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6-1 
Chapter 2 
Financial Statement 
Analysis
6-2 
Financial 
Statement Analysis 
Financial Statements 
A Possible Framework for Analysis 
Ratio Analysis 
Trend Analysis 
Common-Size and Index Analysis
6-3 
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.
6-4 
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.
Balance Sheet 
6-5 
Primary Types of 
Financial Statements 
 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.
Basket Wonders Balance Sheet (thousands) Dec. 31, 2003a 
6-6 
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 Assetsb $2,169
Basket Wonders Balance Sheet (thousands) Dec. 31, 2003 
6-7 
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
6-8 
Basket Wonders’ 
Income Statement 
Basket Wonders Statement of Earnings (in thousands) 
for Year Ending December 31, 2003a 
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 Expensee 59 
EBT f $ 151 
Income Taxes 60 
EATg $ 91 
Cash Dividends 38 
Increase in RE $ 53
6-9 
Framework for 
Financial Analysis 
Analytical Tools Used 
Sources and Uses Statement 
Statement of Cash Flows 
Cash Budgets 
1. Analysis of the funds 
needs of the firm. 
Trend / Seasonal Component 
How much funding will be 
required in the future? 
Is there a seasonal 
component?
6-10 
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.
6-11 
Framework for 
Financial Analysis 
Examples: 
Volatility in sales 
Volatility in costs 
Proximity to break-even 
point 
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. 
Business risk relates to 
the risk inherent in the 
operations of the firm.
6-12 
Framework for 
Financial Analysis 
A Financial 
Manager 
must 
consider all 
three jointly 
when 
determining 
the 
financing 
needs of the 
firm. 
Determining 
the 
financing 
needs 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.
6-13 
Framework for 
Financial Analysis 
Negotiations 
with 
suppliers of 
capital. 
Determining 
the 
financing 
needs 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.
6-14 
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.
6-15 
Basket Wonders’ Common 
Size Balance Sheets 
Regular (thousands of $) Common-Size (%) 
Assets 2001 2002 2003 2001 2002 2003 
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
6-16 
Basket Wonders’ Common 
Size Balance Sheets 
Regular (thousands of $) Common-Size (%) 
Liab+Equity 2001 2002 2003 2001 2002 2003 
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
6-17 
Basket Wonders’ Common 
Size Income Statements 
Regular (thousands of $) Common-Size (%) 
2001 2002 2003 2001 2002 2003 
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
6-18 
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.
6-19 
Basket Wonders’ 
Indexed Balance Sheets 
Regular (thousands of $) Indexed (%) 
Assets 2001 2002 2003 2001 2002 2003 
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
6-20 
Basket Wonders’ 
Indexed Balance Sheets 
Regular (thousands of $) Indexed (%) 
Liab+Equity 2001 2002 2003 2001 2002 2003 
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
6-21 
Basket Wonders’ Indexed 
Income Statements 
Regular (thousands of $) Indexed (%) 
2001 2002 2003 2001 2002 2003 
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
6-22 
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.
6-23 
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.”
Balance Sheet Ratios 
6-24 
Liquidity Ratios 
Current 
Current Assets 
Current Liabilities 
For Basket Wonders 
December 31, 2003 
Liquidity Ratios 
Shows a firm’s 
ability to cover its 
current liabilities 
with its current 
assets. 
$1,195 
$500 
= 2.39
6-25 
Liquidity Ratio 
Comparisons 
BW Industry 
2.39 2.15 
2.26 2.09 
1.91 2.01 
Year 
2003 
2002 
2001 
Current Ratio 
Ratio is stronger than the industry average.
Balance Sheet Ratios 
6-26 
Liquidity Ratios 
Acid-Test (Quick) 
Current Assets - Inv 
Current Liabilities 
For Basket Wonders 
December 31, 2003 
Liquidity Ratios 
Shows a firm’s 
ability to meet 
current liabilities 
with its most liquid 
assets. 
$1,195 - $696 
$500 
= 1.00
6-27 
Liquidity Ratio 
Comparisons 
BW Industry 
1.00 1.25 
1.04 1.23 
1.11 1.25 
Year 
2003 
2002 
2001 
Acid-Test Ratio 
Ratio is weaker than the industry average.
