ACC 223-BASIC FINANCIAL

MANAGEMENT

Financial Statements Analysis

Presented by Kipangula Henrique

 Financial Statements
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 The statement of comprehensive income or the

Income statement
 The statement of financial position
 The Statement of Cash Flows
 The statement of changes in owners` equity

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 Financial Statement Analysis
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 It is a data processing system designed to

provide information for decision makers.
 Financial statement analysis provides a starting
point towards understanding the performance
and the financial status of the corporation
[Gitman 1994, 104].

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 It is a means of uncovering further information

that is hidden behind the figures appearing on the
financial statements.
 Through financial statement analysis, it is possible
to uncover more information about the nature of
the transactions whose outcomes are contained in
these financial statement figures [Kasilo 1997].

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 The fundamental process of financial statement

analysis involves comparisons between items
having logical relationship with one another,
leading to computations and interpretation of the
results.

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 Users of Information from Financial Statements
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i. Investors: For making investment decisions.

ii. Management: For performance evaluation and
making day to day decisions of the
organizations, decisions are such as investing
decisions and financing decisions.
iii. Lenders: For assessing the credit worthiness
of borrowers.

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iv. Suppliers: To assess the liquidity position of their
customers
v. Customers: To evaluate the reliability of their
suppliers
vi. Regulatory authorities: To make sure
organizations comply with principles, standards
and laws
vii. The public: To know the goodwill of the
organization.
Objectives of Financial Statement Analysis

 Standardize financial information for comparisons

 Evaluate current operations
 Compare performance with past performance
 Compare performance against other firms or industry
standards
 Study the efficiency of operations
 Study the risk of operations
 The Approaches of Financial Statement
Analysis:
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I. Common Size Income Statement OR Balance

Sheet
II. Cross Section Analysis including Industry
Comparison
III. Time Series [Trend] Analysis of individual firm
IV. Time Series [Trend] analysis coupled with
industry comparison
V. The DuPont System

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Common Size Analysis
 Common size analysis, also referred as vertical
analysis, is a tool that financial managers use to
analyze financial statements.
 It evaluates financial statements by expressing each
line item as a percentage of the base amount for
that period.
 The analysis helps to understand the impact of each
item in the financial statement and its contribution
to the resulting figure.
Common Size Analysis Fomular
Common Size Analysis Example
 From the table above, we can deduce that cash
represents 14.5% of the total assets while inventory
represents 12% of the total assets.
 In the liabilities section, we can deduce that
accounts payable represent 15%, salaries 10%,
long-term debt 30%, and shareholder’s equity 40%
of the total liabilities and stockholder’s equity.
 Common Size Income Statement
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 A common size income statement is obtained by

dividing every item in the income statement to the
total revenue [sales], and
 Expressing the results as a percentages

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 Common size Balance sheet
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 In a common sized balance sheet all items are

expressed as percentages of Total Assets

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 Time Series [Trend] Analysis
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 Time Series [Trend] Analysis evaluates the firm’s

performance over a number of years, using
financial ratios as performance indicators in this
case.
 For instance, the question is, ‘ HOW HAS THE
COMPANY PERFORMED IN THE PERIOD
2009 - 2019? Has it been growing? Declining?
Stagnant? Why? Where did it get right/wrong?

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 The Du Pont System of Analysis
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 The Du Pont System of analysis is used by financial

managers and consultants as a structure for
dissecting the financial statements in order to assess
a firm’s financial condition.
 The system merges the income statement and the
balance sheet into two summary measurements of
profitability: return on investment - ROI, and return
on shareholders’ equity - ROE (Gitman, 1991,131).

