CHAPTER 4

FINANCIAL
STATEMENT ANALYSIS
What is Financial Statement Analysis?
 Financial statement analysis is a process which
examines past and current financial data for the
purpose of evaluating performance and estimating
future risks and potential.
 Financial statement analysis is used by investors,
creditors, bank lending officers, etc
 Thus, these analyses will help to measure:
 efficiency,
 profitability,
 financial soundness and
 Future prospects of the business units.
Objectives Of Financial Statement Analysis
 The major objectives of financial statement analysis are as
follows
1. Assessment of Past Performance
Past performance is a good indicator of future performance.
Investors or creditors are interested in the trend of past sales,
cost of good sold, operating expenses, net income, cash flows
and return on investment. These trends offer a means for judging
management's past performance and are possible indicators of
future performance.
2. Assessment of current position
Financial statement analysis shows the current position of the
firm in terms of the types of assets owned by a business firm and
the different liabilities due against the enterprise.
3. Prediction of profitability and growth prospects
Financial statement analysis helps in assessing and predicting
the earning prospects and growth rates of firms.
4. Prediction of bankruptcy and failure
Financial statement analysis is an important tool in assessing
and predicting bankruptcy and probability of business failure.
5. Assessment of the operational efficiency
Financial statement analysis helps to assess the operational
efficiency of the management of a company. The actual
performance of the firm which are revealed in the financial
statements can be compared with some standards set earlier
and the deviation of any between standards and actual
performance can be used as the indicator of efficiency of the
management
Rationale of Financial Statement Analysis
 Financial statement analysis is not an end in itself but is
performed for the purpose of providing information that is useful
in making the right decisions.
 Thus, financial statement analysis serves the following
purposes:
 Measuring the profitability

 The main objective of a business is to earn a satisfactory return on

the funds invested in it. Financial analysis helps in ascertaining
whether adequate profits are being earned on the capital invested in
the business or not. It also helps in knowing the capacity to pay the
interest and dividend.

 Indicating the trend of Achievements

 Financial statements of the previous years can be compared and the
trend regarding various expenses, purchases, sales, gross profits
and net profit etc. can be ascertained. Value of assets and liabilities
can be compared and the future prospects of the business can be
predicted.
 Assessing the growth potential of the business
 The trend and other analysis of the business provide
sufficient information indicating the growth potential of the
business.

 Comparative position in relation to other firms

 The purpose of financial statements analysis is to help the
management to make a comparative study of the
profitability of various firms engaged in similar businesses.
Such comparison also helps the management to study the
position of their firm in respect of sales, expenses,
profitability and utilising capital, etc.
 Assess overall financial strength
 The purpose of financial analysis is to assess the
financial strength of the business. Analysis also
helps in taking decisions, whether funds required
for the purchase of new machines and equipments
are provided from internal sources of the business
or not if yes, how much? And also, to assess how
much funds have been received from external
sources.

 Assess solvency of the firm

 The different tools of an analysis tell us whether
the firm has sufficient funds to meet its short term
and long term liabilities or not.
Generally, Financial statement analysis
helps users to make better decisions.

Internal Users External Users

Managers Shareholders
Officers Lenders
Internal Auditors Customers
Design of Financial Statements for
Analysis
Classified Comparative Consolidated
Financial Financial Financial
Statements Statements Statements

Items with certain Amounts from Information for the

characteristics are several years parent and subsidiary
grouped together. appear side by side. are presented.

Results Helps identify Presented as if

in standardized, significant the two companies
meaningful changes and are a single
subtotals. trends. business unit.
 Techniques and Tools of Financial
statement analysis
 Different techniques are employed for analysing and
interpreting the financial statements.
 Techniques of analysis of financial statements are
mainly classified into three categories.

1. Cross-sectional analysis
It is also known as inter firm comparison. This
analysis helps in analysing financial characteristics
of an enterprise with financial characteristics of
another similar enterprise in that accounting period.
 Techniques and Tools of Financial
statement analysis
2. Time series analysis
 It is also called as intra-firm comparison. According to this
method, the relationship between different items of financial
statement is established, comparisons are made and
results obtained.
 The basis of comparison may be Comparison of the
financial statements of different years of the same business
unit.

