Lecture Notes – Finance 220 – Week 2

  1. Our lecture this week covers the topics of financial ratio analysis and forecasting. This lecture will be divided into several sections. As you listen to this presentation, you might want to follow along in the text. Although this presentation stands alone, it was designed to augment the text material.
  2. The key concepts we will cover in Week 2 relate to ratio analysis and the use of ratios for measurement. We will explore the DuPont analysis and trend analysis. Our lecture will discuss the 3 financial statements that provide us the information for ratio analysis. In addition, we will explore the percent-of-sales method and the aspects that affect cash flow of firms.
  3. Ratio analysis is atool used by individuals to conduct a quantitative analysis of informationin a company's financial statements. Ratios arecalculated from current year numbers and are then compared to previous years, other companies, the industry, or even the economy to judge the performance of the company.Ratio Analysis is a form of Financial Statement Analysis that is used to obtain a quick indication of a firm's financial performance in several key areas. Ratio Analysis as a tool possesses several important features.
  4. The types of categories of ratios we will examine include profitability ratios, liquidity ratios, asset utilization ratios and debt utilization ratios. Financial ratios are useful indicators of a firm's performance and financial situation. Most ratios can be calculated from information provided by the financial statements. Every firm is most concerned with its profitability. One of the most frequently used tools of financial ratio analysis is profitability ratios which are used to determine the company's bottom line. Profitability measures are important to company managers and owners alike.
  5. Profitability ratios show a company's overall efficiency and performance. We can divide profitability ratios into two types: margins and returns. Ratios that show margins represent the firm's ability to translate sales dollars into profits at various stages of measurement. Ratios that show returns represent the firm's ability to measure the overall efficiency of the firm in generating returns for its shareholders.A Common-Size Income Statement lists each income item as a percent of sales. This method allows for easy review of the firm’s profitability in relation to the sales.
  6. A common size statement analysis indicates the relation of each component to the whole. A common size statement analysis is a type of ratio analysis where in case of income statements, sales is the denominator (base). All items are expressed as a relation to it.As shown in this example, Net Sales is listed at 100%. All other accounts in the income statement are calculated as a percent of sales. In other words, Gross Profit of $25,913 divided by Revenues of $70,134 is 36.9% of sales. Income taxes of $3,766 divided by Revenues of $70,134 equals 5.4% of sales.Common size Financial Statements are used for vertical financial analysis and comparison of two business enterprises or two years of financial data.
  7. When doing a simple profitability ratio analysis, net profit margin is the most often margin ratio used. The net profit margin shows how much of each sales dollar shows up as net income after all expenses are paid. For example, if the net profit margin is 5%, this shows that 5 cents of every dollar is profit. The net profit margin measures profitability after consideration of all expenses including taxes, interest and depreciation. The calculation is: net income/net sales. Both terms of the equation come from the income statement. The Return on Assets ratio is an important profitability ratio because it measures the efficiency with which the company is managing its investment in assets and using them to generate profit. It measures the amount of profit earned relative to the firm’s level of investment in total assets. The calculation for the return on assets ratio is net income/total assets. Net income is taken from the income statement and total assets is taken from the balance sheet. The higher the percentage, the better as this means the company is doing a good job using its assets to generate sales. The return on equity ratio is perhaps the most important of all the financial ratios to investors in the firm. It measures the return on the money the investors have put into the company. This is the ratio potential investors look at when deciding whether or not to invest in the company. The calculation is net income/stockholders’ equity. Net income comes from the income statement and stockholders’ equity comes from the balance sheet. In general, the higher the percentage, the better as it relays the firm is doing a good job using the investors’ money.
  8. Here is an example. Dental Delights has two divisions. Division A has a profit of $200,000 on sales of $4,000,000. Division B is only able to make $30,000 on sales of $480,000. Based on the profit margins, which division is superior?
  9. The profit margin is determined from net income divided by sales. Division A has a 5% profit margin while Division B has a 6.25% profit margin. Division B is more profitable.
  10. Let us solve this problem. Franklin Mint and Candy Shop can open a new store that will do an annual sales volume of $750,000. It will turn over its assets 2.5 times per year. The profit margin on sales will be 6 percent. What would net income and return on assets be for the year?
  11. To solve this problem we must first compute net income and assets. The formula to solve for net income is Sales x Profit Margin. Net Income is $750,000 and the profit margin was given at 6 percent. Therefore, $750,000 times 6 percent equals $45,000. Next, to determine the Total Assets, the formula is Sales divided by the Total asset turnover. Since sales are $750,000 and the asset turnover was given at 2.5 times, assets will equal $750,000 divided by 2.5. Now we have computed the net income of $45,000 and the assets of $300,000.
