2. • Financial Statements
• A Possible Framework for Analysis
• Balance Sheet Ratios
• Income Statement and Income/Balance Sheet
Ratios
• Trend Analysis
• Common-Size and Index Analysis
Financial Statement Analysis
3. • 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.
Examples of External Uses of
Statement Analysis
4. • 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.
Examples of Internal Uses of
Statement Analysis
5. • Convergence of Accounting Standards: Aims to
narrow or remove differences so that investors can
better understand financial statements prepared under
different accounting frameworks
• IASB – International Accounting Standards Board has the
responsibility of IFRS
• IFRS – International Financial Reporting Standards (EU
countries adopted)
• US GAAP – US Generally Accepted Accounting Principles
determined by FASB
• FASB – Financial Accounting Standards Board determines
accounting standards for financial statements
Global Accounting Standards
6. Income Statement
• A summary of a firm’s revenues and
expenses over a specified period, ending with
net income or loss for the period.
Balance Sheet
• A summary of a firm’s financial position on a
given date that shows total assets = total liabilities
+ owners’ equity.
Primary Types of Financial Statements
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.
Cash $ 90
Acct. 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
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007a
Basket Wonders’ Balance Sheet (Asset Side)
8. 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.
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
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007
Basket Wonders’ Balance Sheet (Liability Side)
9. 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.
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
Basket Wonders Statement of Earnings (in thousands) for Year Ending December 31,
2007a
Basket Wonders’ Income Statement
10. Analytical Tools Used
Sources and Uses Statement
Statement of Cash Flows
Cash Budgets
1. Analysis of the funds
needs of the firm.
Trend/Seasonal Component
How much funding will be required in the future?
Is there a seasonal component?
Framework for Financial Analysis
11. Health of a Firm
Financial Ratios
1. Individually
2. Over time
3. In combination
4. In comparison
1. Analysis of the funds
needs of the firm.
2. Analysis of the financial
condition and profitability
of the firm.
Framework for Financial Analysis
12. Examples:
Volatility in sales
Volatility in costs
Proximity to break-even
point
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.
Framework for Financial Analysis
13. A Financial
Manager
must consider
all three
jointly when
determining
the financing
needs of the
firm.
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.
Framework for Financial Analysis
16. Current
Current Assets
Current Liabilities
For Basket Wonders
December 31, 2007
Shows a firm’s ability
to cover its current
liabilities with its
current assets.
Balance Sheet Ratios
Liquidity Ratios
$1,195
$500
= 2.39
Liquidity Ratios
17. BW Industry
2.39 2.15
2.26 2.09
1.91 2.01
Year
2007
2006
2005
Current Ratio
Ratio is stronger than the industry average.
Liquidity Ratio Comparisons
18. Acid-Test (Quick)
Current Assets - Inv
Current Liabilities
For Basket Wonders
December 31, 2007
Shows a firm’s ability
to meet current
liabilities with its most
liquid assets.
Balance Sheet Ratios
Liquidity Ratios
$1,195 – $696
$500
= 1.00
Liquidity Ratios
19. BW Industry
1.00 1.25
1.04 1.23
1.11 1.25
Year
2007
2006
2005
Acid-Test Ratio
Ratio is weaker than the industry average.
Liquidity Ratio Comparisons
20. • 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.
Ratio BW Industry
Current 2.39 2.15
Acid-Test 1.00 1.25
Summary of the Liquidity Ratio Comparisons
21. Trend Analysis of Current Ratio
1.5
1.7
1.9
2.1
2.3
2.5
2005 2006 2007
Analysis Year
RatioValue
BW
Industry
Current Ratio – Trend Analysis Comparison
22. Trend Analysis of Acid-Test Ratio
0.5
0.8
1.0
1.3
1.5
2005 2006 2007
Analysis Year
RatioValue
BW
Industry
Acid-Test Ratio – Trend Analysis Comparison
23. • 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.
• The current ratio for BW has been rising at the
same time the acid-test ratio has been
declining.
Summary of the Liquidity Trend Analyses
24. Debt-to-Equity
Total Debt
Shareholders’ Equity
For Basket Wonders
December 31, 2007
Shows the extent to
which the firm is
financed by debt.
Balance Sheet Ratios
Financial Leverage
Ratios
$1,030
$1,139
= 0.90
Financial Leverage Ratios
25. BW Industry
0.90 0.90
0.88 0.90
0.81 0.89
Year
2007
2006
2005
Debt-to-Equity Ratio
BW has average debt utilization
relative to the industry average.
Financial Leverage Ratio Comparisons
26. Debt-to-Total-Assets
Total Debt
Total Assets
For Basket Wonders
December 31, 2007Shows the percentage
of the firm’s assets that
are supported by debt
financing.
