PowerPoint

Presentations for
Finance for
Non-Financial Managers:
Seventh Edition

Prepared by
Pierre Bergeron
University of Ottawa

Copyright © 2014 Nelson Education Ltd. 4–1

 CHAPTER 4
Financial Statement
Analysis

Copyright © 2014 Nelson Education Ltd. 4–2

 Learning Objectives
1. Explain why financial statements need to be
analyzed.
2. Evaluate a company’s statement of financial
position and statement of income by using vertical
and horizontal analysis.
3. Analyze financial statements by using meaningful
ratios.
4. Describe how financial ratios can be used to
measure and improve a company’s financial
performance.
5. Examine financial statements by using the DuPont
financial system.
6. Discuss the limitations of financial ratios.

Copyright © 2014 Nelson Education Ltd. 4–3

 LO 1
Why Analyze Financial Statements?

1. Ensure liquidity

2. Maintain solvency

3. Improve productivity of assets

4. Maximize return

5. Secure long-term prosperity

Copyright © 2014 Nelson Education Ltd. 4–4

 LO 2
Modern Industries Ltd. —Vertical Analysis
2013 2012
$ % of sales $ % of sales
Revenue $ 2,500,000 100.0 $ 2,300,000 100.0
Cost of sales (1,400,000) (56.0) (1,334,000) (58.0)
Gross profit 1,100,000 44.0 966,000 42.0
Operating expenses
Salaries (820,000) (32.8) (763,600) (33.2)
Lease payments (20,000) (0.8) (18,000) (0.8)
Depreciation (50,000) (2.0) (30,000) (1.3)
Other expenses (50,000) (2.0) (48,000) (2.1)

Total operating expenses (940,000) (37.6) (859,600) (37.4)

Profit before taxes 160,000 6.4 106,400 4.6
Income tax expense (80,000) (3.2) (53,200) (2.3)
Profit for the year $ 80,000 3.2 $ 53,200 2.3
Copyright © 2014 Nelson Education Ltd. 4–5
Modern Industries Ltd. —Horizontal Analysis LO 2
Amount of % of
2013 2012 change change
Revenue $ 2,500,000 $ 2,300,000 $ 200,000 8.69
Cost of sales (1,400,000) (1,334,000) 66,000 4.95
Gross profit 1,100,000 966,000 134,000 13.87
Operating expenses
Salaries (820,000) (763,600) 56,400 7.38
Lease payments (20,000) (18,000) 2,000 11.10
Depreciation (50,000) (30,000) 20,000 66.67
Other expenses (50,000) (48,000) 2,000 4.17

Total operating expenses (940,000) (859,600) 80,400 9.35

Profit before taxes 160,000 106,400 53,600 50.37
Income tax expense (80,000) (53,200) 26,800 50.37
Profit for the year $ 80,000 $ 53,200 $ 26,800 50.37
Copyright © 2014 Nelson Education Ltd. 4–6
 LO 3
Financial Ratios
Statement of financial position Statement of Income
Non-current Equity Revenue
assets
Cost of sales

Current assets Non-current Gross profit

liabilities
Operating expenses

Current liabilities Profit for the year

1. Statement of financial position ratios Liquidity ratios

2. Statement of income ratios Debt/coverage ratios
3. Combined ratios Asset-management ratios
4. Vertical analysis Profitability ratios

5. Horizontal analysis Market-value ratios

Copyright © 2014 Nelson Education Ltd. 4–7

Modern Industries Ltd. LO 3
Statement of Financial Position
As at December 31, 2013

Non-current assets Equity

Property, plant & equipment $ 900,000 Share capital $ 100,000
Accumulated depreciation (100,000) Retained earnings 300,000
Total non-current assets $ 800,000 Total equity $ 400,000

Current assets Non-current liabilities

Inventories $ 150,000 Mortgage $ 500,000
Trade receivables 190,000 Long-term borrowings 100,000
Marketable securities 10,000 Total non-current liabilities $ 600,000
Cash 50,000
Current liabilities
Total current assets $ 400,000 $ 100,000
Trade and other payables
Notes payable 80,000
Accruals 20,000
Total current liabilities $ 200,000

