Chapter 3 financial analysis

CHAPTER 3

Financial Analysis:
Sizing up Firm Performance

Copyright © 2011 Pearson Prentice Hall. All rights reserved.
4-1

Learning Objectives
1. Explain what we can learn by analyzing a
firm’s financial statements.
2. Use common size financial statements as a
tool of financial analysis.
3. Calculate and use a comprehensive set of
financial ratios to evaluate a company’s
performance.
4. Select an appropriate benchmark for use in
performing a financial ratio analysis.
5. Describe the limitations of financial ratio
analysis.
4-2

Why Do We Analyze Financial
Statements?
• An internal financial analysis might be done:
– To evaluate employees’ performance –
determine pay raises and bonuses.
– To compare the financial performance of the
firm’s different divisions.
– To prepare financial projections, eg. launch of a
new product.
– To evaluate the firm’s financial performance –
for improvement.

4-3

Why Do We Analyze Financial
Statements? (cont.)

• An external financial analysis might be done:
– Banks: to decide whether to loan money to the
firm.
– Suppliers: to grant credit to the firm.
– Credit-rating agencies: to determine the firm’s
creditworthiness.
– Professional analysts & individual investors: for
investment purposes.

4-4

Common Size Statements – Standardizing
Financial Information

• A common size financial statement :
standardized version of a financial statement in
which all entries are presented in percentages.

– For a common size income statement, divide
each entry in the income statement by the
company’s sales.
– For a common size balance sheet, divide each
entry in the balance sheet by the firm’s total
assets.

4-5

Common Size Income Statement
(H. J. Boswell, Inc.)

4-6

Common Size
Balance Sheet
(H. J. Boswell,
Inc.)

4-7

Using Financial Ratios

Question Category of Ratios Used
1. How liquid is the firm? Will it be Liquidity ratios
able to pay its bills as they
become due?
2. How has the firm financed the Capital structure ratios
purchase of its assets?
3. How efficient has the firm’s Asset management efficiency
management been in utilizing it ratios
assets to generate sales?
4. Has the firm earned adequate Profitability ratios
returns on its investments?
5. Are the firm’s managers Market value ratios
creating value for
shareholders?

4-8

Liquidity Ratios

• Liquidity ratios address a basic question:
How liquid is the firm?
• A firm is financially liquid if it is able to pay
its bills on time. We can analyze a firm’s
liquidity from two perspectives:
– Overall or general firm liquidity
– Liquidity of specific current asset accounts

4-9

Liquidity Ratios (cont.)

• Overall liquidity is analyzed by comparing
the firm’s current assets to the firm’s
current liabilities.

• Liquidity of specific assets is analyzed by
examining the timeliness in which the
firm’s primary liquid assets – accounts
receivable and inventories – are converted
into cash.

4-10

Liquidity Ratios: Current Ratio
• The overall liquidity of a firm is analyzed
by computing the current ratio and acid-
test ratio.

• Current Ratio: Current Ratio compares a
firm’s current (liquid) assets to its current
(short-term) liabilities.

4-11

Liquidity Ratios: Quick Ratio

• The overall liquidity of a firm is also
analyzed by computing the Acid-Test
(Quick) Ratio. This ratio excludes the
inventory from current assets as inventory
may not always be very liquid.

4-12

Liquidity Ratios:
Individual Asset Categories

• We can also measure the liquidity of the
firm by examining the liquidity of individual
current asset accounts, including
accounts receivable and inventories.
• We can assess the liquidity of the firm by
measuring how long it takes the firm to
convert its accounts receivables and
inventories into cash.

4-13

Liquidity Ratios: Accounts Receivable

• Average Collection Period measures the
number of days it takes the firm to collects
its receivables.

4-14

Liquidity Ratios: Accounts Receivable
(cont.)

• Daily Credit Sales
– = $2,500 million ÷ 365 days = $6.85 million
• Average Collection Period
= Accounts Receivable ÷ Daily Credit
Sales
= $139.5m ÷ $6.85m = 20.37 days
• The firm collects its accounts receivable in
20.37 days.

4-15

Liquidity Ratios: Accounts
Receivable Turnover Ratio

• Accounts Receivable Turnover Ratio
measures how many times accounts
receivable are “rolled over” during a year.

4-16

Receivable Turnover Ratio (cont.)

• The text computes the accounts receivable
turnover ratio for H.J. Boswell, Inc. for
2010.

• What will be the accounts receivable
turnover ratio for 2009 if we assume that
the annual credit sales were $2,500 million
in 2009?

4-17

Receivable Turnover Ratio (cont.)

