BA713 FINANCIAL MANAGEMENT

Topic 3: Financial Statement

Analysis

Larry Holmes Tara

Semester 2, 2020
Solomon Islands National University
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Learning Objectives:
• Discuss the need for comparative analysis
and identify the tools of financial statement
analysis.
Horizontal analysis
Vertical analysis.
Ratio analysis
• Limitations of financial statement
analysis.
• Relation to investment and financing
decision making
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Financial statement Analysis

• Involves careful selection of data from
Financial Statements for the primary
purpose of assessing the financial health of
the company.
• Provides the basis or tools for financial planning,
including estimation of cash flows relating to
investment and financing decisions.
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Interested Parties
• Management
• Owners / Investors
• Lenders / Creditors
• Customers
• Tax Office
• ASIC
Financial statements
• Two financial statements are common in
financial statements analysis:
1. Statement of financial performance – profit and
loss statement
2. Statement of financial position – balance sheet
statement
Components of statement of financial
performance
• Revenue:
▫ Sales
▫ Other incomes
• Expenses:
▫ Cost of goods sold
▫ Operating expenses
▫ Other expenses
Components of statement of financial
position
• Assets
▫ Current Assets – cash, A/R, Inventory, etc
▫ Long-term Assets – Vehicle, Equipments, Building
• Liabilities
▫ Current Liabilities – Accounts Payable, etc
▫ Long-term Liabilities – Bank loans, etc
• Owners Equity
▫ Capital
▫ Retained Earnings
▫ Reserves
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Comparative Analysis

• Intra-company – within a single company

(detects changes in financial relationships and
trends)
• industry averages – between companies in same
industry (determines position relative to others)
• Inter-company – between other companies
(indicates competitive position)
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Three basic techniques

▫ horizontal analysis
 to evaluate a series of financial data over time
▫ vertical analysis
 to evaluate financial items in relation to a base
amount
▫ ratio analysis
 to evaluate a comprehensive range of financial
relationships representing different aspects of an
entity’s activities
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Limitations of Financial Statement Analysis

• Estimates
▫ some valuations rely on estimations (e.g. rate of
depreciation, doubt debts) which may be incorrect
• Cost
▫ historic cost does not account for the effects of
price-level changes
▫ Effect of inflation
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Ratio Analysis – Limitations

• Alternative accounting methods

▫ differences in accounting policies for the similar
financial activities are often allowed (e.g.
inventory valuation – FIFO, LIFO)
• Atypical data
▫ some end-of-period data may not represent
normal business conditions (year end data)
• Diversification
▫ entities unable to be classified by industry
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1. Horizontal Analysis

• Used to analyse increases or decreases over a

series of financial periods
• Establishes trends
• Stated as both dollar amounts and as
percentages
• Percentages removes the effect of size, so
relative magnitude of change is revealed
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Horizontal Analysis
Percentages:
▫ can be stated relative to a nominated
base year
▫ or stated as a percentage change from
year to year
Dollar amount should be reported with
percentages
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Horizontal Analysis example

2015 2014 $ %
Cash at Bank $363 $288 $75 26.04

Dollar Change: Current yr – Last yr = 363 -288 = 75

% change : Dollar change / last yr = 75 / 288 = 26.04%

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2. Vertical Analysis

• Percentages used to indicate relative magnitude

of items with respect to a base amount
• Useful for comparing companies of different
sizes
• Calculated percentages can also be tracked over
time to determine relative changes (patterns of
change)
Vertical Analysis

2016 2016 2015 2015

$ % $ %
Sales 3074 100% 2567 100%
COGS 2088 67.92 1711 66.65

Workings:
Vertical analysis 2016: COGS / Sales = 2088 / 3074 = 67.92%

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3. Ratio Analysis
Involves a wide range of financial relationships:
• Liquidity – short-term ability to meet debt
obligations and unexpected needs for cash
• Solvency
▫ Ability to survive over a long period of time
▫ Ability to pay interest, dividends
▫ Stakeholders
 Long-term creditors & Shareholders
• Profitability
▫ Important to investors and creditors
▫ Often used to assess management’s effectiveness
Importance of ratio analysis
• Good financial planning is dependent on good ratio analysis
• In terms of investment and financing decision making, good
analysis of cash flow and other financial relationships
displayed from ratio analysis of a firm’s liquidity, solvency and
profitability is required.
• Ratio analysis helps in estimation of cash flows for alternative
investment and financing options
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1. Liquidity
• Current ratio
• Quick ratio
• Current cash debt coverage
• Receivables Turnover
• Average Collection Period
• Inventory Turnover
• Average days in Inventory
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2. Solvency

