This document provides an overview of financial statement analysis. It discusses the objectives of ratio analysis, which involves calculating ratios to analyze a company's profitability, liquidity, asset management, financial leverage, and investor returns. Specific profitability, liquidity, and leverage ratios are defined. The document also covers cash flow analysis, interpreting ratio results, drivers of profitability and growth, and the importance of considering both financial and non-financial accounting information in analysis.

1. Financial Statements
Analysis
Lecture 6
Part 1: Ratio analysis

2. Lecture Objectives
By the end of this lecture you should be able to:
 Discuss the role of accounting information financial
statement analysis
 Conduct performance analysis based on the 5
main ratio categories
 Interpret the ratios
 Explain drivers of profitability and growth
 Discuss the role and importance of cashflow
analysis
 Discuss other accounting & non-financial
information in the annual reports

3. (i)
Assessing
Strategic
Direction
(ii)
Financial
Statement
Analysis
(iii)
Stock Market
Assessment
The General Framework
• Assessing strategic
capability
• Taking action to add value
• Finding information on
companies & their markets
• Accounting for profit
• Accounting for cash
• Comparative financial
analysis
• Share price movements
•Short-term share valuation
•Long-term share valuation

4. Financial Statement Analysis
FSA provides business owners and
other interested parties with specific
techniques to analyse the
information in financial statements
to uncover the soundness of prior
decisions for survival and growth of
the business.

5. Financial Statement Analysis
Financial statement analysis involves
analysing the financial information provided
in company’s annual report to:
Provide information about the organisation’s:
 Past performance
 Present condition
 Future performance
Assess the organisation’s:
 Earnings in terms of
power, persistence, quality and growth
 Solvency

6. Effective Financial Statement Analysis
Requires that you:
 Understand the nature of the industry in which the
organisation works. This is an industry factor.
 Understand that the overall state of the economy
may also have an impact on the performance of
the organisation.
→ Financial statement analysis is more than just
“crunching numbers”; it involves obtaining a
broader picture of the organisation in order to
evaluate appropriately how that organisation is
performing.

7. Effective Financial Statement Analysis
To perform an effective financial statement
analysis, you need to be aware of the
organisation’s:
 business strategy
 objectives
 annual report and other documents like
articles about the organisation in newspapers
and business reviews.
These are called specific/unique organisational
factors.

8. Uses of Accounting Information
• measure how much dividend might be paid
• provide assurance of financial strength to creditors
• provide a basis for measuring future growth for
stock market analysis
• measure mgmt performance in an agency context
• provide the basis of taxation
• give employees an idea of company’s strength
• provide convenient templates for financial
planning
• assist in setting performance targets
• assist in imposing restrictions on managers

9. Tools of Financial Statement Analysis
Financial ratio analysis is the commonly used tools for
financial statement analysis
Comparative analysis
 Cross sectional analysis across sector
 Time series/Trend analysis within the company
 Time series/Trend analysis with other companies or
competitors
Benchmarks:
 Past period achievements
 Budgeted achievements
 Other business achievements
 Averages of business achievements in the same area

10. Financial Ratio Analysis
 Financial ratio analysis involves calculating and
analysing ratios that use data from one, two or
more financial statements.
 Ratio analysis also expresses relationships
between different financial statements.
 Financial Ratios can be classified into 5 main
categories:
 Profitability ratios
 Asset management or activity ratios
 Liquidity or short-term solvency ratios
 Gearing ratios
 Investment ratios

11. Financial Ratio Analysis
Investment
[5]
Profitability
[1]
Liquidity
[2]
Efficiency/activity or
assets mgmt
[4]
Gearing
[3]
Categories
of ratios

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GGrroossss pprrooffiitt 550000,,000000
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eexxppeennsseess
440000,,000000
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LLeessss:: iinntteerreesstt 1166,,000000
((NNeett)) PPrrooffiitt bbeeffoorree ttaaxx 8844,,000000
LLeessss:: iinnccoommee ttaaxx 1144,,000000
((NNeett)) PPrrooffiitt aafftteerr ttaaxx 7700,,000000
LLeessss:: ddiivviiddeenndd 3300,,000000
RReettaaiinneedd pprrooffiitt 4400,,000000
Income Statement
Note:
Average daily net credit sales = net credit sales / 365

