Financial Statement Analysis

Financial Analysis defined

Financial analysis is the use of financial statements to analyze a company’s financial position and
performance, and to assess future financial performance.

Focus of Financial Statement Analysis

Financial statement analysis is a process which examines past and current financial data for the
purpose of evaluating performance and estimating future risks and potential.

Analysis of financial statements focuses primarily on data provided in external reports plus
supplementary information provided by management. The analysis should identify major changes or
turning points in trends, amounts, and relationships.

Assessment of Past Performance and Current Position

Past performance is often a good indicator of future performance. Therefore, an investor or creditor
looks at the trend of past sales, expenses, net income, cash flow, and return on investment not only
as a means for judging management’s past performance but also as a possible indicator of future
performance.

Assessment of Future Potential and Related Risk

Information about the past and present is useful only to the extent that it bears on decisions about
the future. An investor judges the potential earning ability of a company because that ability will affect
the market price of the company’s stock and the amount of dividends the company will pay. The
riskiness of an investment or loan depends on how easy it is to predict future profitability or liquidity

Three broad areas of financial statement analysis

 Profitability analysis – is the evaluation of a company’s return on investment. It focuses on a

company’s sources and levels of profits and involves identifying and measuring the impact of
various profitability drivers. It also includes evaluation of the two major sources of
profitability—margins (the portion of sales not offset by costs) and turnover (capital
utilization).
 Risk analysis – is the evaluation of a company’s ability to meet its commitments. Risk analysis
involves assessing the solvency and liquidity of a company along with its earnings variability.
 Analysis of sources and uses off funds - is the evaluation of how a company is obtaining and
deploying its funds. This analysis provides insights into a company’s future financing
implications. It is the evaluation of how a company is obtaining and deploying its funds. This
analysis provides insights into a company’s future financing implications.
Basic Considerations

Financial statement analysis begins with establishing the objective(s) of the analysis. After the
objective of the analysis is established, the data is accumulated from the financial statements and
from other sources. The results of the analysis are summarized and interpreted. Conclusions are
reached and a report is made to the person(s) for whom the analysis was undertaken. To evaluate
financial statements, you must:

1. Be acquainted with business practices,

2. Understand the purpose, nature, and limitations of accounting,
3. Be familiar with the terminology of business and accounting,
4. Have a working knowledge of the fundamentals of finance, and
5. Be acquainted with the tools of financial statement analysis.

Financial analysis of a company should include an examination of financial statements of the company,
including notes to the financial statements, and the auditor’s report. Analysts often compare the
financial statements of one company with those of other companies in the same industry and of the
industry in which the company operates as well as with prior year statements of the company being
analyzed. This procedure substantially broadens the scope of financial statement analysis.

Sources of Information

In order to perform an equity or credit analysis of a company, an analyst must collect a great deal of
information. The nature of the information will vary based on the individual task but will typically
include information about the economy, industry, and company as well as information about
comparable peer companies. Much of this information will come from outside the company, such as
economic statistics, industry reports, trade publications, and databases containing information on
competitors.

 Financial Statements and Supplementary Information

 Other Sources of Information

Major Tools of Analysis

Accountants and others have developed a variety of standardized tools and techniques which can be
used in financial statement analysis. The following analytical tools will be discussed in this chapter :

1. Comparative financial statements:

a. Horizontal analysis

b. Vertical analysis

2. Common-size financial statements analysis

3. Ratio Analysis

4. Special-purpose examinations

5. Cash flow analysis

6. Valuation analysis
Comparative financial statement analysis

Financial statements presenting financial data for two or more periods are called comparative
statements. Comparative statements are considerably more significant than are single-year
statements. It emphasize the fact that financial statements for a single accounting period are only one
part of the continuous history of the company.

Trend Analysis

Trend analysis indicates in which direction a company is headed. Trend percentages are computed by
taking a base year and assigning its figures as a value of 100. Figures generated in subsequent years
are expressed as percentages of base-year numbers.

The following selected figures are given for a five-year period:

20x1 20x2 20x3 20x4 20x5

Net Sales P775 P760 P830 P875 P910
Cost of goods sold 460 441 483 510 573
Gross profit 315 319 347 365 337

A schedule showing trend percentages is as follows:

20x1 20x2 20x3 20x4 20x5

Net Sales 100% 98% 107% 113% 117%
Cost of goods sold 100% 96% 105% 111% 125%
Gross profit 100% 101% 110% 116% 107%

With 20x1 taken as the base year, its numbers are divided into those from subsequent years to yield
comparative percentages.

