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# Analysis Of Financial Statement 1

## ANALYSIS OF FINANCIAL STATEMENT

Learning Objectives: 1. Prepare and interpret financial statements in comparative and common-size form. 2. Compute and interpret financial ratios that would be most useful to a common stock holder. 3. Compute and interpret financial ratios that would be most useful to a short-term creditor 4. Compute and interpret financial ratios that would be most useful to long -term creditors.

## Definition and Explanation of Financial Statement Analysis:

Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account. 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, and ratios analysis. Financial statements are prepared to meet external reporting obligations and 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 and interpretation of financial statements.

## TOOLS AND TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS:

Following are the most important tools and techniques of financial statement analysis:

## 1. Horizontal and Vertical Analysis

2. Ratios Analysis

## Horizontal Analysis or Trend Analysis:

Definition and Explanation of Horizontal or 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 as has been done in the example below. Showing changes in dollar form helps the analyst focus on key factors t hat have affected profitability or financial position. Observe in the example that sales for 2002 were up \$4 million over 2001, but that this increase in sales was more than negated by a \$4.5million increase in cost of goods sold. Showing changes between years in percentage form helps the analyst to gain perspective and to gain a feel for the significance of the changes that are taking place. For example a \$1 million increase in sales is much more significant if the prior year's sales were \$2 million than if the prior year's sales were \$20 million. In the first situation, the increase would be 50% that is undoubtedly a significant increase for any firm. In the second situation, the increase would be 5% that is just a reflection of normal progress. Example of Horizontal or Trend Analysis: Balance Sheet:
Comparative Balance Sheet 2001

31,

2002,

## and Increase (Decrease)

2002

2001

Amount

Percent

Assets Current Assets: Cash Accounts receivable Inventory Prepaid Expenses \$1,200 6,000 8,000 300 ---------Total current assets \$15,500 ----------Property and equipment: Land Building 4,000 12,000 ----------4,000 8,500 ----------0 3,500 ---------0% 41.2% \$2,350 4,000 10,000 120 ----------\$16,470 ----------\$(1,150)* 2000 (2000) 180 ---------(970) ---------(48.9)% 50% (20.0)% 150.0% ---------(5.9)% ---------

## Analysis Of Financial Statement

Total property and equipment 16,000 ---------Total assets 31,500 ====== 12,500 ----------28,970 ====== 3,500 ---------2,530 ====== 28% --------8.7% ======

Liabilities and Stockholders' Equity Current liabilities: Accounts payables Accrued payables Notes payables \$5,800 900 300 ---------Total current liabilities 7,000 ---------Long term liabilities: Bonds payable 8% 7,500 ---------Total long term liabilities 7,500 ---------Total Liabilities Stock holders equity: Preferred stock, 100 par, 6%, \$100 liquidation value Common stock, \$12 par Additional paid in capital \$2,000 6,000 1,000 ---------Total paid in capital Retained earnings 9,000 8,000 ---------Total stockholders' equity 17,000 ---------Total liabilities and stockholders' equity \$31,500 ===== \$2,000 6,000 1,000 ---------0 0 0 --------0% 0% 0% -------\$14,500 8,000 (500) (6.3)% \$4,000 400 600 ---------5,000 1800 500 (300) ----------2,000 45% 125% (50%) --------40%

----------

----------

-----------

---------8,000 ---------13,000

---------(500) ---------1,500

---------6.3% ---------(11.5)%

## Analysis Of Financial Statement

*Since we are measuring the change between 2001 and 2002, the dollar amounts for 2001 become the base figure for expressing these changes in percentage form. For example, cash decreased by figures \$1,150 between 2001 and 2002. This decrease expressed in percentage form is computed as follows: \$1,150 \$2,350 = 48.9% Other percentage figures in this example are computed by the same formula. Income Statement:
Comparative income For the year (dollars in thousands) statement ended and reconciliation December 31, of retained 2002, and earnings 2001

Increase (Decrease) 2002 Sales Cost of goods sold \$52,000 36,000 -----------Gross margin 16,000 -----------Operating expenses: Selling expenses Administrative expense 7,000 5,860 -----------Total operating expenses 12,860 -----------Net operating income Interest expense 3,140 640 -----------Net income before taxes Less income taxes (30%) 2,500 750 -----------Net income 1,750 6,500 6,100 -----------12,600 -----------3,900 700 -----------3,200 960 -----------2,240 500 (240) -----------260 -----------(760) (60) -----------(700) (210) -----------\$ (490) ====== Dividends to preferred stockholders, \$6 per share (see 7.7% (3.9)% -----------2.1% -----------(19.5)% (8.6)% -----------(21.9)% (21.9)% -----------21.9% 2001 \$48,000 31,500 -----------16,500 -----------Amount \$4,000 4,500 -----------(500) -----------Percent 8.3% 14.3% ----------(3.0)% ------------

