Chapter

3 Financial Analysis
Financial Analysis

What is financial analysis?

 Evaluating a firm’s financial performance

 Ratios are calculated by dividing one value on

financial statements by another related value

 Used to weight and evaluate operating

performance of a firm
 A long-run trend analysis over a number of

years shows changes over time

Ratios, trends and other calculations are
used to interpret and compare the
financial performance of a company to
its industry and to its past results
Financial analysis may not answer

questions, but leads to further inquiry.

4 Primary Categories of Ratios

Profitability Ratios

Asset Utilization Ratios

Liquidity Ratios

Debt Utilization Ratios

Classification system for ratios
A. Profitability Ratios
1. Profit margin
2. Return on assets (ROA) (investment)
3. Return on equity (ROE) (common shareholders)
B. Asset Utilization Ratios
4. Receivable turnover
5. Average collection period (days sales outstanding)
6. Inventory turnover
7. Fixed Asset turnover
8. Total asset turnover
Four categories of financial ratios
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
Importance of Ratios
 ProfitabilityRatios: Measures the ability of the firm
to earn an adequate return on sales, total assets and
invested capital
 Asset Utilization Ratios: Measures the speed at

which the firm is turning over accounts receivables,

inventory and longer term assets.
 They measure how many times per year a firm sells
its inventory or collect all of its accounts receivables.
 For long term assets, they tell us how productive the

fixed assets are in terms of generating sales.

 Liquidity Ratios: Measures the firm’s ability
to pay off short term obligations as they come
due.

 DebtUtilization Ratio: Shows the overall

debt of the firm in the light of asset base and
earning power.
Importance of Ratios
Which ratios are most important?
It depends on your perspective
 Suppliers and banks (lenders) are most interested

in liquidity ratios
 Shareholders are most interested in profitability

ratios
 Long-term creditors concentrate on debt utilization

ratios
 The effective utilization of assets is management’s

responsibility
 Table 3-1a
Financial statements for ratio analysis

SAXTON COMPANY
Income Statement
For the Year Ended Dec 31, 2015

Sales (all on credit) . . . . . . . . . . . . . . . . . . $ 4,000,000

Cost of goods sold . . . . . . . . . . . . . . . . . . 3,000,000
Gross profit . . . . . . . . . . . . . . . . . . . . . 1,000,000
Selling and administrative expense* . . . . . . . . . . . 450,000
Operating profit . . . . . . . . . . . . . . . . . . . 550,000
Interest expense . . . . . . . . . . . . . . . . . . 50,000
Extraordinary loss . . . . . . . . . . . . . . . . . . 200,000
Net income before taxes . . . . . . . . . . . . . . . . 300,000
Taxes (33%) . . . . . . . . . . . . . . . 100,000

Net income . . . . . . . . . . . . . . . . . . . . . $ 200,000

* Includes $50,000 in lease payments.
 PPT 3-10
Table 3-1b
Financial statements for ratio analysis
Balance Sheet
As of December 31, 2015
Assets
Cash $ 30,000
Marketable securities 50,000
Accounts receivable 350,000
Inventory 370,000
Total current assets 800,000
Net plant and equipment 800,000
Total assets $1,600,000
Liabilities and Shareholders' Equity
Accounts payable $ 50,000
Notes payable 250,000
Total current liabilities 300,000
Long-term liabilities 300,000
Total liabilities 600,000
Common stock 400,000
Retained earnings 600,000
Total liabilities and shareholders' equity $1,600,000
 Profitability Ratios

 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 Assets

Net Income Net Income
Sales Total Assets
Net Income
Total Owner’s Equity

Return on Equity
 PPT 3-12

Profitability ratios(a)
Saxton Company Industry Average

3-1. Profit margin = Net income $200,000

= 5% 6.7%
Sales $4,000,000
3-2. Return on assets (ROA) (investment) =

a. Net income
= 12.5% $200,000 10%
Total assets $1,600,000

b. 5%  2.5 = 12.5% 6.7%  1.5 = 10%

Net income  Sales
Sales Total assets
 Profitability ratios(b)
Saxton Company Industry Average
3-3. Return on equity (ROE) =

a. Net income
= 20% $200,000 15%
Shareholders’ equity $1,000,000

b. Equity multiplier = Total assets $1,600,000

= 1.6 =1.5 1
Equity $1,000,000 0.6667

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

 PPT 3-14
Figure 3-1
Du Pont analysis

Net income
 Profit margin
Return on
Sales  assets
 Asset
turnover
Total assets Return on
 = Equity
Total assets
Financing plan
 (Equity multiplier)
Equity
Asset Utilization Ratios
 Measure how efficiently the company uses its assets to
generate sales
 The higher the ratio, the greater the company’s efficiency

