What Is Financial Analysis?

Financial analysis is the process of evaluating businesses, projects, budgets, and other
finance-related transactions to determine their performance and suitability. Typically, financial
analysis is used to analyze whether an entity is stable, solvent, liquid, or profitable enough to
warrant a monetary investment.

KEY TAKEAWAYS

 If conducted internally, financial analysis can help fund managers make future business
decisions or review historical trends for past successes.
 If conducted externally, financial analysis can help investors choose the best possible
investment opportunities.
 Fundamental analysis and technical analysis are the two main types of financial
analysis.
 Fundamental analysis uses ratios and financial statement data to determine the intrinsic
value of a security.
 Technical analysis assumes a security's value is already determined by its price, and it
focuses instead on trends in value over time.
 Understanding Financial Analysis
 Financial analysis is used to evaluate economic trends, set financial policy, build long-
term plans for business activity, and identify projects or companies for investment. This
is done through the synthesis of financial numbers and data. A financial analyst will
thoroughly examine a company's financial statements—the income statement, balance
sheet, and cash flow statement. Financial analysis can be conducted in both corporate
finance and investment finance settings.
 One of the most common ways to analyze financial data is to calculate ratios from the
data in the financial statements to compare against those of other companies or against
the company's own historical performance.
 Corporate Financial Analysis
 In corporate finance, the analysis is conducted internally by the accounting department
and shared with management in order to improve business decision making. This type
of internal analysis may include ratios such as net present value (NPV) and internal rate
of return (IRR) to find projects worth executing.
 Many companies extend credit to their customers. As a result, the cash receipt from
sales may be delayed for a period of time. For companies with large receivable
balances, it is useful to track days sales outstanding (DSO), which helps the company
identify the length of time it takes to turn a credit sale into cash. The average collection
period is an important aspect of a company's overall cash conversion cycle.
 A key area of corporate financial analysis involves extrapolating a company's past
performance, such as net earnings or profit margin, into an estimate of the company's
future performance. This type of historical trend analysis is beneficial to identify
seasonal trends.
 For example, retailers may see a drastic upswing in sales in the few months leading up
to Christmas. This allows the business to forecast budgets and make decisions, such
as necessary minimum inventory levels, based on past trends.
 Investment Financial Analysis
 In investment finance, an analyst external to the company conducts an analysis for
investment purposes. Analysts can either conduct a top-down or bottom-up
investment approach. A top-down approach first looks
 for macroeconomic opportunities, such as high-performing sectors, and then drills down
to find the best companies within that sector. From this point, they further analyze the
stocks of specific companies to choose potentially successful ones as investments by
looking last at a particular company's fundamentals.
 A bottom-up approach, on the other hand, looks at a specific company and conducts a
similar ratio analysis to the ones used in corporate financial analysis, looking at past
performance and expected future performance as investment indicators. Bottom-up
investing forces investors to consider microeconomic factors first and foremost. These
factors include a company's overall financial health, analysis of financial statements, the
products and services offered, supply and demand, and other individual indicators of
corporate performance over time.

 Financial analysis is only useful as a comparative tool. Calculating a single instance of
data is usually worthless; comparing that data against prior periods, other general
ledger accounts, or competitor financial information yields useful information.
 Types of Financial Analysis
 There are two types of financial analysis: fundamental analysis and technical analysis.
 Fundamental Analysis
 Fundamental analysis uses ratios gathered from data within the financial statements,
such as a company's earnings per share (EPS), in order to determine the business's
value. Using ratio analysis in addition to a thorough review of economic and financial
situations surrounding the company, the analyst is able to arrive at an intrinsic value for
the security. The end goal is to arrive at a number that an investor can compare with a
security's current price in order to see whether the security is undervalued or
overvalued.
 Technical Analysis
 Technical analysis uses statistical trends gathered from trading activity, such as moving
averages (MA). Essentially, technical analysis assumes that a security’s price already
reflects all publicly available information and instead focuses on the statistical analysis
of price movements. Technical analysis attempts to understand the market sentiment
behind price trends by looking for patterns and trends rather than analyzing a security’s
fundamental attributes.
 Horizontal vs. Vertical Analysis
 When reviewing a company's financial statements, two common types of financial
analysis are horizontal analysis and vertical analysis. Both use the same set of data,
though each analytical approach is different.
 Horizontal analysis entails selecting several years of comparable financial data. One
year is selected as the baseline, often the oldest. Then, each account for each
subsequent year is compared to this baseline, creating a percentage that easily
identifies which accounts are growing (hopefully revenue) and which accounts are
shrinking (hopefully expenses).
 Vertical analysis entails choosing a specific line item benchmark, then seeing how
every other component on a financial statement compares to that benchmark. Most
often, net sales is used as the benchmark. A company would then compare cost of
goods sold, gross profit, operating profit, or net income as a percentage to this
benchmark. Companies can then track how the percent changes over time.
 Types of Financial Reports
 As a business owner, you’re likely to work in a few different formats of financial reporting,
depending on your specific needs and goals at that moment. Here are a few of the most
common and most important types of financial statements:
 Balance Sheet
 Think of a balance sheet as a snapshot of your business’s financial health at a specific
date. These are often considered one of the most essential financial reports since they
clearly present your business’s, and shareholder’s equity, providing a clear, overall
perspective on your business’s financial status. A classified balance sheet distinguishes
current and noncurrent assets and liabilities.
 Income Statement
 Also sometimes called a Profit & Loss Report, an income statement is a common tool to
help you obtain information about your company’s revenues, expenses, gains, and losses
during a particular period. Unlike the balance sheet, which provides information about a
company’s financial position on a given date (for example, as of December 31, 20xx), the
income statement summarizes the changes in shareholder’s equity that occurred during a
period (year, quarter). Since this report focuses on profit-generating activities, it can be a
very useful tool for potential investors and creditors.
 Statement of Cash Flows
 This type of statement is used to analyze how much cash is generated by the business and
where it is spent. This statement shows changes in cash during the period. It is often used
by business owners in need of insight into their business’s insolvency and liquidity. It can
be used to track and manage spending as well as to help in securing loans and other
funding.
 Statement of Shareholders’ Equity
 This statement is intended to help business owners keep track of any changes in retained
earnings after dividends are released to shareholders. Its purpose is to report changes in
shareholders’ accounts during the period from investments by owners, distributions to
owners, net income, and other comprehensive income. This is invaluable for providing
insight to those supporting the business financially. It also provides more in-depth insight
into a company’s performance thanks to reporting on equity withdrawals and dividend
payments.
 Notes to Financial Statements
 Notes to financial statements (also called financial disclosures) refer to any other notes and
information provided alongside financial statements. These notes allow other readers to
better read and interpret the information provided in statements as well as evaluate the
firm’s performance. The notes usually include a summary of significant accounting policies
(accounting methods, depreciation methods, and inventory measurement methods, like
LIFO or FIFO). For instance, a note to financial statements will often state the ‘basis for
accounting’ (whether cash or accrual accounting methods were used). Other notes will
explain how figures were calculated in detail, providing greater reliability and accountability
to your reports.
 Why Is Financial Reporting Important?
 When done properly, financial reporting offers many benefits to all who are involved with a
business. With that said, however, the main goal of financial reporting is to provide insight
and information to stakeholders, business owners, partners, and other important roles.
Using the information gained from financial reporting, these parties can make more
informed decisions for the good of the business and their investments.
 Financial statements provide various important financial information that helps investors,
creditors, and analysts evaluate a company’s financial performance. A lot of the financial
information in financial reports is also required by law or by accounting standard practices.
 Financial reporting helps management communicate important business events and
transactions, as well as past successes and future expectations of the business.
 Here are a few reasons why financial reporting is important to your business:
 1. Ensuring Tax Compliance (and Optimizing Liability)
 The most important reason to use financial reports is that you have to and are required by
law to do so. The Internal Revenue Agency uses these reports to make sure you’re paying
your fair share of taxes.
 Businesses that make a lot of profit have to pay quite a lot of taxes. Accurate financial
reporting helps reduce their tax burden and helps them ensure that all their resources are
not depleted in a short amount of time.
 2. Showing Financial Condition to Potential Investors
 Potential investors want to know how well the company is doing before they invest.
Investors, creditors, and other capital providers rely on a company’s financial reporting to
gauge the safety and profitability of their investments. Stakeholders want to know where
 their money went and where it is now. Financial statements like the balance sheet address
provide detailed information about the company’s asset investments and outstanding debt
and equity components. Investors and creditors can use this information to better
understand the company’s position and capital mix.
 3. Evaluating Operations at Scale Over Longer Periods of Time
 The information on a balance sheet is a snapshot of a company’s assets and liabilities at
the end of a financial period. However, a balance sheet doesn’t show what operational
changes might have occurred to cause changes in the financial condition of a company.
Operating results during the period are also something investors need to consider. A
change statement, such as an income statement, shares results about sales, expenses,
and profit or losses during the period. Using the income statement, investors can both
evaluate a company’s past income performance and assess future cash flow.
 4. Examining and Analyzing Cash Flow
 A company’s profits are reported in the income statement but provide no direct information
on the company’s cash changes. A company incurs cash inflows and outflows during a
period from operating activities and non-operating activities, namely investing and
financing. Cash from all sources, not only revenue from operations, is what pays investors
back. That’s why a cash flow statement is an important statement for an investor to review.
The cash flow statement shows the changes in cash during a period of time. By reviewing
this statement, investors can know if a company has enough cash to pay for expenses and
purchases.
 5. Examining and Distributing Information on Shareholder Equity
 The statement of shareholders’ equity is important to equity investors. It shows the changes
to various equity components like retained earnings during a period. Shareholder equity is
a company’s total assets minus its total liabilities and represents a company’s net worth.
Steady growth in a business’s shareholders’ equity because of increasing retained
earnings, as opposed to expanding the shareholder base, means higher investment returns
for current equity shareholders.
 6. Help with Business Decision-Making, Planning, and Forecasting
 When a business needs to make a decision, analyzing financial statements is crucial.
Managers can look at the value of the assets that a business currently holds and decide if
they can afford to purchase more to expand business operations. Conversely, when the
value of assets is severely depreciated, managers can decide if they need to be sold off.
  7. Mitigate Financial Reporting Errors
 Accurate financial reporting can help businesses catch costly mistakes and inter errors
early on in the process. There is no better way to detect illegal financial activities than
through discrepancies found in financial statements. Through a reconciliation process,
errors that have been made can be found. Companies spend a lot of time reconciling their
books of accounts and verifying each journal entry, so they can find if an accounting error
has occurred or if anyone has tampered with any part of the business.

