Financial

Financial Statement
Statement
Analysis
Analysis
© Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
1
 After studying this Chapter, you
should be able to:
 Understand the purpose of basic financial statements and their
contents.
 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
2 gain additional insights into a firm's performance.
 Financial versus management
accounting
 Financial accounting (FA) -> external
financial reporting
 Management Accounting (MA) -> financial
information useful in internal decision and
management processes
 Starting from the same source data + FA is
frame of reference for MA

3
 Annual financial statements

 Income statement
 Balance sheet
 Notes to the accounts
 Cash flow statement
 Statement of changes in equity
 Audit report
4
 Objective of financial statements

“ The objective of financial statements is

to provide information about the
financial position, performance and
changes in financial position of an
entity that is useful to a wide range of
users in making economic decisions.”
IIASB, Framework for the Preparation and Presentation of Financial Statements, par.12

5
 Users of financial statements

 Investors
 Employees
 Lenders
 Suppliers
 Customers
 Governments
 Public

6
 Users of financial statements

Employees
Employees
Shareholders
Shareholders Trade creditors
Trade creditors

Government
Government Management
Management Customers
Customers

Loan providers
Loan providers Public
Public
Potential
Potential
Investors
Investors

7
 Examples
Examples of
of External
External Uses
Uses
of
of Statement
Statement Analysis
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.
8
 Examples
Examples of
of Internal
Internal Uses
Uses
of
of Statement
Statement Analysis
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.
9
 Accounting traditions

 Anglo-Saxon tradition
 Continental European tradition

10
 Anglo-Saxon accounting
 US, UK, Australia, Canada, New
Zealand, etc.
 Financial statements as a function of
a company’s financing
 Market solution to accounting
rules
 Powerful accounting profession
11
 Continental European
accounting
 Financial statement as a product of
government regulating of the
economy
 All businesses are subject to
accounting rules, with extra rules for:
 Limited liability companies
 Listed companies
12
 Accounting choices
 Accounting is not a set of precise
measurement rules which permit the exact
measurement of company profit and
company value
 Measurement of profit can never be
anything but an estimate
 Accounting measurement is full of choices
 Choices made should be stated clearly in the
annual financial statements

13
 Financial
Financial Statement
Statement Analysis
Analysis

 Financial Statements
 A Possible Framework for Analysis
 Balance Sheet Ratios
 Income Statement and Income
Statement/Balance Sheet Ratios
 Trend Analysis
 Common-Size and Index Analysis
14
 Accounting choices –
Relevance versus reliability
 To be useful, accounting information
should be both relevant and reliable
 Information has the quality of relevance
when it influences the economic decisions
of users by helping them evaluate past,
present or future events or confirming or
correcting their past evaluations
 Relevant information is timely
 Relevant information has predictive or feedback
value

15
 Accounting choices –
Relevance versus reliability
(cont.)
 Information has the quality of reliability
when it is free from material error and bias
and can be depended upon by users to
represent faithfully what it purports (or is
expected to) represent
 Accounting choices may imply trade-offs
between relevance and relaibility of
information

16
 Accounting regulation

 Accounting regulation will discipline

accounting choices
 Types of regulatory body:
 Government
 Stock exchange
 Private sector body
 Professional accountants
 Specialist industry organizations
 Usually separate rules for banks and
insurance companies.
17
 Government as accounting
regulator
 Regulation of accounting designed to
ensure that the markets can operate free
from fraud and misrepresentation
 Accounting laws
 Commercial codes
 Government regulatory agencies
 Regulation of accounting for tax collection
purposes

18
 Stock exchange as accounting
regulator

 Stock exchange regulates the financial

information to be provided by listed
companies
 In some countries this is done by a
government regulator
 US: Securities and Exchange
Commission (SEC) as accounting
regulator

19
 Private sector as accounting
regulator
 Delegation of responsibility of writing detailed accounting
rules to private sector bodies, financed by contributions
from companies, audit industry, etc..
 US: Financial Accounting Standards Board (FASB)
 Global: International Accounting Standards Board
(IASB)
 Flexible and rapid rule-making, as opposed to
governmental rule-making
 Technical committees from professional accounting bodies
may function as catalyst

20
 International bodies
 International Accounting Standards Board (IASB)
 Accepted as an international source of best practice
 Issues the International Financial Reporting Standards (IFRS)
 International Organization of Securities Commissions (IOSCO)
 Represents the world’s stock exchange regulators
 Strives for a single, uniform set of accounting standards worldwide
 Intergovernmental Working Group of Experts on International Standards of
Accounting and Reporting (ISAR)
 Under the auspices of the UN Conference on Trade and Development
(UNCTAD)
 Commissions research reports into current accounting problems
 International Federation of Accountants (IFAC)
 International representative of the accounting profession

21
 International Financial Reporting
Standards
 Single set of global accounting and
reporting standards, issued by the IASB
 Increasingly used by many large and
mutinational companies
 Accepted by most security market
authorities
 Used as a basis for national accounting
requirements (partially or in full) or as a
benchmark for the development of national
accounting rules
22
 International Accounting
Standards Board
 A private sector body
 Operates under the International Accounting
Standards Committee Foundation (IASCF)
 Has no responsibility to any governmental
organization
 Has no enforcement authority
 Develops and issues both main standards (IAS /
IFRS) and interpretations (SIC / IFRIC)

23
 Fig. 1.1 The structure of the IASB
IASC Foundation
22 Trustees
Appoint, Oversee, Raise Funds

Board
12 full time and 2 part time
Set technical agenda. Approve standards,
Standards Advisory exposure drafts and Interpretations
Council
30 or more members
International financial reporting
interpretations committee
12 members
Working groups
for major agenda projects Key:
Appoints
Reports to
Advises

