MS4004

Lecture 2
Dr. K. D. N. Kumari
Contents

• Introduction
• Parameters
• Purpose
• Interested Parties
• Limitations
• Tools for Financial Statement Analysis

2
Main objectives of a business organization
Survival

Sales Revenue maximization

Profit

Growth

Increase the shareholders value

MS4004: Statement Analysis 3

Survival
• During early stage
of the business
• When trading
becomes difficult
• Threat of takeover

MS4004: Statement Analysis 4

 Financial Statement Analysis( FSA)
• is the process of reviewing and
analyzing a company’s financial
Introductio statements to make better
n economic decisions.
• asses the financial health and
performance of the company
Balance Sheets
Income Statements
Cash Flow Statements
5
 Financ
ia
stabili l
ty
company

define is
di
terms n
o
Liquidity

Solvency
its abi f
lity

Profitability
to
facilita
te
an d
enhan
c
econo e
m
proces ic
ses
manag ,
e
risks, a
nd
absorb
shocks
.
Diagnose following parameters of the

Stability

6
Objectives of Financial Statement Analysis
To Evaluate

• Financial Performance:
is a complete evaluation of a company's overall standing in
categories such as assets, liabilities, equity, expenses, revenue,
and overall profitability.
• Financial Position:
is the current balances of the recorded assets, liabilities, and equity
of an organization.
• Prediction of Future performance

• Operating efficiency

7
 Comparative Analysis

The most popular comparative techniques are ,

8
Intra-company basis

comparison within same company: The

basis compares an item or financial inside
the company in the current year with one
or more prior years

Intracompany comparisons are useful for

finding changes in financial relationship
and discovering trends

9
 • This basis compares an item
of one company with the
Intercompany same item of the other
company(Competitor)
basis • Intercompany comparisons
are useful for understanding
a companies’ competitive
position.

10
Industry averages
Comparison with other companies in the
same industry

This basis compares an item with

industry average value of that item.

These industry averages are determined

and published by financial rating
agencies such as Fitch Rating, ICRA
Lanka Limited and Lanka Rating Agency
Limited.

comparison with industry average gives

the information how well a company is
performing within its industry. 11
Users of Financial Statements

12
• Who are directly involved in
running and managing the
organization.
• Examples: Owners, managers
and employees
• What do internal users use it
for?
Planning, evaluating and
controlling company operations

13
14
 • Who are not directly involved in
running an organization?

• Shareholders/ Investors
• Regulators: often have legal authority
over certain activities of organizations.
• Lenders/Creditors :are individuals or
organizations who loan money or
other valuable resource to an
organization. Examples :Banks and
loans, mortgage and finance
companies are lenders.
• Government/Legislators , regulatory
agencies & stock market analysts
• auditors

What do external users use it for?

 Assessing past performance and current financial position
 Making predictions about the future profitability and solvency
of the company
 Evaluating the effectiveness of management 15
16
17
Limitations • Characteristics of Financial
Statement Analysis
• The useful information must be
relevance and reliable.
• The accounting information should be
comparable and consistent.
Information that lacks either of these
characteristics is considered
insufficient for decision making.
• FSA ignores non-monetary aspect
of the company

18
Methods of
Financial Statement Analysis

Horizontal Analysis(Comparative
Statements )
• Balance Sheet
Vertical Analysis (Common-Size • Income Statement
Statements)
Trend Percentages
Ratio Analysis

Cash Flow Statement

19
Horizontal Analysis

Using
Using comparative
comparative financial
financial
statements
statements to to calculate
calculate dollar
dollar
or
or percentage
percentage changes
changes in in aa
financial
financial statement
statement item
item from
from
one
one period
period to
to the
the next
next

20
Horizontal Analysis Example
The management of ABC Company provides you with
comparative balance sheets of the years ended
December 31, 2018 and 2019. Management asks
you to prepare a horizontal analysis on the
information.

