Financial Statement Analysis

Financial Statement Analysis Methods: Horizontal
vs. Vertical Analysis

Introduction
Financial statement information is used by both external and internal users,
including investors, creditors, managers, and executives. These users must
analyze the information in order to make business decisions, so
understanding financial statements is of great importance. Several methods
of performing financial statement analysis exist. This article discusses two of
these methods: horizontal analysis and vertical analysis.
Horizontal Analysis
Methods of financial statement analysis generally involve comparing certain
information. The horizontal analysis compares specific items over a number
of accounting periods. For example, accounts payable may be compared
over a period of months within a fiscal year, or revenue may be compared
over a period of several years. These comparisons are performed in one of
two different ways.
Absolute Dollars
One method of performing a horizontal financial statement analysis

compares the absolute dollar amounts of certain items over a period of time.
For example, this method would compare the actual dollar amount of
operating expenses over a period of several accounting periods. This method
is valuable when trying to determine whether a company is conservative or
excessive in spending on certain items. This method also aids in determining
the effects of outside influences on the company, such as increasing gas
prices or a reduction in the cost of materials.
Percentage
The other method of performing horizontal financial statement analysis

compares the percentage difference in certain items over a period of time.
The dollar amount of the change is converted to a percentage change. For
example, a change in operating expenses from $1,000 in period one to
$1,050 in period two would be reported as a 5% increase. This method is
particularly useful when comparing small companies to large companies.
(1050 – 1000)/1000 X 100 = 5%
Qazi Ashfaq | Financial Statement Analysis 1

Vertical Analysis
The vertical analysis compares each separate figure to one specific figure in
the financial statement. The comparison is reported as a percentage. This
method compares several items to one certain item in the same accounting
period. Users often expand upon vertical analysis by comparing the analyses
of several periods to one another. This can reveal trends that may be helpful
in decision making. An explanation of Vertical analysis of the income
statement and vertical analysis of the balance sheet follows.
Income Statement
Performing vertical analysis of the income statement involves comparing

each income statement item to sales. Each item is then reported as a
percentage of sales. For example, if sales equals $10,000 and operating
expenses equals $1,000, then operating expenses would be reported as 10%
of sales.
1000/10,000 X 100 = 10%
Balance Sheet
Performing vertical analysis of the balance sheet involves comparing each

balance sheet item to total assets. Each item is then reported as a
percentage of total assets. For example, if cash equals $5,000 and total
assets equals $25,000, then cash would be reported as 20% of total assets.
References
Edmonds, C., Edmonds, T., Olds, P., & Schneider, N. (2006). "Fundamental
Managerial Accounting Concepts." 3rd ed. New York: McGraw-Hill Irwin.

Session 1: Vertical and Horizontal Analysis Technique
Session Learning Outcomes

Learners will understand and be appreciative on the use of the horizontal
and vertical analysis technique while analyzing the financial statements
information, its application and interpretation.
Important Learning Terms
• Financial analysis
• Horizontal financial statements analysis
• Vertical financial statements analysis
• Cross sectional financial statement analysis
Introduction
Financial analysis: is a process which involves reclassification and

summarization of information through the establishment of ratios and
trends.
Analysis of financial statement: Refers to the examination of the statements

for the purpose of acquiring additional information regarding the activities of
the business.
The users of the financial information often find analysis desirable for the
interpretation of the firm’s activities.
Note: The financial statement to be used for the purpose of analysis should
be the audited ones. The audited financial statements give the analyst the
auditor’s statement as to whether the records represent a fair view of the
company’s affairs.
The Objectives of Financial Statement Analysis

The overall objective of financial statement analysis is the examination of a
firm’s financial position and returns in relation to risk. This must be done
with a view to forecasting the firm’s future prospective.
For the purpose of understanding, the following financial statements will be
used.

A: Horizontal Financial Statement Analysis
This technique is also known as comparative analysis.
It is conducted by setting consecutive balance sheet, income statement or
statement of cash flow side-by-side and reviewing changes in individual
categories on a year-to-year or multiyear basis. The most important item
revealed by comparative financial statement analysis is trend.
A comparison of statements over several years reveals direction, speed and
extent of a trend(s). The horizontal financial statements analysis is done by
restating amount of each item or group of items as a percentage.

Such percentages are calculated by selecting a base year and assign a
weight of 100 to the amount of each item in the base year statement.
Thereafter, the amounts of similar items or groups of items in prior or
subsequent financial statements are expressed as a percentage of the base
year amount. The resulting figures are called index numbers or trend ratios.
From the balance sheet statement in exhibit 1. The following indexed
balance sheet can be established.
As basis of Analysis, the analyst may seek variables which seem to improve
or deteriorate and bring a challenge to the stakeholders in their various
decisions. Example from the previous table one can ask the following
questions?
• Why is there an increase in the stock of the company? Has the

company changed its inventory policy?
• Why did taxation increase so tremendously? Were there any changes
in taxation? Is it reflected by the increase in sales? Profit?

• Why is there an increase in the fixed assets and at the same time
decrease in the long-term debt? How were these assets financed?
• And many more question which can be elaborated by the management
or which can be used as the basis for discussions.
Individual Assignment 1:
From the Exhibit 1, prepare horizontal analysis for the income statement of
TeleTalk (T) Ltd and comment on the relevant changes. Associate the
comments from the balance sheet and income statement you have
established, what is your general comment on the company undertakings in
the past three years of operation.
B: Vertical/Cross-Sectional/Common Size Analysis Techniques

Vertical/Cross-sectional/Common size statements came from the problems
in comparing the financial statements of firms that differ in size.
• In the balance sheet, for example, the assets as well as the liabilities
and equity are each expressed as a 100% and each item in these
categories is expressed as a percentage of the respective totals.
• In the common size income statement, turnover is expressed as 100%
and every item in the income statement is expressed as a percentage
of turnover (sales).

