Topics

p covered
2

Why evaluate financial statements

Primary types of financial statements
Framework for financial analysis
Financial ratios
Th DuPont
The
D P SSystem

LECTURE 1
FINANCIAL ANALYSIS
Prepared by Hoang Thi Anh Ngoc

Whyy evaluate financial statements?

3

Why
y evaluate financial statements?
4

Internal uses
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.
y
Understand -- Focus on understanding how
suppliers
pp
of funds analyze
y the firm.

External uses
Trade

Creditors -- Focus on the liquidity of the firm.

Bondholders -- Focus on the
long term cash flow
long-term
of the firm.
Shareholders -- Focus on the profitability and longterm health of the firm.

Standardized Financial Statements

5

Common-Size Balance Sheets

Assets

Compute all accounts as a percent of total assets

Compute all line items as a percent of sales

Index analysis

Regular (thousands of $)

Common-Size Income Statements

Basket Wonders Common Size

B l
Balance
Sh
Sheets
t

Base year ititem = 100

B
100, other
th years items
it
computed
t d as % off base
b
year item

Standardized statements make it easier to compare financial

information, particularly as the company grows
They are also useful for comparing companies of different
sizes particularly within the same industry
sizes,

Basket Wonders Common Size

B l
Balance
Sh
Sheets
t
Regular
g
(thousands
(
of $))
Liab+Equity

2005

2006

2007

2005

2006

2007

Common-Size (%)
2005

2006

2007

Cash
AR
Inv
Other CA

148
283
322
10

100
410
616
14

90
394
696
15

12.10
23.14
23
14
26.33
0.82

4.89
20.06
20
06
30.14
0.68

4.15
18.17
18
17
32.09
0.69

Tot CA
Net FA
LT Inv
Other LT

763
349
0
111

1,140
631
50
223

1,195
701
50
223

62.39
28.54
0.00
0
00
9.08

55.77
30.87
2.45
5
10.91

55.09
32.32
2.31
3
10.28

1,223

2,044

2,169

100.0

100.0

100.0

Tot Assets

Basket Wonders Common Size

I
Income
St
Statements
t
t

Common-Size ((%))
2005

2006

2007

Note Pay
Acct Pay
Accr Tax
Other Accr

290
81
13
15

295
94
16
100

290
94
16
100

23.71
6.62
1.06
1 23
1.23

14.43
4.60
0.78
4 89
4.89

13.37
4.33
0.74
4 61
4.61

Tot CL
LT Debt
Equity

399
150
674

505
453
1,086

500
530
1,139

32.62
12.26
55.11

24.71
22.16
53.13

Tot L+E

1,223

2,044

2,169

100.0

100.0

Regular (thousands of $)
2005
Net Sales
COGS

2006

2007

Common-Size
Common
Size (%)
2005

2006

2007

1,235
849

2,106
1,501

2,211
1,599

100.0
68.7

100.0
71.3

100.0
72.3

Gross Profit
Ad
Adm.

386
180

605
383

612
402

31.3
14.6
14
6

28.7
18.2
18
2

27.7
18.2
18
2

23.05
24.44
52.51

EBIT
Int Exp

206
20

222
51

210
59

16.7
1.6

10.5
2.4

9.5
2.7

EBT

186

171

151

15.1

8.1

6.8

100.0

EAT

112

103

91

9.1

4.9

4.1

Cash Div

50

50

50

4.0

2.4

2.3

Basket Wonders Indexed Balance

Sh t
Sheets
Regular (thousands of $)
Assets

2005

2006

2007

Basket Wonders Indexed Balance

Sh t
Sheets

Indexed (%)

Regular
g
(thousands
(
of $))

