9
Foundations of Financial
Management
NINTH
th
EDITION
Financial Analysis
Block
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Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc. 2000
NINTH
9
th
EDITION
Foundations of Financial
Management
T 3-1
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.
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9
th
EDITION
Foundations of Financial
Management
T 3-1
Classification System
B. Asset utilization ratios.
4. Receivable turnover.
5. Average collection period.
6. Inventory turnover.
7. Fixed asset turnover.
8. Total asset turnover.
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9
th
EDITION
Foundations of Financial
Management
T 3-1
Classification System
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.
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NINTH
9
Foundations of Financial
Management
th
EDITION
T 3-2
Table 3-1a
Financial Statement for Ratio Analysis
SAXTON COMPANY
Income Statement
For the Year Ended December 31, 2001
Sales (all on credit)
Cost of goods sold
Gross Profit
Selling and administrative expense*
Operating profit
Interest expense
Extraordinary loss
Net income before taxes
Taxes (33%)
Net income
* Includes $50,000 in lease payments.
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$ 4,000,000
3,000,000
1,000,000
450,000
550,000
50,000
200,000
300,000
100,000
$ 200,000
©The McGraw-Hill Companies, Inc. 2000
NINTH
9
th
EDITION
Foundations of Financial
Management
T 3-2
Table 3-1b
Financial Statement for Ratio Analysis
Balance Sheet
As of December 31, 2001
Assets
Cash
Marketable securities
Accounts receivable
Inventory
Total current assets
Net plant and equipment
Total assets
Liabilities and Stockholders’ Equity
Accounts payable
Notes payable
Total current liabilities
Long-term liabilities
Total liabilities
Common stock
Retained earnings
Total liabilities and stockholders’ equity
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$
30,000
50,000
350,000
370,000
800,000
800,000
$1,600,000
$
50,000
250,000
300,000
300,000
600,000
400,000
600,000
$1,600,000
©The McGraw-Hill Companies, Inc. 2000
NINTH
9
Foundations of Financial
Management
th
EDITION
T 3-3
Profitability Ratios
Saxton Company
1. Profit margin =
Net income
sales
Industry Average
$200,000
= 5%
$4,000,000
6.7%
2. Return on assets (investment) =
Net income
$200,000
a.
= 12.5%
Total assets
$1,600,000
Sales
b. Net income 
Sales
Total assets
3. Return on equity =
Net income
a.
Stockholders’ equity
b.
Return on assets (investment)
(1 – Debt/Assets)
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10%
5%  2.5 = 12.5% 6.7%  1.5 = 10%
$200,000
= 20%
$1,000,000
0.125
= 20%
1 – 0.375
15%
0.10
1 – 0.33
= 15%
©The McGraw-Hill Companies, Inc. 2000
NINTH
9
Foundations of Financial
Management
th
EDITION
T 3-4
Figure 3-1
DuPont analysis
Net Income

Profit Margin
Sales


Asset
Turnover
Total Assets
Return on
Assets
Return on Assets 
(1 - Debt/Assets)
=
Return on
Equity
Total Debt

