Lecture

Financial Accounting
Financial statement
analysis
Comparisons can be made on a number of
different bases.
1. Intracompany basis.
 Comparisons within a company are often useful to
detect changes in financial relationships and
significant trends. For example, a comparison of
M&S’s current year’s cash amount with the prior
year’s cash amount shows either an increase or a
decrease. Likewise, a comparison of M&S’s year-
end cash amount with the amount of its total assets
at year-end shows the proportion of total assets in
the form of cash
Cont…
2. Industry averages.
Comparisons with industry averages provide
information about a company’s relative position
within the industry. For example, financial statement
readers can compare M&S’s financial data with the
averages for its industry compiled by financial rating
organizations such as the U.S. companies Dun &
Bradstreet, Moody’s, and Standard & Poor’s, or within
formation provided on the Internet by organizations
such as Yahoo! on its financial site.
Cont…
3. Intercompany basis.
 Comparisons with other companies provide insight
into a company’s competitive position. For example,
investors can compare M&S’s total sales for the year
with the total sales of its competitors in retail
Tools of Analysis
We use various tools to evaluate the significance of
financial statement data. Three commonly used tools
are as follows.
• Horizontal analysis evaluates a series of financial
statement data over a period of time.
• Vertical analysis evaluates financial statement data
by expressing each item in a financial statement as a
percentage of a base amount.
• Ratio analysis expresses the relationship among
selected items of financial statement data.
Horizontal analysis
Horizontal analysis, also called trend analysis, is a
technique for evaluating a series of financial statement
data over a period of time. Its purpose is to determine
the increase or decrease that has taken place.
Exercise
Vertical analysis
Vertical analysis, also called common-size analysis, is
a technique that expresses each financial statement
item as a percentage of a base amount. On a statement
of financial position, we might say that current assets
are 22% of total assets total assets being the base
amount.
Ratio Analysis
Liquidity Ratios
Measure short-term ability of the company to
pay its maturing obligations and to meet unexpected
needs for cash.
Profitability Ratios
Measure the income or operating success of a
company for a given period of time.
Solvency Ratios
Measure the ability of the company to survive
over a long period of time.
Liquidity Ratio
1. CURRENT RATIO
The current ratio is a widely used measure for valuating a
company’s liquidity and short-term debt-paying ability.
The ratio is computed by dividing current assets by
current liabilities.
Cont…
2. ACID-TEST RATIO
The acid-test (quick) ratio is a measure of a
company’s immediate short-term liquidity. We
compute this ratio by dividing the sum of cash, short-
term investments, and net receivables by current
liabilities.
Cont…
3. ACCOUNTS RECEIVABLE TURNOVER
We can measure liquidity by how quickly a
company can convert certain assets to cash. How
liquid, for example, are the receivables? The ratio used
to assess the liquidity of the receivables is the accounts
receivable turnover.
Cont….
AVERAGE COLLECTION PERIOD
A popular variant of the accounts receivable turnover
ratio is to convert it to an average collection period in
terms of days. To do so, we divide the accounts
receivable turnover ratio into 365 days.
4. INVENTORY TURNOVER
Inventory turnover measures the number of
times, on average, the inventory is sold during the
period. Its purpose is to measure the liquidity of
the inventory.
Cont…
DAYS IN INVENTORY
We calculate it by dividing the inventory turnover into
365.
Profitability Ratio
Profit margin:
Ability to earn profit generated from sales
 Ability to control costs, expenses
How many %profit left after paying cost of goods sold
 Higher = good control of cost of goods sold
 Lower = cost of goods sold are too high
Cont…
ASSE T TURNOVER
Asset turnover measures how efficiently a company
uses its assets to generate sales. It is determined by
dividing net sales by average assets
Cont…
RETURN ON ASSETS
An overall measure of profitability is return on assets.
We compute this ratio by dividing net income by
average assets.
Cont….
RETURN ON ORDINARY SHAREHOLDERS’
EQUITY
It measures profitability from the ordinary
shareholders’ viewpoint. This ratio shows how many
euros of net income the company earned for each euro
invested by the owners.
Cont…
EARNINGS PER SHARE (EPS)
Earnings per share (EPS) is a measure of the net income
earned on each ordinary share.
Solvency Ratios
Solvency ratios measure the ability of a company to
survive over a long period of time.
DEBT TO TOTAL ASSETS RATIO
The debt to total assets ratio measures the percentage of
the total assets that creditors provide. We compute it by
dividing total debt (both current and noncurrent
liabilities) by total assets.
CONT…
TIMES INTEREST EARNED
Times interest earned provides an indication of the
company’s ability to meet interest payments as they
come due.

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Financial Accounting

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