Chapter 3

Business Finance
Financial Statement
Analysis
INTRODUCTION
Financial statement analysis involves the examination of both the
relationships among financial statement numbers and the trends in
those numbers over time. One purpose of financial statement
analysis is to use the past performance of a company to predict
how it will do in the future. Another purpose is to evaluate the
performance of a company with an eye toward identifying problem
areas. In sum, financial statement analysis is both diagnosis
identifying where a firm has problems and prognosis predicting
how a firm will perform in the future.
 Key Financial Statements
• There are three key financial statements that are important to
investors, security analysts, management, and creditors. these
are the income statement, balance sheet, and statement of
cash flows. note that there is a fourth financial statement
(statement of retained earnings) that is provided in financial
reports. However, the other three capture the majority of the
information needed for financial statement analysis.
 Balance Sheet
• The balance sheet provides a snapshot of the company’s assets, liabilities,
and owners’ equity at a specific point in time. The company’s assets must
be financed by either debt (liabilities) or ownership interest (equity).
Therefore, assets will always equal liabilities plus owners equity (A = L +
OE). It is important to remember that the values reported on the balance
sheet are “book values” and do not necessarily represent the market value
of the asset or ownership interest for a variety of reasons:
• The value of brand names, patents and other intellectual property which are
often quite valuable to a corporation are not typically recorded on the
balance sheet.
• The book (balance sheet) value of assets is based on historical cost less
accumulated depreciation. The real (market) value of the assets is based on
the ability of the firm to generate cashflows from those assets.
 Income Statement
• The income statement provides information on the company’s revenues
and expenses over a specific time period (usually annually or quarterly).
These revenues and expenses are accounting-based and not necessarily
reflective of cash flows generated. For example, when a long-term asset
is purchased the cash is spent at that time. However, its expenses are
recognized over time as depreciation instead of at the point of purchase.
Also, the method chosen to account for inventory can cause
discrepancies between net income and cash flows from operations. The
cost of our inventory is recognized when it is sold not when it is paid for.
While the income statement is not cash based, that does not imply that it
is meaningless. It still provides a good picture of how well the company
is doing, but we must recognize that net income is not cash.
 Statement of Cash Flows
The statement of cash flows attempts to reconcile the differences between net income
according to Generally Accepted Accounting Principles (GAAP) and cash flows.
Cash flows are broken down into three primary areas — Cash Flow from Operating
Activities, Cash Flow from Investing Activities, and Cash Flow from Financing
Activities.
Cash Flow from Operating Activities
• This is the most critical component of the statement of cash flows. Cash flow from
operating activities provides insights into how well the firm is doing at generating
cash flows from its day-to-day operations before factoring in any capital
investments or financing issues. This is done by starting with net income and then
adjusting back to a cash-based version of income. For example, depreciation lowers
net income, but is not a cash expense. Therefore, depreciation is added back in. If
our accounts receivable declines, that means we’ve collected additional cash from
sales (remember from accounting that revenue is recorded when the sale is made,
not when the cash is collected).
Cash Flow From Investing Activities
• Again, it is important for firm’s to operate as a going concern, which
means that they need to invest in their business. This may be updating
long-term assets that are getting worn out, spending money on new
equipment to improve productivity, or spending money on expanding
the business. These investments into long-term assets are commonly
referred to as capital expenditures and are essential to a firm
remaining competitive and successful. They are also a key element in
the cash flow from investing activities segment of the statement of
cash flows as they represent investment into the company. Because
the firm is spending money on these investments, they will typically
be negative (cash out flows).
Cash Flow from Financing Activities
• If a firm generates more cash flow from its operating activities than it
spends on investing activities, it will have cash left over to return to
investors (or add to cash balances). Alternatively, if a firm spends more
cash flow on its investing activities than it generates from operating
activities, it will need to raise additional cash from investors (or draw
down cash balances). This is an area that can be as much about where a
firm is in its growth cycle as it is about the firm’s health. Typically,
younger firms and/or rapidly growing firms need to spend a lot of cash on
expanding the business and may not have enough operating cash flows to
fund those investing activities. As such, it is common for them to be
raising capital by issuing shares of stock or issuing debt and they are
unlikely to be using much, if any, cash to pay dividends. This leads to
positive cash flows from financing activities
OBJECTIVES OF FINANCIAL STATEMENTS

