Topic

Financial analysis
Introduction to Financial
Management course

By Dr. Nguyen Thu Hien

Why Evaluating Financial
Performance ?

Why?

Evaluate the success of an
ongoing business

Determine weaknesses of an
ongoing business

Compare current performance
with past performance

Compare current performance
with industry standards.
Financial Statements:Review

 Assets
Balance = Liabilities + Owner’s Equity
Sheet
Current Assets Current Liabilities Common Stock
Cash A/P Par Value
Inventory Accruals Paid-In Capital
A/R S-T Debt Retained Earnings

Fixed Assets L-T Liabilities

Land Bonds
Plant L-T Bank Debt
Equipment Mortgages
Less:Depreciation
Preferred Stock
 Financial Statements:Review
 The balance sheet for the Simsboro
Computer Company is as follows:
Balance Sheet
Simsboro Computer Company
Assets Liabilities
Cash $175 Accounts Payable $115
Accounts Receivable 430 S-T Notes Payable 115
Inventories 625 Current Liabilities $230
Current Assets $1,230 Bonds $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock (par) $300
Net Fixed Assets $1,300 Paid-in Capital 600
Total Assets $2,530 Retained Earnings 800
Total Owners’ Equity $1,700
Total Liabilities and
Owners Equity $2,530
Financial Statements:Review

 Income Statement
Revenues - Expenses = Net Income
Sales COGS
Investment Income Salaries
Gains Depreciation Addition to
Interest Received Taxes Dividends
Dividend Received Other Expenses
Retained
Interest Paid Earnings
 Financial Statements: Review
 The income statement for the Simsboro
Computer Company is as follows:
Income Statement
Simsboro Computer Company
Sales $1,450
Cost of Goods Sold 875
Gross Profit $575
Operating Expenses 45
Depreciation 200
Net Operating Income $330
Interest Expense 60
Net Income Before Taxes $270
Taxes (40%) 108
Net Income $162
Dividends Paid 100
Addition to Retained Earnings $62
Basic Teminology:
Balance Sheet
Simsboro Computer Company
Per Share Data: (100 SharesAssets Outstanding) Liabilities
Cash $175 Accounts Payable $115
Net Income
Accounts Receivable 430 S-T Notes Payable 115
Earnings Per Share (EPS) = Shares Outstanding
Inventories 625 Current Liabilities $230
Current Assets $1,230 Bonds $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock (par) $300
Net Fixed Assets $1,300 Paid-in Capital 600
Income Statement Total Assets $2,530 Retained Earnings 800
Simsboro Computer Company Total Owners’ Equity $1,700
Sales $1,450 Total Liabilities and
Cost of Goods Sold 875 Owners Equity $2,530
Gross Profit $575
Operating Expenses 45
Depreciation 200
Net Operating Income $330
Interest Expense 60 EPS = $162 = $1.62
Net Income Before Taxes $270 100
Taxes (40%) 108
Net Income $162
Dividends Paid 100
Addition to Retained Earnings $62
Basic Terminology
Balance Sheet
Simsboro Computer Company
Per Share Data: (100 SharesAssets Outstanding) Liabilities
Cash $175 Accounts Payable $115
Accounts Receivable 430 S-T Notes Payable 115
Dividends Per Share =Inventories Total Dividends Paid
625 Current Liabilities $230
Shares
Current Assets Outstanding
$1,230 Bonds $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock (par) $300
Net Fixed Assets $1,300 Paid-in Capital 600
Income Statement Total Assets $2,530 Retained Earnings 800
Simsboro Computer Company Total Owners’ Equity $1,700
Sales $1,450 Total Liabilities and
Cost of Goods Sold 875 Owners Equity $2,530
Gross Profit $575
Operating Expenses 45
Depreciation 200
Net Operating Income $330
Interest Expense 60 Dividends Per Share = $100 = $1.00
Net Income Before Taxes $270 100
Taxes (40%) 108
Net Income $162
Dividends Paid 100
Addition to Retained Earnings $62
Ratio Analysis
Financial Ratios: attempt to standardize
financial information  facilitate meaningful
comparisons over time and between firms.

