Financial Analysis

Financial Analysis for the IAA

Analytical procedures are one type of audit
evidence used by all auditors.
Example: The cost of items in inventory flows to cost of
goods sold as sales are made. If someone is recording
fraudulent sales and receivables that have no
corresponding cost, then the gross margin percentage
(sales revenue less cost of sales divided by sales
revenue) may increase unaccountably (that is, not
explainable by cost-cutting procedures, for example). If
inventory theft is occurring, the gross margin
percentage may be inexplicably low (due to costs
without corresponding sales revenue). Internal auditors
should be comfortable with the use of financial ratios as
analytical procedures.
EBIT and EBT
Earnings before interest and taxes (EBIT)
and earnings before taxes (EBT) are terms
frequently used in financial statement
analysis, although they do not appear as
summations on a statement of profit or
loss.
Revenue XXXXX
Cost of goods sold (XXXX)
Gross margin XXXX
Selling expenses ( XXX)
General & administrative expenses ( XXX)
Research & development expenses ( XXX)
Other business income XX
Other business expense ( XX)
Income (loss) from operations XX
Financial income (such as gains on sale of assets and interest income) X
Financial expenses (such as losses on sale of assets but not interest expense) ( X)
Earnings before interest & taxes (EBIT) XXX
Interest expense ( X)
Earnings before taxes (EBT) XXX
Income tax expense, continuing operations ( XX)
Income from continuing operations XX
Revenue XXXXX
Cost of goods sold (XXXX)
Gross margin XXXX
Selling expenses ( XXX)
General & administrative expenses ( XXX)
Research & development expenses ( XXX)
Other business income XX
Other business expense ( XX)
Income (loss) from operations XX
Financial income (such as gains on sale of assets and interest income) X
Financial expenses (such as losses on sale of assets but not interest expense) ( X)
Earnings before interest & taxes (EBIT) XXX
Interest expense ( X)
Earnings before taxes (EBT) XXX
Income tax expense, continuing operations ( XX)
Income from continuing operations XX
Revenue XXXXX
Cost of goods sold (XXXX)
Gross margin XXXX
Selling expenses ( XXX)
General & administrative expenses ( XXX)
Research & development expenses ( XXX)
Other business income XX
Other business expense ( XX)
Income (loss) from operations XX
Financial income (such as gains on sale of assets and interest income) X
Financial expenses (such as losses on sale of assets but not interest expense) ( X)
Earnings before interest & taxes (EBIT) XXX
Interest expense ( X)
Earnings before taxes (EBT) XXX
Income tax expense, continuing operations ( XX)
Income from continuing operations XX
Revenue XXXXX
Cost of goods sold (XXXX)
Gross margin XXXX
Selling expenses ( XXX)
General & administrative expenses ( XXX)
Research & development expenses ( XXX)
Other business income XX
Other business expense ( XX)
Income (loss) from operations XX
Financial income (such as gains on sale of assets and interest income) X
Financial expenses (such as losses on sale of assets but not interest expense) ( X)
Earnings before interest & taxes (EBIT) XXX
Interest expense ( X)
Earnings before taxes (EBT) XXX
Income tax expense, continuing operations ( XX)
Income from continuing operations XX
Comparative FS Analysis
We often need to compare different
companies, and we need to have a way to
do that when the companies are different
in size.
Comparison over time may be difficult as
well as companies grow (or get smaller).
1. Vertical (Common size) FS
2. Horizontal (Trend analysis) FS
1. Vertical Common Size FS
A simple vertical common-size financial
statement covers one year’s operating
results and expresses each component as a
percentage of a total.
• Line items on the statement of profit or
loss are presented as a percentage of sales
revenue
• Line items on the balance sheet are
presented as a percentage of total assets
Using Vertical FS
Compare a company’s common-size
statement of profit or loss with industry
common-size profit or loss statements to
potentially reveal a problem.
Common-size financial statements for one
company can be arranged side by side for
a period of several years to reveal trends
over time in individual line items as
percentages of sales revenue.
Example: A common-size vertical statement.
Following is a statement of financial position and a
statement of profit or loss for a company with the actual
monetary amounts (in thousands, 000 omitted) in the
first column and the common size vertical statement
percentages in the second column. Each individual
statement of financial position item has been divided by
the total assets and each individual profit or loss
statement item has been divided by net revenues.
 20X3 20X3
Actual Common Size
Statement of Financial Position:
ASSETS
Non-current Assets:
Property, plant & equipment, net 2,400 9.1%
Intangible assets 4,500 17.0%
Other non-current assets 1,200 4.5%
Total non-current assets 8,100 30.6%
Current Assets:
Inventories 400 1.5%
Marketable securities 14,100 53.2%
Other current assets 300 1.1%
Accounts receivable, net 700 2.7%
Cash & cash equivalents 2,895 10.9%
Total current assets 18,395 69.4%
Total assets 26,495 100.0%
 20X3 20X3
Actual Common Size
Statement of Profit or Loss:
Revenues:
Net revenues 10,400 100.0%
Cost of goods sold 3,200 30.8%
Gross margin 7,200 69.2%
Operating expenses:
Selling expenses 600 5.8%
General and administrative expense 900 8.7%
Research and development expense 3,000 28.9%
Total operating expenses 4,500 43.3%
Income from operations 2,700 25.9%
2. Horizontal Financial Statements
Horizontal trend analysis is used to evaluate
trends over a period of several years for a
single business.
• The first year is the base year.
• Amounts for subsequent years are
presented not as dollar amounts but as
percentages of the base year amount, with
the base year assigned a value of 100%, or
100.
Example: A common-base year statement. Below are the
same company’s profit or loss statements for three years. The
statements appear first, and below them the common-base year
statements follow. In the common-base year statements of profit
or loss, amounts from 20X1 are expressed as 100%, and on
each line, amounts from 20X2 and 20X3 are expressed as
percentages of the 20X1 values. The same type of analysis can
be done using balance sheet amounts.
Statement of Profit or Loss:
Year 3 Year 2 Year 1
Net revenues 10,400 11,100 9,900
Cost of goods sold 3,200 3,400 3,000
Gross profit 7,200 7,700 6,900
Research and development expense 3,000 1,800 1,200
Selling, general and administrative exp 1,500 1,700 1,400
Operating income 2,700 4,200 4,300
Statement of Profit or Loss:
Year 3 Year 2 Year 1
Net revenues 105.1% 112.1% 100.0%
Cost of goods sold 106.7% 113.3% 100.0%
Gross profit 104.3% 111.6%100.0%
Research and development expense250.0% 150.0% 100.0%
Selling, general and administrative exp. 107.1% 121.4% 100.0%
Operating income 62.8% 97.7% 100.0%
Individual Line Growth Rates
For each line item, the percentage of
change year-over-year is calculated. Each
year’s value is compared with that of the
previous year.

