Financial Management Test

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Overview, Objectives and Readings 315 ̀ N~- ZPage 1 v f 1

Overview

Analysis of Financial Statements: This chapter brings us back to some of the concepts learned in principles of accounting courses. You may want to refer to chapter 2 for a refresher on basic accounting principles. In this chapter, we review some financial analysis and interpretation ratios focused on profitability, asset utilization, liquidity and debt utilization.

Practice Problems -Please see the syllabus for problems assigned for homework/practice.

Objectives Readings

After completing this module, you will be able to Chapter 3

Financial Analysis Week 2 lecture materials

1. Ratio analysis provides a meaningful comparison of a (Review chapter 2 for an accounting refresher) company to its industry.

2. Ratios can be used to measure profitability, asset utilization, liquidity, and debt utilization.

3. The Du Pont system of analysis identifies the true sources of return on assets and return to stockholders.

4. Trend analysis shows company performance over time. 5. Reported income must be further evaluated to identify

sources of distortion.

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Lecture

Financial Analysis

Content Authors: Louise August, CPA, PhD

Overview of Ratio Analysis

I n the next several lecture segments, we'll look at how financial statements can be analyzed to get a more in-depth understanding of the firm's financial position, operations and its overall financial health.On the basis of this information, management can take actions to exploit strengths and correct weaknesses.

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It's not only insiders who perform ratio analysis to assist in their evaluations of a firm. Financial ratios are used by various groups:

1. Insiders: Managers, supervisors who employ ratios to help plan, analyze, control, and thus improve their firm's operations.

2. Lenders: Credit analysts, bank loan officers or bond rating analysts, who analyze ratios to help ascertain a company's credit rating and ability to pay its debts.

3. Vendors and suppliers: these are also lenders, who are interested in the firm's ability to pay invoices as they come due. 4. Investors: Stock analysts, brokers, wealth advisers who are interested in a company's financial health, risk, and growth

prospects. 5. Customers: current and prospective customers who want to know whether the firm will be able to supply product &

services now and in the future.

We can glean quite a lot of information about the firm directly from the financial statements themselves: Lets begin by taking a look at the three basic financial statements for Acme Products, Inc. that we'll be using for ratio analysis to see what we can learn about the company.

• $6 million in sales Income Statement $567,600 in operating profit

• $227,000 in net income

• $20,000 in cash

Balance Sheet •Receivables are up • Inventory is up • Debt is up, too

Statement of Cash Flows 'Positive cash flow from operations • Decrease in end of period cash balance

Overall, the firm has grown from $3.36 million in total assets to $4.00 million, but we can't tell how the firm is doing on a more detailed level or how it measures up to the standard for its industry. Ratio Analysis gives us tools to evaluate the financial statements and help make absolute values (dollar amounts) more meaningful. This kind of analysis provides insight that is helpful for many purposes:

1. Externally- an investor's point of view a. A current investor (shareholder) wishing to evaluate their holdings b. A potential investor (an individual, a fund manager or an investment advisor) deciding whether this firm is a good

investment choice 2. Internally- managements point of view to analyze, control, improve

a. Keep tabs on whaYs going on internally -the ratios are flags; little warnings signs of situations that you might otherwise miss. For example, if Accounts Receivable is increasing, what could it mean? Is it good or bad?

b. How does current performance compare to our budgets and forecasts? c. How do we compare to the competition?

There are many ratios that can be calculated. Some may be unique to particular industries. We will look at some of the most common ones. NOTE: Beware when reading other sources -- some ratios can have different names for the same formula; some may have the same name but use different formulas, resulting in different answers. However, for purposes of this

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course, we will use the name and formula described for each in this and the following lecture segments, which are the same as in our textbook.

There are four main groups of ratios that we will be discussing:

• Liquidity Ratios • Asset Management Ratios • Debt Management Ratios • Profitability Ratios

If you haven't done so already, you should print out (or at least have them open and view-able) the sample financial statements for Acme Products, Inc. provided in last week's module. We'll be using them as the source for ratio calculations.

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Lecture

Liquidity Ratios

Content Author: Louise August, CPA, PhD

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Recall that liquidity refers to how quickly an asset can be converted to cash. An asset that can be converted to cash quickly without having to reduce the asset's price very much is a liquid asset. Liquid assets can be converted to cash quickly at the going market price. The liquidity ratios show the relationship of a firm's current assets to its current liabilities (those coming due in the next year). It measures a company's ability to pay those short-term debts/obligations when due using their current assets. Two commonly used liquidity ratios are (1) current ratio and (2) quick, or acid test, ratio.

Current ratio: The current ratio measures the extent to which current liabilities can be satisfied (paid) by current assets. It is calculated by dividing current assets by current liabilities. It is the most commonly used measure of short-term solvency:

cui-rei~t assets

~UI'I'8rit R~tiO current liabilities

2440 _ = 3.' sL~ndard = ~.2

sao

The ratio result is greater than one (1). That means that current assets exceed current liabilities. In fact, Acme has over three times the amount of current assets compared to current liabilities. So for every dollar of current liability, Acme has $3.20 in current assets with which to pay it. This seems like a pretty comfortable cushion. But when we look at the industry standard of 4.2, we see that Acme doesn't have quite enough cushion.

I n ratio analysis, iYs also important to understand how changes in circumstances or management decisions will be reflected in the ratios.

Q: If the company begins to pay off its bills more slowly, what will happen to the current ratio?

Click here for answer

Quick ratio: The Quick Ratio is a more stringent measure of liquidity -for that reason, its sometimes called the Acid-Test Ratio. IYs the current ratio with Inventory subtracted from the numerator. We subtract inventory because it is the least current of the current assets -- meaning that it takes the longest to be converted into cash.

{~1FIC~{ Rc7t10

currentassets—inventory

ciirre~~t liabilities

?70 _ = 1.Z standard = 2.1

Ei2o

At least the number is positive, so the firm could collect its AR and still meet its short term obligations. Again, the firm is not doing as well as the standard would suggest is appropriate.

Thinking Beyond the Numbers

While it is important to calculate the ratios accurately and understand what they represent, iYs also necessary to think about and interpret the information more broadly. Consider these questions:

Q: Which of the various outsider groups is likely to be interested in a firm's liquidity ratios?

Click here for answer

Q: Is the current ratio or the quick ratio a better measure of a firm's liquidity?

Click here for answer

Q: Can a current ratio be too high?

Click here for answer____ ___.

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Lecture

Asset Management Ratios

Content Author: Louise August, CPA, PhD

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These ratios are also called asset utilization or activity ratios. They measure how well the firm's investment in assets is able to generate sales, or conversely, in terms of sales whether the level of assets is appropriate or too high or too low. Many of these are "the turnovers", which are "sales over something".

I nventory Turnover (ITO): The inventory turnover ratio measures the speed with which we "turn" the inventory, or how many times each year (theoretically speaking since this isn't how physical inventory is actually handled) the inventory is sold out and replaced. IYs a measure of how efficiently inventory is being managed. It may be desirable to use average inventories rather than year-end if a firm's business is highly seasonal, or if there has been a significant increase or decrease in the level of inventory during the year.

II1V~II~OI'y _ sales _ bt~00 _ ~.4 standard = 9.2 Turnover f~ventory 1230

Acme's inventory is turned (sold out and replaced) approximately 5 times. Compared to the industry standard thaYs too slow. This could be due to carrying excess inventory, the presence of damaged or obsolete goods, or poor purchasing practices. In any case, there are either too many dollars invested in inventory that are not generating a suitable level of sales.

