Chapter 2: Financial Analysis

Financial Analysis: Financial Analysis is the process of identifying the financial

strengths and weaknesses of the firm by properly establishing relationships between the
items of the balance sheet and the profit and loss account.

Users of Financial Analysis:

Financial Analysis can be undertaken by
• Management of the firm
• Parties outside the firm, viz. owners, creditors, investors and others.

# Nature of analysis will differ depending on the purpose of the analyst.

Ratio Analysis
• Ratio analysis is a powerful tool of financial analysis. A Ratio is defined as “the
indicated quotient of two mathematical expressions” and as “the relationship
between the two things.
• In financial analysis, a ratio is used as an index for evaluating the financial
position and performance of a firm.
• The relationship between two accounting figures, which is expressed
mathematically, is known as financial ratio.

Standards of Comparison
A single ratio in itself does not indicate favorable or unfavorable condition. It should be
compared with some standard. Standards of comparison may consist of
• Ratios calculated from the past financial statements of the same firm;
• Ratios developed using the projected, or pro forma, financial statements of the
same firms;
• Ratios of some selected firms, especially the most progressive and successful, at
the same point in time, and
• Ratios of the industry to which the firm belongs.

Types of Ratios
1. Liquidity Ratios: Liquidity ratios measure the firm’s ability to meet current
obligation.
2. Leverage Ratios: Leverage ratios show the proportions of debt and equity in
financing the firm’s assets.
3. Activity Ratios: Activity ratios reflect the firm’s efficiency in utilizing its assets.
4. Profitability Ratios: Profitability ratios measure the overall performance and
effectiveness of the firm.
5. Market Value Ratio: A set of ratios that relate the firm’s stocks price to its
earnings and book value per share. These ratios give management an indication of
what investors think of the company’s past performance and future prospects.
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1. Liquidity Ratios
Current Assets
(a) Current Ratio = ----------------------
Current Liabilities
• Current Assets include cash and those assets which can be converted into cash
within a year, such as marketable securities, debtors(= accounts receivables) and
inventories, prepaid expenses etc.
• Current Liabilities include creditors(= accounts payables), bills payable, accrued
expenses, short term bank loan, income tax liability and long term debt maturing
in the current year.
• Current ratio indicates the availability of current assets in taka for every one taka
of current liability. A ratio of greater than one means that the firm has more
current assets than current claims against them.
• higher current ratio → greater ability to cover short-term
debt obligations
• current ratio “too high” → the firm may be "wasting"
money by holding too much cash, etc. That money could
conceivably be invested to earn a higher rate of return.

Current Assets -- Inventories

(b) Quick Ratio = ----------------------------------
Current Liabilities
– higher quick ratio → the greater is the ability to cover
short-term debt obligations without selling off inventory.
– As before, if the quick ratio is too high, the firm may be
wasting money.

Cash + Marketable Securities

(c) Cash Ratio = ------------------------------------
Current Liabilities
• Actual capacity to payoff its most upcoming liabilities
2. Leverage Ratios
Total Debt
(a) Debt to Total Assets = ------------------
Total Assets
– example: $100 initial investment in a project that pays off
$120, all equity firm
• return to shareholders is 20%
– example: same, but 50% debt (at 6% interest), 50% equity
firm:
• $50 × 1.06 = $53 goes to debtholders
• $67 to shareholders ⇒ ($67-$50) / $50 = 34%
return to shareholders
– Other benefits of higher debt
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• greater control (less shares outstanding)
• interest tax deduction
– Drawbacks of higher debt
• greater risk of bankruptcy
• must appease debtholders

Income before Interest and Taxes

(b) Time Interest Earned = ------------------------------------------
Interest

• Time Interest Earned indicates the number of times that income before interest
and taxes covers the interest obligation.
• higher times-interest-earned ratio → the higher the profits
beyond what is necessary to pay debtholders.
o BUT… a firm with too little debt may have a high
TIE → we must be cautious in interpreting the
ratio.

Income before Fixed Charges and Taxes

(c) Fixed Charge Coverage = ---------------------------------------------------
Fixed Charges

• Fixed Charge Coverage measures the firm’s ability to meet all fixed obligations
rather than interest payments alone, on the assumption that failure to meet any
financial obligation will endanger the position of the firm.

3. Activity Ratios
Cost of goods sold
(a) Inventory Turnover = ------------------------
Inventory

• This ratio indicates the efficiency of the firm in selling its product.
• higher asset turnover → more effective use of inventory.
• We often also specify the inventory turnover in days ≡
inventory / (COGS/n), where n is the number of days in the
reporting period.