The business: a storehouse of resources (i.e.

assets on the balance sheet) which will be
converted to profit through production and then
sales (reported on the income statement)
Ratio Analysis
Five Categories of Ratios

1. Liquidity Ratios (short-term solvency)

2. Efficiency Ratios (asset utilization)
3. Leverage Ratios (long-term solvency)
4. Profitability Ratios
5. Market Value Ratios
Ratio Analysis
Liquidity Ratios

 Measure the ability of the firm to meet its

short-term financial obligations.
Current Assets
Current Ratio =
Current Liabilities

Is there a sufficient amount of current

assets to pay off current liabilities? What
is the cushion of safety?
 Ratio Analysis
Balance Sheet
Simsboro Computer Company
Assets Liabilities
Cash $175 Accounts Payable $115
Accounts Receivable 430 S-T Notes Payable 115
Inventories 625 Current Liabilities $230
Current Assets $1,230 Bonds $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock (par) $300
Net Fixed Assets $1,300 Paid-in Capital 600
Income Statement Total Assets $2,530 Retained Earnings 800
Simsboro Computer Company Total Owners’ Equity $1,700
Sales Current $1,450
Assets Total Liabilities and
Current RatioSold
Cost of Goods = 875 Owners Equity $2,530
Current Liabilities
Gross Profit $575
Operating Expenses 45
Depreciation 200
Net Operating Income $330
Interest Expense 60 Current Ratio = $1,230 = 5.35x
Net Income Before Taxes $270 $230
Taxes (40%) 108
Net Income $162
Dividends Paid 100
Addition to Retained Earnings $62
Ratio Analysis
Liquidity Ratios

 Measure the ability of the firm to meet its

short-term financial obligations.

Current Assets - Inventory

Quick Ratio = Current Liabilities

What happens to the firm’s ability to repay

current liabilities after the least liquid of
the current assets is subtracted?
 Ratio Analysis
Balance Sheet
Simsboro Computer Company
Assets Liabilities
Cash $175 Accounts Payable $115
Accounts Receivable 430 S-T Notes Payable 115
Inventories 625 Current Liabilities $230
Current Assets $1,230 Bonds $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock (par) $300
Net Fixed Assets $1,300 Paid-in Capital 600
Income Statement Total Assets $2,530 Retained Earnings 800
Simsboro Computer Company Total Owners’ Equity $1,700
Sales Current Assets - Inventory
$1,450 Total Liabilities and
Acid--Test Ratio =
Acid Current
Cost of Goods Sold 875 Liabilities Owners Equity $2,530
Gross Profit $575
Operating Expenses 45
Depreciation 200
Net Operating Income $330
$1,230 -$625
Interest Expense 60 Quick Ratio = =2.63x
Net Income Before Taxes $270 $230
Taxes (40%) 108
Net Income $162
Dividends Paid 100
Addition to Retained Earnings $62
Ratio Analysis
Liquidity Ratios

 Measure the ability of the firm to meet its

short-term financial obligations.

Current Assets - Current Liabilities

NWC to TA = Total Assets

What proportion of Total Assets is

dedicated to short-term liquidity?
 Ratio Analysis
Balance Sheet
Simsboro Computer Company
Assets Liabilities
Cash $175 Accounts Payable $115
Accounts Receivable 430 S-T Notes Payable 115
Inventories 625 Current Liabilities $230
Current Assets $1,230 Bonds $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock (par) $300
Net Fixed Assets $1,300 Paid-in Capital 600
Income Statement Total Assets $2,530 Retained Earnings 800
Simsboro Computer Company Total Owners’ Equity $1,700
Sales $1,450 Total Liabilities and
Cost of Goods Sold Current
875 Assets - Current LiabilitiesOwners Equity $2,530
NWC
Gross Profit to TA = $575
Total Assets
Operating Expenses 45
Depreciation 200
Net Operating Income $330
$1,230 -$230
Interest Expense 60 NWC to TA =
Net Income Before Taxes $270 $2,530 =39.53%
Taxes (40%) 108
Net Income $162 $1,230 -$230
Dividends Paid 100 NWC to TA = =.40x
Addition to Retained Earnings $62 $2,530
Ratio Analysis
Efficiency Ratios

 Provide basis for assessing how effectively

the firm is using it’s resources to generate
sales

Sales
Receivables Turnover Ratio = Accounts Receivable

Is the level of accounts receivable

appropriate given the firm’s sales?
Turnover!