13. NNoonn ccuurrrreenntt aasssseettss 11,,115500,,000000
CCuurrrreenntt aasssseettss
-- SSttoocckk//iinnvveennttoorriieess
-- DDeebbttoorrss//rreecceeiivvaabblleess
220000,,000000
300,000
550000,,000000
TToottaall aasssseettss 11,,665500,,000000
EEqquuiittyy ((ccaappiittaall aanndd rreesseerrvveess)) 11,,000000,,000000
NNoonn ccuurrrreenntt lliiaabbiilliittiieess
LLoonngg tteerrmm llooaannss 330000,,000000
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TToottaall eeqquuiittyy aanndd lliiaabbiilliittiieess 11,,665500,,000000
Statement of financial position
Note:
Market price per share = £2.50

14. Financial Ratio Analysis
Profitability ratios
4 elements of the profitability analysis:
 Analysing on sales and trading margin (cost of sales)
◦ focus on gross profit
 Analysing on the control of operating expenses (O/Hs)
◦ focus on net operating profit (EBITDA)
 Analysing on the amount of interest and tax paid
o focus on net profit after interest and tax (NOPAT)
 Assessing the return on assets (ROA) and return on
equity (ROE).
Profitability [1]

15. Income Statement Ratios for
Assessing Operating Management
Common-sized income statements facilitate
comparisons of key line items across time and
different firms.
The following ratios are helpful :
i. Gross profit margin (by function only).
ii. Earnings Before Interest, Taxes, Depreciation &
Amortization (EBITDA) margin.
iii. Net Operating Profit After Tax (NOPAT) margin.
Profitability [1]

16. Profitability Ratios
Profitability [1]
Gross Profit Margin
Measures the profitability of sales, less direct costs of
sales:
The gross profit margin is an indicator of:
• The price premium that a firm’s product commands in
the market,
• The efficiency of a firm’s procurement and/or
production process.

17. Profitability Ratios
Profitability [1]

18. NOPAT and EBITDA Margins
 The EBITDA margin eliminates the significant non-cash expenses
of depreciation and amortization along with interest and taxes:
Profitability Ratios
Profitability [1]
* NOPAT = Net profit + interest expense after tax [Palepu et al., p.211]
• The NOPAT margin provides a comprehensive measure of
operations:
84/2000 = 4.2%

19. Profitability Ratios
Return on capital employed (ROCE)
Profitability [1]
Return on Equity (ROE) measures overall profitability
ROE is a comprehensive measure of and is a good
starting point to systematically analyze firm performance.

20. Profitability Ratios
Profitability [1]
Alternative calculation of ROE
Net assets = Total assets minus all liabilities
Palepu et al., p. 211

21. Profitability Ratios
Alternative calculation of ROE
Profitability [1]
 Spread is the incremental effect from introducing debt into the capital
structure. Positive effect of borrowing is when the operating ROA is
greater than the cost of browning. That is, firms that do not earn adequate
operating ROA to pay for interest cost reduce their ROE by borrowing.


22. Financial Leverage Analysis
Borrowing allows a firm access to
capital, but increases the risk of
ownership for equity holders.
Analysis of leverage can be performed on
both current and non-current debts:
1. Liquidity analysis relates to evaluating current
liabilities
2. Solvency analysis relates to longer term
liabilities
Liquidity [2]

23. The following ratios attempts to measure
the ability of a firm to pay its current
obligations:
Liquidity or Short-Term Solvency ratios
Liquidity [2]

24. Short-term funds management
Working capital management is important as it
signals the firm’s ability to meet short term debt
obligations.
Liquidity [2]
Liquidity or Short-Term Solvency ratios

25. Solvency Analysis
Beyond short-term survival, solvency measures the
ability of a firm to meet long-term obligations.
Several useful ratios used to analyze solvency with
shareholders’ equity as a denominator are:
Gearing [3]

26. Solvency Ratios
Long term funds management
Measures the riskiness of business in terms of debt gearing.
Gearing [3]

27. Solvency Analysis
Ratios that specifically address the ability to pay
interest on debts are:
Gearing [3]

28. Asset Management [activity ration]
Asset management is a key indicator of
how effective a firm’s management is.
Asset turnover may be broken into two
primary components:
1. Working capital management
2. Non-current asset management
Efficiency/activity or assets mgmt [4]

