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Analysis of financial statement

This document provides an overview of financial statement analysis for a company called Basket Wonders. It includes sample financial statements for Basket Wonders including a balance sheet and income statement. It then discusses various types of ratio analysis that can be used to analyze the financial statements including liquidity ratios, leverage ratios, coverage ratios, and activity/turnover ratios. It calculates these ratios for Basket Wonders and compares them to industry averages to identify areas of strength or weakness for the company. Key findings include potential issues with Basket Wonders' inventory levels and lower than average profitability.

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6-1 Chapter 6 Financial Statement Analysis
6-2 Financial Statement Analysis Financial Statements A Possible Framework for Analysis Ratio Analysis Trend Analysis Common-Size and Index Analysis
6-3 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.
6-4 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.
Balance Sheet 6-5 Primary Types of Financial Statements  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.
Basket Wonders Balance Sheet (thousands) Dec. 31, 19X3a 6-6 Basket Wonders’ Balance Sheet (Asset Side) 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 and C.E. $ 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, 19X3 6-7 Basket Wonders’ Balance Sheet (Liability Side) 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
6-8 Basket Wonders’ Income Statement Basket Wonders Statement of Earnings (in thousands) for Year Ending December 31, 19X3a a. Measures profitability over a time period. b. Received, or receivable, from customers. c. Sales comm., adv., officer’s 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
6-9 Framework for Financial Analysis 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?
6-10 Framework for Financial Analysis 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.
6-11 Framework for Financial Analysis 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.
6-12 Framework for Financial Analysis 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.
6-13 Framework for Financial Analysis Negotiations with suppliers of capital. 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.
6-14 Use of Financial Ratios Types of Comparisons Internal Comparisons External Comparisons A Financial Ratio is an index that relates two accounting numbers and is obtained by dividing one number by the other.
6-15 External Comparisons and Sources of Industry Ratios Examples: Robert Morris Associates Dun & Bradstreet Almanac of Business and Industrial Financial 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”.
Balance Sheet Ratios 6-16 Liquidity Ratios Current Current Assets Current Liabilities For Basket Wonders December 31, 19X3 Liquidity Ratios Shows a firm’s ability to cover its current liabilities with its current assets. $1,195 $500 = 2.39
6-17 Liquidity Ratio Comparisons BW Industry 2.39 2.15 2.26 2.09 1.91 2.01 Year 19X3 19X2 19X1 Current Ratio Ratio is stronger than the industry average.
Balance Sheet Ratios 6-18 Liquidity Ratios Acid-Test (Quick) Current Assets - Inv Current Liabilities For Basket Wonders December 31, 19X3 Liquidity Ratios Shows a firm’s ability to meet current liabilities with its most liquid assets. $1,195 - $696 $500 = 1.00
6-19 Liquidity Ratio Comparisons BW Industry 1.00 1.25 1.04 1.23 1.11 1.25 Year 19X3 19X2 19X1 Acid-Test Ratio Ratio is weaker than the industry average.
6-20 Summary of the Liquidity Ratio Comparisons Ratio BW Industry Current 2.39 2.15 Acid-Test1.00 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.
6-21 Current Ratio -- Trend Analysis Comparison Trend Analysis of Current Ratio 2.5 2.3 2.1 1.9 1.7 1.5 19X1 19X2 19X3 Analysis Year Ratio Value BW Industry
6-22 Acid-Test Ratio -- Trend Analysis Comparison Trend Analysis of Acid-Test Ratio 1.5 1.3 1.0 0.8 0.5 19X1 19X2 19X3 Analysis Year Ratio Value BW Industry
 The current ratio for BW has been rising 6-23 Summary of the Liquidity Trend Analyses 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.
Balance Sheet Ratios 6-24 Financial Leverage Ratios Debt-to-Equity Total Debt Shareholders’ Equity For Basket Wonders December 31, 19X3 Financial Leverage Ratios Show the extent to which the firm is financed by debt. $1,030 $1,139 = .90
6-25 Financial Leverage Ratio Comparisons Debt-to-Equity Ratio BW Industry .90 .90 .88 .90 .81 .89 Year 19X3 19X2 19X1 BW has average debt utilization relative to the industry average.
