Financial Statement Analysis – Chapter 4

Ryan Williams

Learning ObjectivesPrepare common-sized Income Statements

and Balance Sheets.Compute financial ratios listed in Table 4.1.Discuss uses and limitations of the financial

ratios in Table 4.1.

Who does this?Creditors

• Firm’s ability to repay borrowed funds, i.e., creditworthiness

Stockholders/owners• Firm’s future prospects (cash flows )

Managers• Identify strengths & weaknesses• Improve firm performance

Two companies:Three Months Ended

April 3, 2009

 

NET OPERATING REVENUES $

7,169

 

Cost of goods sold

2,590

 

GROSS PROFIT

4,579

 

Selling, general and administrative expenses

2,624

 

Other operating charges

92

 

OPERATING INCOME

1,863

 

Interest income

60

 

Interest expense

85

 

Equity income — net

17

 

Other income (loss) — net

(40)

 

INCOME BEFORE INCOME TAXES

1,815

 

Income taxes

456

 

CONSOLIDATED NET INCOME

1,359

   June 27, 

2010

     

REVENUES    

Sales  $ 12,350

Franchise fees and royalties     1,255

License royalties     1,799

Interest income     208

Other income     14

Total revenues     15,626

       

COSTS AND EXPENSES      

Cost of sales     9,488

Restaurant operating expenses     825

Depreciation and amortization     232

General and administrative expenses     2,564

Total costs and expenses     13,109

       

Income before provision for income taxes     2,517

Provision for income taxes     857

Net income  $ 1,660

Step 1 -Common Size StatementsWhy common size?Allow comparisons through time

• -e.g., did company improve on last year’s performance

Allow comparisons among firms in same industry • -did company do better or worse than similar

firms in same industry

Common Size Statements – cont.How to create common size:

Balance sheet • Divide each item by total assets and express

the result in percent

Income statement• Divide each item by net sales and express the

result in percent

Common Size Statement - ContNote:In common size income statement, profit

measures are renamed. • Gross profit becomes gross profit margin• Operating income becomes operating profit margin

• Net income becomes net profit margin

Interpretation:Gross profit margin = gross profit per unit soldSimilar interpretation for operating profit

margin, net profit margin.

Step 2 – Financial RatiosExamine relationships between

• Balance sheet accounts

E.g., compare current assets to current liabilities

• Balance sheet accounts and values on the

income statement

E.g., compare net income to total assets

What ratios do we use?Liquidity ratios

Activity ratios

Debt utilization ratios

Profitability ratios

Liquidity RatiosMeasure how well company can meet short-

term obligationsCurrent ratioQuick ratio

• Same denominator as current ratio• But numerator excludes inventory

• Higher ratios mean firm is better able to meet obligations on time

Activity RatiosAlso called ‘asset utilization’ ratios or

‘efficiency’ ratiosUnused or inactive assets are nonearning

assets Either utilize assets more effectively or

eliminate them

Activity RatiosAverage collection period (ACP)

Measures how fast company collects payments from credit sales.

In number of days. Denominator uses credit sales. If not reported,

use total sales. Inventory turnover ratio

Measures how efficiently company is employing inventory.

Larger ratio more efficient. Industry specific. If COGS not available, use sales as numerator.

Activity RatiosInventory conversion period

Measures the time period that an inventory item is in stock before it is sold.

In number of daysTotal asset turnover

Measures how productive a firm’s total assets are at producing final sales.

Higher ratio means firm is more efficient in using total assets.

Industry specific.

Activity RatiosPayables period

Measures how quickly company pays its trade accounts (suppliers)

In number of days

Activity Terms, A/R and A/P industry credit terms usually include discount

for early payment Typical: 2/10 net 30• For 2/10 net 30, effective cost is 29-45% per

year

Debt Utilization RatiosMeasures the extent to which firm uses

borrowed funds to finance operations.Leverage: using debt to finance

assets/operationsDebt utilization ratios also known as leverage

ratios

Debt Utilization RatiosDebt ratio

• Measures proportion of all assets financed with debt

• Higher the ratio, higher the risk of default.Debt to equity ratio

• Ratio of total liabilities to equity

Debt Utilization RatiosTimes interest earned (TIE)

Measures how many times the firm’s annual operating earnings cover its debt-servicing charges (mainly interest).

Larger ratio means firm is more likely to pay debt-servicing charges despite a drop in sales.

Profitability RatiosCompare a firm’s earnings to various factors

that are needed to generate the earnings (assets, sales, equity)Return on assetsReturn on equityGross profit marginOperating profit marginNet profit margin

Cash conversion cycleThe length of time (in days) between cash

expenditures and cash collections• Cash expenditures: spending money to produce

goods for sale or to buy goods for resale• Cash collections: collecting money from

customers• Firm should shorten CCC without harming

business operationsCash expenditure

Cash collection

Time passes

Cash conversion cycle

DuPont EquationBreaks down ROE into three components:

Activity (total asset turnover)Profitability (net profit margin)Leverage (equity multiplier = total

assets/equity)

ROE = net profit margin x total asset turnover

x Equity multiplier

If ROE changes, DuPont equation helps you to identify the reason for the change.

DuPont Equation - 2Another way to calculate equity multiplierEquity multiplier =

11 – debt ratio

(use the balance sheet identity:Total assets = Total liabilities + Equity)

What are the limitations?1) Balance sheet values are stock measures

• Capture values of assets & liabilities on a specific date

• Ratios using balance sheet values may not reflect company’s situation during rest of the year

• Example: A company that reports $1 million in cash on last day of fiscal year may have only $100k two days later, after paying salaries and suppliers

Limitations - 22) Financial ratios are calculated using

accounting data not market valuesAccounting data is based on an asset’s

historical costs.Market values are based on the asset’s market

value. Example: if inventory value declines below

historical cost but management did not adjust for this – every ratio involving total assets will be inaccurate.

Limitations - 33) Lack of a standard for each ratio. Example: current ratio. What is a good current

ratio value?How about using industry average ratio as

standard? Not necessarily useful. Deviations from

industry average not always bad.

What did we look at today?Reasons for conducting financial statement

analysisCommon size financial statements4 types of ratios: liquidity, activity, debt

utilization, profitabilityCash conversion cycleExtended DuPont Equation Limitations of financial ratios

Class activity