Materials WIP Finished goods Sales Cash

AR
Turnover 1
Turnover 2
Turnover 3
Turnover …

Business Cycles
Ratio Analysis
Balance Sheet
Simsboro Computer Company
Assets Liabilities
Cash $175 Accounts Payable $115
Accounts Receivable 430 S-T Notes Payable 115
Inventories 625 Current Liabilities $230
Current Assets $1,230 Bonds $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock (par) $300
Net Fixed Assets $1,300 Paid-in Capital 600
Income Statement Total Assets $2,530 Retained Earnings 800
Simsboro Computer Company Accts Rec. Total Owners’ Equity $1,700
Sales
Sales $1,450 Turnover = Total Liabilities and
Cost of Goods Sold 875 Accounts Receivable
Owners Equity $2,530
Ratio
Gross Profit $575
Operating Expenses 45
Depreciation 200
Net Operating Income $330
Interest Expense 60 Accts Rec Turnover = $1450 = 3.37x
Net Income Before Taxes $270 $430
Taxes (40%) 108
Net Income $162
Dividends Paid 100
Addition to Retained Earnings $62
Ratio Analysis
Efficiency Ratios

Provide basis for assessing how effectively

the firm is using it’s resources to generate
Average Collection Period = Accounts Receivable
sales Daily Credit Sales
(Days’ sales in receivables)

How long does it take for the firm to

collect its credit sales from customers?
Ratio Analysis
Balance Sheet
Simsboro Computer Company
Assets Liabilities
Cash $175 Accounts Payable $115
Accounts Receivable 430 S-T Notes Payable 115
Inventories 625 Current Liabilities $230
Current Assets $1,230 Bonds $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock (par) $300
Net Fixed Assets $1,300 Paid-in Capital 600
Income Statement Total Assets
Average $2,530 Retained Earnings 800
Simsboro Computer Company Accounts Receivable
Total Owners’ Equity $1,700
Collection =
Sales $1,450 Daily
TotalCredit Sales
Liabilities and
Cost of Goods Sold 875
Period Owners Equity $2,530
Gross Profit $575
Operating Expenses 45
Depreciation 200
Net Operating Income $330
$430
Interest Expense 60 ACP = = 108.24 days
Net Income Before Taxes $270 $1,450/365
Taxes (40%) 108
Net Income $162
Dividends Paid 100 Days in a
Addition to Retained Earnings $62 year
Ratio Analysis
Efficiency Ratios

 Provide basis for assessing how effectively

the firm is using it’s resources to generate
sales

Cost of Goods Sold

Inventory Turnover Ratio = Inventory

Is the level of inventory appropriate given

the firm’s sales?
Ratio Analysis
Balance Sheet
Simsboro Computer Company
Assets Liabilities
Cash $175 Accounts Payable $115
Accounts Receivable 430 S-T Notes Payable 115
Inventories 625 Current Liabilities $230
Current Assets $1,230 Bonds $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock (par) $300
Net Fixed Assets $1,300 Paid-in Capital 600
Income Statement Total Assets $2,530 Retained Earnings 800
Simsboro Computer Company Inventory Total Owners’ Equity $1,700
Cost of Goods Sold
Sales $1,450 Turnover = Total Liabilities and
Cost of Goods Sold 875 Inventory
Owners Equity $2,530
Ratio
Gross Profit $575
Operating Expenses 45
Depreciation 200
Net Operating Income $330
Interest Expense 60 Inventory Turnover = $875 = 1.40x
Net Income Before Taxes $270 $625
Taxes (40%) 108
Net Income $162
Dividends Paid 100
Addition to Retained Earnings $62
Ratio Analysis
Efficiency Ratios