Balance Sheet Ratios 6-26 Financial Leverage Ratios Debt-to-Total-Assets Total Debt Total Assets For Basket Wonders Financial Leverage Ratios Show the percentage December 31, 19X3 of the firm’s assets that are supported by debt financing. $1,030 $2,169 = .47
6-27 Financial Leverage Ratio Comparisons Debt-to-Total-Asset Ratio BW Industry .47 .47 .47 .47 .45 .47 Year 19X3 19X2 19X1 BW has average debt utilization relative to the industry average.
Balance Sheet Ratios 6-28 Financial Leverage Ratios Total Capitalization (i.e., LT-Debt + Equity) Total Debt Total Capitalization For Basket Wonders December 31, 19X3 Financial Leverage Ratios Show the relative importance of long-term debt to the long-term financing of the firm. $1,030 $1,669 = .62
6-29 Financial Leverage Ratio Comparisons Total Capitalization Ratio BW Industry .62 .60 .62 .61 .67 .62 Year 19X3 19X2 19X1 BW has average long-term debt utilization relative to the industry average.
6-30 Coverage Ratios Interest Coverage EBIT Interest Charges For Basket Wonders Income Statement Ratios Coverage Ratios Indicates a firm’s December 31, 19X3 ability to cover interest charges. $210 $59 = 3.56
6-31 Coverage Ratio Comparisons Interest Coverage Ratio BW Industry 3.56 5.19 4.35 5.02 10.30 4.66 Year 19X3 19X2 19X1 BW has below average interest coverage relative to the industry average.
6-32 Coverage Ratio -- Trend Analysis Comparison Trend Analysis of Interest Coverage Ratio 11.0 9.0 7.0 5.0 3.0 19X1 19X2 19X3 Analysis Year Ratio Value BW Industry
 The interest coverage ratio for BW has 6-33 Summary of the Coverage Trend Analysis been falling since 19X1. It has been below industry averages for the past two years.  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.
Income Statement / 6-34 Activity Ratios Receivable Turnover (Assume all sales are credit sales.) Annual Net Credit Sales Receivables For Basket Wonders Balance Sheet Ratios Activity Ratios Indicates quality of December 31, 19X3 receivables and how successful the firm is in its collections. $2,211 $394 = 5.61
Income Statement / 6-35 Activity Ratios Avg Collection Period Days in the Year Receivable Turnover For Basket Wonders Balance Sheet Ratios Activity Ratios Average number of days December 31, 19X3 that receivables are outstanding. (or RT in days) 365 5.61 = 65 days
6-36 Activity Ratio Comparisons Average Collection Period BW Industry 65.0 65.7 71.1 66.3 83.6 69.2 Year 19X3 19X2 19X1 BW has improved the average collection period to that of the industry average.
Income Statement / 6-37 Activity Ratios Payable Turnover (PT) (Assume annual credit purchases = $1,551.) Annual Credit Purchases Accounts Payable For Basket Wonders December 31, 19X3 Balance Sheet Ratios Activity Ratios Indicates the promptness of payment to suppliers by the firm. $1551 $94 = 16.5
Income Statement / 6-38 Activity Ratios PT in Days Days in the Year Payable Turnover For Basket Wonders December 31, 19X3 Balance Sheet Ratios Activity Ratios Average number of days that payables are outstanding. 365 16.5 = 22.1 days
6-39 Activity Ratio Comparisons Payable Turnover in Days BW Industry 22.1 46.7 25.4 51.1 43.5 48.5 Year 19X3 19X2 19X1 BW has improved the PT in Days. Is this good?
Income Statement / 6-40 Activity Ratios Inventory Turnover Cost of Goods Sold Inventory For Basket Wonders December 31, 19X3 Balance Sheet Ratios Activity Ratios Indicates the effectiveness of the inventory management practices of the firm. $1,599 $696 = 2.30
6-41 Activity Ratio Comparisons Inventory Turnover Ratio BW Industry 2.30 3.45 2.44 3.76 2.64 3.69 Year 19X3 19X2 19X1 BW has a very poor inventory turnover ratio.
