Financial Analysis and

Control

MFI-5022

CHAPTER ONE
OVERVIEW OF FINANCIAL
ANALYSIS

The nature of Financial

statements
Financial statements are accounting reports
that provide financial information to users.
Basic financial statements:
Balance Sheet
Income Statement
Statement of Retained Earnings
Statement of Cash Flows

The nature of Financial

statements (continued)
Primary

financial statements answer basic

questions including:

What is the companys current financial status?

What was the companys operating results for

the period?
How did the company obtain and use cash
during the period?

The Balance sheet

Summary of the financial position of a
company at a particular date
Assets:

cash, accounts receivable,

inventory, land, buildings, equipment and
intangible items.
Liabilities:

accounts payable, notes

payable and mortgages payable
Owners

Equity: Net assets after all

obligations have been satisfied

continued
The balance sheet answers the following
questions;
What are the resources of the company?
What are the companys existing
obligations?
What are the companys net assets?

Accounting Equation
Assets = Liabilities + Owners Equity
Resources

Resources
to use to
generate
revenues

Sources of Funding

Creditors
claims
against
resources

Owners
claims
against
resources

Classified and comparative

Balance sheet
They

distinguish between:

Current and long-term assets

Current and long-term liabilities
Listed

in decreasing order of liquidity

Comparative

so that financial statement

users can identify significant changes over
time. They have more than one year on the
Balance Sheet.

The Income statement

Shows

the results of a companys

operations over a period of time.
What
goods were sold or services
performed that provided revenue for the
company?
What costs were incurred in normal
operations to generate these revenues?
What are the earnings or company profit?

continued
Revenues
Assets (cash or AR) created through
business operations
Expenses
Assets (cash or AP) consumed through
business operations
Net Income or (Net Loss)
Revenues - Expenses

Statement of Retained
Earnings
An additional financial statement that
identifies changes in retained earnings
from one accounting period to the next.
Beginning retained earnings
+ Net income
Dividends paid
= Ending retained earnings

Statement of Cash Flows

Reports

the amount of cash collected and

paid out by a company in operating,
investing and financing activities for a period
of time.
How did the company receive cash?
How did the company use its cash?
Complementary to the income statement.
Indicates ability of a company to generate
income in the future.

Continued
Cash inflows
Sell goods or services
Sell other assets or by borrowing
Receive cash from investments by owners
Cash outflows
Pay operating expenses
Expand operations, repay loans
Pay owners a return on investment

What is financial analysis?

Financial analysis refer the use of financial
data to evaluate the current and past
performance of a firm and to assess its
sustainability.
The goal of financial analysis is to assess the
performance of a firm in the context of its
stated goals and strategy

Objectives of Financial Analysis

Understand reported financial data

Provide a base for rational decision
making
Better manage a business
Make a reasonable assessment of future
financial condition based on present and
past financial conditions and on best
available estimate of future economic
occurrences

Objectives of Financial Analysis

Why

not accept prepared

statements at face value?

Prepared

financial

financial statements require some

analysis as first step toward extracting
information from presented data.
Decisions made on basis of financial analysis
are important and accepting presented
financial data at face value is poor policy.

Continued
There

are two principal tools of

financial analysis: ratio analysis and
cash flow analysis.

Ratio analysis
Ratio

analysis involves assessing how

various line items in a firms financial
statements relate to one another.

Ratios

are used to develop a set of

statistics that reveal key financial
characteristics of a company.

Ratio Analysis
In analyzing the financial data, the objective
is to assess;

1. Profitability: bottom-line ratios designed to

2.
3.

measure earning power and profitability record

of company
Liquidity: ratios designed to measure ability of
firm to meet its short-term liabilities as they
come due
Solvency: Measures the ability of the

company to survive over a long period of

time

Ratio Analysis
Analyzing financial statements involves:
Comparison
Bases

Characteristics

Profitability

Liquidity

Solvency

Intracompany

Industry
averages

Intercompany

Tools of
Analysis

Horizontal

Vertical

Ratio

Horizontal Analysis
Horizontal analysis, also called trend analysis,
is a technique for evaluating a series of financial
statement data over a period of time.