• Accounts Receivable Turnover
= $2,500 million ÷ $139.50
= 17.92 times
• The firm’s accounts receivable were
turning over at 17.92 times per year.

4-18

Liquidity Ratios:
Inventory Turnover Ratio

• Inventory turnover ratio measures how
many times the company turns over its
inventory during the year. Shorter
inventory cycles lead to greater liquidity
since the items in inventory are converted
to cash more quickly.

4-19

Liquidity Ratios:
Inventory Turnover Ratio (cont.)

• The text computes the inventory turnover
ratio for H.J. Boswell, Inc. for 2010.

• What will be the inventory turnover ratio
for 2009 if we assume that the cost of
goods sold were $1,980 million in 2009?

4-20

Liquidity Ratios:
Inventory Turnover Ratio (cont.)

• Inventory Turnover Ratio
= $1,980 ÷ $229.50
= 8.63 times
• The firm turned over its inventory 8.63
times per year.

4-21

Liquidity Ratios:
Days’ Sales in Inventory
• We can express the inventory turnover ratio in
terms of the number of days the inventory sits
unsold on the firm’s shelves.
• Days’ Sales in Inventory
= 365÷ inventory turnover ratio
= 365 ÷ 8.63 = 42.29 days
• The firm, on average, holds it inventory for about
42 days.

4-22

Can a Firm Have Too Much Liquidity?

• A high investment in liquid assets will
enable the firm to repay its current
liabilities in a timely manner.

• However, an excessive investments in
liquid assets can prove to be costly as
liquid assets (such as cash) generate
minimal return.

4-23

Capital Structure Ratios

• Capital structure refers to the way a firm
finances its assets.
• Capital structure ratios address the
important question: How has the firm
financed the purchase of its assets?
• We will use two ratios, debt ratio and
times interest earned ratio, to answer
the question.

4-24

Capital Structure Ratios (cont.)

• Debt ratio measures the proportion of the
firm’s assets that are financed by
borrowing or debt financing.

4-25


• The text computes the debt ratio for H.J.
Boswell, Inc. for 2010.

• What will be the debt ratio for 2009?

4-26


• Debt Ratio
– = $1,012.50 million ÷ $1,764 million
– = 57.40%

• The firm financed 57.39% of its assets
with debt.

4-27


• Times Interest Earned Ratio measures
the ability of the firm to service its debt or
repay the interest on debt.

– We use EBIT or operating income as interest
expense is paid before a firm pays its taxes.

4-28


• The text computes the times interest
earned ratio for H.J. Boswell, Inc. for
2010.

• What will be the times interest earned
ratio for 2009 if we assume interest
expense of $65 million and EBIT of $350
million?

4-29


• Times Interest Earned
= $350 million ÷ $65 million = 5.38
times
• Thus the firm can pay its total interest expense
5.38 times or interest consumed 1/5.38th or
18.58% of its EBIT. Thus, even if the EBIT shrinks
by 81.42% (100-18.58), the firm will be able to
pay its interest expense.

4-30

Asset Management Efficiency Ratios

• Asset management efficiency ratios
measure a firm’s effectiveness in utilizing
its assets to generate sales.
• They are commonly referred to as
turnover ratios as they reflect the
number of times a particular asset account
balance turns over during a year.

4-31

(cont.)

• Total Asset Turnover Ratio represents
the amount of sales generated per dollar
invested in firm’s assets.

4-32

(cont.)

• The text computes the total asset turnover

• What will be the total asset turnover ratio
for 2009 if we assume the total sales in
2009 were $2,500 million?

4-33

(cont.)

• Total Asset Turnover
– = $2,500 million ÷ $1,764 million = 1.42 times

• Thus the firm generated $1.42 in sales per
dollar of assets in 2009.

4-34

(cont.)

• Fixed asset turnover ratio measures
firm’s efficiency in utilizing its fixed assets
(such as property, plant and equipment).

4-35

(cont.)

• The text computes the fixed asset turnover

• What will be the fixed asset turnover ratio
for 2009 if we assume sales of $2,500
million for 2009?

4-36

(cont.)

• Fixed Asset Turnover
– = $2,500 million ÷ $1,287 million = 1.94
times

• The firm generated $1.94 in sales per
dollar invested in plant and equipment.

4-37

(cont.)

• We could similarly compute the turnover
ratio for other assets.

• We had earlier computed the receivables
turnover and inventory turnover, which
measured firm effectiveness in managing
its investments in accounts receivables and
inventories.

4-38

(cont.)

