chapter 3 financial analysis

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CHAPTER 3

Financial Analysis: Sizing up Firm Performance


Learning Objectives

1. Explain what we can learn by analyzing a firm’s financial statements.

2. Use common size financial statements as a tool of financial analysis.

3. Calculate and use a comprehensive set of financial ratios to evaluate a company’s performance.

4. Select an appropriate benchmark for use in performing a financial ratio analysis.

5. Describe the limitations of financial ratio analysis.


Why Do We Analyze Financial Statements?

• An internal financial analysis might be done:– To evaluate employees’ performance –

determine pay raises and bonuses.– To compare the financial performance of the

firm’s different divisions.– To prepare financial projections, eg. launch of a

new product.– To evaluate the firm’s financial performance –

for improvement.


Why Do We Analyze Financial Statements? (cont.)

• An external financial analysis might be done:– Banks: to decide whether to loan money to the

firm.– Suppliers: to grant credit to the firm.– Credit-rating agencies: to determine the firm’s

creditworthiness.– Professional analysts & individual investors: for

investment purposes.


Common Size Statements – Standardizing Financial Information

• A common size financial statement : standardized version of a financial statement in which all entries are presented in percentages.

– For a common size income statement, divide each entry in the income statement by the company’s sales.

– For a common size balance sheet, divide each entry in the balance sheet by the firm’s total assets.


Common Size Income Statement(H. J. Boswell, Inc.)


Common Size Balance Sheet(H. J. Boswell, Inc.)


Using Financial Ratios

Question Category of Ratios Used

1. How liquid is the firm? Will it be able to pay its bills as they become due?

Liquidity ratios

2. How has the firm financed the purchase of its assets?

Capital structure ratios

3. How efficient has the firm’s management been in utilizing it assets to generate sales?

Asset management efficiency ratios

4. Has the firm earned adequate returns on its investments?

Profitability ratios

5. Are the firm’s managers creating value for shareholders?

Market value ratios


Liquidity Ratios

• Liquidity ratios address a basic question: How liquid is the firm?

• A firm is financially liquid if it is able to pay its bills on time. We can analyze a firm’s liquidity from two perspectives:– Overall or general firm liquidity– Liquidity of specific current asset accounts


Liquidity Ratios (cont.)

• Overall liquidity is analyzed by comparing the firm’s current assets to the firm’s current liabilities.

• Liquidity of specific assets is analyzed by examining the timeliness in which the firm’s primary liquid assets – accounts receivable and inventories – are converted into cash.


Liquidity Ratios: Current Ratio

• The overall liquidity of a firm is analyzed by computing the current ratio and acid-test ratio.

• Current Ratio: Current Ratio compares a firm’s current (liquid) assets to its current (short-term) liabilities.


Liquidity Ratios: Quick Ratio

• The overall liquidity of a firm is also analyzed by computing the Acid-Test (Quick) Ratio. This ratio excludes the inventory from current assets as inventory may not always be very liquid.


Liquidity Ratios: Individual Asset Categories

• We can also measure the liquidity of the firm by examining the liquidity of individual current asset accounts, including accounts receivable and inventories.

• We can assess the liquidity of the firm by measuring how long it takes the firm to convert its accounts receivables and inventories into cash.


Liquidity Ratios: Accounts Receivable

• Average Collection Period measures the number of days it takes the firm to collects its receivables.


Liquidity Ratios: Accounts Receivable (cont.)

• Daily Credit Sales – = $2,500 million ÷ 365 days = $6.85 million

• Average Collection Period= Accounts Receivable ÷ Daily Credit

Sales= $139.5m ÷ $6.85m = 20.37 days

• The firm collects its accounts receivable in 20.37 days.


Liquidity Ratios: Accounts Receivable Turnover Ratio

• Accounts Receivable Turnover Ratio measures how many times accounts receivable are “rolled over” during a year.


Liquidity Ratios: Accounts Receivable Turnover Ratio (cont.)

• The text computes the accounts receivable turnover ratio for H.J. Boswell, Inc. for 2010.

• What will be the accounts receivable turnover ratio for 2009 if we assume that the annual credit sales were $2,500 million in 2009?


Liquidity Ratios: Accounts Receivable Turnover Ratio (cont.)