Year 2 – Year 1
Year 1
Example: A variation analysis showing growth rates
of individual line items on the statement of financial
position and statement of profit or loss. Below are
financial statements for the same company for two
years showing the growth rate in each balance sheet
and profit or loss statement item from 20X2 to 20X3 (in
thousands, 000 omitted). (Note that growth rates can be
negative.)
 20X3 20X2 Growth Rate
Statement of Financial Position:
ASSETS
Non-current Assets:
Property, plant & equipment, net 2,400 2,100 +14.3%
Intangible assets 4,500 4,600 − 2.2%
Other non-current assets 1,200 1,200 0.0%
Total non-current assets8,100 7,900 + 2.5%
Ratio Analysis
Ratio Analysis
Ratio analysis compares relationships among
financial statement elements.
By looking at these relationships you can see
if they indicate positive or negative trends
developing within a company.
Ratios in Context
A ratio is only a number and the ratio
needs to be put in context to have value.
1. Same company over time
2. To other companies in the industry
Limitations of Ratio Analysis
• Ratios are constructed from accounting data,
much of which is subject to estimation.
• Comparability of financial statement amounts
and the ratios derived from them is impaired if
different firms choose different accounting
policies.
• Ratios are more useful is comparing like
companies vs. comparing conglomerates
(firms that operate a variety of industries).
Limitations of Ratio Analysis
• Different ratios may yield opposite
conclusions about a firm’s financial health.
• Different sources of information may
compute ratios differently.
Categories of Ratios
There are four categories of ratios:
1. Liquidity
2. Leverage
3. Asset management, or usage
4. Profitability ratios
1. Liquidity Ratios
Liquidity ratios measure the short-term
viability of a business.
Working Capital
Working capital is a measure of the ability of
the company to meet its liabilities as they
come due.