2005

2006

2007

Liab+Equity

2005

2006

2007

Indexed ((%))
2005

2006

2007

100.0
100.0
100.0
100.0

101.7
116.0
123.1
666.7

100.0
116.0
123.1
666.7

Cash
AR
Inv
Other CA

148
283
322
10

100
410
616
14

90
394
696
15

100.0
100 0
100.0
100.0
100.0

67.6
144.9
144
9
191.3
140.0

60.8
139.2
139
2
216.1
150.0

Note Pay
Acct Pay
Accr Tax
Other Accr

290
81
13
15

295
94
16
100

Tot CA
Net FA
LT Inv
Other LT

763
349
0
111

1,140
631
50
223

1,195
701
50
223

100.0
100.0
100.0
00 0
100.0

149.4
180.8
inf.
200.9

156.6
200.9
inf.
200.9

Tot CL
LT Debt
Equity

399
150
674

505
453
1,086

500 100.0
530 100.0
1,139 100.0

126.6
302.0
161.1

125.3
353.3
169.0

1,223

2,044

2,169

100.0

167.1

177.4

Tot L+E

1,223

2,044

2,169 100.0

167.1

177.4

Tot Assets

Basket Wonders Indexed Income

St t
Statements
t
Regular (thousands of $)
2005
Net Sales
COGS

2006

2007

290
94
16
100

Primary Types of Financial

St t
Statements
t
Income Statement

Indexed (%)
2005

2006

2007

1,235
849

2,106
1 501
1,501

2,211
1 599
1,599

100.0
100 0
100.0

170.5
176 8
176.8

179.0
188 3
188.3

Gross Profit
Adm.

386
180

605
383

612
402

100.0
100.0

156.7
212.8

158.5
223.3

EBIT
Int Exp

206
20

222
51

210
59

100.0
100.0

107.8
255.0

101.9
295.0

EBT

186

171

151

100 0
100.0

91 9
91.9

81 2
81.2

EAT

112

103

91

100.0

92.0

81.3

Cash Div

50

50

50

100.0

100.0

100.0

A summary of a firms revenues and expenses

over a specified
p
period,
p
, ending
g with net income
or loss for the period.

Balance Sheet

A summary of a firms financial position on a given

date that shows total assets = total liabilities +
owners equity.

Basket Wonders Balance Sheet

(A t side)
(Assets
id )
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007a

Cash and C.E.

$ 90
c
Acct. Rec.
394
Inventories
696
d
Prepaid Exp
5
Accum Tax Prepay
10
Current Assetse $1,195
Fixed Assets (@Cost)f 1030
Less: Acc. Depr.
p g
((329)
9)
Net Fix. Assets $ 701
Investment, LT
50
Other Assets,
Assets LT
223
Total Assets b
$2,169

a. How the firm stands on a

specific date.
b Wh
b.
Whatt BW owned.
d
c. Amounts owed by customers.
d. Future expense items already
paid.
e. Cash/likely convertible to
cash within 1 year.
year
f. Original amount paid.
g. Acc. deductions for wear and
tear.

Basket Wonders Income Statement

Basket Wonders Balance Sheet

(Li biliti side)
(Liabilities
id )
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007

Notes Payable
$
290
c
Acct. Payable
94
Accrued Taxes d
16
d
Other Accrued Liab.
100
Current Liab.
Liab. e $ 500
Long-Term Debt f
530
Shareholders Equity
Com. Stock ($
($1 par)
p )g
200
Add Pd in Capital g
729
h
210
Retained Earnings
Total Equity
$1,139
1 139
Total Liab/Equitya,b $2,169

Framework for Financial Analysis

y
Trend / Seasonal Component
p

Basket Wonders Statement of Earnings (in thousands) for Year Ending December
31 2007a
31,

Net Sales
Cost of Goods Sold b
Gross Profit
SG&A Expenses c
EBITd
Interest Expensee
EBT f
Income Taxes
EATg
Cash Dividends
Increase in RE

$ 2,211
1 599
1,599
$
612
402
$
210
59
$
151
60
$
91
38
$
53

a. Measures profitability over a

time period.
period
b. Cost of goods that was sold
to customers
c. Sales comm., adv., officers
salaries, etc.
d. Operating
p
g income.
e. Cost of borrowed funds.
f. Taxable income.
A
t earnedd for
f
g. Amount
shareholders.

a. Note, Assets = Liabilities +

Equity.
b Wh
b.
Whatt BW owedd andd
ownership position.
c. Owed to suppliers for goods
and services.
d. Unpaid wages, salaries, etc.
e Debts payable < 1 year.
e.
year
f. Debts payable > 1 year.
g. Original investment.
h. Earnings reinvested.

How much funding will be

required
q
in the future?
1. Analysis of the funds
needs of the firm.

Is there a seasonal component?

Analytical Tools Used

Sources and Uses Statement
Statement of Cash Flows
Cash Budgets

Framework for Financial Analysis

y

Framework for Financial Analysis

y

Health of a Firm
Financial Ratios
1. Analysis of the funds
needs of the firm.
2. Analysis of the financial
condition and profitability
of the firm.

1.
2.
3.
4.

Individually
y
Over time
In combination
In comparison

Framework for Financial Analysis

y

1 Analysis of the funds

1.
needs of the firm.
2. Analysis of the financial
condition and profitability
of the firm.
3. Analysis of the business
risk of the firm.

Determining
the
financing
needs of
the firm.