For Boswell, 2010
• Total Asset Turnover
= Sales ÷ Total Assets
= $2,700m ÷ $1,971m =
1.37
• Fixed Asset Turnover
= Sales ÷ Net Plant and
Equipment
= $2,700m ÷$1,327.5m = 2.03

4-39

(cont.)
For Boswell, 2010
• Receivables Turnover
= Credit Sales ÷ Accounts Receivable
= $2,700m ÷ $162m = 16.67 times
• Inventory Turnover
= Cost of Goods Sold ÷ Inventories
= $2,025m ÷$378m = 3.36 times

4-40

(cont.)

• The following grid summarizes the efficiency
of Boswell’s management in utilizing its
assets to generate sales in 2010.

Turnover Boswell Peer Group Assessmen
Ratio t
Total 1.37 1.15 Good
Assets
Fixed 2.03 1.75 Good
Assets
Receivable 16.67 14.60 Good
s
Inventory 5.36 7.0 Poor
4-41

Profitability Ratios

• Profitability ratios address a very
fundamental question: Has the firm earned
adequate returns on its investments?
• We answer this question by analyzing the
firm’s profit margin, which predict the
ability of the firm to control its expenses,
and the firm’s rate of return on
investments.

4-42

Profitability Ratios (cont.)

• Two fundamental determinants of firm’s
profitability and returns on investments
are the following:
– Cost Control
• Is the firm controlling costs and earning reasonable
profit margin?
– Efficiency of asset utilization
• Is the firm efficiently utilizing the assets to generate
sales?

4-43


• Gross profit margin shows how well the
firm’s management controls its expenses
to generate profits.

4-44


• The text computes the gross profit margin

• What will be the gross profit margin ratio
for 2009 if we assume sales of $2,500
million and gross profit of $650 million for
2009?

4-45


• Gross Profit Margin
– = $650 million ÷ $2,500 million = 26%

• The firm spent $0.74 for cost of goods sold
for each dollar of sales. Thus, $0.26 out of
each dollar of sales goes to gross profits.

4-46


• Operating Profit Margin measures how
much profit is generated from each dollar
of sales after accounting for both costs of
goods sold and operating expenses. It thus
also indicates how well the firm is
managing its income statement.

4-47


• The text computes the operating profit
margin ratio for H.J. Boswell, Inc. for
2010.

• What will be the operating profit margin
ratio for 2009 if we assume sales of
$2,500 million and net operating income
of $350 million for 2009?

4-48


• Operating Profit Margin
= $350 million ÷ $2,500 million = 14%

• Thus the firm generates $0.14 in operating
profit for each dollar of sales.

4-49


• Net Profit Margin measures how much
income is generated from each dollar of
sales after adjusting for all expenses
(including income taxes).

•

4-50


• The text computes the net profit margin

• What will be the net profit margin ratio for
2009 if we assume sales of $2,500 million
and net income of $217.75 million for
2009?

4-51


• Net Profit Margin
– = $217.75 million ÷ $2,500 million = 8.71%

• The firm generated $0.087 for each dollar
of sales after all expenses (including
income taxes) were accounted for.

4-52


• Operating Return on Assets ratio is the
summary measure of operating
profitability, which takes into account both
the management’s success in controlling
expenses, contributing to profit margins,
and its efficient use of assets to generate
sales.

4-53


• The text computes the operating return on
assets ratio for H.J. Boswell, Inc. for 2010.

• What will be the operating return on assets
ratio for 2009 if we assume EBIT or net
operating income of $350 million for 2009?

4-54


• Operating Return on Assets
– = $350 million ÷$1,764 million = 19.84%

• The firm generated $0.1984 of operating
profits for every $1 of its invested assets.

4-55

• Decomposing the OROA ratio: We can use the
following equation to decompose the OROA ratio
that allows us to analyze the firm’s ability to
control costs and utilize its investments in assets
efficiently.

4-56


4-57

Figure 4-1 Observations
• Firm’s OROA (operating return on assets) is better
than its peers. Thus the firm earned more net
operating income per dollar invested in assets.
• Firm’s OPM (operating profit margin) is lower
than its peers. Thus the firm retained a lower
percentage of its sales in net operating income.
• Firm’s TATO (total asset turnover ratio) is higher
than its peers. Thus the firm generated more
sales from its assets.

4-58

Figure 4-1 Recommendations

• The firm has two opportunities to improve
its profitability:
1.Reduce costs - The firm must investigate
the cost of goods sold and operating
expenses to see if there are opportunities
to reduce costs.
2.Reduce inventories – The firm must
investigate if it can reduce the size of its
inventories.

