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Chapter 7

FINANCIAL STATEMENT
ANALYSIS
Topics:

 What is financial statement Analysis?

 Purposes of financial statement analysis

 Design of Financial Statement analysis

 Techniques and Tools of Financial Analysis


What is Financial Statement Analysis?
 Financial statement analysis is a process which
examines past and current financial data for the
purpose of evaluating performance and estimating
future risks and potential.
 Financial statement analysis is used by investors,
creditors, bank lending officers, etc
 These analyses will help to measure:
 efficiency
 profitability
 financial soundness and
 Future prospects of the business units
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 of firms.
4. Prediction of bankruptcy and failure
Financial statement analysis is an
important tool in assessing and predicting
bankruptcy and probability of business
failure.
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
Design of Financial Statements for Analysis

Classified Comparative Consolidated


Financial Financial Financial
Statements Statements Statements

Items with certain Amounts from Information for the


characteristics are several years parent and subsidiary
grouped together. appear side by side. are presented.

Results Helps identify Presented as if


in standardized, significant the two companies
meaningful changes and are a single
subtotals. trends. business unit.
Techniques and Tools of Financial
statement analysis
 Different techniques are employed for analysing and
interpreting the financial statements.
 Techniques of analysis of financial statements are
mainly classified into three categories.

1. Cross-sectional analysis
It is also known as inter firm comparison. This
analysis helps in analysing financial characteristics
of an enterprise with financial characteristics of
another similar enterprise in that accounting period.
2. Time series analysis
 It is also called as intra-firm comparison. According to this
method, the relationship between different items of financial
statement is established, comparisons are made and
results obtained.
 The basis of comparison may be Comparison of the
financial statements of different years of the same business
unit.

3. Combination of Cross-sectional & time series


analysis
 This analysis is intended to compare the financial
characteristics of two or more enterprises for a defined
accounting period. It is possible to extend such a
comparison over the year. This approach is most effective
in analysing of financial statements.
Tools of Financial Statement Analysis
 A number of tools or methods or devices are used to
study the relationship between financial statements.
 The most important tools which are commonly used
for analysing and interpreting financial statements are
the following:
Comparative statements
Dollar & Percentage Changes Common size statements
Trend Percentages Trend analysis
Component Percentages
Ratio analysis
Ratios
Funds flow analysis
Cash flow analysis
Dollar and Percentage Changes
 The dollar amount of any change is the
difference between the amount for a
comparison year and the amount for a base
year.
 The percentage change is computed by
dividing the amount of the dollar change by
the amount for the base year.
Dollar and Percentage Changes

Dollar Change:

Dollar Analysis Period Base Period


Change = Amount – Amount

Percentage Change:

% Percent
Change = Dollar Change
÷
Base Period
Amount
Dollar and Percentage Changes
Example
Let’s look at the asset section of ABC
Corporation’s comparative balance
sheet and income statement for 2003
and 2002 on the next slid.
Compute the dollar change and the
percentage for cash.
ABC CORPORATION
Comparative Balance Sheets
December 31,
Dollar Percent
2003 2002 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 ? ?
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $ 155,000 $ 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700
* Percent rounded to one decimal point.
ABC CORPORATION
Comparative Balance Sheets
December 31,
Dollar Percent
2003 2002 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) ?
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $ 155,000–
$12,000 $23,500
$ 164,700 = $(11,500)
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700
* Percent rounded to one decimal point.
ABC CORPORATION
Comparative Balance Sheets
December 31,
Dollar Percent
2003 2002 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) -48.9%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets ($11,500 ÷ $23,500)
$ 155,000 × 100% = 48.94%
$ 164,700
Property and equipment:
Land 40,000 40,000 Complete the
Buildings and equipment, net 120,000 85,000 analysis for
Total property and equipment $ 160,000 $ 125,000 the other
Total assets $ 315,000 $ 289,700
assets.
* Percent rounded to one decimal point.
ABC CORPORATION
Comparative Balance Sheets
December 31,
Dollar Percent
2003 2002 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) -48.9%
Accounts receivable, net 60,000 40,000 20,000 50.0%
Inventory 80,000 100,000 (20,000) -20.0%
Prepaid expenses 3,000 1,200 1,800 150.0%
Total current assets $ 155,000 $ 164,700 (9,700) -5.9%
Property and equipment:
Land 40,000 40,000 - 0.0%
Buildings and equipment, net 120,000 85,000 35,000 41.2%
Total property and equipment $ 160,000 $ 125,000 35,000 28.0%
Total assets $ 315,000 $ 289,700 $ 25,300 8.7%
* Percent rounded to one decimal point.
ABC CORPORATION
Comparative Balance Sheets
December 31,
2003
Dollar Percentag
2003 2002 change e change
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 $ 23,000 52.3%
Notes payable 3,000 6,000 $ (3,000) -50.0%
Total current liabilities $ 70,000 $ 50,000 $ 20,000 40.0%
Long-term liabilities: $ -
Bonds payable, 8% 75,000 80,000 $ (5,000) -6.3%
Total liabilities $ 145,000 $ 130,000 $ 15,000 11.5%
Shareholders' equity:
Preferred stock 20,000 20,000 $ - 0.0%
Common stock 60,000 60,000 $ - 0.0%
Additional paid-in capital 10,000 10,000 $ - 0.0%
Total paid-in capital $ 90,000 $ 90,000 $ - 0.0%
Retained earnings 80,000 69,700 $ 10,300 14.8%
Total shareholders' equity $ 170,000 $ 159,700 $ 10,300 6.4%
Total liabilities and shareholders' equity $ 315,000 $ 289,700 $ 25,300 8.7%
* Percent rounded to first decimal point.
Interpretation
(i) The comparative balance sheet of the company reveals that
during 2003 there has been an increase in fixed assets of
$35,000 i.e. 28.2% and Long term liabilities to outsiders have
relatively decreased by $6,000, i.e. -6.3%, . Equity share capital
has no change, but retaining earnings of the company increases
by $10,800, i.e. 14.8%.
 This fact indicates that the sources of finance of the company to
purchase fixed assets are short term debts and company’s
retaining earnings.
(ii) The current assets have decreased by $ 9,700 i.e. -5.9%,
whereas the current liabilities have increased by $20, 000 i.e.
40.0%. This further confirms that the company has used short-
term finances to acquired fixed assets.
(iii) Retain Earnings have increased from $ 69,700 to
$80,000,($10,300 i.e. 14.8%) which shows that the company has
utilized Retained earnings for acquiring of fixed assets.
Trend Analysis
 The change in financial statement items
from a base year to following years are
often expressed as trend percentages to
show the extent and direction of change.
 Two steps are necessary to compute trend
percentages.
1. Select base year and assign a weight of 100%
for each item in the base year
2. Express each item following years as a
percentage of its base year amount.
Trend Analysis

Trend analysis is used to reveal patterns in data


covering successive period.

Trend Analysis Period Amount


Percent
=
Base Period Amount
× 100%
Trend Analysis - Example
Berry Products
Income Information
For the Years Ended December 31,
Item 2003 2002 2001 2000 1999
Revenues $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000
Item
Item 2003
2003 2002
2002 2001
2001 2000
2000 1999
1999
Revenues
Revenues 145% 129% 116% 105%
105% 100%
100%
Cost of
Cost of sales
sales 150% 132% 118% 104%
104% 100%
100%
Gross profit
Gross profit 135% 124% 112% 108%
108% 100%
100%

1999 is the base period


(290,000  275,000)  100% = 105% so its amounts will
equal 100%.
(198,000  190,000)  100% = 104%
(92,000  85,000)  100% = 108%
160%

140%

120%

100% Revenues
80% Cost of sales
60% Gross profit

40%

20%

0%
1999 2000 2001 2002 2003
Component Percentages
 Indicate the relative size of each item included in a total.
 Examine the relative size of each item in the financial statements
by computing component (or common-sized) percentages.

