Financial Management: Chapter 2 - Financial Statement Analysis

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
performance.
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 firm
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/(Decrease)
2005 2004 Amount Percent
Sales $41,500 $37,850 $3,650 9.6%
Expenses 40,000 36,900 3,100 8.4%
Net income 1,500 950 550 57.9%
2005 2004 Difference
Sales $41,500 $37,850 $3,650
$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 profit $12,293 $ 9,506 $ 8,669
2003 is the base year.
What are the trend percentages?

Trend Percentages - Example
Year 2005 2004 2003

Revenues 127% 111% 100%
Cost of sales 117% 113% 100%
Gross profit 142% 110% 100%
These percentages were calculated by dividing each

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 %
Current assets:
Cash $ 1,816 4.7
Receivables net 10,438 26.9
Inventories 6,151 15.9
Prepaid expenses 3,526 9.1
Total current assets $21,931 56.6
Plant and equipment, net 6,847 17.7
Other assets 9,997 25.7
Total assets $38,775 100.0
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 $ 5,406 14.1
Other income 2,187 5.7
Income before taxes $ 7,593 19.8
Income taxes 2,827 7.4
Net income $ 4,766 12.4
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 ability to
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 unacceptable for a manufacturing firm.
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 to pay

all current liabilities if they come due immediately.
•Quick Assets = Current Assets – (Inventories and
Prepaid Assets)
Acid-test ratio =(Cash + STIs+ Net current receivables)
÷ Total current liabilities
Acid-test ratio: QA/CL
❑ Conventionally (The rule of thumb), a Quick ratio of 1:1 is

considered satisfactory (sound).
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 expense

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.
= Net Profit / Net Sales

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 boast its P/E multiple.
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.
• Equity multiplier is a measure of the firm’s financial leverage.

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.
• ROE = 15,000-4,000/50,000 =22%
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.

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Financial Management

• Need for Financial Statement Analysis

• Sources of Financial Statement Analysis

• Tools of Financial Analysis

• Horizontal and Vertical Analysis

• Limitations of Ratio Analysis

◼ Financial analysis refers to an assessment of the

◼ Financial analysis is also known as analysis and

◼ Both internal management and external users (such as analysts,

◼ The nature of the analysis depends upon their [users] purpose or

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.

1. Horizontal and Vertical Analysis

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

▪ Horizontal analysis is facilitated by showing changes

▪ Horizontal analysis of financial statements can also be

▪ Trend percentage states several years' financial data in

▪ Therefore, the changes in financial statements from a base

▪ 2nd is to express each item in the FSs for following years as a

$3,650 ÷ $37,850 = .0964, or 9.6%

Trend % = Any year $ ÷ Base year $

Year 2005 2004 2003

What are the trend percentages?

Year 2005 2004 2003

These percentages were calculated by dividing each

▪ These ratios help to evaluate the short term paying capacity

▪ Following are the most important liquidity ratios:

▪ Liquid/Acid Test/Quick Ratio

A CR of 2:1 is professionally cited as acceptable but

• 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

• It measures liquidity by considering only quick assets.

• Quick assets include:

– Receivables (such as notes receivable and account receivable)

The acid-test ratio shows the company’s ability to pay

❑ Conventionally (The rule of thumb), a Quick ratio of 1:1 is

▪ Asset management ratios, measures how effectively

Average collection 365 days

Cost of Goods Sold or Sales

Inventory 365 days

Total Assets Net Sales

• Financial leverage ratios are based on the relationship between

• Some of the common Leverage ratios include:

✓ Debt – equity ratio

✓ Times – interest – earned ratio

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

supported by debt financing.

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

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 expense