Copyright © 2011 Nelson Education Limited Finance for Non-Financial Managers, 6 th edition PowerPoint Slides to accompany Prepared by Pierre Bergeron, University of Ottawa

Copyright © 2011 Nelson Education Limited Finance for Non-Financial Managers, 6 th edition CHAPTER 4 FINANCIAL STATEMENT ANALYSIS

Copyright © 2011 Nelson Education Limited Financial Statement Analysis Chapter Objectives 1. Explain why financial statements should be analyzed. 2. Evaluate a company’s statement of financial position and the statement of income by using vertical and horizontal analysis. 3. Analyze financial statements by using meaningful ratios. 4. Describe how external financial ratios can be used to measure and improve a company’s financial performance. 5. Examine financial statements by using the Du Pont system. 6. Comment on the limitations of financial ratios. Chapter Reference Chapter 4: Financial Statement Analysis

Copyright © 2011 Nelson Education Limited 1. Why Analyze Financial Statements? 1.Ensure liquidity 2.Maintain solvency 3.Improve productivity of assets 4.Maximize return 5.Secure long-term prosperity

Copyright © 2011 Nelson Education Limited 2. Modern Industries Ltd. – Vertical Analysis Revenue Cost of sales Gross profit Operating expenses Salaries Lease payments Depreciation Other expenses Total operating expenses Profit before taxes Income tax expense Profit for the year $ 2,500,000 (1,400,000) 1,100,000 (820,000) (20,000) (50,000) (940,000) 160,000 (80,000) $ 80, $ % of sales (56.0) 44.0 (32.8) (0.8) (2.0) (37.6) 6.4 (3.2) (58.0) 42.0 (33.2) (0.8) (1.3) (2.1) (37.4) 4.6 (2.3) $ % of sales $ 2,300,000 (1,334,000) 966,000 (763,600) (18,000) (30,000) (48,000) (859,600) 106,400 (53,200) $ 53,200

Copyright © 2011 Nelson Education Limited Modern Industries Ltd. – Horizontal Analysis Revenue Cost of sales Gross profit Operating expenses Salaries Lease payments Depreciation Other expenses Total operating expenses Profit before taxes Income tax expense Profit for the year $ 2,500,000 (1,400,000) 1,100,000 (820,000) (20,000) (50,000) (940,000) 160,000 (80,000) $ 80,000 $ 2,300,000 (1,334,000) 966,000 (763,600) (18,000) (30,000) (48,000) (859,600) 106,400 (53,200) $ 53, Amount of change $ 200,000 66, ,000 56,400 2,000 20,000 2,000 80,400 53,600 26,800 $ 26,800 % of change

Copyright © 2011 Nelson Education Limited 3. Financial Ratios 4. Vertical analysis Revenue Operating expenses Cost of sales Gross profit Profit for the year Statement of Income 2. Statement of income ratios 3. Combined ratios Non-current liabilities Non-current assets Equity Current assets Current liabilities Statement of financial position 1. Statement of financial position ratios 5. Horizontal analysis Liquidity ratios Debt/coverage ratios Asset-management ratios Profitability ratios Market-value ratios

Copyright © 2011 Nelson Education Limited Modern Industries Ltd. – Statement of Financial Position As at December 31, 2010 Non-current assets Property, plant & equipment Accumulated depreciation Total non-current assets Total assets $ 900,000 (100,000) $ 800,000 $ 1,200,000 Non-current liabilities Mortgage Long-term borrowings Total non-current liabilities $ 500, ,000 $ 600,000 Equity Share capital Retained earnings Total equity $ 100, ,000 $ 400,000 Total equity & liabilities$ 1,200,000 Current assets Inventories Trade receivables Marketable securities Cash Total current assets $ 150, ,000 10,000 50,000 $ 400,000 Current liabilities Trade and other payables Notes payable Accruals Total current liabilities $ 100,000 80,000 20,000 $ 200,000

Copyright © 2011 Nelson Education Limited Modern Industries Ltd. – Statement of Income For the period ended December 31, 2010 Revenue Cost of sales Gross profit Other income Distribution costs Salaries Advertising Supplies Total distribution costs Administrative expenses Salaries Other expenses Lease payments Depreciation Total administrative expenses Finance costs Total other income and expenses Profit before taxes Income tax expense Profit for the year $2,500,000 (1,400,000) 1,100,000 $ 80,000 (355,000) (590,000) (75,000) ($ 300,000) (50,000) (5,000) ($ 360,000) (160,000) (20,000) (50,000) (940,000) 160,000 (80,000) $ 80,

Copyright © 2011 Nelson Education Limited Categories of Financial Ratios ratios Indicate a company’s ability to meet its short-term obligations. Liquidity ratios Measure the extent to which a business can be financed by debt. Debt/ coverage ratios Show how effectively management utilizes the assets of a business. Asset- management ratios Indicate the management’s overall effectiveness and efficiencies as measured by return on revenue, on assets, on equity. Profitability short-term lenders everybody employees Investors (shareholders & long-term lenders) managers suppliers

