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3 Chapte r Financial Analysis McGraw-Hill Ryerson ©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca College Revised by PChua References: Block et al Gitman et al

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Page 1: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

33Chapt

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Chapt

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Financial AnalysisFinancial Analysis

McGraw-Hill Ryerson ©2003 McGraw-Hill Ryerson Limited

Prepared by:Terry FegartySeneca CollegeRevised by PChua

References:Block et alGitman et al

Page 2: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Chapter 3 - Outline

What is Financial Analysis? Uses of Ratio Analysis Approaches to Ratio Analysis 4 Categories of Financial Ratios Profitability Ratios (including Dupont Analysis) Asset Utilization Ratios Liquidity Ratios Debt Utilization Ratios Importance of Ratios Final Notes on Using Financial Ratios Summary and Conclusions

PPT 3-2

Page 3: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Financial Analysis

Financial Analysis is performed using Ratio Analysis Ratio Analysis involves the method of calculating and

interpreting financial ratios to assess the firm’s performance

A ratio is a numerator divided by a denominator; can be a percentage, times(x) or days

Ratio Analysis uses Income and Balance Sheet Statements for input

PPT 3-3

Page 4: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Uses of Financial Ratio Analysis

To decide whether to invest in a firm

To determine whether to lend funds to a firm

To plan for the future direction of a firm

To conduct routine financial analysis of a firm

Page 5: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Approaches to Ratio Analysis

Cross-Sectional Analysis Trend analysis Combined Analysis Common-size statements

PPT 3-4

Page 6: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

4 Categories of Ratios

Profitability Ratios

Asset Utilization Ratios

Liquidity Ratios

Debt Utilization Ratios

PPT 3-5

Page 7: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Sources of Published Ratios

D & B’s Industry Norms and key Business Ratios Canada Company Handbook Statistics Canada’s Financial Indicators for

Canadian Business www.globeinvestor.com www.nasdaq-canada.com

Page 8: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Classification system for ratios(a)A. Profitability Ratios

1. Profit margin (Return on Sales)

2. Return on assets (ROA)

3. Return on equity (ROE)

B. Asset Utilization Ratios4a. Receivable turnover

4b. Average collection period (days sales outstanding)

5a. Inventory turnover

5b. Inventory holding period

6a. Accounts payable turnover

6b. Accounts payable period

PPT 3-6

Page 9: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Four categories of financial ratios (b)B. Asset Utilization Ratios (cont’d)

7. Capital asset turnover

8. Total asset turnover

C. Liquidity Ratios9. Current Ratio 10. Quick Ratio

D. Debt Utilization Ratios11. Debt to total assets12. Times interest earned13. Fixed charge coverage

PPT 3-7

Page 10: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Other Useful Ratios

P/E Ratio = Market Share Price Earnings per share (EPS)

MV to BV = Market Value of Share Book Value per share

Way of measuring desirability of a stock.

Influenced by earnings and sales growth of the firm, risk (debt-equity structure), quality of management, dividend policy, among others.

Indicates Expectations as to the company’s future performance.

Page 11: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Which ratios are most important?

It depends on its use Shareholders are most interested in profitability

ratios Suppliers and banks (lenders) are most interested

in liquidity ratios Long-term creditors concentrate on debt utilization

ratios The effective utilization of assets is management’s

responsibility

PPT 3-8

Page 12: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

PPT 3-9Table 3-1aFinancial statements for ratio analysis

SAXTON COMPANY Income Statement For the Year 2002

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%) . . . . . . . . . . . . . . .

Net income . . . . . . . . . . . . . . . . . . . . .* Includes $50,000 in lease payments.

$ 4,000,0003,000,0001,000,000

450,000550,000

50,000100,000400,000200,000

$ 200,000

Page 13: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Balance SheetAs of December 31, 2002

AssetsCash $ 30,000Marketable securities 50,000Accounts receivable 350,000Inventory 370,000 Total current assets 800,000Net plant and equipment 800,000Total assets $1,600,000

Liabilities and Shareholders' EquityAccounts payable $ 50,000Notes payable 250,000

Total current liabilities 300,000Long-term liabilities 300,000

Total liabilities 600,000Common stock 400,000Retained earnings 600,000Total liabilities and shareholders' equity $1,600,000

PPT 3-10Table 3-1bFinancial statements for ratio analysis

Page 14: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Measure overall company profitability for potential investors (income to investment base)

