Introduction to Financial Analysis Case Study Example PDF

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This is a very detailed case study showing examples of how financial statements are created, along with formulas, explanations, and informative notes....

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Introduction to Financial Analysis Case Study Example

Table of Contents 1. Financial Statements - Start with a complete set of financial statements 2. Common Size Statements - Express the financials in terms of a common size for easy analysis

3. Ratio Analysis - Apply a complete set of ratios to the financial statements Industry Trend Analysis - Benchmark your performance horizontally against industry averages 4. ROI Model - Construct a model that explains the sources behind Return on Investment Cost of Capital - Calculate the weighted average cost of capital

5. Economic Analysis - Analyze a major investment using economic indicators 6. Sales Forecast - Prepare a sales forecast for the next annual year

Balance Sheet Year ending Year ending 12/31/2005 12/31/2006 ($ in thousands of dollars)

Assets Current Assets Cash Marketable Securities Accounts Receivable Inventories Total Current Assets

$

Long-Term Assets Property & Equipment at cost Less Accumulated Depreciation Net Property & Equipment Total Long-Term Assets TOTAL ASSETS

2,081 1,625 16,850 26,470 47,026

$

39,500 9,500 30,000 30,000

2,540 1,800 18,320 27,530 50,190

43,100 11,400 31,700 31,700

$

77,026

$

81,890

$

8,340 5,635 3,150 1,750 2,000 20,875

$

9,721 8,500 3,200 2,102 2,000 25,523

Liabilities Current Liabilities Accounts Payable Notes Payable @ 10% Taxes Payable Other Current Liabilities Current Portion of Longterm Debt Total Current Liabilities Long-Term Liabilities Mortgage Bonds @ 9.58% Total Long-Term Liabilities TOTAL LIABILITIES

24,000 24,000

22,000 22,000

$

44,875

$

47,523

$

13,000 10,000 9,151

$

13,000 10,000 11,367

$

32,151

$

34,367

Equity Common Stock Paid in Capital in excess of par value Retained Earnings TOTAL EQUITY

Income Statement Revenues

Year ending 12/31/2006 ($ in thousands of dollars)

Gross Sales Revenues Allowance for Sales Returned Net Sales Revenues TOTAL SALES

$

116,900 4,140 112,760 112,760

Expenses Cost of Goods Sold Gross Profits Operating Expenses: Selling & Marketing General Administrative Total Operating Expenses Operating Income

85,300 27,460

6,540 9,400 15,940 11,520

Interest Expenses: Interest on Loans Interest on Mortgage Bonds Total Interest Expenses

850 2,310 3,160

Earnings Before Taxes

8,360

Federal & State Taxes @ 40% NET INCOME

3,344 5,016

Introduction to Financial Analysis Common Size Financial Statements Vertical analysis of financial statements is most often performed by expressing the Balance Sheet and Income Statement as common size statements. We can easily understand the relationships between accounts when we express financials as a percentage of total balances.

Balance Sheet Year ending 12/31/2005

Assets

Year ending 12/31/2006

(% of Total Assets) Cash Marketable Securities Accounts Receivable Inventories Total Current Assets

2.70% 2.11% 21.88% 34.37% 61.05%

3.10% 2.20% 22.37% 33.62% 61.29%

Net Property & Equipment

38.95%

38.71%

100.00%

100.00%

Current Liabilities

27.10%

31.17%

Long-Term Liabilities

31.16%

26.87%

TOTAL LIABILITIES

58.26%

58.03%

TOTAL EQUITY

41.74%

41.97%

100.00%

100.00%

TOTAL ASSETS

Liabilities

Equity

TOTAL LIABILITIES & EQUITY

Key Points per Review of the Common Size Balance Sheet: 1 The company is fairly liquid since current assets are 61% of total assets. 2 About 55% of all assets are tied up in either Accounts Receivable or Inventories. Therefore, it is very important to effectively manage these two assets on the Balance Sheet. 3 The company does not appear to be too overly leveraged in debt with a debt leverage below 60%