24
 IFRS – Standard-setting due
process
 The IASB’s standard-setting procedures
have to ensure that resulting IFRS are of
high quality and are issued only after
giving IASB’s constituencies opportunities
to make their views known at several
points in the standard-setting due process

25
 Standard-setting due process
of the IASB
National
Standard Others
Setters

Research

Discussion
Discussion Comment Exposure
Exposure Comment Effectiv
Standard
Standard
paper analysis draft analysis
paper draft e Date

9-15 months 9-15 months 6-18 months

26
 IFRS in the world
 Recent decisions of various governments result in
the requirement or permission of the use of IFRS by
more than one hundred countries
 Europe: IAS Regulation of 2002
 Requirement of use of IFRS for consolidated financial
statements of EU qouted companies as from 1 January
2005
 Member state option to extend the application of IFRS to
not-listed companies and to individual financial statements
 Adoption of IFRS (-equivalent) as national
accounting rules in a number of countries
(Australia, Singapore, Hong Kong, …)
 US: convergence process of US accounting rules
and IFRS started in 2002 (“Norwalk Agreement”)

27
 List of IASB rules as of September 2005

Conceptual Framework
CF Framework for the Preparation and Presentation of Financial Statements
Main standards
IAS 1 Presentation of Financial Statements
IAS 2 Inventories
IAS 7 Cash Flow Statements
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
IAS 10 Events after the Balance Sheet Date
IAS 11 Constructions Contracts
IAS 12 Income Taxes
IAS 14 Segment Reporting
IAS 16 Property, Plant and Equipment
IAS 17 Leases
IAS 18 Revenue
IAS 19 Employee Benefits
IAS 20 Accounting for Government Grants and Disclosure of Government Assistance
IAS 21 The Effects of Changes in Foreign Exchange Rates
IAS 23 Borrowing Costs
IAS 24 Related Party Disclosures

28
 List of IASB rules as of September 2005 (
cont.)
Main standards (continued)
IAS 26 Accounting and Reporting by Retirement Benefit Plans
IAS 27 Consolidated and Separate Financial Statements
IAS 28 Investments in Associates
IAS 29 Financial Reporting in Hyperinflationary Economies
IAS 30 Disclosure in the Financial Statements of Banks and Similar Financial Institutions
IAS 32 Financial Instruments: Disclosure and Presentation
IAS 33 Earnings per Share
IAS 34 Interim Financial Reporting
IAS 36 Impairment of Assets
IAS 37 Provisions, Contingent Liabilities and Contingent Assets
IAS 38 Intangible Assets
IAS 39 Financial Instruments: Recognition and Measurement
IAS 40 Investment Property
IAS 41 Agriculture

IFRS 1 First-time Adoption of International Financial Reporting Standards

IFRS 2 Share-based Payment
IFRS 3 Business Combinations
IFRS 4 Insurance Contracts
IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
IFRS 6 Exploration for and Evaluation of Mineral Resources
IFRS 7 Financial Instruments: Disclosures

29
 List of IASB rules as of September 2005 -
Interpretations
Interpretations
SIC 7 Introduction of the Euro (IAS 21)
SIC 10 Government Assistance – No Specific Relation to Operating Activities (IAS 20)
SIC 12 Consolidation – Special Purpose Entities (IAS 27)
SIC 13 Jointly Controlled Entities – Non-Monetary Contributions By Venturers (IAS 31)
SIC 15 Operating Leases – Incentives (IAS 17)
SIC 21 Income Taxes – Recovery of Revalued Non-Depreciable Assets (IAS 12)
SIC 25 Income Taxes – Changes in the Tax Status of an Enterprise or its Shareholders IAS (12)
SIC 27 Evaluating the Substance of Transactions involving the Legal Form of a Lease
SIC 29 Disclosure – Service Concession Arrangements
SIC 31 Revenue – Barter Transactions Involving Services
SIC 32 Intangible Assets – Web Site Costs

IFRIC 1 Changes in Existing Decommissioning, Restoration and Similar Liabilities

IFRIC 2 Members’ Shares in Co-operative Entities and Similar Instruments
IFRIC 3 Emission Rights (withdrawn by the Board in June 2005)
IFRIC 4 Determining Whether an Arrangement contains a Lease
Rights to Interests arising from Decommissioning, Restoration and Environmental
IFRIC 5
Rehabilitation Funds

30
 Primary
Primary Types
Types of
of
Financial
Financial Statements
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.
31
 Basket
Basket Wonders’
Wonders’ Balance
Balance
Sheet
Sheet (Asset
(Asset Side)
Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007a
Cash and C.E. $ 90 a. How the firm stands on
Acct. Rec.c 394 a specific date.
Inventories 696 b. What BW owned.
Prepaid Exp d 5 c. Amounts owed by
Accum Tax Prepay 10 customers.
d. Future expense items
Current Assets $1,195
e
already paid.
Fixed Assets (@Cost) 1030
f
e. Cash/likely convertible
Less: Acc. Depr. g (329)
to cash within 1 year.
Net Fix. Assets $ 701
Investment, LT 50 f. Original amount paid.
Other Assets, LT 223 g. Acc. deductions for
32
Total Assets b $2,169 wear and tear.
 Basket
Basket Wonders’
Wonders’ Balance
Balance
Sheet
Sheet (Liability
(Liability Side)
Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007
Notes Payable $ 290 a. Note, Assets = Liabilities
Acct. Payablec 94 + Equity.
Accrued Taxes d 16 b. What BW owed and
Other Accrued Liab. d 100 ownership position.
Current Liab. e $ c. Owed to suppliers for
500 Long-Term Debt f goods and services.
530 Shareholders’ d. Unpaid wages, salaries,
Equity Com. Stock ($1 etc.
par) g 200 Add Pd in Capital g e. Debts payable < 1 year.
729 Retained f. Debts payable > 1 year.
Earnings h 210 Total g. Original investment.
Equity $1,139 h. Earnings reinvested.
33
Total Liab/Equitya,b $2,169
 Basket
Basket Wonders’
Wonders’
Income
Income Statement
Statement
Basket Wonders Statement of Earnings (in thousands)
for Year Ending December 31, 2007a
Net Sales $ 2,211 a. Measures profitability
Cost of Goods Sold b 1,599 over a time period.
Gross Profit $ 612 b. Received, or receivable,
SG&A Expenses c 402 from customers.
EBITd $ c. Sales comm., adv.,
210 Interest Expensee officers’ salaries, etc.
59 EBT f $ d. Operating income.
151 Income Taxes e. Cost of borrowed funds.
60 EATg $ 91 f. Taxable income.
Cash Dividends 38 g. Amount earned for
34
Increase in RE $ 53 shareholders.
 Framework
Framework for
for
Financial
Financial Analysis
Analysis
Trend / Seasonal Component
How much funding will be
required in the future?
1. Analysis of the funds
needs of the firm. Is there a seasonal
component?

