1. 6-1 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

2. 6-2 After studying Chapter 6, you should be able to: u Understand the purpose of basic financial statements and their contents. u Explain why financial statement analysis is important to the firm and to outside suppliers of capital. u 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. u Define, calculate, and discuss a firm’s operating cycle and cash cycle. u Use ratios to analyze a firm's health and then recommend reasonable alternative courses of action to improve the health of the firm. u Analyze a firm’s return on investment (i.e., “earning power”) and return on equity using a DuPont approach. u Understand the limitations of financial ratio analysis. u Use trend analysis, common-size analysis, and index analysis to gain additional insights into a firm's performance.

3. 6-3 Financial Statement Analysis u Financial Statements u A Possible Framework for Analysis u Balance Sheet Ratios u Income Statement and Income Statement/Balance Sheet Ratios u Trend Analysis u Common-Size and Index Analysis u Financial Statements u A Possible Framework for Analysis u Balance Sheet Ratios u Income Statement and Income Statement/Balance Sheet Ratios u Trend Analysis u Common-Size and Index Analysis

4. 6-4 Examples of External Uses of Statement Analysis u Trade Creditors u Trade Creditors -- Focus on the liquidity of the firm. u Bondholders u Bondholders -- Focus on the long-term cash flow of the firm. u Shareholders u Shareholders -- Focus on the profitability and long-term health of the firm. u Trade Creditors u Trade Creditors -- Focus on the liquidity of the firm. u Bondholders u Bondholders -- Focus on the long-term cash flow of the firm. u Shareholders u Shareholders -- Focus on the profitability and long-term health of the firm.

5. 6-5 Examples of Internal Uses of Statement Analysis u Plan u Plan -- Focus on assessing the current financial position and evaluating potential firm opportunities. u Control u Control -- Focus on return on investment for various assets and asset efficiency. u Understand u Understand -- Focus on understanding how suppliers of funds analyze the firm. u Plan u Plan -- Focus on assessing the current financial position and evaluating potential firm opportunities. u Control u Control -- Focus on return on investment for various assets and asset efficiency. u Understand u Understand -- Focus on understanding how suppliers of funds analyze the firm.

6. 6-6 Primary Types of Financial Statements Income Statement u A summary of a firm’s revenues and expenses over a specified period, ending with net income or loss for the period. Income Statement u A summary of a firm’s revenues and expenses over a specified period, ending with net income or loss for the period. Balance Sheet u A summary of a firm’s financial position on a given date that shows total assets = total liabilities + owners’ equity. Balance Sheet u A summary of a firm’s financial position on a given date that shows total assets = total liabilities + owners’ equity.

7. 6-7 Basket Wonders’ Balance Sheet (Asset Side) a. How the firm stands on a specific date. b. What BW owned. c. Amounts owed by customers. d. Future expense items already paid. e. Cash/likely convertible to cash within 1 year. f. Original amount paid. g. Acc. deductions for wear and tear. a. How the firm stands on a specific date. b. What BW owned. c. Amounts owed by customers. d. Future expense items already paid. e. Cash/likely convertible to cash within 1 year. f. Original amount paid. g. Acc. deductions for wear and tear. c d Current Assets e $1,195 f g Net Fix. Assets $ 701 Total Assets b $2,169 Cash and C.E. $ 90 Acct. Rec. c 394 Inventories 696 Prepaid Exp d 5 Accum Tax Prepay 10 Current Assets e $1,195 Fixed Assets (@Cost) f 1030 Less: Acc. Depr. g (329) Net Fix. Assets $ 701 Investment, LT 50 Other Assets, LT 223 Total Assets b $2,169 Basket Wonders Balance Sheet (thousands) Dec. 31, 2007 Basket Wonders Balance Sheet (thousands) Dec. 31, 2007 a

8. 6-8 Basket Wonders’ Balance Sheet (Liability Side) 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. 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. c d d Current Liab. e $ 500 f g g h Total Equity $1,139 Notes Payable $ 290 Acct. Payable c 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/Equity a,b $2,169 Basket Wonders Balance Sheet (thousands) Dec. 31, 2007

