Financial Statement Analysis

The analysis refers to the application of analytical

tools to the financial statements and related data for
making business decisions.
It involves transforming accounting data into more
useful information
It reduces decision makers reliance on hunches,
guesses, and intuition as well as uncertainty.
It provides an effective and systematic basis for
making business decisions.
Users of Accounting Information
Internal users are those involved in strategically
managing and operating the company. They include
Managers, internal auditors, consultants, budget
directors, and market researchers.
External users are those who are not directly
involved in running the company. They include:
Shareholders, lenders, directors, customers,
suppliers, regulators, brokers, the press, financial
analysts (e.g., Dun & Bradstreet, Moodys, and
Standard & Poors] and others (e.g., the public)
Benchmarks
To make good judgment using the measures
obtained from the analysis. You need to have
some benchmarks for comparisons. They could
be:
Internal to the company.
Competitors performance
Industry averages
general guidelines (rule of thumb)
Tools (Techniques) of Analysis
Horizontal Analysis
Vertical Analysis
Ratio Analysis
Statistical Models
Other Models
Horizontal Analysis
This analysis refers to establishing relations
between numbers, groups of numbers, and
changes in these numbers across time.
Examples include percentage change over
different periods. We calculate the amount of
change (increase or decrease) and divide it by
the amount of the base year.
Assume the following schedule of comparative
current assets of West Corp is available. Year
2012 is the base year. We can calculate the
percentage changes as follows:
Horizontal Analysis (% change)
Dec. 31 Dec. 31 Increase (Decrease) Percentage
2013 2012 Amount Amount Change
Cash 15,000 10,000 5,000 50%
Accounts Receivable 30,000 24,000 6,000 25%
Prepaid Items 8,400 12,000 (3,600) (30%)
Percentage change = difference between two periods/ base period
For example for cash using 2012 as the base period
The difference is 15,000-10,000 = 5,000
The percentage change is =5,000/10,000 = 50%
Vertical Analysis
Vertical analysis evaluates individual financial
item or a group of items in terms of a specific
base amount for the same period.
Examples include Common-size statements
and common-size graphs. For income
statement we express each item as a
percentage of sales. On a balance sheet, we
express each item as a percentage of total
assets.
Solve Exercise 17-3, Problem 17-1A
Ratio Analysis
A ratio expresses a relationship between two
numbers.
Ratios are among the more widely used tools
of financial analysis
Several ratios are used to judge liquidity,
solvency, profitability, and market propspects.
Liquidity Ratios
They include:
Current ratio
Acid-test ratio
Accounts receivable turnover
Inventory turnover
Days sales uncollected
Days sales in inventory
Total asset turnover
Solvency Ratios
They include:
Debt and Equity Ratio
Debt-to-Equity Ratio
Times Interest Earned

Profitability Ratios
They include:
Profit margin
Return on total assets
Return on common stockholders equity
Market Prospects Ratios
They include:
Price-earnings ratio:
Market price per share/EPS
Dividend yield:
Annual Cash Dividends/Market price per share
Solve Problem 17-4A (1,2,3,12, 13,14,16,17)
Use of analyzed Information
Financial statement analyses are essential in a
variety of tasks:
Managing Investments
Managing corporate finance
Commercial lending
Extension of credit
Performance Evaluation

Limitations of Financial Statements
These limitations include
Information relates mainly to historical cost and
does not portray market values of all items
Some assets and liabilities for some firms are not
shown on the balance sheet
Use of alternative accounting methods that require
making adjustments before performing the analysis