Introduction to Financial Analysis

Case Study Example

This workbook summarizes many of the concepts that are taught in the course: Introduction to Financial
Analysis. Information about this course and other free resources can be found at: www.exinfm.com

Table of Contents
1
2
3
4
5
6
7
8

Financial Statements - Start with a complete set of financial statements

Common Size Statements - Express the financials in terms of a common size for easy analysis
Ratio Analysis - Apply a complete set of ratios to the financial statements
Industry Trend Analysis - Benchmark your performance horizontally against industry averages
ROI Model - Construct a model that explains the sources behind Return on Investment
Cost of Capital - Calculate the weighted average cost of capital
Economic Analysis - Analyze a major investment using economic indicators
Sales Forecast - Prepare a sales forecast for the next annual year

This workbook is used in conjunction with a course that is subject to copyright protection.
You may print, download and use this workbook for your own personal use in conjunction
with this course. You may not reproduce or redistribute this workbook without first
obtaining the express permission of the author:
Matt H. Evans, CPA, CMA, CFM
Email: matt@exinfm.com
Phone: 1-877-807-8756

on to Financial

or easy analysis

ustry averages
estment

Balance Sheet
Year ending
Year ending
12/31/2005
12/31/2006
($ in thousands of dollars)

Assets
Current Assets
Cash
Marketable Securities
Accounts Receivable
Inventories
Total Current Assets

Long-Term Assets
Property & Equipment at cost
Less Accumulated Depreciation
Net Property & Equipment
Total Long-Term Assets
TOTAL ASSETS

2,081
1,625
16,850
26,470
47,026

39,500
9,500
30,000
30,000

2,540
1,800
18,320
27,530
50,190

43,100
11,400
31,700
31,700

77,026

81,890

8,340
5,635
3,150
1,750
2,000
20,875

9,721
8,500
3,200
2,102
2,000
25,523

Liabilities
Current Liabilities
Accounts Payable
Notes Payable @ 10%
Taxes Payable
Other Current Liabilities
Current Portion of Longterm Debt
Total Current Liabilities
Long-Term Liabilities
Mortgage Bonds @ 9.58%
Total Long-Term Liabilities
TOTAL LIABILITIES

24,000
24,000
$

44,875

13,000
10,000
9,151

32,151

22,000
22,000
$

47,523

Equity
Common Stock
Paid in Capital in excess of par value
Retained Earnings
TOTAL EQUITY

###
10,000
11,367
$

34,367

Income Statement
Year ending
12/31/2006
($ in thousands of dollars)

Revenues
Gross Sales Revenues
Allowance for Sales Returned
Net Sales Revenues
TOTAL SALES

116,900
4,140
112,760
112,760

Expenses
Cost of Goods Sold
Gross Profits
Operating Expenses:
Selling & Marketing
General Administrative
Total Operating Expenses
Operating Income
Interest Expenses:
Interest on Loans
Interest on Mortgage Bonds
Total Interest Expenses
Earnings Before Taxes
Federal & State Taxes @ 40%
NET INCOME

85,300
27,460

6,540
9,400
15,940
11,520

850
2,310
3,160
8,360
3,344
5,016

Introduction to Financial Analysis

Common Size Financial Statements
Vertical analysis of financial statements is most often performed by expressing the Balance Sheet and
Income Statement as common size statements. We can easily understand the relationships between
accounts when we express financials as a percentage of total balances.

Balance Sheet
Year ending
Year ending
12/31/2005
12/31/2006
(% of Total Assets)

Assets
Cash
Marketable Securities
Accounts Receivable
Inventories
Total Current Assets

2.70%
2.11%
21.88%
34.37%
61.05%

3.10%
2.20%
22.37%
33.62%
61.29%

Net Property & Equipment

38.95%

38.71%

100.00%

100.00%

Current Liabilities

27.10%

31.17%

Long-Term Liabilities

31.16%

26.87%

TOTAL LIABILITIES

58.26%

58.03%

TOTAL EQUITY

41.74%

41.97%

100.00%

100.00%

TOTAL ASSETS

Liabilities

Equity

TOTAL LIABILITIES & EQUITY

Key Points per Review of the Common Size Balance Sheet:

