FINANCIAL STATEMENT

AND ITS ANALYSIS

Learning objectives:
 To review basic accounting information and understand the reported
financial statement of the firm
 To understand the process & procedures of financial analysis,
particularly ratio analysis, that can be used to assess a firm’s basic
viability
FINANCIAL STATEMENT

 Financial statement typically are part of the annual report.

It provides a summarized view of the financial position and
operation of a firm
 Financial statement consists of
 Balance sheet
 Income statement
 Statement of retained earnings
 Statement of cash flows
BALANCE SHEET
 Balance sheet is an accounting statement of a firm’s financial
position at a specified point in time.


investment decision Financing decision

current asset current liabilities
Fixed asset long term debt
shareholder equity
INCOME STATEMENT & OTHER
STATEMENT
 Income statement is a financial statement showing a firm’s
revenues and expenses during a specified period.
Revenue-expenses= Income
 Statement of retained earnings shows how much of the firm’s
earnings are retained in the business rather than paid out in
dividend
 Statement of cash flows shows cash receipts and cash
payments during a period.
FINANCIAL ANALYSIS
 Financial analysis is associated with ratio analysis.
 Ratio analysis is defined as the analysis of
relationship among various statements items both at a
point in time and over time.
 five types of ratios:

liquidity ratio
Activity ratio
Leverage ratio
Profitability ratio
Market ratio
FINANCIAL STATEMENT
ANALYSIS
Who analyzes financial statements?
 Internalusers (i.e., management)
 External users (emphasis of chapter)

 Examples?
 Investors, creditors, regulatory agencies & …
 stock market analysts and
 auditors
FINANCIAL STATEMENT
ANALYSIS
 What do internal users use it for?
Planning, evaluating and controlling company operations
 What do external users use it for?
Assessing past performance and current financial position and
making predictions about the future profitability and solvency of
the company as well as evaluating the effectiveness of
management
RATIO ANALYSIS
Expression
Expression of of logical
logical relationships
relationships
between
between items
items in in aa financial
financial
statement
statement ofof aa single
single period
period
(e.g.,
(e.g., percentage
percentage relationship
relationship
between
between revenue
revenue andand netnet income)
income)
RATIOS
Ratios can be expressed in three different ways:
1. Ratio (e.g., current ratio of 2:1)
2. % (e.g., profit margin of 2%)
3. $ (e.g., EPS of $2.25)
USE
USE OF
OF FINANCIAL
FINANCIAL RATIOS
RATIOS

A Financial Ratio is an Types of

index that relates two Comparisons
accounting numbers and
is obtained by dividing Internal
one number by the Comparisons
other. External
Comparisons
 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 Acct. a. How the firm stands on a
Rec.c 394 Inventories specific date.
696 Prepaid Exp d b. What BW owned.
5 Accum Tax Prepay c. Amounts owed by customers.
10 d. Future expense items
Current Assetse $1,195 Fixed already paid.
Assets (@Cost)f 1030 Less: Acc. e. Cash/likely convertible to
Depr. g (329) Net Fix. cash within 1 year.
Assets $ 701 Investment, LT
f. Original amount paid.
50 Other Assets, LT
g. Acc. deductions for wear
223 Total Assets b $2,169
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 Acct. a. Note, Assets = Liabilities +
Payablec 94 Accrued Equity.
Taxes d 16 Other Accrued b. What BW owed and
Liab. d 100 ownership position.
Current Liab. e $ 500 Long-Term c. Owed to suppliers for goods
Debt f 530 Shareholders’ and services.
Equity Com. Stock ($1 d. Unpaid wages, salaries, 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 Equity g. Original investment.
$1,139 h. Earnings reinvested.
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 over a
Cost of Goods Sold b 1,599 Gross time period.
Profit $ 612 SG&A Expenses b. Received, or receivable, from
c 402 customers.
EBITd $ 210 Interest c. Sales comm., adv., officers’
Expensee 59 EBT f salaries, etc.
$ 151 Income d. Operating income.
Taxes 60 EATg e. Cost of borrowed funds.
$ 91 Cash Dividends f. Taxable income.
38 Increase in RE g. Amount earned for
$ 53 shareholders.
LIQUIDITY RATIOS
 it shows the relationship of firm’s cash and
other assets to current liabilities. It measures the
ability of the firm to meet its short term
obligations. The ratios which indicate the
liquidity of a firm:
 current ratio=current asset/current liabilities

 quick ratio= current asset-inventory-prepaid

exp. /current liabilities
 LIQUIDITY
LIQUIDITY RATIOS
RATIOS
Balance Sheet Ratios Acid-Test (Quick)
Current Assets - Inv
Liquidity Ratios Current Liabilities

For Basket Wonders December

Shows a firm’s ability 31, 2007
to meet current
liabilities with its most
$1,195 - $696 = 1.00
liquid assets. $500
 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.

