Financial Analysis Chapter 3 Chapter Outline • • • • 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