TBS 901

Module 3

Financial
Statement
Analysis

3-1
 Key Interests of Stakeholders

•  Economic sector of the enterprise

•  Profitability of the enterprise
•  Solvency of the enterprise
•  Growth prospects of the enterprise
•  Financial structure of the enterprise
•  Investment performance of the enterprise

3-2
 Information Sources
•  Required by law/quasi law
- annual report and accounts
- annual return
- prospectuses, circulars, etc
•  Voluntarily disclosed
- magazines and newsletters
- advertising
•  Subscription basis
- Extel, Datastream, etc
- trade associations
•  Informed comment
- financial press
3-3
- other media
 Financial Statement Analysis

What is financial analysis?

–  Evaluating a firm’s financial performance
–  Examining relationships by using trend
analysis and horizontal analysis
–  Analysing ratios or numerical calculations
–  Comparing a company to its industry

3-4
 Limitations of Financial
Statement Analysis

Differences in accounting methods between

companies sometimes make comparisons difficult.

We use the weighted We use the FIFO method to

average method to value value inventory.
3-5 inventory.
 The Need to Look Beyond Ratios

In addition to ratios, an analyst

should consider . . .

Changes
Industry within the firm
Consumer
trends tastes

Technological Economic
changes factors

3-6
 $ and % Changes on Statements
Comparing financial statements underscores
movements and trends and may provide valuable clues
about what to expect in the future.

Horizontal Trend
analysis analysis

Horizontal Analysis
Horizontal analysis shows the changes between years
in the financial data in both dollar and percentage
form.
3-7
 CLOVER CORPORATION
Comparative Balance Sheets
31 December, 20X2 and 20X1

Increase (Decrease)
20X2 20X1 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets 155,000 164,700 (9,700) (5.9)
Property and equipment:
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment 160,000 125,000 35,000 28.0
Total assets $ 315,000 $ 289,700 $ 25,300 8.7

3-8
 Trend Percentages

Trend percentages state

several years’ financial
data in terms of a base
year, which equals 100
percent.

3-9
 Trend Analysis

Trend Current Year Amount

= × 100%
Percentage Base Year Amount

Year
Item 20X5 20X4 20X3 20X2 20X1
Sales 145% 129% 116% 105% 100%
Cost of goods sold 150% 132% 118% 104% 100%
Gross margin 135% 124% 112% 108% 100%
By analysing the trends for Berry Products, we
can see that cost of goods sold is increasing
faster than sales, which is slowing the increase
in gross profit.
3-10
 Trend Analysis

We can use the trend

percentages to construct a
graph so we can see the
150
trend over time.
140
Sales Percentage

130

120

110
Sales
100
20X1 20X2 20X3 20X4 20X5
Year

3-11
 Basket Wonders’ Balance Sheet
(Asset Side)
Basket Wonders Balance Sheet (thousands) 31 Dec 20X5a
Cash and C.E. $ 90 a. How the firm stands on
Acct. Rec.c 394 a specific date
Inventories 696 b. What BW owned
Prepaid Exp d 5 c. Amounts owed by
Accum Tax Prepay 10 customers
Current Assetse $1,195 d. Future expense items
Fixed Assets (@Cost)f 1030 already paid
Less: Acc. Depr. g (329) e. Cash/likely convertible
Net Fix. Assets $ 701 to cash within 1 year
Investment, LT 50 f. Original amount paid
Other Assets, LT 223 g. Total deprec to date
Total Assetsb $2,169

3-12
 Basket Wonders’ Balance Sheet
(Liability Side)
Basket Wonders Balance Sheet (thousands) 31 Dec 20X5
Notes Payable $ 290 a. NB: Assets
Acct. Payablec 94 = Liabilities + Equity
Accrued Wages d 16 b. What BW owed and
Other Accrued Liab. d 100 ownership position
Current Liab. e $ 500 c. Owed to suppliers for
Long-Term Debt f 530 goods and services
Shareholders’ Equity d. Unpaid wages, salaries,
Ord. Shares ($1 par) g 200 utilities, etc
Add Pd up Capital g 729 e. Debts payable < 1 year
Retained Earnings h 210 f. Debts payable > 1 year
Total Equity $1,139 g. Original investment
Total Liab/Equitya,b $2,169 h. Earnings reinvested
3-13
Basket Wonders’ Income Statement
Basket Wonders Statement of Earnings (in thousands)
for Year Ending 31 December 20X5a
Net Sales b $ 2,211 a. Measures profitability
Cost of Goods Sold * 1,599 over a time period
Gross Profit $ 612 b. Received, or receivable,
SG&A Expenses c 402
from customers
EBITd $ 210
Interest Expensee 59 c. Sales comm, advert,
EBT f $ 151 officer’s salaries, etc
Income Taxes 60 d. Operating income
EATg $ 91 Cash e. Cost of borrowed funds
Dividends 38 Incr f. Taxable income
in Ret Earning $ 53 g. Amount earned for
shareholders
*includes $1551 in credit purchases

3-14
 Profitability Ratios
1. Return on equity capital employed
Profit after taxation
. .

