financial statement analysis

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financial statement analysis

  1. 1. Chapter 6 Financial Statement Analysis 6.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  2. 2. After Studying Chapter 6, you should be able to: 1. Understand the purpose of basic financial statements and their contents. 2. Understand what is meant by “convergence” in accounting standards. 3. Explain why financial statement analysis is important to the firm and to outside suppliers of capital. 4. 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. 5. Define, calculate, and discuss a firm’s operating cycle and cash cycle. 6. Use ratios to analyze a firm's health and then recommend reasonable alternative courses of action to improve the health of the firm. 7. Analyze a firm’s return on investment (i.e., “earning power”) and return on equity using a DuPont approach. 8. Understand the limitations of financial ratio analysis. 9. Use trend analysis, common-size analysis, and index analysis to gain additional insights into a firm's performance. 6.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  3. 3. Financial Statement Analysis • • A Possible Framework for Analysis • Balance Sheet Ratios • Income Statement and Income/Balance Sheet Ratios • Trend Analysis • 6.3 Financial Statements Common-Size and Index Analysis Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  4. 4. 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. 6.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  5. 5. 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. 6.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  6. 6. Global Accounting Standards Convergence of Accounting Standards: Aims to Standards • narrow or remove differences so that investors can better understand financial statements prepared under different accounting frameworks • • IFRS – International Financial Reporting Standards (EU countries adopted) • US GAAP – US Generally Accepted Accounting Principles determined by FASB • 6.6 IASB – International Accounting Standards Board has the responsibility of IFRS FASB – Financial Accounting Standards Board determines accounting standards for financial statements Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  7. 7. 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 • 6.7 A summary of a firm’s revenues and expenses over a specified period, ending with net income or loss for the period. Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  8. 8. Basket Wonders’ Balance Sheet (Asset Side) Basket Wonders Balance Sheet (thousands) Dec. 31, 2007 a Cash Acct. Rec.c Inventories Prepaid Exp d Accum Tax Prepay 90 a. How the firm stands on 394 a specific date. 696 b. What BW owned. 5 c. Amounts owed by 10 customers. d. Future expense items Current Assetse $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. Total Assets b $2,169 6.8 $ Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  9. 9. Basket Wonders’ Balance Sheet (Liability Side) Basket Wonders Balance Sheet (thousands) Dec. 31, 2007 Notes Payable $ 290 Acct. Payablec 94 Accrued Taxes d 16 Other Accrued Liab. d 100 Current Liab. e $ 500 Long-Term Debt f 530 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 6.9 a. Note, Assets = Liabilities + Equity. b. What BW owed and ownership position. c. Owed to suppliers for goods and services. d. Unpaid wages, salaries, etc. e. Debts payable < 1 year. f. Debts payable > 1 year. g. Original investment. h. Earnings reinvested. Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  10. 10. Basket Wonders’ Income Statement Basket Wonders Statement of Earnings (in thousands) for Year Ending December 31, 2007a Net Sales $ 2,211 a. Measures profitability over a time period. Cost of Goods Sold b 1,599 Gross Profit $ 612 b. Received, or receivable, SG&A Expenses c 402 from customers. EBITd $ c. Sales comm., adv., 210 Interest Expensee officers’ salaries, etc. 59 EBT f $ d. Operating income. 151 Income Taxes 60 e. Cost of borrowed funds. EATg $ 91 f. Taxable income. Cash Dividends 38 g. Amount earned for Increase in RE $ 53 shareholders. 6.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  11. 11. 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 6.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  12. 12. 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. 6.12 Financial Ratios 1. 2. 3. 4. Individually Over time In combination In comparison Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  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. 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 6.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  14. 14. 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. 