Chapter 5: Analysis of Financial Statements

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Analysis of Financial Statements
Chapter 5
Sep. 9, 2009
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Learning Objectives

• How financial ratio analysis helps managers
  assess the firms health.
• Compute profitability, liquidity, debt, asset
  activity, and market value ratios.
• Compare financial information over time (trends)
  and among companies (benchmarking).
• Look at sources of financial information

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Ratio Analysis

• Managers use ratios to interpret the raw numbers
  on financial statements.
• Relative measures allow comparison over time
  (trends), to other firms, and to benchmarks
  Rule Of Thumb, ROT)
• Ratios are used by financial managers, other
  business managers, creditors, investors and
  college students

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Ratio Analysis
Five Categories of Ratios

• Profitability ratios
• Liquidity ratios (cash)
• Debt ratios (Solvency)
• Asset activity ratios
• Market value ratios

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Ratio Analysis
Profitability Ratios

• Measure the overall effectiveness of the firms
  management.
• Measures how the firms returns (earnings)
  compare with its sales, asset investments and
  equity

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Ratio Analysis
Profitability Ratios
How effective is the firm at generating revenue
in excess of its cost of goods sold? ROT says
gt40
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Balance Sheet Excalibur Corporation
Cash 175 Accounts Payable 115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities 230
Current Assets 1,230 Bonds 600 Plant
Equipment 2,500 Owners Equity LessAcc.
Depr. (1,200) Common Stock 300 Net Fixed
Assets 1,300 Capital in Excess of Par 600
Total Assets 2,530 Retained Earnings 800 Total
Owners Equity 1,700 Total Liabilities and
Owners Equity 2,530
Income Statement Excalibur Corporation
Sales 1,450 Cost of Goods Sold 875 Gross
Profit 575 Operating Expenses 45 Depreciation 200
Net Operating Income 330 Interest Expense
60 Income Before
Taxes 270 Taxes (40) 108 Net Income 162
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Ratio Analysis
Profitability Ratios
How effective is the firm in keeping costs of
production and operating expenses low? How much
profit am I earning just from the basic
operations of my business. EBIT. ROT says 20 or
better
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Balance Sheet Excalibur Corporation
Cash 175 Accounts Payable 115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities 230
Current Assets 1,230 Long-term Debt 600 Plant
Equipment 2,500 Owners Equity LessAcc.
Depr. (1,200) Common Stock 300 Net Fixed
Assets 1,300 Capital in Excess of Par 600
Total Assets 2,530 Retained Earnings 800 Total
Owners Equity 1,700 Total Liabilities and
Owners Equity 2,530
Income Statement Excalibur Corporation
Sales 1,450 Cost of Goods Sold 875 Gross
Profit 575 Operating Expenses 45 Depreciation 200
Operating Income 330 Interest Expense 60 Income
Before Taxes 270 Taxes (40) 108 Net Income 162
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Ratio Analysis
Profitability Ratios
Note Net Income increases Retained Earnings.
Dividends, either preferred or common, are paid
out of retained earnings
How much net profit is being generated from each
dollar of sales? ROT says gt 10
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Balance Sheet Excalibur Corporation
Assets Liabilities
Cash 175 Accounts Payable 115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities 230
Current Assets 1,230 Long-term Debt 600 Plant
Equipment 2,500 Owners Equity LessAcc.
Depr. (1,200) Common Stock 300 Net Fixed
Assets 1,300 Capital in Excess of Par 600
Total Assets 2,530 Retained Earnings 800 Total
Owners Equity 1,700 Total Liabilities and
Owners Equity 2,530
Income Statement Excalibur Corporation
Sales 1,450 Cost of Goods Sold 875 Gross
Profit 575 Operating Expenses 45 Depreciation 200
Operating Income 330 Interest Expense 60 Income
Before Taxes 270 Taxes (40) 108 Net Income 162
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Ratio Analysis
Profitability Ratios
How effectively is the firm generating net income
from its investment in assets ? How much income
each dollar of assets produces. ROT says gt 10
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Balance Sheet Excalibur Corporation
Assets Liabilities
Cash 175 Accounts Payable 115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities 230
Current Assets 1,230 Long-term debt 600 Plant
Equipment 2,500 Owners Equity LessAcc.
Depr. (1,200) Common Stock 300 Net Fixed
Assets 1,300 Capital in Excess of Par 600
Total Assets 2,530 Retained Earnings 800 Total
Owners Equity 1,700 Total Liabilities and
Owners Equity 2,530
Income Statement Excalibur Corporation
Sales 1,450 Cost of Goods Sold 875 Gross
Profit 575 Operating Expenses 45 Depreciation 200
Operating Income 330 Interest Expense 60 Income
Before Taxes 270 Taxes (40) 108 Net Income 162
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Ratio Analysis
Profitability Ratios
How well is the firm generating return to its
equity providers the common stockholders? ROT
says gt 15 How many dollars of income for each
dollar invested in the company by owners
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Balance Sheet Excalibur Corporation
Assets Liabilities
Cash 175 Accounts Payable 115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities 230
Current Assets 1,230 Long-term Debt 600 Plant
Equipment 2,500 Owners Equity LessAcc.
Depr. (1,200) Common Stock 300 Net Fixed
Assets 1,300 Capital in Excess of Par 600
Total Assets 2,530 Retained Earnings 800 Total
Owners Equity 1,700 Total Liabilities and
Owners Equity 2,530
Income Statement Excalibur Corporation
Sales 1,450 Cost of Goods Sold 875 Gross
Profit 575 Operating Expenses 45 Depreciation 200
Operating Income 330 Interest Expense 60 Income
Before Taxes 270 Taxes (40) 108 Net Income 162
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Ratio Analysis
Liquidity Ratios

