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Chapter 6

Financial Statement
Analysis
6-1

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
A

Statements

Possible Framework for Analysis

Ratio

Analysis

Trend

Analysis

Common-Size
6-2

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.

6-3

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.

6-4

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.

Income Statement

6-5

A summary of a firms revenues and


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

Basket Wonders Balance


Sheet (Asset Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2003a
Cash and C.E.
$ 90
a. How the firm stands on
Acct. Rec.c
394
a specific date.
Inventories 696 Prepaid Exp d b. What BW owned.
5 Accum Tax Prepay c. Amounts owed by
10
customers.
Current Assetse
d. Future expense items
f
$1,195 Fixed Assets (@Cost)
already paid.
g
1030 Less: Acc. Depr.
e. Cash/likely convertible
(329) Net Fix. Assets $ 701
to cash within 1 year.
Investment, LT
50 Other
Assets, LT
223 Total f. Original amount paid.
g. Acc. deductions for
b
Assets
$2,169
wear and tear.
6-6

Basket Wonders Balance


Sheet (Liability Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2003
Notes Payable
$ 290 a. Note, Assets =
Liabilities + Equity.
Acct. Payablec
94
Accrued Taxes d
16 Other b. What BW owed and
ownership position.
Accrued Liab. d
100
Current Liab. e $ 500 c. Owed to suppliers for
goods and services.
Long-Term Debt f 530
Shareholders Equity
d. Unpaid wages, salaries,
etc.
Com. Stock ($1 par) g
200
Add Pd in Capital g 729
e. Debts payable < 1 year.
Retained Earnings h
210 f. Debts payable > 1 year.
Total Equity
$1,139 g. Original investment.
a,b $2,169
h. Earnings reinvested.
6-7 Total Liab/Equity

Basket Wonders
Income Statement
Basket Wonders Statement of Earnings (in thousands)
for Year Ending December 31, 2003a
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
6-8

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

1. Analysis of the funds


needs of the firm.

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
6-9

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.

6-10

Financial Ratios
1.
2.
3.
4.

Individually
Over time
In combination
In comparison

Framework for
Financial Analysis

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.

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

6-11

Framework for
Financial Analysis

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.

6-12

Determining
the
financing
needs of
the firm.

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

Framework for
Financial Analysis

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.

6-13

Determining
the
financing
needs of
the firm.

Negotiations
with
suppliers of
capital.

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.
6-14

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.
6-15

Examples:
Robert Morris
Associates
Dun & Bradstreet
Almanac of
Business and
Industrial
Financial Ratios

Liquidity Ratios
Balance Sheet Ratios

Current

Liquidity Ratios

Current Assets
Current Liabilities

Shows a firms ability


to cover its current
liabilities with its
current assets.
6-16

For Basket Wonders


December 31, 2003
$1,195 = 2.39
$500

Liquidity Ratio
Comparisons
Current Ratio
Year

BW

Industry

2003

2.39

2.15

2002

2.26

2.09

2001

1.91

2.01

Ratio is stronger than the industry average.


6-17

Liquidity Ratios
Balance Sheet Ratios

Acid-Test (Quick)

Liquidity Ratios

Current Assets - Inv


Current Liabilities

Shows a firms
ability to meet
current liabilities
with its most liquid
assets.
6-18

For Basket Wonders


December 31, 2003
$1,195 - $696 = 1.00
$500

Liquidity Ratio
Comparisons
Acid-Test Ratio
Year

BW

Industry

2003

1.00

1.25

2002

1.04

1.23

2001

1.11

1.25

Ratio is weaker than the industry average.


6-19

Summary of the Liquidity


Ratio Comparisons
Ratio
BW
Current
2.39
Acid-Test1.00

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.