6-28 
Summary of the Liquidity 
Ratio Comparisons 
Ratio BW Industry 
Current 2.39 2.15 
Acid-Test 1.00 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.
6-29 
Current Ratio -- Trend 
Analysis Comparison 
Trend Analysis of Current Ratio 
2.5 
2.3 
2.1 
1.9 
1.7 
1.5 
2001 2002 2003 
Analysis Year 
Ratio Value 
BW 
Industry
6-30 
Acid-Test Ratio -- Trend 
Analysis Comparison 
Trend Analysis of Acid-Test Ratio 
1.5 
1.3 
1.0 
0.8 
0.5 
2001 2002 2003 
Analysis Year 
Ratio Value 
BW 
Industry
 The current ratio for BW has been rising 
6-31 
Summary of the Liquidity 
Trend Analyses 
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.
Balance Sheet Ratios 
6-32 
Financial Leverage Ratios 
Debt-to-Equity 
Total Debt 
Shareholders’ Equity 
For Basket Wonders 
December 31, 2003 
Financial Leverage 
Ratios 
Shows the extent to 
which the firm is 
financed by debt. 
$1,030 
$1,139 
= .90
6-33 
Financial Leverage 
Ratio Comparisons 
Debt-to-Equity Ratio 
BW Industry 
.90 .90 
.88 .90 
.81 .89 
Year 
2003 
2002 
2001 
BW has average debt utilization 
relative to the industry average.
Balance Sheet Ratios 
6-34 
Financial Leverage Ratios 
Debt-to-Total-Assets 
Total Debt 
Total Assets 
For Basket Wonders 
Financial Leverage 
Ratios 
Shows the percentage December 31, 2003 
of the firm’s assets 
that are supported by 
debt financing. 
$1,030 
$2,169 
= .47
6-35 
Financial Leverage 
Ratio Comparisons 
Debt-to-Total-Asset Ratio 
BW Industry 
.47 .47 
.47 .47 
.45 .47 
Year 
2003 
2002 
2001 
BW has average debt utilization 
relative to the industry average.
Balance Sheet Ratios 
6-36 
Financial Leverage Ratios 
Total Capitalization 
(i.e., LT-Debt + Equity) 
Total Debt 
Total Capitalization 
For Basket Wonders 
December 31, 2003 
Financial Leverage 
Ratios 
Shows the relative 
importance of long-term 
debt to the long-term 
financing of the firm. 
$1,030 
$1,669 
= .62
6-37 
Financial Leverage 
Ratio Comparisons 
Total Capitalization Ratio 
BW Industry 
.62 .60 
.62 .61 
.67 .62 
Year 
2003 
2002 
2001 
BW has average long-term debt utilization 
relative to the industry average.
6-38 
Coverage Ratios 
Interest Coverage 
EBIT 
Interest Charges 
For Basket Wonders 
Income Statement 
Ratios 
Coverage Ratios 
Indicates a firm’s December 31, 2003 
ability to cover 
interest charges. 
$210 
$59 
= 3.56
6-39 
Coverage 
Ratio Comparisons 
Interest Coverage Ratio 
BW Industry 
3.56 5.19 
4.35 5.02 
10.30 4.66 
Year 
2003 
2002 
2001 
BW has below average interest coverage 
relative to the industry average.
6-40 
Coverage Ratio -- Trend 
Analysis Comparison 
Trend Analysis of Interest Coverage Ratio 
11.0 
9.0 
7.0 
5.0 
3.0 
2001 2002 2003 
Analysis Year 
Ratio Value 
BW 
Industry
 The interest coverage ratio for BW has 
6-41 
Summary of the Coverage 
Trend Analysis 
been falling since 2001. It has been 
below industry averages for the past 
two years. 
 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.
Income Statement / 
6-42 
Activity/Efficiency Ratios 
Receivable Turnover 
(Assume all sales are credit sales.) 
Annual Net Credit Sales 
Receivables 
For Basket Wonders 
Balance Sheet 
Ratios 
Activity Ratios 
Indicates quality of December 31, 2003 
receivables and how 
successful the firm is in 
its collections. 
$2,211 
$394 
= 5.61
Income Statement / 
6-43 
Activity Ratios 
Avg Collection Period 
Days in the Year 
Receivable Turnover 
For Basket Wonders 
December 31, 2003 
Balance Sheet 
Ratios 
Activity Ratios 
Average number of days 
that receivables are 
outstanding. 
