FINANCIAL STATEMENT ANALYSIS

RAJESH KEVIN SANJAY

CONTENTS

• FINANCIAL STATEMENTS

• FRAMEWORK FOR ANALYSIS

• BALANCE SHEET RATIOS

• VERTICAL AND HORIZONTAL ANALYSIS

• INCOME STATEMENT RATIOS AND TREND ANALYSIS

• COMMON-SIZE AND INDEX ANALYSIS

Users of Financial Statement AnalysisThere are a large number of people that use financial statement analysis but the few major ones are;

• Creditor; A person who has lent funds to a company is interested in its ability to pay back

• Investors; Current and prospective investors examine financial statements to learn about the company’s ability to pay dividends

• Management

• Regulatory authorities; Financial statements are examined by the Securities and Exchange Commission

FINANCIAL STATEMENTS

• Financial Statements represent a formal record of the financial activities of an entity. These record/statements are;

• INCOME STATEMENTS

• BALANCE SHEET

• CASH FLOW STATEMENT

• EQUITY (Statement of Retained Earnings)

Income Statement

• It shows managers and investors whether the company was profitable during the period being reported. Income statement is composed of

• Income; the business earnings over a period (e.g. sales revenue)

• Expenses; the cost incurred by the company over a period (e.g. salaries)

ADVANTAGES AND DISADVANTAGES OF INCOME STATEMENTS

• Advantages

• Revenue Information

• Investor Analysis

• Disadvantages

• Misrepresentation of Value

• Additional Company Factors

Preparation Methods

• Single Step Method

• It has the advantage of simplicity

• Multi-Step Method

• Provides more information about the profitability of a company

• Formula for Income Statement

• Revenue – Expenses = Net Income

• Graphical Comparison Between Single and Multi Step Method

Terms Used in Income Statements

• Expenses

• Gains

• Losses

• Discontinued operations

• Extraordinary gains or losses

• Net income

Example and Format in Excel

Balance Sheet

• A financial statement that summarizes a company’s assets, liabilities and shareholders equity at a specific period.

• It shows the financial Position of a company

• Assets = Liabilities + Shareholders’ Equity

Purpose and Importance of Balance Sheet

• Helps users assess the financial health of an entity

• Assist in identifying underlying trends

• Helps in determining the state of the entity’s;

• Liquidity Risk

• Financial Risk

• Credit Risk

Example and Format in Excel

Cash Flow Statement

• Cash Flow Statement represents the movement in cash and bank balances over a period. It is classifies into the following segments

• Operating Activities ; From primary activities

• Investing Activities ; From the purchase and sale of assets other than inventory

• Financing Activities ; Cash flow generated or spent on raising or repaying share capital and debts

Example and Format in Excel

Cash Flow Basis of Preparation

• Cash Flow Statements represents the movement in cash and cash equivalents, which are;

• Cash in hand

• Cash in bank

• Short term investments that are liquid

• Bank overdrafts

Operating Activities

• It is the movement in cash during an accounting period from the primary revenue generating activities. Profits before tax in the income statements can be used as a starting point to calculate operating activities cash flow. The following adjustments are

• Elimination of non cash expenses

• Removal of expenses

• Elimination of non cash income

• Removal of income

• Working capital changes

Investing Activities

• Movement in Cash flow as a result of the purchase or sale of assets other than the entity's inventory. It primarily consists of ;

• Cash outflow expended on the purchase of investments or fixed assets

• Cash inflow from income from investments

• Cash inflow from disposal of investments or fixed assets

Financing Activities

• Movement of cash flow resulting from the following;

• Proceeds from issuance of share capitals, debentures and bank loans

• Cash outflow expended on the cost of finance

• Cash outflow on the repurchase of share capital and repayment of loans.

