Financial Statement

Analysis
© Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
Financial Statement
Analysis
© Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
 Financial
Statement Analysis
u Financial Statements
u A Possible Framework for Analysis
u Balance Sheet Ratios
u Income Statement and Income
Statement/Balance Sheet Ratios
u Trend Analysis
u Common-Size and Index Analysis
 Examples of External Uses
of Statement Analysis
u Trade Creditors -- Focus on the
liquidity of the firm.
u Loading…
Bondholders -- Focus on the
long-term cash flow of the firm.
u Shareholders -- Focus on the
profitability and long-term health of
the firm.
 Examples of Internal Uses
of Statement Analysis
u Plan -- Focus on assessing the current
financial position and evaluating
potential firm opportunities.
u Control -- Focus on return on investment
for various assets and asset efficiency.
u Understand -- Focus on understanding
how suppliers of funds analyze the firm.
 Primary Types of Financial
Statements
is a
picture
&

Balance Sheet gives you

tinees
only
revenues & expenses on
specific

u A summary of a firm’s financial position on

Loading…
a given date that shows total assets = total
liabilities + owners’ equity.
Income Statement
u 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)
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 b. What BW owned.
Prepaid Exp d 5 c. Amounts owed by
Accum Tax Prepay customers.
10 d. Future expense items
Current Assetse already paid.
$1,195 Fixed Assets (@Cost)f e. Cash/likely convertible
1030 Less: Acc. Depr. g to cash within 1 year.
(329) Net Fix. Assets $ f. Original amount paid.
701 Investment, LT 50 g. Acc. deductions for
Other Assets, LT 223 wear and tear.
 Total Assets b $2,169

Basket Wonders’ Balance

Sheet (Liability Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007

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 $ c. Owed to suppliers for
500 Long-Term Debt f 530 goods and services.
Shareholders’ Equity d. Unpaid wages,
Com. Stock ($1 par) g 200 salaries, 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.
Total Liab/Equitya,b $2,169 h. Earnings reinvested.
 Basket Wonders’ Income
Statement
Basket Wonders Statement of Earnings (in thousands) for Year Ending December
31, 2007a

Net Sales $ 2,211 Cost a. Measures profitability

of Goods Sold b 1,599 over a time period.
Gross Profit $ 612 b. Received, or receivable,
SG&A Expenses c from customers.
402 EBITd c. Sales comm., adv.,
$ 210 Interest Expensee officers’ salaries, etc.
59 EBT f earning
>
before $ d. Operating income.
taxes
151 Income Taxes e. Cost of borrowed funds.
60 EATg earing
>
-
$
after
taxes
91 f. Taxable income.
Cash Dividends 38 g. Amount earned for
Increase in RE $ 53 shareholders.
 Use of Financial Ratios

A Financial Ratio is Types of

an index that relates Comparisons
two accounting
Internal
numbers and is
Comparisons
obtained by dividing
one number by the External
other. Comparisons
 External Comparisons and
Sources of Industry Ratios
This involves Examples:
comparing the ratios Risk Management
of one firm with those Association
of similar firms or with Dun & Bradstreet
industry averages.
Almanac of
Similarity is important Business and
as one should Industrial
compare “apples to Financial Ratios
apples.”
 ratio
current
For
balance
scheel *
①Current ratio
we
use

&
Liquidity Ratios ② acid test radio
Cquick ratio)

Balance Sheet Ratios Formula of

Current
current ration

Current Assets
Liquidity Ratios
Loading… Current Liabilities
de
ratio

Shows a firm’s For Basket Wonders

December 31, 2007
ability to cover its
current liabilities
$1,195 = 2.39
with its current $500
assets.
 Liquidity Ratio
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.
 Liquidity Ratios
Balance Sheet Ratios Acid-Test (Quick)

Current Assets - Inv

Liquidity Ratios Current Liabilities

Shows a firm’s For Basket Wonders

December 31, 2007
ability to meet
current liabilities
$1,195 - $696 = 1.00
with its most liquid $500
assets.
 Liquidity Ratio
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.
 Summary of the Liquidity
Ratio Comparisons
Ratio BW Industry
Current 2.39 2.15
Acid-Test 1.00 1.25

u Strong current ratio and weak acid-test

ratio indicates a potential problem in the
inventories account.
u 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
2005 2006 2007
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
2005 2006 2007
Analysis Year
 Summary of the Liquidity
Trend Analyses
u The current ratio for BW has been rising
at the same time the acid-test ratio has
been declining.
u The current ratio for the industry has
been rising slowly at the same time the
acid-test ratio has been relatively stable.
u This indicates that inventories are a
significant problem for BW. quick ratio is usually less

