FM 2016 Week 4 - Chapter 4

Chapter 4
Financial
Analysis
Sizing up Firm
Performance
Slide Contents
PRINCIPLES APPLIED IN THIS
CHAPTER
1.Why Do We Analyze Financial Statements
2.Common Size Statements Standardizing
Financial Information
3.Using Financial Ratios
4.Selecting a Performance Benchmark
5.Limitations of Ratio Analysis
Copyright 2014 Pearson Education, Inc. All rights reserved.
4-2
4.1 WHY DO WE ANALYZE

FINANCIAL STATEMENTS?
4-3
Why Do We Analyze Financial

Statements?
An internal financial analysis might be done:
To evaluate the performance of employees

To compare the performance of different divisions
To prepare financial projections
To evaluate the firms financial performance in
light of its competitors performance
4-4
Why Do We Analyze Financial

Statements? (cont.)
External financial analysis is done by:
Banks and other lenders

Suppliers
Credit-rating agencies
Professional analysts
Individual investors
4-5
4.2 COMMON SIZE

STATEMENTS:
STANDARDIZING FINANCIAL
INFORMATION
4-6
Common Size Statements:

Standardizing Financial
Information
A common size financial statement is a

standardized version of a financial statement
in which all entries are presented in
percentages.
It helps to compare a firms financial
statements with those of other firms, even if
the other firms are not of equal size.
4-7
Common Size Statements:

Standardizing Financial
Information (cont.)
How to prepare a common size financial
statement?
For a common size income statement, divide
each entry in the income statement by sales.
For a common size balance sheet, divide each
entry in the balance sheet by total assets.
4-8
Table 4.1 H. J. Boswell, Inc.
4-9
Table 4.2
H. J.
Boswell,
Inc.
4-10
4.3 USING FINANCIAL

RATIOS
4-11
Using Financial Ratios

Financial ratios provide a second method
for standardizing the financial information on
the income statement and balance sheet.
A ratio by itself may have no meaning.
Hence, a given ratio is generally compared
to: (a) ratios from previous years; or (b)
ratios of other firms in the same industry.
4-12
Using Financial Ratios (cont.)
4-13
LIQUIDITY RATIOS
4-14
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 firms
liquidity from two perspectives (see next
slide).
4-15
Liquidity Ratios (cont.)

1. Overall liquidity - analyzed by comparing
the firms current assets to the firms
current liabilities.
2. Liquidity of specific assets - analyzed by
examining the timeliness in which the firms
liquid assets (accounts receivable and
inventories) are converted into cash.
4-16
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 firms current (liquid) assets to
its current (short-term) liabilities.
4-17
Liquidity Ratios: Current Ratio

(cont.)
What is the current ratio for 2012 for
Boswell?
Current Ratio = $477 292.5 = 1.63 times
The firm had $1.63 in current assets for
every $1 it owed in current liability.
4-18
Liquidity Ratios: Quick Ratio

Acid-Test (Quick) Ratio excludes the
inventory from current assets as inventory
may not be very liquid.
4-19
Liquidity Ratios: Quick Ratio

(cont.)
What is the quick ratio for Boswell for 2012?
Quick Ratio
= ($477-$229.50) ($292.50) = 0.84 times
The firm has only $0.84 in current assets

(less inventory) to cover $1 in current
liabilities.
4-20
Liquidity Ratios:
Individual Asset Categories
We can also measure the liquidity of the firm
by examining the liquidity of accounts
receivable and inventories to see how long
it takes the firm to convert its accounts
receivables and inventories into cash.
4-21
Liquidity Ratios: Accounts

Receivable
Average Collection Period measures the
number of days it takes the firm to collects its
receivables.
4-22

Receivable (cont.)
What will be the average collection period
for Boswell, Inc. for 2012 if we assume that
the annual credit sales were $2,500 million?
Daily Credit Sales
= $2,500 365 days = $6.85 million
Average Collection Period

= $139.5m $6.85m = 20.37 days
4-23

Receivable Turnover Ratio
Accounts Receivable Turnover Ratio
measures how many times receivables are
rolled over during a year.
4-24

Receivable Turnover Ratio
(cont.)
What will be the accounts receivable
turnover ratio for Boswell, Inc. for 2012 if
we assume that the annual credit sales were
$2,500 million?
Accounts Receivable Turnover
= $2,500 million $139.50 = 17.92 times
The firms accounts receivable were turning over
at 17.92 times per year.
4-25
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.
4-26
Liquidity Ratios:
(cont.)
What will be the inventory turnover ratio for

