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McGraw-Hill Ryerson

Financial Analysis

Prepared by: Zhen Wang Laurentian University Modified by: David Pearce

2005 McGraw-Hill Ryerson Limited

Chapter 3 - Outline
What is Financial Analysis? 4 Categories of Financial Ratios Techniques of Ratio Analysis Distortion in Financial Reporting Summary

PPT 3-2

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PPT 3-3

What is Financial Analysis?

Evaluating a firms financial performance Calculating ratios to reveal relationships between different accounts of financial statements Linking ratios to reveal the factors determining a firms profitability and value
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PPT 3-4

Classification of Financial Ratios

A. B. C. D.

Profitability Ratios Asset Utilization Ratios Liquidity Ratios Debt Utilization Ratios
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PPT 3-5

A. Profitability Ratios
Show how profitable a company is The ratios are
1. Profit margin 2. Return on assets (ROA) (investment) 3. Return on equity (ROE) (common shareholders)

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PPT 3-6

B. Asset Utilization Ratios

Show how effectively a company uses its assets The ratios
4a. Receivable turnover 4b. Average collection period (days sales outstanding) 5a. Inventory turnover 5b. Inventory holding period 6a. Accounts payable turnover 6b. Accounts payable period 7. Capital asset turnover 8. Total asset turnover

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PPT 3-7

C. Liquidity Ratios
Show how liquid a company is or how much cash it has to meet short-term needs. The ratios are
9. Current Ratio 10. Quick Ratio

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PPT 3-8

D. Debt Utilization Ratios

Show how well a company is managing or using debt The ratios are
11. Debt to total assets 12. Times interest earned 13. Fixed charge coverage

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PPT 3-9

Which ratio(s) is/are most important?

It depends on your perspective
Suppliers and banks (short-term creditors) are most interested in liquidity ratios Shareholders are most interested in profitability ratios Long-term creditors concentrate on debt utilization ratios The utilization ratios may help determine strengths and weaknesses

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Table 3-1a

PPT 3-10

Financial statements for ratio analysis

SAXTON COMPANY Income Statement For the Year 2005

Sales (all on credit) . . . . . . . . . . . . . . . . Cost of goods sold . . . . . . . . . . . . . . . . Gross profit . . . . . . . . . . . . . . . . . . . Selling and administrative expense* . . . . . . . . . Operating profit . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . Extraordinary loss . . . . . . . . . . . . . . . . Net income before taxes . . . . . . . . . . . . . . Taxes (50%) . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . .

$ 4,000,000 3,000,000 1,000,000 450,000 550,000 50,000 100,000 400,000 200,000 $ 200,000
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Net income . . . . . . . . . . . . . . . . . . . . .
* Includes $50,000 in lease payments.

Table 3-1b
Balance Sheet As of December 31, 2005 Assets
Cash Marketable securities Accounts receivable Inventory Total current assets Net plant and equipment Total assets Liabilities and Shareholders' Equity Accounts payable Notes payable Total current liabilities Long-term liabilities Total liabilities Common stock Retained earnings Total liabilities and shareholders' equity

PPT 3-11

Financial statements for ratio analysis

30,000 50,000 350,000 370,000 800,000 800,000 $1,600,000 50,000 250,000 300,000 300,000 600,000 400,000 600,000 $1,600,000
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PPT 3-12

Profitability ratios(a)
Saxton Company 3-1. Profit margin = Net income Sales $200,000 = 5% $4,000,000 Industry Average 6.5%

3-2. Return on assets (ROA) (investment) =

a.

Net income Total assets

$200,000 $1,600,000

= 12.5%

10%

b.

Net income Sales Sales Total assets

5% x 2.5 = 12.5%

6.5% x 1.5 = 10%

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PPT 3-13

Profitability ratios(b)
Saxton Company 3-3. Return on equity (ROE) = Net income Shareholders equity Industry Average

a.

$200,000 = 20% $1,000,000 = 1.6 1 0.6667

15%

Total assets $1,600,000 b. Equity multiplier = $1,000,000 Equity c. ROA Equity multiplier =

=1.5

0.125 1.60 = 20%

0.10 1.50 = 15%

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Asset utilization ratios(a)

Saxton Company 3-4a. Receivables turnover = Sales (credit) Receivables 3-4b. Average collection period = Accounts receivable Average daily credit sales 3-5a. Inventory turnover = Cost of Goods Sold Inventory Industry Average

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

10 times

$350,000 = 32 $10,959
$3,000,000 = 8.1 $370,000

36 days

7 times

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Asset utilization ratios(b)

Saxton Company 3-5b. Inventory holding period = Inventory Average daily COGS 3-6a. Accounts payable turnover = Cost of goods sold Accounts payable 3-6b. Accounts payable period = Accounts payable Average daily purchases (COGS) Industry Average

$370,000 = 45 $8,219

52 days

$3,000,000 = 60.0 $50,000

12 times

$50,000 = 6 $8,219

30 days

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Asset utilization ratios(c)

Saxton Company 3-7. Capital asset turnover = Sales Capital assets 3-8. Total asset turnover = Sales Total assets $4,000,000 = 2.5 $1,600,000 $4,000,000 = 5.0 $800,000 5.4 times Industry Average

1.5 times

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Liquidity ratios
Saxton Company 3-9. Current ratio = Current assets Current liabilities 3-10. Quick ratio = Current assets Inventory Current liabilities $430,000 = 1.43 $300,000 Industry Average