because there's no
inventory
 Financial Leverage 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 =
financed by debt. $1,139 .90
 Financial Leverage
Ratio Comparisons
Debt-to-Equity Ratio
Year BW Industry
2007 .90 .90
2006 .88 .90
2005 .81 .89
BW has average debt
utilization
 Financial Leverage 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 =
debt financing. $2,169 .47
 Financial Leverage
Ratio Comparisons
Debt-to-Total-Asset Ratio
Year BW Industry
2007 .47 .47
2006 .47 .47
2005 .45 .47
BW has average debt
utilization
 Financial Leverage 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 =
financing of the firm. $1,669 .32
 Financial Leverage
Ratio Comparisons
Total Capitalization Ratio
Year BW Industry
2007 .32 .30
2006 .32 .31
2005 .37 .32
BW has average long-term debt
utilization
 Coverage Ratios
Income Interest Coverage
Statement
Ratios EBIT
Interest Charges
Coverage Ratios
For Basket Wonders
Indicates a firm’s December 31, 2007
ability to cover
interest charges. $21 = 3.56
0
$59
 Coverage
Ratio 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
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
2005 2006 2007
Analysis Year
 Summary of the Coverage
Trend Analysis
u The interest coverage ratio for BW has
been falling since 2005. It has been
below industry averages for the past
two years.
u This indicates that low earnings (EBIT)
may be a potential problem for BW.
u Note, we know that debt levels are in
line with the industry averages.
 Activity Ratios
Income Statement / Receivable Turnover
(Assume all sales are credit
Balance Sheet sales.)
Ratios Annual Net Credit Sales
Loading… Receivables

Activity Ratios For Basket Wonders

December 31, 2007
Indicates quality of
receivables and how
successful the firm is in $2,211 = 5.61
its collections. $394
 Activity Ratios
Income Statement / Avg Collection Period
Balance Sheet
Days in the Year
Ratios
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) 5.6
1
 Activity
Ratio 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
 Activity 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
 Activity 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
 Activity
Ratio 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.
Is this good?
 Activity Ratios #
Income Statement / Inventory Turnover
the higher the better
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.
 Activity
Ratio 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.
 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
2005 2006 2007
Analysis Year
 Activity 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.
 Activity
Ratio 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.
Why is this ratio considered weak?
 Profitability 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
 Profitability
Ratio 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.
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
2005 2006 2007
Analysis Year
 Profitability 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.
 Profitability Ratio
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.
Net Profit Margin --
Trend Analysis Comparison
Trend Analysis of Net Profit Margin
10
9
Ratio Value (%)

8
7 BW
6 Industry

5
4
2005 2006 2007
Analysis Year
 Profitability Ratios
Income Statement / Return on Investment
Balance Sheet
Ratios Net Profit after Taxes
Total Assets

Profitability Ratios For Basket Wonders

December 31, 2007
Indicates the
profitability on the
assets of the firm (after $91 = .042
all expenses and taxes). $2,160
 Profitability Ratio
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.
Return on Investment –
Trend Analysis Comparison
Trend Analysis of Return on Investment
12

10
Ratio Value (%)

8 BW
Industry
6

4
2005 2006 2007
Analysis Year
 Profitability Ratios
Income Statement / Return on Equity
Balance Sheet
Ratios Net Profit after Taxes
Shareholders’ Equity

Profitability Ratios For Basket Wonders

December 31, 2007
Indicates the profitability
to the shareholders of
the firm (after all $91 =
expenses and taxes). $1,139 .08
 Profitability Ratio
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.
Return on Equity --
Trend Analysis Comparison
Trend Analysis of Return on Equity
21.0

17.5
Ratio Value (%)

14.0 BW
Industry
10.5

7.0
2005 2006 2007
Analysis Year
 Summary of the Profitability
Trend Analyses
u The profitability ratios for BW have ALL
been falling since 2005. Each has been
below the industry averages for the past
three years.
u This indicates that COGS and
administrative costs may both be too
high and a potential problem for BW.
u Note, this result is consistent with the
low interest coverage ratio.
 Summary of Ratio Analyses

u Inventories are too high.

u May be paying off creditors
(accounts payable) too soon.
u COGS may be too high.
u 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.
 Basket Wonders’ Common
Size Balance 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
 Basket Wonders’ Common
Size Balance 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
 Basket Wonders’ Common
Size Income 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
 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 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
 Basket Wonders’
Indexed Balance 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
 Basket Wonders’ Indexed
Income 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
 Funds Analysis, Cash-Flow
Analysis, and Financial Planning

u Flow of Funds (Sources and Uses)

Statement
u Accounting Statement of Cash Flows
u Cash-Flow Forecasting
u Range of Cash-Flow Estimates
u Forecasting Financial Statements
 Flow of Funds Statement
A summary of a firm’s changes in
financial position from one period to
another; it is also called a sources and
uses of funds statement or a statement
of changes in financial position.
Has been replaced by the cash flow
statement (1989) in U.S. audited
annual reports.
 Why Examine the Flow
of Funds Statement
QUESTION?

Why should we bother to

understand a Flow of Funds
Statement that is no longer
required to appear in U.S.
audited annual reports?
 Why Examine the Flow of
Funds Statement
The Flow of Funds Statement:
u Includes important noncash transactions
while the cash flow statement does not.
u Is easy to prepare and often preferred by
managers for analysis purposes over the
more complex cash flow statement.
u Helps you to better understand the cash
flow statement, especially if it is prepared
under the “indirect method.”
 Flow of Funds Statement

What are “funds”?

All of the firm’s investments and

claims against those investments.
Extends beyond just transactions
involving cash.
 Sources and
Uses Statement
The letters labeling
the boxes stand for
Uses, Sources, A L
Assets, and
Liabilities (broadly
defined). The pluses S - +
(minuses) indicate
increases + -
(decreases) in
assets or liabilities. U