Introduction to Financial Analysis

Case Study Example

This workbook summarizes many of the concepts that are taught in the course: Introduction to Financial
Analysis. Information about this course and other free resources can be found at: www.exinfm.com

Table of Contents

1 Financial Statements - Start with a complete set of financial statements

2 Common Size Statements - Express the financials in terms of a common size for easy analysis
3 Ratio Analysis - Apply a complete set of ratios to the financial statements
4 Industry Trend Analysis - Benchmark your performance horizontally against industry averages
5 ROI Model - Construct a model that explains the sources behind Return on Investment
6 Cost of Capital - Calculate the weighted average cost of capital
7 Economic Analysis - Analyze a major investment using economic indicators
8 Sales Forecast - Prepare a sales forecast for the next annual year

This workbook is used in conjunction with a course that is subject to copyright protection.
You may print, download and use this workbook for your own personal use in conjunction
with this course. You may not reproduce or redistribute this workbook without first
obtaining the express permission of the author:
Matt H. Evans, CPA, CMA, CFM
Email: matt@exinfm.com
Phone: 1-877-807-8756
n to Financial

or easy analysis

ustry averages
estment
 Balance Sheet

Year ending Year ending

12/31/2005 12/31/2006
Assets ($ in thousands of dollars)
Current Assets
Cash $ 2,081 $ 2,540
Marketable Securities 1,625 1,800
Accounts Receivable 16,850 18,320
Inventories 26,470 27,530
Total Current Assets 47,026 50,190

Long-Term Assets
Property & Equipment at cost 39,500 43,100
Less Accumulated Depreciation 9,500 11,400
Net Property & Equipment 30,000 31,700
Total Long-Term Assets 30,000 31,700

TOTAL ASSETS $ 77,026 $ 81,890

Liabilities
Current Liabilities
Accounts Payable $ 8,340 $ 9,721
Notes Payable @ 10% 5,635 8,500
Taxes Payable 3,150 3,200
Other Current Liabilities 1,750 2,102
Current Portion of Longterm Debt 2,000 2,000
Total Current Liabilities 20,875 25,523

Long-Term Liabilities
Mortgage Bonds @ 9.58% 24,000 22,000
Total Long-Term Liabilities 24,000 22,000

TOTAL LIABILITIES $ 44,875 $ 47,523

Equity

Common Stock $ 13,000 ###

Paid in Capital in excess of par value 10,000 10,000
Retained Earnings 9,151 11,367

TOTAL EQUITY $ 32,151 $ 34,367

 Income Statement
Year ending
12/31/2006
Revenues ($ in thousands of dollars)

Gross Sales Revenues $ 116,900

Allowance for Sales Returned 4,140
Net Sales Revenues 112,760

TOTAL SALES 112,760

Expenses
Cost of Goods Sold 85,300

Gross Profits 27,460

Operating Expenses:
Selling & Marketing 6,540
General Administrative 9,400
Total Operating Expenses 15,940

Operating Income 11,520

Interest Expenses:
Interest on Loans 850
Interest on Mortgage Bonds 2,310
Total Interest Expenses 3,160

Earnings Before Taxes 8,360

Federal & State Taxes @ 40% 3,344

NET INCOME 5,016

 Introduction to Financial Analysis
Common Size Financial Statements
Vertical analysis of financial statements is most often performed by expressing the Balance Sheet and
Income Statement as common size statements. We can easily understand the relationships between
accounts when we express financials as a percentage of total balances.

Balance Sheet

Year ending Year ending

12/31/2005 12/31/2006
Assets (% of Total Assets)

Cash 2.70% 3.10%

Marketable Securities 2.11% 2.20%
Accounts Receivable 21.88% 22.37%
Inventories 34.37% 33.62%
Total Current Assets 61.05% 61.29%

Net Property & Equipment 38.95% 38.71%

TOTAL ASSETS 100.00% 100.00%

Liabilities

Current Liabilities 27.10% 31.17%

Long-Term Liabilities 31.16% 26.87%

TOTAL LIABILITIES 58.26% 58.03%

Equity

TOTAL EQUITY 41.74% 41.97%

TOTAL LIABILITIES & EQUITY 100.00% 100.00%

Key Points per Review of the Common Size Balance Sheet:

1 The company is fairly liquid since current assets are 61% of total assets.
2 About 55% of all assets are tied up in either Accounts Receivable or Inventories. Therefore, it is
very important to effectively manage these two assets on the Balance Sheet.
3 The company does not appear to be too overly leveraged in debt with a debt leverage below 60%

Income Statement
 Year ending
12/31/2006
(% of Total Net Sales)

NET SALES 100.00%

Cost of Goods Sold 75.65%

Gross Margin 24.35%

Operating Expense 14.14%

Operating Margin 10.22%

Interest Expense 2.80%

Earnings Before Taxes 7.41%

Tax Expense 2.97%

NET INCOME 4.45%

Key Points per Review of the Common Size Income Statement:

1 Cost of products sold represents 75% of all costs the company incurs
2 Operating costs appear to be modest at 14%
3 Return on Sales is rather low at 4.45%
 Introduction to Financial Analysis
Ratio Analysis
A complete set of ratios is probably the best analytical approach to evaluating the financial strengths and
weaknesses of a company.
Year ending
Liquidity Ratios 12/31/2006

1. Current Ratio = Current Assets / Current Liabilities 1.97

2. Acid Test or Quick Ratio = (Current Assets - Inventories - Prepaid

Expenses) / Current Liabilities 0.89

3. Operating Cash Flow to Current Liabilities 0.45

Asset Management Ratios

4. Accounts Receivable Turnover = Annual Credit Sales / Average

Receivable Balance 6.41

5. Accounts Receivable Collection = 360 Days / Accounts

Receivable Turnover 56.14

6. Inventory Turnover = Cost of Goods Sold / Average Inventory 3.16

7. Days Held in Inventory = 360 Days / Inventory Turnover 113.95

8. Fixed Asset Turnover = Sales / Average Net Fixed Assets 3.66

9. Total Asset Turnover = Sales / Average Total Assets 1.42

Leverage Ratios

10. Debt Ratio = Total Debt / Total Assets 0.58

11. Debt to Equity Ratio = Total Debt / Total Equity 1.38

12. Times Interest Earned = Earnings Before Interest and Taxes / Interest 3.65

Profitability Ratios

13. Gross Profit or Margin = (Sales - Cost of Goods Sold) / Sales 0.24

14. Operating Income Ratio = Operating Income / Sales 0.10

15. Return on Sales = Earnings after Taxes / Sales 0.04

16. Return on Investment = Earnings after Taxes / Average Total Assets 0.06

17. Return on Equity = Earnings after Taxes / Average Owners Equity 0.22
 Introduction to Financial Analysis
Industry Trend Analysis
Compare the company performance against benchmark data for the overall industry. Where practical, try
to plot performance over long periods of time, such as five years to identify trends.

