CHAPTER

THREE

Financial Analysis

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The classification system for ratios

We will separate 13 significant ratios into four primary categories.

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A. Profitability Ratios.
1. Profit margin.
2. Return on assets (investment).
3. Return on equity (common shareholders).
B. Asset utilization ratios.
4. Receivable turnover.
5. Average collection period.
6. Inventory turnover.
7. Capital asset turnover.
8. Total asset turnover.
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.

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Table 3-1a
Financial statements for ratio analysis
SAXTON COMPANY
Income Statement
For the Year 1999

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Sales (all on credit) . . . . . . .

Cost of goods sold . . . . . . . .
Gross profit . . . . . . . . . .
Selling and administrative expense*
Operating profit . . . . . . . .
Interest expense . . . . . . . .
Extraordinary loss . . . . . . .
Net income before taxes . . . . .
Taxes (50%) . . . . . . . . . .
Net income . . . . . . . . . . .

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. $ 4,000,000
.
3,000,000
.
1,000,000
.
450,000
.
550,000
.
50,000
.
100,000
.
400,000
.
200,000
. $ 200,000

* Includes $50,000 in lease payments.

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Table 3-1b
Financial statements for ratio analysis
Balance Sheet
As of December 31, 1999
Assets

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Cash
Marketable securities
Accounts receivable
Inventory
Total current assets
Net plant and equipment
Total assets
Liabilities and Shareholders' Equity
Accounts payable
Notes payable
Total current liabilities
Long-term liabilities
Total liabilities
Common stock
Retained earnings
Total liabilities and shareholders' equity
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30,000
50,000
350,000
370,000
800,000
800,000
$1,600,000
$

50,000
250,000
300,000
300,000
600,000
400,000
600,000
$1,600,000
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Profitability ratios
Saxton Company
Net income
3-1. Profit margin =
sales

Industry Average

$200,000
$4,000,000 = 5%

6.5%

3-2. Return on assets (investment) =

Net income
$200,000
a.
= 12.5%
Total assets
$1,600,000
Sales
b. Net income
Sales
Total assets
3-3. Return on equity =
Net income
a.
Shareholders equity
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PPT 3-3

b.

Return on assets (investment)

(1 Debt/Assets)

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10%

5% 2.5 = 12.5% 6.5% 1.5 = 10%

$200,000
= 20%
$1,000,000
0.125
= 20%
1 0.375

15%
0.10
1 0.33

= 15%

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Figure 3-1
Du Pont analysis
Net Income

Profit Margin

Sales

Asset
Turnover

Total Assets

Return on
Assets
Return on Assets
(1 - Debt/Assets)

Return on
Equity

Total Debt

Financing
Plan

Total Assets
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Applying Du Pont analysis at Dylex, January 1, 1999

Profit
Company Margin

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Womens
Wear
6.47%
Tip Top
3.10
Biway
2.81
Thriftys
14.80
Overall (before
corporate
charges)
5.10
Overall (with
corporate
charges)
1.85
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Asset
Turnover

Return on
Assets
(1 Debt/Assets)

x
x
x
x

5.43
2.54
4.40
4.42

= 35.13%
= 7.87
= 12.36
= 65.42

4.17

= 21.27

3.38

= 6.25

(1-.419)

Return
on Equity

10.76%

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Asset utilization ratios

Saxton Company
3-4. Receivables turnover =
Sales (credit)
Receivables

$4,000,000
$350,000

= 11.4

Industry Average

10 times

3-5. Average collection period =

Accounts receivable
Average daily credit sales

$350,000
$10,959

= 32

36 days

$3,000,000
$370,000

= 8.1

7 times

3-6. Inventory turnover =

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Cost of Goods Sold

Inventory
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Asset utilization ratios

Saxton Company

Industry Average

3-7. Capital asset turnover =

Sales
Capital assets
3-8. Total asset turnover =
Sales
Total assets

$4,000,000
$800,000 = 5

5.4 times

$4,000,000
= 2.5
$1,600,000

1.5 times

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Liquidity ratios
Saxton Company

Industry Average

3-9. Current ratio =

Current assets
Current liabilities

$800,000
$300,000

= 2.67

2.1

3-10. Quick ratio =

Current assets Inventory
Current liabilities

$430,000
$300,000

= 1.43

1.0

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Debt utilization ratios

Saxton Company

Industry Average

3-11. Debt to total assets =

Total debt
Total assets

$600,000
$1,600,000

= 37.5%

33%

3-12. Times interest earned =

Income before
interest and taxes
Interest

$550,000
$50,000

= 11

$600,000
$100,000

=6

7 times

3-13. Fixed charge coverage =

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Income before
fixed charges and taxes
Fixed charges
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5.5 times

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Table 3-2
Ratio analysis
Saxton
Company

Industry
Average

1. Profit margin
2. Return on assets...

5%
12.5%

6.5%
10%

3. Return on equity.

20%

15%

11.4
32.0
8.1
5.0
2.5

10.0
36.0
7.0
5.4
1.5

Conclusion

A. Profitability
Below average
Above average due
to high turnover
Good due to
ratios 2 and 11

B. Asset Utilization
4.
5.
6.
7.
8.

Receivables turnover ...

Average collection period.
Inventory turnover ...
Capital asset turnover .
Total asset turnover .

