© 2003 mcgraw-hill ryerson limited 3 3 chapter financial analysis mcgraw-hill ryerson©2003...
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© 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
© 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
© 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
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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
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Approaches to Ratio Analysis
Cross-Sectional Analysis Trend analysis Combined Analysis Common-size statements
PPT 3-4
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4 Categories of Ratios
Profitability Ratios
Asset Utilization Ratios
Liquidity Ratios
Debt Utilization Ratios
PPT 3-5
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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
© 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
© 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
© 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.
© 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
© 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
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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
© 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
© 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)
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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
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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
© 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
© 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)
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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)
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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
© 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
© 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
© 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
© 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
© 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)
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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)
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Figure 3-2aTrend analysis
A. Profit Margin Percent
7
5
3
1
1990 1992 1994 1996 1998 2000 2002
Saxton
PPT 3-27
© 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
© 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
© 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
© 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
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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
© 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
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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