29. Working Capital Management
Working capital is the difference between current
assets and current liabilities i.e. CA-CL
Key ratios useful to analyzing the management of
working capital include:
a) Operating working capital (OWC)
- distinguishes between operating current assets (i.e.
receivables, inventories and payables) and financing
current assets (cash, marketable securities and notes
payable)
Efficiency/activity or assets mgmt [4]

30. Working Capital Management-cont.
b) Inventory management
Efficiency/activity or assets mgmt [4]
c) Debtors management
d) Creditors management
* Average daily net credit sales = net credit sales / 365

31. Non-current Asset (NCA) Management
It is concerned with utilisation of firm’s non-
currents i.e. efficiency in using net fixed assets:
NCA = net property, plant & equipment
(PP&E), intangibles and other assets
Efficiency/activity or assets mgmt [4]
Example of noninterest bearing non-current liabilities: Deferred
taxes

32. Investment Ratios
Based on the share market's perception of the company
70
960
30
960
30
70
2.5
0.073
Investment [5]
= £0.073
= £0.03
x 100 = 42.86%
= 34.25 times
No. of shares = 1,000 – 40 = 960, 40 = reserves or retained earning

33. Interpreting ratio analysis (see ratio
results in earlier lecture)
Profitability ratios: Benchmarks Company
Gross Profit Margin Industry 25% 25%
Net Profit Margin Industry 7% 3.5%
Return on Capital
Employed
Industry 12% 7.7%
Return on Equity Industry 20% 7%
Asset Management ratios:
Inventory Turnover Industry 6 times 7.5 times
Asset Turnover Industry 4 times 1.21 times

34. Interpreting ratio analysis
Liquidity ratios: Benchmarks Company
Current Ratio Ideal standard 2:1 1.43:1
Quick Ratio Ideal standard 1:1 1:1
Financial Structure ratios:
Debt/Equity Industry 60% 30%
TIE (Times
Interest Earned )
Standard benchmark:
Between 3 and 5.
Below 3 risky.
Above 5 very favourable
6.25

35. Drivers of profitability and growth

36. Assessing the Sustainable Growth Rate
A comprehensive measure of a firm’s
ratios is the sustainable growth rate:
Sustainable growth rate measures the
ability of a firm to maintain its profitability
and financial policies.
Measure dividend policy
7%x (1 – 0.4286) = 4%

38. Cash Flow Analysis
 The ratio analysis previously discussed used
accrual accounting.
 Cash flow analysis can provide further insights into
operating, investing, and financing activities.
 All companies using IFRS are required to include a
statement of cash flows in their financial
statements.
◦ Differences in reporting cash flow information allow for
variation across firms that complicate comparisons.
◦ Analysts can make adjustments to net income to arrive at
free cash flows, a commonly used metric for financial
analysis.

39. Analyzing Cash Flow Information
Analysis of the statement of cash flows helped
answer a number of questions such as:
Operating activities
How strong is the firm’s internal cash flow generation?
How well is working capital being managed?
Investing activities
How much cash did the company invest in growth assets?
Financing activities
• What type of external financing does the company rely on?
• Did the company use internally generated funds for
investments?
• Did the company use internally generated funds to pay
dividends?

40. Cash flow Analysis
Opening cash & cash equivalents £1,788m
plus
Net cash in £3,960m
Less
Investments £5,974m
Plus
Finance raised £3,615m
Plus
Foreign exchange gains £120m
Net cash balance at year end £3,509m
Question
Does spending fit with story given in the narrative?
Look for special items e.g. purchase of intangibles; big
increase in borrowings

41. Useful cash flow metrics
 Cash Flow / Maturing Obligations
 Operating Cash Flow (from the CFS) Current Liabilities
 Cash Flow per share
 Operating Cash Flow (from the CFS) No of shares in issue
(Weighted Average.)
 Free cash flow per share
 Free cash flow No of shares in issue.
 Most useful BUT be warned – no regulatory definitions
 Free cash flow = C – I = cash from operation – cash invested in
operation
 Measures cash available for discretionary expenditure on
capital, projects, new stores, refurbishments, extra dividends, etc.

