WEEK: ONE

SESSION: 1

ANALYSIS OF FINANCIAL
STATEMENTS
OSMAN BIN SAIF

Self Introduction
Finance Graduate;
MSC. Accounting and Finance (University of Exeter, UK)
MBA- Finance (SZABIST, Islamabad)
Certified Financial Consultant (IFC , Canada)
Certifications in Project Management, Monitoring and
Evaluation and Research Policy Development.

Consultant with SDPI

Previously , Senior Researcher with TP WING, MOC
Visiting Faculty various universities and institutes.
Permanent Faculty member at Bahria University.

Introduction
What is Financial Analysis?

Defining Financial Analysis

Financial analysis is the process of
evaluating financial and other
information for decision-making.
A six-step approach is suggested for
systematic financial analysis.

Six-step Process

Identify purpose of financial analysis

Corporate overview
Financial analysis techniques
Detailed accounting analysis
Comprehensive analysis
Decision or recommendation

Corporate Overview
Industry analysis--key economic
characteristics, historical context,
profit drivers, business risks
Firms business strategy--competitive
strategy given the industry
characteristics

Industry Analysis
Competition--growth rates,
concentration ratios, degree of
product differentiation, economies of
scale (& relative fixed & variable
costs), substitute products
Legal barriers--patent & copyrights,
licensing, regulation
Bargaining power of buyers (&
suppliers) & price sensitivity

Industry Analysis Criteria

What is the industry?

Relative size & significance
Largest companies
Geographic presence
Business cycle effects, current
situation
Future potential

Business Strategy
Cost leadership: low cost producer,
economies of scale, efficient
production, low input prices
Product differentiation: specific
attributes that customers value (e.g.,
quality, variety, service, delivery
time), brand name
Importance of core competencies

Business Strategy Criteria

Historical perspective
Primary focus of operations
Most important strategy
Major operating segments
Corporate outlook/ forecast

Qualitative Analysis--Dell Computer

Industryprimarily PCs: high tech,
competitive (e.g., Gateway, IBM, Apple,
others), changing products, high growth
rates, low barriers of entry
Business strategy--(1) cost leadership
strategy: direct selling, made-to-order
manufacturing, early on the internet, low
receivables; (2) product differentiation?? [IBM
clones, Intel & Microsoft components]
Current situationmarket share; what is the
impact of the business cycle (e.g., PCs are
durable goods)?

Quantitative Financial
Analysis
Systematic analysis of key elements
based on analysis context
Ratios, cash flows, common-size,
time series, comparative (e.g.,
specific firms, industry, all firms),
models (e.g., DuPont, Altmans)
In-depth analysis for red flag items

Quantitative Financial
Analysis

Financial Statements
Common-Size Analysis
Financial Ratios
Growth/Trend Analysis
Quarterly Analysis
DuPont Model
Market Analysis

Detailed Accounting
Analysis
Does accounting information capture
the underlying business reality?
Identify areas of accounting
flexibility & evaluate accounting
policies (choices) & disclosures;
especially notes & MD&A
Evaluate earnings management
potential
Recast accounting numbers when
necessary

Comprehensive Analysis
Summarize key points: what is
particularly important for decision
making?
Red flags are particularly important
Consider a written executive
summary
Consider a rating scale, such as 1-10

Decision
What is the recommendation or
decision?
What is the key rationale for this
decision? [This is based on the
specific decision: for a credit
decision the key factors relate to
credit risk, with particular focus on
leverage and liquidity.]
Be prepared to defend this decision.

Examples of External
Uses of Statement
Analysis
Trade Creditors -- Focus on the
liquidity of the firm.
Bondholders -- Focus on the longterm cash flow of the firm.
Shareholders -- Focus on the
profitability and long-term health of
the firm.

Examples of Internal
Uses of Statement
Analysis
Plan -- Focus on assessing the current
financial position and evaluating
potential firm opportunities.
Control -- Focus on return on
investment for various assets and
asset efficiency.
Understand -- Focus on understanding
how suppliers of funds analyze the
firm.

Primary Types of
Financial Statements
Balance Sheet

A summary of a firms financial position on a

given date that shows total assets = total
liabilities + owners equity.

Income Statement
A summary of a firms revenues and
expenses over a specified period, ending
with net income or loss for the period.