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

1. Analysis of the funds

needs of the firm.
2. Analysis
y of the financial
condition and profitability
of the firm.
3. Analysis
y of the business
risk of the firm.

Business risk relates to the

risk inherent in the operations
of the firm.
Examples:
Volatility in sales
Volatility in costs
Proximity to break-even
point

Framework for Financial Analysis

y

1 Analysis of the funds

1.
needs of the firm.
2. Analysis of the financial
condition and profitability
of the firm.
3. Analysis of the business
risk of the firm.

Determining
the
financing
needs of
the firm.

Negotiations
with
suppliers of
capital.

External Comparisons and Sources

off Industry
I d t Ratios
R ti

Use of Financial Ratios

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

Types of Comparisons
Internal Comparisons
External Comparisons

Liquidity
q
y Ratios

This involves comparing the ratios of one firm

with those of similar firms or with industry
averages.
averages
Similarityy is important
p
as one should compare
p
apples to apples.

Liquidity
q
y Ratio Comparisons
p

Balance Sheet Ratios

Current
C

Li idit R
Liquidity
Ratios
ti

Current Assets
Current Liabilities

Shows a firms ability to

cover its current
liabilities with its current
assets.

For Basket Wonders

December 31, 2007
$1,195 = 2.39
$500
$

Current Ratio
Year
Y
2007
2006
2005

BW
2.39
2.26
1 91
1.91

I d t
Industry
2.15
2.09
2 01
2.01

Ratio is stronger
g than the industry
y average.
g

Liquidity
q
y Ratio Comparisons
p

Balance Sheet Ratios

Acid-Test (Q
(Quick))

Li idit R
Liquidity
Ratios
ti

Current Assets - Inv

Current Liabilities

Shows a firms ability to

meet current liabilities
with its most liquid
assets.

For Basket Wonders

December 31, 2007
$1,195 - $696 = 1.00
$500
$

Summary of the Liquidity Ratio

C
Comparisons
i
Ratio
Current
A
Acid-Test

BW
2.39
1.00

Industry
2.15
1.25

Strong current ratio and weak acid-test ratio

indicates a potential problem in the inventories
account
account.
Note that this industry has a relatively high level
off inventories.
i
t i

Acid Test Ratio

Acid-Test
Year
2007
2006
2005

BW
1.00
1 04
1.04
1.11

Industryy
1.25
1 23
1.23
1.25

Ratio is weaker than the industry average.

Current Ratio -- Trend Analysis

C
Comparison
i
Trend Analysis of Current Ratio
2.5
Ratio V
Value

Liquidity
q
y Ratios

2.3
2.1
BW
Industry

1.9
1.7
1.5
2005

2006
Analysis Year

2007

Acid-Test Ratio -- Trend Analysis

C
Comparison
i
Trend Analysis of Acid-Test
Acid Test Ratio

Summary of the Liquidity Trend

A l i
Analysis

Ratio V
Value

1.5

1.3
BW
Industry

10
1.0
0.8

0.5
2005

2006

The current ratio for BW has been rising at the

same time the acid-test ratio has been declining.
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.

2007

Analysis Year

Financial Leverage
g Ratios
Balance Sheet Ratios
Financial
Fi
i lL
Leverage
Ratios

Shows the extent to which

the firm is financed by
debt.

Debt-to-Equity
q y
Total Debt
Shareholders Equity
For Basket Wonders
December 31, 2007
$1,030 = .90
$1,139
$
,

Financial Leverage Ratio

C
Comparison
i
Debt to Equity Ratio
Debt-to-Equity
Year
2007
2006
2005

BW
.90
.88
.81

Industry
.90
.90
.89

BW has average debt utilization

relative to the industry average.

Financial Leverage
g Ratio
Balance Sheet Ratios
Financial
Fi
i lL
Leverage
Ratios

Shows the percentage of

the firms
firm s assets that are
supported by debt
financing
financing.

Debt-to-Total-Assets
Total Debt
Total Assets
For Basket Wonders
December 31, 2007
$1,030 = .47
$2,169
$
,

Financial Leverage
g Ratios
B l
Balance
Sh
Sheett R
Ratios
ti

Total Capitalization

Financial Leverage
Ratios

Long-term Debt
Total Capitalization

Shows the relative

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

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

For Basket Wonders

December
D
b 31,
31 2007
$530 = .32
$1 669
$1,669

Financial Leverage Ratio

C
Comparison
i
Debt-to-Total-Asset Ratio
Year
2007
2006
2005

BW
.47
.47
47
.45

Industryy
.47
.47
47
.47

BW has average debt utilization

relative to the industry average.

