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# 3

Chapter

Financial Analysis

McGraw-Hill/Irwin

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

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Ratio Analysis
Financial ratios
Used to weigh and evaluate the operating performance of a firm Used to compare performance record as against similar firms in the industry Analyzing ratios and numerical calculations Such data is provided by various organizations

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## Ratios and their Classification

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

B.
4. 5. 6. 7. 8.

## Asset utilization ratios

Receivable turnover Average collection period Inventory turnover Fixed asset turnover Total asset turnover
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## Ratios and their Classification (contd)

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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Types of Ratios
Profitability ratios
Measurement of the firms ability to earn an adequate return on:
Sales Assets Invested capital

## Asset utilization ratios

Measures the speed at which the firm is turning over accounts receivable
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## Types of Ratios (contd)

Liquidity ratios
Emphasizes the firms ability to pay off shortterm obligations as and when due

## Debt utilization ratios

Estimates the overall debt position of the firm Evaluates in the light of asset base and earning power

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## Financial Statement for Ratio Analysis

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Profitability Ratios

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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 (contd)

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 Macys using the Du Pont method of analysis, 2007

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## Asset Utilization Ratios

These ratios relate the balance sheet to the income statement

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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 (contd)

Fixed charge coverage measures the firms 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

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## Liquidity and Efficiency

Current Assets Current Ratio = Current Liabilities Cash + Marketable Securities + AR Acid - test Ratio = Current Liabilities Net Sales Accounts Receivable Turnover = Accounts Receivable Cost of Goods Sold Inventory Turnover = Inventory Net Sales Total Asset Turnover = Total Assets 360 Net Sales Average Collection Period = x 360 AR Turnover AR 360 Net Sales Day's Sales in Inventory = x 360 Inventory Turnover Inventory
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Solvency
Total Liabilities Debt Ratio = Total Assets Equity Equity Ratio = Total Assets Total Liabilities Debt - to - Equity = Total Equity Interest Expense Times Interest Earned= EBIT

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Profitability
Net Income Profit Margin Ratio = Sales Gross Profit Gross Margin Ratio = Sales Net Income Return on Total Assets = Sales NetIncome Return on Equity = Stockholders' Equity Net Income Earnings Per Share = Number of Shares Outstanding Common Stocks

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Market Prospects
Market Price Per Share Price Earnings Ratio = Earnings Per Share Dividend Per Share Dividend Yield = Market Price Per Share Total Dividends Dividend Payout = Income

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## Reconstruction of Financial Statements

Page: 83 Number: 31

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Exercises
Pages: 84 and 85 Numbers: 33 and 34

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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 (contd)

Replacement cost reduces income but increases assets
An increase lowers the debt-to-assets ratio A decrease indicates 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 (contd)

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 (contd)

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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