CHAPTER 4

FINANCIAL STATEMENT ANALYSIS PART 1

Financial Statement Analysis

 For forecasting the financial health of the company.
 To identify financial strength and weaknesses.
 Accomplished by:
a) Examining trends in key financial data
b) Comparing financial data across companies
c) Analyzing key financial ratios
 Comparison between actual and expected financial conditions.
o Expected conditions are represented by (1) predetermined standards, (2) past
performance, or (3) competitor’s/industry performance.

Current Concerned about investment income and company’s overall

Shareholders/Owners profitability and stability for continued operation.
Concerned on the stability of operations, earnings, and
Potential Investors dividends with moderate growth or in some cases, rapid
growth and diversification of business.
Concerned on the company’s ability to pay current obligations
Short-Term Creditors
as they mature.
Concerned on the long-term security of interest income and
Long-Term Creditors
on the company’s cash flows to meet continuing financial
commitments.

General Approach to Financial Statement Analysis

1) Background Analysis – start the analysis with an evaluation of the environment (industry, economy,
etc) in which the firm conducts business.
2) Short-term solvency analysis – which refers to the company’s ability to meet near-term demand for
cash and normal operating requirements.
 Indicators of a satisfactory short-term solvency position:
 Favorable credit position
 Satisfactory proportion of cash to the requirements of the current volume
 Ability to pay current debts in the regular course of business
 Ability to extend more credit to customers
 Ability to replenish inventory promptly
3) Capital Structure and long-term solvency analysis – pertains to the evaluation of the amount and
proportion of debt in a firm’s capital structure to know its ability to pay debt. Also used to know the
owner’s financial leverage over the capital (vs debt).
 Indicators of a satisfactory long-term financial position:
 Well-balanced relationship between liabilities and equity
 Effectively employ borrowed funds and equity
 Declare satisfactory amount of dividends to shareholders
 Withstand adverse business conditions
 Engaged in R&D
 Meet long-term liabilities
4) Operating efficiency and Profitability Analysis – is the evaluation of how well assets have been used
by the company in terms of generating revenues and maximizing returns on such assets.
 Indicators of efficient use of resources:
 Ability to earn a satisfactory return on its investment of borrowed funds and equity
 Ability to control operating costs with reasonable limits
 More Investment in assets
5) Other Measures: Quality of Earnings – the objective is to arrive at a performance measure which best
reflects both financial reality and the future operating potential of the economy.
 Reasons to manipulate earnings
 Meet internal earnings target (internal profit or sales target)
 Meet external expectations (economic and industry expectations)
  Even-out Income or Income Smoothing – timing in recognizing revenues and expenses
from one year to another (for credit appeal)
 Window dressing
 Techniques to manage earnings
 Strategic matching – timing transactions so that large one-time gains and losses occur
within the same period resulting in a smooth upward trend in reported earnings
 Change in methods or estimates with little or no disclosure in the notes to the financial
statement
 Deliberate violation of accounting rules
 Deliberate recording of non-existent and fictitious revenue transactions
6) Other Measures: Quality of Assets and Relative Amount of Debt – a look in the composition of assets,
their condition and liquidity, the timing of repayment of liabilities and the total amount of debt
outstanding.
 During a period of significant inflation, financial statements prepared in terms of historical
costs do not reflect fully the economic resources or the real income of a business
organization.
7) Other Measures: Transparent Financial Reporting
 More confidence from investors to place money in the business
 Allows better decision making that reduces risk
 Allows managers to easily access correct financial information needed to make decisions

Steps in Financial Statement Analysis

1) Establish objectives of the analysis
2) Background analysis
3) Develop knowledge of the firm and the quality of management
4) Evaluate financial statements
 Techniques:  Major areas of analysis:
a) Horizontal analysis of comparative a) Short-Term Solvency
statements b) Capital Structure and Long-Term Solvency
b) Trend percentages c) Operating Efficiency and Profitability
c) Common size financial statements d) Segmented Analysis
d) Financial ratios
5) Summarize findings based on analysis and draw conclusions relevant to the objectives

Limitations of Financial Statement Analysis

1) Information derived by the analysis are not absolute measures of performance in any and all of
the areas of business operations. They are only indicators of degrees of profitability and
financial strength of the firm.
2) Limitations inherent in the accounting data.
a) Variation and inconsistent application of accounting rules
b) Too-condensed presentation of data
c) Failure to reflect change in purchasing power
3) Limitations of the performance measures or tools and techniques used in the analysis (averaging
and other quantitative measurement may affect the results).
4) Potential influence of the management on the outcome of the financial statements.

Horizontal Analysis of Comparative Statements

 Significant changes in financial data are easier to see when financial statement amount for two or
more years are placed side by side in adjacent columns expressed in percentages.
 The study of percentage changes in comparative statements is called horizontal analysis.
 Widely used for short-period analysis between two periods or two operating cycles (year).
 Steps:
1) Compute the difference from the earlier year (base year) to the later year (current
year or year being compared).
2) Divide the difference by the base year

Trend Percentages
 Trend percentages are index numbers showing relative changes in financial data resulting with the
passage of time. Trend percentages state several years’ financial data compared to a base year.
 Trend percentages emphasize changes in the financial and operating data between specific periods
and make horizontal analysis and study of comparative financial statement data possible.
 Two-year comparisons are good but longer-term comparisons are better since special
circumstances can distort a two-year comparison. Ex. Sales between 2000 and 2001 is good data
but sales from 2001 to 2010 compared to 2000 is better and see the sales growth and performance
growth of a business.
 Steps:
1) Choose the year to be used as the base year and convert the amount to 100%
(serving as base comparison from other succeeding years) which represents the
normal operating activity of the firm.
2) Compute the percentage relationship from each year to the base year.
3) Compare the trends of related financial and operating data to form an opinion (if
the increase is consistent and what other factors affect the consistency and
inconsistency of the business’ growth).