Good
Good
Good
Below average
Good

C. Liquidity
9. Current ratio
10. Quick ratio ..

2.67
1.43

2.1
1.0

37.5%
11
6

33%

Good
Good

D. Debt Utilization
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11. Debt to total assets ..

12. Times interest earned .
13. Fixed charge coverage .
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5.5

Slightly more debt

7Good
Good
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Figure 3-2a
Trend analysis
A. Profit Margin
Percent
Industry

Saxton

5
3
1
1986

1988

1990

1992

1994

1996

1999

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Figure 3-2
Trend Analysis
B. Total asset turnover
3.5X
3.0X
2.5X

Saxton

2.0X
1.5X
Industry

1.0X
.5X
1986

1988

1990

1992

1994

1996

1999

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Table 3-3
Trend analysis for banking industry
Bank of Montreal

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1981
1983
1985
1987
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998

Profit Return on
Equity
Margin
19.9%
4.2%
11.8
4.0
9.8
4.3
*
5.8
1.4
0.5
14.5
4.9
14.9
6.0
14.1
7.2
14.0
7.4
14.4
8.3
15.4
8.2
17.0
9.0
17.1
9.0
15.2
7.8

Royal Bank
Profit Return on
Margin
Equity
17.0%
4.2%
9.5
3.5
10.9
4.9
*
6.0
9.1
4.5
17.5
6.6
15.4
7.0
0.3
0.9
2.4
2.6
16.8
8.7
16.6
8.2
17.6
8.7
19.3
9.5
18.4
9.2

Toronto-Dominion Bank
Profit Return on
Margin
Equity
4.5%
20.5%
5.2
14.4
7.4
15.6
2.5
18.3
10.2
18.2
7.7
13.6
6.3
10.7
6.2
8.4
3.9
5.4
9.2
13.3
9.1
15.9
9.7
14.4
10.1
15.6
8.2
14.0

*Large loan loss provisions on Third World loans.

Source: Annual reports

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Table 3-7
Comparison of replacement cost accounting and historical cost
accounting
10 Chemical
Companies
Replacement Historical
Cost
Cost

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8 Drug
Companies
Replacement Historical
Cost
Cost

Increase in assets. . . . . . . . 28.4%

15.4%

Decrease in net income

before taxes . . . . . . . . . 45.8%

19.3%

Return on assets . . . . . . . . 2.8%

6.2%

8.3%

11.4%

Return on equity. . . . . . . . 4.9%

13.5%

12.8%

19.6%

Debt-to-assets ratio. . . . . . 34.3%

43.8%

30.3%

35.2%

Interest coverage ratio

(times interest earned) 7.1

8.4

15.4

16.7

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Table 3-8
Illustration of conservative versus high reported income firms
Income Statement
For the Year 1999
A

High Reported
Income
B

$4,000,000
3,000,000
1,000,000
450,000
550,000
50,000
500,000
200,000
300,000
60,000
$ 240,000

$4,200,000
2,400,000
1,800,000
450,000
1,350,000
50,000
1,300,000
520,000
780,000

$ 780,000

Conservative

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Sales . . . . . . . . . . . .
Cost of goods sold . . . . . . . .
Gross profit . . . . . . . . . .
Selling and administrative expense . . .
Operating profit . . . . . . . .
Interest expense
. . . . . . . .
Net income before taxes . . . . . .
Taxes (40%)
. . . . . . . . .
Net income . . . . . . . . . .
Extraordinary loss (net of tax)
. . . .
Net income transferred to retained earnings .
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Chapter 3 - Outline

LT 3-1

Financial Analysis
4 Categories of Financial Ratios
Importance of Ratios
Inflation and its Impact on Profits
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Financial Analysis and Ratios

LT 3-2

What is financial analysis?

Evaluating a firms financial performance
Analyzing ratios or numerical calculations
Comparing a company to its industry and to its past
performance
A long-run trend analysis over a 5-10 year period is
usually performed by an analyst.
Ratio analysis may not answer questions, but leads to
further inquiry
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4 Categories of Ratios

LT 3-3

Profitability Ratios
Asset Utilization Ratios
Liquidity Ratios
Debt Utilization Ratios
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Profitability Ratios

LT 3-4

Show how profitable a company is.

The ratios express:
Profit Margin or Return on Sales (%)
Return on Assets or Return on Investment (%)
Return on Equity (%)
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Asset Utilization Ratios

LT 3-5

Show how effectively a company uses its assets.

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The ratios express:

Receivables Turnover (times)
Average Collection Period (days)
Inventory Turnover (times)
Capital Asset Turnover (times)
Total Asset Turnover (times)
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Liquidity Ratios

LT 3-6

Show how liquid a company is or how much $ it has

to meet S/T needs.
The ratios express:
Current Ratio (times)
Quick Ratio or Acid-Test Ratio (times)
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Debt Utilization Ratios

LT 3-7

Show how well a company is managing or using

debt.

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The ratios express:

Debt-to-Total Assets (%)
Times Interest Earned (times)
Fixed Charge Coverage (times)
(Fixed Charges = lease payments, interest
expense)
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Importance of Ratios

LT 3-8

Which ratios are most important?

It depends on your perspective.
Suppliers and banks (lenders) are most interested in
liquidity ratios.
Shareholders are most interested in profitability ratios
Bondholders concentrate on debt utilization ratios
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The effective utilization of assets is managements

responsibility
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Inflations Impact on Profits

LT 3-9

FIFO (First-In, First-Out) Inventory:

Lowers COGS
Raises Profits
LIFO (Last-In, First-Out) Inventory:
Raises COGS
Lowers Profits

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