Financial Management

Chapter 2 –
Financial Statement Analysis
 Topics to be covered
• Introduction
• Need for Financial Statement Analysis
• Sources of Financial Statement Analysis
• Tools of Financial Analysis
• Horizontal and Vertical Analysis
• Ratio Analysis
• Limitations of Ratio Analysis
 Introduction
• Financial statements are accounting reports with
past performance information that a firm issues
periodically.

• Every public company is required to produce four

financial statements: Statement of Financial Position,
statement of Profit or Loss and Other
Comprehensive Income, statement of cash flows,
and statement of changes in equity.
• These financial statements provide investors and
creditors with an overview of the firm’s financial
 Financial Statement Analysis
 Financial analysis is a process of selecting, evaluating,
and interpreting financial data, along with other
pertinent information, in order to formulate an
assessment of a company’s present and future financial
condition and performance.

 Financial analysis refers to an assessment of the

viability, stability and profitability of a business, sub-
business or project.

 Financial analysis is also known as analysis and

interpretation of financial statements.
 Need for FSA
 Financial statement analysis is used to identify the trends and
relationships between financial statement items.
 Both internal management and external users (such as analysts,
creditors, and investors) of the financial statements need to
evaluate a company's profitability, Efficiency, liquidity, and
solvency.
 The nature of the analysis depends upon their [users] purpose or
requirement. Users make the necessary analysis and take the
decision, based on their assessment of the results obtained.
Cont’d
External Uses of Financial Statement Analysis:

• Trade Creditors - Focus on the liquidity of the firm.

• Bondholders - the long-term cash flow of the firm.

• Shareholders - the profitability and long-term health.

Internal Uses of Financial Statement Analysis:

• Plan - Focus on assessing the current financial position and evaluating

potential firm opportunities.

• Control - Focus on return on investment for various assets and asset

efficiency.

• Understand - Focus on understanding how suppliers of funds analyze the

 Sources of Financial Statement Analysis
 Annual reports of a company usually contains:

1.Financial statements.

2.Notes to the financial statements.

3.A summary of accounting methods used.

4.Management discussion & analysis of the financial statements.

5.An auditor’s report.

6.Comparative financial data.

 All these documents can be the source of financial statement analysis.

 Tools of Financial Analysis

The most important tools and techniques of financial

statement analysis:
1. Horizontal and Vertical Analysis
2. Ratio Analysis
 Horizontal (Trend) Analysis

 Comparison of two or more year's financial data is

known as horizontal analysis, or trend analysis.
 Horizontal analysis is facilitated by showing changes
between years in both dollar and percentage form.
 Horizontal analysis of financial statements can also be
carried out by computing trend percentages.
 Trend percentage states several years' financial data in
terms of a base year.
Cont’d

 The base year equals 100%, with all other years stated in
some percentage of this base.
 Therefore, the changes in financial statements from a base
year to following years are expressed as a trend percentage
to show the extent and direction of changes.
 1st, a base year is selected and each item in the FSs for the
base year is given a weight of 100%.
 2nd is to express each item in the FSs for following years as a
percentage of its base-year amount.
 Horizontal Analysis-
Example
Increase/(D
2005 2004 Amount Per
$41,500 $37,850 $3,650 9.6
es 40,000 36,900 3,100 8.4%
ome 1,500 950 550 57.9%
2005 2004 Diff
Sales $41,500 $37,850

$3,650 ÷ $37,850 = .0964, or 9.6%

 Trend Percentages -
Example
Trend % = Any year $ ÷ Base year $

Year 2005
2004 2003
Revenues $27,611
$24,215 $21,718
Cost of sales 15,318
14,709 13,049
Gross
Whatprofit $12,293
are the trend percentages? $
9,506 $ 8,669
2003 is the base year.
Trend Percentages - Example

Year 2005
2004 2003
Revenues 127%
111% 100%
Cost of sales 117%
113% 100%
Gross profit
These percentages were142% 110%
calculated by dividin
100%
item by the base year.
 Vertical Analysis

 Vertical analysis is the procedure of preparing and

presenting common size statements.
 Common size statement is one that shows the items
appearing on it in percentage form as well as in dollar form.
 Each item is stated as a percentage of some total of which
that item is a part.
 It compares each item in a financial statement to a base
number set to 100%.
 Cont’d

Assets 2005
sets:
$ 1,816
s net 10,438
s 6,151
penses 3,526
nt assets $21,931 5
equipment, net 6,847 17.7
ts 9,997
s $38,775
Cont’d

2005 %
Revenues
$38,303 100.0
Cost of sales
19,688 51.4
Gross profit
$18,615 48.6
Total operating expenses 13,209
34.5
Operating income $
 Ratio Analysis
 Ratios analysis is the most powerful tool of financial

statement analysis.
 Ratio is a statistical measure by means of which relationship

between two or various figures can be compared.

 Ratios can be found out by dividing one number by another

number.
 Ratios show how one number is related to another
 Types of Financial Ratios
• Financial ratios can be divided for convenience in to four
basic groups or categories.
1. Liquidity Ratios

2. Activity Ratio

3. Debt Ratio

4. Profitability Ratio

5. Market Ratio
 1. Liquidity Ratios
 Liquidity ratios measure the short term solvency of financial
position of a firm.
 These ratios help to evaluate the short term paying capacity
or the firm's ability to meet its current obligations.
 Following are the most important liquidity ratios:
 Current Ratio
 Liquid/Acid Test/Quick Ratio
 Current ratio
The current ratio measures the company’s abi
pay current liabilities with current assets.

