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Analysis of FinancialStatements

Overview of Financial Analysis

• First order of business is to SPECIFY THE OBJECTIVES OF THE ANALYSIS

• Remember -- the identity of the user helps define what information is needed

Potential Financial Statement Users:

• Creditors• Investors• Managers• Employees

• What types of questions do each of these users seek answers to?

Creditors

• Why does the firm want/need to borrow funds?

• What is the firm’s capital structure? How leveraged are they?

• How will they pay it back? What kind of cash flows are being generated by operations?

Investors

• How has the firm performed/what are future expectations?

• How much RISK is inherent in the capital structure?

• What are expected returns from the firm?

• What is firm’s competitive position?

Managers• Need all info creditors and investors

need PLUS:• What operating areas have

contributed to success and which have not?

• What are strengths/weaknesses of company’s financial position?

• What changes are indicated to improve future performance?

Caution!!!

• Keep in mind: management PREPARES financial statements

• Analyst should be alert to potential for management to influence reporting to make data more “appealing”

• May want to supplement analysis with information apart from Annual Report prepared by management

Where to look for data...

• Financial statements (and notes)• Annual Report • 10K and 10Q reports filed with SEC• Computerized data bases

• Info on industry norms/ratios• Info on particular

companies/industries/mutual funds

• Websites

Basic Tools

• Common size financial statements

• Financial ratios• Trend analysis• Industry comparisons

Common Sizing

Firm A Firm B

Sales 2531456.24 4561234.87

COGS 784564.54 1556456.24

Gr. Profit 1746891.70 3004778.63

Common Sizing

Firm A Firm B

Sales 2,531,456 4,561,234

COGS 784,564 1,556,456

Gr. Profit 1,746,891 3,004,778

Common Sizing

Firm A Firm B

Sales 2,531,456 100% 4,561,234 100%

COGS 784,564 31% 1,556,456 34%

Gr. Profit 1,746,891 69% 3,004,778 66%

Common Size Statements

• Common size income statement• expresses each income statement

category as a percentage of sales• Common size balance sheet

• expresses each item on balance sheet as a percentage of total assets or equities

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Ratio Analysis

• Profitability• Liquidity• Debt Utilization• Asset Utilization ratios

Four Categories of RatiosFour Categories of Ratios

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Ratio Analysis

Profitability Ratios

• Measure the overall effectiveness of the firm’s management.

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Gross Profit Margin =Gross Profit Margin =Gross Profit

Sales

How effective is the firm at generating revenue in excess of its cost of goods sold?

Ratio Analysis

Profitability Ratios

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Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

Income StatementExcalibur Corporation

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Net Operating Income $330Interest Expense 60 Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings $62

$575 $1,450

Gross Profit Margin = = 39.7%

GrossProfit =Margin

Gross ProfitSales

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Operating Profit Margin =Operating Profit Margin =Operating Income

Sales

How effective is the firm in keeping costs of production low?

Ratio AnalysisProfitability Ratios

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Balance SheetExcalibur Corporation

Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings $62

Income StatementExcalibur Corporation

$330 $1,450

Oper. Profit Margin = = 22.8%

OperatingProfit =Margin

Operating IncomeSales

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Profit Margin orProfit Margin orReturn on Sales =Return on Sales =

Net IncomeSales

How much net profit is being generated from each dollar of sales?

Ratio Analysis

Profitability Ratios

Note: Net Income equals Earnings Available to CS

when there is no preferred stock.

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Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

Assets Liabilities

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings $62

Income StatementExcalibur Corporation

$162 $1,450

Profit Margin = = 11.2%

NetProfit =Margin

Net IncomeSales

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Return on Assets = Return on Assets = Net IncomeTotal Assets

How effectively is the firm generating net income from its assets ?

Ratio AnalysisProfitability Ratios

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Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term debt $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

Assets Liabilities

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40) 108Net Income% $162Common Dividends Paid 100Addition to Retained Earnings $62

Income StatementExcalibur Corporation

$162 $2,530ROA = = 6.4%

Return onAssets

Net IncomeTotal Assets=

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Return on Common Equity =Return on Common Equity = Net Income Equity

How well is the firm generating return to its equity providers?

Ratio Analysis

Profitability Ratios

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Balance SheetExcalibur Corporation

Assets Liabilities

Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530Sales $1,450

Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings $62

Income StatementExcalibur Corporation

$162 $1,700

ROE = = 9.53%

Return on Equity = Net Income Equity

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Ratio AnalysisLiquidity RatiosLiquidity Ratios

Current Ratio =Current Ratio = Current Assets Current Liabilities

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

Are there sufficient current assets to pay off current liabilities? What is the cushion of safety?

