Chapter 5

Financial Statement Analysis

What is Financial Statement Analysis?
 FSA is the process of identifying financial strengths
& weaknesses of the firm by properly establishing
relationship b/n the items of the balance sheet & the
income statement.
 There are various methods or techniques that are
used in analyzing financial statements, such as
comparative statements, schedule of changes in
working capital, common size percentages, funds
analysis, trend analysis, & ratios analysis.
 Financial statements are prepared to meet external reporting
obligations & also for decision making purposes.
 They play a dominant role in setting the framework of
managerial decisions.
 But the information provided in the financial statements
is not an end in itself as no meaningful conclusions can
be drawn from these statements alone.
 However, the information provided in the financial
statements is of immense use in making decisions
through analysis & interpretation of financial
statements.
Sources of Financial Statement Analysis

❑ Annual reports a company usually contains:

1. Financial statements.
2. Notes to the financial statements.
3. A summary of accounting methods used.
4. Management discussion and analysis of the
financial statements.
5. An auditor’s report.
6. Comparative financial data for 5 to 10 years.
 All these documents can be the source of financial
statement analysis.
Tools and Techniques of Financial Statement Analysis

 Following are the most important tools and techniques

of financial statement analysis:
1.Horizantal and Vertical Analysis
2. Ratio Analysis
1.Horizontal and Vertical Analysis

❑ Horizontal (Trend) Analysis

 Comparison of two or more year's financial data is
known as horizontal analysis, or trend analysis.
 Horizontal analysis is facilitated by showing changes
between years in both dollar and percentage form
 Horizontal analysis of financial statements can also
be carried out by computing trend percentages.
 Trend percentage states several years' financial data in
terms of a base year.
 The base year equals 100%, with all other years stated
in some percentage of this base.
 Therefore, the changes in financial statements from a
base year to following years are expressed as a trend
percentage to show the extent & direction of changes.
 1st , a base year is selected & each item in the FSs for
the base year is given a weight of 100%.
 2nd is to express each item in the FSs for following
years as a percentage of its base-year amount.
Horizontal Analysis-Example

Increase/(Decrease)
2005 2004 Amount Percent
Sales $41,500 $37,850 $3,650 9.6%
Expenses 40,000 36,900 3,100 8.4%
Net income 1,500 950 550 57.9%
Horizontal Analysis-Example

2005 2004 Difference

Sales $41,500 $37,850 $3,650

$3,650 ÷ $37,850 = .0964, or 9.6%

Trend Percentages - Example

…are computed by selecting a base year whose

amounts are set equal to 100%.
 The amounts of each following year are expressed as

a percentage of the base amount.

Trend % = Any year $ ÷ Base year $

 Trend Percentages - Example
Year 2005 2004 2003
Revenues $27,611 $24,215 $21,718
Cost of sales 15,318 14,709 13,049
Gross profit $12,293 $ 9,506 $ 8,669
2003 is the base year.

What are the trend percentages?

 Trend Percentages - Example
Year 2005 2004 2003
Revenues 127% 111% 100%
Cost of sales 117% 113% 100%
Gross profit 142% 110% 100%

These percentages were calculated by

dividing each item by the base year.
Vertical Analysis
 Vertical analysis is the procedure of preparing &
presenting common size statements.
 Common size statement is one that shows the items
appearing on it in percentage form as well as in dollar
form.
 Each item is stated as a percentage of some total of
which that item is a part.
 Key financial changes & trends can be highlighted
by the use of common size statements.
Vertical Analysis...

…compares each item in a financial statement to a base

number set to 100%.
 Every item on the financial statement is then

reported as a percentage of that base.