Trend percentages show horizontally the degree of increase or decrease, but they do not indicate the
reason for the changes. They do serve to indicate unfavorable developments that will require further
investigation and analysis.

Note: Comparisons between financial statements are most informative and useful under the following
conditions:

1. The presentations are in good form; that is, the arrangements within the statements are
identical.
2. The content of the statements is identical; that is, the same items from the underlying
accounting records are classified under the same captions.
 3. Accounting principles are not changed or, if they are changed, the financial effects of the
changes are disclosed.
4. Changes in circumstances or in the nature of the underlying transactions are disclosed.

Horizontal Analysis

Horizontal analysis spotlights trends and establishes relationships between items that appear on the
same row of a comparative statement. Horizontal analysis discloses changes on items in financial
statements over time. Each item (such as sales) on a row for one fiscal period is compared with the
same item in a different period. Horizontal analysis can be carried out in terms of changes in peso
amounts, in percentages of change, or in a ratio format.

Percentages of change: the amount of change is computed by subtracting the amount for the bases
year from the amount for the current year. The percentage of change is computed by dividing the
amount of change by the base year.

Year – to year ratio: is computed by dividing the current year data.

Base-year-to-date approach: is sometimes used to disclose the cumulative percentage changes. The
initial year is used as the base year, and the cumulative results from subsequent years are compared
with the initial year to determine the cumulative percentage changes.

Common size financial statement analysis

Common - size analysis involves expressing financial data, including entire financial statements, in
relation to a single financial statement item, or base. Items used most frequently as the bases are total
assets or revenue. In essence, common - size analysis creates a ratio between every financial
statement item and the base item.

Cross – sectional analysis

Cross - sectional analysis (sometimes called relative analysis ) compares a specific metric for one
company with the same metric for another company or group of companies, allowing comparisons
even though the companies might be of significantly different sizes and/or operate in different
currencies.

Ratio analysis

A ratio is an expression of a mathematical relationship between one quantity and another. If a ratio is
to have any utility, the element which constitutes the ratio must express a meaningful relationship.
For example, there is a relationship between accounts receivable and sales, between net income and
total assets, and between current assets and current liabilities. Ratio analysis can disclose relationships
which reveal conditions and trends that often cannot be noted by inspection of the individual
components of the ratio.

Category Description
 Activity ratio Activity ratios measure how efficiently a company performs day-to-day tasks, such
as the collection of receivables and management of inventory.

Liquidity ratio Liquidity ratios measure the company’s ability to meet its short-term obligations.

Solvency ratio Solvency ratios measure a company’s ability to meet long-term obligations.
Subsets of these ratios are also known as “leverage” and “long-term debt” ratios.

Profitability Profitability ratios measure the company’s ability to generate profitable sales from
ratios its resources (assets).

Valuation Valuation ratios measure the quantity of an asset or flow (e.g., earnings)
associated with ownership of a specified claim (e.g., a share or ownership of the
enterprise).
Summary of common used financial ratios

Activity ratios

Activity ratio Formula Measures

Inventory Cost of goods sold How many times inventory is
Average inventory created and sold during the period.
Interpretation:
It indicates the resources (money) tied up in inventory (i.e., the carrying costs) and can, therefore, be used to
indicate inventory management effectiveness. The higher the inventory turnover ratio, the shorter the period
that inventory is held.

Receivable turnover Total revenue How many times accounts

Average receivable receivable are created and
collected during the period.

The number of DSO represents the elapsed time between a sale and cash collection, reflecting how fast the
company collects cash from customers it offers credit. A relatively high receivables turnover ratio might indicate
highly efficient credit and collection. Alternatively, a high receivables turnover ratio could indicate that the
company ’ s credit or collection policies are too stringent, suggesting the possibility of sales being lost to
competitors offering more lenient terms. A relatively low receivables turnover ratio would typically raise
questions about the efficiency of the company ’ s credit and collections procedures.

Total asset turnover Total revenue The extent to which total assets
Average total assets create revenue during the period.

