Chapter 6
Financial Statement Analysis
After studying Chapter 6, you should be able to:
Understand the purpose of basic financial statements and their contents.
Explain why financial statement analysis is important to the firm and to outside suppliers of capital.
Define, calculate, and categorize (according to liquidity, financial leverage, coverage, activity, and profitability) the major financial ratios and understand what they can tell us about the firm.
Define, calculate, and discuss a firm’s operating cycle and cash cycle.
Use ratios to analyze a firm's health and then recommend reasonable alternative courses of action to improve the health of the firm.
Analyze a firm’s return on investment (i.e., “earning power”) and return on equity using a DuPont approach.
Understand the limitations of financial ratio analysis.
Use trend analysis, common-size analysis, and index analysis to gain additional insights into a firm's performance.
Financial
Statement Analysis
Statement Analysis
Financial Statements
A Possible Framework for Analysis
Balance Sheet Ratios
Income Statement and Income Statement/Balance Sheet Ratios
Trend Analysis
Common-Size and Index Analysis
Examples of External Uses of Statement Analysis
Trade Creditors -- Focus on the liquidity of the firm.
Bondholders -- Focus on the long-term cash flow of the firm.
Shareholders -- Focus on the profitability and long-term health of the firm.
Examples of Internal Uses of Statement Analysis
Plan -- Focus on assessing the current financial position and evaluating potential firm opportunities.
Control -- Focus on return on investment for various assets and asset efficiency.
Understand -- Focus on understanding how suppliers of funds analyze the firm.
Primary Types of Financial Statements
Income Statement
A summary of a firm’s revenues and expenses over a specified period, ending with net income or loss for the period.
Basket Wonders’ Balance Sheet (Asset Side)
a. How the firm stands on a specific date.
b. What BW owned.
c. Amounts owed by customers.
d. Future expense items already paid.
e. Cash/likely convertible to cash within 1 year.
f. Original amount paid.
g. Acc. deductions for wear and tear.
Cash and C.E. $ 90 Acct. Rec.c 394 Inventories 696 Prepaid Exp d 5 Accum Tax Prepay 10 Current Assetse $1,195 Fixed Assets (@Cost)f 1030 Less: Acc. Depr. g (329) Net Fix. Assets $ 701 Investment, LT 50 Other Assets, LT 223 Total Assets b $2,169
Basket Wonders’ Balance Sheet (Liability Side)
a. Note, Assets = Liabilities + Equity.
b. What BW owed and ownership position.
c. Owed to suppliers for goods and services.
d. Unpaid wages, salaries, etc.
e. Debts payable < 1 year.
f. Debts payable > 1 year.
g. Original investment.
h. Earnings reinvested.
Notes Payable $ 290 Acct. Payablec 94 Accrued Taxes d 16 Other Accrued Liab. d 100 Current Liab. e $ 500 Long-Term Debt f 530 Shareholders’ Equity Com. Stock ($1 par) g 200 Add Pd in Capital g 729 Retained Earnings h 210 Total Equity $1,139
Total Liab/Equitya,b $2,169
Basket Wonders’ Income Statement
a. Measures profitability over a time period.
b. Received, or receivable, from customers.
c. Sales comm., adv., officers’ salaries, etc.
d. Operating income.
e. Cost of borrowed funds.
f. Taxable income.
g. Amount earned for shareholders.
Net Sales $ 2,211 Cost of Goods Sold b 1,599 Gross Profit $ 612 SG&A Expenses c 402 EBITd $ 210 Interest Expensee 59 EBT f $ 151 Income Taxes 60 EATg $ 91 Cash Dividends 38 Increase in RE $ 53
Framework for Financial Analysis
Analytical Tools Used
Sources and Uses Statement
Statement of Cash Flows
Cash Budgets
Framework for Financial Analysis
Health of a Firm
Financial Ratios
1. Individually
2. Over time
3. In combination
4. In comparison
Framework for Financial Analysis
Examples:
Volatility in sales
Volatility in costs
Proximity to break-even point
Framework for Financial Analysis
A Financial Manager must consider all three jointly when determining the financing needs of the firm.
