1.
Financial Statement Analysis
LECTURE OUTLINE
1. Basis of Financial Statement Analysis
1.1 Analysing financial statements involves evaluating three characteristics of a company:
its liquidity, its profitability, and its solvency.
1.1.1 A short-term creditor, such as s bank, is primarily interested in the ability of the
borrower to pay obligations when they come due.
1.1.2 A long-term creditor, such as a bondholder looks to measures of profitability
and solvency that indicate the firm’s ability to survive over a long period of time.
1.1.3 Shareholders are interested in the profitability and solvency of the enterprise.
They assess the likelihood of dividends and the growth potential of the shares.
1.2 Comparison of financial information can be made on a number of different bases.
1.2.1 Intracompany basis compares an item or financial relationship within a company
in the current year with the same item or relationship in one or more prior years.
1.2.2 Intercompany basis compares an item or financial relationship of one company
with the same item or relationship in one or more competing companies.
1.2.3 Industry averages basis compares an item or financial relationship of a
company with industry averages published by Dun & Bradstreet, Statistics
Canada, etc.
2. Tools of Financial Statement Analysis
There are three basic tools of analysis:
• Horizontal (trend) analysis.
• Vertical (common size) analysis.
• Ratio analysis.
2.1 Horizontal Analysis
Horizontal analysis (trend analysis) is a technique for evaluating a series of financial
statement data over a period of time. Its purpose is to determine the increase or
decrease that has taken place, expressed as either an amount or a percentage.
Although a horizontal analysis is relatively straightforward, complications can occur. If an
item has no value in the base year or preceding year and a value in the next year, no
percentage change can be calculated. If a negative amount appears in the base or
2.
preceding year and a positive amount exists the following year, or vice versa, no
percentage change can be calculated.
Horizontal analysis compares changes in a single item between any two years. (SEE
PAGE 892)
formula: current year - base year
base year
It is often useful to study percentages over a number of years to determine the direction,
or trend a business is taking. This is done by comparing each year's amounts to the base
year.
formula: current year
base year
2.2 Vertical Analysis
Vertical analysis (common size analysis) is a technique that expresses each item
within a financial statement as a percentage of a base amount. The base amount for
asset items is total assets. The base amount for liability and shareholders’ equity items
is total liabilities and shareholders’ equity. The base amount for income statement
items is net sales. Vertical analysis is seldom performed on the statement of retained
earnings or the cash flow statement.
Vertical analysis shows the relative size of each item on the balance sheet and income
statement. It can also show the change in the percentage for individual items from one
period to the next. Another benefit of vertical analysis is that it enables one to compare
companies of different sizes.
Vertical analysis highlights the relationship of each item to a total figure. (SEE PAGE
895)
formulas: income statement item
net sales
balance sheet item
total assets
2. 3 Ratio Analysis
Ratio analysis expresses the relationships between selected items of financial
statement data. The relationship is expressed in terms of a percentage, a rate, or a
simple proportion.
Ratios can be classified as follows:
Liquidity ratios measure the short-term ability of the enterprise to pay its
maturing obligations and to meet unexpected needs for cash.
3.
Profitability (Performance) ratios measure the income or operating success of
an enterprise for a given period of time.
Solvency (Leverage) ratios measure the ability of the enterprise to survive over
a long period of time.
Liquidity Ratios
The current ratio is a widely used measure of a company’s liquidity and short-
term debt paying ability. It is calculated by dividing current assets by current
liabilities. It does not take into account the composition of the current assets.
The acid test ratio (quick ratio) is a measure of a company’s immediate short-
term liquidity. It is calculated by dividing the sum of cash, temporary investments,
and net receivables by current liabilities.
Profitability (Performance) Ratios
The profit margin (Net income %, Return on Sales) ratio is a measure of the
percentage of each dollar of sales that results in net income. It is calculated by
dividing net income by net sales. High-volume enterprises such as grocery stores
generally have low profit margins. Low-volume enterprises such as jewellery
stores generally have high profit margins.
