Introduction to Financial AnalysisCase Study Example

This workbook summarizes many of the concepts that are taught in the course: Introduction to FinancialAnalysis. Information about this course and other free resources can be found at: www.exinfm.com

Table of Contents

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Financial Statements - Start with a complete set of financial statementsCommon Size Statements - Express the financials in terms of a common size for easy analysisRatio Analysis - Apply a complete set of ratios to the financial statementsIndustry Trend Analysis - Benchmark your performance horizontally against industry averagesROI Model - Construct a model that explains the sources behind Return on InvestmentCost of Capital - Calculate the weighted average cost of capitalEconomic Analysis - Analyze a major investment using economic indicatorsSales Forecast - Prepare a sales forecast for the next annual year

This workbook is used in conjunction with a course that is subject to copyright protection. You may print, download and use this workbook for your own personal use in conjunction with this course. You may not reproduce or redistribute this workbook without first obtaining the express permission of the author: Matt H. Evans, CPA, CMA, CFMEmail: matt@exinfm.comPhone: 1-877-807-8756

This workbook summarizes many of the concepts that are taught in the course: Introduction to Financial

Common Size Statements - Express the financials in terms of a common size for easy analysis

Industry Trend Analysis - Benchmark your performance horizontally against industry averagesROI Model - Construct a model that explains the sources behind Return on Investment

Balance Sheet

Year ending Year ending12/31/2005 12/31/2006

Assets ($ in thousands of dollars)Current Assets

Cash $ 2,081 $ 2,540 Marketable Securities 1,625 1,800Accounts Receivable 16,850 18,320Inventories 26,470 27,530

Total Current Assets 47,026 50,190

Long-Term AssetsProperty & Equipment at cost 39,500 43,100Less Accumulated Depreciation 9,500 11,400Net Property & Equipment 30,000 31,700

Total Long-Term Assets 30,000 31,700

TOTAL ASSETS $ 77,026 $ 81,890

LiabilitiesCurrent Liabilities

Accounts Payable $ 8,340 $ 9,721 Notes Payable @ 10% 5,635 8,500Taxes Payable 3,150 3,200Other Current Liabilities 1,750 2,102Current Portion of Longterm Debt 2,000 2,000

Total Current Liabilities 20,875 25,523

Long-Term LiabilitiesMortgage Bonds @ 9.58% 24,000 22,000

Total Long-Term Liabilities 24,000 22,000

TOTAL LIABILITIES $ 44,875 $ 47,523

Equity

Common Stock $ 13,000 $ 13,000 Paid in Capital in excess of par value 10,000 10,000Retained Earnings 9,151 11,367

TOTAL EQUITY $ 32,151 $ 34,367

Income StatementYear ending

12/31/2006Revenues ($ in thousands of dollars)

Gross Sales Revenues $ 116,900 Allowance for Sales Returned 4,140 Net Sales Revenues 112,760

TOTAL SALES 112,760

ExpensesCost of Goods Sold 85,300

Gross Profits 27,460

Operating Expenses:Selling & Marketing 6,540General Administrative 9,400

Total Operating Expenses 15,940

Operating Income 11,520

Interest Expenses:Interest on Loans 850Interest on Mortgage Bonds 2,310

Total Interest Expenses 3,160

Earnings Before Taxes 8,360

Federal & State Taxes @ 40% 3,344

NET INCOME 5,016

Introduction to Financial AnalysisCommon Size Financial Statements

Vertical analysis of financial statements is most often performed by expressing the Balance Sheet andIncome Statement as common size statements. We can easily understand the relationships betweenaccounts when we express financials as a percentage of total balances.

Balance Sheet

Year ending Year ending12/31/2005 12/31/2006

Assets (% of Total Assets)

Cash 2.70% 3.10%Marketable Securities 2.11% 2.20%Accounts Receivable 21.88% 22.37%Inventories 34.37% 33.62%

Total Current Assets 61.05% 61.29%

Net Property & Equipment 38.95% 38.71%

TOTAL ASSETS 100.00% 100.00%

Liabilities

Current Liabilities 27.10% 31.17%

Long-Term Liabilities 31.16% 26.87%

TOTAL LIABILITIES 58.26% 58.03%

Equity

TOTAL EQUITY 41.74% 41.97%

TOTAL LIABILITIES & EQUITY 100.00% 100.00%

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 ending12/31/2006

(% of Total Net Sales)

NET SALES 100.00% Cost of Goods Sold 75.65%

Gross Margin 24.35%

Operating Expense 14.14%

Operating Margin 10.22%

Interest Expense 2.80%

Earnings Before Taxes 7.41%

Tax Expense 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 incurs2 Operating costs appear to be modest at 14%3 Return on Sales is rather low at 4.45%

Introduction to Financial AnalysisRatio Analysis

A complete set of ratios is probably the best analytical approach to evaluating the financial strengths andweaknesses of a company.

