CHAPTER 6

Financial
Statement Analysis
Financial Statements

Framework for Analysis Ratio Analysis

Trend Analysis

Common-Size and Index Analysis

CONTENT
FINANCIAL STATEMENT ANALYSIS

The art of transforming data from financial

statements into information that is useful for
informed decision making.
 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.
 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
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.
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
FRAMEWORK FOR FINANCIAL ANALYSIS

Analysis of the funds needs of the firm.

Analysis of the financial condition and profitability of
the firm.

Health of a Firm
Financial Ratios
In In
Individually Over time
combination comparison
8
FRAMEWORK FOR FINANCIAL ANALYSIS

Analysis of the funds needs of the firm.

Analysis of the financial condition and profitability of the firm.
Analysis of the business risk of the firm

Business risk relates to the risk inherent in the operations of the

firm.
Examples: Volatility in sales,Volatility in costs, Proximity to break-
even point

9
FRAMEWORK FOR FINANCIAL ANALYSIS

Analysis of the funds needs of the firm.

Analysis of the financial condition and profitability of the firm.
Analysis of the business risk of the firm

Determining the financing needs of firm

A Financial Manager must consider all three jointly

when determining the financing needs of the firm.
FRAMEWORK FOR FINANCIAL ANALYSIS
Analysis of the funds needs of the firm.
Analysis of the financial condition and profitability of the firm.
Analysis of the business risk of the firm

Determining the financing needs of firm

Negotiation of suppliers of capital

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
• Internal Comparisons
• External Comparisons

12
 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.”

13
 Balance Sheet
Ratios

Liquidity Ratios
LIQUIDITY RATIOS

LIQUIDITY RATIOS
LIQUIDITY RATIOS

Shows a firm’s ability to cover its

current liabilities with its current
assets.

Current
Current Assets
Current Liabilities
 LIQUIDITY RATIO COMPARISONS

Current Ratio
Year BW Industry
2003 2.39 2.15
2002 2.26 2.09
2001 1.91 2.01
Ratio is stronger than the industry average.
17
LIQUIDITY RATIOS

Shows a firm’s ability to meet

current liabilities with its most liquid
assets.
Current Asset
Acid-Test (Quick)

Quick Asset Quick Asset__

Current Liabilities
 LIQUIDITY RATIO COMPARISONS

Acid-Test Ratio
Year BW Industry
2003 1.00 1.25
2002 1.04 1.23
2001 1.11 1.25
Ratio is weaker than the industry average.
18
SUMMARY OF THE LIQUIDITY RATIO
COMPARISONS

Ratio BW Industry
Current 2.39 2.15
Acid-Test 1.00 1.25
Strong current ratio and weak acid-test
ratio indicates a possible problem in the
inventories account.
Note that this industry has a relatively
19
high level of inventories.
 Balance sheet

Financial leverage
ratios

FINANCIAL LEVERAGE RATIOS

 FINANCIAL LEVERAGE RATIOS

Shows the percentage of the firm’s

assets that are supported by debt
financing.

Debt-to-Total-Assets

Total Debt
Total Assets
26
 FINANCIAL LEVERAGE RATIO
COMPARISONS

Debt-to-Total-Asset Ratio
Year BW Industry
2003 .47 .47
2002 .47 .47
2001 .45 .47
BW has average debt utilization
22

relative to the industry average.

 FINANCIAL LEVERAGE RATIOS

Shows the extent to which the

firm is financed by debt.

Debt-to-Equity

Total Debt
Shareholders’ Equity
23
 FINANCIAL LEVERAGE RATIO
COMPARISONS

Debt-to-Equity Ratio
Year BW Industry
2003 .90 .90
2002 .88 .90
2001 .81 .89
BW has average debt utilization
24

relative to the industry average.

COVERAGE RATIOS

Income
statement ratios

Coverage Ratios
 COVERAGE RATIOS

Indicates a firm’s ability to cover

interest charges.

Interest Coverage

EBIT
Interest Charges
26
 COVERAGE
RATIO COMPARISONS

Interest Coverage Ratio

Year BW Industry
2003 3.56 5.19
2002 4.35 5.02
2001 10.30 4.66
BW has below average interest coverage
27

relative to the industry average.

ACTIVITY RATIOS

Balance statement/
Income statement

Activity Ratios
 ACTIVITY RATIOS

Indicates quality of receivables and how

successful the firm is in its collections.

Debtor/Receivable Turnover
Net Credit Sales
Receivables
29
 ACTIVITY RATIOS

Average number of days that receivables are

outstanding.
(or RT in days)

Avg Collection Period

Days in the Year

Receivable Turnover 30
 ACTIVITY
RATIO COMPARISONS

Average Collection Period

Year BW Industry
2003 65.0 65.7
2002 71.1 66.3
2001 83.6 69.2
BW has improved the average collection
31

period to that of the industry average.

 ACTIVITY RATIOS

Indicates the promptness of

payment to suppliers by the firm.

Payable Turnover (PT)

Credit Purchases
Accounts Payable 32
 ACTIVITY RATIOS

Average number of days that

payables are outstanding.