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 Ratio Analysis
 Financial ratios express relationships between
financial statement items. Although they provide
historical data, management can use ratios to
identify internal strengths and weaknesses, and
estimate future financial performance.
 Investors can use ratios to compare companies in
the same industry. Ratios are not generally
meaningful as standalone numbers, but they are
meaningful when compared to historical data and
industry averages.
Liquidity Ratios
 In accounting, the term liquidity is defined as the
ability of a company to meet its financial obligations
as they come due. The liquidity ratio, then, is a
computation that is used to measure a company's
ability to pay its short-term debts. There are two
common calculations that fall under the category of
liquidity ratios. The current ratio is the most liberal of
the three. It is followed by the acid ratio, and the cash
ratio. These three ratios are often grouped together by
financial analysts when attempting to accurately
measure the liquidity of a company.
Current Ratio
 The current ratio indicates a company's
ability to pay its current liabilities from
its current assets. This ratio is one used
to quickly measure the liquidity of a
company. The formula for the current
ratio is:
 Current Ratio = Current Assets ÷

Current Liabilities
Acid Test Ratio
 The second ratio that we will discuss is the acid
ratio. This ratio is also referred to as the quick ratio.
The purpose of this ratio is to measure how well a
company can meet its short-term obligations with its
most liquid assets. Remember, liquid assets are those
that can be quickly turned into cash. Most of the
current assets are highly liquid with the exception of
inventory, which often takes a longer amount of time
to turn into cash. The formula for calculating the acid
ratio is:
 Acid Ratio = (Current Assets - Inventory) ÷
Current Liabilities
 The cash ratio is the ratio of a company's total cash
and cash equivalents to its current liabilities.
 The cash ratio is most commonly used as a measure
of company's liquidity. The metric calculates a
company's ability to pay current liabilities using only
cash and cash equivalents on hand. If the company is
forced to pay all current liabilities immediately, this
metric shows the company's ability to do so without
having to sell or liquidate other assets.
 Cash Ratio = Cash and cash equivalents
Current Liabilities
Profitability Ratios
 A profitability ratio is a measure of profitability,
which is a way to measure a company's
performance. Profitability is simply the capacity
to make a profit, and a profit is what is left over
from income earned after you have deducted all
costs and expenses related to earning the income.
Profitability ratios can be used to judge a
company's performance and to compare its
performance against other similarly-situated
companies.
I. Gross profit margin = Gross profit/Sales
 Example: Imagine that you run a company that
sold $50,000,000 in running shoes last year and had
a gross profit of $7,000,000. What was your
company's gross margin for the year?
 GPM = $7,000,000 / $50,000,000 * 100
 GPM = .14 * 100
 GPM = 14%
 For every dollar in shoe sales, you earned 14 cents
in profit but spent 86 cents to make it.
ii. Return on equity measures how much a company
makes for each dollar that investors put into it.
You calculate it by taking the net income earned
(NI) by the amount of money invested by
shareholders (SI) and multiplying the quotient by
100:
 Return on Equity = Net Income / Shareholder

Investment * 100
 ROE = NI / SI * 100
iii. Return on Assets measures how effectively the company produces
income from its assets. You calculate it by dividing net income (NI) for
the current year by the value of all the company's assets (A) and
multiplying the quotient by 100:
 Return on Assets = Net Income / Assets * 100

 ROA = NI/A * 100

 Example: Imagine that you are the president of a large company that
manufactures steel. Last year, your company had net income of
$25,000,000, and the total value of its assets, such as plant, equipment
and machinery, totaled $135,000,000. What was your return on assets
last year?
 ROA = $25,000,000 / $135,000,000 * 100
 ROA = 0.185 * 100
 ROA = 18.5%
 This means that you generate 18.5 cents of income for every dollar your
company holds in assets.
Solvency Ratios
 Solvency ratios indicate financial stability because
they measure a company's debt relative to its assets
and equity. A company with too much debt may not
have the flexibility to manage its cash flow if interest
rates rise or if business conditions deteriorate.
 The common solvency ratios are debt-to-asset and
debt-to-equity. The debt-to-asset ratio is the ratio of
total debt to total assets. The debt-to-equity ratio is
the ratio of total debt to shareholders' equity, which is
the difference between total assets and total
liabilities.
I. Debt to Asset Ratio = Total Debt/ Total
Assets

