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Chapter
McGraw-Hill/IrwinCopyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Financial Analysis
3
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Chapter Outline
Ratio analysis and its importance
Use of ratio for measurements
The DuPont system of analysis Trend analysis
Evaluation of reported income to identify
distortion
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Ratios and their Classification
A. Profitability ratios1. Profit margin
2. Return on assets (investment)
3. Return on equity
B. Asset utilization ratios4. Receivable turnover
5. Average collection period6. Inventory turnover
7. Fixed asset turnover
8. Total asset turnover
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Ratios and their Classification
(contd)
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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Types of Ratios
Profitability ratios
Measurement of the firms ability to earn anadequate return on:
Sales
Assets
Invested capital
Asset utilization ratios Measures the speed at which the firm is turning
over accounts receivable
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Types of Ratios (contd)
Liquidity ratios
Emphasizes the firms ability to pay off short-term obligations as and when due
Debt utilization ratios
Estimates the overall debt position of the firm
Evaluates in the light of asset base and earning
power
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Financial Statement
for Ratio Analysis
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Profitability Ratios
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DuPont System of Analysis
A satisfactory return on assets might bederived through:
A high profit margin
A rapid turnover of assets (generating moresales per dollar of its assets)
Or both
Return on assets (investment) = Profit margin Asset
turnover
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DuPont System of Analysis (contd)
A satisfactory return on equity might bederived through:
A high return on total assets
A generous utilization of debt
Or a combination of both
Return on equity = Return on assets (investment)
(1 Debt/Assets)
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DuPont Analysis
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Return of Wal-Mart versus Macys using
the Du Pont method of analysis, 2007
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Asset Utilization Ratios
These ratios relate the balance sheet to theincome statement
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Asset Utilization Ratios (contd)
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Liquidity Ratios
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Debt Utilization Ratios
Measures the prudence of the debtmanagement policies of the firm
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Debt Utilization Ratios (contd)
Fixed charge coverage measures the firmsability to meet the fixed obligations
Interest payments alone are not considered
Income before interest and taxes..$550,000
Lease payments $50,000
Income before fixed charges and taxes$600,000
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Ratio Analysis
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Trend Analysis
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Liquidity and Efficiency
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Current Ratio =Current Assets
Current Liabilities
Acid - test Ratio =Cash + Marketable Securities + AR
Current Liabilities
Accounts Receivable Turnover = Net SalesAccounts Receivable
Inventory Turnover =Cost of Goods Sold
Inventory
Total Asset Turnover =
Net Sales
Total Assets
Average Collection Period =360
AR Turnover
Net Sales
ARx 360
Day's Sales in Inventory =360
Inventory Turnover
Net Sales
Inventory
x 360
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Solvency
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Debt Ratio =Total Liabilities
Total Assets
Equity Ratio =
Equity
Total Assets
Debt - to - Equity =Total Liabilities
Total Equity
Times Interest Earned=Interest Expens
EBIT
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Profitability
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Profit Margin Ratio =Net Income
Sales
Gross Margin Ratio =Gross Profit
Sales
Return on Total Assets =Net Income
Sales
Return on Equity =Net Income
Stockholders' Equity
Earnings Per Share =Net Income
Number of Shares Outstanding Common Stoc
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Market Prospects
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Price Earnings Ratio =Market Price Per Shar
Earnings Per Share
Dividend Yield =Dividend Per Share
Market Price Per Share
Dividend Payout =Total Dividends
Income
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Exercises
3-26
Pages: 84 and 85Numbers: 33 and 34
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Trend Analysis
in the Computer Industry
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Impact of Inflation
on Financial Analysis
Inflation
Revenue is stated in current dollars
Plant, equipment, or inventory may have been
purchased at lower price levels
Profits may be more a function of increasingprices than due to good performance
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Comparison of Replacement and
Historical Cost Accounting
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Comparison of Replacement and
Historical Cost Accounting (contd)
Replacement cost reduces income butincreases assets
An increase lowers the debt-to-assets ratio
A decrease indicates decrease in the financialleverage of the firm
A declining income results in a decreased ability
to cover interest costs
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Impact of Disinflation
on Financial Analysis
Disinflation
Financial assets such as stocks and bonds havethe potential to do well encouraging investors
Tangible assets do not have the potential
Deflation
Actual reduction of prices affecting everybody
due to bankruptcies and declining profits
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Other Elements of Distortion
in Reported Income
Effect of changing prices
Reporting of revenues
Treatment of nonrecurring items Tax write-off policies
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Income Statements
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Explanation of Discrepancies
(contd)
Sales
Firm may defer recognition until each payment isreceived or full recognition at earliest possible
date Cost of goods sold
Use of different accounting principles LIFO
versus FIFO
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Explanation of Discrepancies
(contd)
Extraordinary gains/losses
Inclusion of events in computing current incomeor leaving them out
Net income Use of different methods of financial reporting