Analytical Tools Used

Sources and Uses Statement
Statement of Cash Flows
Cash Budgets
35
 Framework
Framework for
for
Financial
Financial Analysis
Analysis
Health of a Firm

1. Analysis of the funds Financial Ratios

needs of the firm.
2. Analysis of the financial
condition and profitability
1. Individually
of the firm. 2. Over time
3. In combination
4. In comparison

36
 Framework
Framework for
for
Financial
Financial Analysis
Analysis

Business risk relates to

the risk inherent in the
1. Analysis of the funds
needs of the firm.
operations of the firm.
2. Analysis of the financial Examples:
condition and profitability
of the firm. Volatility in sales
3. Analysis of the business
risk of the firm. Volatility in costs
Proximity to break-even
point
37
 Framework
Framework for
for
Financial
Financial Analysis
Analysis
A Financial
Manager
must
1. Analysis of the funds
needs of the firm. Determining consider all
2. Analysis of the financial
the three jointly
financing
condition and profitability
needs of
when
of the firm. determining
the firm.
3. Analysis of the business
risk of the firm.
the
financing
needs of the
38 firm.
 Framework
Framework for
for
Financial
Financial Analysis
Analysis

1. Analysis of the funds

needs of the firm. Determining Negotiations
the
2. Analysis of the financial with
financing
condition and profitability suppliers of
needs of
of the firm. capital.
the firm.
3. Analysis of the business
risk of the firm.

39
 Use
Use of
of Financial
Financial Ratios
Ratios

A Financial Ratio is Types of

an index that relates Comparisons
two accounting
numbers and is Internal
obtained by dividing Comparisons
one number by the External
other. Comparisons

40
 External
External Comparisons
Comparisons and
and
Sources
Sources of
of Industry
Industry Ratios
Ratios
This involves Examples:
comparing the ratios Risk Management
of one firm with those Association
of similar firms or with
industry averages. Dun & Bradstreet
Almanac of
Similarity is important Business and
as one should Industrial
compare “apples to Financial Ratios
41
apples.”
 Liquidity
Liquidity Ratios
Ratios
Balance Sheet Ratios Current

Current Assets
Liquidity Ratios Current Liabilities

Shows a firm’s For Basket Wonders

ability to cover its December 31, 2007
current liabilities
$1,195 = 2.39
with its current
$500
assets.
42
 Liquidity
Liquidity Ratio
Ratio
Comparisons
Comparisons
Current Ratio
Year BW Industry
2007 2.39 2.15
2006 2.26 2.09
2005 1.91 2.01
Ratio is stronger than the industry average.
43
 Liquidity
Liquidity Ratios
Ratios
Balance Sheet Ratios Acid-Test (Quick)

Current Assets - Inv

Liquidity Ratios Current Liabilities

Shows a firm’s For Basket Wonders

ability to meet December 31, 2007
current liabilities
$1,195 - $696 = 1.00
with its most liquid $500
44
assets.
 Liquidity
Liquidity Ratio
Ratio
Comparisons
Comparisons
Acid-Test Ratio
Year BW Industry
2007 1.00 1.25
2006 1.04 1.23
2005 1.11 1.25
Ratio is weaker than the industry average.
45
 Summary
Summary of
of the
the Liquidity
Liquidity
Ratio
Ratio Comparisons
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 potential problem in the
inventories account.
 Note that this industry has a relatively
high level of inventories.
46
 Current
Current Ratio
Ratio --
-- Trend
Trend
Analysis
Analysis Comparison
Comparison
Trend Analysis of Current Ratio

2.5
2.3
Ratio Value

2.1
BW
1.9 Industry
1.7
1.5
2005 2006 2007
Analysis Year
47
 Acid-Test
Acid-Test Ratio
Ratio --
-- Trend
Trend
Analysis
Analysis Comparison
Comparison
Trend Analysis of Acid-Test Ratio

1.5

1.3
Ratio Value

1.0 BW
Industry
0.8

0.5
2005 2006 2007
Analysis Year
48
 Summary
Summary of
of the
the Liquidity
Liquidity
Trend
Trend Analyses
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.
BW
49
 Financial
Financial Leverage
Leverage Ratios
Ratios
Balance Sheet Ratios Debt-to-Equity

Total Debt
Financial Leverage Shareholders’ Equity
Ratios
For Basket Wonders
December 31, 2007
Shows the extent to
which the firm is $1,030 = .90
financed by debt. $1,139
50
 Financial
Financial Leverage
Leverage
Ratio
Ratio Comparisons
Comparisons
Debt-to-Equity Ratio
Year BW Industry
2007 .90 .90
2006 .88 .90
2005 .81 .89
BW has average debt utilization
51
relative to the industry average.
 Financial
Financial Leverage
Leverage Ratios
Ratios
Balance Sheet Ratios Debt-to-Total-Assets

