Chapter 6

Financial Statement
Analysis
6-1

Financial
Statement Analysis
Financial
A

Statements

Possible Framework for Analysis

Ratio

Analysis

Trend

Analysis

Common-Size
6-2

and Index Analysis

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.

6-3

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.

6-4

Primary Types of
Financial Statements
Balance Sheet

A summary of a firms financial position on

a given date that shows total assets = total
liabilities + owners equity.

Income Statement

6-5

A summary of a firms revenues and

expenses over a specified period, ending
with net income or loss for the period.

Basket Wonders Balance

Sheet (Asset Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2003a
Cash and C.E.
$ 90
a. How the firm stands on
Acct. Rec.c
394
a specific date.
Inventories 696 Prepaid Exp d b. What BW owned.
5 Accum Tax Prepay c. Amounts owed by
10
customers.
Current Assetse
d. Future expense items
f
$1,195 Fixed Assets (@Cost)
already paid.
g
1030 Less: Acc. Depr.
e. Cash/likely convertible
(329) Net Fix. Assets $ 701
to cash within 1 year.
Investment, LT
50 Other
Assets, LT
223 Total f. Original amount paid.
g. Acc. deductions for
b
Assets
$2,169
wear and tear.
6-6

Basket Wonders Balance

Sheet (Liability Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2003
Notes Payable
$ 290 a. Note, Assets =
Liabilities + Equity.
Acct. Payablec
94
Accrued Taxes d
16 Other b. What BW owed and
ownership position.
Accrued Liab. d
100
Current Liab. e $ 500 c. Owed to suppliers for
goods and services.
Long-Term Debt f 530
Shareholders Equity
d. Unpaid wages, salaries,
etc.
Com. Stock ($1 par) g
200
Add Pd in Capital g 729
e. Debts payable < 1 year.
Retained Earnings h
210 f. Debts payable > 1 year.
Total Equity
$1,139 g. Original investment.
a,b $2,169
h. Earnings reinvested.
6-7 Total Liab/Equity

Basket Wonders
Income Statement
Basket Wonders Statement of Earnings (in thousands)
for Year Ending December 31, 2003a
Net Sales
$ 2,211 Cost of
Goods Sold b 1,599
Gross Profit $
612 SG&A
Expenses c
402
EBITd
$
210
Interest Expensee
59
EBT f $
151 Income
Taxes
60 EATg
$
91 Cash Dividends
38 Increase in RE
$
53
6-8

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.

Framework for
Financial Analysis
Trend / Seasonal Component

1. Analysis of the funds

needs of the firm.

How much funding will be

required in the future?
Is there a seasonal
component?

Analytical Tools Used

Sources and Uses Statement
Statement of Cash Flows
Cash Budgets
6-9

Framework for
Financial Analysis
Health of a Firm
1. Analysis of the funds
needs of the firm.
2. Analysis of the financial
condition and profitability
of the firm.

6-10

Financial Ratios
1.
2.
3.
4.

Individually
Over time
In combination
In comparison

Framework for
Financial Analysis

1. Analysis of the funds

needs of the firm.
2. Analysis of the financial
condition and profitability
of the firm.
3. 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

6-11

Framework for
Financial Analysis

1. Analysis of the funds

needs of the firm.
2. Analysis of the financial
condition and profitability
of the firm.
3. Analysis of the business
risk of the firm.

6-12

Determining
the
financing
needs of
the firm.

A Financial
Manager
must
consider all
three jointly
when
determining
the
financing
needs of the
firm.

Framework for
Financial Analysis

1. Analysis of the funds

needs of the firm.
2. Analysis of the financial
condition and profitability
of the firm.
3. Analysis of the business
risk of the firm.

6-13

Determining
the
financing
needs of
the firm.

Negotiations
with
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.
6-14

Types of
Comparisons
Internal
Comparisons
External
Comparisons

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.
6-15

Examples:
Robert Morris
Associates
Dun & Bradstreet
Almanac of
Business and
Industrial
Financial Ratios

Liquidity Ratios
Balance Sheet Ratios

Current

Liquidity Ratios

Current Assets
Current Liabilities

Shows a firms ability

to cover its current
liabilities with its
current assets.
6-16

For Basket Wonders

December 31, 2003
$1,195 = 2.39
$500

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.

6-17

Liquidity Ratios
Balance Sheet Ratios

Acid-Test (Quick)

Liquidity Ratios

Current Assets - Inv

Current Liabilities

Shows a firms
ability to meet
current liabilities
with its most liquid
assets.
6-18

For Basket Wonders

December 31, 2003
$1,195 - $696 = 1.00
$500

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.

6-19

Summary of the Liquidity

Ratio Comparisons
Ratio
BW
Current
2.39
Acid-Test1.00

Industry
2.15
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.

6-20

Current Ratio -- Trend

Analysis Comparison
Trend Analysis of Current Ratio

Ratio Value

2.5
2.3
2.1
1.9
1.7
1.5
2001
6-21

BW
Industry

2002
Analysis Year

2003

Acid-Test Ratio -- Trend

Analysis Comparison
Trend Analysis of Acid-Test Ratio

Ratio Value

1.5
1.3

0.8
0.5
2001

6-22

BW
Industry

1.0

2002
Analysis Year

2003

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.
BW

6-23

Financial Leverage Ratios

Balance Sheet Ratios
Financial Leverage
Ratios

Shows the extent to

which the firm is
financed by debt.
6-24

Debt-to-Equity
Total Debt
Shareholders Equity
For Basket Wonders
December 31, 2003
$1,030 = .90
$1,139

Financial Leverage
Ratio Comparisons
Debt-to-Equity Ratio

6-25

Year

BW

Industry

2003

.90

.90

2002

.88

.90

2001

.81

.89

BW has average debt utilization

relative to the industry average.

Financial Leverage Ratios

Balance Sheet Ratios
Financial Leverage
Ratios

Shows the percentage

of the firms assets
that are supported by
debt financing.
6-26

Debt-to-Total-Assets
Total Debt
Total Assets
For Basket Wonders
December 31, 2003
$1,030 = .47
$2,169

Financial Leverage
Ratio Comparisons
Debt-to-Total-Asset Ratio

6-27

Year

BW

Industry

2003

.47

.47

2002

.47

.47

2001

.45

.47

BW has average debt utilization

relative to the industry average.

Financial Leverage Ratios

Balance Sheet Ratios

Total Capitalization

Financial Leverage
Ratios

Total Debt
Total Capitalization

Shows the relative

importance of long-term
debt to the long-term
financing of the firm.
6-28

(i.e., LT-Debt + Equity)

For Basket Wonders

December 31, 2003

$1,030 = .62
$1,669

Financial Leverage
Ratio Comparisons
Total Capitalization Ratio
Year

BW

Industry

2003

.62

.60

2002

.62

.61

2001

.67

.62

BW has average long-term debt utilization

relative to the industry average.
6-29