Credit Sales
(b) Receivable Turnover = -----------------
Receivables
• The receivables turnover indicates the number of times on the average that
receivables turnover each year.
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Accounts Receivable
(c) Average Collection Period = -----------------------------------
Average Daily Credit Sales
360
= -----------------------------
Receivable Turnover
– higher collection period → lower “quality” of sales
– Note that we often do not have “credit sales,” so we proxy
by using actual sales

Sales
(d) Fixed Assets Turnover = ---------------------
Fixed Assets
• Fixed assets turnover shows the firm’s efficiency of utilizing fixed assets.
• higher fixed asset turnover → more effective use of fixed
assets.

Sales
(e) Total Assets Turnover = -----------------
Total Assets
– higher asset turnover → more effective use of assets.
– BUT…may imply that the company has old assets.

4. Profitability Ratios
Gross Profit
(a) Gross Profit Margin = ---------------------
Sales
Sales – Cost Of Goods Sold
= ----------------------------------
Sales
• The gross profit margin reflects the efficiency with which management produces
each unit of product. This ratio indicates the average spread between the cost of
goods sold and the sales revenue.
• higher gross margin → efficient control of costs or efficient
generation of sales

Net Income
(b) Net Profit Margin = ----------------------
Sales

• Net profit margin ratio establishes a relationship between net profit and sales and
indicates management’s efficiency in manufacturing, administering and selling the
products.
• higher net profit margin → higher fraction of revenues kept
as profits.
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Net Income
(c) Return on Assets = -------------------
Total Assets

Net Income
(d) Return on Equity = ------------------------
Shareholder’s Equity
– higher ROE → more profitable use of firm equity.
– Of course a profitable firm with a lot of debt will tend to
have a high ROE (since equity is low). So, we must be
cautious in interpreting the ratio.
6. Market Value Ratios
i. price to earnings ≡ market share price / earnings per share
1. higher P/E ratio → better market opinion of the future
prospects of the firm.
a. BUT…P/Es for firm’s with extremely low earnings
can be misleading.
b. One rule of thumb is to ignore P/E when the profit
margin is less than some arbitrary value (4%
perhaps?)
c. Mathematically, it is more reasonable to look at E/P.
ii. market to book ≡ market value of equity / book value of equity
1. higher market to book ratio → better market opinion of the
current state of the firm.
a. BUT…M/B may be high if assets are old.
2. M/B < 1 is a special case. Why?
a. Two main explanations:
b. 1. Book value of assets (and hence book value of
equity) is misleading
c. 2. The company has a high risk of bankruptcy

The Du Pont Identity

Net Income Sales Assets
ROE = --------------- X ------------- X -------------
Sales Assets Equity

= Net Profit margin X Total Assets Turnover X Equity Multiplier

The Du Pont Identity tells us that ROE is affected by three things

• Operating Efficiency (as measured by profit margin)
• Asset use efficiency (as measured by total assets turnover)
• Financial Leverage (as measured by the equity multiplier)
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Utility of Ratio Analysis
• Many diverse groups of people use ratios to determine the financial characteristics
of the firm in which they are interested. With the help of ratios one can determine:
 the ability of the firm to meet its current obligation;
 the extend to which the firm has used its long-term solvency by borrowing
funds;
 the efficiency with which the firm is utilizing its various assets in
generating sales revenue, and
 the overall operating efficiency and performance of the firm.
• In credit analysis, the analyst will usually select a few important ratios. He may
use the current ratio or quick ratio to judge the firm’s liquidity or debt paying
ability; debt ratio to determine the stake of the owners in the business and the
firm’s capacity to survive in the long-run and any one of the profitability ratios,
for example return on assets, to determine the firm’s earnings prospects.
• The ratio analysis is also useful in security analysis. The major focus in security
analysis is on the long-term profitability. Profitability is dependent on a number of
factors and, therefore, the security analyst also analyses other ratios.

Cautions In Using Ratio Analysis

• It is difficult to decide on the proper basis of comparison.
• The comparison is rendered difficult because of differences in situations of two
companies or of one company over years.
• The price level changes make the interpretations of ratios invalid.
• The differences in the definitions of items in the balance sheet and the profit and
loss statement make the interpretation of ratios difficult.
• The ratios calculated at a point of time are less informative and defective as they
suffer from short-term changes.
• The ratios are generally calculated from past financial statements and, thus are no
indicators of future.

.
QUESTION: BRIEFLY comment on the difficulties one faces in using financial
statements to analysis the health of companies.