Total Debt
Financial Leverage Total Assets
Ratios
For Basket Wonders
Shows the percentage December 31, 2007
of the firm’s assets
that are supported by $1,030 = .47
debt financing. $2,169
52
 Financial
Financial Leverage
Leverage
Ratio
Ratio Comparisons
Comparisons
Debt-to-Total-Asset Ratio
Year BW Industry
2007 .47 .47
2006 .47 .47
2005 .45 .47
BW has average debt utilization
53
relative to the industry average.
 Financial
Financial Leverage
Leverage Ratios
Ratios
Balance Sheet Ratios Total Capitalization
(i.e., LT-Debt + Equity)

Financial Leverage Long-term Debt

Ratios Total Capitalization

Shows the relative For Basket Wonders

importance of long-term December 31, 2007
debt to the long-term $530 = .32
financing of the firm. $1,669
54
 Financial
Financial Leverage
Leverage
Ratio
Ratio Comparisons
Comparisons
Total Capitalization Ratio
Year BW Industry
2007 .32 .30
2006 .32 .31
2005 .37 .32
BW has average long-term debt utilization
55
relative to the industry average.
 Coverage
Coverage Ratios
Ratios
Income Statement Interest Coverage
Ratios
EBIT
Interest Charges
Coverage Ratios
For Basket Wonders
Indicates a firm’s December 31, 2007
ability to cover
interest charges. $210 = 3.56
$59
56
 Coverage
Coverage
Ratio
Ratio Comparisons
Comparisons
Interest Coverage Ratio
Year BW Industry
2007 3.56 5.19
2006 4.35 5.02
2005 10.30 4.66
BW has below average interest coverage
57
relative to the industry average.
 Coverage
Coverage Ratio
Ratio --
-- Trend
Trend
Analysis
Analysis Comparison
Comparison
Trend Analysis of Interest Coverage Ratio
11.0

9.0
Ratio Value

7.0 BW
Industry
5.0

3.0
2005 2006 2007
Analysis Year
58
 Summary
Summary of
of the
the Coverage
Coverage
Trend
Trend Analysis
Analysis
 The interest coverage ratio for BW has
been falling since 2005. It has been
below industry averages for the past
two years.
 This indicates that low earnings (EBIT)
may be a potential problem for BW.
BW
 Note, we know that debt levels are in
line with the industry averages.
59
 Activity
Activity Ratios
Ratios
Income Statement / Receivable Turnover
(Assume all sales are credit sales.)
Balance Sheet
Ratios Annual Net Credit Sales
Receivables
Activity Ratios
For Basket Wonders
Indicates quality of December 31, 2007
receivables and how
successful the firm is in $2,211 = 5.61
its collections. $394
60
 Activity
Activity Ratios
Ratios
Income Statement / Avg Collection Period
Balance Sheet
Days in the Year
Ratios
Receivable Turnover

Activity Ratios For Basket Wonders

December 31, 2007
Average number of days
that receivables are
outstanding. 365 = 65 days
(or RT in days) 5.61
61
 Activity
Activity
Ratio
Ratio Comparisons
Comparisons
Average Collection Period
Year BW Industry
2007 65.0 65.7
2006 71.1 66.3
2005 83.6 69.2
BW has improved the average collection
62
period to that of the industry average.
 Activity
Activity Ratios
Ratios
Income Statement / Payable Turnover (PT)
(Assume annual credit
Balance Sheet purchases = $1,551.)
Ratios
Annual Credit Purchases
Accounts Payable
Activity Ratios
For Basket Wonders
Indicates the
December 31, 2007
promptness of payment
to suppliers by the firm. $1551
= 16.5
$94
63
 Activity
Activity Ratios
Ratios
Income Statement / PT in Days
Balance Sheet
Ratios Days in the Year
Payable Turnover
Activity Ratios
For Basket Wonders
December 31, 2007
Average number of days
that payables are 365
outstanding. = 22.1 days
16.5
64
 Activity
Activity
Ratio
Ratio Comparisons
Comparisons
Payable Turnover in Days
Year BW Industry
2007 22.1 46.7
2006 25.4 51.1
2005 43.5 48.5
BW has improved the PT in Days.
65
Is this good?
 Activity
Activity Ratios
Ratios
Income Statement / Inventory Turnover
Balance Sheet
Ratios Cost of Goods Sold
Inventory
Activity Ratios
For Basket Wonders
December 31, 2007
Indicates the
effectiveness of the $1,599 = 2.30
inventory management $696
66
practices of the firm.
 Activity
Activity
Ratio
Ratio Comparisons
Comparisons
Inventory Turnover Ratio
Year BW Industry
2007 2.30 3.45
2006 2.44 3.76
2005 2.64 3.69
BW has a very poor inventory turnover ratio.
67
 Inventory
Inventory Turnover
Turnover Ratio
Ratio --
--
Trend
Trend Analysis
Analysis Comparison
Comparison
Trend Analysis of Inventory Turnover Ratio
4.0

