Financial and Management Accounting

Chapter 3
Financial Statement Analysis

Course leader : Million Gizaw (Assistant

professor)
 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.
 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.
 Global Accounting Standards
• Convergence of Accounting Standards:
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
 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.
 BWs’ Balance Sheet
(Asset Side)
BW Balance Sheet (thousands) Dec. 31, 2020 a
Cash br. 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 Assetse $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.
Total Assets b $2,169
 BWs’ Balance Sheet
(Liability Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2020
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 $
500 Long-Term Debt f c. Owed to suppliers for
530 Shareholders’ goods and services.
Equity Com. Stock ($1 d. Unpaid wages,
par) g 200 Add Pd in Capital g salaries, etc.
729 Retained e. Debts payable < 1 year.
Earnings h 210 Total f. Debts payable > 1 year.
Equity $1,139 g. Original investment.
Total Liab/Equitya,b $2,169
 BW’ Income Statement
Basket Wonders Statement of Earnings (in thousands)
for Year Ending December 31, 2020a
Net Sales $ 2,211 a. Measures profitability
Cost of Goods Sold b 1,599 over a time period.
Gross Profit $ 612 b. Received, or receivable,
SG&A Expenses c 402 from customers.
EBITd $ c. Sales comm., adv.,
210 Interest Expensee officers’ salaries, etc.
59 EBT f $ d. Operating income.
151 Income Taxes e. Cost of borrowed funds.
60 EATg $ 91 f. Taxable income.
Cash Dividends 38 g. Amount earned for
Increase in RE $ 53 shareholders.
 Use of Financial Ratios

A Financial Ratio is an Types of

index that relates Comparisons
two accounting
numbers and is Internal
obtained by dividing Comparisons
one number by the External
other. Comparisons
 External Comparisons and
Sources of Industry 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.”
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.
 Liquidity Ratios
Balance Sheet Ratios Current

Current Assets
Liquidity Ratios Current Liabilities
Shows a firm’s
For BW’S December
ability to cover its 31, 2020
current liabilities
with its current $1,195 = 2.39
assets. $500
 Liquidity Ratio
Comparisons
Current Ratio
Year BW Industry
2020 2.39 2.15
2019 2.26 2.09
2018 1.91 2.01
Ratio is stronger than the industry average.
 Liquidity Ratios
Balance Sheet Ratios Acid-Test (Quick)

Current Assets - Inv

Liquidity Ratios Current Liabilities
Shows a firm’s For BW’S December
ability to meet 31, 2020
current liabilities
with its most liquid $1,195 – $696 = 1.00
assets. $500
 Liquidity Ratio
Comparisons
Acid-Test Ratio
Year BW Industry
2020 1.00 1.25
2019 1.04 1.23
2018 1.11 1.25
Ratio is weaker than the industry average.
 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.
 Current Ratio – Trend
Analysis Comparison
Trend Analysis of Current Ratio
2.5
2.3
Ratio Value

2.1
BW
1.9 Industry
1.7
1.5
2018 2019 2020
Analysis Year
 Acid-Test Ratio – Trend
Analysis Comparison
Trend Analysis of Acid-Test Ratio

1.5

1.3
Ratio Value

1.0 BW
Industry
0.8

0.5
2018 2019 2020
Analysis Year
 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
 Financial Leverage Ratios
Balance Sheet Ratios Debt-to-Equity

Total Debt
Financial Leverage Shareholders’ Equity
Ratios
For BW’S December
31, 2020
Shows the extent to
which the firm is $1,030 = 0.90
financed by debt. $1,139
 Financial Leverage
Ratio Comparisons
Debt-to-Equity Ratio
Year BW Industry
2020 0.90 0.90
2019 0.88 0.90
2018 0.81 0.89
BW has average debt utilization
relative to the industry average.
 Financial Leverage Ratios
Balance Sheet Ratios Debt-to-Total-Assets

Total Debt
Financial Leverage Total Assets
Ratios
For BW’S December 31,
Shows the percentage 2020
of the firm’s assets
that are supported by $1,030 = 0.47
debt financing. $2,169
 Financial Leverage
Ratio Comparisons
Debt-to-Total-Asset Ratio
Year BW Industry
2020 0.47 0.47
2019 0.47 0.47
2018 0.45 0.47
BW has average debt utilization
relative to the industry average.
 Financial Leverage Ratios
Balance Sheet Ratios Total Capitalization
(i.e., LT-Debt + Equity)