1. Current Ratio Comparison - 5 Years

2002 2003 2004 2005 2006

Company 1.97 1.94 1.82 1.91 1.97
Industry 1.86 1.88 1.80 1.84 1.88

Current Ratio
2.00
1.95
1.90
Company
Ratio

1.85
Industry
1.80
1.75
1.70
2002 2003 2004 2005 2006
Year

2. Acid Test or Quick Ratio Comparison - 5 Years

2002 2003 2004 2005 2006

Company 0.83 0.79 0.77 0.81 0.89
Industry 0.80 0.83 0.81 0.77 0.79

Acid Test Ratio

0.90

0.85

Company
Ratio

0.80
Industry
0.75

0.70
2002 2003 2004 2005 2006
Year
 Industry

R
0.75

0.70
2002 2003 2004 2005 2006
Year

3. Accounts Receivable Turnover Comparison - 5 Years

2002 2003 2004 2005 2006

Company 6.79 6.71 6.58 6.34 6.41
Industry 7.07 7.01 6.98 6.84 6.91

Receivable Turnover Ratio

7.20
7.00
6.80
6.60
Company
Ratio

6.40
Industry
6.20
6.00
5.80
2002 2003 2004 2005 2006
Year

4. Accounts Receivable Collection Comparison - 5 Years

2002 2003 2004 2005 2006

Company 51.30 52.41 55.73 57.08 56.14
Industry 47.26 48.33 49.02 51.44 50.62

Receivable Collection in Days

58.00
56.00
54.00
52.00
50.00
Company
Days

48.00
Industry
46.00
44.00
42.00
40.00
2002 2003 2004 2005 2006
Year
5. Inventory Turnover Comparison - 5 Years

2002 2003 2004 2005 2006

Company 3.96 3.44 3.72 3.09 3.16
Industry 3.80 3.69 3.74 3.97 3.88

Inventory Turnover Ratio

4.50
4.00
3.50
3.00
2.50
Company
Ratio

2.00
Industry
1.50
1.00
0.50
0.00
2002 2003 2004 2005 2006
Year

6. Days Held in Inventory Comparison - 5 Years

2002 2003 2004 2005 2006

Company 109.77 111.08 116.20 117.33 113.95
Industry 108.00 114.00 102.00 111.00 106.00

Days Held in Inventory

120.00
115.00
110.00
Company
Days

105.00
Industry
100.00
95.00
90.00
2002 2003 2004 2005 2006
Year

7. Total Asset Turnover Comparison - 5 Years

 2002 2003 2004 2005 2006
Company 1.61 1.55 1.39 1.48 1.42
Industry 1.70 1.62 1.68 1.59 1.55

Total Asset Turnover Ratio

1.80
1.60
1.40
1.20
1.00
Company
Ratio

0.80
Industry
0.60
0.40
0.20
0.00
2002 2003 2004 2005 2006
Year

8. Debt Ratio Comparison - 5 Years

2002 2003 2004 2005 2006

Company 0.61 0.67 0.51 0.64 0.58
Industry 0.65 0.61 0.63 0.72 0.69

Debt Ratio
0.75
0.70
0.65
0.60
0.55
Company
Ratio

0.50
Industry
0.45
0.40
0.35
0.30
2002 2003 2004 2005 2006
Year

9. Debt to Equity Ratio Comparison - 5 Years

2002 2003 2004 2005 2006

Company 1.36 1.30 1.44 1.33 1.38
Industry 1.40 1.48 1.41 1.44 1.50
 Debt to Equity Ratio
1.60
1.50
1.40
Company
Ratio

1.30
Industry
1.20
1.10
1.00
2002 2003 2004 2005 2006
Year

10. Gross Profit or Margin Comparison - 5 Years

2002 2003 2004 2005 2006

Company 0.29 0.31 0.23 0.28 0.24
Industry 0.22 0.28 0.20 0.28 0.29

Gross Profit Margin

0.34
0.32
0.30
0.28
Margin

0.26 Company
0.24 Industry
0.22
0.20
0.18
2002 2003 2004 2005 2006
Year

11. Operating Income Ratio Comparison - 5 Years

2002 2003 2004 2005 2006

Company 0.07 0.11 0.08 0.14 0.10
Industry 0.14 0.08 0.09 0.11 0.13

Operating Margin
0.15

0.13

0.11
in
 Operating Margin
0.15

0.13
M argin 0.11
Company
0.09 Industry
0.07

0.05
2002 2003 2004 2005 2006
Year

12. Return on Sales Comparison - 5 Years

2002 2003 2004 2005 2006

Company 0.06 0.05 0.07 0.04 0.04
Industry 0.07 0.08 0.05 0.06 0.05

Return on Sales
0.10
0.09
0.08
0.07
Return

Company
0.06
Industry
0.05
0.04
0.03
2002 2003 2004 2005 2006
Year

13. Return on Investment Comparison - 5 Years

2002 2003 2004 2005 2006

Company 0.09 0.06 0.07 0.10 0.06
Industry 0.07 0.11 0.10 0.09 0.08

Return on Investment
0.15

0.13

0.11
Return

Company
0.09 Industry
 Return on Investment
0.15

0.13

0.11

Return
Company
0.09 Industry
0.07

0.05
2002 2003 2004 2005 2006
Year

14. Return on Equity Comparison - 5 Years

2002 2003 2004 2005 2006

Company 0.22 0.20 0.24 0.19 0.22
Industry 0.28 0.22 0.23 0.26 0.29

Return on Equity
0.32
0.30
0.28
0.26
Return

Company
0.24
Industry
0.22
0.20
0.18
2002 2003 2004 2005 2006
Year
 Introduction to Financial Analysis
Return on Investment (ROI) Model
Given the importance of returns on investments, it is useful to structure a model that explains the root drivers behind returns:

Return on Capital invested by Owners

Return on Equity

14.60%
Convert ROI on Assets to ROI for Equity
Total Assets to
Shareholder Equity
2.383
Return on Investments in Assets
Return on
Investment
6.13%
Two Drivers behind ROI on Assets
Total Asset
Profit Margin
Turnover
4.45% 1.38
Three Lower
Drivers Net Income Sales Total Assets

$ 5,016 $ 112,760 $ 81,890

Lowest Level - Accounts

in Financial Statements Income Statement Balance Sheet

Breakdown of all Breakdown of all

major expense accounts asset accounts
 Introduction to Financial Analysis
Cost of Capital Calculation
Cost of Capital is an important benchmark by which you should evaluate long term investments.

1. Identify the interest bearing debt on the Balance Sheet:

Notes Payable @ 10%

Mortgage Bonds @ 9.58%

2. Calculate the effective rate by deducting out the tax rate since interest is deductible:

Tax Rate per Balance Sheet 40.00%

Notes Payable @ 10% 10.00% 60.00% 6.00%
Mortgage Bonds @ 9.58% 9.58% 60.00% 5.75%

3. Calculate the cost of equity using the Capital Asset Pricing Model:

a. Risk Free Rate of Return - 10 Year Treasury Bonds 3.50%

b. Beta Risk Factor for Stock of Company 1.22
c. Market Portfolio Returns 13.50%
Rate of Return for Stock 15.70%

4. Assign market values to each of the components of capital and calculate the Weighted Average Cost of Capital:

Cost of Market Weighted

Capital Values Percents Cost of Cap
Notes Payable 6.00% $ 6,000 9% 0.55%
Mortagage Bonds 5.75% $ 15,000 23% 1.31%
Stock (Equity) 15.70% $ 45,000 68% 10.70%
$ 66,000 100% 12.56%

Investments need to generate a rate greater than

erage Cost of Capital:
 Introduction to Financial Analysis
Economic Analysis
Long term investments should be evaluated using economic analysis. This will involve estimating the
discounted cash flows of the investment.

During the year, an investment was made in Property & Equipment $ 3,600

Evaluate the economics of this investment as follows:

1 Determine the useful life of the investment > 10 Years

2 Cash flow outlays and benefits from this investment are:

Year Year Year
0 1 2
Initial cash outlay to acquire and install -3,600
Cash outlays to operate and maintain -30 -25
Cash benefit - higher efficiencies 400 400
Cash benefit - costs avoided 300 300
Cash benefit - increased sales 500 500
Net Cost or Benefit -3,600 1,170 1,175

3 Calculate the discounted cash flows for this investment

Cost of Capital Rate > 12.56%

Present Value Interest Factor 1.0000 0.8884 0.7893

Discounted Amounts -3,600 1,039 927

4 Summarize your results using economic indicators
a. Key Economic Indicator is NPV >

b. Another Key Economic Indicator is Rate of Return >

c. A third economic indicator is discounted payback period - How long does it take before you recover your inves
-2,561 -1,633

Conclusion: This investment creates positive value for the company, has an estimated rate of return
higher than the cost of capital, and reaches payback mid way in the useful life of the asset.
Based on these economic indicators, this appears to be a good investment.
 Year Year Year Year Year Year Year Year
3 4 5 6 7 8 9 10 Total
-3,600
-20 -20 -20 -15 -15 -15 -15 -15 -190
400 420 420 420 430 430 450 450 4,220
150 100 50 50 50 50 50 50 1,150
600 600 600 600 650 650 650 650 6,000
1,130 1,100 1,050 1,055 1,115 1,115 1,135 1,135 7,580

0.7013 0.6230 0.5535 0.4918 0.4369 0.3882 0.3449 0.3064

792 685 581 519 487 433 391 348 2,604

Net Present Value

You can also use this formula for NPV which yields a more conservative value > 2,314

Rate to use for reinvestment of residual cash flows > 5% Rate of Return 14.62%

take before you recover your investment?