3.5
Ratio Value

3.0 BW
Industry
2.5

2.0
2005 2006 2007
Analysis Year
68
 Activity
Activity Ratios
Ratios
Income Statement / Total Asset Turnover
Balance Sheet
Ratios Net Sales
Total Assets
Activity Ratios
For Basket Wonders
December 31, 2007
Indicates the overall
effectiveness of the firm $2,211 = 1.02
in utilizing its assets to $2,169
69
generate sales.
 Activity
Activity
Ratio
Ratio Comparisons
Comparisons
Total Asset Turnover Ratio
Year BW Industry
2007 1.02 1.17
2006 1.03 1.14
2005 1.01 1.13
BW has a weak total asset turnover ratio.
70
Why is this ratio considered weak?
 Profitability
Profitability Ratios
Ratios
Income Statement / Gross Profit Margin
Balance Sheet
Ratios Gross Profit
Net Sales
Profitability Ratios
For Basket Wonders
December 31, 2007
Indicates the efficiency
of operations and firm $612 = .277
pricing policies. $2,211
71
 Profitability
Profitability
Ratio
Ratio Comparisons
Comparisons
Gross Profit Margin
Year BW Industry
2007 27.7% 31.1%
2006 28.7 30.8
2005 31.3 27.6
BW has a weak Gross Profit Margin.
72
 Gross
Gross Profit
Profit Margin
Margin --
--
Trend
Trend Analysis
Analysis Comparison
Comparison
Trend Analysis of Gross Profit Margin
35.0

32.5
Ratio Value (%)

30.0 BW
Industry
27.5

25.0
2005 2006 2007
Analysis Year
73
 Profitability
Profitability Ratios
Ratios
Income Statement / Net Profit Margin
Balance Sheet
Ratios Net Profit after Taxes
Net Sales
Profitability Ratios
For Basket Wonders
December 31, 2007
Indicates the firm’s
profitability after taking $91 = .041
account of all expenses $2,211
74
and income taxes.
 Profitability
Profitability
Ratio
Ratio Comparisons
Comparisons
Net Profit Margin
Year BW Industry
2007 4.1% 8.2%
2006 4.9 8.1
2005 9.0 7.6
BW has a poor Net Profit Margin.
75
 Net
Net Profit
Profit Margin
Margin --
--
Trend
Trend Analysis
Analysis Comparison
Comparison
Trend Analysis of Net Profit Margin
10
9
Ratio Value (%)

8
7 BW
6 Industry

5
4
2005 2006 2007
Analysis Year
76
 Profitability
Profitability Ratios
Ratios
Income Statement / Return on Investment
Balance Sheet
Ratios Net Profit after Taxes
Total Assets
Profitability Ratios
For Basket Wonders
Indicates the December 31, 2007
profitability on the
assets of the firm (after $91 = .042
all expenses and taxes). $2,160
77
 Profitability
Profitability
Ratio
Ratio Comparisons
Comparisons
Return on Investment
Year BW Industry
2007 4.2% 9.8%
2006 5.0 9.1
2005 9.1 10.8
BW has a poor Return on Investment.
78
 Return
Return on
on Investment
Investment ––
Trend
Trend Analysis
Analysis Comparison
Comparison
Trend Analysis of Return on Investment
12

10
Ratio Value (%)

8 BW
Industry
6

4
2005 2006 2007
Analysis Year
79
 Profitability
Profitability Ratios
Ratios
Income Statement / Return on Equity
Balance Sheet
Ratios Net Profit after Taxes
Shareholders’ Equity
Profitability Ratios
For Basket Wonders
Indicates the profitability December 31, 2007
to the shareholders of
the firm (after all $91 = .08
expenses and taxes). $1,139
80
 Profitability
Profitability
Ratio
Ratio Comparisons
Comparisons
Return on Equity
Year BW Industry
2007 8.0% 17.9%
2006 9.4 17.2
2005 16.6 20.4
BW has a poor Return on Equity.
81
 Return
Return on
on Equity
Equity --
--
Trend
Trend Analysis
Analysis Comparison
Comparison
Trend Analysis of Return on Equity
21.0

17.5
Ratio Value (%)

14.0 BW
Industry
10.5

7.0
2005 2006 2007
Analysis Year
82
 Return
Return on
on Investment
Investment and
and
the
the Du
Du Pont
Pont Approach
Approach
Earning Power = Sales profitability X
Asset efficiency
ROI = Net profit margin X
Total asset turnover
ROI2007 = .041 x 1.02 = .042 or 4.2%
ROIIndustry = .082 x 1.17 = .098 or 9.8%

83
 Return
Return on
on Equity
Equity and
and
the
the Du
Du Pont
Pont Approach
Approach
Return On Equity = Net profit margin X
Total asset turnover X
Equity Multiplier
Total Assets
Equity Multiplier =
Shareholders’ Equity

ROE2007 = .041 x 1.02 x 1.90 = .080

ROEIndustry = .082 x 1.17 x 1.88 = .179
84
 Summary
Summary of
of the
the Profitability
Profitability
Trend
Trend Analyses
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.
BW
 Note, this result is consistent with the low
85
interest coverage ratio.
 Summary
Summary of
of Ratio
Ratio Analyses
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.
86
 A horizontal analysis of a
company’s financial statements
Show how to perform a horizontal analysis of a company’s
financial statements.

87
 Comparative Financial
Statements
 Investors and creditors cannot evaluate and make
decisions based on one year’s data
 This is why most financial statements cover at least two
years so as to make comparisons.
 In fact, most financial analysis covers trends of 3 to 5
years.
 Horizontal analysis is the study of percent changes in
accounts from year-to-year.

