Financial Statement Analysis

1. Financial Reporting:
Advantage of Standard Reporting Format:
Financial results of a company can be evaluated on a comparable
basis with other companies. Example, GAAP, NFRS, US GAAP

The process of compiling financial data includes,

Recording a business transaction
Classifying the transaction
“Posting” a transaction to the appropriate Ledger account
Summarizing the Ledger accounts
 Financial Statement Analysis

Business transactions fall into five main accounts on the balance sheet
and the income statement.
They are,
Assets
Liabilities
Shareholders’ Equity
Revenues
Expenses
Accountants develop a Chart of Accounts for their particular business.
For instance, in the Asset account, the accountant will likely include
accounts for cash, accounts receivable, and pre-paid expenses among
others.
Financial Statement Analysis
 Financial Statement Analysis
One important distinction between the Balance Sheet and the Income
Statement are the reporting periods.
The Balance Sheet reports the Assets, Liabilities, and Shareholder’s
Equity as of a particular date, such as December 31, 2025.
The Income Statement reports Revenues and Expenses for a given span
of time, such as for the month of December, 2025, or for the year 2025.

Shareholder’s Equity is the portion of the company that is owned by the

shareholders. For a sole proprietor or partnership this account may be
called Owner’s Equity or Partner’s Capital. In this course, we will use
the term Shareholder’s Equity.
Chart of Accounts
 Financial Statement Analysis
GAAP also requires a Statement of Cash Flows to accompany the
Balance Sheet and Income Statement to fully reveal the financial
condition of the business. The purpose of the Statement of Cash Flows
is to show the inflows and outflows of cash of the company.

Since financial statements are usually based on accrual accounting

procedures it may be difficult to really understand how much cash the
business is actually generating.
For instance, the income statement may show a strong profit for a given
month due to great sales. But since many sales are on terms, the actual
cash may not be collected for another 30-90 days, if at all.
 Financial Statement Analysis
It takes all three statements, the Balance Sheet, the Income Statement,
and the Statement of Cash Flows to get a true picture of a company’s
financial condition.

The Statement of Cash Flows is divided into three sections:

The first section shows cash generated by the normal operation of the business,
such as customers paying for the items they have purchased.

The second section covers the inflows and outflows of cash from investing
activities such as buying and selling real estate and buildings or from making
investments.

The final section involves financing activities such as receiving cash from
investors and from loans.
 Financial Statement Analysis
Statement of Retained Earnings

This is a simple document that links the Income Statement to the

Balance
Sheet.
The Statement of Retained Earnings shows how much of the net income
was distributed as dividends and how much was retained on the Balance
Sheet.

Since net income can sometimes be a loss, or negative number, the

retained earnings on the balance sheet may decrease instead of
increasing.
Financial Statement Analysis
 BALANCE SHEET (SFP)
Its purpose is to reveal the assets, liabilities, and equity of the company.

The assets of a company are what the company uses to operate the
business. The liabilities and equity of the company are used to support
the assets.

Assets = Liabilities + Shareholder’s Equity

The balance sheet equation must always be in balance, meaning that

the assets of the company must always equal the sum of the liabilities
and equity.
 BALANCE SHEET (SFP)
The items on the balance sheet are often presented in order of decreasing liquidity, which
means that cash is shown first, followed by items that can be quickly converted to cash, etc.,
called Marshalling.
 BALANCE SHEET (SFP)
Assets are broken down into current assets and
fixed assets.
Currents assets are items that are expected into
be converted to cash within a 12-month period.
Current assets include cash, accounts
receivable, Inventory, prepaid assets, and other
current assets.
Normally the inventory will be valued at cost, but if
the inventory is obsolete, perhaps because of new
technology, the value of the inventory may need to be
written down to its market value. There are four
accepted methods for valuing inventory: Specific
Identification, FIFO, LIFO, and Weighted Average .
Non-current assets are considered long term,
or fixed assets.
 BALANCE SHEET (SFP)
Long term debt is not a current liability, but is a liability that may
extend for several years or over several reporting periods. This debt may
be in the form of debentures or loans.
The portion of a long term debt that will be retired within one year
should be reported as a current liability, along with the interest charges,
with a corresponding reduction in the long term debt account.

Shareholder’s Equity is the owners’ share of the company. The

ownership is reflected in the capital stock owned by the shareholders and
the retained earnings of the company.
Common stock carries voting rights and the value of a common stock can increase
(or decrease) dramatically based on the marketplace’s opinion of the value of the
company. The par value of the stock is usually Rs. 100 per share.
 BALANCE SHEET (SFP)

Retained Earnings:
When a company earns profits, it may either distribute the earnings to
the shareholders in the form of dividends or reinvest the earnings back
into the company. The profits that are not distributed as dividends are
known as retained earnings.
 INCOME STATEMENT (SCI)
The income statement shows the operating results of the company for
a given time period.
It matches revenues from sales against the cost of making those sales to
arrive at a net income (or loss). [Matching Concept]

Sales: Revenue generated from making sales of the company’s

products is the source of sales.

Cost of Goods Sold: The cost of goods sold is the direct cost of the
merchandise that the company sold during the year.
INCOME STATEMENT (SCI)

Operating Expenses: Expenses that are

not directly related to the cost of the
merchandise sold are grouped under
operating expenses.
 CASH FLOW STATEMENT (CFS)
Remember, that because of the accrual method of accounting, the net
income shown on the income statement does not represent the cash
received by the company.

