Financial Statement Analysis

Financial Statements

A Possible Framework for Analysis

Ratio Analysis

Trend Analysis

Common-Size and Index Analysis

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.

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.

Primary Types of Financial Statements

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 (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 (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

Basket Wonders’ Income Statement

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 Expense               59      EBT f       $      151 Income Taxes                60   EATg     $        91 Cash Dividends               38     Increase in RE      $        53

Framework for Financial Analysis

Analytical Tools Used

Sources and Uses Statement

Statement of Cash Flows

Cash Budgets

Framework for Financial Analysis

Health of a Firm

Financial Ratios

  1.  Individually

  2.  Over time

  3.  In combination

  4.  In comparison

Framework for Financial Analysis

Examples:

Volatility in sales

Volatility in costs

Proximity to break-even point

Framework for Financial Analysis

A Financial Manager must consider all three jointly when determining the financing needs of the firm.

Framework for Financial Analysis

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.

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.”

Liquidity Ratios

Current

Current Assets

Current Liabilities

For Basket Wonders December 31, 2003

Shows a firm’s ability to cover its current liabilities with its current assets.

Liquidity Ratio Comparisons

BW      Industry

2.39  2.15

2.26  2.09

1.91  2.01

Liquidity Ratios

Acid-Test (Quick)

Current Assets - Inv

Current Liabilities

For Basket Wonders December 31, 2003

Shows a firm’s ability to meet current liabilities with its most liquid assets.

Liquidity Ratio Comparisons

BW      Industry

1.00  1.25

1.04  1.23

1.11  1.25

Summary of the Liquidity Ratio Comparisons

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

Current Ratio -- Trend Analysis Comparison

   

Acid-Test Ratio -- Trend Analysis Comparison

   

Summary of the Liquidity Trend Analyses

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.

Financial Leverage Ratios

Debt-to-Equity

Total Debt

Shareholders’ Equity

For Basket Wonders December 31, 2003

Shows the extent to which the firm is financed by debt.

Financial Leverage  
Ratio Comparisons

BW      Industry

 .90  .90

 .88  .90

 .81  .89

Financial Leverage Ratios

Debt-to-Total-Assets

Total Debt

Total Assets

For Basket Wonders December 31, 2003

Shows the percentage of the firm’s assets that are supported by debt financing.

Financial Leverage  
Ratio Comparisons

BW      Industry

 .47  .47

 .47  .47

 .45  .47

Financial Leverage Ratios

Total Capitalization

Total Debt

Total Capitalization

For Basket Wonders December 31, 2003

Shows the relative importance of long-term debt to the long-term financing of the firm.

Financial Leverage  
Ratio Comparisons

BW      Industry

 .62  .60

 .62  .61

 .67  .62

Coverage Ratios

Interest Coverage

EBIT

Interest Charges

For Basket Wonders December 31, 2003

Indicates a firm’s ability to cover interest charges.

Coverage 
Ratio Comparisons

  BW       Industry

  3.56  5.19

  4.35  5.02

10.30  4.66

Coverage Ratio -- Trend Analysis Comparison

   

Summary of the Coverage Trend Analysis

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.

Activity Ratios

Receivable Turnover

Annual Net Credit Sales

Receivables

For Basket Wonders December 31, 2003

Indicates quality of receivables and how successful the firm is in its collections.

Activity Ratios

Avg Collection Period

Days in the Year

Receivable Turnover

For Basket Wonders December 31, 2003

Average number of days that receivables are outstanding.

(or RT in days)

Activity 
Ratio Comparisons

BW      Industry

65.0  65.7

71.1  66.3

83.6  69.2

Activity Ratios

Payable Turnover (PT)

Annual Credit Purchases

Accounts Payable

For Basket Wonders December 31, 2003

Indicates the promptness of payment to suppliers by the firm.

Activity Ratios

PT in Days

Days in the Year

Payable Turnover

For Basket Wonders December 31, 2003

Average number of days that payables are outstanding.

Activity 
Ratio Comparisons

BW      Industry

22.1  46.7

25.4  51.1

43.5  48.5

Activity Ratios

Inventory Turnover

Cost of Goods Sold

Inventory

For Basket Wonders December 31, 2003

Indicates the effectiveness of the inventory management practices of the firm.

Activity 
Ratio Comparisons

BW      Industry

2.30  3.45

2.44  3.76

2.64  3.69

Inventory Turnover Ratio --Trend Analysis Comparison

   

Activity Ratios

Total Asset Turnover

Net Sales

Total Assets

For Basket Wonders December 31, 2003

Indicates the overall effectiveness of the firm in utilizing its assets to generate sales.

Activity 
Ratio Comparisons

BW      Industry

1.02  1.17

1.03  1.14

1.01  1.13

Profitability Ratios

Gross Profit Margin

Gross Profit

Net Sales

For Basket Wonders December 31, 2003

Indicates the efficiency of operations and firm pricing policies.

Profitability 
Ratio Comparisons

BW      Industry

27.7%  31.1%

28.7  30.8

31.3  27.6

Gross Profit Margin -- 
Trend Analysis Comparison

   

Profitability Ratios

Net Profit Margin

Net Profit after Taxes

Net Sales

For Basket Wonders December 31, 2003

Indicates the firm’s profitability after taking account of all expenses and income taxes.

Profitability  Ratio Comparisons

BW      Industry

4.1%  8.2%

4.9  8.1

9.0  7.6

Net Profit Margin -- 
Trend Analysis Comparison

   

Profitability Ratios

Return on Investment

Net Profit after Taxes

Total Assets

For Basket Wonders December 31, 2003

Indicates the profitability on the assets of the firm (after all expenses and taxes).

Profitability  Ratio Comparisons

BW      Industry

4.2%    9.8%

5.0    9.1

9.1  10.8

Return on Investment –
Trend Analysis Comparison

   

Profitability Ratios

Return on Equity

Net Profit after Taxes

Shareholders’ Equity

For Basket Wonders December 31, 2003

Indicates the profitability to the shareholders of the firm (after all expenses and taxes).

Profitability  Ratio Comparisons

 BW       Industry

  8.0%  17.9%

  9.4  17.2

16.6  20.4

Return on Equity -- 
Trend Analysis Comparison

   

Return on Investment and the Du Pont Approach

ROI2003      = .041 x 1.02 = .042 or 4.2%

ROIIndustry  = .082 x 1.17 = .098 or 9.8%

Return on Equity and
the Du Pont Approach

ROE2003      = .041 x 1.02 x 1.90 = .080

ROEIndustry  = .082 x 1.17 x 1.88 = .179

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.

Note, this result is consistent with the low interest coverage ratio.

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.

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.