6-42 Inventory Turnover Ratio -- Trend Analysis Comparison Trend Analysis of Inventory Turnover Ratio 4.0 3.5 3.0 2.5 2.0 19X1 19X2 19X3 Analysis Year Ratio Value BW Industry
Income Statement / 6-43 Activity Ratios Total Asset Turnover Net Sales Total Assets For Basket Wonders December 31, 19X3 Balance Sheet Ratios Activity Ratios Indicates the overall effectiveness of the firm in utilizing its assets to generate sales. $2,211 $2,169 = 1.02
6-44 Activity Ratio Comparisons Total Asset Turnover Ratio BW Industry 1.02 1.17 1.03 1.14 1.01 1.13 Year 19X3 19X2 19X1 BW has a weak total asset turnover ratio. Why is this ratio considered weak?
Income Statement / Profitability Ratios 6-45 Profitability Ratios Gross Profit Margin Gross Profit Net Sales For Basket Wonders December 31, 19X3 Balance Sheet Ratios Indicates the efficiency of operations and firm pricing policies. $612 $2,211 = .277
6-46 Profitability Ratio Comparisons Gross Profit Margin BW Industry 27.7% 31.1% 28.7 30.8 31.3 27.6 Year 19X3 19X2 19X1 BW has a weak Gross Profit Margin.
6-47 Gross Profit Margin -- Trend Analysis Comparison Trend Analysis of Gross Profit Margin 35.0 32.5 30.0 27.5 25.0 19X1 19X2 19X3 Analysis Year Ratio Value (%) BW Industry
Income Statement / Profitability Ratios 6-48 Profitability Ratios Net Profit Margin Net Profit after Taxes Net Sales For Basket Wonders December 31, 19X3 Balance Sheet Ratios Indicates the firm’s profitability after taking account of all expenses and income taxes. $91 $2,211 = .041
6-49 Profitability Ratio Comparisons BW Industry 4.1% 8.2% 4.9 8.1 9.0 7.6 Year 19X3 19X2 19X1 Net Profit Margin BW has a poor Net Profit Margin.
6-50 Net Profit Margin -- Trend Analysis Comparison Trend Analysis of Net Profit Margin 10 9 8 7 6 5 4 19X1 19X2 19X3 Analysis Year Ratio Value (%) BW Industry
Income Statement / Profitability Ratios 6-51 Profitability Ratios Return on Investment Net Profit after Taxes Total Assets For Basket Wonders Balance Sheet Ratios Indicates the December 31, 19X3 profitability on the assets of the firm (after all expenses and taxes). $91 $2,160 = .042
6-52 Profitability Ratio Comparisons Return on Investment BW Industry 4.2% 9.8% 5.0 9.1 9.1 10.8 Year 19X3 19X2 19X1 BW has a poor Return on Investment.
6-53 Return on Investment -- Trend Analysis Comparison Trend Analysis of Return on Investment 12 10 8 6 4 19X1 19X2 19X3 Analysis Year Ratio Value (%) BW Industry
Income Statement / Profitability Ratios 6-54 Profitability Ratios Return on Equity Net Profit after Taxes Shareholders’ Equity For Basket Wonders Balance Sheet Ratios Indicates the profitability December 31, 19X3 to the shareholders of the firm (after all expenses and taxes). $91 $1,139 = .08
6-55 Profitability Ratio Comparisons BW Industry 8.0% 17.9% 9.4 17.2 16.6 20.4 Year 19X3 19X2 19X1 Return on Equity BW has a poor Return on Equity.
6-56 Return on Equity -- Trend Analysis Comparison Trend Analysis of Return on Equity 21.0 17.5 14.0 10.5 7.0 19X1 19X2 19X3 Analysis Year Ratio Value (%) BW Industry
6-57 Return on Investment and the Du Pont Approach Earning Power = Sales profitability X Asset efficiency ROI = Net profit margin X Total asset turnover ROI19X3 = .041 x 1.02 = .042 or 4.2% ROIIndustry = .082 x 1.17 = .098 or 9.8%
Equity Multiplier = 6-58 Return on Equity and the Du Pont Approach Return On Equity = Net profit margin X Total asset turnover X Equity Multiplier Total Assets Shareholders’ Equity ROE19X3 = .041 x 1.02 x 1.90 = .080 ROEIndustry = .082 x 1.17 x 1.88 = .179
6-59 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.
