1

Chapter 6
Financial
Financial Statement
Statement
Analysis
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:

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 firms 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 firms 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.

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

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.

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

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, 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
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 Other g. Acc. deductions for
Assets, LT
223 Total
wear and tear.
b

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

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 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

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.

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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.

Types of
Comparisons
Internal
Comparisons
External
Comparisons

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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.

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Liquidity Ratios
Balance Sheet Ratios

Current

Liquidity Ratios

Current Assets
Current Liabilities

Shows a firms
ability to cover its
current liabilities
with its current
assets.

For Basket Wonders

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

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Liquidity Ratio
Comparisons
Current Ratio
Year
2007
2006
2005

BW
2.39
2.26
1.91

Industry
2.15
2.09
2.01

Ratio is stronger than the industry average.

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Liquidity Ratios
Balance Sheet Ratios

Acid-Test (Quick)

Liquidity Ratios

Cash + AR + MS
Current Liabilities

Shows a firms
ability to meet
current liabilities
with its most liquid
assets.

For Basket Wonders

December 31, 2007
$485
$500

= 0.968

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Liquidity Ratio
Comparisons
Acid-Test Ratio
Year
2007
2006
2005

BW
0.97
1.04
1.11

Industry
1.25
1.23
1.25

Ratio is weaker than the industry average.

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Summary of the Liquidity

Ratio Comparisons
Ratio
BW
Current
2.39
Acid-Test1.00

Industry
2.15
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.

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Current Ratio -- Trend

Analysis Comparison

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Acid-Test Ratio -- Trend

Analysis Comparison

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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.

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Financial Leverage Ratios

Balance Sheet Ratios
Financial Leverage
Ratios

Shows the extent to

which the firm is
financed by debt.

Debt-to-Equity
Total Debt
Shareholders Equity
For Basket Wonders
December 31, 2007
$1,030 = .90
$1,139

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Financial Leverage
Ratio Comparisons
Debt-to-Equity Ratio
Year
2007
2006
2005

BW
.90
.88
.81

Industry
.90
.90
.89

BW has average debt utilization

relative to the industry average.

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Financial Leverage Ratios

Balance Sheet Ratios
Financial Leverage
Ratios

Shows the
percentage of the
firms assets that are
supported by debt
financing.

Debt-to-Total-Assets
Total Debt
Total Assets
For Basket Wonders
December 31, 2007
$1,030 = .47
$2,169

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Financial Leverage
Ratio Comparisons
Debt-to-Total-Asset Ratio
Year
2007
2006
2005

BW
.47
.47
.45

Industry
.47
.47
.47

BW has average debt utilization

relative to the industry average.

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Financial Leverage Ratios

Balance Sheet Ratios
Financial Leverage
Ratios
Shows the relative
importance of long-term
debt to the long-term
financing of the firm.

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

Long-term Debt
Total Capitalization
For Basket Wonders
December 31, 2007
$530 = .32
$1,669

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Financial Leverage
Ratio Comparisons
Total Capitalization Ratio
Year
2007
2006
2005

BW
.32
.32
.37

Industry
.30
.31
.32

BW has average long-term debt utilization

relative to the industry average.

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Coverage Ratios
Income Statement
Ratios
Coverage Ratios

Indicates a firms
ability to cover
interest charges.

Interest Coverage
EBIT
Interest Charges
For Basket Wonders
December 31, 2007
$210 = 3.56
$59

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Coverage
Ratio Comparisons
Interest Coverage Ratio
Year
2007
2006
2005

BW
3.56
4.35
10.30

Industry
5.19
5.02
4.66

BW has below average interest coverage

relative to the industry average.

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Coverage Ratio -- Trend

Analysis Comparison

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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.
Note, we know that debt levels are in
line with the industry averages.

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Activity Ratios
Income Statement /
Balance Sheet
Ratios
Activity Ratios
Indicates quality of
receivables and how
successful the firm is in
its collections.

Receivable Turnover
(Assume all sales are credit sales.)

Annual Net Credit Sales

Receivables
For Basket Wonders
December 31, 2007
$2,211 = 5.61
$394

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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)

Days in the Year

Receivable Turnover

365
5.61

= 65 days

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Activity
Ratio Comparisons
Average Collection Period
Year
2007
2006
2005

BW
65.0
71.1
83.6

Industry
65.7
66.3
69.2

BW has improved the average collection

period to that of the industry average.

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Activity Ratios
Income Statement /
Balance Sheet
Ratios
Activity Ratios
Indicates the
promptness of payment
to suppliers by the firm.

Payable Turnover (PT)

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

Annual Credit Purchases

Accounts Payable
For Basket Wonders
December 31, 2007
$1551
= 16.5
$94

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Activity Ratios
Income Statement /
Balance Sheet
Ratios
Activity Ratios
Average number of days
that payables are
outstanding.

