3-1
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.
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.
LO4. Trend analysis shows company performance over time.
LO5. Reported income must be further evaluated to identify sources of distortion.
3
3-2
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.
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 Ratio Analysis and Classification System
1. Profitability ratios: Measures of returns on sales, total assets, and invested
capital
PPT Saxton Company— Financial statement for ratio analysis (Table 3-1)
PPT The Analysis—Profitability Ratios
PPT Du Pont Analysis (Figure 3-1)
3-3
PPT Return on Equity: Wal-Mart vs. Target Using the Du Pont Method of
Analysis, 2017 (Table 3-2)
A
B
A × B
C
(A × B)/D
Name
Profit
Margin
Asset
Turnover
Return on
Assets
Debt/Assets
Return on
Equity
Walmart Stores
Inc.
2.81%
2.44
6.86%
60.87%
17.54%
Target
3.94%
1.86
7.31%
70.74%
24.99%
2. Asset utilization ratios: Measures how well the firm is managing its
accounts receivable, inventories, and long-term assets.
a. Receivable turnover = Sales/Receivables
PPT The Analysis—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
PPT The Analysis—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.
3-4
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
important as industry comparisons
PPT Ratio Analysis (Table 3-3)
PPT Trend Analysis (Figure 3-2)
Perspective 3-4: Figure 3-2 and Table 3-4 illustrate the importance of trends.
PPT Trend Analysis in the Computer Industry (Table 3-4)
Finance in Action: Are Financial Analysts Friends or Foes to Investors? Reader Beware!
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.”
3. A leveling off of prices referred to as disinflation may cause a reduction in
1. Assets on the balance sheet are recorded at cost.
3. The use of replacement cost accounting increases asset values during
3-5
inflationary periods. This increase lowers the debt to asset ratio but does
not necessarily enhance the firm’s ability to service its debt.
PPT Net Income for 2018 (Table 3-5)
PPT Net Income for 2019 (Table 3-6)
PPT Comparison of Replacement Cost Accounting and Historical Cost
Accounting (Table 3-7)
C. Raising capital
2. Although earnings may drop because of disinflation, the declining rate of
3. The movement away from financial assets (stocks and bonds) into tangible
assets (gold, silver, etc.) by investors during periods of inflation makes it
IV. Other Elements of Distortion in Reported Income
PPT An Illustration
A. Recognition of revenue
1. A conservative firm may recognize long-term installment sales revenues
2. Firms may use different inventory write-off policies to influence profits.
Finance in Action: Sustainability, ROA, and the “Golden Rule”
3-6
B. Differences in inventory valuation (LIFO versus FIFO) may cause incomparable
differences between companies.
PPT Income Statements (Table 3-8)
Other Chapter Supplements
Cases for Use with Foundations of Financial Management
Case 1, Harrod’s Sporting Goods (ratio analysis)