Chapter 18: FINANCIAL Chapter 18: FINANCIAL STATEMENT ANALYSISSTATEMENT ANALYSIS

Due date for summative is the last day, Due date for summative is the last day, December 19December 19

• Ratio Analysis expresses the relationships between selected financial statement items.

•There are 3 types of ratio analysis: 1. Liquidity Ratios : Measure short-term ability of

the enterprise to pay its debts and to meet unexpected needs for cash.

2. Solvency ratios : Measure the ability of the enter prise to survive over a long period of time.

3. Profitability ratios: Measure the income or operating success of an enterprise for a given period of time.

Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis

RETURN ON COMMON RETURN ON COMMON SHAREHOLDERS’ EQUITYSHAREHOLDERS’ EQUITY

• Measures profitability of common shareholders’ investment

• It shows how much net income is generated by one dollar of equity (which is invested by shareholders) in the company. = The higher the better

Return on common shareholders’ equity =Net income

Average common shareholders’ equity

(Discussed in Chapter 14)

Return on CSEReturn on CSE

• Hometown 2004 = 75000 / (211500 + 166500)/2 = 39.7%• 2005 = 82000 / (262300 + 211500) /2 = 34.6%• Industry Average = 23.9%• Canadian Tire = 13.9%• Although this ratio decreased from 2004 to 2005,

Hometown’s number is better than industry average and Canadian Tire’s number.

• It seems like a good number.

SOLVENCY RATIOSSOLVENCY RATIOS

• Debt to total assets

• Interest coverage

• Cash total debt coverage

DEBT TO TOTAL ASSETSDEBT TO TOTAL ASSETS

• Measures % of total assets provided by creditors

Debt to total assets =

Total liabilities Total assets

(Discussed in Chapter 16)

Debt to Total AssetsDebt to Total Assets

• This ratio indicates the company’s degree of leverage. (=indebtness)

• Leverage = how much debt the company carries.• The higher number indicates that greater risk that the

company might not be able to pay their debts. • Generally speaking, the lower the better for this number. • The number should be less than 1 (or 100%) to be a good

number.

Debt to Total AssetsDebt to Total Assets

• 2004: 78.9%• 2005: 73.8%• Industry Average: 61.9%• Canadian Tire: 57.8%• 73.8% means that lenders provided 73.8% of the total assets.

Only 26.2% of the total assets was provided by shareholders.• Year over year trend is going down, so it seems OK. • But when you compare it to industry average or Canadian

Tire, the debt portion is bigger not so good

INTEREST COVERAGEINTEREST COVERAGE

• Measures ability to meet interest payments as they come due

• EBIT = Earnings before interest and tax

Interest coverage = Income before interest expenseand income tax expense (EBIT)

Interest expense

(Discussed in Chapter 16)

Interest CoverageInterest Coverage

• The higher the better• 2004: 4.2 times• 2005: 4.7 times• Industry Average: 13.6 times • Canadian Tire : 7.3 times.• Year to year trend shows positive, but comparing it to

industry average, (or competitor) 4.7 is not a great number. • Their EBIT is only 4.7 times of their interest expense, when

other companies in this industry has 13.6 times of their interest expense.

CASH TOTAL DEBT COVERAGECASH TOTAL DEBT COVERAGE

• Measures long-term debt-paying ability (cash basis)

Cash total debt coverage ratio =Net cash provided by operating

activitiesAverage total liabilities

(Discussed in Chapter 18)

• Estimates

• Historical cost

• Alternative accounting methods

• Atypical data

• Diversification

LIMITATIONS OF FINANCIAL LIMITATIONS OF FINANCIAL ANALYSISANALYSIS

Cash Total Debt CoverageCash Total Debt Coverage

• Will not show up in final exam

Classwork / HomeworkP959 E18.8, E18.9, E18.10 (ones you did not do yet),

E18.11 (ones you did not do yet)P963 P18.3 (ones you did not do yet)

P966 P18.6