  12. Finally, the return on assets equals net income divided by total assets. The net income of $45,000 divided by total assets of $300,000 gives us a ROA of 15 percent.
  13. The next problem involves calculating the return on stockholders’ equity. Sharpe Razor Company has total assets of $2,500,000 and current assets of $1,000,000. It turns over its fixed assets 5 times a year and has $700,000 of debt. Its return on sales is 3 percent. What is Sharpe’s return on stockholders’ equity?
  14. In order to calculate the ratio, we must first determine net income and stockholders’ equity. In order to determine stockholders’ equity we know that Total Assets minus Debt equals stockholders’ equity. To calculate the total assets, the problem gives us the information for fixed assets and current assets. It also provides the total debt of $700,000. Therefore current assets plus fixed assets equal the total assets of $2,500,000. Next, the total assets of $2,500,000 less the debt equals the stockholders’ equity of $1,800,000. In order to calculate net income we must first calculate the sales. The problem tells us that the fixed asset turnover is 5 times. Therefore the fixed assets of $1,500,000 times the turnover of 5 total the sales of $7,500,000.
  15. The net income is solved by taking the sales times the profit margin. Finally, we have the information needed to solve for ROE. The net income of $225,000 divided by Stockholders’ equity of $1,800,000 equals 12.5 percent.
  1. Liquidity refers to a company’s ability to pay its bills from cash or from assets that can be turned into cash very quickly. Liquidity ratios provide information about a firm's ability to meet its short-term financial obligations. They are of particular interest to those extending short-term credit to the firm. Even if a business has high profitability, it can face short-term financial problems if its funds are locked up in inventories and receivables not realizable for months. A business has to pay its suppliers, meet current expenses like staff salaries and marketing incidentals, and other immediate obligations on a continuing basis. Any failure to meet these can damage its reputation and creditworthiness and in extreme cases even lead to bankruptcy. Liquidity ratios are the business ratios that can reveal the likelihood and causes of any such problems.
  2. Liquidity ratios work with cash and near-cash assets (together called "current" assets) of a business on one side, and the immediate payment obligations (current liabilities) on the other side. The near-cash assets mainly include receivables from customers and inventories of finished goods and raw materials. The payment obligations include money due to suppliers, operating and financial expenses that must be paid shortly and maturing installments under long-term debt. Liquidity ratios measure a business' ability to meet the payment obligations by comparing the cash and near-cash with the payment obligations. If the coverage of the latter by the former is insufficient, it indicates that the business might face difficulties in meeting its immediate financial obligations. This can, in turn, affect the company's business operations and profitability. Current ratio works with all the items that go into a business' working capital, and gives a quick look at its short-term financial position. Current assets include Cash, Cash equivalents, Marketable securities, Receivables and Inventories. Current liabilities include Payables, Notes payable, Accrued expenses and taxes, and Accrued installments of term debt). Quick Ratio = Current Assets minus (Inventories + Prepaid expenses + Deferred income taxes + Other illiquid items) / Current Liabilities: Quick ratio excludes the illiquid items from current assets and gives a better view of the business' ability to meet its maturing liabilities.
  3. To provide an example of liquidity ratios, we will use Joe T’s balance sheet. The current ratio is determined by current assets divided by current liabilities. The quick ratio is solved by current assets minus inventory divided by current liabilities.
  4. The total current assets in this example include cash, accounts receivable and inventory. Likewise the current liabilities consist of accounts payable and accrued taxes.
  5. The difference between the current ratio and quick ratio involve inventory. In the current ratio, inventory is included in the calculation. The quick ratio excludes inventory. As shown in the example, the current ratio is 3.714 and the quick ratio is 1.714.
  1. Asset utilization ratios are measuring how efficiently the firm is using its invested capital.
    Asset utilization ratios each involve dividing an income statement item by a balance sheet item. Remember that income statements contain items that measure the flow of cash throughout a time period, whereas balance sheet figures contain items that capture a snapshot of the amount in an account at a particular point in time. By taking the average of these two snapshots, we get a measurement of what the "typical" amount was in that particular balance sheet account during the entire time frame spanned by the income statement.