6-60 Summary of the Profitability Trend Analyses  The profitability ratios for BW have ALL been falling since 19X1. 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.
6-61 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.
6-62 Basket Wonders’ Common Size Balance Sheets Regular (thousands of $) Common-Size (%) Assets 19X1 19X2 19X3 19X1 19X2 19X3 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
6-63 Basket Wonders’ Common Size Balance Sheets Regular (thousands of $) Common-Size (%) Liab+Equity 19X1 19X2 19X3 19X1 19X2 19X3 Note Pay 290 295 290 23.71 14.43 13.37 Acct Pay 81 94 94 6.62 4.60 4.33 Accr Tax 13 16 16 1.06 0.78 0.74 Other Accr 15 100 100 1.23 4.89 4.61 Tot CL 399 505 500 32.62 24.71 23.05 LT Debt 150 453 530 12.26 22.16 24.44 Equity 674 1,086 1,139 55.11 53.13 52.51 Tot L+E 1,223 2,044 2,169 100.0 100.0 100.0
6-64 Basket Wonders’ Common Size Income Statements Regular (thousands of $) Common-Size (%) 19X1 19X2 19X3 19X1 19X2 19X3 Net Sales 1,235 2,106 2,211 100.0 100.0 100.0 COGS 849 1,501 1,599 68.7 71.3 72.3 Gross Profit 386 605 612 31.3 28.7 27.7 Adm. 180 383 402 14.6 18.2 18.2 EBIT 206 222 210 16.7 10.5 9.5 Int Exp 20 51 59 1.6 2.4 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
6-65 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.
6-66 Basket Wonders’ Indexed Balance Sheets Regular (thousands of $) Indexed (%) Assets 19X1 19X2 19X3 19X1 19X2 19X3 Cash 148 100 90 100.0 67.6 60.8 AR 283 410 394 100.0 144.9 139.2 Inv 322 616 696 100.0 191.3 216.1 Other CA 10 14 15 100.0 140.0 150.0 Tot CA 763 1,140 1,195 100.0 149.4 156.6 Net FA 349 631 701 100.0 180.8 200.9 LT Inv 0 50 50 100.0 inf. inf. Other LT 111 223 223 100.0 200.9 200.9 Tot Assets 1,223 2,044 2,169 100.0 167.1 177.4
6-67 Basket Wonders’ Indexed Balance Sheets Regular (thousands of $) Indexed (%) Liab+Equity 19X1 19X2 19X3 19X1 19X2 19X3 Note Pay 290 295 290 100.0 101.7 100.0 Acct Pay 81 94 94 100.0 116.0 116.0 Accr Tax 13 16 16 100.0 123.1 123.1 Other Accr 15 100 100 100.0 666.7 666.7 Tot CL 399 505 500 100.0 126.6 125.3 LT Debt 150 453 530 100.0 302.0 353.3 Equity 674 1,086 1,139 100.0 161.1 169.0 Tot L+E 1,223 2,044 2,169 100.0 167.1 177.4
6-68 Basket Wonders’ Indexed Income Statements Regular (thousands of $) Indexed (%) 19X1 19X2 19X3 19X1 19X2 19X3 Net Sales 1,235 2,106 2,211 100.0 170.5 179.0 COGS 849 1,501 1,599 100.0 176.8 188.3 Gross Profit 386 605 612 100.0 156.7 158.5 Adm. 180 383 402 100.0 212.8 223.3 EBIT 206 222 210 100.0 107.8 101.9 Int Exp 20 51 59 100.0 255.0 295.0 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

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Analysis of financial statement

  • 1.
    6-1 Chapter 6 Financial Statement Analysis
  • 2.
    6-2 Financial StatementAnalysis Financial Statements A Possible Framework for Analysis Ratio Analysis Trend Analysis Common-Size and Index Analysis
  • 3.
    6-3 Examples ofExternal 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.
    6-4 Examples ofInternal 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.