4-59

Is the Firm Providing a Reasonable
Return on the Owner’s Investment?

• A firm’s net income consists of earnings
that is available for distribution to the
firm’s shareholders. Return on Equity
ratio measures the accounting return on
the common stockholders’ investment.

4-60

Is the Firm Providing a Reasonable Return on
the Owner’s Investment (cont.)

• The text computes the return on equity

• What will be the return on equity ratio for
2009 if we assume net income of $217.75
million for 2009?

4-61

Is the Firm Providing a Reasonable Return on
the Owner’s Investment (cont.)

• Return on Equity
– = $217.75 million ÷ $751.50 million =
28.98%

• Thus the shareholders earned 28.97% on their investments.
• Note common equity includes both common stock plus the
firm’s retained earnings.

4-62

Using the DuPont Method for
Decomposing the ROE ratio
• DuPont method analyzes the firm’s ROE by
decomposing it into three parts: profitability,
efficiency and an equity multiplier.

– ROE = Profitability × Efficiency × Equity
Multiplier

• Equity multiplier captures the effect of the firm’s
use of debt financing on its return on equity. The
equity multiplier increases in value as the firm
uses more debt.

4-63

Decomposing the ROE ratio (cont.)
• ROE = Profitability × Efficiency × Equity Multiplier

• ROE = Net Profit Margin × Total Asset
Turnover Ratio × 1/(1-debt ratio)

4-64


• The following table shows why Boswell’s
return on equity was higher than its peers.

Return Net Total Equity
on Profit Asset Multiplier
Equity Margin Turnover
H. J. 22.5% 7.6% 1.37 2.16
Boswell,
Inc.
Peer 18.0% 10.2% 1.15 1.54
Group

4-65


• The table suggests that Boswell had a
higher ROE as it was able to generate
more sales from its assets (1.37 versus
1.15 for peers) and used more leverage
(2.16 versus 1.54).
• Note use of financial leverage may not
always generate value for shareholders.
Impact of financial leverage is discussed in
detail in chapter 15.

4-66

Using the
DuPont
Method for
Decomposing
the ROE ratio
(cont.)

4-67

Market Value Ratios

• Market value ratios address the
question, how are the firm’s shares valued
in the stock market?

• Two market value ratios are:
– Price-Earnings Ratio
– Market-to-Book Ratio

4-68

Market Value Ratios (cont.)

• Price-Earnings (PE) Ratio indicates how
much investors are currently willing to pay
for $1 of reported earnings.

4-69


• The text computes the PE ratio for H.J.
Boswell, Inc. for 2010.

• What will be the PE ratio for 2009 if we
assume the firm’s stock was selling for $22
per share at a time when the firm reported
a net income of $217.75 million, and the
total number of common shares
outstanding are 90 million?

4-70


• Earnings per share
– = $217.75 million ÷ 90 million = $2.42
• PE ratio = $22 ÷ $2.42 = 9.09
• The investors were willing to pay $9.09 for
every dollar of earnings per share that the
firm generated.
4-71


• Market-to-Book Ratio measures the
relationship between the market value and
the accumulated investment in the firm’s
equity.

4-72


• The text computes the market-to-book

• What will be the market-to-book ratio for
2009 given that the current market price
of the stock is $22 and the firm has 90
million shares outstanding?

4-73


• Book Value per Share
– = 751.50 million ÷ 90 million = $8.35 per
share

• Market-to-Book Ratio
= Market price per share ÷ Book value per
share
= $22 ÷ $8.35 = 2.63 times

4-74

Selecting a Performance Benchmark

• There are two types of benchmarks that
are commonly used:
– Trend Analysis – involves comparing a firm’s
financial statements over time.
– Peer Group Comparisons – involves comparing
the subject firm’s financial statements with
those of similar, or “peer” firms. The
benchmark for peer groups typically consists of
firms from the same industry or industry
average financial ratios.

4-75

Trend Analysis

4-76

Financial Analysis of the Gap, Inc., June
2009

4-77

The Limitations of Ratio Analysis

1. Picking an industry benchmark can
sometimes be difficult.
2. Published peer-group or industry
averages are not always representative of
the firm being analyzed.
3. An industry average is not necessarily a
desirable target or norm.

4-78

The Limitations of Ratio Analysis
(cont.)
4. Accounting practices differ widely among firms.
5. Many firms experience seasonal changes in their
operations.
6. Financial ratios offer only clues. We need to
analyze the numbers in order to fully understand
the ratios.
7. The results of financial analysis are dependent
on the quality of the financial statements.

4-79

Chapter 3 financial analysis

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