EXC 3451

Financial Statement Analysis

Basics of financial statement analysis

Every item reported in a financial statement has significance.

Various analytical techniques are used to evaluate the

significance of financial statement data.

Basics of financial statement analysis

Analyzing financial statements involves:

Characteristics

Comparison
Bases

Tools of
Analysis

Liquidity

Intracompany

Horizontal

Profitability

Vertical

Solvency

Industry
averages

Ratio

Intercompany

Basics of financial statement analysis

Analyzing financial statements involves evaluating 3
characteristics:
1. Liquidity: ability of a firm to pay its financial
obligations when they come due.
2. Profitability: indicates the ability if a firm to survive
over a long period of time.
3. Solvency: the ability of a firm to meet its longterm financial obligations

Basics of financial statement analysis

Tools of analysis:
Horizontal analysis: evaluates a series of financial statements
over time. Used primarily in intracompany comparisons.
Vertical analysis: evaluates financial statement data by
expressing each financial item as a percentage of a base
amount. Used in both intra- and intercompany analysis.
Ratio analysis: expresses the relationship among selected items
of financial statement data. Used in intra- and inter company as
well as in industry average comparisons.

Horizontal analysis
Horizontal analysis, also called trend analysis, is a technique for
evaluating a series of financial statement data over a period of time.

Purpose is to determine the increase or decrease that has taken

place.

Commonly applied to the statement of financial position,

income statement, and retained earnings statement.

Horizontal analysis
Illustration 14-5
Horizontal analysis of
statements of financial
position

Changes suggest that the

company expanded its
asset base during 2014
and financed this
expansion primarily by
retaining income rather
than assuming additional
long-term debt.

Horizontal analysis
Illustration 14-6
Horizontal analysis of
Income statements

Overall, gross profit and net

income were up
substantially. Gross profit
increased
17.1%, and net income,
26.5%. Qualitys profit trend
appears favorable.

Horizontal analysis

Illustration 14-7
Horizontal analysis
of
retained earnings
statements

In the horizontal analysis of the statement of financial position the

ending retained earnings increased 38.6%. As indicated earlier, the
company retained a significant portion of net income to finance
additional plant facilities.

Horizontal analysis
EXERCISE: Summary financial information for Rosepatch Company is
as follows:
December 31, 2014
Property, Plant and Equipment

December 31, 2013

300,000 $

250,000

Current assets

100,000

76,500

Total assets

400,000

326,500

Compute the amount and percentage changes in 2014 using horizontal

analysis, assuming 2013 is the base year.

Vertical analysis
Vertical analysis, also called common-size analysis, is a
technique that expresses each financial statement item as a
percent of a base amount.

On an income statement, we might say that selling expenses

are 16% of net sales.

On a statement of financial position, we might say that current

assets are 22% of total assets.

Vertical analysis is commonly applied to the statement of

financial position and the income statement.

Vertical analysis
Illustration 14-8
Vertical analysis of
statements of financial
position

These results reinforce

the earlier observations
that Quality is
choosing to finance
its growth through
retention of earnings
rather than through
issuing additional
debt.

Vertical analysis
Illustration 14-9
Vertical analysis of
Income statements

Quality appears
to be a profitable
enterprise that is
becoming even more
successful.

Vertical analysis
Enables a comparison of companies of different sizes.

Illustration 14-10
Intercompany income
statement comparison

Vertical analysis

Lets solve together problem 14-1 a):

Net sales

Lionel Company
2014
2013
$1,549,035

Barrymore Company
2014
2013
$339,038

Costs of goods sold

1,053,345

237,325

Operating expenses

278,825

77,979

7,745

2,034

61,960

8,476

Interest expense
Income tax expense
Plant assets (net)

596,920

575,610

142,842

128,927

Current assets

401,584

388,020

86,450

82,581

Share capital-ordinary, $5 par

578,765

578,765

137,435

137,435

Retained earnings

252,224

225,358

55,528

47,430

Non-current liabilities

102,500

84,000

16,711

11,989

65,015

75,507

19,618

14,654

Current liabilities

a) Prepare a vertical analysis of the 2014 income statement and statements of

financial position data for both firms.

Ratio Analysis
Ratio analysis expresses the relationship among selected items
of financial statement data.
We can express them as:
Percentage (74%)
Rate (0.74)
Proportion (.74:1)

A ratio on its own does not mean much. We can use them:
Intracompany comparisons
Industry average comparisons
Intercompany comparisons

Ratio Analysis
Financial Ratio Classifications

Liquidity
Measure short-term
ability of the
company to pay its
maturing obligations
and to meet
unexpected needs
for cash.

