1. FINANCIAL ANALYSIS

2. After Studying Chapter 6, 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.
4. 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.

3. 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.
Acc. deductions for wear
and tear.

10. Basket Wonders’ Balance Sheet (Liability Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007
Notes Payable $ 290
Acct. Payablec
Accrued Taxes d Other Accrued Liab. d Current Liab. e $ Long-Term Debt f 530 Shareholders’ Equity Com. Stock ($1 par) g
Add Pd in Capital g 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 ,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?
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.
2. Analysis of the financial
condition and profitability
of the firm.
3. Analysis of the business
risk of the firm.
Negotiations
with
suppliers of
capital.

17. Use of Financial Ratios
Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firm’s financial condition and performance.
It is of interest to shareholders, creditors, and the firm’s own management.
Financial ratios allow you analyze raw data in the balance sheet or income statement then compare it to targets.
Ratios help you understand how you are managing financial resources.

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

19. Using Financial Ratios: Types of Ratio Comparisons
Trend or time-series analysis
Used to evaluate a firm’s performance over time

20. Using Financial Ratios: Types of Ratio Comparisons (cont.)
Trend or time-series analysis
Cross-sectional analysis
Used to compare different firms at the same point in time

21. Using Financial Ratios: Types of Ratio Comparisons (cont.)
Trend or time-series analysis
Cross-sectional analysis
Industry comparative analysis
One specific type of cross sectional analysis. Used to compare one firm’s financial performance to the industry’s average performance

22. Using Financial Ratios: Types of Ratio Comparisons (cont.)
Trend or time-series analysis
Cross-sectional analysis
Benchmarking
A type of cross sectional analysis in which the firm’s ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate

23. Using Financial Ratios: Types of Ratio Comparisons (cont.)
Trend or time-series analysis
Cross-sectional analysis
Combined Analysis
Combined analysis simply uses a combination of both time series analysis and cross-sectional analysis

24. Using Financial Ratios: Types of Ratio Comparisons (cont.)
Industry Average Ratios for Selected Lines of Business

25. Using Financial Ratios: Types of Ratio Comparisons (cont.)
Figure 2.1 Combined Analysis

26. Using Financial Ratios: Cautions for Doing Ratio Analysis
Ratios must be considered together; a single ratio by itself means relatively little.
Financial statements that are being compared should be dated at the same point in time.
Use audited financial statements when possible.
The financial data being compared should have been developed in the same way.
Be wary of inflation distortions.

27. For Basket Wonders December 31, 2007
Liquidity Ratios
Current Ratio =
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

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

29. Liquidity Ratios Acid-Test (Quick Ratio) Balance Sheet Ratios
Current Assets - Inventories
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

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

31. 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.

32. 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

33. 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

34. 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.

35. 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

36. 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.

37. 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

38. 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.

39. 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

40. 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.

41. Coverage Ratios Interest Coverage Income Statement Ratios 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

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

43. 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

44. 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.

45. Activity Ratios Receivable Turnover Income Statement/ Balance Sheet
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

46. 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

47. 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.

48. 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

49. 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

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

51. 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

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

53. 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

54. 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

55. 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?

56. 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

57. 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.

58. 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

59. 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

60. 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.

61. 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

62. 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

63. 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.

64. 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

65. 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

66. 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.

67. 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

68. DuPont System of Analysis
The DuPont system of analysis is used to dissect the firm’s financial statements and to assess its financial condition.
It merges the income statement and balance sheet into two summary measures of profitability.
The Modified DuPont Formula relates the firm’s ROA to its ROE using the financial leverage multiplier (FLM), which is the ratio of total assets to common stock equity:
ROA and ROE as shown in the series of equations on the following slide and in Figure 2.2 on the following slide.

69. DuPont System of Analysis

70. 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)

71. DuPont System of Analysis (cont.)
Figure 2.2 DuPont System of Analysis

72. 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)

73. 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.
Note, this result is consistent with the low interest coverage ratio.

74. 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.

75. 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.

76. Basket Wonders’ Common Size Balance Sheets

77. Basket Wonders’ Common- Size Balance Sheets

78. Basket Wonders’ Common- Size Income Statements

79. 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.

80. Basket Wonders’ Indexed Balance Sheets

81. Basket Wonders’ Indexed Balance Sheets

82. 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