

Chapter 2:Financial Statement

Analysis
• This chapter deals with the following points
• Financial statement analysis
• Purpose of Financial statement analysis
• Advantages of Financial Statement
Analysis
• Types of Financial Statements
• Sources of Financial Statement Analysis
• Methods of Financial Statement Analysis
• Tools of Financial analysis
• Ratio analysis
 Basic Questions
1. What are the trends in financial measures over
time?
2. How our performance is compared to the others?
3. How can you determine what departments or
divisions have performed well?
4. As a lender, how do decide the borrower will be able
to pay back as promised?
5. As a manager of a corporation, how do you know
when existing capacity will be exceeded and
enlarged capacity will be needed?
6. As an investor, how do you predict how well the
securities of one company will perform relative to
that of another?
7. How can you tell whether one security is riskier
 Financial Statement Analysis
 Financial statements provide a wealth of
information that is helpful in evaluating
financial performance.
 Financial performance is the results of a firm's
policies and operations expressed in monetary
terms or
 Financial statement analysis involves
taking key items from these financial
statements and pick up as much useful
information as possible from them.
Financial statements are prepared to meet
external reporting obligations & also for
decision making purposes.
They play a dominant role in setting the
framework of managerial decisions.
 But the information provided in the financial
statements is
 not an end in itself as no meaningful conclusions can be
drawn from these statements alone.
 However, the information provided in the
financial statements is of immense use in
making decisions through analysis &
interpretation of financial statements.
 Financial Statement Analysis is the process of
identifying
 financial strengths & weaknesses of the firm by
properly establishing relationship b/n the items of the
balance sheet & the income statement.
 It helps to understand firms financial statements
better.
 Financial statement analysis helps users make
better decisions.
• Financial statement analysis is a process of
analyzing financial condition for decision
making purpose.
• It allows to evaluate the financial
performance of the company and its
business value.
Uses of Financial Analysis
 Financial analysis is the selection,
evaluation, and interpretation of financial
data, along with other pertinent
information, to assist in investment and
financial decision-making.
 Financial analysis may be used
 internally to evaluate issues such as
employee performance, the efficiency of
operations, and credit policies, and
 externally to evaluate potential
investments and the credit-worthiness of
borrowers, among other things.
 Purpose of Analysis
Financial measures are often used
to rank corporate performance.
Example measures include:

Growth Return to Profit Return on

in sales stockholders margins equity

Determined by
analyzing the
financial
statements.
 Advantages of Financial Statement Analysis
1. The major benefit is that the investors get
enough idea to decide about the investments of
their funds in the specific company.
2. Secondly, regulatory authorities like IASB can
ensure whether the company is following
accounting standards or not.
3. Thirdly, financial statements analysis can help
the government agencies to analyze the taxation
due to the company.
4. Moreover, company can analyze its own
performance over the period of time through
financial statement analysis.
 Types of Financial Statements

Financial
Statement

Income Balance
SRE SCF
statement sheet

Revenue Expenses Assets Liabilities SHE

 Types of Financial Statements-Preparation

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.
Sources of Financial Statement Analysis
❑Annual reports a company usually contains:
1. Financial statements.
2. Notes to the financial statements.
3. A summary of accounting methods used.
4. Management discussion and analysis of the
financial statements.
5. An auditor’s report.
6. Comparative financial data for 5 to 10 years.
 All these documents can be the source of
financial statement analysis.
 Methods of Financial Statement Analysis

 There are various methods or techniques that

are used in analyzing financial statements,
such as
1. Comparative statements analysis
2. Common size percentages analysis/Vertical
Analysis: the procedure of preparing and
presenting common size statements
3. Trend analysis:
4. Ratio analysis.
Tools of Financial Analysis

Amount &
Trend
Percentage
Percentages
Changes

Component
Percentages Ratios
Tools of Financial Analysis
1. Amount & Percentage Changes: shows how
item changed as a percentage from one period
to another period.
2. Trend Percentages/Horizontal Analysis:
comparison of two or more year's financial
data
3. Component percentages/Vertical Analysis:
4. Ratio Analysis
1. Amount and Percentage Changes
Amount Change:

Amount Analysis Period Base Period

Change = Amount – Amount

Percentage Change:

% Percent
Change = Birr Change ÷ Base Period
Amount
Amount and Percentage Changes
Evaluating Percentage Changes
in Sales and Earnings

Sales and earnings In measuring quarterly

should increase at changes, compare to
more that the rate the same quarter in
of inflation. the previous year.

