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02.

Financial Statement Analysis-I


Mr.Kasun Tharaka Dissanayake
B.Sc. Finance (Special)-First class honours-University of Sri Jayewardenapura
CA Finalist

1. Introduction

Financial analysis involves appraising and communicating the position, performance and prospects of a
business based on given and prepared statements and ratios. The ability to review, analyze and interpret a set
of financial statements is a key skill for a financial accountant. Analysis may involve any or all of the
following:

• Vertical or horizontal trend analysis


• Common size analysis
• Ratio analysis

1.1Vertical or horizontal trend analysis


Trend analysis involves comparing financial statements. Vertical trend analysis is comparing the financial
statements of one company from one year to the next. Horizontal analysis is comparing the financial
statements of one company with those of an equivalent company in the same period.
This type of analysis involving comparisons has drawbacks:
(a) The financial results of one year may be skewed by a significant event, making comparison with another
year less meaningful
(b) An 'equivalent company', i.e. a company of a similar size in the same industry may be difficult to find.

1.2 Common size analysis


Common size analysis again involves comparison – either of the same company in different periods or different
companies in the same period.
In this case, however, comparison is not of the 'raw' numbers presented in the financial statements. Instead, a
common base figure is adopted and amounts are expressed as a percentage of this base number. These percentages
are then compared. A common base figure when analyzing the statement of profit or loss is revenue.
1.2.1 Example: common size analysis
The following example shows the results of PLYMOUTH Company for two years
2016 % of 2017 % of
Rs'000 revenue Rs revenue
Revenue 100,000 90,000
Cost of sales (35,000) (30,000)
Gross profit 65,000 60,000
Distribution costs (20,000) (16,000)
Administrative expenses (15,000) (21,000)
Operating profit 30,000 23,000
Finance costs (5,000) (3,000)
Profit before tax 25,000 20,000
Tax (5,000) (4,000)
Retained profit 20,000 16,600

Common size analysis helps to identify whether costs have increased proportionately. Questions that might
be asked as a result of performing this analysis are as follows.

(a) Why has cost of sales increased as a proportion of revenue? Have selling prices reduced while cost per
unit remains the same or have costs increased?

(b) Why have distribution costs increased as a proportion of revenue? Have costs such as petrol increased or
are proportionately more items being distributed (this would be the case if prices have decreased)?

(c) There is a significant drop in the proportion of revenue spent on admin expenses. Is there a one-off item
of income in 2014 or a one-off expense in 2013 that has caused the change?

(d) Finance costs as a proportion of revenue have increased; the company appears to have borrowed money in
the year. This has been employed in the business and resulted in increased revenue.

1.3 Ratio analysis

Ratio analysis involves manipulating amounts in the financial statements to produce a ratio. This is then
compared with the same ratio for any of:

• The same company in a different year


• A different company in the same year
• Industry averages

Ratios can be grouped into five categories:

(1) Profitability
(2) Long-term solvency
(3) Short-term liquidity
(4) Efficiency (turnover ratios)
(5) Shareholders' investment ratios
2. Ratio analysis
For each of the categories of ratio, we will identify a number of standard measures or ratios that are normally
calculated and generally accepted as meaningful indicators.
It must be stressed, however, that each individual business must be considered separately, and a ratio that is
meaningful for a manufacturing company may be completely meaningless for a financial institution. Try not to be
too mechanical when working out ratios and constantly think about what you are trying to achieve.

To illustrate the calculation of ratios, the following statement of financial position and statement of profit or loss
figures will be used. We are using a separate statement of profit or loss for this example, as no items of other
comprehensive income are involved.