6-20

Current Ratio -- Trend


Analysis Comparison
Trend Analysis of Current Ratio

Ratio Value

2.5
2.3
2.1
1.9
1.7
1.5
2001
6-21

BW
Industry

2002
Analysis Year

2003

Acid-Test Ratio -- Trend


Analysis Comparison
Trend Analysis of Acid-Test Ratio

Ratio Value

1.5
1.3

0.8
0.5
2001

6-22

BW
Industry

1.0

2002
Analysis Year

2003

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.
BW

6-23

Financial Leverage Ratios


Balance Sheet Ratios
Financial Leverage
Ratios

Shows the extent to


which the firm is
financed by debt.
6-24

Debt-to-Equity
Total Debt
Shareholders Equity
For Basket Wonders
December 31, 2003
$1,030 = .90
$1,139

Financial Leverage
Ratio Comparisons
Debt-to-Equity Ratio

6-25

Year

BW

Industry

2003

.90

.90

2002

.88

.90

2001

.81

.89

BW has average debt utilization


relative to the industry average.

Financial Leverage Ratios


Balance Sheet Ratios
Financial Leverage
Ratios

Shows the percentage


of the firms assets
that are supported by
debt financing.
6-26

Debt-to-Total-Assets
Total Debt
Total Assets
For Basket Wonders
December 31, 2003
$1,030 = .47
$2,169

Financial Leverage
Ratio Comparisons
Debt-to-Total-Asset Ratio

6-27

Year

BW

Industry

2003

.47

.47

2002

.47

.47

2001

.45

.47

BW has average debt utilization


relative to the industry average.

Financial Leverage Ratios


Balance Sheet Ratios

Total Capitalization

Financial Leverage
Ratios

Total Debt
Total Capitalization

Shows the relative


importance of long-term
debt to the long-term
financing of the firm.
6-28

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

For Basket Wonders


December 31, 2003

$1,030 = .62
$1,669

Financial Leverage
Ratio Comparisons
Total Capitalization Ratio
Year

BW

Industry

2003

.62

.60

2002

.62

.61

2001

.67

.62

BW has average long-term debt utilization


relative to the industry average.
6-29

Coverage Ratios
Income Statement
Ratios
Coverage Ratios

Indicates a firms
ability to cover
interest charges.
6-30

Interest Coverage
EBIT
Interest Charges
For Basket Wonders
December 31, 2003
$210 = 3.56
$59

Coverage
Ratio Comparisons
Interest Coverage Ratio
Year

BW

Industry

2003

3.56

5.19

2002

4.35

5.02

2001

10.30

4.66

BW has below average interest coverage


relative to the industry average.
6-31

Coverage Ratio -- Trend


Analysis Comparison
Trend Analysis of Interest Coverage Ratio

Ratio Value

11.0
9.0
7.0

BW
Industry

5.0
3.0
2001

2002
Analysis Year

6-32

2003

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.

This indicates that low earnings (EBIT)


may be a potential problem for BW.
BW

Note, we know that debt levels are in


line with the industry averages.

6-33

Activity Ratios
Income Statement /
Balance Sheet
Ratios
Activity Ratios
Indicates quality of
receivables and how
successful the firm is in
its collections.
6-34

Receivable Turnover
(Assume all sales are credit sales.)

Annual Net Credit Sales


Receivables
For Basket Wonders
December 31, 2003
$2,211 = 5.61
$394

Activity Ratios
Income Statement /
Balance Sheet
Ratios

Avg Collection Period

Activity Ratios

For Basket Wonders


December 31, 2003

Average number of days


that receivables are
outstanding.
(or RT in days)
6-35

Days in the Year


Receivable Turnover

365
5.61

= 65 days

Activity
Ratio Comparisons
Average Collection Period
Year

BW

Industry

2003

65.0

65.7

2002

71.1

66.3

2001

83.6

69.2

BW has improved the average collection


period to that of the industry average.
6-36

Activity Ratios
Income Statement /
Balance Sheet
Ratios
Activity Ratios
Indicates the
promptness of payment
to suppliers by the firm.
6-37

Payable Turnover (PT)


(Assume annual credit
purchases = $1,551.)

