Ratio Analysis

Understanding Financial Statements
NINTH EDITION Lyn M. Fraser Aileen Ormiston
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall
Copyright Notice
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.
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Chapter 6: The Analysis of Financial Statements

Ratios are tools, and their value is limited when used alone. The more tools used, the better the analysis. For example, you cant use the same golf club for every shot and expect to be a good golfer. The more you practice with each club, however, the better able you will be to gauge which club to use on one shot. So to, we need to be skilled with the financial tools we use. - Diane Morrison Chief Executive Officer, R.E.C. Inc.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-3
Objectives of Analysis
Objectives will vary depending on the perspective of the financial statement user specific questions that are addressed by the analysis The identity of the user helps define what information is needed.
Objectives of Analysis Creditors

A creditor is ultimately concerned with the ability of an existing or prospective borrower to make interest and principal payments on borrowed funds.
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Objectives of Analysis Creditors

Questions raised in a credit analysis should include
What is the borrowing cause? What is the firms capital structure? What will be the source of debt repayment?
Objectives of Analysis Investors

An investor attempts to arrive at an estimation of a companys future earnings stream in order to attach a value to the securities being considered for purchase or liquidation.
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Objectives of Analysis Investors

The investment analyst poses questions such as:

What is the companys performance record? What are the future expectations? How much risk is inherent in the existing capital structure? What are expected returns? What is firms competitive position?
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Objectives for Analysis Management

Management relates to all questions raised by creditors and investors. Management must also consider its employees, the general public, regulators, and the financial press.
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Objectives of Analysis Management

Looks to financial statement data to determine
How well has the firm performed and why? What operating areas have contributed to success and which have not? What are strengths and weaknesses of the companys financial position? What changes should be implemented to improve future performance?

Financial statements provide insight into the companys current status lead to the development of policies and strategies for the future
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Management prepares financial statements. Analyst should be alert to potential for management to influence reporting to make data more appealing to creditors, investors, and other users. It may be helpful to supplement analysis with other material in the annual report and other sources of information apart from the annual report.
Sources of Information
Financial statement user has access to a wide range of data sources. Objective of analysis dictates the approach and resources used. Beginning point should be financial statements and the notes.
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Sources of Information
The analyst will want to consider the following resources:
Proxy statement Auditors report Management discussion and analysis Supplementary schedules From 10-K and From 10-Q Other Sources
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Other Sources of Information
Computerized databases
Enhance analytical process Provide time-saving features
Computerized financial statement analysis packages

Perform ratio calculations Other analytical tools
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Other Sources of Information

It is important to review the annual reports of suppliers, customers, and competitors. Many internet sites charge subscription fees to access information, but public and university libraries often subscribe, making this information free to the public.
Tools and Techniques
Common-size financial statements Key financial ratios Trend analysis Structural analysis Industry comparisons Common sense and judgment
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Common-Size Financial Statements

Express each account on the balance sheet as a percentage of total assets income statement as a percentage of net sales
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Key Financial Ratios

Five categories of ratios Liquidity ratios Activity ratios Leverage ratios Profitability ratios Market ratios
Key Financial Ratios

Ratios are valuable analytical tools and serve as screening devices, but they
do not provide answers in and of themselves are not predictive should be used with other elements of financial analysis
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Key Financial Ratios Liquidity Ratios

Liquidity ratios measure a firms ability to meet cash needs as they arise. Liquidity ratios include

current ratio quick or acid-test ratio cash flow liquidity ratio average collection period days inventory held days payable outstanding
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Liquidity Ratios Short-Term Solvency

Current Ratio
Measures the ability of a firm to meet debt requirements as they come due Current assets
Current liabilities

Quick or Acid-Test Ratio Measures ability to meet short-term cash needs more rigorously by eliminating inventory
Current assets - Inventory Current liabilities


Cash Flow Liquidity Ratio Focuses on ability of the firm to generate operating cash flows as a source of liquidity Cash + Marketable securities + CFO * Current liabilities
*Cash flow from operating activities

Average Collection Period Helps gauge liquidity of accounts receivable (ability to collect cash from customers) and may help provide information about a companys credit policies
Net accounts receivable Average daily sales


Days Inventory Held Measures the efficiency of the firm in managing its inventory Inventory Average daily cost of sales

Days Payable Outstanding Offers insight into a firms pattern of payments to suppliers Accounts payable Average daily cost of sales
Cash Conversion Cycle or Net Trade Cycle

The normal cycle of a firm that consists of buying or manufacturing inventory, with some purchases on credit selling inventory, with some sales on credit and creation of accounts receivable collecting the cash

Helps the analyst understand why cash flow generation has improved or deteriorated by analyzing key balance sheet accounts that affect cash flow from operating activities: Accounts Receivable Inventory Accounts Payable