From the vertical analysis above, an analyst can compare the percentage
mark-up of asset items and how they have been financed. The strategies
may include increase/decrease the holding of certain assets. The analyst
may as well observe the trend of the increase in the assets and liabilities
over several years.
Example: It can be observed that there is an increase in the holding of the

current assets of the company. The management can seek the reasons of
why the holding of these assets is continuing increasing.
Exercise 2:
From the Exhibit 1, prepare vertical analysis for the income

statement of TeleTalk (T) Ltd and comment on the relevant changes.
Associate the comments from the balance sheet and income
statement you have established, what is your general comment on
the company undertakings in the past three years of operation.

Financial Analysis revised
Page 8 of 54 pages. Chapter: 17: Module 3.4: Sensitivity Analysis of ICT Invest...
Session 1: Building a Financial Analysis Model for ICT
Session Learning Outcome

The purpose of this session is to show how the different variables studied in this
course and other courses can affect the analysis of a project. In actual undertakings
of projects, there are micro and micro variables which affect overall project analysis.
Introduction
Sensitivity Analysis (SA) is the study of how the variation in the output of a model
(numerical or otherwise) can be apportioned, qualitatively or quantitatively, to
different sources of variation.
Sensitivity Analysis (SA) aims to ascertain how the model depends upon the
information fed into it, upon its structure and upon the framing assumptions made to
build it. This information can be invaluable, as:
• Different level of acceptance (by the decision-makers and stakeholders) may be

attached to different types of uncertainty.
• Different uncertainties impact differently on the reliability, the robustness and
the efficiency of the model.
Sensitivity analysis is also referred to as “what if analysis”
Building Financial Analysis Model

Several activities can be considered in building financial analysis model. In the
building of the financial model the following have to be considered:
1. Conservative estimations of the revenues/benefits

This is helpful to ensure that the viability of the proposed project is not easily
threatened by unfavorable circumstances. The capital budgeting should be done
in a such a way that it has a build in system for conservative estimations. The
revenue figures should be justifiable given the capital expenditure proposals.
2. Safety Margin Cost figures
A margin of safety for the cost items should be estimated. He margin can be
between 10% -30%. For instance, in estimation of installation costs of a
wireless telephone system, 10%-30% of the normal installation costs can be
added. The management can decide on the percentages in the cost estimation
of various items depending on the experience and other firm considerations.
3. Flexible Investment yardsticks
Cutting point for the investments can be changed considerably to allow more

room for seeing beyond the normal cut-off points. Example if the policy of a
company is to accept the projects with payback period of less than three years,
the use of a prolonged period can be assessed to determine the impact thereto.
4. Calculating the Overall risk index
Some projects may call for the calculation of the overall risk index for various
project components. These cutoff points may be based on sales, prices,
operating cots, etc.
The company may vary all the items by 62% favorable, given the risks index
consideration.
5. Judgment on Three point estimation

Telecommunication companies may judge their operations on three point
estimation based on the hours of access as follows:
o Business (peak) hours
E.g. From 0800hrs – 1800hrs
o Evening/Morning (off-peak) hours
E.g. from 0600hrs – 0800 hrs and from 1800hrs – 2200hrs.
o Night Hours
E.g 2200hrs-0600hrs
Various interconnection and charging rates are considered between three

different times as indicated above. Reasons may be due to the fact that the use
of bandwidth (which is paid even if not consumed) varies from the three time
zones indicated above.
Other considerations may be backed on the market responses and returns. The
returns for this case may be classified as:
• Most pessimistic
• Most likely

Session 2: Ratio Analysis Techniques

Learners will understand and be appreciative on the use of the time series
analysis technique while analysing the financial statements information, its
application and interpretation
• Ratio
• Types of Ratios
• Liquidity Ratios
• Asset management/Activity ratios
• Financial Leverage/Gearing ratios
• Profitability ratios
• Market valuation ratios
• Ratio limitations
A ratio: Is the mathematical relationship between two quantities in the form

of a fraction or percentage.
Ratio analysis: is essentially concerned with the calculation of relationships

which after proper identification and interpretation may provide information
about the operations and state of affairs of a business enterprise.
The analysis is used to provide indicators of past performance in terms of

critical success factors of a business. This assistance in decision-making
reduces reliance on guesswork and intuition and establishes a basis for
sound judgement.
Note: A ratio on its own has little or no meaning at all.
Consider a current ratio of 2:1. This means that for every 1 monetary value
of current liabilities there are 2 of assets. However each business is different
and each has different working capital requirements. From this ratio, we
cannot make any comments about the liquidity of the business, whether it
carries too much or too little working capital.
Significance of Using Ratios

The significance of a ratio can only truly be appreciated when:

1. It is compared with other ratios in the same set of financial
statements.
2. It is compared with the same ratio in previous financial statements
(trend analysis).
3. It is compared with a standard of performance (industry average).
Such a standard may be either the ratio which represents the typical
performance of the trade or industry, or the ratio which represents the
target set by management as desirable for the business.
Types of Ratios
Note that throughout this section, ratios are derived from Exhibit one in
Session 1 of this chapter
A: Liquidity Ratios
• Liquidity refers to the ability of a firm to meet its short-term financial

obligations when and as they fall due.
• The main concern of liquidity ratio is to measure the ability of the firms
to meet their short-term maturing obligations. Failure to do this will
result in the total failure of the business, as it would be forced into
liquidation.
Current Ratio
The Current Ratio expresses the relationship between the firm’s current
assets and its current liabilities.
Current assets normally includes cash, marketable securities, accounts
receivable and inventories. Current liabilities consist of accounts payable,
short term notes payable, short-term loans, current maturities of long term
debt, accrued income taxes and other accrued expenses (wages).
The rule of thumb says that the current ratio should be at least 2, that is the
current assets should meet current liabilities at least twice.
What does the calculated ratio tells us? In 2000, the company only had 85
cents worth of current assets for every dollar of liabilities. This grew to 92
cents in 2002 indicating increasing trend on liquidity, however the company
is still unable to support its short-term debt from its currents assets.