Days Sales Outstanding (DSO): Sometimes this is called Average Collection Period (ACP) or Days Sales in Receivables (DSR). This is exactly what it sounds like - on average, how long after a sale will we collect the money? Thus, the DSO represents the average length of time that a dollar of sales is tied up in receivables. Here the calculation uses 360 days per year -this is a very common convention in ratio calculations and the difference in result is minimal compared to 365 days.

.l~V~T'a ~ ~O~~f'GClOII _ ~ec~iva~les receivables :+~t1

~ - - = 45.I7 days st~nc~~rd = 30.0 days Period (.4CP~ Avg, d~tlkr sags saes/3~o ~

6000~36~

Acme's DSO is 45 days versus the industry average of 30 days. If as is common, our terms are net 30 days it means that overall customers don't pay on time. This could be a result of many things -poor collection efforts, loose credit policy, or one big customer in trouble, perhaps. It probably warrants further investigation. On the other hand, a ratio that isn't close to the industry average doesn't necessarily mean that the company isn't doing well or should try to change to bring their ratios into line with the industry average. Perhaps we've made special credit arrangements with that one big customer. What the ratios should do is raise red flags--something to be examined to determine if there is a problem and what if anything should be done about it

Fixed Assets Turnover: This is the ratio of sales to net fixed assets. It measures how effectively the firm is able to use its investment in property, plant and equipment (PPE) to generate sales.

Fires t~sset _ Sales _ boo4- - - 3.0 standard = 3.0 Turnover FixedAss~ets zoos

At just equal to the standard, this suggests that Acme is using its assets as intensively as other firms in the same industry classification. It also suggests that Acme has the correct level of dollars invested in fixed assets for the level of sales generated.

Total Asset Turnover: This is the ratio of sales to all of the firm's assets. Similar to the FA turnover ratio, it measures how effectively the firm is able to utilize its investment in assets to generate sales.

total Asset s~1~~ e000

Turnover ~`~c~t ~Ss~r~ aoafl

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Acme's ratio is below the standard, indicating that it is not generating a sufficient volume of business given the level of investment in its assets. Sales should be increased; poor performing assets disposed of, or managed more tightly.

Thinking Beyond the Numbers

Q: Can the inventory turnover ratio be too high?

Click here for answer

Q: Why might the fixed asset turnover ratio be difficult to interpret when comparing and older firm with a newer one?

Click here for answer .. ................................................................. _ _..............

Q: Can DSO be too low?

Click here for answer

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Lecture

Debt Management Ratios

Content Author: Louise August, CPA, PhD

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Also called debt utilization ratios, they measure the extent to which a firm is using debt financing and their ability to service that debt. How much debt should be used in the firm's capital structure is one of the fundamental questions in finance, and not one that's easily answered. We explore this topic in depth in a later week.

Debt to Capital Ratio: This is the ratio of total interest-bearing debt to total capital and measures the percentage of funds provided by creditors. In this ratio, Debt includes both current and long-term interest-bearing debt. Capital includes interest- bearing debt and total equity.

The lower the ratio, the greater the protection afforded creditors in the event of liquidation. So generally, creditors prefer a lower percent because it provides a greater cushion against default. Shareholders on the other hand prefer more debt as a source of capital because it doesn't dilute earnings, or voting control.

Debtta Ca 111 _ total deUt 22Q+1508 1728 0

p - - - = 48.~t:o stancTai•el = 1.S

~ail0 total capital 220+Y508+1372 3604

tocai liabilities ~,zc~+ ~5c~s a ze ~2~JL ~dtl0 ~ tuta[ assets m dO~G~ M ~Lflflo =

53.2~i sfand~rd = #S.Q~'n

More than half the firm's financing comes from its creditors (debt providers) vs. from its equity investors. This exceeds the industry average. As a result creditors may feel the firm is carrying too much debt (over-leveraged) and be reluctant to supply additional debt unless more equity is raised first or interest rates are increased.

Times Interest Earned (TIE): This ratio measures the firm's ability to meet its contractual interest payments. It indicates the extent to which operating income (EBIT) could decline before the firm is unable to meet its obligations to debt providers such as bankers, bondholders or other lenders. Failure to make timely payments has negative consequences, from reduced credit ratings to bankruptcy. Note that EBIT, rather than net income, is used in the numerator because we want to measure the firm's ability to service its debt from its core operation.

Times Interest _ Est~r 56' .6

- - - 3.Z tines stane~ard = 5.8 times

Earned (TIE) ~nter~st ~~6

So for every dollar of interest the firm must pay, it earns $3.20 in operating income, but compared to the standard this is a slimmer margin than desirable. The higher the TIE ratio is, the more operating earnings are available to pay interest on debt, and the more likely the firm is to obtain additional debt financing at attractive rates.

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Lecttn~e

Profitability Ratios

Content Author: Louise August, CPA, PhD

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This group of ratios include various measures of the return the company is able to generate. They examine the overall success of the firm; its ability to utilize its resources to earn a return. The first set of profitability measures are the Margin Ratios. The Income Statement has various sub-total, or interim profit points, before arriving at Net Income. The Margin Ratios measure the various profit points as a percentage of sales. Because most these ratios use "bottom line" numbers such at net profit and total assets the results reflect the results we've already seen in looking at the other ratio groups.

Gross Profit Margin: Keep in mind that Gross Profit =Sales -Cost of Goods Sold (COGS). For a manufacturing operation this includes: raw materials, component parts, factory labor, and factory overhead -- in other words all the costs directly traceable to the product that the firm sells. So this ratio (also called just Gross Margin) calculates Gross Profit as a percentage of sales and measures the firm's ability to generate profit from sales of its products/service.

Gross Profit Vross profit 2.7 0

_ — 454/o stanclarc{ = 49.5% Maf•gi~1 sale s,000

For every $100 dollars of sales, Acme is able to generate 45% or $45.00 in gross profit. That's not as good as the industry standard of 49.5%. Perhaps Acme isn't as good at controlling costs, on the other hand perhaps they make top-of-the-line l uxury goods whose raw materials and component parts cost more.

Q: Would a higher level of sales improve this?

Click here for answer_...._

Operating Margin: It calculates Income form Operations (EBIT) as a percentage of sales and measures the firm's ability to generate earnings from its core operation.

~23I'T' 5ti7, C)pBT~tlTfg _ .__.~..._ _ ___._._m. _ 9.5ara s~rada~•ci = 9.84~n ~1C~111 Sales t~,~QO m

For every $100 dollars of sales, Acme is able to generate 9.5% or $9.50 in operating profit. Not quite as good as the standard, but they've made up some ground from gross margin. Perhaps they are better than most at controlling indirect or period costs.

Profit Margin: This is sometimes called "Net Profit Margin" to distinguish it from other margin ratios. It calculates the firm's profit per dollar of sales as a percentage.

Net PI'ofit _ ~`et income _ 235

~.t3~?~0 sYandarel. = 5A6o.. Margin S31es ti,400

For every dollar of sales, Acme is able to generate $3.80 of net income. Their 3.8°/o margin is lower than the industry standard, so less overall ability to earn a profit compared to others. This could be caused by a number of things: perhaps operating costs are too high, or interest costs are too high (too much debt?), or both.

Q: Would a higher level of sales improve this?

Click here for answer .........._..__ ....................................._.........._...............

Return on Assets (ROA): ROA is the ratio of net income to total assets. It calculates net profit as a percentage of total assets and helps us examine issues such as the level of return the firm earns on the dollars invested in assets or how effectively/efficiently assets are being used to generate profits.