Percentages may be
misleading when the
base amount is small.
 Amount and Percentage Changes
Example: Using BCC Corporation’s
comparative balance sheet and income
statement for 2003 and 2002,
1. Compute the Amount change for cash.
2. The percentage for cash.
 BCC Corporation
Balance sheet
December 31,
Amount Percent
2003 2002 Change Change*
Assets
Current assets:
Cash and equivalents Br 12000 Br 23500 ? ?
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets Br 155,000 Br 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment Br 160,000 Br 125,000
Total assets Br 315,000 Br289,700
* Percent rounded to one decimal point.
 BCC CORPORATION
Comparative Balance Sheets
December 31,
Percent
2003 2002 Birr Change Change*
Assets
Current assets:
Cash and equivalents Br 12,000 Br 23,500 (Br 11,500) ?
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets Br 155,000
Br12,000Br –
164,700
Br23,500 =
Property and equipment:
Br(11,500)
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment Br 160,000 Br 125,000
Total assets Br 315,000 Br 289,700
* Percent rounded to one decimal point.
 BCC CORPORATION
Comparative Balance Sheets
December 31,
Percent
2003 2002 Birr Change Change*
Assets
Current assets:
Cash and equivalents Br 12,000 Br 23,500 (Br 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 (Br11,500 ÷ Br23,500)
Br 155,000 × 100% = 48.94%
Br 164,700
Property and equipment:
Land 40,000 40,000 Complete the
Buildings and equipment, net 120,000 85,000
analysis for the
Total property and equipment Br 160,000 Br 125,000
Total assets Br 315,000 Br 289,700
other assets.
* Percent rounded to one decimal point.
 2. Horizontal (Trend) Analysis

 Comparison of two or more year's financial

data is known as horizontal analysis, or trend
analysis.
 Horizontal analysis is facilitated by showing
changes between years in both dollar and
percentage form
 Horizontal analysis of financial statements
can also be carried out by computing trend
percentages.
Trend percentage states several years' financial
data in terms of a base year.
The base year equals 100%, with all other years
stated in some percentage of this base.
Therefore, the changes in financial statements
from a base year to following years are expressed
as a trend percentage to show the extent &
direction of changes.
1st a base year is selected & each item in the FSs
for the base year is given a weight of 100%.
2nd is to express each item in the FSs for
following years as a percentage of its base-year
amount.
 Trend Analysis

Trend analysis is used to reveal patterns in data

covering successive periods.

Trend Analysis Period Amount

Percent
=
Base Period Amount
× 100%
 Horizontal Analysis-Example

Increase/(Decrease)
2005 2004 Amount Percent
Sales $41,500 $37,850 $3,650 9.6%
Expenses 40,000 36,900 3,100 8.4%
Net income 1,500 950 550 57.9%
Horizontal Analysis-Example

2005 2004 Difference

Sales $41,500 $37,850 $3,650

$3,650 ÷ $37,850 = .0964, or 9.6%

 Trend Percentages - Example

…are computed by selecting a base year

whose amounts are set equal to 100%.
 The amounts of each following year are
expressed as a percentage of the base
amount.

Trend % = Any year $ ÷ Base year $

Trend Percentages - Example
Year 2005 2004 2003
Revenues $27,611 $24,215 $21,718
Cost of sales 15,318 14,709 13,049
Gross profit $12,293 $ 9,506 $ 8,669
2003 is the base year.

What are the trend percentages?