Year endingLiquidity Ratios 12/31/2006

1. Current Ratio = Current Assets / Current Liabilities 1.97

2. Acid Test or Quick Ratio = (Current Assets - Inventories - PrepaidExpenses) / Current Liabilities 0.89

3. Operating Cash Flow to Current Liabilities 0.45

Asset Management Ratios

4. Accounts Receivable Turnover = Annual Credit Sales / AverageReceivable Balance 6.41

5. Accounts Receivable Collection = 360 Days / Accounts Receivable Turnover 56.14

6. Inventory Turnover = Cost of Goods Sold / Average Inventory 3.16

7. Days Held in Inventory = 360 Days / Inventory Turnover 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

A complete set of ratios is probably the best analytical approach to evaluating the financial strengths and

Introduction to Financial AnalysisIndustry Trend Analysis

Compare the company performance against benchmark data for the overall industry. Where practical, tryto plot performance over long periods of time, such as five years to identify trends.

1. Current Ratio Comparison - 5 Years

2002 2003 2004 2005 2006Company 1.97 1.94 1.82 1.91 1.97Industry 1.86 1.88 1.80 1.84 1.88

2. Acid Test or Quick Ratio Comparison - 5 Years

2002 2003 2004 2005 2006Company 0.83 0.79 0.77 0.81 0.89Industry 0.80 0.83 0.81 0.77 0.79

2002 2003 2004 2005 20061.70

1.75

1.80

1.85

1.90

1.95

2.00

Current Ratio

CompanyIndustry

Year

Ratio

2002 2003 2004 2005 20060.70

0.74

0.78

0.82

0.86

0.90

Acid Test Ratio

CompanyIndustry

Year

Ratio

3. Accounts Receivable Turnover Comparison - 5 Years

2002 2003 2004 2005 2006Company 6.79 6.71 6.58 6.34 6.41Industry 7.07 7.01 6.98 6.84 6.91

4. Accounts Receivable Collection Comparison - 5 Years

2002 2003 2004 2005 2006Company 51.30 52.41 55.73 57.08 56.14Industry 47.26 48.33 49.02 51.44 50.62

5. Inventory Turnover Comparison - 5 Years

2002 2003 2004 2005 2006Company 3.96 3.44 3.72 3.09 3.16Industry 3.80 3.69 3.74 3.97 3.88

2002 2003 2004 2005 20065.80

6.00

6.20

6.40

6.60

6.80

7.00

7.20

Receivable Turnover Ratio

CompanyIndustry

Year

Ratio

2002 2003 2004 2005 200640.0042.0044.0046.0048.0050.0052.0054.0056.0058.00

Receivable Collection in Days

CompanyIndustry

Year

Days

2002 2003 2004 2005 20060.000.501.001.502.002.503.003.504.004.50

Inventory Turnover Ratio

CompanyIndustry

Year

Ratio

6. Days Held in Inventory Comparison - 5 Years

2002 2003 2004 2005 2006Company 109.77 111.08 116.20 117.33 113.95Industry 108.00 114.00 102.00 111.00 106.00

7. Total Asset Turnover Comparison - 5 Years

2002 2003 2004 2005 2006Company 1.61 1.55 1.39 1.48 1.42Industry 1.70 1.62 1.68 1.59 1.55

2002 2003 2004 2005 20060.000.501.001.502.002.503.003.504.004.50

Inventory Turnover Ratio

CompanyIndustry

Year

Ratio

2002 2003 2004 2005 200690.00

95.00

100.00

105.00

110.00

115.00

120.00

Days Held in Inventory

CompanyIndustry

Year

Days

2002 2003 2004 2005 20060.000.200.400.600.801.001.201.401.601.80

Total Asset Turnover Ratio

CompanyIndustry

Year

Ratio

8. Debt Ratio Comparison - 5 Years

2002 2003 2004 2005 2006Company 0.61 0.67 0.51 0.64 0.58Industry 0.65 0.61 0.63 0.72 0.69

9. Debt to Equity Ratio Comparison - 5 Years

2002 2003 2004 2005 2006Company 1.36 1.30 1.44 1.33 1.38Industry 1.40 1.48 1.41 1.44 1.50