88
 Comparative Income Statements

2006 2007 $ Change % Change

Total revenue $ 430,000 $ 403,000 $ 27,000 6.3%
Expenses:
Cost of goods sold $ 202,000 $ 188,000 $ 14,000 6.9%
Selling & general 90,000 93,000 (3,000) -3.3%
Interest expense 10,000 4,000 6,000 60.0%
Income tax expense 42,000 37,000 5,000 11.9%
Total expenses 344,000 322,000 22,000 6.4%
Net Income $ 86,000 $ 81,000 $ 5,000 5.8%

89
 Vertical Analysis
 Shows relationship of each financial statement
item and its base
 For the income statement, base is total
revenue
 For the balance sheet, base is total assets
 Each account is divided by its base
 Expressed as a percent

90
 Balance Sheet
Percent of
Assets total
Total current assets $ 92,000 24.6%
Property, plant and equipment, net 247,000 66.0%
Other assets 35,000 9.4%
Total assets $ 374,000 100.0%
Liabilities
Total current liabilities 48,000 12.8%
Long-term debt 108,000 28.9%
Total liabilities 156,000 41.7%
Stockholders' equity
Total stockholders' equity 218,000 58.3%
Total liabilities & equity $ 374,000 100.0%

91
 Horizontal Analysis

 Computing a percentage change takes two

steps:
 1. Compute the dollar amount of the change from
one period (the base period) to the next.
 2. Divide the dollar amount of change by the
base-period (prior year) amount.

92
 Common-size
Common-size Analysis
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.
 In other words, financial statements are
expressed in percentages only
 No dollar amounts
 Percentages derived from vertical analysis

93
 BWs’
BWs’ Common
Common Size
Size
Balance
Balance Sheets
Sheets
Regular (thousands of $) Common-Size (%)
Assets 2005 2006 2007 2005 2006 2007
Cash 148 100 90 12.10 4.89 4.15
AR 283 410 394 23.14 20.06 18.17
Inv 322 616 696 26.33 30.14 32.09
Other CA 10 14 15 0.82 0.68 0.69
Tot CA 763 1,140 1,195 62.39 55.77 55.09
Net FA 349 631 701 28.54 30.87 32.32
LT Inv 0 50 50 0.00 2.45 2.31
Other LT 111 223 223 9.08 10.91 10.28
Tot Assets 1,223 2,044 2,169 100.0 100.0 100.0

94
 BWs’
BWs’ Common
Common Size
Size
Balance
Balance Sheets
Sheets
Regular (thousands of $) Common-Size (%)
Liab+Equity 2005 2006 2007 2005 2006 2007
Note Pay 290 295 290 23.71 14.43 13.37
Acct Pay 81 94 94 6.62 4.60 4.33
Accr Tax 13 16 16 1.06 0.78 0.74
Other Accr 15 100 100 1.23 4.89 4.61
Tot CL 399 505 500 32.62 24.71 23.05
LT Debt 150 453 530 12.26 22.16 24.44
Equity 674 1,086 1,139 55.11 53.13 52.51
Tot L+E 1,223 2,044 2,169 100.0 100.0 100.0

95
 BWs’
BWs’ Common
Common Size
Size
Income
Income Statements
Statements
Regular (thousands of $) Common-Size (%)
2005 2006 2007 2005 2006 2007
Net Sales 1,235 2,106 2,211 100.0 100.0 100.0
COGS 849 1,501 1,599 68.7 71.3 72.3
Gross Profit 386 605 612 31.3 28.7 27.7
Adm. 180 383 402 14.6 18.2 18.2
EBIT 206 222 210 16.7 10.5 9.5
Int Exp 20 51 59 1.6 2.4 2.7
EBT 186 171 151 15.1 8.1 6.8
EAT 112 103 91 9.1 4.9 4.1
Cash Div 50 50 50 4.0 2.4 2.3
96
 Index
Index Analyses
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.
97
 BWs’
BWs’
Indexed
Indexed Balance
Balance Sheets
Sheets
Regular (thousands of $) Indexed (%)
Assets 2005 2006 2007 2005 2006 2007
Cash 148 100 90 100.0 67.6 60.8
AR 283 410 394 100.0 144.9 139.2
Inv 322 616 696 100.0 191.3 216.1
Other CA 10 14 15 100.0 140.0 150.0
Tot CA 763 1,140 1,195 100.0 149.4 156.6
Net FA 349 631 701 100.0 180.8 200.9
LT Inv 0 50 50 100.0 inf. inf.
Other LT 111 223 223 100.0 200.9 200.9
Tot Assets 1,223 2,044 2,169 100.0 167.1 177.4

98
 BWs’
BWs’
Indexed
Indexed Balance
Balance Sheets
Sheets
Regular (thousands of $) Indexed (%)
Liab+Equity 2005 2006 2007 2005 2006 2007
Note Pay 290 295 290 100.0 101.7 100.0
Acct Pay 81 94 94 100.0 116.0 116.0
Accr Tax 13 16 16 100.0 123.1 123.1
Other Accr 15 100 100 100.0 666.7 666.7
Tot CL 399 505 500 100.0 126.6 125.3
LT Debt 150 453 530 100.0 302.0 353.3
Equity 674 1,086 1,139 100.0 161.1 169.0
Tot L+E 1,223 2,044 2,169 100.0 167.1 177.4

99
 BWs’
BWs’ Indexed
Indexed Income
Income
Statements
Statements
Regular (thousands of $) Indexed (%)
2005 2006 2007 2005 2006 2007
Net Sales 1,235 2,106 2,211 100.0 170.5 179.0
COGS 849 1,501 1,599 100.0 176.8 188.3
Gross Profit 386 605 612 100.0 156.7 158.5
Adm. 180 383 402 100.0 212.8 223.3
EBIT 206 222 210 100.0 107.8 101.9
Int Exp 20 51 59 100.0 255.0 295.0
EBT 186 171 151 100.0 91.9 81.2
EAT 112 103 91 100.0 92.0 81.3
Cash Div 50 50 50 100.0 100.0 100.0
100
 Comparative Financial
Statements
 Investors and creditors cannot evaluate and make
decisions based on one year’s data
 This is why most financial statements cover at least two
years so as to make comparisons.
 In fact, most financial analysis covers trends of 3 to 5
years.
 Horizontal analysis is the study of percent changes in
accounts from year-to-year.

