03 Financial Analysis

FINANCIAL
ANALYSIS
BALANCE SHEET
INCOME STATEMENT
FINANCIAL RATIO ANALYSIS
1. LIQUIDITY RATIOS
2. ASSET MANAGEMENT RATIOS
3. DEBT MANAGEMENT RATIOS
4. PROFITABILITY RATIOS
5. MARKET VALUE RATIOS

FINANCIAL ANALYSIS
1. LIQUIDITY RATIOS
Current ratio = Current assets / Current liabilities

=1000 / 310 = 3.2
Industry Average = 4.2
• Current assets include cash, marketable securities, accounts receivable

and inventories.
• Current liabilities consist of accounts payable, short-term notes
payable, current maturities of long-term debt, accrued taxes and other
accrued expenses.
The Quick, or Acid Test, Ratio = (Current assets − Inventories) / Current
liabilities
• = 385 / 310 = 1.2
• Industry Average = 2.1
FINANCIAL ANALYSIS
ASSET MANAGEMENT RATİOS
Inventory turnover ratio = Sales / Inventories
=3000 / 615 = 4.9
Industry avrg= 9
• It means that each item of MicroDrive’s inventory is sold
out and restocked or “turned over,” 4.9 times per year.
• If industry average is 9, it shows that MicroDrive is holding
too much inventory.
• High levels of inventory add to net operating working
capital (NOWC), which reduces FCF.
• Since, sales occur over entire year, it is better to use
average inventory (Average inventory = (EP-BP) / 2), but
single time inventory balance can used also.
FINANCIAL ANALYSIS
Days sales outstanding (DSO) =Average collection period (ACP)=

Receivables / Average sales per day = Receivables / (Annual
sales/365)
=375 / (3000 / 365) = 375 / 8.2192 = 45.6 days

Industry avrg= 36 days
• Considering industry average of 36, MicroDrive’s 36 days of

sales are outstanding indicates that customers, on average, are
not paying their bill on time.
• Considering also inventory, high levels of accounts receivable

cause high levels of NOWC, which hurts FCF and stock price.
Financial Analysis
• Fixed assets turnover ratio = Sales / Net fixed

assets
• =3000 / 1000 = 3
• Ind. Average= 3
• Total assets turnover ratio = Sales / Total

assets
• =3000 / 2000 = 1.5
• Ind. Average= 1.8
FINANCIAL ANALYSIS
DEBT MANAGEMENT RATIOS
Debt ratio = Total liabilities / Total assets

=(310 + 754) / 2000 = 1064 / 2000 = 53.2% Industry Average = %40
Debt-to-equity ratio = Total liabilities / (Total assets − Total liabilities)

=(310 +754) / 2000 – (310 + 754) = 1064 / 936 = 1.14 Ind. Average= 0.67
Market debt ratio = Total liabilities / (Total liabilities + Market value of equity) =
1064 / (1064 + 1050) = 48.1 %
Market value of equity = stock price * Number of shares = 23*50 = 1050
• If there is increase in market debt ratio, lit can be due to liabilities may
increased or stock price fell.
• Since the stock price reflects a company’s prospects for generating future cash
flows, a decline in stock price indicates a likely decline in future cash flows.
• Thus, the market debt ratio reflects a source of risk that is not captured by the
conventional book value debt ratio.
FINANCIAL ANALYSIS
Times-interest-earned (TIE) ratio (Interest coverage

ratio) = EBIT / Interest expense = 283.8 / 88 =3.2
Industry aver.=6
• It means that MicroDrive’s interest is covered 3.2

times.
• The TIE ratio measures the extent to which
operating income can decline before the firm is
unable to meet its annual interest costs.
• Failure to meet this obligation can bring legal action
by the firm’s creditors, possibly resulting in
bankruptcy (financial distress).
FINANCIAL ANALYSIS
• EBITDA coverage ratio = (EBITDA + Lease payments) /
(Interest + Principal payments + Lease payments)
• = 383.8 + 28 / 88 + 20 + 28 = 411.8 / 136 = 3 (times)
• Industry average = 4.3
• EBITDA coverage ratio considers all fixed financial

obligations of a company.
• The EBITDA coverage ratio is most useful for short-term
lenders such as banks, which usually give ST loans
• Therefore, banks and other short-term lenders focus on
the EBITDA coverage ratio, whereas long-term
bondholders focus on the TIE ratio.
FINANCIAL ANALYSIS
PROFITABILITY RATIOS
Net profit margin = Net income available to common stockholders / Sales
= 113.5 / 3.000 =3.8% Industry average = 5 %
Operating profit margin = EBIT / Sales
Gross profit margin = (Sales − Cost of goods sold)/ Sales
Basic earning power BEP) ratio = EBIT / Total assets

=283.8 / 2.000 = 14.2% Industry average = 17.2 %
BEP ratio shows the raw earning power of the firm’s assets before
the influence of taxes and leverage.
MARKET VALUE RATIOS
Market value ratios relate a firm’s stock price to its earnings,

cash flow, and book value per share. Market value ratios are a
way to measure the value of a company’s stock relative to that
of another company.
Price/Earnings Ratio
The price/earnings (P/E) ratio shows how much investors are
willing to pay per dollar of reported profits. MicroDrive’s
stock sells for $23, so with an earnings per
share (EPS) of $2.27 its P/E ratio is 10.1:
FINANCIAL RATIOS
FINANCIAL RATIOS
FINANCIAL
ANALYSIS
Trend Analysis, Common Size Analysis
and Percentage Change Analysis
• To do a trend analysis, you examine a ratio over

time
• In a common size analysis, all income statement
items are divided by sales and all balance sheet
items are divided by total assets
• In percentage change analysis, growth rates are
calculated for all income statement items and
balance sheet accounts relative to a base year.
FINANCIAL ANALYSIS
FINANCIAL ANALYSIS
FINANCIAL ANALYSIS
FINANCIAL ANALYSIS: BENCHMARKING
FINANCIAL ANALYSIS
A company’s ratios are compared with those of other firms in the same
industry. This technique is called benchmarking.
Companies used for the comparison are called benchmark companies.
Limitations of Ratio Analysis

