Youth Involvement in an Innovative Coconut Value Chain by Mwalimu Menza
Chapter 3 Financial statement analysis (3).ppt
1.
2. Financial and Management Accounting
Chapter 3
Financial Statement Analysis
Course leader : Million Gizaw (Assistant
professor)
3. Lecture objectives
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.
4. • 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
5. • 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
6. • 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
7. 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
8. 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 br. 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 Assetsb $2,169
BW Balance Sheet (thousands) Dec. 31, 2020a
BWs’ Balance Sheet
(Asset Side)
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.
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, 2020
BWs’ Balance Sheet
(Liability Side)
10. 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, 2020a
BW’ Income Statement
12. 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.”
External Comparisons and
Sources of Industry Ratios
13. Types of Ratios
Ratio can be classified as
Balance sheet ratios
Income statement/Balance sheet ratios
Additionally, we can further subdivide
financial ratios into five distinct types:
Liquidity ratio
Financial leverage (or debt) ratio
Coverage ratio
Activity ratio and
Profitability ratios.
14. Current
Current Assets
Current Liabilities
For BW’S December
31, 2020
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
15. BW Industry
2.39 2.15
2.26 2.09
1.91 2.01
Year
2020
2019
2018
Current Ratio
Ratio is stronger than the industry average.
Liquidity Ratio
Comparisons
16. Acid-Test (Quick)
Current Assets - Inv
Current Liabilities
For BW’S December
31, 2020
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
17. BW Industry
1.00 1.25
1.04 1.23
1.11 1.25
Year
2020
2019
2018
Acid-Test Ratio
Ratio is weaker than the industry average.
Liquidity Ratio
Comparisons
18. • 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
19. Trend Analysis of Current Ratio
1.5
1.7
1.9
2.1
2.3
2.5
2018 2019 2020
Analysis Year
Ratio
Value
BW
Industry
Current Ratio – Trend
Analysis Comparison
20. Trend Analysis of Acid-Test Ratio
0.5
0.8
1.0
1.3
1.5
2018 2019 2020
Analysis Year
Ratio
Value
BW
Industry
Acid-Test Ratio – Trend
Analysis Comparison
21. • 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
22. Debt-to-Equity
Total Debt
Shareholders’ Equity
For BW’S December
31, 2020
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
23. BW Industry
0.90 0.90
0.88 0.90
0.81 0.89
Year
2020
2019
2018
Debt-to-Equity Ratio
BW has average debt utilization
relative to the industry average.
Financial Leverage
Ratio Comparisons
24. Debt-to-Total-Assets
Total Debt
Total Assets
For BW’S December 31,
2020
Shows 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
25. BW Industry
0.47 0.47
0.47 0.47
0.45 0.47
Year
2020
2019
2018
Debt-to-Total-Asset Ratio
BW has average debt utilization
relative to the industry average.
Financial Leverage
Ratio Comparisons
26. Total Capitalization
Total Debt
Total Capitalization
For BW’S December 31,
2020
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
27. BW Industry
0.62 0.60
0.62 0.61
0.67 0.62
Year
2020
2019
2018
Total Capitalization Ratio
BW has average long-term debt utilization
relative to the industry average.
Financial Leverage
Ratio Comparisons
28. Interest Coverage
EBIT
Interest Charges
For BW’S December 31,
2020
Indicates a firm’s
ability to cover
interest charges.
Income Statement
Ratios
Coverage Ratios
$210
$59
= 3.56
Coverage Ratios
29. BW Industry
3.56 5.19
4.35 5.02
10.30 4.66
Year
2020
2019
2018
Interest Coverage Ratio
BW has below average interest coverage
relative to the industry average.
Coverage
Ratio Comparisons
30. Trend Analysis of Interest Coverage Ratio
3.0
5.0
7.0
9.0
11.0
2018 2019 2020
Analysis Year
Ratio
Value
BW
Industry
Coverage Ratio – Trend
Analysis Comparison
31. • 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 2018. It has been
below industry averages for the past
two years.
Summary of the Coverage
Trend Analysis
32. Receivable Turnover
Annual Net Credit Sales
Receivables
For BW’S December 31,
2020
Indicates 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
33. Avg Collection Period
Days in the Year
Receivable Turnover
For BW’S December 31,
2020
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
34. BW Industry
65.0 65.7
71.1 66.3
83.6 69.2
Year
2020
2019
2018
Average Collection Period
BW has improved the average collection
period to that of the industry average.
Activity
Ratio Comparisons
35. Payable Turnover (PT)
Annual Credit Purchases
Accounts Payable
For BW’S December 31,
2020
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
36. PT in Days
Days in the Year
Payable Turnover
For BW’S December 31,
2020
Average number of days
that payables are
outstanding.