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Ti~ti22'11 flit _ het in~ana~ _ : 3S

Assets `1'c~tal ~s~ets ~,oQt~

Acme's ROA of 5.9% indicates a lower than desirable ability to earn, this time based on the firm's investment in assets. Perhaps there are obsolete or idle fixed assets, or perhaps the problem is in current assets -DSO was longer which suggests a higher AR balance.

Return on Equity (ROE): ROE measures the rate of return that the firm earns on the capital invested by the common shareholders. IYs sometimes called "Return on Common Equity." Recall that common equity is equal to total equity unless there is preferred stock in the firm's capital structure. If thaYs the case, as it is with Acme, the preferred stock is excluded. This is a very important measure - if the return we earn is less than adequate, shareholders may elect to invest their dollars elsewhere.

Net in~c~ai~ ~3S ~iiE~C11F1T OIl = _ = 1'3.I7 ~ st.~Ild.~l'tl = l~.tj'}• Ef~tiity ~os~a~gzroi~squit~r 1,~~~5~

Acme's ROE of 13.1 %indicates that they are earning asub-standard return for their shareholders, compared to other similar firms in this industry. We'll need to dig deeper to learn what might be causing this and how it might be improved.

Both ROE and ROA are important measures used by shareholders, potential investors, financial analysts, etc. to make decisions about whether and how much to invest. We'll examine both ratios in more detail when we look at the DuPont Ratios that break ROA and ROE down into their component parts.

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Lecture

DuPont Analysis Disaggregated

This "system" of analysis was originally created by financial analysts at DuPont Chemical, hence the name.

Content Authors: Steve Ranger and Louise August, CPA, PhD.

Page 1 of 4

DuPont Analysis (or the DuPont Equation) breaks down ROA (and later ROE) into its component parts. The benefit is that it helps us to see how the various ratios are related and provides clues to the forces behind deteriorating or improving financial performance.

Recall the basic equation: A = L (debt) + E If the firm was all equity financed (i.e., no debt)

Then A = E

And ROA would be equal to ROE, right?

N I = A would be equal to NI = E, so ROA =ROE

Here's a simple number example:

-~~~~ -~

~~~ -~

---

_-__

Components of ROA

Recall that in its most simplified form, ROA is a ratio that compares Net Income to Total Assets. Put into equation form, the simplified ROA looks like this:

Rt)A = NI

total asst

We c~~ilc~ ex~ancl the Ftt~A f~ E~~~i1a like 's:

ROA = R11 x sales

sales total asset

Net Profit Margin A~:set Ti~rr~over

The sales generated from an investment in production assets (Asset Turnover) are intrinsically related to (and the product ofl the profit ultimately derived from those sales (Profit Margin) as well as the ability to contain costs.

Example: If a company's overall profitability as represented by ROA is failing to meet industry standards or competitor levels, the problem could be traced to:

a. asset utilization issues and/or

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b. managements inability to convert sales to profit by controlling/managing expenses

Once we discover which of the two ratio parts of ROA is falling short (or perhaps we discover it is both parts), we can then turn our attention to what may be causing the problem. For instance:

If ROA is low and its due to a lower than desired Net Profit Margin, then the issue is the ability to generate profit from sales and an apparent inability to control expenses. More specifically, the problems) may be:

Cost of Goods Sold is too high. Analysis of Gross Profit Margin may help to uncover this.

Operating Expenses -one or more line items may have risen. Operating profit margin and its relation to gross profit margin may provide insight into this portion of the income statement.

Other Expenses may have increased. Looking at trends between NOI, EBIT and Net Profit Margin may illuminate problems areas in this portion of the Income Statement.

Tax Expense obligations may have risen, perhaps due to tax law changes or the extinguishment of tax credits. Looking at EBIT and EBT trends and Net Operating Profit Margin relative to Net Profit Margin may give insight into the overall tax situation.

If ROA is low and its due to a lower than desired Total Asset Turnover, then the issue is related more to the mix of assets and their ability to help generate sales. More specifically, the problems) may be:

Inventory issues -perhaps too much inventory on hand or inventory thaYs not moving. DSI, other inventory ratios and the liquidity ratios in general may help to uncover the problem.

Receivables issues — possibly customers failing to pay in a timely manner. DSR and the other receivables ratios may help to uncover the problem.

Fixed assets issues - perhaps assets are i nefficient and/or too expensive to maintain, thereby hurting their ability to generate income; or perhaps there is too much reliance on non-operating assets in the mix of total assets. Operating Asset Turnover and perhaps a trend analysis of COGS and Operating Expenses may help to uncover this problem.

Lets close the loop by canceling out the sales figure in the denominator of Net Profit Margin and the sales figure in the numerator of Total Asset Turnover. We can see that we get back to Net Income =Average Total Assets, which is the simplified formula for ROA we started with:

FDA = NI x s R~c~1l that t~lgebea allows u~ to ~in~~jlify ~. tGt~~l assets

ec~u~~tions key canceling aut like terms

occur rind in tt~e numerator ar~d der~onjir~a Net Profit Markin Asset Turnover

Now with Debt in the Capital Structure

We saw that no debt, ROA =ROE. With debt in the capital structure, what happens to the relationship between ROA and ROE? Which ought to be larger?

It may help to recreate accounting equation from above, this time with some debt in the capital structure

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Lecture

A = L + E

4 = 1 + 3 (N1=2)

ROA = 2=4 = 50%

ROE = 2-3 = 66°/a

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A: With debt in the mix, ROE will be > ROA. So there must be another term to represent the leveraging effect of debt. In other words, some factor, an equity multiplier, so, ROE = ROA x equity multiplier.

This makes sense, since we know that debt increases risk, and in turn that forces a higher rate of return to compensate the i nvestor for the additional risk.

The Equity Multiplier or Financial Leverage Ratio (FLR)

We can expand DuPont Analysis to include an evaluation of a company's ROE and its capital structure by incorporating a third ratio to represent that Equity Multiplier.

The Financial Leverage Ratio is related to the Debt Ratio and D/E ratio. All three ratios will provide insight into the capital structure and the firm's relative reliance on debt in financing asset acquisition.

The relationship between:

Debt Ratio liabilities and assets L=A

Debt-to-Equity Ratio liabilities and equity L=E

Financial Leverage Ratio assets and equity A=E

The Financial Leverage Ratio (FLR), also known as the Solvency Ratio, is a way to quantify the effect of using of debt. An increased reliance on debt =increased FLR

• unleveraged (debt-free): FLR = 1.0 • 50% debt: FLR = 2.0

A = L + E FLR

Debt free 4 = 0 + 4 1.0

50%debt 4 = 2 + 2 2.0

Components of ROE: ROE = ROA x equity multiplier

RC~E = R~~A x F

RQE = N[ x ~alP:S x total assts

safes tc~taC assets ec~~aity

Pt~afit Mar~t~ Asset Turrio~rer Fi[~'I L~vera~e

ROE is the product of these three major components:

The ability to generate profits as measured by Net Profit Margin

The efficient asset use as measured by Asset TO

The use of debt financing as measured by Fin'I Leverage

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Lecture

Finally, we can cancel out the terms to prove that it really is equal to the original ROE formula:

RtiE = Nh x ~ x ~^+ ~,

s +~,+~-~;--~~~ equity

Finally, let's work through an example:

• Sales 3,000,000 • Profit 113,500 • Assets 2,000,000 • Liabilities 1,140,000 • Equity 896,000

Page 4 of 4

RC~E = Prafit i~~argin Asset ~~~ ir~'I Leverage

Rt~E = N! x sales x total assets

gales total assets equity

113.5 x 30i~0 x 200?

3000 2Q40 $9G

0.0378 1.5400 2.2321 = 0.1267

Below is tt~e sirr~~le RCjE fnr-r~~ula... anc~ ~rrre can see tt~~t tthe twc~ are ~nc~eeci ~valent

R(~E = NI = 113.5 = 0.1267

ec~uity B~+G

Use as an Analytical Tool

The strength of DuPont Analysis is its ability to help discover where an organization may be struggling to meet expectations, or perhaps, where it is successful. Once an area of concern is noted, we can use other ratios and trend analysis to further explore the issue.

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Lecture

Trend Analysis and Limitations to Ratio Analysis

Content Author: Louise August, CPA, PhD

Trend Analysis

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This is another important technique in the analysts toolbox. Although comparing Acme Products to the industry average can help us determine the current health of the company, another use for ratio analysis is to calculate certain ratios for Acme over a number of periods. Then we can examine the trend which shows how performance changes through time. It is i mportant to analyze trends in ratios as well as their absolute levels. Doing so can provide clues as to whether, and perhaps why, the firm's financial situation is improving or to deteriorating. Graphing can help make patterns stand out even more.

Here's a set of Gross Profit data for a firm and for the industry standard. How do you think the firm is doing?

=ir:-~ t~:cus±ry

~~P:~f ~, 5.5~j h.C:~3 ~ 11.0"5 ~----_—___—'— __'_

7 ~'C ~ ''~' ' GrossProfA mmoarisw~t 1.^.dustrvAvere e

Year 3 5.7': 6„5% i s.r~ +...._......_......_...—..__._....__._..___.~.--------

Year _> e a~~ s.~s~ ~ `"~ Click here to see what I think Year6 S.S~: 6.7Y

i.~4 -' .........._ .._......_. .. __. ..... ~M~hY. i ........

'tadrS 5.3"'s 7.C}Q/a oov . ......._•—~------._,.--r-T~-----~---~

Y Year Yex You Yew

~T ~clrg ]. ~~~`J 7.~~

Y<u ter u Yta~ Y az Yeu

I Z 3 d ~ 6 7 9 '9 ]0

Year 10 ~.1`,~~ 7.2°l

When analysis involves comparisons to the "industry average" that means comparisons to the ratios of other firms in the same i ndustry. Comparative ratios are available from a number of sources including ValueLine, Dun &Bradstreet, Robert Morris Associates, and the U. S. Commerce Department. Depending on our circumstances, we may wish to create a subset of the entire industry rather than comparing ourselves to every single firm in the industry classification. Perhaps it makes more sense to compare the firm with its local or regional competitors only. Perhaps we'd like to compare ourselves to the "best in the business", not just the average.

Limitations to Ratio Analysis

Distortions and Limitations: There are some inherent problems and limitations to ratio analysis that necessitate care and judgment. Ratio analysis isn't a magic box. You can't just crank out the numbers and expect that "all will be revealed". A mechanical application and interpretation of ratio analysis is at best naive and possibly dangerous.

r '~ ~

Ratios are often not useful for analyzing the operations of large firms that ,~~ j~ operate in many different industries because comparative ratios are not ;,;~.. l.~ ~~ meaningful.

€ ~ Industry averages include the best and the worst firms in an industry and so

~,'~-~~ ~ r̀ ~ may not provide a very challenging target for high-level performance.

I nflation effects depreciation charges, inventory costs, and therefore, the value of both balance sheet items and net income. For this reason, the

'̀ analysis of a firm over time, or a comparative analysis of firms of different x ,. ages, can be misleading.

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;~ ~ ; ~.

.~ ~}• Ratios may be distorted by seasonal factors. But be cautious about assuming whether a business is seasonal. Toy retailing is highly seasonal, whereas a

l ~ .. . motorcycle dealership is surprisingly not seasonal at all.

\ ~ Financial statements (and therefore ratios) can be manipulated by:.>> ~~~,;•Y' ,,~,~~

~'r"~~~~ management to give the impression of a sound financial condition. For

~ ~~"` 3fl/~~~ r b.:

example, ashort-term loan at year-end to improve cash. This is sometimes called window dressing.

~ 41„0~J J l ,~~Q... .. - .tM

v̀

,,.~

'~r~islll~ Different operating policies and accounting practices, such as the decision to ~~'~ ~ lease rather than to buy equipment, can distort comparisons. So can the use

of differing methods of valuing inventory or revenue recognition policies.