Financial Leverage Ratio

C
Comparisons
i
Total Capitalization Ratio
Year
2007
2006
2005

BW
.32
.32
32
.37

Industryy
.30
.31
31
.32

BW has average long-term debt utilization

relative to the industry average.

Coverage
g Ratios

Coverage
g Ratio Comparison
p
Interest Coverage

IIncome Statement
St t
t
Ratios

Interest Coverage Ratio

Year
2007
2006
2005

EBIT
Interest Charges

Coverage Ratios

For Basket Wonders

December 31, 2007

Indicates a firms ability

to cover interest
i
charges.
h

$210 = 3.56
$59

Summary of the Coverage Trend

A l i
Analysis

Ratio Value

11.0
9.0

7.0

BW
Industry

5.0
3.0
2005

2006
Analysis Year

2007

Industryy
5.19
5 02
5.02
4.66

BW has below average interest coverage

relative to the industry average.

Coverage Ratio -- Trend Analysis

C
Comparison
i
Trend Analysis
y of Interest Coverage
g Ratio

BW
3.56
4 35
4.35
10.30

The interest coverage

g ratio for BW
W has been
falling since 2005. It has been below industry
g for the past
p two years.
y
averages
This indicates that low earnings (EBIT) may be a
potential problem for BW.
BW
Note, we know that debt levels are in line with
th industry
the
i d t averages.

Activityy (Efficiency)
(
y) Ratios
Receivable
v
Turnover
v

Income Statement /
Balance Sheet
Ratios
at os

(Assume all sales are credit sales.)

Annual Net Credit Sales

Receivables

Activity Ratios

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

For Basket Wonders

December 31, 2007
$2,211 = 5.61
$394
$

Activityy Ratio Comparison

p
Average Collection Period
Year
2007
2006
2005

BW
65.0
71 1
71.1
83.6

Industryy
65.7
66 3
66.3
69.2

BW has improved the average collection

period to that of the industry average.

Activity
y ((Efficiency)
y) Ratios
Avg
g Collection Period

Income Statement /
Balance Sheet
Ratios
at os
Activity Ratios

Average number of days

that receivables are
outstanding.
( RT in
(or
i d
days))

Days in the Year

Receivable Turnover
For Basket Wonders December
31, 2007
365
5.61

= 65 days

Activity
y ((Efficiency)
y) Ratios
Income Statement /
Balance Sheet
Ratios
at os
Activity Ratios

promptness
p
of
Indicates the p
payment to suppliers by the
firm.

Payable
y
Turnover
v (PT)
( )
(Assume annual credit
purchases = $1,551.)

Annual Credit Purchases

Accounts Payable
For Basket Wonders
December 31, 2007
$1551
= 16.5
$94

Activityy (Efficiency)
(
y) Ratios
Income Statement /
Balance Sheet
Ratios
at os

PT in Days
y
Days
y in the Year
Payable Turnover

Activity Ratios

For Basket Wonders December

31, 2007
Average
g number of days
y
that payables are
365 = 22.1 days
outstanding.
16.5

Activityy (Efficiency)
(
y) Ratios
Income Statement /
Balance Sheet
Ratios
at os
Activity Ratios

Inventory
v
y Turnover
v
Cost of Goods Sold
Inventory

For Basket Wonders December

31, 2007
Indicates the effectiveness
of the inventory
$1,599 = 2.30
management practices of
$696
$
the firm.

Activity
y Ratio Comparisons
p
Payable Turnover in Days
Year
2007
2006
2005

BW
22.1
25 4
25.4
43.5

Industryy
46.7
51 1
51.1
48.5

BW has improved the PT in Days.

Is this good?

Activity
y Ratio Comparisons
p
Inventory Turnover Ratio
Year
2007
2006
2005

BW
2.30
2 44
2.44
2.64

Industryy
3.45
3 76
3.76
3.69

BW has a very poor inventory turnover ratio.

Inventory Turnover Ratio --Trend

A l i C
Analysis
Comparison
i
Trend Analysis
y
of Inventory
y Turnover Ratio

Ratio
o Value

4.0
3.5
3.0

BW
Industry

2.5
2.0
2005

2006

2007

Analysis Year

Activityy Ratio Comparison

p
Total Asset Turnover Ratio
Year
2007
2006
2005

BW
1.02
1 03
1.03
1.01

Industryy
1.17
1 14
1.14
1.13

BW has a weak total asset turnover ratio.

Why is this ratio considered weak?

