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## FINANCIAL ANALYSIS

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**After Studying Chapter 6, you should be able to:**• Understand the purpose of basic financial statements and their contents. • Understand what is meant by “convergence” in accounting standards. • Explain why financial statement analysis is important to the firm and to outside suppliers of capital. 4. 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.**Define, calculate, and discuss a firm’s operating cycle**and cash cycle. • Use ratios to analyze a firm's health and then recommend reasonable alternative courses of action to improve the health of the firm. • Analyze a firm’s return on investment (i.e., “earning power”) and return on equity using a DuPont approach. • Understand the limitations of financial ratio analysis. • Use trend analysis, common-size analysis, and index analysis to gain additional insights into a firm's performance.**Financial Statement Analysis**• Financial Statements • A Possible Framework for Analysis • Balance Sheet Ratios • Income Statement and Income/Balance Sheet Ratios • Trend Analysis • 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.**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.**Global Accounting Standards**• Convergence of Accounting Standards: Aims to narrow or remove differences so that investors can better understand financial statements prepared under different accounting frameworks • IASB – International Accounting Standards Board has the responsibility of IFRS • IFRS – International Financial Reporting Standards (EU countries adopted) • US GAAP – US Generally Accepted Accounting Principles determined by FASB • FASB – Financial Accounting Standards Board determines accounting standards for financial statements**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. • Balance Sheet • A summary of a firm’s financial position on a given date that shows total assets = total liabilities + owners’ equity.**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. Acc. deductions for wear and tear. Cash $ 90 Acct. Rec.c 394 Inventories 696 Prepaid Expd5 AccumTax Prepay 10Current Assetse $1,195 Fixed Assets (@Cost)f 1030 Less: Acc. Depr. g (329) Net Fix. Assets$ 701 Investment, LT 50 Other Assets, LT 223Total Assets b $2,169 Basket Wonders’ Balance Sheet (Asset Side) Basket Wonders Balance Sheet (thousands) Dec. 31, 2007a**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. Payablec94 Accrued Taxesd 16 Other Accrued Liab.d 100Current Liab.e$ 500 Long-Term Debtf530Shareholders’ Equity Com. Stock ($1 par)g200 Add Pd in Capitalg 729 Retained Earningsh 210 Total Equity $1,139 Total Liab/Equitya,b $2,169 Basket Wonders’ Balance Sheet (Liability Side) Basket Wonders Balance Sheet (thousands) Dec. 31, 2007**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. Net Sales $ 2,211 Cost of Goods Soldb1,599 Gross Profit$ 612 SG&A Expenses c 402EBITd$ 210 Interest Expensee 59 EBT f$151Income Taxes 60 EATg$ 91 Cash Dividends 38 Increase in RE $ 53 Basket Wonders’ Income Statement Basket Wonders Statement of Earnings (in thousands) for Year Ending December 31, 2007a**Framework for Financial Analysis**Analytical Tools Used Sources and Uses Statement Statement of Cash Flows Cash Budgets Trend/Seasonal Component How much funding will be required in the future? Is there a seasonal component? Analysis of the funds needs of the firm.**Framework for Financial Analysis**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 of the firm.**Framework for Financial Analysis**Examples: Volatility in sales Volatility in costs Proximity to break-even point Business risk relates to the risk inherent in the operations 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**A Financial Manager must consider all three jointly when determining the financing needs of the firm. 1. Analysis of the funds needs of the firm. Determining the financing 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**1. Analysis of the funds needs of the firm. Determining the financing needs of the firm. 2. Analysis of the financial condition and profitability of the firm. 3. Analysis of the business risk of the firm. Negotiations with suppliers of capital.**Use of Financial Ratios**• Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firm’s financial condition and performance. • It is of interest to shareholders, creditors, and the firm’s own management. • Financial ratios allow you analyze raw data in the balance sheet or income statement then compare it to targets. • Ratios help you understand how you are managing financial resources.**Types of Comparisons**A Financial Ratio is an index that relates two accounting numbers and is obtained by dividing one number by the other. Use of Financial Ratios External Comparisons Internal Comparisons**Using Financial Ratios: Types of Ratio Comparisons**• Trend or time-series analysis • Used to evaluate a firm’s performance over time**Using Financial Ratios: Types of Ratio Comparisons (cont.)**• Trend or time-series analysis • Cross-sectional analysis • Used to compare different firms at the same point in time**Using Financial Ratios: Types of Ratio Comparisons (cont.)**• Trend or time-series analysis • Cross-sectional analysis • Industry comparative analysis • One specific type of cross sectional analysis. Used to compare one firm’s financial performance to the industry’s average performance**Using Financial Ratios: Types of Ratio Comparisons (cont.)**• Trend or time-series analysis • Cross-sectional analysis • Benchmarking • A type of cross sectional analysis in which the firm’s ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate**Using Financial Ratios: Types of Ratio Comparisons (cont.)