Chapter

3
Financial Analysis

Anwar Zahid
Lecturer
Independent University, Bangladesh
© 2003 McGraw-Hill Ryerson Limited
Chapter 3 - Outline
 What is Financial Analysis?

4 Categories of Financial Ratios

 Profitability Ratios

 Asset Utilization Ratios

 Liquidity Ratios

 Debt Utilization Ratios

 Summary and Conclusions © 2003 McGraw-Hill Ryerson Limited

Financial Analysis
What is financial analysis?
 Evaluating a firm’s financial performance
 Ratios are calculated by dividing one value on
financial statements by another related value
 A long-run trend analysis over a number of years
shows changes over time
 Ratios, trends and other calculations are used to
interpret and compare the financial performance of
a company to its industry and to its past results
 Financial analysis may not answer questions, but
leads to further inquiry

© 2003 McGraw-Hill Ryerson Limited

4 Categories of Ratios

Profitability Ratios

Asset Utilization Ratios

Liquidity Ratios

Debt Utilization Ratios

© 2003 McGraw-Hill Ryerson Limited

 See page 95
(Pdf text
Classification system for ratios book)
A. Profitability Ratios
1. Profit margin /Return on sales
2. Return on assets (ROA) /(investment)
3. Return on equity (ROE) (common shareholders)

B. Asset Utilization Ratios

4. Receivable turnover
5. Average collection period (days sales outstanding)
6. Inventory turnover
7. Fixed Asset Turnover
8. Total Asset Turnover

© 2003 McGraw-Hill Ryerson Limited

Four categories of financial ratios
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

© 2003 McGraw-Hill Ryerson Limited

 Importance of Ratios
Which ratios are most important?
It depends on your perspective
 Suppliers and banks (lenders) are most interested in
liquidity ratios
 Shareholders are most interested in profitability ratios
 Long-term creditors concentrate on debt utilization
ratios
 The effective utilization of assets is management’s
responsibility
© 2003 McGraw-Hill Ryerson Limited
 1. Profitability Ratios

 Measure overall company profitability for potential

investors (income to investment base)
 The higher the ratio score, the more profitable the firm
Return on Sales/ P.M Return on Assets (ROA)

Net Income Net Income

Sales Total Assets
Return on Equity (ROE)

Net Income
Total Owner’s Equity
© 2003 McGraw-Hill Ryerson Limited
 Profitability ratios [ Pg 96, pdf ]
1. Low Carb Diet Supplement Inc.

1. Profit margin = Net income= = $ 156,000 7.76 %

Division A Sales $20,10,000
Division B is
superior
Profit margin = Net income = $ 28,800 = 8.75 %
Division B Sales $3,29,000

© 2003 McGraw-Hill Ryerson Limited

 Asset Utilization Ratios
 Measure how efficiently the company uses its assets to
generate sales

( * credit ) Sales
Total Asset
Accounts Receivable
Receivable Inventory Turnover
Turnover Total Sales
Turnover
Total Assets
Total Sales
Inventory
© 2003 McGraw-Hill Ryerson Limited
Pg 99,Pdf - 18 A firm has sales of $3 million, and 10 percent
of the sales are for cash. The year-end accounts receivable
balance is $285,000. What is the average collection period?
*(Use a 360-day year.)
   Average   Collection   period= Account receivable
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐝𝐚𝐢𝐥𝐲 𝐜𝐫𝐞𝐝𝐢𝐭 𝐬𝐚𝐥𝐞𝐬
  285,000
 Step  2 :  Average   Collection   period= = 38 days Ans
𝟕𝟓𝟎𝟎

10 % Cash sales So, Annual Credit sales = [ $ 30,00,000 * 90% ]

90% Credit sales = $27,00,000
  = $ 7500
© 2003 McGraw-Hill Ryerson Limited
 Asset
Cash ........................................... $ 60,000
Accounts receivable ................... 240,000
Inventory ..................................... 350,000
Plant and equipment .................... 410,000
Lib & OE
Accounts payable ....................... $ 220,000
Accrued taxes ............................... 30,000
Bonds payable (long-term) ......... 150,000
Common stock ........................... 80,000

Paid-in capital ............................ 200,000

Retained earnings ...................... 380,000
Total assets ............................. $1,060,000 Total liabilities and equity .... $1,060,000

Current Asset
   A  ) Current   ratio (CR )=
Current Liabilities /debt Math 22 /

Current
   Asset = Cash  +  Accounts  Receivable + Inventory       Stud clothiers
 = $6,50,000 pg - 100pdf
Current
   liabilities  = Accounts  Payable  + Accrued  Taxes
  =$2,50,000

  Current   ratio= 6,50,000 C .R = 2.6 times

2,50,000
© 2003 McGraw-Hill Ryerson Limited
 Math 22 /
   B  ) Quick   ratio= Current Asset − Inventory Stud clothiers
Current Liabilitiy pg - 100 pdf