• Debt to Total Asset

• Times interest earned
• Cash debt coverage
• Free cash flow
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3. Profitability
• Return on ordinary shareholders equity
• Return on assets
• Profit margin ratio
• Asset turnover
• Gross profit rate
• Operating expenses to sales
• Cash return on sales ratio
• Earnings per share
• Price earnings ratio
• Cash dividend payout
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1.1 Current ratio

• Important to bankers, suppliers and other short-

term creditors

– indicates short-term debt-paying ability:

current assets
current liabilities

Acceptable ratio: 2 : 1
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1.2 Quick ratio

indicates immediate short-term ability to pay
debts by removing less liquid assets from current
asset numerator
e.g. Inventory and Prepayments

cash + marketable securities + net receivables

current liabilities
OR
current assets – inventory -prepayments
current liabilities
Acceptable ratio: 1 : 1
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1.3 Current cash debt coverage

reflects cash over a period, not just a single

point in time:

net cash provided by operating activities

average current liabilities
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1.4a Receivables turnover

indicates effectiveness of credit collection
policies (number of times trade receivables
are converted into cash during the period):
net credit sales
average net trade receivables

1.4b Average collection period

– converts receivables turnover figure into a
measure of days for receivables collection:
365 days
receivables turnover
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1.5a Inventory turnover

reflects effectiveness of inventory
management:
cost of goods sold
average inventory
1.5b Average days in inventory
converts inventory turnover into a measure of
days for inventory to be sold:
365 days
inventory turnover
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2.1 Debt to total assets ratio

• indicates degree of leverage
▫ percent of total assets funded through debt
total liabilities
total assets
2.2 Debt to equity ratio
• indicates relative size of debt with respect to
equity
• Gearing
▫ High gear (debt > equity)

total liabilities
total equity
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2.3 Times interest earned

• indicates ability to sustain debt
▫ number of times interest obligations can be
covered by operating profit
profit before interest and tax
interest expense

2.4 Cash debt coverage

• reflects whole period, not just a single point
in time
net cash from operating activities
average total liabilities
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2.5 Free cash flow

• indicates estimated discretionary cash

net cash from operating activities less capital

expenditure
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3.1 Return on ordinary

shareholders’ equity ratio
• indicates earnings per dollar invested by the
owners:

profits available to ordinary shareholders

average ordinary shareholder equity
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3.2 Return on assets

• indicates overall profitability with respect to
investment in assets:
net profit
average total assets
▫ Note: degree of leverage (interest expense),
profit margins and asset base affect this ratio
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3.3 Profit margin

• indicates rate of return on net sales

net profit
net sales

3.4 Gross profit rate

• indicates level of inventory costs to selling price:
gross profit
net sales
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3.5 Asset turnover

• indicates how efficiently assets are used to
generate sales:
net sales
average total assets
3.6 Operating expenses to sales ratio
• indicates level of other costs incurred to support
sales
operating expenses
net sales
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3.7 Cash return on sales ratio

• similar to net profit ratio, but uses cash
numerator instead of accrual profit

net cash from operating activities

net sales
3.8 Cash dividend payout ratio
• relates actual dividends paid to profits

cash dividend
net profit
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3.9 Earnings per share

• indicates level of net profit available for each
share:
profit available to ordinary shareholders
weighted average number of shares
3.10 Price-earnings ratio
• relates market confidence with profits available
to ordinary shareholders
market share price
earnings per share
Summary
• Liquidity and Solvency primarily measure RISK
• Profitability primarily measure RETURN
• Market ratios capture both RISK and RETURN
• Good Financial Analysis is the foundation for
Good Financial Planning, including accurate
estimation of cash flows relating to investment
and financing decisions
Review questions
1. Why is it preferable to compare ratios calculated from
financial reports that are dated at the same point in time?
2. To assess a firm’s average collection period and average
payment period ratios, what additional information is
needed, and why?
3. What is financial leverage?
4. What ratio measures the firm’s degree of indebtedness?
What ratio measures the firm’s ability to service debts?
5. What would explain a firm’s having a high gross profit
margin and a low net profit margin?
6. Which measure of profitability is probably of greatest
interest to the investing public? Why?