Robles, Ceejay D.

FINANCIAL STATEMENT ANALYSIS

COURSE OBJECTIVES:

After completion of this module, LEARNERS will be able to know and

understand: 1. Know the importance and uses of FS analysis.
2. Understand the methods of FS analysis.
3. Learn the different ratios and their relevance to FS analysis.
4. Understand the problems encountered in FS analysis.

Overview of Financial Statement Analysis

Financial statement analysis involves gaining an understanding of an organization's financial situation by

reviewing its financial statements. This review involves identifying the following items for a company's
financial statements over a series of reporting periods:

∙ Trends. Create trend lines for key items in the financial statements over multiple time periods, to see
how the company is performing. Typical trend lines are for revenues, the gross margin, net
profits, cash, accounts receivable, and debt.

∙ Proportion analysis. An array of ratios are available for discerning the relationship between the size
of various accounts in the financial statements. For example, one can calculate a company's
quick ratio to estimate its ability to pay its immediate liabilities, or its debt to equity ratio to see if it
has taken on too much debt. These analyses are frequently between the revenues and expenses
listed on the income statement and the assets, liabilities, and equity accounts listed on the
balance sheet.

Financial statement analysis is an exceptionally powerful tool for a variety of users of financial statements,
each having different objectives in learning about the financial circumstances of the entity.

Objectives of Financial Statement Analysis

The major objectives of financial statement analysis are as follows:

1. Assessment Of Past Performance

Past performance is a good indicator of future performance. Investors or creditors are interested in the
trend of past sales, cost of good sold, operating expenses, net income, cash flows and return on
investment. These trends offer a means for judging management's past performance and are possible
indicators of future performance.

2. Assessment of current position

Financial statement analysis shows the current position of the firm in terms of the types of assets owned
by a business firm and the different liabilities due against the enterprise.
3. Prediction of profitability and growth prospects

Financial statement analysis helps in assessing and predicting the earning prospects and growth rates in
earning which are used by investors while comparing investment alternatives and other users in judging
earning potential of business enterprise.

4. Prediction of bankruptcy and failure

Financial statement analysis is an important tool in assessing and predicting bankruptcy andprobability of
business failu

5. Assessment of the operational efficiency

Financial statement analysis helps to assess the operational efficiency of the management of a company.
The actual performance of the firm which are revealed in the financial statements can be compared with
some standards set earlier and the deviation of any between standards and actual performance can be
used as the indicator of efficiency of the management.

Importance of Financial Statement Analysis

The financial statement analysis is important for different reasons:

1. Holding of Share

Shareholders are the owners of the company. Time and again, they may have to take decisions whether
they have to continue with the holdings of the company's share or sell them out. The financial statement
analysis is important as it provides meaningful information to the shareholders in taking such decisions.

2. Decisions and Plans

The management of the company is responsible for taking decisions and formulating plans and policies for
the future. They, therefore, always need to evaluate its performance and effectiveness of their action to
realise the company's goal in the past. For that purpose, financial statement analysis is important to the
company's management.

3. Extension of Credit

The creditors are the providers of loan capital to the company.Therefore they may have to take decisions
as to whether they have to extend their loans to the company and demand for higher interest rates. The
financial statement analysis provides important information to them for their purpose.

4. Investment Decision

The prospective investors are those who have surplus capital to invest in some profitableopportunities.
Therefore, they often have to decide whether to invest their capital in the company's share. The financial
statement analysis is important to them because they can obtain useful information for their investment
decision making purpose.
Users of Financial Statement Analysis

There are a number of users of financial statement analysis. They are:

∙ Creditors. Anyone who has lent funds to a company is interested in its ability to pay back the debt,
and so will focus on various cash flow measures.

∙ Investors. Both current and prospective investors examine financial statements to learn about a
company's ability to continue issuing dividends, or to generate cash flow, or to continue growing at
its historical rate (depending upon their investment philosophies).

∙ Management. The company controller prepares an ongoing analysis of the company's financial
results, particularly in relation to a number of operational metrics that are not seen by outside
entities (such as the cost per delivery, cost per distribution channel, profit by product, and so
forth).

∙ Regulatory authorities. If a company is publicly held, its financial statements are examined by the
Securities and Exchange Commission (if the company files in the United States) to see if its
statements conform to the various accounting standards and the rules of the SEC.

