Summary of the Previous Lecture 1.Differentiate and understand the various terms used to express value including liquidation value, going concern value, book value, market value and intrinsic value. 2.Determine the value of bonds, preferred stocks, and common stocks. 3.Dividend valuation models 4.Yield to maturity and determination of required rate of return 5.Behavior of bond prices under different conditions

Chapter 6 (I) Financial Statement Analysis

After studying Chapter 6, you should be able to: 1. Understand the purpose of basic financial statements and their contents. 2. Explain why financial statement analysis is important to the firm and to outside suppliers of capital. 3. 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. 4. Define, calculate, and discuss a firm’s operating cycle and cash cycle.

After studying Chapter 6, you should be able to: 5. Use ratios to analyze a firm's health and then recommend reasonable alternative courses of action to improve the health of the firm. 6. Analyze a firm’s return on investment (i.e., “earning power”) and return on equity using a DuPont approach. 7. Understand the limitations of financial ratio analysis. 8. Use trend analysis, common-size analysis, and index analysis to gain additional insights into a firm's performance.

Financial Statement Analysis 1. Financial Statements 2. A Possible Framework for Analysis 3. Balance Sheet Ratios 4. Income Statement and Income Statement/Balance Sheet Ratios 5. Trend Analysis 6. Common-Size and Index Analysis 1. Financial Statements 2. A Possible Framework for Analysis 3. Balance Sheet Ratios 4. Income Statement and Income Statement/Balance Sheet Ratios 5. Trend Analysis 6. Common-Size 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. Trade Creditors -- Focus on the liquidity of the firm. Bondholders -- Focus on the long-term cash flow of the firm. Shareholders -- Focus on the profitability and long-term health of the firm.

Examples of Internal Uses of Statement Analysis  Plan -- Focus on assessing the current financial position and evaluating potential firm opportunities.  Control -- Focus on return on investment for various assets and asset efficiency.  Understand -- Focus on understanding how suppliers of funds analyze the firm.  Plan -- Focus on assessing the current financial position and evaluating potential firm opportunities.  Control -- Focus on return on investment for various assets and asset efficiency.  Understand -- Focus on understanding how suppliers of funds analyze the firm.

Primary Types of Financial Statements Income Statement  A summary of a firm’s revenues and expenses over a specified period, ending with net income or loss for the period. Income Statement  A summary of a firm’s revenues and expenses over a specified period, ending with net income or loss for the period. Balance Sheet  A summary of a firm’s financial position on a given date that shows total assets = total liabilities + owners’ equity. Balance Sheet  A summary of a firm’s financial position on a given date that shows total assets = total liabilities + owners’ equity.

Basket Wonders’ Balance Sheet (Asset Side) a. How the firm stands on a specific date. b. What BW owned. c. Amounts owed by customers. d. Future expense items already paid. e. Cash/likely convertible to cash within 1 year. f. Original amount paid. g. Acc. deductions for wear and tear. a. How the firm stands on a specific date. b. What BW owned. c. Amounts owed by customers. d. Future expense items already paid. e. Cash/likely convertible to cash within 1 year. f. Original amount paid. g. Acc. deductions for wear and tear. Cash and C.E. $ 90 Acct. Rec. c 394 Inventories 696 Prepaid Exp d 5 Accum Tax Prepay 10 Current Assets e $ 1,195 Fixed Assets f 1,030 Less: Acc. Depr. g (329) Net Fix. Assets $ 701 Investment, LT 50 Other Assets, LT 223 Total Assets b $2,169 Basket Wonders Balance Sheet (thousands) Dec. 31, 2007 a

Basket Wonders’ Balance Sheet (Liability Side) a. Note, Assets = Liabilities + Equity. b. What BW owed and ownership position. c. Owed to suppliers for goods and services. d. Unpaid wages, salaries, etc. e. Debts payable < 1 year. f. Debts payable > 1 year. g. Original investment. h. Earnings reinvested. a. Note, Assets = Liabilities + Equity. b. What BW owed and ownership position. c. Owed to suppliers for goods and services. d. Unpaid wages, salaries, etc. e. Debts payable < 1 year. f. Debts payable > 1 year. g. Original investment. h. Earnings reinvested. Notes Payable $ 290 Acct. Payable c 94 Accrued Taxes d 16 Other Accrued Liab. d 100 Current Liab. e $ 500 Long-Term Debt f 530 Shareholders’ Equity Com. Stock ($1 par) g 200 Add Pd in Capital g 729 Retained Earnings h 210 Total Equity $1,139 Total Liab/Equity a,b $ 2,169 Basket Wonders Balance Sheet (thousands) Dec. 31, 2007

Basket Wonders’ Income Statement 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. 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. b c f Increase in RE $ 53 Net Sales $ 2,211 Cost of Goods Sold b 1,599 Gross Profit $ 612 SG&A Expenses c 402 EBIT d $ 210 Interest Expense e 59 EBT f $ 151 Income Taxes 60 EAT g $ 91 Cash Dividends 38 Increase in RE $ 53 Basket Wonders Statement of Earnings (in thousands) for Year Ending December 31, 2007 a

Framework for Financial Analysis Analytical Tools Used Sources and Uses Statement Statement of Cash Flows Cash Budgets Analytical Tools Used Sources and Uses Statement Statement of Cash Flows Cash Budgets 1. Analysis of the funds needs of the firm. Trend / Seasonal Component How much funding will be required in the future? Is there a seasonal component? Trend / Seasonal Component How much funding will be required in the future? Is there a seasonal component?