• Accounts Receivable Turnover = $2,500 million ÷ $139.50= 17.92 times

• The firm’s accounts receivable were turning over at 17.92 times per year.


Liquidity Ratios: Inventory Turnover Ratio

• Inventory turnover ratio measures how many times the company turns over its inventory during the year. Shorter inventory cycles lead to greater liquidity since the items in inventory are converted to cash more quickly.


Liquidity Ratios: Inventory Turnover Ratio (cont.)

• The text computes the inventory turnover ratio for H.J. Boswell, Inc. for 2010.

• What will be the inventory turnover ratio for 2009 if we assume that the cost of goods sold were $1,980 million in 2009?


Liquidity Ratios: Inventory Turnover Ratio (cont.)

• Inventory Turnover Ratio= $1,980 ÷ $229.50= 8.63 times

• The firm turned over its inventory 8.63 times per year.


Liquidity Ratios: Days’ Sales in Inventory

• We can express the inventory turnover ratio in terms of the number of days the inventory sits unsold on the firm’s shelves.

• Days’ Sales in Inventory = 365÷ inventory turnover ratio= 365 ÷ 8.63 = 42.29 days

• The firm, on average, holds it inventory for about 42 days.


Can a Firm Have Too Much Liquidity?

• A high investment in liquid assets will enable the firm to repay its current liabilities in a timely manner.

• However, an excessive investments in liquid assets can prove to be costly as liquid assets (such as cash) generate minimal return.


Capital Structure Ratios

• Capital structure refers to the way a firm finances its assets.

• Capital structure ratios address the important question: How has the firm financed the purchase of its assets?

• We will use two ratios, debt ratio and times interest earned ratio, to answer the question.


Capital Structure Ratios (cont.)

• Debt ratio measures the proportion of the firm’s assets that are financed by borrowing or debt financing.



• The text computes the debt ratio for H.J. Boswell, Inc. for 2010.

• What will be the debt ratio for 2009?



• Debt Ratio – = $1,012.50 million ÷ $1,764 million– = 57.40%

• The firm financed 57.39% of its assets with debt.



• Times Interest Earned Ratio measures the ability of the firm to service its debt or repay the interest on debt.

– We use EBIT or operating income as interest expense is paid before a firm pays its taxes.



• The text computes the times interest earned ratio for H.J. Boswell, Inc. for 2010.

• What will be the times interest earned ratio for 2009 if we assume interest expense of $65 million and EBIT of $350 million?



• Times Interest Earned = $350 million ÷ $65 million = 5.38

times• Thus the firm can pay its total interest expense

5.38 times or interest consumed 1/5.38th or 18.58% of its EBIT. Thus, even if the EBIT shrinks by 81.42% (100-18.58), the firm will be able to pay its interest expense.


Asset Management Efficiency Ratios

• Asset management efficiency ratios measure a firm’s effectiveness in utilizing its assets to generate sales.

• They are commonly referred to as turnover ratios as they reflect the number of times a particular asset account balance turns over during a year.


Asset Management Efficiency Ratios (cont.)

• Total Asset Turnover Ratio represents the amount of sales generated per dollar invested in firm’s assets.



• The text computes the total asset turnover ratio for H.J. Boswell, Inc. for 2010.

• What will be the total asset turnover ratio for 2009 if we assume the total sales in 2009 were $2,500 million?



• Total Asset Turnover– = $2,500 million ÷ $1,764 million = 1.42 times

• Thus the firm generated $1.42 in sales per dollar of assets in 2009.



• Fixed asset turnover ratio measures firm’s efficiency in utilizing its fixed assets (such as property, plant and equipment).



• The text computes the fixed asset turnover ratio for H.J. Boswell, Inc. for 2010.

• What will be the fixed asset turnover ratio for 2009 if we assume sales of $2,500 million for 2009?



• Fixed Asset Turnover– = $2,500 million ÷ $1,287 million = 1.94

times

• The firm generated $1.94 in sales per dollar invested in plant and equipment.



• We could similarly compute the turnover ratio for other assets.

• We had earlier computed the receivables turnover and inventory turnover, which measured firm effectiveness in managing its investments in accounts receivables and inventories.



