Chapter 6

Financial Statement
Analysis
Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
6-1
 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.

6-2
 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
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.
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
A summary of a firms revenues and
expenses over a specified period, ending
with net income or loss for the period.
6-6
 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 Prepaid Exp d b. What BW owned.
5 Accum Tax Prepay c. Amounts owed by
10 customers.
Current Assetse d. Future expense items
$1,195 Fixed Assets (@Cost) f
already paid.
1030 Less: Acc. Depr. g
e. Cash/likely convertible
(329) Net Fix. Assets $ 701
to cash within 1 year.
Investment, LT 50 Other
Assets, LT 223 Total f. Original amount paid.
Assets b $2,169 g. Acc. deductions for
6-7 wear and tear.
 Basket Wonders Balance
Sheet (Liability Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007
Notes Payable $ 290 a. Note, Assets =
Acct. Payablec 94 Liabilities + Equity.
Accrued Taxes d 16 Other b. What BW owed and
Accrued Liab. d 100 ownership position.
Current Liab. e $ 500 c. Owed to suppliers for
Long-Term Debt f 530 goods and services.
Shareholders Equity d. Unpaid wages, salaries,
Com. Stock ($1 par) g 200 etc.
Add Pd in Capital g 729 e. Debts payable < 1 year.
Retained Earnings h 210 f. Debts payable > 1 year.
Total Equity $1,139 g. Original investment.
6-8 Total Liab/Equity
a,b $2,169
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
6-9 shareholders.
 Framework for
Financial Analysis
Trend / Seasonal Component
How much funding will be
required in the future?
1. Analysis of the funds
needs of the firm. Is there a seasonal
component?

Analytical Tools Used

Sources and Uses Statement
Statement of Cash Flows
Cash Budgets
6-10
 Framework for
Financial Analysis

Health of a Firm

1. Analysis of the funds

needs of the firm.
Financial Ratios
2. Analysis of the financial
condition and profitability 1. Individually
of the firm. 2. Over time
3. In combination
4. In comparison

6-11
 Framework for
Financial Analysis

Business risk relates to

the risk inherent in the
1. Analysis of the funds
needs of the firm.
operations of the firm.
2. Analysis of the financial Examples:
condition and profitability
of the firm. Volatility in sales
3. Analysis of the business
risk of the firm. Volatility in costs
Proximity to break-even
point
6-12
 Framework for
Financial Analysis
A Financial
Manager
must
1. Analysis of the funds
needs of the firm. Determining consider all
2. Analysis of the financial
the three jointly
financing
condition and profitability
needs of
when
of the firm. determining
the firm.
3. Analysis of the business
risk of the firm.
the
financing
needs of the
6-13 firm.
 Framework for
Financial Analysis

1. Analysis of the funds

needs of the firm. Determining Negotiations
the
2. Analysis of the financial with
financing
condition and profitability suppliers of
needs of
of the firm. capital.
the firm.
3. Analysis of the business
risk of the firm.

6-14
 Use of Financial Ratios

A Financial Ratio is Types of

an index that relates Comparisons
two accounting
numbers and is Internal
obtained by dividing Comparisons
one number by the External
other. Comparisons

6-15
 External Comparisons and
Sources of Industry Ratios
This involves Examples:
comparing the ratios Risk Management
of one firm with those Association
of similar firms or with
industry averages. Dun & Bradstreet
Almanac of
Similarity is important Business and
as one should Industrial
compare apples to Financial Ratios
6-16
apples.
 Liquidity Ratios
Balance Sheet Ratios Current

Current Assets
Liquidity Ratios
Current Liabilities

Shows a firms ability For Basket Wonders

to cover its current December 31, 2007
liabilities with its
current assets. $1,195 = 2.39
$500
6-17
 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.
6-18
 Liquidity Ratios
Balance Sheet Ratios Acid-Test (Quick)

Current Assets - Inv

Liquidity Ratios
Current Liabilities

Shows a firms For Basket Wonders

ability to meet December 31, 2007
current liabilities $1,195 - $696 = 1.00
with its most liquid $500
6-19
assets.
 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.
6-20
 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.
6-21
 Current Ratio -- Trend
Analysis Comparison

6-22
 Acid-Test Ratio -- Trend
Analysis Comparison

6-23
 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
6-24
 Financial Leverage Ratios
Balance Sheet Ratios Debt-to-Equity

Total Debt
Financial Leverage
Shareholders Equity
Ratios
For Basket Wonders
December 31, 2007
Shows the extent to
which the firm is $1,030 = .90
financed by debt. $1,139
6-25
 Financial Leverage
Ratio Comparisons
Debt-to-Equity Ratio
Year BW Industry
2007 .90 .90
2006 .88 .90
2005 .81 .89
BW has average debt utilization
6-26
relative to the industry average.
 Financial Leverage Ratios
Balance Sheet Ratios Debt-to-Total-Assets

Total Debt
Financial Leverage
Total Assets
Ratios
For Basket Wonders
Shows the percentage December 31, 2007
of the firms assets
that are supported by $1,030 = .47
debt financing. $2,169
6-27
 Financial Leverage
Ratio Comparisons
Debt-to-Total-Asset Ratio
Year BW Industry
2007 .47 .47
2006 .47 .47
2005 .45 .47
BW has average debt utilization
6-28
relative to the industry average.
 Financial Leverage Ratios
Balance Sheet Ratios Total Capitalization
(i.e., LT-Debt + Equity)

