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ACT3211 FINANCIAL MANAGEMENT
Analyzing Financial Statements
Chapter 3
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Chapter 3 Learning Goals
LG1: Calculate and interpret major liquidity ratios
LG2: Calculate and interpret major asset management ratios
LG3: Calculate and interpret major debt ratios
LG4: Calculate and interpret major profitability ratios
LG5: Calculate and interpret major market value ratios
LG6: Appreciate how various ratios relate to one another
LG7: Discuss the differences between time series and cross-sectional ratio
analysis and decide which is most appropriate given an analytical
situation
LG8: Explain cautions that should be taken when examining financial ratios
and financial information in general
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Table
3-1
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Liquidity Ratios
Liquidity ratios provide an indication of the
ability of the firm to meet its obligations as
they come due
The three most common liquidity ratios are
the current ratio, the quick (or acid-test) ratio,
and the cash ratio
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The broadest liquidity measure is the current ratio,which measures the dollars of current assets availableto pay each dollar of current liabilities
Current Ratio = CA / CL
Inventory is the least liquid of the current assets, and isthe current asset for which book values are the leastreliable measure of market value. The quick, or acid-test ratio excludes inventory in the numerator, and
measures the firms ability to pay off short-termobligations without relying on inventory sales:
Quick Ratio = (CA Inventory) / CL
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The cash ratio measures a firms ability to payshort-term obligations with its available cash andmarketable securitiesCash Ratio = Cash / CL
The liquidity ratios for DPH Tree Farm are:Current Ratio = CA / CL
Current Ratio = 205 / 120
Current Ratio = 1.71 times
The industry average current ratio is 1.50
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Quick Ratio = (CAInventory) / CL
Quick Ratio = (205111) / 120
Quick Ratio = 0.78 times
The industry average quick ratio is 0.50
Cash Ratio = Cash / CL
Cash Ratio = 24 / 120
Cash Ratio = 0.20 times
The industry average cash ratio is 0.15
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Based on all three measures, DPH has moreliquidity on its balance sheet than the industry
average
The more liquid assets a firm holds, the more likelythe firm can pay its bills, so it has less liquidity risk.
However, liquid assets do not generate profits forthe firm
Managers must consider the tradeoff of lowerliquidity risk versus the disadvantages of reducedprofits
Note that a firm with very predictable cash flows cansafely maintain lower levels of liquidity
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Asset Management Ratios
Asset management ratios measure how
efficiently a firm uses its assets
Many of these ratios are focused on a specific
asset, such as inventory or accounts receivable
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The days sales in inventory ratio measures the average number of
days that inventory is held
Days Sales in Inventory = Inventory x 365 / Sales or COGS
Firms want to turn inventory over as quickly as possible to reduce
costs associated with warehousing, monitoring, insurance A high inventory turnover ratio and a low days sales in inventory
ratio indicate good management
However, if inventory is too low then the firm risks losing sales orrunning out of raw materials, so there is a tradeoff betweensufficient levels of inventory versus the costs of holding too much
Note that companies with good supply chain relations canmaintain lower inventory levels
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Accounts Receivable Management
The Average Collection Period (ACP) measuresthe number of days that accounts receivableare held until they are collected
Average collection period (ACP) = Accounts receivable x 365 / Credit sales
The Accounts Receivable Turnover ratiomeasures the dollars of sales produced per
dollar of accounts receivableAccounts receivables turnover = Credit Sales / Accounts Receivable
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Firms want to produce a high level of sales
per dollar of accounts receivable, and turnaccounts receivable into cash as quickly aspossible A high accounts receivable turnover ratio and a
low average collection period are indicators ofgood receivables management
If these ratios are too good, it may indicate thatcredit terms are so strict that the firm may belosing sales
Managers must consider the tradeoff betweenincreasing sales through credit terms versus thecost of high accounts receivable
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Accounts Payable The Average Payment Period (APP) measures the
number of days that the firm holds accounts payablebefore it has to extend the cash to pay for rawmaterials
Average payment period (APP) = Accounts payable x 365 / COGS
The Accounts Payable Turnover ratio measures thedollar COGS per dollar of accounts receivable
Accounts payable turnover = COGS / Accounts payable
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Firms want to pay for purchases as slowly aspossible Accounts payable represent a form of financing
from suppliers
The more the accounts payable, the less the firm
will need other costly sources of financing such asnotes payable or long-term debt.
A high APP and a low accounts payable turnoverratio is generally a sign of good management
If these indicators are too good it may indicate thatthe firm is abusing their credit terms and jeopardizingtheir relationship with suppliers
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Fixed Asset and Working Capital Management
The Fixed Asset Turnover ratio measures the numberof dollars of sales produced per dollar of fixed assets
Fixed asset turnover ratio = Sales / Fixed assets
The Sales to Working Capital ratio measures thedollars of sales produced per dollar of net workingcapital (NWC = current assetscurrent liabilities)
Sales to Working Capital ratio = Sales / Working capital
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The higher the level of sales produced per dollar offixed assets or working capital, the more efficientlythe firm is being run.