9. 6-9 Basket Wonders’ Income Statement 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. 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. b c f Increase in RE $ 53 Net Sales $ 2,211 Cost of Goods Sold b 1,599 Gross Profit $ 612 SG&A Expenses c 402 EBIT d $ 210 Interest Expense e 59 EBT f $ 151 Income Taxes 60 EAT g $ 91 Cash Dividends 38 Increase in RE $ 53 Basket Wonders Statement of Earnings (in thousands) for Year Ending December 31, 2007 Basket Wonders Statement of Earnings (in thousands) for Year Ending December 31, 2007 a

10. 6-10 Framework for Financial Analysis Analytical Tools Used Sources and Uses Statement Statement of Cash Flows Cash Budgets Analytical Tools Used Sources and Uses Statement Statement of Cash Flows Cash Budgets 1. Analysis of the funds needs of the firm. needs of the firm. Trend / Seasonal Component How much funding will be required in the future? Is there a seasonal component? Trend / Seasonal Component How much funding will be required in the future? Is there a seasonal component?

11. 6-11 Framework for Financial Analysis Health of a Firm Financial Ratios 1. Individually 2. Over time 3. In combination 4. In comparison Health of a Firm Financial Ratios 1. Individually 2. Over time 3. In combination 4. In comparison 1. Analysis of the funds needs of the firm. 2. Analysis of the financial condition and profitability condition and profitability of the firm. of the firm.

12. 6-12 Framework for Financial Analysis Examples: Volatility in sales Volatility in costs Proximity to break-even point Examples: Volatility in sales Volatility in costs Proximity to break-even point 1. Analysis of the funds needs of the firm. 2. Analysis of the financial condition and profitability of the firm. 3. Analysis of the business risk of the firm. risk of the firm. Business risk Business risk relates to the risk inherent in the operations of the firm.

13. 6-13 Framework for Financial Analysis A Financial Manager must consider all three jointly when determining the financing needs of the firm. Determiningthefinancing needs of the firm. 1. Analysis of the funds needs of the firm. needs of the firm. 2. Analysis of the financial condition and profitability condition and profitability of the firm. of the firm. 3. Analysis of the business risk of the firm. risk of the firm.

14. 6-14 Framework for Financial Analysis Negotiationswith suppliers of capital. Determiningthefinancing needs of the firm. 1. Analysis of the funds needs of the firm. needs of the firm. 2. Analysis of the financial condition and profitability condition and profitability of the firm. of the firm. 3. Analysis of the business risk of the firm. risk of the firm.

15. 6-15 Use of Financial Ratios Types of Comparisons Internal Comparisons External Comparisons Types of Comparisons Internal Comparisons External Comparisons A Financial Ratio is an index that relates two accounting numbers and is obtained by dividing one number by the other.

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

17. 6-17 Liquidity Ratios Current Current Assets Current Liabilities For Basket Wonders December 31, 2007Current Current Assets Current Liabilities For Basket Wonders December 31, 2007 Shows a firm’s ability to cover its current liabilities with its current assets. Balance Sheet Ratios Liquidity Ratios $1,195$500 2.39 = 2.39

18. 6-18 Liquidity Ratio Comparisons BW Industry 2.392.15 2.262.09 1.912.01 BW Industry 2.392.15 2.262.09 1.912.01 Year 2007 2006 2005 Current Ratio Ratio is stronger than the industry average.

19. 6-19 Liquidity Ratios Acid-Test (Quick) Current Assets - Inv Current Liabilities For Basket Wonders December 31, 2007 Acid-Test (Quick) Current Assets - Inv Current Liabilities For Basket Wonders December 31, 2007 Shows a firm’s ability to meet current liabilities with its most liquid assets. Balance Sheet Ratios Liquidity Ratios $1,195 - $696 $500 1.00 = 1.00

20. 6-20 Liquidity Ratio Comparisons BW Industry 1.001.25 1.041.23 1.111.25 BW Industry 1.001.25 1.041.23 1.111.25 Year 2007 2006 2005 Acid-Test Ratio Ratio is weaker than the industry average.