Total assets $ 1,200,000 Total equity & liabilities $ 1,200,000

Copyright © 2014 Nelson Education Ltd. 4–8
Modern Industries Ltd. LO 3
Statement of Income
For the period ended December 31, 2013
Revenue $2,500,000
Cost of sales (1,400,000)
1 Gross profit 1,100,000

Other income $ 80,000

Distribution costs
Salaries ($ 300,000)
Advertising (50,000)
Supplies (5,000)
Total distribution costs (355,000)
Administrative expenses
Salaries ($ 360,000)
Other expenses (160,000)
Lease payments (20,000)
Depreciation (50,000)
Total administrative expenses (590,000)
Finance costs (75,000)
Total other income and expenses (940,000)
2 Profit before taxes 160,000
Income tax expense (80,000)
3 Profit for the year $ 80,000

Copyright © 2014 Nelson Education Ltd. 4–9

 LO 3
Categories of Financial Ratios
Liquidity ratios Indicate a company’s ability to meet its
short-term obligations.
• short-term lenders
• suppliers
• employees

Debt/ ratios Measure the extent to which a business

coverage can be financed by debt.
• Investors
(shareholders & long-term lenders)

Asset- ratios Show how effectively management utilizes

management the assets of a business.
• managers

Profitability ratios Indicate the management’s overall

effectiveness and efficiencies as measured
• everybody
by return on revenue, on assets, on equity.

Copyright © 2014 Nelson Education Ltd. 4–10

 LO 3
Commonly Used Financial Ratios

Copyright © 2014 Nelson Education Ltd. 4–11

 LO 3
Ratio 1: Current
Purpose To give a general indication of the ability of a
business (borrower) to meet its current
obligations.

• collateral • growth • cushion

Current assets $400,000
= = 2.0 times
Current liabilities $200,000

Current assets Current liabilities

Inventories $ 150,000 Trade and other payables $ 100,000
Trade receivables 190,000 Notes payable 80,000
Marketable securities 10,000 Accruals 20,000
Cash 50,000
Total current assets $ 400,000 Total current liabilities $ 200,000

Copyright © 2014 Nelson Education Ltd. 4–12

 LO 3
Ratio 2: Quick or Acid Test
Purpose To supplement the current ratio in measuring
liquidity, this ratio places more emphasis on
liquid assets that can be quickly converted into
cash.

Current assets – Inventories $250,000

= = 1.25 times
Current liabilities $200,000

Current assets Current liabilities

Inventories ----- Trade and other payables $ 100,000
Trade receivables $ 190,000 Notes payable 80,000
Marketable securities 10,000 Accruals 20,000
Cash 50,000
Total current assets $ 250,000 Total current liabilities $ 200,000

Copyright © 2014 Nelson Education Ltd. 4–13

 LO 3
Ratio 3: Debt-to-Total Assets
Purpose Measures the proportion of “all” debts
provided by lenders to finance “all” assets.
It is also called the debt ratio.

Total liabilities $800,000

= = 67%
Total assets $1,200,000

Non-current assets $ 800,000 Equity $ 400,000

Current assets 400,000 Non-current liabilities 600,000

Current liabilities 200,000
Total liabilities 800,000
Total assets $ 1,200,000 Total equity & liabilities $ 1,200,000

Copyright © 2014 Nelson Education Ltd. 4–14

 LO 3
Applying for a Mortgage
A person in the 40% tax bracket
applies for a mortgage

Payment $ 2,000 Payment = $ 1,500

= = .40 = .30
Salary $ 5,000 Salary $ 5,000

Mortgage $ 2,000 Mortgage $ 1,500

Income taxes $ 2,000 Income taxes $ 2,000
Other $ 1,000 Other $ 1,500
Total $ 5,000 Total $ 5,000

Copyright © 2014 Nelson Education Ltd. 4–15

 LO 3
Ratio 5: Times-Interest-Earned
Purpose Shows the debt-paying ability of a business
or its capacity to service the finance costs.