Purpose and Importance of Cash Flow Statements

• Provides insights about the liquidity and solvency of a company

• Allows analysts to use the information of previous cash flow to project future cash flows

• Highlights the priorities of management

Statements of Retained Earnings

• Its details the change in owners’ equity over a period. It comprises of the following elements ;

• Net profit/loss during the period attributable to shareholders

• Increase/decrease in share capital reserves

• Dividend payments to shareholders

• Gains and losses recognized directly in equity

• Effect of changes in accounting policies

• Effect of correction of prior period error

Financial Statement Analysis Framework

The following steps are used as a framework for financial statements analysis;

• Identify the purpose and objectives of the analysis

• Review financial statements, notes and audits

• Determine the necessary adjustments to enhance the comparability of the statements

• Determine if the firm’s size, capital structure and product mix are appropriate to proceed to ration calculations

Framework Cont’d

• Conduct horizontal and vertical analysis

• Calculate liquidity ratio and profitability ratio

• Evaluate firms capital structure

• Examine firms market performance using investor ratio

• Examine any inconsistencies in the ratio results and notes

Types of Ratios

• Liquidity Ratio

• Capital Structure and Solvency Ratio

• Return on Investment

• Operating Performance

• Asset Utilization

• Market Measures

Use of Financial Ratio

• A tool used in assessing the relative strength of a firm

• It gives investors more relevant information

• Provides a standardized method to compare companies and industries

Ratio Analysis

Purpose : Evaluate relation between two or more economically important items

Output: Mathematical expression of relationbetween two or more items

Cautions: Prior Accounting analysis is important

Interpretation is key - long vs short term & benchmarking

Balance Sheet Ratio

• Current Ratio

• Acid-test/ Quick Ratio

• Debt-to-worth Ratio

• Working capital

• Working capital per dollar of sales

Current RatioCurrent ratio =

Current assetsCurrent liabilities

Measures solvency: The number of dollars in current assets for every $1 in Current LiabilitiesFor example: a Current Ratio of 1.76 means that for every $1 of Current Liabilities, the company has $1.76 in current Assets with which to pay them

Acid-Test Ratio

Cash + Account Receivable

Current Liabilities

Acid-Test Ratio =

Measures liquidity: The number of dollars in Cash and Accounts Receivable for each $1 in Current Liabilities. For example: a Quick Ratio of 1.14 means that for every $1 of Current Liabilities, the company has $1.14 in Cash and Accounts Receivable with which to pay them

Example and Format in Excel

Income Statement Ratio

• The following are the ratio analysis related to the income statements

• Gross Margin

• Profit Margin

• Earning Per Share

• Times Interest Earned

• Return on Stockholders’ Equity

Example and Format in Excel

Methods of Financial Statement Analysis

There are two methods for analysing financial statements, these are

• Horizontal Analysis; is the comparison of financial information over a series of reporting periods. Also known as trend analysis

• Vertical Analysis; is the proportional analysis of a financial statement.

Trend Analysis

• It is the direction the business is taking

• Base year percentage is 100%

• Trend Percentage = Analysis year dollar amount

Base year dollar amount

Trend Analysis Example

2008 2007 2006 2005 2004Net revenue 1318 1187 1106 1009 1043Net income 122 114 83 71 85

Complete a trend analysis for thousand Oaks Realty’s net revenue and net income for the following 5-year period, using 2004 as the base year. Round to the nearest full percent

2008 2007 2006 2005 2004

Net revenue 126% 114% 106% 97% 100%

Net income 144% 134% 98% 84% 100%

Common Size Income Statement• A common size income statement presents all the income

statement as a percentage of net sales. Example is a corporation’s common size income statement after each item from the income statement was divided by net sales of $500,000

Example and Format in Excel

Ratio How to Calculate it

Gross Margin = Gross Profit ÷ Net Sales= $120,000 ÷ $500,00= 24.0%

Profit Margin (after tax)

= Net Income after Tax ÷ Net Sales= $23,000 ÷ $500,000= 4.6%

Earning Per Share (EPS) = Net Income after Tax ÷ Weighted Average Number of Common Share Outstanding= $23,000 ÷ 100,000= $0.23

Index Analysis

An analysis of percentage financial statements where all balance sheet or income statement figures for a base year equal 100.0 (percent) and subsequent financial statement items are expressed as percentages of their values in the base year.

Index Analysis of a Balance Sheet

Regular (thousands of $) Indexed (%)

Assets 2005 2006 2007 2005 2006 2007

Cash 148 100 90 100.0 67.6 60.8

AR 283 410 394 100.0 144.9 139.2

Inv 322 616 696 100.0 191.3 216.1

Other CA 10 14 15 100.0 140.0 150.0

Tot CA 763 1,140 1,195 100.0 149.4 156.6

Net FA 349 631 701 100.0 180.8 200.9

LT Inv 0 50 50 100.0 inf. inf.

Other LT 111 223 223 100.0 200.9 200.9

Tot Assets 1,223 2,044 2,169 100.0 167.1 177.4

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