1. Chapter 4 Financial Statement Analysis
Updated

2. Why Do We Analyze Financial Statements?
To know firm’s financial strengths & weaknesses
Financial statements can be analyzed:
Internally -- by managers
Externally -- by bankers, suppliers, investors

3. Common Size Financial Statements – Standardizing Financial Information
A common size financial statement is a standardized version of a financial statement in which all entries are presented in percentages.
A common size financial statement helps to compare entries in a firm’s financial statements, even if firms are not of equal size.
How to prepare a common size financial statement?
For a common size income statement, divide each entry in income statement by company’s sales.
For a common size balance sheet, divide each entry in balance sheet by firm’s total assets.

4. From
Chapter 3
Income Statement
Table 1
2013
2013

5. Common Size Income Statement (H. J. Boswell, Inc.)
Table 1
2013

6. From
Chapter 3
Table 2
2012 and 2013
2012
2013
2012
2013

7. Common Size Balance Sheet (H. J. Boswell, Inc.)
Table 2
Common Size Balance Sheet (H. J. Boswell, Inc.)
2012
2013
2012
2013

8. Financial Ratios & Analysis
Financial ratios provide another method for standardizing financial information on income statement & balance sheet.
Financial ratios analysis:
Industry comparative analysis
Cross sectional analysis
Time series analysis

9. Five Groups of Financial Ratios
Questions
Category of Ratios Used
1. How liquid is the firm? Will it be able to pay its bills as they become due?
Liquidity ratios
2. How has the firm financed the purchase of its assets?
Capital structure ratios
3. How efficient has the firm’s management been in utilizing it assets to generate sales?
Asset management ratios
(Efficiency ratios)
4. Has the firm earned enough returns on its investments?
Profitability ratios
5. Are the firm’s managers creating value for shareholders?
Market value ratios

10. Liquidity Ratios Liquidity ratios address a basic question:
How liquid is the firm?
A firm is financially liquid if it is able to pay its bills on time.
Firm’s liquidity can be analyzed from two perspectives:
1. Overall or general firm liquidity:
is analyzed by comparing current assets to current liabilities.
Current ratio & Quick ratio
2. Liquidity of specific current asset:
is analyzed by examining timeliness in which firm’s liquid assets – accounts receivable & inventories – are converted into cash.
Accounts Receivable Turnover Ratio (ARTO)
Average Collection Period (ACP)
Inventory Turnover Ratio (INVTO)
Days’ Sales in Inventory (or Inventory Period)

11. Liquidity Ratios: Current Ratio
Current Ratio (CR):
compares a firm’s current (liquid) assets to its current (short-term) liabilities
CR for H.J. Boswell, Inc. for 2013=
If CR of industry avg. for 2013 = 1.8 times
Analysis: Better

12. Liquidity Ratios: Quick Ratio
Quick ratio excludes inventory from current assets as inventory may not always be very liquid.
QR for H.J. Boswell, Inc. for 2013=
If QR of industry avg. for 2013 = 0.94 times
Analysis: On Par

13. Liquidity Ratios: Individual Asset Categories
We can also measure liquidity of firm by examining liquidity of individual current asset including accounts receivable & inventories.
How long it takes firm to convert its accounts receivables & inventories into cash.
Accounts Receivable Turnover Ratio (ARTO)
Average Collection Period (ACP)
Inventory Turnover Ratio (INVTO)
Days’ Sales in Inventory (or Inventory Period)

14. Liquidity Ratios: Accounts Receivable Turnover Ratio
Accounts Receivable Turnover Ratio (ARTO)
measures how many times accounts receivable are “rolled over” during a year
ARTO for H.J. Boswell, Inc. for 2013=
If ARTO of industry avg. for 2013 = 14.6 times
Analysis: Better

15. Liquidity Ratios: Accounts Receivable
Average Collection Period (ACP)
measures number of days it takes firm to collects its receivables
ACP for H.J. Boswell, Inc. for 2013=
If ACP of industry avg. for 2013 = 25 days
Analysis: Better

16. Liquidity Ratios: Inventory Turnover Ratio
Inventory Turnover Ratio (INVTO)
measures how many times company turns over its inventory during the year.
INVTO for H.J. Boswell, Inc. for 2013=
If INVTO of industry avg. for 2013 = 7 times
Analysis: Worse