Financial Leverage Total Debt

Ratios Total Capitalization

Shows the relative For BW’S December 31,

importance of long-term 2020
debt to the long-term $1,030 = 0.62
financing of the firm. $1,669
 Financial Leverage
Ratio Comparisons
Total Capitalization Ratio
Year BW Industry
2020 0.62 0.60
2019 0.62 0.61
2018 0.67 0.62
BW has average long-term debt utilization
relative to the industry average.
 Coverage Ratios
Income Statement Interest Coverage
Ratios
EBIT
Interest Charges
Coverage Ratios
For BW’S December 31,
Indicates a firm’s 2020
ability to cover
interest charges. $210 = 3.56
$59
 Coverage
Ratio Comparisons
Interest Coverage Ratio
Year BW Industry
2020 3.56 5.19
2019 4.35 5.02
2018 10.30 4.66
BW has below average interest coverage
relative to the industry average.
Coverage Ratio – Trend
Analysis Comparison
Trend Analysis of Interest Coverage Ratio
11.0

9.0
Ratio Value

7.0 BW
Industry
5.0

3.0
2018 2019 2020
Analysis Year
 Summary of the Coverage
Trend Analysis
• The interest coverage ratio for BW has
been falling since 2018. 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.
 Activity Ratios
Income Statement/ Receivable Turnover
(Assume all sales are credit sales.)
Balance Sheet
Ratios Annual Net Credit Sales
Receivables
Activity Ratios
For BW’S December 31,
Indicates quality of 2020
receivables and how
successful the firm is in $2,211 = 5.61
its collections. $394
 Activity Ratios
Income Statement/ Avg Collection Period
Balance Sheet
Ratios Days in the Year
Receivable Turnover

Activity Ratios For BW’S December 31,

2020
Average number of days
that receivables are
outstanding. 365 = 65 days
(or RT in days) 5.61
 Activity
Ratio Comparisons
Average Collection Period
Year BW Industry
2020 65.0 65.7
2019 71.1 66.3
2018 83.6 69.2
BW has improved the average collection
period to that of the industry average.
 Activity Ratios
Income Statement/ Payable Turnover (PT)
(Assume annual credit
Balance Sheet purchases = $1,551.)
Ratios
Annual Credit Purchases
Accounts Payable
Activity Ratios

Indicates the For BW’S December 31,

promptness of payment 2020
to suppliers by the firm. $1551
= 16.5
$94
 Activity Ratios
Income Statement/ PT in Days
Balance Sheet
Ratios Days in the Year
Payable Turnover
Activity Ratios
For BW’S December 31,
2020
Average number of days
that payables are 365
outstanding. = 22.1 days
16.5
 Activity
Ratio Comparisons
Payable Turnover in Days
Year BW Industry
2020 22.1 46.7
2019 25.4 51.1
2018 43.5 48.5
BW has improved the PT in Days.
Is this good?
 Activity Ratios
Income Statement/ Inventory Turnover
Balance Sheet
Ratios Cost of Goods Sold
Inventory
Activity Ratios
For BW’S December 31,
Indicates the 2020
effectiveness of the
inventory management $1,599 = 2.30
practices of the firm. $696
 Activity
Ratio Comparisons
Inventory Turnover Ratio
Year BW Industry
2020 2.30 3.45
2019 2.44 3.76
2018 2.64 3.69
BW has a very poor inventory turnover ratio.
 Inventory Turnover Ratio –
Trend Analysis Comparison
Trend Analysis of Inventory Turnover Ratio
4.0

3.5
Ratio Value

3.0 BW
Industry
2.5

2.0
2018 2019 2020
Analysis Year
 Activity Ratios
Income Statement/ Total Asset Turnover
Balance Sheet
Ratios Net Sales
Total Assets
Activity Ratios
For BWs December 31,
Indicates the overall 2020
effectiveness of the firm
in utilizing its assets to $2,211 = 1.02
generate sales. $2,169
 Activity
Ratio Comparisons
Total Asset Turnover Ratio
Year BW Industry
2020 1.02 1.17
2019 1.03 1.14
2018 1.01 1.13
BW has a weak total asset turnover ratio.
Why is this ratio considered weak?
 Profitability Ratios
Income Statement/ Gross Profit Margin
Balance Sheet
Ratios Gross Profit
Net Sales
Profitability Ratios
For BW’S December 31,
2020
Indicates the efficiency
of operations and firm $612 = 0.277
pricing policies. $2,211
 Profitability
Ratio Comparisons
Gross Profit Margin
Year BW Industry
2020 27.7% 31.1%
2019 28.7 30.8
2018 31.3 27.6
BW has a weak Gross Profit Margin.
Gross Profit Margin –
Trend Analysis Comparison
Trend Analysis of Gross Profit Margin
35.0

