Financial Statement Analysis

Prepared by

DR. ROLANDO E. ROBLEDO

1
 Financial Statement Analysis

After studying this module, you should be able to:

• Describe and apply horizontal analysis.
• Describe and apply vertical analysis.
• Identify and compute ratios used in
analyzing a company’s liquidity, solvency,
and profitability.
• Understand the concept of quality of
earnings.

2
 Comparative Analysis
• Any item reported in a financial statement has
significance if:
– Its inclusion indicates that the item exists at a given
time and in a certain quantity.
• For example, when ABC Company reports $136.4
million on its balance sheet as cash, we know that the
company did have cash and that the quantity was
$136.4 million.

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 Comparative Analysis
• Whether the amount represents an increase
over prior years, or whether it is adequate in
relation to the company's needs, cannot be
determined from the amount alone.
• The amount must be compared with other
financial data to provide more information.

4
 Comparative Analysis
There are three types of comparisons to
provide decision usefulness of financial
information:
• Intracompany basis
• Intercompany basis
• Industry averages

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 Intracompany Basis
• Comparisons within a company are often useful
to detect changes in financial relationships and
significant trends.
• A comparison of ABC's current year's cash
amount with the prior year's cash amount shows
either an increase or a decrease.
• A comparison of ABC's year-end cash amount
with the amount of total assets at year-end
shows the proportion of total assets in the form
of cash.
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 Intercompany Basis
• Comparisons with other companies provide
insight into a company's competitive position.
• ABC's total sales for the year can be compared
with the total sales of its competitors.

7
 Industry Averages
• Comparisons with industry averages provide
information about a company's relative
position within the industry.
• ABC's financial data can be compared with
the averages for its industry compiled by
financial ratings organizations such as Dun &
Bradstreet, Moody's, and Standard & Poor's.

8
 Financial Statement Analysis
Three basic tools are used in financial statement
analysis :
• Horizontal analysis
• Vertical analysis
• Ratio analysis

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 Horizontal Analysis
• Is a technique for evaluating a series of financial
statement data over a period of time.
• Purpose is to determine whether an increase or
decrease has taken place.
• The increase or decrease can be expressed as either
an amount or a percentage.

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Horizontal Analysis

11
 Percentage Change in Sales
The percentage change in sales for each of the 5 years,
assuming 2017 as the base period is:
Kellogg Company
Net Sales (in millions) Base Period 2017

2021 2010 2019 2018

2017
$8,853.3 $6,954.7 $6,984.2 $6762.1
$6,830.1
129.62% 101.82 % 102.26% 99%
100.0%
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 Horizontal Analysis
of a Balance Sheet
ABC COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions)
Increase (Decrease)
during 2021

2021 2020 Amount Percent

Assets
Current Assets $ 1,902.0 $1,617.1 $ 284.9 17.6
Plant assets 2,952.8 2,526.9 425.9 16.9
Other assets 5,513.8 742.0 4,771.8 643.1
Total assets $10,368.6 $4,886.0 $5,482.6 112.2
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 Horizontal Analysis
of a Balance Sheet Increase (Decreas
during 2021
2021 2020 Amount Percen
Liabilities and
Stockholders' Equity
Current liabilities $ 2,207.6 $2,482.3 $ (274.7) (11.1)
Long-term liabilities 7,289.5 1,506.2 5,783.3 384.0
Total liabilities 9,497.1 3,988.5 5,508.6 138.1
Stockholders' equity
Common stock 195.3 205.8 (10.5) (5.1)
Retained earnings
and other 1,013.3 1,065.7 (52.4) (4.9)
Treasury stock (337.1) (374.0) 36.9 9.9
Total stockholders'
equity 871.5 897.5 (26.0) (2.9)
Total liabilities and
stockholders' equity $10,368.6 $4,886.0 $5,482.6 112.2