For Boswell, 2010• Total Asset Turnover

= Sales ÷ Total Assets= $2,700m ÷ $1,971m =

1.37• Fixed Asset Turnover

= Sales ÷ Net Plant and Equipment

= $2,700m ÷$1,327.5m = 2.03



For Boswell, 2010• Receivables Turnover

= Credit Sales ÷ Accounts Receivable= $2,700m ÷ $162m = 16.67 times

• Inventory Turnover= Cost of Goods Sold ÷ Inventories= $2,025m ÷$378m = 3.36 times



• The following grid summarizes the efficiency of Boswell’s management in utilizing its assets to generate sales in 2010.

Turnover Ratio

Boswell Peer Group

Assessment

Total Assets

1.37 1.15 Good

Fixed Assets

2.03 1.75 Good

Receivables

16.67 14.60 Good

Inventory 5.36 7.0 Poor


Profitability Ratios

• Profitability ratios address a very fundamental question: Has the firm earned adequate returns on its investments?

• We answer this question by analyzing the firm’s profit margin, which predict the ability of the firm to control its expenses, and the firm’s rate of return on investments.


Profitability Ratios (cont.)

• Two fundamental determinants of firm’s profitability and returns on investments are the following:– Cost Control

• Is the firm controlling costs and earning reasonable profit margin?

– Efficiency of asset utilization• Is the firm efficiently utilizing the assets to generate

sales?



• Gross profit margin shows how well the firm’s management controls its expenses to generate profits.



• The text computes the gross profit margin ratio for H.J. Boswell, Inc. for 2010.

• What will be the gross profit margin ratio for 2009 if we assume sales of $2,500 million and gross profit of $650 million for 2009?



• Gross Profit Margin – = $650 million ÷ $2,500 million = 26%

• The firm spent $0.74 for cost of goods sold for each dollar of sales. Thus, $0.26 out of each dollar of sales goes to gross profits.



• Operating Profit Margin measures how much profit is generated from each dollar of sales after accounting for both costs of goods sold and operating expenses. It thus also indicates how well the firm is managing its income statement.



• The text computes the operating profit margin ratio for H.J. Boswell, Inc. for 2010.

• What will be the operating profit margin ratio for 2009 if we assume sales of $2,500 million and net operating income of $350 million for 2009?



• Operating Profit Margin= $350 million ÷ $2,500 million = 14%

• Thus the firm generates $0.14 in operating profit for each dollar of sales.



• Net Profit Margin measures how much income is generated from each dollar of sales after adjusting for all expenses (including income taxes).

•



• The text computes the net profit margin ratio for H.J. Boswell, Inc. for 2010.

• What will be the net profit margin ratio for 2009 if we assume sales of $2,500 million and net income of $217.75 million for 2009?



• Net Profit Margin – = $217.75 million ÷ $2,500 million = 8.71%

• The firm generated $0.087 for each dollar of sales after all expenses (including income taxes) were accounted for.



• Operating Return on Assets ratio is the summary measure of operating profitability, which takes into account both the management’s success in controlling expenses, contributing to profit margins, and its efficient use of assets to generate sales.



• The text computes the operating return on assets ratio for H.J. Boswell, Inc. for 2010.

• What will be the operating return on assets ratio for 2009 if we assume EBIT or net operating income of $350 million for 2009?



• Operating Return on Assets– = $350 million ÷$1,764 million = 19.84%

• The firm generated $0.1984 of operating profits for every $1 of its invested assets.



• Decomposing the OROA ratio: We can use the following equation to decompose the OROA ratio that allows us to analyze the firm’s ability to control costs and utilize its investments in assets efficiently.


Figure 4-1 Observations

• Firm’s OROA (operating return on assets) is better than its peers. Thus the firm earned more net operating income per dollar invested in assets.

• Firm’s OPM (operating profit margin) is lower than its peers. Thus the firm retained a lower percentage of its sales in net operating income.

• Firm’s TATO (total asset turnover ratio) is higher than its peers. Thus the firm generated more sales from its assets.


Figure 4-1 Recommendations

• The firm has two opportunities to improve its profitability:

1.Reduce costs - The firm must investigate the cost of goods sold and operating expenses to see if there are opportunities to reduce costs.

2.Reduce inventories – The firm must investigate if it can reduce the size of its inventories.