    Balance Sheet 6-5 Primary Types of Financial Statements  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.
    Basket Wonders BalanceSheet (thousands) Dec. 31, 19X3a 6-6 Basket Wonders’ Balance Sheet (Asset Side) 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 and C.E. $ 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
  • 7.
    Basket Wonders BalanceSheet (thousands) Dec. 31, 19X3 6-7 Basket Wonders’ Balance Sheet (Liability Side) 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
  • 8.
    6-8 Basket Wonders’ Income Statement Basket Wonders Statement of Earnings (in thousands) for Year Ending December 31, 19X3a a. Measures profitability over a time period. b. Received, or receivable, from customers. c. Sales comm., adv., officer’s 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
  • 9.
    6-9 Framework for Financial Analysis 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?
  • 10.
    6-10 Framework for Financial Analysis 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.
  • 11.
    6-11 Framework for Financial Analysis 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.
  • 12.
    6-12 Framework for Financial Analysis 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.
  • 13.
    6-13 Framework for Financial Analysis Negotiations with suppliers of capital. 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.
  • 14.
    6-14 Use ofFinancial Ratios Types of Comparisons Internal Comparisons External Comparisons A Financial Ratio is an index that relates two accounting numbers and is obtained by dividing one number by the other.
  • 15.
    6-15 External Comparisonsand Sources of Industry Ratios Examples: Robert Morris Associates Dun & Bradstreet Almanac of Business and Industrial Financial 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”.
  • 16.
    Balance Sheet Ratios 6-16 Liquidity Ratios Current Current Assets Current Liabilities For Basket Wonders December 31, 19X3 Liquidity Ratios Shows a firm’s ability to cover its current liabilities with its current assets. $1,195 $500 = 2.39
  • 17.
    6-17 Liquidity Ratio Comparisons BW Industry 2.39 2.15 2.26 2.09 1.91 2.01 Year 19X3 19X2 19X1 Current Ratio Ratio is stronger than the industry average.
  • 18.
    Balance Sheet Ratios 6-18 Liquidity Ratios Acid-Test (Quick) Current Assets - Inv Current Liabilities For Basket Wonders December 31, 19X3 Liquidity Ratios Shows a firm’s ability to meet current liabilities with its most liquid assets. $1,195 - $696 $500 = 1.00
  • 19.
    6-19 Liquidity Ratio Comparisons BW Industry 1.00 1.25 1.04 1.23 1.11 1.25 Year 19X3 19X2 19X1 Acid-Test Ratio Ratio is weaker than the industry average.
  • 20.
    6-20 Summary ofthe Liquidity Ratio Comparisons Ratio BW Industry Current 2.39 2.15 Acid-Test1.00 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.
  • 21.
    6-21 Current Ratio-- Trend Analysis Comparison Trend Analysis of Current Ratio 2.5 2.3 2.1 1.9 1.7 1.5 19X1 19X2 19X3 Analysis Year Ratio Value BW Industry
  • 22.
    6-22 Acid-Test Ratio-- Trend Analysis Comparison Trend Analysis of Acid-Test Ratio 1.5 1.3 1.0 0.8 0.5 19X1 19X2 19X3 Analysis Year Ratio Value BW Industry
  • 23.
     The currentratio for BW has been rising 6-23 Summary of the Liquidity Trend Analyses 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.
  • 24.
    Balance Sheet Ratios 6-24 Financial Leverage Ratios Debt-to-Equity Total Debt Shareholders’ Equity For Basket Wonders December 31, 19X3 Financial Leverage Ratios Show the extent to which the firm is financed by debt. $1,030 $1,139 = .90
  • 25.
    6-25 Financial Leverage Ratio Comparisons Debt-to-Equity Ratio BW Industry .90 .90 .88 .90 .81 .89 Year 19X3 19X2 19X1 BW has average debt utilization relative to the industry average.
  • 26.
    Balance Sheet Ratios 6-26 Financial Leverage Ratios Debt-to-Total-Assets Total Debt Total Assets For Basket Wonders Financial Leverage Ratios Show the percentage December 31, 19X3 of the firm’s assets that are supported by debt financing. $1,030 $2,169 = .47
  • 27.