Indicates how well the

Shareholders’ funds company employed
the owners’
investments to earn
$91 income
BW: = .08
$1,139

Year BW Industry
20X5 8.0% 17.9%
20X4 9.4 17.2
20X3 16.6 20.4

3-15
BW has a poor Return on Equity
 Trend Analysis of Return on Equity
21.0
Ratio Value (%)
17.5

14.0 BW
Industry
10.5

7.0
20X3 20X4 20X5
Analysis Year

3-16
 Profitability Ratios
2. Return on total capital employed/Return on
assets
. Operating profit .

Measures
Total capital employed/Total assets how well
assets have
$210
BW: = .097 been
$2,169
employed
Year BW Industry
20X5 9.7% 10.8%
20X4 9..5 10.1
20X3 9.1 9.8
BW has a slightly improving ROI,
3-17 but still below industry average
 Trend Analysis of Return on Investment
12

Ratio Value (%)

10

8 BW
Industry
6

4
20X3 20X4 20X5
Analysis Year

3-18
 Profitability Ratios
2. Return on long-term capital employed
. Operating profit .

Total long term capital employed Measures

how well
financing
$210
BW: = .126 has been
$1,669
utilised
Year BW Industry
20X5 12.6% 16.8%
20X4 14.1 16.1
20X3 15.1 16.8

3-19
BW has a poor, and declining, result
 Trend Analysis of Return on Long Term
Capital Employed
18

16
Ratio Value (%)

14 BW
Industry
12

10

8
20X3 20X4 20X5
Analysis Year

3-20
 Profit Ratios
Indicates the
1. Gross profit percentage efficiency of
Gross profit x 100 operations and firm
Sales turnover pricing policies

$612
BW: = .277
$2,211

Year BW Industry
20X5 27.7% 31.1%
20X4 28.7 30.8
20X3 31.3 27.6

3-21
BW has a weak Gross Profit percentage
 Trend Analysis of Gross Profit Margin
35.0
Ratio Value (%)
32.5

30.0 BW
Industry
27.5

25.0
20X3 20X4 20X5
Analysis Year

3-22
 Profit Ratios
Indicates the
2. Net profit percentage firm’s profitability
after taking
Net profit after taxation x 100
account of all
Sales turnover expenses and
income taxes
$91
BW: = .041
$2,211

Year BW Industry
20X5 4.1% 8.2%
20X4 4.9 8.1
20X3 9.0 7.6

3-23
BW has a poor Net Profit Margin
 Trend Analysis of Net Profit Margin
10
Ratio Value (%) 9

7 BW
Industry
6

4
20X3 20X4 20X5
Analysis Year

3-24
 Profit Ratios

3. Expense ratios
Amount of expense x 100
Sales turnover

eg Selling costs
Administrative costs

3-25
 Summary of the Profitability and Profit
Comparisons
•  The profitability ratios for BW have ALL
been falling since 20X3. Each has been
below the industry averages for the past
three years.
•  This indicates that COGS and
administrative costs may both be too high
and a potential problem for BW.
•  Note, this result is consistent with the low
interest coverage ratio.

3-26
 Solvency and Liquidity Ratios

1. Current ratio Shows a firm’s

ability to cover its
Current assets
current liabilities
.

