Financial Analysis Notes

Importance of Ratio Analysis

• Ratios serve as a measurement tool to evaluate a firm's performance.
• DuPont analysis system helps in understanding the factors driving return on equity.
• Trend analysis provides insights into a company's performance over time.
• Ratios are used to evaluate operating performance, compare against industry peers, and assess management and facilities.

Ratio Analysis

• Financial ratios are crucial for evaluating a firm's operating performance.
• Analysis involves numerical calculations and comparisons against similar firms in the industry.
• Additional evaluations consider company management, physical facilities, and other relevant factors.
• Various organizations provide data for ratio analysis.

Ratios and Their Classification

• Profitability ratios:
  • Profit margin
  • Return on assets (investment)
  • Return on equity
• Asset-utilization ratios:
  • Receivable turnover
  • Average collection period
  • Inventory turnover
  • Fixed asset turnover
  • Total asset turnover
• Liquidity ratios:
  • Current ratio
  • Quick ratio
• Debt-utilization ratios:
  • Debt to total assets
  • Times interest earned
  • Fixed charge coverage

Types of Ratios

• Profitability ratios measure a firm’s ability to earn an adequate return on sales, assets, and invested capital.
• Asset-utilization ratios measure the speed at which a firm turns over accounts receivable, inventory, and long-term assets.
• Liquidity ratios emphasize a firm’s ability to pay off short-term obligations as they come due.
• Debt-utilization ratios estimate the overall debt position of a firm and are evaluated in light of the asset base and earning power.

Importance of Ratios to Financial Statement Users

• Potential investors/security analysts:
  • Primary consideration: profitability ratios
  • Secondary considerations: liquidity and debt utilization
• Bankers or trade creditors: liquidity ratios
• Long-term creditors: debt utilization ratios and profitability ratios

Financial Statement for Ratio Analysis

• Income Statement (For the Year Ended December 31, 2013):
  • Sales (all on credit): $4,000,000$
  • Cost of goods sold: $3,000,000$
  • Gross profit: $1,000,000$
  • Selling and administrative expense (includes $50,000$ in lease payments): $450,000$
  • Operating profit: $550,000$
  • Interest expense: $50,000$
  • Extraordinary loss: $200,000$
  • Net income before taxes: $300,000$
  • Taxes (33%): $100,000$
  • Net income: $200,000$
• Balance Sheet (As of December 31, 2013):
  • Assets:
    • Cash: $30,000$
    • Marketable securities: $50,000$
    • Accounts receivable: $350,000$
    • Inventory: $370,000$
    • Total current assets: $800,000$
    • Net plant and equipment: $800,000$
    • Net assets: $1,600,000$
  • Liabilities and Stockholders' 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 stockholders' equity: $1,600,000$

Profitability Ratios

• Profit margin $= \frac{\text{Net Income}}{\text{Sales}}$
• Saxton Company: \frac{$200,000}{$4,000,000} = 5\%, Industry Average: 6.7%
• Return on assets (investment) $= \frac{\text{Net income}}{\text{Total assets}}$
• Saxton Company: \frac{$200,000}{$1,600,000} = 12.5\%, Industry Average: 10%
• DuPont System of Analysis: Return on assets (investment) = Profit margin × Asset turnover $5\% \times 2.5 = 12.5\%$, $6.7\% \times 1.5 = 10\%$. This illustrates how return on assets is a function of both the profit margin and asset turnover.
• Return on equity $= \frac{\text{Net income}}{\text{Stockholders' equity}}$
  • Saxton Company: \frac{$200,000}{$1,000,000} = 20\%, Industry Average: 15%
• Return on equity $= \frac{\text{Return on assets (investment)}}{(1 - \text{Debt/Assets})}$
  • Saxton Company: $\frac{0.125}{(1 - 0.375)} = 20\%$, Industry Average: $\frac{0.10}{(1 - 0.33)} = 15\%$.

DuPont System of Analysis

• Satisfactory return on assets can be derived through:
  • High profit margin
  • Rapid asset turnover (generating more sales per dollar of assets)
  • Combination of both
• Return on assets (investment) = Profit margin × Asset turnover
• Satisfactory return on equity can be derived through:
  • High return on total assets
  • Generous utilization of debt
  • Combination of both
• Return on equity = Return on assets (investment) / (1 – Debt/Assets)
• Net income / Sales X Sales / Total assets = return on assets
• Return on assets / (1-Total debt / Total assets) = Return on Equity

Wal-Mart vs. Abercrombie, Du Pont Analysis

Asset Utilization Ratios

• Relate balance sheet (assets) to income statement (sales).
• Note: Inventory turnover ratio may also be computed by using “cost of goods sold” in the numerator.

Asset Utlization Ratios: Calculations and Comparison

• Fixed asset turnover $= \frac{\text{Sales}}{\text{Fixed assets}}$
  • Saxton Company: \frac{$4,000,000}{$800,000} = 5 times, Industry Average: 5.4 times
• Total asset turnover $= \frac{\text{Sales}}{\text{Total assets}}$
  • Saxton Company: \frac{$4,000,000}{$1,600,000} = 2.5 times, Industry Average: 1.5 times

Liquidity Ratios

• These ratios determine if the firm can meet each maturing obligation as it comes due.

Debt Utilization Ratios

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

Debt Utlization Ratios: Fixed Charge Coverage Measurement

• Fixed charge coverage measures the firm’s ability to meet all fixed obligations rather than interest payments alone.
• Income before interest and taxes: $550,000</li> <li>Lease payments:$50,000
• Income before fixed charges and taxes: $$600,000

Ratio Analysis - Saxton Company

Trend Analysis

• Gives picture of performance over number of years against industry averages.

Trend Analysis Example in the Computer Industry