 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.
 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
ACTIVITY RATIOS
 this ratio indicate how well the firm manages its
assets
 inventory turnover= COGS/inventory
 average collection period = Receivables/credit
sales per day
 Average payment period= AP/Credit Purchase
per day
 fixed asset turnover= sales/ fixed assets
 total assets turnover= sales/ total assets
 ACTIVITY
ACTIVITY RATIOS
RATIOS

Income Statement / Receivable Turnover

(Assume all sales are credit sales.)
Balance Sheet
Annual Net Credit Sales
Ratios
Receivables

Activity Ratios For Basket Wonders December

31, 2007
Indicates quality of receivables
and how successful the firm is in
its collections. $2,211 = 5.61
$394
 ACTIVITY
ACTIVITY RATIOS
RATIOS

Income Statement / Avg Collection Period

Balance Sheet Days in the Year
Ratios Receivable Turnover

For Basket Wonders December 31,

Activity Ratios 2007

Average number of days that

receivables are outstanding.
(or RT in days) 365 = 65 days
5.61
 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

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 December 31,
2007
Indicates the promptness of
payment to suppliers by the firm.
$1551
= 16.5
$94
 ACTIVITY
ACTIVITY RATIOS
RATIOS
Income Statement / PT in Days
Balance Sheet
Days in the Year
Ratios
Payable Turnover

Activity Ratios For Basket Wonders December 31,

2007
Average number of days that
payables are outstanding.
365 = 22.1 days
16.5
 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.

Is this good?
 ACTIVITY
ACTIVITY RATIOS
RATIOS
Income Statement / Inventory Turnover
Balance Sheet
Cost of Goods Sold
Ratios
Inventory

Activity Ratios For Basket Wonders December 31,

2007
Indicates the effectiveness of the
inventory management practices
of the firm. $1,599 = 2.30
$696
 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.

 ACTIVITY
ACTIVITY RATIOS
RATIOS
Income Statement / Total Asset Turnover
Balance Sheet
Net Sales
Ratios
Total Assets

Activity Ratios For Basket Wonders December 31,

2007
Indicates the overall effectiveness
of the firm in utilizing its assets
to generate sales. $2,211 = 1.02
$2,169
 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.

Why is this ratio considered weak?
LEVERAGE RATIO
 The long term solvency of a firm can be examined by
using leverage ratio. it indicate to what extent the firm
has financed its investment by borrowing.
 Debt equity ratio= debt/equity
 Debt ratio= total debt/total asset
 Times interest earned=net operating income/interest
expense
 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 financed by $1,030 = .90
debt. $1,139
 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

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 December
31, 2007
Shows the percentage of
the firm’s assets that are
supported by debt $1,030 = .47
financing. $2,169
 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

relative to the industry average.
 COVERAGE
COVERAGE RATIOS
RATIOS
Income Statement Interest Coverage
Ratios
EBIT
Interest Charges
Coverage Ratios
For Basket Wonders December
31, 2007
Indicates a firm’s ability
to cover interest charges.
$210 = 3.56
$59
 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

relative to the industry average.
 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.
PROFITABILITY RATIO
 it measures the profits of the firm relative to sales,
assets or equity.
 Gross Profit margin=Gross profit / sales
 Net Profit margin=net income after tax/sales
 return on assets= net income/total asset
 return on equity= net income after tax/common equity
 PROFITABILITY
PROFITABILITY RATIOS
RATIOS
Income Statement / Gross Profit Margin
Balance Sheet
Gross Profit
Ratios
Net Sales

Profitability Ratios For Basket Wonders December 31,

2007
Indicates the efficiency of
operations and firm pricing
policies. $612 = .277
$2,211
 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.

 PROFITABILITY
PROFITABILITY RATIOS
RATIOS

Income Statement / Net Profit Margin

Balance Sheet
Net Profit after Taxes
Ratios
Net Sales

Profitability Ratios For Basket Wonders December 31,

2007
Indicates the firm’s profitability
after taking account of all
expenses and income taxes. $91 = .041
$2,211
 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.

 PROFITABILITY
PROFITABILITY RATIOS
RATIOS

Income Statement / Return on Investment

Balance Sheet
Net Profit after Taxes
Ratios
Total Assets

Profitability Ratios For Basket Wonders December 31,

2007
Indicates the profitability on the
assets of the firm (after all
expenses and taxes). $91 = .042
$2,160
 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.

 PROFITABILITY
PROFITABILITY RATIOS
RATIOS
Income Statement / Return on Equity
Balance Sheet
Net Profit after Taxes
Ratios
Shareholders’ Equity

Profitability Ratios For Basket Wonders December 31,

2007
Indicates the profitability to the
shareholders of the firm (after all
expenses and taxes). $91 = .08
$1,139
 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.