Benefits Of Financial Reporting

Still wondering about the benefits of setting up a strong financial reporting system for your
business? While it can lead to additional administrative work, good financial reporting offers
countless benefits to your business as well. These include:

 Optimized debt management

 Real-time insights and tracking for quick business decisions
 Identification and forecasting of business trends
 Managing liabilities and keeping them in check with assets
 Greater ease of access and communication of important financial records
 Cash flow insights and analysis
 Providing useful information to current and potential investors and creditors
 Internal controls to prevent fraudulent activities
What Is the Purpose of Financial Reporting?

The main objective behind financial reporting is to provide business owners, shareholders, and
other decision-makers with all of the information they need to make the best choices for the
company. Financial reporting affects everything from cash flow to dividends and should account for
all streams of profit and loss to ensure a complete, useful picture.

Generally, financial reporting provides information about the results of operations, financial
position, and cash flows of a business. Readers review the statements to decide the allocations of
resources.
Financial reporting is a way of following standard accounting practices to give an accurate
depiction of a company’s finances, including:

 Revenues
 Expenses
 Profits
 Capital
 Cashflow
What Does Financial Reporting Include?

The process of producing statements that disclose a business’s financial status to management,
investors, and the government is known as Financial Reporting.

Financial reporting includes:

 External financial statements (e.g., income statement, statement of comprehensive

income, balance sheet, statement of cash flows, and statement of stockholders’ equity)
 Notes to the financial statements
 Communications regarding quarterly earnings and related information (often via press
releases and conference calls)
 Quarterly and annual reports to stockholders
 Financial information and reports posted on a business’s website
 Financial reports to governmental agencies, including quarterly and annual reports to the
Securities and Exchange Commission (SEC)
 Documentation pertaining to the issuance of common stock and other securities
Financial Analysis Techniques or Tools, The Ultimate Guides
In this article, we will cover in detail the financial analysis techniques or tools to analyze financial
statements. These ultimate guides of financial analysis techniques will provide you an insights
into how to use various techniques or tools in performing the financial analysis of the financial
statements of a company.
Reading financial statements is not just a simple thing. It requires skill how to read them and
applying certain techniques or tools to analyze those statements. Therefore, what are those
tools or techniques in Financial Statements Analysis?
Before going into detail about those techniques or tools, let’s understand some basic definitions
of Financial Statement Analysis, the need or importance of Financial Statements Analysis as
well as the purpose of such analysis.
Definition
 Financial Statements Analysis sometimes called Financial Analysis involves the process of
applying analytical tools or techniques on the financial statements as well as other related data
such as disclosure notes to financial statements to make any business decision. In other words,
financial statement analysis refers to the way how to read financial statements to get insights
that are very important for any investments or financing arrangements.
Typically, we do the analysis on income statement, balance sheet, statement of retained
earnings, and statement of cash flow as well as the disclosure notes in the financial statements.
Analyzing financial statements involves using various techniques or tools and all of these
techniques or tools will be covered in detail in the later section below.
Purpose of Financial Statement Analysis
Two key stakeholder groups are interested in financial statement analysis. These are internal
and external stakeholders.
The purpose of financial analysis for internal stakeholders is to provide them with the
necessary strategic financial information for business decision-making as well as to improve the
company's efficiency and effectiveness for the provision of products and services. Internal
stakeholders refer to all levels of management, officers, internal auditors, consultants, and other
staff.
On the other hand, the purpose of financial analysis for external stakeholders is to provide them
with the necessary financial information for them to make better and more informed decisions in
pursuing their own goals. These external stakeholders are not directly involved in the running or
operation of the company. Those stakeholders are shareholders, lenders, customers, suppliers
or creditors, regulators, lawyers, brokers, and other stakeholders outside the company.
Shareholders and lenders need financial statements and their analysis to make any future
investment or lending prospect. Customers analyze financial statements to assess if they need
to establish a supplier relationship with the company. Suppliers or creditors need financial
analysis to assess and determine the credit terms if they engage to provide a product or service
to the company. Regulators, for example, tax authorities, need financial statements and their
analysis to assess the tax that the company needs to pay to the tax authority.

