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.
• The Du Pont system of analysis.
• Trend analysis.
• Evaluation of reported income to identify
distortion.

3-2
 Ratio Analysis
• Financial ratios
– Used to weigh and evaluate the operating
performance of a firm.
– Used to compare performance record as against
other firms in the industry.
– Analyzing ratios and numerical calculations.
– Such data is provided by various organizations.

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 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.
3-4
 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.

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 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.

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 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.

3-7
Financial Statement for Ratio
Analysis

3-8
Profitability Ratios

3-9
 Du Pont System of Analysis
• A satisfactory return on assets might be
derived through:
– A high profit margin
– A rapid turnover of assets (generating more
sales per dollar of its assets)
– Or both
Return of assets (investment) =
(Profit margin) X (Asset turnover)

3-10
Du Pont System of Analysis (cont’d)
• A satisfactory return on equity might be
derived through:
– A high return on total assets;
– A generous utilization of debt;
– Or a combination of both.

Return on equity = Return on assets (investments)

[1 – (Debt/ Assets)]

3-11
Du Pont Analysis

3-12
Examples for Analysis using the Du
Pont System

3-13
 Asset Utilization Ratios
• These ratios relate the balance sheet to the
income statement.

3-14
Asset Utilization Ratios (cont’d)

3-15
Liquidity Ratios

3-16
 Debt Utilization Ratios
• Measures the prudence of the debt
management policies of the firm.

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 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

3-18
Summary of Ratio Analysis

3-19
Trend Analysis

3-20
Trend Analysis in the Computer
Industry

3-21
 Impact of Inflation on Financial
Analysis
• Inflation
– Revenue is stated in current dollars.
– Plant, equipment, or inventory may have been
purchased at lower price levels.
– Profits may be more a function of increasing
prices than due to good performance.

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Comparison of Replacement and
Historical Cost Accounting

3-23
 Comparison of Replacement and
Historical Cost Accounting (cont’d)
• Replacement costs - reduces income but
increases assets.
– An increase lowers the debt-to-assets ratio.
– A decrease indicates a decrease in the financial
leverage of the firm.
– A declining income results in a decreased ability
to cover interest costs.

3-24
 Impact of Disinflation on Financial
Analysis
• Disinflation
– Financial assets such as stocks and bonds have
the potentials to do well – encouraging
investors.
– Tangible assets do not have the potential.
• Deflation
– Actual reduction of prices affecting everybody
due to bankruptcies and declining profits.

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 Other Elements of Distortion in
Reported Income
• Effect of changing prices.
• Reporting of revenues.
• Treatment of nonrecurring items.
• Tax write-off policies.

3-26
Explanation of Discrepancies

3-27
 Explanation of Discrepancies
(cont’d)
• Sales
– Use of defer recognition until each payment is
received or full recognition at the earliest
possible date.
• Cost of goods sold
– Use of different accounting principles - LIFO
versus FIFO.

3-28
 Explanation of Discrepancies
(cont’d)
• Extraordinary gains/ losses
– Inclusion of events when computing current
income or leaving them out.
• Net income
– Use of different methods of financial reporting.

3-29