Basket Wonders
Balance Sheet (Asset
Side)
a

sket Wonders Balance Sheet (thousands) Dec. 31, 2007

a. How the firm stands

Cash and C.E.

$
90
on a specific date.
Acct. Rec.c
394 Inventories
b. What BW owned.
696 Prepaid Exp d
5
Accum Tax Prepay
10 c. Amounts owed by
Current Assetse $1,195
Fixed Assets (@Cost)f 1030
Less: Acc. Depr. g
(329)
Net Fix. Assets $ 701
Investment, LT 50 Other
Assets, LT
223
Total Assets b
$2,169

d.
e.
f.
g.

customers.
Future expense items
already paid.
Cash/likely convertible
to cash within 1 year.
Original amount paid.
Acc. deductions for
wear and tear.

Basket Wonders
Balance Sheet
(Liability
Side)
Basket Wonders Balance Sheet (thousands) Dec. 31, 2007
Notes Payable
$
290
Acct. Payablec
94
Accrued Taxes d
16
Other Accrued Liab. d
100
Current Liab.
e
$ 500 Long-Term Debt f
530 Shareholders Equity
Com. Stock ($1 par) g 200
Add Paid in Capital g 729
Retained Earnings h
210
Total Equity
$1,139
Total Liab/Equitya,b $2,169

a. Note, Assets =
Liabilities + Equity.
b. What BW owed and
ownership position.
c. Owed to suppliers for
goods and services.
d. Unpaid wages,
salaries, etc.
e. Debts payable < 1
year.
f. Debts payable > 1
year.

Basket Wonders
Income Statement
Basket Wonders Statement of Earnings (in thousands) for Year Ending
December 31, 2007a

Net Sales
$ 2,211 Cost of
Goods Sold b
1,599
Gross Profit $
612
SG&A Expenses c
402
EBITd
$
210 Interest Expensee
59
EBT f
$
151
Income Taxes
60
EATg
$
91
Cash Dividends
38
Increase in RE
$
53

a. Measures profitability
over a time period.
b. Received, or
receivable, from
customers.
c. Sales comm., adv.,
officers salaries, etc.
d. Operating income.
e. Cost of borrowed
funds.
f. Taxable income.

Framework for
Financial Analysis
Trend / Seasonal Component

1. Analysis of the fund

needs of the firm.

How much funding will be

required in the future?
Is there a seasonal component?

Analytical Tools Used

Sources and Uses Statement
Statement of Cash Flows
Cash Budgets

Framework for
Financial Analysis
Health of a Firm
1. Analysis of the funds
needs of the firm.
2. Analysis of the financial
condition and profitability
of the firm.

Financial Ratios
1.
2.
3.
4.

Individually
Over time
In combination
In comparison

Framework for
Financial Analysis

1. Analysis of the funds

needs of the firm.
2. Analysis of the financial
condition and profitability
of the firm.
3. Analysis of the business
risk of the firm.

Business risk relates to

the risk inherent in the
operations of the firm.
Examples:
Volatility in sales
Volatility in costs
Proximity to breakeven point

Framework for
Financial Analysis

1. Analysis of the funds

needs of the firm.
2. Analysis of the financial
condition and profitability
of the firm.
3. Analysis of the business
risk of the firm.

Determining
the
financing
needs of
the firm.

A Financial
Manager
must
consider all
three
jointly
when
determinin
g the
financing
needs of

Framework for
Financial Analysis

1. Analysis of the funds

needs of the firm.
2. Analysis of the financial
condition and profitability
of the firm.
3. Analysis of the business
risk of the firm.

Determining
the
financing
needs of
the firm.

Negotiations
with
suppliers of
capital.

Use of Financial Ratios

A Financial Ratio is
an index that
relates two
accounting
numbers and is
obtained by
dividing one
number by the
other.

Types of
Comparisons
Internal
Comparisons
External
Comparisons

External Comparisons
and Sources of
Industry Ratios

This involves
comparing the ratios
of one firm with
those of similar firms
or with industry
averages.
Similarity is
important as one
should compare
apples to apples.

Examples:
Risk
Management
Association
Dun &
Bradstreet
Almanac of
Business and
Industrial

Questions?

30

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