• Measure the ability of the firm to meet its
  short-term financial obligations.
• Failure to pay can lead to bankruptcy.

Are there sufficient current assets to pay off
current liabilities? What is the cushion of
safety? ROT says gt 2 x
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Balance Sheet Excalibur Corporation
Assets Liabilities
Cash 175 Accounts Payable 115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities 230
Current Assets 1,230 Long-term Debt 600 Plant
Equipment 2,500 Owners Equity LessAcc.
Depr. (1,200) Common Stock 300 Net Fixed
Assets 1,300 Capital in Excess of Par 600
Total Assets 2,530 Retained Earnings 800 Total
Owners Equity 1,700 Total Liabilities and
Owners Equity 2,530
Is this good?
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Ratio Analysis
Liquidity Ratios

• Measure the ability of the firm to meet its
  short-term financial obligations.

What happens to the firms ability to repay
current liabilities after what is usually the
least liquid of the current assets (inventory) is
subtracted? ROT says gt 1.5 x
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Balance Sheet Excalibur Corporation
Assets Liabilities
Cash 175 Accounts Payable 115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities 230
Current Assets 1,230 Long-term Debt 600 Plant
Equipment 2,500 Owners Equity LessAcc.
Depr. (1,200) Common Stock 300 Net Fixed
Assets 1,300 Capital in Excess of Par 600
Total Assets 2,530 Retained Earnings 800 Total
Owners Equity 1,700 Total Liabilities and
Owners Equity 2,530
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Ratio Analysis
Debt Ratios - Solvency

• Measure the relative size of the firms debt load
  and the firms ability to pay off the debt.
• What percent of the firms assets are financed by
  debt?
• The reciprocal is the percent of assets financed
  by equity.

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Ratio Analysis
Debt Ratios
What proportion of the firms assets is financed
with debt? ROT says between 40 and 50 ok.
Higher than 50 becomes more risky.
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Balance Sheet Excalibur Corporation
Assets Liabilities
Cash 175 Accounts Payable 115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities 230
Current Assets 1,230 Long-term Debt 600 Plant
Equipment 2,500 Owners Equity LessAcc.
Depr. (1,200) Common Stock 300 Net Fixed
Assets 1,300 Capital in Excess of Par 600
Total Assets 2,530 Retained Earnings 800 Total
Owners Equity 1,700 Total Liabilities and
Owners Equity 2,530
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Ratio Analysis
Debt Ratios
What is the proportion of debt relative to equity
financing for the firm? ROT says lt 1.0
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Balance Sheet Excalibur Corporation
Assets Liabilities
Cash 175 Accounts Payable 115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities 230
Current Assets 1,230 Long-term Debt 600 Plant
Equipment 2,500 Owners Equity LessAcc.
Depr. (1,200) Common Stock 300 Net Fixed
Assets 1,300 Capital in Excess of Par 600
Total Assets 2,530 Retained Earnings 800 Total
Owners Equity 1,700 Total Liabilities and
Owners Equity 2,530
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Ratio Analysis
Debt Ratios
What is the firms ability to repay interest
payments from its operating income? ROT says gt
7.0 x
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Balance Sheet Excalibur Corporation
Assets Liabilities
Cash 175 Accounts Payable 115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities 230
Current Assets 1,230 Long-term Debt 600 Plant
Equipment 2,500 Owners Equity LessAcc.
Depr. (1,200) Common Stock 300 Net Fixed
Assets 1,300 Capital in Excess of Par 600
Total Assets 2,530 Retained Earnings 800 Total
Owners Equity 1,700 Total Liabilities and
Owners Equity 2,530
Income Statement Excalibur Corporation
Sales 1,450 Cost of Goods Sold 875 Gross
Profit 575 Operating Expenses 45 Depreciation 200
Operating Income 330 Interest Expense 60 Income
Before Taxes 270 Taxes (40) 108 Net Income 162
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Ratio Analysis
Asset Activity Ratios