32.5
Ratio Value (%)

30.0 BW
Industry
27.5

25.0
2018 2019 2020
Analysis Year
 Profitability Ratios
Income Statement/ Net Profit Margin
Balance Sheet
Ratios Net Profit after Taxes
Net Sales
Profitability Ratios
For BWs December 31,
Indicates the firm’s 2020
profitability after taking
$91 = 0.041
account of all expenses
$2,211
and income taxes.
 Profitability
Ratio Comparisons
Net Profit Margin
Year BW Industry
2020 4.1% 8.2%
2019 4.9 8.1
2018 9.0 7.6
BW has a poor Net Profit Margin.
Net Profit Margin –
Trend Analysis Comparison
Trend Analysis of Net Profit Margin
10
9
Ratio Value (%)

8
7 BW
Industry
6
5
4
2018 2019 2020
Analysis Year
 Profitability Ratios
Income Statement/ Return on Investment
Balance Sheet
Ratios Net Profit after Taxes
Total Assets
Profitability Ratios
For BW’S December 31,
Indicates the 2020
profitability on the
assets of the firm (after $91 = 0.042
all expenses and taxes). $2,160
 Profitability
Ratio Comparisons
Return on Investment
Year BW Industry
2020 4.2% 9.6%
2019 5.0 9.1
2018 9.1 10.8
BW has a poor Return on Investment.
Return on Investment –
Trend Analysis Comparison
Trend Analysis of Return on Investment
12

10
Ratio Value (%)

8 BW
Industry
6

4
2018 2019 2020
Analysis Year
 Profitability Ratios
Income Statement/ Return on Equity
Balance Sheet
Ratios Net Profit after Taxes
Shareholders’ Equity
Profitability Ratios
For BW’S December 31,
Indicates the profitability 2020
to the shareholders of
the firm (after all $91 = 0.08
expenses and taxes). $1,139
 Profitability
Ratio Comparisons
Return on Equity
Year BW Industry
2020 8.0% 18.0%
2019 9.4 17.2
2018 16.6 20.4
BW has a poor Return on Equity.
Return on Equity –
Trend Analysis Comparison
Trend Analysis of Return on Equity
21.0
Ratio Value (%)

17.5

14.0 BW
Industry
10.5

7.0
2018 2019 2020
Analysis Year
 Return on Investment and
the Du Pont Approach
Earning Power = Sales profitability ×
Asset efficiency
ROI = Net profit margin ×
Total asset turnover
ROI2020 = 0.041 × 1.02 = 0.042 or 4.2%
ROIIndustry = 0.082 × 1.17 = 0.096 or 9.6%
(Note: values are rounded)
 Return on Equity and
the Du Pont Approach
Return On Equity = Net profit margin X
Total asset turnover X
Equity Multiplier
Total Assets
Equity Multiplier =
Shareholders’ Equity
ROE2020 = 0.041 × 1.02 × 1.90 = 0.080
ROEIndustry = 0.082 × 1.17 × 1.88 = 0.180
(Note: values are rounded)
 Summary of the Profitability
Trend Analyses
• 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.
BW
• Note, this result is consistent with the low
interest coverage ratio.
 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

3-58
 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.
BW’S’ Common Size
Balance Sheets
 Basket Wonders’ Common-
Size Balance Sheets
Regular (thousands of $) Common-Size (%)
Liab+Equity 2018 2019 2020 2018 2019 2020
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
 Basket Wonders’ Common-
Size Income Statements
Regular (thousands of $) Common-Size (%)
2018 2019 2020 2018 2019 2020
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
 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.
 Basket Wonders’
Indexed Balance Sheets
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
Regular (thousands of $) Indexed (%)
Liab+Equity 2018 2019 2020 2018 2019 2020
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
 Basket Wonders’ Indexed
Income Statements
Regular (thousands of $) Indexed (%)
2018 2019 2020 2018 2019 2020
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
End of lecture 3
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