Quick Ratio
Measures assets that are quickly converted into cash and they are compared
with current liabilities. This ratio realizes that some of current assets are not
easily convertible to cash e.g. inventories.
The quick ratio, also referred to as acid test ratio, examines the ability of the
business to cover its short-term obligations from its “quick” assets only (i.e.
it ignores stock). The quick ratio is calculated as follows
insert
Clearly this ratio will be lower than the current ratio, but the difference
between the two (the gap) will indicate the extent to which current assets
consist of stock.
B: Asset Management/Activity Ratios

If a business does not use its assets effectively, investors in the business
would rather take their money and place it somewhere else. In order for the
assets to be used effectively, the business needs a high turnover.
Unless the business continues to generate high turnover, assets will be idle
as it is impossible to buy and sell fixed assets continuously as turnover
changes. Activity ratios are therefore used to assess how active various
assets are in the business.
Note: Increased turnover can be just as dangerous as reduced turnover if

the business does not have the working capital to support the turnover
increase. As turnover increases more working capital and cash is required
and if not, overtrading occurs.
Asset Management ratios are discussed next.
Average Collection Period

The average collection period measures the quality of debtors since it
indicates the speed of their collection.
• The shorter the average collection period, the better the quality of
debtors, as a short collection period implies the prompt payment by
debtors.
• The average collection period should be compared against the firm’s
credit terms and policy to judge its credit and collection efficiency.
• An excessively long collection period implies a very liberal and
inefficient credit and collection performance.
• The delay in collection of cash impairs the firm’s liquidity. On the other
hand, too low a collection period is not necessarily favourable, rather it

may indicate a very restrictive credit and collection policy which may
curtail sales and hence adversely affect profit.
Inventory Turnover
This ratio measures the stock in relation to turnover in order to determine
how often the stock turns over in the business.
It indicates the efficiency of the firm in selling its product. It is calculated by
dividing he cost of goods sold by the average inventory.
The ratio shows a relatively high stock turnover which would seem to
suggest that the business deals in fast moving consumer goods.
• The company turned over stock every 24 days in 2000 and every 28
days in 2002.
• The trend shows a marginal increase in days which indicates a slow
down of stock turnover.
• The high stock turnover ratio would also tend to indicate that there
was little chance of the firm holding damaged or obsolete stock.
Total Assets Turnover

Asset turnover is the relationship between sales and assets

• The firm should manage its assets efficiently to maximise sales.
• The total asset turnover indicates the efficiency with which the firm
uses all its assets to generate sales.
• It is calculated by dividing the firm’s sales by its total assets.
• Generally, the higher the firm’s total asset turnover, the more
efficiently its assets have been utilised.
Fixed Asset Turnover

The fixed assets turnover ratio measures the efficiency with which the firm
has been using its fixed assets to generate sales.
It is calculated by dividing the firm’s sales by its net fixed assets as follows:
• Generally, high fixed assets turnovers are preferred since they indicate
a better efficiency in fixed assets utilisation.
From the above calculations:
• It appears that the activity of the business is relatively constant, with

a slight upward trend.
• The ratio also confirms that the business places a much greater
reliance on working capital than it does on the fixed assets as the fixed
assets (2001 and 2002) turned over more quicker than stock turnover.
C: Financial Leverage (Gearing) Ratios
• The ratios indicate the degree to which the activities of a firm are
supported by creditors’ funds as opposed to owners.
• The relationship of owner’s equity to borrowed funds is an important
indicator of financial strength.
• The debt requires fixed interest payments and repayment of the loan
and legal action can be taken if any amounts due are not paid at the

appointed time. A relatively high proportion of funds contributed by
the owners indicates a cushion (surplus) which shields creditors
against possible losses from default in payment.
Note: The greater the proportion of equity funds, the greater the
degree of financial strength. Financial leverage will be to the
advantage of the ordinary shareholders as long as the rate of earnings
on capital employed is greater than the rate payable on borrowed
funds.
The following ratios can be used to identify the financial strength and
risk of the business.
Equity Ratio
The equity ratio is calculated as follows:
This indicates that only 32.1% of the total assets in 2002 is supplied by the
ordinary stockholders and this has shown a slight decrease from 32.8% in
2000.
• A high equity ratio reflects a strong financial structure of the company.

A relatively low equity ratio reflects a more speculative situation
because of the effect of high leverage and the greater possibility of
financial difficulty arising from excessive debt burden.
Debt Ratio
This is the measure of financial strength that reflects the proportion of
capital which has been funded by debt, including preference shares.
This ratio is calculated as follows:

With higher debt ratio (low equity ratio), a very small cushion has developed
thus not giving creditors the security they require. The company would
therefore find it relatively difficult to raise additional financial support from
external sources if it wished to take that route. The higher the debt ratio the
more difficult it becomes for the firm to raise debt.
Debt to Equity ratio

This ratio indicates the extent to which debt is covered by shareholders’
funds. It reflects the relative position of the equity holders and the lenders
and indicates the company’s policy on the mix of capital funds. The debt to
equity ratio is calculated as follows:
• The debt to equity ratio shows that for every 1 dollar of shareholders
funds in 2002 there was 2.12 dollars of debt. This compares to 2.05
dollars in 2000. This ratio is extremely high and indicates the financial
weakness of the business.
Times Interest Earned Ratio

This ratio measure the extent to which earnings can decline without causing
financial losses to the firm and creating an inability to meet the interest cost.
• The times interest earned shows how many times the business can
pay its interest bills from profit earned.
• Present and prospective loan creditors such as bondholders, are vitally
interested to know how adequate the interest payments on their loans
are covered by the earnings available for such payments.
• Owners, managers and directors are also interested in the ability of
the business to service the fixed interest charges on outstanding debt.
The ratio is calculated as follows:
• The company’s major forms of credit are non-interest bearing (trade

creditors) which results in the business enjoying very healthy interest

coverage rates. In 2002 the company could pay their interest bill 16.5
times from earnings before interest and tax. However this is a massive
drop from 51.5 times in 2001 and 37.7 times in 2000.
D: Profitability Ratios
Profitability is the ability of a business to earn profit over a period of time.
Although the profit figure is the starting point for any calculation of cash
flow, as already pointed out, profitable companies can still fail for a lack of
cash.
Note: Without profit, there is no cash and therefore profitability must be

seen as a critical success factors.
• A company should earn profits to survive and grow over a long period
of time.
• Profits are essential, but it would be wrong to assume that every
action initiated by management of a company should be aimed at
maximising profits, irrespective of social consequences.
The ratios examined previously have tendered to measure management

efficiency and risk.
Profitability is a result of a larger number of policies and decisions. The

profitability ratios show the combined effects of liquidity, asset management
(activity) and debt management (gearing) on operating results. The overall
measure of success of a business is the profitability which results from the
effective use of its resources.
Gross Profit Margin
• Normally the gross profit has to rise proportionately with sales.

