FM Assignment 1

Financial Statement Analysis
Financial statement analysis is the process of analyzing a company's financial statements for
decision-making purposes. External stakeholders use it to understand the overall health of an
organization as well as to evaluate financial performance and business value. Internal
constituents use it as a monitoring tool for managing the finances.
Balance Sheet
The balance sheet is a report of a company's financial worth in terms of book value. It is broken
into three parts to include a company’s assets, liabilities, and shareholders' equity. Short-term
assets such as cash and accounts receivable can tell a lot about a company’s operational
efficiency. Liabilities include its expense arrangements and the debt capital it is paying off.
Shareholder’s equity includes details on equity capital investments and retained earnings from
periodic net income. The balance sheet must balance with assets minus liabilities equaling
shareholder’s equity. The resulting shareholder’s equity is considered a company’s book value.
This value is an important performance metric that increases or decreases with the financial
activities of a company.
Income Statement
The income statement breaks down the revenue a company earns against the expenses involved
in its business to provide a bottom line, net income profit or loss. The income statement is
broken into three parts which help to analyze business efficiency at three different points. It
begins with revenue and the direct costs associated with revenue to identify gross profit. It then
moves to operating profit which subtracts indirect expenses such as marketing costs, general
costs, and depreciation. Finally it ends with net profit which deducts interest and taxes.
Basic analysis of the income statement usually involves the calculation of gross profit margin,
operating profit margin, and net profit margin which each divide profit by revenue. Profit margin
helps to show where company costs are low or high at different points of the operations.
Cash Flow Statement

The cash flow statement provides an overview of the company's cash flows from operating
activities, investing activities, and financing activities. Net income is carried over to the cash
flow statement where it is included as the top line item for operating activities. Like its title,
investing activities include cash flows involved with firmwide investments. The financing
activities section includes cash flow from both debt and equity financing. The bottom line shows
how much cash a company has available.
Free Cash Flow and Other Valuation Statements
Companies and analysts also use free cash flow statements and other valuation statements to
analyze the value of a company. Free cash flow statements arrive at a net present value by
discounting the free cash flow a company is estimated to generate over time. Private companies
may keep a valuation statement as they progress toward potentially going public.
Overview of Financial Statement Analysis
Financial statement analysis involves gaining an understanding of an organization's financial
situation by reviewing its financial reports. The results can be used to make investment and
lending decisions. This review involves identifying the following items for a company's financial
statements over a series of reporting periods:
 Trends. Create trend lines for key items in the financial statements over multiple time
periods, to see how the company is performing. Typical trend lines are for revenue, the
gross margin, net profits, cash, accounts receivable, and debt.
 Proportion analysis. An array of ratios are available for discerning the relationship
between the size of various accounts in the financial statements. For example, one can
calculate a company's quick ratio to estimate its ability to pay its immediate liabilities, or
its debt to equity ratio to see if it has taken on too much debt. These analyses are
frequently between the revenues and expenses listed on the income statement and the
assets, liabilities, and equity accounts listed on the balance sheet.
Financial statement analysis is an exceptionally powerful tool for a variety of users of financial
statements, each having different objectives in learning about the financial circumstances of the
entity.
Users of Financial Statement Analysis
There are a number of users of financial statement analysis. They are:
 Creditors. Anyone who has lent funds to a company is interested in its ability to pay back
the debt, and so will focus on various cash flow measures.
 Investors. Both current and prospective investors examine financial statements to learn
about a company's ability to continue issuing dividends, or to generate cash flow, or to
continue growing at its historical rate (depending upon their investment philosophies).
 Management. The company controller prepares an ongoing analysis of the company's
financial results, particularly in relation to a number of operational metrics that are not
seen by outside entities (such as the cost per delivery, cost per distribution channel, profit
by product, and so forth).
 Regulatory authorities. If a company is publicly held, its financial statements are
examined by the Securities and Exchange Commission (if the company files in the
United States) to see if its statements conform to the various accounting standards and the
rules of the SEC.
Methods of Financial Statement Analysis
There are two key methods for analyzing financial statements. The first method is the use of
horizontal and vertical analysis. Horizontal analysis is the comparison of financial information
over a series of reporting periods, while vertical analysis is the proportional analysis of a
financial statement, where each line item on a financial statement is listed as a percentage of
another item. Typically, this means that every line item on an income statement is stated as a
percentage of gross sales, while every line item on a balance sheet is stated as a percentage of
total assets. Thus, horizontal analysis is the review of the results of multiple time periods, while
vertical analysis is the review of the proportion of accounts to each other within a single period.
The second method for analyzing financial statements is the use of many kinds of ratios. Ratios
are used to calculate the relative size of one number in relation to another. After a ratio is
calculated, you can then compare it to the same ratio calculated for a prior period, or that is based
on an industry average, to see if the company is performing in accordance with expectations. In a
typical financial statement analysis, most ratios will be within expectations, while a small
number will flag potential problems that will attract the attention of the reviewer. There are
several general categories of ratios, each designed to examine a different aspect of a company's
performance. The general groups of ratios are:
 Liquidity ratios. This is the most fundamentally important set of ratios, because they
measure the ability of a company to remain in business. Click the following links for a
thorough review of each ratio.
o Cash coverage ratio. Shows the amount of cash available to pay interest.
o Current ratio. Measures the amount of liquidity available to pay for current
liabilities.
o Quick ratio. The same as the current ratio, but does not include inventory.
o Liquidity index. Measures the amount of time required to convert assets into cash.
 Activity ratios. These ratios are a strong indicator of the quality of management, since
they reveal how well management is utilizing company resources. Click the following
links for a thorough review of each ratio.
o Accounts payable turnover ratio. Measures the speed with which a company pays
its suppliers.
o Accounts receivable turnover ratio. Measures a company's ability to collect
accounts receivable.
o Fixed asset turnover ratio. Measures a company's ability to generate sales from a
certain base of fixed assets.
o Inventory turnover ratio. Measures the amount of inventory needed to support a
given level of sales.
o Sales to working capital ratio. Shows the amount of working capital required to
support a given amount of sales.
o Working capital turnover ratio. Measures a company's ability to generate sales
from a certain base of working capital.
 Leverage ratios. These ratios reveal the extent to which a company is relying upon debt to
fund its operations, and its ability to pay back the debt. Click the following links for a
thorough review of each ratio.
o Debt to equity ratio. Shows the extent to which management is willing to fund
operations with debt, rather than equity.
o Debt service coverage ratio. Reveals the ability of a company to pay its debt
obligations.
o Fixed charge coverage. Shows the ability of a company to pay for its fixed costs.
 Profitability ratios. These ratios measure how well a company performs in generating a
profit. Click the following links for a thorough review of each ratio.
o Breakeven point. Reveals the sales level at which a company breaks even.
o Contribution margin ratio. Shows the profits left after variable costs are subtracted
from sales.
o Gross profit ratio. Shows revenues minus the cost of goods sold, as a proportion
of sales.
o Margin of safety. Calculates the amount by which sales must drop before a
company reaches its break even point.
o Net profit ratio. Calculates the amount of profit after taxes and all expenses have
been deducted from net sales.
o Return on equity. Shows company profit as a percentage of equity.
o Return on net assets. Shows company profits as a percentage of fixed assets and
working capital.
o Return on operating assets. Shows company profit as percentage of assets utilized.

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Financial Statement Analysis

Cash Flow Statement

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