Chapte
3
Slides Developed by:
Terry Fegarty
Seneca College
Financial Information
and Analysis
Chapter 3 – Outline (1)
• Financial Information
 Users of Financial Information
 Sources of Financial Information
 The Annual Report
• Ratio Analysis
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Comparisons
Common Size Statements
Categories of Ratios
Liquidity Ratios
Asset Management Ratios
© 2006 by Nelson, a division of Thomson Canada Limited
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Chapter 3 – Outline (2)
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Debt Management Ratios
Profitability Ratios
Market Value Ratios
Dupont Equations
Sources of Comparative Information
Limitations and Weaknesses of Ratio Analysis
Words of Caution
© 2006 by Nelson, a division of Thomson Canada Limited
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Financial Information
• Financial information—results of
business operations in monetary terms
 Responsibility of management
 Created by company’s accountants
 Creates a potential conflict of interest
• Management wants to portray firm in positive light
 Published to a variety of audiences
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Users of Financial Information
• Investors and Financial Analysts
 Financial analysts interpret information about
companies and make recommendations to investors
 Major part of analyst’s job is to study recent financial
statements
• Vendors/Creditors
 Use financial info to determine if firm is expected to
make good on loans
• Management
 Use financial info to pinpoint strengths and
weaknesses in operations
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Sources of Financial Information
• Annual Report
 Required from all publicly traded firms
 Tends to portray firm in positive light
• Brokerage firms and investment advisory
services
 For example: Value Line Investment Survey
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The Annual Report
• Typically includes:
 Letter to shareholders, reviewing the results and
events of past year, and management’s strategies
and plans for future
 Management discussion and analysis, analyzing
and explaining financial results for the year
 Audited financial statements for past year and
previous year, including income statement, balance
sheet, statement of retained earnings, and
statement of cash flows
 Notes to the financial statements (audited)
 Other recent and historic financial information.
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The Orientation of Financial
Analysis
• Accounting—preparing financial
statements
• Financial analysis—using financial
statements to evaluate businesses
 Financial analysis is critical and
investigative
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Ratio Analysis
• Used to highlight different areas of
performance
• Involves taking related numbers from the
financial statements and forming ratios
with them
• Each ratio is meaningful to operation of
the business
• Can vary widely among industries
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Comparisons
• When examined separately, ratios don’t convey
much information. Ratios are compared with:
 History—examine trends (how ratio has changed
over time)
 Competition—compare with other firms in same
industry
 Budget—compare actual ratios with expected or
desired ratios
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Common Size Statements
• First step in financial analysis is usually
common size statement
 Common size income statement
• Presents each line as percent of revenue
 Common size balance sheet
• Presents each line as percent of total assets
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Common Size Statements
Example
Alpha
$
Sales
$ 2,187,460
COGS
$ 1,203,103
Gross margin $
984,357
Expenses
EBIT
Interest
EBT
Tax
Net Income
$
$
$
$
$
$
505,303
479,054
131,248
347,806
118,254
229,552
Beta
%
100.0%
55.0%
45.0%
23.1%
21.9%
6.0%
15.9%
5.4%
10.5%
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$
$
$
$
150,845
72,406
78,439
%
100.0%
48.0%
52.0%
$
$
$
$
$
$
39,974
38,465
15,386
23,079
3,462
19,617
26.5%
25.5%
10.2%
15.3%
2.3%
13.0%
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Categories of Ratios
 Liquidity—indicate firm’s ability to pay its bills in
short run
 Asset Management—show firm’s ability to generate
revenue using minimum amount of assets
 Debt Management—determine if the firm is using
so much debt that it is assuming excessive financial
risk
 Profitability—allow assessment of the firm’s ability
to make money
 Market Value—give an indication of how investors
feel about firm’s financial future
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Liquidity Ratios
• Current Ratio
Current Assets
Current Ratio 
Current Liabilities
 To ensure solvency, current ratio is
expected to exceed 1.0
 Average is 1.3 for industrial
corporations
 May be too high if too much money is
tied up in receivables and inventory
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Liquidity Ratios
• Quick Ratio (or Acid-Test Ratio)
Current Assets-Inventory
Quick Ratio 
Current Liabilities
 Measures liquidity without considering
inventory (least liquid current asset)
 May be too high if too much money is
tied up in receivables
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Asset Management Ratios
• Average Collection Period (ACP)
Accounts Receivable
ACP =
Average Daily (Credit) Sales
or
ACP =
Accounts Receivable × 365
Annual (Credit) Sales
 AKA: days sales outstanding (DSO)
 Measures time to collect on credit sales.