 Trend Percentages - Solution
Year 2005 2004 2003
Revenues 127% 111% 100%
Cost of sales 117% 113% 100%
Gross profit 142% 110% 100%

These percentages were calculated by

dividing each item by the base year.
3. Vertical Analysis (Component Percentages)
 Vertical analysis is the procedure of preparing and
presenting common size statements.
 Common size statement is one that shows the items
appearing on it in percentage form as well as in dollar
form.
 Each item is stated as a percentage of some total of which
that item is a part.
 Key financial changes and trends can be highlighted by
the use of common size statements.
compares each item in a financial statement to a base
number set to 100%.
 Every item on the financial statement is then reported as a
percentage of that base.
 Component Percentages
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
Example: Consider the following case
and conduct common size analysis

2005 %
Revenues $38,303 100.0
Cost of sales 19,688 51.4
Gross profit $18,615 48.6
Total operating expenses 13,209 34.5
Operating income $ 5,406 14.1
Other income 2,187 5.7
Income before taxes $ 7,593 19.8
Income taxes 2,827 7.4
Net income $ 4,766 12.4
Example: Lucent Technologies: Financial
Statements

Assets 2005 %
Current assets:
Cash $ 1,816 4.7
Receivables net 10,438 26.9
Inventories 6,151 15.9
Prepaid expenses 3,526 9.1
Total current assets $21,931 56.6
Plant and equipment, net 6,847 17.7
Other assets 9,997 25.7
Total assets $38,775 100.0
 Common-size Statements

 On the income statement, each item is

expressed as a percentage of net sales.
 On the balance sheet, the common size is
the total on each side of the accounting
equation.
 Common-size statements are used to
compare one company to other companies,
and to the industry average.
 Common-size Statements-Solution
Lucent Technologies Percent of Net Sales

10.8%

8.0%

12.4%
MCI
43.0%

7.4%

51.4%
38.2%

28.8%

Cost of goods sold Operating expenses

Income tax Net income
 4. Ratio Analysis
 The ratios analysis is the most powerful tool of financial
statement analysis.
 Ratios simply means one number expressed in terms of
another/by dividing one number by another number.
 A ratio is a statistical yardstick by means of which
relationship between two or various figures can be
compared or measured.
 Ratios show how one number is related to another.
 What is Ratio?

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 Other companies to

present performance. your company.
 Classification of Ratio
1. Liquidity Ratios: Measuring ability to pay
current liabilities
2. Activity Ratios: Measuring ability to sell
inventory and collect receivables
3. Leverage Ratios: Measuring ability to pay
short-term and long-term debt
4. Profitability Ratios: Measuring profitability
5. Market Value Ratios: Analyzing stock as an
investment
Liquidity ratio
1. Current ratio
2. Quick ratio
 Activity ratio
3. Inventory turnover
4. Receivable turnover
5. Average Collection Period
6. Total asset turnover
 Leverage ratio
7. Debt ratio
8. Time interest earned
 Profitability
9. Return on sales
10.Return on assets
11. Return on SHE
12.EPS
 Marketability ratios
13. Earnings per Share (EPS)
14. Dividend per Share (DPS)
15. Dividend-Payout Ratio
16. Price- Earnings Ratio
17. Market value-to-Book value (MV/BV) Ratio
1. Liquidity Ratios
Measuring ability to pay current liabilities

Liquidity ratios measure the short-term

solvency of financial position of a firm.
These ratios are calculated to comment upon
the short-term paying capacity of a concern
or the firm's ability to meet its current
obligations.
Following are the most important liquidity
ratios:
1. Current Ratio=CA/CL
2. Acid Test/Quick Ratio=QA/CL
 Illustrations:
consider the case of Stylistic Furniture
and determine each types of

1. Liquidity Ratios
2. Activity Ratios
3. Leverage Ratios
4. Profitability Ratios
 Stylistic Furniture
Income statement
Net sales (Year, 2005) $858,000
Cost of goods sold 513,000
Gross profit $345,000
Total operating expenses 244,000
Operating income $101,000
Interest revenue 4,000
Interest expense (24,000)
Income before taxes $ 81,000
Income taxes 33,000
Net income $ 48,000
 Stylistic Furniture
Balance Sheet