Vertical Analysis

2005 %
Revenues $38,303 100.0
Cost of sales 19,688 51.4
Gross profit $18,615 48.6
Total operating expenses 13,209 34.5
Operating income $ 5,406 14.1
Other income 2,187 5.7
Income before taxes $ 7,593 19.8
Income taxes 2,827 7.4
Net income $ 4,766 12.4
Vertical Analysis

Assets 2005 %
Current assets:
Cash $ 1,816 4.7
Receivables net 10,438 26.9
Inventories 6,151 15.9
Prepaid expenses 3,526 9.1
Total current assets $21,931 56.6
Plant and equipment, net 6,847 17.7
Other assets 9,997 25.7
Total assets $38,775 100.0
Common-size Statements

 On the income statement, each item is expressed as

a percentage of net sales.
 On the balance sheet, the common size is the total
on each side of the accounting equation.
 Common-size statements are used to compare one
company to other companies, and to the industry
average.
Common-size Statements-example

Lucent Technologies
12.4% 10.8% MCI
8.0%
7.4%
43.0%

51.4%

38.2%
28.8%

Cost of goods sold Operating expenses

Income tax Net income
2. Ratio Analysis
 The ratios analysis is the most powerful tool of financial
statement analysis.
 Ratios simply means one number expressed in terms of
another.
 A ratio is a statistical yardstick by means of which
relationship between two or various figures can be
compared or measured.
 Ratios can be found out by dividing one number by
another number.
 Ratios show how one number is related to another
 Ratio Classifications

1 Measuring ability to pay current liabilities (Liquidity

Ratios)
2 Measuring ability to sell inventory and collect
receivables (Activity Ratios)
3 Measuring ability to pay short-term and long-term
debt (Leverage Ratios)
4 Measuring profitability (Profitability Ratios)
5 Analyzing stock as an investment (Market Value
Ratios).
1.Measuring ability to pay current liabilities (Liquidity Ratios)

 Liquidity ratios measure the short term solvency of

financial position of a firm.
 These ratios are calculated to comment upon the
short term paying capacity of a concern or the firm's
ability to meet its current obligations.
 Following are the most important liquidity ratios:
◼ CurrentRatio
◼ Liquid/Acid Test/Quick Ratio
Stylistic Furniture Example
Net sales (Year 2005) $858,000
Cost of goods sold 513,000
Gross profit $345,000
Total operating expenses 244,000
Operating income $101,000
Interest revenue 4,000
Interest expense (24,000)
Income before taxes $ 81,000
Income taxes 33,000
Net income $ 48,000
Stylistic Furniture Example

Assets 2005 2004

Current assets:
Cash $ 29,000 $ 32,000
Receivables net 114,000 85,000
Inventories 113,000 111,000
Prepaid expenses 6,000 8,000
Total current assets $262,000 $236,000
Long-term investments 18,000 9,000
Plant and equipment, net 507,000 399,000
Total assets $787,000 $644,000
Stylistic Furniture Example

Liabilities 2005 2004

Current liabilities:
Notes payable $ 42,000 $ 27,000
Accounts payable 73,000 68,000
Accrued liabilities 27,000 31,000
Total current liabilities $142,000 $126,000
Long-term debt 289,000 198,000
Total liabilities $431,000 $324,000
Stylistic Furniture Example

Stockholders’ Equity 2005 2004

Common stock, no par $186,000 $186,000
Retained earnings 170,000 134,000
Total stockholders’ equity $356,000 $320,000
Total liabilities and
stockholders’ equity $787,000 $644,000
Measuring Ability to Pay Current Liabilities

1.The current ratio measures the company’s

ability to pay current liabilities with current
assets.

Current ratio =
Total current assets ÷ Total current liabilities
Measuring Ability to Pay Current
Liabilities
❑ Stylistic current ratio: CA/CL
➢ 2004: $236,000 ÷ $126,000 = 1.87

➢ 2005: $262,000 ÷ $142,000 = 1.85

➢ The industry average is 1.50.

