & unions
korth
5
The Analyst’s Perspective
Determines::
Determines

What to evaluate?

How to evaluate it?

What to do w/ the results?
korth
6
2
9/16/2010
Audited Financial Statements

An outside, independent
accountant evaluates the
financial statements and
attests that they:
• Are correctly prepared &
• Fairly represent the firm’s financial
condition at the time of the audit
korth
7
Basic Types of Analysis


Trend analysis:
analysis: Comparing the
ratios for the same firm over
several (or many) years
Comparative analysis:
analysis: Comparing
the firm’s against comparable
firms
korth
8
Benchmarking

Benchmark: a standard against
Benchmark:
which to measure the firm’s
performance:
• Time
Time--trend benchmark
• Comparative benchmark


Industry
Peer group
korth
9
3
9/16/2010
Financial Ratios
korth
10
Financial Ratios


Dividing one number by another
Both numbers generally come
from the firm’s financial
statements.
korth
11
5 Sets of Financial Ratios

Liquidity ratios

Asset--management ratios
Asset

Debt--management ratios
Debt

Profitability ratios

Market--value ratios
Market
korth
12
4
9/16/2010
Liquidity Ratios
korth
13
Liquidity Ratios
A measure of the firm’s
ability to meet its maturing
d bt obligations
debt
bli ti
korth
14
What Is Liquidity
Liquidity??

An asset that can:
• Can be sold quickly
• With low risk of loss of value
korth
15
5
9/16/2010
Importance of Liquidity


One of a financial manager’s
principal responsibility is to always
be able to pay bills when due.
Bills are paid:
• With liquid assets
• With safe credit lines
16
Importance of Liquidity

Even profitable businesses can
fail, if they cannot pay their
bills on time!
time!
• Illiquidity

Credit crunch
korth
17
Current Ratio
= (current assets) ÷
(current liabilities)
korth
18
6
9/16/2010
Quick Ratio
= (current assets – inventories)
÷ (current liabilities
liabilities)
)
korth
19
Liquidity Ratios: Summary

Current ratio:
ratio: C/A ÷ C/L

Quick ratio:
ratio: (C/A – invy) ÷ C/L
korth
20
Asset--Management Ratios
Asset
korth
21
7
9/16/2010
Asset--Management Ratios
Asset
A measure of how effectively
the firm is using its assets
korth
22
Asset--Management Ratios
Asset

= Efficiency ratios

= Asset
Asset--turnover ratios
korth
23
Asset--Management Ratios
Asset

Account--receivable turnover ratio
Account

Inventory turnover ratio

Fixed--asset turnover ratio
Fixed

Total--asset turnover ratio
Total
korth
24
8
9/16/2010
Accounts--Receivable Turnover
Accounts
Ratio

= (net sales) ÷ (accounts receivable)
Days sales outstanding =
(365 days) ÷ (A/R turnover)

korth
25
Inventory Turnover Ratio
(ITR
ITR))

= (net sales) ÷ (inventory)
[Note: this is different from the book.]

Days sales in inventory =
(365 days) ÷ ITR
korth
26
Fixed--Asset Turnover Ratio
Fixed


= (net sales) ÷ (net fixed assets
assets)
)
Measures dollars of sales for every
$ of F/A (net) -- very important
for a firm w/ substantial P&E
korth
27
9
9/16/2010
Total--Asset Turnover Ratio
Total


= (net sales) ÷ (total assets
assets)
)
Measures dollars of sales for
every $ of T/A
korth
28
Turnover Ratios: Summary


ITR = (Net
(Net sales)
sales) ÷ (inventory)
ART = (Net
(Net sales)
sales)
÷ (accounts receivable)

FAT = (Net
(Net sales)
sales) ÷ (fixed assets)

TAT = (Net
(Net sales)
sales) ÷ (total assets)
korth
29
Debt--Management Ratios
Debt
korth
30
10
9/16/2010
Debt--Management Ratios
Debt
To what extent is the firm
financed by debt?

