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  • 1. 1 Chapter 6 Financial Statement Analysis
  • 2. 2 Financial Statement Analysis Financial Statements A Possible Framework for Analysis Ratio Analysis Trend Analysis Common-Size and Index Analysis
  • 3. 3 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.
  • 4. 4 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.
  • 5. 5 Primary Types of Financial Statements Balance Sheet A summary of a firm’s financial position on a given date that shows total assets = total liabilities + owners’ equity. Income Statement A summary of a firm’s revenues and expenses over a specified period, ending with net income or loss for the period.
  • 6. 6 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 b. What BW owned. Prepaid Exp d 5 c. Amounts owed by Accum Tax Prepay 10 customers. d. Future expense items Current Assets $1,195 already paid. Fixed Assets (@Cost)f 1030 e. Cash/likely convertible Less: Acc. Depr. g (329) to cash within 1 year. Net Fix. Assets $ 701 f. Original amount paid. Investment, LT 50 g. Acc. deductions for Other Assets, LT 223 wear and tear. b
  • 7. 7 Basket Wonders’ Balance Sheet (Liability Side) Basket Wonders Balance Sheet (thousands) Dec. 31, 2003 Notes Payable $ 290 a. Note, Assets = Acct. Payablec 94 Liabilities + Equity. Accrued Taxes d 16 b. What BW owed and Other Accrued Liab. d 100 ownership position. Current Liab. e $ c. Owed to suppliers for 500 Long-Term Debt f goods and services. 530 Shareholders’ d. Unpaid wages, Equity Com. Stock ($1 salaries, etc. par) g 200 Add Pd in Capital g e. Debts payable < 1 year. 729 Retained f. Debts payable > 1 year. h Earnings 210 Total g. Original investment. Equity $1,139 h. Earnings reinvested. a,b
  • 8. 8 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 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.
  • 9. 9 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
  • 10. 10 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
  • 11. 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. 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
  • 12. 12 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. Determining the financing needs of the firm. A Financial Manager must consider all three jointly when determining the financing needs of the firm.
  • 13. 13 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. Determining the financing needs of the firm. Negotiations with suppliers of capital.
  • 14. 14 Framework of financial analysis Greater the funds requirement the greater the total requirement if financing. Nature of the need influence the type of financing. Greater the business risk less desirable the debt financing is. Why equity financing is desirable in case of high business risk?
  • 15. 15 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
  • 16. 16 Liquidity ratios Liquidity of a firm is measured by its ability to satisfy its short term obligations as they come due. Liquidity refers the solvency of the firm’s overall financial position----------it means the ease with which it can pay its bills
  • 17. 17 Liquidity Ratios Balance Sheet Ratios Current Liquidity Ratios Current Assets Current Liabilities Liquidity ratios measure a firm’s ability to meet short term obligations. Current ratio: Shows a firm’s ability to cover its current liabilities with its current assets. For Basket Wonders December 31, 2003 $1,195 = 2.39 $500
  • 18. 18 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.
  • 19. 19 Liquidity Ratios Balance Sheet Ratios Acid-Test (Quick) Liquidity Ratios Current Assets - Inv Current Liabilities Acid-Test (Quick) Shows a firm’s ability to meet current liabilities with its most liquid assets. For Basket Wonders December 31, 2003 $1,195 - $696 = 1.00 $500
  • 20. 20 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.
  • 21. 21 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.
  • 22. 22 Quick (acid test )ratio This ratio is similar to current ratio except that it excludes inventory which is the least liquid asset current asset. Low liquidity of inventory results from two primary factors Many types of inventory cant be sold because of their partial completion, special purpose items etc. Inventory is sold on credit ,which means that it become an account receivable before being converted into cash.
