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Chapter 6

Chapter 6. Financial Statement Analysis. © Pearson Education Limited 2004 Fundamentals of Financial Management, 12/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI. After studying Chapter 6, you should be able to:.

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Chapter 6

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  1. Chapter 6 Financial Statement Analysis © Pearson Education Limited 2004 Fundamentals of Financial Management, 12/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI

  2. 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.

  3. Financial Statement 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

  4. 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.

  5. 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.

  6. 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. • Balance Sheet • A summary of a firm’s financial position on a given date that shows total assets = total liabilities + owners’ equity.

  7. 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 Expd 5 Accum Tax Prepay 10Current Assetse $1,195 Fixed Assets (@Cost)f 1030 Less: Acc. Depr. g (329) Net Fix. Assets $ 701 Investment, LT 50 Other Assets, LT 223Total Assets b $2,169 Basket Wonders’ Balance Sheet (Asset Side) Basket Wonders Balance Sheet (thousands) Dec. 31, 2007a

  8. 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 Taxesd 16 Other Accrued Liab.d 100Current Liab.e $ 500 Long-Term Debtf530Shareholders’ Equity Com. Stock ($1 par)g200Add Pd in Capitalg 729 Retained Earningsh 210 Total Equity $1,139 Total Liab/Equitya,b $2,169 Basket Wonders’ Balance Sheet (Liability Side) Basket Wonders Balance Sheet (thousands) Dec. 31, 2007

  9. 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 Soldb1,599 Gross Profit $ 612 SG&A Expenses c 402EBITd$ 210 Interest Expensee 59 EBT f$151Income Taxes 60 EATg$ 91 Cash Dividends 38 Increase in RE $ 53 Basket Wonders’ Income Statement Basket Wonders Statement of Earnings (in thousands) for Year Ending December 31, 2007a

  10. Framework for Financial Analysis Trend / Seasonal Component 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 1. Analysis of the funds needs of the firm.

  11. Framework for Financial Analysis Health of a Firm Financial Ratios 1. Individually 2. Over time 3. In combination 4. In comparison 1. Analysis of the funds needs of the firm. 2. Analysis of the financial condition and profitability of the firm.

  12. Framework for Financial Analysis Examples: Volatility in sales Volatility in costs Proximity to break-even point Business riskrelates to the risk inherent in the operations of the firm. 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.

  13. Framework for Financial Analysis A Financial Manager must consider all three jointly when determining the financing needs of the firm. 1. Analysis of the funds needs of the firm. Determining the financing needs of the firm. 2. Analysis of the financial condition and profitability of the firm. 3. Analysis of the business risk of the firm.

  14. Framework for Financial Analysis 1. Analysis of the funds needs of the firm. Determining the financing needs of the firm. Negotiations with suppliers of capital. 2. Analysis of the financial condition and profitability of the firm. 3. Analysis of the business risk of the firm.

  15. Types of Comparisons Internal Comparisons External Comparisons A Financial Ratio is an index that relates twoaccountingnumbers and is obtained by dividing one number by the other. Use of Financial Ratios

  16. Examples: Risk Management Association 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.” External Comparisons and Sources of Industry Ratios

  17. Current Current Assets Current Liabilities For Basket Wonders December 31, 2007 Shows a firm’s ability to cover its current liabilities with its current assets. Liquidity Ratios Balance Sheet Ratios Liquidity Ratios $1,195 $500 = 2.39

  18. BW Industry 2.39 2.15 2.26 2.09 1.91 2.01 Year 2007 2006 2005 Liquidity Ratio Comparisons CurrentRatio Ratio is stronger than the industry average.

  19. Acid-Test (Quick) Current Assets - Inv Current Liabilities For Basket Wonders December 31, 2007 Shows a firm’s ability to meet current liabilities with its most liquid assets. Liquidity Ratios Balance Sheet Ratios Liquidity Ratios $1,195 - $696 $500 = 1.00

  20. BW Industry 1.00 1.25 1.04 1.23 1.11 1.25 Year 2007 2006 2005 Liquidity Ratio Comparisons Acid-Test Ratio Ratio is weaker than the industry average.

  21. 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. RatioBWIndustry Current 2.39 2.15 Acid-Test 1.00 1.25 Summary of the Liquidity Ratio Comparisons

  22. Current Ratio -- Trend Analysis Comparison

  23. Acid-Test Ratio -- Trend Analysis Comparison

  24. 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. 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.

  25. Debt-to-Equity Total Debt Shareholders’ Equity For Basket Wonders December 31, 2007 Shows the extent to which the firm is financed by debt. Financial Leverage Ratios Balance Sheet Ratios Financial Leverage Ratios $1,030 $1,139 = .90

  26. BW Industry .90 .90 .88 .90 .81 .89 Year 2007 2006 2005 Financial Leverage Ratio Comparisons Debt-to-Equity Ratio BW has average debt utilization relative to the industry average.

  27. Debt-to-Total-Assets Total Debt Total Assets For Basket Wonders December 31, 2007 Shows the percentage of the firm’s assets that are supported by debt financing. Financial Leverage Ratios Balance Sheet Ratios Financial Leverage Ratios $1,030 $2,169 = .47

  28. BW Industry .47 .47 .47 .47 .45 .47 Year 2007 2006 2005 Financial Leverage Ratio Comparisons Debt-to-Total-Asset Ratio BW has average debt utilization relative to the industry average.

