FINANCIAL STATEMENT ANALYSIS.

COURSE NOTES
Course structure
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2.
3.
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7.
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12.
13.
14.

Financial statement analysis: An Introduction

Understanding the Balance Sheet
Understanding the Income Statement
Assets and liabilities structure analysis
Liquidity analysis
Solvency analysis
Static financial balance analysis
Dynamic financial balance analysis
Asset turnover analysis
Working Capital Requirement elements turnover
analysis
Profitability analysis
Return on invested capital
Risk analysis
Comparative analysis of international financial
statements

Course no. 1
Course no. 2
Course no. 3
Course no. 4
Course no. 5
Course no. 6
Course no. 7
Course no. 8
Course no. 9
Course no. 10
Course no. 11
Course no. 12
Course no. 13
Course no. 14

Tutorials structure
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2.
3.
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11.
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13.
14.

Usefulness of financial statement analysis: case study

Balance sheet analysis
Income statement analysis
Assets and liabilities structure analysis
Liquidity analysis
Solvency analysis
Static financial balance analysis
Dynamic financial balance analysis
Asset turnover analysis
Working Capital Requirement elements turnover analysis
Profitability analysis
Return on invested capital
Risk analysis
Comparative analysis of international financial statements

Seminar nr. 1
Seminar nr. 2
Seminar nr. 3
Seminar nr. 4
Seminar nr. 5
Seminar nr. 6
Seminar nr. 7
Seminar nr. 8
Seminar nr. 9
Seminar nr. 10
Seminar nr. 11
Seminar nr. 12
Seminar nr. 13
Seminar nr. 14

Financial Statement Analysis, Course No. 1

Course No. 1. FINANCIAL STATEMENT ANALYSIS: AN INTRODUCTION

1.1. Definition, purpose and continent of financial statement analysis
Financial statement analysis is a complex activity that uses a system of instruments,
methods and techniques to assess financial position, financial performances and potential of an
enterprise.
Financial position represents a barometer of enterprises policy, reflecting a certain state of
its capital from the perspective of its existence, its use and its generated performance
Data required to carry out a financial analysis have as source financial statements, namely
balance sheet, income statement and other auxiliary documents from the financial report (such as
explanatory notes). Data from other sources is used as well, such sources being end-of-year
management report, forecasted budgets for ended period or for future periods, macroeconomic data
(industry statistics, national economy statistics etc.).
The purpose of financial statement analysis, depending upon the amplitude of the
approach, could be defined in a double manner:
in a limited manner assessment of the enterprise financial diagnosis;
in a broad manner supplying financial information to the enterprises stakeholders, both
from within as well as outside the enterprise.
Delivering financial information to all stakeholders should take into account a set of
professional ethic regulations, an example of sources for such regulations are the corporate
governance codes embraced by certain companies that are listed on financial markets.
The result of financial statement analysis is represented by:
improving financial management performance by providing management with proper
informational support;
financial decision making support (for instance contracting a bank loan, issuing new
shares etc.);
recommending sale or purchase of a companys shares;
analyzing a business partner financial reliability.
Users of financial statement analysis, i.e. the parties interested in a companys financial
position and performance are:
companys management uses information provided by financial statement analysis to base
decision-making in the area of financial decisions;
companys owners (shareholders) want to know the evolution their wealth, objectified by
the proportion of companys equity owned by each of them;
banks provide loans for the company and are interested in the companys reliability as a
business partner and the its capability to repay these loans and corresponding interest;
business partners (clients or suppliers), that change their strategic options depending on
partners financial situation;
labor unions track companys financial situation, considering this a basis for negotiations
regarding wage raises;
public institutions (especially Internal Revenue Service), both local and national, are
interested in companys financial situation because it represents their revenue source and a
means of solving different public issues;
competitors are interested in the companys financial state in order to strengthen their own
market position.
Financial statement analysis could be classified according to several criteria:
Depending upon the moment financial analysis is carried out:


Post-factum analysis represents an investigation of financial situation of the
company during past periods; this kind of analysis is useful only if it indicates
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Financial Statement Analysis, Course No. 1

factors that generated weaknesses in the past that could be limited or eliminated in
the future, as well as factors that lead to strengths in order to maintain their action
during future periods;


Real-time analysis is carried out to asses companys financial situation at any time
in order to take immediate actions when the situation tends to deviate from the
established objectives; in order to carry out such a type of analysis it is required an
up-to-date information system that allows information to be supplied to the analysts
as soon as events happen;


Prospective analysis is undertaken based upon forecasts regarding future periods.
Some opinions expressed in the subject literature consider this type of analysis as
being the most important of them all, as it reflects a proactive attitude of decision
makers towards future challenges that a company will encounter.
According to the time coverage of financial information:


Static analysis studies financial condition of a company at a certain moment in
time, usually based upon the balance sheet data, highlighting the relationship
between different elements and factors that cause a certain position of the company;


Dynamic analysis tackle financial position based upon financial flows data
covering a certain period of time.
According to manner of balance sheet correlations analysis:


Horizontal analysis includes comparisons between assets and liabilities,
highlighting the extent to which fixed and current assets are funded from proper
sources;


Vertical analysis studies the structure of different balance sheet elements,
comparing their value to the value of groups of elements they are part of or to the
total value of assets/liabilities;


Combined analysis mixes the two approaches presented above.
According to the extent to which the essential features or quantitative issues of financial
information are analyzed:


Qualitative analysis pursue the essence of financial phenomena, their basic
features, factors that are of the same nature as the element they cause;


Quantitative analysis implies the examination of financial phenomena by
measuring them in terms of quantity.
Depending on the provenience of the financial analyst:


Internal analysis carried out by specialized personnel from within the company;


External analysis that is carried out by external specialists or institutions (banks,
internal revenue service, consultancy companies etc.).
The content of the financial statement analysis includes:
Asset and liability structure analysis;
Liquidity and solvency analysis;
Financial balance analysis;
Asset management analysis (asset turnover ratios);
Profitability analysis;
Risk analysis.
Each of these components presents a certain perspective of the financial condition of a
company using a set of specialized financial indicators.
Financial statement analysis has a coagulated methodology, which provides certain clear steps
for carrying out an analysis, the most important of which are:
1) Establishment of a purpose and identification of objectives for financial analysis;
2) Selection of the indicator or set of indicators that define best and in the most
realistic and exact fashion the issue that is being analyzed;
3) Collecting and processing information required for analysis:
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Financial Statement Analysis, Course No. 1

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the level, dynamics and structure of the financial issue or indicator that is
being analyzed;
- factor analysis measuring the causal relationship;
4) Companys financial condition diagnosis, identification of strengths and
weaknesses related to the analyzed financial issue or indicator;
5) Devise an improvement measures plan to limit weaknesses and generalize the
strengths.
1.2. The main concepts used in financial statement analysis
Financial statement analysis process development requires use of some specific concepts such
as phenomena, factors, causes, financial indicators.
A phenomenon (from Greek o), is any observable occurrence. Phenomena are
often, but not always, understood as 'appearances' or 'experiences'. From a financial point of view, a
phenomenon is an observable form of financial reality, i.e. those aspects, sides and relations
between financial happenings that could be known by people in a direct way.
An element is one of the simplest or essential parts or principles of which anything consists,
or upon which the constitution or fundamental powers of anything are based. A financial element is
a component of a financial occurrence.
A factor represents that driving force that, in certain circumstances, causes or induces an
occurrence.
A cause is the source or reason of an event or action. Causes directly explain the genesis of a
phenomenon.
Financial indicator a figure that express through numbers an aspect or a group of aspects
that describe a phenomenon, a process or a financial occurrence, defined in time, space and
organizational structure.
Financial indicators could be:
simple or derivate;
analytic or synthetic;
expressed as absolute, relative or average measures.
Absolute measures express quantitatively, from a physical or value perspective, the volume
or the level of certain phenomena. Elements that these measures are based upon should comply with
certain rules: to be homogeneous, to refer to the same period of time etc.
Relative measures allow comparisons between absolute measures in time, space or structure.
These are calculated by dividing the compared value of an absolute measure to the comparison
basis value.
Relative measures have several forms:
structure;
intensity;
correspondence.
Indexes represent one of the most important forms of relative measures. As such, indexes
have several forms:
q
qp
simple indexes: quantitative ( I1 / 0 = 1 100 ) or value ( I1 / 0 = 1 1 100 );
q0
q0p0