t~;3 t °,' Interpretation isn't always straightforward and many ratios can be interpreted _,,,,, in different ways. Whether a particular ratio is good or bad should be based

cam,, upon a complete financial analysis rather than the level of a single ratio at a single point in time. For example: A high current ratio might indicate a strong,

~~.. ~~ ~ liquid firm or excess cash and uncollectible receivables. A high fixed asset

turnover ratio could mean efficient use of assets orunder-capitalized and ~ " ~ t~ ~ can't afford to buy.

"True values" -The balance sheet may contain highly appreciated assets ,~ ~ 3 recorded at cost or very valuable, though fully depreciated assets at zero net

book value.

Despite its widespread use and the fact that ROE and shareholder wealth are ,. often highly correlated, some problems can arise when firms use ROE as the

sole measure of performance, since it fails to consider risk or the amount of total capital invested. A projects return, risk, and size combine to determine the amount of shareholder wealth the project creates. To the extent that ROE focuses only on rate of return and ignores risk and size, increasing ROE may in some cases be inconsistent with increasing shareholder wealth.

Qualitative Factors to Consider: While it is important to understand and interpret financial statements, sound financial analysis involves more than just calculating and interpreting numbers. Good analysts recognize that certain qualitative factors must be considered when evaluating a company. Some of these factors are:

• The company's revenues being tied to one key customer. • The extent the company's revenues are tied to one key product. • The extent the company relies on a single supplier. • The percentage of the company's business generated overseas. • Competition. • Future prospects. • Legal and regulatory environment.

think you'll agree that by calculating and examining these ratios, we know more about Acme and its financial condition than we would have by looking at the financial statements only.

https://ool-content.walshcollege.edu/CourseFiles/FIN/FIN315/MASTER/Week01 /TrendA... 10/9/2017

Lecture

I mage source: http://www. pri me-force.com/en/pri me-force-web/bra nches. htm http://www. mommygaga.com/2013/02/the-talk-top-toys-2013-cb. htm

Page 3 of 3

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Lecture

Trend Analysis and Limitations to Ratio Analysis

Content Author: Louise August, CPA, PhD

Trend Analysis

Page 1 of 3

This is another important technique in the analysts toolbox. Although comparing Acme Products to the industry average can help us determine the current health of the company, another use for ratio analysis is to calculate certain ratios for Acme over a number of periods. Then we can examine the trend which shows how performance changes through time. It is important to analyze trends in ratios as well as their absolute levels. Doing so can provide clues as to whether, and perhaps why, the firm's financial situation is improving or to deteriorating. Graphing can help make patterns stand out even more.

Here's a set of Gross Profit data for a firm and for the industry standard. How do you think the firm is doing?

Year 1

l'aar Z

Y~ar3

Y~ar~

'r~er~

Year 6

Year 7

Year S

Year9

vea~ is

'Firm

ss~ 5.6`5

6.7`.

6.5`.

6.6`%

s.s~l 6.193

5.3`

s.~=% ~.i`,!

[~csustry

e.a~~ fi.33e

6.4`,~

r,.a%

e.s~:~ 6.7;%

6.95c

?.G%

7.1~c

7.2~

For most of the years presented, the firm has under-performed the industry. They improved in Years 3, 4 & 5 but then fell below the average again. Though they improved slightly in Year 7, the gap is widening and looks as though that trend might continue.

The important question to answer is what is causing this and what can be done to remedy the situation. Without any other information it could be any number of thing, here's just a few:

• declining sales volume • failure or inability to raise prices • failure to control direct costs • inability to pass increasing direct costs along to customers

Limitations to Ratio Analysis

~, t~

Ratios are often not useful for analyzing the operations of large firms that operate in many different industries because comparative ratios are not meaningful.

I ndustry averages include the best and the worst firms in an industry and so may not provide a very challenging target for high-level performance.

■ " ~....

hops://ool-content.walshcollege.edu/CourseFiles/FIN/FIN315/MASTER/Week01 /TrendA... 10/9/2017

Lecture Page ? of 3

Inflation effects depreciation charges, inventory costs, and therefore, the ~..~ value of both balance sheet items and net income. For this reason, the

r~ analysis of a firm over time, or a comparative analysis of firms of different ' ages, can be misleading.

Ratios may be distorted by seasonal factors. But be cautious about assuming t `^`'` `'

~~ '` whether a business is seasonal. Toy retailing is highly seasonal, whereas a motorcycle dealership is surprisingly not seasonal at all.

'~ ~~

'~'~ ~~~,F'~" Financial statements (and therefore ratios) can be manipulated by "1~~.̀ ~x•ì~, r̀ .,6~ -

~ ~'~ ' management to give the impression of a sound financial condition. For

. r, , ~. ~ ỳt~'~~ `y J~ci example, ashort-term loan at year-end to improve cash. This is sometimes~y

3° o`~~p~ b, called window dressing. if 4»mat

III

e*'

'~j~t Different operating policies and accounting practices, such as the decision to ~~~~~ lease rather than to buy equipment, can distort comparisons. So can the use

of differing methods of valuing inventory or revenue recognition policies.

~ '~`~ Interpretation isn't always straightforward and many ratios can be interpreted ̀~ in different ways. Whether a particular ratio is good or bad should be based

+~"" ::K=. upon a complete financial analysis rather than the level of a single ratio at a single point in time. For example: A high current ratio might indicate a strong,

~~, ~`~,.>, ,,,~ liquid firm or excess cash and uncollectible receivables. A high fixed asset

~~ ~ `~ '-~ turnover ratio could mean efficient use of assets orunder-capitalized and can't afford to buy.

~"~ ~~~~~ "True values" -The balance sheet may contain highly appreciated assets recorded at cost or very valuable, though fully depreciated assets at zero net book value.

_ _ __ __ Despite its widespread use and the fact that ROE and shareholder wealth are often highly correlated, some problems can arise when firms use ROE as the sole measure of performance, since it fails to consider risk or the amount of total capital invested. A projects return, risk, and size combine to determine

~,, the amount of shareholder wealth the project creates. To the extent that ROE focuses only on rate of return and ignores risk and size, increasing ROE may in some cases be inconsistent with increasing shareholder wealth.

https://ool-content.walshcollege.edu/CourseFiles/FIN/FIN315/MASTER/Week01 /TrendA... 10/9/2017

Lecture Page 3 of 3

• Future prospects. • Legal and regulatory environment.

think you'll agree that by calculating and examining these ratios, we know more about Acme and its financial condition than we would have by looking at the financial statements only.

I mage source: http://www.prime-force.com/en/prime-force-web/branches. html http://www.mommygaga.com/2013/02/the-talk-top-toys-2013-cb. html

https://ool-content.walshcollege.edu/CourseFiles/FIN/FIN315/MASTER/Week01 /TrendA... 10/9/2017

DuPont ROE = Profit Margin Asset Turnover Fin'I Leverage

= NI x sales x total assets sales total assets equity

= 235 x 6000 x 4000 6000 4000 1792

= 3.9% x 1.50 x 2.23

= 13.1%

Acme Products, Inc.

Balance Sheets December 31

in thousands (000)

ASSETS 20X2 20X1

Current assets:

Cash $ 20 $ 160

Receivables 750 630

I nventory 1,230 830

Total current assets 2,000 1,620

Net fixed asstes 2,000 1,740

Total assets 4 000 3 360

LIABILITIES &EQUITY

Current liabilities: Accounts payables $ 120 $ 60

Notes payable 220 120

Accruals 280 260

Total current liabilities 620 440

Long-term bonds 1,508 1,160

Preferred stock 80 80

Common stock 260 260

Retained earnings 1,532 1,420

Total equity 1,872 1,760

Total liabilities &equity 4 000 3 360

Acme Products, Inc.

Income Statement For the year ended December 31, 20X2

in thousands (000)

Sales $ 6,000.0 Cost of Goods Sold (3,300.0)

Gross Profit $ 2,700.0 Operating expenses (1,932.4)

Depreciation (200.0) Earnngs before interest &taxes 567.6 EBIT I nterest (176.0)

Taxable income 391.6 EBT Taxes (40%) (156.6)

Net income $ 235.0

Acme Products, Inc.

Statement of Cash Flows For the year ended December 31, 20X2

in thousands (000)

Operating Activities:

Net income before preferred dividend $ 235.0 Depreciation 200.0 Increase in payables 60.0 I ncrease in accruals 20.0 I ncrease in receivables (120.0) I ncrease in inventory (400.0)

$ (5.0) Investing Activities:

I ncrease in fixed asstes $ (460.0)

Financing Activities:

Increase in notes payable 100.0 Increase in bonds 348.0 Dividends paid (123.0)

$ 325.0

Net decrease in cash $ (140.0) Cash at beginning of year 160.0 Cash at end of year 20.0

Acme Products, Inc.

Statement of Retained Earnings

For the year ended December 31, 20X2

i n thousands (000)

Balance as of 12/31/2006 $ 1,420.0

Net income 235.0

Dividend to preferred shares (8.0)

Dividend to common shares 115.0

Balance as of 12/31/2007 1 532.0

LIQUIDITY RATIOS

current

quick

ASSET MANAGEMENT RATIOS

DSO (ACP)

i nventory t.o.

fixed asset t.o.

total asset t.o.

DEBT MANAGEMENT RATIOS

debt to capital ratio

times interest earmed

PROFITABLILITY RATIOS

gross margin

operating margin

profit margin

ROA

ROE

ROTC

current assets 2000 = current liabilities 620

current assets - inventory 770 = current liabilities 620

A/R 750 sales / 365 17

sales 6000 = inventory 1230

sales 6000 = net fixed assets 2000

sales 6000 = total assets 4000

total debt 1728 = total capital 3600

EBIT 567.6 = interest charge 176

gross profit 2700 = sales 6000

EBIT 567.6 = sales 6000

net income 235 = sales 6000

net income 235 = total assets 4000

net income 235 = common equty 1792

NOPAT 341 = total capital 3600

DuPont ROE Ratio --see next tab

3.2 4.1 <

1.2 1.85 <

45.0 36.0 <

4.9 9.0 <

3.0 3.0 =

1.5 1.8 <

48.0% 40.0% <

3.2 6.0 <

45.0% 49.5% <

9.5% 9.8% <

3.9% 5.0% <

5.9% 9.0% <

13.1% 15.0% <

9.5% 15.0% <

Week 2 HW Questions —Financial Statements Analysis &Forecasting

Acme Corporation has a DSO of 40 days. The company's average daily sales are $20,000. Assume a

365-day year.