2002 2003 2004 2005 20060.000.200.400.600.801.001.201.401.601.80

Total Asset Turnover Ratio

CompanyIndustry

Year

Ratio

2002 2003 2004 2005 20060.300.350.400.450.500.550.600.650.700.75

Debt Ratio

CompanyIndustry

Year

Ratio

2002 2003 2004 2005 20061.00

1.10

1.20

1.30

1.40

1.50

1.60

Debt to Equity Ratio

CompanyIndustry

Year

Ratio

10. Gross Profit or Margin Comparison - 5 Years

2002 2003 2004 2005 2006Company 0.29 0.31 0.23 0.28 0.24Industry 0.22 0.28 0.20 0.28 0.29

11. Operating Income Ratio Comparison - 5 Years

2002 2003 2004 2005 2006Company 0.07 0.11 0.08 0.14 0.10Industry 0.14 0.08 0.09 0.11 0.13

2002 2003 2004 2005 20061.00

1.10

1.20

1.30

1.40

1.50

1.60

Debt to Equity Ratio

CompanyIndustry

Year

Ratio

2002 2003 2004 2005 20060.180.200.220.240.260.280.300.320.34

Gross Profit Margin

CompanyIndustry

Year

Mar

gin

2002 2003 2004 2005 20060.05

0.07

0.09

0.11

0.13

0.15

Operating Margin

CompanyIndustry

Year

Mar

gin

12. Return on Sales Comparison - 5 Years

2002 2003 2004 2005 2006Company 0.06 0.05 0.07 0.04 0.04Industry 0.07 0.08 0.05 0.06 0.05

13. Return on Investment Comparison - 5 Years

2002 2003 2004 2005 2006Company 0.09 0.06 0.07 0.10 0.06Industry 0.07 0.11 0.10 0.09 0.08

14. Return on Equity Comparison - 5 Years

2002 2003 2004 2005 2006Company 0.22 0.20 0.24 0.19 0.22Industry 0.28 0.22 0.23 0.26 0.29

2002 2003 2004 2005 20060.03

0.04

0.05

0.06

0.07

0.08

0.09

0.10

Return on Sales

CompanyIndustry

Year

Ret

urn

2002 2003 2004 2005 20060.05

0.07

0.09

0.11

0.13

0.15

Return on Investment

CompanyIndustry

Year

Ret

urn

2002 2003 2004 2005 20060.18

0.20

0.22

0.24

0.26

0.28

0.30

0.32

Return on Equity

CompanyIndustry

Year

Ret

urn

Compare the company performance against benchmark data for the overall industry. Where practical, try

Introduction to Financial AnalysisReturn 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 OwnersReturn on Equity

14.60%Convert ROI on Assets to ROI for Equity

2.383Return on Investments in Assets

6.13%Two Drivers behind ROI on Assets

Profit Margin

4.45% 1.38 Three Lower

Net Income Sales Total AssetsDrivers

$ 5,016 $112,760 $ 81,890

Lowest Level - Accountsin Financial Statements Income Statement Balance Sheet

Breakdown of all Breakdown of allmajor expense accounts asset accounts

Total Assets to Shareholder Equity

Return on Investment

Total Asset Turnover

Introduction to Financial AnalysisCost 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 40.00%Notes Payable @ 10% 10.00% 60.00% 6.00%Mortgage Bonds @ 9.58% 9.58% 60.00% 5.75%

3. Calculate the cost of equity using the Capital Asset Pricing Model:

a. Risk Free Rate of Return - 10 Year Treasury Bonds 3.50%b. Beta Risk Factor for Stock of Company 1.22c. Market Portfolio Returns 13.50%

Rate of Return for Stock 15.70%

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

Cost of Market WeightedCapital Values Percents Cost of Cap

Notes Payable 6.00% $ 6,000 9% 0.55%Mortagage Bonds 5.75% $ 15,000 23% 1.31%Stock (Equity) 15.70% $ 45,000 68% 10.70%

$ 66,000 100% 12.56%

Investments need to generate a rate greater than

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

Introduction to Financial AnalysisEconomic Analysis

Long term investments should be evaluated using economic analysis. This will involve estimating thediscounted 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:Year Year Year

0 1 2Initial cash outlay to acquire and install -3,600Cash outlays to operate and maintain -30 -25Cash benefit - higher efficiencies 400 400Cash benefit - costs avoided 300 300Cash benefit - increased sales 500 500

Net Cost or Benefit -3,600 1,170 1,175

3 Calculate the discounted cash flows for this investmentCost of Capital Rate > 12.56% Present Value Interest Factor 1.0000 0.8884 0.7893

Discounted Amounts -3,600 1,039 9274 Summarize your results using economic indicators

a. Key Economic Indicator is NPV >

b. Another Key Economic Indicator is 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

Conclusion: This investment creates positive value for the company, has an estimated rate of returnhigher 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.

