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Financial Statement Analysis


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Objectives

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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 firms 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 firms 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 to gain additional insights into a firm's performance.

Financial Statement Analysis


Financial A

Statements

Possible Framework for Analysis Sheet Ratios

Balance Income

Statement and Income Statement/Balance Sheet Ratios

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Examples of External Uses of Statement Analysis


Trade

Creditors -- Focus on the liquidity of the firm.


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

Bondholders

Shareholders

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Examples of Internal Uses of Statement Analysis


Plan

-- Focus on assessing the current financial position and evaluating potential firm opportunities. -- Focus on return on investment for various assets and asset efficiency.
-- Focus on understanding how suppliers of funds analyze the firm.

Control

Understand

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Primary Types of Financial Statements


Balance Sheet

A summary of a firms financial position on a given date that shows total assets = total liabilities + owners equity. A summary of a firms revenues and expenses over a specified period, ending with net income or loss for the period.

Income Statement

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Basket Wonders Balance Sheet (Asset Side)


Basket Wonders Balance Sheet (thousands) Dec. 31, 2007a

Cash and C.E. $ 90 Acc. 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 6-7

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.

Basket Wonders Balance Sheet (Liability Side)


Basket Wonders Balance Sheet (thousands) Dec. 31, 2007

Notes Payable Acct. Payablec Accrued Taxes d Other Accrued Liab. d Current Liab. e Long-Term Debt f Shareholders Equity Com. Stock ($1 par) g Add Pd in Capital g Retained Earnings h Total Equity a,b 6-8 Total Liab/Equity

$ 290 94 16 100 $ 500 530

a. Note, Assets = Liabilities + Equity. b. What BW owed and ownership position. c. Owed to suppliers for goods and services. d. Unpaid wages, 200 salaries, etc. 729 e. Debts payable < 1 year. 210 f. Debts payable > 1 year. $1,139 g. Original investment. $2,169 h. Earnings reinvested.

Balance sheet of Basket Wonders( In thousands)


Cash and C.E. $ 90 . Acc. 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
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. Notes Payable

Acct. Payablec Accrued Taxes d Other Accrued Liab. d Current Liab. e Long-Term Debt f 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

$ 290 94 16 100 $ 500 530

Basket Wonders Income Statement


Basket Wonders Statement of Earnings (in thousands) for Year Ending December 31, 2007a 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 6-10 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.

Framework for Financial Analysis


Trend / Seasonal Component
How much funding will be required 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
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Framework for Financial Analysis


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

Financial Ratios 1. 2. 3. 4. Individually Over time In combination In comparison

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Framework for Financial Analysis


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
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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. 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.

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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.
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Types of Comparisons
Internal Comparisons External Comparisons

External Comparisons and Sources of Industry 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. 6-16

Examples: Risk Management Association

Dun & Bradstreet


Almanac of Business and Industrial Financial Ratios

Liquidity Ratios
Balance Sheet Ratios
Liquidity Ratios

Current
Current Assets Current Liabilities For Basket Wonders December 31, 2007 $1,195 = 2.39 $500

Shows a firms ability to cover its current liabilities with its current assets. 6-17

Liquidity Ratio Comparisons


Current Ratio
Year 2007 2006 BW 2.39 2.26 Industry 2.15 2.09

2005
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1.91

2.01

Ratio is stronger than the industry average.

Liquidity Ratios
Balance Sheet Ratios
Liquidity Ratios

Acid-Test (Quick)
Current Assets - Inv Current Liabilities For Basket Wonders December 31, 2007 $1,195 - $696 = 1.00 $500

Shows a firms ability to meet current liabilities with its most liquid assets. 6-19

Liquidity Ratio Comparisons


Acid-Test Ratio
Year 2007 2006 BW 1.00 1.04 Industry 1.25 1.23

2005
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1.11

1.25

Ratio is weaker than the industry average.

Summary of the Liquidity Ratio Comparisons


Ratio Current 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. Note that this industry has a relatively high level of inventories.

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Current Ratio -- Trend Analysis Comparison


Trend Analysis of Current Ratio
2.5
Ratio Value

2.3 2.1 1.9 1.7 1.5 2005 2006 Analysis Year 2007 BW Industry

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Acid-Test Ratio -- Trend Analysis Comparison


Trend Analysis of Acid-Test Ratio
1.5
Ratio Value

1.3 1.0 0.8 0.5 2005 BW Industry

2006 Analysis Year

2007

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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.

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.

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Financial Leverage Ratios


Balance Sheet Ratios
Financial Leverage Ratios

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

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


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Financial Leverage Ratio Comparisons


Debt-to-Equity Ratio
Year 2007 2006 BW .90 .88 Industry .90 .90

2005
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.81

.89

BW has average debt utilization relative to the industry average.

Financial Leverage Ratios


Balance Sheet Ratios
Financial Leverage Ratios

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

Shows the percentage of the firms assets that are supported by debt financing.
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Financial Leverage Ratio Comparisons


Debt-to-Total-Asset Ratio
Year 2007 2006 BW .47 .47 Industry .47 .47

2005
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.45

.47

BW has average debt utilization relative to the industry average.

Coverage Ratios
Income Statement Ratios Coverage Ratios

Interest Coverage
EBIT+ Depreciation Interest Charges For Basket Wonders December 31, 2007 $210 = 3.56 $59

Indicates a firms ability to cover interest charges.


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Coverage Ratio Comparisons


Interest Coverage Ratio
Year 2007 2006 BW 3.56 4.35 Industry 5.19 5.02

2005

10.30

4.66

BW has below average interest coverage relative to the industry average. 6-30

Coverage Ratio -- Trend Analysis Comparison


Trend Analysis of Interest Coverage Ratio
11.0 9.0 7.0 5.0 3.0 2005
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Ratio Value

BW Industry

2006 Analysis Year

2007

Summary of the Coverage Trend Analysis

The interest coverage ratio for BW has been falling since 2005. It has been below industry averages for the past two years. 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.