Purpose is to determine the increase or

decrease that has taken place.

Commonly applied to the balance sheet,

income statement, and statement of
retained earnings.

Horizontal Analysis
Horizontal analysis of
balance sheets

Changes suggest
that the company
expanded its asset
base during 2011
and financed this
expansion
primarily by
retaining income
rather than
assuming
additional longterm debt.

Horizontal Analysis
Horizontal analysis of
Income statements

Overall, gross profit

and net income
were up
substantially. Gross
profit increased
17.1%, and net
income, 26.5%.
Qualitys profit trend
appears favorable.

Horizontal Analysis

Horizontal analysis of
retained earnings
statements

In the horizontal analysis of the balance sheet the ending

retained earnings increased 38.6%. As indicated earlier,
the company retained a significant portion of net income
to finance additional plant facilities.

Vertical Analysis
Vertical analysis, also called common-size
analysis, is a technique that expresses each
financial statement item as a percent of a base
amount.

On an income statement, we might say

that selling expenses are 16% of net sales.

Vertical analysis is commonly applied to the

balance sheet and the income statement.

Vertical Analysis
Vertical analysis of
balance sheets

These results reinforce

the earlier observations
that Quality is
choosing to finance
its growth through
retention of earnings
rather than through
issuing additional
debt.

Vertical Analysis
Vertical analysis of
Income statements

Quality appears
to be a profitable
enterprise that is
becoming even more
successful.

Vertical Analysis
Enables a comparison of companies of different sizes.

Ratio Analysis
Ratio analysis expresses the relationship among selected
items of financial statement data.
Financial Ratio Classifications

Liquidity
Measures
shortterm ability of the
company to pay its
maturing
obligations and to
meet unexpected
needs for cash.

Profitability
Measures the
income or
operating success
of a company for a
given period of
time.

Solvency
Measures the
ability of the
company to
survive over a long
period of time.

Ratio Analysis
A single ratio by itself is not very meaningful.
The discussion of ratios will include the
following types of comparisons.
1. Intracompany comparisons
2. Industry average comparisons
3. Intercompany comparisons.

Ratio Analysis

Liquidity Ratios

Measure the short-term ability of the company to

pay its maturing obligations and to meet
unexpected needs for cash.

Short-term creditors such as bankers and

suppliers are particularly interested in
assessing liquidity.

Ratios include the current ratio, the acidtest ratio, accounts receivable turnover,
and inventory turnover.

Current Ratio
The current ratio is calculated by dividing
current assets by current liabilities.
Current
assets normally include cash,
marketable securities, accounts receivable,
and inventories.
Current liabilities consist of accounts payable,
short-term notes payable, current maturities of
long-term debt, accrued taxes, and other
accrued expenses.

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets

For the Years Ended December 31

Condensed Income Statements

For the Years Ended December 31

Illustration 18-12

Current Ratio

Ratio of 2.96:1 means that for every dollar of current liabilities, Quality
has $2.96 of current assets.

Acid-Test Ratio
Acid-test ratio measures immediate liquidity
The quick, or acid test, ratio is calculated by
deducting inventories and other prepaid
expenses from current assets and then
dividing the remainder by current liabilities.

Acid-Test Ratio

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets

For the Years Ended December 31

Balance Sheet (partial)

For the Years Ended December 31

Illustration 18-12

Acid-Test Ratio

Accounts receivable turnover ratio

measures the number of times, on
average, the company collects receivables
during the period.

It

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial)
For the Years Ended December 31

Condensed Income Statements

For the Years Ended December 31

Accounts Receivable Turnover

Assume the beginning receivable for 2010 is $200,000.