How capable is the firm of paying
those debt obligations?

korth
31
Leverage

The extent to which debt is used
to finance a firm’s operations
• Both short
short--term & longlong-term debt

Higher debt = higher leverage:
• Increases earnings potential
• Increases the risk
korth
32
Debt Ratio


How much of the firm’s financing
(the right
right--hand of the balance
sheet) comes from debt?
Total debt ratio =
(total debt) ÷ (total assets)
korth
33
11
9/16/2010
Equity Ratio

Equity ratio =
(total equity) ÷ (total assets)
• Equity multiplier = (total assets) ÷
(total equity)

Debt ratio + equity ratio = ???
korth
34
Debt--Equity Ratio
Debt

Debt-equity ratio =
Debt(total
(
debt)
)÷(
(total equity)
q
y)
korth
35
Coverage Ratios

How well can the firm’s operating
earnings “cover” its fixed
obligations:
• Interest payments
• Interest + lease payments
korth
36
12
9/16/2010
Times--Interest
Times
Interest--Earned Ratio


Measures number of times operating
income (EBIT
(EBIT)
) covers % expense
TIE = (EBIT) ÷ (interest expense)
korth
37
Fixed--Charge Coverage Ratio
Fixed


Coverage of interest + lease
payments
FCC = (EBIT + lease) ÷
(interest + lease)
korth
38
Debt-Management
DebtRatios: Summary (1)

Debt and equity ratios
• Debt
b ratio
i
• Equity ratio
• Debt/equity ratio
korth
39
13
9/16/2010
Debt-Management
DebtRatios: Summary (2)

Coverage ratios
• Times
Times--interest earned ratio
• Cash coverage ratio
• fixed
fixed--charge coverage ratio
korth
40
Profitability Ratios
How profitable is the firm?
korth
41
Profitability Ratios

Return on sales [NI ÷ Net sales]
• = profit margin

Return on assets [NI ÷ TA]

Return on equity [NI ÷ TEq]
korth
42
14
9/16/2010
Profit Margin
(Return on Sales)

The amount of net income
generated by each $ of net sales
• P/M = (Net income) ÷ (Net sales)

The higher the ratio, the more
profitable the sales of the firm
korth
43
Return on Assets
(RoA
RoA))



Amount of net income generated by
each $ of total assets
R A = (N
RoA
(Nett iincome)
) ÷ (total
(t t l assets)
t )
How effectively is the firm using its
assets?
• Low RoA Look at asset management!
44
Return on Equity (RoE
RoE))


Amount of net income per $ of
shareholders equity
RoE = (Net income) ÷ (total equity)
korth
45
15
9/16/2010
Profitability Ratios: Summary

Profit margin (RoS) =
(Net income)
income) ÷ (Net sales)

RoA = (Net
(Net income)
income) ÷ (total assets)

RoE = (Net
(Net income)
income) ÷ (total equity)
korth
46
Market--Value Ratios
Market

How does the market view the
firm’s performance?
korth
47
Earnings per Share (EPS
EPS))


Net income (i.e., earnings after
taxes) for each share outstanding
EPS = (net income) ÷ (# of shares)
korth
48
16
9/16/2010
Price--Earnings Ratio
Price
P/E ratio = (price per share) ÷
(earnings per share)

Indicates how investors value the
firm—
firm
—based upon both its
historical performance and its
future prospects

korth
49
Summary: Financial Ratios

Liquidity ratios

Asset--management ratios
Asset

Debt--management ratios
Debt

Profitability ratios

Market--value ratios
Market
50
Limitations of Ratio Analysis

Multinational firms deal w/
many accounting standards
• Difficult to compare financials

Even domestically, differences:
• Depreciation
• Inventory valuation
korth
51
17
9/16/2010
korth
52
Exhibit 4.1: Common
Common--Size
Balance Sheets
Exhibit 4.2: Common
Common--Size
Income Statements
18
9/16/2010
Exhibit 4.3: Ratios for TimeTimeTrend Analysis
Two Basic Strategies to Earn a
Higher ROA
Peer Group Ratios for Diaz
Manufacturing
19
9/16/2010
Exhibit 4.7: Peer Group
Analysis for Diaz Manufacturing
20