High fixed asset turnover ratios and sales toworking capital ratios are signs of good
management If these ratios are too high the firm may be close to
maximum capacity and may indicate thatmanagement has not made accommodations forgrowth
Caution: the age of a firms fixed assets will affectthe fixed asset turnover ratio. A firm with newer(more expensive) fixed assets may appear to havea lower turnover ratio.
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Total Asset Management
The Total Asset Turnover ratio measures thedollars of sales produced per dollar of total assets
Total assets turnover ratio = Sales / Total assets
The Capital Intensity ratio is simply the inverse ofthe total assets turnover ratio and measures thedollars of total assets needed to produce a dollarof sales
Capital intensity ratio = Total assets / Sales
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These ratios provide an indication of how
efficiently assets are being utilized
If the ratios are too good however it may
indicate that the firm is in danger of inventory
stockouts, capacity problems, or excessively
tight credit terms which might indicate poor
management
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Asset Management Ratios for
DPH Tree FarmAsset Management Ratio Industry Average
Inventory Turnover = Sales / Inventory
Inventory Turnover = 315/ 111
Inventory Turnover = 2.84 times
2.15 times
Days Sales in Inventory = Inventory x 365 / Sales
Days Sales in Inventory = 111 x 365 / 315Days Sales in Inventory = 129 days
1.70 days
Average collection period (ACP) = Accounts receivable x 365 /
Credit sales
ACP = 70 x 365 / 315
ACP = 81 days
95 days
Accounts receivables turnover = Credit Sales / AccountsReceivable
Accounts receivables turnover = 315 / 70
Accounts receivables turnover = 4.50 times
3.84 times
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Average payment period (APP) = Accounts payable x 365 / COGS
APP = 55 x 365 / 150
APP = 134 days
102 days
Accounts payable turnover = COGS / Accounts payable
Accounts payable turnover = 150 / 55
Accounts payable turnover = 2.73 times
3.55 times
Fixed asset turnover ratio = Sales / Fixed assetsFixed asset turnover ratio = 315 / 315
Fixed asset turnover ratio = 1.0
0.85 times
Sales to Working Capital ratio = Sales / Working capital
Sales to Working Capital ratio = 315 / 205-120
Sales to Working Capital ratio = 3.71 times
3.20 times
Total assets turnover ratio = Sales / Total assetsTotal assets turnover ratio = 315 / 570
Total assets turnover ratio = 0.55 times
0.40 times
Capital intensity ratio = Total assets / Sales
Capital intensity ratio = 570 / 315
Capital intensity ratio = 1.81 times
2.50 times
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In all cases DPH has better asset management
than the industry average
Produces more sales per dollar of inventory
Collects its accounts receivables faster
Pays its accounts payables slower
Produces more sales per dollar of fixed assets,
working capital, and total assets
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Debt Management Ratios
Debt management ratios measure the extent
to which the firm uses debt (financial
leverage) versus equity to finance its assets
There are two major types of debt
management ratios
Ratios that measure the amountof debt
Ratios that indicate the ability of the firm to
service its debt
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Debt vs. Equity financing The debt ratio measures the percentage of total
assets financed with debt.
Debt ratio = Total debt / Total assets
The debt-to-equity ratio measures the dollars of
debt financing used for every dollar of equity
financing.
Debt-to-equity ratio = Total debt / Total equity
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The Equity Multiplier ratio measures thedollars of assets on the balance sheet for
every dollar of equity financing
Equity multiplier ratio = Total assets / Total equity
All three of these measures are related:
Equity multiplier = 1 / (1Debt ratio) = Debt-to-equity ratio +1
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When a firm issues debt to finance its assets it gives
the debtholders first claim to a fixed amount of its cashflows
Stockholders are entitled to any residual cash flows
When the firm does well, financial leverage increases
the return to stockholders since the cash flowspromised to debtholders is constant
Stockholders encourage the use of debt financing up to apoint
Financial leverage also increases the risk of financialdistress
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Investors view equity financing as a safetycushion that can absorb fluctuations in the firmsearnings and asset values
The larger the fluctuations or variability of afirms cash flows the greater the need for anequity cushion
In deciding the level of debt versus equityfinancing managers must consider the trade-off
between maximizing cash flows to the firmsstockholders versus the risk of being unable tomake promised debt payments
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Coverage Ratios The Times Interest Earned ratio measures the number
of dollars of operating earnings available to meet eachdollar of interest obligations
Times interest earned = EBIT / Interest expense
The Fixed Charge Coverage ratio measures thenumber of dollars of operating earnings available tomeet the firms interest and other fixed charges
Fixed charge coverage = Earnings available to meet fixed charges / Fixedcharges
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The Cash Coverage ratio measures the number ofdollars of operating cash available to meet eachdollar of interest and other fixed charges
Cash coverage ratio = (EBIT + Depreciation) / Fixedcharges
These coverage measures can indicatewhether a firm has taken on a debt burdenthat is too large
A value less than 1 means that the firm has
less than $1 of earnings or cash available topay each dollar of interest or fixed charges
Example 3 3
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Example 3-3
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The Profit Margin is the percent of sales left after all firm expensesare paid
Profit margin = Net income available to common stockholders / Sales
The Basic Earnings Power ratio measures the EBIT earned per dollarof assets on the balance sheet and represents the operating returnon the firms assets irrespective of financial leverage and taxes.