    6-27 Financial Leverage Ratio Comparisons Debt-to-Total-Asset Ratio BW Industry .47 .47 .47 .47 .45 .47 Year 19X3 19X2 19X1 BW has average debt utilization relative to the industry average.
  • 28.
    Balance Sheet Ratios 6-28 Financial Leverage Ratios Total Capitalization (i.e., LT-Debt + Equity) Total Debt Total Capitalization For Basket Wonders December 31, 19X3 Financial Leverage Ratios Show the relative importance of long-term debt to the long-term financing of the firm. $1,030 $1,669 = .62
  • 29.
    6-29 Financial Leverage Ratio Comparisons Total Capitalization Ratio BW Industry .62 .60 .62 .61 .67 .62 Year 19X3 19X2 19X1 BW has average long-term debt utilization relative to the industry average.
  • 30.
    6-30 Coverage Ratios Interest Coverage EBIT Interest Charges For Basket Wonders Income Statement Ratios Coverage Ratios Indicates a firm’s December 31, 19X3 ability to cover interest charges. $210 $59 = 3.56
  • 31.
    6-31 Coverage RatioComparisons Interest Coverage Ratio BW Industry 3.56 5.19 4.35 5.02 10.30 4.66 Year 19X3 19X2 19X1 BW has below average interest coverage relative to the industry average.
  • 32.
    6-32 Coverage Ratio-- Trend Analysis Comparison Trend Analysis of Interest Coverage Ratio 11.0 9.0 7.0 5.0 3.0 19X1 19X2 19X3 Analysis Year Ratio Value BW Industry
  • 33.
     The interestcoverage ratio for BW has 6-33 Summary of the Coverage Trend Analysis been falling since 19X1. It has been below industry averages for the past two years.  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.
  • 34.
    Income Statement / 6-34 Activity Ratios Receivable Turnover (Assume all sales are credit sales.) Annual Net Credit Sales Receivables For Basket Wonders Balance Sheet Ratios Activity Ratios Indicates quality of December 31, 19X3 receivables and how successful the firm is in its collections. $2,211 $394 = 5.61
  • 35.
    Income Statement / 6-35 Activity Ratios Avg Collection Period Days in the Year Receivable Turnover For Basket Wonders Balance Sheet Ratios Activity Ratios Average number of days December 31, 19X3 that receivables are outstanding. (or RT in days) 365 5.61 = 65 days
  • 36.
    6-36 Activity RatioComparisons Average Collection Period BW Industry 65.0 65.7 71.1 66.3 83.6 69.2 Year 19X3 19X2 19X1 BW has improved the average collection period to that of the industry average.
  • 37.
    Income Statement / 6-37 Activity Ratios Payable Turnover (PT) (Assume annual credit purchases = $1,551.) Annual Credit Purchases Accounts Payable For Basket Wonders December 31, 19X3 Balance Sheet Ratios Activity Ratios Indicates the promptness of payment to suppliers by the firm. $1551 $94 = 16.5
  • 38.
    Income Statement / 6-38 Activity Ratios PT in Days Days in the Year Payable Turnover For Basket Wonders December 31, 19X3 Balance Sheet Ratios Activity Ratios Average number of days that payables are outstanding. 365 16.5 = 22.1 days
  • 39.
    6-39 Activity RatioComparisons Payable Turnover in Days BW Industry 22.1 46.7 25.4 51.1 43.5 48.5 Year 19X3 19X2 19X1 BW has improved the PT in Days. Is this good?
  • 40.
    Income Statement / 6-40 Activity Ratios Inventory Turnover Cost of Goods Sold Inventory For Basket Wonders December 31, 19X3 Balance Sheet Ratios Activity Ratios Indicates the effectiveness of the inventory management practices of the firm. $1,599 $696 = 2.30
  • 41.
    6-41 Activity RatioComparisons Inventory Turnover Ratio BW Industry 2.30 3.45 2.44 3.76 2.64 3.69 Year 19X3 19X2 19X1 BW has a very poor inventory turnover ratio.
  • 42.