Framework for Financial Analysis
Use of Financial Ratios
Types of Comparisons
Internal Comparisons
External Comparisons
A Financial Ratio is an index that relates two accounting numbers and is obtained by dividing one number by the other.
External Comparisons and Sources of Industry Ratios
Examples:
Risk Management Association
Dun & Bradstreet
Almanac of Business and Industrial Financial Ratios
This involves comparing the ratios of one firm with those of similar firms or with industry averages.
Similarity is important as one should compare “apples to apples.”
Liquidity Ratios
Current
Current Assets
Current Liabilities
For Basket Wonders December 31, 2007
Shows a firm’s ability to cover its current liabilities with its current assets.
Liquidity Ratio Comparisons
BW Industry
2.39 2.15
2.26 2.09
1.91 2.01
Year
2007
2006
2005
Liquidity Ratios
Acid-Test (Quick)
Current Assets - Inv
Current Liabilities
For Basket Wonders December 31, 2007
Shows a firm’s ability to meet current liabilities with its most liquid assets.
Liquidity Ratio Comparisons
BW Industry
1.00 1.25
1.04 1.23
1.11 1.25
Year
2007
2006
2005
Summary of the Liquidity Ratio Comparisons
Strong current ratio and weak acid-test ratio indicates a potential problem in the inventories account.
Note that this industry has a relatively high level of inventories.
Ratio BW Industry
Current 2.39 2.15
Acid-Test 1.00 1.25
Current Ratio -- Trend Analysis Comparison
Acid-Test Ratio -- Trend Analysis Comparison
Summary of the Liquidity Trend Analyses
The current ratio for the industry has been rising slowly at the same time the acid-test ratio has been relatively stable.
This indicates that inventories are a significant problem for BW.
Financial Leverage Ratios
Debt-to-Equity
Total Debt
Shareholders’ Equity
For Basket Wonders December 31, 2007
Shows the extent to which the firm is financed by debt.
Financial Leverage
Ratio Comparisons
Ratio Comparisons
BW Industry
.90 .90
.88 .90
.81 .89
Year
2007
2006
2005
Financial Leverage Ratios
Debt-to-Total-Assets
Total Debt
Total Assets
For Basket Wonders December 31, 2007
Shows the percentage of the firm’s assets that are supported by debt financing.
Financial Leverage
Ratio Comparisons
Ratio Comparisons
BW Industry
.47 .47
.47 .47
.45 .47
Year
2007
2006
2005
Financial Leverage Ratios
Total Capitalization
Long-term Debt
Total Capitalization
For Basket Wonders December 31, 2007
Shows the relative importance of long-term debt to the long-term financing of the firm.
Financial Leverage
Ratio Comparisons
Ratio Comparisons
BW Industry
.32 .30
.32 .31
.37 .32
Year
2007
2006
2005
Coverage Ratios
Interest Coverage
EBIT
Interest Charges
For Basket Wonders December 31, 2007
Indicates a firm’s ability to cover interest charges.
Coverage
Ratio Comparisons
Ratio Comparisons
BW Industry
3.56 5.19
4.35 5.02
10.30 4.66
Year
2007
2006
2005
Coverage Ratio -- Trend Analysis Comparison
Summary of the Coverage Trend Analysis
This indicates that low earnings (EBIT) may be a potential problem for BW.
Note, we know that debt levels are in line with the industry averages.
Activity Ratios
Receivable Turnover
Annual Net Credit Sales
Receivables
For Basket Wonders December 31, 2007
Indicates quality of receivables and how successful the firm is in its collections.
Activity Ratios
Avg Collection Period
Days in the Year
Receivable Turnover
For Basket Wonders December 31, 2007
Average number of days that receivables are outstanding.
(or RT in days)
Activity
Ratio Comparisons
Ratio Comparisons
BW Industry
65.0 65.7
71.1 66.3
83.6 69.2
Year
2007
2006
2005
Activity Ratios
Payable Turnover (PT)
Annual Credit Purchases
Accounts Payable
For Basket Wonders December 31, 2007
Indicates the promptness of payment to suppliers by the firm.
Activity Ratios
PT in Days
Days in the Year
Payable Turnover
For Basket Wonders December 31, 2007
Average number of days that payables are outstanding.