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 ABC COMPANY, INC.
Condensed Income Statement
For the Years Ended December 31
(In millions)
Increase (Decrease)
during 2021
2021 2020 Amount Percent
Net sales $ 8,853.3 $6,954.7 $1,898.6 27.3
Cost of goods sold 4,128.5 3,327.0 801.5 24.1
Gross profit 4,724.8 3,627.7 1,097.1 30.2
Selling & Admin. 3,523.6 2,551.4 972.2 38.1
Nonrecurring charges 33.3 86.5 (53.2) (61.5)
Income from operations 1,167.9 989.8 178.1 18.0
Interest expense 351.5 137.5 214.0 155.6
Other income
(expense), net (12.3) 15.4 (27.7) (179.9)
Income before taxes 804.1 867.7 (63.6) (7.3)
Income tax expense 322.1 280.0 42.1 15.0
Net income $ 482.0 $ 587.7 $ (105.7) (18.0)
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 Let’s Review
In horizontal analysis, each item is
expressed as a percentage of the:

a. net income amount.

b. stockholders’ equity amount.
c. total assets amount.
d. base-year amount.

16
 Let’s Review
In horizontal analysis, each item is
expressed as a percentage of the:

a. net income amount.

b. stockholders’ equity amount.
c. total assets amount.
d. base-year amount.

17
 Vertical Analysis
• Is a technique for evaluating financial
statement data that expresses each item
in a financial statement as a percent of
a base amount.
• Total assets is always the base amount
in vertical analysis of a balance sheet.
• Net sales is always the base amount in
vertical analysis of an income
statement. 18
 ABC COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions)

2021 2020 z
Assets Amount Percent Amount Percent
Current Assets $ 1,902.0 18.3 $1,617.1 33.1
Property Assets 2,952.8 28.5 2,526.9 51.7
Other assets 5,513.8 53.2 742.0 15.2
Total assets $10,368.6 100.0% $4,886.0 100.0%

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 ABC COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions)

2021 2020
Liabilities and Amount Percent* Amount Percent*
Stockholders' Equity
Current liabilities $ 2,207.6 21.3 $2,482.3 50.8
Long-term liabilities 7,289.5 70.3 1,506.2 30.8
Total liabilities 9,497.1 91.6 3,988.5 81.6
Stockholders' equity
Common stock 195.3 1.9 205.8 4.2
Retained earnings
and other 1,013.3 9.8 1,065.7 21.8
Treasury stock (337.1) (3.3) (374.0) (7.6)
Total stockholders'
equity 871.5 8.4 897.5 18.4
Total liabilities and
stockholders' equity $10,368.6 100.0 $4,886.0 100.0

*Percentages may be rounded up or down

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 ABC COMPANY, INC.
Condensed Income Statement
For the Years Ended December 31
(In millions)
2021 2020
Amount Percent* Amount
Percent*
Net sales $8,853.3 100.0 $6,954.7 100.0
Cost of goods sold 4,128.5 46.6 3,327.0 47.8
Gross profit 4,724.8 53.4 3,627.7 52.2
Selling & admin. 3,523.6 39.8 2,551.4 36.7
Nonrecurring chgs. 33.3 0.4 86.5 1.3
Income operations 1,167.9 13.2 989.8 14.2
Interest expense 351.5 4.0 137.5 2.0
Other income
(expense),net (12.3) (0.1) 15.4 0.2
Income before
income taxes 804.1 9.1 867.7 12.4
Income tax ex. 322.1 3.6 280.0 4.0
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Net income $ 482.0 5.5 $ 587.7 8.4
 Condensed Income Statements
For the Year Ended December 31, 2021
(in millions)
ABC Company, Inc. XYZ Company, Inc
Amount Percent* Amount Percent*

Net sales $8,853.3 100.0 $7,949.0 100.0

Cost of goods sold 4,128.5 46.6 4,767.0 60.0
Gross profit 4,724.8 53.4 3,182.0 40.0
Selling and administrative
expenses 3,523.6 39.8 1,909.0 24.0
Nonrecurring charges 33.3 0.4 190.0 2.4
Income from operations 1,167.9 13.2 1,083.0 13.6
Other expenses and
revenues (including
income taxes) 685.9 7.7 622.0 7.8
Net income $ 482.0 5.5 $ 461.0 5.8