➢ The current ratio decreased slightly during 2005.
Measuring Ability to
Pay Current Liabilities
2.The acid-test ratio shows the company’s
ability to pay all current liabilities
if they come due immediately.
•Quick Assets = Current Assets –
(Inventories & Prepaid Assets)

Acid-test ratio =(Cash + STIs+ Net current

receivables)
÷ Total current liabilities
 Measuring Ability to Pay Current Liabilities

❑ Stylistic’ acid-test ratio: QA/CL

2004
 ($32,000 + $85,000) ÷ $126,000 = .93
2005
 ($29,000 + $114,000) ÷ $142,000 = 1.01
 The industry average is .40.
 The company’s acid-test ratio improved considerably
during 2005.
2.Measuring ability to sell inventory & collect receivables. (Activity Ratios)

 Activity ratios are calculated to measure the efficiency

with which the resources of a firm have been
employed.
 These ratios are also called turnover ratios b/c they
indicate the speed with which assets are being turned over into
sales.
 Following are the most important activity ratios: -
Inventory turnover ratio
-Receivables turnover ratio
-Average Collection period
Measuring Ability to Sell Inventory

1.Inventory turnover ratio is a measure of the

number of times the average level of inventory
is sold during a year.

Inventory turnover = CGS÷ Average inventory

•Average Inventories = (Beginning Inventories
+ Ending Inventories) / 2
 Measuring Ability to Sell Inventory

❑ Stylistics' inventory turnover:

 2005: $513,000 ÷ $112,000 = 4.58
 The industry average is 3.4.
 A high number indicates an ability to quickly sell
inventory.
Measuring Ability to Collect Receivables

2.Accounts receivable turnover measures a

company’s ability to collect cash from credit
customers.

Accounts receivable turnover =

Net credit sales ÷ Average accounts receivable
Measuring Ability to Collect Receivables

❑ Stylistics' A/R Turnover:

 2005: $858,000 ÷ $99,500 = 8.62 times
 The industry average is 51 times.
 Stylistics’ receivable turnover is much lower than the
industry average.
 The company is a home-town store that sells to local
people who tend to pay their bills over a lengthy
period of time.
Measuring Ability to Collect Receivables

3.Days’ sales in receivable ratio measures how

many day’s sales remain in Accounts Receivable.

One day’s sales = Net sales ÷ 365 days

Days’ sales in Accounts Receivable =

Average net Accounts Receivable ÷ One day’s
sales
Measuring Ability to Collect Receivables

❑ Stylistics’ days’ sales in Accounts Receivable for

2005:
 One day’s sales:
 $858,000 ÷ 365 = $2,351
 Days’ sales in Accounts Receivable:
 $99,500 ÷ $2,351 = 42 days
 The industry average is 7 days.
3.Measuring ability to pay short-term and long-term
debt (Leverage Ratios)
 Long term solvency or leverage ratios convey a firm's

ability to meet the interest costs & payment

schedules of its long term obligations.
 Following are some of the most important long term
solvency or leverage ratios
➢ Debt Ratio
➢ Times-Interest-Earned2(Coverage Ratio)
Measuring Ability to Pay Debt

1.The debt ratio indicates the proportion

of assets financed with debt.

Total liabilities ÷ Total assets

Measuring Ability to Pay Debt

Stylistics’ debt ratio: TL/TA

2004
$324,000 ÷ $644,000 = 0.50
2005
$431,000 ÷ $787,000 = 0.55
The industry average is 0.64.
Stylistic Furniture expanded operations during 2005 by
financing through borrowing.
Measuring Ability to Pay Debt

2.Interest Coverage Ratio(Times-Interest-Earned

Ratio) measures the number of times
operating income can cover interest expense.

Interest Coverage Ratio(Times-Interest-Earned)

= Income from operations÷ Interest expense
Measuring Ability to Pay Debt

❑ Stylistics’ Times-Interest-Earned Ratio:

2004
 $ 57,000 ÷ $14,000 = 4.07
2005
 $101,000 ÷ $24,000 = 4.21
 The industry average is 2.80.
 The company’s times-interest-earned ratio increased
in 2005.
 This is a favorable sign.
4. Measuring profitability (Profitability Ratios)

 Profitability ratios measure the results of business

operations or overall performance & effectiveness of the
firm.
 Some of the most popular profitability ratios are as
under:
- Rate of return on net sales (ROS)
- Rate of return on total assets (ROA)
-Rate of return on common SHE
-Earnings per share of common stock
Measuring Profitability

1.Rate of return on net sales shows the

percentage of each sales dollar earned as
net income.