 Provide basis for assessing how effectively

the firm is using it’s resources to generate
sales

Sales
Fixed Asset Turnover Ratio = Net Fixed Assets

How effective is the firm in using its fixed

assets in generating sales?
Ratio Analysis
Balance Sheet
Simsboro Computer Company
Assets Liabilities
Cash $175 Accounts Payable $115
Accounts Receivable 430 S-T Notes Payable 115
Inventories 625 Current Liabilities $230
Current Assets $1,230 Bonds $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock (par) $300
Net Fixed Assets $1,300 Paid-in Capital 600
Income Statement Total Assets $2,530 Retained Earnings 800
Simsboro Computer Company Fixed Asset Total Owners’ Equity $1,700
Sales $1,450 Turnover = LiabilitiesSales
Total and
Cost of Goods Sold 875 Ratio Net Equity
Owners Fixed Assets
$2,530
Gross Profit $575
Operating Expenses 45
Depreciation 200
Net Operating Income $330
Interest Expense 60 Fixed Asset Turnover = $1,450 = 1.12x
Net Income Before Taxes $270 $1,300
Taxes (40%) 108
Net Income $162
Dividends Paid 100
Addition to Retained Earnings $62
Ratio Analysis
Efficiency Ratios

 Provide basis for assessing how effectively

the firm is using it’s resources to generate
sales

Sales
Total Asset Turnover Ratio = Total Assets

How effective is the firm in using all

assets to generate sales?
Ratio Analysis
Balance Sheet
Simsboro Computer Company
Assets Liabilities
Cash $175 Accounts Payable $115
Accounts Receivable 430 S-T Notes Payable 115
Inventories 625 Current Liabilities $230
Current Assets $1,230 Bonds $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock (par) $300
Net Fixed Assets $1,300 Paid-in Capital 600
Income Statement Total Assets $2,530 Retained Earnings 800
Simsboro Computer Company Total Owners’ Equity $1,700
Sales $1,450 Total Liabilities and
Total Asset OwnersSales
Equity $2,530
Cost of Goods Sold 875
Gross Profit $575 Turnover = Total Assets
Operating Expenses 45 Ratio
Depreciation 200
Net Operating Income $330
Interest Expense 60 Total Asset Turnover = $1,450 = 0.57x
Net Income Before Taxes $270 $2,530
Taxes (40%) 108
Net Income $162
Dividends Paid 100
Addition to Retained Earnings $62
Ratio Analysis
Leverage Ratios

 Used to measure the extent to which

non-owner supplied funds have been used
to finance the firm’s assets

 Two Types
 Balance Sheet Leverage Ratios
 Coverage Ratios
Ratio Analysis
Leverage Ratios

 Balance Sheet Leverage Ratios focus entirely

on items found on the balance sheet.

Debt Ratio = Total Debt

Total Assets

What proportion of the firm’s assets are

financed with debt?
Ratio Analysis
Balance Sheet
Simsboro Computer Company
Assets Liabilities
Cash $175 Accounts Payable $115
Accounts Receivable 430 S-T Notes Payable 115
Inventories 625 Current Liabilities $230
Current Assets $1,230 Bonds $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock (par) $300
Net Fixed Assets $1,300 Paid-in Capital 600
Income Statement Total Assets $2,530 Retained Earnings 800
Simsboro Computer Company Total Owners’ Equity $1,700
Sales $1,450 Total Liabilities and
Cost of Goods Sold 875 Debt Ratio =Owners Total
EquityDebt$2,530
Gross Profit $575 Total Assets
Operating Expenses 45
Depreciation 200
Net Operating Income $330
Interest Expense 60 Debt Ratio = $230 + $600 = 32.81%
Net Income Before Taxes $270 $2,530
Taxes (40%) 108
Net Income $162
Dividends Paid 100 Debt Ratio = $230 + $600 = .33x
Addition to Retained Earnings $62 $2,530
Ratio Analysis
Leverage Ratios

 Balance Sheet Leverage Ratios focus entirely

on items found on the balance sheet.