• The main object of financial statements is to provide information

about the financial position, performance and changes taken place
in an enterprise. Financial statements are prepared to meet the
common needs of most users. The important objectives of financial
statements are given below:
1. Providing information for taking Economic decisions:
• The economic decisions that are taken by users of financial
statements require an evaluation of the ability of an enterprise to
generate cash and cash equivalents and of the timing and certainty
of their generation.
• This ability ultimately determines the capacity of an enterprise to
pay its employees and suppliers meet interest payments, repay
loans and make distributions to its owners.
2. Providing information about financial position:
• The financial position of an enterprise is effected by the economic
resources it controls, its financial structures its liquidity and
solvency and its capacity to adapt to changes in the environment in
which it operates.
• Information about financial structure is useful in predicting future
borrowing needs and how future profits and cash flows will be
distributed among those with an interest in the enterprise.
3. Providing information about performance(working results) of
an enterprise:
• Another important objective of the financial statements is that it
provides information about the performance and in particular its
profitability, which requires in order assessing potential changes in
the economic resources that are likely to control in future.
Information about performance is useful in predicting the capacity
of the enterprise to generate cash inflows from its existing
resource base as well in forming judgment about the effectiveness
with which the enterprises might employ additional resources.
 Key Financial Ratios
There are a large variety of different financial ratios that attempt to
evaluate different aspects of a company’s health and performance.
Some of these are specific to certain industries. For example, a
popular ratio for brick-and- mortar retailers is sales-per-square-foot
as it addresses how well the retailer is using its floor space to
generate revenue. However, this same ratio would not make sense in
evaluating the performance of a heavy equipment manufacturer like
caterpillar. Another challenge with ratios is that they can be
calculated in different ways. For example, the inventory turnover
ratio is sometimes calculated as sales/inventory and sometimes as
cost of goods sold/inventory.
Liquidity Ratio
1. Current Ratio= Current Assets
Current Liabilities
2. Quick Ratio= Current Asset- Inventory
Current Liability
Activity Ratio
3. Inventory Turn over= Cost of Goods Sold
Inventory
4. Days Sales Outstanding= Account Receivable
Sales /365
5. Fixed Asset Turn Over= Sales
Net Property, Plant & Equipment
 6. Total Turn Over= Sales
Total Asset
Debt Management
7. Total Debt to Total Asset= Liabilities
Assets
8. Total Debt to Total Asset= Liability
Owner’s Equity
9. Times Interest Earned= EBIT
Interest
Profitability Ratios
10. Gross Profit Margin= (Sales- Cost of Goods Sold)
Sales
 11. Net Profit Margin= Net Income
Sales
12. Return on Assets= Net Income
Total Asset
13. Return on Equity= Net Income
Owner’s Equity
Market Values
14. Price/ Earning Ratio= Market Price Per Share
EPS
15. Market/ Book Ratio= Market Price Per Share
Book Value Per Share
 Common Size Statements
• In addition to ratios, we can also glean information from financial
statements by comparing them from year to year or from firm to
firm. However, we need to be careful. If our sales go up from year
to year, most likely so will our costs. What becomes important
then is not did costs go up, but how did they change relative to
sales. Alternatively, our inventory may be down, but if all of our
other assets are down as well, we may be starting to carry too
much inventory. Our selling and administrative expenses (or
accounts receivable) may appear relatively low to our competitors.
However, if their firm is three times the size of ours, these
expenses or receivables may still be too high.
Common-Size Statements

Vertical analysis focuses

on the relationships
among financial statement
items at a given point in
time. A common-size
financial statement is a
vertical analysis in which
each financial statement
item is expressed as a
percentage.
Common-Size Statements

In income
statements, all
items are
usually
expressed as a
percentage of
sales.
Gross Margin Percentage

Gross Margin Gross Margin

=
Percentage Sales

This measure indicates how much

of each sales dollar is left after
deducting the cost of goods sold to
cover expenses and provide a profit.
Common-Size Statements

In balance
sheets, all items
are usually
expressed as a
percentage of
total assets.
Common-Size Statements

Example

Let’s take another look at the information from the

comparative income statements of Clover Corporation
for 2005 and 2004.
This time let’s prepare common-size statements.
Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2005 2004 2005 2004
Sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000 Sales is
Operating expenses 128,600 126,000 usually the
Net operating income 31,400 39,000 base and is
Interest expense 6,400 7,000 expressed
Net income before taxes 25,000 32,000
as 100%.
Less income taxes (30%) 7,500 9,600
Net income $ 17,500 $ 22,400
 t

Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2005 2004 2005 2004
Sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000 69.2 65.6
Gross margin 160,000 165,000
Operating expenses 128,600 126,000
2005 Cost
Net operating ÷ 2005 Sales
income 31,400× 100%
39,000
( $360,000
Interest expense ÷ $520,000 ) × 100%
6,400 7,000= 69.2%
Net income before taxes 25,000 32,000
2004(30%)
Less income taxes Cost ÷ 2004
7,500 Sales × 100%
9,600
Net income ( $315,000$ ÷17,500 $480,000 ) × 100% = 65.6%
$ 22,400
Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2005 2004 Amount %
Sales $ 520,000 $ 480,000
Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000
Operating expenses 128,600 126,000
Net operating income 31,400 39,000
Interest expense 6,400 7,000
Net income before taxes 25,000 32,000
Less income taxes (30%) 7,500 9,600
Net income $ 17,500 $ 22,400
Dollar and Percentage Changes on Statements
Horizontal analysis (or trend analysis) shows the changes
between years in the financial data in both dollar and
percentage form.
Horizontal Analysis
Example

The following slides illustrate a horizontal analysis of

Clover Corporation’s December 31, 2005 and 2004,
comparative balance sheets and comparative income
statements.
Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2005 2004 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
Horizontal Analysis
Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure

The dollar
amounts for
2004 become
the “base” year
figures.
Horizontal Analysis
Calculating Change as a Percentage

Percentage Dollar Change

Change
=
Base Year Figure × 100%
Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2005 2004 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $12,000 –155,000
$23,500164,700
= $(11,500)
Property and equipment:
Land 40,000 40,000
($11,500
Buildings and equipment, net ÷ $23,500)
120,000 × 100% = 48.9%
85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
Quick Check 
Which of the following statements describes
horizontal analysis?
a. A statement that shows items appearing
on it in percentage and dollar form.
b. A side-by-side comparison of two or
more years’ financial statements.
c. A comparison of the account balances on

the current year’s financial statements.

d. None of the above.
Potential Problems with Trend Analysis
• One challenge with financial statement analysis is that many of the techniques we use help
provide context for analysis, but they typically also have some flaws. Trend analysis is no
different.
Seasonality
• Due to seasonality in quarterly financial statements (and annual balance sheets), seasonality
concerns may lead to distortions in trends. We must be aware of how seasonality can impact
our ratios and common size statements before we can properly analyze trends.
Trend Changes
• Trend analysis is designed to help us identify weaknesses and forecast future performance.
The problem is trends can change suddenly. Often we can not identify changes in trends until
after they have happened which can hinder our ability to use trends for predictions.
Fundamental Changes
• Significant changes in firm strategy or industry dynamics may make comparisons to
previous years less meaningful.
 Who Uses Financial Statement Analysis?

• Who uses financial statement analysis? The answer is many different

groups of individuals and institutions who are concerned with identifying
the health and performance of a company. This includes, but is not limited
to the following groups:
Company Management
• Managers need to evaluate a variety of ratios in order to properly manage
their firm. They need to understand the liquidity situation, how well the
company is doing at generating sales from their assets, what the debt
picture is telling them, how profitable they are, and how investors are
valuing their stock. As such, they need the big picture view provided by
all the ratios, an evaluation of the statement of cash flows and common
size statements.
Competitors
• Like management of our own company, management of our competitors are going
to need a big picture overview of our firm (as well as their other competitors) to
evaluate their own strengths and weaknesses relative to their competition.
Long-term Lenders
• While current and potential bondholders (and other long-term lenders) are going to
evaluate many areas covered by financial statement analysis, there are certain areas
that are more important and others that are less critical. For example, a
current/potential bondholder is not likely to care much about the firm’s PE ratio or
inventory turnover ratio. On the other hand, debt management and liquidity ratios
are going to be a big focus. Profitability ratios are somewhat in the middle. While
long-term lenders prefer rms be pro table enough to have a margin of error in
generating enough cash flows to meet their interest obligations and repay the
principal, they are not really concerned with seeing profitability ratios be on the
high end of the industry as they don’t bene t from excess profits like stockholders
do.
Short-term Creditors
• Like long-term lenders, short-term creditors are focused on the firm’s
ability to repay its liabilities. However, they are less concerned with debt
management ratios and more concerned with liquidity ratios. Whether the
firm can meet their long-term obligations is less relevant as long as the
firm can generate enough cash flows to meet their current obligations.
Stock Investors
• Stock investors are going to have more of a big-picture focus than
creditors. This is because the firm has to be generating sufficient cash
flows, have significant and reliable profitability, meet its debt obligations
(as stockholders come after bondholders in the priority of claims), and be
able to purchase shares at a reasonable price.
Limitations of Financial Statement Analysis

Changes within
the company
Industry Consumer
trends tastes

Technological
changes
Economic
factors

Analysts should look beyond

the ratios.
1. Explain how can the analysis of financial statement be
carried out?
2. Explain profit and loss account debit balance?