(or RT in days) 
365 
5.61 
= 65 days
6-44 
Activity 
Ratio Comparisons 
Average Collection Period 
BW Industry 
65.0 65.7 
71.1 66.3 
83.6 69.2 
Year 
2003 
2002 
2001 
BW has improved the average collection 
period to that of the industry average.
Income Statement / 
6-45 
Activity Ratios 
Payable Turnover (PT) 
(Assume annual credit 
purchases = $1,551.) 
Annual Credit Purchases 
Accounts Payable 
For Basket Wonders 
December 31, 2003 
Balance Sheet 
Ratios 
Activity Ratios 
Indicates the 
promptness of payment 
to suppliers by the firm. 
$1551 
$94 
= 16.5
Income Statement / 
6-46 
Activity Ratios 
PT in Days 
Days in the Year 
Payable Turnover 
For Basket Wonders 
December 31, 2003 
Balance Sheet 
Ratios 
Activity Ratios 
Average number of days 
that payables are 
outstanding. 
365 
16.5 
= 22.1 days
6-47 
Activity 
Ratio Comparisons 
Payable Turnover in Days 
BW Industry 
22.1 46.7 
25.4 51.1 
43.5 48.5 
Year 
2003 
2002 
2001 
BW has improved the PT in Days. 
Is this good?
Income Statement / 
6-48 
Activity Ratios 
Inventory Turnover 
Cost of Goods Sold 
Inventory 
For Basket Wonders 
December 31, 2003 
Balance Sheet 
Ratios 
Activity Ratios 
Indicates the 
effectiveness of the 
inventory management 
practices of the firm. 
$1,599 
$696 
= 2.30
6-49 
Activity 
Ratio Comparisons 
Inventory Turnover Ratio 
BW Industry 
2.30 3.45 
2.44 3.76 
2.64 3.69 
Year 
2003 
2002 
2001 
BW has a very poor inventory turnover ratio.
6-50 
Inventory Turnover Ratio -- 
Trend Analysis Comparison 
Trend Analysis of Inventory Turnover Ratio 
4.0 
3.5 
3.0 
2.5 
2.0 
2001 2002 2003 
Analysis Year 
Ratio Value 
BW 
Industry
Income Statement / 
6-51 
Activity Ratios 
Total Asset Turnover 
Net Sales 
Total Assets 
For Basket Wonders 
December 31, 2003 
Balance Sheet 
Ratios 
Activity Ratios 
Indicates the overall 
effectiveness of the firm 
in utilizing its assets to 
generate sales. 
$2,211 
$2,169 
= 1.02
6-52 
Activity 
Ratio Comparisons 
Total Asset Turnover Ratio 
BW Industry 
1.02 1.17 
1.03 1.14 
1.01 1.13 
Year 
2003 
2002 
2001 
BW has a weak total asset turnover ratio. 
Why is this ratio considered weak?
Income Statement / 
Profitability Ratios 
6-53 
Profitability Ratios 
Gross Profit Margin 
Gross Profit 
Net Sales 
For Basket Wonders 
December 31, 2003 
Balance Sheet 
Ratios 
Indicates the efficiency 
of operations and firm 
pricing policies. 
$612 
$2,211 
= .277
6-54 
Profitability 
Ratio Comparisons 
Gross Profit Margin 
BW Industry 
27.7% 31.1% 
28.7 30.8 
31.3 27.6 
Year 
2003 
2002 
2001 
BW has a weak Gross Profit Margin.
6-55 
Gross Profit Margin -- 
Trend Analysis Comparison 
Trend Analysis of Gross Profit Margin 
35.0 
32.5 
30.0 
27.5 
25.0 
2001 2002 2003 
Analysis Year 
Ratio Value (%) 
BW 
Industry
Income Statement / 
Profitability Ratios 
6-56 
Profitability Ratios 
Net Profit Margin 
Net Profit after Taxes 
Net Sales 
For Basket Wonders 
December 31, 2003 
Balance Sheet 
Ratios 
Indicates the firm’s 
profitability after taking 
account of all expenses 
and income taxes. 