Profit before taxes + Finance costs $235,000

= = 3.1 times
Finance costs $75,000
Revenue $ 2,500,000
Cost of sales (1,400,000) • Finance costs
Gross profit 1,100,000 • Principal
Other income 80,000
Total distribution costs (355,000)
• Taxes
Total administrative expenses (590,000) • Dividends
Finance costs (75,000)
• Retained
Profit before taxes 160,000 earnings
Income tax expense (80,000)
Profit for the year $ 80,000

Copyright © 2014 Nelson Education Ltd. 4–16

 LO 3
Ratio 6: Fixed-Charges Coverage
Purpose Similar to the times-interest-earned ratio except this ratio
includes “all” fixed charges, or the capacity to service
the finance costs and other fixed obligations.
P.B.T. + Finance costs + Lease payments $255,000
= = 2.7 times
Finance costs + Lease payments $95,000

Revenue $ 2,500,000
Cost of sales (1,400,000)
Gross profit 1,100,000
Other income 80,000
Total distribution costs (355,000)
Total administrative expenses* (590,000)
Finance costs (75,000)
Profit before taxes 160,000
Income tax expense (80,000)
Profit for the year $ 80,000
* Includes $20,000 in lease payments

Copyright © 2014 Nelson Education Ltd. 4–17

 LO 3
Ratio 7: Average Collection Period
Purpose Measures the number of days it takes a business to
collect payments after credit sales have been made.
Revenue $ 2,500,000
Step 1: Average sales per day = = = $ 6,849
365 365
Trade $190,000
Step 2: Average collection period = receivables = = 27.7 days
$6,849
Average sales
per day

Statement of Income Statement of Financial Position

Revenue $ 2,500,000 Current assets -----

Cost of sales 1,400,000 Trade receivables $ 190,000

Gross profit $ 1,100,000 Total current $ 400,000

assets

Copyright © 2014 Nelson Education Ltd. 4–18

 LO 3
Ratio 8: Inventory Turnover
Purpose Shows how long it takes for inventories to
turn around or how fast it moves.

Cost of sales $1,400,000

= = 9.3 times
Average inventories $150,000

Statement of Income Statement of Financial Position

Revenue $ 2,500,000 Current assets -----

Cost of sales 1,400,000 Inventories $ 150,000

Gross profit $ 1,100,000 Total current $ 400,000

assets

Copyright © 2014 Nelson Education Ltd. 4–19

 LO 3
Ratio 9: Capital Assets Turnover
Purpose Measures how intensively a firm’s non-current assets
such as property, plant, and equipment are working.

Revenue $2,500,000
= = 3.1 times
Non-current assets $800,000
Statement of Income Statement of Financial Position
Revenue $ 2,500,000
Cost of sales (1,400,000)
Non-current assets $ 800,000
Gross profit 1,100,000
Other income 80,000
Current assets $ 400,000
Total distribution costs (355,000)
Total administrative expenses (590,000)
Finance costs (75,000) Total assets $ 1,200,000
Profit before taxes 160,000
Income tax expense (80,000)
Profit for the year $ 80,000

Copyright © 2014 Nelson Education Ltd. 4–20

 LO 3
Ratio 10: Total Assets Turnover
Purpose Measures the intensity by which all assets, that is, current
and non-current assets, are used to generate revenue.
Revenue $2,500,000
= = 2.1 times
Total assets $1,200,000

Statement of Income Statement of Financial Position

Revenue $ 2,500,000
Cost of sales (1,400,000)
Non-current assets $ 800,000
Gross profit 1,100,000
Other income 80,000
Current assets $ 400,000
Total distribution costs (355,000)
Total administrative expenses (590,000)
Finance costs (75,000) Total assets $ 1,200,000
Profit before taxes 160,000
Income tax expense (80,000)
Profit for the year $ 80,000

Copyright © 2014 Nelson Education Ltd. 4–21

Ratio 11: Profit Margin on Revenue LO 3

Purpose Shows the efficiency of a business.

