chapter three financial statement analysis

© 2005 Pearson Education Canada Inc.

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Chapter ThreeFinancial Statement Analysis

Principles of Corporate FinanceCanadian Edition

Lawrence J. Gitman and Sean Hennessey


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Learning Goals

LG1 – Introduce financial ratio analysis, three types of ratio comparisons, and four categories of ratios.

LG2 – Analyze liquidity and effectiveness at managing inventory, accounts receivable, accounts payable, fixed and total assets.

LG3 – Discuss financial leverage, ratios used to assess how assets were financed, and ability to cover financing charges.


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Learning Goals (continued)LG4 – Evaluate profitability using common-size

analysis, and relative to sales, total assets, common equity, and common share price.

LG5 – Explore link between various categories of ratios, liquidity and activity ratios, leverage, and profitability ratios.

LG6 – Use DuPont system and summary of financial ratios to perform complete ratio analysis, with caution.


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Using Financial Ratios

• Financial Ratios are measures of relative values of key financial information.

• Ratio Analysis involves methods of calculating and interpreting financial ratios to assess the firm’s performance.

• Ratios are measured as (1) percentages; (2) times or multiples; and (3) number of days.


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Parties interested in Ratios• Ratios are of interest as key indicators of

financial health to:– shareholders,– creditors,– management, and– prospective investors.

• Ratio analysis directs attention to potential areas of concern, but are not conclusive evidence of problems.


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Types of Ratio Comparisons• Cross-Sectional Analysis involves the

comparison of different firms at the same time.– Benchmarking firm performance against industry

averages is very popular.• Time-Series Analysis evaluates performance

over time, allowing for comparisons of current and past ratio values.

• Combined Analysis mixes both features of Cross-Sectional and Time Series Analysis.


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Categories of Financial Ratios

• Ratios are grouped into four basic categories:– liquidity ratios,– activity ratios,– leverage ratios, and – profitability ratios.


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Analyzing Liquidity

• Liquidity refers to the firm’s ability to satisfy its short-term obligations as they come due.

• Three areas are of particular concern:– Net Working Capital,– The Current Ratio, and– The Quick (Acid-Test) Ratio.


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Net Working Capital

• This measure of liquidity is simply a measure of current assets minus liabilities.

Net Working Capital = Current Assets – Current Liabilities


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Current Ratio

• Commonly used, the Current Ratio measures the ability to meet short-term obligations.

Current Ratio = Current Assets/Current Liabilities


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Quick (Acid Test) Ratio

• The Quick Ratio focuses on only the most liquid of the firm’s current assets: cash, marketable securities, and accounts receivable.

Quick Ratio = Cash+Marketable Securities+Accounts Receivable

Current Liabilities


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Analyzing Activity

• Activity Ratios measure the effectiveness of managing accounts receivable, inventory, accounts payable, fixed assets, and total assets.

• There are Activity Ratios for each of these management issues.


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Average Age of Inventory

• This ratio measures the effective management of inventory in terms of number of days inventory is held.

Average Age of Inventory = Inventory Daily COGS

Where Daily COGS equals the daily value of the Cost of Goods Sold.


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Average Collection Period

• Useful for evaluating credit and collections policies of the firm, this ratio is also measured in days.

Average Collection Period = Accounts Receivable Average Sales Per

Day


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Average Payment Period

• This ratio evaluates the speed of satisfying the Accounts Payable for the firm.

Average Payment Period = Accounts Payable Average Purchase Per

Day


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Fixed and Total Asset Turnover

• These ratios evaluate the use of Fixed and Total Assets to generate Sales.

Fixed Asset Turnover = Sales Net Fixed Assets

Total Asset Turnover = Sales Total Assets


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Analyzing Leverage

• Leverage measures the amounts of borrowed money being used by the firm.

• Leverage Ratios are classified as either– Capitalization Ratios, focusing on how

investments are financed; or– Coverage Ratios, focusing on the ability to

service the firm’s sources of financing.


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Debt Ratio• The Debt Ratio measures the proportion of total

assets financed by creditors.Debt Ratio = Total Liabilities/Total Assets• The Preferred Equity Ratio shows only that

portion of total assets financed by preferred shareholders.

• The Common Equity Ratio shows only that portion of total assets financed by common shareholders.


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Debt/Equity Ratio

• The popularly mentioned Debt/Equity Ratio measures the proportion of long-term debt to common equity of the firm.

Debt/Equity Ratio = Long-Term Debt Common Equity


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Times Interest Earned Ratio

• Also called the Interest Coverage Ratio, measures the ability to make contractual interest payments.

Times Interest Earned = EBITInterest

Recall that EBIT stands for Earnings Before Interest and Taxes.


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Fixed-Charge Coverage Ratio

• This ratio measures the ability to meet all fixed financial payments.