Financial Leverage Long-term Debt

Ratios Total Capitalization

Shows the relative For Basket Wonders

importance of long-term December 31, 2007
debt to the long-term $530 = .32
financing of the firm. $1,669
6-29
 Financial Leverage
Ratio Comparisons
Total Capitalization Ratio
Year BW Industry
2007 .32 .30
2006 .32 .31
2005 .37 .32
BW has average long-term debt utilization
6-30
relative to the industry average.
 Coverage Ratios
Income Statement Interest Coverage
Ratios
EBIT
Interest Charges
Coverage Ratios
For Basket Wonders
Indicates a firms December 31, 2007
ability to cover
interest charges. $210 = 3.56
$59
6-31
 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
6-32
relative to the industry average.
 Coverage Ratio -- Trend
Analysis Comparison

6-33
 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.
6-34
 Activity Ratios
Income Statement / Receivable Turnover
(Assume all sales are credit sales.)
Balance Sheet
Ratios Annual Net Credit Sales
Receivables
Activity Ratios
For Basket Wonders
Indicates quality of December 31, 2007
receivables and how
successful the firm is in $2,211 = 5.61
its collections. $394
6-35
 Activity Ratios
Income Statement / Avg Collection Period
Balance Sheet
Ratios Days in the Year
Receivable Turnover

Activity Ratios For Basket Wonders

December 31, 2007
Average number of days
that receivables are
outstanding. 365 = 65 days
(or RT in days) 5.61
6-36
 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
6-37
period to that of the industry average.
 Activity Ratios
Income Statement / Payable Turnover (PT)
(Assume annual credit
Balance Sheet purchases = $1,551.)
Ratios
Annual Credit Purchases
Accounts Payable
Activity Ratios
For Basket Wonders
Indicates the
December 31, 2007
promptness of payment
to suppliers by the firm. $1551
= 16.5
$94
6-38
 Activity Ratios
Income Statement / PT in Days
Balance Sheet
Ratios Days in the Year
Payable Turnover
Activity Ratios
For Basket Wonders
December 31, 2007
Average number of days
that payables are 365
outstanding. = 22.1 days
16.5
6-39
 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.
6-40
Is this good?
 Activity Ratios
Income Statement / Inventory Turnover
Balance Sheet
Ratios Cost of Goods Sold
Inventory
Activity Ratios
For Basket Wonders
December 31, 2007
Indicates the
effectiveness of the $1,599 = 2.30
inventory management $696
practices of the firm.
6-41
 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.
6-42
 Inventory Turnover Ratio
--Trend Analysis
Comparison

6-43
 Activity Ratios
Income Statement / Total Asset Turnover
Balance Sheet
Ratios Net Sales
Total Assets
Activity Ratios
For Basket Wonders
December 31, 2007
Indicates the overall
effectiveness of the firm $2,211 = 1.02
in utilizing its assets to $2,169
generate sales.
6-44
 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.
6-45
Why is this ratio considered weak?
 Profitability Ratios
Income Statement / Gross Profit Margin
Balance Sheet
Ratios Gross Profit
Net Sales
Profitability Ratios
For Basket Wonders
December 31, 2007
Indicates the efficiency
of operations and firm $612 = .277
pricing policies. $2,211
6-46
 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.
6-47
 Gross Profit Margin --
Trend Analysis Comparison

6-48
 Profitability Ratios
Income Statement / Net Profit Margin
Balance Sheet
Ratios Net Profit after Taxes
Net Sales
Profitability Ratios
For Basket Wonders
December 31, 2007
Indicates the firms
profitability after taking $91 = .041
account of all expenses $2,211
and income taxes.
6-49
 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.
6-50
 Net Profit Margin --
Trend Analysis Comparison

6-51
 Profitability Ratios
Income Statement / Return on Investment
Balance Sheet
Ratios Net Profit after Taxes
Total Assets
Profitability Ratios
For Basket Wonders
Indicates the profitability December 31, 2007
on the assets of the firm
(after all expenses and $91 = .042
taxes). $2,160
6-52
 Profitability
Ratio Comparisons
Return on Investment
Year BW Industry
2007 4.2% 9.8%
2006 5.0 9.1
2005 9.1 10.8
BW has a poor Return on Investment.
6-53
 Return on Investment
Trend Analysis Comparison

6-54
 Profitability Ratios
Income Statement / Return on Equity
Balance Sheet
Ratios Net Profit after Taxes
Shareholders Equity
Profitability Ratios
For Basket Wonders
Indicates the profitability December 31, 2007
to the shareholders of
the firm (after all $91 = .08
expenses and taxes). $1,139
6-55
 Profitability
Ratio Comparisons
Return on Equity
Year BW Industry
2007 8.0% 17.9%
2006 9.4 17.2
2005 16.6 20.4
BW has a poor Return on Equity.
6-56
 Return on Equity --
Trend Analysis Comparison

6-57
 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%

6-58
 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
6-59
 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
6-60
interest coverage ratio.
 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.
6-61
 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.

6-62
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6-64
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C ashDiv 5050504.02.42.3
 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.
6-66
 Basket Wonders

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6-67
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6-68
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C ashDiv 50505010.010.010.0