Financial Analysis
Purpose of financial analysis:
identify the major strengths and weaknesses of a business enterprise
Financial ratio—relationship indicates something about a firm’s
activities—frequently must dissect the ratio to discover its meaning
(ratio is only meaningful when to compared to a benchmark or
used as a trend measure)
FINANCIAL INFORMATION:
Results of operations in money terms
Basis for projecting future results
Responsibility of management
created by accountants and reviewed by auditors but neither
guarantee it correctness (management portrays results as
favorably as possible which may overstate or undeerstate
values)
USERS OF FINANCIAL INFORMATION
Investors
Make judgments about the firm's securities
Investors---growth
Lenders-firm’s stability and cash flows
Financial Analysts recommendation to investment community
based upon their analysis of financial statements
Vendors
Sell to the firm on credit—concerned about stability and cash flows
Management
Highlight areas in which attention will improve performance
SOURCES OF FINANCIAL INFORMATION
Dun and Bradstreet
Robert Morris Assoc.
Quarterly Fin. Report for Manufacturing Co's
Financial Studies of Small Business
Moody's or Standard & Poor's Industrial, Financial,
Transportation, & Over-the Counter
10-k
Trade journals
Annual Report
Management's report card to stockholders on
its own
Performance. Tends to be favorably biased
Other Sources
Brokerage firms, credit bureaus
ORIENTATION OF FINANCIAL ANALYSTS
Critical and investigative
Looking for current or potential problems
Looking for the physical reasons behind financial results
RATIO ANALYSIS
Pairs of numbers from the financial statements formed into ratios
Each ratio high-lights a particular aspect of running the business
COMPARISONS
Ratios are most meaningful when compared with similar figures
History
Prior performance - look for trends
Competitors
Identify strong or weak spots relative to similar businesses
Plan
Is performance better or worse than expected?
AVERAGE OR ENDING BALANCES
Ending when measuring a status
Average when measuring an activity
Distinction important when growth is rapid
CATEGORIES OF RATIOS





Liquidity
Activity--Asset Management
Debt Management
Profitability
Market Value
Ratios Don't Provide Answers
They Help You Ask The Right Questions
Liquidity Ratios
quick measures of a firms ability to provide sufficient cash to conduct business
over next few months.
Current Assets
cash and any assets that can be converted into cash within a "normal" operating
period of 12 months.
Current Liabilities
any financial obligations expected to fall due within the next year.
Current Ratios:
Current Assets = X
Current Liabilities
ability to convert (sell) current assets at $1.00/X in order to meet current
liabilities, i.e. if X = 2 then must liquidate C.A. at 50 cents on the dollar.
Some analyst eliminate prepaid expenses from the numerator because they
are not a source of cash
Quick Ratio:
Current Assets - Inventories = Y
Current Liabilities
i.e. if Y = 1.5 then must liquidate C.A. at 67 cents on the dollar. As Y becomes
smaller must liquidate C.A. at full value.
Adjusted Quick Ratio: C.A. - Inventories - Accounts Receivable over 90 days
C.L.
if significantly different from Quick Ratio may indicate collection problem.
Some analysts eliminate prepaid expenses and supplies from
numerator because they are not a source of cash
Cash Flow Liquidity Ratio:
Cash + Marketable Securities +Cash Flow From Operating Activities
Current Liabilities
ASSET MANAGEMENT RATIOS
(Use average balances)
indicate how much a firm has invested in a particular type of asset relative to the
revenue the asset is producing - efficiency.
Account Receivable Turnover:
Net sales = X times
Accounts receivable
Average Collection Period:
Accounts Receivable = X days
(Annual Credit Sales/365)
How long resources are tied up in receivable? If exceeds the norm for the industry
then indicate collection problems.
If X < Industry then
may have a too restrictive credit policy
If X > Industry then
problems with collection
too lenient credit policy
Inventory Turnover Ratio: Cost of Goods Sold = X times
Average Inventories
Days Inventory:
Average Inventories:
365
(Cost of Goods Sold/Inventory ratio)
= X Days
beginning + ending
2
if
Seasonal Sales:
Add month-end
12
If X < Industry then
may be carrying too much inventory
obsolete, damaged, or slow-moving inventory
If X > Industry then
problems with restocking which may cause loss of sales
Days Payable:
365
(Cost of Goods Sold/Payables Ratio)
= X Days
If X > Industry then
problems with stretching payables which may cause vendors to put
firm on COD
Fixed Asset Turnover Ratio:
Net Sales
= X times
Net Fixed Assets
extent to which a firm is utilizing property, plant and equipment.
Total Asset Turnover Ratio:
Net Sales
Total Assets
= X times
use as flag to look at other activity ratios
X < Industry - using assets less efficiently therefore look at other activity
ratios.
DEBT MANAGEMENT RATIOS
Measures the firm's debt level relative to assets, equity, and
income (Use ending balances)
indicate a firm's capacity to meet short and long term debt.