group indexes: quantitative ( I1 / 0 =

fixed basis indexes ( I t / 0 =

q
q

100 ) or value ( I1 / 0 =

q p
q p

1 1

100 );

Yt
Y
100 ) and chain-based indexes ( I t / t 1 = t 100 );
Y1
Yt 1

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Financial Statement Analysis, Course No. 1

special forms of indexes: rhythm of variation ( R = n

Yn
), rhythm of growth
Y0

( r = n r1 r2 r3 ... rn or r = R 1 ).
Average measures are used to synthesize in specific elements individual levels, so that
generalizations could be made to describe the aggregate. Their calculation is based on the principle
of reciprocal compensation between positive and negative influences of non-essential factors, so
that the influence of essential factors could be emphasized.
Averages could be arithmetic, geometric, harmonic, quadratic etc. and could be calculated as
simple or weighted averages.
Averages have different methods of calculations if one refers to string of intervals are
moments. Thus, for string of intervals, constituted form simple cumulative flow measures the
n
n
1 n
average is calculated this way: x 1 + x 2 + x 3 + ... + x n = x i , X = x i n X = x i ,
n i=1
i =1
i =1
In case each of xi characteristic has a certain frequency of occurrence ni, the calculation
method used is weighted arithmetic average:
1 k
X= k
xi .

i =1
ni
i =1

For string of moments, that are stock measures and cannot be cumulated, the average is
calculated using the first and the last value of the string:
y + yt
Y = t 1
.
2
1.3. The main methods used by financial statement analysis
1.3.1. Division
The financial reality is extremely complex, so that it is difficult to study it as a whole. In order
to overrun this inconveniency, financial analysts use the method of division, which allows studying
the financial phenomena by understanding their structure, their basic elements.
The use of this method implies separating the contribution of each factor to make the whole,
expressing the global change of the analyzed phenomenon in its constituent parts and, as well,
pinpointing in space and time the source and causes of these components.
A phenomenon could be decomposed using several criteria, such as:
1. division by time of financial phenomena genesis (semesters, trimesters, months, days, hours)
has the purpose of identifying the contribution of different time units to the whole;
2. division by place of phenomena formation (plant, department, workshop, workplace) has the
purpose of highlighting the degree to which each place contributed to the analyzed aspect.
This type of division is used to indicate at each place the correlation between the effect
yielded and the resource allocated;
3. division by parts and components specific to the analyzed phenomenon (for instance: assets
could be divided into fixed and current, short term liabilities into financial and operational
etc.)
1.3.2. Comparison
No judgments related to analyzed issues could be made without a standard or a basis of
comparison. Any financial performance could not be assessed without a reference value that is
considered as such, even if it was established statistically (empirically).
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Financial Statement Analysis, Course No. 1

Based upon the criterion which it is made by, there are several types of comparisons:
time comparisons a phenomenon is compared in different moments of its evolution;
space comparisons between the analyzed enterprise and similar enterprises;
mixed comparisons (time and space);
comparisons with a previously established level: programs, regulations, standards, contract
clauses etc.

