Engineering Management 452 Advanced Financial Management

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Engineering Management 452 Advanced Financial
Management
Chapter 3 Analysis of Financial Statements Review
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Analysis of Financial Statements

• Ratio analysis
• Du Pont system
• Effects of improving ratios
• Limitations of ratio analysis
• Qualitative factors

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Ratio Analysis

• A ratio is simply one number divided by another.
  Not all ratios are relevant for all industries.
  Must understand what the ratio is telling us to
  determine its usefulness.
• What is the unit of measurement? What might a
  high or low value be telling us? How can this
  number be improved?

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Why are ratios useful?

• Standardize numbers facilitate comparisons
• Used to highlight weaknesses and strengths

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Five Major Categories of Ratios

• Liquidity Can we make required payments as they
  fall due?
• Asset management Do we have the right amount of
  assets for the level of sales?
• Debt management Do we have the right mix of
  debt and equity?
• Profitability Do sales prices exceed unit
  costs, and are sales high enough as reflected in
  PM, ROE, and ROA?
• Market value Do investors like what they see as
  reflected in P/E and M/B ratios?

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Examples of Liquidity Ratios

• Current ratio Current assets / Current
  liabilities
• Quick ratio (Current assets Inventory) /
  Current liabilities
• Cash Ratio Cash / Current Liabilities

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Examples of Asset Management Ratios

• Inventory Turnover Ratio Sales / Inventories
• Days Sales Outstanding Receivables / Average
  Sales per day (also called Average Collection
  Period
• Fixed Asset Turnover ratio Sales / Net Fixed
  Assets
• Total Asset Turnover ratio Sales / Total Assets

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Examples of Debt Management Ratios

• Debt ratio (Total Debt) / Total assets
• Times Interest Earned EBIT / Interest charges
• EBITDA Coverage Ratio (EBIT Lease Payments) /
  (Interest charges Principal payments Lease
  Payments

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Examples of Profitability Ratios

• Profit margin Net Income available to CS /
  Sales
• Basic Earning Power EBIT / Total Assets
• Return on Assets Net Income available to CS /
  Total Assets
• Return on Common Equity Net Income available to
  CS / Common Equity

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Examples of Market Value Ratios

• Price Earnings Ratio Price per Share / Earnings
  per share
• Price to Cash Flow Ratio Price per share / Cash
  Flow per share
• Market to Book Ratio Market value per share /
  Book value per share
• Book value per share is common equity divided by
  the number of shares outstanding

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Trend Analysis

• Trend analysis simply plots a trend over time
• Common Size Analysis
• All income items are divided by sales and all
  balance sheet items are divided by total assets
• Percentage Change Analysis
• Growth rates are calculated for all income
  statement items and balance sheet accounts

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Du Pont System
Focuses on

• Expense control (PM)
• Asset utilization (TATO)
• Debt utilization (EM)

It shows how these factors combine to determine
the ROE.
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Du Pont Equation

• ROA Profit Margin x Total Asset Turnover ROE
  Profit Margin x Total Asset Turnover x Equity
  Multiplier

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Potential problems and limitations of financial
ratio analysis

• Comparison with industry averages is difficult if
  the firm operates many different divisions.
• Average performance is not necessarily good.
• Seasonal factors can distort ratios.

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Potential problems and limitations of financial
ratio analysis

• Window dressing techniques can make statements
  and ratios look better.
• Different accounting and operating practices can
  distort comparisons.
• Sometimes it is difficult to tell if a ratio
  value is good or bad.
• Often, different ratios give different signals,
  so it is difficult to tell, on balance, whether a
  company is in a strong or weak financial
  condition.

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Qualitative factors

• Are the companys revenues tied to a single
  customer?
• To what extent are the companys revenues tied to
  a single product?
• To what extent does the company rely on a single
  supplier?

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Qualitative factors

• What percentage of the companys business is
  generated overseas?
• What is the competitive situation?
• What does the future have in store?
• What is the companys legal and regulatory
  environment?
• And so on.