3. Combination of Cross-sectional & time series

analysis
 This analysis is intended to compare the financial
characteristics of two or more enterprises for a defined
accounting period. It is possible to extend such a
comparison over the year. This approach is most effective
in analysing of financial statements.
Tools of Financial Statement Analysis
 A number of tools or methods or devices are used to
study the relationship between financial statements.
 The most important tools which are commonly used
for analysing and interpreting financial statements are
the following:
Comparative statements
Common size statements
Dollar & Percentage Changes

Trend Percentages
Trend analysis
Component Percentages
Ratio analysis
Ratios
Funds flow analysis
Cash flow analysis
Dollar and Percentage Changes
 The dollar amount of any change is the
difference between the amount for a
comparison year and the amount for a base
year.
 The percentage change is computed by
dividing the amount of the dollar change
between years by the amount for the base
year.
Dollar and Percentage Changes

Dollar Change:

Dollar Analysis Period Base Period

Change = Amount – Amount

Percentage Change:

% Percent
Change = Dollar Change
÷
Base Period
Amount
Dollar and Percentage Changes
Example
Let’s look at the asset section of Clover
Corporation’s comparative balance
sheet and income statement for 2003
and 2002 on the next slid.
Compute the dollar change and the
percentage for cash.
 CLOVER CORPORATION
Comparative Balance Sheets
December 31,
Dollar Percent
2003 2002 Change Change*
Assets
Current assets:
Cash and equivalents $ 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
* Percent rounded to one decimal point.
 CLOVER CORPORATION
Comparative Balance Sheets
December 31,
Dollar Percent
2003 2002 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) ?
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– $23,500
$ 164,700 = $(11,500)
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
* Percent rounded to one decimal point.
 CLOVER CORPORATION
Comparative Balance Sheets
December 31,
Dollar Percent
2003 2002 Change Change*
Assets
Current assets:
Cash and equivalents $ 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 ($11,500 ÷ $23,500)
$ 155,000 × 100% = 48.94%
$ 164,700
Property and equipment:
Land 40,000 40,000 Complete the
Buildings and equipment, net 120,000 85,000 analysis for
Total property and equipment $ 160,000 $ 125,000 the other
Total assets $ 315,000 $ 289,700
assets.
* Percent rounded to one decimal point.
 CLOVER CORPORATION
Comparative Balance Sheets
December 31,
Dollar Percent
2003 2002 Change Change*
Assets
Current assets:
Cash and equivalents $ 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%
* Percent rounded to one decimal point.
 CLOVER CORPORATION
Comparative Balance Sheets
December 31,
2003
Dollar Percentag
2003 2002 change e change
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 $ 23,000 52.3%
Notes payable 3,000 6,000 $ (3,000) -50.0%
Total current liabilities $ 70,000 $ 50,000 $ 20,000 40.0%
Long-term liabilities: $ -
Bonds payable, 8% 75,000 80,000 $ (5,000) -6.3%
Total liabilities $ 145,000 $ 130,000 $ 15,000 11.5%
Shareholders' equity:
Preferred stock 20,000 20,000 $ - 0.0%
Common stock 60,000 60,000 $ - 0.0%
Additional paid-in capital 10,000 10,000 $ - 0.0%
Total paid-in capital $ 90,000 $ 90,000 $ - 0.0%
Retained earnings 80,000 69,700 $ 10,300 14.8%
Total shareholders' equity $ 170,000 $ 159,700 $ 10,300 6.4%
Total liabilities and shareholders' equity $ 315,000 $ 289,700 $ 25,300 8.7%
* Percent rounded to first decimal point.
 Interpretation
(i) The comparative balance sheet of the company reveals that during
2003 there has been an increase in fixed assets of $35,000 i.e.
28.2% and Long term liabilities to outsiders have relatively
decreased by $6,000, i.e. -6.3%, . Equity share capital has no
change, but retaining earnings of the company increases by
$10,800, i.e. 14.8%.
 This fact indicates that the sources of finance of the company to
purchase fixed assets are short term debts and company’s retaining
earnings.
(ii) The current assets have decreased by $ 9,700 i.e. -5.9%, whereas
the current liabilities have increased by $20, 000 i.e. 40.0%. This
further confirms that the company has used short-term finances to
acquired fixed assets.
(iii) Retain Earnings have increased from $ 69,700 to $80,000,($10,300
i.e. 14.8%) which shows that the company has utilized Retained
earnings for acquiring of fixed assets.
Trend Analysis
 The change in financial statement items
from a base year to following years are
often expressed as trend percentages to
show the extent and direction of change.
 Two steps are necessary to compute trend
percentages.
1. Select base year and assign a weight of 100%
for each item in the base year
2. Express each item following years as a
percentage of its base year amount.
 Trend Analysis
Trend analysis is used to reveal patterns in data
covering successive period.

