2. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.1 Finance for Non-Financial Managers Fifth Edition Slides prepared by Pierre G. Bergeron University of Ottawa

3. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.2 Financial Statement Analysis Chapter Objectives 1. Explain why financial statements need to be analyzed. 2. Evaluate a company’s balance sheet and income statement by using vertical analysis 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

4. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.3 1. Why Analyze Financial Statements? 1.Ensure liquidity 2.Maintain solvency 3.Improve productivity of assets 4.Maximize return 5.Secure long-term prosperity

5. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.4 2. Modern Industries Ltd. – Vertical Analysis Sales revenue Cost of sales Gross profit Operating expenses Salaries Lease payments Amortization Other expenses Total operating expenses Income before taxes Income taxes Net income $2,500,000 1,400,000 1,100,000 820,000 20,000 50,000 940,000 160,000 80,000 $ 80,000 2006 $ % of sales 100.0 56.0 44.0 32.8 0.8 2.0 37.6 6.4 3.2 100.0 58.0 42.0 33.2 0.8 1.3 2.1 37.4 4.6 2.3 2005 $ % 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

6. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.5 Modern Industries Ltd. – Horizontal Analysis Sales revenue Cost of sales Gross profit Operating expenses Salaries Lease payments Amortization Other expenses Total operating expenses Income before taxes Income taxes Net income $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 $ 53,200 20062005 $ 200,000 66,000 134,000 56,400 2,000 20,000 2,000 80,400 53,600 26,800 $ 26,800 Amount of change 8.69 4.95 13.87 7.38 11.10 66.67 4.17 9.35 50.37 % of change

7. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.6 3. Financial Ratios 4. Vertical analysis Sales revenue Operating expenses Cost of sales Gross profit Net income Income Statement 2. Income statement ratios 3. Combined ratios Current assets Current liabilities Capital assets Long-term debts Equity Balance Sheet 1. Balance sheet ratios 5. Horizontal analysis Liquidity ratios Debt/coverage ratios Asset-management ratios Profitability ratios Market-value ratios

8. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.7 Modern Industries Ltd. – The Balance Sheet Current assets Cash $ 50,000 Accounts receivable190,000 Marketable securities 10,000 Inventory150,000 Total current assets $ 400,000 Current liabilities Accounts payable $ 100,000 Notes payable 80,000 Accruals 20,000 Total current liabilities $ 200,000 Capital assets Gross capital assets $ 900,000 Less: accumulated (100,000) amortization Total capital assets $ 800,000 Long-term debts Mortgage $ 500,000 Long-term Note 100,000 Long-term Debts $ 600,000 Equity Capital shares $ 100,000 Retained earnings 300,000 Total equity 400,000 Total assets $ 1,200,000Total liabilities & equity $1,200,000 As at December 31, 2006

9. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.8 Modern Industries Ltd. – The Income Statement Sales revenue$2,500,000 Cost of sales 1,400,000 Gross profit 1,100,000 1 For the Period Ended December 31, 2006 2 Operating expenses Selling expenses$300,000 Advertising 50,000 Supplies 5,000 Total selling expenses$355,000 Administrative expenses Executive salaries$360,000 Office salaries 160,000 Lease payments 20,000 Amortization 50,000 Total administrative expenses$590,000 $ 945,000 Operating income 155,000 3 Add: interest income $ 80,000 Operating income plus other revenue 235,000 Less: interest charges 75,000 Income before taxes 160,000 Income taxes 80,000 Net income $ 80,000

10. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.9 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 as measured by return on sales, on assets, on equity. Profitability short-term lenders everybody employees Investors (shareholders & long-term lenders) managers suppliers

11. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.10 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 sales (percent) 11.Return on total assets (percent) 12.Return on equity (percent)

12. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.11 Ratio 1: Current Ratio PurposeTo give a general indication of the ability of a business (borrower) to meet its current obligations. Current assetsCurrent liabilities Cash$ 50,000Accounts payable$100,000 Accounts receivable 190,000Notes payable 80,000 Marketable securities 10,000Accruals 20,000 Inventory 150,000 Total current assets$400,000Total current liabilities$200,000 Current assets Current liabilities $400,000 $200,000 == 2.0 times collateral growth cushion

13. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.12 Ratio 2: Quick Ratio or Acid Test Ratio PurposeTo supplement the current ratio in measuring liquidity, this ratio places more emphasis on liquid assets which can be quickly converted into cash. Current assetsCurrent liabilities Cash$ 50,000Accounts payable$100,000 Accounts receivable 190,000Notes payable 80,000 Marketable securities 10,000Accruals 20,000 Inventory ---------- Total current assets$250,000Total current liabilities$200,000 Current assets – Inventory Current liabilities $250,000 $200,000 == 1.25 times

14. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.13 Ratio 3: Debt-to-Total Assets PurposeMeasures the proportion of “all” debts provided by lenders to finance “all” assets. It is also called debt ratio. Total current assets $ 400,000Total current liabilities$ 200,000 Total capital assets 800,000Total long-term debts 600,000 Total debts 800,000 Equity 400,000 Total assets $ 1,200,000Total liabilities & equity $ 1,200,000 Total debts Total assets $800,000 $1,200,000 == 67 percent

15. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.14 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

16. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.15 Ratio 4: Times-Interest-Earned PurposeShows the debt-paying ability of a business or its capacity to service the interest charges. Sales revenue $ 2,500,000 Cost of sales 1,400,000 Gross profit 1,100,000 Operating expenses Total selling expenses$ 355,000 Total admin. expenses 590,000 945,000 Operating income 155,000 Add: interest income 80,000 Less: interest charges 75,000 5,000 Income before taxes 160,000 Income taxes 80,000 Net income $ 80,000 Income before taxes + Interest charges Interest charges $235,000 $75,000 == 3.1 times Interest Principal Taxes Dividends Retained earnings

17. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.16 Ratio 5: Fixed-Charges-Coverage Ratio PurposeSimilar to the times-interest-earned ratio except this ratio includes “all” fixed charges, or the capacity to service the interest charges and other fixed obligations. Sales revenue $2,500,000 Cost of sales 1,400,000 Gross profit 1,100,000 Operating expenses Total selling expenses$355,000 Total administrative expenses 590,000* 945,000 Operating income 155,000 Add: interest income 80,000 Less: interest charges 75,000 5,000 Income before taxes 160,000 Income taxes 80,000 Net income$ 80,000 *Includes $20,000 lease payments I.B.T. + Interest charges + Lease payments Interest charges + Lease payments $255,000 $95,000 == 2.7 times

18. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.17 Ratio 6: Average Collection Period PurposeMeasures the number of days it takes a business to collect payments after credit sales have been made. Balance Sheet Current assets Accounts receivable $ 190,000 Total current assets $ 400,000 Sales revenue 365 $2,500,000 365 === $6,849 Step 1 Average sales per day Step 2 Average collection period Accounts receivable Average sales per day $190,000 $6,849 = = = 27.7 days Income Statement Sales revenue $2,500,000 Cost of sales 1,400,000 Gross profit $ 1,100,000

19. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.18 Ratio 7: Inventory Turnover PurposeShows how long it takes for inventory to turn around or how fast it moves. Balance Sheet Current assets Inventory $ 150,000 Total current assets $ 400,000 Income Statement Sales revenue $2,500,000 Cost of sales 1,400,000 Gross profit $1,100,000 Cost of sales Average inventory $1,400,000 $150,000 == 9.3 times

20. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.19 Ratio 8: Capital Assets Turnover PurposeMeasures how intensively a firm’s assets such as land, buildings, and equipment are working. Current assets $ 400,000 Net capital assets 800,000 Total assets $ 1,200,000 Sales revenue $ 2,500,000 Cost of sales 1,400,000 Gross profit 1,100,000 Total op. expenses 945,000 Operating income 155,000 Other income 5,000 Income before taxes 160,000 Income taxes 80,000 Net income $ 80,000 Sales revenue Net capital assets $2,500,000 $800,000 = = 3.1 times Income Statement Balance Sheet

21. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.20 Ratio 9: Total Assets Turnover PurposeMeasures the intensity by which all assets, that is, current and capital assets are used to generate sales. Balance Sheet Current assets $ 400,000 Net capital assets 800,000 Total assets $ 1,200,000 Income Statement Sales revenue $ 2,500,000 Cost of sales 1,400,000 Gross profit 1,100,000 Total op. expenses945,000 Operating income155,000 Other income 5,000 Income before taxes160,000 Income taxes 80,000 Net income $ 80,000 Sales revenue Total assets $2,500,000 $1,200,000 == 2.1 times

22. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.21 Ratio 10: Profit Margin on Sales PurposeShows the efficiency of the business. Sales revenue$ 2,500,000 Cost of sales 1,400,000 Gross profit 1,100,000 Operating expenses Total selling expenses$355,000 Total admin. expenses 590,000 945,000 Operating income 155,000 Add: interest income 80,000 Less: interest charges 75,000 5,000 Income before taxes 160,000 Income taxes 80,000 Net income $ 80,000 Operating income Sales revenue $155,000 $2,500,000 == 6.2 percent Vertical analysis 100.0 44.0 6.2 3.2

23. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.22 Ratio 11: Return on Total Assets PurposeMeasures the return on funds invested in the business by both the owners and the lenders. Balance Sheet Current assets $ 400,000 Net capital assets 800,000 Total assets $ 1,200,000 Income Statement Sales revenue $2,500,000 Cost of sales 1,400,000 Gross profit 1,100,000 Total op. expenses945,000 Operating income155,000 Other income 5,000 Income before taxes160,000 Income taxes 80,000 Net income $ 80,000 Net income Total assets $ 80,000 $ 1,200,000 = = 6.7 percent

24. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.23 Ratio 12: Return on Equity PurposeShows how profitable a business is to its owners. Balance Sheet Current liabilities $ 200,000 Total long-term debts 600,000 Total debts 800,000 Equity 400,000 Total liabilities & equity $1,200,000 Income Statement Sales revenue $2,500,000 Cost of sales 1,400,000 Gross profit 1,100,000 Total op. expenses945,000 Operating income155,000 Other income 5,000 Income before taxes160,000 Income taxes 80,000 Net income$80,000 Net income Owners’ equity $80,000 $400,000 == 20.0 percent

25. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.24 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.Accounts receivable turnover (times) 5.Day’s sales to inventory (days) 6.Income after taxes to sales (percent) 7.Gross margin on sales (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)

26. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.25 4. External 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 sales (percent) 11.Return on total assets (percent) 12.Return on equity (percent) 2.00 1.25.67 3.10 2.70 27.70 9.30 3.10 2.10 6.20 6.70 20.00 Modern Industries Ltd. 1.50 1.00.55 5.00 35.00 8.00 4.50 3.50 5.50 15.00 External ratios

27. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.26 5. Du Pont Financial System Cash + Accounts receivable + Prepaid expenses + Inventory Cost of sales + Amortization + Selling expenses + Administrative expenses Current assets + Capital assets Sales - Total cost of operation Total assets turnover X Return on total assets Sales ÷ Total assets ÷ Sales Operating margin Operating margin

28. © 2008 by Nelson, a division of Thomson Canada Limited Transparency 4.27 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).