PT in Days
Days in the Year
Payable Turnover
For Basket Wonders
December 31, 2007
365
16.5

= 22.1 days

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Activity
Ratio Comparisons
Payable Turnover in Days
Year
2007
2006
2005

BW
22.1
25.4
43.5

Industry
46.7
51.1
48.5

BW has improved the PT in Days.

Is this good?

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Activity Ratios
Income Statement /
Balance Sheet
Ratios
Activity Ratios
Indicates the
effectiveness of the
inventory management
practices of the firm.

Inventory Turnover
Cost of Goods Sold
Inventory
For Basket Wonders
December 31, 2007
$1,599 = 2.30
$696

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Activity
Ratio Comparisons
Inventory Turnover Ratio
Year
2007
2006
2005

BW
2.30
2.44
2.64

Industry
3.45
3.76
3.69

BW has a very poor inventory turnover ratio.

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Inventory Turnover Ratio

--Trend Analysis
Comparison

Activity Ratios
Income Statement /
Balance Sheet
Ratios
Activity Ratios

Indicates the overall

effectiveness of the firm
in utilizing its assets to
generate sales.
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Total Asset Turnover

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

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Activity
Ratio Comparisons
Total Asset Turnover Ratio
Year
2007
2006
2005

BW
1.02
1.03
1.01

Industry
1.17
1.14
1.13

BW has a weak total asset turnover ratio.

Why is this ratio considered weak?

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Profitability Ratios
Income Statement /
Balance Sheet
Ratios
Profitability Ratios
Indicates the efficiency
of operations and firm
pricing policies.

Gross Profit Margin

Gross Profit
Net Sales
For Basket Wonders
December 31, 2007
$612 = .277
$2,211

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Profitability
Ratio Comparisons
Gross Profit Margin
Year
2007
2006
2005

BW
27.7%
28.7
31.3

Industry
31.1%
30.8
27.6

BW has a weak Gross Profit Margin.

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Gross Profit Margin -Trend Analysis Comparison

Profitability Ratios
Income Statement /
Balance Sheet
Ratios
Profitability Ratios

Indicates the firms

profitability after taking
account of all expenses
and income taxes.
44

Net Profit Margin

Net Profit after Taxes
Net Sales
For Basket Wonders
December 31, 2007
$91 = .041
$2,211

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Profitability
Comparisons

Ratio

Net Profit Margin

Year
2007
2006
2005

BW
4.1%
4.9
9.0

Industry
8.2%
8.1
7.6

BW has a poor Net Profit Margin.

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Net Profit Margin -Trend Analysis Comparison

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Profitability Ratios
Income Statement /
Balance Sheet
Ratios
Profitability Ratios
Indicates the
profitability on the
assets of the firm (after
all expenses and taxes).

Return on Investment
Net Profit after Taxes
Total Assets
For Basket Wonders
December 31, 2007
$91 = .042
$2,160

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Profitability
Comparisons

Ratio

Return on Investment
Year
2007
2006
2005

BW
4.2%
5.0
9.1

Industry
9.8%
9.1
10.8

BW has a poor Return on Investment.

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Return on Investment
Trend Analysis Comparison

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Profitability Ratios
Income Statement /
Balance Sheet
Ratios
Profitability Ratios
Indicates the profitability
to the shareholders of
the firm (after all
expenses and taxes).

Return on Equity
Net Profit after Taxes
Shareholders Equity
For Basket Wonders
December 31, 2007
$91 = .08
$1,139

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Profitability
Comparisons

Ratio

Return on Equity
Year
2007
2006
2005

BW
8.0%
9.4
16.6

Industry
17.9%
17.2
20.4

BW has a poor Return on Equity.

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Return on Equity -Trend Analysis Comparison

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Return on Investment and

the Du Pont Approach
Earning Power = Sales profitability X
Asset efficiency
ROI = Net profit margin X
Total asset turnover

ROI2007

= .041 x 1.02 = .042 or 4.2%

ROIIndustry = .082 x 1.17 = .098 or 9.8%

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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

= .041 x 1.02 x 1.90 = .080

ROEIndustry = .082 x 1.17 x 1.88 = .179

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Summary
Summary of
of the
the Profitability
Profitability
Trend
Trend Analyses
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.
Note, this result is consistent with the
low interest coverage ratio.

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Summary
Summary of
of Ratio
Ratio Analyses
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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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.

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Basket Wonders Common

Size Balance Sheets

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Basket Wonders Common

Size Balance Sheets

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Basket Wonders Common

Size Income Statements

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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.

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Basket Wonders
Indexed Balance Sheets

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Basket Wonders
Indexed Balance Sheets

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Basket Wonders Indexed

Income Statements