Mai Tiến Doanh

MBA in UBI Business School – Brussels,

Belgium
MBA in University of Economics and Law -
Vietnam National University HCMC

Lecturer in
Finance, Accounting, Statistics and Maths

© 2003 McGraw-Hill Ryerson Limited

 2
Chapter
Financial Analysis

Prepared by:
Mai, Tiến Doanh (MBA)
Lecturer in Finance, Accounting, Statistics & Maths)

© 2003 McGraw-Hill Ryerson Limited

 Outline
1) Overview of Financial Analysis
2) 4 Categories of Financial Ratios
3) Importance of Ratios
4) Profitability Ratios
5) Du Pont Analysis
6) Asset Utilization Ratios
7) Liquidity Ratios
8) Debt Utilization Ratios
9) Trend Analysis
10) Summary and Conclusion
© 2003 McGraw-Hill Ryerson Limited
 Overview of Financial Analysis

What is financial analysis?

 evaluating a firm’s financial performance

 Financial ratios are calculated by dividing one value on

financial statements by another related value.
 A long-run trend analysis over a number of years shows

changes over time.

 Ratios & trends are used to interpret and compare the
financial performance of a company to its industry & to its
past results.

© 2003 McGraw-Hill Ryerson Limited

 Table 2.3:
Ratio analysis

Saxton Industry
Company Average Conclusion
A. Profitability
1. Profit margin……………… 5% 6.7% Below average
2. Return on assets………..…. 12.5% 10% Above
average
3. Return on equity…………. 20% 15% Good

B. Asset Utilization
4. Receivables turnover ……... 11.4 10
Good
5. Average collection period…. 32 36
Good
6. Inventory turnover ………... 10.8 7 Good
7. Fixed asset turnover ……. 5.0 5.4 Below average
8. Total asset turnover ………. 2.5 1.5 Good

© 2003 McGraw-Hill Ryerson Limited

 Saxton Industry
Company Average Conclusion
C. Liquidity
9. Current ratio ……………… 2.67
2.1 Good
10. Quick ratio ……………….. 1.43 1
Good

D. Debt Utilization
11. Debt to total assets ……….. 37.5% 33%
Slightly more debt
12. Times interest earned ……. 11 7 Good
13. Fixed charge coverage……. 6 5.5 Good

© 2003 McGraw-Hill Ryerson Limited

 4 Categories of Financial Ratios

 Profitability Ratios

 Asset Utilization Ratios

 Liquidity Ratios

 Debt Utilization Ratios

© 2003 McGraw-Hill Ryerson Limited

 Classification System for Ratios

A. Profitability Ratios
1. Profit margin
2. Return on assets (ROA)
3. Return on equity (ROE)

B. Asset Utilization Ratios

4. Receivables turnover
5. Average collection period
6. Inventory turnover
7. Fixed asset turnover
8. Total asset turnover

© 2003 McGraw-Hill Ryerson Limited

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

© 2003 McGraw-Hill Ryerson Limited

 Importance of Ratios

Which ratios are most important?

 It depends on your perspective.

 Suppliers & banks (lenders) are most interested in liquidity

ratios.
 Shareholders are most interested in profitability ratios.
 Long-term creditors concentrate on debt utilization ratios.
 The effective utilization of assets is management’s
responsibility.

© 2003 McGraw-Hill Ryerson Limited

 Table 2-1:
Financial Statements for Ratio Analysis

SAXTON COMPANY
Income Statement
For the Year Ended December 31, 2004

Sales (all on credit) . . . . . . . . . . . . . . . . $ 4,000,000

Cost of goods sold . . . . . . . . . . . . . . . 3,000,000
Gross profit . . . . . . . . . . . . . . . . . . . 1,000,000
Selling and administrative expense* . . . . . . . . . 450,000
Operating profit . . . . . . . . . . . . . . . . . 550,000
Interest expense . . . . . . . . . . . . . . . . 50,000
Extraordinary loss . . . . . . . . . . . . . . . . 200,000
Net income before taxes . . . . . . . . . . . . . 300,000
Taxes (50%) . . . . . . . . . . . . . . . 100,000
Net income . . . . . . . . . . . . . . . . . . . $ 200,000

* Includes $50,000 in lease payments.