Component Analysis Amount


Percent
= Base Amount × 100%

Financial Statement Base Amount


Balance Sheet Total Assets
Income Statement Revenues
ABC CORPORATION
Comparative Balance Sheets
December 31,
Complete the common-size analysis for the other Common-size
assets. Percents*
2003 2002 2003 2002
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
($12,000 ÷ $315,000)
Total current assets $ 155,000× 100% = 3.8%
$ 164,700
Property and equipment:
Land ÷ $289,700)
($23,50040,000 × 100% = 8.1%
40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
ABC CORPORATION
Comparative Balance Sheets
December 31,
Common-size
Percents*
2003 2002 2003 2002
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000 19.0% 13.8%
Inventory 80,000 100,000 25.4% 34.5%
Prepaid expenses 3,000 1,200 1.0% 0.4%
Total current assets $ 155,000 $ 164,700 49.2% 56.9%
Property and equipment:
Land 40,000 40,000 12.7% 13.8%
Buildings and equipment, net 120,000 85,000 38.1% 29.3%
Total property and equipment $ 160,000 $ 125,000 50.8% 43.1%
Total assets $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
CLOVER CORPORATION
ABC CORPORATION
Comparative
Comparative Balance
Balance Sheets
Sheets
December
December 31,31,
Complete the common-size analysis for the liabilities and equity Common-size
Common-size
accounts. Percents*
Percents*
2003
2003 2002
2002 2003
2003 2002
2002
Liabilities
Liabilities and
and Shareholders'
Shareholders' Equity
Equity
Current liabilities:
Current liabilities:
Accounts
Accounts payable
payable $$ 67,000
67,000 $$ 44,000
44,000 21.3% 15.2%
Notes
Notes payable
payable 3,000
3,000 6,000
6,000 1.0% 2.1%
Total
Total current
current liabilities
liabilities $$ 70,000
70,000 $$ 50,000
50,000 22.2% 17.3%
Long-term
Long-term liabilities:
liabilities:
Bonds
Bonds payable,
payable, 8% 8% 75,000
75,000 80,000
80,000 23.8% 27.6%
Total
Total liabilities
liabilities $$ 145,000
145,000 $$ 130,000
130,000 46.0% 44.9%
Shareholders'
Shareholders' equity:
equity:
Preferred
Preferred stock
stock 20,000
20,000 20,000
20,000 6.3% 6.9%
Common
Common stock
stock 60,000
60,000 60,000
60,000 19.0% 20.7%
Additional
Additional paid-in
paid-in capital
capital 10,000
10,000 10,000
10,000 3.2% 3.5%
Total
Total paid-in
paid-in capital
capital $$ 90,000
90,000 $$ 90,000
90,000 28.6% 31.1%
Retained
Retained earnings
earnings 80,000
80,000 69,700
69,700 25.4% 24.1%
Total
Total shareholders'
shareholders' equityequity $$ 170,000
170,000 $$ 159,700
159,700 54.0% 55.1%
Total
Total liabilities
liabilities and
and shareholders'
shareholders' equity
equity $$ 315,000
315,000 $$ 289,700
289,700 100.0% 100.0%
** Percent
Percent rounded
rounded to to first
first decimal
decimal point.
point.
ABC CORPORATION
Comparative Income Statements
For the Years Ended December 31,
Common-size
Percents*
2003 2002 2003 2002
Revenues $ 520,000 $ 480,000 100.0% 100.0%
Costs and expenses:
Cost of sales 360,000 315,000 69.2% 65.6%
Selling and admin. 128,600 126,000 24.7% 26.3%
Interest expense 6,400 7,000 1.2% 1.5%
Income before taxes $ 25,000 $ 32,000 4.8% 6.7%
Income taxes (30%) 7,500 9,600 1.4% 2.0%
Net income $ 17,500 $ 22,400 3.4% 4.7%
Net income per share $ 0.79 $ 1.01
Avg. # common shares 22,200 22,200
* Rounded to first decimal point.
Ratios
A ratio is a simple mathematical expression of
the relationship between one item and another.

Along with dollar and percentage changes, trend


percentages, and component percentages, ratios
can be used to compare:

Past performance to present performance.

Other companies to your company.


Common-Size Analysis
Common-size analysis is the restatement of financial statement
information in a standardized form.
 Horizontal common-size analysis uses the amounts in

accounts in a specified year as the base, and subsequent


years’ amounts are stated as a percentage of the base value.
 Useful when comparing growth of different accounts over
time.
 Vertical common-size analysis uses the aggregate value in

a financial statement for a given year as the base, and each


account’s amount is restated as a percentage of the
aggregate.
 Balance sheet: Aggregate amount is total assets.

 Income statement: Aggregate amount is revenues or sales.

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Example: Common-size analysis
Consider the CS Company, which reports the following financial
information:
Year 2008 2009 2010 2011 2012 2013
Cash $400.00 $404.00 $408.04 $412.12 $416.24 $420.40
Inventory 1,580.00 1,627.40 1,676.22 1,726.51 1,778.30 1,831.65
Accounts receivable 1,120.00 1,142.40 1,165.25 1,188.55 1,212.32 1,236.57
Net plant and equipment 3,500.00 3,640.00 3,785.60 3,937.02 4,094.50 4,258.29
Intangibles 400.00 402.00 404.01 406.03 408.06 410.10
Total assets $6,500.00 $6,713.30 $6,934.12 $7,162.74 $7,399.45 $7,644.54

1. Create the vertical common-size analysis for the CS


Company’s assets.
2. Create the horizontal common-size analysis for CS Company’s
assets, using 2008 as the base year.