The higher the ratio, the more profitable the firm

Return on Sales Return on Sales

Return on EquityReturn on Equity

Return on AssetsReturn on AssetsNet IncomeSales

Net IncomeTotal Owner’s Equity

Net IncomeTotal Assets

Profitability Ratios

PPT 3-11

Page 15: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Saxton Company Industry Average

3-1. Profit margin = = 5% 6.5%

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

a. = 12.5% 10%

b. 5% 2.5 = 12.5% 6.5% 1.5 = 10%

Net incomeSales

$200,000$4,000,000

Net incomeTotal assets

Net incomeSales

SalesTotal assets

$200,000$1,600,000

PPT 3-12

Profitability ratios(a)

Page 16: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Saxton Company Industry Average3-3. Return on equity (ROE) =

a. = 20% 15%

b. Equity multiplier = = 1.6 =1.5

c. ROA × Equity multiplier = 0.125 × 1.60 = 20% 0.10 × 1.50 = 15%

Total assetsEquity

$1,600,000$1,000,000

Net incomeShareholders’ equity

$200,000$1,000,000

PPT 3-13

Profitability ratios(b)

1 0.6667

Page 17: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Figure 3-1Du Pont analysis

Net income

Sales

Total assets

Profit margin

Asset turnover

Total assets

Equity

Return onassets

Financing plan(Equity multiplier)

Return onEquity=

PPT 3-14

Page 18: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Measure how efficiently the company uses its assets to generate sales

The higher the ratio, the greater the company’s efficiency

Sales Accounts Receivable

Asset Utilization Ratios

Cost of Goods SoldInventory

Inventory Inventory Turnover Turnover

Capital Capital Asset Asset Turnover Turnover

Receivable Receivable Turnover Turnover Sales

Capital Assets

PPT 3-16

Page 19: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Saxton Company Industry Average

3-4a. Receivables turnover =

= 11.4 10 times

3-4b. Average collection period =

= 32 36 days

3-5a. Inventory turnover =

Cost of Goods Sold = 8.1 7 times

Inventory

Sales (credit)Receivables

$4,000,000$350,000

Accounts receivable Average daily credit sales

$350,000$10,959

$3,000,000$370,000

PPT 3-17

Asset utilization ratios(a)

Page 20: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Saxton Company Industry Average

3-5b. Inventory holding period =

= 45 52 days

3-6a. Accounts payable turnover =

= 60.0 12 times

3-6b. Accounts payable period =

Accounts payable = 6 30 days

Average daily purchases

(COGS)

InventoryAverage daily COGS

$370,000$8,219

Cost of goods soldAccounts payable

$3,000,000$50,000

$50,000$8,219

PPT 3-18

Asset utilization ratios(b)

Page 21: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Asset utilization ratios(c)

Saxton Company Industry Average

3-7. Capital asset turnover =

= 5.0 5.4 times

3-8. Total asset turnover =

= 2.5 1.5 times

SalesCapital assets

$4,000,000$800,000

SalesTotal assets

$4,000,000$1,600,000

PPT 3-19

Page 22: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Measure the company’s liquidity (its ability to pay short-term debts)

The higher the ratio, the lower the risk of inability to pay

Current RatioCurrent Ratio

Quick RatioQuick Ratio Current AssetsCurrent Liabilities “Quick” Assets

Current Liabilities

Liquidity Ratios

PPT 3-21

Page 23: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Liquidity ratiosSaxton Company Industry

Average

3-9. Current ratio =

= 2.67 2.1

3-10. Quick ratio =

= 1.43 1.0

Current assetsCurrent liabilities

$800,000$300,000

Current assets – InventoryCurrent liabilities

$430,000$300,000

PPT 3-22

Page 24: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Measure the company’s ability to pay long-term debts The higher the ratio, the less risk of insolvency

Debt Total Assets

Debt Utilization Ratios

Debt-to-Total Assets RatioDebt-to-Total Assets Ratio

Times Interest Times Interest EarnedEarned

Operating Income Interest Expense

Fixed Charge Fixed Charge CoverageCoverage

Operating Income “Fixed” Charges

PPT 3-23

Page 25: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Debt utilization ratiosSaxton Company Industry

