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### Chapter 6

Financial Statement Analysis

© 2001 Prentice-Hall, Inc.

Fundamentals of Financial Management, 11/e

Created by: Gregory A. Kuhlemeyer, Ph.D.

Carroll College, Waukesha, WI

Financial Statement Analysis

- Financial Statements
- A Possible Framework for Analysis
- Ratio Analysis
- 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.

- Balance Sheet
- A summary of a firm’s financial position on a given date that shows total assets = total liabilities + owners’ equity.

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 Expd 5 Accum Tax Prepay 10Current Assetse $1,195 Fixed Assets (@Cost)f 1030 Less: Acc. Depr. g (329) Net Fix. Assets $ 701 Investment, LT 50 Other Assets, LT 223Total Assets b $2,169

Basket Wonders’ Balance Sheet (Asset Side)Basket Wonders Balance Sheet (thousands) Dec. 31, 2003a

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 Taxesd 16 Other Accrued Liab.d 100Current Liab.e $ 500 Long-Term Debtf530Shareholders’ Equity Com. Stock ($1 par)g200Add Pd in Capitalg 729 Retained Earningsh 210 Total Equity $1,139

Total Liab/Equitya,b $2,169

Basket Wonders’ Balance Sheet (Liability Side)Basket Wonders Balance Sheet (thousands) Dec. 31, 2003

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 Soldb1,599 Gross Profit $ 612 SG&A Expenses c 402EBITd$ 210 Interest Expensee 59 EBT f$151Income Taxes 60 EATg$ 91 Cash Dividends 38 Increase in RE $ 53

Basket Wonders’ Income StatementBasket Wonders Statement of Earnings (in thousands) for Year Ending December 31, 2003a

Framework for Financial Analysis

Trend / Seasonal Component

How much funding will be required in the future?

Is there a seasonal component?

Analytical Tools Used

Sources and Uses Statement

Statement of Cash Flows

Cash Budgets

1. Analysis of the funds

needs of the firm.

Framework for Financial Analysis

Health of a Firm

Financial Ratios

1. Individually

2. Over time

3. In combination

4. In comparison

1. Analysis of the funds

needs of the firm.

2. Analysis of the financial

condition and profitability

of the firm.

Framework for Financial Analysis

Examples:

Volatility in sales

Volatility in costs

Proximity to break-even point

Business riskrelates to the risk inherent in the operations 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 Analysis

A Financial Manager must consider all three jointly when determining the financing needs of the firm.

1. Analysis of the funds

needs of the firm.

Determining

the

financing

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 Analysis

1. Analysis of the funds

needs of the firm.

Determining

the

financing

needs of

the firm.

Negotiations

with

suppliers of

capital.

2. Analysis of the financial

condition and profitability

of the firm.

3. Analysis of the business

risk of the firm.

Internal Comparisons

External Comparisons

A Financial Ratio is an index that relates twoaccountingnumbers and is obtained by dividing one number by the other.

Use of Financial RatiosRobert Morris Associates

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.”

External Comparisons and Sources of Industry RatiosCurrent Assets

Current Liabilities

For Basket Wonders December 31, 2003

Shows a firm’s ability to cover its current liabilities with its current assets.

Liquidity RatiosBalance Sheet Ratios

Liquidity Ratios

$1,195

$500

= 2.39

BW Industry

2.39 2.15

2.26 2.09

1.91 2.01

Year

2003

2002

2001

Liquidity Ratio ComparisonsCurrentRatio

Ratio is stronger than the industry average.

Current Assets - Inv

Current Liabilities

For Basket Wonders December 31, 2003

Shows a firm’s ability to meet current liabilities with its most liquid assets.

Liquidity RatiosBalance Sheet Ratios

Liquidity Ratios

$1,195 - $696

$500

= 1.00

BW Industry

1.00 1.25

1.04 1.23

1.11 1.25

Year

2003

2002

2001

Liquidity Ratio ComparisonsAcid-Test Ratio

Ratio is weaker than the industry average.

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.

RatioBWIndustry

Current 2.39 2.15

Acid-Test 1.00 1.25

Summary of the Liquidity Ratio ComparisonsCurrent Ratio -- Trend Analysis Comparison potential problem in the inventories account.

Acid-Test Ratio -- Trend Analysis Comparison potential problem in the inventories account.

The current ratio for the potential problem in the inventories account.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.

Summary of the Liquidity Trend Analyses- The current ratio for BW has been rising at the same time the acid-test ratio has been declining.

Debt-to-Equity potential problem in the inventories account.

Total Debt

Shareholders’ Equity

For Basket Wonders December 31, 2003

Shows the extent to which the firm is financed by debt.