Annual Credit Purchases


Accounts Payable
For Basket Wonders
December 31, 2003
$1551
= 16.5
$94

Activity Ratios
Income Statement /
Balance Sheet
Ratios
Activity Ratios
Average number of days
that payables are
outstanding.
6-38

PT in Days
Days in the Year
Payable Turnover
For Basket Wonders
December 31, 2003
365
16.5

= 22.1 days

Activity
Ratio Comparisons
Payable Turnover in Days
Year

BW

Industry

2003

22.1

46.7

2002

25.4

51.1

2001

43.5

48.5

BW has improved the PT in Days.


6-39

Is this good?

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

6-40

Inventory Turnover
Cost of Goods Sold
Inventory
For Basket Wonders
December 31, 2003
$1,599 = 2.30
$696

Activity
Ratio Comparisons
Inventory Turnover Ratio
Year

BW

Industry

2003

2.30

3.45

2002

2.44

3.76

2001

2.64

3.69

BW has a very poor inventory turnover ratio.


6-41

Inventory Turnover Ratio


--Trend Analysis
Comparison

Trend Analysis of Inventory Turnover Ratio

Ratio Value

4.0
3.5
3.0

BW
Industry

2.5
2.0
2001

2002
Analysis Year

6-42

2003

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

6-43

Total Asset Turnover


Net Sales
Total Assets
For Basket Wonders
December 31, 2003
$2,211 = 1.02
$2,169

Activity
Ratio Comparisons
Total Asset Turnover Ratio
Year

BW

Industry

2003

1.02

1.17

2002

1.03

1.14

2001

1.01

1.13

BW has a weak total asset turnover ratio.


6-44

Why is this ratio considered weak?

Profitability Ratios
Income Statement /
Balance Sheet
Ratios
Profitability Ratios
Indicates the efficiency
of operations and firm
pricing policies.
6-45

Gross Profit Margin


Gross Profit
Net Sales
For Basket Wonders
December 31, 2003
$612 = .277
$2,211

Profitability
Ratio Comparisons
Gross Profit Margin
Year

BW

Industry

2003

27.7%

31.1%

2002

28.7

30.8

2001

31.3

27.6

BW has a weak Gross Profit Margin.


6-46

Gross Profit Margin -Trend Analysis Comparison


Trend Analysis of Gross Profit Margin
Ratio Value (%)

35.0
32.5
30.0

BW
Industry

27.5
25.0
2001

2002
Analysis Year

6-47

2003

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

6-48

Net Profit Margin


Net Profit after Taxes
Net Sales
For Basket Wonders
December 31, 2003
$91 = .041
$2,211

Profitability
Ratio Comparisons
Net Profit Margin
Year

BW

Industry

2003

4.1%

8.2%

2002

4.9

8.1

2001

9.0

7.6

BW has a poor Net Profit Margin.


6-49

Net Profit Margin -Trend Analysis Comparison


Trend Analysis of Net Profit Margin
Ratio Value (%)

10
9
8
7

BW
Industry

6
5
4
2001

2002
Analysis Year

6-50

2003

Profitability Ratios
Income Statement /
Balance Sheet
Ratios
Profitability Ratios
Indicates the profitability
on the assets of the firm
(after all expenses and
taxes).
6-51

Return on Investment
Net Profit after Taxes
Total Assets
For Basket Wonders
December 31, 2003
$91 = .042
$2,160

Profitability
Ratio Comparisons
Return on Investment
Year

BW

Industry

2003

4.2%

9.8%

2002

5.0

9.1

2001

9.1

10.8

BW has a poor Return on Investment.


6-52

Return on Investment
Trend Analysis Comparison
Trend Analysis of Return on Investment
Ratio Value (%)

12
10
8

BW
Industry

6
4
2001

2002
Analysis Year

6-53

2003

Profitability Ratios
Income Statement /
Balance Sheet
Ratios
Profitability Ratios
Indicates the profitability
to the shareholders of
the firm (after all
expenses and taxes).
6-54

Return on Equity
Net Profit after Taxes
Shareholders Equity
For Basket Wonders
December 31, 2003
$91 = .08
$1,139

Profitability
Ratio Comparisons
Return on Equity
Year

BW

Industry

2003

8.0%

17.9%

2002

9.4

17.2

2001

16.6

20.4

BW has a poor Return on Equity.


