TCH3 Chapter 3 Financial Analysis

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3
Chapter
Financial Analysis
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Chapter 3 - Outline

• Financial Analysis
• 4 Categories of Financial Ratios
• Importance of Ratios
• Inflation and its Impact on Profits

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What is financial analysis?

• Evaluating a firms financial performance
• Analyzing ratios or numerical calculations
• Comparing a company to its industry

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4 Categories of Ratios

• Profitability Ratiosability of the firm to earn
  an adequate return and control costs.
• Asset Utilization RatiosHow efficiently the
  firms assets are being utilized.
• Liquidity Ratiosfocus on short term risk
  management.
• Debt Utilization Ratiosfocus on the capital
  structure and long-term risk management.

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Classification System
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.
• B. Asset utilization ratios.
• 4. Receivable turnover.
• 5. Average collection period.
• 6. Inventory turnover.
• 7. Fixed asset turnover.
• 8. Total asset turnover.
• 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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PPT 3-2
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Profitability Ratios show how profitable a
company is.
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Profitability ratios express

• Profit Margin or Return on Sales ()what
  fraction of sales goes to the bottom line.
• Return on Assets or Return on Investment ()what
  percent are we earning on the assets we have
  invested in the firm.
• Return on Equity ()probably of most interest to
  shareholders

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Profitability RatiosPage 58
T 3-3

• Saxton Company Industry Average
• 1. Profit margin 5 6.7
• 2. Return on assets (investment)
• a. 12.5 10
• b. 5 ? 2.5 12.5 6.7 ? 1.5 10
• 3. Return on equity
• a. 20 15
• b. 20 15

?
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Figure 3-1DuPont analysisPage 60
T 3-4
Net Income
?
Profit Margin
Return on Assets
?
Sales
?
Asset Turnover
Return on Equity
Total Assets
Return on Assets ? (1 - Debt/Assets)

Total Debt
Financing Plan
?
Total Assets
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Table 3-2 (Page 58) illustrates a very important
point

• IN ORDER TO PROPERLY INTERPRET A RATIO, WE MUST
  KNOW WHAT THE COMPANY IS TRYING TO ACCOMPLISH.
• Ratios are a diagnostic tool that tells us
  whether we are properly executing our plan.

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PPT 3-5
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Asset Utilization Ratios show how effectively a
company uses its assets.
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Asset Utilization ratios express

• Receivables Turnover (times)In a 360 day year,
  how many times do our receivables turn over in
  terms of sales.
• Average Collection Period (days)the inverse of
  receivables turnover.
• Inventory Turnover (times)how many times must we
  replenish inventory to achieve this level of
  salesoften, COGS is used instead of sales.
• Fixed Asset Turnover (times)how many times would
  our fixed assets turnover to represent this level
  of sales.
• Total Asset Turnover (times)this is a
  combination of the above ratios.

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Asset Utilization RatiosPage 60-61
T 3-6
Saxton Company Industry Average 4.
Receivables turnover
11.4 10 times 5. Average collection period
32 36 days 6. Inventory
turnover 10.8 7 times
Accounts receivable Average daily credit sales
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Asset Utilization RatiosPage 61
T 3-6
Saxton Company Industry Average 7. Fixed
asset turnover 5 5.4
times 8. Total asset turnover 2.5
1.5 times
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Profitability and Turnover Ratios

• Remember
• Return on X Net Income / X
• X Turnover Sales / X

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Liquidity Ratios show how liquid a company is or
how much it has to meet S/T needs.
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Liquidity ratios express

• Current Ratio (times)how many times our current
  assets, if liquidated, pay our current
  liabilities?
• Quick Ratio or Acid-Test Ratio (times) excluding
  inventory, how many times will our current
  assets, if liquidated, cover our current
  liabilities?

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Liquidity RatiosPage 61
T 3-7
Saxton Company Industry Average 9.
Current ratio
2.67 2.1 10. Quick ratio 1.43
1.0
800,000 300,000
430,000 300,000
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Debt Utilization Ratios show how well a company
is managing or using debt.
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Debt utilization ratios express

• Debt-to-Total Assets ()debt as a percent of
  total assetswhat part of assets is financed with
  long-term debt.
• Times Interest Earned (times)a measure of
  safetyhow many times will our EBIT cover
  interest expenses?
• Fixed Charge Coverage (times)income before fixed
  charges and taxes divided by fixed charges
• (Fixed Charges lease payments, i expense)

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Debt Utilization RatiosPage 62
T 3-8
Saxton Company Industry Average 11. Debt
to total asets
37.5 33 12. Times interest earned
11 7 times 13. Fixed charge coverage
6 5.5 times
600,000 1,600,000
550,000 50,000
600,000 100,000
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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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Table 3-3--Ratio AnalysisPage 62
T 3-9