Compare to business credit terms (ex: 30
days)
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Asset Management Ratios
• Average Collection Period (ACP)
• When ACP is too long, we can suspect:
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poor credit management
inefficient collection procedures
risk of uncollectible accounts
risk of cash shortages
more reliance on bank financing, and
more interest expense.
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Asset Management Ratios
• Inventory Turnover
Cost of Goods Sold
Inventory Turnover =
Inventory
 Measures how many times a year firm
uses up an average stock of goods
 Higher turnover implies doing business
with less tied up in inventory
 Indicates quality of inventory as well as
how it is managed
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Asset Management Ratios
• Inventory Turnover
• A higher inventory turnover minimizes costs
and risks of:
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
unsaleable stock
damage and shortages
insurance, storage, and financing costs, and
cash shortages
• A higher turnover is essential if inventory is
 perishable (for example, food)
 fashionable (for example, women’s fashions)
 low margin goods (for example, consumer staples)
.
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Asset Management Ratios
• Capital Asset Turnover
Sales
Capital Asset Turnover =
Capital Assets
 Appropriate in industries where significant
plant or equipment is required
 High ratio may indicate full utilization of
capacity
 Low ratio may reflect new capital assets
coming on stream
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Asset Management Ratios
• Total Asset Turnover
Sales (Total)
Total Asset Turnover 
Total Assets
 More widely used than Capital Asset
Turnover
 Long-term measure of performance
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Debt Management Ratios
• Debt management ratios measure
financial risk from borrowing
 High ratios viewed as risky by lenders and
investors
 Riskiness associated with debt and interest is
called financial risk
 High level of debt can burden income
statement with excessive interest, a fixed
financial charge
 Firm may not be able to repay debt and
interest if profits decline
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Debt Management Ratios
• Debt-to-equity ratio
 Can be stated as a percentage, or as a x:y
value
Debt-to-Equity  LT debt : Common Equity
or
Debt-to-Equity 
LT Debt
Common Equity
 Measures mix of LT debt and equity
within firm’s total capital
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Debt Management Ratios
• Debt Ratio
Long-term debt  Current Liabilities
Debt Ratio 
Total Assets
 Need to determine if company is using
so much debt that it is assuming
excessive financial risk
 High debt ratio is viewed as risky by
investors
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Debt Management Ratios
• Times Interest Earned
EBIT
TIE 
Interest Expense
 TIE is a coverage ratio
• Reflects how much EBIT covers interest
expense
• High level of interest coverage implies
safety for lenders
 High TIE ratio often means a low
debt/equity ratio
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Debt Management Ratios
• Cash Coverage
EBIT + Amortization
Cash Coverage =
Interest Expense
 TIE ratio has problems
• Interest is a cash payment but EBIT is not
exactly a source of cash
• By adding amortization back into the
numerator we have a more representative
measure of cash income
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Debt Management Ratios
• Fixed Charge Coverage
EBIT  Lease Payments
Fixed Charge Coverage 
Interest Expense  Lease Payments
 Interest payments are not the only
fixed charges
 Lease payments are fixed financial
charges similar to interest
• Must be paid regardless of business
conditions
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Profitability Ratios
• Return on Sales (or: Profit Margin,
Net Profit Margin)
Net Income
ROS 
Sales
 Measures control of income statement:
revenue, cost and expense
 Indicates overall profitability of the
business
 Low ROS may be OK for large firm
 Small firm needs higher ROS
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Profitability Ratios
• Gross Profit Margin
Gross Profit
Gross Profit Margin=
Sales
 Indicates how efficiently firm buys or
manufactures its products, and how well it
marks up and maintains selling prices
 Will vary, depending on industry and product
lines involved.
