Chapter 2

Analysis of Financial
Statement
Learning Objective
At the end of this chapter, you should be able to:
1. Compare company performance using various types of analysis
2. Compare different company performances using financial ratios,
historical financial ratio trends, and industry ratios.
3. To standardize financial statements for comparison purposes
4. Know how to compute and interpret important financial ratios
 Financial Statements
Just like a doctor takes a look at a patient’s x-rays or cat-scan when
diagnosing health problems, a manager or analyst can look at a firm’s
primary financial statements i. e. the income statement and the balance
sheet, when trying to gauge the status or performance of a firm.
A financial statement is a formal record of the financial activities of a
business, person or other entity for more complex business record.
Income statement (Statement of Profit and Loss): periodic recording of
the sources of revenue and expenses of a firm,
Balance sheet (Statement of Financial Position): provides a point in time
snapshot of the firm’s assets, liabilities and owner’s equity.
 Financial Analysis and Financial Ratios
• Various method can be used in measuring and evaluate the financial health
of a business such as horizontal, vertical analyses and ratio analysis
• Financial analysis is the use of financial statements to analyse a firm’s
financial position and its performance.
Questions:
• Does a firm have the resources to succeed and grow?
• Does it have adequate resources to invest in new projects?
• What are its sources of profitability?
• Did the earnings of the firm meet its forecast earnings?
• What are the sources of a firm’s future earnings power?
 Financial Analysis
• Financial analyst uses the ratios to make two types of comparisons:
• Industry comparison (Benchmarking).. The ratios of a firm are compared with those
of similar firms or with industry averages or norms to determine how the company is
faring relative to its competitors.
• Trend analysis. A firm’s present ratio is compared with its past and expected future
ratios to determine whether the company’s financial condition is improving or
deteriorating over time.
• After completing the financial statement analysis, the firm’s financial analyst
will consult with management to discuss their plans and prospects, any
problem areas identified in the analysis, and possible solutions.
 Horizontal Analysis @ Trend Analysis
• Horizontal analysis is used to evaluate the trend in the accounts over the years.
• It is a financial statement analysis technique that shows changes in the amounts of
corresponding financial statement items over a period of time.
• Horizontal analysis is usually shown in comparative financial statements and
companies often show comparative financial data for 5 years in annual report.
• The earliest period is usually used as the base period and the items on the statements
for all later periods are compared with items on the statements of the base period.
• The changes are generally shown both in dollars and percentage.
Example
In fiscal years 2010 and 2009, Coca-Cola had the operating income shown as
follows. (Amounts are in millions).

Percentage Change
2010 2009 Dollar Change
%

Operating Income 8,449 8,231 218 2.65

Dollar change = current year amount – base year amount

= 8499-8231
= 218
Percentage change = dollar change / base year amount
= 218/8499
= 2.65
Example
Analysis

The net sales increased by $4,129,000,000, or 13.3 percent. Cost of goods sold
had a corresponding increase of $1,605,000,000, or 14.5 percent.
The increase in net sales and related increase in cost of goods sold resulted in an
increase in gross margin of $2,524,000,000, or 12.7 percent.
The increase in selling and administrative expenses of $1,800,000,000, or 15.8
percent, outpaced the increase in net sales, resulting in a relatively small increase
in operating income of $218,000,000, or 2.6 percent.
The significant increase in other income (expenses), net of 555.6 percent relates
to a one-time gain of $4,978,000,000 resulting from Coca-Cola’s acquisition
of Coca-Cola Enterprises, Inc., in 2010
Horizontal Analysis over several years
• A common approach is to establish the oldest year as the base year and compute
future years as a percentage of the base year.
• The trending of items on these financial statements can give a company valuable
information on overall performance and specific areas for improvement

