Financial Statement Analysis

 To make informed decisions about a company

o Helpful in managing the company
o Comparison with the competition
o Charting a company’s progress, measure performance
o Establish financial health
o Used for investment decisions
 Generally based on comparative financial data
o From one year to the next (trend analysis; comparing self with self)
o With a competing company (comparing self to another company)
o With the industry as a whole (industry average: level of a company’s acceptable
performance)
 Three main ways to analyze FS
o Horizontal analysis: year to year comparison
o Vertical Analysis: compare different companies
o Using industry averages: compare company’s performance against the industry averages

Perform a Horizontal analysis of Financial Statement

Horizontal analysis – the study of percentage changes in comparative statements

 Compute dollar changes
o (current year – past year)
 Compute percentage changes
o (dollar amount of change/base-period amount=percentage change) or (current year-
base year/base year=percentage change)
Trend Percentages
 Form of horizontal analysis
o Indicates business direction
o How have things changed over the years?
 Select a period of three to five years’
 Base year, earliest year, is selected and set equal to 100%
 Subsequent years expressed as a percentage of the base period
o (Any year $ / base year $ x 100 = trend %)

*Revenues increases higher rate than total expenses

Perform a vertical analysis of financial statements

Vertical analysis – shows relationship of each item to a base amount on financial statements
 Income statement – each item expressed as percentage of net sales
o (each income statement item / revenues (net sales) x 100
 Balance sheet – each item expressed as percentage of total assets or total liabilities and equity

Prepare and use common-size financial statements

Common-size statements
 Common-size statements compare one company to another
 o Report only percentages (same as vertical analysis)
o Remove dollar value bias

Benchmarking
 Comparing a company with another leading company
 Two main types
o Against a key competitor
o Against the industry average

Compute and evaluate the standard financial ratios

Financial ratios
 No single ratio tells the whole picture
 Different ratios explain different aspects
 Types:
o Evaluating ability to pay current liabilities
o Evaluating ability to sell inventory and collect receivables
o Evaluating ability to pay long-term debt
o Evaluating profitability
o Evaluating stock as an investment

Evaluating ability to pay current liabilities

 Working capital – measures ability to meet short-term obligations
o Working capital = current assets – current liabilities
 Current ratio – proportion of current assets to current liabilities
o Current ratio = current assets / current liabilities
 Acid-test ratio – tells if company could pay all its current liabilities immediately
o Acid test ratio = cash + short term investments + net current receivables / current
liabilities

Evaluating ability to sell inventory and collect receivables

 Inventory turnover ratio
o Measures number of times a company sells inventory during a year
o High rate indicates ease in selling
o Low rate indicates difficulty in selling
o Inventory turnover = COGS / Average inventory (beginning + ending / 2)
o Sales will be used as numerator if COGS is not given
 Days in inventory ratio
o Measures the average number of day inventory is held by the company
o Days in inventory = 365 days / inventory turnover ratio
o If the problem says 360 days, then use 360 days
 Gross profit percentage
o Measures the profitability of each net sales dollar
o Gross profit percentage = gross profit / net sales
 Accounts receivable turnover ratio
o Measures ability to collect cash from credit customers
 o A/R turnover = net credit sales / average net accounts receivable
 Days’ sales in receivable ratio or average collection period or days sales outstanding
o Measures ability to collect receivables (how long can A/R be collected)
o Day’s sales in average A/R = 365 days/ accounts receivable turnover

Evaluating ability to pay long-term debt

 Debt ratio
o Shows portion of assets financed with debt
o The higher the ratio, the higher the risk
o Debt ratio = total liabilities / total assets
 Debt to equity ratio
o The proportion of total liabilities to the proportion of total equity that is financing the
company’s assets
o Measures the financial leverage.
o Debt to equity = total liabilities / total equity
 Times-interest-earned ratio or interest coverage ratio
o Measures number of times income can cover interest expense
o High ratio indicates ease in paying interest
o Times-interest earned = EBIT / interest expense

Measuring Profitability
 Return on net sales
o Percent of each sales dollar earned as net income
o Rate of return on net sales = Net Income / Net Sales
 Return on total assets or return on investment
o Measures success in using assets to earn a profit
o Rate of return on total assets = net income + interest expense / average total assets
o If the numerator is income statement account and denominator is SFP account then the
denominator would be average
 Asset turnover ratio
o Measures the amount of net sales generated for each average dollar of total assets
invested
o Asset turnover ratio = net sales / average total assets
 Return on common stockholders’ equity or return on equity
o How much income is earned for each dollar invested by common shareholders
o Rate of return on equity = net income – preferred dividends / average common
stockholders’ equity
 Leverage
o Trading on the equity
 Company borrows at a lower rate, the invests the money to earn a higher rate
 Return on equity > return on assets
o Increases profits during good times
o Compound losses during bad times

Measuring Profitability
 Earnings per share
 o Net income earned for each share of outstanding common stock
o Outstanding stock = issued stock – treasury stock
o Earnings per share of common stock = net income – preferred dividends / number of
shares of common stock outstanding

Analyzing Stock Investments

 Price/earnings ratio (P/E)
o Market price compared to earnings per share
o P/E ratio = market price per share of common stock (MPS) / earnings per share (EPS)
 Dividend yield
o Percentage of market value that is returned as dividends
o Dividend yield on common stock = annual dividends per share of common stock (DPS) /
market price per share of common stock (MPS)
 Dividend payout
o The ratio of annual dividends declared relative to the earnings per share of the company
o Dividend payout = annual dividends per share (DPS) / earnings per share (EPS)
 Book value
o Common equity per share
o Some argue its relevance to investors
o Book value per share of common stock = total SHE – preferred equity / number of
shares of common stock outstanding

Red Flags
Analysts look for red flags that may signal financial trouble