Finance

Chapter 3Analysis of financial statements

Financial statement analysis

Financial ratios Show the strengths and weaknesses of a company

when compared to other companies in the same industry

Is the company improving or not? A starting point to help predict future conditions

and planning appropriate actions Types of ratios

Liquidity – assets that can be quickly converted to cash

Asset management Debt management Profitability Market value

Liquidity & Asset Ratios

Liquidity ratios – current ratio Current ratio = current assets/current liabilities

Asset management ratios Inventory turnover ration = sales/inventories Days sales outstanding = receivables/average

sales per day How many days it must wait to receive cash

Fixed assets turnover ratio = sales/net fixed assets Effective use of plant and equipment

Total assets turnover ration = sales/total assets

Debt management ratios

Financial leveraging – use of debt financing Ratios reveal:

The extent the firm is financed with debt Likelihood of default (inability to pay debts)

Debt ratio Times-interest-earned ratio EBITDA coverage ration

Debt management ratios:Financial leverage

Using debt for financing (raising capital) - implications:

1. Stockholders maintain control of debt while limiting their investment

2. Creditors look to equity – the higher the proportion of capital provided by stockholders, the less risk to creditors

3. If income from borrowed funds investment exceeds interest paid on loans, the return on owners’ capital is magnified, or “leveraged”

Debt management ratios

Debt ratio = total debt/total assets Ability to pay interest: times-interest-earned

ratio TIE = EBIT/interest charges

EBITDA coverage ratio = EBITDA + lease payments/interest + principal payments + lease payments

Profitability ratios

A group of ratios showing combined effects of liquidity, asset management, and debt on operating results

Profit margin on sales = net income/sales Basic earning power (BEP)

BEP = EBIT/total assets Return on total assets (ROA)

ROA = net income/total assets Price/Earnings ratio (P/E) – the price per share to

earnings per share P/E = price per share/earnings per share

Market/Book ratio (M/B) – the ratio of a stock’s market price to its book value Book value = common equity/shares outstanding M/B = market price per share/book value per share

Financial statement analysis

Other analysis include: Trend analysis Extended Du Pont equation – rate of return on

equity Benchmarking Economic Value Added (EVA) – accounts for the

cost of equity as well as debt