Assets 2005 2004

Current assets:
Cash $ 29,000 $ 32,000
Receivables net 114,000 85,000
Inventories 113,000 111,000
Prepaid expenses 6,000 8,000
Total current assets $262,000 $236,000
Long-term investments 18,000 9,000
Plant and equipment, net 507,000 399,000
Total assets $787,000 $644,000
continued

Liabilities 2005 2004

Current liabilities:
Notes payable $ 42,000 $ 27,000
Accounts payable 73,000 68,000
Accrued liabilities 27,000 31,000
Total current liabilities $142,000 $126,000
Long-term debt 289,000 198,000
Total liabilities $431,000 $324,000
continued
Stockholders’ Equity 2005 2004
Common stock, no par $186,000 $186,000
Retained earnings 170,000 134,000
Total stockholders’ equity $356,000 $320,000
Total liabilities and
stockholders’ equity $787,000 $644,000
Measuring Ability to Pay Current Liabilities

1.The current ratio measures the company’s

ability to pay current liabilities with current
assets.

Current ratio =
Total current assets ÷ Total current liabilities
 solutions

❑Stylistic current ratio: CA/CL

➢ 2004: $236,000 ÷ $126,000 = 1.87
➢ 2005: $262,000 ÷ $142,000 = 1.85
➢ The industry average is 1.50.
➢ The current ratio decreased slightly during
2005.
Measuring Ability to Pay Current
Liabilities
2.The acid-test ratio shows the company’s
ability to pay all current liabilities
if they come due immediately.
•Quick Assets = Current Assets –
(Inventories & Prepaid Assets)

Acid-test ratio =(Cash + STIs+ Net current

receivables)
÷ Total current liabilities
 Measuring Ability to Pay Current
Liabilities
❑Stylistic’ acid-test ratio: QA/CL
2004
($32,000 + $85,000) ÷ $126,000 = 0.93
2005
($29,000 + $114,000) ÷ $142,000 = 1.01
The industry average is 0.40.
The company’s acid-test ratio improved
considerably during 2005.
2. Activity Ratios: Measuring Ability to
Sell Inventory & Collect Receivables
 Activity ratios are calculated to measure the
efficiency with which the resources of a firm have
been employed.
 These ratios are also called turnover ratios as they
indicate the speed with which assets are being
turned over into sales.
 Following are the most important activity ratios:
1. Inventory turnover ratio
2. Receivables turnover ratio
3. Average Collection period
4. Total Assets Turnover ratio
Measuring Ability to Sell Inventory

1. Inventory turnover ratio is a measure of the

number of times the average level of inventory
is sold during a year.

Inventory turnover = CGS÷ Average inventory

Average Inventories = (Beginning Inventories

+ Ending Inventories) / 2
 Measuring Ability to Sell Inventory

❑Stylistics' inventory turnover:

 2005: $513,000 ÷ $112,000 = 4.58
 The industry average is 3.4.
 A high number indicates an ability to
quickly sell inventory.
Measuring Ability to Collect Receivables

2. Accounts receivable turnover measures a

company’s ability to collect cash from credit
customers.

Accounts receivable turnover =

Net credit sales ÷ Average accounts receivable
Measuring Ability to Collect Receivables

❑Stylistics' A/R Turnover:

2005: $858,000 ÷ $99,500 = 8.62 times
The industry average is 51 times.
Stylistics’ receivable turnover is much
lower than the industry average.
 Average Collection Period/Days in Account Receivable
 The amount of time it takes for a business to
receive payments owed by its clients in terms of
accounts receivable
 ACP = 360 or = Debtors x 360
 Debtors turnover Sales

One day’s sales = Net sales ÷ 365 days

Days’ sales in Accounts Receivable =

Average net Accounts Receivable ÷ One day’s
sales
Measuring Ability to Collect Receivables

