Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Financial Analysis 3 Chapter OutlineRatio analysis and its importance.Use of ratio for measurements.The Du Pont system of analysis.Trend analysis.Evaluation of reported income to identify distortion. Ratio AnalysisFinancial ratiosUsed to weigh and evaluate the operating performance of a firm.Used to compare performance record as against other firms in the industry.Analyzing ratios and numerical calculations.Such data is provided by various organizations. Ratios and their Classification A. Profitability ratios 1. Profit margin. 2. Return on assets (investment). 3. Return on equity. B. Asset utilization ratios 4. Receivable turnover. 5. Average collection period. 6. Inventory turnover. 7. Fixed asset turnover. 8. Total asset turnover. Ratios and their Classification (cont’d) 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. Types of RatiosProfitability ratiosMeasurement of the firm’s ability to earn an adequate return on:SalesAssetsInvested capitalAsset utilization ratiosMeasures the speed at which the firm is turning over accounts receivable. Types of Ratios (cont’d)Liquidity ratiosEmphasizes the firm’s ability to pay off short-term obligations as and when due.Debt utilization ratiosEstimates the overall debt position of the firm.Evaluates in the light of asset base and earning power. Financial Statement for Ratio Analysis Profitability Ratios Administrator (A) - Replace equations with appropriate graphics. Du Pont System of AnalysisA satisfactory return on assets might be derived through:A high profit marginA rapid turnover of assets (generating more sales per dollar of its assets)Or both Return of assets (investment) = (Profit margin) X (Asset turnover) Du Pont System of Analysis (cont’d)A satisfactory return on equity might be derived through:A high return on total assets; A generous utilization of debt;Or a combination of both. Return on equity = Return on assets (investments) [1 – (Debt/ Assets)] Du Pont Analysis Examples for Analysis using the Du Pont System Asset Utilization RatiosThese ratios relate the balance sheet to the income statement. Administrator (A) - Replace equations with appropriate graphics Asset Utilization Ratios (cont’d) Administrator (A) - Replace equations with appropriate graphics Liquidity Ratios Administrator (A) - Replace equations with appropriate graphics Debt Utilization RatiosMeasures the prudence of the debt management policies of the firm. Administrator (A) - Replace equations with appropriate graphics Debt Utilization Ratios (cont’d)Fixed charge coverage measures the firm’s ability to meet the fixed obligations. Interest payments alone.

1. Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All
rights reserved.
Financial Analysis
3
Chapter OutlineRatio analysis and its importance.Use of ratio
for measurements.The Du Pont system of analysis.Trend
analysis.Evaluation of reported income to identify distortion.
Ratio AnalysisFinancial ratiosUsed to weigh and evaluate the
operating performance of a firm.Used to compare performance
record as against other firms in the industry.Analyzing ratios
and numerical calculations.Such data is provided by various
organizations.
Ratios and their Classification
A. Profitability ratios
1. Profit margin.
2. Return on assets (investment).
3. Return on equity.
B. Asset utilization ratios
4. Receivable turnover.

2. 5. Average collection period.
6. Inventory turnover.
7. Fixed asset turnover.
8. Total asset turnover.
Ratios and their Classification (cont’d)
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.
Types of RatiosProfitability ratiosMeasurement of the firm’s
ability to earn an adequate return on:SalesAssetsInvested
capitalAsset utilization ratiosMeasures the speed at which the
firm is turning over accounts receivable.
Types of Ratios (cont’d)Liquidity ratiosEmphasizes the firm’s
ability to pay off short-term obligations as and when due.Debt
utilization ratiosEstimates the overall debt position of the
firm.Evaluates in the light of asset base and earning power.
Financial Statement for Ratio Analysis

3. Profitability Ratios
Administrator (A) - Replace equations with appropriate
graphics.
Du Pont System of AnalysisA satisfactory return on assets
might be derived through:A high profit marginA rapid turnover
of assets (generating more sales per dollar of its assets)Or both
Return of assets (investment) =
(Profit margin) X (Asset turnover)
Du Pont System of Analysis (cont’d)A satisfactory return on
equity might be derived through:A high return on total assets; A
generous utilization of debt;Or a combination of both.
Return on equity = Return on assets (investments)
[1 – (Debt/ Assets)]
Du Pont Analysis
Examples for Analysis using the Du Pont System

4. Asset Utilization RatiosThese ratios relate the balance sheet to
the income statement.
Administrator (A) - Replace equations with appropriate graphics
Asset Utilization Ratios (cont’d)
Administrator (A) - Replace equations with appropriate graphics
Liquidity Ratios
Administrator (A) - Replace equations with appropriate graphics
Debt Utilization RatiosMeasures the prudence of the debt
management policies of the firm.
Administrator (A) - Replace equations with appropriate graphics
Debt Utilization Ratios (cont’d)Fixed charge coverage measures
the firm’s ability to meet the fixed obligations. Interest
payments alone are not considered.
Income before interest and taxes………………..$550,000
Lease payments…………………………………… $50,000
Income before fixed charges and taxes…………$600,000

5. Summary of Ratio Analysis
Trend Analysis
Trend Analysis in the Computer Industry
Impact of Inflation on Financial AnalysisInflationRevenue is
stated in current dollars.Plant, equipment, or inventory may
have been purchased at lower price levels. Profits may be more
a function of increasing prices than due to good performance.
Comparison of Replacement and Historical Cost Accounting
Comparison of Replacement and Historical Cost Accounting
(cont’d)Replacement costs - reduces income but increases
assets.An increase lowers the debt-to-assets ratio.A decrease
indicates a decrease in the financial leverage of the firm.A
declining income results in a decreased ability to cover interest
costs.

6. Impact of Disinflation on Financial
AnalysisDisinflationFinancial assets such as stocks and bonds
have the potentials to do well – encouraging investors.Tangible
assets do not have the potential.DeflationActual reduction of
prices affecting everybody due to bankruptcies and declining
profits.
Other Elements of Distortion in Reported IncomeEffect of
changing prices.Reporting of revenues.Treatment of
nonrecurring items.Tax write-off policies.
Explanation of Discrepancies
Explanation of Discrepancies (cont’d) SalesUse of defer
recognition until each payment is received or full recognition at
the earliest possible date.Cost of goods soldUse of different
accounting principles - LIFO versus FIFO.
Explanation of Discrepancies (cont’d)Extraordinary gains/
lossesInclusion of events when computing current income or
leaving them out.Net incomeUse of different methods of
financial reporting.
7.

7. 8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
25.
27.
28.
29.
30.
31.

8. 32.
33.
34.
35.
36.