Building Blocks of Financial Analysis

Typically, there are four building blocks for the financial statements analysis and this analysis
focuses on one or more elements of the financial condition or performance of a company.
As financial analysts, they shall need to select the building block of financial statement analysis
to which it best relates to their business environment. However, they should over-focus on only
one building block. This is because, when we over-focus on only one building block, we miss
the other very important aspects. Thus, a financial analyst shall need to maintain the balance
between those four building blocks for the analysis of financial statements.
Below are the four building blocks of financial statement analysis:
  Liquidity and efficiency: This building block refers to the ability to meet short-term
obligations and the efficiency of generating revenues for a company.
 Solvency: This refers to the ability to meet long-term obligations, commonly for bank
loans and other long-term liabilities.
 Profitability: This refers to how profitable the company is. This is very important to enable
the company to provide any financial rewards sufficiently to attract and retain any
financing arrangements.
 Market prospect: This involves the ability to show or indicate the positive market
expectation from the users of financial statements.
Important Information for Financial Analysis
The stakeholders need general-purpose financial statements to perform their analysis. The
general purpose financial statements refer to all types of financial statements as follows:
1. Income Statement
2. Balance Sheet
3. Statement of Changes in Equity or Statement of Stockholders’ Equity or Statement of
Retained Earnings;
4. Statement of Cash Flow and;
5. Notes to financial statements.
All these components form part of the general-purpose financial statements.
In addition to the general purpose of financial statements, to have complete information for their
analysis, all those stakeholders also need Financial Reporting. Financial Reporting here
refers to all kinds of communication of financial information which is useful for their decision
making. They need not only general-purpose financial statements but also other information
such as below:

 All relevant information from the Stock Exchange Commission (SEC), where applicable;
 Other related information of filings;
 Press Releases;
 Shareholders’ meetings;
 Forecasts;
 Management Letters;
 Auditors’ reports and;
 Any Webcast where applicable
All the above information is crucial for their analysis.
Now, we have covered all the necessary information to provide the reader with a financial
statement to be able for their analysis. Therefore, let’s jump into the detailed analytical tools or
techniques that are necessary to perform the analysis of financial statements.
Financial Statement Analysis Tools or Techniques
Financial Statement Analysis Tools are sometimes called Financial Statement Analysis
Techniques. There are 3 main tools that we can use to analyze financial statements and those
tools are divided into several other methods. These are as follows:

 Horizontal Analysis: This is also called Comparative Statements. This analysis

includes the comparison of an entity’s financial statements overtime periods.
 Vertical Analysis: This is also called Common Size Financial Statements This
analysis includes a comparison of an entity’s financial statements against any based
amount.
 Financial Ratios Analysis: This is also called Accounting Ratios Analysis.
In the later section below, we cover in detail each of the financial analysis tools with examples.
Let’s dive in:
1. Horizontal Analysis or Comparative Statements
How to do a horizontal analysis of financial statements?

As mentioned above, horizontal analysis is also known as comparative analysis of financial

statements. It is one of the financial analysis techniques or tools that we use to analyze financial
statements. In the Horizontal Analysis, we normally do the comparison of financial statements
over some time. The word horizontal analysis arises from the analysis that compares from left to
right or from right to left movement of financial data when we perform the review of comparative
financial statements overtime periods.
So what are comparative financial statements?
Comparative financial statements are one type of financial analysis technique that we prepare in
multiple periods. The purpose of preparing comparative financial statements is to enable the
user to compare the financial performance or financial position from year to year or from period
to period.
The comparative financial statements are commonly prepared in both changes of value term
and percentage.

So how to compute the changes in value or percentage?

In horizontal analysis, we compute the percent change by subtracting the base period amount
from the analysis period amount and then dividing it by the base period amount. While the
changes in value are just subtracting the base period amount from the analysis period amount.
The formula is then summarized below:

Dollar Amount Change = Amount of Analysis Period – Amount of Base Period

Percentage Change (%) = (Amount of Analysis Period – Amount of Base Period)/Amount
of Base Period × 100
Typically, the horizontal analysis of comparative financial statements includes both comparative
balance sheets and comparative income statements. In addition, trend analysis is also
categorized under horizontal analysis.
Comparative Balance Sheet
In comparative balance sheet, consists of balance sheet amounts from two or more periods
prepared comparatively side by side. In this technique of financial analysis, it is typically useful
to prepare the comparative balance sheet to include the changes in both value terms and
percentages. By doing so, it is easy for the user or reader of financial statements to compare
the performance over periods.
Commonly, in the comparative balance sheet analysis, the user looks at the big changes in
value terms and percentages and then digs down or investigates the real consequences of such
big changes.
Below is an example of the horizontal comparative balance sheet:

ABC Co

Comparative
Balance Sheet

For the Year Ended

31 December 20X9

20X9 20X8 Dollar Percent

US$ ‘000 US$ ‘000 Change Change

Assets

Current Assets
Cash and cash
equivalents 35,200 25,300 9,900 39.1%

Short-term
investments 23,800 16,500 7,300 44.2%

Accounts receivable,
net 35,000 26,000 9,000 34.6%

Inventories 25,500 17,500 8,000 45.7%

Prepaid expenses 4,500 3,200 1,300 40.6%

Other current assets 24,300 20,100 4,200 20.9%

Total current assets 148,300 108,600 39,700 36.6%

Non-current assets

Property and
equipment, net 205,500 115,200 90,300 78.4%

Long-term
investments 5,200 13,500 (8,300) -61.5%

Intangible assets 50,100 16,300 33,800 207.4%

Other long-term
assets 15,300 13,600 1,700 12.5%

Total non-current
assets 276,100 158,600 117,500 74.1%

Total assets 424,400 267,200 157,200 58.8%

Liabilities

Current liabilities
Account payable 15,500 14,300 1,200 8.4%

Accrued expenses 22,500 28,100 (5,600) -19.9%

Current portion of
long-term debt 3,200 1,000 2,200 220.0%

Other current
liabilities 22,600 13,800 8,800 63.8%

Total current
liabilities 63,800 57,200 6,600 11.5%

Non-current
liabilities

Long-term debt, net of

current portion 50,900 4,600 46,300 1006.5%

Other long-term
liabilities 24,500 9,400 15,100 160.6%

Total non-current
liabilities 75,400 14,000 61,400 438.6%

Total liabilities 139,200 71,200 68,000 95.5%

Shareholders’
Equity

Common stock 180,500 125,600 54,900 43.7%

Accumulated other
comprehensive
income (loss) (1,500) 520 (2,020) -388.5%

Retained earnings 102,403 68,925 33,478 48.6%

Other Equity 3,797 955 2,842 297.6%

 Total shareholders’
equity 285,200 196,000 89,200 45.5%

Total liabilities and

shareholders’ equity 424,400 267,200 157,200 58.8%

From the comparative balance sheet above, we notice a few items have stood out. As you can
see, almost all asset elements substantially increase. This indicates that ABC Co is at the
growth stage. There are substantial increases in property and equipment as well as intangible
assets which account for 78.4% and 207.4% respectively and these substantial increases came
from the financing activities. As you can see, there is also a substantial increase in long-term
debt (both current and non-current portion) and common stockholders’ equity.

READ: What is Utilization Rate and How to Calculate It?

This indicates that ABC Co is using a growth strategy by obtaining funds from both loans and
stocks to finance its investment in assets. This results in a total substantial increase in assets of
58.8%.
Comparative Income Statement
The same as the comparative balance sheet, the comparative income statement is prepared for
two or more accounting periods comparatively year by year in both value terms and
percentages.
In the horizontal comparative income statement, the technique for financial analysis is that the
reader of financial statements is interested in looking at the changes or increase/decrease of
revenues and expenses of an entity. Below is an example of a horizontal comparative income
statement:

ABC Co

Comparative Income
Statement

For the Year Ended 31

December 20X9

20X9 20X8 Dollar Percent

 US$ ‘000 US$ ’000 Change Change

Total revenues 520,500 430,500 90,000 20.9%

Cost of sales 402,388 344,132 58,256 16.9%

General and administrative

expenses 30,200 28,700 1,500 5.2%

Depreciation and
amortization expenses 14,200 9,100 5,100 56.0%

Other expenses 9,700 3,500 6,200 100.0%

Other losses 5,200 2,200 3,000 136.4%

Loss on sales of property

and equipment 1,500 890 610 68.5%

Profit before interest and

taxes 57,312 41,978 15,334 36.5%

Interest income 1,966 2,980 (1,014) -34.0%

Interest expense 2,300 780 1,520 194.9%

Profit before income

taxes 56,978 44,178 12,800 29.0%

Income taxes 23,500 17,800 5,700 32.0%

Net Income 33,478 26,378 7,100 26.9%

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From the comparative income statement above, ABC Co has a substantial revenue growth of
20.9% while they can manage cost-effectively. ABC Co can manage its cost of sales as well as
the general and administrative expenses at 16.9% and 5.2% respectively. Ultimately, there is a
substantial net profit growth of 26.9%.
This indicates that ABC Co is in the growth stages. While there is an aggressive revenue growth
strategy, it can also maintain a lower increase in costs.
Trend Analysis
Similar to a comparative balance sheet and comparative income statement, trend analysis
involves more than one period. It is one of the financial analysis techniques that includes more
periods than normal comparative balance sheets and income statements. That is why we
call trend analysis. Another difference from the comparative financial statements is the way
how we calculate the percentage. In this technique of financial analysis, we do not subtract the
base period amount in the numerator to calculate the percentage. Instead, we divide the
analysis period amount with the base period amount straight away.
Below is the formula to calculate percentage in trend analysis:
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Trend Percent (%) = (Analysis amount/Base amount) × 100

To illustrate the trend analysis, let’s use the 5 years of main elements in the income statement of
ABC Co as below:

20X5 20X6 20X7 20X8 20X9

US$ US$ US$ US$ US$

‘000 ‘000 ‘000 ‘000 ‘000

Total revenues 190,500 225,000 320,000 430,500 520,500

Cost of sales 162,300 200,500 255,200 344,132 402,388

General and
administrative
expenses 11,600 15,300 21,500 28,700 30,200

In this trend analysis, we will use 20×5 as the base year. Thus, in calculating the percentage, we
will divide each amount of revenue and expenses against the base year which is 20×5.

Thus, based on the selected accounts of the income statement above, we can prepare the trend
analysis in percentages as below:
 20X5 20X6 20X7 20X8 20X9

Total revenues 100.0% 118.1% 168.0% 226.0% 273.2%

Cost of sales 100.0% 123.5% 157.2% 212.0% 247.9%

General and
administrative
expenses 100.0% 131.9% 185.3% 247.4% 260.3%

We can also present it in the graph below showing the trend line of each revenue and expense
account:

As you can see from the trend table and graph, ABC Co has a constant growth of both revenue
and expenses. This is because ABC Co. now is a high-growth company.

The trend line of general and administrative expenses is above the revenue line for most of the
year except the last year (20×9). This is good news that ABC Co. can prove to management that
finally after consistently increasing the trend of the general and administrative expenses
exceeding the revenue trend, now they can manage the trend of expenses lower than the
revenue.
2. Vertical Analysis
How to do vertical analysis of financial statements?
Vertical analysis is a financial analysis technique that we use to evaluate individual financial
statement items or groups of items against a specific base amount.
In this technique of financial analysis, we typically divide each item or group of items on the
balance sheet with total assets and each item or group of items on the income statement with
total revenue.
Vertical analysis is also known as the common-size statements. As mentioned above, in the
common size statements, we divide each financial statement line item or group of items with the
base amount. The vertical analysis formula for both the balance sheet and income statement is
as follows:
Common size percentage (%) = (Analysis amount/Base amount) × 100
In the vertical analysis, the common size statements can be used to analyze both the balance
sheet and income statement.
Common Size Balance Sheet
As mentioned above, in the common size, we commonly divide each balance sheet item or
group of items with total assets. Below is an example of the common size balance sheet:

ABC Co

Common Size
Balance Sheet

For the Year Ended

31 December 20X9

Common Common
Size Size

20X9 20X8 20X9 20X8

US$ ‘000 US$ ‘000 % %

Assets

Current Assets

Cash and cash

equivalents 35,200 25,300 8.3% 9.5%
Short-term
investments 23,800 16,500 5.6% 6.2%