6-55

Return on Equity -Trend Analysis Comparison


Trend Analysis of Return on Equity
Ratio Value (%)

21.0
17.5
14.0

BW
Industry

10.5
7.0
2001

2002
Analysis Year

6-56

2003

Return on Investment and


the Du Pont Approach
Earning Power = Sales profitability X
Asset efficiency
ROI = Net profit margin X
Total asset turnover

ROI2003

= .041 x 1.02 = .042 or 4.2%

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


6-57

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

ROE2003

= .041 x 1.02 x 1.90 = .080

ROEIndustry = .082 x 1.17 x 1.88 = .179


6-58

Summary of the Profitability


Trend Analyses

The profitability ratios for BW have ALL


been falling since 2001. 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.
BW

Note, this result is consistent with the low


interest coverage ratio.

6-59

Summary of Ratio Analyses

6-60

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.

Common-size Analysis
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.
6-61

Basket Wonders Common


Size Balance Sheets
Regular (thousands of $)
Assets

2002

2003

2001

2002

2003

Cash
AR
Inv
Other CA

148
283
322
10

100
410
616
14

90
394
696
15

12.10
23.14
26.33
0.82

4.89
20.06
30.14
0.68

4.15
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
9.08

55.77
30.87
2.45
10.91

55.09
32.32
2.31
10.28

1,223

2,044

2,169

100.0

100.0

100.0

Tot Assets
6-62

2001

Common-Size (%)

Basket Wonders Common


Size Balance Sheets
Regular (thousands of $)
Liab+Equity

6-63

2001

2002

2003

Common-Size (%)
2001

2002

2003

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

14.43
4.60
0.78
4.89

13.37
4.33
0.74
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

23.05
24.44
52.51

Tot L+E

1,223

2,044

2,169

100.0

100.0

100.0

Basket Wonders Common


Size Income Statements
Regular (thousands of $)
2001
Net Sales
COGS

6-64

2002

2003

Common-Size (%)
2001

2002

2003

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
Adm.

386
180

605
383

612
402

31.3
14.6

28.7
18.2

27.7
18.2

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

EAT

112

103

91

9.1

4.9

4.1

Cash Div

50

50

50

4.0

2.4

2.3

Index Analyses
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.
6-65

Basket Wonders
Indexed Balance Sheets
Regular (thousands of $)
Assets

2002

2003

2001

2002

2003

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

67.6
144.9
191.3
140.0

60.8
139.2
216.1
150.0

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
100.0

149.4
180.8
inf.
200.9

156.6
200.9
inf.
200.9

1,223

2,044

2,169

100.0

167.1

177.4

Tot Assets
6-66

2001

Indexed (%)

Basket Wonders
Indexed Balance Sheets
Regular (thousands of $)
Liab+Equity

6-67

2001

2002

2003

Indexed (%)
2001

2002

2003

Note Pay
Acct Pay
Accr Tax
Other Accr

290
81
13
15

295
94
16
100

290
94
16
100

100.0
100.0
100.0
100.0

101.7
116.0
123.1
666.7

100.0
116.0
123.1
666.7

Tot CL
LT Debt
Equity

399
150
674

505
453
1,086

500
530
1,139

100.0
100.0
100.0

126.6
302.0
161.1

125.3
353.3
169.0

Tot L+E

1,223

2,044

2,169

100.0

167.1

177.4

Basket Wonders Indexed


Income Statements
Regular (thousands of $)
2001
Net Sales
COGS

6-68

2002

2003

Indexed (%)
2001

2002

2003

1,235
849

2,106
1,501

2,211
1,599

100.0
100.0

170.5
176.8

179.0
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

91.9

81.2

EAT

112

103

91

100.0

92.0

81.3

Cash Div

50

50

50

100.0

100.0

100.0