MARKET RATIO
 it relates the firm’s stock price to its earnings and book
value per share.
 price earnings ratio= Market price per share of common
stock/ earnings per share
 Market/Book ratio= market value/ book value
DUPONT SYSTEM OF ANALYSIS
 is used to dissect the firm’s financial statements and to
assess its financial condition. It is defined as the overall
profitability of the company.
 DuPont formula

 net profit margin X total asset turnover

THE DUPONT SYSTEM
 Method to breakdown ROE into:
 ROA and Equity Multiplier
 ROA is further broken down as:
 Profit Margin and Asset Turnover
 Helps to identify sources of strength and weakness in
current performance
 Helps to focus attention on value drivers

4
9
THE DUPONT SYSTEM

ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r

5
0
THE DUPONT SYSTEM

ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r

ROE  ROA  Equity Multiplier

Net Income Total Assets
 
Total Assets Common Equity 5
1
THE DUPONT SYSTEM

ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r

ROA  Profit Margin  Total Asset Turnover

Net Income Sales
 
Sales Total Assets 5
2
 THE DUPONT SYSTEM

ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r

ROE  Profit Margin  Total Asset Turnover  Equity Multiplier

Net Income Sales Total Assets
  
Sales Total Assets Common Equity
5
3
 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
THE DUPONT SYSTEM: DELL

Net Income Sales Total Assets

ROE   
Sales Total Assets Common Equity
 Profit Margin  Total Asset Turnover  Equity Multiplier
 ROA  Equity Multiplier

$1,666.00 $25,265.00 $11,471.00

ROE   
$25,265.00 $11,471.00 $5,308.00
 0.0659  2.2025  2.1611
 0.1452  2.1611
 31.39% 5
5
QUESTION
The
Thecurrent
currentratio
ratioisisaameasure
measureof ofliquidity
liquiditythat
thatisiscomputed
computed
by
bydividing
dividingtotal
totalassets
assetsby
bytotal
totalliabilities.
liabilities.
a.a.True
True
b.b.False
False
 Question
The
The current
current ratio
ratio is
is aa measure
measure of of
liquidity
liquidity that
that is
is computed
computed by by dividing
dividing
total
total assets
assets by by total
total liabilities.
liabilities.
a.
a. True
True
b.
b. False
False The
The current
current ratio
ratio is
is aa measure
measure of
of
liquidity,
liquidity, but
but is
is computed
computed byby
dividing
dividing current
current assets
assets by
by
current
current liabilities
liabilities
QUESTION
Quick
Quickassets
assetsare
aredefined
definedas
asCash,
Cash,Marketable
MarketableSecurities
Securitiesand
and
net
netreceivables.
receivables.
a.a.True
True
b.b.False
False
 Question
Quick
Quick assets
assets are
are defined
defined as
as Cash,
Cash,
Marketable
Marketable Securities
Securities and
and net
net
receivables.
receivables.
a.
a. True
True
b.
b. False
False
No more ratios, please!
LIMITATIONS OF RATIO ANALYSIS
 Difficulty in comparison
 impact of inflation
 conceptual diversity
LIMITATIONS OF RATIO ANALYSIS
 A firm’s industry category is often difficult to identify
 Published industry averages are only guidelines
 Accounting practices differ across firms
 Sometimes difficult to interpret deviations in ratios
 Industry ratios may not be desirable targets
 Seasonality affects ratios

62
 EXERCISE
Complete the balance sheet and sales information in the table
that follows for Chowdhury industries using the following
financial data: 10
 Debt ratio (total debt/total asset) : 50%
 Current ratio: 1.8 times
 Total asset turnover: 1.5 times
 Days sales outstanding (average collection period):
36.5 days
 Gross profit margin on sales: (Sales- cost of goods
sold)/sales: 25%
 Inventory turnover ratio: 5 times
COMPLETE THIS BALANCE SHEET

Balance sheet

Cash Account payable

--------------------- ---------------

Account receivable Long term debt

--------------------- 60000

Inventories Common stock

---------------------- ---------------

Fixed assets Retained earnings

---------------------- 97500

Total assets Total liabilities and equity

$ 300,000 ----------------

Sales Cost of goods sold

------------------------ ----------------
 INCOME STATEMENT
FOR THE YEAR ENDED ON DEC. 31, 2009
Sales revenue $ 600000
Less: cost of goods sold 460000
Gross profit $140000
less: operating expenses:
general & adm. Expenses 30000
depreciation 30000

Operating profit $ 80000

Less: interest exp 10000
Net profit before tax $ 70000
less\: tax 27100
Net profit after tax (earnings
available to
Common stockholder) $42900
EPS $ 2.15
BALANCE SHEET
DECEMBER 31, 2009
Asset:
Cash $ 15000
Marketable securities 7200
Account receivable 34100
Inventories 82000
total current asset 138300
Net Fixed asset 270000
Total asset 408300
Liabilities & shareholder’s equity
Account payable 57000
Notes payable 13000
Accruals 5000

Total current liabilities $ 75000

Long term debt $ 150000
Shareholder equity
Common stock $ 110200
Retained earnings 73100
Total shareholder’s equity 183300
Total liabilities and share holder's equity 408300
REQUIREMENTS:
Industry average
 current ratio 2.35
 Quick ratio 0.87
 inventory turnover 4.55
 average collection period 35.8 days
 total asset turnover 1.09
 debt/asset ratio 0.33
 times interest earned ratio 12.33
 gross profit margin 0.202
 operating profit margin 0.135
 net profit margin 0.091
 EPS $ 3.10
 ROA 0.099
 ROE 0.167