What is the level of Accounts Receivable?

2. Acme Corporation has $500,000 of debt outstanding and it pays an interest rate of 10% annually.

Annual sales are $2 million, its average tax rate is 30%and its net profit margin on sales is 5%.

What is their Times Interest Earned ratio?

3. After examining the firm's operations, you conclude that the inventory the firm carries is too large.

Through more efficient inventory management techniques you conclude that inventory could be

reduced to the point that the current ratio is 2.5x. Using the financial statement information

provided below...

a. Calculate current inventory turnover.

b. What is the decrease in inventory?

c. What percentage reduction does this represent?

d. Calculate the new inventory turnover.

By making this change, you'll free up quite a bit of cash. Suppose you use it to reduce common

equity by buying back shares in the market. By how much will ROE change?

Current New

Cash 10,000 10,000

Accounts Receivable 50,000 50,000

Inventory 150,000 ?

Property, plant, Equipment 90,000 90,000

Total assets 300,000 ?

Accounts Payable 30,000 30,000

Accruals 20,000 20,000

Bonds 50,000 50,000

Common equity 200,000 ?

Total liabilities &equity 300,000 ?

Sales 200,000 200,000

Net income 15,000 15,000

4. Use the information below to calculate the firm's Return on Equity (ROE) using the DuPont formula

Sales 385,000

EBIT 55,000

Net Income 19,250

Total Assets 200,000

Total Liabilities 75,000

Total Equity 125,000

Week 2 HW Solutions —Financial Statements Analysis

1. Acme Corporation has a DSO of 40 days. The company's average daily sales are $20,000.

Assume a 365-day year.

What is the level of Accounts Receivable?

DSO = AR

avg sales

40 = AR (multiply each side by 20,000)

20,000

DSO x avg sales 40 x 20,000

AR = 800,000

2. Acme Corporation has $500,000 of debt outstanding and it pays an interest rate of 10%

annually. Annual sales are $2 million, its average tax rate is 30%and its net profit margin on

sales is 5%. What is their Times Interest Earned ratio?

TIE = EBIT = INT, so we need to find those two numbers.

This might help with Step 3:

EBT 100% he tax rate is 30% of taxable income or EBT. So if you

- tax 30% know what net income is (and we do from step 2)

N I 70% hen NI must equal 70% of taxable income

EBIT 192,857

- interest 50 000 Step 1 500,000 debt @10% = 50,000 interest expense

EBT 142,857 Step 3 100,000 = (1-t) or 70% = 100,000 = .7 = 142,857

- tax 42 857

N I 100,000 Step 2 sales of 2,000,000 x profit margin of 5% = 100,000 NI

Step 4 EBIT = INT =TIE: 192,857 = 50,000 = 3.86 times

3. After examining the firm's operations, you conclude that the inventory the firm carries is

too large. Through more efficient inventory management techniques you conclude that

inventory could be reduced to the point that the current ratio is 2.5x.

Using the financial statement information provided below...

a. Calculate current inventory turnover.

b. What is the decrease in inventory?

c. What percentage reduction does this represent?

d. Calculate the new inventory turnover.

By making this change, you'll free up quite a bit of cash. Suppose you use it to reduce

common equity by buying back shares in the market. By how much will ROE change?

Current New

Cash 10,000 10,000

Accounts Rec 50,000 50,000

I nventory 150,000 65,000 Fewer dollars tied up ($85k)

PPE 90,000 90,000

Total assets 300,000 215,000

Accounts Payable 30,000 30,000

Accruals 20,000 20,000

Bonds 50,000 50,000

Common equity 200,000 115,000 Shares repurchased

Total liab &equity 300,000 215,000

Sales 200,000 200,000

Net income 15,000 15,000

current assets 210,000 125,000 n = 50,000 = 2.5, so 50,000x2.5= 125,000

current liab 50,000 50,000

current ratio 4.2 2.5 improvement

sales=inv, so 200=65=3.08

inventory t.o. 1.33 3.08 improvement

inv reduction 85,000

reduction 56.7%

ROE 7.50% 13.04% NI =equity, so 15=115=.1304 or 13.04%

5.54% improvement

4. Use the information below to calculate the firm's Return on Equity (ROE) using the DuPont

formula

Sales 385,000 margin 0.050 NI/sales

EBIT 55,000 asset t.o. 1.93 sales/assets

Net Income 19,250 FLR 1.6 A/E

0.1544

Total Assets 200,000 or 15.44%

Total Liabilities 75,000

Total Equity 125,000

Acme Products, Inc.

Balance Sheets December 31

in thousands (000)

ASSETS 20X2 20X1

Current assets:

Cash $ 20 $ 160

Receivables 750 630

I nventory 1,230 830

Total current assets 2,000 1,620

Net fixed asstes 2,000 1,740

Total assets 4 000 3 360

LIABILITIES &EQUITY

Current liabilities:

Accounts payables $ 120 $ 60

Notes payable 220 120

Accruals 280 260

Total current liabilities 620 440

Long-term bonds 1,508 1,160

Preferred stock 80 80

Common stock 260 260

Retained earnings 1,532 1,420

Total equity 1,872 1,760

Total liabilities &equity 4 000 3 360

Acme Products, Inc.

Income Statement For the year ended December 31, 20X2

in thousands (000)

Sales $ 6,000.0

Cost of Goods Sold (3,300.0)

Gross Profit $ 2,700.0

Operating expenses (1,932.4)

Depreciation (200.0)

Earnngs before interest &taxes 567.6 EBIT

I nterest (176.0)

Taxable income 391.6 EBT

Taxes (40%) (156.6)

Net income $ 235.0

A c m e P r o d u c t s , I nc .

S t a t e m e n t o f C a s h F l o w s

F or

t he

y ea

r e n d e d D e c e m b e r 3 1 , 2 0 X 2

in t h o u s a n d s ( 0 0 0 )

O pe

ra ti

ng A ct

iv it

ie s:

N et

i n c o m e b ef

or e pr

ef er

re d di vi de nd

$ 2 3 5 . 0

D ep re ci at io n

2 0 0 . 0

I n c r e a s e i n p a y a b l e s

6 0 . 0

I n c r e a s e i n ac cr ua ls

2 0 . 0

I n c r e a s e i n re

ce iv

ab le

s ( 1 2 0 . 0 )

I n c r e a s e i n in

ve nt

or y

( 4 0 0 . 0 )

(5 .0 )

In v e s t i n g A ct

iv it

ie s:

In c r e a s e i n fi xe d a s s t e s

$ ( 4 6 0 . 0 )

F i n a n c i n g A ct

iv it

ie s:

In c r e a s e i n n o t e s p a y a b l e

1 0 0 . 0

In c r e a s e i n b o n d s

3 4 8 . 0

D iv

id en

ds p ai

d ( 1 2 3 . 0 )

$ 3 2 5 . 0

N et

d e c r e a s e i n c a s h

$ ( 1 4 0 . 0 )

C a s h a t be gi nn in g of

y ea

r 1 6 0 . 0

C a s h a t e n d o f ye

2 0 . 0

Learning Objectives

Fir~~r~c~~ ~~~l~~

R Ratio analysis provides comparison to industry

a Ratios measure profitability, asset utilization, liquidity and debt utilization

s DuPont system of analysis identifies return on assets and return to shareholders

Block, Hirt, and Danielsen g Trend analysis shows company performance

Foundations of Financial Management over time

16t" edition ~ Reported income needs further evaluation to . .. ~...a .~ . , ~ . . ,...~ . .. w ,, ~:.. identify sources of distortion

Ratio Analysis Classification System

a Financial ratios

Used to weigh and evaluate operating performance of firm

m Measured in relation to other values

• Compares performance record against similar firms in industry

Additional evaluation of company management, physical facilities and other factors is needed

Financial data reported by S&P, Moody's, etc.

A. Profitability ratios 1. Profit margin

* 2. Return on assets (investment)

3. Return on equity

B. Asset-utilization ratios 4. Receivable turnover 5. Average collection period

6. Inventory turnover

7. Fixed asset turnover

• 8. Total asset turnover

:~~:. ~ .. ,, -.

Classification System

• C. Liquidity ratios

9. Current ratio

10. Quick ratio

• D. Debt-utilization ratios

11. Debt to total assets

12. Times interest earned

a 13. Fixed charge coverage

Classification System

a Profitability ratios (category A) ~~ Measure firm's ability to earn adequate returns

Sales

V Total assets

I nvested capital

Asset-utilization ratios (category B) Measure speed at which firm turns over

Accounts receivable

I nventory

Long-term assets

_. ._~ d.:_ ,-s ~.. ~~~,~__.~.~..2-~.~,.~.~~~a_ ..a.. ~:~, ~. ~ ,.... ,,.

Classification System Classification System

6 Users of financial statements have differing • Liquidity ratios (category C) degrees of importance in categories of ratios

• Emphasize firm's ability to pay off short-term Potential investors and security analysts obligations as they come due •Primary considerations —profitability ratios

• Debt-utilization ratios (category D) •Secondary considerations —liquidity and debt

• Estimate overall debt position of firm utilization

• Evaluate in light of asset base, earning power ° For banker or trade creditor • Primary consideration -liquidity ratios

• For long-term creditors (bondholder) • Primary consideration -debt utilization ratios (debt to total assets) and profitability ratios

~.;..~ :.~_;....., .,..: _ ,.. . ._._ _:. „, .: _ : ~~.. ,_:~ tom.: ,.,: ,_~~....~~,,, _ _- _._ _. a te:.. ,~

Table 3-1 Financial Statement

for Ratio Analysis The Analysis —Profitability Ratios

Smc~n Co~apany Industry Average Ne14uotne

Proftt m~r~n = $206,000

= 93~ 6.7%

Sees ~q ppp ppp

Retum on assets (Investment}

a. Netlnco~ne $200,000 _ 12.6% f0% Total asse4s 51,600,000 Netlttcome Sales

b. x~~ T~ ~a bS: x 2.6 ~ 12:5% 6.7°t< x 1.5 ~ tO b

Retum on equity

Net income 8.

yppp,p~

y 2~: f5%

Sbckholdets'eq~ltf' Si,040~000 b. Rehun on assets (rnvestnettit) D.125 ~ 20,E 0.10 = t 5~

(1 — DehtlAssats) i — 0.375 1 — 0.33

rf. h +n:.S. L•

The Analysis —DuPont system The Analysis —DuPont system

of analysis of analysis

Satisfactory return on assets can be derived Satisfactory return on equity can be derived

through through

High profit margin High return on total assets

Rapid asset turnover (generating more sales per °Generous utilization of debt

dollar of assets) Combination of both

Combination of both

Return on assets (investment)

= Profit margin x Asset turnover

Return on equity =Return on assets (investment)

(1 —Debt/Assets)

Table 3-2 Return of Walmart vs. Abercrombie &Fitch Figure 3-1 DuPont Analysis using the Du Pont Method of Analysis

P,(ofd margin ,

fleWm onx assets , <

- AsSet tumove~'

Rehm on assets (t -DebUAssets)

F, 3'a

~ ~s Nti .

~ ~~

S~~.v ~ig::i.

b B AxB C D= i-C Ax6/D

Name Profit Mar fn

Asset Turnover

Return on Assets

Debt/ Assets 1-DebtJAsseu

Return on E ut

Walmart 3.34% 3.63 12.1% 37.8% 62.2% 19.5%

bercrombie &Fitch 4.24% 2.15 9.1% 13.4% 86.6% 10.5%

r :.. ~. z. ,~ . ..: ..'

The Analysis -Asset Utilization Ratios The Analysis -Asset Utilization Ratios

• Relate balance sheet (assets) to income

statement (sales) Saxton C+om pony IR~US~F]il AYEIBgB Sexton Company Industry dveraga Ff7Ced fie&ettuFncrvef =

ReceWabtes Wmaver = SAf85 x,000,000 - ~

5.4tfines Sa~s(crec~t) ~~~,~ - t1.a loiknes ~x~s~~s