Answer: Financial statement analysis is difficult because we never have current

numbers, the numbers we do have are accounting ones and are backward looking,
and financial managers have incentives to create statements that misrepresent the
true status of the firm. Furthermore, companies may have different fiscal years,
which make it difficult to determine appropriate industry averages. Most
importantly, firms are not identical, so finding truly comparable companies may not
be possible.
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Problem 1: Backer Oats had an asset turnover of 1.6 times per year.
a) If the return on total assets (investment) was 11.2%, what was Backer’s profit
margin?
b) The following year, on the same level of assets, Baker’s asset turnover declined to
1.4 times and its profit margin was 8 percent. How did the return on total assets
change from that of the previous year? (Problem 5 on text)

Problem 2: The balance sheet for Stud Clothiers is given below. Sales for the year were
$2,40,000, with 90 percent of sales sold on credit.
STUD
CLOTHIERS
Balance Sheet 199X

Assets Liabilities and Equity

Cash 60000 Accounts Payable 220000
Accounts Receivable 240000 Accrued Taxes 30000
Bonds Payable (long
Inventory 350000 term) 150000
Plant and Equipment 410000 Common stock 80000
Paid in capital 200000
Retained earnings 380000
106000 Total liabilities and 106000
Total assets 0 equity 0

Compute the following rations:

a) Current Ratio
b) Quick Ratio
c) Debt-to-total assets ratio
d) Asset turnover
e) Average collection period (problem 12 on text)
Problem 3 Complete the balance sheet by using following data

Debt ratio 50%

Quick ratio 0.80 times
Total assets turnover 1.5 times
Days sales outstanding 36 days
Gross profit margin on sales: (Sales –Cost of goods sold)/sales 25%
Inventory turnover ratio 5 times
Balance Sheet
Cash ? Accounts payables ?
Accounts Receivables ? Long term debt 60000
Inventories ? Common stocks ?
Fixed Assets ? Retained earnings 97000
Total Assets 300000 Total liabilities and equities ?
Sales ? Cost of goods solds ?
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SOLVED PROBLEM
Problem 1: You have been investigating a certain company and have calculated the
following ratios for the company and average ratios for that company’s industry.

Ratio Company Industry Average

current ratio 2.2 3.1
quick ratio 1.2 2.4
inventory turnover 16.8 16.5
fixed asset turnover 6.4 6.2
total asset turnover 2.6 2.5
collection period 25.1 13.4
times interest earned 4.8 5.1
debt ratio 10% 10%
profit margin 6.4% 6.2%
return on equity 18.5% 17.2%
return on assets 16.7% 15.5%
price to earnings 17.1 16.8
market to book 3.8 3.4

Analyze the firm from the perspective of both shareholders and debt holders. What
problem area is evident (be as specific as possible). Should shareholders be concerned?
Should debt holders be concerned?
Answer: As always, we begin by examining the factors of the Dupont equation.
Notice that the profit margin, total assets turnover, and debt ratio (and hence the
equity multiplier) are close to the industry average. This suggests that the firm has
no serious problems in terms of expense control, asset management, and debt
management. We do notice, however, that the average collection period is unusually
high and that the current and quick ratios are unusually low. Since all three ratios
deal with current assets, this suggests that the firm may be having trouble managing
its current assets. Both the current ratio and quick ratio are low, so it is unlikely
that inventory is contributing to the problem. This leaves accounts receivable as the
most likely problem. It appears that the firm may be granting too much credit and
that this has somehow contributed to the low liquidity ratios. Notice, however, that
the P/E ratio, the market-to-book ratio, ROA, and ROE all look fine. We conclude
that although the firm may be having some trouble with receivables, the trouble
does not appear to have affected the bottom line for the firm. Thus, the firm is not
experiencing any major problems and debtholders and shareholders should not be
overly concerned.
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Problem 2: You have examined a firm’s financial statements and have calculated the
following ratios.

Industry
Ratio Company Average
current ratio 2.9 2.8
quick ratio 2.2 2.1
inventory turnover 15 17
collection period 24 22
fixed assets turnover 4.2 5.6
total assets turnover 1.6 2.4
debt ratio 65% 65%
times interest earned 3.8 3.4
profit margin 5% 3%
return on total assets 10% 14%
return on equity 23% 21%
price to earnings 14 14

Analyze the ratios from the perspective of shareholders. What problem area is evident?
Analyze the ratios from the perspective of debtholders. Will the firm be able to issue
additional debt if necessary?
Answer: As always, we begin by examining the factors of the DuPont equation. The
profit margin and debt ratio look good, but the total assets turnover is low. This
suggests that the firm is having trouble effectively managing its assets. The
inventory turnover is above average, so the problem is probably not with inventory.
The fixed asset turnover is below average, however. This suggests that the problem
is with fixed assets. One possible explanation is that the firm is using outdated
(inefficient) machinery. Another is that the firm has fixed assets that are not
currently being used. The current ratio, the quick ratio, and times-interest-earned
are above average. The debt ratio is average. So, there appear to be no problems as
far as debtholders are concerned. If the firm needs to issue additional debt in the
near future, it should have no problems doing so.