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Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,10/4/2011,#,1,CHAPTER 8,Analysis of Financial Statements,2,Topics in Chapter,Ratio analysis,Du Pont system,Effects of improving ratios,Limitations of ratio analysis,3,Why are ratios useful?,Standardize numbers; facilitate comparisons,Used to highlight weaknesses and strengths,4,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?,(More),5,Ratio Categories (Continued),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?,6,Effects of Debt on ROA and ROE,ROA is lowered by debt-interest expense lowers net income, which also lowers ROA.,However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase.,7,Interpreting Market Based Ratios,P/E: How much investors will pay for $1 of earnings. Higher is better.,M/B: How much paid for $1 of book value. Higher is better.,P/E and M/B are high if ROE is high, risk is low.,Common Size Balance Sheets,Divide all asset categories by total assets.,Divide all liability and equity categories by total liabilities plus equities.,Expressed as percentages in order to facilitate comparison between years or companies.,8,Percent Change Income Statement/Balance Sheet,Choose a base year and calculate a percentage change for each item in the income statement from that year until the current year.,Allows comparison of company performance over time.,9,10,Explain the Du Pont System,The Du Pont system focuses on:,Expense control (PM),Asset utilization (TATO),Debt utilization (EM),It shows how these factors combine to determine the ROE.,11,(,) ( ) (,),= ROE,Profit,margin,TA,turnover,Equity,multiplier,NI,Sales,Sales,TA,TA,CE,x,x,= ROE.,The Du Pont System,12,Potential Problems and Limitations of 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.,Different accounting and operating practices can distort comparisons.,13,Problems and Limitations (Continued),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.,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?,(More),Qualitative Factors,(Continued),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?,
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