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Balance SheetExcalibur Corporation

Assets Liabilities

Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

$1,230$230

Current Ratio = = 5.35x

Current Ratio = Current Assets Current Liabilities

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Ratio AnalysisLiquidity RatiosLiquidity Ratios• Measure the ability of the firm to meet

its short-term financial obligations.

Quick Ratio =Quick Ratio = Current Assets - InventoryCurrent Liabilities

What happens to the firm’s ability to repay current liabilities after what is usually the least liquid of the current assets is subtracted?

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Balance SheetExcalibur Corporation

Assets Liabilities

$1,230 -$625$230

Acid-Test Ratio = = 2.63x

Quick Ratio = Current Assets - Inventory Current Liabilities

Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

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Ratio Analysis

Debt Utilization RatiosDebt Utilization Ratios

• Measure the relative size of the firm’s debt load and the firm’s ability to pay off the debt.

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Debt Ratio =Debt Ratio = Total Debt Total Assets

What proportion of the firm’s assets is financed with debt?

Ratio Analysis

Debt RatiosDebt Ratios

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Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

Assets Liabilities

Income StatementExcalibur Corporation

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings $62

$230 + $600 $2,530

Debt Ratio = = 33%

Debt Ratio = Total Debt Total Assets

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Times Interest Earned Ratio =Times Interest Earned Ratio = Operating IncomeInterest Expense

What is the firm’s ability to repay interest payments from its operating income?

Ratio Analysis

Debt RatiosDebt Ratios

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Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

Assets Liabilities

$330 $330 $60$60TIE Ratio =TIE Ratio = = 5.50x= 5.50x

TimesInterest =Earned Ratio

Operating IncomeInterest Expense

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings $62

Income StatementExcalibur Corporation

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Ratio Analysis

Asset Management RatiosAsset Management Ratios

• Help assess how effectively the firm is using assets to generate sales.

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Ratio Analysis

Asset Utililzation RatiosAsset Utililzation Ratios

How long does it take for the firm on average to collect its credit sales from customers?

Average Collection Period =Average Collection Period = Accounts Receivable Avg. Daily Cr. Sales

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Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Bonds $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

Assets Liabilities

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings $62

Income StatementExcalibur Corporation

AverageCollection = Period

Accounts ReceivableAvg. Daily Sales

$430 $1,450/365 ACP = = 108.24 days

Days in a year

Days in a year

Additional Info:Additional Info:We assume all We assume all sales are creditsales are creditsales.sales.

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Inventory Turnover Ratio =Inventory Turnover Ratio = Sales Inventory

Is inventory efficiently translating into sales for the firm?

Ratio Analysis

Asset Management RatiosAsset Management Ratios

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Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

Assets Liabilities

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings $62

Income StatementExcalibur Corporation

$1450$625

Inventory Turnover = = 2.3x

InventoryTurnover =Ratio

Sales Inventory

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Fixed Asset Turnover Ratio =Fixed Asset Turnover Ratio = Sales

Net Fixed Assets

How effective is the firm in using its fixed assets to help generate sales?

Ratio Analysis

Asset Management RatiosAsset Management Ratios

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Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

Assets Liabilities

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings $62

Income StatementExcalibur Corporation

$1,450$1,300

Fixed Asset Turnover = = 1.12x

Fixed AssetTurnover = Ratio

Sales Net Fixed Assets

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Total Asset Turnover Ratio =Total Asset Turnover Ratio = Sales Total Assets

How effective is the firm in using its overall assets to generate sales?

Ratio Analysis

Asset Management RatiosAsset Management Ratios

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Assets Liabilities

Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Balance SheetExcalibur Corporation

$1,450 $2,530

Total Asset Turnover = = 0.57x

Total AssetTurnover = Ratio

Sales Total Assets

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings $62

Income StatementExcalibur Corporation

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Price to Earnings Ratio =Price to Earnings Ratio = Price per ShareEarnings per Share

How much are investors willing to pay per dollar of earnings of the firm?

(Indicator of investor’s attitudes toward future prospects of the firm and of the firm’s risk.)

Ratio AnalysisMarket Value RatiosMarket Value Ratios

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Cash $175 Accounts Payable $115Accounts Receivable 430 S-T Notes Payable 115Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800

Total Owners’ Equity $1,700Total Liabilities and Owners Equity $2,530

Assets Liabilities

Balance SheetExcalibur Corporation

Additional Info:100 shares$20.00 per share

$20.00 $162/100

P/E ratio = = 12.35x

P/E Ratio

Price/ShareEPS

=

Sales $1,450Cost of Goods Sold 875Gross Profit $575Operating Expenses 45Depreciation 200Operating Income $330Interest Expense 60 Income Before Taxes $270Taxes (40%) 108Net Income $162Common Dividends Paid 100Addition to Retained Earnings $62

Income StatementExcalibur Corporation

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RatioRatio Industry Industry Excalibur ExcaliburProfitabilityProfitabilityGross Profit Margin 38% 39.7%Operating Profit Margin 20% 22.8%Net Profit Margin 12% 11.2%Return on Assets 9.0% 6.4%Return on Equity 13.4% 9.5%

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RatioRatio Industry Industry Excalibur ExcaliburProfitabilityProfitabilityGross Profit Margin 38% 39.7%Operating Profit Margin 20% 22.8%Net Profit Margin 12% 11.2%Return 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.