1 The company is fairly liquid since current assets are 61% of total assets.
2 About 55% of all assets are tied up in either Accounts Receivable or Inventories. Therefore, it is
very important to effectively manage these two assets on the Balance Sheet.
3 The company does not appear to be too overly leveraged in debt with a debt leverage below 60%

Income Statement

Year ending
12/31/2006
(% of Total Net Sales)
NET SALES

100.00%

Cost of Goods Sold

75.65%
Gross Margin

Operating Expense

24.35%
14.14%

Operating Margin
Interest Expense

10.22%
2.80%

Earnings Before Taxes

Tax Expense

7.41%
2.97%

NET INCOME

4.45%

Key Points per Review of the Common Size Income Statement:

1 Cost of products sold represents 75% of all costs the company incurs
2 Operating costs appear to be modest at 14%
3 Return on Sales is rather low at 4.45%

Introduction to Financial Analysis

Ratio Analysis
A complete set of ratios is probably the best analytical approach to evaluating the financial strengths and
weaknesses of a company.
Year ending
Liquidity Ratios
12/31/2006
1. Current Ratio = Current Assets / Current Liabilities

1.97

2. Acid Test or Quick Ratio = (Current Assets - Inventories - Prepaid

Expenses) / Current Liabilities

0.89

3. Operating Cash Flow to Current Liabilities

0.45

Asset Management Ratios

4. Accounts Receivable Turnover = Annual Credit Sales / Average
Receivable Balance
5. Accounts Receivable Collection = 360 Days / Accounts
Receivable Turnover
6. Inventory Turnover = Cost of Goods Sold / Average Inventory
7. Days Held in Inventory = 360 Days / Inventory Turnover

6.41

56.14
3.16
113.95

8. Fixed Asset Turnover = Sales / Average Net Fixed Assets

3.66

9. Total Asset Turnover = Sales / Average Total Assets

1.42

Leverage Ratios
10. Debt Ratio = Total Debt / Total Assets

0.58

11. Debt to Equity Ratio = Total Debt / Total Equity

1.38

12. Times Interest Earned = Earnings Before Interest and Taxes / Interest

3.65

Profitability Ratios
13. Gross Profit or Margin = (Sales - Cost of Goods Sold) / Sales

0.24

14. Operating Income Ratio = Operating Income / Sales

0.10

15. Return on Sales = Earnings after Taxes / Sales

0.04

16. Return on Investment = Earnings after Taxes / Average Total Assets

0.06

17. Return on Equity = Earnings after Taxes / Average Owners Equity

0.22

Introduction to Financial Analysis

Industry Trend Analysis
Compare the company performance against benchmark data for the overall industry. Where practical, try
to plot performance over long periods of time, such as five years to identify trends.
1. Current Ratio Comparison - 5 Years