Financial Leverage RatiosBalance Sheet Ratios

Financial Leverage

Ratios

$1,030

$1,139

= .90

BW potential problem in the inventories account.Industry

.90 .90

.88 .90

.81 .89

Year

2003

2002

2001

Financial Leverage Ratio ComparisonsDebt-to-Equity Ratio

BW has average debt utilization

relative to the industry average.

Debt-to-Total-Assets potential problem in the inventories account.

Total Debt

Total Assets

For Basket Wonders December 31, 2003

Shows the percentage of the firm’s assets that are supported by debt financing.

Financial Leverage RatiosBalance Sheet Ratios

Financial Leverage

Ratios

$1,030

$2,169

= .47

BW potential problem in the inventories account.Industry

.47 .47

.47 .47

.45 .47

Year

2003

2002

2001

Financial Leverage Ratio ComparisonsDebt-to-Total-Asset Ratio

BW has average debt utilization

relative to the industry average.

Total Capitalization potential problem in the inventories account.

Total Debt

Total Capitalization

For Basket Wonders December 31, 2003

Shows the relative importance of long-term debt to the long-term financing of the firm.

Financial Leverage RatiosBalance Sheet Ratios

(i.e., LT-Debt + Equity)

Financial Leverage

Ratios

$1,030

$1,669

= .62

BW potential problem in the inventories account.Industry

.62 .60

.62 .61

.67 .62

Year

2003

2002

2001

Financial Leverage Ratio ComparisonsTotal Capitalization Ratio

BW has average long-term debt utilization

relative to the industry average.

Interest Coverage potential problem in the inventories account.

EBIT

Interest Charges

For Basket Wonders December 31, 2003

Indicates a firm’s ability to cover interest charges.

Coverage RatiosIncome Statement

Ratios

Coverage Ratios

$210

$59

= 3.56

BW potential problem in the inventories account.Industry

3.56 5.19

4.35 5.02

10.30 4.66

Year

2003

2002

2001

Coverage Ratio ComparisonsInterest Coverage Ratio

BW has below average interest coverage

relative to the industry average.

Coverage Ratio -- Trend Analysis Comparison potential problem in the inventories account.

This indicates that potential problem in the inventories account.low earnings (EBIT) may be a potential problem for BW.

Note, we know that debt levels are in line with the industry averages.

Summary of the Coverage Trend Analysis- The interest coverage ratio for BW has been falling since 2001. It has been below industry averages for the past two years.

Receivable Turnover potential problem in the inventories account.

Annual Net Credit Sales

Receivables

For Basket Wonders December 31, 2003

Indicates quality of receivables and how successful the firm is in its collections.

Activity RatiosIncome Statement /

Balance Sheet

Ratios

(Assume all sales are credit sales.)

Activity Ratios

$2,211

$394

= 5.61

Avg Collection Period potential problem in the inventories account.

Days in the Year

Receivable Turnover

For Basket Wonders December 31, 2003

Average number of days that receivables are outstanding.

(or RT in days)

Activity RatiosIncome Statement /

Balance Sheet

Ratios

Activity Ratios

365

5.61

= 65 days

BW potential problem in the inventories account.Industry

65.0 65.7

71.1 66.3

83.6 69.2

Year

2003

2002

2001

Activity Ratio ComparisonsAverage Collection Period

BW has improved the average collection

period to that of the industry average.

Payable Turnover (PT) potential problem in the inventories account.

Annual Credit Purchases

Accounts Payable

For Basket Wonders December 31, 2003

Indicates the promptness of payment to suppliers by the firm.

Activity RatiosIncome Statement /

Balance Sheet

Ratios

(Assume annual credit

purchases = $1,551.)

Activity Ratios

$1551

$94

= 16.5

PT in Days potential problem in the inventories account.

Days in the Year

Payable Turnover

For Basket Wonders December 31, 2003

Average number of days that payables are outstanding.

Activity RatiosIncome Statement /

Balance Sheet

Ratios

Activity Ratios

365

16.5

= 22.1 days

BW potential problem in the inventories account.Industry

22.1 46.7

25.4 51.1

43.5 48.5

Year

2003

2002

2001

Activity Ratio ComparisonsPayable Turnover in Days

BW has improved the PT in Days.

Is this good?

Inventory Turnover potential problem in the inventories account.

Cost of Goods Sold

Inventory

For Basket Wonders December 31, 2003

Indicates the effectiveness of the inventory management practices of the firm.

Activity RatiosIncome Statement /

Balance Sheet

Ratios

Activity Ratios

$1,599

$696

= 2.30

BW potential problem in the inventories account.Industry

2.30 3.45

2.44 3.76

2.64 3.69

Year

2003

2002

2001

Activity Ratio ComparisonsInventory Turnover Ratio

BW has a very poor inventory turnover ratio.

Inventory Turnover Ratio --Trend Analysis Comparison potential problem in the inventories account.

Total Asset Turnover potential problem in the inventories account.

