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INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS

Financial statement analysis can be referred as a process of understanding the risk

and profitability of a company by analyzing reported financial info, especially annual

and quarterly reports. Putting another way, financial statement analysis is a study

about accounting ratios among various items included in the balance sheet. These

ratios include asset utilization ratios, profitability ratios, leverage ratios, liquidity

ratios, and valuation ratios. Moreover, financial statement analysis is a quantifying

method for determining the past, current, and prospective performance of a company.

Advantages of financial statement analysis

The different advantages of financial statement analysis are listed below:

 The most important benefit if financial statement analysis is that it provides an

idea to the investors about deciding on investing their funds in a particular

company.

 Another advantage of financial statement analysis is that regulatory authorities

like IASB can ensure the company following the required accounting standards.

 Financial statement analysis is helpful to the government agencies in analyzing

the taxation owed to the firm.

 Above all, the company is able to analyze its own performance over a specific time

period.

Limitations of financial statement analysis

In spite of financial statement analysis being a highly useful tool, it also features some

limitations, including comparability of financial data and the need to look beyond

ratios. Although comparisons between two companies can provide valuable clues
about a company’s financial health, alas, the differences between companies’

accounting methods make it, sometimes, difficult to compare the data of the two.

Besides, many a times, sufficient data are on hand in the form of foot notes to the

financial statements so as to restate data to a comparable basis. Or else, the analyst

should remember the lack of data comparability before reaching any clear-cut

conclusion. However, even with this limitation, comparisons between the key ratios of

two companies along with industry averages often propose avenues for further

investigation.

Methods of Financial Statement Analysis are:

1. Horizontal Analysis

2. Vertical Analysis

3. Common-Size Statements

4. Trend Percentages

5. Ratio Analysis

I. HORIZONTAL ANALYSIS

Horizontal analysis of financial statements involves comparison of a financial ratio, a

benchmark, or a line item over a number of accounting periods. This method of

analysis is also known as trend analysis. Horizontal analysis allows the assessment of

relative changes in different items over time. It also indicates the behavior of revenues,

expenses, and other line items of financial statements over the course of time.

Formula: (Current Year – Base Year)/ Base Year

Accounting periods can be two or more than two periods. Accounting period can be a

month, a quarter or a year. It will depend on the analyst’s discretion when choosing an

appropriate number of accounting periods. During the investment appraisal, the


number of accounting periods for analysis is based on the time horizon under

consideration.

Horizontal analysis of financial statements can be performed on any of the item in the

income statement, balance sheet and statement of cash flows. For example, this

analysis can be performed on revenues, cost of sales, expenses, assets, cash, equity

and liabilities. It can also be performed on ratios such as earnings per share (EPS),

price earning ratio, dividend payout, and other similar ratio.

Horizontal analysis can be performed in one of the following two different methods i.e.

absolute comparison or percentage comparison.

 Absolute Comparison:

One way of performing horizontal analysis is comparing the absolute currency

amounts of some items over the period of time. For example, cash in hand at the end

of an accounting period can be compared to other accounting periods. This method is

helpful in identifying the items which are changing the most.

 Percentage Comparison:

In the second method of horizontal analysis, percentage differences in certain items

are compared over a period of time. The absolute currency amounts are converted into

the percentages for the purpose of comparison. For example, a change in cash from

$5,000 to $5,500 will be reported as 10% increase in cash. It can also be reported as

110%, which means that the cash is 110% of the cash at the end of previous

accounting period. This method is useful when comparing performance of two

companies of different scale and size.

II. VERTICAL ANALYSIS


Vertical analysis of financial statements is a technique in which the relationship

between items in the same financial statement is identified by expressing all amounts

as a percentage a total amount. This method compares different items to a single item

in the same accounting period. The financial statements prepared by using this

technique are known as common size financial statements.

This analysis is performed on the income statement as well as the balance sheet.

