Fundamentals of financial statement analysis. (Lecture 1)

1.

LECTURE 1. FUNDAMENTALS OF
FINANCIAL STATEMENT ANALYSIS
Olga Uzhegova, DBA
2015
Brooks, Raymond. 2010. Financial management : core concepts. 1st ed, The
Prentice Hall series in finance. Boston: Prentice Hall. (Chapters 2, 14)
FIN 3121 Principles of Finance

2. LEARNING OBJECTIVES

Understand and conduct horizontal analysis
Create, understand, and interpret common-size
financial statements.
Calculate and interpret financial ratios.
Compare different company performances, using
financial ratios, historical financial ratio trends, and
industry ratios.

3.

I. Overview of Financial Statements
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4. TYPES OF FINANCIAL STATEMENTS

T Y P E S O F F I N A N C I A L S TAT E M E N T S
• Balance Sheet
• Income Statement
• Statement of Cash Flows
• Statement of Changes in the Owner’s Equity
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5. BALANCE SHEET

Statement of financial position
Assets
=
Statement of financial Condition
Liabilities
+
Equity
The balance sheet provides a snapshot of a firm’s
financial position at a particular date.
assets ≡ liabilities + owners’ equity
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6. INCOME STATEMENT (P/L STATEMENT)

It is also known as Profit/Loss Statement, Operating Statement,
or Statement of Operations
It measures the results of firm’s operation over a specific period.
The bottom line of the income statement shows the firm’s
profit or loss for a period.
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7. INCOME STATEMENT (P/L STATEMENT)

Total Sales / Revenues
Cost of Goods Sold (COGS)
=
Gross Profit
Operating Expenses
=
Operating Income
+/Other Income/Other expenses
=
Earnings before Interest and Taxes ( EBIT)
+/Interest Income / Interest Expenses
=
Earnings Before Taxes (EBT) or Pre-Tax Income
Taxes
=
Net Income
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8. CASH FLOWS STATEMENT

Cash flows from Operations
+
Cash flows from Investments
+
Cash flows from Financing
=
Net change in cash
Cash Flows Statement shows:
how cash was generated, and
how it was used.
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9. STATEMENT OF OWNER’S EQUITY

Statement of Changes in the Owner’s Equity is a financial statement
that presents a summary of the changes in owners’ equity accounts over
the reporting period. It reconciles the opening balances of equity accounts
with their closing balances.
Figures used to compile this statement are derived from previous and
current Balance Sheets and from the current Income Statement.
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10.

Stockholders’ (Owners’) Equity accounts
Owners’ claims to the assets of a corporation
Common Stock
Owners’ investment in the corporation
through the ownership of stock
Retained
Earnings
Net income (loss) earned over the
company’s lifetime, minus dividends
Dividends
Distribution to stockholders

11.

Stockholders’ (Owners’) Equity accounts
Owners’ claims to the assets of a corporation
Revenues
Expenses
Increase in stockholders’ equity from
delivering goods or services to customers
(revenues are embedded in Balance
sheet through Retained earnings and
classified as Income statement accounts)
Decrease in stockholders’ equity due to
the cost of operating the business
(expenses are embedded in Balance
sheet through Retained earnings and
classified as Income statement accounts)

12.

(1) Increases in stockholders’ equity: Sale of stock and net
income (revenue greater than expenses).
(2) Decreases in stockholders’ equity: Dividends and net
loss (expenses greater than revenue).

13.

II. ANALYSIS OF FINANCIAL STATEMENTS
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14. APPROACHES TOWARDS FINANCIAL ANALYSIS

To conduct financial analysis it is possible to
1.
Compare actual with budgeted values
2.
Compare a firm’s current performance against that of its own performance
(and/or of the performance of other companies in the industry) over a certain time
period by looking at the growth (decline) rate in various key items such as sales,
costs, and profits (trend analysis). Once trends are established, future
performance could be predicted.
3.
Recast the income statement and the balance sheet into common-size
statements by expressing each income statement item as a percent of sales and
each balance sheet item as a percent of total assets.
4.
Conduct ratio analysis. This allows for more in-depth diagnosis through
individual item analyses and comparisons
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Setting up a standard of comparison is a benchmarking.

15. PERFORMANCE ANALYSIS: BUDGETED VS. ACTUAL

Favourable Variance
Unfavourable Variance
Budgeted
Actual
Budgeted
Actual
Revenue
$ nnn
$ NNN
$ NNN
$ nnn
Expenses
$ NNN
$ nnn
$ nnn
$ NNN
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16. PERFORMANCE ANALYSIS: BUDGETED VS. ACTUAL

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17.