Basic earnings power ratio (BEP) = EBIT / Total assets
BEP is a useful ratio for comparing firms that differ in financialleverage and taxes
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The Return on Assets (ROA) measures the overall return onthe firms assets, inclusive of leverage and taxes
Return on Assets (ROA) = Net income available to commonstockholders / Total Assets
The Return on Equity (ROE) measures the return oncommon stockholders investment
Return on Equity (ROE) = Net income available to commonstockholders / Common stockholders equity
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ROE is affected by net income as well as the amount offinancial leverage
A high ROE is generally considered to be a positive signof firm performance
Unless it is driven by excessively high leverage
The Dividend Payout Ratio measures the fraction ofearnings paid out to common stockholders asdividends
Dividend payout ratio = Common stock dividends / Netincome available to common stockholders
Example 3-4
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Example 3-4
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Market Value Ratios
While ROE is a very important financial statement ratio,
it doesnt specifically incorporate risk.
Market prices of publicly traded firms do incorporate
risk, and so ratios that incorporate stock market valuesare important.
Market values reflect what investors think of the
companys future performance and risk
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The Price-Earnings ratio is the best known andmost often quoted figure
Price-earnings ratio = Market price per share / Earnings per share
Measures how much investors are willing to pay foreach dollar of earnings
A high PE ratio is often an indication of anticipated
growth Stocks are classified as growth stocks or value stocks based
on the PE ratio
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Example 3-5
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DuPont Analysis
DuPont analysis is a decomposition model ROA and ROE can be broken down into
components in an effort to explain why
they may be low (or high). The Basic DuPont equation
ROA = Profit Margin x Total asset
turnover
= xNI
SalesSales
TA
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The ROA depends on the firms profit margin
(which is an indicator of expense control) and
total asset turnover, an indicator of how
efficiently the firm manages its assets
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The full DuPont formula looks at thedecomposition of ROE:
ROE = profit margin x total asset turnover x equitymultiplier
ROE = X XNI
Sales
Sales
TA
TA
CE
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The DuPont model focuses on
Expense control (PM)
Asset utilization (TATO)
Debt utilization (EM)
Notice that the first two terms in the ROE model
are the same as ROA, so:ROE = ROA x equity multiplier
E l 3 6
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Example 3-6
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Other Ratios
Spreading the Financial Statements
Managers, analysts, and investors often create
common size financial statements
Balance sheet items are divided by total assets Income statement items are divided by sales
Common size statements are conducive to:
Identifying trends for the firm
Comparisons across firms in the industry
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Internal and Sustainable Growth Rates
The internal growth rate measures the amount of
growth a firm can sustain if it uses only internal
financing (retained earnings)
Internal growth rate = (ROA x RR) / [(1-ROA) x RR] where RR = retention ratio
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If the firm uses retained earnings to support
asset growth, the firms capital structure will
change over time
More equity financing and decreasing debt ratio
To maintain the same capital structure
managers must use both debt and equity
financing to support asset growth
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The sustainable growth rate measures theamount of growth a firm can achieve using
internal equity and maintaining a constantdebt ratio:Sustainable growth rate = (ROE x RR) / [(1-ROE) x RR]
Combining this with the DuPont equation, thesustainable growth rate depends on four factors: Profit margin (operating efficiency)
Total asset turnover (efficiency in asset use)
Financial leverage (using debt vs. equity to finance
assets) Profit retention (reinvestment of NI rather paying
dividends)
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Time Series and Cross Sectional
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Time Series and Cross-Sectional
Analysis
To analyze ratios in a meaningful way theymust be compared to some benchmark
There are two types of benchmarks:
Performance of the firm over time (time
series analysis) Performance of the firm against other
companies in the same industry (cross-sectional analysis)
Comparative ratios for industries are availablefrom Value Line, Robert Morris Associates, Dun &Bradstreet, Hoovers Online, and MSN Money
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Cautions in Using Ratios
1. Financial statement data are historical2. Firms use different accounting procedures E.g. LIFO/FIFO, depreciation methods
3. Sales and expenses may be seasonal
1. Some items may be unusually high or low at the closeof the fiscal year
4. Large firms have multiple lines of business
5. Firms can use window dressing to make
financial statement look better