Income Statement Year ending 12/31/2006 (% of Total Net Sales) NET SALES

100.00%

Cost of Goods Sold

75.65% Gross Margin

Operating Expense

24.35% 14.14%

Operating Margin Interest Expense

10.22% 2.80%

Earnings Before Taxes Tax Expense

7.41% 2.97%

NET INCOME

4.45%

Key Points per Review of the Common Size Income Statement: 1 Cost of products sold represents 75% of all costs the company incurs 2 Operating costs appear to be modest at 14% 3 Return on Sales is rather low at 4.45%

Introduction to Financial Analysis Ratio Analysis A complete set of ratios is probably the best analytical approach to evaluating the financial strengths and weaknesses of a company. Year ending Liquidity Ratios 12/31/2006 1. Current Ratio = Current Assets / Current Liabilities

1.97

2. Acid Test or Quick Ratio = (Current Assets - Inventories - Prepaid Expenses) / Current Liabilities

0.89

3. Operating Cash Flow to Current Liabilities

0.45

Asset Management Ratios 4. Accounts Receivable Turnover = Annual Credit Sales / Average Receivable Balance 5. Accounts Receivable Collection = 360 Days / Accounts Receivable Turnover 6. Inventory Turnover = Cost of Goods Sold / Average Inventory 7. Days Held in Inventory = 360 Days / Inventory Turnover

6.41

56.14 3.16 113.95

8. Fixed Asset Turnover = Sales / Average Net Fixed Assets

3.66

9. Total Asset Turnover = Sales / Average Total Assets

1.42

Leverage Ratios 10. Debt Ratio = Total Debt / Total Assets

0.58

11. Debt to Equity Ratio = Total Debt / Total Equity

1.38

12. Times Interest Earned = Earnings Before Interest and Taxes / Interest

3.65

Profitability Ratios 13. Gross Profit or Margin = (Sales - Cost of Goods Sold) / Sales

0.24

14. Operating Income Ratio = Operating Income / Sales

0.10

15. Return on Sales = Earnings after Taxes / Sales

0.04

16. Return on Investment = Earnings after Taxes / Average Total Assets

0.06

17. Return on Equity = Earnings after Taxes / Average Owners Equity

0.22

Introduction to Financial Analysis Industry Trend Analysis Compare the company performance against benchmark data for the overall industry. Where practical, try to plot performance over long periods of time, such as five years to identify trends. 1. Current Ratio Comparison - 5 Years

Company Industry

2002 1.97 1.86

2003 1.94 1.88

2004 1.82 1.80

2005 1.91 1.84

2006 1.97 1.88

Current Ratio 2.00 1.95 Ratio

1.90

Company

1.85

Industry

1.80 1.75 1.70 2002

2003

2004

2005

2006

Year

2. Acid Test or Quick Ratio Comparison - 5 Years

Company Industry

2002 0.83 0.80

2003 0.79 0.83

2004 0.77 0.81

2005 0.81 0.77

2006 0.89 0.79

Ratio

Acid Test Ratio 0.90 0.88 0.86 0.84 0.82 0.80 0.78 0.76 0.74 0.72 0.70

Company Industry

2002

2003

2004 Year

2005

2006

3. Accounts Receivable Turnover Comparison - 5 Years

Company Industry

2002 6.79 7.07

2003 6.71 7.01

2004 6.58 6.98

2005 6.34 6.84

2006 6.41 6.91

Ratio

Receivable Turnover Ratio 7.20 7.00 6.80 6.60 6.40 6.20 6.00 5.80

Company Industry

2002

2003

2004

2005

2006

Year

4. Accounts Receivable Collection Comparison - 5 Years

Company Industry

2002 51.30 47.26

2003 52.41 48.33

2004 55.73 49.02

2005 57.08 51.44

2006 56.14 50.62

Days

Receivable Collection in Days 58.00 56.00 54.00 52.00 50.00 48.00 46.00 44.00 42.00 40.00

Company Industry

2002

2003

2004 Year

5. Inventory Turnover Comparison - 5 Years

2005

2006

Company Industry

2002 3.96 3.80

2003 3.44 3.69

2004 3.72 3.74

2005 3.09 3.97

2006 3.16 3.88

Ratio

Inventory Turnover Ratio 4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00

