nullChapter 6Chapter 6Financial Statement Analysis© Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WIAfter studying Chapter 6, you should be able to: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 AnalysisFinancial
Statement AnalysisFinancial Statements
A Possible Framework for Analysis
Balance Sheet Ratios
Income Statement and Income Statement/Balance Sheet Ratios
Trend Analysis
Common-Size and Index AnalysisExamples of External Uses of Statement AnalysisExamples of External Uses of Statement AnalysisTrade 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 AnalysisExamples of Internal Uses of Statement AnalysisPlan -- 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 StatementsPrimary Types of Financial StatementsIncome Statement
A summary of a firm’s revenues and expenses over a specified period, ending with net income or loss for the period.Balance Sheet
A summary of a firm’s financial position on a given date that shows total assets = total liabilities + owners’ equity.Basket Wonders’ Balance Sheet (Asset Side)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 $2,169Basket Wonders Balance Sheet (thousands) Dec. 31, 2007aBasket Wonders’ Balance Sheet (Liability Side)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 $2,169Basket Wonders Balance Sheet (thousands) Dec. 31, 2007Basket Wonders’ Income StatementBasket Wonders’ Income Statementa. 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 $ 53Basket Wonders Statement of Earnings (in thousands) for Year Ending December 31, 2007aFramework for Financial AnalysisFramework for Financial AnalysisAnalytical Tools Used
Sources and Uses Statement
Statement of Cash Flows
Cash Budgets1. Analysis of the funds
needs of the firm.Trend / Seasonal Component
How much funding will be required in the future?
Is there a seasonal component?Framework for Financial AnalysisFramework for Financial AnalysisHealth of a Firm
Financial Ratios
1. Individually
2. Over time
3. In combination
4. In comparison1. Analysis of the funds
needs of the firm.2. Analysis of the financial
condition and profitability
of the firm.Framework for Financial AnalysisFramework for Financial AnalysisExamples:
Volatility in sales
Volatility in costs
Proximity to break-even point1. Analysis of the funds
needs of the firm.2. Analysis of the financial
condition and profitability
of the firm.3. Analysis of the business
risk of the firm.Business risk relates to the risk inherent in the operations of the firm.
Framework for Financial AnalysisFramework for Financial AnalysisA Financial Manager must consider all three jointly when determining the financing needs of the firm.Determining
the
financing
needs of
the firm.1. Analysis of the funds
needs of the firm.2. Analysis of the financial
condition and profitability
of the firm.3. Analysis of the business
risk of the firm.Framework for Financial AnalysisFramework for Financial AnalysisNegotiations
with
suppliers of
capital.Determining
the
financing
needs of
the firm.1. Analysis of the funds
needs of the firm.2. Analysis of the financial
condition and profitability
of the firm.3. Analysis of the business
risk of the firm.Use of Financial RatiosUse of Financial RatiosTypes of Comparisons
Internal Comparisons
External ComparisonsA 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 RatiosExternal Comparisons and Sources of Industry RatiosExamples:
Risk Management Association
Dun & Bradstreet
Almanac of Business and Industrial Financial RatiosThis 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 RatiosLiquidity RatiosCurrent
Current Assets
Current Liabilities
For Basket Wonders December 31, 2007Shows a firm’s ability to cover its current liabilities with its current assets.Balance Sheet RatiosLiquidity Ratios$1,195
$500= 2.39Liquidity Ratio ComparisonsLiquidity Ratio ComparisonsBW Industry
2.39 2.15
2.26 2.09
1.91 2.01Year
2007
2006
2005Current RatioRatio is stronger than the industry average.Liquidity RatiosLiquidity RatiosAcid-Test (Quick)
Current Assets - Inv
Current Liabilities
For Basket Wonders December 31, 2007Shows a firm’s ability to meet current liabilities with its most liquid assets.Balance Sheet RatiosLiquidity Ratios$1,195 - $696
$500= 1.00Liquidity Ratio ComparisonsLiquidity Ratio ComparisonsBW Industry
1.00 1.25
1.04 1.23
1.11 1.25Year
2007
2006