Accounts Receivable Turnover

$2,097,000
($180,000 + $230,000) / 2

= 10.2 times

A variant of the accounts receivable turnover ratio is to convert it

to an average collection period in terms of days.

365 days / 10.2 times = every 35.78 days

Accounts receivable are collected on average every 36 days.

Inventory Turnover
Measures the number of times, on average,
the inventory is sold during the period
It is defined as cost of goods sold divided by
average (beginning plus ending divided by
two) inventories.

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Balance Sheet (partial)

For the Years Ended December 31

Condensed Income Statements

For the Years Ended December 31

Illustration 18-12

Inventory Turnover

Inventory Turnover
$1,281,000
($500,000 + $620,000) / 2

= 2.3 times

A variant of inventory turnover is the days in inventory.

365 days / 2.3 times = every 159 days

Inventory turnover ratios vary considerably among industries.

Ratio Analysis

Profitability Ratios

Measure the income or operating success of a

company for a given period of time.

Income, or the lack of it, affects the companys

ability to obtain debt and equity financing,
liquidity position, and the ability to grow.

Ratios include the profit margin, asset

turnover, return on assets, return on
common stockholders equity, earnings per
share, price-earnings, and payout ratio.

Profit Margin
Measures

the percentage of each

dollar of sales that results in net
income.
It is calculated by dividing net income
by sales.

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets

For the Years Ended December 31

Condensed Income Statements

For the Years Ended December 31

Profit Margin

Asset Turnover
Measures

how efficiently a company

uses its assets to generate sales.

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets

For the Years Ended December 31

Condensed Income Statements

For the Years Ended December 31

Illustration 18-12

Asset Turnover

Assume the beginning total asset for 2010 is $1,446,000

Return on Asset
The

ratio of net income to total assets

measures the return on total assets
(ROA) after interest and taxes

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets

For the Years Ended December 31

Condensed Income Statements

For the Years Ended December 31

Illustration 18-12

Return on Asset

Return on Common Stockholders Equity

Shows how many dollars of net income the
company earned for each dollar invested by
the owners.
ROE is a comprehensive indicator of a firms
performance because it provides an
indication of how well managers are
employing the funds invested by the firms
shareholders to generate returns

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets

For the Years Ended December 31

Condensed Income Statements

For the Years Ended December 31

Illustration 18-12

Return on Common Stockholders Equity

Assume the beginning stockholders equity for the year 2010 was
$667000.

Earnings Per Share (EPS)

A measure of the net income earned on each

share of common stock.

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets

For the Years Ended December 31

Condensed Income Statements

For the Years Ended December 31

Illustration 18-12

Earnings Per Share (EPS)

Price-Earnings Ratio

Measures how much investors are willing to

pay per dollar of current earnings
Calculated market price of the share/earning
per share

Assume the market price of the share is $12

in 2011 and $8 in 2010

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets

For the Years Ended December 31

Condensed Income Statements

For the Years Ended December 31

Illustration 18-12

Price-Earnings Ratio

Payout Ratio

Measures the percentage of earnings

distributed in the form of cash dividends.

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets

For the Years Ended December 31

Condensed Income Statements

For the Years Ended December 31

Illustration 18-12

Payout Ratio

Ratio Analysis

Solvency Ratios

Solvency ratios measure the ability of a

company to survive over a long period of time.

Debt to Assets and

Times Interest Earned are two ratios that

provide information about debt-paying
ability.

Debt to Total Assets Ratio

Measures the percentage of the total
assets that creditors provide.

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets

For the Years Ended December 31

Condensed Income Statements

For the Years Ended December 31

Illustration 18-12

Debt to Total Assets Ratio

Times Interest Earned

Provides an indication of the companys
ability to meet interest payments as they
come due.

