Financhial Statement Analysis Van Horne Ratios

Chapter 6
Financial Statement
Analysis
6.1
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
After Studying Chapter 6,

you should be able to:
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 firms 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 firms 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.
6.2
Examples of External Uses

of Statement Analysis
Trade Creditors Focus on the

liquidity of the firm.
Bondholders Focus on the

term cash flow of the firm.
Shareholders Focus on the

profitability and long-term health of
the firm.
6.4
long-
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.
6.5
Primary Types of
Financial Statements
Balance Sheet
A summary of a firms financial position on
a given date that shows total assets = total
liabilities + owners equity.
Income Statement
6.7
A summary of a firms 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, 2007 a
Cash
Rec.c
$ 90 Acct. a. How the firm stands on

394 Inventories
a specific date.
696 Prepaid Exp d
b. What BW owned.
5 Accum Tax Prepay c. Amounts owed by
10
customers.
d. Future expense items
Current Assetse $1,195 Fixed
already paid.
Assets (@Cost)f 1030 Less: e. Cash/likely convertible
Acc. Depr. g
(329) Net
to cash within 1 year.
Fix. Assets $ 701
f. Original amount paid.
Investment, LT
50 Other g. Acc. deductions for
Assets, LT
223 Total
wear and tear.
b
Assets
$2,169
6.8
Basket Wonders Balance

Sheet (Liability Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007
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
6.9
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.
Basket Wonders
Income 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
shareholders.
6.10
Use of Financial Ratios

A Financial Ratio is an
index that relates
two accounting
numbers and is
obtained by dividing
one number by the
other.
6.16
Types of
Comparisons
Internal
Comparisons
External
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.
Examples:
Risk Management
Association
Similarity is important
as one should
compare apples to
apples.
Almanac of
Business and
Industrial
Financial Ratios
6.17
Dun & Bradstreet
Liquidity Ratios
Balance Sheet Ratios
Current Ratio
Liquidity Ratios
Current Assets
Current Liabilities
Shows a firms
ability to cover its
current liabilities
with its current
assets.
6.18
For Basket Wonders

December 31, 2007
$1,195 = 2.39
$500
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.

6.19
Liquidity Ratios
Liquidity Ratios
Shows a firms
ability to meet
current liabilities
with its most liquid
assets.
6.20
Acid-Test (Quick) Ratio

Current Assets - Inv
Current Liabilities
For Basket Wonders
December 31, 2007
$1,195 $696 = 1.00

$500
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.

6.21
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.
6.22
Current Ratio Trend

Analysis Comparison
Trend Analysis of Current Ratio
Ratio Value
2.5
2.3
2.1
BW
Industry
1.9
1.7
1.5
2005
2006
2007
Analysis Year
6.23
Acid-Test Ratio Trend

Analysis Comparison
Trend Analysis of Acid-Test Ratio
Ratio Value
1.5
1.3
BW
Industry
1.0
0.8
0.5
2005
2006
2007
Analysis Year
6.24
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
6.25
Financial Leverage Ratios

Financial Leverage
Ratios
Shows the extent to

which the firm is
financed by debt.
6.26
Debt-to-Equity
Total Debt
Shareholders Equity
For Basket Wonders
December 31, 2007
$1,030 = 0.90
$1,139
Financial Leverage
Ratio Comparisons
Debt-to-Equity Ratio
Year
BW
Industry
2007
0.90
0.90
2006
0.88
0.90
2005
0.81
0.89
BW has average debt utilization

relative to the industry average.
6.27

Financial Leverage
Ratios
Shows the percentage

of the firms assets
that are supported by
debt financing.
6.28
Debt-to-Total-Assets
Total Debt
Total Assets
For Basket Wonders
December 31, 2007
$1,030 = 0.47
$2,169
Financial Leverage
Ratio Comparisons
Debt-to-Total-Asset Ratio
Year
BW
Industry
2007
0.47
0.47
2006
0.47
0.47
2005
0.45
0.47
BW has average debt utilization

6.29

Total Capitalization
Financial Leverage
Ratios
Total Debt
Total Capitalization
Shows the relative

importance of long-term
debt to the long-term
financing of the firm.
6.30
(i.e., LT-Debt + Equity)
For Basket Wonders