Activity
Ratio Comparisons
Ratio Comparisons
BW Industry
22.1 46.7
25.4 51.1
43.5 48.5
Year
2007
2006
2005
Activity Ratios
Inventory Turnover
Cost of Goods Sold
Inventory
For Basket Wonders December 31, 2007
Indicates the effectiveness of the inventory management practices of the firm.
Activity
Ratio Comparisons
Ratio Comparisons
BW Industry
2.30 3.45
2.44 3.76
2.64 3.69
Year
2007
2006
2005
Inventory Turnover Ratio --Trend Analysis Comparison
Activity Ratios
Total Asset Turnover
Net Sales
Total Assets
For Basket Wonders December 31, 2007
Indicates the overall effectiveness of the firm in utilizing its assets to generate sales.
Activity
Ratio Comparisons
Ratio Comparisons
BW Industry
1.02 1.17
1.03 1.14
1.01 1.13
Year
2007
2006
2005
Profitability Ratios
Gross Profit Margin
Gross Profit
Net Sales
For Basket Wonders December 31, 2007
Indicates the efficiency of operations and firm pricing policies.
Profitability
Ratio Comparisons
Ratio Comparisons
BW Industry
27.7% 31.1%
28.7 30.8
31.3 27.6
Year
2007
2006
2005
Gross Profit Margin --
Trend Analysis Comparison
Trend Analysis Comparison
Profitability Ratios
Net Profit Margin
Net Profit after Taxes
Net Sales
For Basket Wonders December 31, 2007
Indicates the firm’s profitability after taking account of all expenses and income taxes.
Profitability Ratio Comparisons
BW Industry
4.1% 8.2%
4.9 8.1
9.0 7.6
Year
2007
2006
2005
Net Profit Margin --
Trend Analysis Comparison
Trend Analysis Comparison
Profitability Ratios
Return on Investment
Net Profit after Taxes
Total Assets
For Basket Wonders December 31, 2007
Indicates the profitability on the assets of the firm (after all expenses and taxes).
Profitability Ratio Comparisons
BW Industry
4.2% 9.8%
5.0 9.1
9.1 10.8
Year
2007
2006
2005
Return on Investment –
Trend Analysis Comparison
Trend Analysis Comparison
Profitability Ratios
Return on Equity
Net Profit after Taxes
Shareholders’ Equity
For Basket Wonders December 31, 2007
Indicates the profitability to the shareholders of the firm (after all expenses and taxes).
Profitability Ratio Comparisons
BW Industry
8.0% 17.9%
9.4 17.2
16.6 20.4
Year
2007
2006
2005
Return on Equity --
Trend Analysis Comparison
Trend Analysis Comparison
Return on Investment and the Du Pont Approach
ROI2007 = .041 x 1.02 = .042 or 4.2%
ROIIndustry = .082 x 1.17 = .098 or 9.8%
Return on Equity and
the Du Pont Approach
the Du Pont Approach
ROE2007 = .041 x 1.02 x 1.90 = .080
ROEIndustry = .082 x 1.17 x 1.88 = .179
Summary of the Profitability Trend Analyses
The profitability ratios for BW have ALL been falling since 2005. Each has been below the industry averages for the past three years.
This indicates that COGS and administrative costs may both be too high and a potential problem for BW.
Note, this result is consistent with the low interest coverage ratio.
Summary of Ratio Analyses
Inventories are too high.
May be paying off creditors (accounts payable) too soon.
COGS may be too high.
Selling, general, and administrative costs may be too high.
Common-size Analysis
An analysis of percentage financial statements where all balance sheet items are divided by total assets and all income statement items are divided by net sales or revenues.
Basket Wonders’ Common Size Balance Sheets
Basket Wonders’ Common Size Balance Sheets
Basket Wonders’ Common Size Income Statements
Index Analyses
An analysis of percentage financial statements where all balance sheet or income statement figures for a base year equal 100.0 (percent) and subsequent financial statement items are expressed as percentages of their values in the base year.
Basket Wonders’
Indexed Balance Sheets
Indexed Balance Sheets
Basket Wonders’
Indexed Balance Sheets
Indexed Balance Sheets
Basket Wonders’ Indexed Income Statements
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