Income Statement/
Balance Sheet
Ratios
Activity Ratios
365
16.5
= 22.1 days
Activity Ratios
37. BW Industry
22.1 46.7
25.4 51.1
43.5 48.5
Year
2020
2019
2018
Payable Turnover in Days
BW has improved the PT in Days.
Is this good?
Activity
Ratio Comparisons
38. Inventory Turnover
Cost of Goods Sold
Inventory
For BW’S December 31,
2020
Indicates the
effectiveness of the
inventory management
practices of the firm.
Income Statement/
Balance Sheet
Ratios
Activity Ratios
$1,599
$696
= 2.30
Activity Ratios
39. BW Industry
2.30 3.45
2.44 3.76
2.64 3.69
Year
2020
2019
2018
Inventory Turnover Ratio
BW has a very poor inventory turnover ratio.
Activity
Ratio Comparisons
40. Trend Analysis of Inventory Turnover Ratio
2.0
2.5
3.0
3.5
4.0
2018 2019 2020
Analysis Year
Ratio
Value
BW
Industry
Inventory Turnover Ratio –
Trend Analysis Comparison
41. Total Asset Turnover
Net Sales
Total Assets
For BWs December 31,
2020
Indicates 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
42. BW Industry
1.02 1.17
1.03 1.14
1.01 1.13
Year
2020
2019
2018
Total Asset Turnover Ratio
BW has a weak total asset turnover ratio.
Why is this ratio considered weak?
Activity
Ratio Comparisons
43. Gross Profit Margin
Gross Profit
Net Sales
For BW’S December 31,
2020
Indicates the efficiency
of operations and firm
pricing policies.
Income Statement/
Balance Sheet
Ratios
Profitability Ratios
$612
$2,211
= 0.277
Profitability Ratios
44. BW Industry
27.7% 31.1%
28.7 30.8
31.3 27.6
Year
2020
2019
2018
Gross Profit Margin
BW has a weak Gross Profit Margin.
Profitability
Ratio Comparisons
45. Trend Analysis of Gross Profit Margin
25.0
27.5
30.0
32.5
35.0
2018 2019 2020
Analysis Year
Ratio
Value
(%)
BW
Industry
Gross Profit Margin –
Trend Analysis Comparison
46. Net Profit Margin
Net Profit after Taxes
Net Sales
For BWs December 31,
2020
Indicates 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
47. BW Industry
4.1% 8.2%
4.9 8.1
9.0 7.6
Year
2020
2019
2018
Net Profit Margin
BW has a poor Net Profit Margin.
Profitability
Ratio Comparisons
48. Trend Analysis of Net Profit Margin
4
5
6
7
8
9
10
2018 2019 2020
Analysis Year
Ratio
Value
(%)
BW
Industry
Net Profit Margin –
Trend Analysis Comparison
49. Return on Investment
Net Profit after Taxes
Total Assets
For BW’S December 31,
2020
Indicates 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
50. BW Industry
4.2% 9.6%
5.0 9.1
9.1 10.8
Year
2020
2019
2018
Return on Investment
BW has a poor Return on Investment.
Profitability
Ratio Comparisons
51. Trend Analysis of Return on Investment
4
6
8
10
12
2018 2019 2020
Analysis Year
Ratio
Value
(%)
BW
Industry
Return on Investment –
Trend Analysis Comparison
52. Return on Equity
Net Profit after Taxes
Shareholders’ Equity
For BW’S December 31,
2020
Indicates 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
53. BW Industry
8.0% 18.0%
9.4 17.2
16.6 20.4
Year
2020
2019
2018
Return on Equity
BW has a poor Return on Equity.
Profitability
Ratio Comparisons
54. Trend Analysis of Return on Equity
7.0
10.5
14.0
17.5
21.0
2018 2019 2020
Analysis Year
Ratio
Value
(%)
BW
Industry
Return on Equity –
Trend Analysis Comparison
55. ROI2020 = 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
56. ROE2020 = 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
57. • The profitability ratios for BW have ALL
been falling since 2018. 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
58. 3-
Computing Market Value
Measures
Market Price = $25 per share
Shares outstanding = 200,000
PE Ratio = Price per share/Earnings per
share
25 / 0.445 = 56.2 times
Market-to-book ratio = market value per
share/book value per share
56.2 / (2,169,000 / 200,000) = 5.2 times
59. • 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
60. 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
64. 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.
Index Analyses
65. Regular (thousands of $) Indexed (%)
Assets 2018 2019 2020 2018 2019 2020
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
Basket Wonders’
Indexed Balance Sheets
