Chapter 2

Financial Statement
Analysis

6.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 After Studying Chapter 6,
you should be able to:
1. Understand the purpose of basic financial statements and their contents.
2. Understand what is meant by “convergence” in accounting standards.
3. 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.
5. Define, calculate, and discuss a firm’s operating cycle and cash cycle.
6. Use ratios to analyze a firm's health and then recommend reasonable
alternative courses of action to improve the health of the firm.
7. Analyze a firm’s return on investment (i.e., “earning power”) and return on
equity using a DuPont approach.
8. Understand the limitations of financial ratio analysis.
9. Use trend analysis, common-size analysis, and index analysis to gain
additional insights into a firm's performance.

6.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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
6.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Financial Analysis
What is financial analysis?
 Evaluating a firm’s financial performance
 Analyzing ratios or numerical calculations
 Comparing a company to its industry and to its
past performance
 A long-run trend analysis over a 5-10 year period
is usually performed by an analyst.
 Ratio analysis may not answer questions, but leads
to further inquiry

6.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Objectives of Financial
Analysis
Analysis of financial statements can
examine:
 financial strengths and weaknesses,
 its credit worthiness,
 safety of funds invested in the firm,
 adequacy or otherwise of its earnings,
 ability to meet its obligations of firms.

6.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Importance of Ratios
Which ratios are most important?
 It depends on your perspective.
 Suppliers and banks (lenders) are most
interested in liquidity ratios.
 Shareholders are most interested in
profitability ratios.
 Bondholders concentrate on debt utilization
ratios
 The effective utilization of assets is
management’s responsibility.
6.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Types of Ratios
1. Profitability ratios:
Measures management's overall effectiveness as shown
by returns of the period. Ratios in this group are:

i. Net Profit Margin

ii. Basic Earning Power (BEP) Ratio
iii. Return on Total Assets
iv. Return on Common Equity

6.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 2. Asset Utilization ratios
Measures the effective use of resources. This ratio
includes:
i. Receivable turnover(RTO)
ii. Daily sales Outstanding (DSO)/ACP
iii. Inventory turnover(ITO)
iv. Fixed Asset turn over(FATO)
v.Total Asset turn over(TATO)

6.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 3. Liquidity Ratios
 Measures the firm's ability to
meet short term obligations.
 Current ratio
 Quick or Acid test ratio

6.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 4. Debt utilization
Ratios:
 Measures the extent of which the firm's
assets are financed by long term debt. It
includes:

i. Total Liabilities to Total Assets

ii. Times -Interest-Earned Ratio

iii. EBITDA Coverage Ratio

6.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 5. Market Value ratios
 measures the value of a company’s
stock relative to that of another
company.
i. Price /Earnings Ratio
ii. Price/ Cash Flow Ratio
iii. Market/Book Ratio

6.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
6.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.

6.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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
6.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Primary Types of
Financial Statements
Balance Sheet
• A summary of a firm’s financial position on
a given date that shows total assets = total
liabilities + owners’ equity.
Income Statement
 A summary of a firm’s revenues and
expenses over a specified period, ending
with net income or loss for the period.
6.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Basket Wonders’ Balance
Sheet (Asset Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007 a
Cash $ 90 Acct. a. How the firm stands on
Rec.c 394 Inventories a specific date.
696 Prepaid Exp d b. What BW owned.
5 Accum Tax Prepay c. Amounts owed by
10 customers.
Current d. Future expense items
Assetse $1,195 Fixed Assets already paid.
(@Cost)f 1030 Less: Acc. e. Cash/likely convertible
Depr. g (329) Net Fix. to cash within 1 year.
Assets $ 701 Investment, LT f. Original amount paid.
50 Other Assets, LT g. Acc. deductions for
223 Total Assets b wear and tear.
$2,169
6.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Basket Wonders’ Balance
Sheet (Liability Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007
Notes Payable $ 290 a. Note, Assets =
Acct. Payablec 94 Liabilities + Equity.
Accrued Taxes d 16 b. What BW owed and
Other Accrued Liab. d 100 ownership position.
Current Liab. e $ c. Owed to suppliers for
500 Long-Term Debt f 530 goods and services.
Shareholders’ Equity d. Unpaid wages,
Com. Stock ($1 par) g 200 Add salaries, etc.
Pd in Capital g 729 e. Debts payable < 1 year.
Retained Earnings h 210 f. Debts payable > 1 year.
Total Equity $1,139 g. Original investment.
Total Liab/Equitya,b $2,169 h. Earnings reinvested.
6.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Basket Wonders’
Income Statement
Basket Wonders Statement of Earnings (in thousands)
for Year Ending December 31, 2007a
Net Sales $ 2,211 a. Measures profitability
Cost of Goods Sold b 1,599 over a time period.
Gross Profit $ 612 b. Received, or receivable,
SG&A Expenses c 402 from customers.
EBITd $ c. Sales comm., adv.,
210 Interest Expensee officers’ salaries, etc.
59 EBT f $ 151 d. Operating income.
Income Taxes 60 e. Cost of borrowed funds.
EATg $ 91 Cash f. Taxable income.
Dividends 38 g. Amount earned for
Increase in RE $ 53 shareholders.
6.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Construct a balance sheet