$91 
$2,211 
= .041
6-57 
Profitability 
Ratio Comparisons 
BW Industry 
4.1% 8.2% 
4.9 8.1 
9.0 7.6 
Year 
2003 
2002 
2001 
Net Profit Margin 
BW has a poor Net Profit Margin.
6-58 
Net Profit Margin -- 
Trend Analysis Comparison 
Trend Analysis of Net Profit Margin 
10 
9 
8 
7 
6 
5 
4 
2001 2002 2003 
Analysis Year 
Ratio Value (%) 
BW 
Industry
Income Statement / 
Profitability Ratios 
6-59 
Profitability Ratios 
Return on Investment 
Net Profit after Taxes 
Total Assets 
For Basket Wonders 
Balance Sheet 
Ratios 
Indicates the December 31, 2003 
profitability on the 
assets of the firm (after 
all expenses and taxes). 
$91 
$2,160 
= .042
6-60 
Profitability 
Ratio Comparisons 
Return on Investment 
BW Industry 
4.2% 9.8% 
5.0 9.1 
9.1 10.8 
Year 
2003 
2002 
2001 
BW has a poor Return on Investment.
6-61 
Return on Investment – 
Trend Analysis Comparison 
Trend Analysis of Return on Investment 
12 
10 
8 
6 
4 
2001 2002 2003 
Analysis Year 
Ratio Value (%) 
BW 
Industry
Income Statement / 
Profitability Ratios 
6-62 
Profitability Ratios 
Return on Equity 
Net Profit after Taxes 
Shareholders’ Equity 
For Basket Wonders 
Balance Sheet 
Ratios 
Indicates the profitability December 31, 2003 
to the shareholders of 
the firm (after all 
expenses and taxes). 
$91 
$1,139 
= .08
6-63 
Profitability 
Ratio Comparisons 
BW Industry 
8.0% 17.9% 
9.4 17.2 
16.6 20.4 
Year 
2003 
2002 
2001 
Return on Equity 
BW has a poor Return on Equity.
6-64 
Return on Equity -- 
Trend Analysis Comparison 
Trend Analysis of Return on Equity 
21.0 
17.5 
14.0 
10.5 
7.0 
2001 2002 2003 
Analysis Year 
Ratio Value (%) 
BW 
Industry
6-65 
Return on Investment and 
the Du Pont Approach 
Earning Power = Sales profitability X 
Asset efficiency 
ROI = Net profit margin X 
Total asset turnover 
ROI2003 = .041 x 1.02 = .042 or 4.2% 
ROIIndustry = .082 x 1.17 = .098 or 9.8%
Equity Multiplier = 
6-66 
Return on Equity and 
the Du Pont Approach 
Return On Equity = Net profit margin X 
Total asset turnover X 
Equity Multiplier 
Total Assets 
Shareholders’ Equity 
ROE2003 = .041 x 1.02 x 1.90 = .080 
ROEIndustry = .082 x 1.17 x 1.88 = .179
6-67 
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.
6-68 
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.

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Chapter 2

  • 1. 6-1 Chapter 2 Financial Statement Analysis
  • 2. 6-2 Financial Statement Analysis Financial Statements A Possible Framework for Analysis Ratio Analysis Trend Analysis Common-Size and Index Analysis
  • 3. 6-3 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.
  • 4. 6-4 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.
  • 5. Balance Sheet 6-5 Primary Types of Financial Statements  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 Wonders Balance Sheet (thousands) Dec. 31, 2003a 6-6 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 Assetsb $2,169
  • 7. Basket Wonders Balance Sheet (thousands) Dec. 31, 2003 6-7 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
  • 8. 6-8 Basket Wonders’ Income Statement Basket Wonders Statement of Earnings (in thousands) for Year Ending December 31, 2003a 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 Expensee 59 EBT f $ 151 Income Taxes 60 EATg $ 91 Cash Dividends 38 Increase in RE $ 53
  • 9. 6-9 Framework for Financial Analysis Analytical Tools Used Sources and Uses Statement Statement of Cash Flows Cash Budgets 1. Analysis of the funds needs of the firm. Trend / Seasonal Component How much funding will be required in the future? Is there a seasonal component?
  • 10. 6-10 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.