• It can also be useful to compare the gross profit margin across similar
businesses although there will often be good reasons for any disparity.
• The ratio above shows the increasing trend in the gross profit since the
ratio has improved from 15.2% in 2000 to 20.3% on 2002. This
indicates that the rate in increase in cost of goods sold are less than
rate of increase in sales, hence the increased efficiency.

Net Profit Margin
This is a widely used measure of performance and is comparable across
companies in similar industries. The fact that a business works on a very low
margin need not cause alarm because there are some sectors in the industry
that work on a basis of high turnover and low margins, for examples
supermarkets and motorcar dealers.
What is more important in any trend is the margin and whether it compares
well with similar businesses.
The net margin ratio shows that the margin is fairly stable over time with
slight improvement to 1.73% in 2001. However, to know how well the firm is
performing one has to compare this ratio with the industry average or a firm
dealing in a similar business.
Return on Investment (ROI)

Income is earned by using the assets of a business productively. The more
efficient the production, the more profitable the business. The rate of return
on total assets indicates the degree of efficiency with which management
has used the assets of the enterprise during an accounting period. This is an
important ratio for all readers of financial statements.
Investors have placed funds with the managers of the business. The
managers used the funds to purchase assets which will be used to generate
returns. If the return is not better than the investors can achieve elsewhere,
they will instruct the managers to sell the assets and they will invest
elsewhere. The managers lose their jobs and the business liquidates.
• The ratio indicates that there is increase in the ROI from 8.38% in
2000 to 8.95% in 2002.
Return on Equity (ROE)

This ratio shows the profit attributable to the amount invested by the owners
of the business. It also shows potential investors into the business what they

might hope to receive as a return. The stockholders’ equity includes share
capital, share premium, distributable and non-distributable reserves. The
ratio is calculated as follows:
Again, the profitability to ordinary shareholders is strong and showing an

upward trend. Note that the return in 2002 as in all the years is after tax
and the shareholders should be extremely comfortable with these returns.
Earning Per Share (EPS)

Whatever income remains in the business after all prior claims, other than
owners claims (i.e. ordinary dividends) have been paid, will belong to the
ordinary shareholders who can then make a decision as to how much of this
income they wish to remove from the business in the form of a dividend, and
how much they wish to retain in the business. The shareholders are
particularly interested in knowing how much has been earned during the
financial year on each of the shares held by them. For this reason, an
earning per share figure must be calculated. Clearly then, the earning per
share calculation will be:
Exercises
1. Reconsider the ratios which have been calculated for analysis on

profitability. In your own words, analyse the trends in these ratios
and discuss the linkage between ROI and ROE.
2. How will the gross margin ratio assist you in determining the
profitability of a business?
3. In your own words, explain the calculation used for ROI.
4. When calculating EPS, explain how we should deal with
preference shares dividends.
E: Market Value Ratios

These ratios indicate the relationship of the firm’s share price to dividends

and earnings. Note that when we refer to the share price, we are talking
about the Market value and not the Nominal value as indicated by the par
value.
For this reason, it is difficult to perform these ratios on unlisted companies

as the market price for their shares is not freely available. One would first
have to value the shares of the business before calculating the ratios. Market
value ratios are strong indicators of what investors think of the firm’s past
performance and future prospects.
Dividend Yield Ratio

The dividend yield ratio indicates the return that investors are obtaining on
their investment in the form of dividends. This yield is usually fairly low as
the investors are also receiving capital growth on their investment in the
form of an increased share price. It is interesting to note that there is strong
correlation between dividend yields and market prices. Invariably, the higher
the dividend, the higher the market value of the share. The dividend yield
ratio compares the dividend per share against the price of the share and is
calculated as:
Notice a healthy increase in the yield from 2000 to 2002. The main reason
for this is that the dividend per share increased while at the same time, the
price of a share dropped.
This is fairly unusual because share prices usually increase when dividends
increase. However there could be number of reasons why this has happened,
either due to the economy or to mismanagement, leading to a loss of faith in
the stock market or in this particular stock.
Normally a very high dividend yield signals potential financial difficulties and
possible dividend payout cut. The dividend per share is merely the total
dividend divided by the number of shares issued. The price per share is the
market price of the share at the end of the financial year.

Price/Earning Ratio (P/E ratio)
• P/E ratio is a useful indicator of what premium or discount investors

are prepared to pay or receive for the investment.
• The higher the price in relation to earnings, the higher the P/E ratio
which indicates the higher the premium an investor is prepared to pay
for the share. This occurs because the investor is extremely confident
of the potential growth and earnings of the share.
The price-earning ratio is calculated as follows:
1. High P/E generally reflects lower risk and/or higher growth prospects
for earnings.
2. The above ratio shows that the shares were traded at a much higher
premium in 2000 than were in 2002. In 2000 the price was 26.8 times
higher than earnings while in 2002, the price was only 12 times
higher.
Dividend Cover
• This ratio measures the extent of earnings that are being paid out in
the form of dividends, i.e. how many times the dividends paid are
covered by earnings (similar to times interest earned ratio discussed
above).
• A higher cover would indicate that a larger percentage of earnings are
being retained and re-invested in the business while a lower dividend
cover would indicate the converse.
Dividend pay-out ratio

This ratio looks at the dividend payment in relation to net income and can be
calculated as follows:

Note: Even though the dividend yield has increased, the dividend payout
ratio has reduced, showing that a lower proportion of earnings was paid out
as dividend. The ratio has only reduced slightly, however, from 50.7% in
2000 to 49.4% in 2002. Generally, the low growth companies have higher
dividends payouts and high growth companies have lower dividend payouts.
Exercise:
1. In your own words, comment on the market value ratios in our
example. In your answer, assume the following industry average for
2002
Dividend yield: 3.2%
P/E Ratio: 12.8 times.
2. What is the purpose of calculating the market value ratio?
3. What actions can directors take to ensure a stable dividend yield
growth over time?
4. The P/E ratio indicates the premium an investor is prepared to
pay for a share. Discuss?
5. Explain what activities can cause the dividend payout ratio to
change.
Relationship Among Ratios

Session 3: Time-Series Techniques/Trend Analysis
Session Learning Outcomes

Learners will understand and be appreciative on the use of the time series
analysis technique while analysing the financial statements information, its
application and interpretation
Trend analysis: Is the type of analysis in which the information for a single
company is compared over time.
Over the course of the business cycle, sales and profitability may expand
and contract, so the ratio analysis for one year may not present an accurate
picture of the firm.
Therefore we look at trend analysis of performance over a number of years.
However without industry comparisons even trend analysis may not present
a complete picture.

By looking at the company profit margin over time in relation to the
industrial average it can be observed that a company was showing the
decreasing trend up to 1995 after that the company shows an increasing
trend. However the company was performing above the average up to 1989
then below the industry average up to 1995.
Trend analysis can be used to compare various other items in the
industry/sector such as:
• Number of subscribers
• Investment in fixed assets
• Investment in total assets
• Sales
• Charging rates
Trend analysis can be established by comparing items in the regional area

such as:
• Number of telephone operators in Tanzania and average number of

operators per country in Sub Saharan Africa
• Charge rates of Botswana mobile subscribers and the average charge
rates in the Sub Saharan region over years
Trend analysis can help telecommunication operators enhance their policy

making decisions by comparing themselves to other countries and providers
in the region. At the same time may seek expertise in the areas which the
sector wants to improve if there is a country of comparative benefits as
compared to others.
Module 1.4: Learning Activity for Financial Statement Analysis and Interpretation

The following are extracts from the financial statements of a telephone
company.
The eight per cent debentures are redeemable in instalments and the final
instalment is due to be paid in 2003.
The regulatory authority is concerned about the poor liquidity of the

company and has asked you to report on the company’s recent performance.
After calculating appropriate ratios, comment on the performance and
financial health of the company.

Session 4: Indicators and Souces of Financial Distress
Learning Objectives
At the end of this session, students should be able to:
• Determine the costs of financial distress

• Explain the factors influencing the risk of financial distress
• Financial distress
• Costs of financial distress
• Indicators for financial distress
In the real world companies do not, generally raise their debt-to-equity

ratios to very high levels. This suggests that there are other important
influences on capital structure besides lower costs of debt and tax relief on
debt. The basic additional factors which have a bearing on the gearing level
are: financial distress (bankruptcy costs); agency costs; borrowing capacity;
managerial preference; pecking order; financial slack; signalling; control;
and industry group gearing.
Financial Distress
Financial distress is defined as a condition where obligations are not met or
are met with difficulty.
A major disadvantage for a firm taking on higher levels of debt is that it
increases the risk of financial distress, and ultimately liquidation. This may
have detrimental effect on both the equity and debt holders.
Effects of Financial Distress
• The risk of incurring the costs of financial distress has a negative effect
on a firm's value which offsets the value of tax relief of increasing debt
levels.
• These costs become considerable with very high gearing. Even if a firm
manages to avoid liquidation its relationships with suppliers,
customers, employees and creditors may be seriously damaged.
• Suppliers providing goods and services on credit are likely to reduce
the generosity of their terms, or even stop supplying altogether, if
they believe that there is an increased chance of the firm not being in
existence in a few months' time.

• Customers may develop close relationships with their suppliers, and
plan their own production on the assumption of a continuance of that
relationship. If there is any doubt about the longevity of a firm it will
not be able to secure high-quality contracts. In the consumer markets
customers often need assurance that firms are sufficiently stable to
deliver on promises.
In a financial distress situation, employees may become demotivated as they

sense increased job insecurity and few prospects for advancement. The best
staff will start to move to posts in safer companies.
Bankers and other lenders will tend to look upon a request for further
finance from a financially distressed company with a prejudiced eye – taking
a safety-first approach – and this can continue for many years after the
crisis has passed.
Management find that much of their time is spent "fire fighting" – dealing
with day-to-day liquidity problems – and focusing on short-term cash flow
rather than long-term shareholder wealth.
The indirect costs associated with financial distress can be much more
significant than the more obvious direct costs such as paying for lawyers,
accountants and for refinancing programs. Some of these indirect and direct
costs are shown in the table below:

Some Indicators of Financial Distress
As the risk of financial distress rises with the gearing ratio shareholders (and
lenders) demand an increasing return in compensation.
The important issue is at what point does the probability of financial distress
so increase the cost of equity and debt that it outweighs the benefit of the
tax relief on debt?
Financial Analysis may be used to view some of the indicators of the financial
distress. Important ratios to be considered include:
• Liquidity ratios
• Debt management ratios
• Asset utilization ratios
The ratios provide indicators on whether the firm is facing financial problems
in meeting both its current and long term debt obligations. Other indicators
are as discussed below.
Some Factors Influencing the Risk of Financial Distress Costs
The susceptibility to financial distress varies from company to company.
Here are some influences:
1. The sensitivity of the company's revenues to the general level of

economic activity.
If a company is highly responsive to the ups and downs in the
economy, shareholders and lenders may perceive a greater risk of
liquidation and/or distress and demand a higher return in
compensation for gearing compared with that demanded for a firm
which is less sensitive to economic events.
2. The proportion of fixed to variable costs.
A firm which is highly operationally geared, and which also takes on
high borrowing, may find that equity and debt holders demand a high
return for the increased risk
3. The liquidity and marketability of the firm's assets.
Some firms invest in a type of asset which can be easily sold at a
reasonably high and certain value should they go into liquidation. This
is of benefit to the financial security holders and so they may not
demand such a high-risk premium.
4. The cash-generative ability of the business.
Some firms produce a high regular flow of cash and so can reasonably
accept a higher gearing level than a firm with lumpy and delayed cash
inflows.
Discussion 6
Post your response in the discussions area. (See the procedure for
discussions in Course Info.)
Discuss whether there is any rationale to study the financial distress
of telecommunication companies:
1. Explain what are the possible costs for the ICT industry given
the financial distress situation?
2. What action will the regulators take if in the market where the
firm(s) encountered financial distress? Express your answer
based on two nature of economies (monopoly and competitive
market)
3. You are given a set of financial statements including the
balance sheet and the income statement of S.O.SONEY for the
three consecutive years. All data is in million shillings.