Company
Industry

2002
1.97
1.86

2003
1.94
1.88

2004
1.82
1.80

2005
1.91
1.84

2006
1.97
1.88

Current Ratio

Ratio

2.00
1.95
1.90

Compan
y
Industry

1.85
1.80
1.75
1.70
2002

2003

2004

2005

2006

Year

2. Acid Test or Quick Ratio Comparison - 5 Years

Company
Industry

2002
0.83
0.80

2003
0.79
0.83

2004
0.77
0.81

2005
0.81
0.77

2006
0.89
0.79

Acid Test Ratio

Ratio

0.90
0.85
Compan
y
Industry

0.80
0.75
0.70
2002

2003

2004
Year

2005

2006

0.80

Industry

0.75
0.70
2002

2003

2004

2005

2006

Year

3. Accounts Receivable Turnover Comparison - 5 Years

Company
Industry

2002
6.79
7.07

2003
6.71
7.01

2004
6.58
6.98

2005
6.34
6.84

2006
6.41
6.91

Receivable Turnover Ratio

Ratio

7.20
7.00
6.80

Compan
y
Industry

6.60
6.40
6.20
6.00
5.80
2002

2003

2004

2005

2006

Year

4. Accounts Receivable Collection Comparison - 5 Years

Company
Industry

2002
51.30
47.26

2003
52.41
48.33

2004
55.73
49.02

2005
57.08
51.44

2006
56.14
50.62

Days

Receivable Collection in Days

58.00
56.00
54.00
52.00
50.00
48.00
46.00
44.00
42.00
40.00
2002

Compan
y
Industry

2003

2004
Year

2005

2006

5. Inventory Turnover Comparison - 5 Years

Company
Industry

2002
3.96
3.80

2003
3.44
3.69

2004
3.72
3.74

2005
3.09
3.97

2006
3.16
3.88

Ratio

Inventory Turnover Ratio

4.50
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
2002

Compan
y
Industry

2003

2004

2005

2006

Year

6. Days Held in Inventory Comparison - 5 Years

Company
Industry

2002
109.77
108.00

2003
111.08
114.00

2004
116.20
102.00

2005
117.33
111.00

2006
113.95
106.00

Days Held in Inventory

Days

120.00
115.00
110.00

Compan
y
Industry

105.00
100.00
95.00
90.00
2002

2003

2004
Year

2005

2006

7. Total Asset Turnover Comparison - 5 Years

Company
Industry

2002
1.61
1.70

2003
1.55
1.62

2004
1.39
1.68

2005
1.48
1.59

2006
1.42
1.55

Ratio

Total Asset Turnover Ratio

1.80
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
0.00
2002

Compan
y
Industry

2003

2004

2005

2006

Year

8. Debt Ratio Comparison - 5 Years

Company
Industry

2002
0.61
0.65

2003
0.67
0.61

2004
0.51
0.63

2005
0.64
0.72

2006
0.58
0.69

Ratio

Debt Ratio
0.75
0.70
0.65
0.60
0.55
0.50
0.45
0.40
0.35
0.30
2002

Compan
y
Industry

2003

2004
Year

9. Debt to Equity Ratio Comparison - 5 Years

2005

2006

Company
Industry

2002
1.36
1.40

2003
1.30
1.48

2004
1.44
1.41

2005
1.33
1.44

2006
1.38
1.50

Debt to Equity Ratio

Ratio

1.60
1.50
1.40

Compan
y
Industry

1.30
1.20
1.10
1.00
2002

2003

2004

2005

2006

Year

10. Gross Profit or Margin Comparison - 5 Years

Company
Industry

2002
0.29
0.22

2003
0.31
0.28

2004
0.23
0.20

2005
0.28
0.28

2006
0.24
0.29

Margin

Gross Profit Margin

0.34
0.32
0.30
0.28
0.26
0.24
0.22
0.20
0.18
2002

Compan
y
Industry

2003

2004

2005

2006

Year

11. Operating Income Ratio Comparison - 5 Years

Company

2002
0.07

2003
0.11

2004
0.08

2005
0.14

2006
0.10

Industry

0.14

0.08

0.09

0.11

0.13

M argin

Operating Margin
0.15
0.13
0.11

Company
Industry

0.09
0.07
0.05
2002

2003

2004

2005

2006

Year

12. Return on Sales Comparison - 5 Years

Company
Industry

2002
0.06
0.07

2003
0.05
0.08

2004
0.07
0.05

2005
0.04
0.06

2006
0.04
0.05

Return

Return on Sales
0.10
0.09
0.08
0.07

Company

0.06

Industry

0.05
0.04
0.03
2002

2003

2004

2005

2006

Year

13. Return on Investment Comparison - 5 Years

Company
Industry

2002
0.09
0.07

2003
0.06
0.11

2004
0.07
0.10

2005
0.10
0.09

Return

Return on Investment
0.15
0.13

2006
0.06
0.08

Return

Return on Investment
0.15
0.13
0.11

Company
Industry

0.09
0.07
0.05
2002

2003

2004

2005

2006

Ye ar

14. Return on Equity Comparison - 5 Years

Company
Industry

2002
0.22
0.28

2003
0.20
0.22

2004
0.24
0.23

2005
0.19
0.26

2006
0.22
0.29

Return

Return on Equity
0.32
0.30
0.28
0.26

Company

0.24

Industry

0.22
0.20
0.18
2002

2003

2004
Ye ar

2005

2006

Introduction to Financial Analysis

Return on Investment (ROI) Model
Given the importance of returns on investments, it is useful to structure a model that explains the root drivers behind returns:
Return on Capital invested by Owners
Return on Equity
14.60%
Convert ROI on Assets to ROI for Equity

