Module 01: Discussion MF
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Cornett_Finance_5e_Chapter_03_PPT.pptxAnalyzing Financial Statements
Finance 5th Edition
Cornett, Adair, and Nofsinger
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Introduction
Various uses of financial statements
Provide information on firm’s financial position at a point in time or its operations over some past period
Information contained in financial statements may be used to analyze the current financial performance of the firm
Information provided assists in decision-making that improves the firm’s future performance, and ultimately, its market value
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Ratio Analysis
Ratio analysis is the process of calculating and analyzing financial ratios to assess a firm’s performance and to identify actions needed to improve firm performance
Five groups of ratios
Liquidity
Asset management
Debt management
Profitability
Market value
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Managers, investors, and analysts universally use ratios to assess a firm’s performance and to identify actions that could improve firm performance.
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Ratio Analysis Options
Trend analysis
Comparison to the same firm over time
Industry analysis
Comparison to other firms in the same industry
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Liquidity Ratios
Liquidity ratios measure the relationship between a firm’s liquid (or current) assets and its current liabilities
Commonly-used liquidity ratios
Current ratio
Quick (or acid-test) ratio
Cash ratio
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Current Ratio
Broadest liquidity measure
Measures the dollars of current assets available to pay each dollar of current liabilities
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Quick Ratio
Measures the firm’s ability to pay off short-term obligations without relying on inventory sales
Inventories are generally the least liquid of a firm’s current assets
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Cash Ratio
Measures a firm’s ability to pay short-term obligations with its available cash and marketable securities
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Asset Management Ratios
Asset management ratios measure how efficiently a firm uses its assets, as well as how efficiently the firm manages its accounts payable
Inventory management
Accounts receivable management
Accounts payable management
Fixed asset and working capital management
Total asset management
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Inventory Management
The inventory turnover ratio measures the number of dollars of sales produced per dollar of inventory
Cost of goods sold is used as the numerator when managers want to emphasize that inventory is listed on the balance sheet at cost, that is, the cost of sales generated per dollar of inventory
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Managers are faced with considering the trade-off between the advantages of holding sufficient levels of inventory to keep the production process going versus the costs of holding large amounts of inventory.
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Inventory Management (continued)
The days’ sales in inventory ratio measures the number of days that inventory is held before the final product is sold
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Accounts Receivable Management
The accounts receivable turnover measures the number of dollars of sales produced per dollar of accounts receivable
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Accounts Receivable Management (continued)
The average collection period (ACP) measures the number of days accounts receivable are held before the firm collects cash from the sale
Also referred to as days’ sales outstanding (DSO)
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Accounts Payable Management
The accounts payable turnover ratio measures the dollar cost of goods sold (COGS) per dollar of accounts payable
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Accounts Payable Management (continued)
The average payment period (APP) ratio measures the number of days that the firm holds accounts payable before it has to extend cash to pay for its purchases
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Fixed Asset and Working Capital Management
The fixed asset turnover ratio measures the number of dollars of sales produced per dollar of net fixed assets
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Fixed Asset and Working Capital Management (continued)
The sales to working capital ratio measures the number of dollar of sales produced per dollar of net working capital (current assets minus current liabilities)
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Total Asset Management
The total asset turnover ratio measures the number of dollars of sales produced per dollar of total assets
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Total Asset Management (continued)
The capital intensity ratio measures the dollars of total assets needed to produce a dollar of sales
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Debt Management Ratios
Debt management ratios measure the extent to which the firm uses debt (or financial leverage) versus equity to finance its assets as well as how well the firm can pay off its debt
Two major types of debt management ratios
Evaluate whether a firm is financing its assets with a reasonable amount of debt versus equity financing
Measure whether the firm is generating sufficient earnings or cash to make promised debt payments
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Debt versus Equity Financing
Capital structure refers to the amount of debt versus equity financing held on the balance sheet
Three primary ratios
Debt ratio
Debt-to-equity
Equity multiplier
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Debt Ratio
The debt ratio measures the percentage of total assets financed with debt
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Debt-to-Equity Ratio
The debt-to-equity ratio measures the dollars of debt financing used for every dollar of equity financing
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Equity Multiplier Ratio
The equity multiplier ratio measures the dollars of debt financing used for every dollar of equity financing
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Times Interest Earned Ratio
The times interest earned ratio measures the number of dollars of operating earnings dollars available to meet each dollar of interest obligations on the firm’s debt
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The times interest earned, fixed charge coverage, and cash coverage ratios are different measures of a firm’s ability to meet its debt obligations.