21. 6-21 Summary of the Liquidity Ratio Comparisons u Strong current ratio and weak acid-test ratio indicates a potential problem in the inventories account. u Note that this industry has a relatively high level of inventories. u Strong current ratio and weak acid-test ratio indicates a potential problem in the inventories account. u Note that this industry has a relatively high level of inventories. RatioBWIndustry RatioBWIndustry Current2.39 2.15 Acid-Test1.00 1.25

22. 6-22 Current Ratio -- Trend Analysis Comparison

23. 6-23 Acid-Test Ratio -- Trend Analysis Comparison

24. 6-24 Summary of the Liquidity Trend Analyses industry u The current ratio for the industry has been rising slowly at the same time the acid-test ratio has been relatively stable. inventories BW u This indicates that inventories are a significant problem for BW. industry u The current ratio for the industry has been rising slowly at the same time the acid-test ratio has been relatively stable. inventories BW u This indicates that inventories are a significant problem for BW. BW u The current ratio for BW has been rising at the same time the acid-test ratio has been declining.

25. 6-25 Financial Leverage Ratios Debt-to-Equity Total Debt Shareholders’ Equity For Basket Wonders December 31, 2007Debt-to-Equity Total Debt Shareholders’ Equity For Basket Wonders December 31, 2007 Shows the extent to which the firm is financed by debt. Balance Sheet Ratios Financial Leverage Ratios $1,030$1,139.90 =.90

26. 6-26 Financial Leverage Ratio Comparisons BW Industry.90.88.90.81.89 BW Industry.90.88.90.81.89 Year 2007 2006 2005 Debt-to-Equity Ratio BW has average debt utilization relative to the industry average.

27. 6-27 Financial Leverage Ratios Debt-to-Total-Assets Total Debt Total Assets For Basket Wonders December 31, 2007Debt-to-Total-Assets Total Debt Total Assets For Basket Wonders December 31, 2007 Shows the percentage of the firm’s assets that are supported by debt financing. Balance Sheet Ratios Financial Leverage Ratios $1,030$2,169.47 =.47

28. 6-28 Financial Leverage Ratio Comparisons BW Industry.47.47.47.45.47 BW Industry.47.47.47.45.47 Year 2007 2006 2005 Debt-to-Total-Asset Ratio BW has average debt utilization relative to the industry average.

29. 6-29 Financial Leverage Ratios Total Capitalization Long-term Debt Total Capitalization For Basket Wonders December 31, 2007 Total Capitalization Long-term Debt Total Capitalization For Basket Wonders December 31, 2007 Shows the relative importance of long-term debt to the long-term financing of the firm. Balance Sheet Ratios Financial Leverage Ratios $530 $530$1,669.32 =.32 (i.e., LT-Debt + Equity)

30. 6-30 Financial Leverage Ratio Comparisons BW Industry.32.30.32.31.37.32 BW Industry.32.30.32.31.37.32 Year 2007 2006 2005 Total Capitalization Ratio BW has average long-term debt utilization relative to the industry average.

31. 6-31 Coverage Ratios Interest Coverage EBIT Interest Charges For Basket Wonders December 31, 2007 Interest Coverage EBIT Interest Charges For Basket Wonders December 31, 2007 Indicates a firm’s ability to cover interest charges. Income Statement Ratios Coverage Ratios $210$59 3.56 = 3.56

32. 6-32 Coverage Ratio Comparisons BW Industry 3.565.19 4.355.02 10.304.66 BW Industry 3.565.19 4.355.02 10.304.66 Year 2007 2006 2005 Interest Coverage Ratio BW has below average interest coverage relative to the industry average.

33. 6-33 Coverage Ratio -- Trend Analysis Comparison

34. 6-34 Summary of the Coverage Trend Analysis low earnings BW u This indicates that low earnings (EBIT) may be a potential problem for BW. debt levels industry u Note, we know that debt levels are in line with the industry averages. low earnings BW u This indicates that low earnings (EBIT) may be a potential problem for BW. debt levels industry u Note, we know that debt levels are in line with the industry averages. BW industry u The interest coverage ratio for BW has been falling since 2005. It has been below industry averages for the past two years.

