Financial Statement Analysis

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1. Financial Accounting
Lecture 07: Financial Statement Analysis
Chapter
19
Masud Jahan
Department of Science and Humanities
Military Institute of Science and Technology

2. Financial statement analysis helps users
make better decisions.
Purpose of Analysis
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Internal Users External Users
Shareholders
Lenders
Customers
Managers
Officers
Internal Auditors

3. A ratio is simply the
relationship between
two numbers.
The large money
amounts reported on the
financial statements of
many companies, and the
varying size of
Purpose of Analysis
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many companies, and the
varying size of
companies, make ratio
analysisthe only sensible
method of evaluating
various financial
characteristics.

4. Learning Objective
To prepare a classified
balance sheet and
compute widely used
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compute widely used
measures of liquidity
and credit risk.
LO1

5. Current assets:
Cash 30,000$
Notes receivable 16,000
Accounts receivable 60,000
Inventory 70,000
Babson Builders, Inc.
Balance Sheet
December 31, 2007
Asset Section of the Balance SheetAsset Section of the Balance Sheet
A Classified Balance Sheet
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Inventory 70,000
Prepaid expenses 4,000
Total current assets 180,000
Plant and equipment:
Land 150,000$
Building 121,000$
Less: Accumulated depreciation (10,000) 111,000
Equipment and Fixtures 46,000
Less: Accumulated depreciation (27,000) 19,000
Total plant and equipment 280,000
Other assets:
Patents 170,000
Total assets 630,000$

6. Current liabilities
Notes payable 10,000$
Accounts payable 62,000
Income taxes payable 16,000
Accrued expenses payable 8,000
Total current liabilities 4,000
Long-term liabilities: 100,000
Liability and Stockholders’ Equity Section of the Balance SheetLiability and Stockholders’ Equity Section of the Balance Sheet
A Classified Balance Sheet (cont.)
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Long-term liabilities: 100,000
Mortgage payable (due in 25 years) 65,000$
Bonds payable (due in 15 years) 100,000
Total long-term liabilities 165,000
Total liabilities 265,000
Stockholders' equity
Capital stock (15,000 shares) 15,000$
Retained earnings 350,000
Total stockholders' equity 365,000
Total liabilities and stockholders' equity 630,000$

7. Working capitalis the excess of current
assets over current liabilities. The result
of this calculation must be a positive
number
Working Capital
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12/31/07
Current assets 180,000$
Current liabilities(100,000)
Working capital 80,000$

8. This ratio measures the ability
of the company to pay current
debts as they become due.
As a rule of thumb, a current ratio
of 2.0 is considered indicative of
Current Ratio
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Current
Ratio
Current Assets
Current Liabilities
=
= 1.8 : 11.8 : 1
of 2.0 is considered indicative of
adequate liquidity.
Current
Ratio
$180,000
$100,000
=

9. Quick Assets
Current Liabilities
=
Acid-Test
Ratio
Quick assets are Cash
(including temporary cash
investments) and Accounts
Quick Ratio
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investments) and Accounts
Receivable.
This ratio provides information about an almost worst-case
situation—the firm’s ability to meet its current obligations
even if none of the inventory can be sold.
As a rule of thumb, an acid-test ratio of 1.0 is considered
indicative of adequate liquidity.

10. Quick Assets
Current Liabilities
=
Quick
Ratio
$106,000
=1.06 : 11.06 : 1=
Quick
Quick Ratio
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This ratio is like the currentThis ratio is like the current
ratio but excludes current assets ratio but excludes current assets
such as inventories that may be such as inventories that may be
difficult to quickly convert into cash. difficult to quickly convert into cash.
$106,000
$100,000
=1.06 : 11.06 : 1=
Quick
Ratio

11. Learning Objective
To prepare a multiple-step
income statement and
compute widely used
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compute widely used
measures of profitability.
LO2

12. Babson Builders, Inc.
Income Statement
For the Year Ended 12/31/07
Sales, net 785,250$
Cost of goods sold 351,800
Gross margin 433,450$
Operating expenses:
Selling expenses 197,350$
Proper HeadingProper Heading
Gross MarginGross Margin
Income Statement (Multiple-Step)
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Selling expenses 197,350$
General & Admin. 78,500
Depreciation 17,500 293,350
Income from Operations 140,100$
Other revenues & gains:
Dividend income 62,187$
Gain on sale of plant assets 24,600 86,787
Other expenses:
Loss: sale of investment 9,000 (9,000)
Income before taxes 217,887$
Income taxes 62,500
Net income 155,387$
Operating ExpensesOperating Expenses
NonNon--operating Itemsoperating Items

13. This ratio is the percentage of sales
money left after subtracting the cost
of goods sold from net sales. It
measures the percentage of sales
money remaining (after obtaining or
manufacturing the goods sold)
Gross Margin Ratio
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manufacturing the goods sold)
available to pay the overhead
expenses of the company.
Gross Margin
Ratio
Gross Profit
Net Sales
=
$ 433,450
$ 785,250
= 55.20%55.20%
Gross Margin
Ratio
=