## Analysis Of Financial Statement

balance sheet above) 120 -----------Net income remaining for common stockholders Dividend to common stockholders, \$1.20 per share 1,630 600 -----------Net income added to retained earnings Retained earnings, beginning of year 1,030 6,970 -----------Retained earnings, end of year \$ 8,000 ======= 120 -----------2,120 600 -----------1,520 5,450 -----------\$ 6,970 =======

Horizontal analysis of financial statements can also be carried out by computing trend percentages.

Trend Percentage:
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.

## Vertical Analysis and Common Size Statements:

Definition and Explanation of Vertical Analysis and Common Size Statements: Vertical analysis is the procedure of preparing and 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 and trends can be highlighted by the use of common size statements. Common size statements are particularly useful when comparing data from different companies. For example, in one year, Wendy's net income was about \$110 million, whereas McDonald's was \$1,427 million. This comparison is somewhat misleading because of the dramatically different size of the two companies. To put this in better perspective, the net income figures can be expressed as a percentage of the sales revenues of each company, Since Wendy's sales revenue were \$1,746 million and McDonald's were \$9,794 million, Wendy's net income as a percentage of sales was about 6.3% and McDonald's was about 14.6%.

## Analysis Of Financial Statement

Example: Balance Sheet: One application of the vertical analysis idea is to state the separate assets of a company as percentages of total sales. A common type statement of an electronic company is shown below:
Common Size December (dollars in thousands) Comparative 31, Balance and Sheet 2001

2002,

## Common-Size Percentages 2002 2001 2002 2001

Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses \$ 1,200 6,000 8,000 300 -----------Total current assets 15,500 -----------Property and equipment: Land Building and equipment 4,000 12,000 -----------Total property and equipment 16,000 -----------Total assets \$ 31,500 ====== 4,000 8,5000 -----------12,500 -----------\$ 28,970 ====== 12.7% 38.1% -----------50.8% -----------100.0% ====== 13.8% 29.3% -----------43.1% -----------100.0% ====== \$ 2,350 4,000 10,000 120 -----------16,470 -----------3.8% 19.0% 25.4% 1.0% ----------49.2% -----------8.1% 13.8% 34.5% 0.4% -----------56.9% ------------

Liabilities and Stockholders' Equity Current liabilities: Accounts payable Accrued payable Notes payable, short term \$ 5,800 900 300 \$ 4,000 400 600 18.4% 2.9% 1.0% 13.8% 1.4% 2.1%

## Analysis Of Financial Statement

-----------Total current liabilities 7,000 -----------Long term liabilities: Bonds payable, 8% 7,500 -----------Total liabilities 14,500 -----------Stockholders' equity: Preferred stock, \$100, 6%, \$100 liquidation value Common stock, \$12 par Additional paid in capital 2,000 6,000 1,000 -----------Total paid in capital Retained earnings 9,000 8,000 -----------Total stockholders equity 17,000 -----------\$ 31,500 ====== 2,000 6,000 1,000 -----------9,000 6,970 -----------15,970 -----------\$ 28,970 ====== 6.3% 19.0% 3.2% -----------28.6% 25.4% -----------54.0% -----------100.0% ====== 6.9% 20.7% 3.5% -----------31.1% 24.1% -----------55.1% -----------100.% ====== 8,000 -----------13,000 -----------23.8% -----------46.0% -----------27.6% -----------44.9% ----------------------5,000 ----------------------22.2% ----------------------17.3% ------------

*Each

asset in common size statement is expressed in terms of total assets, and each liability and equity account is expressed in terms of total liabilities and stockholders' equity. For example, the percentage figure above for cash in 2002 is computed as follows: [\$1,200 / \$31,500 = 3.8%]

Notice from the above example that placing all assets in common size form clearly shows the relative importance of the current assets as compared to the non-current assets. It also shows that the significant changes have taken place in the composition of the current assets over the last year. Notice, for example, that the receivables have increased in relative importance and that both cash and inventory have declined in relative importance. Judging from the sharp increase in receivables, the deterioration in cash position may be a result of inability to collect from customers. The main advantages of analyzing a balance sheet in this manner is that the balance sheets of businesses of all sizes can easily be compared. It also makes it easy to see relative annual changes in one business.