Accounts receivable,
net 35,000 26,000 8.2% 9.7%

Inventories 25,500 17,500 6.0% 6.5%

Prepaid expenses 4,500 3,200 1.1% 1.2%

Other current assets 24,300 20,100 5.7% 7.5%

Total current assets 148,300 108,600 34.9% 40.6%

Non-current assets

Property and
equipment, net 205,500 115,200 48.4% 43.1%

Long-term investments 5,200 13,500 1.2% 5.1%

Intangible assets 50,100 16,300 11.8% 6.1%

Other long-term assets 15,300 13,600 3.6% 5.1%

Total non-current
assets 276,100 158,600 65.1% 59.4%

Total assets 424,400 267,200 100.0% 100.0%

Liabilities

Current liabilities

Account payable 15,500 14,300 3.7% 5.4%

Accrued expenses 22,500 28,100 5.3% 10.5%

Current portion of long-
term debt 3,200 1,000 0.8% 0.4%

Other current liabilities 22,600 13,800 5.3% 5.2%

Total current
liabilities 63,800 57,200 15.0% 21.4%

Non-current liabilities

Long-term debt, net of

current portion 50,900 4,600 12.0% 1.7%

Other long-term
liabilities 24,500 9,400 5.8% 3.5%

Total non-current
liabilities 75,400 14,000 17.8% 5.2%

Total liabilities 139,200 71,200 32.8% 26.6%

Shareholders’ Equity

Common stock 180,500 125,600 42.5% 47.0%

Accumulated other
comprehensive income
(loss) (1,500) 520 -0.4% 0.2%

Retained earnings 102,403 68,925 24.1% 25.8%

Other Equity 3,797 955 0.9% 0.4%

Total shareholders’
equity 285,200 196,000 67.2% 73.4%

Total liabilities and

shareholders’ equity 424,400 267,200 100.0% 100.0%
From the comparative common size balance above, we notice some increases and decreases
that stand out as follows:
(1). Accounts receivable decreased from 9.7% to 8.2%
(2). Property and equipment increased from 43.1% to 48.4%
(3). Intangible assets increased from 6.1% to 11.8%
(4). Accrued expenses decreased from 10.5% to 5.3%
(5). Long-term debts increased from 1.7% to 12%
These changes indicate that ABC Co is a successful growth company. The only concern is
whether this company can generate sufficient revenues to support its assets buildup as well as
the increase in financing facility.
Common Size Income Statement
Similar to the common size balance sheet, in the common size income statement, we commonly
divide each income statement item or group of items with total revenue. Below is an example of
the common size income statement:
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ABC Co

Common Size Income

Statement

For the Year Ended 31

December 20X9

Common Commo
Size n Size

20X9 20X8 20X9 20X8

US$ ‘000 US$ ‘000 % %

Total revenues 520,500 430,500 100.0% 100.0%

 Cost of sales 402,388 344,132 77.3% 79.9%

General and
administrative expenses 30,200 28,700 5.8% 6.7%

Depreciation and
amortization expenses 14,200 9,100 2.7% 2.1%

Other expenses 9,700 3,500 1.9% 0.8%

Other losses 5,200 2,200 1.0% 0.5%

Loss on sales of property

and equipment 1,500 890 0.3% 0.2%

Profit before interest

and taxes 57,312 41,978 11.0% 9.8%

Interest income 1,966 2,980 0.4% 0.7%

Interest expense 2,300 780 0.4% 0.2%

Profit before income

taxes 56,978 44,178 10.9% 10.3%

Income taxes 23,500 17,800 4.5% 4.1%

Net Income 33,478 26,378 6.4% 6.1%

From the comparative common size income statement above, we notice that the cost of sales
decreased from 79.9% to 77.3%. In addition, general and administrative expenses also
decreased from 6.7% to 5.8%. This indicates that the management of ABC Co has effectively
controlled costs while the company is reaping growth benefits which is commonly
called economies of scale.

READ: What is the Operating Margin Ratio? How to Calculate It?

In contrast, the depreciation and amortization expenses as well as interest expenses increased
from 2.1% to 2.7% and from 0.2% to 0.4% respectively. This is because the company has
borrowed more funds to finance its investment in assets both property and equipment and
intangible assets. This typically implies that the company is in the growth stage. Commonly, if a
company is growing, it needs to invest more capital thus increasing assets to utilize it to
generate revenue.
3. Financial Ratios Analysis
Financial ratios are widely used for financial analysis. They are popular financial analysis
techniques or tools as they provide both in value, percentage, or proportion between two or
more numbers. Financial ratios can help uncover conditions or trends to enable the reader to
detect by inspecting each component for each ratio.
In this technique of financial analysis, a financial ratio is commonly expressed as a
mathematical relationship between two or more quantities. As mentioned above, it can be
expressed as a percentage, rate, or proportion. For example, the growth rate is calculated by
subtracting the base amount from the analysis amount and then dividing it by the base amount.
This would provide the growth as a rate or percentage.
Financial ratio computation is simple as we use simple arithmetic operations; however, the
interpretation might not be simple. The meaningful interpretation and analysis depend on the
capability of the reader or financial analyst.
In this section, we will describe the important set of each financial ratio and its application as
well as how to interpret each ratio. In analyzing the financial statements, the financial analyst
shall need to select the building block of financial statement analysis to which it best relates to
the nature of the business operation of each company.
There are typically four building blocks of financial statement analysis. These are (1) Liquidity
and Efficiency, (2) Solvency, (3) profitability and (4) market prospect. Different building blocks
provide different information for each component of the financial ratios.
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Please note that in the section below, for any ratios that are required to calculate the average of
balance sheet items, we will illustrate the analysis only one year which is 20X9. This is because
we do not have the opening balance brought down from 20X7.
Liquidity and Efficiency Ratios
The Liquidity and efficiency ratios are the first building block of financial statement analysis.
Liquidity provides information on the availability of a company’s resources to meet short-term
obligations or cash requirements. It is typically affected by the timing of cash inflows and cash
outflows.
Efficiency, on the other hand, provides information on how productive a company is in utilizing
its assets. The efficiency ratios commonly measure the relationship between the utilization of
assets against the revenues. This means that these ratios are interested in indicating how the
assets can generate revenues for a company. Efficiency ratios are commonly called asset
utilization ratios.
Thus, in this building block of financial statement analysis, we can divide it into two
subcategories. These are liquidity ratios and efficiency ratios or asset utilization. These financial
analysis techniques, involve using various financial ratios about the liquidity and efficiency
position of a company as follows:
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So let’s go one by one of the liquidity and efficiency ratios.

