Introduction to Financial Analysis Case Study Example

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 $ 77,026 2,540 1,800 18,320 27,530 50,190 43,100 11,400 31,700 31,700 $ 81,890 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 8,340 5,635 3,150 1,750 2,000 20,875 $ 24,000 24,000 9,721 8,500 3,200 2,102 2,000 25,523 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 Interest Expenses: Interest on Loans Interest on Mortgage Bonds Total Interest Expenses Earnings Before Taxes Federal & State Taxes @ 40% NET INCOME 85,300 27,460 6,540 9,400 15,940 11,520 850 2,310 3,160 8,360 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% Net Property & Equipment 3.10% 2.20% 22.37% 33.62% 61.29% 38.95% 38.71% 100.00% 100.00% Current Liabilities 27.10% 31.17% Long-Term Liabilities 31.16% 26.87% 58.26% 58.03% TOTAL ASSETS Liabilities TOTAL LIABILITIES Equity TOTAL EQUITY TOTAL LIABILITIES & EQUITY 41.74% 41.97% 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 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 2005 0.81 0.77 2006 0.89 0.79 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 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 2005 0.04 0.06 2006 0.04 0.05 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 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 1.38 Net Income $ Lowest Level - Accounts in Financial Statements Sales 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% b.Another Key Economic Indicator is Rate of Return > 2,604 Net Present Value You can also use this formula for NPV which yields a more conservative 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 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: Product Lectin Protela Sucula < - - - - - - - - Per Unit Cost - - - - - - - - -> Materials Labor Overhead 1.15 1.84 1.32 6.20 7.55 4.40 2.60 3.21 2.84 Total Unit Prod Cost Units Sold 9.95 12.60 8.56 Total Cost of Goods Sold 4,112 $ 2,593 $ 1,786 $ $ 40,918 32,672 15,285 88,876 4.2 Marketing and selling costs are estimated based on the advertising budget and sales support team needed to meet targeted sales for 2008 Advertising Plan and Budget for 2008 Sales Salaries and Commissions for 2008 General Marketing Expenses Reserve and Allowance for Contigencies 2,390 3,585 550 325 Total 6,850 4.3 General and administrative costs are estimated based on staff plans for 2008 in all service support functions Executive Management Engineering & Operations Accounting & Finance Human Resource Mgmt General Administrative Other Support Functions Total 4,130 2,705 1,510 1,006 460 194 10,005 4.4 Interest on debt is calculated based on anticipated borrowing of funds in 2008. The total required fixed assets to 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 Interest payments on mortgage debt Total 810 2,260 3,070 Step 5 - Summarize Steps 3 and 4 into a Forecasted Income Statement Forecasted Income Statement for 2008 Ref 3.1 Gross Sales Revenues Estimated Allowance for Sales Returned @ 3.5% Net Sales Revenues 3.2 Revenue from Divesting in Assets TOTAL REVENUES 4.1 Cost of Goods Sold 124,488 4,357 120,131 6,500 126,631 88,876 Gross Profits 4.2 4.3 $ Operating Expenses: Selling & Marketing General Administrative Total Operating Expenses 37,756 6,850 10,005 16,855 Operating Income 20,901 Earnings Before Taxes 17,831 4.4 Interest Expenses 3,070 Federal & State Taxes @ 40% NET INCOME 7,132 10,698