Current ratio =
Total current assets ÷ Total current liabilities

A CR of 2:1 is professionally cited as

acceptable but a value’s acceptability depends

on the industry in which the firm operates.

For Example, a CR of 1:1 could be

Cont’d

• A very high current ratio may indicate (is caused by):

 Excessive cash due to poor cash management
 Excessive accounts receivable due to poor credit management
 Excessive inventory due to poor inventory management.

Note that the current ratio is a crude measure of a firm’s liquidity

position as it takes in to account all current assets without any
distinction in their composition. It is a quantitative (not qualitative
index of liquidity).
 Quick (acid-test) ratio
• The quick (acid-test) ratio is similar to the current ratio except that
it excludes inventory, which is generally the least liquid current
assets, and prepaid expenses.

• It measures liquidity by considering only quick assets.

• Quick assets include:

– Cash

– Marketable securities

– Receivables (such as notes receivable and account receivable)

Cont’d

The acid-test ratio shows the company’s ability

all current liabilities if they come due immedia
• Quick Assets = Current Assets – (Inventories
Prepaid Asse
Acid-test ratio =(Cash + STIs+ Net current rec
÷ Total current liabilities
Acid-test ratio: QA/CL

 Conventionally (The rule of thumb), a Quick ratio

 2. Activity (or utilization/efficiency) ratios

 Asset management ratios, measures how

effectively the firm is managing its assets
to generate sales and profit. That is why
these activity ratios are also known as
‘efficiency ratios’.
 Reflect firm’s efficiency in utilizing assets
(the speed with which various accounts are
converted into sales or cash)
Cont’d
Accounts Receivable Credit Sales
Turnover Average Accounts Receivable

Average collection 365 days

period Accounts receivable turnover

Cost of Goods Sold or Sales

Inventory turnover
Average Inventory

Inventory 365 days

Conversion Period Inventory Turn over Ratio

Net Sales
Fixed Asset Turnover Net Fixed Assets

Total Assets Net Sales

Turnover Total Assets
 3. Leverage /debt Ratios
• These ratios examine balance sheet ratio and determine the extent
to which borrowed funds have been used to finance the firm.

• Financial leverage ratios are based on the relationship between

borrowed funds and owner’s capital.

• Some of the common Leverage ratios include:

 Debt – ratio

 Debt – equity ratio

 Times – interest – earned ratio

Cont’d

• Debt-to-Total-Assets - the percentage of the firm’s assets that are

supported by debt financing.

= Total Debt/Total Assets

• The debt equity ratio is a common ratio used to assess a firm’s

leverage.

Debt to Equity Ratio = Total Debt/Total Equity

• Times-Interest-Earned Ratio (Coverage ratio) measures the

number of times operating income can cover interest expense.

Times-Interest-Earned = Income from operations ÷ Interest

 4. Profitability Ratios
• Profitability is the net result of a large number of policies and
decisions. Thus, profitability ratios give final answers about
how effectively the firm is being managed.

• These ratios are used to evaluate the overall management

effectiveness and specifically indicate how effectively a firm’s
management generates profits on Sales, Total assets, and
Owners equity.
Cont’d

a) Gross profit margin: indicates the efficiency of

operations and firm pricing policies. It reflects its
ability to sell a product for more than the cost of
producing it.

Gross Margin = Gross Profit/ Net Sales

b) Net profit margin: Indicates the profitability after

taking account of all expenses and income taxes.
Cont’d

c) Return on investment (ROI) : indicates the profitability

on the assets (after all expenses and taxes).
= Net Profit /Total Assets

d) Return on equity (ROE): indicates the profitability to the

shareholders (after all expenses and taxes).

= Net Profit/ Total Shareholders’ Equity

 5. Market value ratios
• The most common measurement of market value of a firm is price-earnings
ratio (P/E):

P/E ratio= Market Capitalization/Net Income

= Share Price/Earnings per Share

• P/E ratio uses to assess whether a stock is over or undervalued based on the
idea that the value of a stock should be proportional to the level of earnings
it can generate for its shareholders.

• Note: A high P/E multiple often reflects the market’s perception of the firm’s
growth prospects. Thus, if investors believe that a firms future earnings
potential is good, they may be willing to pay a higher price for the stock and
 DuPont Analysis
• DuPont analysis (DuPont Identity) (named for the company that

popularized its use), which expresses ROE in terms of the firm’s

profitability, asset efficiency & leverage.

ROE = (NI/Sales) * (Sales/TA)*(TA/BV of Equity)

= NPM * Asset Turnover * Equity Multiplier

• The first term measures its overall profitability.

• The 2nd term measures how efficiently the firm is utilizing its assets to

generate sales.
Cont’d

• The greater the firm’s reliance on debt financing, the higher the
equity multiplier will be.

• How does Leverage work?

• Suppose we have an all equity-financed firm worth $100,000. Its

earnings this year total $15,000.

• ROE = 15,000/100,000 =15%

• Suppose the same $100,000 firm is financed with half equity, and
half 8% debt (bonds). Earnings are still $15,000.

•
 Limitations of ratio analysis
• No underlying theory to identify correct ratios
to use or appropriate benchmarks.
• Benchmarking is difficult for diversified firms.
• Firms may use different accounting
procedures.
• Firms may have different recording periods.
• One-off events can severely affect financial
performance.