101
 Horizontal Analysis

 Computing a percentage change takes two

steps:
 1. Compute the dollar amount of the change from
one period (the base period) to the next.
 2. Divide the dollar amount of change by the
base-period (prior year) amount.

102
 Comparative Income Statements

2006 2007 $ Change % Change

Total revenue $ 430,000 $ 403,000 $ 27,000 6.3%
Expenses:
Cost of goods sold $ 202,000 $ 188,000 $ 14,000 6.9%
Selling & general 90,000 93,000 (3,000) -3.3%
Interest expense 10,000 4,000 6,000 60.0%
Income tax expense 42,000 37,000 5,000 11.9%
Total expenses 344,000 322,000 22,000 6.4%
Net Income $ 86,000 $ 81,000 $ 5,000 5.8%

103
 Vertical Analysis
 Shows relationship of each financial statement
item and its base
 For the income statement, base is total
revenue
 For the balance sheet, base is total assets
 Each account is divided by its base
 Expressed as a percent

104
 Balance Sheet
Percent of
Assets total
Total current assets $ 92,000 24.6%
Property, plant and equipment, net 247,000 66.0%
Other assets 35,000 9.4%
Total assets $ 374,000 100.0%
Liabilities
Total current liabilities 48,000 12.8%
Long-term debt 108,000 28.9%
Total liabilities 156,000 41.7%
Stockholders' equity
Total stockholders' equity 218,000 58.3%
Total liabilities & equity $ 374,000 100.0%

105
 Common-Size Statements
 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.
 In other words, financial statements are
expressed in percentages only
 No dollar amounts
 Percentages derived from vertical analysis

106
 Example of Common-Size
Income Statement
Common-size Income Statements

2006 2007
Total revenue 100% 100%
Expenses:
Cost of goods sold 47% 46%
Selling & general 21% 23%
Interest expense 2% 1%
Income tax expense 10% 8%
Total expenses 80% 78%
Net Income 20% 22%

107
 Benchmarking
 Compares company results to set
standard
 Goal is improvement
 Example:
 Company compares its common-
size statements to an industry
leader
108
 Using the Statement of Cash
Flows
 Helpful for finding weaknesses than gauging
strength
 Cash flow signs of a healthy company
 Operations are the major source of cash
 Investing activities have more than purchases
than sales of long-term assets
 Financing activities are not dominated by
borrowing

109
 Measuring Ability to Pay Current
Liabilities
Working Current assets – current liabilities;
capital Expressed as a $ amount

Current assets
Current Current liabilities
ratio Expressed as a ratio; Rule of thumb = 1.5

Cash + ST investments + Net receivables

Acid-test Current liabilities
ratio Expressed as a ratio; Rule of thumb = .9 - 1.0

110
 Measuring Ability to Sell Inventory and
Collect Receivables
Cost of goods sold
Inventory Average inventory
turnover Measures how often a company sell inventory;
Varies greatly among industries

A grocery store would have a high inventory

Turnover; a furniture store - low

Accounts Net sales

receivable Average net accounts receivable
Measures how often a company collects AR
turnover
A receivable turnover of 12 would mean
a company collects the AR balance once a month
111
 Days’ Sales in Receivables
Shows how many days’ sales remain in accounts
receivable

One day’s sales =

Step one: Net sales
365 days

Step two: Days’ Sales in Receivables =

Average net accts rec.
One day’s sales

The fewer the days, the more quickly

receivables are being converted to cash

112
 (a)

Located on
the balance
sheet

113
 (b) Acid-test ratio:
Cash + ST Inv. + Net Rec.
Current liabilities
$17,000 + 11,000 + 64,000 $92,000 = 0.83
$111,000 $111,000

114
 Located on the
(c) Inventory turnover: income statement
Cost of goods sold = 4.42
Average inventory $74,000 times

Beginning inventory + ending inventory

2

($77,000 + $71,000)/2 $74,000

115
Receivables turnover:
Net Credit Sales $654,000 = 9.55
Average receivables $68,500 times

Beginning receivables + ending

receivables
2

________________________________
$68,500
(Current year +
preceding
116 year)/2
 Days' Sales in Receivables:
One day's sales
Net credit sales $654,000 = $1,791.78
365 days 365
Use the
amount
Days' Sales in Receivables computed for
Average net receivables receivable
38.23
turnover
One day's sales $1,791.78 days

117
 Measuring Ability to Pay Debts
Total liabilities
Debt ratio Total assets
Tells proportion of assets financed with debt;
Average for most companies = .62

The higher the ratio, the greater the

pressure to pay debt

Times- Income from operations

Interest- Interest expense
Measures # of times interest can cover interest
Earned
High ratio indicates ease of paying interest;
low indicates difficulty
118
 Measuring Profitability
Return on Net Income/Net sales
Shows percentage of each sales dollar that
sales makes it to the “bottom line”

Net income + Interest expense

Return on Average total assets
total assets Measures success in using assets to earn a profit

Return on Net Income – Preferred Dividends

Average common stockholders’ equity
equity How much income is earned for every dollar invested

119
 Earnings per Share (EPS)
Key measure of company’s success

Net Income - Preferred Dividends

Average number of common shares
outstanding

Most widely quoted ratio

120
 Analyzing Stock Investments
Price – Market price per share of common stock
Earnings per share
Earnings Compares market price to earnings
Ratio
Dividend per share
Dividend Market price per share
yield Compares dividends per share to market price

Book value Total stockholders’ equity – preferred equity

per share # of common shares outstanding

121
 EVA & Shareholder Value

 What is the best way to measure

shareholder value?
 Fortune 500 sales?
 Earnings per share?
 Business Week survey of market value of
equity?
 Stock market share price?
 Market value added?