2012 for Boswell, Inc. if we assume that the
cost of goods sold were $1,980 million in
2012?
= $1,980 $229.50 = 8.63 times
The firm turned over its inventory 8.63 times per
year.
4-27
Liquidity Ratios:
Days Sales in Inventory
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.
4-28
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.
4-29
CAPITAL STRUCTURE RATIOS
4-30
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?
4-31

(cont.)
Debt ratio measures the proportion of the
firms assets that are financed by borrowing or
debt financing.
4-32

(cont.)
What is the debt ratio for H.J. Boswell, Inc.
for 2012?
Debt Ratio
= $1,012.50 million $1,764 million = 57.40%
The firm financed 57.39% of its assets with debt.
4-33

(cont.)
Times Interest Earned Ratio measures
the ability of the firm to service its debt or
repay the interest on debt.
4-34

(cont.)
What will be the times interest earned ratio
for Boswell for 2012 if we assume interest
expense of $65 million and EBIT of $350
million?
Times Interest Earned
= $350m $65m = 5.38 times
The firm can pay its interest expense 5.38 times
or interest used 1/5.38th or 18.58% of its EBIT.
4-35
ASSET MANAGEMENT
EFFICIENCY RATIOS
4-36
Asset Management
Efficiency Ratios
Asset management efficiency ratios
measure a firms 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.
4-37
Asset Management Efficiency

Ratios (cont.)
Total Asset Turnover Ratio represents the
amount of sales generated per dollar
invested in firms assets.
4-38

Ratios (cont.)
What will be the total asset turnover ratio for
Boswell, Inc. for 2012 if we assume total sales
to be $2,500 million?
Total Asset Turnover
= $2,500 million $1,764 million = 1.42 times
The firm generated $1.42 in sales per dollar of
assets in 2012.
4-39

Ratios (cont.)
Fixed asset turnover ratio measures
firms efficiency in utilizing its fixed assets
(such as property, plant and equipment).
4-40

Ratios (cont.)
What will be the fixed asset turnover ratio for
Boswell for 2012 if we assume sales of $2,500
million for 2012?
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.
4-41

Ratios (cont.)
The following grid summarizes the efficiency
of Boswells management in utilizing its assets
to generate sales in 2013.
4-42
PROFITABILITY RATIOS
4-43
Profitability Ratios
Profitability ratios address a very
fundamental question: Has the firm earned
adequate returns on its investments?
4-44
Profitability Ratios (cont.)

Two fundamental determinants of firms
profitability and returns on investments:
Cost Control How well has the firm
controlled its costs relative to each dollar of
firm sales?
Efficiency of asset utilization How
effective is the firm in using the assets to
generate sales?
4-45
Cost Control: Is the Firm

Earning Reasonable Profit
Margins?
Gross profit margin shows how well the
firms management controls its expenses to
generate profits.
4-46

Margins? (cont.)
What will be the gross profit margin ratio for
2012 for Boswell if we assume sales of $2,500
million and gross profit of $650 million?
Gross Profit Margin
= $650 million $2,500 million = 26%
The firm spent $0.74 for cost of goods sold and
thus $0.26 out of each dollar of sales went
towards gross profits.
4-47

Margins? (cont.)
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 also indicates
how well the firm is managing its income
statement.
4-48

Margins? (cont.)
What will be the operating profit margin ratio

for Boswell for 2012 if we assume sales of
$2,500 million and net operating income of
$350 million?
Operating Profit Margin
= $350 million $2,500 million = 14%
The firm generates $0.14 in operating profit for
each dollar of sales.
4-49

Margins? (cont.)
Net Profit Margin measures how much
income is generated from each dollar of sales
after adjusting for all expenses (including
income taxes).
4-50

Margins? (cont.)
What will be the net profit margin ratio for

2012 if we assume sales of $2,500 million and
net income of $217.75 million?
Net Profit Margin
= $217.75 million $2,500 million = 8.71%
The firm generated $0.087 for each dollar of
sales after all expenses were accounted for.
4-51
Return on Invested Capital

Operating Return on Assets ratio is the
summary measure of operating profitability. It
takes into account the managements success
in controlling expenses and its efficient use of
assets.
4-52
Profitability Ratios (cont.)