HORIZONTAL (TREND) ANALYSIS
Type 1: Percentage changes from year-to-year
Two steps:
1. Compute dollar (or any currency) amount of change
from one period to the next
2. Divide dollar (or any currency) amount of change by
base-period amount

18.

Illustration: Amazon.com, Inc.
Amazon.com’s net sales (in millions) increased by 27.1%
during 2012, computed as follows:
Step 1 Compute the dollar amount
of change from 2011 to 2012
Step 2 Percentage change for the period

19.

Illustration: Amazon.com, Inc.
Comparative Consolidated Statements of Operations—Horizontal Analysis
(partial exhibit)

20.

Illustration: Amazon.com, Inc.
Consolidated Balance Sheets—Horizontal Analysis (partial exhibit)

21.

Illustration
Prepare a horizontal analysis of the comparative income
statements of Ama Music Co.

22.

HORIZONTAL (TREND) ANALYSIS
Type 2: Trend Percentages
Base year selected and set equal to 100%
Amount of each following year stated as a percent of
base

23.

HORIZONTAL (TREND) ANALYSIS
Type2: Trend Percentages
Amazon.com, Inc., showed income from operations as follows:
Trend percentages are computed by dividing each successive
year’s amount by the 2008 amount

24. HORIZONTAL (TREND) ANALYSIS

• Type 3: Used to find an average growth (declining)
rate and to find an expected value of an account

25. HORIZONTAL (TREND) ANALYSIS

• Cogswell Cola’s Abbreviated Income Statements ($ in
thousands)

26.

VERTICAL ANALYSIS
Shows relationship of a financial-statement item to its
base
Income statement, base is total revenue
Balance sheet, base is total assets

27.

Illustration: Amazon.com, Inc.
Comparative Consolidated Statements of Operations—Vertical Analysis (partial
exhibit)

28.

Illustration: Amazon.com, Inc.
Consolidated Balance Sheets—Vertical Analysis (partial exhibit)

29.

COMMON-SIZE FINANCIAL STATEMENTS
Type of vertical analysis
Report only percentages (no dollar amounts)
Assists in the comparison of different companies
Expresses financial results in terms of a common
denominator

30.

Calculate the common-size percentages
for the following income statement:

31. FINANCIAL RATIO ANALYSIS

F I N A N C I A L R AT I O A N A LY S I S
Financial ratios are relationships between different
accounts from financial statements (due to this they are
relative values)
Financial ratios allow for meaningful comparisons across
time, between competitors, and with industry averages.
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32. FINANCIAL RATIO ANALYSIS

F I N A N C I A L R AT I O A N A LY S I S
Firm’s performance can be analyzed by using five key sets
of financial ratios:
1. Profitability ratios: How well has the company performed
overall?
2. Liquidity ratios: Can the company meet its obligations over
the short term?
3. Solvency ratios (also known as financial leverage ratios): Can
the company meet its obligations over the long term?
4. Activity ratios are designed to show how effectively a
company employs the resources
5. Investment Valuation Ratios / Market value ratios: How does
the market (investors) view the company’s financial prospects?
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33. PROFITABILITY RATIOS

P R O F I TA B I L I T Y R AT I O S
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34. NET INCOME AS A % OF SALES (NET PROFIT MARGIN)

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35. RETURN ON ASSETS (ROA)

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36.

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37. RETURN ON EQUITY (ROE)

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38.

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39. LIQUIDITY RATIOS / SHORT-TERM SOLVENCY RATIOS

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40. CURRENT RATIO

C U R R E N T R AT I O
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41. QUICK RATIO OR ACID RATIO TEST

Q U I C K R AT I O O R AC I D R AT I O T E S T
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42. SOLVENCY RATIOS / FINANCIAL LEVERAGE RATIOS

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43. FINANCIAL LEVERAGE RATIOS

F I N A N C I A L L E V E R A G E R AT I O S
Financial Leverage
Ratios
Company A
Company B
Debt Ratio
0.6042
0.6398
Times Interest Earned
28.3483
6.8879
Cash Coverage
34.5955
9.7757
In the area of financial leverage, Company A is in a much better
position than Company B, since it has relatively less debt and a
significantly greater ability to cover its interest obligations by using
either its EBIT (times interest earned ratio) or its net cash flow43(cash
coverage ratio).

44.