Balance-Sheet Approach:
Debt Ratio:
Total debt = Y
Total Assets
i.e. Y = .58; 58% of assets financed by debt.
Higher ratio less protection the creditors have in the event of bankruptcy.
Debt ratio = 85%; the total assets value can decrease by 15% before creditors at
risk
IF Y > Industry borrowing more than industry - cost will be higher.
Ability to maintain a high debt depends upon debt ratio growth and stability of
cash flows.
Long-Term Debt-to-Long Term-Debt and Equity:
Measures the amount long-term debt is used for the firm’s permanent
financing
Long-Term Debt
Long-Term Debt + Equity
Debt-to-Equity:
Measures the riskiness of the firm’s capital structure in terms of the
relationship between creditors and investors
Total Debt = Y
Total Equity
If Y = 1.5 then 150% debt financing compared to equity (for every $1 of equity
raise $1.50 in debt)
Income Statement (Debt Coverage Ratios)
Measure the firm's ability to service debt with operating income and cash flows
Time Int. Earned Ratio:
Measures the interest burden relative to the ability to pay it
EBIT
= X times
Int. Charges
If X = 3.65, annual interest payments is covered 3.65 times by current earnings.
Cash Coverage:
A variation on TIE to better get at cash flow
= EBIT + depreciation
Interest
Fixed Charge Coverage Ratio:
A variation on TIE to include lease payments as fixed financial
charges equivalent to interest
EBIT + Lease Payments
= X times
Int.+ Lease Pymts + Pref. Div. before tax + before tax sinking fund
Lease payments are added back in the numerator because they were deducted as an
operating expense to calculate operating profits. They are similar to interest expense in
they both represent obligations that must be met on an annual basis.
X = 1.65, Fixed charges can be covered 1.65 times by EBIT & Lease Payments
X < industry, firm operating at a higher level of risk
lower ratio - problems in securing credit
Cash Flow Adequacy Ratio:
Measures how well a company can cover annual payments such as debt, capital
expenditures, and dividends from operating cash flow
Cash flow from operating activities
=X times
Average annual long-term debt maturities
PROFITABILITY RATIOS
Measure profitability relative to sales, assets, and the owners'
investment (equity) (Use average balances)
Gross Profit Margin:
Sales - CGS = Y
Sales
Y = .2463;
24.64% (return before operating expenses, interest or taxes)
Y < Industry
pricing policies or
production methods
 Problems (look at Activity Ratio)
Net Profit Margin (Return on Sales):
EAT = Y
Sales
Indicates how profitable a firm's sales are after all expenses, interest, & taxes.
Operating Profit Measure:
EBIT
Sales
Separates financing decision
Usually more suitable for comparing the profit performance of different firms.
If Y < Ind.
Problems
Controlling total expenses
Pricing policy
Cash Flow Margin:
Measures the ability of the company to convert sales into cash
Cash flow from operating activities
Net Sales
Return on Investment:
ROI:
EAT
= Y
Total Assets
Net Profit Margin x Total Asset Turnover
EAT x
Sales
Sales
Total Assets
Y < Industry
Problem:
- low activity ratios
- low profit margin
Return on Equity:
EAT
= Y
Stockholder's Equity
ROE = ROI x Equity Multiplier = EAT x Sales x T.A.
Sales T.A. Equity
Y < Industry
Problem:
- low activity ratios
- low profit margins
- debt leverage
Interpretation: Measures control of pricing, costs, and expenses and
asset utilization, and the use of leverage
Cash Return on Assets:
Measures the company’s firm’s cash-generating ability of assets
Cash flow from operating activities
Total assets
= X%
MARKET VALUE RATIOS
Measure the market's opinion of the stock as an investment based on its price
(Use ending balances)
PRICE/EARNINGS RATIO (P/E)
= Market Price Per Share/Current Earnings per Share
P/E increases as risk of firm drops
P/E increases as earnings grow
P/E < Industry
Problems
- higher risk
- lower growth
Interpretation:
The amount investors will pay for each dollar of earnings
Based primarily on expected growth
MARKET TO BOOK VALUE RATIO
= market price per share / book value per share
higher the rate of return a firm is earning on its common equity relative to return
required by investors, the higher will be the P/B ratio.
Book Value:
Total Common Stockholders Equity
Number of firms outstanding
Stockholders equity: T.A. - T.L.
Interpretation: Identifies the going concern value of the firm as
perceived by investors
Dividend Policy Ratios
Payout Ratio:
Dividend per share
Earnings per share
Dividend Yield:
Expected dividend per share
Stock Price
DU PONT EQUATIONS
Identify relationships between ratios
Using the Du Pont Equations to Analyze Problems
ROA =
ROS x Total Asset Turnover
Pillbox Inc.
12%
6%
2x
Industry
15%
5%
3x
Focus attention on revenue or assets rather than on cost or expense