Chapter 6

Financial
Financial Statement
Statement
Analysis
Analysis
© Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
1
 After studying Chapter 6,
you should be able to:
 Understand the purpose of basic financial statements and their
contents.
 Explain why financial statement analysis is important to the firm and
to outside suppliers of capital.
 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.
 Define, calculate, and discuss a firm’s operating cycle and cash cycle.
 Use ratios to analyze a firm's health and then recommend reasonable
alternative courses of action to improve the health of the firm.
 Analyze a firm’s return on investment (i.e., “earning power”) and
return on equity using a DuPont approach.
 Understand the limitations of financial ratio analysis.
 Use trend analysis, common-size analysis, and index analysis to gain
additional insights into a firm's performance.

2
 Financial
Financial
Statement
Statement Analysis
Analysis
 Financial Statements
 A Possible Framework for Analysis
 Balance Sheet Ratios
 Income Statement and Income
Statement/Balance Sheet Ratios
 Trend Analysis
 Common-Size and Index Analysis
3
 Examples
Examples of
of External
External Uses
Uses
of
of Statement
Statement Analysis
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
 Examples
Examples of
of Internal
Internal Uses
Uses
of
of Statement
Statement Analysis
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
 Primary
Primary Types
Types of
of
Financial
Financial Statements
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
 Basket
Basket Wonders’
Wonders’ Balance
Balance
Sheet
Sheet (Asset
(Asset Side)
Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007a
Cash and C.E. $ 90 a. How the firm stands on
Acct. Rec.c 394 a specific date.
Inventories 696 Prepaid Exp d b. What BW owned.
5 Accum Tax Prepay c. Amounts owed by
10 customers.
Current Assetse d. Future expense items
$1,195 Fixed Assets (@Cost) f
already paid.
1030 Less: Acc. Depr. g
e. Cash/likely convertible
(329) Net Fix. Assets $ 701
to cash within 1 year.
Investment, LT 50 Other
Assets, LT 223 Total f. Original amount paid.
Assets b $2,169 g. Acc. deductions for
7 wear and tear.
 Basket
Basket Wonders’
Wonders’ Balance
Balance
Sheet
Sheet (Liability
(Liability Side)
Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007
Notes Payable $ 290 a. Note, Assets =
Acct. Payablec 94 Liabilities + Equity.
Accrued Taxes d 16 Other b. What BW owed and
Accrued Liab. d 100 ownership position.
Current Liab. e $ 500 c. Owed to suppliers for
Long-Term Debt f 530 goods and services.
Shareholders’ Equity d. Unpaid wages, salaries,
Com. Stock ($1 par) g 200 etc.
Add Pd in Capital g 729 e. Debts payable < 1 year.
Retained Earnings h 210 f. Debts payable > 1 year.
Total Equity $1,139 g. Original investment.
8 Total Liab/Equitya,b $2,169 h. Earnings reinvested.
 Basket
Basket Wonders’
Wonders’
Income
Income Statement
Statement
Basket Wonders Statement of Earnings (in thousands)
for Year Ending December 31, 2007a
Net Sales $ 2,211 Cost of a. Measures profitability
Goods Sold b 1,599 over a time period.
Gross Profit $ 612 SG&A b. Received, or receivable,
Expenses c 402 from customers.
EBITd $ 210 c. Sales comm., adv.,
Interest Expensee 59 officers’ salaries, etc.
EBT f $ 151 Income d. Operating income.
Taxes 60 EATg $ e. Cost of borrowed funds.
91 Cash Dividends f. Taxable income.
38 Increase in RE $ g. Amount earned for
53
9 shareholders.
 Framework
Framework for
for
Financial
Financial Analysis
Analysis
Trend / Seasonal Component
How much funding will be
required in the future?
1. Analysis of the funds
needs of the firm. Is there a seasonal
component?

Analytical Tools Used

Sources and Uses Statement
Statement of Cash Flows
Cash Budgets
10
 Framework
Framework for
for
Financial
Financial Analysis
Analysis
Health of a Firm

1. Analysis of the funds

needs of the firm.
Financial Ratios
2. Analysis of the financial
condition and profitability 1. Individually
of the firm. 2. Over time
3. In combination
4. In comparison

11
 Framework
Framework for
for
Financial
Financial Analysis
Analysis

Business risk relates to

the risk inherent in the
1. Analysis of the funds
needs of the firm.
operations of the firm.
2. Analysis of the financial Examples:
condition and profitability
of the firm. Volatility in sales
3. Analysis of the business
risk of the firm. Volatility in costs
Proximity to break-even
point
12
 Framework
Framework for
for
Financial
Financial Analysis
Analysis
A Financial
Manager
must
1. Analysis of the funds
needs of the firm. Determining consider all
2. Analysis of the financial
the three jointly
financing
condition and profitability
needs of
when
of the firm. determining
the firm.
3. Analysis of the business
risk of the firm.
the
financing
needs of the
13 firm.
 Framework
Framework for
for
Financial
Financial Analysis
Analysis

1. Analysis of the funds

needs of the firm. Determining Negotiations
the
2. Analysis of the financial with
financing
condition and profitability suppliers of
needs of
of the firm. capital.
the firm.
3. Analysis of the business
risk of the firm.