6.14 Determining the financing needs of the firm. A Financial Manager must consider all three jointly when determining the financing needs of the firm. Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  15. 15. 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. 6.15 Determining the financing needs of the firm. Negotiations with suppliers of capital. Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  16. 16. 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. 6.16 Types of Comparisons Internal Comparisons External Comparisons Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  17. 17. External Comparisons and Sources of Industry Ratios This involves comparing the ratios of one firm with those of similar firms or with industry averages. Examples: Risk Management Association Similarity is important as one should compare “apples to apples.” Almanac of Business and Industrial Financial Ratios 6.17 Dun & Bradstreet Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  18. 18. Liquidity Ratios Balance Sheet Ratios Current Liquidity Ratios Current Assets Current Liabilities Shows a firm’s ability to cover its current liabilities with its current assets. 6.18 For Basket Wonders December 31, 2007 $1,195 = 2.39 $500 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  19. 19. Liquidity Ratio Comparisons Current Ratio Year BW Industry 2007 2.39 2.15 2006 2.26 2.09 2005 1.91 2.01 Ratio is stronger than the industry average. 6.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  20. 20. Liquidity Ratios Balance Sheet Ratios Acid-Test (Quick) Liquidity Ratios Current Assets - Inv Current Liabilities Shows a firm’s ability to meet current liabilities with its most liquid assets. 6.20 For Basket Wonders December 31, 2007 $1,195 – $696 = 1.00 $500 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  21. 21. Liquidity Ratio Comparisons Acid-Test Ratio Year BW Industry 2007 1.00 1.25 2006 1.04 1.23 2005 1.11 1.25 Ratio is weaker than the industry average. 6.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  22. 22. 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. 6.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  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 2005 2006 2007 Analysis Year 6.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  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 2005 2006 2007 Analysis Year 6.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  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 6.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  26. 26. Financial Leverage Ratios Balance Sheet Ratios Financial Leverage Ratios Shows the extent to which the firm is financed by debt. 6.26 Debt-to-Equity Total Debt Shareholders’ Equity For Basket Wonders December 31, 2007 $1,030 = 0.90 $1,139 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  27. 27. Financial Leverage Ratio Comparisons Debt-to-Equity Ratio Year BW Industry 2007 0.90 0.90 2006 0.88 0.90 2005 0.81 0.89 BW has average debt utilization relative to the industry average. 6.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  28. 28. Financial Leverage Ratios Balance Sheet Ratios Financial Leverage Ratios Shows the percentage of the firm’s assets that are supported by debt financing. 6.28 Debt-to-Total-Assets Total Debt Total Assets For Basket Wonders December 31, 2007 $1,030 = 0.47 $2,169 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  29. 29. Financial Leverage Ratio Comparisons Debt-to-Total-Asset Ratio Year BW Industry 2007 0.47 0.47 2006 0.47 0.47 2005 0.45 0.47 BW has average debt utilization relative to the industry average. 6.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  30. 30. 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. 6.30 Total Capitalization (i.e., LT-Debt + Equity) Total Debt Total Capitalization For Basket Wonders December 31, 2007 $1,030 = 0.62 $1,669 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  31. 31. Financial Leverage Ratio Comparisons Total Capitalization Ratio Year BW Industry 2007 0.62 0.60 2006 0.62 0.61 2005 0.67 0.62 BW has average long-term debt utilization relative to the industry average. 6.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  32. 32. Coverage Ratios Income Statement Ratios Coverage Ratios Indicates a firm’s ability to cover interest charges. 6.32 Interest Coverage EBIT Interest Charges For Basket Wonders December 31, 2007 $210 = 3.56 $59 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  33. 33. Coverage Ratio Comparisons Interest Coverage Ratio Year BW Industry 2007 3.56 5.19 2006 4.35 5.02 2005 10.30 4.66 BW has below average interest coverage relative to the industry average. 6.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  34. 34. 