Profitability
Measure the
income or operating
success of a
company for a
given period of
time.

Solvency
Measure the ability
of the company to
survive over a long
period of time.

Ratio Analysis: Liquidity ratios

Measure the short-term ability of the company to pay its
maturing obligations and to meet unexpected needs for cash.

Short-term creditors such as bankers and suppliers are

particularly interested in assessing liquidity.

Ratios include the current ratio, the acid-test ratio,

receivable turnover, and inventory turnover.

Ratio Analysis: Liquidity ratios

What does this mean? Ratio of 2.96:1 means that for every dollar of current
liabilities, Quality has $2.96 of current assets.

Any trend analysis should be done with care because the ratio is susceptible to quick
Changes and is easily influenced by management.

Ratio Analysis: Liquidity ratios

Ratio Analysis: Liquidity ratios

Acid-Test ratio measures immediate liquidity.

Ratio Analysis: Liquidity ratios

We can measure liquidity by how quickly a firm can convert certain assets to cash.
Accounts receivable turnover measures the number of times, on average, the company
collects receivables during the period.
Unless seasonal factors are significant, average net accounts receivable can be
computed from the beginning and ending balances of the net accounts receivables.

Ratio Analysis: Liquidity ratios

A variant of the Accounts Receivable Turnover ratio is to convert it to
an average collection period in terms of days.
365 days / 10.2 times = every 35.78 days

Receivables are collected every 35.78 days

Ratio Analysis: Liquidity ratios

Measures the number of times, on average, the inventory is sold during

the period.
A variant of inventory turnover is the days in inventory.
365 days / 2.3 times = every 159 days

Inventory turnover ratios vary considerably among industries.

Ratio Analysis: Profitability ratios

Measure the income or operating success of a company for a
given period of time.

Income, or the lack of it, affects the companys ability to obtain

debt and equity financing, liquidity position, and the ability to
grow.

Ratios include the profit margin, asset turnover, return on

assets, return on ordinary shareholders equity, earnings per
share, price-earnings, and payout ratio.

Ratio Analysis: Profitability ratios

Measures the percentage of each dollar of sales that results in net income.
High inventory turnover businesses, such as grocery stores, generally
experience low profit margins. Low inventory turnover businesses, have high
profit margins.

Ratio Analysis: Profitability ratios

Measures how efficiently a company uses its assets to generate

sales.
Asset turnover ratios vary considerably among industries.

Ratio Analysis: Profitability ratios

How many dollars of profit can we generate for every dollar invested
in assets?

Ratio Analysis: Profitability ratios

Shows how many euros of net income the company earned for each
euro invested by the owners.
Why is ROE>ROA in this case? Leverage.

Ratio Analysis: Profitability ratios

How much net income has been earned on each ordinary share?

It is meaningless to compare EPS with other firms because it

depends on the number of shares outstanding. The only meaningful
comparison is intracompany.

Ratio Analysis: Profitability ratios

What does the market think about the firms future earnings?

Ratio Analysis: Profitability ratios

It measures the percentage of earnings distributed in the form of

cash dividends.
High growth firms tend to have low payout ratios. Why?

Ratio Analysis: Solvency ratios

Solvency ratios measure the ability of a company to
survive over a long period of time.
Long-term creditors and shareholders are particularly
interested in a companys ability to pay interest as it
comes due and to repay the face value of debt at
maturity.

Ratio Analysis: Solvency ratios

Measures the percentage of the total assets that creditors provide.

It indicates the firms leverage.
It has a direct influence on risk, which at the same time has an impact
on the shareholders required rate of return.
On one side interest on debt is tax deductible, on the other, it increases
the risk of the firm. This is the basis of the trade-off theory of capital
structure (Kraus and Litzenberger, 1973).
Stable earnings usually are connected to higher leverage. Why?

Ratio Analysis: Solvency ratios

Provides an indication of the companys ability to meet interest

payments as they come due.

Ratio analysis

Lets solve together problem 14-1 b):

Net sales

Lionel Company
2014
2013
$1,549,035

Barrymore Company
2014
2013
$339,038

Costs of goods sold

1,053,345

237,325

Operating expenses

278,825

77,979

7,745

2,034

61,960

8,476

Interest expense
Income tax expense
Plant assets (net)

596,920

575,610

142,842

128,927

Current assets

401,584

388,020

86,450

82,581

Share capital-ordinary, $5 par

578,765

578,765

137,435

137,435

Retained earnings

252,224

225,358

55,528

47,430

Non-current liabilities

102,500

84,000

16,711

11,989

65,015

75,507

19,618

14,654

Current liabilities

b) Comment on the relative profitability of the companies by computing the

ROA and the ROE for both firms..