❑Stylistics’ days’ sales in Accounts

Receivable for 2005:
One day’s sales: $858,000 ÷ 365 = $2,351
Days’ sales in Accounts Receivable:
$99,500 ÷ $2,351 = 42 days
The industry average is 7 days.
 Total Assets Turnover Ratio
 shows the firm’s ability in generating sales
from all financial resources committed to total
assets
 Total assets turnover ratio= Sales
 Total assets
 For Stylistics Total assets turnover ratio is
 858,000/787,000=1.09
 The company generates a sale of $1.09 for one
dollar investment in fixed and current assets
together
3. Leverage Ratios: Measuring ability to pay
short-term and long-term debt

 Long-term solvency or leverage

ratios convey a firm's ability to meet the
interest costs & payment schedules of its
long-term obligations.
 Following are some of the most important
long-term solvency or leverage ratios
➢Debt Ratio
➢Times-Interest-Earned2(Coverage Ratio)
Measuring Ability to Pay Debt

1.The debt ratio indicates the proportion

of assets financed with debt.

Total liabilities ÷ Total assets

 Measuring Ability to Pay Debt

❑ Stylistics’ debt ratio: Total Liability/Total Assets

2004
$324,000 ÷ $644,000 = 0.50
2005
$431,000 ÷ $787,000 = 0.55
The industry average is 0.64.
Stylistic Furniture expanded operations
during 2005 by financing through borrowing.
 Measuring Ability to Pay Debt

2. Interest Coverage Ratio (Times-Interest-Earned

Ratio) measures the number of times operating
income can cover interest expense.

Interest Coverage Ratio (Times-Interest-Earned)

= Income from operations ÷ Interest expense
 Measuring Ability to Pay Debt

❑Stylistics’ Times-Interest-Earned Ratio:

2004
$57,000 ÷ $14,000 = 4.07
2005
$101,000 ÷ $24,000 = 4.21
The industry average is 2.80.
The company’s times-interest-earned ratio
increased in 2005.
This is a favorable sign.
4. Profitability Ratios: Measuring
Profitability
Profitability ratios measure the results of
business operations or overall performance
& effectiveness of the firm.
 Some of the most popular profitability
ratios are as under:
1. Rate of return on net sales (ROS)
2. Rate of return on total assets (ROA)
3. Rate of return on common SHE
4. Earnings per share of common stock
Measuring Profitability
1. Rate of return on net sales shows the
percentage of each sales dollar earned as
net income.

Rate of return on net sales =Net income

÷ Net sales
 Measuring Profitability
❑Stylistics’ rate of return on sales:
2004
 $26,000 ÷ $803,000 = 0.032
2005
 $48,000 ÷ $858,000 = 0.056
 The industry average is 0.008.
 The increase is significant in itself & also b/c it is much
better than the industry average.
 Measuring Profitability

2. Rate of return on total assets measures how

profitably a company uses its assets.
• This ratio is generally considered the best
overall measure of a company’s profitability.
Rate of return on total assets =
(Net income + interest expense)/Average total assets
i.e., operating income to average total assets is
usually used to compute return on total assets.
 Measuring Profitability

❑Stylistics’ rate of return on total assets for

2005:
($48,000 + $24,000) ÷ $715,500 = 0.101
The industry average is 0.078.
How does Stylistics’ compare to the industry?
Very favorably.
 Measuring Profitability

• Common equity includes additional paid-in

capital on common stock & retained earnings.
• This measure indicates how well the
company employed the owners’ investments
to earn income.

3. Rate of return on common stockholders’ equity

= (Net income – preferred dividends)
÷ Average common stockholders’ equity
 Measuring Profitability

❑Stylistics’ rate of return on common

stockholders’ equity for 2005:
($48,000 – $0) ÷ $338,000 = 0.142
The industry average is 0.121.
Q. Why is this ratio larger than the return on
total assets (.101)?
Measuring Profitability