Company Industry

2002

2003

2004

2005

2006

2005 117.33 111.00

2006 113.95 106.00

Year

6. Days Held in Inventory Comparison - 5 Years

Company Industry

2002 109.77 108.00

2003 111.08 114.00

2004 116.20 102.00

Days Held in Inventory 120.00 115.00 Days

110.00

Company

105.00

Industry

100.00 95.00 90.00 2002

2003

2004

2005

2006

Year

7. Total Asset Turnover Comparison - 5 Years

Company Industry

2002 1.61 1.70

2003 1.55 1.62

2004 1.39 1.68

2005 1.48 1.59

2006 1.42 1.55

Ratio

Total Asset Turnover Ratio 1.80 1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00

Company Industry

2002

2003

2004

2005

2006

2005 0.64 0.72

2006 0.58 0.69

Year

8. Debt Ratio Comparison - 5 Years

Company Industry

2002 0.61 0.65

2003 0.67 0.61

2004 0.51 0.63

Ratio

Debt Ratio 0.75 0.70 0.65 0.60 0.55 0.50 0.45 0.40 0.35 0.30

Company Industry

2002

2003

2004

2005

2006

2005 1.33 1.44

2006 1.38 1.50

Year

9. Debt to Equity Ratio Comparison - 5 Years

Company Industry

2002 1.36 1.40

2003 1.30 1.48

2004 1.44 1.41

Debt to Equity Ratio 1.60

1.60 1.50 Ratio

1.40

Company

1.30

Industry

1.20 1.10 1.00 2002

2003

2004

2005

2006

2005 0.28 0.28

2006 0.24 0.29

Year

10. Gross Profit or Margin Comparison - 5 Years

Company Industry

2002 0.29 0.22

2003 0.31 0.28

2004 0.23 0.20

Margin

Gross Profit Margin 0.34 0.32 0.30 0.28 0.26 0.24 0.22 0.20 0.18

Company Industry

2002

2003

2004

2005

2006

2005 0.14 0.11

2006 0.10 0.13

Year

11. Operating Income Ratio Comparison - 5 Years

Company Industry

2002 0.07 0.14

2003 0.11 0.08

2004 0.08 0.09

rgin

Operating Margin 0.15 0.14 0.13 0.12 0.11 0 10

Company

Mar

0.10 0.09 0.08 0.07 0.06 0.05

Industry

2002

2003

2004

2005

2006

Year

12. Return on Sales Comparison - 5 Years

Company Industry

2002 0.06 0.07

2003 0.05 0.08

2004 0.07 0.05

2005 0.04 0.06

2006 0.04 0.05

Return

Return on Sales 0.10 0.09 0.08 0.07 0.06 0.05 0.04 0.03

Company Industry

2002

2003

2004

2005

2006

2005 0.10 0.09

2006 0.06 0.08

Year

13. Return on Investment Comparison - 5 Years

Company Industry

2002 0.09 0.07

2003 0.06 0.11

2004 0.07 0.10

Return

Return on Investment 0.15 0.14 0.13 0.12 0.11 0.10 0.09 0.08 0.07 0.06 0 05

Company Industry

0.05 2002

2003

2004

2005

2006

2005 0.19 0.26

2006 0.22 0.29

Year

14. Return on Equity Comparison - 5 Years

Company Industry

2002 0.22 0.28

2003 0.20 0.22

2004 0.24 0.23

Return

Return on Equity 0.32 0.30 0.28 0.26 0.24 0.22 0.20 0.18

Company Industry

2002

2003

2004 Year

2005

2006

Introduction to Financial Analysis Return on Investment (ROI) Model Given the importance of returns on investments, it is useful to structure a model that explains the root drivers behind returns: Return on Capital invested by Owners Return on Equity 14.60% Convert ROI on Assets to ROI for Equity

Total Assets to Shareholder Equity 2.383

Return on Investments in Assets

Return on Investment 6.13%

Two Drivers behind ROI on Assets

Total Asset Turnover

Profit Margin 4.45% Three Lower Drivers

Sales

Net Income $

Lowest Level - Accounts in Financial Statements

1.38

5,016

$ 112,760

Total Assets $ 81,890

Income Statement

Balance Sheet

Breakdown of all major expense accounts

Breakdown of all asset accounts

Introduction to Financial Analysis Cost of Capital Calculation Cost of Capital is an important benchmark by which you should evaluate long term investments. 1. Identify the interest bearing debt on the Balance Sheet: Notes Payable @ 10% Mortgage Bonds @ 9.58% 2. Calculate the effective rate by deducting out the tax rate since interest is deductible: Tax Rate per Balance Sheet Notes Payable @ 10% Mortgage Bonds @ 9.58%