• For instance, margin on jewellery typically is much
higher than that on most food products
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Profitability Ratios
• Return on Assets
Net Income
ROA 
Total Assets
 Adds effectiveness of asset
management to Return on Sales
 Measures ability of firm to utilize
assets to earn profit
 Often compared to firm’s cost of
financing (after tax)
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Profitability Ratios
• Return on Equity
Net Income
R eturn on Equity =
Shareholders' Equity
 Adds effect of borrowing to Return on Assets
 Measures ability to earn a return on owners’
investment
 If firm has substantial debt, ROE tends to be higher
than ROA in good times and lower in bad times
 Compared to returns available from alternate
investments
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Earnings and Book Value per Share
• Earnings per Share
Net Income
Earnings per Share=
Number of Common Shares
 Indicates how much income was earned for each
common share outstanding
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Earnings and Book Value per Share
• Book Value per Share
Common Equity
Book Value per Share=
Number of Common Shares
 Indicates how much equity was attributable to each
common share outstanding
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Market Value Ratios
• Price/Earnings Ratio (PE Ratio)
Market Price per Share
Price-Earnings Ratio =
Earnings per Share
 Indicates value that stock market
places on company
 Tells how much investors are willing to
pay for a dollar of firm’s earnings
 Firm’s P/E is primarily function of
investors’ expectations for its growth
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Market Value Ratios
• Market-to-Book Value Ratio
Market Price per Share
Market - to - Book Value=
Book Value per Share
 Healthy company is expected to have market value
greater than its book value (Ratio > 1.0)
• Known as going concern value of firm
• Future earnings will be worth more than assets are worth
today
• High ratio may indicate undervalued property on balance
sheet
 A ratio < 1.0 indicates poor outlook for firm
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Du Pont Equations
• Ratio measures are not entirely
independent
• Performance on one is sometimes tied to
performance on others
• Du Pont equations express
relationships between ratios that give
insights into successful operation
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Du Pont Equations
• Du Pont equation involves ROA, which can be
written as:
Net Income
ROA =
Total Assets
or
Net Income
Sales
ROA =
×
Sales
Total Assets
© 2006 by Nelson, a division of Thomson Canada Limited
States that to
run a business
well, a firm must
manage pricing,
costs and
expenses as
well as generate
lots of sales per
dollar of assets.
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Du Pont Equations
• Du Pont equation involves ROE, which can be
written as:
Net income
ROE 
Equity
or
Net income Total assets
ROE 

Total assets
Equity
Equity Multiplier
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Related to the
proportion to
which the firm
is financed by
other people’s
money as
opposed to
owner’s money.
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Du Pont Equations
• Extended Du Pont equation states that
operation of a business is reflected in its
ROA
 However, this result—good or bad—can be
multiplied by borrowing, resulting in ROE
 The way you finance a business can
exaggerate the results from operations
• Du Pont equations can be used to isolate
problems
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Table 3.2:
Sources of Comparative
Information
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Limitations and Weaknesses of Ratio
Analysis
• Ratio analysis requires judgment and
experience
 Examples of significant problems
• Diversified companies—comparing companies operating in
several industries can be a problem
• Window dressing—companies make balance sheet items
look better through temporary improvements
• Different accounting principles—similar companies may
report same thing differently
• Inflation may distort numbers
• Illegal and/or misleading accounting practices may
overstate assets, understate debt, or hide losses
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Words of Caution
• Ratios are only as good as information on
which they are based
• Ratios become most valuable when:
 Compared to past, competition, or budget
• When comparing ratios among different
firms, ensure the ratios calculated using
same method
• Ratios should cause one to ask
questions; rarely do they provide
answers themselves
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