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Learning Objectives

1. Calculate 13 financial ratios that measure profitability, asset utilization, liquidity and debt utilization. (LO1)

2. Assess a company’s source of profitability using the DuPont system of analysis. (LO2)

3. Examine the ratios in comparison to industry averages. (LO3)

4. Examine the ratios and company performance by means of trend analysis. (LO4)

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Saxton Company Industry Average

3-4a. Receivables turnover =

= 11.410 times

3-4b. Average collection period =

= 32 36 days

3-5a. Inventory turnover =

Cost of Goods Sold = 8.1 7 times

Inventory

Sales (credit)Receivables

$4,000,000$350,000

Accounts receivable Average daily credit sales

$350,000$10,959

$3,000,000$370,000

Asset utilization ratios(a)

LO1 and LO3

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Saxton Company Industry Average

3-5b. Inventory holding period =

= 45 52 days

3-6a. Accounts payable turnover =

= 60.0 12 times

3-6b. Accounts payable period =

Accounts payable = 6 30 days

Average daily purchases

(COGS)

InventoryAverage daily COGS

$370,000$8,219

Cost of goods soldAccounts payable

$3,000,000$50,000

$50,000$8,219

Asset utilization ratios(b)

LO1 and LO3

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Asset utilization ratios(c)

Saxton Company Industry Average

3-7. Capital asset turnover =

= 5.0 5.4 times

3-8. Total asset turnover =

= 2.5 1.5 times

SalesCapital assets

$4,000,000$800,000

SalesTotal assets

$4,000,000$1,600,000

LO1 and LO3

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Liquidity ratios

Saxton Company Industry Average

3-9. Current ratio =

= 2.67 2.1

3-10. Quick ratio =

= 1.43 1.0

Current assetsCurrent liabilities

$800,000$300,000

Current assets – InventoryCurrent liabilities

$430,000$300,000

LO1/LO3

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Debt utilization ratios

Saxton Company Industry Average

3-11. Debt to total assets =

= 37.5% 33%

3-12. Times interest earned =

= 11 7 times

3-13. Fixed charge coverage =

= 6 5.5 times

Total debtTotal assets

$600,000$1,600,000

Income before interest and taxes

Interest$550,000$50,000

Income before fixed charges and taxes

Fixed charges$600,000$100,000

LO1/LO3

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Table 3-2a

Ratio analysis(a) Saxton IndustryCompany AverageComparison

A. Profitability1. Profit margin……………… 5% 6.5% Below average2. Return on assets………..…. 12.5% 10% Above

average due to high 83. Return on equity…………. 20% 15% Good due to ratios 2 and

11B. Asset Utilization4a. Receivables turnover ……... 11.4 10.0 Good4b. Average collection period…. 32.0 36.0 Good5a. Inventory turnover ………... 8.1 7.0 Good5b. Inventory holding period...... 45 52 Good6a. Accounts payable turnover... 60 12 Good6b. Accounts payable period...... 6 30 Good

7. Capital asset turnover ……. 5.0 5.4 Below average

8. Total asset turnover ………. 2.5 1.5 Good

LO3

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Table 3-2b

Ratio analysis(b)

LO3

Saxton IndustryCompany Average Comparison

C. Liquidity9. Current ratio …………… 2.67 2.1 Good

10. Quick ratio ……………….. 1.43 1.0 Good

D. Debt Utilization11. Debt to total assets ……….. 37.5% 33% Slightly

more debt12. Times interest earned ……. 11 7 Good13. Fixed charge coverage …… 6 5.5 Good

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Techniques of Ratio Analysis

1. DuPont Analysis

2. Comparative Analysis

3. Trend Analysis

4. Common-Size Statements

LO1/LO2/LO3/LO4

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Comparative vs. Trend Analysis

• Ratios on their own do not mean a lot• Comparing a company’s ratios to

those of its industry or its competitors is comparative analysis and may reveal what ratios are out of line with certain standards

• Comparing the same company’s ratios over a number of years is trend analysis and may reveal whether ratios are improving or worsening

LO3 and LO4

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Table 3-3

Trend analysis of competitors

2000200120022003200420052006200720082009

0.79 18.0 0.8119.8

0.60 13.8 0.7416.4

0.56 13.4 0.7615.5

0.71 16.4 0.7316.8 0.87 18.1 0.6615.7 0.81 14.5 0.7217.1 0.83 17.7 0.8821.4 0.58 13.9 0.9022.1

0.50 13.0 0.6318.1

0.41 9.9 0.5911.9

Return onAssets

Return onEquity

Royal Bank Bank of MontrealReturn on

AssetsReturn on

Equity

Source: Bank of Montreal annual reports www.bmo.com Royal Bank of Canada annual reports www.rbcroyalbank.com

LO3 and LO4

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Figure 3-2Trend analysis

LO3 and LO4