2010 2009 2008 2007 2006

Net Sales 35,119 30,990 31,994 28,857 24,088
Percentage Change 146 129 133 120 100
Operating Income 8,449 8,231 8,446 7,252 6,308
Percentage Change 134 130 134 115 100
Problem 1
1. Calculate the dollar change and percentage change using
horizontal analysis
2. Evaluate your findings
Vertical Analysis @ Common Size Analysis
• In vertical analysis, a significant item on a financial statement is used as a base value, and all
other items on the financial statement are compared to it.
• Common-Size Balance Sheets
• Total asset is assigned 100 percent
• Total liabilities and stockholders’ equity is also assigned 100 percent.
• Common-Size Income Statements
• Compute all line items as a percent of sales.
• Standardized statements make it easier to compare financial information, particularly as the
company grows.
• They are also useful for comparing companies of different sizes, particularly within the same
industry
Example
 Vertical Analysis @ Common Size Analysis
• It helps a business to know how much of one item is contributing to overall
operation.
• For example, a company may want to know how much inventory contributes
to total assets.
• They can then use this information to make business decisions such as
preparing the budget, cutting costs, increasing revenues, or capital
investments.
• Common size analysis is also an effective way of comparing two companies
with different level of revenues and assets.
• It helps us to compare companies on equal ground.
Combination
• Now we already understand the basic. Let combine both horizontal
and vertical.
• We can see that there are 8% increase in cash holding as a percentage
of total assets
 Can GO Corporation
Balance Sheet as at December 31,2022 and 2023
Horizontal Vertical Combine
Assets 2008 2009 2008 2009
Current Asset
Cash 84 98 17% 2.5% 2.7% 8%
Account Receivable 165 188 14% 4.9% 5.2%
Inventory 393 422 7% 11.7% 11.8%
Total 642 708 10% 19.0% 19.7%

Fixed Asset
Net Plant and Equipment 2,731 2,880 5% 81% 80.3%
Total Assets 3,373 3,588 6% 100.0% 100.0%

Liabilities and Owners' Equity

Current Liabilities
Account Payable 312 344 10% 9.2% 9.6%
Notes Payable 231 196 -15% 6.8% 5.5%
Total 543 540 -1% 16.1% 15.1%
Long Term Debt 531 457 -14% 15.7% 12.7%
Owners' Equity
Common Stock and Paid-in
Surplus 500 550 10% 14.8% 15.3%
Retained Earnings 1,799 2,041 13% 53.3% 56.9%
Total 2,299 2,591 13% 68.2% 72.2%
Total Liabilities and Owners' Equity 3,373 3,588 6% 100.0% 100.0%
Problem 2
Coca Cola Company
Income Statement
Years Ended December 31
(dollar amount are in millions)

2010 2009
Amount Percentage (%) Amount Percentage (%)
Net Sales 35,119 30,990
COGS - 12,693 - 11,088
Gross Margin 22,426 19,902
Selling and administrative expenses - 13,158 - 11,358
Other operating expenses - 819 - 313
Operating income 8,449 8,231
Interest expenses - 733 - 355
Other income 6,477 988
Income before taxes 14,193 8,864
Income tax expenses - 2,384 - 2,040
Net Income 11,809 6,824
 Ratio Analysis
• Ratios also allow for better comparison through time or between companies.
• Horizontal and vertical analyses compare one figure to another within the same category.
• It is also essential to compare figures from different categories. This is accomplished through ratio analysis.
• There are various kind of ratios that an analyst can use, depending upon what he or she considers to be
important relationships.
Financial ratios are used by:
• Lenders in deciding whether or not to lend to a company.
• Credit-rating agencies in determining a firm’s credit worthiness. (Not only on one factor, many factors, eg.
Fundamental)
• Investors (shareholders and bondholders) in deciding whether or not to invest in a company.
• Major suppliers in deciding to whether or not to extend credit to a company and/or in designing the specific
credit terms.
5 key areas of a firm’s performance can be analyzed using financial ratios:

1. Liquidity ratios: Can the company meet its obligations over the short term?
2. Solvency ratios: (also known as financial leverage ratios): Can the company
meet its obligations over the long term?
3. Asset management ratios: How efficiently is the company managing its assets
to generate sales?
4. Profitability ratios: How well has the company performed overall?
5. Market value ratios: How does the market (investors) view the company’s
financial prospects?
 Liquidity

Market Leverage

Financial Ratio

Efficiency Profitability
Income
Statement
Balance
Sheet
Liquidity Ratio
• A liquid asset is one that can be converted quickly and routinely into cash at the
current market price.
• Liquidity measures the firm’s ability to pay its bills on time. It indicates the ease with
which non-cash assets can be converted to cash to meet the financial obligations.
• It attempt to measure a company ability to pay off short-term debt obligation
• 3 key liquidity ratios include: The current ratio, quick ratio, and cash ratio
• NWC = CA - CL
Example
• Cogswell has better liquidity and short-
term solvency than Spacely,

• Spacely has only $1.02 in current assets

for every $1 in current liabilities.
Cogswell’s liquidity is higher than Spacely,
which has a current ratio of 1.06