17. Liquidity Ratios: Days’ Sales in Inventory
We can express inventory turnover ratio in terms of number of days inventory sits unsold on firm’s shelves.
Shorter inventory cycle (less number of days) leads to greater liquidity since inventory are converted to cash more quickly.
Days’ Sales in Inventory (DSI) = 365÷Inventory Turnover Ratio
DSI for H.J. Boswell, Inc. for 2013=365÷5.36 = days
If DSI of industry avg. for 2013 = days
Analysis: Worse

18. Can a Firm Have Too Much Liquidity?
A high investment in liquid assets will enable firm to repay its current liabilities in a timely manner.
However, an excessive investments in liquid assets is costly to firm because liquid assets (i.e. cash) generate minimal return.

19. Capital Structure Ratios
Capital structure refers to the way a firm finances its assets.
Capital structure ratios address the important question:
How has the firm financed the purchase of its assets?
We will use two ratios, debt ratio & times interest earned ratio (TIE), to answer the question.

20. Capital Structure Ratios
Debt ratio (DR)
measures proportion of firm’s assets that are financed by borrowing or debt financing
DR for H.J. Boswell, Inc. for 2013=
If DR of industry avg. for 2013 = 35%
Analysis=Worse

21. Capital Structure Ratios
Times Interest Earned Ratio (TIE)
measures ability of firm to service its debt or repay interest on debt
We use EBIT (operating income) as interest expense is paid before a firm pays its taxes.
TIE for H.J. Boswell, Inc. for 2013=
If TIE of industry avg. for 2013 = 7 times
Analysis: Worse

22. Asset Management Ratios (Efficiency Ratios)
Asset management (efficiency) ratios
measure a firm’s effectiveness in utilizing its assets to generate sales
They are commonly referred to as turnover ratios as they reflect number of times a particular asset account (A/R, INV, FA, TA) turns over during a year.

23. Asset Management Ratios (Efficiency Ratios)
Total Asset Turnover Ratio
represents the amount of sales generated per dollar invested in firm’s total assets
TATO for H.J. Boswell, Inc. for 2013=
If TATO of industry avg. for 2013 = 1.15 times
Analysis: Better

24. Asset Management Ratios (Efficiency Ratios)
Fixed asset turnover ratio
measures firm’s efficiency in utilizing its fixed assets (i.e. property, plant & equipment) to generate sales
FATO for H.J. Boswell, Inc. for 2013=
If FATO of industry avg. for 2013 = 1.75 times
Analysis: Better

25. Asset Management Ratios or Efficiency Ratios
We can similarly compute turnover ratios for other assets (INV, A/R).
We had earlier computed receivables turnover & inventory turnover, which measured firm effectiveness in managing its investments in accounts receivables & inventories.

26. Profitability Ratios
Profitability ratios address a fundamental question:
Has firm earned enough returns on its investments?
We answer this question by analyzing firm’s profit margin, which predict the ability of firm to control its expenses, and the firm’s rate of return on investments.
Two fundamental determinants of firm’s profitability and returns on investments are:
Cost control (profit margin)
Is firm control its costs and earn reasonable profit margin?
Efficiency of asset utilization
Is firm efficiently utilize assets to generate sales?

27. Profitability Ratios Gross profit margin (GPM)
shows how well firm’s management controls its cost of goods sold to generate gross profits
GPM for H.J. Boswell, Inc. for 2013=
If GPM of industry avg. for 2013 = 28.2%
Analysis: Worse

28. Profitability Ratios Operating Profit Margin (OPM)
measures how much operating profit is generated from sales after accounting for both costs of goods sold & operating expenses
OPM for H.J. Boswell, Inc. for 2013=
If OPM of industry avg. for 2013 = 15.5%
Analysis: Worse

29. Profitability Ratios Net Profit Margin (NPM)
measures how much net income is generated from sales after adjusting for all costs & expenses (including income taxes)
NPM for H.J. Boswell, Inc. for 2013=
If NPM of industry avg. for 2013 = 10.2%
Analysis: Worse

30. Profitability Ratios
Operating Return on Assets ratio (OROA) is a summary measure of operating profitability, which takes into account both management’s success in controlling expenses, contributing to operating profit margins, and its efficient use of assets to generate sales.
OROA for H.J. Boswell, Inc. for 2013=
If OROA of industry avg. for 2013 = 17.8%
Analysis: Better

31. Profitability Ratios Decomposing OROA ratio:
We can use the following equation to decompose OROA ratio to analyze firm’s ability to control costs & utilize its investments in assets efficiently

32. Profitability Ratios
Figure 1

33. Figure 1: Observations
Firm’s OROA (operating return on assets) is better than its peers.
Firm earned more net operating income (EBIT) per dollar invested in total assets.
Firm’s OPM (operating profit margin) is lower than its peers.
Firm retained a lower percentage of its sales in net operating income (problem with cost controlling).
Firm’s TATO (total asset turnover ratio) is higher than its peers.
Firm generated more sales from its assets (better TA utilization).

