financial statement analysis.pdf

EXC 3451

Financial Statement Analysis

Basics of financial statement analysis

• Every item reported in a financial statement has significance.

• Various analytical techniques are used to evaluate the

significance of financial statement data.


• Analyzing financial statements involves:

Characteristics Comparison

Bases

Tools of

Analysis

Liquidity

Profitability

Solvency

Intracompany

Industry

averages

Intercompany

Horizontal

Vertical

Ratio


• Analyzing financial statements involves evaluating 3

characteristics:

1. Liquidity: ability of a firm to pay its financial

obligations when they come due.

2. Profitability: indicates the ability if a firm to survive

over a long period of time.

3. Solvency: the ability of a firm to meet its long-

term financial obligations


• Tools of analysis:

– Horizontal analysis: evaluates a series of financial statements

over time. Used primarily in intracompany comparisons.

– Vertical analysis: evaluates financial statement data by

expressing each financial item as a percentage of a base

amount. Used in both intra- and intercompany analysis.

– Ratio analysis: expresses the relationship among selected items

of financial statement data. Used in intra- and inter company as

well as in industry average comparisons.

Horizontal analysis

• Horizontal analysis, also called trend analysis, is a technique for

evaluating a series of financial statement data over a period of time.

• Purpose is to determine the increase or decrease that has taken

place.

• Commonly applied to the statement of financial position,

income statement, and retained earnings statement.

𝐶ℎ𝑎𝑛𝑔𝑒 𝑠𝑖𝑛𝑐𝑒 𝑏𝑎𝑠𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 =𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑎𝑚𝑜𝑢𝑛𝑡 − 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑎𝑚𝑜𝑢𝑛𝑡

𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑎𝑚𝑜𝑢𝑛𝑡

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑒𝑠𝑢𝑙𝑡𝑠 𝑖𝑛 𝑟𝑒𝑙𝑎𝑡𝑖𝑜𝑛 𝑡𝑜 𝑏𝑎𝑠𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 =𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑎𝑚𝑜𝑢𝑛𝑡

𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑎𝑚𝑜𝑢𝑛𝑡

Horizontal analysis

Changes suggest that the

company expanded its

asset base during 2014

and financed this

expansion primarily by

retaining income rather

than assuming additional

long-term debt.

Illustration 14-5

Horizontal analysis of

statements of financial

position

Horizontal analysis

Overall, gross profit and net

income were up

substantially. Gross profit

increased

17.1%, and net income,

26.5%. Quality’s profit trend

appears favorable.

Illustration 14-6

Horizontal analysis of

Income statements

Horizontal analysis

In the horizontal analysis of the statement of financial position the

ending retained earnings increased 38.6%. As indicated earlier, the

company retained a significant portion of net income to finance

additional plant facilities.

Illustration 14-7

Horizontal analysis

of

retained earnings

statements

Horizontal analysis EXERCISE: Summary financial information for Rosepatch Company is

as follows:

Compute the amount and percentage changes in 2014 using horizontal

analysis, assuming 2013 is the base year.

December 31, 2014 December 31, 2013

Property, Plant and Equipment $ 300,000 $ 250,000

Current assets 100,000 76,500

Total assets 400,000 326,500

Vertical analysis • Vertical analysis, also called common-size analysis, is a

technique that expresses each financial statement item as a

percent of a base amount.

• On an income statement, we might say that selling expenses

are 16% of net sales.

• On a statement of financial position, we might say that current

assets are 22% of total assets.

• Vertical analysis is commonly applied to the statement of

financial position and the income statement.

Vertical analysis

These results reinforce

the earlier observations

that Quality is

choosing to finance

its growth through

retention of earnings

rather than through

issuing additional

debt.

Illustration 14-8

Vertical analysis of

statements of financial

position

Vertical analysis

Quality appears

to be a profitable

enterprise that is

becoming even more

successful.

Illustration 14-9

Vertical analysis of

Income statements

Vertical analysis

• Enables a comparison of companies of different sizes.

Illustration 14-10

Intercompany income

statement comparison

Vertical analysis • Let’s solve together problem 14-1 a):

a) Prepare a vertical analysis of the 2014 income statement and statements of

financial position data for both firms.

Lionel Company Barrymore Company

2014 2013 2014 2013

Net sales $1,549,035 $339,038

Costs of goods sold

1,053,345 237,325

Operating expenses

278,825 77,979

Interest expense

7,745

2,034

Income tax expense

61,960

8,476

Plant assets (net)

596,920 575,610 142,842 128,927

Current assets

401,584 388,020 86,450 82,581

Share capital-ordinary, $5 par

578,765 578,765 137,435 137,435

Retained earnings

252,224 225,358 55,528 47,430

Non-current liabilities

102,500

84,000 16,711 11,989

Current liabilities

65,015

75,507 19,618 14,654

Ratio Analysis

• Ratio analysis expresses the relationship among selected items

of financial statement data.