  • 11. 6-11 Framework for Financial Analysis Examples: Volatility in sales Volatility in costs Proximity to break-even point 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. Business risk relates to the risk inherent in the operations of the firm.
  • 12. 6-12 Framework for Financial Analysis A Financial Manager must consider all three jointly when determining the financing needs of the firm. Determining the financing needs 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. 6-13 Framework for Financial Analysis Negotiations with suppliers of capital. Determining the financing needs 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.
  • 14. 6-14 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.
  • 15. 6-15 Basket Wonders’ Common Size Balance Sheets Regular (thousands of $) Common-Size (%) Assets 2001 2002 2003 2001 2002 2003 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
  • 16. 6-16 Basket Wonders’ Common Size Balance Sheets Regular (thousands of $) Common-Size (%) Liab+Equity 2001 2002 2003 2001 2002 2003 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
  • 17. 6-17 Basket Wonders’ Common Size Income Statements Regular (thousands of $) Common-Size (%) 2001 2002 2003 2001 2002 2003 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
  • 18. 6-18 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.
  • 19. 6-19 Basket Wonders’ Indexed Balance Sheets Regular (thousands of $) Indexed (%) Assets 2001 2002 2003 2001 2002 2003 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
  • 20. 6-20 Basket Wonders’ Indexed Balance Sheets Regular (thousands of $) Indexed (%) Liab+Equity 2001 2002 2003 2001 2002 2003 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
  • 21. 6-21 Basket Wonders’ Indexed Income Statements Regular (thousands of $) Indexed (%) 2001 2002 2003 2001 2002 2003 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
  • 22. 6-22 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.
  • 23. 6-23 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.”
  • 24. Balance Sheet Ratios 6-24 Liquidity Ratios Current Current Assets Current Liabilities For Basket Wonders December 31, 2003 Liquidity Ratios Shows a firm’s ability to cover its current liabilities with its current assets. $1,195 $500 = 2.39
  • 25. 6-25 Liquidity Ratio Comparisons BW Industry 2.39 2.15 2.26 2.09 1.91 2.01 Year 2003 2002 2001 Current Ratio Ratio is stronger than the industry average.
  • 26. Balance Sheet Ratios 6-26 Liquidity Ratios Acid-Test (Quick) Current Assets - Inv Current Liabilities For Basket Wonders December 31, 2003 Liquidity Ratios Shows a firm’s ability to meet current liabilities with its most liquid assets. $1,195 - $696 $500 = 1.00
  • 27. 6-27 Liquidity Ratio Comparisons BW Industry 1.00 1.25 1.04 1.23 1.11 1.25 Year 2003 2002 2001 Acid-Test Ratio Ratio is weaker than the industry average.
  • 28. 6-28 Summary of the Liquidity Ratio Comparisons Ratio BW Industry Current 2.39 2.15 Acid-Test 1.00 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.
  • 29. 6-29 Current Ratio -- Trend Analysis Comparison Trend Analysis of Current Ratio 2.5 2.3 2.1 1.9 1.7 1.5 2001 2002 2003 Analysis Year Ratio Value BW Industry
  • 30. 6-30 Acid-Test Ratio -- Trend Analysis Comparison Trend Analysis of Acid-Test Ratio 1.5 1.3 1.0 0.8 0.5 2001 2002 2003 Analysis Year Ratio Value BW Industry
  • 31.  The current ratio for BW has been rising 6-31 Summary of the Liquidity Trend Analyses 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.
  • 32. Balance Sheet Ratios 6-32 Financial Leverage Ratios Debt-to-Equity Total Debt Shareholders’ Equity For Basket Wonders December 31, 2003 Financial Leverage Ratios Shows the extent to which the firm is financed by debt. $1,030 $1,139 = .90
  • 33. 6-33 Financial Leverage Ratio Comparisons Debt-to-Equity Ratio BW Industry .90 .90 .88 .90 .81 .89 Year 2003 2002 2001 BW has average debt utilization relative to the industry average.
  • 34. Balance Sheet Ratios 6-34 Financial Leverage Ratios Debt-to-Total-Assets Total Debt Total Assets For Basket Wonders Financial Leverage Ratios Shows the percentage December 31, 2003 of the firm’s assets that are supported by debt financing. $1,030 $2,169 = .47
  • 35. 6-35 Financial Leverage Ratio Comparisons Debt-to-Total-Asset Ratio BW Industry .47 .47 .47 .47 .45 .47 Year 2003 2002 2001 BW has average debt utilization relative to the industry average.