Current liabilities with its current

assets
$1,195
BW: = 2.39
$500

Year BW Industry
20X5 2.39 2.15
20X4 2.26 2.09
20X3 1.91 2.01

3-27
Ratio is stronger than the industry average
 Trend Analysis of Current Ratio
2.5

2.3
Ratio Value

2.1
BW
1.9 Industry

1.7

1.5
20X3 20X4 20X5
Analysis Year

3-28
 Solvency and Liquidity Ratios

2. Liquid (quick) ratio Shows a firm’s

Current assets - inventory ability to meet
current
Current liabilities
liabilities with
$1,195 - $696 = 1.00 its most liquid
BW: assets
$500

Year BW Industry
20X5 1.00 1.25
20X4 1.04 1.23
20X3 1.11 1.25

3-29
Ratio is weaker than the industry average
 Trend Analysis of Acid-Test Ratio
1.5

1.3
Ratio Value

1.0 BW
Industry
0.8

0.5
20X3 20X4 20X5
Analysis Year

3-30
 Summary of the Liquidity Comparisons
Ratio BW Industry
Current 2.39 2.15
Quick 1.00 1.25

•  Strong current ratio and weak quick ratio indicates a

potential problem in the inventories account.
•  Note that this industry has a relatively high level of
inventories.
•  The current ratio for BW has been rising at the same
time the acid-test ratio has been declining.
•  The current ratio for the industry has been rising slowly
at the same time the acid-test ratio has been relatively
stable.
•  This indicates that inventories are a significant problem
3-31
for BW.
 Solvency and Liquidity Ratios
Indicates the
3. Stock turnover period effectiveness of the
Stock x 365 inventory management
Cost of sales practices of the firm

$696 x 365
BW: = 158.70 days
$1,599

Year BW Industry
20X5 158.70 105.80
20X4 149.59 97.07
20X3 138.26 98.92

3-32
Inventory turnover is very poor
 Solvency and Liquidity Ratios
Indicates quality of
4. Debtor turnover period receivables and how
Debtors x 365 successful the firm is
in its collections
Credit sales

$394 x 365
BW: = 65 days
$2,211

Year BW Industry
20X5 65.0 65.7
20X4 71.1 66.3
20X3 83.6 69.2
BW has improved the average collection period
3-33 to that of the industry average
 Solvency and Liquidity Ratios
Indicates the
5. Creditor turnover period promptness of
Creditors x 365 payment to
suppliers by the
Credit purchases
firm
$94 x 365
BW: = 22.1 days
$1,551

Year BW Industry
20X5 22.1 46.7
20X4 25.4 51.1
20X3 43.5 48.5
BW has improved the payable turnover in days.
3-34 Is this good?
 Financing Ratios
Shows the relative
1. Balance sheet gearing
importance of long-
(leverage) term debt to the
Debt capital x 100 .

long-term financing
Debt capital + equity capital of the firm
$530 x100
BW: = 32%
$1,669

Year BW Industry
20X5 32% 30%
20X4 32 31
20X3 37 32
BW has average long-term debt utilisation
3-35 relative to the industry average
 Financing Ratios
2. Income gearing ratio
Interest & other prior charges on income x 100
Operating profit
Indicates a firm’s
$59 x100 ability to cover
BW: = 28.1% interest charges
$210

Year BW Industry
20X5 28.1% 19.3%
20X4 23.0 19.9
20X3 9.7 21.5
BW has below average interest coverage
3-36 relative to the industry average
 Summary of Financing Comparisons
•  The interest coverage ratio for BW has been falling
since 20X3. It has been below industry averages for
the past two years.
•  This indicates that low earnings (EBIT) may be a
potential problem for BW.
•  Note, we know that debt levels are in line with the
industry averages.

3-37
 Investment Performance Ratios
1. Earnings per share
Earnings attributable to shareholders
No. of shares in issue

Indicates how much income was earned for each

ordinary share

2. Price earnings ratio

Market price of a share
Earnings per share

Often used by investors as a general guideline in gauging

share values. Generally, the higher the price-earnings
3-38 ratio, the more opportunity a company has for growth.
 Investment Performance Ratios
3. Dividend cover
Earnings attributable to shareholders
Dividends

Gauges the portion of current earnings being

paid out in dividends

4. Dividend yield
Dividend per share x 100
Market price of a share
Identifies the return, in terms of cash dividends,
on the current market price of the shares
3-39
 Summary of Ratio Analyses for BW

•  Inventories are too high.

•  May be paying off creditors (accounts
payable) too soon.
•  COGS may be too high.
•  Selling, general, and administrative costs
may be too high.

3-40
 Importance of Ratios

Which ratio is most important?

•  It depends on YOUR perspective.
•  Suppliers and banks (lenders) are most
interested in liquidity ratios.
•  Shareholders are most interested in
profitability ratios.
•  A long-run trend analysis over a 5-10 year
period is usually performed by an analyst.

3-41
 TBS 901
Module 3

Financial
Statement
Analysis

3-42