Balance Sheet Ratios
Financial Leverage
Ratios
$1,030
$2,169
= 0.47
Financial Leverage Ratios
27. BW Industry
0.47 0.47
0.47 0.47
0.45 0.47
Year
2007
2006
2005
Debt-to-Total-Asset Ratio
BW has average debt utilization
relative to the industry average.
Financial Leverage Ratio Comparisons
28. Total Capitalization
Total Debt
Total Capitalization
For Basket Wonders
December 31, 2007
Shows the relative
importance of long-term
debt to the long-term
financing of the firm.
Balance Sheet Ratios
Financial Leverage
Ratios
$1,030
$1,669
= 0.62
(i.e., LT-Debt + Equity)
Financial Leverage Ratios
29. BW Industry
0.62 0.60
0.62 0.61
0.67 0.62
Year
2007
2006
2005
Total Capitalization Ratio
BW has average long-term debt utilization
relative to the industry average.
Financial Leverage Ratio Comparisons
30. Interest Coverage
EBIT
Interest Charges
For Basket Wonders
December 31, 2007Indicates a firm’s
ability to cover interest
charges.
Income Statement
Ratios
Coverage Ratios
$210
$59
= 3.56
Coverage Ratios
31. BW Industry
3.56 5.19
4.35 5.02
10.30 4.66
Year
2007
2006
2005
Interest Coverage Ratio
BW has below average interest coverage
relative to the industry average.
Coverage Ratio Comparisons
32. Trend Analysis of Interest Coverage Ratio
3.0
5.0
7.0
9.0
11.0
2005 2006 2007
Analysis Year
RatioValue
BW
Industry
Coverage Ratio – Trend Analysis Comparison
33. • 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.
• The interest coverage ratio for BW has been
falling since 2005. It has been below industry
averages for the past two years.
Summary of the Coverage Trend Analysis
34. Receivable Turnover
Annual Net Credit Sales
Receivables
For Basket Wonders
December 31, 2007Indicates quality of
receivables and how
successful the firm is in its
collections.
Income Statement/
Balance Sheet
Ratios
Activity Ratios
$2,211
$394
= 5.61
(Assume all sales are credit sales.)
Activity Ratios
35. Avg Collection Period
Days in the Year
Receivable Turnover
For Basket Wonders December
31, 2007
Average number of days
that receivables are
outstanding.
(or RT in days)
Income Statement/
Balance Sheet
Ratios
Activity Ratios
365
5.61
= 65 days
Activity Ratios
36. BW Industry
65.0 65.7
71.1 66.3
83.6 69.2
Year
2007
2006
2005
Average Collection Period
BW has improved the average collection
period to that of the industry average.
Activity Ratio Comparisons
37. Payable Turnover (PT)
Annual Credit Purchases
Accounts Payable
For Basket Wonders
December 31, 2007
Indicates the promptness
of payment to suppliers by
the firm.
Income Statement/
Balance Sheet
Ratios
Activity Ratios
$1551
$94
= 16.5
(Assume annual credit
purchases = $1,551.)
Activity Ratios
38. PT in Days
Days in the Year
Payable Turnover
For Basket Wonders December
31, 2007
Average number of days
that payables are
outstanding.
Income Statement/
Balance Sheet
Ratios
Activity Ratios
365
16.5
= 22.1 days
Activity Ratios
39. BW Industry
22.1 46.7
25.4 51.1
43.5 48.5
Year
2007
2006
2005
Payable Turnover in Days
BW has improved the PT in Days.
Is this good?
Activity Ratio Comparisons
40. Inventory Turnover
Cost of Goods Sold
Inventory
For Basket Wonders December
31, 2007Indicates the
effectiveness of the
inventory management
practices of the firm.
Income Statement/
Balance Sheet
Ratios
Activity Ratios
$1,599
$696
= 2.30
Activity Ratios
41. Inventory Turnover
Cost of Goods Sold
Inventory
For Basket Wonders December
31, 2007Indicates the effectiveness
of the inventory
management practices of
the firm.
Income Statement/
Balance Sheet
Ratios
Activity Ratios
$1,599
$696
= 2.30
Activity Ratios
42. BW Industry
2.30 3.45
2.44 3.76
2.64 3.69
Year
2007
2006
2005
Inventory Turnover Ratio
BW has a very poor inventory turnover ratio.
Activity
Ratio Comparisons
43. Trend Analysis of Inventory Turnover Ratio
2.0
2.5
3.0
3.5
4.0
2005 2006 2007
Analysis Year
RatioValue
BW
Industry
Inventory Turnover Ratio –Trend
Analysis Comparison
44. Total Asset Turnover
Net Sales
Total Assets
For Basket Wonders December
31, 2007Indicates the overall
effectiveness of the firm in
utilizing its assets to
generate sales.