Operating profit $155,000 6.2%

= =
Revenue $2,500,000
Vertical analysis
Statement of Income
Revenue $ 2,500,000 100.0
Cost of sales (1,400,000)
Gross profit 1,100,000 44.0
Total distribution costs (355,000)
Total administrative expenses (590,000)
Operating profit 155,000 6.2
Other income & finance costs 5,000
Profit before taxes 160,000
Income tax expense (80,000)
Profit for the year $ 80,000 3.2

Copyright © 2014 Nelson Education Ltd. 4–22

 LO 3
Ratio 13: Return on Total Assets
Purpose Measures the return on funds invested in the
business by both the owners and the lenders.
Profit for the year $ 80,000
= = 6.7%
Total assets $ 1,200,000

Statement of Income Statement of Financial Position

Revenue $ 2,500,000
Cost of sales (1,400,000)
Non-current assets $ 800,000
Gross profit 1,100,000
Other income 80,000
Current assets $ 400,000
Total distribution costs (355,000)
Total administrative expenses (590,000)
Finance costs (75,000) Total assets $ 1,200,000
Profit before taxes 160,000
Income tax expense (80,000)
Profit for the year $ 80,000

Copyright © 2014 Nelson Education Ltd. 4–23

 LO 3
Ratio 14: Return on Equity
Purpose Shows how profitable a business is to its owners.

Profit for the year $80,000

= = 20.0%
Equity $400,000

Statement of Income Statement of Financial Position

Revenue $ 2,500,000
Cost of sales (1,400,000) Equity $ 400,000
Gross profit 1,100,000
Other income 80,000 Non-current liabilities 600,000
Total distribution costs (355,000)
Current liabilities 200,000
Total administrative expenses (590,000)
Total liabilities 800,000
Finance costs (75,000)
Profit before taxes 160,000
Income tax expense (80,000) Total equity & liabilities $ 1,200,000
Profit for the year $ 80,000

Copyright © 2014 Nelson Education Ltd. 4–24

 LO 4
Financial Benchmarks
Modern
Industries Ltd. Benchmarks

Liquidity Current (times) 2.00 1.50

ratios
Quick or acid test (times) 1.25 1.00

Debt/coverage Debt-to-total assets (percent) 67.00 55.00

ratios
Times-interest-earned (times) 3.10 5.00
Fixed-charges coverage (times) 2.70 5.00

Asset- Average collection period (days) 27.70 35.00

management
ratios Inventory turnover (times) 9.30 8.00
Capital assets turnover (times) 3.10 4.50
Total assets turnover (times) 2.10 3.5

Profitability Profit margin on revenue (percent) 6.20 5.50

ratios
Return on total assets (percent) 6.70 5.50
Return on equity (percent) 20.00 15.00

Copyright © 2014 Nelson Education Ltd. 4–25

 LO 5
DuPont Financial System

Inventories
+
Revenue
Trade Current Total assets
÷
receivables assets turnover
Total
+ + assets
Prepaid Non-current
expenses assets
+
Cash Return on
× total
Cost of assets
sales
+ Revenue
Depreciation - Operating
+ Total cost profit
Distribution of operation Profit on
÷ revenue
costs
+
Revenue
Administrative
expenses

Copyright © 2014 Nelson Education Ltd. 4–26

 LO 6
Limitations of Financial Ratios

• To make ratios meaningful…

1. Look at trends
2. Compare financial performance with other
businesses or industry averages

Copyright © 2014 Nelson Education Ltd. 4–27

 LO 6
Limitations of Financial Ratios

• Limitations:
• Only give signals— do not answer questions
relating to why, what, or how
• When comparing ratios with other businesses,
make sure closing dates of financial statements
are the same
• Ensure that numbers used are similar
• Business size may make a difference
• Nature of the operations may also be different
(new plant versus worn-out plant)

Copyright © 2014 Nelson Education Ltd. 4–28