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Example: Common-size analysis
Vertical Common-Size Analysis:
Year 2008 2009 2010 2011 2012 2013
Cash 6% 6% 5% 5% 5% 5%
Inventory 23% 23% 23% 23% 22% 22%
Accounts receivable 16% 16% 16% 15% 15% 15%
Net plant and equipment 50% 50% 51% 51% 52% 52%
Intangibles 6% 6% 5% 5% 5% 5%
Total assets 100% 100% 100% 100% 100% 100%

Graphically:
100%

Proportion
50%
of Assets
0%
2008 2009 2010 2011 2012 2013
Fiscal Year

Cash Inventory Accounts receivable Net plant and equipment Intangibles

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Example: Common-Size Analysis
Horizontal Common-Size Analysis (base year is 2008):
Year 2008 2009 2010 2011 2012 2013
Cash 100.00% 101.00% 102.01% 103.03% 104.06% 105.10%
Inventory 100.00% 103.00% 106.09% 109.27% 112.55% 115.93%
Accounts receivable 100.00% 102.00% 104.04% 106.12% 108.24% 110.41%
Net plant and equipment 100.00% 104.00% 108.16% 112.49% 116.99% 121.67%
Intangibles 100.00% 100.50% 101.00% 101.51% 102.02% 102.53%
Total assets 100.00% 103.08% 106.27% 109.57% 112.99% 116.53%

Graphically:
130%
Percentage 120%
of Base
110%
Year
Amount 100%
90%
2008 2009 2010 2011 2012 2013
Fiscal Year
Cash Inventory Accounts receivable Net plant and equipment Intangibles Total assets

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Financial Ratio Analysis
 Financial ratio analysis is the use of relationships
among financial statement accounts to gauge the financial
condition and performance of a company.
 We can classify ratios based on the type of information
the ratio provides:

Solvency Profitability
Activity Ratios Liquidity Ratios
Ratios Ratios

Effectiveness Ability to
in putting its Ability to meet manage
Ability to
asset short-term, expenses to
satisfy debt
investment to immediate produce
obligations.
use. obligations. profits from
sales.

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Activity Ratios
 Turnover ratios reflect the number of times assets flow into and out
of the company during the period.
 A turnover is a measure of the efficiency of putting assets to work.
 Ratios:
How many times inventory is
created and sold during the
period.

How many times accounts


receivable are created and
collected during the period.

The extent to which total assets


create revenues during the
period.

The efficiency of putting working


capital to work

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Operating cycle components
 The operating cycle is the length of time from when a
company makes an investment in goods and services to the
time it collects cash from its accounts receivable.
 The net operating cycle is the length of time from when a
company makes an investment in goods and services,
considering the company makes some of its purchases on
credit, to the time it collects cash from its accounts
receivable.
 The length of the operating cycle and net operating cycle
provides information on the company’s need for liquidity:
The longer the operating cycle, the greater the need for
liquidity.
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Operating Cycle Formulas
Average time it
takes to create
and sell
inventory.

Average time it
takes to collect
on accounts
receivable.

Average time it
takes to pay
suppliers.

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Operating Cycle Formulas
Time from investment in
inventory to collection
of accounts.

Time from investment in


inventory to collection
of accounts,
considering the useof
trade credit in
purchases.

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Liquidity
 Liquidity is the ability to satisfy the company’s short-
term obligations using assets that can be most readily
converted into cash.
 Liquidity ratios:
Ability to satisfy current
liabilities using current assets.

Ability to satisfy current


liabilities using the most liquid
of current assets.

Ability to satisfy current


liabilities using only cash and
cash equivalents.

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Solvency Analysis
 A company’s business risk is determined, in large part,
from the company’s line of business.
 Financial risk is the risk resulting from a company’s
choice of how to finance the business using debt or equity.
 We use solvency ratios to assess a company’s financial
risk.
 There are two types of solvency ratios: component
percentages and coverage ratios.
 Component percentages involve comparing the elements
in the capital structure.
 Coverage ratios measure the ability to meet interest and
other fixed financing costs.

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Solvency ratios
Proportion of assets financed with debt.
Component-Percentage

Proportion of assets financed with long-


term debt.
Solvency Ratios

Debt financing relative to equity financing.

Reliance on debt financing.

Ability to satisfy interest obligations.


Coverage Ratios

Ability to satisfy interest and lease


obligations.

Ability to satisfy interest obligations with


cash flows.

Length of time needed to pay off debt with


cash flows.

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Profitability

 Margins and return ratios provide information


on the profitability of a company and the
efficiency of the company.
 A margin is a portion of revenues that is a
profit.
 A return is a comparison of a profit with the
investment necessary to generate the profit.

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Profitability ratios: Margins

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Profitability Ratios: Returns

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