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45. ACTIVITY / ASSET MANAGEMENT RATIOS

These ratios measure how efficiently a firm is using its
assets to generate revenues or how much cash is being
tied up in other assets such as receivables and inventory.
Total Assets Turnover Ratio
Fixed Asset Turnover Ratio
Inventory Turnover
Account Receivable Turnover
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46. TOTAL ASSETS TURNOVER RATIO / MANAGEMENT EFFICIENCY RATIO

TOTA L A S S E T S T U R N O V E R R AT I O /
M A N A G E M E N T E F F I C I E N C Y R AT I O
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47. FIXED ASSET TURNOVER RATIO

F I X E D A S S E T T U R N OV E R R AT I O
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48. INVENTORY TURNOVER

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49. INVENTORY TURNOVER

A lower inventory turnover ratio may be an indication of over-stocking
which may pose risk of obsolescence and increased inventory holding
costs.
A very high value of this ratio may be accompanied by loss of sales due to
inventory shortage.
Inventory turnover is different for different industries. Businesses which
trade perishable goods have very higher turnover compared to those
dealing in durables. Hence a comparison would only be fair if made
between businesses of same industry.
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50. INVENTORY TURNOVER

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51. INVENTORY TURNOVER

A low turnover is usually a bad sign because products tend to
deteriorate as they sit in a warehouse.
Companies selling perishable items have very high turnover.
For more accurate inventory turnover figures due to fluctuation
in the level of inventory throughout the year, the average
inventory figure [(beginning inventory + ending inventory)/2] is
used when computing inventory turnover. Average inventory
accounts for any seasonality effects on the ratio.
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52. RECEIVABLE TURNOVER

R E C E I VA B L E T U R N O V E R
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53. RECEIVABLE TURNOVER

R E C E I VA B L E T U R N O V E R
Accounts receivable turnover measures the efficiency of a business in
collecting its credit sales. Generally a high value of accounts receivable
turnover is favorable and lower figure may indicate inefficiency in
collecting outstanding sales. Increase in accounts receivable turnover
overtime generally indicates improvement in the process of cash
collection on credit sales.
However, a normal level of receivables turnover is different for different
industries. Also, very high values of this ratio may not be favourable, if
achieved by extremely strict credit terms since such policies may repel
potential buyers.
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54. RECEIVABLE TURNOVER

R E C E I VA B L E T U R N O V E R
Example: Total sales of Company A during the year ended
December 31, 2013 were $984,000. Customers returned goods
invoiced at $31,400 during the year. Average accounts
receivable during the period were $23,880. Calculate accounts
receivable turnover ratio and explain it.
Solution
Net Sales = $984,000 − $31,400 = $952,600
Receivables Turnover = $952,600 ÷ $23,880 ≈ 39.89 times
365/39,89 ≈ 9 days is required to collect all receivables
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55. INVESTMENT VALUATION RATIOS / MARKET VALUE RATIOS

I N V E S T M E N T VA L U AT I O N R AT I O S /
M A R K E T VA L U E R AT I O S
Investment valuation ratios are used by investors to estimate the
attractiveness of a potential or existing investment and get an idea of
its valuation.
Key ratios are:
• Earning per Share
• Price to Earnings Ratio (P/E Ratio)
• Price / Earning to Growth Ratio (PEG Ratio)
• Market to Book value (Price to Book Ratio)
Typically, if a firm has a high price-to-earnings and a high market-tobook value ratio, it is an indication that investors have a good
perception about the firm’s performance.
However, if these ratios are very high, it could also mean that 55a firm
is overvalued.

56. EARNINGS PER SHARE

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57. PRICE PER EARNINGS (P/E) RATIO

P R I C E P E R E A R N I N G S ( P / E ) R AT I O
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58. PRICE / EARNING TO GROWTH RATIO (PEG RATIO)

P R I C E / E A R N I N G TO G R O W T H R AT I O
( P E G R AT I O )
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59. PRICE / EARNING TO GROWTH RATIO (PEG RATIO)

P R I C E / E A R N I N G TO G R O W T H R AT I O
( P E G R AT I O)
Example: Company A is currently trading with a P/E ratio of 30.
Typically, this would be considered an "expensive" stock.
Assume that an expected
growth in earnings per share of +40%
for the next year.
In this case, Company A’s PEG ratio would be:
PEG Ratio = 30 / +40% = 0.75
A rule of thumb is that any PEG ratio below 1.0 is considered to be
a good value. So even though XYZ is highly valued based on the
P/E ratio, the PEG ratio says that it is undervalued relative to59 its
growth potential.

60. MARKET TO BOOK VALUE (PRICE TO BOOK RATIO)

M A R K E T TO B O O K VA L U E
( P R I C E TO B O O K R AT I O)
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61.

Limitations of Ratio Analysis
To be useful, ratios should be analyzed over a period of
years to consider all relevant factors
Any one year, or even any two years, may not represent
the company’s performance over the long term

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THE END