Chapter 3
Financial Analysis
Chapter 3 - Outline
 Financial Analysis
 4 Categories of Financial Ratios
 Importance of Ratios
 Inflation and its Impact on Profits
Financial Analysis and Ratios
What is financial analysis?
 Evaluating a firm’s financial performance
 Analyzing ratios or numerical calculations
 Comparing a company to its industry
4 Categories of Ratios
 Profitability Ratios
 Asset Utilization Ratios
 Liquidity Ratios
 Debt Utilization Ratios
Classification System
We will separate 13 significant ratios into four primary categories.
A. Profitability Ratios.
1. Profit margin.
2. Return on assets (investment).
3. Return on equity.
B. Asset utilization ratios.
4.
5.
6.
7.
8.
Receivable turnover.
Average collection period.
Inventory turnover.
Fixed asset turnover.
Total asset turnover.
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.
TABLE 3-1
Financial statement
for ratio analysis
Profitability Ratios
Show how profitable a company is.
The ratios express:
— Profit Margin or Return on Sales (%)
— Return on Assets or Return on Investment (%)
— Return on Equity (%)
Profitability Ratios
1. Profit margin =
Saxton Company
Industry Average
Net income $200,000
= 5%
6.7%
sales
$4,000,000
2. Return on assets (investment) =
a.
Net income
Total assets
$200,000
$1,600,000
= 12.5%
10%
Net income 
Sales
Sales
Total assets 5%  2.5 = 12.5% 6.7%  1.5 = 10%
b.
3. Return on equity =
a.
Net income
Stockholders’ equity
b.
Return on assets (investment)
(1 – Debt/Assets)
$200,000
$1,000,000
= 20%
15%
0.125
0.10
1 – 0.375 = 20% 1 – 0.33= 15%
FIGURE 3-1
Du Pont analysis
Return of Wal-Mart versus Macy’s using the
Du Pont method of analysis, 2007
Asset Utilization Ratios
Show how effectively a company uses its assets.
The ratios express:
— Receivables Turnover (times)
— Average Collection Period (days)
— Inventory Turnover (times)
— Fixed Asset Turnover (times)
— Total Asset Turnover (times)
Asset Utilization Ratios
Saxton Company
Industry Average
4. Receivables turnover =
Sales (credit)
Receivables
$4,000,000
$350,000
= 11.4
10 times
5. Average collection period =
Accounts receivable
Average daily credit sales
6. Inventory turnover =
Sales
Inventory
$350,000
$11,111
= 32
$4,000,000
= 10.8
$370,000
36 days
7 times
Asset Utilization Ratios
Saxton Company
Industry Average
7. Fixed asset turnover =
Sales
Fixed assets
8. Total asset turnover =
Sales
Total assets
$4,000,000
=5
$800,000
5.4 times
$4,000,000
= 2.5
$1,600,000
1.5 times
Profitability and Turnover Ratios
Remember:
Return on X = Net Income / X
X Turnover = Sales / X
Liquidity Ratios
Show how liquid a company is or how much $ it
has to meet S/T needs.
The ratios express:
—Current Ratio (times)
—Quick Ratio or Acid-Test Ratio (times)
Liquidity Ratios
Average
Saxton Company
Industry
9. Current ratio =
Current assets
Current liabilities
10. Quick ratio =
Current assets − Inventory
Current liabilities
$800,000
$300,000
= 2.67
= 1.43
$430,000
$300,000
2.1
1.0
Debt Utilization Ratios
Show how well a company is managing or using debt.
The ratios express:
—Debt-to-Total Assets (%)
—Times Interest Earned (times)
—Fixed Charge Coverage (times)
(Fixed Charges = lease payments, i expense)
Debt Utilization Ratios
Saxton Company
Industry Average
11. Debt to total asets =
Total debt
Total assets
$600,000
$1,600,000
= 37.5%
33%
12. Times interest earned =
Income before
interest and taxes
Interest
13. Fixed charge coverage =
Income before
fixed charges and taxes
Fixed charges
$550,000
$50,000
= 11
$600,000
$100,000
=6
7 times
5.5 times
TABLE 3-3
Ratio analysis
FIGURE 3-2
Trend analysis
Trend Analysis
in the Computer Industry
1-21
TABLE 3-7
Comparison of replacement
cost accounting and historical
cost accounting
Inflation’s Impact on Profits
 FIFO (First-In, First-Out) Inventory:
—Lowers COGS
—Raises Profits
 LIFO (Last-In, First-Out) Inventory:
—Raises COGS
—Lowers Profits
Importance of Ratios
Which ratio is most important?
It depends on your perspective.
 Suppliers and banks (lenders) are most interested in
liquidity ratios.
 Stockholders are most interested in profitability ratios.
 A long-run trend analysis over a 5-10 year period is
usually performed by an analyst.