1- For all companies it is difficult to develop a meaningful set of industry averages.
So, industry averages are more applicable to small, narrowly focused firms than
to large and multidivisional ones.
• 2- Inflation may have badly distorted firms’ balance sheets and reported values
are often substantially different from “true” values.
• 3- Seasonal factors can also distort a ratio analysis.
• 4- Firms can employ “window dressing” techniques to make their financial
statements look stronger.
• 5- Companies’ choices of different accounting practices can distort
comparisons. For example, choices of different inventory valuation and
depreciation methods affect financial statements
In summary, conducting ratio analysis in a mechanical, unthinking manner is

dangerous, but when ratio analysis is used intelligently and with good
judgment, it can provide useful insights into a firm’s operations
?
?
Questions and Answers
(ST–1)
Debt Ratio
Argent Corporation had earnings per share of $4
last year, and it paid a $2 dividend. Total retained
earnings increased by $12 million during the year,
and book value per share at year-end was $40.
Argent has no preferred stock, and no new common
stock was issued during the year. If Argent’s year-
end debt (which equals its total liabilities) was $120
million, what was the company’s year-end
debt/assets ratio?
(3–12)
Comprehensive Ratio Calculations
The Kretovich Company had a quick ratio of 1.4, a current ratio

of 3.0, an inventory turnover of 6 times, total current assets of
$810,000, and cash and marketable securities of $120,000. What
were Kretovich’s annual sales and its DSO? Assume a 365-day
year.
(3–10)
Times-Interest-Earned Ratio
The Manor Corporation has $500,000 of debt outstanding,

and it pays an interest rate of 10% annually: Manor’s
annual sales are $2 million, its average tax rate is 30%, and
its net profit margin on sales is 5%. If the company does not
maintain a
TIE ratio of at least 5 to 1, then its bank will refuse to renew
the loan and bankruptcy will result. What is Manor’s TIE
ratio?
(3–9)
Current and Quick Ratios
The Nelson Company has $1,312,500 in current assets and

$525,000 in current liabilities. Its initial inventory level is
$375,000, and it will raise funds as additional notes payable
and use them to increase inventory. How much can Nelson’s
short-term debt (notes payable) increase without pushing its
current ratio below 2.0? What will be the firm’s quick ratio
after Nelson has raised the maximum amount of short-term
funds?
(3–7)
Current and Quick Ratios
Ace Industries has current assets equal to $3

million. The company’s current ratio is
1.5, and its quick ratio is 1.0. What is the firm’s
level of current liabilities? What is
the firm’s level of inventories?
(3–13)
Comprehensive Ratio Analysis
Data for Morton Chip Company and its industry averages follow.
a. Calculate the indicated ratios for Morton.
b. Construct the extended Du Pont equation for both Morton and the
industry.
c. Outline Morton’s strengths and weaknesses as revealed by your analysis.
d. Suppose Morton had doubled its sales as well as its inventories, accounts
receivable, and common equity during 2010. How would that information
affect the validity of your ratio analysis? (Hint: Think about averages and
the effects of
rapid growth on ratios if averages are not used. No calculations are needed.)

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FINANCIAL

2. ASSET MANAGEMENT RATIOS

3. DEBT MANAGEMENT RATIOS

5. MARKET VALUE RATIOS

Current ratio = Current assets / Current liabilities

• Current assets include cash, marketable securities, accounts receivable

Days sales outstanding (DSO) =Average collection period (ACP)=

=375 / (3000 / 365) = 375 / 8.2192 = 45.6 days

• Considering industry average of 36, MicroDrive’s 36 days of

• Considering also inventory, high levels of accounts receivable

• Fixed assets turnover ratio = Sales / Net fixed

• Total assets turnover ratio = Sales / Total

Debt ratio = Total liabilities / Total assets

Debt-to-equity ratio = Total liabilities / (Total assets − Total liabilities)

Market value of equity = stock price * Number of shares = 23*50 = 1050

Times-interest-earned (TIE) ratio (Interest coverage

• It means that MicroDrive’s interest is covered 3.2

• EBITDA coverage ratio considers all fixed financial

Net profit margin = Net income available to common stockholders / Sales

= 113.5 / 3.000 =3.8% Industry average = 5 %

Operating profit margin = EBIT / Sales

Gross profit margin = (Sales − Cost of goods sold)/ Sales

Basic earning power BEP) ratio = EBIT / Total assets

Market value ratios relate a firm’s stock price to its earnings,

• To do a trend analysis, you examine a ratio over

Limitations of Ratio Analysis

In summary, conducting ratio analysis in a mechanical, unthinking manner is

Comprehensive Ratio Calculations

The Kretovich Company had a quick ratio of 1.4, a current ratio

The Manor Corporation has $500,000 of debt outstanding,

The Nelson Company has $1,312,500 in current assets and

Ace Industries has current assets equal to $3

c. Outline Morton’s strengths and weaknesses as revealed by your analysis.

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