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

36. 6-36 Activity Ratios Avg Collection Period Days in the Year Receivable Turnover For Basket Wonders December 31, 2007 Avg Collection Period Days in the Year Receivable Turnover For Basket Wonders December 31, 2007 Average number of days that receivables are outstanding. (or RT in days) Income Statement / Balance Sheet Ratios Activity Ratios 3655.61 65 days = 65 days

37. 6-37 Activity Ratio Comparisons BW Industry 65.065.7 71.166.3 83.669.2 BW Industry 65.065.7 71.166.3 83.669.2 Year 2007 2006 2005 Average Collection Period BW has improved the average collection period to that of the industry average.

38. 6-38 Activity Ratios Payable Turnover (PT) Annual Credit Purchases Accounts Payable For Basket Wonders December 31, 2007 Payable Turnover (PT) Annual Credit Purchases Accounts Payable For Basket Wonders December 31, 2007 Indicates the promptness of payment to suppliers by the firm. Income Statement / Balance Sheet Ratios Activity Ratios $1551$94 16.5 = 16.5 (Assume annual credit purchases = $1,551.)

39. 6-39 Activity Ratios PT in Days Days in the Year Payable Turnover For Basket Wonders December 31, 2007 PT in Days Days in the Year Payable Turnover For Basket Wonders December 31, 2007 Average number of days that payables are outstanding. Income Statement / Balance Sheet Ratios Activity Ratios 36516.5 22.1 days = 22.1 days

40. 6-40 Activity Ratio Comparisons BW Industry 22.146.7 25.451.1 43.548.5 BW Industry 22.146.7 25.451.1 43.548.5 Year 2007 2006 2005 Payable Turnover in Days BW has improved the PT in Days. Is this good?

41. 6-41 Activity Ratios Inventory Turnover Cost of Goods Sold Inventory For Basket Wonders December 31, 2007 Inventory Turnover Cost of Goods Sold Inventory For Basket Wonders December 31, 2007 Indicates the effectiveness of the inventory management practices of the firm. Income Statement / Balance Sheet Ratios Activity Ratios $1,599$696 2.30 = 2.30

42. 6-42 Activity Ratio Comparisons BW Industry 2.303.45 2.443.76 2.643.69 BW Industry 2.303.45 2.443.76 2.643.69 Year 2007 2006 2005 Inventory Turnover Ratio BW has a very poor inventory turnover ratio.

43. 6-43 Inventory Turnover Ratio -- Trend Analysis Comparison

44. 6-44 Activity Ratios Total Asset Turnover Net Sales Total Assets For Basket Wonders December 31, 2007 Total Asset Turnover Net Sales Total Assets For Basket Wonders December 31, 2007 Indicates the overall effectiveness of the firm in utilizing its assets to generate sales. Income Statement / Balance Sheet Ratios Activity Ratios $2,211$2,169 1.02 = 1.02

45. 6-45 Activity Ratio Comparisons BW Industry 1.021.17 1.031.14 1.011.13 BW Industry 1.021.17 1.031.14 1.011.13 Year 2007 2006 2005 Total Asset Turnover Ratio BW has a weak total asset turnover ratio. Why is this ratio considered weak?

46. 6-46 Profitability Ratios Gross Profit Margin Gross Profit Net Sales For Basket Wonders December 31, 2007 Gross Profit Margin Gross Profit Net Sales For Basket Wonders December 31, 2007 Indicates the efficiency of operations and firm pricing policies. Income Statement / Balance Sheet Ratios Profitability Ratios $612$2,211 277 =.277

47. 6-47 Profitability Ratio Comparisons BW Industry 27.7%31.1% 28.730.8 31.327.6 BW Industry 27.7%31.1% 28.730.8 31.327.6 Year 2007 2006 2005 Gross Profit Margin BW has a weak Gross Profit Margin.

48. 6-48 Gross Profit Margin -- Trend Analysis Comparison

49. 6-49 Profitability Ratios Net Profit Margin Net Profit after Taxes Net Sales For Basket Wonders December 31, 2007 Net Profit Margin Net Profit after Taxes Net Sales For Basket Wonders December 31, 2007 Indicates the firm’s profitability after taking account of all expenses and income taxes. Income Statement / Balance Sheet Ratios Profitability Ratios $91$2,211.041 =.041

50. 6-50 Profitability Ratio Comparisons BW Industry 4.1%8.2% 4.98.1 9.07.6 BW Industry 4.1%8.2% 4.98.1 9.07.6 Year 2007 2006 2005 Net Profit Margin BW has a poor Net Profit Margin.

