November 24, 2014

Chapter 4. Financial Statement Analysis for Financial Decision Making

 Financial ratio analysis
 Du Pont equations
 Trend analysis
 Limitations in ratio analysis
 Looking beyond the numbers
 Financial ratio analysis

Evaluating a firm’s financial statement to predict the firm’s future performance
(1) Liquidity ratios: show a firm’s ability to pay off short-term debt (the relationship of a firm’s cash and other current assets to its current liabilities)
Current ratio = current assets / current liabilities
Quick ratio (acid test ratio) = (current assets - inventory) / current liabilities

The traditional recommended value for current ratio is 2:1 and quick ratio is 1:1.

(2) Asset management ratios: measure how effectively a firm manages its assets
Inventory turnover = sales / inventory
Days Sales Outstanding (DSO) = account receivables / average daily sales
Fixed asset turnover = sales / net fixed assets
Total asset turnover = sales / total assets
Firms want to increase turnover ratios and keep DSO as low as possible

(3) Debt management ratios: show how the firm has financed its assets as well as the firm’s ability to pay off its long-term debt (how effectively a firm manages its debt)

Using debt has tax benefit (interests on debt are tax deductible). On the other hand, too much debt increases the firm’s risk of being bankruptcy.

Effect of Financial Leverage (effect of using debt)
Debt ratio = total debt / total assets
Times interest earned (TIE) = operating income (EBIT) / interest expenses
The higher the TIE, the better

(4) Profitability ratios: show how profitable a firm is operating and utilizing its
assets (shows the combined effects)
Operating profit margin = EBIT / sales
Profit margin = net income / sales
Return on assets (ROA) = net income / total assets
Basic earnings power (BEP) = EBIT / total assets
Return on equity (ROE) = net income / common equity
The higher the returns, the better the performance

(5) Market value ratios: relate stock price to earnings and book value and show
what investors think about the firm and its future prospects
Price / earnings ratio (P/E ratio) = price per share / earnings per share
Market / book ratio = market price per share / book value per share

 Du Pont equations
ROA = net income / total assets = (net income / sales) * (sales / total assets)
 = profit margin* total assets turnover
In order to increase ROA, firms can try to improve profit margin and/or total asset  turnover

ROE = net income / common equity
 = (net income / sales)* (sales / total assets) * (total assets / common equity)
 = profit margin * total assets turnover * equity multiplier
In order to increase ROE, firms can try to improve profit margin and/or total asset
turnover and/or equity multiplier

 Trend analysis
Analyzing a firm’s financial ratios over time to estimate the likelihood of improvement or deterioration in its financial conditions.

 Limitations in ratio analysis

Different divisions in different industries
Industry average
Accounting methods
Window dressing

 Beyond the numbers  - Problem issues
Tied to one customer?
Tied to one product?
Rely on one supplier?
Having operations overseas?
Having more competition?
Developing future products?
Having legal issues?

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