 Balance Sheet:

When applying this method on the balance sheet, all of the three major categories

accounts (i.e. assets, liabilities, and equity) are compared to the total assets. All of the

balance sheet items are presented as a proportion of the total assets. These

percentages are shown along with the absolute currency amounts. For example,

suppose a company has three assets; cash worth $4 million, inventory worth $7

million and fixed assets worth $9million. The vertical analysis method will show these

as

Formula: Account/Base Account (for Income Statement the base account is Sales, for

Balance Sheet is Total Assets)

Cash: 20%

Inventories: 35%

Fixed Assets: 45%

 Income Statement:

And when applying this technique to the income statement, each of the expense is

compared to the total sales revenue. The expenses are presented as a proportion of

total sales revenue along with the absolute amounts. For example, if the sales revenue

of a company is $10 million and the cost of sales is $6 million, the cost of sales will be

reported as 60% of the sales revenue.


The main advantage of using vertical analysis of financial statements is that income

statements and balance sheets of companies of different sizes can be compared.

Comparison of absolute amounts of companies of different sizes does not provide

useful conclusions about their financial performance and financial position.

Usually the vertical analysis is performed for a single accounting period to see the

relative proportions of different account balances. But it is also useful to perform

vertical analysis over a number of periods to identify changes in accounts over time. It

can help to identify unusual changes in the behavior of accounts. For example, if the

cost of sales has been consistently 45% in the history, then a sudden new percentage

of 60% should catch the attention of analysts. Reasons behind this change should be

investigated and then measures should be taken to bring this percentage back to its

normal level.

III. COMMON-SIZE ANALYSIS

A common-size financial statement is displays line items as a percentage of one

selected or common figure. Creating common-size financial statements makes it easier

to analyze a company over time and compare it with its peers. Using common-size

financial statements helps investors spot trends that a raw financial statement may

not uncover.

IV. TREND PERCENTAGES

Trend analysis is one of the tools for the analysis of the company’s monetary

statements for the investment purposes. Investors use this analysis tool a lot in order

to determine the financial position of the business. In a trend analysis, the financial

statements of the company are compared with each other for the several years after

converting them in the percentage. In the trend analysis, the sales of each year from
the 2008 to 2011 will be converted into percentage form in order to compare them

with each other.

V. RATIO ANALYSIS

Ratio Analysis formulas enable the business owner/manager to spot trends in a

business and to compare its performance and condition with the average performance

of similar businesses in the same industry. To do this compare your ratios with the

average of businesses similar to yours and compare your own ratios for several

successive years, watching especially for any unfavorable trends that may be starting.

Ratio analysis may provide the all-important early warning indications that allow you

to solve your business problems before your business is destroyed by them.

Liquidity Ratios

These ratios indicate the ease of turning assets into cash. They include the Current

Ratio, Quick Ratio, and Working Capital.

Current Ratios. The Current Ratio is one of the best known measures of financial

strength. It is figured as shown below:

Current Ratio = Current Asset / Current Liabilities

The main question this ratio addresses is: "Does your business have enough current

assets to meet the payment schedule of its current debts with a margin of safety for

possible losses in current assets, such as inventory shrinkage or collectable

accounts?" A generally acceptable current ratio is 2 to 1. But whether or not a specific

ratio is satisfactory depends on the nature of the business and the characteristics of

its current assets and liabilities. The minimum acceptable current ratio is obviously

1:1, but that relationship is usually playing it too close for comfort.
If you decide your business's current ratio is too low, you may be able to raise it by:

•Paying some debts.

•Increasing your current assets from loans or other borrowings with a maturity of

more than one year.

•Converting non-current assets into current assets.

•Increasing your current assets from new equity contributions.

•Putting profits back into the business.

Quick Ratios. The Quick Ratio is sometimes called the "acid-test" ratio and is one of

the best measures of liquidity. It is figured as shown below:

Quick Ratio = Quick Assets / Current Liabilities

The Quick Ratio is a much more exacting measure than the Current Ratio. By

excluding inventories, it concentrates on the really liquid assets, with value that is

fairly certain. It helps answer the question: "If all sales revenues should disappear,

could my business meet its current obligations with the readily convertible `quick'

funds on hand?"