Copyright © 2011 Nelson Education Limited Commonly Used Financial Ratios Liquidity ratios Debt/coverage ratios Asset/management ratios Profitability ratios 1.Current ratio (times) 2.Quick or acid test ratio (times) 3.Debt-to-total assets (percent) 4.Times-interest-earned (times) 5.Fixed-charges coverage (times) 6.Average collection period (days) 7.Inventory turnover (times) 8.Capital assets turnover (times) 9.Total assets turnover (times) 10.Profit margin on revenue (percent) 11.Return on total assets (percent) 12.Return on equity (percent)

Copyright © 2011 Nelson Education Limited Ratio 1: Current Ratio To give a general indication of the ability of a business (borrower) to meet its current obligations. Current assets Current liabilities $400,000 $200,000 == 2.0 times collateral growth cushion Current assets Inventories Trade receivables Marketable securities Cash Total current assets $ 150, ,000 10,000 50,000 $ 400,000 Current liabilities Trade and other payables Notes payable Accruals Total current liabilities $ 100,000 80,000 20,000 $ 200,000 Purpose

Copyright © 2011 Nelson Education Limited Ratio 2: Quick Ratio or Acid Test Ratio To supplement the current ratio in measuring liquidity, this ratio places more emphasis on liquid assets which can be quickly converted into cash. Current assets – Inventories Current liabilities $250,000 $200,000 = = 1.25 times Purpose Current assets Inventories Trade receivables Marketable securities Cash Total current assets $ 190,000 10,000 50,000 $ 250,000 Current liabilities Trade and other payables Notes payable Accruals Total current liabilities $ 100,000 80,000 20,000 $ 200,000

Copyright © 2011 Nelson Education Limited Ratio 3: Debt-to-Total Assets Measures the proportion of “all” debts provided by lenders to finance “all” assets. It is also called the debt ratio. Total liabilities Total assets $800,000 $1,200,000 == 67 percent Purpose Non-current assets Current assets Total assets $ 800, ,000 $ 1,200,000 Equity Non-current liabilities Current liabilities Total liabilities Total equity & liabilities $ 400, , , ,000 $ 1,200,000

Copyright © 2011 Nelson Education Limited Applying for a Mortgage A person in the 40% tax bracket applies for a mortgage Payment Salary $ 1,500 $ 5,000 = =.30 = $ 2,000 $ 5,000 =.40 Payment Salary Mortgage $ 1,500 Income taxes $ 2,000 Mortgage $ 2,000 Other $ 1,500 Total $ 5,000 Other $ 1,000 Total $ 5,000 Income taxes $ 2,000

Copyright © 2011 Nelson Education Limited Ratio 4: Times-Interest-Earned Shows the debt-paying ability of a business or its capacity to service the finance costs. Finance costs Principal Taxes Dividends Retained earnings Purpose Profit before taxes + Finance costs Finance costs $235,000 $75, times== Revenue Cost of sales Gross profit Other income Total distribution costs Total administrative expenses Finance costs Profit before taxes Income tax expense Profit for the year $ 2,500,000 (1,400,000) 1,100,000 80,000 (355,000) (590,000) (75,000) 160,000 (80,000) $ 80,000

Copyright © 2011 Nelson Education Limited Ratio 5: Fixed-Charges-Coverage Ratio Similar to the times-interest-earned ratio except this ratio includes “all” fixed charges, or the capacity to service the finance costs and other fixed obligations. Purpose P.B.T. + Finance costs + Lease payments Finance costs + Lease payments $255,000 $95, times== Revenue Cost of sales Gross profit Other income Total distribution costs Total administrative expenses* Finance costs Profit before taxes Income tax expense Profit for the year $ 2,500,000 (1,400,000) 1,100,000 80,000 (355,000) (590,000) (75,000) 160,000 (80,000) $ 80,000 * Includes $20,000 in lease payments

Copyright © 2011 Nelson Education Limited Ratio 6: Average Collection Period Measures the number of days it takes a business to collect payments after credit sales have been made. Revenue 365 $ 2,500, Step 1: Average sales per day Step 2: Average collection period Trade receivables Average sales per day $190,000 $6, days Purpose == == $ 6,849= = Revenue Cost of sales Gross profit $ 2,500,000 1,400,000 $ 1,100,000 Statement of IncomeStatement of Financial Position Current assets Trade receivables Total current assets $ 190,000 $ 400,000

Copyright © 2011 Nelson Education Limited Ratio 7: Inventory Turnover Shows how long it takes for inventories to turn around or how fast it moves. Cost of sales Average inventories $1,400,000 $150,000 Purpose 9.3 times== Revenue Cost of sales Gross profit $ 2,500,000 1,400,000 $ 1,100,000 Statement of IncomeStatement of Financial Position Current assets Inventories Total current assets $ 150,000 $ 400,000

