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Complete basic problems 1-5 in chapter 3 

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Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Analysis
3

Chapter Outline
Ratio analysis and its importance.
Use of ratio for measurements.
The Du Pont system of analysis.
Trend analysis.
Evaluation of reported income to identify distortion.

Ratio Analysis
Financial ratios
Used to weigh and evaluate the operating performance of a firm.
Used to compare performance record as against other firms in the industry.
Analyzing ratios and numerical calculations.
Such data is provided by various organizations.

Ratios and their Classification
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.

Ratios and their Classification (cont’d)
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.

Types of Ratios
Profitability ratios
Measurement of the firm’s ability to earn an adequate return on:
Sales
Assets
Invested capital
Asset utilization ratios
Measures the speed at which the firm is turning over accounts receivable.

Types of Ratios (cont’d)
Liquidity ratios
Emphasizes the firm’s ability to pay off short-term obligations as and when due.
Debt utilization ratios
Estimates the overall debt position of the firm.
Evaluates in the light of asset base and earning power.

Financial Statement for Ratio Analysis

Profitability Ratios

Administrator (A) – Replace equations with appropriate graphics.

Du Pont System of Analysis
A satisfactory return on assets might be derived through:
A high profit margin
A rapid turnover of assets (generating more sales per dollar of its assets)
Or both
Return of assets (investment) =
(Profit margin) X (Asset turnover)

Du Pont 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 (investments)
[1 – (Debt/ Assets)]

Du Pont Analysis

Examples for Analysis using the Du Pont System

Asset Utilization Ratios
These ratios relate the balance sheet to the income statement.

Administrator (A) – Replace equations with appropriate graphics

Asset Utilization Ratios (cont’d)

Administrator (A) – Replace equations with appropriate graphics

Liquidity Ratios

Administrator (A) – Replace equations with appropriate graphics

Debt Utilization Ratios
Measures the prudence of the debt management policies of the firm.

Administrator (A) – Replace equations with appropriate graphics

Debt Utilization Ratios (cont’d)
Fixed charge coverage measures the firm’s ability to meet the fixed obligations.
Interest payments alone are not considered.

Income before interest and taxes………………..$550,000
Lease payments…………………………………… $50,000
Income before fixed charges and taxes…………$600,000

Summary of Ratio Analysis

Trend Analysis

Trend Analysis in the Computer Industry

Impact of Inflation on Financial Analysis
Inflation
Revenue is stated in current dollars.
Plant, equipment, or inventory may have been purchased at lower price levels.
Profits may be more a function of increasing prices than due to good performance.

Comparison of Replacement and Historical Cost Accounting

Comparison of Replacement and Historical Cost Accounting (cont’d)
Replacement costs – reduces income but increases assets.
An increase lowers the debt-to-assets ratio.
A decrease indicates a decrease in the financial leverage of the firm.
A declining income results in a decreased ability to cover interest costs.

Impact of Disinflation on Financial Analysis
Disinflation
Financial assets such as stocks and bonds have the potentials to do well – encouraging investors.
Tangible assets do not have the potential.
Deflation
Actual reduction of prices affecting everybody due to bankruptcies and declining profits.

Other Elements of Distortion in Reported Income
Effect of changing prices.
Reporting of revenues.
Treatment of nonrecurring items.
Tax write-off policies.

Explanation of Discrepancies

Explanation of Discrepancies (cont’d)
Sales
Use of defer recognition until each payment is received or full recognition at the earliest possible date.
Cost of goods sold
Use of different accounting principles – LIFO versus FIFO.

Explanation of Discrepancies (cont’d)
Extraordinary gains/ losses
Inclusion of events when computing current income or leaving them out.
Net income
Use of different methods of financial reporting.