This document provides an overview of financial statement analysis. It discusses the different types of financial statements, including the balance sheet, income statement, and statement of cash flows. It also presents various ratios used in financial analysis to evaluate a firm's liquidity, leverage, coverage, activity, and profitability. These ratios are calculated for a sample company, Basket Wonders, and compared to industry averages. Trend analyses reveal declining coverage and inventory turnover ratios for Basket Wonders relative to peers. Overall, the document introduces key concepts in financial statement analysis using example ratios.

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.