1. Dear students,
I found out this material that would be beneficial for you to enrich your knowledge about some basic matters of accounting in English language.
Try to comprehend this material afterwards please do the exercise on your workbook page 16 (Exercise 2), 18 (Exercise 7), and 19 (Exercise 8) directly on your book.
One more thing, next week we’re going to have 3 groups for presentation. Be prepared. Thank you..

2. Financial Statement Analysis

3. After studying this material, you should be able to:
Understand the purpose of basic financial statements and their contents.
Understand what is meant by “convergence” in accounting standards.
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 firm’s 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 firm’s 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.

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

5. 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. 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.

7. Global Accounting Standards
Convergence of Accounting Standards: Aims to narrow or remove differences so that investors can better understand financial statements prepared under different accounting frameworks
IASB – International Accounting Standards Board has the responsibility of IFRS
IFRS – International Financial Reporting Standards (EU countries adopted)
US GAAP – US Generally Accepted Accounting Principles determined by FASB
FASB – Financial Accounting Standards Board determines accounting standards for financial statements

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

9. Basket Wonders’ Balance Sheet (Asset Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007a
Cash $ Acct. Rec.c Inventories Prepaid Exp d Accum Tax Prepay Current Assetse $1,195 Fixed Assets Less: Acc. Depr. g (329) Net Fix. Assets $ Investment, LT Other Assets, LT Total Assets b $2,169
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.

10. Basket Wonders’ Balance Sheet (Liability Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007
Notes Payable $ Acct. Payablec Accrued Taxes d Other Accrued Liab. d Current Liab. e $ Long-Term Debt f 530 Shareholders’ Equity Com. Stock ($1 par) g 200 Add Pd in Capital g 729 Retained Earnings h 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.

11. 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 $ SG&A Expenses c EBITd $ Interest Expensee EBT f $ Income Taxes EATg $ Cash Dividends Increase in RE $
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.

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

13. Framework for Financial Analysis
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
of the firm.

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

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

16. Framework for Financial Analysis
1. Analysis of the funds
needs of the firm.
Determining
the
financing
needs of
the firm.
Negotiations
with
suppliers of
capital.
2. Analysis of the financial
condition and profitability
of the firm.
3. Analysis of the business
risk of the firm.

17. Use of Financial Ratios
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.

18. 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.”
Examples:
Risk Management Association
Dun & Bradstreet
Almanac of Business and Industrial Financial Ratios

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

20. Liquidity Ratio Comparisons
Current Ratio
Year
2007
2006
2005
BW Industry
Ratio is stronger than the industry average.

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

22. Liquidity Ratio Comparisons
Acid-Test Ratio
Year
2007
2006
2005
BW Industry
Ratio is weaker than the industry average.

23. Summary of the Liquidity Ratio Comparisons
Ratio BW Industry
Current
Acid-Test
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.

24. Current Ratio – Trend Analysis Comparison
Trend Analysis of Current Ratio
1.5
1.7
1.9
2.1
2.3
2.5
2005
2006
2007
Analysis Year
Ratio Value BW
Industry

25. Acid-Test Ratio – Trend Analysis Comparison
Trend Analysis of Acid-Test Ratio
0.5
0.8
1.0
1.3
1.5
2005
2006
2007
Analysis Year
Ratio Value BW
Industry

26. 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.

27. Financial Leverage Ratios
Debt-to-Equity
Total Debt
Shareholders’ Equity
For Basket Wonders December 31, 2007
Balance Sheet Ratios
Financial Leverage
Ratios
Shows the extent to which the firm is financed by debt.
$1,030
$1,139
= 0.90

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

29. Debt-to-Total-Assets For Basket Wonders December 31, 2007
Financial Leverage Ratios
Debt-to-Total-Assets
Total Debt
Total Assets
For Basket Wonders December 31, 2007
Balance Sheet Ratios
Financial Leverage
Ratios
Shows the percentage of the firm’s assets that are supported by debt financing.
$1,030
$2,169
= 0.47

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

31. For Basket Wonders December 31, 2007
Financial Leverage Ratios
Total Capitalization
Total Debt
For Basket Wonders December 31, 2007
Balance Sheet Ratios
(i.e., LT-Debt + Equity)
Financial Leverage
Ratios
Shows the relative importance of long-term debt to the long-term financing of the firm.
$1,030
$1,669
= 0.62

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

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

34. Coverage Ratio Comparisons
Interest Coverage Ratio
Year
2007
2006
2005
BW Industry
BW has below average interest coverage
relative to the industry average.

35. Coverage Ratio – Trend Analysis Comparison
Trend Analysis of Interest Coverage Ratio
3.0
5.0
7.0
9.0
11.0
2005
2006
2007
Analysis Year
Ratio Value BW
Industry

36. Summary of the Coverage Trend Analysis
The interest coverage ratio for BW has been falling since 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.

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

38. Activity Ratios Avg Collection Period Income Statement/ Balance Sheet
Days in the Year
Receivable Turnover
For Basket Wonders December 31, 2007
Income Statement/
Balance Sheet
Ratios
Activity Ratios
Average number of days that receivables are outstanding.
(or RT in days)
365
5.61
= 65 days

39. Activity Ratio Comparisons
Average Collection Period
Year
2007
2006
2005
BW Industry
BW has improved the average collection
period to that of the industry average.

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

41. Activity Ratios PT in Days Income Statement/ Balance Sheet
Days in the Year
Payable Turnover
For Basket Wonders December 31, 2007
Income Statement/
Balance Sheet
Ratios
Activity Ratios
Average number of days that payables are outstanding.
365
16.5
= 22.1 days

42. Payable Turnover in Days BW has improved the PT in Days.
Activity Ratio Comparisons
Payable Turnover in Days
Year
2007
2006
2005
BW Industry
BW has improved the PT in Days.
Is this good?