  • 23. 23 Current Ratio -- Trend Analysis Comparison Trend Analysis of Current Ratio Ratio Value 2.5 2.3 2.1 BW Industry 1.9 1.7 1.5 2001 2002 Analysis Year 2003
  • 24. 24 Acid-Test Ratio -- Trend Analysis Comparison Trend Analysis of Acid-Test Ratio Ratio Value 1.5 1.3 BW Industry 1.0 0.8 0.5 2001 2002 Analysis Year 2003
  • 25. 25 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
  • 26. 26 Financial Leverage Ratios Balance Sheet Ratios Financial Leverage Ratios Shows the extent to which the firm is financed by debt. Debt-to-Equity Total Debt Shareholders’ Equity For Basket Wonders December 31, 2003 $1,030 = .90 $1,139
  • 27. 27 Debt ratio The ratio tells us that creditors are providing 90 cents of financing for each $1 being provided by shareholders. Creditors want this ratio to be low. The lower the ratio the higher the level of financing being provided by shareholders and the more margin of protection for creditors
  • 28. 28 Financial Leverage Ratio Comparisons Debt-to-Equity Ratio Year BW Industry 2003 .90 .90 2002 .88 .90 2001 .81 .89 BW has average debt utilization relative to the industry average.
  • 29. 29 Financial Leverage Ratios Balance Sheet Ratios Financial Leverage Ratios Shows the percentage of the firm’s assets that are supported by debt financing. Debt-to-Total-Assets Total Debt Total Assets For Basket Wonders December 31, 2003 $1,030 = .47 $2,169
  • 30. 30 Debt to total assets 47 percent of the firms assets are financed with debt and the remaining 53 percent of financing comes from shareholders equity. The higher this ratio the higher the financial risk.
  • 31. 31 Financial Leverage Ratio Comparisons Debt-to-Total-Asset Ratio Year BW Industry 2003 .47 .47 2002 .47 .47 2001 .45 .47 BW has average debt utilization relative to the industry average.
  • 32. 32 Financial Leverage Ratios Balance Sheet Ratios Financial Leverage Ratios Shows the relative importance of long-term debt to the long-term financing of the firm. Total Capitalization (i.e., LT-Debt + Equity) Total Debt Total Capitalization For Basket Wonders December 31, 2003 $1,030 = .62 $1,669
  • 33. 33 Total capitalization Total capitalization represents all long term debt and shareholders equity.
  • 34. 34 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.
  • 35. 35 Coverage Ratios Income Statement Ratios Coverage Ratios Indicates a firm’s ability to cover interest charges. Interest Coverage EBIT Interest Charges For Basket Wonders December 31, 2003 $210 = 3.56 $59
  • 36. 36 Coverage ratio This ratio serves as one measure of the firms ability to meet its interest payments and so avoid bankruptcy. The higher the ratio the greater the likelihood that the company could cover its interest payments without difficulty
  • 37. 37 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.
  • 38. 38 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 2003
  • 39. 39 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.
  • 40. 40 Activity Ratios Income Statement / Balance Sheet Ratios Activity Ratios Indicates quality of receivables and how successful the firm is in its collections. Receivable Turnover (Assume all sales are credit sales.) Annual Net Credit Sales Receivables For Basket Wonders December 31, 2003 $2,211 = 5.61 $394
  • 41. 41 Activity Ratios Income Statement / Balance Sheet Ratios Activity Ratios Average number of days that receivables are outstanding. (or RT in days) Avg Collection Period Days in the Year Receivable Turnover For Basket Wonders December 31, 2003 365 5.61 = 65 days
  • 42. 42 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.
  • 43. 43 Activity Ratios Income Statement / Balance Sheet Ratios Activity Ratios Indicates the promptness of payment to suppliers by the firm. Payable Turnover (PT) (Assume annual credit purchases = $1,551.) Annual Credit Purchases Accounts Payable For Basket Wonders December 31, 2003 $1551 = 16.5 $94
  • 44. 44 Activity Ratios Income Statement / Balance Sheet Ratios Activity Ratios Average number of days that payables are outstanding. PT in Days Days in the Year Payable Turnover For Basket Wonders December 31, 2003 365 16.5 = 22.1 days
  • 45. 45 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. Is this good?