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 2005 2006 2007 Analysis Year 6.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  35. 35. 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. BW • Note, we know that debt levels are in line with the industry averages. 6.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  36. 36. Activity Ratios Income Statement/ Balance Sheet Ratios Activity Ratios Indicates quality of receivables and how successful the firm is in its collections. 6.36 Receivable Turnover (Assume all sales are credit sales.) Annual Net Credit Sales Receivables For Basket Wonders December 31, 2007 $2,211 = 5.61 $394 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  37. 37. Activity Ratios Income Statement/ Balance Sheet Ratios Activity Ratios Average number of days that receivables are outstanding. (or RT in days) 6.37 Avg Collection Period Days in the Year Receivable Turnover For Basket Wonders December 31, 2007 365 5.61 = 65 days Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  38. 38. Activity Ratio Comparisons Average Collection Period Year BW Industry 2007 65.0 65.7 2006 71.1 66.3 2005 83.6 69.2 BW has improved the average collection period to that of the industry average. 6.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  39. 39. Activity Ratios Income Statement/ Balance Sheet Ratios Activity Ratios Indicates the promptness of payment to suppliers by the firm. 6.39 Payable Turnover (PT) (Assume annual credit purchases = $1,551.) Annual Credit Purchases Accounts Payable For Basket Wonders December 31, 2007 $1551 = 16.5 $94 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  40. 40. Activity Ratios Income Statement/ Balance Sheet Ratios Activity Ratios Average number of days that payables are outstanding. 6.40 PT in Days Days in the Year Payable Turnover For Basket Wonders December 31, 2007 365 16.5 = 22.1 days Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  41. 41. Activity Ratio Comparisons Payable Turnover in Days Year BW Industry 2007 22.1 46.7 2006 25.4 51.1 2005 43.5 48.5 BW has improved the PT in Days. Is this good? 6.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  42. 42. Activity Ratios Income Statement/ Balance Sheet Ratios Activity Ratios Indicates the effectiveness of the inventory management practices of the firm. 6.42 Inventory Turnover Cost of Goods Sold Inventory For Basket Wonders December 31, 2007 $1,599 = 2.30 $696 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  43. 43. Activity Ratio Comparisons Inventory Turnover Ratio Year BW Industry 2007 2.30 3.45 2006 2.44 3.76 2005 2.64 3.69 BW has a very poor inventory turnover ratio. 6.43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  44. 44. 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 2005 2006 2007 Analysis Year 6.44 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  45. 45. Activity Ratios Income Statement/ Balance Sheet Ratios Activity Ratios Indicates the overall effectiveness of the firm in utilizing its assets to generate sales. 6.45 Total Asset Turnover Net Sales Total Assets For Basket Wonders December 31, 2007 $2,211 = 1.02 $2,169 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  46. 46. Activity Ratio Comparisons Total Asset Turnover Ratio Year BW Industry 2007 1.02 1.17 2006 1.03 1.14 2005 1.01 1.13 BW has a weak total asset turnover ratio. Why is this ratio considered weak? 6.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  47. 47. Profitability Ratios Income Statement/ Balance Sheet Ratios Profitability Ratios Indicates the efficiency of operations and firm pricing policies. 6.47 Gross Profit Margin Gross Profit Net Sales For Basket Wonders December 31, 2007 $612 = 0.277 $2,211 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  48. 48. Profitability Ratio Comparisons Gross Profit Margin Year BW 2007 27.7% 31.1% 2006 28.7 30.8 2005 31.3 27.6 Industry BW has a weak Gross Profit Margin. 6.48 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  49. 49. 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 2005 2006 2007 Analysis Year 6.49 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  50. 50. Profitability Ratios Income Statement/ Balance Sheet Ratios Profitability Ratios Indicates the firm’s profitability after taking account of all expenses and income taxes. 6.50 Net Profit Margin Net Profit after Taxes Net Sales For Basket Wonders December 31, 2007 $91 = 0.041 $2,211 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  51. 51. Profitability Ratio Comparisons Net Profit Margin Year BW 2007 4.1% 8.2% 2006 4.9 8.1 2005 9.0 7.6 Industry BW has a poor Net Profit Margin. 6.51 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  52. 