14
 Use
Use of
of Financial
Financial Ratios
Ratios

A Financial Ratio is Types of

an index that relates Comparisons
two accounting
numbers and is Internal
obtained by dividing Comparisons
one number by the External
other. Comparisons

15
 External
External Comparisons
Comparisons and
and
Sources
Sources of
of Industry
Industry Ratios
Ratios
This involves Examples:
comparing the ratios Risk Management
of one firm with those Association
of similar firms or with
industry averages. Dun & Bradstreet
Almanac of
Similarity is important Business and
as one should Industrial
compare “apples to Financial Ratios
16
apples.”
 Liquidity
Liquidity Ratios
Ratios
Balance Sheet Ratios Current

Current Assets
Liquidity Ratios
Current Liabilities

Shows a firm’s ability For Basket Wonders

to cover its current December 31, 2007
liabilities with its
current assets. $1,195 = 2.39
$500
17
 Liquidity
Liquidity Ratio
Ratio
Comparisons
Comparisons
Current Ratio
Year BW Industry
2007 2.39 2.15
2006 2.26 2.09
2005 1.91 2.01
Ratio is stronger than the industry average.
18
 Liquidity
Liquidity Ratios
Ratios
Balance Sheet Ratios Acid-Test (Quick)

Current Assets - Inv

Liquidity Ratios
Current Liabilities

Shows a firm’s For Basket Wonders

ability to meet December 31, 2007
current liabilities $1,195 - $696 = 1.00
with its most liquid $500
19
assets.
 Liquidity
Liquidity Ratio
Ratio
Comparisons
Comparisons
Acid-Test Ratio
Year BW Industry
2007 1.00 1.25
2006 1.04 1.23
2005 1.11 1.25
Ratio is weaker than the industry average.
20
 Summary
Summary of
of the
the Liquidity
Liquidity
Ratio
Ratio Comparisons
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
 Current
Current Ratio
Ratio --
-- Trend
Trend
Analysis
Analysis Comparison
Comparison

22
 Acid-Test
Acid-Test Ratio
Ratio --
-- Trend
Trend
Analysis
Analysis Comparison
Comparison

23
 Summary
Summary of
of the
the Liquidity
Liquidity
Trend
Trend Analyses
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
24
 Financial
Financial Leverage
Leverage Ratios
Ratios
Balance Sheet Ratios Debt-to-Equity

Total Debt
Financial Leverage
Shareholders’ Equity
Ratios
For Basket Wonders
December 31, 2007
Shows the extent to
which the firm is $1,030 = .90
financed by debt. $1,139
25
 Financial
Financial Leverage
Leverage
Ratio
Ratio Comparisons
Comparisons
Debt-to-Equity Ratio
Year BW Industry
2007 .90 .90
2006 .88 .90
2005 .81 .89
BW has average debt utilization
26
relative to the industry average.
 Financial
Financial Leverage
Leverage Ratios
Ratios
Balance Sheet Ratios Debt-to-Total-Assets

Total Debt
Financial Leverage
Total Assets
Ratios
For Basket Wonders
Shows the percentage December 31, 2007
of the firm’s assets
that are supported by $1,030 = .47
debt financing. $2,169
27
 Financial
Financial Leverage
Leverage
Ratio
Ratio Comparisons
Comparisons
Debt-to-Total-Asset Ratio
Year BW Industry
2007 .47 .47
2006 .47 .47
2005 .45 .47
BW has average debt utilization
28
relative to the industry average.
 Financial
Financial Leverage
Leverage Ratios
Ratios
Balance Sheet Ratios Total Capitalization
(i.e., LT-Debt + Equity)