Financing
Plan
Total Assets
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©The McGraw-Hill Companies, Inc. 2000
NINTH
9
Foundations of Financial
Management
th
EDITION
T 3-6
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
$350,000
$11,111
= 32
36 days
6. Inventory turnover =
Sales
Inventory
$4,000,000
$370,000
= 10.8
7 times
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NINTH
9
Foundations of Financial
Management
th
EDITION
T 3-6
Asset Utilization Ratios
Saxton Company
Industry Average
7. Fixed asset turnover =
Sales
Fixed assets
8. Total asset turnover =
Sales
Total assets
Block
Hirt Irwin/McGraw-Hill
$4,000,000
=5
$800,000
5.4 times
$4,000,000
= 2.5
$1,600,000
1.5 times
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NINTH
9
th
EDITION
Foundations of Financial
Management
T 3-7
Liquidity Ratios
Saxton Company
Industry Average
9. Current ratio =
Current assets
Current liabilities
10. Quick ratio =
Current assets – Inventory
Current liabilities
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Hirt Irwin/McGraw-Hill
$800,000
$300,000
= 2.67
2.1
$430,000
= 1.43
$300,000
1.0
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NINTH
9
Foundations of Financial
Management
th
EDITION
T 3-8
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
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Hirt Irwin/McGraw-Hill
$550,000
$50,000
= 11
$600,000
$100,000
=6
7 times
5.5 times
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NINTH
9
Foundations of Financial
Management
th
EDITION
T 3-9
Table 3-3
Ratio Analysis
Saxton
Company
Industry
Average
A. Profitability
1. Profit Margin ……………… 5.0%
2. Return on Assets ………….. 12.5%
6.7%
10.0%
3. Return on Equity ………….. 20.0%
15.0%
B. Asset Utilization
4. Receivables turnover …….
5. Average collection period….
6. Inventory turnover ………...
7. Fixed asset turnover ……….
8. Total asset turnover ……….
C. Liquidity
9. Current ratio ………………
10. Quick Ratio ………………..
D. Debt Utilization
11. Debt to total assets ………..
12. Times interest earned …….
13. Fixed charge coverage …...
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11.4
32.0
10.8
5.0
2.5
10.0
36.0
7.0
5.4
1.5
Conclusion
Below average
Above average due
to high turnover
Good due to
ratios 2 and 10
Good
Good
Good
Below average
Good
2.67
1.43
2.1
1.0
Good
Good
37.5%
11.0
6.0
33.0%
7.0
5.5
Slightly more debt
Good
Good
©The McGraw-Hill Companies, Inc. 2000
NINTH
9
Foundations of Financial
Management
th
EDITION
T 3-10
Figure 3-2
Trend analysis
A. Profit Margin
Percent
Industry
7
Saxton
5
3
1
1985
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1987
1989
1991
1993
1995
1997
©The McGraw-Hill Companies, Inc. 2000
NINTH
9
Foundations of Financial
Management
th
EDITION
T 3-10
Figure 3-2
Trend Analysis
B. Total asset turnover
3.5X
3.0X
2.5X
Saxton
2.0X
1.5X
Industry
1.0X
.5X
1985
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Hirt Irwin/McGraw-Hill
1987
1989
1991
1993
1995
1997
©The McGraw-Hill Companies, Inc. 2000
NINTH
9
th
EDITION
Foundations of Financial
Management
T 3-13
Table 3-8
Income Statement
For the Year 2001
Conservative
A
Sales . . . . . . . . . . . . $4,000,000
Cost of goods sold . . . . . . . . 3,000,000
Gross profit . . . . . . . . . . 1,000,000
Selling and administrative expense . . .
450,000
Operating profit . . . . . . . .
550,000
Interest expense
. . . . . . . .
50,000
Extraordinary loss
. . . . . . .
100,000
Net income before taxes . . . . . .
400,000
Taxes (30%)
. . . . . . . . .
120,000
Net income . . . . . . . . . .
280,000
Extraordinary loss (net of tax)
. . . .
—
Net income transferred to retained earnings
$ 280,000
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High Reported
Income
B
$4,200,000
2,700,000
1,500,000
450,000
1,050,000
50,000
—
1,000,000
300,000
700,000
70,000
$ 630,000
©The McGraw-Hill Companies, Inc. 2000
9
NINTH
th
EDITION
Chapter 3 - Outline
•
•
•
•
Foundations of Financial
Management
LT 3-1
Financial Analysis
4 Categories of Financial Ratios
Importance of Ratios
Inflation and its Impact on Profits
Block
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9
NINTH
th
EDITION
Foundations of Financial
Management
Financial Analysis and Ratios
LT 3-2
What is financial analysis?
• Evaluating a firm’s financial performance
• Analyzing ratios or numerical calculations
• Comparing a company to its industry
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9
NINTH
th
EDITION
4 Categories of Ratios
•
•
•
•
Foundations of Financial
Management
LT 3-3
Profitability Ratios
Asset Utilization Ratios
Liquidity Ratios
Debt Utilization Ratios
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9
NINTH
th
EDITION
Profitability Ratios
Foundations of Financial
Management
LT 3-4
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 (%)
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©The McGraw-Hill Companies, Inc. 2000
9
NINTH
th
EDITION
Foundations of Financial
Management
Asset Utilization Ratios
LT 3-5
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)
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©The McGraw-Hill Companies, Inc. 2000
9
NINTH
th
EDITION
Foundations of Financial
Management
Profitability and Turnover Ratios
LT 3-6
Remember:
Return on X = Net Income / X
X Turnover = Sales / X
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9
NINTH
th
EDITION
Foundations of Financial
Management
Liquidity Ratios
LT 3-7
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)
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©The McGraw-Hill Companies, Inc. 2000
9
NINTH
th
EDITION
Debt Utilization Ratios
Foundations of Financial
Management
LT 3-8
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)
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9
NINTH
th
EDITION
Importance of Ratios
Foundations of Financial
Management
LT 3-9
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.
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9
NINTH
th
EDITION
Inflation’s Impact on Profits
Foundations of Financial
Management
LT 3-10
•FIFO (First-In, First-Out) Inventory:
– Lowers COGS
– Raises Profits
•LIFO (Last-In, First-Out) Inventory:
– Raises COGS
– Lowers Profits
•Provision policy
•Depreciation policy
•Accounting method
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