4. Earnings per share of common stock

= (Net income – Preferred dividends)
÷ Number of shares of common stock
outstanding
 Measuring Profitability
❑Stylistics’ earnings per share:
2004
($26,000 – $0) ÷ 10,000 = $2.60
2005
($48,000 – $0) ÷ 10,000 = $4.80
 This large increase in EPS is considered
very unusual.
 5. Marketability Ratios
 The market value ratios relates the firm’s
stock price to its earnings, cash flow, and
book value per share.
 These ratios give management an indication of
what investors think of the company’s past
performance and future prospects.
 If the liquidity, asset management, debt
management, and profitability ratios all look
good, then the market value ratios will be high,
and the stock price will probably be as high as
can be expected.
Earnings per Share (EPS)
 The earning per share is calculated by dividing the
profit after taxes by the total of ordinary shares
outstanding.
 EPS = Profit after taxes
 Number of shares outstanding
 Stylistics’ EPS assuming the company has 10,000 shares
outstanding, dividend of $10,000 and market value per
share of $1000.
 EPS=48,000/10,000=$4.8
 EPS simply shows the profitability of the firm on a
per-share basis
Dividend per Share (DPS)
 DPS is the earnings distributed to ordinary
shareholders divided by the number of shares
outstanding:

 DPS= Earnings paid to shareholders (Dividends)
 Number of ordinary shares outstanding
 For Stylistics’ DPS assuming the company has 10,000
shares outstanding and paid dividend of $10,000
 DPS=10,000/10,000=$1.00
Dividend-Payout Ratio
 The dividend payout ratio or simply payout
ratio is DPS (total equity dividends) divided by
the EPS (profit after taxes):

 DPR = Equity dividends = Dividends per share
Profit after taxes earning per share
 The retention ratio-1-DPR
 For the DPR=1/4.8=0.20,
 That is the company paid 20% of its earnings to
shareholders and retained 80% of it
Price- Earnings Ratio
 PER= Market value per share
Earnings per share
 The price earnings ratio is widely used by the
security analysts to value the firm’s
performance as expected by investors.
 It indicates investors’ judgment or expectations
about the firm’s performance.
 Management is also interested in this market
appraisal of the firm’s performance and will like
to find the causes if the P/E ratio declines.
 Stylistics’ PER assuming the company has 10,000
shares outstanding and market value per share of
$1,000,
 PER=1000/4.8=208.33
 Market value-to-Book value
(MV/BV) Ratio
 Market value-to-book value (M/B) ratio is the
ratio of share price to book value per share:

 M/B ratio = Market value per share
 Book value per share
 Note that, book value per share is net worth
divided by the number of shares outstanding.
 Stylistics’ M/BR assuming the company has market
value per share of $1,000 and Book value of $500 is
 M/BR=1000/500=2.00
 This shows the current market value of a share
twice of its book value
Exercise: Starbucks Corporation Exercise

Net sales (current year ) 9411

Cost of goods sold 3999
Gross profit $5412
Total operating expenses 4466
Operating income $946
Other revenue 110
Income before taxes $ 1056
Income taxes 384
Net income $ 672
 Starbucks Corporation
Comparative Balance sheets
(dollars in Millions)

Assets End year Beginning Year

Current assets:
Cash $ 281 $313
Marketable Securities 157 141
Receivables net 288 224
Inventories 692 636
Other Current assets 278 216
Total current assets $1696 $1530
Plant and equipment, net 2890 2288
Other assets 758 611
Total assets 5344 4429
 Cont…

Liabilities
Current liabilities:
Accounts payable 391 341
Short term bank loans 710 700
Accrued liabilities 757 662
Other current liabilities 398 233
Total current liabilities $ 2156 1936
Long-term debt 904 265
Total liabilities $3060 2201
Cont…
Stockholders’ Equity
Common stock, no par $40 40
Retained earnings 2244 2188
Total stockholders’ equity $2284 2228
Total liabilities and
stockholders’ equity $5344 4429
 Required: Compute the following

 Based on the information given above

compute all types of ratios for the
company, and interpret them
Textbook and Reading
Williams, Haka, Bettner and Carcello, Financial
and Managerial Accounting -The Basis for Business
Decisions; 18th edition, Tata McGraw-Hill Edition

Thank you so much