Equity Multiplier = Total Assets

Equity

What is the relationship between equity

and total assets?
Ratio Analysis
Balance Sheet
Simsboro Computer Company
Assets Liabilities
Cash $175 Accounts Payable $115
Accounts Receivable 430 S-T Notes Payable 115
Inventories 625 Current Liabilities $230
Current Assets $1,230 Bonds $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock (par) $300
Net Fixed Assets $1,300 Paid-in Capital 600
Income Statement Total Assets $2,530 Retained Earnings 800
Simsboro Computer Company Total Owners’ Equity $1,700
Sales $1,450 Total Liabilities and
Cost of Goods Sold 875 Owners Equity $2,530
Gross Profit $575 Equity Multiplier = Total Assets
Operating Expenses 45 Equity
Depreciation 200
Net Operating Income $330
Interest Expense 60
Net Income Before Taxes $270
Equity Multiplier = $2530
Taxes (40%) 108
= 1.49x
Net Income $162
$1700
Dividends Paid 100
Addition to Retained Earnings $62
 Ratio Analysis
Leverage Ratios

 Coverage Ratios measure the firm’s ability to

cover (pay) the finance charges associated with
its use of financial leverage.

Operating Income
Times Interest Earned Ratio =
Interest Expense

What is the margin of safety in the ability

to repay interest payments?
 Ratio Analysis
Balance Sheet
Simsboro Computer Company
Assets Liabilities
Cash $175 Accounts Payable $115
Accounts Receivable 430 S-T Notes Payable 115
Inventories 625 Current Liabilities $230
Current Assets $1,230 Bonds $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock (par) $300
Net Fixed Assets $1,300 Paid-in Capital 600
Income Statement Total Assets $2,530 Retained Earnings 800
Simsboro Computer Company Total Owners’ Equity $1,700
Sales $1,450 Times Total Liabilities and
Cost of Goods Sold 875 Operating
Owners Equity Income
$2,530
Interest =
Gross Profit $575 Interest Expense
Operating Expenses 45 Earned Ratio
Depreciation 200
Net Operating Income $330
Interest Expense 60 $330 = 5.50x
Net Income Before Taxes $270
TIE Ratio =
Taxes (40%) 108
$60
Net Income $162
Dividends Paid 100
Addition to Retained Earnings $62
 Ratio Analysis
Leverage Ratios
 Coverage Ratios measure the firm’s ability to
cover (pay) the finance charges associated with
its use of financial leverage.

Cash Coverage Ratio = EBIT+Depreciation

Interest Expense

What is the margin of safety in the ability

to repay interest payments?
 Ratio Analysis
Balance Sheet
Simsboro Computer Company
Assets Liabilities
Cash $175 Accounts Payable $115
Accounts Receivable 430 S-T Notes Payable 115
Inventories 625 Current Liabilities $230
Current Assets $1,230 Bonds $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock (par) $300
Net Fixed Assets $1,300 Paid-in Capital 600
Income Statement Total Assets $2,530 Retained Earnings 800
Simsboro Computer Company Total Owners’ Equity $1,700
Sales $1,450 Cash Total Liabilities and
Cost of Goods Sold 875 EBIT+Depreciation
Owners Equity $2,530
Coverage =
Gross Profit $575 Interest Expense
Operating Expenses 45 Ratio
Depreciation 200
Net Operating Income $330
Interest Expense 60 $330+200 = 8.83x
Net Income Before Taxes $270
CC Ratio =
Taxes (40%) 108
$60
Net Income $162
Dividends Paid 100
Addition to Retained Earnings $62
Ratio Analysis
Profitability Ratios

 Measure the overall effectiveness of the

firm’s management.

 Two Types:
 Profit in Relation to Sales
 Profit in Relation to Investment
Ratio Analysis
Profitability Ratios

 Profit in Relation to Sales measures the firm’s

ability to convert sales volume into bottom line
profit.

