Financial Analysis Chapter 3

A ratio converts financial information to a percentage, one approach to standardization Each ratio provides a somewhat different analysis

Liquiditycash, working capital & cash flow

related Activityturnover ratios as possible efficiency measures Leveragedebt & solvency analysis Performance (or profitability)bottom line or earnings related

Ratios for the most recent period are usually the most important

Importance
Illustrates trends and patterns

Limitations
Based on past data and conditions from which it

might be difficult to extrapolate future expectations Relative size is ignored (e.g., both large & small firms can be compared) It is assumed that all numbers used are correct (consider both possible errors and earnings management) If the numbers are not reliable, ratios are not particularly useful

Managers
To assess the efficiency and profitability of operations To judge how effectively resources of the business are

being used

Owners
The way companys earnings are used and distributed The relative value of shares within the security markets

Lenders & Creditors

Concerned about the companys liquidity and cash flow

that affects its ability to make interest payments due them and eventually to repay the principal payment.

Operational analysis

Resource management

CGS Ratio(cost of sales/total sales) Gross Margin (gross profit/ total sales) Profit Margin (NI/total Sales) EBIT Margin (EBIT/total Sales) EBITDA Margin [(EBIT+D+A)/total Sales] NOPAT Margin [Operating Income*(1-tax rate)/total sales] Operating expense analysis (expense/total sales) Contribution Analysis [(sales-direct cost)/total sales]

Asset turnover (Sales/total assets) Working capital management

Inventory turnover (sales/avg. inventory) Receivable turnover(sales/receivables) Payable turnover (sales/payables ) Average days inventory in stock: 365/inventory turnover Average days receivables outstanding: 365/receivables turnover Average days payable outstanding: 365/payables turnover Length of operating cycle: average days inventory + average days receivables

Profitability

ROA (NI/Total assets)

Investment return
ROE (NI/OE) EPS (Net profit to common equity/# of shares

outstanding)

Disposition of earnings
Dividend yield (dividend per share/ price per share) Payout ratio (cash dividend per share/ EPS)

Market indicators
Earnings multiple (share price/EPS) Value of firm

Liquidity
Current ratio (current assets/current liabilities) Acid test ratio [(cash+cash equivalents+A/R)/current

liabilities]

Financial leverage
Debt to assets ratio (Total debt/total assets) Debt to capitalization (LTD/net assets) Debt to equity ratio (total debt/OE)

Debt services
Interest coverage (EBIT/interest expense)

By analyzing each of the three levers that leads to Return on Equity ROE:
Profitability of the operations

How efficient assets are being made to work

Leverage ( the right mix of Equity to Debt)

A way of visualizing the information so that everyone can see it Is a good tool for getting people started in understanding how they can have an impact on results Helps to identify sources of strength and weakness in current performance Helps to focus attention on value drivers

ROE ROA Profit Margin Equity Multiplier

Total Asset Turnover

ROE
Net Income = Total Equity

Net Profit Margin

Net Income

Total Asset Turnover

Sales
X

Debt Ratio
Total Assets Total Equity

Sales

Total Assets
Asset Usage Efficiency

Profitability & operating efficiency

Leverage

Basket Wonders Balance Sheet (thousands) Dec. 31, 2003a

$ 90 Acct. Rec.c 394 Inventories 696 Prepaid Exp d 5 Accum Tax Prepay 10 Current Assetse $1,195 Fixed Assets (@Cost)f 1030 Less: Acc. Depr. g (329) Net Fix. Assets $ 701 Investment, LT 50 Other Assets, LT 223 Total Assets b $2,169 Cash and C.E.

a. How the firm stands on a specific date. b. What BW owned. c. Amounts owed by customers. d. Future expense items already paid. e. Cash/likely convertible to cash within 1 year. f. Original amount paid. g. Acc. deductions for wear and tear.

Basket Wonders Balance Sheet (thousands) Dec. 31, 2003

Notes Payable $ 290 Acct. Payablec 94 Accrued Taxes d 16 Other Accrued Liab. d 100 Current Liab. e $ 500 Long-Term Debt f 530 Shareholders Equity Com. Stock ($1 par) g 200 Add Pd in Capital g 729 Retained Earnings h 210 Total Equity $1,139 Total Liab/Equitya,b $2,169

a. Assets = Liabilities + Equity. b. What BW owed and ownership position. c. Owed to suppliers for goods and services. d. Unpaid wages, salaries,taxes etc. e. Debts payable < 1 year. f. Debts payable > 1 year. g. Original investment. h. Earnings reinvested.

Basket Wonders Income Statement (in thousands) for Year Ending December 31, 2003a

Net Sales $ 2,211 Cost of Goods Sold b 1,599 Gross Profit $ 612 SG&A Expenses c 402 EBITd $ 210 Interest Expensee 59 EBT f $ 151 Income Taxes 60 EATg $ 91 Cash Dividends 38 Increase in RE $ 53

a. Measures profitability over a time period. b. the cost of the units that was sold to customers c. Sales comm., adv., officers salaries, etc. d. Operating income. e. Cost of borrowed funds. f. Taxable income. g. Amount earned for shareholders.