Income Statement/
Balance Sheet
Ratios
Activity Ratios
$2,211
$2,169
= 1.02
Activity Ratios
45. BW Industry
1.02 1.17
1.03 1.14
1.01 1.13
Year
2007
2006
2005
Total Asset Turnover Ratio
BW has a weak total asset turnover ratio.
Why is this ratio considered weak?
Activity
Ratio Comparisons
46. Gross Profit Margin
Gross Profit
Net Sales
For Basket Wonders December
31, 2007
Indicates the efficiency of
operations and firm pricing
policies.
Income Statement/
Balance Sheet
Ratios
Profitability Ratios
$612
$2,211
= 0.277
Profitability Ratios
47. BW Industry
27.7% 31.1%
28.7 30.8
31.3 27.6
Year
2007
2006
2005
Gross Profit Margin
BW has a weak Gross Profit Margin.
Profitability
Ratio Comparisons
48. Trend Analysis of Gross Profit Margin
25.0
27.5
30.0
32.5
35.0
2005 2006 2007
Analysis Year
RatioValue(%)
BW
Industry
Gross Profit Margin –
Trend Analysis Comparison
49. Net Profit Margin
Net Profit after Taxes
Net Sales
For Basket Wonders December
31, 2007Indicates the firm’s
profitability after taking
account of all expenses and
income taxes.
Income Statement/
Balance Sheet
Ratios
Profitability Ratios
$91
$2,211
= 0.041
Profitability Ratios
50. BW Industry
4.1% 8.2%
4.9 8.1
9.0 7.6
Year
2007
2006
2005
Net Profit Margin
BW has a poor Net Profit Margin.
Profitability Ratio
Comparisons
51. Trend Analysis of Net Profit Margin
4
5
6
7
8
9
10
2005 2006 2007
Analysis Year
RatioValue(%)
BW
Industry
Net Profit Margin –
Trend Analysis Comparison
52. Return on Investment
Net Profit after Taxes
Total Assets
For Basket Wonders December
31, 2007Indicates the profitability on
the assets of the firm (after
all expenses and taxes).
Income Statement/
Balance Sheet
Ratios
Profitability Ratios
$91
$2,160
= 0.042
Profitability Ratios
53. BW Industry
4.2% 9.6%
5.0 9.1
9.1 10.8
Year
2007
2006
2005
Return on Investment
BW has a poor Return on Investment.
Profitability
Ratio Comparisons
54. Trend Analysis of Return on Investment
4
6
8
10
12
2005 2006 2007
Analysis Year
RatioValue(%)
BW
Industry
Return on Investment –
Trend Analysis Comparison
55. Return on Equity
Net Profit after Taxes
Shareholders’ Equity
For Basket Wonders December
31, 2007Indicates the profitability to
the shareholders of the firm
(after all expenses and
taxes).
Income Statement/
Balance Sheet
Ratios
Profitability Ratios
$91
$1,139
= 0.08
Profitability Ratios
56. BW Industry
8.0% 18.0%
9.4 17.2
16.6 20.4
Year
2007
2006
2005
Return on Equity
BW has a poor Return on Equity.
Profitability
Ratio Comparisons
57. Trend Analysis of Return on Equity
7.0
10.5
14.0
17.5
21.0
2005 2006 2007
Analysis Year
RatioValue(%)
BW
Industry
Return on Equity –
Trend Analysis Comparison
58. ROI2007 = 0.041 × 1.02 = 0.042 or 4.2%
ROIIndustry = 0.082 × 1.17 = 0.096 or 9.6%
(Note: values are rounded)
ROI = Net profit margin ×
Total asset turnover
Earning Power = Sales profitability ×
Asset efficiency
Return on Investment and the
Du Pont Approach
59. ROE2007 = 0.041 × 1.02 × 1.90 = 0.080
ROEIndustry = 0.082 × 1.17 × 1.88 = 0.180
(Note: values are rounded)
Return On Equity = Net profit margin X
Total asset turnover X
Equity Multiplier
Equity Multiplier =
Total Assets
Shareholders’ Equity
Return on Equity and
the Du Pont Approach
60. • 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.
Summary of the Profitability Trend
Analyses
61. • 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.
Summary of Ratio Analyses
62. 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.
Common-Size Analysis
63. Regular (thousands of $) Common-Size (%)
Assets 2005 2006 2007 2005 2006 2007
Cash 148 100 90 12.10 4.89 4.15
AR 283 410 394 23.14 20.06 18.17
Inv 322 616 696 26.33 30.14 32.09
Other CA 10 14 15 0.82 0.68 0.69
Tot CA 763 1,140 1,195 62.39 55.77 55.09
Net FA 349 631 701 28.54 30.87 32.32
LT Inv 0 50 50 0.00 2.45 2.31
Other LT 111 223 223 9.08 10.91 10.28
Tot Assets 1,223 2,044 2,169 100.0 100.0 100.0
Basket Wonders’ Common Size
Balance Sheets