  29. Total Capitalization Long-term Debt Total Capitalization For Basket Wonders December 31, 2007 Shows the relative importance of long-term debt to the long-term financing of the firm. Financial Leverage Ratios Balance Sheet Ratios (i.e., LT-Debt + Equity) Financial Leverage Ratios $530 $1,669 = .32

  30. BW Industry .32 .30 .32 .31 .37 .32 Year 2007 2006 2005 Financial Leverage Ratio Comparisons Total Capitalization Ratio BW has average long-term debt utilization relative to the industry average.

  31. Interest Coverage EBIT Interest Charges For Basket Wonders December 31, 2007 Indicates a firm’s ability to cover interest charges. Coverage Ratios Income Statement Ratios Coverage Ratios $210 $59 = 3.56

  32. BW Industry 3.56 5.19 4.35 5.02 10.30 4.66 Year 2007 2006 2005 Coverage Ratio Comparisons Interest Coverage Ratio BW has below average interest coverage relative to the industry average.

  33. Coverage Ratio -- Trend Analysis Comparison

  34. 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. Summary of the Coverage Trend Analysis • The interest coverage ratio for BW has been falling since 2005. It has been below industry averages for the past two years.

  35. Receivable Turnover Annual Net Credit Sales Receivables For Basket Wonders December 31, 2007 Indicates quality of receivables and how successful the firm is in its collections. Activity Ratios Income Statement / Balance Sheet Ratios (Assume all sales are credit sales.) Activity Ratios $2,211 $394 = 5.61

  36. Avg Collection Period Days in the Year Receivable Turnover For Basket Wonders December 31, 2007 Average number of days that receivables are outstanding. (or RT in days) Activity Ratios Income Statement / Balance Sheet Ratios Activity Ratios 365 5.61 = 65 days

  37. BW Industry 65.0 65.7 71.1 66.3 83.6 69.2 Year 2007 2006 2005 Activity Ratio Comparisons Average Collection Period BW has improved the average collection period to that of the industry average.

  38. Payable Turnover (PT) Annual Credit Purchases Accounts Payable For Basket Wonders December 31, 2007 Indicates the promptness of payment to suppliers by the firm. Activity Ratios Income Statement / Balance Sheet Ratios (Assume annual credit purchases = $1,551.) Activity Ratios $1551 $94 = 16.5

  39. PT in Days Days in the Year Payable Turnover For Basket Wonders December 31, 2007 Average number of days that payables are outstanding. Activity Ratios Income Statement / Balance Sheet Ratios Activity Ratios 365 16.5 = 22.1 days

  40. BW Industry 22.1 46.7 25.4 51.1 43.5 48.5 Year 2007 2006 2005 Activity Ratio Comparisons Payable Turnover in Days BW has improved the PT in Days. Is this good?

  41. Inventory Turnover Cost of Goods Sold Inventory For Basket Wonders December 31, 2007 Indicates the effectiveness of the inventory management practices of the firm. Activity Ratios Income Statement / Balance Sheet Ratios Activity Ratios $1,599 $696 = 2.30

  42. BW Industry 2.30 3.45 2.44 3.76 2.64 3.69 Year 2007 2006 2005 Activity Ratio Comparisons Inventory Turnover Ratio BW has a very poor inventory turnover ratio.

  43. Inventory Turnover Ratio --Trend Analysis Comparison

  44. Total Asset Turnover Net Sales Total Assets For Basket Wonders December 31, 2007 Indicates the overall effectiveness of the firm in utilizing its assets to generate sales. Activity Ratios Income Statement / Balance Sheet Ratios Activity Ratios $2,211 $2,169 = 1.02

  45. BW Industry 1.02 1.17 1.03 1.14 1.01 1.13 Year 2007 2006 2005 Activity Ratio Comparisons Total Asset Turnover Ratio BW has a weak total asset turnover ratio. Why is this ratio considered weak?

  46. Gross Profit Margin Gross Profit Net Sales For Basket Wonders December 31, 2007 Indicates the efficiency of operations and firm pricing policies. Profitability Ratios Income Statement / Balance Sheet Ratios Profitability Ratios $612 $2,211 = .277

  47. BW Industry 27.7% 31.1% 28.7 30.8 31.3 27.6 Year 2007 2006 2005 Profitability Ratio Comparisons Gross Profit Margin BW has a weak Gross Profit Margin.

  48. Gross Profit Margin -- Trend Analysis Comparison

  49. Net Profit Margin Net Profit after Taxes Net Sales For Basket Wonders December 31, 2007 Indicates the firm’s profitability after taking account of all expenses and income taxes. Profitability Ratios Income Statement / Balance Sheet Ratios Profitability Ratios $91 $2,211 = .041

  50. BW Industry 4.1% 8.2% 4.9 8.1 9.0 7.6 Year 2007 2006 2005 Profitability Ratio Comparisons Net Profit Margin BW has a poor Net Profit Margin.

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