14. Net Income
Net Sales
=
Profit
Margin
$140,100
=17.84%17.84%=
Profit
Net Profit Margin Ratio
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This ratio is the percentage of sales money left This ratio is the percentage of sales money left
after subtracting the Cost of Goods sold and all after subtracting the Cost of Goods sold and all
expenses, except income taxes. It provides a expenses, except income taxes. It provides a
good opportunity to compare your company's good opportunity to compare your company's
"return on sales" with the performance of other "return on sales" with the performance of other
companies in your industrycompanies in your industry
$140,100
$785,250
=17.84%17.84%=
Profit
Margin

15. Learning Objective
To analyze financial
statements from the
viewpoints of owners,
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viewpoints of owners,
creditors, and others.
LO3

16. Measures how efficiently assets are used to
generate sales.
Assets Turnover
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Assets
Turnover
=Net sales ÷ Average total assets
= 53,690$ ÷($300,000 + $346,390) ÷ 2
= 16.61%
Assets
Turnover
=Net sales ÷ Average total assets
= 630,000$ ÷($300,000 + $346,390) ÷ 2
= 1.95Times

17. This ratio describes the rate of return
management was able to earn on the assets
that it had available during the year.
An informed judgment about the firm’s
profitability requires relating net income to
Return On Assets (ROA)
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ROA =Net income ÷ Average total assets
= 53,690$ ÷($300,000 + $346,390) ÷ 2
= 16.61%
profitability requires relating net income to
the assets used to generate that net income.
ROA =Net income ÷ Average total assets
= 53,690$ ÷($300,000 + $346,390) ÷ 2
= 16.61%

18. This measure indicates how well the
company employed the owners’
investments to earn income.
Return On Equity (ROE)
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ROE =Net income ÷ Average total equity
= 53,690$ ÷($180,000 + $234,390) ÷ 2
= 25.91%

19. Use this information to calculate ratios Use this information to calculate ratios
to measure the wellto measure the well--being of the longbeing of the long--
term creditors for Babson Builders.term creditors for Babson Builders.
Analysis by Long-Term Creditors
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Babson Builders, Inc.
2007
Net operating income 84,000$
Total assets 346,390
Total stockholders' equity 234,390
Total liabilities 112,000

20. A measure of creditor’s long-term risk.
The smaller the percentage of assets that
are financed by debt, the smaller the risk
for creditors.
Debt (to total assets) Ratio
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Debt
Ratio
=
Total
Liabilities
÷Total Assets
for creditors.
Debt
Ratio
=
Total
Liabilities
÷Total Assets
= $112,000 ÷$346,390
= 32.33%

21. Babson Builders, Inc.
2007
Cash 30,000$
Accounts receivable, net
Beginning of year 17,000
Use this Use this
information to information to
calculate ratios to calculate ratios to
measure the wellmeasure the well--
Analysis by Short-Term Creditors
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Beginning of year 17,000
End of year 20,000
Inventory
Beginning of year 10,000
End of year 12,000
Total current assets 65,000
Total current liabilities 42,000
Sales on account 500,000
Cost of goods sold 140,000
measure the wellmeasure the well--
being of the being of the shortshort--
term creditorsterm creditorsfor for
Babson Builders, Babson Builders,
Inc.Inc.

22. Net Credit Sales
AverageAccounts Receivable
Accounts
Receivable
Turnover
=
Accounts
Accounts Receivable Turnover Rate
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This ratio measures how many This ratio measures how many
times a company converts its times a company converts its
receivables into cash each year.receivables into cash each year.
= 27.03 times27.03 times
$500,000
($17,000 + $20,000) ÷2
Accounts
Receivable
Turnover
=

23. Average
Collection
Period
=
365 Days
Accounts Receivable Turnover
Average
Number of Days to Collect Receivables
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This ratio measures, on average, This ratio measures, on average,
how many days it takes to collect how many days it takes to collect
an account receivable. an account receivable.
= 13.50 days13.50 days
Average
Collection
Period
=
365 Days
27.03 Times

24. Cost of Goods Sold
AverageInventory
Inventory
Turnover
=
$140,000Inventory
Inventory Turnover Rate
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This ratio measures the numberThis ratio measures the number
of times merchandise inventoryof times merchandise inventory
is sold and replaced during the year.is sold and replaced during the year.
= 12.73 times12.73 times
$140,000
($10,000 + $12,000) ÷2
Inventory
Turnover
=

25. Average
Sale Period
=
365 Days
Inventory Turnover
Average 365 Days
Average Days Sales In Inventory
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This ratio measures how many This ratio measures how many
days, on average, it takes to days, on average, it takes to
sell the inventory.sell the inventory.
= 28.67 days28.67 days
Average
Sale Period
=
365 Days
12.73 Times

26. Ratios help users
Uses
Management may enter
Limitations
Uses and Limitations of Financial Ratios
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Ratios help users
understand
financial relationships.
Ratios provide for
quick comparison
of companies.
Management may enter
into transactions merely
to improve the ratios.
Ratios do not help with
analysis of the company's
progress toward
nonfinancial goals.

27. End of Lecture 07
THANK YOU ALL…THANK YOU ALL…