40.00% 10.00% 9.58%

6.00% 5.75%

60.00% 60.00%

3. Calculate the cost of equity using the Capital Asset Pricing Model: a. Risk Free Rate of Return - 10 Year Treasury Bonds b. Beta Risk Factor for Stock of Company c. Market Portfolio Returns Rate of Return for Stock

3.50% 1.22 13.50% 15.70%

4. Assign market values to each of the components of capital and calculate the Weighted Average Cost of Capital:

Notes Payable Mortagage Bonds Stock (Equity)

Cost of Market Capital Values 6.00% $ 6,000 5.75% $ 15,000 15.70% $ 45,000 $ 66,000

Percents 9% 23% 68% 100%

Weighted Cost of Cap 0.55% 1.31% 10.70% 12.56%

Investments need to generate a rate greater than

Introduction to Financial Analysis Economic Analysis Long term investments should be evaluated using economic analysis. This will involve estimating the discounted cash flows of the investment. During the year, an investment was made in Property & Equipment

$

3,600

Evaluate the economics of this investment as follows: 1 Determine the useful life of the investment >

10 Years

2 Cash flow outlays and benefits from this investment are:

Initial cash outlay to acquire and install Cash outlays to operate and maintain Cash benefit - higher efficiencies Cash benefit - costs avoided Cash benefit - increased sales Net Cost or Benefit

Year 0 -3,600

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

-3,600

-30 400 300 500 1,170

-25 400 300 500 1,175

-20 400 150 600 1,130

-20 420 100 600 1,100

-20 420 50 600 1,050

-15 420 50 600 1,055

-15 430 50 650 1,115

-15 430 50 650 1,115

-15 450 50 650 1,135

-15 450 50 650 1,135

Present Value Interest Factor

1.0000

0.8884

0.7893

0.7013

0.6230

0.5535

0.4918

0.4369

0.3882

0.3449

0.3064

Discounted Amounts 4 Summarize your results using economic indicators a. Key Economic Indicator is NPV >

-3,600

1,039

927

792

685

581

519

487

433

391

348

Total -3,600 -190 4,220 1,150 6,000 7,580

3 Calculate the discounted cash flows for this investment Cost of Capital Rate > 12.56%

You can also use this formula for NPV which yields a more conservative value > b.Another Key Economic Indicator is Rate of Return >

2,604

Net Present Value

Rate to use for reinvestment of residual cash flows >

5% Rate of Return

c. A third economic indicator is discounted payback period - How long does it take before you recover your investment? -2,561 -1,633 -841 -155 426 < In Year 5 we reach payback of our investment

Conclusion: This investment creates positive value for the company, has an estimated rate of return higher than the cost of capital, and reaches payback mid way in the useful life of the asset. Based on these economic indicators, this appears to be a good investment.

2,314 14.62%

Introduction to Financial Analysis Sales Forecast and Forecasted Income Statement Once you have a clear indication of past financial performance, then you can forecast future financial performance. This usually starts with Sales and the Income Statement. A simple example appears below: Step 1 - Determine the expected demand for your products and services next year Historical demand for products are summarized below:

Product

Units Sold in Yr 2005

Lectin Protela Sucula

3,020 2,005 880

Units Sold in Yr 2006 3,305 2,180 1,080

Units Sold in Yr 2007 3,710 2,380 1,410

Step 2 - Determine the expected pricing for your products and services next year Based on competitive analysis and interviews with marketing staff, the following sales prices will be applied in Year 2008: Product Lectin Protela Sucula

Price $ $ $

14.50 17.30 11.20

Step 3 - Calculate total expected sales for the year 3.1 Estimated Sales by Product based on average growth:

Product Lectin Protela Sucula

% Growth in 2006 9.44% 8.73% 22.73%

% Growth in 2007 12.25% 9.17% 30.56%

Average Growth 10.85% 8.95% 26.64%

Expected Sales

Sales Price

Estimated Sales Amt

4,112 $ 14.50 $ 2,593 $ 17.30 $ 1,786 $ 11.20 $ Total $

59,629 44,860 19,999 124,488

3.2 Identify an...