978-1259277160 Chapter 3 Lecture Note

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Financial Analysis

Author’s Overview

The student should be directed to view the thirteen ratios as an overall package that can be used

to evaluate any firm. The use of the Saxton Company analysis provides continuity to the

discussion. The authors like to stress that ratios are easier to remember than students think. For

example, emphasize that net income is the numerator for the profitability ratios, sales is the

numerator for most asset utilization ratios, and that the debt ratios essentially define themselves.

Though the student must be familiar with the calculation and meaning of each individual ratio,

the primary emphasis is on the inter-relationship between the ratios (such as that stressed by the

Du Pont system of analysis). The discussion of inflation/disinflation and distortions in financial

reporting represents an important lesson for the student: do not automatically accept the bottom

line.

Chapter Concepts

LO1. Ratio analysis provides a meaningful comparison of a company to its industry.

LO2. Ratios can be used to measure profitability, asset utilization, liquidity and debt utilization.

LO3. The Du Pont system of analysis identifies the true sources of return on assets and return

to stockholders.

LO4. Trend analysis shows company performance over time.

LO5. Reported income must be further evaluated to identify sources of distortion.

Annotated Outline and Strategy

I. Ratio analysis: Like painting a picture; one ratio (color) does not reveal much by itself,

but when several ratios are taken together, the analyst gets a better picture of the firm.

Ratio analysis provides a basis for evaluating the performance of the firm and facilitates

comparison with other firms, using data from sources such as Dun & Bradstreet, Standard

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& Poor’s, Value Line Investment Survey, etc.

Perspective 3-1: Ratios give additional meaning to absolute values. Show how we use ratios

in everyday life such as miles per gallon, baseball batting averages, etc.

A. Classification System: There are 13 basic ratios presented in the text. We break

them down into four categories:

PPT Ratios and their Classification

1. Profitability ratios: Measures of returns on sales, total assets and invested

capital

a. Profit margin = Net income/Sales

b. Return on assets (investment) = Net income/Total assets

c. Return on equity = Net income/Stockholders’ equity = Return on

assets ÷ (1 – Debt/Assets)

PPT Saxton Co. – Financial Statement for Ratio Analysis (Table 3-1)

PPT Profitability Ratios

PPT Du Pont Analysis (Figure 3-1)

Perspective 3-2: The Du Pont system of analysis carries insights into the relationship between

profitability ratios. Use Figure 3-1 and Table 3-2 to explain this system.

PPT Return of Wal-Mart versus Abercrombie & Fitch (Table 3-2)

A B D A × B = (A × B)/D =

Profit

Margin

Asset

Turnover 1-Debt/Assets Return

on Assets

Return

on Equity

Wal-Mart 3.34% 3.63 .622 12.1% 19.5%

Abercrombi 4.24% 2.15 9.1% 10.5%

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e.866

2. Asset utilization ratios: Measures how well the firm is managing its

accounts receivable, inventories, and long-term assets.

a. Receivables turnover = Sales/Receivables

b. Average collection period = Accounts receivable/Average daily

credit sales

c. Inventory turnover = Sales/Inventory or COGS/Inventory

d. Fixed asset turnover = Sales/Fixed assets

e. Total asset turnover = Sales/Total assets

PPT Asset utilization ratios

Perspective 3-3: This is an excellent opportunity to explain how asset utilization ratios relate

to profitability ratios.

3. Liquidity ratios: Measures of the firm’s ability to pay off short-term

obligations as they come due

a. Curent ratio = Curent assets/Curent liabilities

PPT Liquidity Ratios

b. Quick ratio = Current assets minus inventory/Current liabilities

4. Debt Utilization Ratios: Measures the prudence of the firm’s debt

management policies.

a. Debt to total assets

b. Times interest earned

c. Fixed charge coverage

PPT Debt Utilization Ratios

5. Users focus on different ratios to assess performance of different aspects of

the business.

II. Trend Analysis: Compares company performance over a period of time and is just as

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important as industry comparisons

PPT Ratio Analysis (Table 3-3)

PPT Trend Analysis for the Saxton Company (Figure 3-2)

Perspective 3-4: Figure 3-2 and Table 3-4, illustrate the importance of trends.

PPT Trend Analysis for IBM and Apple (Table 3-4)

Finance in Action: Are Financial Analysts Friends or Foes to Investors? Reader Beware

In this section we discuss the conflict between financial analysts and their ability to remain

objective in their analysis given the relationship their firm may have with the company being

analyzed.

III. Impact of Inflation on Financial Analysis

A. Impact on Profits

1. First-in, first-out (FIFO) inventory valuation during inflation periods

“understates” cost of goods sold and causes “inventory profits.”

2. The use of replacement cost accounting reduces income and interest

coverage during inflationary periods.

3. A leveling off of prices referred to as disinflation may cause a reduction in

profits.

B. Impact on Asset Value

1. Assets on the balance sheet are recorded at cost.

2. In inflationary periods, the replacement cost of long-term assets may

greatly exceed the reported values.

3. The use of replacement cost accounting increases asset values during

inflationary periods. This increase lowers the debt to asset ratio but does

not necessarily enhance the firm’s ability to service its debt.

PPT Comparison of Replacement Cost and Historical Costs (Table 3-7)

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C. Raising capital

1. Investors generally require higher rates of return during periods of

inflation.

2. Although earnings may drop because of disinflation, the declining rate of

return demanded by investors may cause the value of a firm’s securities to

increase.

3. The movement away from financial assets (stocks and bonds) into tangible

assets (gold, silver, etc.) by investors during periods of inflation makes it

difficult and more expensive for firms to raise capital. Likewise the

reverse trend during periods of disinflation enhances a firm’s ability to

issue securities.

IV. Other Elements of Distortion in Reported Income

PPT Illustration of Conservative versus High Reported Income Firms

A. Recognition of revenue

1. A conservative firm may recognize long-term installment sales revenues

when payments are received, whereas other firms report the full amount of

the sale as soon as possible.

2. Firms may use different inventory write-off policies to influence profits.

Finance in Action: Sustainability, ROA, and the “Golden Rule”

This box focuses on the impact of sustainability on corporate profits. In short, a researcher from

Harvard found that companies that emphasize sustainability have higher long-term ROA and

ROE than comparative firms not practicing sustainability. While many view sustainability as an

ethical “golden rule,” it appears that there is additional gold for those companies that practice

this cultural ethic. This also relates back to the Chapter one discussion on wealth maximization

and social responsibility.

B. Differences in inventory valuation (LIFO versus FIFO) may cause incomparable

differences between companies.

C. Extraordinary losses are reported in total as deductions from operating income by

some firms but shown as deductions (net of taxes) from net income by others.

D. The financial analyst should make every attempt to adjust financial reports to a

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consistent format for proper analysis.

Other Chapter Supplements

Cases for Use with Foundations of Financial Management

Case 1, Harrod’s Sporting Goods (ratio analysis)

Case 2, Chem-Med Company (ratio analysis case)

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