  • 36. Balance Sheet Ratios 6-36 Financial Leverage Ratios Total Capitalization (i.e., LT-Debt + Equity) Total Debt Total Capitalization For Basket Wonders December 31, 2003 Financial Leverage Ratios Shows the relative importance of long-term debt to the long-term financing of the firm. $1,030 $1,669 = .62
  • 37. 6-37 Financial Leverage Ratio Comparisons Total Capitalization Ratio BW Industry .62 .60 .62 .61 .67 .62 Year 2003 2002 2001 BW has average long-term debt utilization relative to the industry average.
  • 38. 6-38 Coverage Ratios Interest Coverage EBIT Interest Charges For Basket Wonders Income Statement Ratios Coverage Ratios Indicates a firm’s December 31, 2003 ability to cover interest charges. $210 $59 = 3.56
  • 39. 6-39 Coverage Ratio Comparisons Interest Coverage Ratio BW Industry 3.56 5.19 4.35 5.02 10.30 4.66 Year 2003 2002 2001 BW has below average interest coverage relative to the industry average.
  • 40. 6-40 Coverage Ratio -- Trend Analysis Comparison Trend Analysis of Interest Coverage Ratio 11.0 9.0 7.0 5.0 3.0 2001 2002 2003 Analysis Year Ratio Value BW Industry
  • 41.  The interest coverage ratio for BW has 6-41 Summary of the Coverage Trend Analysis been falling since 2001. It has been below industry averages for the past two years.  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.
  • 42. Income Statement / 6-42 Activity/Efficiency Ratios Receivable Turnover (Assume all sales are credit sales.) Annual Net Credit Sales Receivables For Basket Wonders Balance Sheet Ratios Activity Ratios Indicates quality of December 31, 2003 receivables and how successful the firm is in its collections. $2,211 $394 = 5.61
  • 43. Income Statement / 6-43 Activity Ratios Avg Collection Period Days in the Year Receivable Turnover For Basket Wonders December 31, 2003 Balance Sheet Ratios Activity Ratios Average number of days that receivables are outstanding. (or RT in days) 365 5.61 = 65 days
  • 44. 6-44 Activity Ratio Comparisons Average Collection Period BW Industry 65.0 65.7 71.1 66.3 83.6 69.2 Year 2003 2002 2001 BW has improved the average collection period to that of the industry average.
  • 45. Income Statement / 6-45 Activity Ratios Payable Turnover (PT) (Assume annual credit purchases = $1,551.) Annual Credit Purchases Accounts Payable For Basket Wonders December 31, 2003 Balance Sheet Ratios Activity Ratios Indicates the promptness of payment to suppliers by the firm. $1551 $94 = 16.5
  • 46. Income Statement / 6-46 Activity Ratios PT in Days Days in the Year Payable Turnover For Basket Wonders December 31, 2003 Balance Sheet Ratios Activity Ratios Average number of days that payables are outstanding. 365 16.5 = 22.1 days
  • 47. 6-47 Activity Ratio Comparisons Payable Turnover in Days BW Industry 22.1 46.7 25.4 51.1 43.5 48.5 Year 2003 2002 2001 BW has improved the PT in Days. Is this good?
  • 48. Income Statement / 6-48 Activity Ratios Inventory Turnover Cost of Goods Sold Inventory For Basket Wonders December 31, 2003 Balance Sheet Ratios Activity Ratios Indicates the effectiveness of the inventory management practices of the firm. $1,599 $696 = 2.30
  • 49. 6-49 Activity Ratio Comparisons Inventory Turnover Ratio BW Industry 2.30 3.45 2.44 3.76 2.64 3.69 Year 2003 2002 2001 BW has a very poor inventory turnover ratio.