Net Income
Net Profit Margin =
Sales

What is the amount of Net Profit for each

dollar of sales?
 Ratio Analysis
Balance Sheet
Simsboro Computer Company
Assets Liabilities
Cash $175 Accounts Payable $115
Accounts Receivable 430 S-T Notes Payable 115
Inventories 625 Current Liabilities $230
Current Assets $1,230 Bonds $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock (par) $300
Net Fixed Assets $1,300 Paid-in Capital 600
Income Statement Total Assets $2,530 Retained Earnings 800
Simsboro Computer Company Total Owners’ Equity $1,700
Sales $1,450 Net Total Liabilities and
Cost of Goods Sold 875 Net Income
Owners Equity $2,530
Profit =
Gross Profit $575 Sales
Operating Expenses 45 Margin
Depreciation 200
Net Operating Income $330
Interest Expense 60 Net Profit Margin = $162 = 11.17%
Net Income Before Taxes $270 $1,450
Taxes (40%) 108
Net Income $162
Dividends Paid 100
Addition to Retained Earnings $62
 Ratio Analysis
Profitability Ratios
 Profit in Relation to Investment measures the
firm’s ability to convert resources (investment)
into bottom line profit.

Net Income
Return on Assets = Total Assets

What is the relationship between the

generated profits of the firm and the firm’s
investment in assets?
 Ratio Analysis Balance Sheet
Simsboro Computer Company
Assets Liabilities
Cash $175 Accounts Payable $115
Accounts Receivable 430 S-T Notes Payable 115
Inventories 625 Current Liabilities $230
Current Assets $1,230 Bonds $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock (par) $300
Net Fixed Assets $1,300 Paid-in Capital 600
Income Statement Total Assets $2,530 Retained Earnings 800
Simsboro Computer Company Total Owners’ Equity $1,700
Sales $1,450 Total Liabilities and
Cost of Goods Sold 875 Owners NetEquityIncome
$2,530
Return on Assets = Total Assets
Gross Profit $575
Operating Expenses 45
Depreciation 200
Net Operating Income $330
Interest Expense 60 ROA = $162 = 6.40%
Net Income Before Taxes $270 $2,530
Taxes (40%) 108
Net Income $162
Dividends Paid 100
Addition to Retained Earnings $62
Ratio Analysis
Profitability Ratios
 Profit in Relation to Investment measures the
firm’s ability to convert resources (investment)
into bottom line profit.

Net Income
Return on Equity = Common Equity

What is the relationship between the

generated profits of the firm and the
owner’s investment in the firm?
 Ratio Analysis
Balance Sheet
Simsboro Computer Company
Assets Liabilities
Net Cash
Income $175 Accounts Payable $115
Return on Equity = Common Accounts
Equity Receivable 430 S-T Notes Payable 115
Inventories 625 Current Liabilities $230
Current Assets $1,230 Bonds $600
Plant & Equipment $2,500 Owner’s Equity
Less:Acc. Depr. (1,200) Common Stock (par) $300
Net Fixed Assets $1,300 Paid-in Capital 600
Income Statement Total Assets $2,530 Retained Earnings 800
Simsboro Computer Company Total Owners’ Equity $1,700
Sales $1,450 Total Liabilities and
Cost of Goods Sold 875 Owners Equity $2,530
Gross Profit $575
Operating Expenses 45
Depreciation 200
Net Operating Income $330
Interest Expense 60 ROE = $162 = 9.53%
Net Income Before Taxes $270 $1,700
Taxes (40%) 108
Net Income $162
Dividends Paid 100
Addition to Retained Earnings $62
Market Value Ratios

 Market Price = $57.65 per share

 Shares outstanding = 100

 PE Ratio = Price per share / Earnings per share

 57.65 / 1.62 = 35.58 times

 Market-to-book ratio = market value per share /

book value per share
 57.65 / (1700 / 100) = 3.39 times
Dupont analysis

 ROE = ROA * EM
= PM * TAT * EM

 Strategies to raise ROE?

 Increase PM?
 Increase TAT?
 Increase EM?
Ratio Analysis
DuPont System
 The DuPont System summarizes key relationships which
determine the overall performance of the firm.

