Discussion points

Financial analysis def.

Financial statement analysis

Users of financial statement analysis

Key methods of financial statement analysis

Financial Analysis
 Financial Analysis is

 the process of identifying

 financial strength and weakness of a business

 by establishing relationship between

 the elements of balance sheet and

 income statement

 financial analysis establish

 the key performance indicators

 such as, liquidity solvency, profitability

 and the efficiency of operations

 of a business entity
objective of financial analysis
 the objective of financial analysis is

 to draw information

 to facilitate decision making

 to evaluate

 strength and the weakness of a business

 to determine the earning capacity of a business

 to provide insights on

 liquidity, solvency and profitability and

 to decide

 future prospects of a business entity

Financial statements
 analysis of financial statements is

 known as financial analysis

 a financial statement is

 an organized collection of data

 according to logical and

 consistent accounting procedures

 Its purpose is to convey an understanding of

 financial characteristics of a business firm

 It show assets position at a moment of time

 as in the case of balance sheet, or

 It reveal a series of activities

 over a given period of times

 as in the case of an income statement

types of financial statements
 The four main types of financial statements are:

1. Statement of Financial Position

2. Income statement

3. Statement of Changes in Equity

4. Cash flow statement

1. Statement of Financial Position
also known as

 the Balance Sheet

 presents the financial position of

 an entity at a given date

 It is comprised of the three elements:

Asset

 Something a business owns or controls

 (e.g. cash, inventory, plant and machinery, etc.)

1. Statement of Financial Position
Liability

 Something a business owes to someone

 (e.g. creditors, bank loans, etc.)

Equity

 What the business owes to its owners

 This represents the amount of capital

 that remains in the business

 after its assets are used to pay off

 its outstanding liabilities

 Equity therefore represents

 the difference between

 the assets and liabilities

ASSETS EQUITY AND LIABILITIES

Current assets Current liabilities

Inventories 12,000 Trade and other payables 35,000
Trade receivables 25,000 Short-term borrowings 10,000
Current portion of long-term
Cash and cash equivalents 8,000 15,000
borrowings
45,000 Current tax payable 5,000
Total current liabilities 65,000
Non - current assets Non-current liabilities

Property, plant & equipment 130,000 Long term borrowings 35,000

Goodwill 30,000 Total liabilities 100,000

Intangible assets 60,000 Equity
220,000 Share capital 100,000
Retained earnings 50,000
Revaluation reserve 15,000
Total equity 165,000

TOTAL ASSETS 265,000 TATAL EQUITY AND LIABILITIES 265,000

2. Income Statement
 also known as the Profit and Loss Statement

 reports the company's financial performance

 in terms of net profit or a loss

 over specified period of time

 It is composed of two elements:

 Income : what the business has earned over time

 (e.g. sales revenue, dividend income, etc.)

 Expense : the cost incurred by the business over time

 (e.g. salaries and wages,, rental charges, etc.)

 Net profit or loss is arrived by

 deducting expenses from income

Revenue 120,000
Cost of Sales (65,000)
Gross Profit 55,000
Other Income 17,000
Distribution Cost (10,000)

Administrative Expenses (18,000)

Other Expenses (3,000)

Finance Charges (1,000)
Profit before tax 40,000
Income tax (12,000)
Net Profit 28,000
3. Statement of Changes in Equity
also known as the Statement of Retained Earnings

 details the movement in owners' equity over a period

 the movement in owners' equity is derived from:

 Net Profit or loss during the period

 as reported in the income statement

 Share capital issued or repaid during the period

 Dividend payments

 Gains or losses recognized directly in equity

 (e.g. revaluation surpluses)

 Effects of a change in accounting policy or

 Effects of a correction of accounting error

 Share Retained Revaluation
Total Equity
Capital Earnings Surplus
Balance at 1 January 2011 100,000 30,000 - 130,000
Changes in accounting policy - - - -
Correction of prior period error - - - -
Restated balance 100,000 30,000 - 130,000
Changes in equity for year 2011