Total Assets to
Shareholder Equity
2.383

Return on Investments in Assets

Return on
Investment
6.13%

Two Drivers behind ROI on Assets

Total Asset
Turnover

Profit Margin
4.45%
Three Lower
Drivers

1.38

Net Income

Sales

$ 5,016
Lowest Level - Accounts
in Financial Statements

$ 112,760

Total Assets
$ 81,890

Income Statement

Balance Sheet

Breakdown of all
major expense accounts

Breakdown of all
asset accounts

Introduction to Financial Analysis

Cost of Capital Calculation
Cost of Capital is an important benchmark by which you should evaluate long term investments.
1. Identify the interest bearing debt on the Balance Sheet:
Notes Payable @ 10%
Mortgage Bonds @ 9.58%
2. Calculate the effective rate by deducting out the tax rate since interest is deductible:
Tax Rate per Balance Sheet
Notes Payable @ 10%
Mortgage Bonds @ 9.58%

40.00%
10.00%
9.58%

60.00%
60.00%

6.00%
5.75%

3. Calculate the cost of equity using the Capital Asset Pricing Model:
a. Risk Free Rate of Return - 10 Year Treasury Bonds
b. Beta Risk Factor for Stock of Company
c. Market Portfolio Returns
Rate of Return for Stock

3.50%
1.22
13.50%
15.70%

4. Assign market values to each of the components of capital and calculate the Weighted Average Cost of Capital:

Notes Payable
Mortagage Bonds
Stock (Equity)

Cost of
Market
Capital
Values
6.00% $
6,000
5.75% $
15,000
15.70% $
45,000
$
66,000

Percents
9%
23%
68%
100%

Weighted
Cost of Cap
0.55%
1.31%
10.70%
12.56%

Investments need to generate a rate greater than

erage Cost of Capital:

Introduction to Financial Analysis

Economic Analysis
Long term investments should be evaluated using economic analysis. This will involve estimating the
discounted cash flows of the investment.
During the year, an investment was made in Property & Equipment

3,600

Evaluate the economics of this investment as follows:

1 Determine the useful life of the investment >

10 Years

2 Cash flow outlays and benefits from this investment are:

Initial cash outlay to acquire and install

Cash outlays to operate and maintain
Cash benefit - higher efficiencies
Cash benefit - costs avoided
Cash benefit - increased sales
Net Cost or Benefit

Year
0
-3,600

Year
1

Year
2

-3,600

-30
400
300
500
1,170

-25
400
300
500
1,175

Present Value Interest Factor

1.0000

0.8884

0.7893

Discounted Amounts
4 Summarize your results using economic indicators
a. Key Economic Indicator is NPV >

-3,600

1,039

927

3 Calculate the discounted cash flows for this investment

Cost of Capital Rate >
12.56%

b. Another Key Economic Indicator is Rate of Return >

c. A third economic indicator is discounted payback period - How long does it take before you recover your inves
-2,561
-1,633

Conclusion: This investment creates positive value for the company, has an estimated rate of return
higher than the cost of capital, and reaches payback mid way in the useful life of the asset.
Based on these economic indicators, this appears to be a good investment.

Year
3

Year
4

Year
5

Year
6

Year
7

Year
8

Year
9

Year
10

-20
400
150
600
1,130

-20
420
100
600
1,100

-20
420
50
600
1,050

-15
420
50
600
1,055

-15
430
50
650
1,115

-15
430
50
650
1,115

-15
450
50
650
1,135

-15
450
50
650
1,135

0.7013

0.6230

0.5535

0.4918

0.4369

0.3882

0.3449

0.3064

792

685

581

519

487

433

391

348

Total
-3,600
-190
4,220
1,150
6,000
7,580

2,604

Net Present Value

You can also use this formula for NPV which yields a more conservative value >
Rate to use for reinvestment of residual cash flows >

5% Rate of Return

take before you recover your investment?

