Chapter 6,Financial Statement Analysis,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,1,Financial Statements A Possible Framework for Analysis Ratio Analysis Trend Analysis Common-Size and Index Analysis,Financial Statement Analysis,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,2,Uses of Financial Statement Information,Internal uses: performance evaluation planning for the future External uses: evaluation by outside parties evaluation of main competitors identifying potential takeover targets,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,3,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.,Examples of Internal Uses of Statement Analysis,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,4,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 External Uses of Statement Analysis,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,5,Income Statement A summary of a firms revenues and expenses over a specified period, ending with net income or loss for the period. Revenue Expenses Income,Balance Sheet A summary of a firms financial position on a given date that shows total assets = total liabilities + owners equity.,Primary Types of Financial Statements,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,6,The Balance Sheet,Current Assets,Fixed Assets 1.Tangible fixed assets 2.Intangible fixed assets,Net Working Capital,Current Liabilities,Long-Term Debt,Shareholders Equity,Total Value of Assets,Total Value of Liabilities and Shareholders Equity,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,7,Balance Sheet Analysis,When analyzing a balance sheet, the financial manager should be aware of three concerns: Accounting liquidity Debt versus equity Value versus cost,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,8,Accounting Liquidity,Refers to the ease and quickness with which assets can be converted to cash. Current assets are the most liquid. Some fixed assets are intangible. The more liquid a firms assets, the less likely the firm is to experience problems meeting short-term obligations. Liquid assets frequently have lower rates of return than fixed assets.,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,9,Debt versus Equity,Generally, when a firm borrows it gives the bondholders first claim on the firms cash flow. Thus shareholders equity is the residual difference between assets and liabilities. Financial leverage increases the potential reward to shareholders, but also increases the potential for financial distress and business failure.,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,10,Value versus Cost,Generally Accepted Accounting Principles (GAAP) show that audited financial statements show assets at historical cost or book value. Market value is a completely different concept. Current value of a firm relates to market value, or the price that the asset would yield in the current market place.,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,11,Income Statement Example,Sales $2000 Costs 1400 Depreciation 100 EBIT 500 Interest 100 Taxable Income 400 Taxes 200 Net Income $200 Dividends 80 Addition to R/E $120,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,12,Income Statement Analysis,There are three things to keep in mind when analyzing an income statement: GAAP Non Cash Items Time and Costs,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,13,Generally Accepted Accounting Principles (GAAP),The matching principal of GAAP dictates that revenues be matched with expenses. Thus, income is reported when it is earned, even though no cash flow may have occurred.,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,14,Income Statement Analysis,Non Cash Items Depreciation is the most apparent. No firm ever writes a check for “depreciation”. Another noncash item is deferred taxes, which does not represent a cash flow.,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,15,Income Statement Analysis,Time and Costs In the short run, certain equipment, resources, and commitments of the firm are fixed, but the firm can vary such inputs as labor and raw materials. In the long run, all inputs of production (and hence costs) are variable. Financial accountants do not distinguish between variable costs and fixed costs. Instead, accounting costs usually fit into a classification that distinguishes product costs from period costs.,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,16,1. 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?,Framework for Financial Analysis,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,17,Health of a Firm Financial Ratios 1. Individually 2. Over time 3. In combination 4. In comparison,Framework for Financial Analysis,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,18,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.,Framework for Financial Analysis,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,19,A Financial Manager must consider all three jointly when determining the financing needs of the firm.,Framework for Financial Analysis,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,20,Framework for Financial Analysis,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,21,Ratio Analysis,Financial ratios are relationships determined from a firms financial information. Used to compare and investigate relationships between different pieces of financial information. Ratios eliminate the size problem.,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,22,Categories of Financial Ratios,Liquidity - measures the firms short-term solvency. Capital structure - measures the firms ability to meet long-run obligations (financial leverage). Asset management (turnover) - measures the efficiency of asset usage. Profitability - measures the firms ability to control expenses. Market value - per share ratios,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,23,Liquidity Ratios,(Acid-Test ratio),Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,24,Financial Leverage Ratios,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,25,Turnover Ratios,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,26,Just-in-time,An approach to inventory management and control in which inventories are acquired and inserted in production at the exact times they are needed. The goal of a JIT system is not only reduce inventories but to continuously improve productivity, product quality, and manufacturing flexibility.,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,27,Turnover Ratios (continued),Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,28,Profitability Ratios,ROI = Net profit margin Total asset turnover,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,29,Profitability Ratios (continued),=,Net profit margin,Total asset turnover,Equity Multiplier,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,30,Market Value Ratios,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,31,The Du Pont Identity,Breaks ROE into three parts: operating efficiency asset use efficiency financial leverage,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,32,The Du Pont Approach,Return on equity,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,33,Benchmarks for Comparison,Time-trend analysis - examine how a particular ratio(s) have performed historically. Peer group analysis - using similar firms (competitors) for comparison of results.,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,34,Problems with Ratio Analysis,No underlying theory to identify correct ratios to use or appropriate benchmarks. Consolidated financial statements are not appropriate to use. Firms may use different accounting procedures. Firms may have different recording periods. One-off events can severely affect financial performance.,Copyright 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e by Van Horne and Wachowicz. Slides prepared by Wu Xiaolan,35,BW Industry 2.39 2