Issue of share capital - - - -

Income for the year - 25,000 - 25,000
Revaluation gain - - 10,000 10,000
Dividends - (15,000) - (15,000)
Balance at 31 December 2011 100,000 40,000 10,000 150,000
Changes in equity for year 2012

Issue of share capital - - - -

Income for the year - 30,000 - 30,000
Revaluation gain - - 5,000 5,000
Dividends - (20,000) - (20,000)
Balance at 31 December 2012 100,000 50,000 15,000 165,000
4. Cash Flow Statement

 Cash Flow Statement presents

 the movement in

 cash and bank balances over a period

 the movement in cash flows is

 classified into three segments:

 Operating Activities:

 Represents the cash flow

 from primary activities of a business

4. Cash Flow Statement
 Investing Activities:

 Represents cash flow

 from the purchase and sale of assets

 other than inventories

 (e.g. purchase of a factory plant)

 Financing Activities:

 Represents cash flow

 generated or spent on

 raising share capital

 Repaying debt and

 payments of interest and dividends

Financial Statement Analysis
 Financial statement analysis involves

 Identification of a company's financial

statements

 trends and proportion analysis

 trends

 Create trend lines for key items

 in the financial statements

 over multiple time periods

 to see how the company is performing

 typical trend lines are for

 the gross revenue, net profits

 cash, accounts receivable, and debt

Proportion analysis
 an array of ratios available

 for determining the relationship between

 the size of various accounts

 in the financial statements

 the analyses is done between

 the revenues and expenses listed

 on the income statement and

 the assets, liabilities, and equity accounts

 listed on the balance sheet

Proportion analysis
 For example, you can calculate

 a company's quick ratio to estimate

 its ability to pay its immediate liabilities, or

 its debt to equity ratio to see

 if it has taken on too much debt

Users of Financial Statement Analysis
 there are a number of users of

 financial statement analysis

 they are:

 Creditors

 anyone who has lent funds

 to a company is interested

 in its ability to pay back the debt, and

 so will focus on various cash flow measures

Users of Financial Statement Analysis
 Investors

 Both current and prospective investors

 examine financial statements

 to learn about a company's ability

 to continue issuing dividends, or

 to generate cash flow, or

 to continue growing at its historical rate

 (depending upon

 their investment philosophies)

Users of Financial Statement Analysis
 Management

 The company controller prepares

 an ongoing analysis of the company's

 financial results in relation to

 operational metrics such as

 cost per delivery

 cost per distribution channel

 profit by product, and so forth

Users of Financial Statement Analysis
 Regulatory authorities

 If a company is publicly held

 its financial statements are examined

 by the finance authorities

 to see if its statements conform

 to the various accounting standards and

 the rules of the finance authority

Methods of Financial Statement Analysis

 There are two key methods

 for analyzing financial statements

 The first method is

 the use of horizontal and vertical analysis

 The second method is

 the use of many kinds of ratios

horizontal and vertical analysis
 Horizontal analysis is

 the comparison of financial information

 over a series of reporting periods

 It is a sort of trend analysis

 vertical analysis is

 the proportional analysis of a financial statement

 where each line item on a financial statement

 is listed as a percentage of another item

 e.g., every line item on

 an income statement is stated

 as a percentage of gross sales

horizontal and vertical analysis
 every line item on a balance sheet is stated

 as a percentage of total assets

 Thus

 horizontal analysis is

 the review of the results of

 multiple time periods

 while

 vertical analysis is

 the review of the proportion of accounts

 to each other within a single period

Horizontal Analysis of the Income Statement

 Horizontal analysis

 of the income statement is

 usually in a two-year format

 With a variance showing

 the difference between

 the two years for each line item

Horizontal Analysis of the Income Statement
20X1 20X2 Variance
Sales $1,000,000 $1,500,000 $500,000

