CHAPTER 1:

Overview of Financial
Statement Analysis

(Step 4: Analyze Profitability and Risk and

Step 5: Prepare Forecasted Financial
Statements)
Step 4: Analyze Profitability and Risk
 Most financial statement analysis aims to evaluate a firm’s
profitability and risk. This twofold focus stems from the emphasis of
investment decisions on returns and risk.
 The income statement reports a firm’s net income during the
current year and prior years.
 Assessing the financial risk of a firm assists the investor in
identifying the level of risk incurred when investing in the firm’s
common stock.
 Tools of Profitability and Risk
Analysis
 Common-size Financial Statements
 Percentage Change Financial Statements
 Financial Statement Ratios
 Profitability Ratios
 Risk Ratios
 Common-size Financial Statements

 A tool that is helpful in highlighting relations in a

financial statements.
 Common-size income statements and balance
sheets express all items in the statement as a
percentage of a common base.
Percentage Change Financial Statements

a tool that is helpful in highlighting the relative rates of growth

in financial statement amounts from year to year and over
longer periods of time.
 These statements present the percentage change in the
amount of an item relative to its amount in the previous period
or the compounded average percentage change over several
prior periods.
 Financial Statement Ratios
 most useful analytical tools for assessing
profitability and risk
 it express relations among various items from
the three financial statements
Profitability Ratios
 EPS (earnings per share)
EPS = net income available to the common shareholders ÷
weighted-average number of common shares standing.

 ROCE (return on common equity)

ROCE = net income available to the common shareholders
÷ average common shareholders’ equity for the year
 Risk Ratios
 A simple method to assess the volatility of a firm’s earnings
over time and gauge uncertainty inherent in future earning to
simply calculate the standard deviation of ROCE.
 Alternatively, to assess the ability of firms to repay short-
term obligations, analysts frequently calculate various short-
term liquidity ratios such as the current ratio, which equals
current assets divided by current liabilities.
Step 5: Prepare Forecasted Financial
Statements
 the crucial (and most difficult) step is forecasting future
financial statements
 Such forecasts are the inputs into valuation models or
other financial decisions, and the quality of the decisions
rests on the reliability of the forecasts.
Forecasted financial statements rely on
assumptions you make about the future:
 Will the firm’s strategy remain the same or change?
 At what rate will the firm generate revenue growth?
 Will the firm likely gain or lose market share relative to competitors?
 Will revenues grow because of increases in sales volume, prices, or
both?
 How will its costs change?
 How much will the firm need to increase operating assets
(inventory, plant, and equipment) to achieve its growth strategies?
 How much capital will the firm need to raise to finance growth in
assets?
 Will it change the mix of debt versus equity financing?
 How will a change in the debt-equity mix change the risk of the firm?
THANK YOU FOR
LISTENING!

- GROUP 3 