Rate of return on net sales =Net income

÷ Net sales
Measuring Profitability

❑ Stylistics’ rate of return on sales:

2004
 $26,000 ÷ $803,000 = 0.032
2005
 $48,000 ÷ $858,000 = 0.056
 The industry average is 0.008.
 The increase is significant in itself & also b/c it is
much better than the industry average.
Measuring Profitability

2.Rate of return on total assets measures

how profitably a company uses its assets.

Rate of return on total assets =

(Net income+ interest expense)
÷ Average total assets
i.e., operating income to average total assets is
Usually used to compute return on total assets.
Measuring Profitability

Stylistics’ rate of return on total assets for 2005:

($48,000 + $24,000) ÷ $715,500 = 0.101
The industry average is 0.078.
How does Stylistics’ compare to the industry?
Very favorably.
Measuring Profitability
•Common equity includes additional paid-in
capital on common stock & retained earnings.

3.Rate of return on common stockholders’ equity

= (Net income – preferred dividends)
÷ Average common stockholders’ equity
Measuring Profitability

❑ Stylistics’ rate of return on common stockholders’

equity for 2005:
 ($48,000 – $0) ÷ $338,000 = 0.142

 The industry average is 0.121.

Q. Why is this ratio larger than the return on total assets

(.101)?
Measuring Profitability

4. Earnings per share of common stock

= (Net income – Preferred dividends)
÷ Number of shares of common stock
outstanding
Measuring Profitability
❑ Stylistics’ earnings per share:
2004
 ($26,000 – $0) ÷ 10,000 = $2.60
2005
 ($48,000 – $0) ÷ 10,000 = $4.80
 This large increase in EPS is considered very
unusual.
5. Analyzing stock as an investment( Capital
Market Ratios)

 Relate investors’ expectations about the company’s

performance and financial conditions.
 Following are the most important market value of
investment ratios:
- Price/earning ratio
- Dividend yield
- Dividend per share of common (preferred) stock
-Book value per share of common stock
1. Price- Earning Ratio
 PER= Current Market Price per Share of Common Stock

Earning Per Share

 The investors might have a specific multiple in
mind that indicates whether the stock is
underpriced or overpriced.
Analyzing Stock as an Investment

❑ Price/earning ratio is the ratio of market price per

share to earnings per share.
2004
 $35 ÷ $2.60 = 13.5
2005
 $60 ÷ $4.80 = 12.5
 Given Stylistic Furniture’s 2005 P/E ratio of 12.5,
we would say that the company’s stock is selling at
12.5 times earnings.
Analyzing Stock as an Investment

2.Dividend yield shows the percentage of a

stock’s market value returned as dividends to
stockholders each period.

Dividend per share of common

(or preferred) stock ÷ Market price per share
of common (or preferred) stock
 Analyzing Stock as an Investment

 Dividend yield on Stylistics’ common stock:

2004
 $1.00 ÷ $35.00 = .029 (2.9%)
2005
 $1.20 ÷ $60.00 = .020 (2%)
 An investor who buys Stylistics’ Furniture common
stock for $60 can expect to receive 2% of the
investment annually in the form of cash dividends.
Analyzing Stock as an Investment

3. Book value per share of common stock

= (Total stockholders’ equity – Preferred equity)
÷ Number of shares of common stock
outstanding
Analyzing Stock as an Investment

❑ Book value per share of Stylistics’ common stock:

2004
 ($320,000 – $0) ÷ 10,000 = $32.00
2005
 ($356,000 – $0) ÷ 10,000 = $35.60
Advantages of Financial Statement Analysis

 There are various advantages of financial statements

analysis.
 The major benefit is that the investors get enough idea
to decide about the investments of their funds in the
specific company.
 Financial statements analysis can help the government
agencies to analyze the taxation due to the company.
 Moreover, company can analyze its own performance
over the period of time through financial statement
analysis.
End of Chapter 5