  • 50. 6-50 Inventory Turnover Ratio -- Trend Analysis Comparison Trend Analysis of Inventory Turnover Ratio 4.0 3.5 3.0 2.5 2.0 2001 2002 2003 Analysis Year Ratio Value BW Industry
  • 51. Income Statement / 6-51 Activity Ratios Total Asset Turnover Net Sales Total Assets For Basket Wonders December 31, 2003 Balance Sheet Ratios Activity Ratios Indicates the overall effectiveness of the firm in utilizing its assets to generate sales. $2,211 $2,169 = 1.02
  • 52. 6-52 Activity Ratio Comparisons Total Asset Turnover Ratio BW Industry 1.02 1.17 1.03 1.14 1.01 1.13 Year 2003 2002 2001 BW has a weak total asset turnover ratio. Why is this ratio considered weak?
  • 53. Income Statement / Profitability Ratios 6-53 Profitability Ratios Gross Profit Margin Gross Profit Net Sales For Basket Wonders December 31, 2003 Balance Sheet Ratios Indicates the efficiency of operations and firm pricing policies. $612 $2,211 = .277
  • 54. 6-54 Profitability Ratio Comparisons Gross Profit Margin BW Industry 27.7% 31.1% 28.7 30.8 31.3 27.6 Year 2003 2002 2001 BW has a weak Gross Profit Margin.
  • 55. 6-55 Gross Profit Margin -- Trend Analysis Comparison Trend Analysis of Gross Profit Margin 35.0 32.5 30.0 27.5 25.0 2001 2002 2003 Analysis Year Ratio Value (%) BW Industry
  • 56. Income Statement / Profitability Ratios 6-56 Profitability Ratios Net Profit Margin Net Profit after Taxes Net Sales For Basket Wonders December 31, 2003 Balance Sheet Ratios Indicates the firm’s profitability after taking account of all expenses and income taxes. $91 $2,211 = .041
  • 57. 6-57 Profitability Ratio Comparisons BW Industry 4.1% 8.2% 4.9 8.1 9.0 7.6 Year 2003 2002 2001 Net Profit Margin BW has a poor Net Profit Margin.
  • 58. 6-58 Net Profit Margin -- Trend Analysis Comparison Trend Analysis of Net Profit Margin 10 9 8 7 6 5 4 2001 2002 2003 Analysis Year Ratio Value (%) BW Industry
  • 59. Income Statement / Profitability Ratios 6-59 Profitability Ratios Return on Investment Net Profit after Taxes Total Assets For Basket Wonders Balance Sheet Ratios Indicates the December 31, 2003 profitability on the assets of the firm (after all expenses and taxes). $91 $2,160 = .042
  • 60. 6-60 Profitability Ratio Comparisons Return on Investment BW Industry 4.2% 9.8% 5.0 9.1 9.1 10.8 Year 2003 2002 2001 BW has a poor Return on Investment.
  • 61. 6-61 Return on Investment – Trend Analysis Comparison Trend Analysis of Return on Investment 12 10 8 6 4 2001 2002 2003 Analysis Year Ratio Value (%) BW Industry
  • 62. Income Statement / Profitability Ratios 6-62 Profitability Ratios Return on Equity Net Profit after Taxes Shareholders’ Equity For Basket Wonders Balance Sheet Ratios Indicates the profitability December 31, 2003 to the shareholders of the firm (after all expenses and taxes). $91 $1,139 = .08
  • 63. 6-63 Profitability Ratio Comparisons BW Industry 8.0% 17.9% 9.4 17.2 16.6 20.4 Year 2003 2002 2001 Return on Equity BW has a poor Return on Equity.
  • 64. 6-64 Return on Equity -- Trend Analysis Comparison Trend Analysis of Return on Equity 21.0 17.5 14.0 10.5 7.0 2001 2002 2003 Analysis Year Ratio Value (%) BW Industry
  • 65. 6-65 Return on Investment and the Du Pont Approach Earning Power = Sales profitability X Asset efficiency ROI = Net profit margin X Total asset turnover ROI2003 = .041 x 1.02 = .042 or 4.2% ROIIndustry = .082 x 1.17 = .098 or 9.8%
  • 66. Equity Multiplier = 6-66 Return on Equity and the Du Pont Approach Return On Equity = Net profit margin X Total asset turnover X Equity Multiplier Total Assets Shareholders’ Equity ROE2003 = .041 x 1.02 x 1.90 = .080 ROEIndustry = .082 x 1.17 x 1.88 = .179
  • 67. 6-67 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.
  • 68. 6-68 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.