Trend Analysis Period Amount

Percent
=
Base Period Amount × 100%
 Trend Analysis - Example
Berry Products
Income Information
For the Years Ended December 31,
Item 2003 2002 2001 2000 1999
Revenues $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000
Item 2003 2002 2001 2000 1999
Item 2003 2002 2001 2000 1999
Revenues 145% 129% 116% 105% 100%
Revenues 105% 100%
Cost
Costof
ofsales
sales
1999
150%is the base
132% period
118% so its
104%
104% 100%
100%
Gross
Grossprofit
profit amounts
135% will equal
124% 112%100%.108%
108% 100%
100%
(290,000  275,000)  100% = 105%
(198,000  190,000)  100% = 104%
(92,000  85,000)  100% = 108%
160%
140%
120%
100% Revenues
80% Cost of sales
60% Gross profit

40%
20%
0%
1999 2000 2001 2002 2003
 Component Percentages
 Indicate the relative size of each item included in a total.
 Examine the relative size of each item in the financial statements
by computing component (or common-sized) percentages.

Component Analysis Amount

Percent
=
Base Amount
× 100%

Financial Statement Base Amount

Balance Sheet Total Assets
Income Statement Revenues
 CLOVER CORPORATION 13-27

Comparative Balance Sheets

December 31,
Complete the common-size analysis for the other Common-size
assets. Percents*
2003 2002 2003 2002
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
($12,000 ÷ $315,000)
Total current assets $ 155,000× 100% = 3.8%
$ 164,700
Property and equipment:
Land ($23,50040,000
÷ $289,700) × 100% = 8.1%
40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
 CLOVER CORPORATION 13-28

Comparative Balance Sheets

December 31,
Common-size
Percents*
2003 2002 2003 2002
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000 19.0% 13.8%
Inventory 80,000 100,000 25.4% 34.5%
Prepaid expenses 3,000 1,200 1.0% 0.4%
Total current assets $ 155,000 $ 164,700 49.2% 56.9%
Property and equipment:
Land 40,000 40,000 12.7% 13.8%
Buildings and equipment, net 120,000 85,000 38.1% 29.3%
Total property and equipment $ 160,000 $ 125,000 50.8% 43.1%
Total assets $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
 CLOVER
CLOVER CORPORATION
CORPORATION
Comparative
Comparative Balance
Balance Sheets
Sheets
December
December 31,31,
Complete the common-size analysis for the liabilities and equity Common-size
Common-size
accounts. Percents*
Percents*
2003
2003 2002
2002 2003
2003 2002
2002
Liabilities
Liabilities and
and Shareholders'
Shareholders' Equity
Equity
Current
Current liabilities:
liabilities:
Accounts
Accounts payable
payable $$ 67,000
67,000 $$ 44,000
44,000 21.3% 15.2%
Notes payable
payable 3,000
3,000 6,000
6,000 1.0% 2.1%
Total
Total current liabilities
liabilities $$ 70,000
70,000 $$ 50,000
50,000 22.2% 17.3%
Long-term
Long-term liabilities:
liabilities:
Bonds payable,
payable, 8% 8% 75,000
75,000 80,000
80,000 23.8% 27.6%
Total
Total liabilities
liabilities $$ 145,000
145,000 $$ 130,000
130,000 46.0% 44.9%
Shareholders'
Shareholders' equity:
equity:
Preferred stock
stock 20,000
20,000 20,000
20,000 6.3% 6.9%
Common
Common stock
stock 60,000
60,000 60,000
60,000 19.0% 20.7%
Additional
Additional paid-in
paid-in capital
capital 10,000
10,000 10,000
10,000 3.2% 3.5%
Total
Total paid-in capital
capital $$ 90,000
90,000 $$ 90,000
90,000 28.6% 31.1%
Retained
Retained earnings
earnings 80,000
80,000 69,700
69,700 25.4% 24.1%
Total
Total shareholders'
shareholders' equityequity $$ 170,000
170,000 $$ 159,700
159,700 54.0% 55.1%
Total
Total liabilities and
and shareholders'
shareholders' equity
equity $$ 315,000
315,000 $$ 289,700
289,700 100.0% 100.0%
** Percent
Percent rounded
rounded to to first
first decimal
decimal point.
point.
 CLOVER
CLOVERCORPORATION
CORPORATION
Comparative
Comparative Income
Income Statements
Statements
For
Forthe
the Years
YearsEnded
EndedDecember
December31, 31,
Compute the common-size percentages for Common-size
Common-size
revenues and expenses. Percents*
Percents*
2003
2003 2002
2002 2003
2003 2002
2002
Revenues
Revenues $$520,000
520,000 $$480,000
480,000 100.0% 100.0%
Costs
Costsandandexpenses:
expenses:
Cost
Costofofsales
sales 360,000
360,000 315,000
315,000 69.2% 65.6%
Selling
Sellingand
andadmin.
admin. 128,600
128,600 126,000
126,000 24.7% 26.3%
Interest
Interestexpense
expense 6,400
6,400 7,000
7,000 1.2% 1.5%
Income
Income before
before taxes
taxes $$ 25,000
25,000 $$ 32,000
32,000 4.8% 6.7%
Income
Income taxes
taxes(30%)
(30%) 7,500
7,500 9,600
9,600 1.4% 2.0%
Net
Netincome
income $$ 17,500
17,500 $$ 22,400
22,400 3.4% 4.7%
Net
Netincome
income per
pershare
share $$ 0.790.79 $$ 1.011.01
Avg.
Avg.##common
commonshares
shares 22,200
22,200 22,200
22,200
**Rounded
Roundedto tofirst
firstdecimal
decimalpoint.
point.
 Ratios
A ratio is a simple mathematical expression of
the relationship between one item and another.

