Financial Management

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

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
• Balance Sheet
• Income Statement
• Statement of Cash Flows
• Statement of Changes in the Owner’s Equity
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5. BALANCE SHEET
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Assets Liabilities Equity
= +
Statement of financial position Statement of financial Condition
The balance sheet provides a snapshot of a firm’s
financial position at a particular date.
assets ≡ liabilities + owners’ equity

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 andTaxes ( EBIT)
Interest Income / Interest Expenses
Earnings BeforeTaxes (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. 8
+
+
=

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

11. Stockholders’ (Owners’) Equity accounts
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)
Owners’ claims to the assets of a corporation
Revenues
Expenses
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. APPROACHESTOWARDS 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
Setting up a standard of comparison is a benchmarking.
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15. PERFORMANCE ANALYSIS:
BUDGETEDVS. ACTUAL
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FavourableVariance UnfavourableVariance
Budgeted Actual Budgeted Actual
Revenue $ nnn $ NNN $ NNN $ nnn
Expenses $ NNN $ nnn $ nnn $ NNN

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

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
• 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
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. 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. 36

37. RETURN ON EQUITY (ROE)
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38. 38

39. LIQUIDITY RATIOS /
SHORT-TERM SOLVENCY RATIOS
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40. C U R R E N T R AT I O
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41. QUICK RATIO OR ACID RATIO TEST
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42. SOLVENCY RATIOS /
FINANCIAL LEVERAGE RATIOS
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43. FINANCIAL LEVERAGE RATIOS
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
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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 flow (cash
coverage ratio).

44. 44

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
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47. FIXED ASSET TURNOVER RATIO
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48. I N V E N T O R Y T U R N O V E R
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49. I N V E N T O R Y T U R N O V E R
• 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. 49

50. 50
I N V E N T O R Y T U R N O V E R

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

54. 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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RECEIVABLE TURNOVER

55. INVESTMENT VALUATION RATIOS /
MARKET VALUE RATIOS
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-to-
book 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 a firm
is overvalued.
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56. EARNINGS PER SHARE
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57. PRICE PER EARNINGS (P/E) RATIO
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58. PRICE / EARNING TO GROWTH RATIO
(PEG RATIO)
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59. PRICE / EARNING TO GROWTH RATIO
(PEG RATIO)
Example: CompanyA 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, CompanyA’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 to its
growth potential.
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60. MARKET TO BOOK VALUE
(PRICE TO BOOK RATIO)
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61.  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
Limitations of Ratio Analysis

62. THE END