  • 46. 46 Activity Ratios Income Statement / Balance Sheet Ratios Activity Ratios Indicates the effectiveness of the inventory management practices of the firm. Inventory Turnover Cost of Goods Sold Inventory For Basket Wonders December 31, 2003 $1,599 = 2.30 $696
  • 47. 47 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.
  • 48. 48 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 2003
  • 49. Activity Ratios Income Statement / Balance Sheet Ratios Activity Ratios Indicates the overall effectiveness of the firm in utilizing its assets to generate sales. 49 Total Asset Turnover Net Sales Total Assets For Basket Wonders December 31, 2003 $2,211 = 1.02 $2,169
  • 50. 50 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. Why is this ratio considered weak?
  • 51. 51 Profitability Ratios Income Statement / Balance Sheet Ratios Profitability Ratios Indicates the efficiency of operations and firm pricing policies. Gross Profit Margin Gross Profit Net Sales For Basket Wonders December 31, 2003 $612 = .277 $2,211
  • 52. 52 Profitability Ratio Comparisons Gross Profit Margin Year BW 2003 27.7% 31.1% 2002 28.7 30.8 2001 31.3 27.6 Industry BW has a weak Gross Profit Margin.
  • 53. 53 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 2003
  • 54. Profitability Ratios Income Statement / Balance Sheet Ratios Profitability Ratios Indicates the firm’s profitability after taking account of all expenses and income taxes. 54 Net Profit Margin Net Profit after Taxes Net Sales For Basket Wonders December 31, 2003 $91 = .041 $2,211
  • 55. 55 Profitability Ratio Comparisons Net Profit Margin Year BW 2003 4.1% 8.2% 2002 4.9 8.1 2001 9.0 7.6 Industry BW has a poor Net Profit Margin.
  • 56. 56 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 2003
  • 57. 57 Profitability Ratios Income Statement / Balance Sheet Ratios Profitability Ratios Indicates the profitability on the assets of the firm (after all expenses and taxes). Return on Investment Net Profit after Taxes Total Assets For Basket Wonders December 31, 2003 $91 = .042 $2,160
  • 58. 58 Profitability Ratio Comparisons Return on Investment Year BW 2003 4.2% 9.8% 2002 5.0 9.1 2001 9.1 10.8 Industry BW has a poor Return on Investment.
  • 59. 59 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 2003
  • 60. 60 Profitability Ratios Income Statement / Balance Sheet Ratios Profitability Ratios Indicates the profitability to the shareholders of the firm (after all expenses and taxes). Return on Equity Net Profit after Taxes Shareholders’ Equity For Basket Wonders December 31, 2003 $91 = .08 $1,139
  • 61. 61 Profitability Ratio Comparisons Return on Equity Year BW 2003 8.0% 17.9% 2002 9.4 17.2 2001 16.6 20.4 Industry BW has a poor Return on Equity.
  • 62. 62 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 2003
  • 63. 63 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.
  • 64. 64 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.
  • 65. 65 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.
  • 66. 66 Basket Wonders’ Common Size Balance Sheets Regular (thousands of $) Assets 2001 2002 2003 Common-Size (%) 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
  • 67. 67 Basket Wonders’ Common Size Balance Sheets Regular (thousands of $) Liab+Equity 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
  • 68. 68 Basket Wonders’ Common Size Income Statements Regular (thousands of $) 2001 Net Sales COGS 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
  • 69. 69 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.
  • 70. 70 Basket Wonders’ Indexed Balance Sheets Regular (thousands of $) Assets 2001 2002 2003 Indexed (%) 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
  • 71. 71 Basket Wonders’ Indexed Balance Sheets Regular (thousands of $) Liab+Equity 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
  • 72. 72 Basket Wonders’ Indexed Income Statements Regular (thousands of $) 2001 Net Sales COGS 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
  • 73. 73 Operating cycle The length of time from the commitment of cash for purchases until the collection of receivables resulting from the sale of goods or receivable. ITD+RTD
  • 74. 74 CASH CYCLE (ITD+RTD)-PTD The length of time from the actual outlay of cash for purchases until the collection of receivables resulting from the sale of goods or services.