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Activity Ratios
Income Statement / Balance Sheet Ratios
Activity Ratios Indicates quality of receivables and how successful the firm is in its collections.
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Receivable Turnover
(Assume all sales are credit sales.)

Annual Net Credit Sales Receivables For Basket Wonders December 31, 2007 $2,211 = 5.61 $394

Activity Ratios
Income Statement / Balance Sheet Ratios
Activity Ratios Average number of days that receivables are outstanding. (or RT in days)
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Avg Collection Period


Days in the Year Receivable Turnover For Basket Wonders December 31, 2007 365 5.61

= 65 days

Activity Ratio Comparisons


Average Collection Period
Year 2007 2006 BW 65.0 71.1 Industry 65.7 66.3

2005
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83.6

69.2

BW has improved the average collection period to that of the industry average.

Activity Ratios
Income Statement / Balance Sheet Ratios
Activity Ratios Indicates the effectiveness of the inventory management practices of the firm. 6-36

Inventory Turnover
Cost of Goods Sold Inventory For Basket Wonders December 31, 2007 $1,599 = 2.30 $696

Activity Ratio Comparisons


Inventory Turnover Ratio
Year 2007 2006 BW 2.30 2.44 Industry 3.45 3.76

2005
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2.64

3.69

BW has a very poor inventory turnover ratio.

Inventory Turnover Ratio -Trend Analysis Comparison


Trend Analysis of Inventory Turnover Ratio
4.0 3.5 3.0 2.5 2.0 2005
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Ratio Value

BW Industry

2006 Analysis Year

2007

Activity Ratios
Income Statement / Balance Sheet Ratios
Activity Ratios Indicates the overall effectiveness of the firm in utilizing its assets to generate sales. 6-39

Total Asset Turnover


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

Activity Ratio Comparisons


Total Asset Turnover Ratio
Year 2007 2006 BW 1.02 1.03 Industry 1.17 1.14

2005
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1.01

1.13

BW has a weak total asset turnover ratio.

Profitability Ratios
Income Statement / Balance Sheet Ratios
Profitability Ratios Indicates the efficiency of operations and firm pricing policies.
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Gross Profit Margin


Gross Profit Net Sales For Basket Wonders December 31, 2007 $612 = .277 $2,211

Profitability Ratio Comparisons


Gross Profit Margin
Year 2007 2006 BW 27.7% 28.7 Industry 31.1% 30.8

2005
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31.3

27.6

BW has a weak Gross Profit Margin.

Gross Profit Margin -Trend Analysis Comparison


Trend Analysis of Gross Profit Margin
35.0
Ratio Value (%)

32.5 30.0 27.5 25.0 2005 BW Industry

2006 Analysis Year

2007

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Profitability Ratios
Income Statement / Balance Sheet Ratios
Profitability Ratios Indicates the firms profitability after taking account of all expenses and income taxes. 6-44

Net Profit Margin


Net Profit after Taxes Net Sales For Basket Wonders December 31, 2007 $91 = .041 $2,211

Profitability Ratio Comparisons


Net Profit Margin
Year 2007 2006 BW 4.1% 4.9 Industry 8.2% 8.1

2005
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9.0

7.6

BW has a poor Net Profit Margin.

Net Profit Margin -Trend Analysis Comparison


Trend Analysis of Net Profit Margin
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Ratio Value (%)

9 8 7 6 5 4 2005 BW Industry

2006 Analysis Year

2007

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Profitability Ratios
Income Statement / Balance Sheet Ratios
Profitability Ratios Indicates the profitability on the assets of the firm (after all expenses and taxes).
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Return on Investment
Net Profit after Taxes Total Assets For Basket Wonders December 31, 2007 $91 = .042 $2,169

Profitability Ratio Comparisons


Return on Investment
Year 2007 2006 BW 4.2% 5.0 Industry 9.8% 9.1

2005
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9.1

10.8

BW has a poor Return on Investment.

Return on Investment Trend Analysis Comparison


Trend Analysis of Return on Investment
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Ratio Value (%)

10 8 6 4 2005 BW Industry

2006 Analysis Year

2007

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Profitability Ratios
Income Statement / Balance Sheet Ratios
Profitability Ratios Indicates the profitability to the shareholders of the firm (after all expenses and taxes).
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Return on Equity
Net Profit after Taxes Shareholders Equity For Basket Wonders December 31, 2007 $91 = .08 $1,139

Profitability Ratio Comparisons


Return on Equity
Year 2007 2006 BW 8.0% 9.4 Industry 17.9% 17.2

2005
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16.6

20.4

BW has a poor Return on Equity.

Return on Equity -Trend Analysis Comparison


Trend Analysis of Return on Equity
21.0
Ratio Value (%)

17.5 14.0 10.5 7.0 2005 BW Industry

2006 Analysis Year

2007

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Other Ratios
Earnings

per share

EPS = (Net profit after tax pref. Div) No. of equity shares (common shares) The portion of a company's profit allocated to each outstanding share of common stock
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Other Ratios
dividends Payout ratio = earnings
stock price earnings per share

PE Ratio =

dividend per share Dividend yield = stock price

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Return on Investment and the Du Pont Approach


ROI = ROI Net Profit/ Average assets = Net Profit/ sales Average assets/sales

ROI =Net profit margin X Total asset turnover

ROI2007
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= .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


Return On Equity = Net profit margin X Total asset turnover X Equity Multiplier
Total Assets Equity Multiplier = Shareholders Equity

ROE2007
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= .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.

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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.

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