-841 -155 426 < In Year 5 we reach payback of our investment

rate of return
ife of the asset.
 Introduction to Financial Analysis
Sales Forecast and Forecasted Income Statement
Once you have a clear indication of past financial performance, then you can forecast future financial
performance. This usually starts with Sales and the Income Statement. A simple example appears below:

Step 1 - Determine the expected demand for your products and services next year

Historical demand for products are summarized below:

Units Sold Units Sold Units Sold

Product in Yr 2005 in Yr 2006 in Yr 2007

Lectin 3,020 3,305 3,710

Protela 2,005 2,180 2,380
Sucula 880 1,080 1,410

Step 2 - Determine the expected pricing for your products and services next year

Based on competitive analysis and interviews with marketing staff, the following
sales prices will be applied in Year 2008:

Product Price

Lectin $ 14.50
Protela $ 17.30
Sucula $ 11.20

Step 3 - Calculate total expected sales for the year

3.1 Estimated Sales by Product based on average growth:

% Growth % Growth Average Expected Sales Estimated

Product in 2006 in 2007 Growth Sales Price Sales Amt

Lectin 9.44% 12.25% 10.85% 4,112 $ 14.50 $ 59,629

Protela 8.73% 9.17% 8.95% 2,593 $ 17.30 $ 44,860
Sucula 22.73% 30.56% 26.64% 1,786 $ 11.20 $ 19,999
Total $ 124,488

3.2 Identify any other major sources of revenues anticipated for the year 2008:

Strategic plan and financial plan includes divesting in non performing investments $ 6,500

Step 4 - Based on financial analysis, budgets, and other sources, estimate the costs for 2008

4.1 Cost accounting records and interviews with Engineers indicated the following production costs:

< - - - - - - - - Per Unit Cost - - - - - - - - -> Total Unit Units Cost of

Product Materials Labor Overhead Prod Cost Sold Goods Sold
 Lectin 1.15 6.20 2.60 9.95 4,112 $ 40,918
Protela 1.84 7.55 3.21 12.60 2,593 $ 32,672
Sucula 1.32 4.40 2.84 8.56 1,786 $ 15,285
Total $ 88,876

4.2 Marketing and selling costs are estimated based on the advertising budget and sales support team
needed to meet targeted sales for 2008

Advertising Plan and Budget for 2008 2,390

Sales Salaries and Commissions for 2008 3,585
General Marketing Expenses 550
Reserve and Allowance for Contigencies 325
Total 6,850

4.3 General and administrative costs are estimated based on staff plans for 2008 in all service support functions

Executive Management 4,130

Engineering & Operations 2,705
Accounting & Finance 1,510
Human Resource Mgmt 1,006
General Administrative 460
Other Support Functions 194
Total 10,005

4.4 Interest on debt is calculated based on anticipated borrowing of funds in 2008. The total required fixed assets
to support the sales revenues was considered adequate and thus no additional borrowings were expected.
The total scheduled interest payments for 2008 are:

Interest payments on loans 810

Interest payments on mortgage debt 2,260
Total 3,070

Step 5 - Summarize Steps 3 and 4 into a Forecasted Income Statement

Forecasted Income Statement for 2008

Ref
3.1 Gross Sales Revenues $ 124,488
Estimated Allowance for Sales Returned @ 3.5% 4,357
Net Sales Revenues 120,131
3.2 Revenue from Divesting in Assets 6,500
TOTAL REVENUES 126,631

4.1 Cost of Goods Sold 88,876

Gross Profits 37,756

Operating Expenses:
4.2 Selling & Marketing 6,850
4.3 General Administrative 10,005
Total Operating Expenses 16,855

Operating Income 20,901

4.4 Interest Expenses 3,070

Earnings Before Taxes 17,831

Federal & State Taxes @ 40% 7,132

NET INCOME 10,698

e support functions

equired fixed assets

gs were expected.