What will be the operating return on assets
ratio for Boswell for 2012 if we assume EBIT
or net operating income of $350 million for
2012?
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.
4-53
Decomposing the
Operating Return on
Assets Ratio
4-54
Figure 4.1 Analyzing H. J. Boswell,

Inc.s Operating Return on Assets
(OROA)
4-55
Figure 4-1 Observations

Firms OROA (operating return on assets) is
better than its peers.
Firms OPM (operating profit margin) is
lower than its peers.
Firms TATO (total asset turnover ratio) is
higher than that of its peers.
4-56
Figure 4-1 Recommendations

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.
4-57
Is the Firm Providing a

Reasonable Return on the
Owners Investment?
Return on Equity (ROE) ratio measures the
accounting return on the common
stockholders investment.
4-58
Is the Firm Providing a

Reasonable Return on the Owners
Investment (cont.)
What will be the ROE ratio for Boswell for 2012
if we assume net income of $217.75 million?
ROE = $217.75m $751.50 mi = 28.98%
Thus the shareholders earned 28.97% on their
investments.
4-59
Using the DuPont Method for

Decomposing the ROE ratio
DuPont method analyzes the firms ROE by
decomposing it into three parts.
ROE = Profitability Efficiency Equity Multiplier
Equity multiplier captures the effect of the

firms use of debt financing on its return on
equity. The equity multiplier increases in
value as the firm uses more debt.
4-60

(cont.)
ROE = Profitability Efficiency Equity
Multiplier
4-61

(cont.)
The following table shows why Boswells
return on equity was higher than its peers.
4-62
Using the DuPont

Method for
Decomposing the
ROE ratio (cont.)
Figure 4.2
4-63
MARKET VALUE RATIOS
4-64
Market Value Ratios

Market value ratios address the question,
how are the firms shares valued in the stock
market?
4-65
Price-Earnings Ratio
Price-Earnings (PE) Ratio indicates how
much investors are currently willing to pay for
$1 of reported earnings.
4-66
Price-Earnings Ratio (cont.)

What will be the PE ratio for 2012 for Boswell,
Inc. if we assume the firms 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?
4-67
Market Value Ratios (cont.)

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.
4-68

Market-to-Book Ratio measures the
relationship between the market value and the
accumulated investment in the firms equity.
4-69

What will be the market-to-book ratio for
2012 for Boswell if the market price of the
stock is $22 and the firm has 90 million shares
outstanding?
4-70

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
4-71
4.4 SELECTING A
PERFORMANCE BENCHMARK
4-72
Selecting a Performance
Benchmark
There are two types of benchmarks that are
commonly used:
Trend Analysis compares a firms financial
statements over time (time-series comparisons).
Peer Group Comparisons compares the subject
firms financial statements with peer firms.
4-73
Trend Analysis
Comparing a firms recent financial ratios
with the past financial ratios provides insight
into whether the firm is improving or
deteriorating over time. This type of
financial analysis is referred to as trend
analysis.
4-74
Peer Firm Comparisons

Peer groups often consist of firms from the
same industry. Industry average financial
ratios can be obtained from a number of
financial databases and internet sources (such
as yahoo finance and google finance).
4-75
4.5 LIMITATIONS OF RATIO

ANALYSIS
4-76
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.
4-77
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.
7. The results of financial analysis are no
better than the quality of the financial
statements.
4-78

FM 2016 Week 4 - Chapter 4

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Chapter 4

Copyright 2014 Pearson Education, Inc. All rights reserved.

4.1 WHY DO WE ANALYZE

Copyright 2014 Pearson Education, Inc. All rights reserved.

Why Do We Analyze Financial

To evaluate the performance of employees

Copyright 2014 Pearson Education, Inc. All rights reserved.

Why Do We Analyze Financial

Banks and other lenders

Copyright 2014 Pearson Education, Inc. All rights reserved.

4.2 COMMON SIZE

Copyright 2014 Pearson Education, Inc. All rights reserved.

Common Size Statements:

A common size financial statement is a

Copyright 2014 Pearson Education, Inc. All rights reserved.

Common Size Statements:

Copyright 2014 Pearson Education, Inc. All rights reserved.

Table 4.1 H. J. Boswell, Inc.

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Copyright 2014 Pearson Education, Inc. All rights reserved.

4.3 USING FINANCIAL

Copyright 2014 Pearson Education, Inc. All rights reserved.

Using Financial Ratios

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Using Financial Ratios (cont.)

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Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Liquidity Ratios (cont.)

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Liquidity Ratios: Current Ratio

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Liquidity Ratios: Current Ratio

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Liquidity Ratios: Quick Ratio

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Liquidity Ratios: Quick Ratio

The firm has only $0.84 in current assets

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Copyright 2014 Pearson Education, Inc. All rights reserved.

Liquidity Ratios: Accounts

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Liquidity Ratios: Accounts

Average Collection Period

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Liquidity Ratios: Accounts

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Liquidity Ratios: Accounts

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What will be the inventory turnover ratio for

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Can a Firm Have Too Much

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CAPITAL STRUCTURE RATIOS

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Capital Structure Ratios

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Capital Structure Ratios

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Capital Structure Ratios

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Capital Structure Ratios

Copyright 2014 Pearson Education, Inc. All rights reserved.

Capital Structure Ratios