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Fixed Charge Coverage Ratio
The fixed charge coverage ratio measures the number of dollars of operating earnings available to meet the firm’s interest obligations and other fixed charges
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Cash Coverage Ratio
The cash coverage ratio measures the number of dollars of operating cash available to meet each dollar of interest and other fixed charges that the firm owes
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Profitability Ratios
Ratios that show the combined effect of liquidity, asset management, and debt management on the firm’s overall operating results are profitability ratios
Closely monitored by investors
Stock prices react very quickly to unexpected changes in these ratios
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Profit Margin
The gross profit margin is the percent of sales left after cost of goods sold are deducted
The operating profit margin is the percent of sales left after all operating expenses are deducted
The profit margin is the percent of sales left after all firm expenses are deducted
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Basic Earnings Power Ratio
The basic earnings power ratio measures the operating return on the firm’s assets, regardless of financial leverage and taxes
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Return on Assets (ROA)
Return on assets (ROA) measures the overall return on the firm’s assets, including financial leverage and taxes
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Return on Equity (ROE)
Return on equity (ROE) measures the return on common stockholders’ investment in the assets of the firm
Affected by net income and amount of financial leverage used by the firm
High ROE is usually a positive sign, unless driven by excessively high leverage
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Dividend Payout Ratio
The dividend payout ratio is the percentage of net income available to common stockholders that the firm actually pays as cash to these investors
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Market Value Ratios
Market value ratios relate a firm’s stock price to its earnings and book value
Market values measure what investors think of the company’s future performance and risk
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Market-to-Book Ratio
The market-to-book ratio measures the amount that investors will pay for the firm’s stock per dollar of equity used to finance the firm’s assets
Compares the market (current) value of the firm’s equity to its historical cost
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Price-Earnings Ratio
The price-earnings ratio measures how much investors are willing to pay for each dollar the firm earns per share of its stock
Best known and most often quoted figure
Often quoted in multiples – the number of dollars per share – that fund managers, investors, and analysts compare within industry classes
High PE ratio usually indicates projected growth
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DuPont Analysis
The DuPont system of analysis is an analytical method that uses the balance sheet and income statement to break the ROA and ROE ratios into component pieces
ROA is evaluated as the product of the profit margin and the total asset turnover ratios
ROE is evaluated as the product of ROA and the equity multiplier
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DuPont System Analysis
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Other Ratios
Spreading the financial statement occurs when balance sheet amounts are divided by total assets and income statement amounts are divided by net sales
Result in common-size financial statements
Year-to-year growth rates provide useful ratios for identifying trends and allow for an easy comparison across firms in the industry
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Internal and Sustainable Growth Rates
The internal growth rate is the growth rate a firm can sustain if it uses only internal financing – that is, retained earnings – to finance future growth
The sustainable growth rate is the growth rate a firm can sustain if it finances growth using both debt and internal financing such that the debt ratio remains constant
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Time Series and Cross-Sectional Analyses
Time series analysis occurs when one is analyzing firm performance by monitoring ratio trends
I.e., performance of the firm over time
Cross-sectional analysis occurs when one is analyzing the performance of a firm against one of more companies in the same industry
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Cautions in Using Ratios
Caution should be exercised in using ratios to evaluate firm performance
Historical data may not reflect future performance
Firms utilize different account procedures
Competitors may be based outside of the U.S.
Sales and expenses vary throughout the year
Large firms have multiple divisions/business units
Firms often employ window dressing techniques
Individual analysts may calculate ratios in modified forms
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