Financial Statement Analysis

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Horizontal Analysis
• Study of percentage changes from year-to-
year
• Two steps:
1. Compute dollar amount of change
2. Divide dollar amount of change by base-period
amount

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Exercise
Sensible Music Company
Comparative Income Statements
Years Ended December 31, 2010 and 2009
2010 2009 $ Change % Change
Total revenue $852,000 $912,000 ($60,000) (6.6%)
Expenses:
Cost of goods sold $402,000 $408,000 (6,000) (1.5%)
Selling & gen’l expense 232,000 261,000 (29,000) (11.1%)
Interest expense 9,200 10,500 (1,300) (12.4%)
Income tax expense 83,000 84,000 (1,000) (1.2%)
Total expenses 726,200 763,500 (37,300) (4.9%)
Net income $125,800 $148,500 (22,700) (15.3%)

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Trend Percentages
• Form of horizontal analysis
• Base year selected and set equal to 100%
▫ Amount of each following year stated as a percent
of base

Any year
Trend %
Base year

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Vertical Analysis
• Shows relationship of a financial-statement item
to its base
▫ For Income Statement, total revenue is the base

Vertical Each income statement item

analysis %
Total revenue

▫ For Balance Sheet, total assets is the base

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Benchmarking
• Compares one entity to another
• Compare against
▫ Direct competitor in same industry,
▫ Peers in broader market, or
▫ Any other “aspiration” entities
• Gives context to interpret data

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Common-Size Statements
• Report only percentages
▫ No currency amounts
• Help in the comparison of different
companies
▫ Financial results in terms of a common
denominator
▫ Currency and size differences are eliminated

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Financial Ratios
Ability to pay current liabilities

Cash conversion cycle

Ability to pay long-term debt

Profitability

Analyze shares as an investment

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Ability to Pay Current Liabilities

Working Current
capital ratio
Acid-test
ratio
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Working Capital & Current Ratio
Working Current Current
capital assets liabilities

Current
assets
Current
ratio
Current
liabilities
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Acid-Test Ratio

Cash + Short-term investments

+ Net current receivables

Current liabilities

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Ability to Sell Inventory and
Collect Receivables
Inventory Accounts
receivable
turnover turnover

Days’-sales-
in- receivables

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Inventory Turnover
Cost of goods sold

Average inventory

(Beginning inventory + Ending inventory)/2)

Inventory Resident Period = 365/Inventory Turnover

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Accounts Receivable Turnover
Net sales

Average net accounts receivable

(Beginning net receivables + Ending net receivables)/2)

Receivables Collection Period = 365/Receivables Turnover

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Accounts Payables Turnover
Cost of goods sold

Average accounts payables

(Beginning payables+ Ending payables)/2)

Payables Outstaning Period = 365/Payables Turnover

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Cash Conversion Cycle
Receivables collection period

Inventory resident period

Payables outstanding period

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Exercise
Current Preceding
year year
Balance Sheet:
Cash $26,000 32,000
Short-term investments 14,000 20,000
Net receivables 50,000 73,000
Inventory 94,000 76,000
Prepaid expenses 9,000 8,000
Total current assets 193,000 209,000
Total current liabilities 129,000 96,000
Income Statement:
Net credit sales $490,000
Cost of goods sold 274,000

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Exercise
Current Current Current
ratio assets liabilities

$193,000 $129,000

1.50
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Exercise
Acid- test ratio = .70

Cash + Short-term investments + Net current receivables

Current liabilities

$26,000$+14,000
90,000 + 50,000

$129,000

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Exercise
Inventory turnover =

Cost of goods sold $274,000

Average inventory $85,000

(Beginning inventory + Ending Inventory)/2)

3.22
(76,000 +94,000)/2)

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Exercise
Accounts receivable
7.97=
turnover

Net sales $490,000

Average net
$61,500
accounts receivable

(Beginning net receivables +

Ending net receivables)/2) ($73,000 + 50,000)/2

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 Exercise
Receivables Collection Period

One day’s Net sales

1. sales
365 days

$490,000
$1,342.47
365 days

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 Exercise
Receivables Collection Period

Average net accounts

Days’ sales in
receivable
2. average accounts
receivable
One day’s sales

$61,500
($73,000 + 50,000)/2
46 days
One$1,342.47
day’s sales

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Measuring Ability to Pay Debts
Times-
Debt interest-
ratio earned

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Debt ratio

Total liabilities

Total assets

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Times-Interest-Earned

Income from operations

Interest expense

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Measuring Profitability

Return Return
on sales on assets

Return Earnings
on equity per share
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Rate of Return on Sales

Net income

Net sales

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Rate of Return on Total Assets

Net income + Interest expense

Average total assets

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Rate of Return on Ordinary
Shareholder’s Equity
Net income – Preference dividends

Average ordinary shareholders’

equity

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Leverage
• Borrowing at a lower rate than invested
funds earn
▫ Increases profits during good times
▫ Compounds losses during bad times

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Earnings per Share

Net income –Preference dividends

Weighted average number of ordinary

shares outstanding

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Analyzing Share Investments

Price/ Dividend
Earnings ratio
yield
Book
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Price/Earnings Ratio

Market price per share of

ordinary shares

Earnings per share

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Dividend Yield

Dividend per share of ordinary

shares

Market price per share of

ordinary shares

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Book Value

Total shareholders’
Preference equity
equity

Number of ordinary shares

outstanding

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Economic Value Added (EVA ®)
• Combines accounting and finance data
• Measures if operations have increased
shareholder wealth
▫ Positive EVA® suggests increase in wealth

Net Interest Capital

income expense charge

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Cost of Capital
Capital charge =

Current
Notes maturities of
payable long-term
debt Cost
of
capital
Long-term Shareholders’
debt equity

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Red Flags in Financial Statement
Analysis
• Earnings problems
• Decreased cash flow
• Too much debt
• Inability to collect receivables
• Buildup of inventories
• Trends of sales, inventory and receivables

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Efficient Markets
• Market prices fully reflect all information
▫ Managers cannot fool market with accounting
manipulations
▫ Market sets fair price for shares
• Appropriate investment strategy:
▫ Manage risk
▫ Diversify investments
▫ Minimize transaction costs

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