2005Acid-Test RatioRatio is weaker than the industry average.Summary of the Liquidity Ratio ComparisonsSummary of the Liquidity Ratio ComparisonsStrong 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 1.25Current Ratio -- Trend Analysis ComparisonCurrent Ratio -- Trend Analysis Comparison Acid-Test Ratio -- Trend Analysis ComparisonAcid-Test Ratio -- Trend Analysis Comparison Summary of the Liquidity Trend AnalysesSummary of the Liquidity Trend AnalysesThe 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.The current ratio for BW has been rising at the same time the acid-test ratio has been declining.Financial Leverage RatiosFinancial Leverage RatiosDebt-to-Equity
Total Debt
Shareholders’ Equity
For Basket Wonders December 31, 2007Shows the extent to which the firm is financed by debt.Balance Sheet RatiosFinancial Leverage
Ratios$1,030
$1,139= .90Financial Leverage
Ratio ComparisonsFinancial Leverage
Ratio ComparisonsBW Industry
.90 .90
.88 .90
.81 .89Year
2007
2006
2005Debt-to-Equity RatioBW has average debt utilization
relative to the industry average.Financial Leverage RatiosFinancial Leverage RatiosDebt-to-Total-Assets
Total Debt
Total Assets
For Basket Wonders December 31, 2007Shows the percentage of the firm’s assets that are supported by debt financing.Balance Sheet RatiosFinancial Leverage
Ratios$1,030
$2,169= .47Financial Leverage
Ratio ComparisonsFinancial Leverage
Ratio ComparisonsBW Industry
.47 .47
.47 .47
.45 .47Year
2007
2006
2005Debt-to-Total-Asset RatioBW has average debt utilization
relative to the industry average.Financial Leverage RatiosFinancial Leverage RatiosTotal Capitalization
Long-term Debt
Total Capitalization
For Basket Wonders December 31, 2007Shows the relative importance of long-term debt to the long-term financing of the firm.Balance Sheet RatiosFinancial Leverage
Ratios $530
$1,669= .32(i.e., LT-Debt + Equity)Financial Leverage
Ratio ComparisonsFinancial Leverage
Ratio ComparisonsBW Industry
.32 .30
.32 .31
.37 .32Year
2007
2006
2005Total Capitalization RatioBW has average long-term debt utilization
relative to the industry average.Coverage RatiosCoverage RatiosInterest Coverage
EBIT
Interest Charges
For Basket Wonders December 31, 2007Indicates a firm’s ability to cover interest charges.Income Statement
RatiosCoverage Ratios$210
$59= 3.56Coverage
Ratio ComparisonsCoverage
Ratio Comparisons BW Industry
3.56 5.19
4.35 5.02
10.30 4.66Year
2007
2006
2005Interest Coverage RatioBW has below average interest coverage
relative to the industry average.Coverage Ratio -- Trend Analysis ComparisonCoverage Ratio -- Trend Analysis Comparison Summary of the Coverage Trend AnalysisSummary of the Coverage Trend AnalysisThis 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.The interest coverage ratio for BW has been falling since 2005. It has been below industry averages for the past two years.Activity RatiosActivity RatiosReceivable Turnover
Annual Net Credit Sales
Receivables
For Basket Wonders December 31, 2007Indicates quality of receivables and how successful the firm is in its collections.Income Statement /
Balance Sheet
RatiosActivity Ratios$2,211
$394= 5.61(Assume all sales are credit sales.)Activity RatiosActivity RatiosAvg Collection Period
Days in the Year
Receivable Turnover
For Basket Wonders December 31, 2007Average number of days that receivables are outstanding.
(or RT in days)Income Statement /
Balance Sheet
RatiosActivity Ratios365
5.61= 65 daysActivity
Ratio ComparisonsActivity
Ratio ComparisonsBW Industry
65.0 65.7
71.1 66.3
83.6 69.2Year
2007
2006
2005Average Collection PeriodBW has improved the average collection
period to that of the industry average.Activity RatiosActivity RatiosPayable Turnover (PT)
Annual Credit Purchases
Accounts Payable
For Basket Wonders December 31, 2007Indicates the promptness of payment to suppliers by the firm.Income Statement /
Balance Sheet
RatiosActivity Ratios$1551
$94= 16.5(Assume annual credit
purchases = $1,551.)Activity RatiosActivity RatiosPT in Days
Days in the Year
Payable Turnover
For Basket Wonders December 31, 2007Average number of days that payables are outstanding. Income Statement /
Balance Sheet
RatiosActivity Ratios365
16.5= 22.1 daysActivity
Ratio ComparisonsActivity
Ratio ComparisonsBW Industry
22.1 46.7
25.4 51.1
43.5 48.5Year
2007
2006
2005Payable Turnover in DaysBW has improved the PT in Days.