Required
1. Perform a detailed financial statement analysis and evaluate the

activity and management effectiveness based on
(i) Vertical Analysis

(ii) Horizontal Analysis
(iii) Ratio Analysis
2. What can you conclude as to the financial position of the company?

Session 1: Users and Suppliers of Financial Statements Information

Learners will be able to understand parties that demand and supply financial
statements information as well as their objectives for the need of the
financial statements information. Also, they will learn the conflicts which
may arise among the diverse parties demanding and supplying the financial
statements.
• Demand
• Supply
• Financial statements information
• Internal users of financial statements
• External users of financial statements
A: Users/Demanders of Financial Statements Information

Parties demanding financial statement information include:
• Shareholders, investors and security analysts;

• Managers;
• Employees;
• Lenders and other suppliers;
• Customers; and
• Government regulatory agencies
These parties can also be grouped into internal versus external users.
Internal users consist of managers and employees while external users
consist of the rest in the above list. These parties demand financial
statement information:
• To Facilitate decision-making,
• For Monitoring of management, or
• To Interpret contracts or agreements that include provisions based on
such information.
Shareholders, Investors and Security Analysts

These are major recipients of the financial statements of corporations. These
parties range from individuals with relatively limited resources to large, well-
endowed institutions such as insurance companies and mutual funds.

The decision made by these parties includes:
• Shares to buy, retain, or sell,

• Timing of the purchase or sale of those shares.
Typically, their decisions have either an investment focus or a stewardship

focus; in some cases, both will occur simultaneously. In an investment
focus, the emphasis is on choosing a portfolio of securities that is consistent
with the preferences of the investor for risk, return, dividend yield, liquidity
and so on. The information required for this choice can vary significantly.
An Illustration
Consider approaches aiming to detect mis-priced securities by a fundamental
analysis approach as opposed to a technical analysis approach. The former
approach examines firm,-industry-and – economy-related information;
financial statements play a major role in this approach. An important aspect
is predicting the timing, amounts, and uncertainties of the future cash flows
of the firm. In contrast, technical analysis aims to detect mispriced securities
by examining trends in security prices, security trading volume, and other
related variables; financial statement information typically is not examined
When predicting the timing, amounts, and uncertainties of future cash flows
of the firm, the past record of management in relation to the resources
under its control can be a critical variable. The analysis undertaken for
decisions by shareholders and investors can be done by those parties
themselves or by intermediaries such as security analysts and investment
advisors.
Note: These intermediaries can have different rankings for financial

statement variables than the investors for whom the information analysis is
conducted.
Managers
One source of the demand for financial statement information by managers
arises from contracts that include provisions based on financial statement
variables. e.g. Management incentive contracts. When structuring
agreements between the firm and other entities, management may include
contractual terms based on financial statement variables.
Managers also utilize financial statement information in many of their

financing, investment, and/or operating decisions. A financial-statement
based variable, such as the current debt-to-equity ratio or the interest
coverage ratio, is frequently important in deciding how much long-term debt
to raise.

The financial statement of other firms can also be used in management
decisions. For instance, when deciding where to re-direct the resources of a
firm, the financial statement of other firms can show areas where high profit
margins are currently being earned.
Employees
Employees have several motivations. They have a vested interest in the
continued and profitable operations of their firm. Financial statements are an
important source of information about current and potential future
profitability and solvency. They may also need them to monitor the viability
of their pension plans.
Lenders and Other Suppliers

In the ongoing relationship that exists between suppliers and a firm,
financial statements can play several roles. Consider the relationship
between a firm and the suppliers of its loan capital, e.g. a bank. In the initial
loan-granting stage of the relationship, financial statements typically are an
important item.
Many banks have standard evaluation procedures that stipulate that

information relating to liquidity, leverage, profitability, and so on be
considered when determining the amount of the loan, interest rate and the
security to be requested. Many bank loans include bond covenants that, if
violated, can result in the bank restructuring the existing loan agreement.
One effect of incorporating a covenant into a loan agreement is to create a
demand by the bank for successive financial statements of the firm.
Customers
The relationship between a firm and its customers can extend over many
years. In some cases, these relationships take the form of legal obligations
associated with guarantees, warranties, or deferred benefits. In other cases,
the long-term association is based on continued attention to customer
service.
Government/ Regulatory Agencies

The demand by these bodies can arise in a diverse set of areas such as;
Revenue raising, e.g. for income tax, sales tax, or value-added tax
collection. Government contracting, e.g. for reimbursing suppliers paid on a
cost-plus basis or for monitoring whether companies engaged in government
business are earning excess profits. Rate determination, e.g. deciding the
allowable rate of return that an electric utility can earn. Regulatory
intervention, e.g. determining whether to provide a government-backed loan
agreement to a financially distressed firm.