• We can express them as:

– Percentage (74%)

– Rate (0.74)

– Proportion (.74:1)

• A ratio on its own does not mean much. We can use them:

– Intracompany comparisons

– Industry average comparisons

– Intercompany comparisons

Ratio Analysis

Liquidity Profitability Solvency

Measure short-term

ability of the

company to pay its

maturing obligations

and to meet

unexpected needs

for cash.

Financial Ratio Classifications

Measure the

income or operating

success of a

company for a

given period of

time.

Measure the ability

of the company to

survive over a long

period of time.

Ratio Analysis: Liquidity ratios

• Measure the short-term ability of the company to pay its

maturing obligations and to meet unexpected needs for cash.

– Short-term creditors such as bankers and suppliers are

particularly interested in assessing liquidity.

– Ratios include the current ratio, the acid-test ratio,

receivable turnover, and inventory turnover.


What does this mean? Ratio of 2.96:1 means that for every dollar of current

liabilities, Quality has $2.96 of current assets.

Any trend analysis should be done with care because the ratio is susceptible to quick Changes and is easily influenced by management.


Acid-Test ratio measures immediate liquidity.


• We can measure liquidity by how quickly a firm can convert certain assets to cash. • Accounts receivable turnover measures the number of times, on average, the company collects receivables during the period. • Unless seasonal factors are significant, average net accounts receivable can be computed from the beginning and ending balances of the net accounts receivables.


• A variant of the Accounts Receivable Turnover ratio is to convert it to

an average collection period in terms of days.

• Receivables are collected every 35.78 days

365 days / 10.2 times = every 35.78 days


• Measures the number of times, on average, the inventory is sold during the period.

• A variant of inventory turnover is the days in inventory.

• Inventory turnover ratios vary considerably among industries.

365 days / 2.3 times = every 159 days

Ratio Analysis: Profitability ratios

• Measure the income or operating success of a company for a

given period of time.

– Income, or the lack of it, affects the company’s ability to obtain

debt and equity financing, liquidity position, and the ability to

grow.

– Ratios include the profit margin, asset turnover, return on

assets, return on ordinary shareholders’ equity, earnings per

share, price-earnings, and payout ratio.


• Measures the percentage of each dollar of sales that results in net income.

• High inventory turnover businesses, such as grocery stores, generally

experience low profit margins. Low inventory turnover businesses, have high

profit margins.


• Measures how efficiently a company uses its assets to generate

sales.

• Asset turnover ratios vary considerably among industries.


• How many dollars of profit can we generate for every dollar invested

in assets?


• Shows how many euros of net income the company earned for each

euro invested by the owners.

• Why is ROE>ROA in this case? Leverage.


• How much net income has been earned on each ordinary share?

• It is meaningless to compare EPS with other firms because it

depends on the number of shares outstanding. The only meaningful

comparison is intracompany.


• What does the market think about the firm’s future earnings?


• It measures the percentage of earnings distributed in the form of

cash dividends.

• High growth firms tend to have low payout ratios. Why?

Ratio Analysis: Solvency ratios

• Solvency ratios measure the ability of a company to

survive over a long period of time.

• Long-term creditors and shareholders are particularly

interested in a company’s ability to pay interest as it

comes due and to repay the face value of debt at

maturity.


• Measures the percentage of the total assets that creditors provide.

• It indicates the firm’s leverage.

• It has a direct influence on risk, which at the same time has an impact on the shareholders’ required rate of return.

• On one side interest on debt is tax deductible, on the other, it increases the risk of the firm. This is the basis of the trade-off theory of capital structure (Kraus and Litzenberger, 1973).

• Stable earnings usually are connected to higher leverage. Why?


• Provides an indication of the company’s ability to meet interest

payments as they come due.

Ratio analysis • Let’s solve together problem 14-1 b):

b) Comment on the relative profitability of the companies by computing the

ROA and the ROE for both firms..

Lionel Company Barrymore Company

2014 2013 2014 2013

Net sales $1,549,035 $339,038

Costs of goods sold

1,053,345 237,325

Operating expenses

278,825 77,979

Interest expense

7,745

2,034

Income tax expense

61,960

8,476

Plant assets (net)

596,920 575,610 142,842 128,927

Current assets

401,584 388,020 86,450 82,581

Share capital-ordinary, $5 par

578,765 578,765 137,435 137,435

Retained earnings

252,224 225,358 55,528 47,430

Non-current liabilities

102,500

84,000 16,711 11,989

Current liabilities

65,015

75,507 19,618 14,654

financial statement analysis.pdf

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