December 31, 2007
$1,030 = 0.62
$1,669
Financial Leverage
Ratio Comparisons
Total Capitalization Ratio
Year
BW
Industry
2007
0.62
0.60
2006
0.62
0.61
2005
0.67
0.62
BW has average long-term debt utilization

6.31
Coverage Ratios
Income Statement
Ratios
Coverage Ratios
Indicates a firms
ability to cover
interest charges.
6.32
Interest Coverage
EBIT
Interest Charges
For Basket Wonders
December 31, 2007
$210 = 3.56
$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

6.33
Coverage Ratio Trend

Analysis Comparison
Trend Analysis of Interest Coverage Ratio
11.0
Ratio Value
9.0
7.0
BW
Industry
5.0
3.0
2005
2006
2007
Analysis Year
6.34
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.
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.
6.35
Activity Ratios
Income Statement/
Balance Sheet
Ratios
Activity Ratios
Indicates quality of
receivables and how
successful the firm is in
its collections.
6.36
Receivable Turnover
(Assume all sales are credit sales.)
Annual Net Credit Sales

Receivables
For Basket Wonders
December 31, 2007
$2,211 = 5.61
$394
Activity Ratios
Income Statement/
Balance Sheet
Ratios
Avg Collection Period
Activity Ratios
For Basket Wonders

December 31, 2007
Average number of days

that receivables are
outstanding.
(or RT in days)
6.37
Days in the Year

Receivable Turnover
365
5.61
= 65 days
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

period to that of the industry average.
6.38
Activity Ratios
Income Statement/
Balance Sheet
Ratios
Activity Ratios
Indicates the
promptness of payment
to suppliers by the firm.
6.39
Payable Turnover (PT)

(Assume annual credit
purchases = $1,551.)
Annual Credit Purchases

Accounts Payable
For Basket Wonders
December 31, 2007
$1551
= 16.5
$94
Activity Ratios
Income Statement/
Balance Sheet
Ratios
Activity Ratios
Average number of days
that payables are
outstanding.
6.40
PT in Days
Days in the Year
Payable Turnover
For Basket Wonders
December 31, 2007
365
16.5
= 22.1 days
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?
6.41
Activity Ratios
Income Statement/
Balance Sheet
Ratios
Activity Ratios
Indicates the
effectiveness of the
inventory management
practices of the firm.
6.42
Inventory Turnover
Cost of Goods Sold
Inventory
For Basket Wonders
December 31, 2007
$1,599 = 2.30
$696
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.

6.43
Inventory Turnover Ratio

Trend Analysis Comparison
Trend Analysis of Inventory Turnover Ratio
Ratio Value
4.0
3.5
3.0
BW
Industry
2.5
2.0
2005
2006
2007
Analysis Year
6.44
Activity Ratios
Income Statement/
Balance Sheet
Ratios
Activity Ratios
Indicates the overall
effectiveness of the firm
in utilizing its assets to
generate sales.
6.45
Total Asset Turnover

Net Sales
Total Assets
For Basket Wonders
December 31, 2007
$2,211 = 1.02
$2,169
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?

6.46
Profitability Ratios
Income Statement/
Balance Sheet
Ratios
Indicates the efficiency
of operations and firm
pricing policies.
6.47
Gross Profit Margin

Gross Profit
Net Sales
For Basket Wonders
December 31, 2007
$612 = 0.277
$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.

6.48
Gross Profit Margin

Trend Analysis of Gross Profit Margin
Ratio Value (%)
35.0
32.5
30.0
BW
Industry
27.5
25.0
2005
2006
2007
Analysis Year
6.49
Income Statement/
Balance Sheet
Ratios
Indicates the firms
profitability after taking
account of all expenses
and income taxes.
6.50
Net Profit Margin

Net Profit after Taxes
Net Sales
For Basket Wonders
December 31, 2007
$91 = 0.041
$2,211
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.