Problems with Financial Statement Analysis

While financial statement analysis is an excellent tool, there are several issues to be aware of that can
interfere with your interpretation of the analysis results. These issues are:

∙ Comparability between periods . The company preparing the financial statements may have changed
the accounts in which it stores financial information, so that results may differ from period to
period. For example, an expense may appear in the cost of goods sold in one period, and in
administrative expenses in another period.

∙ Comparability between companies . An analyst frequently compares the financial ratios of different
companies in order to see how they match up against each other. However, each company may
aggregate financial information differently, so that the results of their ratios are not really
comparable. This can lead an analyst to draw incorrect conclusions about the results of a
company in comparison to its competitors.

∙ Operational information. Financial analysis only reviews a company's financial information, not its
operational information, so you cannot see a variety of key indicators of future performance, such
as the size of the order backlog, or changes in warranty claims. Thus, financial analysis only
presents part of the total picture.

Limitations of Financial Statement Analysis

Although analysis of financial statement is essential to obtain relevant information for making several
decisions and formulating corporate plans and policies, it should be carefully performed as it suffers from a
number of the following limitations.
1. Mislead the user
The accuracy of financial information largely depends on how accurately financial statements are
prepared. If their preparation is wrong, the information obtained from their analysis will also be wrong
which may mislead the user in making decisions.

2. Not useful for planning

Since financial statements are prepared by using historical financial data, therefore, the information
derived from such statements may not be effective in corporate planning, if the previous situation does
not prevail.

3. Qualitative aspects

Then financial statement analysis provides only quantitative information about the company's financial
affairs. However, it fails to provide qualitative information such as management labour relation, customer's
satisfaction, management's skills and so on which are also equally important for decision making.

4. Comparison not possible

The financial statements are based on historical data. Therefore comparative analysis of financial
statements of different years can not be done as inflation distorts the view presented by the statements of
different years.

5. Wrong judgement

The skills used in the analysis without adequate knowledge of the subject matter may lead to negative
direction . Similarly, biased attitude of the analyst may also lead to wrong judgement and conclusion.

Methods of Financial Statement Analysis

There are two key methods for analyzing financial statements. The first method is the use of horizontal
and vertical analysis. Horizontal analysis is the comparison of financial information over a series of
reporting periods, while vertical analysis is the proportional analysis of a financial statement, where each
line item on a financial statement is listed as a percentage of another item. Typically, this means that
every line item on an income statement is stated as a percentage of gross sales, while every line item on
a balance sheet is stated as a percentage of total assets. Thus, horizontal analysis is the review of the
results of multiple time periods, while vertical analysis is the review of the proportion of accounts to each
other within a single period.

The second method for analyzing financial statements is the use of many kinds of ratios. Ratios are used
to calculate the relative size of one number in relation to another. After a ratio is calculated, you can then
compare it to the same ratio calculated for a prior period, or that is based on an industry average, to see if
the company is performing in accordance with expectations. In a typical financial statement analysis, most
ratios will be within expectations, while a small number will flag potential problems that will attract the
attention of the reviewer.
Ratio Analysis

Presentation of Ratio
Ratio can be expressed in the following terms:

1. Ratio method

Ratio method shows the relationship between two figures in ratio or proportion. It is expressed bysimple
division of one item by another eg. 2.5:1,0.5:1 and so on.

2. Rate method

This method shows relationship in rate or times, like 2 times or 4 times and so

on. 3. Percentage method

The relationship between two figures can be presented in percentage like 20%, 30% and so

on. Importance And Advantages Of Ratio Analysis

Ratio analysis is an important tool for analyzing the company's financial performance. The following are
the important advantages of the accounting ratios.

1. Analyzing Financial Statements

Ratio analysis is an important technique of financial statement analysis. Accounting ratios are useful for
understanding the financial position of the company. Different users such as investors,management.
bankers and creditors use the ratio to analyze the financial situation of the company for their decision
making purpose.

2. Judging Efficiency

Accounting ratios are important for judging the company's efficiency in terms of its operations and
management. They help judge how well the company has been able to utilize its assets and earn profits.

3. Locating Weakness

Accounting ratios can also be used in locating weakness of the company's operations even though its
overall performance may be quite good. Management can then pay attention to the weakness and take
remedial measures to overcome them.