Copyright © 2011 Nelson Education Limited Ratio 8: Capital Assets Turnover Measures how intensively a firm’s non-current assets such as property, plant, and equipment are working. Revenue Non-current assets $2,500,000 $800,000 Purpose Statement of IncomeStatement of Financial Position 3.1 times== Revenue Cost of sales Gross profit Other income Total distribution costs Total administrative expenses Finance costs Profit before taxes Income tax expense Profit for the year $ 2,500,000 (1,400,000) 1,100,000 80,000 (355,000) (590,000) (75,000) 160,000 (80,000) $ 80,000 Non-current assets Current assets Total assets $ 800,000 $ 400,000 $ 1,200,000

Copyright © 2011 Nelson Education Limited Ratio 9: Total Assets Turnover Measures the intensity by which all assets, that is, current and non-current assets are used to generate revenue. Revenue Total assets $2,500,000 $1,200,000 Purpose 2.1 times== Statement of IncomeStatement of Financial Position Revenue Cost of sales Gross profit Other income Total distribution costs Total administrative expenses Finance costs Profit before taxes Income tax expense Profit for the year $ 2,500,000 (1,400,000) 1,100,000 80,000 (355,000) (590,000) (75,000) 160,000 (80,000) $ 80,000 Non-current assets Current assets Total assets $ 800,000 $ 400,000 $ 1,200,000

Copyright © 2011 Nelson Education Limited Ratio 10: Profit Margin on Revenue Shows the efficiency of a business. Operating profit Revenue $155,000 $2,500,000 Vertical analysis Purpose 6.2 percent== Statement of Income Revenue Cost of sales Gross profit Total distribution costs Total administrative expenses Operating profit Other income & finance costs Profit before taxes Income tax expense Profit for the year $ 2,500,000 (1,400,000) 1,100,000 (355,000) (590,000) 155,000 5, ,000 (80,000) $ 80,000

Copyright © 2011 Nelson Education Limited Ratio 11: Return on Total Assets Measures the return on funds invested in the business by both the owners and the lenders. Profit for the year Total assets $ 80,000 $ 1,200,000 Purpose 6.7 percent== Statement of IncomeStatement of Financial Position Revenue Cost of sales Gross profit Other income Total distribution costs Total administrative expenses Finance costs Profit before taxes Income tax expense Profit for the year $ 2,500,000 (1,400,000) 1,100,000 80,000 (355,000) (590,000) (75,000) 160,000 (80,000) $ 80,000 Non-current assets Current assets Total assets $ 800,000 $ 400,000 $ 1,200,000

Copyright © 2011 Nelson Education Limited Ratio 12: Return on Equity Shows how profitable a business is to its owners. Profit for the year Equity $80,000 $400,000 Purpose 20.0 percent== Statement of IncomeStatement of Financial Position Revenue Cost of sales Gross profit Other income Total distribution costs Total administrative expenses Finance costs Profit before taxes Income tax expense Profit for the year $ 2,500,000 (1,400,000) 1,100,000 80,000 (355,000) (590,000) (75,000) 160,000 (80,000) $ 80,000 Equity Non-current liabilities Current liabilities Total liabilities Total equity & liabilities $ 400, , , ,000 $ 1,200,000

Copyright © 2011 Nelson Education Limited Supplementary Financial and Market Ratios Liquidity ratios Debt/coverage ratios Asset/management ratios Profitability ratios 1.Cash ratio (times) 2.Working capital ratio (times) 3.Debt-to-equity (times) 4.Trade receivables turnover (times) 5.Day’s sales to inventories (days) 6.Profit for the year to revenue (percent) 7.Gross profit on revenue (percent) 8.Return on invested capital (percent) Market ratios 9.Earnings per share (dollars) 10.Cash flow per share (dollars) 11.Return per share (percent) 12.Price/earnings ratio (times)

Copyright © 2011 Nelson Education Limited 4. Financial Benchmarks Liquidity ratios Debt/coverage ratios Asset/manageme nt ratios Profitability ratios 1.Current ratio (times) 2.Quick or acid test ratio (times) 3.Debt-to-total assets (percent) 4.Times-interest-earned (times) 5.Fixed-charges coverage (times) 6.Average collection period (days) 7.Inventory turnover (times) 8.Capital assets turnover (times) 9.Total assets turnover (times) 10.Profit margin on revenue (percent) 11.Return on total assets (percent) 12.Return on equity (percent) Modern Industries Ltd Benchmarks

Copyright © 2011 Nelson Education Limited 5. Du Pont Financial System Inventories + Trade receivables + Prepaid expenses + Cash Cost of sales + Depreciation + Distribution costs + Administrative expenses Current assets Operating profit Revenue - Total cost of operation Revenue Total assets turnover ÷ + Non-current assets Total assets Profit on revenue ÷ Revenue Return on total assets X

Copyright © 2011 Nelson Education Limited 6. Limitations of Financial Ratios To make ratios meaningful, you should … 1.Look at trends 2.Compare your financial performance with other businesses or industry The caveats of financial ratios They only give signals – they do not answer questions relating to why, what, or how. When comparing ratios with other businesses, make sure that the closing dates of the financial statements are the same. Make sure that the numbers used are similar. The size of the business may make a difference. The nature of the operations may also be different (new plant versus worn-out plant).