Activity
y ((Efficiency)
y) Ratios
Total Asset Turnover
v

Income Statement /
Balance Sheet
Ratios
at os
Activity Ratios

Indicates the overall

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

Net Sales
Total Assets
For Basket Wonders December
31, 2007
$2,211 = 1.02
$2,169
$
,

Profitability
y Ratios
Income Statement /
Balance Sheet
Ratios
at os
Profitability Ratios

Gross Profit M
G
Margin
g
Gross Profit
Net Sales

For Basket Wonders December

31, 2007
Indicates the efficiencyy of
operations and firm pricing
$612 = .277
policies.
$2,211
$
,

Gross Profit Margin

Year
2007
2006
2005

BW
27.7%
28 7
28.7
31.3

Industryy
31.1%
30 8
30.8
27.6

BW has a weak Gross Profit Margin.

Gross Profit Margin - Trend

A l i C
Analysis
Comparison
i
Trend Analysis
y
of Gross Profit Margin
g
35.0
Ratio Va
alue (%))

Profitabilityy Ratio Comparison

p

32.5
30 0
30.0

BW
Industry

27.5
25.0
2005

2006

2007

Analysis Year

Profitabilityy Ratios
Income Statement /
Balance Sheet
Ratios
at os
Profitability Ratios

Indicates the firms

profitability after taking
account of all expenses and
income taxes.

Profitability
y Ratio Comparison
p
Net Profit M
N
Margin
g
Net Profit after Taxes
Net Sales

For Basket Wonders December

31, 2007
$91 = .041
$2,211
$
,

Net Profit Margin

Year
2007
2006
2005

BW
4.1%
49
4.9
9.0

Industryy
8.2%
81
8.1
7.6

BW has
as a poo
poor Net
et Profit
o t Margin.
ag

Net Profit Margin - Trend Analysis

C
Comparison
i
Trend Analysis
y
of Net Profit Margin
g

Return on Investment
v

Income Statement /
Balance Sheet
Ratios
at os

10
Ratio V
Value (% )

Profitability
y Ratios

Net Profit after Taxes

Total Assets

8
7

BW
Industry

6
5
4
2005

2006

2007

Profitability Ratios

For Basket Wonders December

31, 2007
Indicates the profitability on
the assets of the firm (after
$91 = .042
all expenses and taxes).
$2,160
$
,

Analysis Year

Profitabilityy Ratio Comparison

p
Return on Investment

Return on Investment Trend

A l i C
Analysis
Comparison
i
Trend Analysis of Return on Investment

Year
2007
2006
2005

BW
4.2%
50
5.0
9.1

Industryy
9.8%
91
9.1
10.8

BW has
as a poo
poor Return
etu o
on Investment.
est e t

Ratio V
Value (%
%)

12
10
8

BW
Industry

6
4
2005

2006
Analysis Year

2007

Profitabilityy Ratios

Profitability
y Ratio Comparison
p
Return on Equity
q y

Income Statement /
Balance Sheet
Ratios
at os

Return on Equity
Year
2007
2006
2005

Net Profit after Taxes

Shareholders Equity

Profitability Ratios

For Basket Wonders December

31, 2007
Indicates the profitability to
the shareholders of the firm
$91 = .08
(after all expenses and
$1,139
$
,
t
taxes).
)

Summary of the Profitability Trend

A l i
Analysis

Trend Analysis
y
of Return on Equity
q y

Ratio V
Value (%)

21.0
17.5

BW
Industry

10.5

7.0
2005

2006
Analysis Year

2007

Industryy
17.9%
17 2
17.2
20.4

BW has
as a poo
poor Return
etu o
on Equity.
qu ty

Return on Equity -T d Analysis

Trend
A l i Compariso
C
i

14.0

BW
8.0%
94
9.4
16.6

The p
profitabilityy ratios for BW
W have
v ALL been
falling since 2005. Each has been below the
g for the past
p three years.
y
industryy averages
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
Note,
coverage ratio.

Summaryy of Ratio Analysis

y

The DuPont System

y
66

Inventories
v
are too high.
g
May be paying off creditors (accounts
payable) too soon.
soon
COGS may be too high.
S ll
Selling,
general,l and
d administrative
d
costs may
be too high.

The DuPont System

y

A breakdown of ROE and ROA into component

ratios

ROA =

Aft - tax
After
t interest
i t
t Net
N t Income
I
Total Assets

ROE =

Net Income
Shareholders' Equity

The DuPont System

y

67

68

After - tax interest Net Income

sales
ROA =
x
sales
Total Assets

asset
turnover

profit
margin

ROE =

NI
assets sales
l
AT interest
i
N Income
Net
I
x
x
x
equity assets
sales
AT interest NI

lleverage asset
profit
fi
ratio turnover margin

debt
d
b
burden