Learning Objectives

Learning Objectives • Calculate 13 financial ratios that measure profitability, asset utilization, liquidity and debt utilization. (LO1) • Assess a company’s source of profitability using the DuPont system of analysis. (LO2) • Examine the ratios in comparison to industry averages. (LO3) • Examine the ratios and company performance by means of trend analysis. (LO4)

What is Financial Analysis? Evaluating a firm’s financial performance Calculating ratios to reveal relationships between different 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 LO1

Classification System of Financial Ratios A. Profitability Ratios B. Asset Utilization Ratios C. Liquidity Ratios D. Debt Utilization Ratios LO1

A. Profitability Ratios Show how profitable a company is The ratios are: Profit margin Return on assets (ROA) (investment) Return on equity (ROE) (common shareholders) LO1

B. Asset Utilization Ratios Show how effectively a company uses its assets The ratios are: 4a. Receivables turnover 4b. Average collection period (days sales outstanding) 5a. Inventory turnover 5b. Inventory holding period 6a. Accounts payable turnover 6b. Accounts payable period 7. Capital asset turnover 8. Total asset turnover LO1

C. Liquidity Ratios Show how liquid a company is or how much cash it has to meet short-term needs. The ratios are: 9. Current Ratio 10. Quick Ratio LO1

D. Debt Utilization Ratios Show how well a company is managing or using debt The ratios are 11. Debt to total assets 12. Times interest earned 13. Fixed charge coverage LO1

Table 3-1aFinancial statements for ratio analysis LO1 SAXTON COMPANY Income Statement For the year 2012 Sales (all on credit). . . . . . . . . . . $4,000,000 Cost of good old . . . . . . . . . .. . . 3,000,000 Gross profits . . . . . . . . . . . . . . . 1,000,000 Selling and administrative expense *. . .. . 450,000 Operating profit . . . . . . . . . . . . . .550,000 Interest expense . . . . . . . . . . . . . . 50,000 Extraordinary loss. . . . . . . . . . . . . . 100,000 Net Income before taxes . . . . . . . . . . 400,000 Taxes (50%). . . . . . . . . . . . . . . 200,000 Net Income . . . . . . . . . . . . . . $ 200,000 *Includes $50,000 in lease payments.

Balance SheetAs of December 31, 2012 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 and 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 and shareholders' equity $1,600,000 Table 3-1bFinancial statements for ratio analysis LO1

Saxton Company Industry Average 3-1. Profit margin = = 5% 6.5% 3-2. Return on assets (ROA) (investment) = a. = 12.5% 10% b. 5% x 2.5 = 12.5% 6.5% x 1.5 = 10% Profitability ratios(a) LO1 Net income Total assets $200,000 $4,000,000 Net income Sales $200,000 $1,600,000 Net income Sales Sales Total assets 

Saxton Company Industry Average 3-3. Return on equity (ROE) = a. = 20% 15% b. Equity multiplier = = 1.6 = 1.5 c. ROA × Equity multiplier = 0.125 × 1.60 = 20% 0.10 × 1.50 = 15% Profitability ratios(b) LO1 and LO2 Net income Shareholders’ equity $200,000 $1,000,000 $1,600,000 $1,000,000 Total assets Equity 1 0.6667

Asset utilization ratios(a) LO1 and LO3 Saxton Company Industry Average 3-4a. Receivables turnover = = 11.4 10 times 3-4b. Average collection period = = 32 36 days 3-5a. Inventory turnover = Cost of Goods Sold = 8.1 7 times Inventory Sales (credit) Receivables $4,000,000 $350,000 $350,000 $10,959 Accounts receivable Average daily credit sales $3,000,000 $370,000

Asset utilization ratios(b) LO1 and LO3 Saxton Company Industry Average 3-5b. Inventory holding period = = 45 52 days 3-6a. Accounts payable turnover = = 60.0 12 times 3-6b. Accounts payable period = Accounts payable= 6 30 days Average daily purchases (COGS) $370,000 $8,219 Inventory Average daily COGS $3,000,000 $50,000 Cost of goods sold Accounts payable $50,000 $8,219

Asset utilization ratios(c) LO1 and LO3 Saxton Company Industry Average 3-7. Capital asset turnover = = 5.0 5.4 times 3-8. Total asset turnover = = 2.5 1.5 times Sales Capital assets $4,000,000 $800,000 Sales Total assets $4,000,000 $1,600,000

Liquidity ratios LO1/LO3 Saxton Company Industry Average 3-9. Current ratio = = 2.67 2.1 3-10. Quick ratio = = 1.43 1.0 Current assets Current liabilities $800,000 $300,000 Current assets – Inventory Current liabilities $430,000 $300,000

Debt utilization ratios LO1/LO3 Saxton Company Industry Average 3-11. Debt to total assets = = 37.5% 33% 3-12. Times interest earned = = 11 7 times 3-13. Fixed charge coverage = = 6 5.5 times Total debt Total assets $600,000 $1,600,000 Income before interest and taxes Interest $550,000 $50,000 Income before fixed charges and taxes Fixed charges $600,000 $100,000

Techniques of Ratio Analysis DuPont Analysis Comparative Analysis Trend Analysis Common-Size Statements LO1/LO2/LO3/LO4

Learning Objectives