6.51
Net Profit Margin

Trend Analysis of Net Profit Margin
10
Ratio Value (%)
9
8
7
BW
Industry
6
5
4
2005
2006
2007
Analysis Year
6.52
Income Statement/
Balance Sheet
Ratios
Indicates the
profitability on the
assets of the firm (after
all expenses and taxes).
6.53
Return on Investment
Total Assets
For Basket Wonders
December 31, 2007
$91 = 0.042
$2,160
Profitability
Ratio Comparisons
Year
BW
Industry
2007
4.2%
9.6%
2006
5.0
9.1
2005
9.1
10.8
BW has a poor Return on Investment.

6.54
Trend Analysis of Return on Investment
Ratio Value (%)
12
10
8
BW
Industry
6
4
2005
2006
2007
Analysis Year
6.55
Income Statement/
Balance Sheet
Ratios
Indicates the profitability
to the shareholders of
the firm (after all
expenses and taxes).
6.56
Return on Equity
Shareholders Equity
For Basket Wonders
December 31, 2007
$91 = 0.08
$1,139
Profitability
Ratio Comparisons
Return on Equity
Year
BW
Industry
2007
8.0%
18.0%
2006
9.4
17.2
2005
16.6
20.4
BW has a poor Return on Equity.

6.57
Return on Equity
Trend Analysis of Return on Equity
Ratio Value (%)
21.0
17.5
14.0
BW
Industry
10.5
7.0
2005
2006
2007
Analysis Year
6.58
Return on Investment and

the Du Pont Approach
Earning Power = Sales profitability
Asset efficiency
ROI = Net profit margin
Total asset turnover
ROI2007
= 0.041 1.02 = 0.042 or 4.2%
ROIIndustry = 0.082 1.17 = 0.096 or 9.6%

(Note: values are rounded)
6.59
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
ROE2007
= 0.041 1.02 1.90 = 0.080
ROEIndustry = 0.082 1.17 1.88 = 0.180

(Note: values are rounded)
6.60
Summary of the Profitability

Trend 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

interest coverage ratio.
6.61
Growth Ratios
Income Statement/
Balance Sheet
Ratios
Growth Ratios
Growth
Ratio
(Value of t+1) (Value of t)

(Value of t)
x100
For Basket Wonders
December 31, 2007
Indicates the firms

growth of any activities
6.62
Stock Ratios
Earning
/ Share =
(EPS)= Net Profit / # of
Shares
6.63
91,000 / 200,000 =0.455
Stock Ratios
Dividends/Share
(Div.)=
Distributed profit / #
of Shares
38,000
6.64
/ 200,000 = 0.19
Stock Ratios
Price
Earning Ratio
(Profit
(PE)=
Multiplier)
Market Price/ Earning/Share
= 6.00 / 0.455= 13.19
OR
= 8.00 / 0.455 = 17.58
6.65
Stock Ratios
Book
Value= Shareholders
Equity / # of Common
Shares
6.66
1,139,000 / 200,000
5.695
Stock Ratios
Market
=
6.67
Price to Book Value
Market Price / Book Value
= 6.00 / 5.695 = 1.05
OR
= 8.00 / 5.695 = 1.40
Stock Ratios
The
Paid Price = 200,000 +

729,000 = 929,000
The
Paid Price / Share =

929,000 / 200,000 = 4.645
6.68
Summary of Ratio Analyses
6.69
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.
6.70
Basket Wonders Common