1.3.3. Chain substitution method

This technique is used to analyze in case of deterministic relationships that take the
mathematical form of multiplication or division.
The method is based upon successive variation of factors specific to the analyzed
phenomenon.
This use of this method implies applying several rules:
1. the factors are arranged according to the criterion of economic conditioning: the factors
classified as quantitative, structural and qualitative;
2. substitutions are made successively, beginning from quantitative factors, following
structural factors and ending with qualitative factors;
3. a substituted factor is maintained at current level in all the following substitutions.
These rules are conventional, they resulted and have been accepted by economic and financial
theory and practice based upon applicative experiments.
a) Product
R = a bc
( Fs = N t s h , where: Fs total wage expense of the company; N - average number of
personnel; t - average annual amount of man-hours per person; s h - average hourly wage)
data from period considered as basis for comparison: R = a 0 b 0 c 0
data from the current period:
R = a 1 b1 c1
The global change of the financial indicator:
R
R = R 1 R 0 = a 1 b1 c1 a 0 b 0 c 0 ; I R = I R 100; I R = 1
R0
Each factor influence calculation:
a b c
R a = a 1 b 0 c 0 a 0 b 0 c 0 ; I R = 1 0 0 100 100 = I a 100
a 0 b 0 c0
a b c
a b c
I I
R b = a1 b1 c 0 a1 b 0 c0 ; I R = 1 1 0 100 1 0 0 100 = a b I a
a1 b0 c0
a 0 b0 c0
100
a b c
I I I I I
a b c
R c = a 1 b1 c1 a 1 b1 c 0 ; I R = 1 1 1 100 1 1 0 100 = a b 2 c a b
a 1 b1 c 0
a1 b 0 c0
100
100
Relative change of the analyzed indicator:
R
R
I R = 1 100; I R = 1 100 100 = I R 100
R0
R0
R a
I R a =
100
R0
R R0
R b
R
I R = 1
100 =
100
I R b =
100
R0
R0
R0
R c
I R c =
100
R0

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Financial Statement Analysis, Course No. 1

b) Division
a
a
a
R= ;
R = 1 0 = R 1 R 0
b
b1 b 0
Taking into account the principles of chain substitution and especially the fact that
substitution should begin with the quantitative factor, the calculation of each factors contribution to
total change of the indicators depends upon the place the factor holds within the mathematical
expression.
b1) The quantitative factor is dividend:
a
a a
a
a
a
R b = 1 1
R a = 1 0 = 1 0 ;
b0 b0
b0
b1 b 0
b1) The quantitative factor is devisor:
a
a
a a
R b = 0 0 ;
R a = 1 0
b1 b 0
b1 b1
1.3.4. Balance method
This method is used to measure the influence of different factors upon the change of certain
phenomena expressed by mathematical expressions of sum of subtraction, or that combines the two:
F=a+bc
F = F1 F0 = (a1 + b1 c1 ) (a 0 + b0 c0 )
a) influence generated by factor a change:
F(a ) = (a1 + b0 c0 ) (a 0 + b0 c0 ) = a1 a 0

b) influence generated by factor b change:

F( b) = (a1 + b1 c0 ) (a1 + b0 c0 ) = b1 b0

c) influence generated by factor c change:

F(c) = (a1 + b1 c1 ) (a1 + b1 c0 ) = (c1 c0 )

1.3.5. Ratio method

A ratio represents a comparison by division between two deferent financial measures
(indicators), which are logically and financially comparable ant that emphasizes some aspects of a
companys activity or its results. The result of the division expressed by a number, percentage or
time duration and allows the following:
- highlight some aspects that could not have been made obvious through separate analysis
of the two measures used to forma ratio;
- make some time, space or mixed comparisons;
- forecasting companys activity either in part or as a whole;
- synthetic assessment of companys activity.
The practical use of the method should take into account certain rules that a ration shall
comply with:
- to be financially meaningful;
- ratios calculated for several successive periods should be compatible between
themselves;
- compared enterprises should be from similar industries and have similar size;
- to bare informational value greater that the two separate indicators that form it taken
independently.
Depending of the analysis purpose, financial ratios could be:
- asset and liability structure ratios;
- liquidity and solvency ratios;
- turnover ratios;
- profitability and return ratios.
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