Financial Analysis

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Ratio Analysis

• Financial ratios– Used to weigh and evaluate the operating

performance of a firm– Numerical calculations and analyzing ratios– Used to compare performance record as

against similar firms in the industry– Additional evaluation of company

management, physical facilities and other factors

– Such data is provided by various organizations

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Ratios and their Classification

A. Profitability ratios: Show the combined effects of liquidity,

asset management, and debt on operating results.

1. Profit margin2. Return on assets (investment)3. Return on equity

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Ratios and their Classification

B. Asset utilization ratios

4. Receivable turnover5. Average collection period6.Inventory turnover7.Fixed asset turnover8.Total asset turnover

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Ratios and their Classification (cont’d)

C. Liquidity ratios 9. Current ratio

10. Quick ratio

D. Debt utilization ratios11. Debt to total assets

12. Times interest earned

13. Fixed charge coverage

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Types of Ratios

• Profitability ratios– Measure the firm’s ability to earn adequate return on:

• Sales• Assets• Invested capital

• Asset utilization ratios– Measure the speed at which the firm is turning over:

• Accounts receivable

• Inventory

• Long-term assets

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Types of Ratios (cont’d)

• Liquidity ratios– Emphasizes the firm’s ability to pay off short-

term obligations as they come due

• Debt utilization ratios– Estimates the overall debt position of the firm– Evaluates in the light of asset base and

earning power

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Importance of Ratios to Users of Financial Statements

• For potential investors/security analysts:– Primary considerations – profitability ratios– Secondary considerations – liquidity and debt

utilization

• For banker or trade creditor – liquidity ratios

• For long-term creditors – debt utilization ratios and profitability ratios

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Financial Statement for Ratio Analysis

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Profitability Ratios

• Profit margin= Net Income/ Sales

• Return on Assets (ROA)= Net Income /

Total Assets

• Return on Equity (ROE) = Net Income /

stock holders’ equity

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Profitability Ratios

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DuPont System of Analysis

• A satisfactory return on assets might be derived through:– a high profit margin, or– a rapid turnover of assets (generating more

sales per dollar of its assets)– or a combination of both

Return on assets (investment) = Profit margin × Asset turnover

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DuPont System of Analysis (cont’d)

• A satisfactory return on equity might be derived through:– a high return on total assets – a generous utilization of debt– or a combination of both

Return on equity = Return on assets (investment)

(1 – Debt/Assets)

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DuPont Analysis

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Return of Wal-Mart versus Abercrombie using the Du Pont method of analysis, 2009

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Asset Utilization Ratios (cont’d)

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Liquidity Ratios

• These ratios determine if the firm can meet

each maturing obligation as it comes due

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Debt Utilization Ratios

• Measures the prudence of the debt management policies of the firm

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Debt Utilization Ratios (cont’d)

• Fixed charge coverage measures the firm’s ability to meet all fixed obligations rather than interest payments aloneIncome before interest and taxes………………..$550,000

Lease payments…………………………………… 50,000

Income before fixed charges and taxes…………$600,000

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Ratio Analysis

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Income Statements

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Explanation of Discrepancies

• Sales– Firm may defer revenue recognition until each

payment received or full recognition at earliest possible date

• Cost of goods sold– Use of different accounting principles .– Varying treatment of R&D costs etc.