Calculated as follows
Average collection period plus Days inventory held minus Days payable outstanding equals Cash conversion or net trade cycle
Key Financial Ratios Activity Ratios

Activity ratios measure the liquidity of specific assets and the efficiency of managing assets. Activity ratios include
accounts receivable turnover inventory turnover accounts payable turnover fixed asset turnover total asset turnover
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Activity Ratios: Asset Liquidity, Asset Management Efficiency

Accounts Receivable Turnover
Measures efficiency of firms collection and credit policies Net sales Net accounts receivable

Inventory Turnover Measures firms efficiency in managing its inventory Cost of goods sold Inventory

Accounts Payables Turnover Helps to gain insight into a firms pattern of payment to suppliers Cost of goods sold Accounts payable
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Fixed Asset Turnover Assesses effectiveness in generating sales from investments in fixed assets Net sales Net property, plant, equipment

Total Asset Turnover Assesses effectiveness in generating sales from investments in all assets Net sales Total assets
Key Financial Ratios Leverage Ratios

Leverage ratios measure the extent of a firms financing with debt relative to equity and its ability to cover interest and other fixed charges.
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Key Financial Ratios Leverage Ratios

Leverage ratios include

Debt ratio Long-term debt to total capitalization Debt to equity Times interest earned Fixed charge coverage Cash flow adequacy
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Leverage Ratios Debt Financing and Coverage

Debt Ratio Considers the proportion of all assets that are financed with debt Total liabilities Total assets
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Long-term Debt to Total Capitalization Reveals the extent to which long-term debt is used for the firms permanent financing (both long-term debt and equity)
Longterm debt Long-term debt + Stockholders equity

Leverage Ratios: Debt Financing and Coverage
(cont.)
Debt to Equity Measures the riskiness of the firms capital structure in terms of the relationship between the funds supplied by creditors (debt) and investors (equity)
Total liabilities Stockholders equity


Times Interest Earned Indicates how well operating earnings cover fixed interest expenses Operating profit Interest expense
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Cash Interest Coverage Measures how many times interest payments can be covered by cash flow from operations before interest and taxes CFO + interest paid + taxes paid Interest paid

Fixed Charge Coverage Broader measure of how well operating earnings cover fixed charges Operating profit + Rent expense Interest expense + Rent expense
*Rent expense = operating lease payments

Cash Flow Adequacy Measures firms ability to cover capital expenditures, long-term debt payments and dividends each year Cash flow from operating activities Capital expenditures + debt repayments + dividends paid
Key Financial Ratios Profitability Ratios

Profitability ratios measure the overall performance of a firm and its efficiency in managing assets, liabilities, and equity.
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Key Financial Ratios Profitability Ratios

Profitability ratios include

gross profit margin operating profit margin net profit margin cash flow margin return on total assets (ROA) or return on investment (ROI) return on equity (ROE) cash return on assets
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Profitability Ratios Overall Efficiency and Performance

Gross Profit Margin Measures ability of a company to control costs of inventories or manufacturing of products and to pass along price increases through sales to customers
Gross profit Net sales

Profitability Ratios
Operating Profit Margin
Overall Efficiency and Performance

Measures overall operating efficiency and incorporates all of the expenses associated with ordinary business activities
Operating profit Net sales

Net Profit Margin

Measures profitability after consideration of all revenue and expense, including interest, taxes, and nonoperating items
Net earnings Net sales

Cash Flow Margin

Measures ability to translate sales into cash Cash flow from operating activities Net sales

Return on Total Assets (ROA) or Return on Investment (ROI) Measures overall efficiency of firm in managing investment in assets and generating profits Net earnings Total assets
Return on Equity (ROE)
Measures rate of return on stockholders investment Net earnings Stockholders equity

Cash Return on Assets

Measures firms ability to generate cash from the utilization of its assets
Cash flow from operating activities Total assets

Key Financial Ratios Market Ratios

Market ratios measure returns to stockholders and the value the marketplace puts on a companys stock. Market ratios include earnings per common share price-to-earnings dividend payout dividend yield
Market Ratios Earnings per Common Share

Earnings per Common Share Provides the investor with a common denominator to gauge investment returns Net earnings Average shares outstanding
Market Ratios Price-to-Earnings

Price-to-Earnings Relates earnings per common share to the market price at which the stock trades, expressing the multiple that the stock market places on a firms earnings
Market price of common stock

Earnings per share
Market Ratios Dividend Payout

Dividend Payout Determined by the formula cash dividends per share divided by earnings per share Dividends per share Earnings per share
Market Ratios Dividend Yield

Dividend Yield Shows the relationship between cash dividends and market price Dividends per share
Market price of common stock

Analyzing the Data

There are five broad areas that would typically constitute a fundamental analysis of financial statements:

Background on the firm, industry, economy, and outlook Short-term liquidity Operating efficiency Capital structure and long-term solvency Profitability
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Background: Economy, Industry, and Firm

Economic developments and the actions of competitors affect the ability of any business enterprise to perform successfully. It is necessary to evaluate the environment in which the firm conducts business. This process involves blending hard facts with guess and estimates.
Short-Term Liquidity
Especially important to creditors, suppliers, management, and others who are concerned with the ability of a firm to meet near-term demands for cash Should include analysis of selected financial ratios and a comparison with industry averages Predicts the future ability of the firm to meet prospective needs for cash
Operating Efficiency
Turnover ratios measure the operating efficiency of a firm. The efficiency in managing a companys accounts receivable, inventory, and accounts payable is discussed in the short-term liquidity analysis.
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Capital Structure and Long-Term Solvency

Analytical process includes an evaluation of the amount and proportion of debt in a firms capital structure as well as the ability to service debt. Debt financing implies risk and leverage.
Profitability
Analysis of how well the firm has performed in terms of profitability, beginning with the evaluation of several key ratios
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Relating the Ratios The Du Pont System

Helpful to complete the evaluation of a firm by considering the interrelationship among the individual ratios Looks at how the various pieces of financial measurement work together to produce an overall return Helps analyst see how the firms decisions and activities over the course of an accounting period interact to produce overall return to shareholders

The summary ratios used are the following:
(1) Net profit margin (2) Total asset turnover (3) Return on investment
Net income
Net sales
(3) Return on investment
Net sales
X Total assets
(4) Financial leverage
Net income
= Total assets
(5) Return on equity
Net income Total assets
Total assets
Net income
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X Stockholder equity = Stockholder equity

The first three ratios reveal that return on investment is a product of the net profit margin and the total asset turnover. The second three ratios show how the return on equity is the product of return on investment and financial leverage.

By reviewing this series of relationships, the analyst can identify strengths and weaknesses as well as trace potential causes of problems in the overall financial condition and performance of the firm. Analyst can evaluate changes in condition and performance. Evaluation can then focus on specific areas contributing to changes.
Projections and Pro Forma Statements

Pro forma financial statements are projections based on a set of assumptions regarding
future revenues expenses level of investment in assets financing methods and costs working capital management
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Projections and Pro Forma Statements

Pro forma financial statements are used primarily for long-range planning and long-term credit decisions. Many firms have made up their own definitions of pro forma statements, which should not be confused with the pro forma statement described above.
Summary of Analysis
Analysis of any firms financial statements consists of a mixture of steps and pieces that interrelate and affect each other. No one part of the analysis should be interpreted in isolation. The last step of analysis is to integrate the separate pieces into a whole, leading to conclusions about the business enterprise.

Ratio Analysis

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Ratio Analysis

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Understanding Financial Statements

NINTH EDITION Lyn M. Fraser Aileen Ormiston

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 6: The Analysis of Financial Statements

Objectives of Analysis Creditors

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Objectives of Analysis Creditors

Objectives of Analysis Investors

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Objectives of Analysis Investors

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Objectives for Analysis Management

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Objectives of Analysis Management

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Other Sources of Information

Computerized financial statement analysis packages

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Other Sources of Information

Tools and Techniques

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Common-Size Financial Statements

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Key Financial Ratios

Key Financial Ratios

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Key Financial Ratios Liquidity Ratios

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Liquidity Ratios Short-Term Solvency

Liquidity Ratios Short-Term Solvency

Current assets - Inventory Current liabilities

Liquidity Ratios Short-Term Solvency

Liquidity Ratios Short-Term Solvency

Net accounts receivable Average daily sales

Liquidity Ratios Short-Term Solvency

Liquidity Ratios Short-Term Solvency

Cash Conversion Cycle or Net Trade Cycle

Cash Conversion Cycle or Net Trade Cycle

Cash Conversion Cycle or Net Trade Cycle

Key Financial Ratios Activity Ratios

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Activity Ratios: Asset Liquidity, Asset Management Efficiency

Activity Ratios: Asset Liquidity, Asset Management Efficiency

Activity Ratios: Asset Liquidity, Asset Management Efficiency

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Activity Ratios: Asset Liquidity, Asset Management Efficiency

Activity Ratios: Asset Liquidity, Asset Management Efficiency

Key Financial Ratios Leverage Ratios

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Key Financial Ratios Leverage Ratios

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Leverage Ratios Debt Financing and Coverage

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Leverage Ratios Debt Financing and Coverage

Longterm debt Long-term debt + Stockholders equity

Leverage Ratios: Debt Financing and Coverage

Total liabilities Stockholders equity

Leverage Ratios Debt Financing and Coverage

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall

Leverage Ratios Debt Financing and Coverage