 = 1.2 times Ans

  C  )  Debt   to   A sset  = Total debt/ Lib  = 37.73%

Total Asset

   D  ) Asset   turnover = Total Sales   = 2.26 x

Total Asset
Account receivable
   E  ) Average   Collection   period=
Average daily credit sales
Total Annual credit sales is given 90% of total sales
So, Credit sales= $2,400,000* 90% = $21,60,000
    = 6,000

  Step  2 :  Average   Collection   period= 2,40,000 = 40 days Ans

𝟔 , 𝟎𝟎𝟎
© 2003 McGraw-Hill Ryerson Limited
Math 33 * Change: The Griggs Corporation has Total sales
/ Griggs Corp. of $12,00,000 and Cash sales is 10% of total sales.
S0, Credit sales will be (12, 00,000 * 90%) = 10,80,000
pg - 103 pdf
  𝑇 . 𝑆𝐴𝐿𝐸𝑆
Total assets turnover .................................... 2.4 times  1.  T . Asset.  turnover=
T . ASSET
Cash to total assets ...................................... 2.0%
Accounts receivable turnover ......................8.0 times  
Inventory turnover ......................................10.0 times
Current ratio .................................................2.0 times
Debt to total assets ........................................61.0%   12,00,000
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡= =$5,00,000
*Workings
2.4
  2.  Cash ¿ total Asset= 𝐶𝑎𝑠h
Total ASSET   A.  R .  turnover= Credit Sales
 3. 
A . Receivable
 
     8= 10,80,000
A . Receivable
  Cash  =(5,00,000 ∗ 0.02)
 A . Receivable= 10,80,000
  Cash  =$ 10,000 8

 A . Receivable=$1,35,000
© 2003 McGraw-Hill Ryerson Limited
   4.  Inventory   turnover= 𝑇 . 𝑆𝐴𝐿𝐸𝑆
Inventory Need to do workings of followings
  -Fixed Asset
-Long term Liability
Inventory -Owner Equity
 

  Current ratio= 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡

 5) 
C 𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦

 
  6.  Debt ¿ Asset = 𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡 / 𝐿𝑖𝑏
Total Asset
 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐲 = 2,65,000 =$ 1,32,500
2  

3,05,000
 

© 2003 McGraw-Hill Ryerson Limited

 Griggs Corp. Balance Sheet
33 Asset $ Liabilities & owner $
equity
 Current Asset  Current debt/
Liability: (d) 1,32,500
Cash
Account Receivable 10,000 Long term Debt/
liability ( c - d)
1,35,000 1,72,500
Inventory
1,20,000 Total Debt/ Lib (c)
Total Current Asset
(a) 3,05,000
2,65,000
 Owners Equity (e-c)
 Fixed Asset (b - a) 1,95,000
 Total Liabilities &
 Total Asset (b) 2,35,000 owner equity (e)

5,00,000
5,00,000

35/ Harrelson Inc

H.W
 Chapter 03: Discussion Question

1. If we divide users of ratios into short-term lenders, long-term lenders,

and stockholders, in which ratios would each group be most
interested, and for what reasons?
Short-term lenders–liquidity ratios because their concern is with
the firm’s ability to pay short-term obligations as they come due.
 
Long-term lenders–leverage ratios because they are concerned with
the relationship of debt to total assets. They also will examine
profitability to insure that interest payments can be made.
 
Stockholders–profitability ratios, with secondary consideration
given to debt utilization, liquidity, and other ratios. Since
stockholders are the ultimate owners of the firm, they are primarily
concerned with profits or the return on their investment.
© 2003 McGraw-Hill Ryerson Limited
 Chapter 03: Discussion Question

2. Why is trend analysis helpful in analyzing ratios?

Trend analysis allows us to compare the present with the

past and evaluate our progress through time. A profit
margin of 5 percent may be particularly impressive if it has
been running only 3 percent in the last ten years. Trend
analysis must also be compared to industry patterns of
change.
© 2003 McGraw-Hill Ryerson Limited
 Chapter 03: Discussion Question
3. Is there any validity in rule-of-thumb ratios for all corporations,
for example, a current ratio of 2 to 1 or debt to assets of 50
percent?

No rule-of-thumb ratio is valid for all corporations. There

is simply too much difference between industries or time
periods in which ratios are computed. Nevertheless, rules-
of-thumb ratios do offer some initial insight into the
operations of the firm, and when used with caution by the
analyst can provide information.
© 2003 McGraw-Hill Ryerson Limited
Summary and Conclusions
Financial analysis involves
evaluating and comparing
financial performance

Basic tools for financial

analysis include financial
ratios and trend analysis

© 2003 McGraw-Hill Ryerson Limited