CHAPTER

3
Financial Analysis

Microsoft® PowerPoint® Presentation

Prepared by Kathy Faber, Conestoga College

© 2021 MCGRAW HILL 1

  What is Financial Analysis?
 4 Categories of Financial Ratios
Chapter 3
Outline  Techniques of Ratio Analysis
 Distortion in Financial Reporting
 Summary and Conclusions

© 2021 MCGRAW HILL 2

Learning Objectives
• Calculate 13 financial ratios that
Calculate measure profitability, asset utilization,
liquidity and debt utilization. (LO1)

• Assess a company’s source of

Assess profitability using the DuPont system
of analysis. (LO2)

Examine
• Examine the ratios in comparison to
industry averages. (LO3)

© 2021 MCGRAW HILL 3

Learning Objectives
• Examine the ratios and company
Examine performance by means of trend
analysis. (LO4)

Interpret
• Interpret ratios and identify corrective
action for abnormal results. (LO4)

Identify
• Identify sources of distortion in
reported income. (LO5)

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  Evaluating a firm’s financial
performance
What is  Calculating ratios to reveal
Financial relationships between different
Analysis? accounts of financial statements
 Linking ratios to reveal the
factors determining a firm’s
profitability and value
 Financial analysis may not
answer questions, but leads to
further inquiry

© 2021 MCGRAW HILL 5

 A. Profitability Ratios
Classification
System of B. Asset Utilization Ratios
Financial
Ratios C. Liquidity Ratios

D. Debt Utilization Ratios

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 Show how profitable a
company is
# Formula
1a Profit margin
A. 1b Gross profit margin
Profitability 2 Return on assets (ROA)
(investment)
Ratios 3 Return on equity (ROE)
(common shareholders)

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 Show how effectively a company
uses its assets
# Formula
4a Receivable turnover
B. Asset 4b Average collection period (day’s
sales outstanding)
Utilization 5a Inventory turnover
Ratios 5b Inventory holding period
6a Accounts payable turnover
6b Accounts payable period
7 Capital asset turnover
8 Total asset turnover

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 Show how liquid a company is
or how much cash it has
available to meet short-term
needs.
# Formula
C. Liquidity 9 Current ratio
Ratios 10 Quick ratio (acid test)

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 Show how well a company is
managing or using debt.
# Formula
11 Debt to total assets
D. Debt 12 Times interest earned
13 Fixed charge coverage
Utilization
Ratios

© 2021 MCGRAW HILL 10

 SAXTON COMPANY
Income Statement
For the Year 20XX
Sales $4,000,000
Table 3-1 Cost of goods sold 3,000,000
Gross profit 1,000,000
Non-IFRS Selling and administrative expense* 450,000
financial Operating profit 550,000
statements for Interest expense 50,000
ratio analysis of Extraordinary loss 100,000
private Net income before taxes 400,000
companies Taxes (50%) 200,000
Net income $ 200,000
*Includes $50,000 lease payments

© 2021 MCGRAW HILL 11

 SAXTON COMPANY
Balance Sheet
As of December 31, 20XX
Assets
Cash $ 30,000
Marketable securities 50,000
Accounts receivable 350,000
Inventory 370,000
Table 3-1 Total current assets 800,000
Non-IFRS Net plant and equipment 800,000
financial Total assets $1,600,000
statements for Liabilities and Shareholders’ Equity
ratio analysis of Accounts payable $50,000
private companies Notes payable 250,000
– Part 2 Total current liabilities 300,000
Long-term liabilities 300,000
Total liabilities 600,000
Common stock 400,000
Retained earnings 600,000
Total liabilities and shareholders’ equity $1,600,000

© 2021 MCGRAW HILL 12

 Profitability Ratios – Part 1
Industry
Ratio Formula Saxton Company
Average
(3-1a)
Profit margin = X 100% = X 100% = 5% 6.5%
(3-1b)
Gross profit = X 100% = X 100% = 25% 22%
margin
(3-2a)
Return on = X 100% = X 100% = 12.5% 9.75%
Assets (ROA)
(3-2b) 6.5% X 1.5
Return on = X = 5% X X 100% = 12.5%
Assets (ROA) = 9.75%

© 2021 MCGRAW HILL 13

 Profitability Ratios – Part 2
Industry
Ratio Formula Saxton Company
Average
(3-3a)
Return on = X 100% = X 100% = 20% 15%
equity (ROE)
(3-3b)
Equity = = = 1.6 times 1.5 times
multiplier
(3-3c) Return
on equity = ROA X Equity multiplier = 12.5% X 1.6 times = 20% 15%
(ROE)

© 2021 MCGRAW HILL 14

 Reveals the relationships
between profitability ratios and
asset utilization ratios and debt
utilization ratios

DuPont
Analysis Decomposes Return on Asset
(ROA) into two factors:
ROA =
= X
= Profit Margin X Asset Turnover

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 Decomposes Return on Equity (ROE)
into three factors:
ROE =
DuPont
Analysis – = X X
Part 2 = Profit Margin X Asset Turnover X Equity Multiplier

ROE = ROA X Equity Multiplier

© 2021 MCGRAW HILL 16

Figure 3-1
DuPont analysis

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Finance in Action
Applying DuPont Analysis

