Analysis and

Interpretation of
Financial
Statements
Financial Statement
Analysis

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 The application of analytical tools and
techniques to financial statement data.
 Allows users to focus on how numbers are
related and how they have changed over time
Objective of Financial
StatementAnalysis

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 External users rely on general purpose financial
statements
 Make predictions about an organization as an
aid in making decisions
 Users highlight important trends or changes
Risk and Return

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 Users try to balance the risk of an investment
with its expected return
 Generally the greater the risk, the higher the
return
 Financial statement analysis is one source of
information for assessing risk and return
Sources of External
Information

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 Public companies must publish an annual
financial report
 Government reports
 SEC 10K, 10Q
 Financial service information
 Moody’s, Dow-Jones
 Financial newspapers and periodicals
 Wall Street Journal
Financial Analysis Tools

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 Horizontal analysis
 Vertical analysis
 Ratio analysis
Horizontal Analysis:
Amounts and Percentages

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of Change
Amount of change = later year amount - Earlier
year amount
 Percentage change = Amount of change /
Earlier year amount
 Look for significant change
Horizontal Analysis:
Trend Percentages

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 Set all amounts in base year at 100%
 Compute percentages for a number of years
 Divide each statement amount by respective
amount in base year
 Shows degree of increase or decrease in
individual statement items
 Used to explain changes in operating
performance
Horizontal analysis
Horizontal analysis
Vertical Analysis

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 Shows how each item in a financial statement
compares to the total of that statement
 Balance sheet
 Set both total assets and total equities at 100%
 Income statement
 Set net sales at 100%
Vertical Analysis

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 Identify significant dollar and percentage
changes
 Explain the changes
 Identify whether they are favorable of
unfavorable
Vertical analysis
Vertical analysis
Vertical analysis
Ratio Analysis

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 Shows the relative size of one financial
statement component to another.
 Effective only when used in combination with
other ratios, analysis, and information
Ratio Analysis

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 Short-term liquidity
 Long-term solvency
 Profitability
 Market performance
 Ratio overview
 There are three types of ratios that exist:

1. Liquidity ratios: these look at the businesses ability to pay its debts
and short-term bills. It includes current ratio but students should also
have an understanding of the acid test ratio.

2. Profitability ratios: profitability ratios allow for the analysis of a

firm’s profits in relation to either its trading performance or in terms of
the capital invested in that company.

3. Efficiency ratios: these ratios will assess how efficiently

management are controlling operations and the day-to-day running of
the business.
Short-term Profitability

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 Current ratio
 Quick ratio
 Accounts receivable turnover
 Days’ sales in receivables
 Inventory turnover
Current Ratio

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 Common measure of liquidity
 Ability to pay debts as they come due
 Rule of thumb 2:1
 Consider other factors

Current Assets

Current Liabilities
Current Ratio

 e.g. a figure of 2.45 means that the

business has £2.45 of current assets
for each £1 of current liabilities that
it owes.

 A current ratio of less than 2 means

that the business may have liquidity
problems. If the ratio is less than 1,
this means that the business has
fewer current assets than current
liabilities — a serious problem
Quick Ratio (Acid Test)

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 More strict measure of short-term liquidity
 Numerator includes only quick current assets
 Assets readily converted to cash

Cash + Short-term investments + Net

Current Receivables
Current liabilities
Accounts Receivable
Turnover

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 How many times we turn accounts receivable
into cash during a period

Net sales

Average net accounts receivable

Days’ Sales in
Receivables

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 How many days’ sales remain uncollected in
accounts receivable

Net sales
Net sales per day =
365 days

Average net accounts receivable

Net sales per day
Inventory Turnover

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 Number of times the company sells and
replaces its inventory during the period
 Holding inventory results in financing and
storage costs

Cost of goods sold

Average inventory
Summary of liquidity
ratios
Long-term Solvency

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 Debt ratio
 Times Interest Earned
Debt Ratio

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 Shows amount of total assets creditors provide
 Higher levels of debt financing means company
has a higher risk of not meeting interest and
principal payments

Total liabilities

Total assets
Summary of solvency
ratio
Times Interest Earned

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 Number of times the company earned interest
expense with current income
 Creditors want to know the firm’s ability to pay
annual interest charges

Net income + Income tax expense

+ Interest expense

Interest expense
Profitability

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 Profit margin
 Total asset turnover
 Return on total assets
 Return on owners’ equity
 Earning per share
Profit Margin

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 Percentage each sales dollar contributes to net
income

Net income

Net sales
Total Asset Turnover

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 Measures the efficiency of the company is using
its investment in assets to generate sales

Net sales

Average total assets

Return on Total Assets

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 Measures the amount a company earns on each
dollar of investment in assets

Net income

Average total assets

Return on Owners’ Equity

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 Measures the earnings in relation to the
owners’ investment in the company

Net income - Preferred dividends

Average owner’s equity

Earnings Per Share

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 Measures the net income available to each
share of common stock
 Discussed in depth in Chapter 14

Net income - Preferred dividends

Weighted average number of common

shares outstanding during the year
Market Performance

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 Price/Earnings (P/E) ratio
 Dividend yield
Price/Earning (P/E) Ratio

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 Number of times earnings per share the stock is
currently selling for in the market

Market price per share of common stock

Earnings per share

Dividend Yield

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 Measure of dividend-paying performance of a
company
 Investors buy stock for two reasons
 Receive cash dividends
 Sell stock at a higher price

Dividends per share

Market price per share

Summary of profitability
ratio
Limitations of Financial
Analysis Tools

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 Historical nature of accounting information
 Changing economic conditions
 Comparisons with industry averages
 Seasonal factors
 Quality of reported income
Answers
Requirements