42. Free Cash Flow
EBIT
+ Depreciation
+ Proceeds of disposals/ other income
- Interest payments (netted off against any receipts)
- Cash taxation figure (not necessarily P&L
figure; but use it if you don’t have anything
else – but check creditors)
- Dividend payments (netted off against any
receipts)
= “Common sense” FREE CASH FLOW
Example using income statement

43. Example Free Cash Flow in
Tesco
£ m 2009 2008
Cash from operations 3960 3343
Other income 1354 1056
FX gains/losses 120 (55)
Interest paid (net) (472) (282)
Tax paid (456) (346)
Dividends paid (net) (814) (704)
Free Cash Flow (FCF) 3692 3012
It can serve as a proxy for measuring changes in earnings per
share
Free cash flow:
 Signals a company's ability to pay debt,
 Pay dividends,
 Buy back shares and facilitate the growth of business.
Give a preliminary prediction concerning future share prices, e.g. when a firm's
share price is low and FCF is on the rise, the prospects are good that earnings
and share price will soon be on the rise. Thus, high free cash flow per share
means that earnings per share should potentially be high as well.
Example using cash flow statement

44. Concluding comments on ratios
There are two primary tools in financial analysis:
Ratio analysis – to assess how various line items
in financial statements relate to each other and to
measure relative performance.
Cash flow analysis – to evaluate liquidity and the
management of operating, investing, and
financing activities as they relate to cash flow.
Both forms of analyses must be evaluated while
considering whether firm performance is
consistent with the strategic initiatives of
management.

45. The Importance of Accounting Information
and Analysis
• Accounting practices govern the types of
disclosures made in the financial statements.
• Non-financial accounting information is equally
important.
• Understanding both financial and non-financial
accounting information allows the business
analyst to effectively use the information
disclosed to assess the value of the companies.
Other Accounting & Non Financial Information

46. Other Accounting & Non Financial Information
• Narrative statements
• Chairman’s report
• Directors report
• Auditor’s report
• Corporate governance report
Other reports
• Value-added
• Segmental report
• Statement of corporate objectives
• Statement of future prospects
• Ethical report / CSR
• Employees report

47. Chairman’s Statement
• overall trading conditions during the period, current
climate & general outlook
• performance achieved by each activity, current
trading & future prospects
• items of special interest
• changes in the board, comments on directors and
other employees and efforts of mgmt team and
workforce
• company’s strategy and plans for the future
• political/social/economic comments about govt.,
tax, accounting standards etc.

48. Director’s Report
• Activities and trading results
• Financial review
* cash from operations & other cash inflows
* types of accounting standards adopted
* maturity profile
* capital structure
*ability to remain a going concern
• Operating review (Operating & Financial Review/
business review]
* marketing & capital expenditure
* diversification, acquisition, growth
* impact of factors in the environment
• Directors
* interest in shares
* interest of directors’ close families

49. Auditor’s Report
• identification of addressee
• identification of financial statements audited
• respective responsibilities of directors
and auditors
* basis & type of audit opinion
• signatures of auditors
• date of audit report

50. Corporate Governance Report
• Report by audit committee
• Report by remuneration committee
* remuneration policy
*share option schemes
*retirement benefits, service agreements
*long-term incentive plan
*annual incentive awards
*directors emoluments

51. Volkswagen Group – Annual Report 2011
Value added generated by the Volkswagen Group – Appropriation of funds
Appropriation of funds in € million 2011 % 2010 %
to shareholders (dividend) 1,406 2.9 1,034 3.1
to employees
(wages, salaries, benefits) 23,854 50.0 19,027 57.8
to the state (taxes, duties) 4,525 9.5 3,105 9.5
to creditors (interest expense) 3,530 7.4 3,563 10.8
to the Company (reserves) 14,393 30.2 6,193 18.8
Value added 47,709 100.0 32,922 100.0
Volkswagen Group – Annual Report 2011
Value added generated by the Volkswagen Group – Source of funds
Source of funds in € million 2011 2010
Sales revenue 159,337 126,875
Other income 13,125 10,787
Cost of materials -104,648 -79,394
Depreciation and amortization -10,346 -10,097
Other upfront expenditures -9,759 -15,250
Value added 47,709 32,922
http://annualreport2011.volkswagenag.com/financialstatements.html?
cat=n

52. Segmental Report
product/service Turnover Operating profit
Brass Hotels & Resorts X X
Brass Leisure X X
Other Activities X X
XX XX
country
United Kingdom X X
United States X X
Rest of Europe X X
XX XX