## Analysis Of Financial Statement

Income Statement:
Another application of the vertical analysis idea is to place all items on the income statement in percentage form in terms of sales. A common size statement of this type of an electronics company is shown below:

## income 31, 2002,

and

statement 2001

Common-Size Percentage 2002 Sales Cost of goods sold \$52,000 36,000 -----------Gross margin 16,000 -----------Operating expenses: Selling expenses Administrative expense 7,000 5,860 -----------Total operating expenses 12,860 -----------Net operating income Interest expense 3,140 640 -----------Net income before taxes Income tax (30%) 2,500 750 -----------Net income \$ 1,750 ====== 6,500 6,100 -----------12,600 -----------3,900 700 -----------3,200 960 -----------\$2,240 ====== 13.5% 11.3% -----------24.7% -----------6% 1.2% -----------4.8% 1.4% -----------3.4% ====== 13.5% 12.7% -----------26.2% -----------8.1% 1.5% -----------6.7% 2.0% -----------4.7% ====== 2001 \$48,000 31,500 -----------16,500 -----------2002 100.0% 69.2% -----------30.8% -----------2001 100.0% 65.6% -----------34.4% ------------

*Note

that the percentage figures for each year are expressed in terms of total sales for the year. For example, the percentage figure for cost of goods sold in 2002 is computed as follows: [(\$36,000 / \$52,000) 100 = 69.2%]

By placing all items on the income statement in common size in terms of sales, it is possible to see at a glance how each dollar of sales is distributed among the various

## Analysis Of Financial Statement

costs, expenses, and profits. And by placing successive years' statements side by side, it is easy to spot interesting trends. For example, as shown above, the cost of goods sold as a percentage of sales increased from 65.6% in 2001 to 69.2% in 2002. Or looking at this form a different view point , the gross margin percentage declined from 34.4% in 2001 to 30.8% in 2002. Managers and investment analysis often pay close attention to the gross margin percentage since it is considered a broad gauge of profitability. The gross margin percentage is computed by the following formula: Gross margin percentage = Gross margin / Sales The gross margin percentage tends to be more stable for retailing companies than for other service companies and for manufacturers. Since the cost of goods sold in retailing exclude fixed costs. When fixed costs are included in the cost of goods sold figure, the gross margin percentage tends to increase of decrease with sales volume. The fixed costs are spread across more units and the gross margin percentage improves. While a higher gross margin percentage is considered to be better than a lower gross margin percentage, there are exceptions. Some companies purposely choose a strategy emphasizing low prices and (hence low gross margin). An increasing gross margin in such a company might be a sign that the company's strategy is not being effectively implemented. Common size statements are also very helpful in pointing out efficiencies and inefficiencies that might other wise go unnoticed. To illustrate, selling expenses, in the above example of electronics company , increased by \$500,000 over 2001. A glance at the common-size income statement shows, however, that on a relative basis, selling expenses were no higher in 2002 than in 2001. In each year they represented 13.5% of sales.

2. Ratios Analysis:
Accounting Ratios Definition, Advantages, Classification and Limitations: 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.

Profitability Ratios:
Profitability ratios measure the results of business operations or overall performance and effectiveness of the firm. Some of the most popular profitability ratios are as under: Gross profit ratio Net profit ratio Operating ratio Expense ratio Return on shareholders investment or net worth Return on equity capital Return on capital employed (ROCE) Ratio Dividend yield ratio

## Analysis Of Financial Statement

Dividend payout ratio Earnings Per Share (EPS) Ratio Price earning ratio

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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. Current ratio Liquid / Acid test / Quick ratio

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 because they indicate the speed with which assets are being turned over into sales. Following are the most important activity ratios: Inventory / Stock turnover ratio Debtors / Receivables turnover ratio Average collection period Creditors / Payable turnover ratio Working capital turnover ratio Fixed assets turnover ratio Over and under trading

## Long Term Solvency or Leverage Ratios:

Long term solvency or leverage ratios convey a firm's ability to meet the interest costs and payment schedules of its long term obligations. Following are some of the most important long term solvency or leverage ratios. Debt-to-equity ratio Proprietary or Equity ratio Ratio of fixed assets to shareholders funds Ratio of current assets to shareholders funds Interest coverage ratio Capital gearing ratio Over and under capitalization

Financial-Accounting- Ratios Formulas: A collection of financial ratios formulas which can help you calculate financial ratios in a given problem. Limitations of Financial Statement Analysis: Although financial statement analysis is highly useful tool, it has two limitations. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios..

## 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. Secondly, regulatory authorities like International Accounting Standards Board can ensure whether the company is following accounting standards or not. Thirdly, 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 statements analysis.

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