6.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Produce Income statement

6.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Framework for
Financial Analysis
Trend/Seasonal Component
How much funding will be
required in the future?
1. Analysis of the funds Is there a seasonal
needs of the firm. component?

Analytical Tools Used

Sources and Uses Statement
Statement of Cash Flows
Cash Budgets

6.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Framework for
Financial Analysis

Health of a Firm

1. Analysis of the funds

needs of the firm.
Financial Ratios
2. Analysis of the financial
condition and profitability 1. Individually
of the firm. 2. Over time
3. In combination
4. In comparison

6.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Framework for
Financial Analysis

Business risk relates to

1. Analysis of the funds the risk inherent in the
needs of the firm.
operations of the firm.
2. Analysis of the financial
condition and profitability Examples:
of the firm.
Volatility in sales
3. Analysis of the business
risk of the firm. Volatility in costs
Proximity to break-even
point
6.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Framework for
Financial Analysis
A Financial
Manager
1. Analysis of the funds must
needs of the firm. Determining consider all
the
2. Analysis of the financial
financing three jointly
condition and profitability when
needs of
of the firm.
the firm. determining
3. Analysis of the business
risk of the firm. the
financing
needs of the
firm.
6.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Framework for
Financial Analysis

1. Analysis of the funds

needs of the firm. Determining Negotiations
the
2. Analysis of the financial with
financing
condition and profitability suppliers of
needs of
of the firm. capital.
the firm.
3. Analysis of the business
risk of the firm.

6.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Summary of Ratio Analysis

6.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Use of Financial Ratios

A Financial Ratio is Types of

an index that relates Comparisons
two accounting
Internal
numbers and is
Comparisons
obtained by dividing
one number by the External
other. Comparisons

6.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 External Comparisons and
Sources of Industry Ratios
This involves Examples:
comparing the ratios Risk Management
of one firm with those
Association
of similar firms or with
industry averages. Dun & Bradstreet
Almanac of
Similarity is important
as one should
Business and
compare “apples to Industrial
apples.” Financial Ratios
6.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Liquidity Ratios
Balance Sheet Ratios Current

Current Assets
Liquidity Ratios Current Liabilities
Shows a firm’s For Basket Wonders
ability to cover its December 31, 2007
current liabilities
with its current $1,195 = 2.39
assets. $500
6.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Liquidity Ratio
Comparisons
Current Ratio
Year BW Industry
2007 2.39 2.15
2006 2.26 2.09
2005 1.91 2.01
Ratio is stronger than the industry average.
6.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Liquidity Ratios
Balance Sheet Ratios Acid-Test (Quick)

Current Assets - Inv

Liquidity Ratios Current Liabilities

Shows a firm’s For Basket Wonders

ability to meet December 31, 2007
current liabilities
with its most liquid $1,195 – $696 = 1.00
assets. $500
6.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Liquidity Ratio
Comparisons
Acid-Test Ratio
Year BW Industry
2007 1.00 1.25
2006 1.04 1.23
2005 1.11 1.25
Ratio is weaker than the industry average.
6.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Summary of the Liquidity
Ratio Comparisons
Ratio BW Industry
Current 2.39 2.15
Acid-Test1.00 1.25
 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.
6.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Current Ratio – Trend
Analysis Comparison
Trend Analysis of Current Ratio
2.5
2.3
Ratio Value