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets

For the Years Ended December 31

Condensed Income Statements

For the Years Ended December 31

Illustration 18-12

Times Interest Earned

Summary of Ratios

Summary of Ratios

Cash flow Analysis

The ratio analysis discussion focused on
analyzing a firms income statement (net
profit margin analysis) or its balance sheet
(asset turnover and financial leverage).
The analyst can get further insights into the
firms operating, investing, and financing
policies by examining its cash flows

Continued

In the reported cash flow statement, firms

classify their cash flows into three categories:
cash flow from operations
cash flow related to investments, and
cash flow related to financing activities.

Analyzing Cash Flow Information

Cash flow analysis can be used to address a
variety of questions regarding a firm's cash flow
dynamics:
How strong is the firm's internal cash flow
generation?

Is the cash flow from operations positive or negative?

If it is negative, why?
Is it because the company is growing?
Is it because its operations are unprofitable?
Or is it having difficulty managing its working capital
properly?

continued

Does the company have the ability to meet

its short-term financial obligations, such as
interest payments, from its operating cash
flow?

Can it continue to meet these obligations without

reducing its operating flexibility?

continued

How much cash did the company invest in growth?

Are these investments consistent with its business

strategy?
Did the company use internal cash flow to finance growth,
or did it rely on external financing?

Did the company pay dividends from internal free

cash flow, or did it have to rely on external financing?

If the company had to fund its dividends from external

sources, is the company's dividend policy sustainable?

Continued

What type of external financing does the

company rely on?

Equity, short-term debt, or long-term debt?

Is the financing consistent with the company's
overall business risk?

Does the company have excess cash flow

after making capital investments?

Is it a long-term trend?
What plans does management have to deploy the
free cash flow?

Operating Cash Flow

Operating Cash Flow (OCF) is broken up into
two components, OCF before working capital
investments and OCF before investments in
long term assets.
Over the long run OCF must be positive, but
firms in the early stages of development,
growing rapidly, or investing heavily in research
and development, marketing and advertising,
and other future growth opportunities will have
negative OCF.

Free Cash Flow

If cash flow after investing in long term assets is
not positive then the firm did not generate
enough cash from operations to pursue longterm growth opportunities and must rely on
external financing.
These firms have less flexibility than firms that
can generate the necessary funds internally.
Cash flow after long term investments is cash
flow available to both debt and equity holders.

Free Cash Flow

Payments

to debt holders include interest

and principal payments.
Firms with negative free cash flow after
investments in long term assets must
borrow additional funds to meet their
interest and principal payments.
They can also reduce their investments.

Free Cash Flow

Cash

flow after payments to creditors is free

cash flow available to owners.
If firms pay dividends despite negative cash
flows available to equity holders then they
are borrowing to pay dividends. This is not
sustainable in the long term.

Summary
Examine cash flow from operations before
investment in working capital to verify the
company is able to generate a cash surplus from
its operations.
Examine cash flow from operations before
investment in long term assets to assess how
the firms working capital is being managed and
to see if the company can invest in long-term
assets for future growth.

Summary
Examine free cash flow to debt and equity
holders to asses a firms ability to meet its
principal and interest payments.
Examine free cash flow to equity holders to
asses a firms ability to sustain its dividend
policy.
All cash flow analysis must be done taking into
consideration the companys business, its
growth strategy, and its financial policies.

Analyzing Quality of Income

The Quality of Income Ratio is calculated as

Cash Flow from Operations
Net Income

Analyzing Quality of Income

If there are significant differences between net income

and operating cash flow ask the following questions:
What are the sources of the difference?
Is it due to accounting policy?
Is it due to one-time events or on-going activities?
Is the relationship changing over time?
If so, why?
Is it because of changes in business conditions or
accounting policies and estimates?

Analyzing Quality of Income

What is the time lag between recognition of
revenues and expenses and the receipt or
payment of cash?
What uncertainties are there regarding cash
collection or cash payments (e.g. bad debts,
contingent liabilities, etc.)
Are the changes in working capital accounts
normal?
If not, is there an adequate explanation for the
changes?

End of CH 1