Size Balance Sheets
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6.71
Basket Wonders CommonSize Balance Sheets
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6.72
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0
5
1
5
9
1
.
6
2
.
4
2
.
7
B
T
1
8
6
1
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1
1
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1
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.
1
8
.
1
6
.
8
E
A
T
1
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2
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0
3
9
1
9
.
1
4
.
9
4
.
1
C
ashD
iv 50 50 504.0 2.4 2.3
6.73
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.
6.74
Basket Wonders
Indexed Balance Sheets
R
e
g
u
l
a
r
(
t
h
o
u
s
a
n
d
s
o
f
$
)
I
n
d
e
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e
d
(
%
)
A
s
s
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t
s
2
0
0
5
2
0
0
6
2
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0
7
2
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2
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7
C
a
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4
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6
7
.
6
6
0
.
8
A
R
2
8
3
4
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3
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4
1
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0
.
0
1
4
4
.
9
1
3
9
.
2
I
n
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3
2
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6
1
6
6
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6
1
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3
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.
1
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tTh
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r
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A
1
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A
7
6
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5
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.
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6
N
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3
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6
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8
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T
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.
9
2
0
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.
9
TotA
ssets1,2232,0442,169100.0167.1177.4
6.75
Basket Wonders
Indexed Balance Sheets
R
e
g
u
l
a
r
(
t
h
o
u
s
a
n
d
s
o
f
$
)
I
n
d
e
x
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d
(
%
)
LiN
ao
bt+
E
q
u
i
t
y
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
5
2
0
0
6
2
0
0
7
e
P
a
y
2
9
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2
9
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2
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0
1
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1
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7
1
0
0
.
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A
c
c
t
P
a
y
8
1
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4
9
4
1
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1
6
.
0
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1
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0
A
c
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a
x
1
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6
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6
1
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1
2
3
.
1
1
2
3
.
1
O
tT
h
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r
1
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1
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0
6
6
6
.
7
6
6
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t
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L
3
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9
5
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5
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1
2
6
.
6
1
2
5
.
3
L
T
D
e
b
t
1
5
0
4
5
3
5
3
0
1
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.
0
3
0
2
.
0
3
5
3
.
3
E
q
u
i
t
y
6
7
4
1
,
0
8
6
1
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1
3
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1
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0
1
6
1
.
1
1
6
9
.
0
TotL+E1,2232,0442,169100.0167.1177.4
6.76
Basket Wonders Indexed

Income Statements
Regular (thousands of $)
2005
Net Sales
COGS
2007
2005
2006
2007
1,235
849
2,106
1,501
2,211
1,599
100.0
100.0
170.5
176.8
179.0
188.3
Gross Profit
Adm.
386
180
605
383
612
402
100.0
100.0
156.7
212.8
158.5
223.3
EBIT
Int Exp
206
20
222
51
210
59
100.0
100.0
107.8
255.0
101.9
295.0
EBT
186
171
151
100.0
91.9
81.2
EAT
112
103
91
100.0
92.0
81.3
50
50
50
100.0
100.0
100.0
Cash Div
6.77
2006
Indexed (%)

Financhial Statement Analysis Van Horne Ratios

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Financhial Statement Analysis Van Horne Ratios

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Chapter 6

After Studying Chapter 6,

Understand the purpose of basic financial statements and their contents.

Understand what is meant by convergence in accounting standards.

Explain why financial statement analysis is important to the firm and to

Define, calculate, and categorize (according to liquidity, financial leverage,

Use ratios to analyze a firm's health and then recommend reasonable

Analyze a firms return on investment (i.e., earning power) and return on

Understand the limitations of financial ratio analysis.

Use trend analysis, common-size analysis, and index analysis to gain

Examples of External Uses

Trade Creditors Focus on the

Bondholders Focus on the

Shareholders Focus on the

Examples of Internal Uses

Plan Focus on assessing the current

Control Focus on return on investment

Understand Focus on understanding

A summary of a firms revenues and

Basket Wonders Balance

$ 90 Acct. a. How the firm stands on

Basket Wonders Balance

Use of Financial Ratios

External Comparisons and

Dun & Bradstreet

For Basket Wonders

Ratio is stronger than the industry average.

Acid-Test (Quick) Ratio

$1,195 $696 = 1.00

Ratio is weaker than the industry average.

Summary of the Liquidity

Strong current ratio and weak acid-test

Note that this industry has a relatively

Current Ratio Trend

Acid-Test Ratio Trend

Summary of the Liquidity

The current ratio for the industry has

This indicates that inventories are a

Financial Leverage Ratios

Shows the extent to

BW has average debt utilization

Financial Leverage Ratios

Shows the percentage

BW has average debt utilization

Financial Leverage Ratios

Shows the relative

(i.e., LT-Debt + Equity)

For Basket Wonders

BW has average long-term debt utilization

BW has below average interest coverage

Coverage Ratio Trend

Summary of the Coverage

This indicates that low earnings (EBIT)

Note, we know that debt levels are in

Annual Net Credit Sales

Avg Collection Period

For Basket Wonders

Average number of days

Days in the Year

BW has improved the average collection

Payable Turnover (PT)

Annual Credit Purchases

BW has improved the PT in Days.