2.1
BW
1.9 Industry
1.7
1.5
2005 2006 2007
Analysis Year
6.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Acid-Test Ratio – Trend
Analysis Comparison
Trend Analysis of Acid-Test Ratio

1.5

1.3
Ratio Value

1.0 BW
Industry
0.8

0.5
2005 2006 2007
Analysis Year
6.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
 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.
6.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Self Test Questions

- What are the characteristics of liquid

assets? Give example of liquid assets?
- What questions are the two liquid ratios
deisgned to answer?
- Which is the least liquid of the firm’s current
assets?

6.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Q1Self Test Question

A company has current liability of $ 500 m, and its

current ratio is 2.0, what is the total of Current

Assets? If the firm’s quick ratio is 1.6, how much

inventory does it have?

6.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Financial Leverage Ratios
Balance Sheet Ratios Debt-to-Equity

Total Debt
Financial Leverage Shareholders’ Equity
Ratios
For Basket Wonders
December 31, 2007
Shows the extent to
which the firm is $1,030 = 0.90
financed by debt. $1,139
6.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Financial Leverage
Ratio Comparisons
Debt-to-Equity Ratio
Year BW Industry
2007 0.90 0.90
2006 0.88 0.90
2005 0.81 0.89
BW has average debt utilization
relative to the industry average.
6.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Financial Leverage Ratios
Balance Sheet Ratios Debt-to-Total-Assets

Total Debt
Financial Leverage Total Assets
Ratios
For Basket Wonders
Shows the percentage December 31, 2007
of the firm’s assets
that are supported by $1,030 = 0.47
debt financing. $2,169
6.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Financial Leverage
Ratio Comparisons
Debt-to-Total-Asset Ratio
Year BW Industry
2007 0.47 0.47
2006 0.47 0.47
2005 0.45 0.47
BW has average debt utilization
relative to the industry average.
6.42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Financial Leverage Ratios
Balance Sheet Ratios Total Capitalization
(i.e., LT-Debt + Equity)

Financial Leverage Total Debt

Ratios Total Capitalization

Shows the relative For Basket Wonders

importance of long-term December 31, 2007
debt to the long-term $1,030 = 0.62
financing of the firm. $1,669
6.43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Financial Leverage
Ratio Comparisons
Total Capitalization Ratio
Year BW Industry
2007 0.62 0.60
2006 0.62 0.61
2005 0.67 0.62
BW has average long-term debt utilization
relative to the industry average.
6.44 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Coverage Ratios
Income Statement Interest Coverage
Ratios
EBIT
Interest Charges
Coverage Ratios
For Basket Wonders
Indicates a firm’s December 31, 2007
ability to cover
interest charges. $210 = 3.56
$59
6.45 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Coverage
Ratio Comparisons
Interest Coverage Ratio
Year BW Industry
2007 3.56 5.19
2006 4.35 5.02
2005 10.30 4.66
BW has below average interest coverage
relative to the industry average.
6.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Coverage Ratio – Trend
Analysis Comparison
Trend Analysis of Interest Coverage Ratio
11.0

9.0
Ratio Value

7.0 BW
Industry
5.0

3.0
2005 2006 2007
Analysis Year
6.47 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
 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.
6.48 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Self Test Questions
 How does the use of financial leverage affect
shareholder’s control position?

 How does the decision to use debt involves a

risk-versus-return trade-off?

 Name two ratios that are used to measure

financial leverage ratio and with their
equations?
6.49 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Asset Utilization Ratio/
Activity Ratios
Income Statement/ Receivable Turnover
(Assume all sales are credit sales.)
Balance Sheet
Ratios Annual Net Credit Sales
Receivables
Activity Ratios
For Basket Wonders
Indicates quality of December 31, 2007
receivables and how
successful the firm is in $2,211 = 5.61
its collections. $394
6.50 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Activity Ratios
Income Statement/ Avg Collection Period
Balance Sheet
Days in the Year
Ratios
Receivable Turnover