Year Year Year Year Year Year Year Year3 4 5 6 7 8 9 10 Total

-3,600-20 -20 -20 -15 -15 -15 -15 -15 -190400 420 420 420 430 430 450 450 4,220150 100 50 50 50 50 50 50 1,150600 600 600 600 650 650 650 650 6,000

1,130 1,100 1,050 1,055 1,115 1,115 1,135 1,135 7,580

0.7013 0.6230 0.5535 0.4918 0.4369 0.3882 0.3449 0.3064

792 685 581 519 487 433 391 348 2,604

Net Present Value

You can also use this formula for NPV which yields a more conservative value > 2,314

Rate to use for reinvestment of residual cash flows > 5% Rate of Return 14.62%

A third economic indicator is discounted payback period - How long does it take before you recover your investment?-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 returnhigher than the cost of capital, and reaches payback mid way in the useful life of the asset.

Introduction to Financial AnalysisSales Forecast and Forecasted Income Statement

Once you have a clear indication of past financial performance, then you can forecast future financialperformance. 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:

Units Sold Units Sold Units Sold Product in Yr 2005 in Yr 2006 in Yr 2007

Lectin 3,020 3,305 3,710Protela 2,005 2,180 2,380Sucula 880 1,080 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 followingsales prices will be applied in Year 2008:

Product Price

Lectin $ 14.50 Protela $ 17.30 Sucula $ 11.20

Step 3 - Calculate total expected sales for the year

3.1 Estimated Sales by Product based on average growth:

% Growth % Growth Average Expected Sales EstimatedProduct in 2006 in 2007 Growth Sales Price Sales Amt

Lectin 9.44% 12.25% 10.85% 4,112 $ 14.50 $ 59,629 Protela 8.73% 9.17% 8.95% 2,593 $ 17.30 $ 44,860 Sucula 22.73% 30.56% 26.64% 1,786 $ 11.20 $ 19,999

Total $ 124,488

3.2 Identify any other major sources of revenues anticipated for the year 2008:

Strategic plan and financial plan includes divesting in non performing investments $ 6,500

Step 4 - Based on financial analysis, budgets, and other sources, estimate the costs for 2008

4.1 Cost accounting records and interviews with Engineers indicated the following production costs:

< - - - - - - - - Per Unit Cost - - - - - - - - -> Total Unit Units Cost ofProduct Materials Labor Overhead Prod Cost Sold Goods Sold

Lectin 1.15 6.20 2.60 9.95 4,112 $ 40,918 Protela 1.84 7.55 3.21 12.60 2,593 $ 32,672 Sucula 1.32 4.40 2.84 8.56 1,786 $ 15,285

Total $ 88,876

4.2 Marketing and selling costs are estimated based on the advertising budget and sales support teamneeded to meet targeted sales for 2008

Advertising Plan and Budget for 2008 2,390Sales Salaries and Commissions for 2008 3,585General Marketing Expenses 550Reserve and Allowance for Contigencies 325

Total 6,850

4.3 General and administrative costs are estimated based on staff plans for 2008 in all service support functions

Executive Management 4,130Engineering & Operations 2,705Accounting & Finance 1,510Human Resource Mgmt 1,006General Administrative 460Other Support Functions 194

Total 10,005

4.4 Interest on debt is calculated based on anticipated borrowing of funds in 2008. The total required fixed assetsto support the sales revenues was considered adequate and thus no additional borrowings were expected.The total scheduled interest payments for 2008 are:

Interest payments on loans 810Interest payments on mortgage debt 2,260

Total 3,070

Step 5 - Summarize Steps 3 and 4 into a Forecasted Income Statement

Forecasted Income Statement for 2008

Ref3.1 Gross Sales Revenues $ 124,488

Estimated Allowance for Sales Returned @ 3.5% 4,357Net Sales Revenues 120,131

3.2 Revenue from Divesting in Assets 6,500TOTAL REVENUES 126,631

4.1 Cost of Goods Sold 88,876

Gross Profits 37,756

Operating Expenses:

4.2 Selling & Marketing 6,8504.3 General Administrative 10,005

Total Operating Expenses 16,855

Operating Income 20,901

4.4 Interest Expenses 3,070

Earnings Before Taxes 17,831

Federal & State Taxes @ 40% 7,132

NET INCOME 10,698

General and administrative costs are estimated based on staff plans for 2008 in all service support functions

Interest on debt is calculated based on anticipated borrowing of funds in 2008. The total required fixed assetsto support the sales revenues was considered adequate and thus no additional borrowings were expected.