3 Financial Analysis

Chapter

Copyright © 2008 by The McGraw-HillMcGraw-Hill/Irwin

Companies, Inc. All
 Chapter Outline
• Ratio analysis and its importance
• Use of ratio for measurements
• The DuPont system of analysis
• Trend analysis
• Evaluation of reported income to identify
distortion (Inflation, Deflation, Disinflation,
and Stagflation)

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 Important Terminologies
• Financial Analysis, Profitability Ratios, Activity
Ratios, Liquidity Ratios (Acid Test), Debt Ratios
(Leverage), Market Ratios, DuPont System of
Analysis, Inflation (Deflation, Disinflation,
Stagflation), etc.

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 Ratio Analysis - Importance
• Financial ratios: A ratio is simply a
comparison of two numbers by division.
– Ratios are an analyst’s microscope; they allow
us a better view of the firm’s financial health
than just looking at the raw financial statements.
– Used to weigh and evaluate the operating
performance of a firm
– Ratios analysis and numerical calculations are
used to compare performance record as against
similar firms in the industry.
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 Financial Ratios - Uses
Ratios are useful to both internal and external
analysts of the firm.
For internal purposes, ratios can be useful in
planning for the future, setting goals, and evaluating
the performance of the managers.
External analysts use ratios to decide whether to
grant credit, to monitor and forecast financial
performance, and to decide whether to invest in that
company.
Such rations are provided by various organizations.

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 Types of Ratios
• Profitability ratios
– Measurement of the firm’s ability to earn an adequate
return on:
(a) Sales (b) Assets, and (c) Invested capital.
– These ratios indicate how profitable a firm has been over a
period of time.
• Asset utilization ratios (Efficiency/Activity Ratios)
– Measures the speed at which the firm is using
investments in various types of assets (accounts
receivable, inventory, total fixed assets and total
assets) to produce sales.
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 Types of Ratios (cont’d)
• Liquidity ratios
– Emphasizes the firm’s ability to pay off short-
term obligations as and when due. They
compare current assets to current liabilities.
• Debt utilization ratios (Leverage Ratio)
– Estimates the overall debt position of the firm
– Evaluates in the light of asset base and earning
power
• Market Ratios
• They compare firm’s market value with some
accounting values.
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 Analyzing Financial Performance
Using Ratio Analysis

Profitability • Relate a firm’s earnings to its sales,

Ratios assets, or equity.

• Measure the speed at which a firm

Activity Ratios converts various accounts into sales or
cash.
• Measure a firm’s ability to satisfy its
Liquidity Ratios short-term obligations as they come due.

• Measure the proportion of total assets

Debt Ratios financed by a firm’s creditors.

• Relate a firm’s market value to certain accounting

Market Ratios values.
 Ratios and their Classification
A. Profitability ratios
1. Profit margin
2. Return on assets (investment)
3. Return on equity
B. Asset utilization ratios (Activity Ratios)
4. Receivable turnover
5. Average collection period
6. Inventory turnover
7. Fixed asset turnover
8. Total asset turnover
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 Ratios and their Classification
(cont’d)
C. Liquidity ratios
9. Current ratio
10. Quick ratio
D. Debt utilization ratios (Leverage Ratio)
11. Debt to total assets
12. Times interest earned
13. Fixed charge coverage
The last two ratios are also known as Coverage Ratios
which show the ability of a firm to pay certain expenses.
E. Market Ratios -
14. P/E Ratio
15. Market/book ratio
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 Classification (cont’d)

• 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 and market ratios.
• 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
Ratios and Their Classification with
Formulas

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B. Asset Utilization Ratios

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C. Liquidity Ratios

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D. Debt Utilization Ratios

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 Market Value Ratios

14. Price/earnings (PE) ratio

= Market Price/EPS

15. Market/book ratio

= Market Price/Book Value per Share

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Table 3-1 Financial Statement for Ratio Analysis

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without the prior written consent of McGraw-Hill Education.
Profitability Ratios

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 DuPont System of Analysis
• DuPont analysis is a framework for analyzing
fundamental performance originally popularized by
the DuPont Corporation, now widely used to
compare the operational efficiency of two similar
firms.

• DuPont analysis is a useful technique used to

decompose the different drivers of return on equity
(ROE).

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 DuPont System of Analysis
• A satisfactory return on assets might be
derived through:
– A high profit margin
– A rapid turnover of assets (generating more
sales per dollar of its assets)
– Or both

Return on assets (investment) = Profit margin × Asset turnover

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DuPont System of Analysis (cont’d)
• A satisfactory return on equity might be
derived through:
– A high return on total assets
– A generous utilization of debt
– Or a combination of both

Return on equity = Return on assets (investment)

(1 – Debt/Assets)

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DuPont Analysis

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Return of Wal-Mart versus Macy’s using
the Du Pont method of analysis, 2007

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 Asset Utilization Ratios/
Activity Ratios
• These ratios relate the balance sheet to the
income statement

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Asset Utilization Ratios (cont’d)

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Liquidity Ratios

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 Debt Utilization Ratios
• Measures the prudence of the debt
management policies of the firm

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 Debt Utilization Ratios (cont’d)
• Fixed charge coverage measures the firm’s
ability to meet the fixed obligations
• Interest payments alone are not considered

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

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

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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
 Figure 3-2 Trend Analysis

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3-31
without the prior written consent of McGraw-Hill Education.
 Trend Analysis
in the Computer Industry

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 Impact of Inflation
on Financial Analysis
• Inflation
– Revenue is stated in current dollars
– Plant, equipment, or inventory may have been
purchased at lower price levels
– Profits may be more a function of increasing
prices than due to good performance

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Comparison of Replacement and
Historical Cost Accounting

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 Comparison of Replacement and
Historical Cost Accounting (cont’d)
• Replacement cost – reduces income but
increases assets
– An increase lowers the debt-to-assets ratio
– A decrease indicates a decrease in the financial
leverage of the firm
– A declining income results in a decreased ability
to cover interest costs

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 Impact of Disinflation
on Financial Analysis
• Disinflation
– Financial assets such as stocks and bonds have
the potential to do well – encouraging investors
– Tangible assets do not have the potential
• Deflation
– Actual reduction of prices affecting everybody
due to 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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Income Statements

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 Explanation of Discrepancies
(cont’d)
• Sales
– Firm may defer recognition until each payment is
received or full recognition at earliest possible
date
• Cost of goods sold
– Use of different accounting principles – LIFO
versus FIFO

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 Explanation of Discrepancies
(cont’d)
• Extraordinary gains/losses
– Inclusion of events in computing current income
or leaving them out
• Net income
– Use of different methods of financial reporting

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