Framework for Financial Analysis Health of a Firm Financial Ratios 1. Individually 2. Over time 3. In combination 4. In comparison Health of a Firm Financial Ratios 1. Individually 2. Over time 3. In combination 4. In comparison 1. Analysis of the funds needs of the firm. 2. Analysis of the financial condition and profitability condition and profitability of the firm. of the firm.

Framework for Financial Analysis Examples: Volatility in sales Volatility in costs Proximity to break-even point Examples: Volatility in sales Volatility in costs Proximity to break-even point 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.

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

Framework for Financial Analysis Negotiations with suppliers of capital. Determining the financing needs of the firm. 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.

Use of Financial Ratios A Financial Ratio is an index that relates two accounting numbers and is obtained by dividing one number by the other. Types of Comparisons Internal Comparisons External Comparisons

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.” Examples: Risk Management Association Dun & Bradstreet Almanac of Business and Industrial Financial Ratios

Liquidity Ratios Current Current Assets Current Liabilities For Basket Wonders December 31, 2007 Shows a firm’s ability to cover its current liabilities with its current assets. Balance Sheet Ratios Liquidity Ratios $1,195 $500 $1,195 $500 = 2.39

Liquidity Ratio Comparisons BW Industry Year Current Ratio Ratio is stronger than the industry average.

Liquidity Ratios Acid-Test (Quick) Current Assets - Inv Current Liabilities For Basket Wonders December 31, 2007 Shows a firm’s ability to meet current liabilities with its most liquid assets. Balance Sheet Ratios Liquidity Ratios $1,195 - $696 $500 = 1.00

Liquidity Ratio Comparisons BW Industry Year Acid-Test Ratio Ratio is weaker than the industry average.

Summary of the Liquidity Ratio Comparisons 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. RatioBWIndustry Current Acid-Test

Current Ratio -- Trend Analysis Comparison Trend Analysis of Current Ratio

Acid-Test Ratio -- Trend Analysis Comparison Trend Analysis of Acid-Test Ratio

Summary of the Liquidity Trend Analyses  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.  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.  The current ratio for BW has been rising at the same time the acid-test ratio has been declining.

Financial Leverage Ratios Debt-to-Equity Total Debt Shareholders’ Equity For Basket Wonders December 31, 2007 Shows the extent to which the firm is financed by debt. Balance Sheet Ratios Financial Leverage Ratios $1,030 $1,139 =.90

Financial Leverage Ratio Comparisons BW Industry Year Debt-to-Equity Ratio BW has average debt utilization relative to the industry average.

Financial Leverage Ratios Debt-to-Total-Assets Total Debt Total Assets For Basket Wonders December 31, 2007 Shows the percentage of the firm’s assets that are supported by debt financing. Balance Sheet Ratios Financial Leverage Ratios $1,030 $2,169 =.47

Financial Leverage Ratio Comparisons BW Industry Year Debt-to-Total-Asset Ratio BW has average debt utilization relative to the industry average.

Financial Leverage Ratios Total Capitalization Long-term Debt Total Capitalization For Basket Wonders December 31, 2007 Shows the relative importance of long-term debt to the long-term financing of the firm. Balance Sheet Ratios Financial Leverage Ratios $530 $1,669 =.32 (i.e., LT-Debt + Equity)

Financial Leverage Ratio Comparisons BW Industry Year Total Capitalization Ratio BW has average long-term debt utilization relative to the industry average.

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

Coverage Ratio Comparisons BW Industry Year Interest Coverage Ratio BW has below average interest coverage relative to the industry average.

Coverage Ratio -- Trend Analysis Comparison Trend Analysis of Interest Coverage Ratio

Summary of the Coverage Trend Analysis  This indicates that low earnings (EBIT) may be a potential problem for BW.  Note, we know that debt levels are in line with the industry averages.  The interest coverage ratio for BW has been falling since It has been below industry averages for the past two years.

Summary Of the Lecture  Liquidity Ratios  Current = Current Assets/Current Liabilities  Acid Test (Quick) = (Current assets – Inventory)/Current Liabilities  Leverage Ratios  Debt to to Equity = Total Debt/Shareholder’s equity  Debt to Total Assets = Total Debt / Total Assets  Coverage Ratio  Interest Coverage Ratio = EBIT / Interest Expense