**• Trend or time-series analysis • Cross-sectional analysis • Combined Analysis • Combined analysis simply uses a combination of both time series analysis and cross-sectional analysis**Using Financial Ratios: Types of Ratio Comparisons (cont.)**Industry Average Ratios for Selected Lines of Business**Using Financial Ratios: Types of Ratio Comparisons (cont.)**Figure 2.1 Combined Analysis**Using Financial Ratios: Cautions for Doing Ratio Analysis**• Ratios must be considered together; a single ratio by itself means relatively little. • Financial statements that are being compared should be dated at the same point in time. • Use audited financial statements when possible. • The financial data being compared should have been developed in the same way. • Be wary of inflation distortions.**Current Ratio =**Current Assets Current Liabilities For Basket Wonders December 31, 2007 Shows a firm’s ability to cover its current liabilities with its current assets. Liquidity Ratios Balance Sheet Ratios Liquidity Ratios $1,195 $500 = 2.39**BW Industry**2.39 2.15 2.26 2.09 1.91 2.01 Year 2007 2006 2005 Liquidity Ratio Comparisons CurrentRatio Ratio is stronger than the industry average.**Acid-Test (Quick Ratio)**Current Assets - Inventories Current Liabilities For Basket Wonders December 31, 2007 Shows a firm’s ability to meet current liabilities with its most liquid assets. Liquidity Ratios Balance Sheet Ratios Liquidity Ratios $1,195 – $696 $500 = 1.00**BW Industry**1.00 1.25 1.04 1.23 1.11 1.25 Year 2007 2006 2005 Liquidity Ratio Comparisons Acid-Test Ratio Ratio is weaker than the industry average.**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. Ratio BW Industry Current 2.39 2.15 Acid-Test 1.00 1.25 Summary of the Liquidity Ratio Comparisons**Trend Analysis of Current Ratio**2.5 2.3 2.1 BW Ratio Value 1.9 Industry 1.7 1.5 2005 2006 2007 Analysis Year Current Ratio – Trend Analysis Comparison**Trend Analysis of Acid-Test Ratio**1.5 1.3 BW 1.0 Ratio Value Industry 0.8 0.5 2005 2006 2007 Analysis Year Acid-Test Ratio – Trend Analysis Comparison**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. Summary of the Liquidity Trend Analyses • The current ratio for BW has been rising at the same time the acid-test ratio has been declining.**Debt-to-Equity**Total Debt Shareholders’ Equity For Basket Wonders December 31, 2007 Shows the extent to which the firm is financed by debt. Financial Leverage Ratios Balance Sheet Ratios Financial Leverage Ratios $1,030 $1,139 = 0.90**BW Industry**0.90 0.90 0.88 0.90 0.81 0.89 Year 2007 2006 2005 Financial Leverage Ratio Comparisons Debt-to-Equity Ratio BW has average debt utilization relative to the industry average.**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. Financial Leverage Ratios Balance Sheet Ratios Financial Leverage Ratios $1,030 $2,169 = 0.47**BW Industry**0.47 0.47 0.47 0.47 0.45 0.47 Year 2007 2006 2005 Financial Leverage Ratio Comparisons Debt-to-Total-Asset Ratio BW has average debt utilization relative to the industry average.**Total Capitalization**Total 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. Financial Leverage Ratios Balance Sheet Ratios (i.e., LT-Debt + Equity) Financial Leverage Ratios $1,030 $1,669 = 0.62**BW Industry**0.62 0.60 0.62 0.61 0.67 0.62 Year 2007 2006 2005 Financial Leverage Ratio Comparisons Total Capitalization Ratio BW has average long-term debt utilization relative to the industry average.**Interest Coverage**EBIT Interest Charges For Basket Wonders December 31, 2007 Indicates a firm’s ability to cover interest charges. Coverage Ratios Income Statement Ratios Coverage Ratios $210 $59 = 3.56**BW Industry**3.56 5.19 4.35 5.02 10.30 4.66 Year 2007 2006 2005 Coverage Ratio Comparisons Interest Coverage Ratio BW has below average interest coverage relative to the industry average.**Trend Analysis of Interest Coverage Ratio**11.0 9.0 7.0 BW Ratio Value Industry 5.0 3.0 2005 2006 2007 Analysis Year Coverage Ratio – Trend Analysis Comparison**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. Summary of the Coverage Trend Analysis • The interest coverage ratio for BW has been falling since 2005. It has been below industry averages for the past two years.**Receivable Turnover**Annual Net Credit Sales Receivables For Basket Wonders December 31, 2007 Indicates quality of receivables and how successful the firm is in its collections. Activity Ratios Income Statement/ Balance Sheet Ratios (Assume all sales are credit sales.) Activity Ratios $2,211 $394 = 5.61**Avg Collection Period**Days in the Year Receivable Turnover For Basket Wonders December 31, 2007 Average number of days that receivables are outstanding. (or RT in days) Activity Ratios Income Statement/ Balance Sheet Ratios Activity Ratios 365 5.61 = 65 days**BW Industry**65.0 65.7 71.1 66.3 83.6 69.2 Year 2007 2006 2005 Activity Ratio Comparisons Average Collection Period BW has improved the average collection period to that of the industry average.**Payable Turnover (PT)**Annual Credit Purchases Accounts Payable For Basket Wonders December 31, 2007 Indicates the promptness of payment to suppliers by the firm. Activity Ratios Income Statement/ Balance Sheet Ratios (Assume annual credit purchases = $1,551.) Activity Ratios $1551 $94 = 16.5**PT in Days**Days in the Year Payable Turnover For Basket Wonders December 31, 2007 Average number of days that payables are outstanding. Activity Ratios Income Statement/ Balance Sheet Ratios Activity Ratios 365 16.5 = 22.1 days**BW Industry**22.1 46.7 25.4 51.1 43.5 48.5 Year 2007 2006 2005 Activity Ratio Comparisons Payable Turnover in Days BW has improved the PT in Days. Is this good?