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RatioRatio Industry Excalibur Industry ExcaliburLiquidityLiquidityCurrent Ratio 5.00x 5.35xQuick Ratio 3.00x 2.63x

Summary of Excalibur Corporation RatiosSummary of Excalibur Corporation Ratios

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RatioRatio Industry Excalibur Industry ExcaliburLiquidityLiquidityCurrent Ratio 5.00x 5.35xQuick Ratio 3.00x 2.63x

Looking at the current ratio it appears that Excalibur is more liquid than the industry.... however when looking at Acid Test (a better measure) they are not as liquid indicating that inventory levels are probably too high.

Summary of Excalibur Corporation RatiosSummary of Excalibur Corporation Ratios

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RatioRatio Industry Industry Excalibur ExcaliburDebtDebtDebt Ratio 35% 33%Times Interest Earned 7.00x 5.50x

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RatioRatio Industry Industry Excalibur ExcaliburDebtDebtDebt Ratio 35% 33%Times Interest Earned 7.00x 5.50x

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.

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RatioRatio Industry Industry Excalibur ExcaliburAsset ManagementAsset Management Avg. Collection Period 90 days 108 daysInventory Turnover 3.00x 2.32xFixed Asset Turnover 1.00x 1.12xTotal Asset Turnover 0.75x .57x

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RatioRatio Industry Industry Excalibur ExcaliburAsset ManagementAsset Management Avg. Collection Period 90 days 108 daysInventory Turnover 3.00x 2.32xFixed Asset Turnover 1.00x 1.12xTotal 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 very efficient at converting Fixed Assets to Sales (fixed assets are productive). However, overall assets are not productive indicating Current Assets (e.g. inventories) are not as productive as for the industry.

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RatioRatio Industry Industry Excalibur ExcaliburMarket ValueMarket Value PE Ratio 18.0 12.35

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RatioRatio Industry Industry Excalibur ExcaliburMarket ValueMarket Value PE Ratio 18.0 12.35

Excalibur’s Investors are not willing to pay as much per dollar of earnings or per dollar of book value as they are for shares in other firms in the industry. This signals that they consider the firm’sprospects to be worse than the average.However, the firm is still selling for more than its accounting book value.

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Relationships Among Ratios:The Du Pont System

• Ratio Analysis generally involves an examination of related ratios.

• Comparison of these relationships over time helps to identify the company’s strengths and weaknesses.

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Net Inc. Net Inc. Sales Assets Sales Assets

= x

The Du Pont Equation

Net ProfitMargin

Total AssetTurnover

Return onAssets

= x

Relationships Among Ratios:The Du Pont System

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Relationships Among Ratios:Relationships Among Ratios:The Du Pont SystemThe Du Pont System

Net Inc. Net Inc. Sales AssetsEquity Sales Assets Equity = x x

Net ProfitMargin

Total AssetTurnover

Return onEquity

EquityMultiplier

= x x

DuPont Equation: TGT vs. Walmart

Net Profit Margin

Asset Turnover

Target 4.0% 1.45

Wal-Mart

3.6% 2.40

Which would you prefer?

DuPont Equation: TGT vs. Walmart

Jan. 2005

Net Profit Margin

Asset Turnover

ROA

Target 4.0% 1.45 5.8%

Wal-Mart

3.6% 2.40 8.6%

DuPont Equation: TGT vs. Walmart

Jan. 2005

Net Profit Margin

Asset Turnover

Equity Multiplier

ROE

Target 4.0% 1.45 2.5 15%

Wal-Mart

3.6% 2.40 2.4 21%

What is Target’s debt ratio?

How much debt would Target need for ROE=21%

• The DuPont approach is nice because it divides the firm into three tasks•expense management (measured by the

profit margin)•asset management (measured by asset

turnover)•debt management (measured by the

equity multiplier)

DuPont Example

Wal-Mart Sears

Profit M. 4% 6%Ass.Turn. 3 1.5ROA ? ?Eq. Mult. 2 1ROE ? ?

What is the top overall ratio?

Ratio Exercise

Inv turn. 5 Cash ______ Acc Pay _____

Debt to net worth

.50

Acc Rec. 14,795

Inv. ______ Stock 25,000

G. P. Margin

.30

Plant Eq. ______ Ret Earn. 35,000

Acid test

1.2

Total Assets

______

Tot. Liab & Eq.

_______

TA turnover

2

Sales ____ COGS ______