Chapter Outline

• Ratio analysis and its importance

• Use of ratios as measurement tool
• The DuPont system of analysis
• Trend analysis
• Evaluation of reported income to identify
sources of distortion

3-1
 Management Functions
• Management Functions are:
• 1) Planning
• 2) Organizing
• 3) Directing and Leading
• 4) Controlling
• In Finance controlling will be through
Financial Analysis.

3-2
 Financial analysis
• Types of Financial analysis:
• 1) Horizontal (Sources& Uses of Funds)
• 2) Vertical (Ratio Analysis)
• Sources of Data for ratio analysis will be
from the Financial Statements (Balance
sheet and Income statement).

3-3
 Financial Statement Analysis
• Financial Statement Analysis is the Art of
transforming Data from Financial
Statements into Information that is useful
for decision making.

3-4
 Kinds of Comparison
• Kinds of Comparison are:
• - First : Internal comparison
1) Past comparison
2) Present comparison
3) Expected Future comparison
• - Second: External comparison
1) Similar firms comparison
2) Industry Average comparison
3-5
 Ratio Analysis
• Financial ratios
– Used to weigh and evaluate the operating
performance of a firm
– Numerical calculations and analyzing ratios
– Used to compare performance record as
against similar firms in the industry
– Additional evaluation of company
management, physical facilities and other
factors
– Such data is provided by various organizations

3-6
 Sources of Industry Average Ratios
• Sources of Industry Average Ratios:
• 1) Dun & Bradstreet
• 2) Prentice Hall
• 3) Almanac of Business & Industrial
Financial Ratios
• 4) Various Trade Associations
• Note: The Industry Average Ratios should
not be a target or goal, rather they provide
a Guidelines to the companies.
3-7
 Types of Ratios
• 1) Liquidity Ratios
• 2)Asset Utilization Ratios or Activity Ratios.
• 3) Debt Ratios
• 4) Profitability Ratios
• 5) Stock Ratios
• 6) Growth Ratios

3-8
 Ratios and their Classification
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
3-9
 Ratios and their Classification
(cont’d)
C. Liquidity ratios
9. Current ratio
10. Quick ratio
D. Debt utilization ratios
11. Debt to total assets
12. Times interest earned
13. Fixed charge coverage

3-10
 Types of Ratios
• Profitability ratios
– Measure the firm’s ability to earn adequate return on:
• Sales
• Assets
• Invested capital
• Asset utilization ratios
– Measure the speed at which the firm is turning over:
• Accounts receivable
• Inventory
• Long-term assets

3-11
 Types of Ratios (cont’d)
• Liquidity ratios
– Emphasizes the firm’s ability to pay off short-
term obligations as they come due
• Debt utilization ratios
– Estimates the overall debt position of the firm
– Evaluates in the light of asset base and
earning power

3-12
Financial Statement
for Ratio Analysis

3-13
 Liquidity Ratios
• These ratios determine if the firm can meet
each maturing obligation as it comes due

3-14
 Asset Utilization Ratios
• These ratios relate the balance sheet
(assets) to the income statement (sales)

*This ratio may also be computed by using “Cost of goods sold” in the numerator.
3-15
Asset Utilization Ratios (cont’d)

3-16
 Debt Utilization Ratios
• Measures the prudence of the debt
management policies of the firm

3-17
 Debt Utilization Ratios (cont’d)
• Fixed charge coverage measures the firm’s
ability to meet all fixed obligations rather
than interest payments alone
Income before interest and taxes………………..$550,000
Lease payments…………………………………… 50,000
Income before fixed charges and taxes…………$600,000

3-18
Profitability Ratios

3-19
Return Turnover

Net Sales
Income

3-20
 DuPont System of Analysis
• A satisfactory return on assets might be
derived through:
– a high profit margin, or
– a rapid turnover of assets (generating more
sales per dollar of its assets)
– or a combination of both

Return on assets (investment) = Profit margin × Asset

turnover

3-21
 DuPont System of Analysis
(cont’d)
• A satisfactory return on equity might be
derived through:
– a high return on total assets
– a generous utilization of debt
– or a combination of both

Return on equity = Return on assets (investment)

(1 – Debt/Assets)

3-22
DuPont Analysis

3-23
 Return of Wal-Mart versus Abercrombie
using the Du Pont method of analysis, 2009

3-24
Ratio Analysis

3-25
 Importance of Ratios to Users of
Financial Statements
• For potential investors/security analysts:
– Primary considerations – profitability ratios
– Secondary considerations – liquidity and debt
utilization
• For banker or trade creditor – liquidity ratios
• For long-term creditors – debt utilization
ratios and profitability ratios

3-26
 Trend Analysis
• Gives a picture of performance over a
number of years against industry averages

3-27
 Trend Analysis
in the Computer Industry (***)

3-28