3 Financial Analysis

Chapter

McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline

• Ratio analysis and its importance

• Use of ratio for measurements
• Trend analysis
• Evaluation of reported income to
identify distortion
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 and their Classification
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
1-4
 Ratios and their Classification
(cont’d)
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

1-5
 Types of Ratios
• Profitability ratios
– Measurement of the firm’s 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

1-6
 Types of Ratios (cont’d)
• Liquidity ratios
– Emphasizes the firm’s ability to pay off short-
term 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

1-7
Financial Statement
for Ratio Analysis

1-8
Profitability Ratios

1-9
 Asset Utilization Ratios
• These ratios relate the balance sheet to the
income statement

1-10
Asset Utilization Ratios (cont’d)

1-11
Liquidity Ratios

1-12
 Debt Utilization Ratios
• Measures the prudence of the debt
management policies of the firm

1-13
 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

1-14
Ratio Analysis

1-15
 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
Inflation’s Impact on Profits LT 3-10

FIFO (First-In, First-Out) Inventory:

—Lowers COGS
—Raises Profits
LIFO (Last-In, First-Out) Inventory:
—Raises COGS
—Lowers Profits
 PPT 3-27
Figure 3-2a

Trend analysis
A. Profit Margin
Percent

Industry
7
Saxton
5

1
1990 1992 1994 1996 1998 2000 2002
 PPT 3-28
Figure 3-2b

Trend Analysis
B. Total asset turnover
3.5X
3.0X
2.5X Saxton
2.0X
1.5X
1.0X Industry
.5X
1990 1992 1994 1996 1998 2000 2002