• Current ratio - We can safely say that for

every RM 1 short term debt that Cogwell
Cola owed, it had RM 1.06 backing by
current asset.
• Quick Ratio – Cogswell is covering its
current liabilities 0.84 times without any
contribution from its inventory.
 Interpreting Liquidity Ratio
• Current Ratio –
• Current ratio compares a firm’s current assets to its current liabilities.
• Higher better
• Quick Ratio –
• Quick ratio compares cash and current assets (minus inventory) that can be
converted into cash during the year with the liabilities that should be paid within
the year
• >1 better
• QR<CR, firm depends on inventory
• Cash Ratio –
• The cash ratio indicates the percentage of current liabilities covered by the
current cash on hand.
Leverage Ratio
• Measure a company’s ability to meet its long-term debt obligations
based on its overall debt level and earnings capacity.
• Failure to meet its interest obligation could put a firm into bankruptcy
• Does the firm finance its assets by debt or equity or both?
• Debt to equity ratio = Total Debt/Owner’s Equity
• Cogswell Cola has relatively less debt
and a significantly greater ability to
cover its interest obligations by using
either its EBIT (times interest earned
ratio) or its net cash flow (cash
coverage ratio) than Spacely Spritzers.

• Leverage must be analyzed as a

combination of debt level and
coverage. If a firm is heavily leveraged
but has good interest coverage, it is
using the interest deductibility feature
of taxes to its benefit. Having a high
leverage with low coverage could put
the firm into a risk of bankruptcy.
Leverage Ratio
• Debt Ratio – Higher ratio = more risk
• This ratio indicates the percentage of the firm’s assets that are financed by debt
(implying that the balance is financed by equity). A low percentage means that the
company is less dependent on leverage.
• One way to look at the debt ratio is to see it as the amount in debtfor every dollar of
assets.
• DR > 1 = lots of debt
• Times Interest Earned – Higher Better
• The times interest earned ratio reflects the number of times before-tax earnings cover
interest expense
• is used to determine how easily a company can pay interest expenses on outstanding
debt
• Cash Coverage Ratio –
• The cash coverage ratio indicates a company’s ability to generate cash from operations
to meet its financial obligations
 Asset Management Ratios
• Measure how efficiently a firm is using its assets to generate revenues or how much
cash is being tied up in other assets such as receivables and inventory.
• Activity ratios are used to determine how quickly various accounts are converted
into sales or cash.
While Cogswell is more efficient at managing its inventory, Spacely seems to be doing a better
job of collecting its receivables and utilizing its total assets in generating revenues

• Inventory turnover –
• Cogswell sold and restocked the entire inventory about eight times during the year.
Spacely sold and restocked about five times.
• Days’ sales in inventory –
• Inventory was “on the shelf ” forty-three days at Cogswell and an average
of seventy-six days at Spacely before it sold.
 Asset Management Ratios
• Receivables turnover –
• The receivables turnover ratio is similar in orientation to inventory turnover. It measures
the number of times per year the company's collected payment on credit accounts. For
Cogswell, it was about ten times, and for Spacely, it was about eighteen times.
• Days’ sales in receivables –
• Customers took an average of thirty-seven days at Cogswell and an average of twenty days
at Spacely to pay for their credit purchases.
• Total asset turnover –
• The total asset turnover ratio relates sales to assets. We call this the management
efficiency ratio because it indicates how well a company uses assets to generate revenue.
 Profitability Ratios
• Profitability ratios such as net profit margin, returns on assets, and return on equity,
measure a firm’s effectiveness in turning sales or assets into profits
• Ultimately, what we want to know is how well the company has performed overall—that is,
how the company has generated profits
• As far as profitability is
concerned, Cogswell is
outperforming Spacely by
about 3%.
Profitability Ratios