Net Income
Return on Assets = Total Assets
Total Asset
Turnover
Can be rewritten as: 0.57 times

Net Income Net Income Sales

= x
Total Assets Sales Total Assets
Net Profit
Margin
11.17% 0.1117 x 0.57 = .0640 = 6.40%
 Ratio Analysis
DuPont System
 The Return on Equity can also be rewritten:

Net Income
Return on Equity = Common Equity

Equity multiplier
1.49
DuPont System
Total Assets
Return on Equity = ROA * Equity
Return on
Assets
6.40% .064 * 1.49 = 0.0953 = 9.53%
Use of financial ratios

 Ratios are not very helpful by themselves;

they need to be compared to something
 Time-Trend Analysis
 Used to see how the firm’s performance is
changing through time
 Internal and external uses
 Peer Group Analysis
 Compare to similar companies or within industries
 SIC and NAICS codes
Ratio Analysis
Summary of Simsboro Computer & Industry
Ratio Industry Simsboro
Liquidity
Current Ratio 5.00x 5.35x
Acid-Test Ratio 3.00x 2.63x

Looking at the current ratio it appears

that Simsboro is more liquid than the
industry.... however when looking at
Acid Test (a better measure) they are
not as liquid indicating that inventory
levels are probably too high.
Ratio Analysis
Summary of Simsboro Computer & Industry
Ratio Industry Simsboro
Efficiency
Avg. Collection Period 90 days 108 days
Inventory Turnover 2.20x 1.40x
Fixed Asset Turnover 1.00x 1.12x
Total Asset Turnover 0.75x .57x

Collection policies need examining, as Simsboro is

slower than average at collecting sales. Inventories
are being sold more slowly than industry, again
indicating too high inventories. Simsboro is very
efficient at converting Fixed Assets to Sales (fixed
assets are productive). However, overall assets are
not productive indicating Current Assets
(inventories) are not as productive as the industry.
Ratio Analysis
Summary of Simsboro Computer & Industry
Ratio Industry Simsboro
Leverage
Debt Ratio .33x .33x
Times Interest Earned 7.00x 5.50x

While debt ratio is the same as the industry,

Simsboro is not as able to cover interest
payments as the industry. This indicates
Simsboro may have too much debt as they
cannot afford their level of debt. Or, Simsboro
is not effective in searching cheap funds.
Ratio Analysis
Summary of Simsboro Computer & Industry
Ratio Industry Simsboro
Profitability
Net Profit Margin 12% 11.17%
Return on Assets 9.0% 6.40%
Return on Equity 13.43% 9.53%

Market ratios
P/E ratio 42 35.58
M/B ratio 3.70 3.39

Simsboro is having a problem with total

costs. The ROA and ROE are all low
mainly due to productivity problems.
Market undervalues Simsboro due to
management ineffectiveness.
Ratio Analysis
Summary of Simsboro Computer & Industry
DuPont Analysis
Net Profit Margin
ROA Simsboro
11.17%
6.40% Computer
= R O E
x TAT ∗ = 9.53%
0.57x EM
1.49

Net Profit Margin

ROA
12.0% Industry
= 9.0% R O E
x TAT ∗ = 13.43%
0.75x EM
1.49
Who uses ratio analysis?
 Internal uses
 Performance evaluation – compensation and
comparison between divisions
 Planning for the future – guide in estimating
future cash flows
 External uses
 Creditors
 Suppliers
 Customers
 Stockholders
Potential Problems with
Ratio Analysis
 There is no underlying theory for financial analysis
 no way to know which ratios are most relevant

 Benchmarking is difficult for diversified firms

 Globalization and international competition makes

comparison more difficult because of differences in
accounting regulations

 Varying accounting procedures, i.e. FIFO vs. LIFO

 Different fiscal years
 Extraordinary events
Standardized Financial Statements
- An Alternative to Ratios

 Common-Size Balance Sheets

 Compute all B/S accounts as a percent of total assets
 Common-Size Income Statements
 Compute all I/S items as a percent of sales

 Standardized statements make it easier to compare

financial information, particularly as the company
grows
 They are also useful for comparing companies of
different sizes, particularly within the same industry
The Basics of Topic
1. What are the major categories of ratios and how do
you compute specific ratios within each category?
2. How do the ratios relate? The Dupont Identity.
3. Who Uses Financial Ratio Analysis?
4. What are some of the problems associated with
financial statement analysis?
5. How do you standardize balance sheets and
income statements and why is standardization
useful?