  2. The "turnover" ratios are measured in terms of pure numbers and technically measure how much of a particular type of asset supported sales (or another income sheet item) during the year. However, they can also be thought of as representing how many times during the period (in this case, during the year) something happened. The receivables turnover measures how many times, on average, a firm collected on it accounts receivable and then turned around and sold more product on credit; the inventory turnover ratio would measure how many times a corporation might have sold out of its inventory and restocked the inventory.
  3. To understand the turnover ratios, please review this problem. The Speed-O Company makes scooters for kids. Sales in 2008 were $8,000,000. Based on the assets in the slide, compute accounts receivable turnover, inventory turnover, fixed asset turnover and total asset turnover.
  4. The Accounts Receivable Turnover equals sales divided by receivables. The sales were given in the problem as $8,000,000 divided by the receivables shown in the balance sheet of $1,600,000. The Accounts receivable turnover is 5 times. The inventory turnover is equal to sales divided by inventory. Once again, the sales number provided in the exercise is $8,000,000 divided by the inventory shown in the balance sheet of $800,000 equals 10 times.
  5. Fixed asset turnover ratio equals sales divided by net plant and equipment. The $8,000,000 divided by the figure provided of $1,000,000 results in 8x. Finally, the total asset turnover is computed by sales divided by the total assets. In this example, we show a 2.2 times turnover of total assets.
  1. A firm's financing is obtained from debt and equity. The greater the proportion of debt relative to equity, the greater the risk to the firm as a whole. Two important factors should be noted when analyzing the capital structure of a firm: 1.) the relative debt levels themselves and 2.) the trend over time in the proportion of debt to equity. Debt allows for the generation of profits with the use of creditors money. It creates claims on earnings with a higher priority than those of the firm’s owners. Financial leverage is a term used to describe the magnification of risk and return resulting from the use of fixed-cost financing such as debt and preferred stock.
  2. The three debt utilization ratios are debt to total assets, times interest earned and fixed charge coverage.The total debt to total assets ratio takes into account all debts of all maturities to all creditors. This ratio shows how much debt a company has per dollar of assets. The times interest earned ratio is a measure of how well a company can cover its interest expense with its pre-tax and pre-interest dollars. The fixed charge coverage ratio includes lease payments as well as interest payments. Lease payments, like interest payments, must be met on an annual basis. The fixed charge coverage ratio is especially important for firms that extensively lease equipment.
  3. Neeley Office Supplies income statement is shown in this slide. What is the times interest earned ratio?What would be the fixed charge coverage ratio?
  4. The times interest earned ratio is calculated by dividing income before interest and taxes by interest. The income of $60,000 divided by $15,000 equals 4 times. The fixed charge coverage – income before fixed charges and taxes divided by fixed charges results in a 2.125 times ratio.
  5. This concludes the Part 1 lecture. Please access Part 2 to continue our discussion of financial statement forecasting.

Lecture Notes – Part 2

  1. Welcome to part 2 of the Week 2 lecture.
  2. Trend Analysis is a method used by interested parties such as investors, creditors, and management to evaluate the past, current, and projected conditions and performance of the firm. With industry comparison, the ratios of a firm are compared with those of similar firms or with industry averages or norms to determine how the company is faring relative to its competitors A firm's present ratio is compared with its past and expected future ratios to determine whether the company's financial condition is improving or deteriorating over time. Common-size financial statements usually involve the balance sheet and the income statement. These two financial statements become “common-size” when their dollar amounts are expressed in percentages.
  3. Financial statements of the previous years can be compared and the trend regarding various expenses, purchases, sales, gross profits and net profits can be ascertained. Value of assets and liabilities can be compared and the future prospects of the business can be considered to determine the growth potential of the business. Historical trend analysis provides the financial story of a business in recent years and assists in monitoring the impact of key decisions.
  4. The purpose of financial statements analysis is to help the management to make a comparative study of the profitability of various firms engaged in similar businesses. Such comparison also helps the management to study the position of their firm in respect of sales, expenses, profitability and utilizing capital. In this example, the chart compares Walmart, Target, the industry and the S&P 500. The aspects it compares includes the increase in sales, the increase in net income, the increase in sales over a 5 year period and the increase in net income over a 5 year period.
  5. Benchmarking within a specific industry often tells a unique story. For example, over the past year, a business maintained consistent sales but the gross profit percentage eroded. The management team thought they were operating above average based on what they had routinely witnessed on the news. To their surprise, the industry benchmarking indicated that, on average, sales within their industry were up 5 percent and the gross profit percentage had remained relatively consistent. Business leaders often find a great deal of value in industry benchmarking. This process provides an opportunity to step back, compare and subsequently monitor the results in comparison to the industry at large.