13 Chapter 2 Financial Statement Analysis

Conceptual Questions

1. Purpose of Financial Statements

The income statement shows a company’s performance over time by detailing revenue, expenses, and net income. The balance sheet provides a snapshot of financial position, listing assets, liabilities, and equity. The cash flow statement tracks cash inflows and outflows across operating, investing, and financing activities. Together, these statements provide a comprehensive view of financial health, profitability, liquidity, and cash management.

2. Accrual Accounting and Cash Flows

Net income differs from cash flow because the income statement is prepared using accrual accounting, where revenues and expenses are recognized when incurred, not when cash is exchanged. Depreciation, a non-cash expense, reduces net income but doesn’t impact cash flow, creating a key difference.

3. Users of Financial Ratios

•Investors: Focus on profitability ratios like return on equity (ROE) to assess return potential.

•Creditors: Emphasize liquidity ratios such as the current ratio to evaluate the company’s ability to meet short-term obligations.

4. Seasonality in Financial Data

Seasonality can cause fluctuations in revenue, expenses, and working capital. For example, a retailer’s income statement will show higher revenue during the holiday season, while the balance sheet might reflect increased inventory levels before peak seasons.

5. Comparative Analysis

Comparing a company’s financial ratios to industry averages or competitors helps identify strengths and weaknesses. Ratios in isolation lack context, while industry benchmarks reveal how well a company performs relative to peers.

Short Calculations

1. Calculating Liabilities

Total liabilities = Total assets – Equity

Total liabilities = $80 million – $35 million = $45 million

2. Inventory Turnover Ratio

Inventory turnover = Cost of Goods Sold (COGS) ÷ Average Inventory

Inventory turnover = $400,000 ÷ $50,000 = 8

3. Days Sales Outstanding (DSO)

DSO = (Accounts Receivable ÷ Annual Sales) × 365

DSO = ($250,000 ÷ $2,000,000) × 365 = 45.63 days

4. Gross Profit Margin

Gross Profit Margin = (Gross Profit ÷ Revenue) × 100

Gross Profit Margin = ($200,000 ÷ $500,000) × 100 = 40%

5. Quick Ratio

Quick Ratio = (Current Assets – Inventory) ÷ Current Liabilities

Quick Ratio = ($120,000 – $50,000) ÷ $80,000 = 0.875

Scenario-Based Problems

1. Common Size Statements for Joe’s Coffee Shop

• • Revenue: $50,000 → 100%
  • Cost of Goods Sold: ($20,000 ÷ $50,000) × 100 = 40%
  • Operating Expenses: ($15,000 ÷ $50,000) × 100 = 30%
  • Net Income: ($15,000 ÷ $50,000) × 100 = 30%

Common Size Income Statement:

• • Revenue: 100%
  • Cost of Goods Sold: 40%
  • Operating Expenses: 30%
  • Net Income: 30%

2. Comparative Analysis

• • Liquidity (Current Ratio): Company B (1.5) is closer to the industry average (1.6) than Company A (1.2). Company B is stronger in liquidity.
  • Profitability (Gross Profit Margin): Company B (40%) exceeds the industry average (35%) and Company A (30%). Company B is more profitable.
  • Efficiency (ROA): Company A (8%) outperforms both the industry average (7%) and Company B (6%). Company A is more efficient in using assets to generate returns.

3. Cash Flow Categories

• • Payment for equipment: Investing activity
  • Collection from customers: Operating activity
  • Loan repayment: Financing activity
  • Dividend payment: Financing activity

4. Trend Analysis

The declining net profit margin (10% → 8% → 6%) suggests worsening profitability. Management should analyze cost structures, pricing strategies, and revenue drivers. Potential actions include reducing expenses, diversifying revenue streams, or improving operational efficiency.

5. Debt-to-Equity Ratio

Debt-to-Equity Ratio = Total Liabilities ÷ Equity

Debt-to-Equity Ratio = $600,000 ÷ $1,200,000 = 0.5

This indicates that for every dollar of equity, the company uses 50 cents of debt, suggesting moderate financial leverage and manageable risk.

Interactive Challenge

1. Financial Ratio Puzzle

• • Current Ratio → Assesses liquidity by comparing current assets to liabilities.
  • ROE → Measures profitability relative to shareholders’ equity.
  • Debt-to-Equity Ratio → Evaluates the proportion of debt used to finance the company.
  • Inventory Turnover → Indicates how effectively inventory is managed.

2. Case Study: Joe’s Coffee Shop Expansion

NPV Calculation:

• • Investment = $50,000
  • Annual cash flows = $12,000
  • Discount rate = 8%
  • NPV = Σ (Cash Flow ÷ (1 + Discount Rate)^t) – Initial Investment
  • NPV = ($12,000 ÷ 1.08) + ($12,000 ÷ 1.08²) + ($12,000 ÷ 1.08³) + ($12,000 ÷ 1.08⁴) + ($12,000 ÷ 1.08⁵) – $50,000
  • NPV = $11,111 + $10,286 + $9,519 + $8,814 + $8,162 – $50,000 = $57,892 – $50,000 = $7,892

Conclusion: Joe should proceed with the expansion since the NPV is positive, indicating a profitable investment.