The gross profit margin ratio measures the amount of gross profit generated by
each dollar of sales.
An overall measure of profitability is the return on assets ratio. It is calculated
by dividing net income by average total assets.
The receivables turnover ratio is used to assess the liquidity of receivables. It
measures the number of times, on average, receivables are collected during the
period. This ratio is calculated by dividing net credit sales by the average net
receivables during the year. The average collection period (days’ sales
outstanding) in days is calculated by dividing 365 days by the receivables
turnover. The general rule is that the collection period should not greatly exceed
the credit limit period.
The inventory turnover (Inventory Turns) ratio measures the number of times,
on average, the inventory is sold during the period. It is calculated by dividing
cost of goods sold by the average inventory during the year. The average days
sales in inventory is calculated by dividing 365 days by the inventory turnover.
The return on common shareholders’ equity shows how many dollars of net
income were earned for each dollar invested by the owners. It is calculated by
dividing net income by average common shareholders’ equity.
4.
** When preferred shares are present, preferred dividend requirements are
deducted from net income to calculate income available to common
shareholders.
** The legal value of preferred shares (or call price) must be deducted from
total shareholders’ equity to arrive at the amount of common share equity
used in the denominator.
Earnings per share is a measure of the net income earned on each common
share. It is calculated by dividing net income by the number of common shares
issued. If preferred dividends have been declared, they must be deducted from
net income to arrive at the income available to common shareholders. In
addition, if common shares have been issued during the period, a weighted
average number of shares must be calculated.
The price-earnings (PE) ratio measures the ratio of the market price of each
common share to the earnings per share. It reflects investors’ assessments of a
company’s future earnings. The ratio is calculated by dividing the market price
per common share by earnings per share.
Book value per share measures the equity a common shareholder has in the
net assets of a corporation for each share owned. It is calculated by dividing total
shareholders’ equity by the number of common shares.
** If preferred shares exist, the legal value of preferred shares (or call price)
must be deducted from total shareholders’ equity to arrive at the amount
of common share equity used in the numerator.
The payout ratio measures the percentage of earnings distributed as cash
dividends. It is calculated by dividing cash dividends by net income. Companies
that have high growth rates usually have low payout ratios, because they
reinvest most of their net income in the business.
The dividend yield reports the rate of return a shareholder earned from
dividends during the year. It is calculated by dividing the cash dividends per
share by the share price.
Solvency (Leverage) Ratios
The debt to total assets ratio (debt ratio) measures the percentage of the
total assets provided by creditors. It is calculated by dividing total debt (both
current and long-term liabilities) by total assets. The ratio indicates the degree
of leverage or trading on the equity. It also provides some indication of the
company’s ability to absorb losses without hurting the interests of creditors.
Generally, companies with relatively stable earnings can have a higher debt to
assets ratios than companies with widely fluctuating earnings.
5.
The interest coverage ratio provides an indication of the company’s ability to
meet interest payments as they come due. It is calculated by dividing income
before interest expense and income taxes (EBIT) by interest expense.
3. Limitations of Financial Analysis
3.1 Estimates: Financial statements contain numerous estimates. To the extent that
estimates are inaccurate, the financial ratios and percentages are inaccurate.
3.2 Cost: Traditional financial statements are based on cost and are not adjusted for price
level changes. Comparisons of financial data from different periods may be rendered
invalid by significant inflation or deflation.
3.3 Alternative accounting methods: Variations among companies in the application of
generally accepted accounting principles may hamper comparability.
3.4 Atypical data: Fiscal year end data may not be typical of the financial condition during
the year. Firms frequently establish a fiscal year-end that coincides with the low point in
operating activity or in inventory levels.
3.5 Diversification of firms: Many firms are so diversified that they cannot be classified by
industry. Others appear to be comparable but are not. The requirement to report
segment information helps to reduce this limitation.
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