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 ABC CORPORATION
Comparative Balance Sheets
December 31, 2018 and 2019

Increase (Decrease)
2019 2018 Amount %
Assets
Current assets:
Cash $ 125,000 $ 240,000
Accounts receivable, net 595,000 395,000
Inventory 770,000 1,000,000
Prepaid expenses 60,000 12,000
Total current assets 1,550,000 1,647,000
Property and equipment:
Land 400,000 400,000
Buildings and equipment, net 1,200,000 850,000
Total property and equipment 1,600,000 1,250,000
Total assets $ 3,150,000 $ 2,897,000

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Horizontal Analysis Example
Calculating Change in Dollar Amounts ($)

Dollar Current Year Base Year

Change == Figure -– Figure

Calculating Change as a Percentage (%)

Since we are measuring the amount of
Percentage the change between
Dollar Change
Change
= Base Year
2018 and 2019,xthe
Figure
100%
dollar amounts for 2018 become the
“base” year figures.

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 Comparative Income Statements
For the Years Ended December 31, 2018 and 2019
Increase (Decrease)
2019 2018 Amount %
Net sales $ 5,200,000 $ 4,800,000 $ 400,000 8.3
Cost of goods sold 3,600,000 3,150,000 450,000 14.3
Gross margin 1,600,000 1,650,000 (50,000) (3.0)
Operating expenses 1,286,000 1,260,000 26,000 2.1
Net operating income 314,000 390,000 (76,000) (19.5)
Interest expense 64,000 70,000 (6,000) (8.6)
Net income before taxes 250,000 320,000 (70,000) (21.9)
Less income taxes (30%) 75,000 96,000 (21,000) (21.9)
Net income $ 175,000 $ 224,000 $ (49,000) (21.9)

Sales increased by 8.3% while net

income decreased by 21.9%. 24
 ABC CORPORATION
Comparative Income Statements
For the Years Ended December 31, 2018mand 2019
Increase (Decrease)
2019 2018 Amount %
Net sales $ 5,200,000 $ 4,800,000 $ 400,000 8.3
Cost of goods sold 3,600,000 3,150,000 450,000 14.3
Gross margin 1,600,000 1,650,000 (50,000) (3.0)
Operating expenses 1,286,000 1,260,000 26,000 2.1
Net operating income 314,000 390,000 (76,000) (19.5)
Interest expense 64,000 70,000 (6,000) (8.6)
Net income before taxes 250,000 320,000 (70,000) (21.9)
Less income taxes (30%) 75,000 96,000 (21,000) (21.9)
Net income $ 175,000 $ 224,000 $ (49,000) (21.9)

There were increases in both cost of goods sold

(14.3%) and operating expenses (2.1%). These
increased costs more than offset the increase in
sales, yielding an overall decrease in net income. 25
Vertical Analysis: Common-Size Statements

For
For aa single
single financial
financial
statement,
statement, each each item
item
is
is expressed
expressed as as aa
percentage
percentage of of aa
significant
significant total,
total,
e.g.,
e.g., all
all income
income
statement
statement items items areare
expressed
expressed as as aa
percentage
percentage of of sales
sales
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Vertical Analysis Example
The management of Sample Company asks you to
prepare a vertical analysis for the comparative
balance sheets of the company.

27
Trend Percentages

Show
Show changes
changes over
over time
time in
in
given
given financial
financial statement
statement items
items
(can
(can help
help evaluate
evaluate financial
financial
information
information of of several
several years)
years)

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 Trend Percentages Example
Wheeler, Inc. provides you with the following
operating data and asks that you prepare a trend
analysis.
Wheeler, Inc.
Operating Data
2018 2017 2016 2015 2014
Revenues $ 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820
Expenses 2,033 1,966 1,870 1,803 1,701
Net income $ 372 $ 278 $ 242 $ 188 $ 119

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Ratio Analysis

Expression
Expression of of logical
logical relationships
relationships
between
between items
items in in aa financial
financial
statement
statement ofof aa single
single period
period
(e.g.,
(e.g., percentage
percentage relationship
relationship
between
between revenue
revenue andand netnet income)
income)

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