Working Capital =
Current Assets – Current Liabilities
Current Assets and Current Liabilities
• Cash • Accounts payable
• Net accounts • Notes payable (short-
receivable
term)
• Inventory
• Unearned revenue
• Marketable
securities • Other accrued
liabilities, i.e., taxes
• Prepayments
payable, wages
payable, etc.
Current Ratio
The current ratio measures working capital as
a ratio instead of a dollar amount.

Current Assets
Current Liabilities
Quick Ratio
The quick ratio is based on the current ratio,
but it does not include inventory in the
numerator.

Cash + Net Receivables + Marketable Securities

Current Liabilities
Defensive Interval Ratio
Measures how many days a company can
meet its basic operational costs.

Cash + Net A/R + Marketable Securities

Daily Operating Cash Flow
2. Leverage Ratios
Leverage ratios (also referred to as gearing)
simply tell you how much the company is
using debt to finance assets and
operations.
Leverage can be advantageous when
earnings from borrowed funds exceed
borrowing costs.
Risk increases as interest rates increase and
returns decrease.
Debt-to-Equity Ratio
The debt-to-equity ratio (also referred to as
gearing) compares the resources provided
by creditors with the resources provided
by the shareholders.
Higher the leverage the higher the risk.

Total Debt
Shareholders’ Equity
Debt Ratio
Measures the percentage of funds provided
by creditors.
It determines the long-term debt payment
ability and the degree to which creditors are
protected from the company’s insolvency.

Total Debt
Total Assets
Times-Interest-Earned Ratio
Evaluates the company’s debt payment
ability.
The ratio indicates the margin of safety over
the fixed interest charges.
A high ratio is desirable.

Earnings before Interest and Taxes (EBIT)

Interest Expense
3. Asset Management Ratios
Asset management ratios measure the company’s
use of assets to generate revenue and income.
Inventory Turnover Ratio
Measures the number of times the company sells its
inventory during the year.
A low number may indicate that they have too much
inventory and too much cash invested in inventory.
A high number may indicate that they do not have
enough inventory and lose sales from stockouts.

Annual Cost of Sales

Average Annual Inventory
Days of Sales in Inventory
Measures the number of days of sales that
are held in inventory, on average.
The higher the number, the less risk that
there is for a stockout; but the more cash is
invested in inventory.

365, 360 or 300

Inventory Turnover
Accounts Receivable Turnover
Like inventory turnover, this measures how
many times during the period the company
collects its receivables.

Annual Net Credit Sales

Average Annual Accounts Receivable
Number of Days Receivables Held
The number of days it takes to collect
receivables.

365, 360 or 300

Receivables Turnover
Accounts Payable Turnover
Low is good as long as the payables are
being paid on time.

Annual Credit Purchases

Average Accounts Payable
Days Purchases in Payables
This is the number of days that we hold
payables before they are paid.

Average Accounts Payable

Average Daily Credit Purchases
Fixed Assets Turnover
Measures how a company uses fixed assets
to generate sales.

Net Sales
Average Net Fixed Assets
Total Assets Turnover
Measures how a company uses its assets to
generate sales.

Net Sales
Average Total Assets
Operating Cycle
Measures the amount of time it takes to
convert an investment in inventory back into
cash after the collection of the sale.

Days in Inventory
+ Days of Sales in Receivables
= Operating Cycle
Cash Cycle
Measures the number of days that cash is
tied up in the operating cycle of the business.

Days in Inventory
+ Days of Sales in Receivables
– Days of Purchases in Payables
= Cash Cycle
4. Profitability Ratios
Profitability ratios measure earnings relative
to some base, such as productive assets,
sales or capital.
Net Profit Margin
The net profit margin ratio equation is:

Net Income after Interest and Taxes

Net Sales
Net Operating Income to Sales
Emphasizes operating results and more
nearly approximates cash flows than other
income measures.

Earnings Before Interest and Taxes

(EBIT)
Net Sales
Return on Assets

Net Income
Total Average Assets
Return on Common Equity
Measures the company’s return on the
book value of its equity.
The average common shareholders’ equity
includes total equity minus the preferred
shareholders’ capital and any minority
interest.
Net Income – Preferred Dividends
Average Book Value of Common Equity
Return on Total Equity
Measures the rate of return on the ownership
interest of the shareholders.

Net Income
Average Total Equity
Categories of Ratios
1. Liquidity
2. Leverage
3. Asset management, or usage
4. Profitability