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

44. Inventory Turnover Ratio BW has a very poor inventory turnover ratio.
Activity Ratio Comparisons
Inventory Turnover Ratio
Year
2007
2006
2005
BW Industry
BW has a very poor inventory turnover ratio.

45. Inventory Turnover Ratio –Trend Analysis Comparison
Trend Analysis of Inventory Turnover Ratio
2.0
2.5
3.0
3.5
4.0
2005
2006
2007
Analysis Year
Ratio Value BW
Industry

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

47. Activity Ratio Comparisons
Total Asset Turnover Ratio
BW Industry
Year
2007
2006
2005
BW has a weak total asset turnover ratio.
Why is this ratio considered weak?

48. Profitability Ratios Gross Profit Margin Income Statement/
Net Sales
For Basket Wonders December 31, 2007
Income Statement/
Balance Sheet
Ratios
Profitability Ratios
Indicates the efficiency of operations and firm pricing policies.
$612
$2,211
= 0.277

49. BW has a weak Gross Profit Margin.
Profitability Ratio Comparisons
Gross Profit Margin
Year
2007
2006
2005
BW Industry
27.7% 31.1%
BW has a weak Gross Profit Margin.

50. Gross Profit Margin – Trend Analysis Comparison
Trend Analysis of Gross Profit Margin
25.0
27.5
30.0
32.5
35.0
2005
2006
2007
Analysis Year
Ratio Value (%) BW
Industry

51. For Basket Wonders December 31, 2007
Profitability Ratios
Net Profit Margin
Net Profit after Taxes
Net Sales
For Basket Wonders December 31, 2007
Income Statement/
Balance Sheet
Ratios
Profitability Ratios
Indicates the firm’s profitability after taking account of all expenses and income taxes.
$91
$2,211
= 0.041

52. BW has a poor Net Profit Margin.
Profitability Ratio Comparisons
Net Profit Margin
Year
2007
2006
2005
BW Industry
4.1% 8.2%
BW has a poor Net Profit Margin.

53. Net Profit Margin – Trend Analysis Comparison
Trend Analysis of Net Profit Margin 4 5 6 7 8 9 10
2005
2006
2007
Analysis Year
Ratio Value (%) BW
Industry

54. For Basket Wonders December 31, 2007
Profitability Ratios
Return on Investment
Net Profit after Taxes
Total Assets
For Basket Wonders December 31, 2007
Income Statement/
Balance Sheet
Ratios
Profitability Ratios
Indicates the profitability on the assets of the firm (after all expenses and taxes).
$91
$2,160
= 0.042

55. BW has a poor Return on Investment.
Profitability Ratio Comparisons
Return on Investment
Year
2007
2006
2005
BW Industry
4.2% %
BW has a poor Return on Investment.

56. Return on Investment – Trend Analysis Comparison
Trend Analysis of Return on Investment 4 6 8 10 12
2005
2006
2007
Analysis Year
Ratio Value (%) BW
Industry

57. For Basket Wonders December 31, 2007
Profitability Ratios
Return on Equity
Net Profit after Taxes
Shareholders’ Equity
For Basket Wonders December 31, 2007
Income Statement/
Balance Sheet
Ratios
Profitability Ratios
Indicates the profitability to the shareholders of the firm (after all expenses and taxes).
$91
$1,139
= 0.08

58. BW has a poor Return on Equity.
Profitability Ratio Comparisons
Return on Equity
Year
2007
2006
2005
BW Industry
8.0% 18.0%
BW has a poor Return on Equity.

59. Return on Equity – Trend Analysis Comparison
Trend Analysis of Return on Equity
7.0
10.5
14.0
17.5
21.0
2005
2006
2007
Analysis Year
Ratio Value (%) BW
Industry

60. Return on Investment and the Du Pont Approach
Earning Power = Sales profitability ×
Asset efficiency
ROI = Net profit margin ×
Total asset turnover
ROI = × 1.02 = or 4.2%
ROIIndustry = × 1.17 = or 9.6%
(Note: values are rounded)

61. 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
ROE = × 1.02 × 1.90 = 0.080
ROEIndustry = × 1.17 × 1.88 = 0.180
(Note: values are rounded)

62. Summary of the Profitability Trend Analyses
The profitability ratios for BW have ALL been falling since 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.

63. 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.

64. 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.

65. Basket Wonders’ Common Size Balance Sheets

66. Basket Wonders’ Common- Size Balance Sheets

67. Basket Wonders’ Common- Size Income Statements

68. Index Analyses
An analysis of percentage financial statements where all balance sheet or income statement figures for a base year equal (percent) and subsequent financial statement items are expressed as percentages of their values in the base year.

69. Basket Wonders’ Indexed Balance Sheets

70. Basket Wonders’ Indexed Balance Sheets

71. Basket Wonders’ Indexed Income Statements
Regular (thousands of $)
Indexed (%)
200 5 6 7
Net Sales
1,235
2,106
2,211
100.0
170.5
179.0
COGS
849
1,501
1,599
176.8
188.3
Gross Profit
386
605
612
156.7
158.5
Adm.
180
383
402
212.8
223.3
EBIT
206
222
210 1
00.0
107.8
101.9
Int Exp 20 51 59
255.0
295.0
EBT
186
171
151
91.9
81.2
EAT
112
103 91
92.0
81.3
Cash Div 50