~~~s~

Receivables $350,Q0(7 TotaEassetturnaver =

Average cdteclbn period =

AcraouMs recePrat~e $35Q,()OCt = 32 36 days Se[8S $4,600,t70C9 _

2.5 1.5 IIn1CS Average d~Ey credit sales ~f 1, 411 TOYdI AGSe1S $1,St1(), 0~0

Irne~tory turnover =

sales sn,00a,00a _ ~o.e rnmes Irnentary $370,QDC~

*This ratio may also be computed by using "cost of goods sold" in the numerator

The Analysis -Liquidity Ratios

These ratios determine if the firm can meet each

maturing obligation as it comes due

Saxton Comparryr Industry Average

Curcent ratlo =

CUrrer~ asset& $800,000 = 2.67 2.1

Cusre~ NebN~ies $300A~0

QIIdCk fdtl0 =

Cuner~ assets -Inver 5-030: 0(7 - 1 ̀ ~

1.0 Curts~t IabNf~es $30fl,Q00

The Analysis -Debt Utilization Ratios

• Measures the prudence of the debt

management policies of the firm

5ax[on Canpany Industry Average

Debt. to total assats =

Total dot $6Q0, 4YK) - 37.50 33a~

itAalassets ~;,6~,~

Times in4erest earned =

Incore~s betore intarest and taxes 5~,~ _ ~ 1 7 times Interest $SO,CUO

F~etl charge coverage =

Incomabefarelfxedchargesandtaxes $6DO,W0 _ fi 5.5Umes

Flxedcharges $1C~D,C~O

The Analysis -Debt Utilization Ratios Table 3-3 Ratio Analysis

s Fixed charge coverage measures the firm's

ability to meet all fixed obligations rather than

i nterest payments alone

I ncome before interest and taxes ....................$550,000

Lease payments ......................................................50,000

I ncome before fixed charges and taxes..........$600,000

Jl. Wontab4lry

1. Proffl margYi _ ......................... 5.0% 6.796 E3ebW evxrage

2. Return m assets ._....._....._....:. 72.5% 10.0% Above avttrage tlue b hk~h

turtaver

3. Rehtm m equity .................... Z0.0% 75.0% Gwtl, tlue to HatWs 2 end 7 7

8.0.+set UUBzatlon

4. ReceNades turnover ._....._...... 71.4 1G.0 Goon

5. Average co0aCllon period ......:.. 32.0 36.0 Good

6. In~~entory lumover ..................... 70.fl 7.0 (;netl

7. fbcsd essel turnover .._ ............. 5.0 5.4 Bebw eve~ege

B. Total asset tumwer ..._....._...... 2.5 1.5 GooO

c. uq„iarry e. cuneni rnb _......_....._............ z.s~ a.t c«~n tO. Qu~CK ratio .._......_....._....._...... 1.43 1.0 Gootl