© 2003 McGraw-Hill Ryerson Limited
 Table 2-1:
Financial Statements for Ratio Analysis
Balance Sheet
As of December 31, 2004
Assets
Cash $ 30,000
Marketable securities 50,000
Accounts receivable 350,000
Inventory 370,000
Total current assets 800,000
Net plant and equipment 800,000
Total assets $1,600,000
Liabilities & Shareholders' Equity
Accounts payable $ 50,000
Notes payable 250,000
Total current liabilities 300,000
Long-term liabilities 300,000
Total liabilities 600,000
Common stock 400,000
Retained earnings 600,000
Total liabilities & shareholders' equity $1,600,000
© 2003 McGraw-Hill Ryerson Limited
 Profitability Ratios
 Measure overall company profitability for potential
investors (income to investment base).
 The higher the ratio, the more profitable the firm.

Profit Margin Return on Assets Return on Equity

Net Income Net Income Net Income
Sales Total Assets Stockholders’ Equity

Net Income x Sales Return on Assets

Sales Total Assets (1 – Debt/Assets)

© 2003 McGraw-Hill Ryerson Limited

 Examples
Saxton Company Industry Average

1. Profit margin = Net income

= 5% $200,000 6.7%
Sales $4,000,000
2. Return on assets (ROA) =

a. Net income
= 12.5% $200,000 10%
Total assets $1,600,000

b. 5%  2.5 = 12.5% 6.7%  1.5 = 10%

Net income Sales
Sales Total assets

© 2003 McGraw-Hill Ryerson Limited

 Saxton Company Industry Average
3. Return on equity (ROE) =

a. Net income
= 20% $200,000 15%
Stockholders’ equity $1,000,000

Return on assets 0.125 0.1

b. = 20% = 15%
1 – 0.33
(1 – Debt/Assets) 1 – 0.375

© 2003 McGraw-Hill Ryerson Limited

 1. BELOW AVERAGE

Saxton earns less income

per dollar of sales than
the industry average.
 2. ABOVE AVERAGE

Saxton generates more

return on total assets
than the industry
average.
 3. GOOD

The rate of return on

common stockholders’
investment of Saxton is
higher than other
shareholders in the
industry.
 Du Pont Analysis

 The Du Pon system of analysis:

 breaks down return on assets between the profit margin & asset
turnover;
 shows how this return on assets is translated into return on equity.

Helps better understand how return on assets & return on equity

are derived.

© 2003 McGraw-Hill Ryerson Limited

 Figure 2-1:
Du Pont Analysis

Net income
 Profit margin
Return on
Sales  assets
 Asset
turnover
Total assets Return on
= equity
Total debt
 Financing plan

Total assets

© 2003 McGraw-Hill Ryerson Limited

 Examples

Profit Asset Return on (1 – Debt/

Return
Company margin X turnover = assets
Assets) = on equity .4150
Wal-Mart 14.56% 6.04% 2.473 14.94%

May
Department 4.92 1.5132 7.44 1.590 11.83
Stores

© 2003 McGraw-Hill Ryerson Limited

 Asset Utilization Ratios
 Measure how efficiently the company uses its assets to
generate sales.
 The higher the ratio, the greater the company’s efficiency.

Receivables Turnover
Sales (credit) Fixed Asset Turnover
Receivables Sales
Fixed assets
Average collection period
Accounts Receivable
Average Daily Credit Sales Total Asset Turnover
Sales
Inventory Turnover Total Assets
Sales
Inventory
© 2003 McGraw-Hill Ryerson Limited
 Examples

Saxton Company Industry Average

4. Receivables turnover =
Sales (credit) $4,000,000
= 11.4 10 times
Receivables $350,000

5. Average collection period =

Accounts receivable
= 32 $350,000
36 days
Average daily credit sales $11,111
6. Inventory turnover =
Sales = 10.8
$4,000,000 7 times
Inventory $370,000

© 2003 McGraw-Hill Ryerson Limited

 Saxton Company Industry Average

7. Fixed asset turnover =

Sales $4,000,000
= 5.0 5.4 times
Fixed assets $800,000

8. Total asset turnover =

Sales = 2.5 $4,000,000
1.5 times
Total assets $1,600,000

© 2003 McGraw-Hill Ryerson Limited

 4. GOOD

The average number of

times Saxton collects
its receivables in a year
is faster than that of
the industry.
 5. GOOD

The average length of

time Saxton must wait
after making a sale
before receiving cash is
faster than the industry
norm.
 6. GOOD

Each item of Saxton’s

inventory is sold out and
restock or “turn over”
10.8 times per year
faster than the industry
norm.
 7. BELOW AVERAGE

Saxton is using its fixed

asset slightly lower
than other firms in its
industry.
 8. GOOD

Saxton is generating a
sufficient volume of
business given its total
asset investment.
 Liquidity Ratios
 Measure the company’s liquidity (its ability to pay short-
term debts).
 The higher the ratio, the lower the risk of inability to pay.

