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# Foundations of Financial Management Page 1

Chapter 3

Chapter 3 - Outline
Financial

LT 3-1

Financial Analysis

Analysis 4 Categories of Financial Ratios Importance of Ratios Inflation and its Impact on Profits

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## Financial Analysis and Ratios

What is financial analysis?
Evaluating

LT 3-2

4 Categories of Ratios
Profitability

LT 3-3

a firms financial performance Analyzing ratios or numerical calculations Comparing a company to its industry

## Ratios Asset Utilization Ratios Liquidity Ratios Debt Utilization Ratios

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## Foundations of Financial Management Page 2

Classification System

PPT 3-1

Classification System
C. Liquidity ratios.
9. Current ratio. 10. Quick ratio.

PPT 3-1

We will separate 13 significant ratios into four primary categories. A. Profitability Ratios.
1. Profit margin. 2. Return on assets (investment). 3. Return on equity.

## D. Debt utilization ratios.

11. Debt to total assets. 12. Times interest earned. 13. Fixed charge coverage.

## B. Asset utilization ratios.

4. 5. 6. 7. 8. Receivable turnover. Average collection period. Inventory turnover. Fixed asset turnover. Total asset turnover.

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## PPT 3-2 TABLE 3-1 Financial statement for ratio analysis

Profitability Ratios
Show how profitable a company is. The ratios express:

LT 3-4

Profit Margin or Return on Sales (%) Return on Assets or Return on Investment (%) Return on Equity (%)

## Foundations of Financial Management Page 3

PPT 3-3 FIGURE 3-1 Du Pont analysis PPT 3-4

Profitability Ratios
Saxton Company 1. Profit margin = Net income
sales \$200,000 = 5% \$4,000,000

## 2. Return on assets (investment) = a.

Net income Total assets Sales Sales Total assets \$200,000 \$1,600,000 = 12.5%

10% 10%

b. Net income

5% 2.5 = 12.5%
\$200,000 = 20% \$1,000,000 0.125 = 20% 1 0.375

3. Return on equity = a. b.
Net income Stockholders equity Return on assets (investment) (1 Debt/Assets)

15% 15%

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PPT 3-5 TABLE 3-2 Return of Wal-Mart versus May Department Stores using the Du Pont method of analysis, 2002

## Asset Utilization Ratios

LT 3-5

Show how effectively a company uses its assets. The ratios express:
Receivables Turnover (times) Average Collection Period (days) Inventory Turnover (times) Fixed Asset Turnover (times) Total Asset Turnover (times)

PPT 3-6 PPT 3-6

## Asset Utilization Ratios

Saxton Company 4. Receivables turnover = Sales (credit) Receivables 5. Average collection period = Accounts receivable Average daily credit sales 6. Inventory turnover = Sales Inventory
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## Asset Utilization Ratios

Saxton Company 7. Fixed asset turnover =

Industry Average

Industry Average

10 times

## \$4,000,000 =5 \$800,000 \$4,000,000 = 2.5 \$1,600,000

5.4 times

\$350,000 = 32 \$11,111

36 days

1.5 times

7 times

## Profitability and Turnover Ratios

Remember: Return on X = Net Income / X X Turnover = Sales / X

LT 3-6

Liquidity Ratios

LT 3-7

Show how liquid a company is or how much \$ it has to meet S/T needs. The ratios express:
Current Ratio (times) Quick Ratio or Acid-Test Ratio (times)

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## Foundations of Financial Management Page 5

PPT 3-7

Liquidity Ratios
Saxton Company 9. Current ratio =
Current assets Current liabilities \$800,000 = 2.67 \$300,000

## Debt Utilization Ratios

Industry Average

LT 3-8

Show how well a company is managing or using debt. The ratios express:
Debt-to-Total Assets (%) Times Interest Earned (times) Fixed Charge Coverage (times) (Fixed Charges = lease payments, i expense)

2.1

## 10. Quick ratio =

Current assets Inventory Current liabilities \$430,000 = 1.43 \$300,000

1.0

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## Debt Utilization Ratios

Saxton Company 11. Debt to total assets = Total debt Total assets 12. Times interest earned = Income before interest and taxes Interest 13. Fixed charge coverage = Income before fixed charges and taxes Fixed charges
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PPT 3-8

PPT 3-9

Industry Average

## \$600,000 = 37.5% \$1,600,000

33%

\$550,000 \$50,000

= 11

7 times

\$600,000 =6 \$100,000

5.5 times

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## Foundations of Financial Management Page 6

PPT 3-10

Importance of Ratios

LT 3-9

## FIGURE 3-2 Trend analysis

Which ratio is most important? It depends on your perspective. Suppliers and banks (lenders) are most interested in liquidity ratios. Stockholders are most interested in profitability ratios. A long-run trend analysis over a 5-10 year period is usually performed by an analyst.

FIFO

LT 3-10

LIFO

## Foundations of Financial Management Page 7

PPT 3-12 TABLE 3-7 Comparison of replacement cost accounting and historical cost accounting TABLE 3-8

PPT 3-13

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