Sales
Accounts Receivable Capital Asset

Receivable Inventory Turnover

Turnover Sales
Turnover
Capital Assets
Cost of Goods Sold
Inventory
Asset utilization ratios(a)
Saxton Company Industry Average

3-4a. Receivables turnover =

Sales (credit) $4,000,000
= 11.4 10 times
Receivables $350,000

3-4b. Average collection period =

Accounts receivable
= 32 $350,000
36 days
Average daily credit sales $10,959
3-5a. Inventory turnover =
Cost of Goods Sold = 8.1
$3,000,000 7 times
Inventory $370,000
Asset utilization ratios(b)
Saxton Company Industry Average

3-5b. Inventory holding period =

Inventory = 45 $370,000
52 days
Average daily COGS $8,219

3-6a. Accounts payable turnover =

Cost of goods sold
= 60.0 $3,000,000
12 times
Accounts payable $50,000
3-6b. Accounts payable period =
Accounts payable =6
$50,000 30 days
Average daily purchases $8,219
(COGS)
Asset utilization ratios
Saxton Company Industry Average

3-7. Capital asset turnover =

Sales $4,000,000
= 5.0 5.4 times
Capital assets $800,000

3-8. Total asset turnover =

Sales = 2.5 $4,000,000
1.5 times
Total assets $1,600,000
Return on Assets
Return on Assets (ROA) = Profit margin × Total asset

turnover

= Net income × Sales

Sales Total assets

= Net income
Assets

Any increase in net income increases ROA

Any decrease in assets increases ROA
 Liquidity Ratios

 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 Ratio
Current Assets Quick Ratio
Current Liabilities “Quick” Assets
Current Liabilities
Liquidity ratios
Saxton Company Industry Average

3-9. Current ratio =

Current assets $800,000
= 2.67 2.1
Current liabilities $300,000

3-10. Quick ratio =

Current assets – Inventory
= 1.43 $430,000
1.0
Current liabilities $300,000
Debt Utilization Ratios
 Measure the company’s ability to pay long-term debts
 The higher the ratio, the less risk of insolvency

Fixed Charge Times Interest

Coverage Earned
Operating Income Operating Income
Debt
“Fixed” Charges Interest Expense
Total Assets

Debt-to-Total Assets Ratio

Debt utilization ratios
Saxton Company Industry Average
3-11. Debt to total assets =
Total debt = 37.5% $600,000
33%
Total assets $1,600,000
3-12. Times interest earned =

Income before
interest and taxes
= 11 $550,000
7 times
Interest $50,000
3-13. Fixed charge coverage =
Income before
fixed charges and taxes
=6 $600,000
5.5 times
Fixed charges $100,000
 Table 3-2a
Ratio analysis(a)
Saxton Industry
Company Average Conclusion
A. Profitability
1. Profit margin……………… 5% 6.5% Below average
2. Return on assets………..…. 12.5% 10% Above average
due to high turnover
3. Return on equity…………. 20% 15% Good
due to ratios 2 and 11
B. Asset Utilization
4a. Receivables turnover ……... 11.4 10.0
Good
4b. Average collection period…. 32.0 36.0
Good
5a. Inventory turnover ………... 8.1 7.0
Good
5b. Inventory holding period...... 45 52
Good
6a. Accounts payable turnover... 60.0 12 Good
6b. Accounts payable period...... 6 30
Good
7. Capital asset turnover ……. 5.0 5.4 Below
Table 3-2b
Ratio analysis(b)
Saxton Industry
Company Average Conclusion
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%
Slightly more debt
12. Times interest earned ……. 11 7 Good
13. Fixed charge coverage ……. 6
5.5 Good
Figure 3-2a
Trend analysis

A. Profit Margin
Percent

Industry
7
Saxton
5

1
1990 1992 1994 1996 1998 2000 2002
Figure 3-2b
Trend Analysis

B. Total asset turnover

3.5X
3.0X
2.5X Saxton
2.0X
1.5X
1.0X Industry
.5X
1990 1992 1994 1996 1998 2000 2002
Summary and Conclusions
Financial analysis involves
evaluating and comparing financial
performance

Basic tools for financial analysis

include financial ratios and trend
analysis

Financial analysis is somewhat

hindered by limitations in financial
reporting, but can suggest aspects
requiring further exploration