Summary of the Previous Lecture 1.Differentiate and understand the various terms used to express value including liquidation value, going concern value,

Summary of the Previous Lecture

1. Differentiate and understand the various terms used to express value including liquidation value, going concern value, book value, market value and intrinsic value.

2. Determine the value of bonds, preferred stocks, and common stocks.

3. Dividend valuation models

4. Yield to maturity and determination of required rate of return

5. Behavior of bond prices under different conditions

Chapter 6 (I)

Financial Statement Analysis

After studying Chapter 6, you should be able to:1. Understand the purpose of basic financial statements and

their contents.

2. Explain why financial statement analysis is important to the firm and to outside suppliers of capital.

3. 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.

4. Define, calculate, and discuss a firm’s operating cycle and cash cycle.

After studying Chapter 6, you should be able to:5. Use ratios to analyze a firm's health and then recommend

reasonable alternative courses of action to improve the health of the firm.

6. Analyze a firm’s return on investment (i.e., “earning power”) and return on equity using a DuPont approach.

7. Understand the limitations of financial ratio analysis.

8. Use trend analysis, common-size analysis, and index analysis to gain additional insights into a firm's performance.

Financial Statement Analysis

1. Financial Statements

2. A Possible Framework for Analysis

3. Balance Sheet Ratios

4. Income Statement and Income Statement/Balance Sheet Ratios

5. Trend Analysis

6. Common-Size and Index Analysis

1. Financial Statements

2. A Possible Framework for Analysis

3. Balance Sheet Ratios

4. Income Statement and Income Statement/Balance Sheet Ratios

5. Trend Analysis

6. Common-Size and Index Analysis

Examples of External Uses of Statement 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.

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.

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.

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.

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.

Balance Sheet A summary of a firm’s financial position on

a given date that shows total assets = total liabilities + owners’ equity.

Basket Wonders’ Balance Sheet (Asset Side)

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.g. Acc. deductions for wear

and tear.

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.g. Acc. deductions for wear

and tear.

Cash and C.E. $ 90 Acct. Rec.c 394 Inventories 696 Prepaid Exp d 5 Accum Tax Prepay 10 Current Assetse $ 1,195 Fixed Assets (@Cost)f 1,030 Less: Acc. Depr. g (329)

Net Fix. Assets $ 701 Investment, LT 50 Other Assets, LT 223

Total Assets b $2,169

Basket Wonders Balance Sheet (thousands) Dec. 31, 2007a

Basket Wonders’ Balance Sheet (Liability Side)

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.

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. Payablec 94 Accrued Taxes d 16 Other Accrued Liab. d 100 Current Liab. e $ 500 Long-Term Debt f

530 Shareholders’ Equity Com. Stock ($1 par) g

200 Add Pd in Capital g

729 Retained Earnings h 210 Total Equity $1,139 Total Liab/Equitya,b $ 2,169

Basket Wonders Balance Sheet (thousands) Dec. 31, 2007

Basket Wonders’ Income Statement

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.

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 Sold b 1,599

Gross Profit $ 612 SG&A Expenses c 402 EBITd $ 210 Interest Expensee 59 EBT f $ 151 Income Taxes 60

EATg $ 91 Cash Dividends 38 Increase in RE $ 53

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

Analytical Tools Used

Sources and Uses Statement

Statement of Cash Flows

Cash Budgets

1. Analysis of the funds needs of the firm.

Trend / Seasonal Component

How much funding will be required in the future?

Is there a seasonal component?

Trend / Seasonal Component

How much funding will be required in the future?

Is there a seasonal component?


Health of a Firm

Financial Ratios

1. Individually2. Over time3. In

combination4. In

comparison

Health of a Firm

Financial Ratios

1. Individually2. Over time3. In

combination4. In

comparison


2. Analysis of the financial condition and profitability of the firm.


Examples:

Volatility in sales

Volatility in costs

Proximity to break-even point

Examples:

Volatility in sales

Volatility in costs

Proximity to break-even point



3. Analysis of the business risk of the firm.

Business risk relates to the risk inherent in the operations of the firm.

Business risk relates to the risk inherent in the operations of the firm.


A Financial Manager must consider all three jointly when determining the financing needs of the firm.

Determiningthe

financingneeds of the firm.





Negotiationswith

suppliers ofcapital.

Determiningthe

financingneeds of the firm.




Use of Financial Ratios

A Financial Ratio is an index that relates two accounting numbers and is obtained by dividing one number by the other.

Types of Comparisons

Internal Comparisons

External Comparisons

External Comparisons and Sources of Industry Ratios

This involves comparing the ratios of one firm with those of similar firms or with industry averages. Similarity is important as one should compare “apples to apples.”