O. Debt UNlradon

11. Debt to lolel assets ..._....._...... 37.5% 33.0% Sdghtty more debt

t2 T4nes Internal enmeG .:....._.._.. 17.0 7.0 600tl

13. Flrzetl cnarga coverage ....._...... 6.0 5.5 G~wN

Trend Analysis Figure 3-2 Trend Analysis

Over course of business cycle, sales and profitability expand and contract

• Ratio analysis for any one year does not reflect accurate picture of the firm

Trend analysis reflects performance over a number of years Without industry comparisons, may not reflect a complete picture

Gives picture of performance over number of years against industry averages

~~~~ p.~orrt

r ~:,~,

5 . .,. y

cc ~~ Y009 M105 1007 II004 2011 20t:t. .. zp15 .

e. rdr ..ri m.~o...

x~ _~ s..~w,zar ~.~ e..~ 200J '. 20D3 Y06T 2009 4011 20t3 2015 --

S<:.NQIN.FGvi ' ~~ti.~~~~v .f ~.ai.

Table 3-4 Trend Analysis in the Impact of Inflation on

Computer Industry Financial Analysis y

,.~., ""~,...:~ .,~. "°`,,,~~.. Major problem of inflationr.,.. ~..

~, ~ ;~ ~<

•Revenue stated in current dollars

:»; ;.; -. ;~ n: • Plant, equipment, or inventory may have been ,,,

Ŷ 't ~ ~.~ ~. u< ">. ;ao purchased at lower price levels

.~, f; x, ~ Profits may be more function of increasing prices

.t ~._ „,.

.. v~_o. than satisfactory performance ,~ :;

Financial reports are distorted by not ~' '`~, ;;; ,,, considering inflation ¢LO +~V 5!b

:;. Affecting financial analysis

Table 3-S Net Income for 2015 Table 3-6 Net Income for 2016

Sales ................................................................................. 5200 (100 unRs at 32) Sales ............,................................................ $220 (100 units ai 2000 price of 52.20)

Cost of goods sold ........................................................... 100 (100 units at $1) Cost o(goods sold ....................................... 100 (100 units at $1.00j

Gross profid ....................................................................... $100 Gross profit ................................................... $120

Selling and administrative expense .................................. 20 (10% of sales) Selling and administrative expense .............. 22 (1090 of sales)

Depreciation ..................................................................... 10 . ............. 10Depreciation .......,........................ ..

Operating profit ................................................................ S 70 OperatingprofR ............................................ $ 8b

Taues j40°1o) ...................................................................... 28 Taxes (40%) .................................................. 35

Aftertax income ................................................................ $ 42 Attertmc income .......................... $ 53

Table 3-7 Comparison of Replacement

Cost and Historical Cost Accounting An Illustration

10 Chemical Com~SaMea ,~

8 Ong Compm~les

Replacement Hlstorlcal Replacement Hlatorlcal

~asf Cosh boat host

Increasa In assets .................... 28.496 — 15.445 —

Decrease In net Income

beforetexes ......................... 45.896 — 19.3% —

Relum on assets ........._....._.... 2.8% 62% 8.3% 11.4%

Retumanequlty ........._....._.... 4.996 13.5% 12A% 19.6%

Debt-to-assetaratlo ...._.....„.... 34.3% 43.8% 30.3% 35.2%

Interest coverage ratio

(limes Merest earned) .......... 7.1 x 8d x 16.4 x 16.7 x

Jeff Garnett and Geoffrey A. Hirt, "Replacement Cost Data: A Study of

the Chemical and Drug Industry for Years 1976 through 1978."

Disinflation Effect

• Disinflation —situation of declining i nflationary pressures Will not impair purchasing power of dollar

Reduction in investors' expectation of returns on financial assets

Financial assets such as stocks and bonds have potential to do well

Tangible (real) assets like precious metals will fall

• Deflation • Actual declining of prices affecting everybody from bankruptcies and declining profits

d Replacement cost —reduces income but

i ncreases assets

• Increase in assets lowers debt-to-assets ratio

• Decreased debt-to-assets ratio indicates decrease

i n financial leverage of firm

• Declining income results in decreased ability to

cover interest costs

Other Elements of Distortion

in Reported Income

Effect of changing prices

Reporting of revenues

Treatment of nonrecurring items

Tax write-off policies

...~ .~ ~...~.. way- .. ~ . Ta- _ .. ~.~ .. z..s~~¢w...bwz.x=~.,s ~s~.e. ~aah...ra. ~mml:, t-28

t-30

Table 3-8 Income Statements Explanation of Discrepancies

Sales ....___

...................................................

Cost of goals sold .......................................

G~osS Profit ...................................................

Senkq and atlministrative expanse ..............

Operatrg pmtrt ........_ ......................_..........

Interest ezpenx ...........................................

ExtraoNinary bss .........................................

Net income belore taxes .............................~

Taxes (30%) .................................................~

Net insane .........................................._......,

Ezi .~ordmary bss (net of taK) .........._...........

Net xa ome transferred to retaine0 earnings

Conyarvullvo Hlgh Reportod

Fhm A Innoma

~e ........... t+.000.000 u.zoa.000 ........... a,000.000 z.~oo.000 ......._. S1.CK~O.oW St.Soo.oOo

......._.. 450.00D <50.~0

........... 5 b.`-U.uoo St.OYJ.Wu

........... s+~.00e ao.000

........_. 1D~.O:C ______._

........... 5 aoo.r~c~c s,.aoo.00a

........... 12U.C{O._.__... 500.000 ......._. s r~c+.eoo s ~oo,000 ........... — 10.00D ---

........... $ 'l.YO~CTA S 630.000

Explanation of Discrepancies

• Sales

• Conservative firms may defer revenue recognition of

the sale until each payment is received

• Other firms may attempt to recognize a fully effected

sale as early as possible

• Cost of goods sold

• Use of different accounting principles

• Company A uses LIFO versus Company B using FIFO

• Varying treatment of R&D costs, etc.

tit _ t32

• Extraordinary gains/losses

• Including extraordinary events in computing current income vs. leaving them out

Net income Use of different methods of financial reporting

Such as inclusion vs. exclusion of extraordinary gains

and/or losses

• Each item must be examined in financial statements, rather than accepting bottom-line figures

~! !qM NrMnA'u ~~I.N.JV i

~ t ~ ~ cc~~ 1 Ovei-vi~w, Objectives and Readings Page 1 of 1

Overview

We'll begin our coverage with an overview of the field of financial management, a look at the fundamental concepts of risk &

return and how interest rates function in the marketplace.

The chapter on financial statements and cash flows: How much of this chapter you read and in how much detail will depend

largely on your prior experience with accounting and your level of comfort with basic accounting concepts and financial

statements. For some a quick skim will do, for others an in depth reading may be required.

Practice Problems -Please see the syllabus for problems assigned for homework/practice.

Objectives

After completing this module, you will be able to:

• Discuss the field of financial management • Identify and distinguish between the three basic forms of

business • List the advantages of the corporate form • Illustrate each advantage with a short example or explanation

• Explain the ways in which a corporation's standing as a separate legal entity confers advantages

• Identify the components of risk • Define and distinguish between diversifiable and non-

diversifiable risk

Readings

See syllabus for weekly reading assignments

https://ool-content.walshcollege.edu/CourseFiles/FIN/FIN315/jesdale/WeekO l /OOR/Objec... 10/9/2017