Net Sales

Total Assets

For Basket Wonders December 31, 2003

Indicates the overall effectiveness of the firm in utilizing its assets to generate sales.

Activity RatiosIncome Statement /

Balance Sheet

Ratios

Activity Ratios

$2,211

$2,169

= 1.02

BW potential problem in the inventories account.Industry

1.02 1.17

1.03 1.14

1.01 1.13

Year

2003

2002

2001

Activity Ratio ComparisonsTotal Asset Turnover Ratio

BW has a weak total asset turnover ratio.

Why is this ratio considered weak?

Gross Profit Margin potential problem in the inventories account.

Gross Profit

Net Sales

For Basket Wonders December 31, 2003

Indicates the efficiency of operations and firm pricing policies.

Profitability RatiosIncome Statement /

Balance Sheet

Ratios

Profitability Ratios

$612

$2,211

= .277

BW potential problem in the inventories account.Industry

27.7% 31.1%

28.7 30.8

31.3 27.6

Year

2003

2002

2001

Profitability Ratio ComparisonsGross Profit Margin

BW has a weak Gross Profit Margin.

Gross Profit Margin -- potential problem in the inventories account.Trend Analysis Comparison

Net Profit Margin potential problem in the inventories account.

Net Profit after Taxes

Net Sales

For Basket Wonders December 31, 2003

Indicates the firm’s profitability after taking account of all expenses and income taxes.

Profitability RatiosIncome Statement /

Balance Sheet

Ratios

Profitability Ratios

$91

$2,211

= .041

BW potential problem in the inventories account.Industry

4.1% 8.2%

4.9 8.1

9.0 7.6

Year

2003

2002

2001

Profitability Ratio ComparisonsNet Profit Margin

BW has a poor Net Profit Margin.

Net Profit Margin -- potential problem in the inventories account.Trend Analysis Comparison

Return on Investment potential problem in the inventories account.

Net Profit after Taxes

Total Assets

For Basket Wonders December 31, 2003

Indicates the profitability on the assets of the firm (after all expenses and taxes).

Profitability RatiosIncome Statement /

Balance Sheet

Ratios

Profitability Ratios

$91

$2,160

= .042

BW potential problem in the inventories account.Industry

4.2% 9.8%

5.0 9.1

9.1 10.8

Year

2003

2002

2001

Profitability Ratio ComparisonsReturn on Investment

BW has a poor Return on Investment.

Return on Investment – potential problem in the inventories account.Trend Analysis Comparison

Return on Equity potential problem in the inventories account.

Net Profit after Taxes

Shareholders’ Equity

For Basket Wonders December 31, 2003

Indicates the profitability to the shareholders of the firm (after all expenses and taxes).

Profitability RatiosIncome Statement /

Balance Sheet

Ratios

Profitability Ratios

$91

$1,139

= .08

BW potential problem in the inventories account.Industry

8.0% 17.9%

9.4 17.2

16.6 20.4

Year

2003

2002

2001

Profitability Ratio ComparisonsReturn on Equity

BW has a poor Return on Equity.

Return on Equity -- potential problem in the inventories account.Trend Analysis Comparison

ROI potential problem in the inventories account.2003= .041 x 1.02 =.042or 4.2%

ROIIndustry = .082 x 1.17 =.098or 9.8%

Return on Investment and the Du Pont ApproachEarning Power = Sales profitability X

Asset efficiency

ROI = Net profit margin X

Total asset turnover

ROE potential problem in the inventories account.2003 = .041 x 1.02 x 1.90 =.080

ROEIndustry = .082 x 1.17 x 1.88 = .179

Return on Equity and the Du Pont ApproachReturn On Equity = Net profit margin X

Total asset turnover X

Equity Multiplier

Total Assets

Equity Multiplier =

Shareholders’ Equity

The profitability ratios for potential problem in the inventories account.BW have ALL been falling since 2001. Each has been below the industry averages for the past three years.

This indicates that COGSandadministrative costsmay both be too high and a potential problem for BW.

Note, this result is consistent with the low interest coverage ratio.

Summary of the Profitability Trend AnalysesInventories are too high. potential problem in the inventories account.

May be paying off creditors (accounts payable) too soon.

COGS may be too high.

Selling, general, and administrative costs may be too high.

Summary of Ratio AnalysesCommon-size Analysis potential problem in the inventories account.

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 potential problem in the inventories account.

Basket Wonders’ Common Size Balance Sheets potential problem in the inventories account.

Basket Wonders’ Common Size Income Statements potential problem in the inventories account.

Index Analyses potential problem in the inventories account.

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’ potential problem in the inventories account.Indexed Balance Sheets

Basket Wonders’ potential problem in the inventories account.Indexed Balance Sheets

Basket Wonders’ Indexed Income Statements potential problem in the inventories account.

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