Examples:

Risk Management Association

Dun & Bradstreet

Almanac of Business and Industrial Financial Ratios

Liquidity Ratios

Current

Current Assets Current Liabilities

For Basket Wonders December 31, 2007

Shows a firm’s ability to cover its current liabilities with its current assets.

Balance Sheet RatiosBalance Sheet Ratios

Liquidity RatiosLiquidity Ratios

$1,195 $500$1,195 $500

= 2.39= 2.39

Liquidity Ratio Comparisons

BW Industry

2.39 2.15

2.26 2.09

1.91 2.01

Year

2007

2006

2005

Current Ratio

Ratio is stronger than the industry average.

Liquidity Ratios

Acid-Test (Quick)

Current Assets - Inv

Current Liabilities

For Basket Wonders

December 31, 2007

Shows a firm’s ability to meet current liabilities with its most liquid assets.

Balance Sheet Ratios

Liquidity Ratios

$1,195 - $696$500

= 1.00

Liquidity Ratio Comparisons

BW Industry

1.00 1.25

1.04 1.23

1.11 1.25

Year

2007

2006

2005

Acid-Test Ratio

Ratio is weaker than the industry average.

Summary of the Liquidity Ratio Comparisons

• 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-Test1.00 1.25

Current Ratio -- Trend Analysis Comparison

1.5

1.7

1.9

2.1

2.3

2.5

2005 2006 2007

Analysis Year

Rat

io V

alu

e

BW

Industry

Trend Analysis of Current Ratio

Acid-Test Ratio -- Trend Analysis Comparison

0.5

0.8

1.0

1.3

1.5

2005 2006 2007

Analysis Year

Rat

io V

alu

e

BW

Industry

Trend Analysis of Acid-Test Ratio

Summary of the Liquidity Trend Analyses

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.

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.

The current ratio for BW has been rising at the same time the acid-test ratio has been declining.

The current ratio for BW has been rising at the same time the acid-test ratio has been declining.

Financial Leverage Ratios

Debt-to-Equity

Total DebtShareholders’ Equity

For Basket Wonders December 31, 2007

Shows the extent to which the firm is financed by debt.


Financial LeverageRatios

$1,030$1,139

= .90

Financial Leverage Ratio Comparisons

BW Industry

.90 .90

.88 .90

.81 .89

Year

2007

2006

2005

Debt-to-Equity Ratio

BW has average debt utilizationrelative to the industry average.


Debt-to-Total-Assets

Total DebtTotal Assets

For Basket Wonders

December 31, 2007

Shows the percentage of the firm’s assets that are supported by debt financing.



$1,030$2,169

= .47


BW Industry

.47 .47

.47 .47

.45 .47

Year

2007

2006

2005

Debt-to-Total-Asset Ratio

BW has average debt utilization relative to the industry average.


Total Capitalization

Long-term DebtTotal Capitalization

For Basket Wonders

December 31, 2007

Shows the relative importance of long-term debt to the long-term financing of the firm.



$530$1,669

= .32

(i.e., LT-Debt + Equity)


BW Industry

.32 .30

.32 .31

.37 .32

Year

2007

2006

2005

Total Capitalization Ratio

BW has average long-term debt utilizationrelative to the industry average.

Coverage Ratios

Interest Coverage

EBITInterest Charges

For Basket Wonders

December 31, 2007

Indicates a firm’s ability to cover interest charges.

Income StatementRatios

Coverage Ratios

$210$59

= 3.56

Coverage Ratio Comparisons

BW Industry

3.56 5.19

4.35 5.02

10.30 4.66

Year

2007

2006

2005

Interest Coverage Ratio

BW has below average interest coveragerelative to the industry average.

Coverage Ratio -- Trend Analysis Comparison

3.0

5.0

7.0

9.0

11.0

2005 2006 2007

Analysis Year

Rat

io V

alu

e

BW

Industry

Trend Analysis of Interest Coverage Ratio

Summary of the Coverage Trend Analysis

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.

The interest coverage ratio for BW has been falling since 2005. It has been below industry averages for the past two years.

Summary Of the Lecture

Liquidity Ratios Current = Current Assets/Current Liabilities Acid Test (Quick) = (Current assets – Inventory)/Current

Liabilities Leverage Ratios Debt to to Equity = Total Debt/Shareholder’s equity Debt to Total Assets = Total Debt / Total Assets Coverage Ratio Interest Coverage Ratio = EBIT / Interest Expense

Documents

Summary of the Previous Lecture 1.Differentiate and understand the various terms used to express value including liquidation value, going concern value,