Current Ratio Quick Ratio

Current Assets Current Assets - Inventory
Current Liabilities Current Liabilities

© 2003 McGraw-Hill Ryerson Limited

 Examples

Saxton Company Industry Average

9. Current ratio =
Current assets $800,000
= 2.67 2.1
Current liabilities $300,000

10. Quick ratio =

Current assets – Inventory
= 1.43 1$430,000
Current liabilities $300,000

© 2003 McGraw-Hill Ryerson Limited

 9+10. GOOD
Liquidity position of Saxton is
good as current liabilities
are covered by those assets
expected to be converted to
cash in the near future in
light of current ratio & quick
ratio.
 Debt Utilization Ratios

 Measure the company’s ability to pay long-term debts.

 The higher the ratio, the less risk of insolvency.

Debt to Total Assets Times Interest Earned

Total Debt Income Before Interest & Taxes
Total Assets Interest Expense

Fixed Charge Coverage

Income Before Fixed Charges & Taxes
Fixed Charges

© 2003 McGraw-Hill Ryerson Limited

 Examples

Saxton Company Industry Average

11. Debt to total assets =
Total debt = 37.5% $600,000
33%
Total assets $1,600,000
12. Times interest earned =

Income before
interest and taxes
= 11 $550,000
7 times
Interest expense $50,000
13. Fixed charge coverage =

Income before
fixed charges and =taxes
6 5.5 times
$600,000
Fixed charges $100,000

© 2003 McGraw-Hill Ryerson Limited

 11. SLIGHTLY MORE DEBT

The percentage of funds

provided by Saxton’s
creditors is 37.5%.
 12+13. GOOD

Saxton’s ability to meet

its annual interest
payment is good in
terms of times interest
earned & fixed charge
coverage.
 Trend Analysis
 Over the course of the business cycle:
 Sales & profitability may expand & contract;

 Ratio analysis for any one year may not present an

accurate picture of the firm.

 Look at the trend analysis of performance over a period of
years

© 2003 McGraw-Hill Ryerson Limited

 Figure 2-2a:
Trend Analysis

A. Profit Margin
Percent

Industry
7
Saxton
5

1
1992 1994 1996 1998 2000 2002 2004

© 2003 McGraw-Hill Ryerson Limited

B. Total Asset Turnover
3.5X
3.0X
2.5X Saxton
2.0X
1.5X
1.0X Industry
.5X
1992 1994 1996 1998 2000 2002 2004

© 2003 McGraw-Hill Ryerson Limited

 Table 2-3:

Trend analysis of competitors

Bank of Montreal Royal Bank
Return on Return on Return on Return on
assets equity assets equity

1992 0.61 14.1 0.08 0.3

1993 0.63 14.1 0.21 2.4
1994 0.68 14.9 0.70 16.8
1995 0.68 15.4 0.69 16.6
1996 0.74 17.0 0.70 17.6
1997 0.66 17.1 0.70 9.3
1998 0.59 15.2 0.70 18.4
1999 0.61 14.1 0.65 15.6
2000 0.79 18.0 0.81 19.8
2001 0.60 13.8 0.74 16.4

Source: Annual reports www.bmo.com Symbol: BMO

www.rbc.com Symbol: RY

© 2003 McGraw-Hill Ryerson Limited

 Financial analysis involves evaluating and comparing
financial performance.

 Basic tools for financial analysis include financial ratios

and trend analysis.

 There are 4 categories of financial ratios: Profitability

Ratios (3 formulas), Asset Utilization Ratios (5 formulas),
Liquidity Ratios (2 formulas) & Debt Utilization Ratios (3
formulas).

© 2003 McGraw-Hill Ryerson Limited