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3

Financial Analysis

Block, Hirt, and Danielsen


Foundations of Financial Management
18th edition

© 2023 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw Hill.
Learning Objectives
• Recognize that ratio analysis provides a meaningful
comparison of a company to its industry.
• Explain what ratios are used for and what they
measure.
• Recall that the DuPont system of analysis identifies
the true sources of return on assets and return to
stockholders.
• Detail what trend analysis shows.
• Explain why reported income must be further
evaluated.

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Ratio Analysis

• Financial ratios
• Used to weigh and evaluate operating
performance of firm
• Measured in relation to other values
• Compares performance record against similar
firms in industry
• Additional evaluation of company management,
physical facilities, and other factors is needed
• Financial data reported by S&P, Moody’s, etc.

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Classification System

• A. Profitability ratios
1. Profit margin
2. Return on assets (investment)
3. Return on equity
• 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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Classification System Continued 1

• 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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Classification System Continued 2
• Profitability ratios (category A)
• Measure firm’s ability to earn adequate returns
• Sales
• Total assets
• Invested capital
• Asset utilization ratios (category B)
• Measure speed at which firm turns over
• Accounts receivable
• Inventory
• Long-term assets

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Classification System Continued 3

• Liquidity ratios (category C)


• Emphasize firm’s ability to pay off short-term
obligations as they come due
• Debt utilization ratios (category D)
• Estimate overall debt position of firm
• Evaluate in light of asset base, earning power

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Classification System Concluded
• Users of financial statements have differing
degrees of importance in categories of ratios
• Potential investors and security analysts
• Primary considerations—profitability ratios
• Secondary considerations—liquidity and debt
utilization
• For banker or trade creditor
• Primary consideration—liquidity ratios
• For long-term creditors (bondholder)
• Primary consideration—debt utilization ratios (debt
to total assets) and profitability ratios
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Table 3-1 Financial Statement
for Ratio Analysis

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The Analysis—Profitability Ratios

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The Analysis—DuPont System
of Analysis
• Satisfactory return on assets can be derived
through
• High profit margin
• Rapid asset turnover (generating more sales per
dollar of assets)
• Combination of both
Return on assets (investment)
= Profit margin × Asset turnover

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The Analysis—DuPont System
of Analysis Continued
• Satisfactory return on equity can be derived
through
• High return on total assets
• Generous utilization of debt
• Combination of both
Return on equity = Return on assets (investment)
(1 – Debt/Assets)

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Figure 3-1 DuPont Analysis

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The Analysis—Asset Utilization Ratios

• Relate balance sheet (assets) to income


statement (sales)

*This ratio may also be computed by using “cost of goods sold” in the numerator
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Table 3-2 Return on Equity: Walmart vs. Target
Using the DuPont Method of Analysis

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The Analysis—Asset Utilization Ratios
Continued

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The Analysis—Liquidity Ratios

• These ratios determine if the firm can meet each


maturing obligation as it comes due

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The Analysis—Debt Utilization Ratios

• Measures the prudence of the debt


management policies of the firm

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The Analysis—Debt Utilization Ratios
Continued

• Fixed charge coverage measures the firm’s


ability to meet all fixed obligations rather than
interest payments alone

Income before interest and taxes………………..$550,000


Lease payments……………………………………………… 50,000
Income before fixed charges and taxes………. $600,000

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Table 3-3 Ratio analysis

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Trend Analysis

• Over course of business cycle, sales and


profitability expand and contract
• Ratio analysis for any one year does not reflect
accurate picture of the firm
• Trend analysis reflects performance over a
number of years
• Without industry comparisons, may not reflect a
complete picture
• Gives picture of performance over number of
years against industry averages
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Figure 3-2 Trend Analysis

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Figure 3-3 Trend Analysis

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Impact of Inflation on
Financial Analysis
• Major problem of inflation
• Revenue stated in current dollars
• Plant, equipment, or inventory may have been
purchased at lower price levels
• Profits may be more function of increasing prices
than satisfactory performance
• Financial reports are distorted by not
considering inflation
• Affecting financial analysis

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Table 3-4 Stein Corporation Income
Statement for 2020

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Table 3-5 Stein Corporation Income
Statement for 2021

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Table 3-6 Comparison of Replacement Cost
Accounting and Historical Cost Accounting

Jeff Garnett and Geoffrey A. Hirt, “Replacement Cost Data: A Study of the
Chemical and Drug Industry for Years 1976 through 1978.”

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An Illustration

• Replacement cost—reduces income but


increases assets
• Increase in assets lowers debt-to-assets ratio
• Decreased debt-to-assets ratio indicates decrease
in financial leverage of firm
• Declining income results in decreased ability to
cover interest costs

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Disinflation Effect
• Disinflation—situation of declining inflationary
pressures
• Will not impair purchasing power of dollar
• Reduction in investors’ expectation of returns on
financial assets
• Financial assets such as stocks and bonds have
potential to do well
• Tangible (real) assets like precious metals will fall
• Deflation
• Actual declining of prices affecting everybody from
bankruptcies and declining profits
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Other Elements of Distortion
in Reported Income

• Effect of changing prices


• Reporting of revenues
• Treatment of nonrecurring items
• Tax write-off policies

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Table 3-7 Income Statements

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Explanation of Discrepancies
• Sales
• Conservative firms may defer revenue recognition of
the sale until each payment is received
• Other firms may attempt to recognize a fully effected
sale as early as possible
• Cost of goods sold
• Use of different accounting principles
• Company A uses LIFO versus Company B using FIFO
• Varying treatment of R&D costs, etc.

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Explanation of Discrepancies Continued

• Extraordinary gains/losses
• Including extraordinary events in computing
current income vs. leaving them out
• Net income
• Use of different methods of financial reporting
• Such as inclusion vs. exclusion of extraordinary gains
and/or losses
• Each item must be examined in financial
statements, rather than accepting bottom-line
figures
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