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Chapter 02 Financial Performance Analysis PDF
Chapter 02 Financial Performance Analysis PDF
Chapter 02 Financial Performance Analysis PDF
Financial Analysis
• Tool of financial management
• Simplifies the financial statements
• Consists of the evaluation of the financial
conditions & operating performance of a firm
• Help in forecasting the firm’s future conditions
& performance
• A means for examining risk & expected return
2
Why Financial Analysis?
• To assess a firm’s past, present, & future
financial health
• To base for intelligent decision making &
starting point for planning the future courses
of actions
• Objectives:
• To determine financial strength
• To identify weaknesses
• To identify significance r/ships existing
among the key figures 3
Financial Statements & Process of
Financial Analysis
• Financial Statements
• Income Statement
• Balance Sheet
• Statement of Retained Earnings
• Statement of Cash flows
• Process of Financial Analysis involves:
• Setting comparison bases
• Applying tools of analysis
• Characterizing profitability and solvency
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Users of Financial Analysis
• Investors: Existing & Potential
• Lenders: Current & Potential
• Managers
• Suppliers
• Employees
• Others:
─ Government Bodies
─ Competitors
─ Rating & Indexing Agencies
─ Investors’ Services
─ Financial Markets
Considerations in Financial
Analysis
1) The financial statements being compared
should be dated at the same point in time
during the year.
2) A single analysis does not provide sufficient
information from which to judge the overall
performance of a firm.
3) Use audited financial statements for analysis.
4) Consider different methods used especially for
inventories & depreciation.
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5) Consider the distortions due to inflation.
Types and Tools of Financial
Analysis
• Benchmarks / Basis for Comparison
• Various Analysis Approaches:
• Time-Series Analysis:
• Applied when evaluating performance
overtime
• Present/recent ratios compared with a
firm’s own past ratios
• Allows a firm to determining whether its
progressing as planned
7
Types and Tools of …
• Cross-Sectional Analysis:
• Comparison of different firms’ financial
ratios at the same point in time
• How well a firm performed / positioned in
relation to its competitors
• To uncover major operating deficiencies
8
Types and Tools of …
• Industry Analysis:
• Comparison of a particular ratio to the
standard made to isolate any deviation
from the norm
• Too high or too low values reflect
symptoms of a problem
• Provides a useful insight on how the firm
measures up to its competitors
• Pro Forma Analysis:
• Comparing a ratio to its corresponding
from the pro forma statements 9
Types of Financial Ratios &
Interpretations
• Liquidity Ratios:
Ability to meet current obligations
• Leverage Ratios:
shows the degree of a firm’s indebtedness
• Activity Ratios:
Proper & effective use of assets
• Profitability Ratios:
Measures management effectiveness
• Market Value Ratios:
Indicators of what investors think of firm’s past results &
future prospects 10
11
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Liquidity Ratios
• CURRENT RATIO
measures a firm’s ability to satisfy or cover claims of short-
term creditors by using only current assets
Current Current Assets
=
Ratio Current Liabilities
16
Activity Ratios …
• RECEIVABLES TURNOVER
measures the liquidity of a firm’s accounts receivable
Receivables Net Sales
=
Turnover Average Accounts Receivables
• AVERAGE COLLECTION PERIOD
shows how long it takes for accounts receivables to be
cleared (collected)
17
Activity Ratios …
• FIXED ASSETS TURNOVER
measures the efficiency with which the firm has been using
its fixed assets to generate revenue
Net Sales
Fixed Assets Turnover =
Average Fixed Assets
• TOTAL ASSETS TURNOVER
measures a firm’s efficiency in managing its total assets
to generate sales
Net Income
Net Profit Margin =
Net Sales
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Profitability Ratios …
• RETURN ON INVESTMENT (ROI)
measures the overall effectiveness of management in
generating profit with its available assets
Net Income
Return on Investment (ROI) =
Total Assets
• RETURN ON EQUITY (ROE)
measures the earning power on shareholders’ book value
investment
Net Income
Return on Equity (ROE) =
SHE
20
Profitability Ratios …
• EARNING PER SHARE
measures profitability of the firm from the view point of
ordinary shareholders
indicates the profit available to each ordinary share
21
Market Value Ratios
• PRICE EARNINGS (P/E) RATIO
indicator of the firm’s growth prospects, risk characteristics,
shareholders orientation, corporate reputation, and the
firm’s level of liquidity
Market Price per Share
P/E Ratio =
Earning per Share
• MARKET-TO-BOOK RATIO
measures a firm’s contributions to wealth creation in the
society
MV per Share
Market-to-Book Ratio =
BV per Share
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Benefits of Ratio Analysis
• Simplifies the financial statements
• Provides useful information concerning a firm’s
operation and financial conditions
• Helps identify symptoms of problems
• Helps reach to the causes of problems
• Provides a common ground for comparisons
• Helps in comparing companies of different size
with each other
• Helps in trend analysis which involves comparing a
single company over a period
• Highlights important information in simple form
quickly
Limitations of Ratio Analysis
• Difficulty to develop a meaningful set of industry
averages
• Tendency of firms just to be better than the
average
• Inflation may distort a firm’s balance sheet
• Employing “window dressing” techniques
• Differences in accounting practices
• Difficulty of generalizing “good” or “bad” on a
ratio
• Difficulty of overall evaluation 24
Du Pont Analysis
• Developed by Donaldson Brown in 1914
• Du Pont Corp. started to use in the 1920s
• Expressing the ROE breaking into 3 parts
• Meant to provide an adequate measure of overall
effectiveness
Sales Assets
ROE =
Profitability
× Efficiency
× Equity Multiplier
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