ii. Debt to Equity Ratio = Total Debt/ Total

Equity
Efficiency Ratios
 Three common efficiency ratios are inventory
turnover, receivables turnover and payables
turnover. Inventory turnover is the ratio of cost of
goods sold to inventory. A high inventory turnover
ratio means that the company is successful in
converting its inventory into sales. The receivables
turnover ratio is the ratio of credit sales to accounts
receivable, which tracks outstanding credit sales. A
high accounts receivable turnover means that the
company is successful in collecting its outstanding
credit balances.
 Accounts Receivable Turnover
 Accounts receivable turnover provides an indication of
a company's efficiency at collecting sales revenues on a
timely basis. Companies using payment terms of 30 to
60 days and being paid on time yield accounts
receivable turnover ratios between 6 and 12. Low ratios
can indicate payment collection problems.
I. Receivable Turnover = (Credit sales/Receivables) x
365
Inventory Turnover
 The inventory turnover ratio gives an indication of how many
times a company sells and restocks its inventory over a given
period of time, or how many days on average it takes the
company to sell out its inventory. Higher inventory turnover
rates are generally considered favorable, evidencing brisk
sales, but excessively frequent turnover may indicate
inefficient ordering or that a company may be having
difficulty meeting demands for orders on a timely basis.
 Comparison with similar firms is helpful for determining what
constitutes a favorable turnover rate.

 Inventory Turnover = (COGS/Average Inventory) x 365

Accounts payable turnover
 The accounts payable turnover ratio reveals how well a
company manages its outflows of cash.
 Higher ratios, indicating the company can keep cash on
hand longer, are generally considered preferable.
 However, a company must balance this with
maintaining good credit and avoiding late payment fees.
 Accounts payable turnover = (Credit
purchases/Payables) x 365
Market Value Ratios
 Market Value Ratios relate an observable market
value, the stock price, to book values obtained
from the firm's financial statements.
Price-Earnings Ratio (P/E Ratio)

 The Price-Earnings Ratio is calculated by dividing the

current market price per share of the stock by earnings
per share (EPS). (Earnings per share are calculated by
dividing net income by the number of shares
outstanding)
 The P/E Ratio indicates how much investors are willing
to pay per dollar of current earnings. As such, high P/E
Ratios are associated with growth stocks. (Investors who
are willing to pay a high price for a dollar of current
earnings obviously expect high earnings in the future.)
 In this manner, the P/E Ratio also indicates how
expensive a particular stock is.

 Where;
Dividend Payout Ratio
 Dividend payout ratio is the percentage of a company’s
earnings that it pays out to investors in the form of
dividends. It is calculated by dividing dividends paid
during a period by net earnings for that period.
 Dividend payout ratio is reciprocal of retention ratio
(or plowback period) which measures the percentage
of earnings a company reinvests in projects to generate
future growth.
 Dividend payout ratio is an important indicator of a
company’s performance from an investor’s point of
view.
 Dividend Payout Ratio = Dividends/Net
Income
 Dividend Yield Ratio

 Dividend yield is the ratio of dividend paid per share

by a company to its current share price. It is a measure
of dollars of dividends received by investors per
hundred dollars of their investments in the stock.
 Dividends are one of the two sources for return equity
shareholders receive on their investment in a
company’s stock, the other being capital gains.
Dividend yield measures the percentage return on a
particular stock that has resulted from the company’s
dividend payments.
 Dividend yield = Dividend per share/ Current share
price
 Some of the Limitations of Ratio Analysis
 Usefulness dependent on the accuracy of
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the figures
 Only a part of the jig-saw – needs other
information to make full judgement
 What has happened in the past is not
necessarily a pointer to what will happen in
the future
 Statistics always have a limitation in that it
depends when they are used and how they
are used.

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 Some of the Limitations of Ratio
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Analysis
 No two businesses are fully
comparable as the differences
between them will always influence
the performance of the business

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 Questions???
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 Read as many
financial statements
as possible and
perform ratio
analysis.

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