For instance, telecommunication regulators may demand financial
statements of the telephone/ICT companies to make decisions on the
following issues:
• Competition strategy set up of the companies

• Monitoring interconnection charges
• Limit entries and incubators in the market
• Deciding on the coverage
• Setting the upper pricing limit for the services provided by the
operators.
• For industrial/regional comparisons of the services offered by the
companies and the returns of the companies.
Other Parties
The set of parties that make demands of the financial statements
information of corporations is open-ended. Diverse parties such as
academicians, environmental protection organizations, and other special
interest lobbying groups approach corporations for details relating to their
financial and other affairs.
B: Suppliers of Financial Statements Information

Business firms are the suppliers of the financial statements information.
Limited liability companies are required by the company act to prepare
financial statements and disclose the audited financial statements to the
public/shareholders. Listed companies are required by the regulations
governing the operation of the stock market to disclose audited financial
statement information.
C: Conflicts among Diverse Parties

As explained in part A of this section, users of financial data have diversity of
interests. These interests sometimes conflict.
Owners/Shareholders
The interest of these parties in financial statement information lies in the
fact that it is their money that is invested in the firm. They would like to
ensure that they are getting a good return on their investment. This is
assessed by how much profit the firm is making and whether their
investment is increasing in value. For shareholders in companies this means
they will get good dividend and the market value of their shares will increase
and they can make capital gains if these were sold.
Management
They are responsible to the owners/shareholders in carrying out policies and
directives, and in running the business efficiently and effectively. They

however, need to be paid well and this increases expenses and thus reduces
returns to shareholders.
Banks/Loan companies
This group is interested not only in the firm's profitability but also in its
ability to repay loans. Managers would prefer using loaned funds for a longer
period.
Employees
They are part of the organization and feel that their efforts contributed to
the firm's profits. They would therefore prefer to be given bonuses and
salary increases. This also increases expenses to the firm.
Suppliers
Suppliers usually extend credit to the firm for goods supplied and they want
to be assured of timely payments of accounts due. Their interest will be
similar to that of the banks and loan companies.
Prospective Investors/Analysts
These are interested in a firm's profitability and potential for growth.
Prospective investors rely on financial statements information in making
their investment decisions. In giving advice to prospective and existing
investors, analysts also make use of financial statements information.
Government
Various ministries and departments have interest in the firm's payments of
taxes. Also see the enactment of laws for the industry and provision of social
services to the public. The government may also want to ensure that the
firm complies with laws on, for example, wage payments and employee
benefits.
Discussion 4
1. What are the possible conflicts in demanding the financial

statement for a telephone operator for the following parties
a) Users of the service and the operators
b) Competitors and the shareholders
c) Shareholders and the users
d) Shareholder and the operator
2. Explain why each of the following groups might want financial

statements information. What type of financial information would

each group find most useful?
a) The company’s existing shareholders
b) Prospective investors
c) Financial analysts who follow the company
d) Company managers
e) Current employees
f) Commercial lenders who loaned money to the company
g) Current suppliers
h) Regulators in the sector like Telecommunication Regulators for
the telecommunication industry

Module 1.2: Preparation of Financial Statements for ICT Firms
Chapter Learning Objectives
• Understand financial reporting for internal and external users.

• Appreciate how financial statements are prepared and what policy and
regulatory issues affect the type of financial results produced.
Chapter Learning Outcomes

At the end of this chapter, the learner will have knowledge on the financial
reporting required for the internal and external users and how policy and
regulatory issues affect the numbers presented in financial statements. The
students will learn how the financial statements are prepared and what
constitutes the financial statements.
Important things to note in this chapter are that the regulators should have
at least a basic knowledge on how the financial statements are prepared by
the companies. This is important since financial statements can have
different forms depending upon who is using the financial statements. Policy
and regulations do affect the results presented in financial statements.
Session to be Covered
Session 1: Preparation of the Income Statement, Balance sheet and Cash
flow statements.

Session 1: Preparation of Income Statement, Balance Sheet and Cash Flow Statements
This session provides details on how to prepare financial statements. Most

commonly used financial statements are income statement, balance sheet
and cash flow statements.

Learners will be able to understand and appreciate the process in the
preparation of the Income Statement or the Trading and Profit and Loss
Account, Balance sheet and Cash Flow statements and their importance.
• Financial Statements
• Income statement
• Balance sheet statement
• Cash flow statement
• Revenue/sales determination
• Cost of goods sold
• Manufacturing overheads
• Sources of funds
• Uses of funds
Basic Definitions
Financial statement
A report of basic accounting data that helps investors understand a firm's
financial history and activities.
Income statement (statement of operations)
A statement showing the revenues, expenses, and income (the difference
between revenues and expenses) of a corporation over some period of time.
Balance sheet
Also called the statement of financial condition, it is a summary of a
company's assets, liabilities, and owners' equity.
The document distributed at the annual meeting to shareholders of record
who wish to vote their shares in person.
Cash flow statement
Statement showing earnings before depreciation, amortization, and non-
cash charges. Sometimes called cash earnings. Cash flow from operations
indicates the ability to pay dividends.

Preparation of Income Statement
The Income Statement normally shows whether the business is earning
profits or sustaining losses. It communicates the financial performance of
the business. The structure of the income statement differs with the nature
of the business. The business can either be a manufacturing,
merchandising/trading or service entity. Regardless of the structure, they
however, communicate the same information.
Factors to be considered in the preparation of income statements are:
Revenues/Sales
This item carries the revenues/sales generations of the company. Sales
consist of Cash Sales (cash is paid at the time of sale) or Credit Sales (Cash
paid later). The sales/revenue is made up with the following items:
Note: Other Incomes/Revenues results from the revenues which are not
core business of the company. Such revenues are for example, if a company
earns interest from banking services, dividends received from investment of
other companies or subsidiaries, money awards, etc.
For a trading and service entity the same consideration is made for the
revenues/income as sown above. The only difference for the service
company is the return inwards since in most cases services are consumed
when manufactured/prepared with nothing to be left as a return.
Cost of Goods Sold

This represents the total cost of buying raw materials, and paying for all the
factors that go into producing finished goods. The cost of goods should be
deducted from the sales revenues.

Note: For manufacturing firm, the process of manufacturing goods is a
continuous process. Hence there might be materials which are in stock or
some of the goods may be half processed (work in progress) both at the
opening of the financial year or at the closure of the financial year. Hence,
calculation of the cost of goods sold should include consideration of all the
items shown in the table above.
Trading Firms
Service Firms
In service companies such as telecommunications, cost of service provided
may be expressed as percentage of sales say 60% of the revenues

generated regarded as cost of services to pay for bandwidth access in a
satellite company.
Gross Profit
This is the difference between Net Sales and the Cost of Goods Sold. Gross
profit is the profit obtained from the normal operation of a business firm
before incurring operating expenses, tax and other deductions.
Expenses
These are the expenses the company incurs in the process of generating
revenues. The expenses depend on the nature of the business firm.
Profit Before Interest and Tax: This is equal to the Cost of goods sold
less expenses

Note: Dividend is a portion of a company's profit paid to common and
preferred shareholders. It is paid to common stock holders only when the
company makes profit.
In arriving at the income statement as shown above, there should be

supporting documents which when totalled brings the figures for the above
items.
Preparation of the Balance Sheet Statement

The Balance Sheet shows the value of assets owned by the business, the
amount of its debts and the equity of the owner. In other words, it
communicates the financial position of the business.