• Help assess how effectively the firm is using
  assets to generate sales.
• Help assess how efficient the firm is in
  converting its current assets into cash

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Ratio Analysis
Asset Activity Ratios
How long does it take for the firm on average to
collect its credit sales from customers? ROT
says 45 to 60 days.
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Balance Sheet Excalibur Corporation
Additional Info We assume all sales are
credit sales.
Assets Liabilities
Cash 175 Accounts Payable 115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities 230
Current Assets 1,230 Bonds 600 Plant
Equipment 2,500 Owners Equity LessAcc.
Depr. (1,200) Common Stock 300 Net Fixed
Assets 1,300 Capital in Excess of Par 600
Total Assets 2,530 Retained Earnings 800 Total
Owners Equity 1,700 Total Liabilities and
Owners Equity 2,530
Income Statement Excalibur Corporation
Sales 1,450 Cost of Goods Sold 875 Gross
Profit 575 Operating Expenses 45 Depreciation 200
Operating Income 330 Interest Expense 60 Income
Before Taxes 270 Taxes (40) 108 Net Income 162
3.97 sales per day
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Ratio Analysis
Asset Activity Ratios
Is inventory being efficiently converted into
cost of goods sold for the firm? How many times
is the company turning its inventory over? ROT
says 3 to 4 times Note Use COGS not sales for
this ratio!
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Balance Sheet Excalibur Corporation
Assets Liabilities
Cash 175 Accounts Payable 115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities 230
Current Assets 1,230 Long-term Debt 600 Plant
Equipment 2,500 Owners Equity LessAcc.
Depr. (1,200) Common Stock 300 Net Fixed
Assets 1,300 Capital in Excess of Par 600
Total Assets 2,530 Retained Earnings 800 Total
Owners Equity 1,700 Total Liabilities and
Owners Equity 2,530
Income Statement Excalibur Corporation
Sales 1,450 Cost of Goods Sold 875 Gross
Profit 575 Operating Expenses 45 Depreciation 200
Operating Income 330 Interest Expense 60 Income
Before Taxes 270 Taxes (40) 108 Net Income 162
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Ratio Analysis
Asset Activity Ratios
How effective is the firm in using its fixed
assets to help generate sales? How many dollars
of sales is generated for each dollar of
investment in fixed assets? ROT says at least
1.50 x.
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Balance Sheet Excalibur Corporation
Assets Liabilities
Cash 175 Accounts Payable 115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities 230
Current Assets 1,230 Long-term Debt 600 Plant
Equipment 2,500 Owners Equity LessAcc.
Depr. (1,200) Common Stock 300 Net Fixed
Assets 1,300 Capital in Excess of Par 600
Total Assets 2,530 Retained Earnings 800 Total
Owners Equity 1,700 Total Liabilities and
Owners Equity 2,530
Income Statement Excalibur Corporation
Sales 1,450 Cost of Goods Sold 875 Gross
Profit 575 Operating Expenses 45 Depreciation 200
Operating Income 330 Interest Expense 60 Income
Before Taxes 270 Taxes (40) 108 Net Income 162
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Ratio Analysis
Asset Activity Ratios
How effective is the firm in using its overall
assets to generate sales? How many dollars of
sales are generated by each dollar invested in
total assets? ROT says 1.0 x.
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Balance Sheet Excalibur Corporation
Assets Liabilities
Cash 175 Accounts Payable 115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities 230
Current Assets 1,230 Long-term Debt 600 Plant
Equipment 2,500 Owners Equity LessAcc.
Depr. (1,200) Common Stock 300 Net Fixed
Assets 1,300 Capital in Excess of Par 600
Total Assets 2,530 Retained Earnings 800 Total
Owners Equity 1,700 Total Liabilities and
Owners Equity 2,530
Income Statement Excalibur Corporation
Sales 1,450 Cost of Goods Sold 875 Gross
Profit 575 Operating Expenses 45 Depreciation 200
Operating Income 330 Interest Expense 60 Income
Before Taxes 270 Taxes (40) 108 Net Income 162
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Ratio Analysis
Market Value Ratios
How much are investors willing to pay per dollar
of earnings of the firm? ROT says PE ratio
about 20 to 30 x. (Indicator of investors
attitudes toward future prospects of the firm and
of the firms risk.)
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Balance Sheet Excalibur Corporation
Additional Info 100 shares Out - standing Market
Price 20.00 per share
Assets Liabilities
Cash 175 Accounts Payable 115 Accounts
Receivable 430 S-T Notes Payable
115 Inventories 625 Current Liabilities 230
Current Assets 1,230 Long-term Debt 600 Plant
Equipment 2,500 Owners Equity LessAcc.
Depr. (1,200) Common Stock 300 Net Fixed
Assets 1,300 Capital in Excess of Par 600
Total Assets 2,530 Retained Earnings 800 Total
Owners Equity 1,700 Total Liabilities and
Owners Equity 2,530
Income Statement Excalibur Corporation
Sales 1,450 Cost of Goods Sold 875 Gross
Profit 575 Operating Expenses 45 Depreciation 200
Operating Income 330 Interest Expense 60
Income Before Taxes 270 Taxes (40) 108 Net
Income 162
(Earnings Per Share 162/100 1.62)
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Industry Comparisons