(1). Current Ratio
The first type of liquidity ratio is the current ratio. It measures the short-term debt-paying ability
of an entity. This ratio is computed by dividing the current assets by the current liabilities.
The current ratio formula is as follows:
Current ratio = Current assets/Current liabilities
Taking the information from ABC Co above, we can compute the current ratio as below:

20X9 20X8

US$’000 US$’000

Current Assets (A) 148,300 108,600

Current Liabilities (B) 63,800 57,200

Current Ratio (A/B) 2.32 times 1.90 times

The current ratio for ABC Co is 2.32 times and 1.9 times respectively. This indicates that ABC
Co is in a strong liquidity position and can use its current assets to cover its current liabilities.
Looking at the ratio for the company alone does not give a good indicator. The company should
compare the ratio with the relevant industry average to have a better judgment on its current
level of ratio.
T00's high level of current ratio does not mean it is good and it indicates that the company does
not utilize its assets efficiently. This is because normally, current assets generate a low level of
return on investment as compared to long-term assets. Thus, a business shall maintain its
current ratio at the appropriate level to ensure that it meets short-term obligations while using
the excessive amount to generate more revenue for the company.
(2). Acid-Test Ratio or Quick Ratio
Another type of liquidity ratio is the Acid-Test Ratio. The Acid-Test Ratio is commonly called
Quick Ratio. This ratio measures the immediate short-term debt-paying ability. It is similar to the
current ratio except for the exclusion of inventory from the numerator. To compute the Acid-Test
Ratio, we take out the inventory from the current assets before we divide it with current
liabilities.
The Acid-Test Ratio can be calculated by using the formula as below:
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Acid-Test Ratio or Quick Ratio= (Total Current Assets – Inventory)/Total Current

Liabilities
In some other calculations, the numerator which is the quick assets consists only of cash and
cash equivalents, short-term investment or marketable securities, and accounts receivable.
In our example, we will take the current assets minus inventory as the numerator.
Taking the extracted data of the ABC Co in the previous section above, we can calculate the
Acid-Test Ratio as follows:

20X9 20X8

US$’000 US$’000

Current Assets (A) 148,300 108,600

Inventory (B) 25,500 17,500

Quick Assets (C = A – B) 122,800 91,100

 Current Liabilities 63,800 57,200

Acid-Test Ratio 1.92 times 1.59 times

From the calculation above, the Acid-Test Ratio of ABC Co is 1.92 times and 1.59 times for
20X9 and 20X8 respectively. This indicates that even though we take out inventory, the
company still has a strong liquidity position to meet current or short-term obligations.
The same as the current ratio, the company should look at the relevant industry average to see
how the current level of the Acid-Test Ratio we compared to the industry average.
(3). Accounts Receivable Turnover

20X9

US$’000

Accounts Receivable
Turnover is Net Sales (A) 520,500 another type
of liquidity and
efficiency Opening Accounts ratio. This
ratio Receivable (B) 26,000 measures
the efficiency of
the collection of
a company’s Closing Accounts accounts
receivable. Receivable (C) 35,000 To compute
this ratio, we take the
total net Average Accounts sales
divided by Receivable [D = the average
accounts (B+C)/2] 30500 receivable.
Typically, to be more
precise, credit sales
shall be Accounts used
instead of Receivable net sales.
However, in Turnover (E = practice, the
credit sales A/D) 17.07 times are not
normally presented.
Therefore, so far, we commonly take net sales as the numerator to calculate the accounts
receivable turnover.
The accounts receivable turnover is calculated as per the formula below:
Accounts Receivable Turnover = Net Sales/ Accounts Receivable in Average
Where: Average Accounts Receivable = (Opening Receivables + Closing Receivables)/2
Using the data from the ABC Co, we can compute the accounts receivable turnover as below:
From the calculation above, ABC Co has an accounts receivable turnover of 17.07 times.
Basically, the higher the turnover, the better the company is. However, if the accounts receivable
turnover is too high, it might indicate that the company has used a very restrictive policy or
credit term and this in the future might negatively affect the sales volume.
To be more precise, ABC Co should also obtain the relevant industry average data and then
compare its turnover to such industry data.
(4). Inventory Turnover
The fourth liquidity and efficiency ratio is inventory turnover. It measures the efficiency of
inventory management of a company. The period of holding inventory will affect the working
capital requirement. Thus, the longer the inventory turnover, the worse it will affect the working
capital requirement.
To compute the inventory turnover, we take the cost of goods sold or the cost of sales divided by
the average inventory.

The formula of inventory turnover is then summarized as follows:

Inventory Turnover = Cost of Sales/Average Inventory
Where: Average Inventory =
(Opening 20X9 Inventory +
Closing Inventory)/2
Taking the data US$’000 from ABC Co
above, we can calculate the
inventory turnover Cost of Sales (A) 402,388 as below:
From the calculation above,
the inventory Opening Inventory turnover of ABC
Co is 18.72 times. (B) 17,500 This indicates that
ABC Co. takes a bit longer to
convert into sales.
Closing Inventory (C) 25,500

READ: The Average Inventory [D Pricing

Strategies: = (B+C)/2] 21,500 Approach to
Product Pricing

Inventory Turnover
(E = A/D) 18.72 times
To have a precise analysis of this,
ABC Co shall need to compare it to
the relevant industry average.
(5). Days Sales Outstanding (DSO) or Day’s Sales Uncollected
The Days Sales Outstanding (DSO) is also commonly known as Average Daily Sales
Outstanding or Day’s Sales Uncollected. It is another ratio under the liquidity and efficiency
building block of financial statement analysis. It measures the liquidity of receivables to how
many days a company can collect its accounts receivable. The less number of days the better
the company is at collecting its accounts receivable.
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The DSO is calculated by dividing the accounts receivable by net sales and multiplying by 365
days.
The formula of DSO is summarized as follows:
DSO = (Accounts Receivable/Net Sales) × 365
The DSO of ABC Co is calculated as follows:

20X9 20X8

US$’000 US$’000

Accounts Receivable
(A) 35,000 26,000

Net Sales (B) 520,500 430,500

DSO [D = (A/B) × 365] 24.54 days 22.04 days

The DSO of ABC Co is 24.54 days and 22.04 days for 20X9 and 20X8 respectively. This
indicates that ABC Co can collect its accounts receivable quickly. Commonly, the credit period of
accounts receivable is 30 days. Thus, ABC Co has collected its accounts receivable more
quickly than the allowable credit term.
However, this figure only cannot be said as good. ABC Co needs to take the relevant industry
average to compare to have a precise analysis.
(6). Days’ Sales in Inventory
Days Sales in Inventory is another type of liquidity and efficiency ratio. This ratio measures the
liquidity of inventory. Days’ sales in inventory are also known as days’ stock on hand. It
analyzes how much inventory is available in terms of the number of days’ sales.
The days’ sales in inventory can also be analyzed as the number of days that a company can
sell its inventory if there are no items restocked or purchased. In addition, it is also commonly
interpreted as a measure of inventory buffer against stock-out. Therefore, it is very useful to
evaluate the liquidity of inventory.
The days’ sales in inventory are computed by dividing the closing inventory by the cost of sales
and then multiplying by 365 days.
The days’ sales in the inventory formula are as follows:
Days Sales in Inventory = (Closing Inventory/Cost of Goods Sold) × 365
By using the financial data of ABC Co above, we can calculate the Days’ Sales in Inventory as
follows:

20X9 20X8

US$’000 US$’000

Closing Inventory (A) 25,500 17,500

Cost of Sales (B) 402,388 344,132

Days Sales in Inventory [D = (A/B) ×

365] 23.13 days 18.56 days

From the calculation above, the days’ sales in inventory are 23.13 days and 18.56 days for
20X9 and 20X8 respectively. This indicates that ABC Co is carrying 23.13 days for 20X9 and
18.56 days for 20X8 of sales in inventory.
(7). Total Asset Turnover
Total Asset Turnover is the last ratio under the liquidity and efficiency building block of financial
statement analysis. It measures the efficiency of assets in generating sales. This is an important
indication of operating efficiency; the way how efficiently a company uses its assets to generate
revenues.
The total assets turnover ratio is calculated by dividing the net sales by the average total assets.
The total assets turnover ratio formula is as follows:
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Total Assets Turnover = Net Sales/Average Assets in Total

Where: Average Total Assets = (Opening Total Assets + Closing Total Assets)/2
Again, as per the financial data of ABC Co above, we can calculate the total assets turnover as
follows:

20X9
 US$’000

Net Sales (A) 520,500

Opening Total Assets (B) 267,200

Closing Total Assets (C) 424,400

Average Total Assets [D =

(B+C)/2] 345,800

Total Assets Turnover (E = A/D) 1.51 times

The total assets turnover of ABC Co is 1.51 times. This indicates that ABC Co can generate
sales of 1.51 times of its total assets.
To be more precise, we need to look at the trend of this ratio as well as the industry average
data.
Solvency Ratios
The second building block of financial statement analysis is solvency ratios. Solvency ratios
measure a company’s long-term financial viability and its ability to cover long-term liabilities or
obligations. This building block involves using various financial analysis techniques or ratios
about the solvency of a company.
In solvency ratios analysis, capital structure is one of the most important components. Capital
structure refers to the sources of finance of a company. These include both equity and debt
financing. In this section, we will cover four main solvency ratios namely debt ratio, equity ratio,
pledged assets to secured liabilities, and time interest earned ratio.

(1). Debt Ratio

The debt ratio is also commonly called debt to total asset. It measures the portion of a
company’s assets that are contributed by creditors or debtors. This ratio expresses the total
liabilities as a percentage of total assets.
The debt ratio can be calculated by using the below formula:
Debt Ratio = (Total Debt/Total Assets) ×100
Based on the balance sheet of ABC Co above, the debt ratio can be calculated as follows:

20X9 20X8
 US$’000 US$’000

Total Debt (A) 139,200 71,200

Total Assets (B) 424,400 267,200

Debt Ratio [C = (A/B) ×

100] 32.80% 26.65%

The debt ratio of ABC Co is 32.80% and 26.65% for 20X9 and 20X8 respectively. This indicates
that ABC Co.’s source of funds is 32.80% for 20X9 and 26.65% for 20X8 from debt. The debt
ratio increased in 20X9 because of the additional long-term debt ABC Co obtained in 20X9.
(2). Equity Ratio
Similar to the debt ratio, the equity ratio measures the portion of a company’s assets that are
contributed by equity holders or shareholders. This ratio expresses the total equity as a
percentage of total assets.
The equity ratio can be calculated by using the below formula:
Equity Ratio = (Total Equity/Total Assets) ×100
Based on the balance sheet of ABC Co. above, the equity ratio can be calculated as follows:

20X9 20X8

US$’000 US$’000

Total Equity (A) 285,200 196,000

Total Assets (B) 424,400 267,200

Equity Ratio [C = (A/B) × 100] 67.20% 73.35%

The equity ratio of ABC Co is 67.20% and 73.35% for 20X9 and 20X8 respectively. This
indicates that ABC Co.’s source of fund majority came from equity holders.
(3). Pledged Assets to Secured Liabilities
The pledged asset to secured liabilities is another solvency ratio that is used to evaluate the risk
of nonpayment faced by secured creditors. This ratio is calculated by dividing the book value of
pledged assets by the book value of secured liabilities.
So in this case, what does secured liability mean?
Secured liabilities refer to the liabilities or debts that a company uses assets as collateral. This
asset is commonly called a pledged asset.
The pledged asset to secured liabilities ratio can be calculated by using the below formula:
Pledged Assets to Secured Liabilities Ratio = Book Value of Pledged Assets/Book Value
of Secured Liabilities
In practice, this ratio is rarely used. This is because normally, the value of pledged assets was
not disclosed or reported in the financial statements.
Typically, the person who can obtain this information from the company is the bankers or
lenders. Before they grant a loan facility, they will enquire about the asset to be pledged. They
use this ratio to assess the ability to recover the debt if it becomes default.
This ratio is generally considered as good at 2:1. That means, the pledged assets need to be
twice higher than the secured liabilities.

(4). Times Interest Earned Ratio

The last solvency ratio is the time's interest earned ratio. This is sometimes called the interest-
covered. This ratio evaluates how much a company has its profit before interest and tax to cover
its interest expense.
Times interest earned ratio indicates the risk of the creditors of non-repayment of loan and
interest from the debtors.
This ratio is calculated by dividing the profit before interest and tax (PBIT) by interest expense.
Thus, the time's interest earned ratio formula can be written as below:
Time Interest Earned Ratio = PBIT/Interest Expense
From the financial data of ABC Co above, we can calculate the time's interest earned ratio as
follows:

20X9 20X8

US$’000 US$’000

PBIT (A) * 57,312 41,978

Interest Income (B) 1,966 2,980

Adjusted PBIT (C = A+B) 59,278 44,958

 Interest Expense (D) 2,300 780

Times Interest Earned Ratio (E =

C/D) 25.77 times 57.64 times

*PBIT above excluded the interest income. Thus, we need to add back the interest income.
From the calculation above, the time's interest earned ratio of ABC Co is 25.77 times and 57.64
times for 20X9 and 20X8 respectively. The decrease in times interest earned ratio in 20X9 is
because of the increase in interest expense as a result of additional long-term debt in 20X9.
This indicates that ABC Co has a PBIT of 25.77 times and 57.64 times its interest expense for
20X9 and 20X8 respectively. That means ABC Co has a very good profit to cover its interest
expense even though there is a big drop in times interest earned ratio in 20X9.
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Profitability Ratios
Another building block of financial statement analysis is profitability ratios. In this building block,
we focus on the profitability of a business. There are several ratios that we can use as financial
analysis techniques in this building block. Thus, we will go into detail one by one as below.
(1). Profit Margin
Profit margin is one of the profitability ratios that measures the ability to earn net income from
sales. This ratio is expressed as a percentage of net income over sales.
Below is the profit margin formula:
Profit Margin = Net Income/Net Sales
Based on the financial data of ABC Co above, we can calculate the profit margin of the
company as follows:

20X9 20X8

US$’000 US$’000

Net Income (A) * 33,478 26,378

Net Sales (B) 520,500 430,500

Profit Margin (C = A/B) 6.43% 6.13%

* We can also use the profit before interest and tax (PBIT) instead of net income to calculate the
profit margin.
From the calculation above, the profit margin of ABC Co slightly increased from 6.13% to 6.43%
for 20X8 and 20X9 respectively.
To interpret whether this ratio is good or bad, we shall need to compare a trend as well as the
industry average.
Let’s assume that, the profit margin for the relevant industry of ABC Co is from 10% to 15%.
Thus, in this case, ABC Co has a lower profit margin as compared to the industry average.
(2). Return on Assets (ROA)
Return on assets is one of the profitability ratios that measure how much net income a company
generates compared to total assets. We can calculate the return on assets by dividing the net
income by the average total assets.
Below is the return on
20X9 assets formula:
Return on Assets (ROA) =
US$’000 Net Income/Total Assets
in Average
Net Income (A) * 33,478 From the financial data of
ABC Co above, we can
calculate the return on
Opening Total Assets (B) 267,200
assets of the company as
follows:
Closing Total Assets (C) 424,400

Average Total Assets [D = * We can also use the profit

(B+C)/2] 345,800 before interest and tax
(PBIT) instead of net
income to calculate the
Return on Assets (E = A/D) 9.68% profit margin.
We can also calculate the
return on assets by breaking it down into profit margin and total asset turnover.
The formula is then re-written as follows:
Return on Asset (ROA) = Profit Margin × Total Asset Turnover
Or ROA = (Net Income/Net Sales) × (Net Sales/Average Total Assets)
Both total asset turnover and profit margin contribute to the overall operating efficiency of a
business. Thus, based on the calculation of total asset turnover and profit margin above, we can
compute the return on assets by using the combination of these two ratios as follows:
Return on Assets = 6.43% × 1.505 = 9.68%
From the calculation above, the return on assets of ABC Co is 9.68%. This indicates that ABC
Co generates 9.68% of its profit from using the total assets.
This percentage alone cannot be judged whether it is good or not. We should look at the trend
as well as the relevant industry average to get more insights.
(3). Return on Common Stockholders’ Equity
Return on common stockholders’ equity is also known as return on equity (ROE). This ratio
measures the profitability compared to the common stockholders’ equity meaning that it
measures how much net income the company generated for its owners or common
stockholders.
We can calculate the return on common stockholders’ equity by dividing the net income after
deducting the dividend for preferred stock with average common stockholders’ equity.
The return on common stockholders’ equity formula is as below:
Return on Common Stockholders’ Equity = (Net Income – Preferred Stock
Dividend)/Average of Common Stockholders’ Equity
From the financial data of ABC Co above, we can calculate the return on common stockholders’
equity as follows:

20X9

US$’000

Net Income (A) * 33,478

Preferred Stock Dividend (B) 0

Opening Common Stockholders’ Equity 125,600

Closing Common Stockholders’ Equity 180,500

Average Common Stockholders’ Equity 153,050

Return on Common Stockholders’ Equity 21.87%

* We can also use the profit before interest and tax (PBIT) instead of net income to calculate the
profit margin.
From the calculation above, the return on common stockholders’ equity is 21.87%. This
indicates that ABC Co generates a good net income for its common stockholders’ equity.
However, to be more precise, we need to look at trends as well as the industry average data for
the relevant industry.
(4). Return on Capital Employed (ROCE)
Return on Capital Employed is another profitability ratio that measures the overall operating
efficiency of capital employed. The capital employed here refers to the total assets minus
current liabilities or we can say it is the sum of total equity and long-term liabilities.
The ROCE is calculated by dividing the profit before interest and tax with capital employed.
We commonly used PBIT instead of net income to calculate the ROCE.
Return on Capital Employed formula is written as below:
ROCE = PBIT/Average Capital Employed
From the financial data of ABC Co above, we have the information below:

20X9

US$’000

PBIT (A) * 59,278

Opening Capital Employed (B) 210,000

Closing Capital Employed (C) 360,600

Average Capital Employed [D = (B+C)/2] 285,300

Return on Capital Employed – ROCE (E

= A/D) 20.01%

*Adjusted PBIT after adding the interest income

From the calculation above, the ROCE of ABC Co is 20.01%. This indicates that the overall
operating efficiency of using the capital employed to generate profit is good. Normally, the good
ROCE ranges from 10% to 15% depending on the industry.
Thus, to be more precise, ABC Co needs to compare with the industry average to see its
position as compared to the relevant industry.
Market Prospect Ratios
Market prospect ratios are the last building block of financial statement analysis. In this building
block, the analysis of the market prospect ratios is very useful for corporations whose shares
are publicly traded. This financial analysis technique as market measures uses stock prices that
reflect the expectation of the publicly traded market. There are two main ratios in the market
prospect. These are the price-earnings ratio and dividend yield.
(1). Price-Earnings Ratio (P/E Ratio)
Price-earnings ratio is one of the market prospect ratios that measures the relationship between
the market value of common stock against earnings per share. This ratio is computed by
dividing the market value of the common share by earnings per share.
The price-earnings ratio formula is as follows:
Price-Earnings Ratio = Market Value per Common Stock/Earnings per Share
Or P/E Ratio = Total Market Value of Common Stock/Total Earnings
To calculate the P/E Ratio, let’s assume that ABC Co has basic earnings per share of $0.61
and$0.49 for 20X9 and 20X8 respectively. In addition, let’s assume further that at the start of
fiscal years 20X7 and 20X8, the market share price of ABC Co is at $23.9 and $30.41
respectively.
Additionally, let’s also assume that the market industry average for the same industry of ABC Co
is at 37.1 of the P/E ratio.
Thus, we can calculate the P/E Ratio of ABC Co as follows:

20X9 20X8

Market Value per Share

(A) 30.41 23.9

Earnings per Share –

EPS (B) 0.61 0.49

P/E Ratio (C = A/B) 49.85 48.78

From the calculation above, ABC Co has its P/E ratio at 49.85 and 48.78 for 20X9 and 20X8
respectively which is higher than the industry average. This indicates that there are higher
investors’ expectations of growth of earnings.
This very good sign for the company and would lead to a further increase in share price.
(2). Dividend Yield
Dividend Yield is another market prospect ratio that measures the dividend-paying performance
of a corporation. This ratio is commonly used to compare the performance of dividend payments
of a corporation. It is computed by dividing the annual cash dividend per share by market value
per share.
The dividend yield formula is as follows:
Dividend Yield = Dividend (in Cash) per Share/Market Value per Share
From the financial data provided, ABC Co did not declare nor pay cash dividends for both years,
20X9 and 20X8. Thus, there is zero cash dividend.
Therefore, we can calculate the dividend yield as follows:
Dividend Yield = 0/30.41 = 0.0%
In some circumstances, a corporation may consider not to distribute any dividend for any fiscal
year. This is because they want to keep the accumulated profit as retained earnings and use it
for further investment.
Conclusion
Financial analysis is very crucial not only for the management of the company itself but also for
all kinds of internal and external stakeholders. There are three main financial analysis
techniques or tools that we generally use to analyze financial statements. These include
horizontal analysis, vertical analysis, and financial ratios. As a financial analyst, he or she
should use such techniques and interpret the result carefully.