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## T-CH3 Chapter 3 Financial Analysis

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Title: T-CH3 Chapter 3 Financial Analysis

1
3
Chapter
Financial Analysis
2
Chapter 3 - Outline
• Financial Analysis
• 4 Categories of Financial Ratios
• Importance of Ratios
• Inflation and its Impact on Profits

3
What is financial analysis?
• Evaluating a firms financial performance
• Analyzing ratios or numerical calculations
• Comparing a company to its industry

4
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.

5
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.

6
PPT 3-2
7
Profitability Ratios show how profitable a
company is.
8
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

9
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

?
10
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
11
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.

12
PPT 3-5
13
Asset Utilization Ratios show how effectively a
company uses its assets.
14
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.

15
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
16
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
17
Profitability and Turnover Ratios
• Remember
• Return on X Net Income / X
• X Turnover Sales / X

18
Liquidity Ratios show how liquid a company is or
how much it has to meet S/T needs.
19
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?

20
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
21
Debt Utilization Ratios show how well a company
is managing or using debt.
22
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)

23
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
24
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.

25
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

26
Interpreting ratios
27
Understand the strategic plan of the firm before
you begin.
28
Compare the ratios of other, similar firms at a
given point in time.
• Do NOT assume that if your firm is different, it
• Be sure you compensate for firm size and other
differences.

29
Perform a trend analysis (over time) to spot
30
starting pointyou must figure out WHY the ratio
is what it isremember Wal Mart and Dillards
31
Bigger isnt necessarily always betteror worse.
32
When in doubt, talk to managementask questions
and study the industry.
33
Figure 3-2Trend analysisPage 64
T 3-10
34
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
35
Table 3-4 (next) shows how intense competition in
decline over time.
36
(No Transcript)
37
Impact of inflation on Financial Analysis
38
Because accountants use historical cost as a
basis for certain expenses, expenses do not keep
up with revenue on the income statement.
39
The result of accountants using historical costs
is that revenue can increase, even though no
change has really occurred in the underlying
40
The next example illustrates how use of
historical cost accounting can distort results.
41
Stein company (Table 3-5 and Table 3-6
combined)Page 65
42
The effect of Inflation on financial numbers
43
Table 3-7 (Page 66) shows selected financial data
for 10 Chemical companies and 8 Drug companies.
44
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?

45
The column labeled Replacement cost shows what
the numbers would be if inflation were properly
considered.
46
The column labeled historical cost shows what the
numbers actually were.
47
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.

48
Disinflationary Effect
49
Disinflation means expensive inventory is charged
against softening sales.
50
Cyclical industries are most susceptible to
sudden declines in earnings as business slows
(disinflation).
51
Disinflation means financial assets will appear
more attractive as investments.
52
Disinflation means bankruptcies can increase.
53
None of these effects of disinflation occurs with
any degree of regularity.
54
Elements of distortion in reported income (other
than disinflation)
55
The Table 3-8Page 68shows two pictures of the
same company and how they vary depending on which
accounting conventions are used.
56
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.

57
Financial analysts spend lots of time and effort
undoing what companies and accountants do, so
that similar companies can be accurately compared.
58
PPT 3-13
59
Inflations Impact on Profits
• FIFO (First-In, First-Out) Inventory
• Lowers COGS
• Raises Profits
• LIFO (Last-In, First-Out) Inventory
• Raises COGS
• Lowers Profits

60
THE END