52. Net Profit Margin – Trend Analysis Comparison Trend Analysis of Net Profit Margin Ratio Value (%) 10 9 8 7 BW Industry 6 5 4 2005 2006 2007 Analysis Year 6.52 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  53. 53. Profitability Ratios Income Statement/ Balance Sheet Ratios Profitability Ratios Indicates the profitability on the assets of the firm (after all expenses and taxes). 6.53 Return on Investment Net Profit after Taxes Total Assets For Basket Wonders December 31, 2007 $91 = 0.042 $2,160 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  54. 54. Profitability Ratio Comparisons Return on Investment Year BW 2007 4.2% 9.6% 2006 5.0 9.1 2005 9.1 10.8 Industry BW has a poor Return on Investment. 6.54 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  55. 55. Return on Investment – Trend Analysis Comparison Trend Analysis of Return on Investment Ratio Value (%) 12 10 8 BW Industry 6 4 2005 2006 2007 Analysis Year 6.55 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  56. 56. Profitability Ratios Income Statement/ Balance Sheet Ratios Profitability Ratios Indicates the profitability to the shareholders of the firm (after all expenses and taxes). 6.56 Return on Equity Net Profit after Taxes Shareholders’ Equity For Basket Wonders December 31, 2007 $91 = 0.08 $1,139 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  57. 57. Profitability Ratio Comparisons Return on Equity Year BW 2007 8.0% 18.0% 2006 9.4 17.2 2005 16.6 20.4 Industry BW has a poor Return on Equity. 6.57 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  58. 58. 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 2005 2006 2007 Analysis Year 6.58 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  59. 59. Return on Investment and the Du Pont Approach Earning Power = Sales profitability × Asset efficiency ROI = Net profit margin × Total asset turnover ROI2007 = 0.041 × 1.02 = 0.042 or 4.2% ROIIndustry = 0.082 × 1.17 = 0.096 or 9.6% (Note: values are rounded) 6.59 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  60. 60. 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 = 0.041 × 1.02 × 1.90 = 0.080 ROEIndustry = 0.082 × 1.17 × 1.88 = 0.180 6.60 (Note: values are rounded) Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  61. 61. 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. BW • Note, this result is consistent with the low interest coverage ratio. 6.61 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  62. 62. Summary of Ratio Analyses • • May be paying off creditors (accounts payable) too soon. • COGS may be too high. • 6.62 Inventories are too high. Selling, general, and administrative costs may be too high. Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  63. 63. 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. 6.63 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  64. 64. Basket Wonders’ Common Size Balance Sheets Regular (thousands of $) Assets 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 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 6.64 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  65. 65. Basket Wonders’ CommonSize Balance Sheets Regular (thousands of $) Liab+Equity 2005 2006 2007 Common-Size (%) 2005 2006 2007 Note Pay Acct Pay Accr Tax Other Accr 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 6.65 290 81 13 15 1,223 2,044 2,169 100.0 100.0 100.0 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  66. 66. Basket Wonders’ CommonSize Income Statements Regular (thousands of $) 2005 Net Sales COGS 2006 2007 Common-Size (%) 2005 2006 2007 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 6.66 1,235 849 50 50 50 4.0 2.4 2.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  67. 67. 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. 6.67 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  68. 68. Basket Wonders’ Indexed Balance Sheets Regular (thousands of $) Assets 2005 2006 2007 Indexed (%) 2005 2006 2007 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 6.68 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  69. 69. Basket Wonders’ Indexed Balance Sheets Regular (thousands of $) Liab+Equity 2005 2006 2007 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 Note Pay Acct Pay Accr Tax Other Accr 290 81 13 15 295 94 16 100 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 Tot L+E 6.69 290 94 16 100 Indexed (%) 1,223 2,044 2,169 100.0 167.1 177.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  70. 70. Basket Wonders’ Indexed Income Statements Regular (thousands of $) 2005 Net Sales COGS 2006 2007 Indexed (%) 2005 2006 2007 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 6.70 1,235 849 50 50 50 100.0 100.0 100.0 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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