    6-42 Inventory TurnoverRatio -- Trend Analysis Comparison Trend Analysis of Inventory Turnover Ratio 4.0 3.5 3.0 2.5 2.0 19X1 19X2 19X3 Analysis Year Ratio Value BW Industry
  • 43.
    Income Statement / 6-43 Activity Ratios Total Asset Turnover Net Sales Total Assets For Basket Wonders December 31, 19X3 Balance Sheet Ratios Activity Ratios Indicates the overall effectiveness of the firm in utilizing its assets to generate sales. $2,211 $2,169 = 1.02
  • 44.
    6-44 Activity RatioComparisons Total Asset Turnover Ratio BW Industry 1.02 1.17 1.03 1.14 1.01 1.13 Year 19X3 19X2 19X1 BW has a weak total asset turnover ratio. Why is this ratio considered weak?
  • 45.
    Income Statement / Profitability Ratios 6-45 Profitability Ratios Gross Profit Margin Gross Profit Net Sales For Basket Wonders December 31, 19X3 Balance Sheet Ratios Indicates the efficiency of operations and firm pricing policies. $612 $2,211 = .277
  • 46.
    6-46 Profitability RatioComparisons Gross Profit Margin BW Industry 27.7% 31.1% 28.7 30.8 31.3 27.6 Year 19X3 19X2 19X1 BW has a weak Gross Profit Margin.
  • 47.
    6-47 Gross ProfitMargin -- Trend Analysis Comparison Trend Analysis of Gross Profit Margin 35.0 32.5 30.0 27.5 25.0 19X1 19X2 19X3 Analysis Year Ratio Value (%) BW Industry
  • 48.
    Income Statement / Profitability Ratios 6-48 Profitability Ratios Net Profit Margin Net Profit after Taxes Net Sales For Basket Wonders December 31, 19X3 Balance Sheet Ratios Indicates the firm’s profitability after taking account of all expenses and income taxes. $91 $2,211 = .041
  • 49.
    6-49 Profitability RatioComparisons BW Industry 4.1% 8.2% 4.9 8.1 9.0 7.6 Year 19X3 19X2 19X1 Net Profit Margin BW has a poor Net Profit Margin.
  • 50.
    6-50 Net ProfitMargin -- Trend Analysis Comparison Trend Analysis of Net Profit Margin 10 9 8 7 6 5 4 19X1 19X2 19X3 Analysis Year Ratio Value (%) BW Industry
  • 51.
    Income Statement / Profitability Ratios 6-51 Profitability Ratios Return on Investment Net Profit after Taxes Total Assets For Basket Wonders Balance Sheet Ratios Indicates the December 31, 19X3 profitability on the assets of the firm (after all expenses and taxes). $91 $2,160 = .042
  • 52.
    6-52 Profitability RatioComparisons Return on Investment BW Industry 4.2% 9.8% 5.0 9.1 9.1 10.8 Year 19X3 19X2 19X1 BW has a poor Return on Investment.
  • 53.
    6-53 Return onInvestment -- Trend Analysis Comparison Trend Analysis of Return on Investment 12 10 8 6 4 19X1 19X2 19X3 Analysis Year Ratio Value (%) BW Industry
  • 54.
    Income Statement / Profitability Ratios 6-54 Profitability Ratios Return on Equity Net Profit after Taxes Shareholders’ Equity For Basket Wonders Balance Sheet Ratios Indicates the profitability December 31, 19X3 to the shareholders of the firm (after all expenses and taxes). $91 $1,139 = .08
  • 55.
    6-55 Profitability RatioComparisons BW Industry 8.0% 17.9% 9.4 17.2 16.6 20.4 Year 19X3 19X2 19X1 Return on Equity BW has a poor Return on Equity.
  • 56.
    6-56 Return onEquity -- Trend Analysis Comparison Trend Analysis of Return on Equity 21.0 17.5 14.0 10.5 7.0 19X1 19X2 19X3 Analysis Year Ratio Value (%) BW Industry
  • 57.
    6-57 Return onInvestment and the Du Pont Approach Earning Power = Sales profitability X Asset efficiency ROI = Net profit margin X Total asset turnover ROI19X3 = .041 x 1.02 = .042 or 4.2% ROIIndustry = .082 x 1.17 = .098 or 9.8%
  • 58.