EBIT + Lease PaymentsInterest + Lease Payments + ((1-T)*(Principal + Dividends))

Where T is the corporate tax rate.


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Analyzing Profitability

• There are many measures of the bottom-line, the profitability of the firm.

• Four main measures examined here are:– Common-Size Income Statements,– Return on Total Assets,– Return on Equity, and– Price/Earnings Ratio.


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Common Size Income Statements

• Gross Margin measures the percentage of each sales dollar after direct cost of goods have been paid.

• Operating Margin measures the percentage of each sales dollar after all expenses associated with producing, selling, and operating the company have bee deducted (EBIT).

• Profit Margin measures the percentage of each sales dollar after all expenses, including interest and taxes, have been paid.


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Return on Total Assets (ROA)

• Also called Return On Investment, measures the overall effectiveness in generating profits with available assets.

ROA = Net Income After TaxesTotal Assets


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Return on Equity (ROE)

• Measures the return earned on the owners’ investment in the firm.

ROE = Earnings Available for Common ShareholdersCommon Equity


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Earnings per Share (EPS)

• Represents the number of dollars earned on behalf of each outstanding common share.

EPS = Earnings Available for Common Shareholders Number of Common Shares Outstanding


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Price/Earnings (P/E) Ratio

• This commonly used ratio is more an appraisal of share value than directly of profitability.

P/E Ratio = Market Price Per Common ShareEarnings Per Share


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Leverage and Profitability

• Leverage is the advantage gained by using a lever. In finance, debt financing is the financial lever.

• Financial leverage allows the firm to acquire assets beyond those available through pure equity financing arrangements.


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Complete Ratio Analysis

• Investors and Analysts want to get a global view of the various ratios in order to make their overall assessment of a firm’s health.

• Two popular approaches are:– The DuPont System of Analysis, and– A summary analysis of all key ratios.


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DuPont System of Analysis

• Developed by the DuPont Corporation. • The DuPont System merges Income

Statement and Balance Sheet into two summary measures of profitability: ROA and ROE.


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DuPont Formula

• The DuPont Formula links the Profit Margin with Total Asset Turnover, as their underlying formulas will summarize Return on Assets.

ROA = Profit Margin Total Asset Turnover• Since,ROA = Net Income After Taxes Sales

Sales Total Assets


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Modified DuPont Formula

• The Financial Leverage Multiplier (FLM) is the ratio of Total Assets to Shareholders’ Equity.

• The FLM transforms ROA into ROE.ROE = ROA FLM• Since,ROE = Net Income After Taxes Total Assets

Total Assets Shareholders’ Equity


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Summarizing All Ratios

• Simply preparing a table of the ratios from the four key categories (liquidity, activity, leverage, and profitability) over a multi-year period allows for a quick and comprehensive review of the firm’s performance.


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Ratio 2000 2001 2002 Industry Ave.2002

Net Working Capital

$583,000 $521,000 $603,000 $427,000

Current Ratio 2.04 2.08 1.97 2.05

Quick Ratio 1.32 1.46 1.51 1.43

Table 3.7 Summary of Barlett Company Liquidity Ratios


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Ave. Age Inventory

71.6 days

64 days

50.7 days

55.3 days

Ave. Collection Period

44.5 days

51.9 days

59.7 days

44.9 days

Ave. Payment Period

76.9 days

82.3 days

95.4 days

67.4 days

Total Asset Turnover

0.94 0.79 0.85 0.75

Table 3.7 Summary of Barlett Company Activity Ratios


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Debt Ratio 36.8% 44.3% 45.7% 40.0%

Debt/Equity Ratio

43.5% 59.7% 58.3% 47.4%

Times Interest Earned

5.6 3.3 4.5 4.3

Fixed Charge Coverage

2.4 1.4 1.9 1.5

Table 3.7 Summary of Barlett Company Leverage Ratios


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Gross Margin 31.4% 33.3% 32.1% 30.0%

Operating Margin 14.6% 11.8% 13.6% 11.0%

Profit Margin 8.8% 5.8% 7.5% 6.4%ROA 8.3% 4.5% 6.4% 4.8%

ROE 14.1% 8.5% 12.6% 8.0%

EPS $3.26 $1.81 $2.90 $2.26

P/E Ratio 10.5 10.0 11.1 12.5

Table 3.7 Summary of Barlett Company Profitability Ratios


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Cautions about Ratio Analysis• A single ratio does not provide sufficient

information to judge overall performance.• Financial statement comparisons should be dated

at the same point during the year.• Audited Financial statements should be used for

calculating ratios.• Data being compared should use the same

accounting rules applied.• Time series comparisons of ratios may be

distorted by inflation.• It is difficult to define categorically what a good

or bad ratio value should be.

chapter three financial statement analysis

Documents

financial ratio analysis

liquidity ratios

complete ratio analysis

profitability ratios

leverage ratios

summary of financial

firms current assets

activityactivity ratios