The total asset turnover ratio measures the company ’ s overall ability to generate revenues with a given level
of assets. A higher ratio indicates greater efficiency. Because this ratio includes both fixed and current assets,
inefficient working capital management can distort overall interpretations. A low asset turnover ratio can be an
indicator of inefficiency or of relative capital intensity of the business.

Working capital turnover Total revenue The efficiency of putting working

Average working capital capital to work.

Working capital turnover indicates how efficiently the company generates revenue with its working capital. A
high working capital turnover ratio indicates greater efficiency (i.e., the company is generating a high level of
 revenues relative to working capital). For some companies, working capital can be near zero or negative,
rendering this ratio incapable of being interpreted.

Number of days of inventory 365 Average time it takes to create and

Inventory turnover sell inventory.

Number of receivables 365 Average time it takes to collect on

Receivable turnover accounts receivable.

Number of days payable 365 Average time to takes to supplier.

Accounts payable turnover
Sample Activity Ratio

Liquidity ratio Formula Measures

Current ratio Current asses Ability to satisfy current liabilities using current
Current liabilities assets.

Interpretation
This ratio expresses current assets (assets expected to be consumed or converted into cash within
one year) in relation to current liabilities (liabilities falling due within one year). A higher ratio
indicates a higher level of liquidity (i.e., a greater ability to meet short - term obligations). A current
ratio of 1.0 would indicate that the book value of its current assets exactly equals the book value of
its current liabilities. A lower ratio indicates less liquidity, implying a greater reliance on operating
cash flow and outside financing to meet short - term obligations.

Quick ratio Cash + Short-term Ability to satisfy current liabilities using the most
investment + Receivables liquid of current assets.
Current liabilities

The quick ratio is more conservative than the current ratio because it includes only the more liquid
current assets (sometimes referred to as “ quick assets ” ) in relation to current liabilities. Like the
current ratio, a higher quick ratio indicates greater liquidity. The quick ratio reflects the fact that
certain current assets — such as prepaid expenses, some taxes, and employee - related
prepayments — represent costs of the current period that have been paid in advance and cannot
usually be converted back into cash.

Cash ratio Cash + Short-term Ability to satisfy current liabilities using only cash and
investments cash equivalents.
Current liabilities

The cash ratio normally represents a reliable measure of an individual entity ’ s liquidity in a crisis
situation. Only highly marketable short - term investments and cash are included. In a general
market crisis, the fair value of marketable securities could decrease significantly as a result of
market factors, in which case even this ratio might not provide reliable information.
 Defensive Cash +short-term This ratio measures how long the company can
interval ratio marketable investments + continue to pay its expenses from its existing liquid
receivables assets without receiving any additional cash inflow.

Daily cash expenditure

A defensive interval ratio of 50 would indicate that the company can continue to pay its operating
expenses for 50 days before running out of quick assets, assuming no additional cash inflows. A
higher defensive interval ratio indicates greater liquidity. If a company ’ s defensive interval ratio is
very low relative to peer companies or to the company ’ s own history, the analyst would want to
ascertain whether there is sufficient cash inflow expected to mitigate the low defensive interval
ratio.

Sample Liquidity ratio

Solvency ratio Formula Measures

Debt to asset ratio Total debt Proportion of assets financed

Total assets with debt.

Interpretation:
This ratio measures the percentage of total assets financed with debt. For example, a debt - to -
assets ratio of 0.40 or 40 percent indicates that 40 percent of the company ’ s assets are financed
with debt. Generally, higher debt means higher financial risk and thus weaker solvency.

Long term debt to assets Long term debt Proportion of assets financed
ratio Total asset with long term debt.

Debt to equity ratio Total debt Debt financing relative to

Total shareholders equity.

The debt - to - equity ratio measures the amount of debt capital relative to equity capital.
Interpretation is similar to the preceding two ratios (i.e., a higher ratio indicates weaker
solvency). A ratio of 1.0 would indicate equal amounts of debt and equity, which is equivalent to
a debt - to - capital ratio of 50 percent. Alternative definitions of this ratio use the market value
of stockholders ’ equity rather than its book value (or use the market values of both stockholders
’ equity and debt).

Financial leverage Total assets Reliance on debt financing.

Total shareholders equity
 This ratio (often called simply the leverage ratio ) measures the amount of total assets supported
for each one money unit of equity. The higher the financial leverage ratio, the more leveraged
the company is in the sense of using debt and other liabilities to finance assets. This ratio is often
defined in terms of average total assets and average total equity and plays an important role in
the DuPont decomposition of return on equity.

