FINANCE IN A CANADIAN SETTING Sixth Canadian Edition

1
FINANCE IN A CANADIAN SETTING Sixth Canadian
Edition

• Lusztig, Cleary, Schwab

2

• CHAPTER THREE
• Financial Statement Analysis

3
Learning Objectives

• 1. Compare and contrast the four types of ratios
  used in financial analysis.
• 2. Discuss the three ratios used in the DuPont
  system of financial analysis of return on equity.
• 3. Understand what common-size analysis is, what
  it measures, and why it is used.

4
Learning Objectives

• 4. Name four types of distortions in financial
  statements caused by changing prices and the
  impact they can have on income statements.
• 5. Discuss some of the implications of foreign
  exchange rates for Canadian companies with global
  operations.

5
Ratio Analysis

• Ratios are helpful for comparison purposes
• Ratios are divided into four categories
• Liquidity Ratios
• Leverage and Coverage Ratios
• Profitability and Activity Ratios
• Market Value Ratios

6
Liquidity Ratios

• Current Ratio current assets
• current liabilities

• Most widely used liquidity ratio
• A value of gt 2 is considered a crude
  suitable measurement for current ratio

7
Liquidity Ratios
Quick ratio current assets inventories
current liabilities

• Used to evaluate a business ability to meet
  current obligations when inventory is considered
  to be a concern

8
Liquidity Ratios
Inventory turnover cost of goods sold
average inventory

• Indicates an organizations efficiency of
  inventory management
• ? inventory turnover signals efficient management

9
Liquidity Ratios
Avg. collection period receivables
avg. daily credit sales

• Indicates the average number of days that credit
  sales are outstanding

10
Leverage and Coverage Ratios
Debt-to-equity long-term debt
shareholders equity

• Common measure of a firms financial leverage
• Used as a safety margin that shareholders are
  provided in the event of liquidation

11
Leverage and Coverage Ratios
Total debt-to-equity long-term debt
total assets

• Broad measurement that looks at the proportion of
  a firms total assets that are financed through
  debt and other liabilities

12
Leverage and Coverage Ratios
Equity multiplier long-term debt
total assets

• Measures the amount of assets a firm finances
  with debt or equity
• The ? ratio, the proportion of companys assets
  financed through equity ?

13
Leverage and Coverage Ratios
Times interest earned EBIT
interest charges

• Used to detect excessive leverage
• An indicator of the safety of a firms periodic
  interest payments

14
Profitability Ratios
Gross operating margin sales COGS
sales

• Net operating margin EBIT
• sales

Asset turnover sales
total sales
15
Profitability Ratios
ROA net profit total assets

• Broad measure of how well management is employing
  assets to earn profits

16
Profitability Ratios
ROE net profit shareholder equity

• Measures how well management serves shareholders
  interest by determining the profit generation per
  dollar of equity invested in the firm

17
DuPont System
ROE net profit x sales x total
assets sales total assets
shareholders equity

• Allows for analysis of critical components that
  influence ROE and help predict future trends

18
Market Value Ratios
P/E price per common share earning
per common share

• Most widely used market value ratio
• Reflects what investors are willing to pay for
  each dollar of reported annual common share
  earnings

19
Market Value Ratios
Dividend payout common share dividend
common share earnings

• Indicates the percentage of earning paid to
  shareholders in the form of dividends

Dividend yield dividend per common share
price per common share

• Widely used market value ratio
• Measures how much investors are willing to pay
  for a firms dividend

20
Common-Size Analysis

• Involves converting dollar amounts on the
  financial statements into percentages
• Helps compare financial statements and identify
  trends that are not caused by the overall size of
  the business
• Enables comparison of companies of different size

21
Summary

• 1. The four categories of ratios used in
  financial analysis are
• Liquidity ratios highlight the firms short-term
  ability to meet financial obligations.
• Leverage ratios reflect the companys long-term
  financing decisions, while coverage ratios
  indicate its long-term ability to service
  outstanding debt.
• Profitability and activity ratios portray the
  earnings power of an enterprise and the
  efficiency with which its resources are used.

22
Summary

• 2. The three ratios used in the DuPont system of
  financial analysis of return on equity are
  Profitability, Leverage, and Asset Turnover.
• 3. Financial statement categories are expressed
  as percentages of total assets for the balance
  sheet and total sales for the income statement.
  These are useful when comparing financial
  statements particularity if there are variations
  in the size of operations.

23
Summary

• 4. The four types of distortions in financial
  statements caused by changing prices are
  depreciation based on historical costs, inventory
  and other holding gains, revaluation of debt, and
  inflated interest expenses.
• 5. Proper measurement and implementation of
  required adjustments are different and
  controversial even though the resulting errors
  can be substantial.

24
Summary

• 6. When firms hold assets and liabilities
  denominated in foreign currencies, the procedure
  for recognizing the gains or losses resulting
  from changes in foreign exchange rates becomes
  important.