Is the Firm Providing a Reasonable Return on the Owner’s Investment?

• A firm’s net income consists of earnings that is available for distribution to the firm’s shareholders. Return on Equity ratio measures the accounting return on the common stockholders’ investment.


Is the Firm Providing a Reasonable Return on the Owner’s Investment (cont.)

• The text computes the return on equity ratio for H.J. Boswell, Inc. for 2010.

• What will be the return on equity ratio for 2009 if we assume net income of $217.75 million for 2009?


Is the Firm Providing a Reasonable Return on the Owner’s Investment (cont.)

• Return on Equity – = $217.75 million ÷ $751.50 million = 28.98%

• Thus the shareholders earned 28.97% on their investments. • Note common equity includes both common stock plus the

firm’s retained earnings.


Using the DuPont Method for Decomposing the ROE ratio

• DuPont method analyzes the firm’s ROE by decomposing it into three parts: profitability, efficiency and an equity multiplier.

– ROE = Profitability × Efficiency × Equity Multiplier

• Equity multiplier captures the effect of the firm’s use of debt financing on its return on equity. The equity multiplier increases in value as the firm uses more debt.


Using the DuPont Method for Decomposing the ROE ratio (cont.)

• ROE = Profitability × Efficiency × Equity Multiplier

• ROE = Net Profit Margin × Total Asset Turnover Ratio × 1/(1-debt ratio)



• The following table shows why Boswell’s return on equity was higher than its peers.

Return on

Equity

Net Profit

Margin

Total Asset

Turnover

EquityMultipli

er

H. J. Boswell, Inc.

22.5% 7.6% 1.37 2.16

Peer Group

18.0% 10.2% 1.15 1.54



• The table suggests that Boswell had a higher ROE as it was able to generate more sales from its assets (1.37 versus 1.15 for peers) and used more leverage (2.16 versus 1.54).

• Note use of financial leverage may not always generate value for shareholders. Impact of financial leverage is discussed in detail in chapter 15.


Market Value Ratios

• Market value ratios address the question, how are the firm’s shares valued in the stock market?

• Two market value ratios are:– Price-Earnings Ratio– Market-to-Book Ratio


Market Value Ratios (cont.)

• Price-Earnings (PE) Ratio indicates how much investors are currently willing to pay for $1 of reported earnings.



• The text computes the PE ratio for H.J. Boswell, Inc. for 2010.

• What will be the PE ratio for 2009 if we assume the firm’s stock was selling for $22 per share at a time when the firm reported a net income of $217.75 million, and the total number of common shares outstanding are 90 million?



• Earnings per share – = $217.75 million ÷ 90 million = $2.42

• PE ratio = $22 ÷ $2.42 = 9.09• The investors were willing to pay $9.09 for

every dollar of earnings per share that the firm generated.



• Market-to-Book Ratio measures the relationship between the market value and the accumulated investment in the firm’s equity.



• The text computes the market-to-book ratio for H.J. Boswell, Inc. for 2010.

• What will be the market-to-book ratio for 2009 given that the current market price of the stock is $22 and the firm has 90 million shares outstanding?



• Book Value per Share – = 751.50 million ÷ 90 million = $8.35 per

share

• Market-to-Book Ratio= Market price per share ÷ Book value per share= $22 ÷ $8.35 = 2.63 times


Selecting a Performance Benchmark

• There are two types of benchmarks that are commonly used:– Trend Analysis – involves comparing a firm’s

financial statements over time.– Peer Group Comparisons – involves comparing

the subject firm’s financial statements with those of similar, or “peer” firms. The benchmark for peer groups typically consists of firms from the same industry or industry average financial ratios.


Trend Analysis


Financial Analysis of the Gap, Inc., June 2009


The Limitations of Ratio Analysis

1. Picking an industry benchmark can sometimes be difficult.

2. Published peer-group or industry averages are not always representative of the firm being analyzed.

3. An industry average is not necessarily a desirable target or norm.


The Limitations of Ratio Analysis (cont.)

4. Accounting practices differ widely among firms.5. Many firms experience seasonal changes in their

operations.6. Financial ratios offer only clues. We need to

analyze the numbers in order to fully understand the ratios.

7. The results of financial analysis are dependent on the quality of the financial statements.

chapter 3 financial analysis

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