Financial
Analysis
Chapter 3
Chapter Outline
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Ratio analysis and its importance
Use of ratio for measurements
The DuPont system of analysis
Trend analysis
1-2
Financial Analysis
What is financial analysis?
• A firm earns: $50,000.
• Is it satisfactory?
• Lets assume that the firm has $500,000 of sales or,
• $5,000,000 of sales
• Ratios are calculated by dividing one value on
financial statements by another related value
• 50,000/500,000*100=10%
• 50,000/5,000,000*100=1%
Financial Analysis
What is financial analysis?
• A long-run trend analysis over a
number of years shows changes over
time
• Compare present with past results
Ratios, trends and other calculations
are used to interpret and compare the
financial performance of a company
to its industry/competitors
Financial Analysis
What is financial analysis?
• Financial analysis may not answer questions, but
leads to further inquiry
4 Categories of
Ratios
Profitability
Ratios
Asset Utilization
Ratios
Liquidity
Ratios
Debt Utilization
Ratios
Categories of
Ratios
Return on Sales or
Profit Margin
Profitability
Ratios
Measure the ability of the firm to earn
an adequate return on sales, total
assets, and invested capital.
Return on Assets
(Investment)
Return on Equity
Categories of
Ratios
Asset Utilization
Ratios
Receivables Turnover
Measure how many times per
year a company sells its inventory
or collects all of its accounts
receivable.
For long-term assets, the
utilization ratio tells us how
productive the fixed assets are in
terms of generating sales.
Average Collection Period
Inventory Turnover
Fixed Asset Turnover
Total Asset turnover
Categories of
Ratios
Liquidity
Ratios
Current Ratio
Measure firm’s ability to pay
off short-term obligations as
they come due.
Quick Ratio
Categories of
Ratios
Debt Utilization
Ratios
Measure the overall debt
position of the firm is
evaluated in light of its asset
base and earning power.
Debt to Total Asset
Times Interest Earned
Fixed Charge Coverage
Importance of
Which ratios
are more important?
Ratios
Suppliers and banks (lenders) 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
Financial statements for ratio analysis
Financial statements for ratio analysis
Profitability Ratios
Measure overall company profitability for potential investors.
Return on Sales
Net Income
Sales
Return on Equity (ROE)
Net Income
Total Owner’s Equity
Return on Assets (ROA)
Net Income
Total Assets
Profitability Ratios
Du Pont System of Analysis
Asset Utilization Ratios
We measure the speed at which the firm is turning over various assets. In other words, they measure
how may times per year a company sells its inventory or collects all of it’s A/R. for long term assets its
measure efficiency/productivity.
Capital Asset Turnover
Receivable Turnover
Sales (credit)
Accounts Receivable
Sales
Capital Assets
Inventory Turnover
Cost of Goods
Sold
Inventory
Receivables Turnover
Explanation: Saxton collects its receivables faster than the industry; which is
shown by the receivables turnover of 11.4 times versus 10 times for the
industry, and, in daily terms, by the average collection period of 32 days,
which is 4 days faster than the industry norms.
*Average daily credit sales = annual credit sales / 360 days
Asset utilization ratios
Saxton Company
Industry Average
Explanation: this ratio tells us that Saxton generates more sales per dollar of
inventory than the average company in the industry, and we can assume
the firm uses very efficient inventory-ordering and cost-control method.
Asset utilization ratios
Saxton Company
Industry Average
The firm maintains a slightly lower ratio of sales to fixed assets (plant
and equipment) than does the industry. This is relatively a minor
consideration in relation to rapid movement of inventory and accounts
receivables. Again, the rapid turnover of total assets is much higher
than the industry average.
Du Pont System of Analysis
Liquidity Ratios
• Measure the company’s liquidity (its ability to pay
short-term debts)
• The higher the ratio, the lower the risk of inability to pay
Current Ratio
Current Assets
Current Liabilities
Quick Ratio
Current Assets-Inventory
Current Liabilities
Liquidity ratios
The firm’s liquidity ratios are very good compare to the industry
average.
Debt Utilization Ratios
• Measure the company’s ability to pay long-term
debts
Times Interest Earned
Fixed Charge Coverage
Operating Income
“Fixed” Charges
Operating Income
Interest Expense
Debt-to-Total Assets Ratio
Debt
Total Assets
Debt utilization ratios
“Income before fixed charges and taxes” = EBIT + other fixed charges (e.g. Lease payment)
Debt utilization ratios: Implications for
Saxton
• Debt to total asset is slightly higher than the industry
average, but well within the prudence range of 50% or less.
• Ratios for times interest earned and fixed charge coverage
show that the Saxton Company debt is being well managed
compared to the debt management of other firms in the
industry.
• Times interest earned indicates the number of times that
EBIT covers the interest obligation. The higher the ratio, the
stronger is the interest paying ability of the firm.
• Fixed charge coverage measures the firm’s ability to meet all
fixed obligations rather than interest alone.
Ratio analysis
Trend analysis