$800,000 = 2.67 $300,000

2.1

1.0

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Debt utilization ratios

Saxton Company 3-11. Debt to total assets = Industry Average

Total debt Total assets

3-12. Times interest earned = Income before interest and taxes Interest 3-13. Fixed charge coverage = Income before fixed charges and taxes Fixed charges

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

33%

$550,000 = 11 $50,000

7 times

$600,000 =6 $100,000

5.5 times

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Table 3-2a

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Ratio analysis(a)
Saxton Company A. Profitability 1. Profit margin 2. Return on assets... 3. Return on equity. B. Asset Utilization 4a. Receivables turnover ... 4b. Average collection period. 5a. Inventory turnover ... 5b. Inventory holding period...... 6a. Accounts payable turnover... 6b. Accounts payable period...... 7. Capital asset turnover . 8. Total asset turnover . Industry Average Conclusion 5% 6.5% Below average 12.5% 10% Above average due to high 8 20% 15% Good due to ratios 2 and 11 11.4 32.0 8.1 45 60.0 6 5.0 2.5 10.0 36.0 7.0 52 12 30 5.4 1.5 Good Good Good Good Good Good Below average Good

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Ratio analysis(b) Saxton

Company C. Liquidity
9. Current ratio 10. Quick ratio .. 2.67 1.43 37.5% 11 6

Industry Average
2.1 1.0 33% 7 5.5

Conclusion
Good Good Slightly more debt Good Good

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

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Techniques of Ratio Analysis

1. DuPont Analysis
2. Comparative Analysis
1. Relative to other firms or to the industry

3. Trend Analysis
1. Relative to past performance

4. Common-Size Statements
1. Each item expressed as a % of sales

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Comparative vs Trend Analysis

Ratios on their own do not mean a lot Comparing a companys ratios to those of its industry or its competitors is comparative analysis and may reveal what ratios are out of line with certain standards Comparing the same companys ratios over a number of years is trend analysis and may reveal whether ratios are improving or worsening
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Trend analysis of competitors

Bank of Montreal
Return on Assets 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Return on Equity

Royal Bank
Return on Assets Return on Equity

0.59 0.61 0.79 0.60 0.56 0.71 0.87 0.81 0.84 0.60

15.2 14.1 18.0 13.8 13.4 16.4 19.41 15.24 18.45 14.39

0.70 0.65 0.81 0.74 0.76 0.73 0.66 0.76 0.90 0.94

18.4 15.6 19.8 16.4 15.5 16.8 15.57 18.01 23.4 24.56

Source: Annual reports and CBA www.cba.ca

www.bmo.com

www.rbc.com
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DuPont Analysis
Reveals the relationships between profitability ratios and asset utilization ratios and debt utilization ratios Decomposes a firms profitability into several determining factors
ROA = = Net Income Assets Net Income x Sales Sales Assets

Profit Margin

Asset Turnover
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DuPont analysis
Net income

Sales

Profit margin

Asset turnover

Return on assets

Total assets

=
Total assets

Return on Equity

Equity

Financing plan (Equity multiplier)

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DuPont Analysis
Net Income = Equity
=

ROE

Net Income x Sales Sales Assets

x Assets Equity

Profit Margin Asset Turnover

Equity Multiplier

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Applying DuPont analysis at Canadian Pacific

Profit Margin
14.56% 4.92

Company
CP Rail CP Ships Fairmont Hotels

Asset Return on Turnover = Assets

.4150 1.5132 6.04% 7.44

Equity Return X Multiplier = on Equity

2.473 1.590 14.94% 11.83

5.81

.9890

5.75

2.482

14.27

Fording

3.86

.9009

3.48

1.894

6.59

PanCanadian Energy 14.40

.7982

11.49

2.244

25.79

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Distortion in Financial Reporting

Historical-based accounting in an environment of changing prices may distort financial results:
-- immediate effect of price changes on revenues versus delayed impact on asset values

Accrual-based accounting allows certain leeway in matching the revenues and expenses
-- cost of goods sold (LIFO vs FIFO) -- asset write-downs -- net income
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Illustration of different income reporting methods

Income Statement For the Year 2005 Conservative (A) Sales . . . . . . . . . . . . $4,000,000 Cost of goods sold . . . . . . . 3,000,000 Gross profit . . . . . . . . . . 1,000,000 Selling and administrative expense . . 450,000 Operating profit . . . . . . . . 550,000 Interest expense . . . . . . . . 50,000 Net income before taxes . . . . . 500,000 Taxes (40%) . . . . . . . . 200,000 Net income . . . . . . . . . 300,000 Extraordinary loss (net of tax) . . . 60,000 Net income transferred to retained earnings $ 240,000 High Reported Income (B) $4,200,000 2,400,000 1,800,000 450,000 1,350,000 50,000 1,300,000 520,000 780,000 $ 780,000

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Inflations Impact on Profits

FIFO (First-In, First-Out) Inventory:
Lowers COGS Raises reported profits

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LIFO (Last-In, First-Out) Inventory:

Raises COGS Lowers reported profits

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Summary
Financial ratios cover 4 areas of management: profitability, asset utilization, liquidity and debt utilization. The DuPont system of analysis tells us that the profit margin, asset turnover, and debt usage each contributes to return on equity. Ratios should be compared to industry average (comparative analysis) as well as historical data (trend analysis). What ratios do is to suggest aspects requiring further exploration. It is the manager/analysts job to answer the questions revealed by ratios.
2005 McGraw-Hill Ryerson Limited