Average

3-11. Debt to total assets =

= 37.5% 33%

3-12. Times interest earned =

= 11 7 times

3-13. Fixed charge coverage =

= 6 5.5 times

Total debtTotal assets

$600,000$1,600,000

Income before interest and taxes

Interest$550,000$50,000

Income before fixed charges and taxes

Fixed charges$600,000$100,000

PPT 3-24

Page 26: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Saxton IndustryCompany Average Conclusion

A. Profitability1. Profit margin……………… 5% 6.5% Below average2. Return on assets………..…. 12.5% 10% Above average due

to high turnover3. Return on equity…………. 20% 15% Good due to ratios 2 and 11

B. Asset Utilization4a. Receivables turnover ……... 11.4 10.0 Good4b. Average collection period…. 32.0 36.0 Good5a. Inventory turnover ………... 8.1 7.0 Good5b. Inventory holding period...... 45 52 Good6a. Accounts payable turnover... 60.0 12 Good6b. Accounts payable period...... 6 30 Good

7. Capital asset turnover ……. 5.0 5.4 Below average8. Total asset turnover ………. 2.5 1.5 Good

PPT 3-25

Table 3-2aRatio analysis(a)

Page 27: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Saxton IndustryCompany Average Conclusion

C. Liquidity9. Current ratio ……………… 2.67 2.1 Good

10. Quick ratio ……………….. 1.43 1.0 Good

D. Debt Utilization11. Debt to total assets ……….. 37.5% 33% Slightly more debt12. Times interest earned ……. 11 7 Good13. Fixed charge coverage ……. 6 5.5 Good

PPT 3-26

Table 3-2bRatio analysis(b)

Page 28: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Figure 3-2aTrend analysis

A. Profit Margin Percent

7

5

3

1

1990 1992 1994 1996 1998 2000 2002

Saxton

PPT 3-27

Page 29: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Figure 3-2aCombined analysis

A. Profit Margin Percent

7

5

3

1

1990 1992 1994 1996 1998 2000 2002

Industry

Saxton

PPT 3-27

Page 30: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

B. Total asset turnover

3.5X

3.0X

2.5X

2.0X

1.5X

1.0X

.5X

1990 1992 1994 1996 1998 2000 2002

Saxton

PPT 3-28

Figure 3-2bTrend Analysis

Page 31: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

B. Total asset turnover

3.5X

3.0X

2.5X

2.0X

1.5X

1.0X

.5X

1990 1992 1994 1996 1998 2000 2002

Industry

Saxton

PPT 3-28

Figure 3-2bCombined Analysis

Page 32: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Table 3-3

Trend analysis of competitors

1992199319941995199619971998199920002001

0.610.630.680.680.74

0.66 0.59 0.61 0.79 0.60

Return onAssets

14.114.114.9

15.417.0

17.1 15.2 14.1 18.0 13.8

Return onEquity

Royal Bank Bank of Montreal

0.080.210.700.69

0.70 0.70 0.70 0.65 0.81 0.74

Return on Assets

<0.3>2.4

16.816.617.69.3

18.415.619.816.4

Return onEquity

PPT 3-29

Source: Annual reports www.bmo.com Symbol: BMOwww.rbc.com Symbol: RY

Page 33: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Inflation and it’s Impact on Profits

FIFO (First-In, First-Out) Inventory: Lowers COGS (Cost of Goods Sold) Raises Profits

LIFO (Last-In, First-Out) Inventory: Raises COGS Lowers Profits

PPT 3-31

Page 34: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Notes on the Use of Ratio Analysis Ratio analysis may not answer questions, but leads to further

inquiry and help you ask the right questions It may merely direct attention to potential areas of concern; it does

not provide evidence as to the existence of a problem Ratios that deviate from the norm are only symptoms of the

problem; further analysis is required to isolate the cause of the problem.

A single ratio does not provide sufficient information to judge overall performance.

Be aware that data being compared may not use the same accounting rules applied.

Time series comparisons of ratios may be distorted by inflation. It is difficult to define categorically what a good or bad ratio value

should be. Requires a large dose of good judgment Ratio analysis will rarely be useful if practiced mechanically

Page 35: © 2003 McGraw-Hill Ryerson Limited 3 3 Chapter Financial Analysis McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca

© 2003 McGraw-Hill Ryerson Limited

Summary and Conclusions

Financial analysis involves evaluating and comparing financial performance

Basic tools for financial analysis include financial ratios, trend analysis and cross-sectional analysis

Financial analysis is somewhat hindered by limitations in financial reporting, but can suggest aspects requiring further exploration

PPT 3-32