122
 EVA & Wealth Creation
 Warren Buffet:
We feel noble intentions should be checked periodically
against results. We test the wisdom of retaining earnings
by assessing whether retention, over time, delivers
shareholders at least $1 of market value for each $1
retained.
 Translation:
Ultimate litmus test of any company’s success lies in
increasing its market value by more than it increases its
capital.

123
View of the Firm

Market Valued Balance Sheet

Assets Debt
Equity
 Value of firm = Value of debt + value of stock
 Market value of a company reflects:
 Earning power of invested assets
 Present value of current operations
 Present value of expected improvement in operating
performance.

124
What is Required to Focus?

 Tie performance methods to capital budgeting

techniques:
Links to
 Economic value added (EVA) NPV
 Market value added (MVA)
 Want to gauge management’s performance
 Focus on:
 Decisions made in the past to help project
the future.

125
 What is MVA?
 MVA = Market value of capital
- book value of capital
 Key elements:
 Calculation of market value of capital
 Market value of debt + market value of equity
 Calculation of capital invested
 Accounting adjustments necessary
 MVA  Related to EVA.

126
 Market Value Added

Market
Premium
Total value added
market
value
Debt &
equity
Investment
capital

127
Also, Market Value Added

MVA = Present value of all future EVA Expected

improvement
in EVA
MVA
Total
market
value
Debt Current level
& of EVA
equity
capita
l
128
 EVA & Market Value
 Market value of a company reflects:
 Value of invested capital
 Value of ongoing operations
 Present value of expected future economic profits
 Captures improvement in operating performance
 EVA related to market value by:
 Measuring all the capital
 Seeing what the firm is going to do with the capital
 Turn FCF forecasts into EVA forecasts
 Discount EVA.

129
 EVA
 Economic Value Added ® (EVA)
 Measures if operations have increased stockholder wealth

EVA = Net income + Interest expense – Capital charge

Capital charge =
Notes payable + Current maturities of long-term
debt + Long-term debt + Stockholders’ Equity

X
Cost of capital

Average return demanded by investors and creditors

130
 What is EVA?
 EVA = Economic profit
 Not the same as accounting profit
 Difference between revenues and costs
 Costs include not only expenses but also cost of
capital
 Economic profit adjusts for distortions caused by accounting
methods
 Doesn’t have to follow GAAP
 R&D, advertising, restructuring costs, ...
 Cost of capital accounted for explicitly
 Rate of return required by suppliers of a firm’s debt and
equity capital
 Represents minimum acceptable return.

131
 Advantages of EVA
 Annual EVA is easy to interpret
 Correlations between market value and various
measures:
 Standardized EVA 0.50
 ROE 0.35
 Fortunes “Most admired firms” 0.24
 Cash flow growth 0.22
 EPS growth 0.18
 Dividend growth 0.16
 Sales growth 0.09
 50% of change in market value explained by
standardized EVA (Standardized EVA = EVA / Capital).
132
 Components of EVA
 NOPLAT
 Net operating profit after tax
 Operating capital
 Net operating working capital, net PP&E, goodwill, and
other operating assets
 Cost of capital
 Weighted average cost of capital %
 Capital charge
 Cost of capital % * operating capital
 Economic value added
 NOPLAT less the capital charge.

133
 What is NOPAT?

Net sales 150,000

Cost of sales 135,000
Depreciation 2,000
SG&A 7,000
Net Operating profit 6,000
Taxes @ 40% 2,400
NOPAT 3,600
Excludes financing charges

134
What is Operating Capital?
 Capital: Net operating assets adjusted for
certain accounting distortions
 Asset write-downs, restructuring charges, …
 Net operating assets:
 Cash, receivables, inventory, prepaids
 Trade payable, accruals, deferred taxes
 Net property, plant, and equipment
 Exclude non-operating assets:
 Marketable securities, investments,...

135
What is Cost of Capital?

 Weighted average cost of capital consists of:

Cost of debt after taxes
= Market interest rate x (1 – tax rate)
Cost of equity
= Risk-free rate + beta x (market risk
premium)
WACC
= Cost of debt after taxes x % debt +
cost of equity x % equity
where % debt + % equity = 100%.

136
What is the Capital Charge?
 Represents a rental charge for the use of
the operating capital
 Minimum rate of return the operating
capital should earn
 Calculated as the firm’s weighted average
cost of capital % x invested capital.

137
Calculating EVA
NOPAT/Average capital
= Return on invested operating capital (ROIC)
- Weight average cost of capital (WACC)
= Spread (= ROIC - WACC)
* Operating capital
= Economic value added (EVA)
Net operating profit after tax (NOPAT)
- Capital charge (= WACC * Capital)
= Economic value added (EVA)

138
 What’s Affecting EVA?
Sales Market potential

- Operating expenses COGS, SG&A + other

Potential gov’t
- Taxes actions
= NOPAT Net working
capital
- Capital charge PP&E
WACC
= EVA

Evaluate the many assumptions!

139
Forward Looking Relationship for
EVA & MVA

EVA EVA EVA EVA

Year 1 Year 2 Year 3 .... Year n

MVA
Market
Value
Market EVA + EVA + EVA + .. + EVA
value = 1+r (1 + r)2 (1 + r)3 (1 + r)n
Capita Market value is based on establishing the
l economic investment made in the
company (capital), making a best guess
about what economic profits (EVA) will
happen in the future, and discounting
those EVAs to the present to get market
value added.
140
Fundamental Strategies

 NOPAT 
EVA    Cost of capital * Capital
 Capital 

Operate: Improve the Decrease: WACC

return on existing
operating capital Build: Invest as long as returns
exceed the cost of capital

Harvest: Re-deploy capital when

returns fail to achieve the cost of
141 capital.
 Red Flags in Financial
Statement Analysis
 Earnings problems
 Decrease in net income over several
years
 Decreased cash flow
 Operating cash flow consistently less
than net income

142