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Essentials for Financial Statements Analysis

The analysis of financial data employs various techniques to emphasize the

comparative and relative importance of the data presented and to evaluate the
position of the firm.

These techniques include ratio analysis, common size analysis, review of

descriptive material, and comparisons of results with other types of data. The
information derived from these types of analyses should be blended to
determine the overall financial position. No one type of analysis supports overall
findings or serves all types of users.

Financial Statement Analysis Project

In this project, you have to:
• Select two listed companies existing in the same industry (e.g. Unilever and
Proctor and Gamble in the food and personal care products, etc)
• Get their financial statements for the most recent three years and
• Perform the afore-mentioned analysis

Theme of the Project

Financial Analysis techniques such as ratio analysis and common size financial
statements can provide valuable insight into a company’s operations, risk
characteristics, and valuation beyond what is readily apparent by examining raw
data. When data is presented analytically, differences across time periods,
interrelationships of financial statement accounts and comparisons among
companies, are more easily understood.

An effective analysis encompasses both computations and interpretations. A

well reasoned analysis differs from a mere complication of various pieces of
information, computations, tables, and graphs by integrating the data collected
into a cohesive whole. Analysis of the past performance, for example, should
address not only what happened but also why it happened and whether it
advanced company’s strategy. Some of the key questions to address include:

 What aspects of performance are critical for this company to successfully

compete in the industry?
 How well did the company‘s performance meet these critical aspects?
(This is established through computations and comparison with
appropriate benchmarks, such as the company’s own historical
performance or competitors’ performance.)
 What are the key causes of this performance, and how would this
performance affect the company in the future?
 What is the likely impact of trends in the company, industry, and
economy on the future cash flows?
 What are your recommendations as an analyst?

Financial Analysis Techniques:

The following techniques can help you in achieving the overall objective of
financial statement analysis of the companies.

1. Ratio Analysis
Ratio analysis is the calculation and comparison of ratios which are derived from
the information in a company's financial statements. Financial ratios are usually
expressed as a percent or as times per period.

a) Liquidity Ratios
Liquidity ratios measure a firm’s ability to meet its current obligations.
These include:
• Current Ratio
• Acid Test Ratio
• Sales to Working Capital
• Working capital

b) Leverage Ratios
Leverage ratios measure the degree of protection of suppliers of long term funds.
These include:
• Time Interest Earned
• Fixed Charge Coverage
• Debt Ratio
• Debt / Equity Ratio
• Debt to Tangible Net worth Ratio
• Current Worth / Net worth Ratio
• Total Capitalization Ratio
• Fixed Asset Ratio / Equity Ratio
• Long term Assets versus Long term Debt

c) Profitability Ratios
Profitability ratios measure the earning ability of a firm.
These include:
• Net Profit Margin
• Return on Assets
• DuPont Return on Assets
• Operating Income Margin
• Operating Assets Turnover
• Return on Operating Assets
• Sales to Fixed Assets
• Return on Investment (ROI)
• Return on Total Equity
• Gross Profit Margin

d) Activity Ratios
Activity ratios measure a firm's ability to convert different accounts within their
balance sheets into cash or sales.
These include:
• Accounts Receivable Turnover
• Average Collection Period
• Accounts Payable Turnover
• Average Payment Period
• Inventory Turnover
• Average Age of Inventory
• Operating Cycle
• Total Assets Turnover
• Fixed Assets Turnover

e) Market Ratios
Market ratios are commonly used by the investors to assess the performance of a
business as an investment and also the cost of issuing stock.
These include:
• Dividend per share
• Earning per Share
• Price/Earning Ratio
• Percentage of Earnings Retained
• Dividend Payout
• Dividend Yield
• Book Value per Share

f) Statements of Cash Flow

Cash flow ratios indicate liquidity, borrowing capacity and profitability.
These include:
• Operating Cash Flow/Current Maturities of Long Term Debt and Current
Notes Payable
• Operating Cash Flow/Total Debt
• Operating Cash Flow per Share
• Operating Cash Flow/Cash Dividends
2. Horizontal Analysis
Horizontal analysis is done by computing the increase or decrease in percentage
terms of each item from the prior year. It highlights items that have changed
unexpectedly or have unexpectedly remained unchanged. It uses one year's
worth of entries as a baseline while every other year represents differences in
terms of changes to that baseline.

3. Vertical Analysis
It is a technique for identifying relationship between items in the same financial
statement by expressing all amounts as the percentage of the total amount taken
as 100.

4. Review of Descriptive Information

The descriptive information found in an annual report, in trade periodicals, and
in industry reviews helps in understanding the financial position of a firm.
Descriptive material might discuss the role of research and development in
producing future sales, present data on capital expansion and the goal related
such as minority hiring or union negotiations, or help explain the dividend
policy of the firm.

5. Comparisons
Absolute figures or ratios appear meaningless unless compared to other figures
or ratios.
Several types of comparisons offer insight, e.g.

a) Trend Analysis
Trend analysis studies the financial history of a firm for comparison. It is the
comparative analysis of a company's financial ratios over time. This helps to
detect problems or observe good management. Ratios are plotted on graph to see
whether the ratios are falling, rising, or remaining relatively constant.

b) Industry Averages and Comparisons with Competitors

The analysis of an entity’s financial statements is more meaningful if the results
are compared with industry averages and with results of competitors.
You are required to select 3-4 companies from the same industry and then
calculate their 8 -10 ratios. You have to compare their ratios results with your
companies’ ratios results. This enables financial analyst to check that where the
selected companies fall in that particular industry.
Please follow these instructions strictly:
• You must provide scanned copies of all the financial statements used for
financial analysis.
(If you have downloaded the financial statements from internet then its
source or web link should be provided. Scanned copies are not required in
such case).
NOTE: Your work will not be considered or accepted in case you do not
provide scanned copies or source of original financial statements.
• You must perform complete financial statements analysis of the selected
companies for the most recent three years.
• You must apply all afore-mentioned techniques when doing analysis of
financial statements.
• You must provide all the supporting calculations, working and
interpretation of results obtained from each ratio. You are required to
calculate/analyze minimum forty (40) ratios.
• NOTE: Failure to provide the financial statements, supporting
calculations and working of analyses in your project will affect the worth
of your work and may result in failure/rejection of the project.
• You must not perform the financial analyses of companies having losses.
• While selecting companies for analyses, keep in mind that they are from
same industry for example; you cannot select one company from textile
spinning and one from textile weaving. Both companies should be either
from textile spinning or weaving sector.
• You can get annual reports of companies from companies’ offices, stock
exchanges or from companies’ websites.