Is this good?Activity RatiosActivity RatiosInventory Turnover
Cost of Goods Sold
Inventory
For Basket Wonders December 31, 2007Indicates the effectiveness of the inventory management practices of the firm. Income Statement /
Balance Sheet
RatiosActivity Ratios$1,599
$696= 2.30Activity
Ratio ComparisonsActivity
Ratio ComparisonsBW Industry
2.30 3.45
2.44 3.76
2.64 3.69Year
2007
2006
2005Inventory Turnover RatioBW has a very poor inventory turnover ratio.Inventory Turnover Ratio --Trend Analysis ComparisonInventory Turnover Ratio --Trend Analysis Comparison Activity RatiosActivity RatiosTotal Asset Turnover
Net Sales
Total Assets
For Basket Wonders December 31, 2007Indicates the overall effectiveness of the firm in utilizing its assets to generate sales. Income Statement /
Balance Sheet
RatiosActivity Ratios$2,211
$2,169= 1.02Activity
Ratio ComparisonsActivity
Ratio ComparisonsBW Industry
1.02 1.17
1.03 1.14
1.01 1.13Year
2007
2006
2005Total Asset Turnover RatioBW has a weak total asset turnover ratio.
Why is this ratio considered weak?Profitability RatiosProfitability RatiosGross Profit Margin
Gross Profit
Net Sales
For Basket Wonders December 31, 2007Indicates the efficiency of operations and firm pricing policies. Income Statement /
Balance Sheet
RatiosProfitability Ratios$612
$2,211= .277Profitability
Ratio ComparisonsProfitability
Ratio ComparisonsBW Industry
27.7% 31.1%
28.7 30.8
31.3 27.6Year
2007
2006
2005Gross Profit MarginBW has a weak Gross Profit Margin.Gross Profit Margin --
Trend Analysis ComparisonGross Profit Margin --
Trend Analysis Comparison Profitability RatiosProfitability RatiosNet Profit Margin
Net Profit after Taxes
Net Sales
For Basket Wonders December 31, 2007Indicates the firm’s profitability after taking account of all expenses and income taxes. Income Statement /
Balance Sheet
RatiosProfitability Ratios$91
$2,211= .041Profitability Ratio ComparisonsProfitability Ratio ComparisonsBW Industry
4.1% 8.2%
4.9 8.1
9.0 7.6Year
2007
2006
2005Net Profit MarginBW has a poor Net Profit Margin.Net Profit Margin --
Trend Analysis ComparisonNet Profit Margin --
Trend Analysis Comparison Profitability RatiosProfitability RatiosReturn on Investment
Net Profit after Taxes
Total Assets
For Basket Wonders December 31, 2007Indicates the profitability on the assets of the firm (after all expenses and taxes). Income Statement /
Balance Sheet
RatiosProfitability Ratios$91
$2,160= .042Profitability Ratio ComparisonsProfitability Ratio ComparisonsBW Industry
4.2% 9.8%
5.0 9.1
9.1 10.8Year
2007
2006
2005Return on InvestmentBW has a poor Return on Investment.Return on Investment –
Trend Analysis ComparisonReturn on Investment –
Trend Analysis Comparison Profitability RatiosProfitability RatiosReturn on Equity
Net Profit after Taxes
Shareholders’ Equity
For Basket Wonders December 31, 2007Indicates the profitability to the shareholders of the firm (after all expenses and taxes). Income Statement /
Balance Sheet
RatiosProfitability Ratios$91
$1,139= .08Profitability Ratio ComparisonsProfitability Ratio Comparisons BW Industry
8.0% 17.9%
9.4 17.2
16.6 20.4Year
2007
2006
2005Return on EquityBW has a poor Return on Equity.Return on Equity --
Trend Analysis ComparisonReturn on Equity --
Trend Analysis Comparison Return on Investment and the Du Pont ApproachReturn on Investment and the Du Pont ApproachROI2007 = .041 x 1.02 = .042 or 4.2%
ROIIndustry = .082 x 1.17 = .098 or 9.8%ROI = Net profit margin X
Total asset turnoverEarning Power = Sales profitability X
Asset efficiencyReturn on Equity and
the Du Pont ApproachReturn on Equity and
the Du Pont ApproachROE2007 = .041 x 1.02 x 1.90 = .080
ROEIndustry = .082 x 1.17 x 1.88 = .179Return On Equity = Net profit margin X
Total asset turnover X
Equity MultiplierEquity Multiplier = Total AssetsShareholders’ EquitySummary of the Profitability Trend AnalysesSummary of the Profitability Trend AnalysesThe 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 AnalysesSummary of Ratio AnalysesInventories 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 AnalysisCommon-size AnalysisAn 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 SheetsBasket Wonders’ Common Size Balance SheetsBasket Wonders’ Common Size Balance SheetsBasket Wonders’ Common Size Balance SheetsBasket Wonders’ Common Size Income StatementsBasket Wonders’ Common Size Income StatementsIndex AnalysesIndex AnalysesAn 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 SheetsBasket Wonders’
Indexed Balance SheetsBasket Wonders’
Indexed Balance SheetsBasket Wonders’
Indexed Balance SheetsBasket Wonders’ Indexed Income StatementsBasket Wonders’ Indexed Income Statements
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