The statement of cash flows shows how much cash the

company actually generated and what it did with the cash.
The statement of cash flows is broken down into three categories,
Operating activities
Investing Activities
Financing Activities
CASH FLOW STATEMENT (CFS)
Free Cash Flow:

Free cash flow is a good measure of a

company’s ability to continue operations.
Free cash flow is determined by subtracting
cash used for capital expenditures from the
cash used in operations.
 MEASURING FINANCIAL HEALTH: RATIO ANALYSIS

There are many financial

measures that are useful in
determining the
financial health of a
company. We will break the
measurements down into
four categories:
Profitability,
Short-term liquidity,
Long term solvency, and
Dividends.
PROFITABILITY RATIO (Illustration)
 PROFITABILITY RATIO (Illustration)

Gross Profit as a percentage Return on Equity (ROE) = 8,280 /

of sales = 34,750 / 118,000 * (52,480+45,400)/2 * 100 = 16.9%
100 = 29.4%
Asset Turnover = 118,000 /
Operating Margin as a (99,830+94,300)/2 = 1.21
percentage of sales =
16,050 / 118,000 * 100 = Return on Assets (ROA) = 16,050 /
13.6% (99,830+94,300)/2 * 100 = 16.5%

Return on Sales = 8,280 / Earnings per Share = 8,280 /

118,000 * 100 = 7.0% (3,000+3,000)/2 = $2.76 per share
SHORT TERM LIQUIDITY RATIO
SHORT TERM LIQUIDITY RATIO (Illustration)
 SHORT TERM LIQUIDITY RATIO (Illustration)

Current Ratio = 60,480 / 26,350 = 2.3.

Quick Ratio = (2,480 + 24,400) / 26,350 = 1.02
Average Collection Period = ((24,400+22,750)/2) * 365 / 118,000 = 73
days
Inventory Turnover = 80,250 / (27,000 + 27,750)/2 = 2.93
LONG TERM SOLVENCY RATIO
LONG TERM SOLVENCY RATIO
 LONG TERM SOLVENCY RATIO (Illustration)

Debt to Assets = 47,350 / 99,830 = 0.47

Debt to Equity = 47,350 / 52,480 = 0.90
TIER = 16,050 / 2,500 = 6.42
DIVIDEND RATIOS
DIVIDEND RATIOS (Illustration)
 DIVIDEND RATIOS (Illustration)

Earnings per Share = 8,280 / (3,000+3,000)/2 = $2.76.

P/E Ratio = 26.50 / 2.76 = 9.6.
Dividend Yield = 0.40 / 26.50 * 100 = 1.5%
Dividend Payout = 0.40 / 2.76 * 100 = 14.5%.
Financial Analysis- Ratio Comparison
 Financial Analysis- Profitability Ratios

• Three income ratios, gross profit, operating margin, & return on sales
are all good & consistent with the previous year’s performance. For
instance, the gross profit from sales in 2006 is reasonable at 29.4%,
which is comparable to the previous year, which was 27.7%.
• The balance sheet ratios, return on equity, asset turnover, and return
on assets are very good, with the return on equity in 2006 of 16.9%.
• For 2006, the asset turnover ratio is okay at 1.21 and slightly better
than previous years’ 1.17.
Remember that asset turnover is a measure of how efficient a
company is using its assets. Generally a ratio greater than one is
considered good, but the best comparison is the trend over several
years.
 Financial Analysis- ST Liquidity Ratios

• The ability to pay bills is pretty good with the current ratio of 2.3. A current ratio
of 1.2 or better is generally considered good though it is dependent on the
industry.
• The quick ratio is better than the previous year, but still weak at 1.02. This
means that company has just barely enough liquid assets to pay its current
liabilities.
• Since the quick ratio is less than the current ratio, the current assets are probably
highly dependent on inventory. Therefore, some of the weakness in these
values may be the result of excessive inventory or slow collections.
• The average collection period is between 70 and 73 days. Most retail companies
will have collection period of 30 days or less. The company should probably
focus more effort on collections and credit policies.
• The inventory turnover is okay, but should be slightly higher probably five or
more.
 Financial Analysis- LT Solvency Ratios

• The total debt when compared to the total assets is 0.47, or about one-
half of the total assets. If sales is slow because of a recession the
company is still obligated to pay its interest obligations so the lower
debt is better. A ratio debt-to-assets ratio of 0.47 is reasonable.
• The company is financed with about equal parts of debt and equity with
a debt to equity ratio of 0.90 and 1.08 last year. Most companies
prefer to keep their debt level below one.
• The company is in a very strong position to pay its debt since the TIE
ratio is 6.42, which means the company has sufficient income to cover
its interest payments 6.42 times. Generally a TIER of five or more is
considered excellent coverage.
 Financial Analysis- Dividend Payout Ratios

• The dividend yield, or rate of return on the common stock is only

1.5%, however this is much better than the previous year. And the
company is returning more of the retained earnings in the form of
dividends this year.
• In 2006 the dividend payout was 14.5% compared to 5.8% for the
previous year. From the statement of retained earnings we can see
that even with the increased dividend payout, the company is still
increasing its retained earnings, which can be used to fund more
growth.
THANK YOU!