-841
-155
426 < In Year 5 we reach payback of our investment

rate of return
ife of the asset.

2,314
14.62%

Introduction to Financial Analysis

Sales Forecast and Forecasted Income Statement
Once you have a clear indication of past financial performance, then you can forecast future financial
performance. This usually starts with Sales and the Income Statement. A simple example appears below:
Step 1 - Determine the expected demand for your products and services next year
Historical demand for products are summarized below:

Product

Units Sold
in Yr 2005

Lectin
Protela
Sucula

3,020
2,005
880

Units Sold
in Yr 2006
3,305
2,180
1,080

Units Sold
in Yr 2007
3,710
2,380
1,410

Step 2 - Determine the expected pricing for your products and services next year
Based on competitive analysis and interviews with marketing staff, the following
sales prices will be applied in Year 2008:
Product
Lectin
Protela
Sucula

Price
$
$
$

14.50
17.30
11.20

Step 3 - Calculate total expected sales for the year

3.1 Estimated Sales by Product based on average growth:

Product
Lectin
Protela
Sucula

% Growth
in 2006
9.44%
8.73%
22.73%

% Growth
in 2007
12.25%
9.17%
30.56%

Average
Growth
10.85%
8.95%
26.64%

Expected
Sales

Sales
Price

4,112 $
14.50
2,593 $
17.30
1,786 $
11.20
Total

Estimated
Sales Amt
$
$
$
$

59,629
44,860
19,999
124,488

6,500

3.2 Identify any other major sources of revenues anticipated for the year 2008:
Strategic plan and financial plan includes divesting in non performing investments
Step 4 - Based on financial analysis, budgets, and other sources, estimate the costs for 2008
4.1 Cost accounting records and interviews with Engineers indicated the following production costs:

Product

< - - - - - - - - Per Unit Cost - - - - - - - - ->

Materials
Labor
Overhead

Total Unit
Prod Cost

Units
Sold

Cost of
Goods Sold

Lectin
Protela
Sucula

1.15
1.84
1.32

6.20
7.55
4.40

2.60
3.21
2.84

9.95
12.60
8.56
Total

4,112 $
2,593 $
1,786 $
$

40,918
32,672
15,285
88,876

4.2 Marketing and selling costs are estimated based on the advertising budget and sales support team
needed to meet targeted sales for 2008
Advertising Plan and Budget for 2008
Sales Salaries and Commissions for 2008
General Marketing Expenses
Reserve and Allowance for Contigencies
Total

2,390
3,585
550
325
6,850

4.3 General and administrative costs are estimated based on staff plans for 2008 in all service support functions
Executive Management
Engineering & Operations
Accounting & Finance
Human Resource Mgmt
General Administrative
Other Support Functions
Total

4,130
2,705
1,510
1,006
460
194
10,005

4.4 Interest on debt is calculated based on anticipated borrowing of funds in 2008. The total required fixed assets
to support the sales revenues was considered adequate and thus no additional borrowings were expected.
The total scheduled interest payments for 2008 are:
Interest payments on loans
Interest payments on mortgage debt
Total

810
2,260
3,070

Step 5 - Summarize Steps 3 and 4 into a Forecasted Income Statement

Forecasted Income Statement for 2008

Ref
3.1 Gross Sales Revenues
Estimated Allowance for Sales Returned @ 3.5%
Net Sales Revenues
3.2 Revenue from Divesting in Assets
TOTAL REVENUES
4.1 Cost of Goods Sold

124,488
4,357
120,131
6,500
126,631
88,876

Gross Profits
Operating Expenses:

37,756

4.2
4.3

Selling & Marketing

General Administrative
Total Operating Expenses
Operating Income

4.4 Interest Expenses

6,850
10,005
16,855
20,901
3,070

Earnings Before Taxes

Federal & State Taxes @ 40%
NET INCOME

17,831
7,132
10,698

e support functions

equired fixed assets

gs were expected.