Activity Ratios For Basket Wonders

December 31, 2007
Average number of days
that receivables are
outstanding. 365 = 65 days
(or RT in days) 5.61
6.51 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Activity
Ratio Comparisons
Average Collection Period
Year BW Industry
2007 65.0 65.7
2006 71.1 66.3
2005 83.6 69.2
BW has improved the average collection
period to that of the industry average.
6.52 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Activity Ratios
Income Statement/ Payable Turnover (PT)
(Assume annual credit
Balance Sheet purchases = $1,551.)
Ratios
Annual Credit Purchases
Accounts Payable
Activity Ratios

Indicates the For Basket Wonders

promptness of payment December 31, 2007
to suppliers by the firm. $1551
= 16.5
$94
6.53 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Activity Ratios
Income Statement/ PT in Days
Balance Sheet
Ratios Days in the Year
Payable Turnover
Activity Ratios
For Basket Wonders
December 31, 2007
Average number of days
that payables are 365
outstanding. = 22.1 days
16.5
6.54 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Activity
Ratio Comparisons
Payable Turnover in Days
Year BW Industry
2007 22.1 46.7
2006 25.4 51.1
2005 43.5 48.5
BW has improved the PT in Days.
Is this good?
6.55 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Activity Ratios
Income Statement/ Inventory Turnover
Balance Sheet
Ratios Cost of Goods Sold
Inventory
Activity Ratios
For Basket Wonders
Indicates the December 31, 2007
effectiveness of the
inventory management $1,599 = 2.30
practices of the firm. $696
6.56 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Activity
Ratio Comparisons
Inventory Turnover Ratio
Year BW Industry
2007 2.30 3.45
2006 2.44 3.76
2005 2.64 3.69
BW has a very poor inventory turnover ratio.
6.57 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Inventory Turnover Ratio –
Trend Analysis Comparison
Trend Analysis of Inventory Turnover Ratio
4.0

3.5
Ratio Value

3.0 BW
Industry
2.5

2.0
2005 2006 2007
Analysis Year

6.58 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Activity Ratios
Income Statement/ Total Asset Turnover
Balance Sheet
Ratios Net Sales
Total Assets
Activity Ratios
For Basket Wonders
Indicates the overall December 31, 2007
effectiveness of the firm
in utilizing its assets to $2,211 = 1.02
generate sales. $2,169
6.59 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Activity
Ratio Comparisons
Total Asset Turnover Ratio
Year BW Industry
2007 1.02 1.17
2006 1.03 1.14
2005 1.01 1.13
BW has a weak total asset turnover ratio.
Why is this ratio considered weak?
6.60 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Self Test Questions
 Write the ratios that are used to measure how
effectively a firm manages its assets?
 If one firm is growing rapidly and another is not,
how might this distort a comparison of their
inventory turnover ratios?
 If you wanted to evaluate a firm’s DSO, with what
could you compare it?

6.61 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Self Test Questions

 A firm has annual sales of $100,000, $20,000 of

inventory, and $30,000 of accounts receivable.

What is its inventory turnover ratio? What is

its DSO?

6.62 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Profitability Ratios
Income Statement/ Gross Profit Margin
Balance Sheet
Ratios Gross Profit
Net Sales
Profitability Ratios
For Basket Wonders
December 31, 2007
Indicates the efficiency
of operations and firm $612 = 0.277
pricing policies. $2,211
6.63 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Profitability
Ratio Comparisons
Gross Profit Margin
Year BW Industry
2007 27.7% 31.1%
2006 28.7 30.8
2005 31.3 27.6
BW has a weak Gross Profit Margin.
6.64 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Gross Profit Margin –
Trend Analysis Comparison
Trend Analysis of Gross Profit Margin
35.0

32.5
Ratio Value (%)

30.0 BW
Industry
27.5

25.0
2005 2006 2007
Analysis Year

6.65 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Profitability Ratios
Income Statement/ Net Profit Margin
Balance Sheet
Ratios Net Profit after Taxes
Net Sales
Profitability Ratios
For Basket Wonders
Indicates the firm’s December 31, 2007
profitability after taking
$91 = 0.041
account of all expenses
$2,211
and income taxes.
6.66 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Profitability Ratio
Comparisons
Net Profit Margin
Year BW Industry
2007 4.1% 8.2%
2006 4.9 8.1
2005 9.0 7.6
BW has a poor Net Profit Margin.
6.67 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Net Profit Margin –
Trend Analysis Comparison
Trend Analysis of Net Profit Margin
10
9
Ratio Value (%)