Discussion 3
1. Review financial statements of communication of the regulatory body

of your country.
a) Identify the common items in the financial statements.
b) Relate the financial statements to three other regulatory bodies in
the SADC region.
2. Review financial statements of at least two telecommunication
companies in your country. Where possible, one company should be a
producer of ICT products and the other should be a service firm.
a) Identify the common items in the financial statements.
b) Relate the financial statements of these firms to each other.
Preparation of Cash flow Statement

This statement shows the changes that have taken place in actual cash and
the working capital of the firm as well as the sources and use of the working
capital during the accounting period.
It is a summary of a firm’s changes in financial position from one period to

another; it is also called the sources and uses of funds statement or a
statement of changes in financial position. The flow of cash/funds in a firm
may be visualized as a continuous process. For every use of cash/funds,
there must be an offsetting source. In a broad sense, the assets of a firm
represent the net uses of cash/funds; its liabilities and net worth represent
net sources.
The fund flow statement is useful to know whether the uses of the funds can
be met by the available sources funds or there is a need for external
financing sources such as bank overdrafts, etc.
Sources and Uses of Funds Statement
Tracing Cash and Net Working Capital
Sources of Funds
Consist of all events that increase cash:
• A net decrease in any asset other than cash or fixed assets

• A gross decrease in fixed assets
• A net increase in any liability
• Proceeds from the sale of preferred or common stock
• Funds provided by operations
Note: Funds provided by operations usually are not expressed directly
on the income statement. To determine them, one must add back
depreciation and any other non-cash item that was deducted and also
deduct any non-cash item that was added to the net income.
Uses of Funds
Consist of all events that decrease cash and include:
• A net increase in any asset other than cash or fixed assets

• A gross increase in fixed assets
• A net decrease in any liability
• A retirement or purchase of stock
• Cash dividends
Statement of Cash Flows

It emphasizes the critical nature of cash flow to the operation of the firm.
The primary sections of the statement of cash flows are:
• Cash flows from operating activities

• Cash flows from investing activities

• Cash flow from financing activities
The results from each section are added together to compute the net
increase or decrease in cash flow for the firm. The format of the cash flows
statement is given below:

Preparation of Other Financial Related Statements
(ii) Explanatory Notes

The explanatory notes communicate additional information regarding items
included and excluded from the body of the statement. These normally
include:
• Accounting policies
• Detailed disclosure regarding individual elements
• Commitments and contingencies
• Business combinations
• Transactions with related parties
• Legal proceedings etc.
These are prepared to justify each accounting figure in the prepared financial
statements.

Financial Statement Analysis

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Financial Statement Analysis

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Financial Statement Analysis Methods: Horizontal

vs. Vertical Analysis

One method of performing a horizontal financial statement analysis

The other method of performing horizontal financial statement analysis

(1050 – 1000)/1000 X 100 = 5%

Qazi Ashfaq | Financial Statement Analysis 1

Performing vertical analysis of the income statement involves comparing

1000/10,000 X 100 = 10%

Performing vertical analysis of the balance sheet involves comparing each

Qazi Ashfaq | Financial Statement Analysis 2

Session Learning Outcomes

Important Learning Terms

Financial analysis: is a process which involves reclassification and

Analysis of financial statement: Refers to the examination of the statements

The Objectives of Financial Statement Analysis

Qazi Ashfaq | Financial Statement Analysis 3

Qazi Ashfaq | Financial Statement Analysis 4

• Why is there an increase in the stock of the company? Has the

Qazi Ashfaq | Financial Statement Analysis 5

B: Vertical/Cross-Sectional/Common Size Analysis Techniques

Qazi Ashfaq | Financial Statement Analysis 6

Example: It can be observed that there is an increase in the holding of the

From the Exhibit 1, prepare vertical analysis for the income

Qazi Ashfaq | Financial Statement Analysis 7

Session Learning Outcome

• Different level of acceptance (by the decision-makers and stakeholders) may be

Building Financial Analysis Model

1. Conservative estimations of the revenues/benefits

Qazi Ashfaq | Financial Statement Analysis 8

5. Judgment on Three point estimation

Various interconnection and charging rates are considered between three

Qazi Ashfaq | Financial Statement Analysis 9

Session Learning Outcome

Important Learning Terms

A ratio: Is the mathematical relationship between two quantities in the form

Ratio analysis: is essentially concerned with the calculation of relationships

The analysis is used to provide indicators of past performance in terms of

Note: A ratio on its own has little or no meaning at all.

Significance of Using Ratios

Qazi Ashfaq | Financial Statement Analysis 10

• Liquidity refers to the ability of a firm to meet its short-term financial

Qazi Ashfaq | Financial Statement Analysis 11

B: Asset Management/Activity Ratios

Note: Increased turnover can be just as dangerous as reduced turnover if

Asset Management ratios are discussed next.

Average Collection Period

Qazi Ashfaq | Financial Statement Analysis 12

Total Assets Turnover

Qazi Ashfaq | Financial Statement Analysis 13

Fixed Asset Turnover

From the above calculations:

• It appears that the activity of the business is relatively constant, with

C: Financial Leverage (Gearing) Ratios

Qazi Ashfaq | Financial Statement Analysis 14

• A high equity ratio reflects a strong financial structure of the company.

This ratio is calculated as follows:

Qazi Ashfaq | Financial Statement Analysis 15

Debt to Equity ratio

Times Interest Earned Ratio

The ratio is calculated as follows:

• The company’s major forms of credit are non-interest bearing (trade

Qazi Ashfaq | Financial Statement Analysis 16

Note: Without profit, there is no cash and therefore profitability must be