Financial Leverage Long-term Debt

Ratios Total Capitalization

Shows the relative For Basket Wonders

importance of long-term December 31, 2007
debt to the long-term $530 = .32
financing of the firm. $1,669
29
 Financial
Financial Leverage
Leverage
Ratio
Ratio Comparisons
Comparisons
Total Capitalization Ratio
Year BW Industry
2007 .32 .30
2006 .32 .31
2005 .37 .32
BW has average long-term debt utilization
30
relative to the industry average.
 Coverage
Coverage Ratios
Ratios
Income Statement Interest Coverage
Ratios
EBIT
Interest Charges
Coverage Ratios
For Basket Wonders
Indicates a firm’s December 31, 2007
ability to cover
interest charges. $210 = 3.56
$59
31
 Coverage
Coverage
Ratio
Ratio Comparisons
Comparisons
Interest Coverage Ratio
Year BW Industry
2007 3.56 5.19
2006 4.35 5.02
2005 10.30 4.66
BW has below average interest coverage
32
relative to the industry average.
 Coverage
Coverage Ratio
Ratio --
-- Trend
Trend
Analysis
Analysis Comparison
Comparison

33
 Summary
Summary of
of the
the Coverage
Coverage
Trend
Trend Analysis
Analysis
 The interest coverage ratio for BW has
been falling since 2005. 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.
34
 Activity
Activity Ratios
Ratios
Income Statement / Receivable Turnover
(Assume all sales are credit sales.)
Balance Sheet
Ratios Annual Net Credit Sales
Receivables
Activity Ratios
For Basket Wonders
Indicates quality of December 31, 2007
receivables and how
successful the firm is in $2,211 = 5.61
its collections. $394
35
 Activity
Activity Ratios
Ratios
Income Statement / Avg Collection Period
Balance Sheet
Ratios Days in the Year
Receivable Turnover

Activity Ratios For Basket Wonders

December 31, 2007
Average number of days
that receivables are
outstanding. 365 = 65 days
(or RT in days) 5.61
36
 Activity
Activity
Ratio
Ratio Comparisons
Comparisons
Average Collection Period
Year BW Industry
2007 65.0 65.7
2006 71.1 66.3
2005 83.6 69.2
BW has improved the average collection
37
period to that of the industry average.
 Activity
Activity Ratios
Ratios
Income Statement / Payable Turnover (PT)
(Assume annual credit
Balance Sheet purchases = $1,551.)
Ratios
Annual Credit Purchases
Accounts Payable
Activity Ratios
For Basket Wonders
Indicates the
December 31, 2007
promptness of payment
to suppliers by the firm. $1551
= 16.5
$94
38
 Activity
Activity Ratios
Ratios
Income Statement / PT in Days
Balance Sheet
Ratios Days in the Year
Payable Turnover
Activity Ratios
For Basket Wonders
December 31, 2007
Average number of days
that payables are 365
outstanding. = 22.1 days
16.5
39
 Activity
Activity
Ratio
Ratio Comparisons
Comparisons
Payable Turnover in Days
Year BW Industry
2007 22.1 46.7
2006 25.4 51.1
2005 43.5 48.5
BW has improved the PT in Days.
40
Is this good?
 Activity
Activity Ratios
Ratios
Income Statement / Inventory Turnover
Balance Sheet
Ratios Cost of Goods Sold
Inventory
Activity Ratios
For Basket Wonders
December 31, 2007
Indicates the
effectiveness of the $1,599 = 2.30
inventory management $696
practices of the firm.
41
 Activity
Activity
Ratio
Ratio Comparisons
Comparisons
Inventory Turnover Ratio
Year BW Industry
2007 2.30 3.45
2006 2.44 3.76
2005 2.64 3.69
BW has a very poor inventory turnover ratio.
42
 Inventory
Inventory Turnover
Turnover Ratio
Ratio
--Trend
--Trend Analysis
Analysis
Comparison
Comparison

43
 Activity
Activity Ratios
Ratios
Income Statement / Total Asset Turnover
Balance Sheet
Ratios Net Sales
Total Assets
Activity Ratios
For Basket Wonders
December 31, 2007
Indicates the overall
effectiveness of the firm $2,211 = 1.02
in utilizing its assets to $2,169
generate sales.
44
 Activity
Activity
Ratio
Ratio Comparisons
Comparisons
Total Asset Turnover Ratio
Year BW Industry
2007 1.02 1.17
2006 1.03 1.14
2005 1.01 1.13
BW has a weak total asset turnover ratio.
45
Why is this ratio considered weak?
 Profitability
Profitability Ratios
Ratios
Income Statement / Gross Profit Margin
Balance Sheet
Ratios Gross Profit
Net Sales
Profitability Ratios
For Basket Wonders
December 31, 2007
Indicates the efficiency
of operations and firm $612 = .277
pricing policies. $2,211
46
 Profitability
Profitability
Ratio
Ratio Comparisons
Comparisons
Gross Profit Margin
Year BW Industry
2007 27.7% 31.1%
2006 28.7 30.8
2005 31.3 27.6
BW has a weak Gross Profit Margin.
47
 Gross
Gross Profit
Profit Margin
Margin --
--
Trend
Trend Analysis
Analysis Comparison
Comparison