• Saxton Industry
• Company Average Conclusion
• A. Profitability
• 1. Profit Margin 5.0 6.7 Below
  average
• 2. Return on Assets .. 12.5 10.0 Above
  average due to high turnover
• 3. Return on Equity .. 20.0 15.0 Good
  due to ratios 2 and 10
• B. Asset Utilization
• 4. Receivables turnover . 11.4 10.0 Good
• 5. Average collection period. 32.0 36.0 Good
• 6. Inventory turnover ... 10.8 7.0 Good
• 7. Fixed asset turnover . 5.0 5.4 Below
  average
• 8. Total asset turnover . 2.5 1.5 Good
• C. Liquidity
• 9. Current ratio 2.67 2.1 Good
• 10. Quick Ratio .. 1.43 1.0 Good
• D. Debt Utilization
• 11. Debt to total assets .. 37.5 33.0 Slig
  htly more debt
• 12. Times interest earned . 11.0 7.0 Good
• 13. Fixed charge coverage ... 6.0 5.5 Good

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Interpreting ratios
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Understand the strategic plan of the firm before
you begin.
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Compare the ratios of other, similar firms at a
given point in time.

• Do NOT assume that if your firm is different, it
  is necessarily bad.
• Be sure you compensate for firm size and other
  differences.

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Perform a trend analysis (over time) to spot
trendsgood or bad.
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Dont jump to conclusionsratios are only a
starting pointyou must figure out WHY the ratio
is what it isremember Wal Mart and Dillards
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Bigger isnt necessarily always betteror worse.
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When in doubt, talk to managementask questions
and study the industry.
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Figure 3-2Trend analysisPage 64
T 3-10
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Figure 3-2Trend AnalysisPage 64
T 3-10
B. Total asset turnover
3.5X 3.0X 2.5X 2.0X 1.5X 1.0X .5X
Saxton
Industry
1985 1987 1989 1991
1993 1995 1997
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Table 3-4 (next) shows how intense competition in
the computer industry has caused return to
decline over time.
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Impact of inflation on Financial Analysis
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Because accountants use historical cost as a
basis for certain expenses, expenses do not keep
up with revenue on the income statement.
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The result of accountants using historical costs
is that revenue can increase, even though no
change has really occurred in the underlying
business.
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The next example illustrates how use of
historical cost accounting can distort results.
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Stein company (Table 3-5 and Table 3-6
combined)Page 65
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The effect of Inflation on financial numbers
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Table 3-7 (Page 66) shows selected financial data
for 10 Chemical companies and 8 Drug companies.
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Table 3-7 / Comparison of replacement cost
accounting and historical cost accountingPage 66
T 3-12

• 10 Chemical
  8 Drug Companies
  Companies
• Replacement Historical Replacement Historical C
  ost Cost Cost Cost
• Increase in assets. . . . . . .
  . 28.4 -- 15.4 --
• Decrease in net incomebefore taxes . . . . . . .
  . . 45.8 -- 19.3 --
• Return on assets . . . . . . . . 2.8 6.2 8.3 11
  .4
• Return on equity. . . . . . . . 4.9 13.5 12.8 1
  9.6
• Debt-to-assets ratio. . . . . . 34.3 43.8 30.3
  35.2
• Interest coverage ratio (times interest
  earned) 7.1? 8.4? 15.4? 16.7?

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The column labeled Replacement cost shows what
the numbers would be if inflation were properly
considered.
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The column labeled historical cost shows what the
numbers actually were.
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Replacement cost

• Reduces income
• Increases assets
• Debt-to-asset ratio is lowered since debt does
  not inflate.
• Declining income causes interest coverage ratio
  to decline.
• Return on assets drops because assets increase
  while net income drops.

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Disinflationary Effect
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Disinflation means expensive inventory is charged
against softening sales.
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Cyclical industries are most susceptible to
sudden declines in earnings as business slows
(disinflation).
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Disinflation means financial assets will appear
more attractive as investments.
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Disinflation means bankruptcies can increase.
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None of these effects of disinflation occurs with
any degree of regularity.
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Elements of distortion in reported income (other
than disinflation)
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The Table 3-8Page 68shows two pictures of the
same company and how they vary depending on which
accounting conventions are used.
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Here is why the aggressive income is higher

• Company B used aggressive revenue recognition
  (booking installment sales immediately, etc.)
• Company B is using FIFO, matching cheap costs
  with current revenue.
• Company B chose not to recognize the
  extraordinary (nonrecurring) loss on the
  statement until AFTER net-income is computed.

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Financial analysts spend lots of time and effort
undoing what companies and accountants do, so
that similar companies can be accurately compared.
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PPT 3-13
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Inflations Impact on Profits

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

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THE END