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Learning Objectives
Explain the purpose and importance of financial analysis. Calculate and use a comprehensive set of measurements to evaluate a companys performance. Describe the limitations of financial ratio analysis.
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Is management providing a good return on the capital provided by the shareholders? - Profitability
ratios
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Table 4-1
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Table 4-2
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Current Ratio
Current ratio compares a firms current assets to its current liabilities. Formula: Current ratio = Current assets/Current liabilities Davies Example: = $143M / $64M = 2.23
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Davies Example: = $36M / ($600M/365) = 21.95 days Davis is faster than peers (25 days) in collecting the accounts receivable.
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Inventory Turnover
How many times is inventory rolled over per year? Formula: Inventory Turnover = Cost of goods sold/Inventory Davies Example = $460M / $84M = 5.48 times # of days = 365/Inventory turnover = 365/5.48 = 67 days Thus Davis carries the inventory for a longer time than its competitors (Competitors = 365/7 = 52 days).
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2.2 Are the Firms Managers Generating Adequate Operating Profits on the Companys Assets?
This question focuses on the profitability of the assets in which the firm has invested. We will consider the following ratios to answer the question:
Operating Return on Assets Operating Profit Margin Total Asset Turnover Fixed Asset Turnover
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(i) Asset Management - relates to balance sheet ORA = Operating profits /Total assets = (Operating profit/sales) * (Sales/assets) = Operating profit margin * Total asset turnover
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Figure 4-3
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Debt Ratio
This ratio indicates the percentage of the firms assets that are financed by debt (implying that the balance is financed by equity). Formula: Debt Ratio = Total debt/Total assets Davies Example = $235M / $438M = .54 or 54% Davies finances 54% of firms assets by debt and 46% by equity. This ratio is higher than peer average of 35%.
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Ratio
Debt Ratio Times Interest Earned
Peers 35% 7X
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2.4 Are the Firms Managers Providing a Good Return on the Capital Provided by the Shareholders?
This is analyzed by computing the firms accounting return on common stockholders investment or return on equity (ROE). Formula: ROE = Net income/Common equity Common equity includes both common stock and retained earnings.
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ROE
Davies Example
ROE = $42M / $203M = .207 or 20.7% Owners of Davies are receiving a higher return (20.7%) compared to the peer group (18%). One of the reasons for higher ROE for Davies is the higher debt used by Davies. Higher debt translates to higher ROE under favorable business conditions.
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Figure 4-4
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Peers 12.0%
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These ratios indicate what investors think of managements past performance and future prospects.
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Price/Earnings Ratio
Measures how much investors are willing to pay for $1 of reported earnings. Formula: PE = Price per share/Earnings per share Davies Example = $32.00 / $2.10 = 15.24X Investors are willing pay less for Davies for every dollar of earnings compared to peers ($15.24 for Davies versus $19 for peers).
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Price/Book Ratio
Compares the market value of a share of stock to the book value per share of the reported equity on the balance sheet. Formula: Price/Book ratio= Price per share/Equity book value per share Davies Example = $32.00 / $10.15 = 3.15X A ratio greater than 1 indicates that the shares are more valuable than what the shareholders originally paid. However, the ratio is lower than the S&P average of 3.70.
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EVA attempts to measure a firms economic profit, rather than accounting profit. EVA recognizes the cost of equity in addition to the cost of debt (interest expense).
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EVA: Formula
EVA = (r k) A where: r = Operating return on assets k = Total cost of capital A = Amount of capital (or Total Assets)
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EVA example
A firm has total assets of $5,000 and has raised money from both debt and equity in equal proportion. Further, assume that cost of debt is 8% and the cost of equity is 16%. Assume that the firm earns 17% operating income on its investments. EVA = (17% 12%)* $5,000 = $250 Where, Cost of capital = .5*(8%) + .5*(16%) = 12%
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Ratio
Price/Earnings Ratio Price/Book Ratio
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Table 4-3
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Key Terms
Accounts receivable turnover ratio Acid-test ratio Asset efficiency Average collection period Current ratio Debt ratio Financial ratios Fixed asset turnover Inventory turnover Liquidity Operating profit margin Operating return on assets Price/book ratio Price/earnings ratio Return on equity Times interest earned Total asset turnover
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