• Comparing a ratio for one company with the same
  ratio for other companies in the same industry
• Benchmarking allows you to put the value of a
  firms ratio in the context of its industry (vs.
  ROT)

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Ratio Industry Excalibur
Profitability Gross Profit Margin
38 39.7 Operating Profit
Margin 20 22.8 Net Profit Margin 12 11.2 Retur
n on Assets 9.0 6.4 Return on Equity 13.4 9.5
Excalibur is good at keeping operating costs
down, but not as good at total costs. ROA and
ROE are low mainly due to productivity problems.
They are not generating enough sales and have a
large investment in accounts receivable and
inventory.
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Summary of Excalibur Corporation Ratios
Ratio Industry Excalibur
Liquidity Current Ratio 3.00x
5.35x Acid-Test Ratio 2.00x
2.63x
Looking at the current ratio it appears that
Excalibur is way more liquid than the
industry.... when looking at Acid Test (a better
measure) they are still more liquid indicating
that inventory and receivable levels are both
probably too high.
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Ratio Industry Excalibur
Debt Debt Ratio 35 33 Times Interest
Earned 7.00x 5.50x Debt to Equity
49 48
While the debt ratio is close to the industry
average, Excalibur is not able to cover interest
payments as easily as the industry. This
indicates Excalibur may have too much debt
relative to what they can realistically afford,
or paying very high interest rates.
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Ratio Industry Excalibur
Asset Activity Avg. Collection Period 60
days 108 days Inventory Turnover 3.00x 1.40x Fixed
Asset Turnover 1.50x 1.12x Total Asset
Turnover 0.75x .57x
Collection policies need examining, as Excalibur
is slower than average at collecting receivables.
Inventories are being sold more slowly than the
industry average, again indicating inventories
that are too high. Excalibur is not efficient at
converting Fixed Assets to Sales (fixed assets
are not as productive as they should be).
However, overall assets are not productive
indicating Current Assets (e.g. inventories and
receivables) are not as productive as the rest of
the industry.
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Ratio Industry Excalibur
Market Value Price Earnings 18.0
12.35
Excaliburs Investors are not willing to pay as
much per dollar of earnings as they are for
shares in other firms in the industry. This
signals that they consider the firms prospects
for earnings and growth to be worse than the
average.
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Trend Analysis

• Comparing a ratio for one year with the same
  ratio for other years
• Helps see whether a companys financial situation
  is improving or worsening.
• See table 5-3 on page 119 (116)

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Summary Analysis

• A complete ratio analysis of a company combines
  both trend analysis and industry comparisons. See
  Industry comparisons (pages 118 to 120).
• Ratio analysis includes examining a companys
  profitability, liquidity, debt management, asset
  activity and market value ratios
• Sources of financial information appear on table
  5-4, p.121 (118)