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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 (%)
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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

Industry Average 6.7%

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)
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Foundations of Financial Management Page 4


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

$4,000,000 = 11.4 $350,000

10 times

Sales Fixed assets 8. Total asset turnover = Sales Total assets

$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

$4,000,000 = 10.8 $370,000

7 times
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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)
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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

TABLE 3-3 Ratio analysis

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.
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PPT 3-11 TABLE 3-4 Trend analysis in the computer industry

Inflations Impact on Profits


FIFO

LT 3-10

(First-In, First-Out) Inventory:

Lowers COGS Raises Profits


LIFO

(Last-In, First-Out) Inventory:

Raises COGS Lowers Profits


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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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