An acid-test of 1:1 is considered satisfactory unless the majority of your "quick assets"

are in accounts receivable, and the pattern of accounts receivable collection lags

behind the schedule for paying current liabilities.

List of financial ratios


Working Capital. Working Capital is more a measure of cash flow than a ratio. The

result of this calculation must be a positive number. It is calculated as shown below:

Working Capital = Total Current Assets - Total Current Liabilities

Bankers look at Net Working Capital over time to determine a company's ability to

weather financial crises. Loans are often tied to minimum working capital

requirements.

A general observation about these three Liquidity Ratios is that the higher they are

the better, especially if you are relying to any significant extent on creditor money to

finance assets.

Leverage Ratio

This Debt/Worth or Leverage Ratio indicates the extent to which the business is

reliant on debt financing (creditor money versus owner's equity):

Debt to Equity = Total Debt / Total Equity

Generally, the higher this ratio, the more risky a creditor will perceive its exposure in

your business, making it correspondingly harder to obtain credit.

The following important State of Income statement Ratios measure profitability:


Gross Margin Ratio

This ratio is the percentage of sales dollars left after subtracting the cost of goods sold

from net sales. It measures the percentage of sales dollars remaining (after obtaining

or manufacturing the goods sold) available to pay the overhead expenses of the

company.

Comparison of your business ratios to those of similar businesses will reveal the

relative strengths or weaknesses in your business. The Gross Margin Ratio is

calculated as follows:

Gross Margin Ratio = Gross Profit / Net Sales

(Gross Profit = Net Sales - Cost of Goods Sold)

How to analyze a balance sheet

Net Profit Margin Ratio

This ratio is the percentage of sales dollars left after subtracting the Cost of Goods

sold and all expenses, except income taxes. It provides a good opportunity to compare

your company's "return on sales" with the performance of other companies in your

industry. It is calculated before income tax because tax rates and tax liabilities vary

from company to company for a wide variety of reasons, making comparisons after

taxes much more difficult. The Net Profit Margin Ratio is calculated as follows:

Net Profit Margin Ratio = EBT/ Sales

Management Ratios
Other important ratios, often referred to as Management Ratios, are also derived from

Balance Sheet and Statement of Income information.

Inventory Turnover Ratio

This ratio reveals how well inventory is being managed. It is important because the

more times inventory can be turned in a given operating cycle, the greater the profit.

The Inventory Turnover Ratio is calculated as follows:

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

Accounts Receivable Turnover Ratio

This ratio indicates how well accounts receivable are being collected. If receivables are

not collected reasonably in accordance with their terms, management should rethink

its collection policy. If receivables are excessively slow in being converted to cash,

liquidity could be severely impaired. The Accounts Receivable Turnover Ratio is

calculated as follows:

Accounts Receivable Turnover = Net Sales / Average Accounts Receivable

Days Credit Sales = 365/ ARTO

This measures how efficiently profits are being generated from the assets employed in

the business when compared with the ratios of firms in a similar business. A low ratio

in comparison with industry averages indicates an inefficient use of business assets.

The Return on Assets Ratio is calculated as follows:

Return on Assets = Net Income / Total Assets


Return on Investment (ROI) Ratio.

The ROI is perhaps the most important ratio of all. It is the percentage of return on

funds invested in the business by its owners. In short, this ratio tells the owner

whether or not all the effort put into the business has been worthwhile. If the ROI is

less than the rate of return on an alternative, risk-free investment such as a bank

savings account, the owner may be wiser to sell the company, put the money in such a

savings instrument, and avoid the daily struggles of small business management. The

ROI is calculated as follows:

Return on Investment = Net Income / Investment

These Liquidity, Leverage, Profitability, and Management Ratios allow the business

owner to identify trends in a business and to compare its progress with the

performance of others through data published by various sources. The owner may

thus determine the business's relative strengths and weaknesses.

SUMMARY

To summarize, financial statement analysis is concerned with analyzing the balance

sheet and the income statement of a business to interpret the business and financial

ratios of a business for financial representations, business evaluation, in addition to

financial forecasting.