    Equity Multiplier = 6-58 Return on Equity and the Du Pont Approach Return On Equity = Net profit margin X Total asset turnover X Equity Multiplier Total Assets Shareholders’ Equity ROE19X3 = .041 x 1.02 x 1.90 = .080 ROEIndustry = .082 x 1.17 x 1.88 = .179
  • 59.
    6-59 Summary ofRatio 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.
  • 60.
    6-60 Summary ofthe Profitability Trend Analyses  The profitability ratios for BW have ALL been falling since 19X1. 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.
  • 61.
    6-61 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.
  • 62.
    6-62 Basket Wonders’Common Size Balance Sheets Regular (thousands of $) Common-Size (%) Assets 19X1 19X2 19X3 19X1 19X2 19X3 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
  • 63.
    6-63 Basket Wonders’Common Size Balance Sheets Regular (thousands of $) Common-Size (%) Liab+Equity 19X1 19X2 19X3 19X1 19X2 19X3 Note Pay 290 295 290 23.71 14.43 13.37 Acct Pay 81 94 94 6.62 4.60 4.33 Accr Tax 13 16 16 1.06 0.78 0.74 Other Accr 15 100 100 1.23 4.89 4.61 Tot CL 399 505 500 32.62 24.71 23.05 LT Debt 150 453 530 12.26 22.16 24.44 Equity 674 1,086 1,139 55.11 53.13 52.51 Tot L+E 1,223 2,044 2,169 100.0 100.0 100.0
  • 64.
    6-64 Basket Wonders’Common Size Income Statements Regular (thousands of $) Common-Size (%) 19X1 19X2 19X3 19X1 19X2 19X3 Net Sales 1,235 2,106 2,211 100.0 100.0 100.0 COGS 849 1,501 1,599 68.7 71.3 72.3 Gross Profit 386 605 612 31.3 28.7 27.7 Adm. 180 383 402 14.6 18.2 18.2 EBIT 206 222 210 16.7 10.5 9.5 Int Exp 20 51 59 1.6 2.4 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
  • 65.
    6-65 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.
  • 66.
    6-66 Basket Wonders’Indexed Balance Sheets Regular (thousands of $) Indexed (%) Assets 19X1 19X2 19X3 19X1 19X2 19X3 Cash 148 100 90 100.0 67.6 60.8 AR 283 410 394 100.0 144.9 139.2 Inv 322 616 696 100.0 191.3 216.1 Other CA 10 14 15 100.0 140.0 150.0 Tot CA 763 1,140 1,195 100.0 149.4 156.6 Net FA 349 631 701 100.0 180.8 200.9 LT Inv 0 50 50 100.0 inf. inf. Other LT 111 223 223 100.0 200.9 200.9 Tot Assets 1,223 2,044 2,169 100.0 167.1 177.4
  • 67.
    6-67 Basket Wonders’Indexed Balance Sheets Regular (thousands of $) Indexed (%) Liab+Equity 19X1 19X2 19X3 19X1 19X2 19X3 Note Pay 290 295 290 100.0 101.7 100.0 Acct Pay 81 94 94 100.0 116.0 116.0 Accr Tax 13 16 16 100.0 123.1 123.1 Other Accr 15 100 100 100.0 666.7 666.7 Tot CL 399 505 500 100.0 126.6 125.3 LT Debt 150 453 530 100.0 302.0 353.3 Equity 674 1,086 1,139 100.0 161.1 169.0 Tot L+E 1,223 2,044 2,169 100.0 167.1 177.4
  • 68.
    6-68 Basket Wonders’Indexed Income Statements Regular (thousands of $) Indexed (%) 19X1 19X2 19X3 19X1 19X2 19X3 Net Sales 1,235 2,106 2,211 100.0 170.5 179.0 COGS 849 1,501 1,599 100.0 176.8 188.3 Gross Profit 386 605 612 100.0 156.7 158.5 Adm. 180 383 402 100.0 212.8 223.3 EBIT 206 222 210 100.0 107.8 101.9 Int Exp 20 51 59 100.0 255.0 295.0 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