Sample Solvency Ratio

Profitability ratios: Margins Formula

Each margin ratio compares a measure of
income with total revenue.
Gross profit margin Gross profit
Total revenue

Gross profit margin indicates the percentage of revenue available to cover operating and other
expenditures. Higher gross profit margin indicates some combination of higher product pricing
and lower product costs. On the cost side, higher gross profit margin can also indicate that a
company has a competitive advantage in product costs.

Operating profit margin Operating profit

Total revenue

Operating profit is calculated as gross margin minus operating costs. So, an operating margin
increasing faster than the gross margin can indicate improvements in controlling operating costs,
such as administrative overheads. In contrast, a declining operating profit margin could be an
indicator of deteriorating control over operating costs.

Net profit margin Net profit

Total revenue
Net profit, or net income, is calculated as revenue minus all expenses. Net income includes both
recurring and nonrecurring components. Generally, the net profit margin adjusted for
nonrecurring items offers a better view of a company ’ s potential future profitability.

Pre-tax profit margin Earnings before taxes

Total revenue
Pre-tax income (also called earnings before tax ) is calculated as operating profit minus interest,
so this ratio reflects the effects on profitability of leverage and other (non-operating) income and
expenses. If a company ’ s pre-tax margin is rising primarily as a result of increasing non-operating
income, the analyst should evaluate whether this increase reflects a deliberate change in a
company ’ s business focus and, therefore, the likelihood that the increase will continue.

Profitability ratios: returns Formula

Return ratios compare a measure of profit with
the investment that produces profit.
Operating return on assets Operating income
Average total assets
 Return on assets Net income
Average total assets

ROA measures the return earned by a company on its assets. The higher the ratio, the more income
is generated by a given level of assets.

Return on total capital Net income

Average interest – bearing debt + Average total
equity
Return on total capital measures the profits a company earns on all of the capital that it employs
(short - term debt, long - term debt, and equity).

Return on equity Net income

Average shareholders equity
ROE measures the return earned by a company on its equity capital, including minority equity,
preferred equity, and common equity. As noted, return is measured as net income (i.e., interest on
debt capital is not included in the return on equity capital). A variation of ROE is return on common
equity, which measures the return earned by a company only on its common equity.

Specialized Analytical Tools

In addition to comparative statements, common-size statements, and ratio analysis, analysts have
many

specialized tools and techniques which they can apply to special purpose studies. Such studies could

include factors such as insurance coverage, the seasonal nature of the business, segment data, foreign

operations, concentration of sales within a small number of customers, unusual events affecting the

company, and the effect of inventory method (LIFO, FIFO) and depreciation methods on financial

statements. Additional procedures that are available for use in special situations include:

1. Gross margin analysis: Gross margin analysis provides special insights into the operating

performance of a company. It helps in evaluating overall gross margin by product mix. This topic

is touched on in Chapter 7 (Profitability Analysis) .

2. Breakeven, cost-volume-profit, and contribution analysis: These tools disclose relationships

between revenue and patterns of cost behavior for fixed and variable expenses. Different

managers within a company use breakeven analysis because it is important when beginning a

new activity, such as starting a new line of business, expanding an existing business, or

introducing a new product or service. This topic is reserved for courses such as Analyzing Cost

Data for Management or Cost Management.

3. Return-on-investment analysis: Return-on-investment analysis provides a comprehensive

measure of financial performance. Especially, the ROI breakdown analysis, known as the Du

Pont formula, gives an insight into how a company can improve its performance. This technique

is discussed in detail in Chapter 7 (Profitability Analysis).

Special analytical procedures are available to isolate the different types of fluctuations as they relate
to

historical data and forecasts. When there is an established relationship between series, it is possible
to

use these relationships to make estimates and forecasts.

Time-series analysis is used where data classified on the basis of interval of time represent vital

information in the control and operation of a business. The changes that can be isolated in time-series

analysis represent the following major types of economic change: secular trend, seasonal variations,

cyclical fluctuations, and random or erratic fluctuations.

Regression analysis is another tool of financial statement analysis. Regression analysis seeks to

determine the relationship between financial statement variables. Correlation analysis measures the

degree of relationship between two or more variables. Time series, regression, and correlation
analyses

are more sophisticated techniques and are beyond the scope of this course.