8
7 BW
Industry
6
5
4
2005 2006 2007
Analysis Year
6.68 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Profitability Ratios
Income Statement/ Return on Investment
Balance Sheet
Ratios Net Profit after Taxes
Total Assets
Profitability Ratios
For Basket Wonders
Indicates the December 31, 2007
profitability on the
assets of the firm (after $91 = 0.042
all expenses and taxes). $2,160
6.69 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Profitability Ratio
Comparisons
Return on Investment
Year BW Industry
2007 4.2% 9.6%
2006 5.0 9.1
2005 9.1 10.8
BW has a poor Return on Investment.
6.70 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Return on Investment –
Trend Analysis Comparison
Trend Analysis of Return on Investment
12

10
Ratio Value (%)

8 BW
Industry
6

4
2005 2006 2007
Analysis Year

6.71 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Profitability Ratios
Income Statement/ Return on Equity
Balance Sheet
Ratios Net Profit after Taxes
Shareholders’ Equity
Profitability Ratios
For Basket Wonders
Indicates the profitability December 31, 2007
to the shareholders of
the firm (after all $91 = 0.08
expenses and taxes). $1,139
6.72 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Profitability Ratio
Comparisons
Return on Equity
Year BW Industry
2007 8.0% 18.0%
2006 9.4 17.2
2005 16.6 20.4
BW has a poor Return on Equity.
6.73 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Return on Equity –
Trend Analysis Comparison
Trend Analysis of Return on Equity
21.0
Ratio Value (%)

17.5

14.0 BW
Industry
10.5

7.0
2005 2006 2007
Analysis Year
6.74 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Return on Investment and
the Du Pont Approach
Earning Power = Sales profitability ×
Asset efficiency
ROI = Net profit margin ×
Total asset turnover
ROI2007 = 0.041 × 1.02 = 0.042 or 4.2%
ROIIndustry = 0.082 × 1.17 = 0.096 or 9.6%
(Note: values are rounded)

6.75 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Return on Equity and
the Du Pont Approach
Return On Equity = Net profit margin X
Total asset turnover X
Equity Multiplier
Total Assets
Equity Multiplier =
Shareholders’ Equity
ROE2007 = 0.041 × 1.02 × 1.90 = 0.080
ROEIndustry = 0.082 × 1.17 × 1.88 = 0.180
(Note: values are rounded)
6.76 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Summary of Ratio Analysis

6.77 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Summary of the Profitability
Trend Analyses
 The profitability ratios for BW have ALL
been falling since 2005. Each has been
below the industry averages for the past
three years.
 This indicates that COGS and
administrative costs may both be too
high and a potential problem for BW.
 Note, this result is consistent with the low
interest coverage ratio.
6.78 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Summary of Ratio Analyses

 Inventories are too high.

 May be paying off creditors
(accounts payable) too soon.
 COGS may be too high.
 Selling, general, and
administrative costs may be too
high.

6.79 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Additional Analyses Tools
 Common-size analysis (Vertical
Anaysis)
- B/S- Total Asset
- I/S - Total sales
 Index analysis

6.80 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 self test (5,10,20)

A company has $20 billion of sales and $1 billion of

net income. Its total assets are $10 billion.
The company’s total assets equal total invested
capital, and its capital consists of half debt and half
common equity. The firm’s interest rate is 5%, and
its tax rate is 40%.
1. What is its profit margin?
2. What is its ROA?
3. What is its ROE?
4. Would the firm’s ROA INCREASES IF IT USED LESS LEVERAGE? ( THE SIZE OF THE
FIRM DONT CHANGE)

6.81 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Common-Size Analysis

An analysis of percentage
financial statements where all
balance sheet items are divided
by total assets and all income
statement items are divided by
net sales or revenues.