4. Formulating Plans

Although accounting ratios are used to analyze the company's past financial performance, they can also
be used to establish future trends of its financial performance. As a result, they help formulate the
company's future plans.
5. Comparing Performance

It is essential for a company to know how well it is performing over the years and as compared to the other
firms of the similar nature. Besides, it is also important to know how well its different divisions are
performing among themselves in different years. Ratio analysis facilitates such comparison.
Nature Of Ratio Analysis

In financial analysis, ratio is used as an index of yardstick for evaluating the financial position and
performance of the firm. It is a technique of analysis and interpretation of financial statements. Ratio
analysis helps in making decisions as it helps establishing relationship between various ratios and
interpret thereon. Ratio analysis helps analysts to make quantitative judgement about the financial
position and performance of the firm. Ratio analysis involves following steps:

1. Relevant data selection from the financial statements related to the objectives of the analysis. 2.
Calculation of required ratios from the data and presenting them either in pure ratio form or in percentage.
3. Comparison of derived different ratios with:
i. The ratio of the same concern over a period of years to know upward or downward trend or static
position to help in estimating the future, or
ii. The ratios of another firm in same line, or
iii. The ratios of projected financial statements, or
iv. The ratios of industry average, or
v. The predetermined standards, or
vi. The ratios between the departments of the same concern assessing either the financial position or
the profitability or both.

4. Interpretation of the ratio

Ratio analysis uses financial report and data and summarizes the key relationship in order to appraise
financial performance. The effectiveness will be greatly improved when trends are identified, comparative
ratios are available and inter-related ratios are prepared.

Classification of Accounting Ratios

Profitability Sustainability Ratios

How well is our business performing over a specific period, will your social enterprise have the financial
resources to continue serving its constituents tomorrow as well as today?
Ratio What does it tell you?

Sales Growth = Percentage increase (decrease) in sales between two time periods.

Current Period – If overall costs and inflation are increasing, then you should see a corresponding
Previous Period increase in sales. If not, then may need to adjust pricing policy to keep up with

Sales costs.
Previous Period
Sales
Reliance on Measures the composition of an organization’s revenue sources (examples are
Revenue Source sales, contributions, grants).
=
The nature and risk of each revenue source should be analyzed. Is it recurring, is
Revenue Source your market share growing, is there a long term relationship or contract, is there a
Total risk that certain grants or contracts will not be renewed, is there adequate
RevenueTotal diversity of revenue sources?
Revenue
Organizations can use this indicator to determine long and short-term trends in
line with strategic funding goals (for example, move towards self-sufficiency and
decreasing reliance on external funding).

Operating Self Measures the degree to which the organization’s expenses are covered by its
Sufficiency = core business and is able to function independent of grant support.

Business For the purpose of this calculation, business revenue should exclude any non
Revenue Total operating revenues or contributions. Total expenses should include all expenses
Expenses (operating and non-operating) including social costs.

A ratio of 1 means you do not depend on grant revenue or other funding.

Gross Profit How much profit is earned on your products without considering indirect costs.
Margin =
Is your gross profit margin improving? Small changes in gross margin can
Gross Profit Total significantly affect profitability. Is there enough gross profit to cover your indirect
Sales costs. Is there a positive gross margin on all products?
Total Sales
Net Profit How much money are you making per every $ of sales. This ratio measures your
Margin = ability to cover all operating costs including indirect costs

Net Profit Sales

SGA to Sales = Percentage of indirect costs to sales. Look for a steady or decreasing ratio which

Indirect Costs means you are controlling overhead

(sales, general,
admin)
Sales
Return on Measures your ability to turn assets into profit. This is a very useful measure of
Assets = comparison within an industry.

Net Profit Average A low ratio compared to industry may mean that your competitors have found a
 Total Assets way to operate more efficiently. After tax interest expense can be added back to
numerator since ROA measures profitability on all assets whether or not they are
financed by equity or debt
Return on Rate of return on investment by shareholders.
Equity =
This is one of the most important ratios to investors. Are you making enough
Net Profit profit to compensate for the risk of being in business?
Average
Shareholder Equity How does this return compare to less risky investments like bonds?

Operational Efficiency Ratios

How efficiently are you utilizing your assets and managing your liabilities? These ratios are used to
compare performance over multiple periods.
Ratio What does it tell you?

Operating Compares expenses to revenue.

Expense Ratio =
A decreasing ratio is considered desirable since it generally indicates increased
Operating efficiency.
Expenses
Total Revenue

Accounts Number of times trade receivables turnover during the year. The higher the
Receivable
Turnover = turnover, the shorter the time between sales and collecting cash.