• Profit Margin –
• It indicates the profitability generated from revenue and hence is an important measure
of operating performance. It also provides clues to a company’s pricing, cost structure,
and production efficiency.
• Cogswell Cola is generating 13 cents of profit from every sales dollar, and Spacely Spritzers
is generating 10 cents.
• ROA –
• This ratio indicates how profitable a company is relative to its total assets.
• The assets of Cogswell Cola are generating 14 cents per investment dollar in profit,
whereas the assets of Spacely Spritzers are generating 11.5 cents per investment dollar.
• ROE –
• This ratio indicates how profitable a company is by comparing its net income to its average
shareholders' equity.
• measures how much the shareholders earned for their investment in the company.
Market Value Ratios
• Used to gauge how attractive or reasonable a firm’s current price is
relative to its earnings, growth rate, and book value.
Market Value Ratios
• Potential investors and analysts often use these ratios as part of their
valuation analysis.
• Typically, if a firm has a high price to earnings and a high market to
book value ratio, it is an indication that investors have a good
perception about the firm’s performance.
• However, if these ratios are very high it could also mean that a firm is
over-valued.
• With the price/earnings to growth ratio (PEG ratio), the lower it is,
the more of a bargain it seems to be trading at, vis-à-vis its growth
expectation.
Market Value Ratios
Ratio Cogswell Cola Spacely Spritzers
EPS 1.85 1.46
P/E 15.41 13.01
BVPS 5.19 4.54
P/B 5.49 4.17

The ratios seem to indicate that investors in both firms seem to have good
expectations about their performance and are therefore paying fairly high prices
relative to their earnings book values.
Market Value Ratios
• EPS –
• Earnings per share indicates the amount of earnings for each common share held.
• Price to earnings Ratio –
• The P/E ratio measures how cheaply valued a company's stock price is by comparing the current stock
price to its (EPS)
• It measures the premium investors are willing to pay for shares of stock relative to the company’s
earnings.
• Book value per share – MP > BV = Ok (amount bersih)
• Book value per share is net assets available to common stockholders divided by shares outstanding,
where net assets is stockholders’ equity minus preferred stock
• (Total equity – preferred equity)/ total shares outstanding
• Market to book value –
• A valuation ratio used by investors which compares a stock's per-share price (market value) to its book
value
• Provides investors a way to compare the market value, or what they are paying for each share, to a
conservative measure of the value of the firm.
Problem 3 Tri-mark Products Inc.
Balance Sheet as at year ended
31st December 2014 (‘000s)
Liabilities:
Current Assets Current Liabilities
Accounts
Cash $6,336 Payable $57,000
Accts.
Rec. $43,000 Short Term Debt $1,500
TOTAL Current
Inventory $42,000 Liabilities. $58,500
Other
Current $12,000 Long Term Debt $74,000
Total
Current $103,336 Other Liabilities $15,000
L- T Inv. $25,340 Total Liabilities $147,500
PP&E $225,000 Owner’s Equity
Goodwill $30,000 Common Stock $189,676
Other Retained
Assets $14,000 Earnings $60,500
Total OE $250,176
Total Total Liab. And
Assets $397,676 OE $397,676

• Re-state Tri-Mark Incorporated’s 2014 financial statements as

common-size statements and comment on them
Answer
Problem 1
 Coca Cola Company
Income Statement
Years Ended December 31
(dollar amount are in millions)

2010 2009
Amount Percentage (%) Amount Percentage (%)
Net Sales 35,119 100.0 30,990 100.0
COGS - 12,693 -36.1 - 11,088 -35.8
Gross Margin 22,426 63.9 19,902 64.2

Problem 2 Selling and administrative expenses

Other operating expenses
- 13,158
- 819
-37.5
-2.3
- 11,358
- 313
-36.7
-1.0
Operating income 8,449 24.1 8,231 26.6
Interest expenses - 733 -2.1 - 355 -1.1
Other income 6,477 18.4 988 3.2
Income before taxes 14,193 40.4 8,864 28.6
Income tax expenses - 2,384 -6.8 - 2,040 -6.6
Net Income 11,809 33.6 6,824 22.0
 % of % of
Total Total
Assets: Assets Liabilities: Assets
Current
Current Assets Liabilities
Accounts
Cash $6,336 0.02 Payable $57,000 0.14
Short
Accts. Term
Rec. $43,000 0.11 Debt $1,500 0.00
TOTAL
Inventory $42,000 0.11 Current Liab. $58,500 0.15
Long
Problem 3 Other Term
Current $12,000 0.03 Debt $74,000 0.19
Total Other
Current $103,336 0.26 Liabilities $15,000 0.04
Total
L- T Inv. $25,340 0.06 Liabilities $147,500 0.37
Owner’s
PP&E $225,000 0.57 Equity
Common
Goodwill $30,000 0.08 Stock $189,676 0.48
Other Retained
Assets $14,000 0.04 Earnings $60,500 0.15
Total Assets $397,676 1.00 Total OE $250,176 0.63
Total Liab.
And OE $397,676 1.00