6.82 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Basket Wonders’ Common
Size Balance Sheets
Regular (thousands of $) Common-Size (%)
Assets 2005 2006 2007 2005 2006 2007
Cash 148 100 90 12.10 4.89 4.15
AR 283 410 394 23.14 20.06 18.17
Inv 322 616 696 26.33 30.14 32.09
Other CA 10 14 15 0.82 0.68 0.69
Tot CA 763 1,140 1,195 62.39 55.77 55.09
Net FA 349 631 701 28.54 30.87 32.32
LT Inv 0 50 50 0.00 2.45 2.31
Other LT 111 223 223 9.08 10.91 10.28
Tot Assets 1,223 2,044 2,169 100.0 100.0 100.0

6.83 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Basket Wonders’ Common-
Size Balance Sheets
Regular (thousands of $) Common-Size (%)
Liab+Equity 2005 2006 2007 2005 2006 2007
Note Pay 290 295 290 23.71 14.43 13.37
Acct Pay 81 94 94 6.62 4.60 4.33
Accr Tax 13 16 16 1.06 0.78 0.74
Other Accr 15 100 100 1.23 4.89 4.61
Tot CL 399 505 500 32.62 24.71 23.05
LT Debt 150 453 530 12.26 22.16 24.44
Equity 674 1,086 1,139 55.11 53.13 52.51
Tot L+E 1,223 2,044 2,169 100.0 100.0 100.0

6.84 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Basket Wonders’ Common-
Size Income Statements
Regular (thousands of $) Common-Size (%)
2005 2006 2007 2005 2006 2007
Net Sales 1,235 2,106 2,211 100.0 100.0 100.0
COGS 849 1,501 1,599 68.7 71.3 72.3
Gross Profit 386 605 612 31.3 28.7 27.7
Adm. 180 383 402 14.6 18.2 18.2
EBIT 206 222 210 16.7 10.5 9.5
Int Exp 20 51 59 1.6 2.4 2.7
EBT 186 171 151 15.1 8.1 6.8
EAT 112 103 91 9.1 4.9 4.1
Cash Div 50 50 50 4.0 2.4 2.3
6.85 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Index Analyses

An analysis of percentage financial

statements where all balance sheet
or income statement figures for a
base year equal 100.0 (percent) and
subsequent financial statement
items are expressed as percentages
of their values in the base year.
6.86 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Basket Wonders’
Indexed Balance Sheets
Regular (thousands of $) Indexed (%)
Assets 2005 2006 2007 2005 2006 2007
Cash 148 100 90 100.0 67.6 60.8
AR 283 410 394 100.0 144.9 139.2
Inv 322 616 696 100.0 191.3 216.1
Other CA 10 14 15 100.0 140.0 150.0
Tot CA 763 1,140 1,195 100.0 149.4 156.6
Net FA 349 631 701 100.0 180.8 200.9
LT Inv 0 50 50 100.0 inf. inf.
Other LT 111 223 223 100.0 200.9 200.9
Tot Assets 1,223 2,044 2,169 100.0 167.1 177.4

6.87 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Basket Wonders’
Indexed Balance Sheets
Regular (thousands of $) Indexed (%)
Liab+Equity 2005 2006 2007 2005 2006 2007
Note Pay 290 295 290 100.0 101.7 100.0
Acct Pay 81 94 94 100.0 116.0 116.0
Accr Tax 13 16 16 100.0 123.1 123.1
Other Accr 15 100 100 100.0 666.7 666.7
Tot CL 399 505 500 100.0 126.6 125.3
LT Debt 150 453 530 100.0 302.0 353.3
Equity 674 1,086 1,139 100.0 161.1 169.0
Tot L+E 1,223 2,044 2,169 100.0 167.1 177.4

6.88 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Basket Wonders’ Indexed
Income Statements
Regular (thousands of $) Indexed (%)
2005 2006 2007 2005 2006 2007
Net Sales 1,235 2,106 2,211 100.0 170.5 179.0
COGS 849 1,501 1,599 100.0 176.8 188.3
Gross Profit 386 605 612 100.0 156.7 158.5
Adm. 180 383 402 100.0 212.8 223.3
EBIT 206 222 210 100.0 107.8 101.9
Int Exp 20 51 59 100.0 255.0 295.0
EBT 186 171 151 100.0 91.9 81.2
EAT 112 103 91 100.0 92.0 81.3
Cash Div 50 50 50 100.0 100.0 100.0
6.89 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.