Cost of goods sold 400,000 600,000 -200,000

Gross margin 600,000 900,000 300,000
Salaries and wages 250,000 375,000 -125,000
Office rent 50,000 80,000 -30,000
Supplies 10,000 20,000 -10,000
Utilities 20,000 30,000 -10,000
Other expenses 90,000 110,000 -20,000
Total expenses 420,000 615,000 -195,000
Net profit $180,000 $285,000 $105,00
Horizontal Analysis of the Balance Sheet
 Horizontal analysis of the balance sheet is

 usually in a two-year format

 with a variance showing

 the difference between

 the two years for each line item

 An alternative format is

 to add as many years as will fit on the page

 without showing a variance

 so that you can see general changes

 by account over multiple years

Horizontal Analysis of the Balance Sheet
20X1 20X2 Variance
Cash $100,000 80,000 ($20,000)
Accounts receivable 350,000 525,000 175,000
Inventory 150,000 275,000 125,000
Total current assets 600,000 880,000 280,000
Fixed assets 400,000 800,000 400,000
Total assets $1,000,000 $1,680,000 $680,000

Accounts payable $180,000 $300,000 $120,000

Accrued liabilities 70,000 120,000 50,000
Total current liabilities 250,000 420,000 170,000
Notes payable 300,000 525,000 225,000
Total liabilities 550,000 945,000 395,000
Capital stock 200,000 200,000 0
Retained earnings 250,000 535,000 285,000
Total equity 450,000 735,000 285,000
Total liabilities and $1,000,000 $1,680,000 $680,000
equity
Vertical Analysis of the Income Statement
 The most common use of vertical analysis

 in an income statement is

 to show the various expense line items

 as a percentage of sales

 to show the percentage of

 revenue line items that make up total sales

 the information provided by

 the income statement is

 for identifying points in expenses

 for determining which expenses are

 so small that they may not be worthy of

 much management attention

 Vertical Analysis of the Income Statement
$ Totals Percent
Sales $1,000,000 100%
Cost of goods sold 400,000 40%
Gross margin 600,000 60%

Salaries and wages 250,000 25%

Office rent 50,000 5%
Supplies 10,000 1%
Utilities 20,000 2%
Other expenses 90,000 9%
Total expenses 420,000 42%
Net profit 180,000 18%
Vertical Analysis of the Balance Sheet
 The central issue for

 a vertical analysis of a balance sheet is

 what to use as the denominator

 in the percentage calculation

 the usual denominator is

 the total asset, but

 one can also use the total of all liabilities

 when calculating all liability line item percentages, and

 the total of all equity accounts

 when calculating all equity line item percentages

Vertical Analysis of the Balance Sheet
$ Totals Percent
Cash $100,000 10%
Accounts receivable 350,000 35%
Inventory 150,000 15%
Total current assets 600,000 60%
Fixed assets 400,000 40%
Total assets $1,000,000 100%
Accounts payable $180,000 18%
Accrued liabilities 70,000 7%
Total current liabilities 250,000 25%
Notes payable 300,000 30%
Total liabilities 550,000 55%
Capital stock 200,000 20%
Retained earnings 250,000 25%
Total equity 450,000 45%
Total liabilities and equity $1,000,000 100%
Vertical Analysis of the Balance Sheet
 The information provided by this

 balance sheet format is

 useful for noting changes

 in a company's investment

 in working capital and

 fixed assets over time

 which may indicate an improved business model

 that requires a different amount of

 ongoing funding
The second method is the use of many kinds of ratios
 ratios are used to calculate

 the relative size of one number

 in relation to another

 After calculating a ratio

 you can compare it

 to the same ratio calculated for a prior period, or

 to an industry average

 to see if the company is performing

 in accordance with expectations

 In a typical financial statement analysis

 ratios will be within expectations

 while a small number will flag potential problems

 that will attract the attention of the reviewer

the use of many kinds of ratios
 There are several general categories of ratios

 each designed to examine a different

 aspect of a company's performance

 the general groups of ratios are:

 Liquidity ratio

 Investment (Activity) ratio

 Leverage ratio and

 Profitability ratio

 Financial ratio