*Percentages may be rounded up or down

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Ratio Analysis

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 Ratios
• Three types:
Liquidity ratios
Solvency ratios
Profitability ratios
• Can provide clues to underlying conditions that
may not be apparent from an inspection of the
individual components.
• Single ratio by itself is not very meaningful.
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Liquidity Ratios
Measure the short-term ability of the
enterprise to pay its maturing
obligations and to meet unexpected
needs for cash.
WHO CARES?
Short-term creditors such as bankers
and suppliers

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 Liquidity Ratios
• Working capital
• Current ratio
• Current cash debt coverage ratio
• Inventory turnover ratio
• Days in inventory
• Receivables turnover ratio
• Average collection period

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 Working Capital

Indicates immediate short-term debt-

paying ability

Current Assets - Current Liabilities

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 Current Ratio

Indicates short-term debt-paying ability

Current Assets
Current Liabilities

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 Current Cash Debt
Coverage Ratio
Indicates short-term debt-paying ability
(cash basis)

Cash provided by operations

Average current liabilities

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 Inventory Turnover Ratio

Indicates liquidity of inventory

Cost of Goods Sold

Average Inventory

30
 Days in Inventory

Indicates liquidity of inventory and

inventory management

365 days
Inventory Turnover Ratio

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 Receivables Turnover Ratio
Indicates liquidity of receivables

Net Credit Sales

Average Gross Receivables

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 Average Collection Period
Indicates liquidity of receivables and
collection success.

365 days
Receivables Turnover Ratio

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Solvency Ratios
Measure the ability of the enterprise to
survive over a long period of time
WHO CARES?
Long-term creditors and stockholders

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 Solvency Ratios
• Debt to total assets ratio
• Cash debt coverage ratio
• Times interest earned ratio
• Free cash flow

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 Debt to Total Assets Ratio

Indicates % of total assets provided by

creditors

Total Liabilities
Total Assets

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 Cash Debt Coverage Ratio
Indicates long-term debt-paying ability
(cash basis)

Cash provided by operations

Average total liabilities

37
 Times Interest Earned Ratio

Indicates company’s ability to meet interest

payments as they come due

Net Income Before Interest

Expense & Income Tax
Interest Expense
38
 Profitability Ratios
Measure the income or operating success of an enterprise
for a given period of time
WHO CARES? Everybody
WHY? A company’s income affects:
• its ability to obtain debt and equity financing
• its liquidity position
• its ability to grow

 39
 Profitability Ratios
• Earnings per share (EPS)
• Price-earnings ratio
• Gross profit rate
• Profit margin ratio
• Return on assets ratio
• Assets turnover ratio
• Payout ratio
• Return on common stockholders’ equity ratio

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 Earnings Per Share (EPS)
Indicates net income earned on each
share of common stock sales

Net Income - Preferred Stock

Average common shares outstanding

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 Price Earnings Ratio
Indicates relationship between market
price per share and earnings per share

Stock Price Per Share

Earnings Per Share

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 Gross Profit Rate

Indicates margin between selling

price and cost of good sold

Gross profit
Net sales

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 Profit Margin Ratio

Indicates net income generated by each

dollar of sales

Net income
Net sales
Higher value suggests favorable
return on each dollar of sales.
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 Return On Assets Ratio
Reveals the amount of net income
generated by each dollar invested

Net income
Average total assets
Higher value suggests favorable
efficiency.
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 Asset Turnover Ratio

Indicates how efficiently assets are

used to generate sales

Net sales
Average total assets

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 Limitations Of
Financial Analysis
• Horizontal, vertical, and ratio analysis are
frequently used in making significant
business decisions.
• One should be aware
of the limitations of
these tools and the
financial statements.

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 Quality of Earnings

Indicates the level of full and transparent

information that is provided to users of the
financial statements.

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 Pro Forma Income

A measure of the net income generated

that usually excludes items that the
company thinks are unusual or
nonrecurring.

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 Let’s Review
In vertical analysis, the base amount for
depreciation expense is generally:

a. net sales.
b. depreciation expense in a previous year.
c. gross profit.
d. fixed assets.

50
 Let’s Review
In vertical analysis, the base amount for
depreciation expense is generally:

a. net sales.
b. depreciation expense in a previous year.
c. gross profit.
d. fixed assets.

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