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 Asset Utilization Ratios - Receviables
Industry
Ratio Formula Saxton Company
Average
(3-4a)
Receivables = = = 11.4 times 10 times
turnover
(3-4b)
Average
collection = = = 32 days 36 days
period

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 Asset Utilization Ratios – Inventory
Industry
Ratio Formula Saxton Company
Average
(3-5a)
Inventory = = = 8.1 times 7 times
turnover
(3-5b)
Inventory
holding = = = 45 days 52 days
period

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 Asset Utilization Ratios – Payables
Industry
Ratio Formula Saxton Company
Average
(3-6a)
Accounts
payable = = = 60.0 times 12 times
turnover
(3-6b)
Accounts
payable = = = 6 days 30 days
period

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 Asset Utilization Ratios – Assets
Industry
Ratio Formula Saxton Company
Average
(3-7)
Capital
asset = = = 5.0 times 5.4 times
turnover
(3-8)
Total asset = = = 2.5 times 1.5 times
turnover

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 Liquidity Ratios
Industry
Ratio Formula Saxton Company
Average
(3-9)
Current = = = 2.67:1 2.1:1
ratio
(3-10)
Quick ratio = = = 1.43:1 1.0:1

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 Debt Utilization Ratios
Industry
Ratio Formula Saxton Company
Average
(3-11)
Debt to
total = X 100% = X 100% = 37.5% 33%
assets
(3-12)
Times
interest = = = 11 times 7 times
earned
(3-13)
Fixed
charge = = = 6 times 5.5 times
coverage

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 Table 3-2 Ratio analysis
Saxton Industry
Company Average Conclusion
A. Profitability
1a. Profit margin 5.0% 6.5% Below average
1b. Gross margin 25.0% 28.0% Below average
2. Return on assets 12.5% 10.0% Above average due to high turnover
3. Return on equity 20.0% 15.0% Good due to ratios 2 and 11
B. Asset Utilization
4a. Receivable turnover 11.4 10.0 Good
4b. Average collection period 32 36 Good
5a. Inventory turnover 8.1 7.0 Good
5b. Inventory holding period 45 52 Good
6a. Accounts payable turnover 60.0 12.0 Poor
7. Capital asset turnover 5.0 5.4 Below average
8. Total asset turnover 2.5 1.5 Good

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Table 3-2 Ratio analysis – Part 2
Saxton Industry
Company Average Conclusion
C. Liquidity
9. Current ratio 2.67 2.1 Good
10. Quick ratio 1.43 1.0 Good
D. Debt Utilization
11. Debt to total assets 37.5% 33.0% Slightly more debt, but reasonable
12. Times interest earned 11 7 Good
13. Fixed charge coverage 6 5.5 Good

© 2021 MCGRAW HILL 26

 Comparing a company’s ratios to the
industry average or industry leader
may not be appropriate.

Interpretation Over the course of the business cycle,

of Ratios by because of sales and profit fluctuations,
yearly ratio analysis may not present an
Trend accurate picture.
Analysis
Comparing the same company’s ratios
on a year-to-year basis is trend analysis
and may reveal whether ratios are
improving or worsening over the length
of a longer time cycle.

© 2021 MCGRAW HILL 27

Figure 3-2
Trend analysis

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 Bank of Montreal Royal Bank
Year ROA ROE ROA ROE
2006 0.83% 17.7% 0.88% 21.4%
2008 0.50 13.0 0.63 18.1
2010 0.44 14.9 0.58 13.2
2012 0.69 15.9 0.86 18.25
2014 0.96 14.9 0.97 19.5
2016 0.64 10.4 0.79 13.1
2019 0.84 14.06 1.04 17.4

Table 3-3
Trend analysis of competitors

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 Historical-based accounting in
an environment of changing
prices may distort financial
results:
 immediate effect of price changes
(inflation/disinflation) on revenues
Distortion in versus delayed impact on asset
Financial values
Reporting Accrual-based accounting allows
certain leeway in matching the
revenues and expenses
 cost of goods sold (LIFO vs. FIFO)
 asset write-downs
 net income

© 2021 MCGRAW HILL 30

Table 3-7
Income Statement
Income Statement For the Year 20XY
Conservative High Reported
(A) Income (B)
Sales $4,000,000 $4,200,000
Cost of goods sold 3,000,000 2,400,000
Gross profit 1,000,000 1,800,000
Selling and administrative expense 450,000 450,000
Operating profit 550,000 1,350,000
Interest expense 50,000 50,000
Net income before taxes 500,000 1,300,000
Taxes (40%) 200,000 520,000
Net income 300,000 780,000
Extraordinary loss (net of tax) 60,000 0
Net income transferred to retained earnings $ 240,000 $ 780,000

© 2021 MCGRAW HILL 31

  Financial ratios cover 4 areas of
management: profitability, asset
utilization, liquidity and debt
utilization.
 The DuPont system of analysis
Summary and tells us that the profit margin,
Conclusions asset turnover, and debt usage
each contributes to return on
equity.
 Ratios should be compared to
industry average (comparative
analysis) as well as historical data
(trend analysis).

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  What ratios do is to suggest
aspects requiring further
exploration. It is the
Summary and manager/analyst’s job to answer
Conclusions – the questions revealed by ratios.
Part 2
 Analysts should also be aware of
the distortion in financial
reporting.

© 2021 MCGRAW HILL 33