Payable Turnover
in Days

Days in the Year

33

Payable Turnover
 ACTIVITY
RATIO COMPARISONS

Payable Turnover in Days

Year BW Industry
2003 22.1 46.7
2002 25.4 51.1
2001 43.5 48.5
BW has improved the PT in Days.
39
 ACTIVITY RATIOS

Indicates the effectiveness of the

inventory management practices of the
firm.

Inventory Turnover

Cost of Goods Sold

Avg Inventory
35
 ACTIVITY
RATIO COMPARISONS

Inventory Turnover Ratio

Year BW Industry
2003 2.30 3.45
2002 2.44 3.76
2001 2.64 3.69
BW has a very poor inventory turnover ratio.
36
 ACTIVITY RATIOS

Indicates the overall effectiveness of

the firm in utilizing its assets to
generate sales.

Total Asset Turnover

Net Sales
Total Assets 37
 ACTIVITY
RATIO COMPARISONS

Total Asset Turnover Ratio

Year BW Industry
2003 1.02 1.17
2002 1.03 1.14
2001 1.01 1.13
BW has a weak total asset turnover ratio.
44
Why is this ratio considered weak?
PROFITABILITY RATIOS

Income statement/
balance sheet

Profitability ratios
 PROFITABILITY RATIOS

Indicates the efficiency of operations

and firm pricing policies.

Gross Profit Margin

Gross Profit
Net Sales
40
 PROFITABILITY
RATIO COMPARISONS

Gross Profit Margin

Year BW Industry
2003 27.7% 31.1%
2002 28.7 30.8
2001 31.3 27.6
BW has a weak Gross Profit Margin. 41
 PROFITABILITY RATIOS

Indicates the firm’s profitability after

taking account of all expenses and
income taxes.

Net Profit Margin

Net Profit after Taxes

Net Sales 42
 PROFITABILITY
RATIO COMPARISONS

Net Profit Margin

Year BW Industry
2003 4.1% 8.2%
2002 4.9 8.1
2001 9.0 7.6
BW has a poor Net Profit Margin. 43
 PROFITABILITY RATIOS

Indicates the profitability on the

assets of the firm (after all expenses
and taxes).

Return on Investment

Net Profit after Taxes

Total Assets 44
 PROFITABILITY
RATIO COMPARISONS

Return on Investment
Year BW Industry
2003 4.2% 9.8%
2002 5.0 9.1
2001 9.1 10.8
BW has a poor Return on Investment. 45
PROFITABILITY RATIOS

Indicates the profitability to the

shareholders of the firm (after all
expenses and taxes).

Return on Equity

Net Profit after Taxes

Shareholders’ Equity 46
 PROFITABILITY
RATIO COMPARISONS

Return on Equity
Year BW Industry
2003 8.0% 17.9%
2002 9.4 17.2
2001 16.6 20.4
BW has a poor Return on Equity. 47
 RETURN ON INVESTMENT AND THE DU
PONT APPROACH

Earning Power = Sales profitability X

Asset efficiency
ROI = Net profit margin X
Total asset turnover
ROI2003 = .041 x 1.02 = .042 or 4.2%
ROIIndustry = .082 x 1.17 = .098 or 9.8%
48
 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

ROE2003 = .041 x 1.02 x 1.90 = .080

ROEIndustry = .082 x 1.17 x 1.88 = .179 49
WHY EVALUATE FINANCIAL STATEMENTS?

 Internal uses:
 performance evaluation
 planning for the future

 External uses:
 evaluation by outside parties
 evaluation of main competitors
 identifying potential takeover targets
BENCHMARKS FOR COMPARISON

 Ratios are most useful when compared to a

benchmark.
 Time-trend analysis—examine how a particular
ratio(s) has performed historically.
 Peer group analysis—using similar firms
(competitors) for comparison of results.
PROBLEMS WITH FINANCIAL STATEMENT
ANALYSIS

 No underlying theory to identify correct ratios to use or

appropriate benchmarks.
 Benchmarking is difficult for diversified firms.
 Firms may use different accounting procedures.
 Firms may have different recording periods.
 One-off events can severely affect financial performance.
OPERATING CYCLE VS CASH CYCLE

The Operating Cycle the length The Cash Cycle is the length of
of time between purchasing time between paying for
inventory and receiving cash inventory and receiving cash
from sales. from sales.
TREND ANALYSIS
COMMON-SIZE ANALYSIS

AN ANALYSIS OF
PERCENTAGE
55
 Index
Analyses

56
SUMMARY AND CONCLUSIONS

 Activities that bring in cash are called ‘sources of cash’, and

activities that involve spending cash are called ‘uses of cash’.
 A Cash Flow Statement summarises sources and uses of cash
over a specified period.
 Financial ratios are grouped together into five main categories:
Liquidity, Capital Structure, Valuation, Profitability, and Turnover.
 Ratios are most useful when compared to a benchmark (e.g. time-
trend and peer group analysis).
 Problems can arise in using financial statements.
THANKYOU
ANY QUESTIONS?