51. 6-51 Net Profit Margin -- Trend Analysis Comparison

52. 6-52 Profitability Ratios Return on Investment Net Profit after Taxes Total Assets For Basket Wonders December 31, 2007 Return on Investment Net Profit after Taxes Total Assets For Basket Wonders December 31, 2007 Indicates the profitability on the assets of the firm (after all expenses and taxes). Income Statement / Balance Sheet Ratios Profitability Ratios $91$2,160.042 =.042

53. 6-53 Profitability Ratio Comparisons BW Industry 4.2% 9.8% 5.0 9.1 9.110.8 BW Industry 4.2% 9.8% 5.0 9.1 9.110.8 Year 2007 2006 2005 Return on Investment BW has a poor Return on Investment.

54. 6-54 Return on Investment – Trend Analysis Comparison

55. 6-55 Profitability Ratios Return on Equity Net Profit after Taxes Shareholders’ Equity For Basket Wonders December 31, 2007 Return on Equity Net Profit after Taxes Shareholders’ Equity For Basket Wonders December 31, 2007 Indicates the profitability to the shareholders of the firm (after all expenses and taxes). Income Statement / Balance Sheet Ratios Profitability Ratios $91$1,139.08 =.08

56. 6-56 Profitability Ratio Comparisons BW Industry 8.0%17.9% 9.417.2 16.620.4 BW Industry 8.0%17.9% 9.417.2 16.620.4 Year 2007 2006 2005 Return on Equity BW has a poor Return on Equity.

57. 6-57 Return on Equity -- Trend Analysis Comparison

58. 6-58 Return on Investment and the Du Pont Approach ROI.0424.2% ROI 2007 =.041 x 1.02 =.042 or 4.2% ROI.0989.8% ROI Industry =.082 x 1.17 =.098 or 9.8% ROI.0424.2% ROI 2007 =.041 x 1.02 =.042 or 4.2% ROI.0989.8% ROI Industry =.082 x 1.17 =.098 or 9.8% ROI ROI = Net profit margin X Total asset turnover Earning Power Earning Power = Sales profitability X Asset efficiency

59. 6-59 Return on Equity and the Du Pont Approach ROE.080 ROE 2007 =.041 x 1.02 x 1.90 =.080 ROE179 ROE Industry =.082 x 1.17 x 1.88 =.179 ROE.080 ROE 2007 =.041 x 1.02 x 1.90 =.080 ROE179 ROE Industry =.082 x 1.17 x 1.88 =.179 Return On Equity Return On Equity = Net profit margin X Total asset turnover X Equity Multiplier Equity Multiplier Equity Multiplier = Total Assets Shareholders’ Equity

60. 6-60 Summary of the Profitability Trend Analyses BW industry u The profitability ratios for BW have ALL been falling since 2005. Each has been below the industry averages for the past three years. COGS administrative costs BW u This indicates that COGS and administrative costs may both be too high and a potential problem for BW. u Note, this result is consistent with the low interest coverage ratio. BW industry u The profitability ratios for BW have ALL been falling since 2005. Each has been below the industry averages for the past three years. COGS administrative costs BW u This indicates that COGS and administrative costs may both be too high and a potential problem for BW. u Note, this result is consistent with the low interest coverage ratio.

61. 6-61 Summary of Ratio Analyses u Inventories are too high. u May be paying off creditors (accounts payable) too soon. u COGS may be too high. u Selling, general, and administrative costs may be too high. u Inventories are too high. u May be paying off creditors (accounts payable) too soon. u COGS may be too high. u Selling, general, and administrative costs may be too high.

62. 6-62 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.

63. 6-63 Basket Wonders’ Common Size Balance Sheets

64. 6-64 Basket Wonders’ Common Size Balance Sheets

65. 6-65 Basket Wonders’ Common Size Income Statements

66. 6-66 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.

67. 6-67 Basket Wonders’ Indexed Balance Sheets

68. 6-68 Basket Wonders’ Indexed Balance Sheets

69. 6-69 Basket Wonders’ Indexed Income Statements