Net Sales What are your customer payment habits compared to your payment terms. You
Average may need to step up your collection practices or tighten your credit policies. These
Accounts ratios are only useful if majority of sales are credit (not cash) sales.
Receivable

Days in
Accounts
Receivable =

Average
Accounts
Receivable
Sales x 365

Inventory The number of times you turn inventory over into sales during the year or how
Turnover = many days it takes to sell inventory.
Cost of Sales This is a good indication of production and purchasing efficiency. A high ratio
Average indicates inventory is selling quickly and that little unused inventory is being stored

Inventory (or could also mean inventory shortage). If the ratio is low, it suggests
overstocking, obsolete inventory or selling issues.
Days in
Inventory =

Average
Inventory
Cost of Sales x
365

Accounts The number of times trade payables turn over during the year.
Payable
Turnover = The higher the turnover, the shorter the period between purchases and payment. A
high turnover may indicate unfavourable supplier repayment terms. A low turnover
Cost of Sales may be a sign of cash flow problems.
Average
Accounts Payable Compare your days in accounts payable to supplier terms of repayment.

Days in
Accounts
Payable =

Average
Accounts
Payable
Cost of Sales x
365

Total Asset How efficiently your business generates sales on each dollar of assets. An
Turnover =
increasing ratio indicates you are using your assets more productively.
Revenue
Average Total
Assets

Fixed Asset
Turnover =

Revenue
Average Fixed
Assets
Liquidity Ratios
Does your enterprise have enough cash on an ongoing basis to meet its operational obligations? This is
an important indication of financial health.
Ratio What does it tell you?

Current Ratio = Measures your ability to meet short term obligations with short term assets., a
useful indicator of cash flow in the near future.
Current Assets
Current A social enterprise needs to ensure that it can pay its salaries, bills and expenses
Liabilities on time. Failure to pay loans on time may limit your future access to credit and
therefore your ability to leverage operations and growth.
(also known as
Working A ratio less that 1 may indicate liquidity issues. A very high current ratio may mean
Capital Ratio) there is excess cash that should possibly be invested elsewhere in the business or
that there is too much inventory. Most believe that a ratio between 1.2 and 2.0 is
sufficient.

The one problem with the current ratio is that it does not take into account the
timing of cash flows. For example, you may have to pay most of your short term
obligations in the next week though inventory on hand will not be sold for another
three weeks or account receivable collections are slow.

Quick Ratio = A more stringent liquidity test that indicates if a firm has enough short-term assets
(without selling inventory) to cover its immediate liabilities.
Cash +AR +
Marketable This is often referred to as the “acid test” because it only looks at the company’s
Securities most liquid assets only (excludes inventory) that can be quickly converted to cash).
Current Liabilities
A ratio of 1:1 means that a social enterprise can pay its bills without having to sell
inventory.

Working WC is a measure of cash flow and should always be a positive number. It

Capital = measures the amount of capital invested in resources that are subject to quick
turnover. Lenders often use this number to evaluate your ability to weather hard
Current Assets times. Many lenders will require that a certain level of WC be maintained.
– Current
Liabilities
 Adequacy of Determines the number of months you could operate without further funds received
Resources = (burn rate)

Cash +
Marketable
Securities +
Accounts
Receivable
Monthly
Expenses

Leverage Ratios

To what degree does an enterprise utilize borrowed money and what is its level of risk? Lenders often use
this information to determine a business’s ability to repay debt.
Ratio What does it tell you?

Debt to Compares capital invested by owners/funders (including grants) and funds provided
Equity = by lenders.

Short Term Lenders have priority over equity investors on an enterprise’s assets. Lenders want
Debt + Long to see that there is some cushion to draw upon in case of financial difificulty. The
Term Debt more equity there is, the more likely a lender will be repaid. Most lenders impose
Total Equity limits on the debt/equity ratio, commonly 2:1 for small business loans.
(including
grants) Too much debt can put your business at risk, but too little debt may limit your
potential. Owners want to get some leverage on their investment to boost profits.
This has to be balanced with the ability to service debt.

Interest Measures your ability to meet interest payment obligations with business income.
Coverage = Ratios close to 1 indicates company having difficulty generating enough cash flow to
pay interest on its debt. Ideally, a ratio should be over 1.5
EBITDA
Interest
Expense

END OF CHAPTER QUESTIONS

1. Research all other ratios and their formula, description and relevance, not dicussed

above. REFERENCES:

∙ Managerial Accounting by Saylor

∙ Managerial Accounting for Managers by Noreen, Brewer and Garrison
 ∙ Management Accounting: Nature and Scope by Malik
∙ Cost and Management Accounting by The Institute of Company Secretaries of India
∙ Managerial and Cost Accounting by Walther & Skousen
∙ Management Accounting Study Manual by CPA Australia

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