Along with dollar and percentage changes, trend

percentages, and component percentages, ratios
can be used to compare:

Past performance to present performance.

Other companies to your company.

 NORTON CORPORATION
2003
Cash $ 30,000
Use this Accounts receivable, net
Beginning of year 17,000
information to
End of year 20,000
calculate the
Inventory
liquidity ratios
Beginning of year 10,000
for Norton End of year 15,000
Corporation. Total current assets 65,000
Total current liabilities 42,000
Total liabilities 103,917
Total assets
Beginning of year 300,000
End of year 346,390
Revenues 494,000
Working Capital
 Gross working capital is total current assets
of firms.
 Net Working capital is the excess of current
assets over current liabilities.
Current Ratio

This ratio measures

the short-term debt-
paying ability of the
company.

Current Current Assets

=
Ratio Current Liabilities

Current $65,000
= = 1.55 : 1
Ratio $42,000
 Quick Ratio

Quick Quick Assets

=
Ratio Current Liabilities

Quick assets are cash, marketable securities,

and receivables.

This ratio is like the current ratio but excludes current

assets such as inventories that may be difficult to quickly
convert into cash.
 Quick Ratio

Quick Quick Assets

=
Ratio Current Liabilities

Quick $50,000
= = 1.19 : 1
Ratio $42,000

This ratio is like the current ratio but

excludes current assets such as
inventories that may be difficult to
quickly convert into cash.
Debt Ratio

A measure of creditor’s long-term risk.

The smaller the percentage of assets that
are financed by debt, the smaller the risk
for creditors.
Measures of Profitability

An income statement can be prepared in either a

multiple-step or single-step format.

The single-step format is simpler.

The multiple-step format provides
more detailed information.
 Income Statement (Multiple-Step) Example

Proper Heading {
Gross
Margin {
Operating
Expenses {
{
Non-
operating
Items

Remember to
compute EPS.
 Income Statement (Single-Step) Example

Proper Heading
{
Revenues
& Gains {
Expenses
& Losses

Remember to
{
compute EPS.
 NORTON CORPORATION
2003
Number of common
Use this
shares outstanding all of
information
2003 27,400
to calculate
Net income from operation $ 53,690
the
Shareholders' equity
profitability
Beginning of year 180,000
ratios for
End of year 234,390
Norton
Revenues 494,000
Corporation. Cost of sales 140,000
Total assets
Beginning of year 300,000
End of year 346,390
Return On Assets (ROA)

This ratio is generally considered

the best overall measure of a
company’s profitability.
Return On Equity (ROE)

This measure indicates how well the company

employed the owners’ investments to earn income.
END OF CHAPTER 4