34. Figure 1: Recommendations
Firm has two opportunities to improve its profitability:
Reduce costs
Firm must investigate cost of goods sold & operating expenses to see if there are opportunities to reduce costs.
Reduce inventories
– Firm must investigate if it can reduce the size of its inventories.

35. Is Firm Providing a Reasonable Return on Owner’s Investment?
A firm’s net income consists of earnings that is available for distribution to firm’s shareholders.
Return on Equity (ROE) ratio
measure accounting return on common stockholders’ investment
ROE for H.J. Boswell, Inc. for 2013=
If ROE of industry avg. for 2013 = 18%
Analysis: Better

36. Using DuPont Method for Decomposing ROE ratio
analyzes ROE by decomposing it into three parts: profitability, efficiency & equity multiplier
Equity multiplier captures the effect of using debt financing on ROE.
Equity multiplier increases in value as firm uses more debt financing.

37. Using DuPont Method for Decomposing ROE ratio
The following table shows why Boswell’s ROE was higher than its peers.
Boswell had a higher ROE because
Higher TATO
Use more debt financing (financial leverage)
Interests are tax deductible expenses
ROE
NPM
TATO EM
H. J. Boswell, Inc.
22.5%
7.6%
1.37
2.16
Peer Group
18.0%
10.2%
1.15
1.54

38. Market Value Ratios Market value ratios address the question:
How are the firm’s shares valued in stock market?
Two market value ratios are:
Price-Earnings Ratio
Market-to-Book Ratio

39. Market Value Ratios Price-Earnings (PE) Ratio
indicate how much investors are currently willing to pay for $1 of reported earnings
PE for H.J. Boswell, Inc. for 2013=
(assume mkt. price per share = $32)
If PE of industry avg. for 2013 = 12 times
Analysis: Better

40. Market Value Ratios Market-to-Book Ratio
measure relationship between market value & accumulated investment in firm’s equity
Market-to-Book ratio for H.J. Boswell, Inc. for 2013=
If Market-to-Book of industry avg. for 2013 = 2.7 times
Analysis: Better

41. Summing up Financial Analysis of H. J. Boswell, Inc.
Liquidity:
With the exception of inventory turnover ratio, liquidity ratios were adequate to good. The firm needs to see how inventory management can be improved.
Financial Leverage:
Firm uses more debt than its peers, which exposes firm to a higher degree of financial risk or potential default on its debt in the future.
Profitability:
Firm had favorable net operating income (despite lower profit margins), largely due to its higher asset turnover ratio.
ROE was also higher than peer group due to the use of more debt.
Market Value Ratios:
These ratios suggest that the market is pleased with the firm as indicated by higher stock valuations.

42. Ch. 4_Q. 27 (Exercise)
2012 and 2013
2012
2013

43. Ch. 4_Q. 27 (Exercise)
2012 and 2013
2012
2013

44. Ch. 4_Q. 27 (Exercise)
Analyze firm’s financial performance during in terms of its liquidity, capital structure, asset management and profitability.
Comment on what you view as weaknesses in the performance of company in year 2013 as compared to 2012.
Perform Dupont analysis for 2012 and 2013.
At the end of 2013, firm has 5,000 shares of common stock outstanding, selling for $15 each. What were the firm’s EPS, P/E, and market-to-book ratio.

45. Industry Averages
2012
2013
Curren ratio 2
Acid-test ratio
0.8
Average collection period
37 days
Inventory turnover
2.5
Debt ratio
58%
Times interest earned
3.8
Operating profit margin
10%
Total asset turnover
1.14
Fixed asset turnover 1%
Operating return on assets
11.40%
Return on equity
9.50%

46. Personal Summary
Write down one thing you learned in this chapter that is interesting, new, or useful to you.
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