48
 Profitability
Profitability Ratios
Ratios
Income Statement / Net Profit Margin
Balance Sheet
Ratios Net Profit after Taxes
Net Sales
Profitability Ratios
For Basket Wonders
December 31, 2007
Indicates the firm’s
profitability after taking $91 = .041
account of all expenses $2,211
and income taxes.
49
 Profitability
Profitability
Ratio
Ratio Comparisons
Comparisons
Net Profit Margin
Year BW Industry
2007 4.1% 8.2%
2006 4.9 8.1
2005 9.0 7.6
BW has a poor Net Profit Margin.
50
 Net
Net Profit
Profit Margin
Margin --
--
Trend
Trend Analysis
Analysis Comparison
Comparison

51
 Profitability
Profitability Ratios
Ratios
Income Statement / Return on Investment
Balance Sheet
Ratios Net Profit after Taxes
Total Assets
Profitability Ratios
For Basket Wonders
Indicates the profitability December 31, 2007
on the assets of the firm
(after all expenses and $91 = .042
taxes). $2,160
52
 Profitability
Profitability
Ratio
Ratio Comparisons
Comparisons
Return on Investment
Year BW Industry
2007 4.2% 9.8%
2006 5.0 9.1
2005 9.1 10.8
BW has a poor Return on Investment.
53
 Return
Return on
on Investment
Investment ––
Trend
Trend Analysis
Analysis Comparison
Comparison

54
 Profitability
Profitability Ratios
Ratios
Income Statement / Return on Equity
Balance Sheet
Ratios Net Profit after Taxes
Shareholders’ Equity
Profitability Ratios
For Basket Wonders
Indicates the profitability December 31, 2007
to the shareholders of
the firm (after all $91 = .08
expenses and taxes). $1,139
55
 Profitability
Profitability
Ratio
Ratio Comparisons
Comparisons
Return on Equity
Year BW Industry
2007 8.0% 17.9%
2006 9.4 17.2
2005 16.6 20.4
BW has a poor Return on Equity.
56
 Return
Return on
on Equity
Equity --
--
Trend
Trend Analysis
Analysis Comparison
Comparison

57
 Return
Return on
on Investment
Investment and
and
the
the Du
Du Pont
Pont Approach
Approach
Earning Power = Sales profitability X
Asset efficiency
ROI = Net profit margin X
Total asset turnover
ROI2007 = .041 x 1.02 = .042 or 4.2%
ROIIndustry = .082 x 1.17 = .098 or 9.8%

58
 Return
Return on
on Equity
Equity and
and
the
the Du
Du Pont
Pont Approach
Approach
Return On Equity = Net profit margin X
Total asset turnover X
Equity Multiplier
Total Assets
Equity Multiplier =
Shareholders’ Equity

ROE2007 = .041 x 1.02 x 1.90 = .080

ROEIndustry = .082 x 1.17 x 1.88 = .179
59
 Summary
Summary of
of the
the Profitability
Profitability
Trend
Trend Analyses
Analyses
 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.
BW
 Note, this result is consistent with the low
60
interest coverage ratio.
 Summary
Summary of
of Ratio
Ratio Analyses
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.
61
 Common-size
Common-size Analysis
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
 Basket
Basket Wonders’
Wonders’ Common
Common
Size
Size Balance
Balance Sheets
Sheets
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

63
 Basket
Basket Wonders’
Wonders’ Common
Common
Size
Size Balance
Balance Sheets
Sheets
Regular (thousands of $) Common-Size (%)
Liab+Equity 2005 2006 2007 2005 2006 2007
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
 Basket
Basket Wonders’
Wonders’ Common
Common
Size
Size Income
Income Statements
Statements
Regular (thousands of $) Common-Size (%)
2005 2006 2007 2005 2006 2007
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
 Index
Index Analyses
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
 Basket
Basket Wonders’
Wonders’
Indexed
Indexed Balance
Balance Sheets
Sheets
Regular (thousands of $) Indexed (%)
Assets 2005 2006 2007 2005 2006 2007
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
 Basket
Basket Wonders’
Wonders’
Indexed
Indexed Balance
Balance Sheets
Sheets
Regular (thousands of $) Indexed (%)
Liab+Equity 2005 2006 2007 2005 2006 2007
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
 Basket
Basket Wonders’
Wonders’ Indexed
Indexed
Income
Income Statements
Statements
Regular (thousands of $) Indexed (%)
2005 2006 2007 2005 2006 2007
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
69
 [email protected]
[email protected]

70