Chapter 12

• Financial statement analysis

 Learning Objectives
 Perform basic analysis on Financial
Statements
 Prepare Common Size Financial Statements
 Prepare financial ratio analysis to make
business decisions
 Use other information to make investment
decisions
 Other issues in Financial Statement Analysis
Analysis of Financial Statements

BASIC FINANCIAL
STATEMENT ANALYSIS

HORIZONTAL ANALYSIS VERTICAL ANALYSIS

 Horizontal Analysis
• Study of percentage changes from year to year
is horizontal analysis.
• It takes two steps:
 Compute the amount of the change from one
period to the next.
 Divide the amount of change by the base
period amount.
For instance….
Horizontal Analysis of Income Statements
The Analysis…
 Trend Analysis
 Trend percentage are a form of horizontal
analysis.
 It indicates the direction a business is taking.
 Trend percentages are computed by selecting a
base year whose amounts are set equal to
100%.
 It can be calculated as = Any year’s amount
Base year’s amount
 Illustration
• Suppose….

Particulars 2019 2018 2017

Operating 30,000 20,000 25,000
profit

• So, the base year here is 2017 and trend analysis could be:
• For 2018 = 20,000= 80%
• 25000
• For 2019 = 30,000= 120%
• 25,000
 Vertical Analysis
 Vertical analysis shows the relationship of
financial – statement items relative to a total,
which is a 100% figure.
 All items on the particular financial statement
are reported as a percentage of the base.
 For an income statement, total revenue(sales)
is usually the base.
How will it be calculated?
Vertical analysis using a Pie Chart
 Common Size Financial Statement
Common Size financial statements
 A direct numerical comparison of companies,
where one company is with huge transactions and
another entity is small, is not meaningful because
of size differences.
 One of the techniques which can be used to
compare is called common – size financial
statements.
Common Size Income Statement
looks like…
 Performing Financial Ratio Analysis
to make business decisions
 Financial ratios are a major tool of financial analysis.
 A ratio expresses the relationship of one number to another.
 The financial ratios are classified as:
 Efficiency ratios
 Financial strength ratios
 Profitability ratios
 Investment ratios
 Efficiency Ratios
 Inventory Turnover
It measures the number of times a company sells its average level of
inventory during a year.
A fast turnover indicates ease in selling inventory, a low turnover indicates
difficulty.
Formula:
=Cost of goods sold
Average Inventory

Cost of goods sold comes from the Income Statement.

Average inventory is the average of beginning and ending inventory.

This ratio is called the inventory resident period.

 Illustration…
• Suppose the cost of goods sold for M/s Ram & Co is $50,000
and Inventory at the beginning of the year is $30,000 and
inventory at the end of the year is $ 40,000. Compute efficiency
ratio.

• Efficiency ratio = Cost of goods sold

• Average inventory
• Average inventory = 30,000 + 40,000 / 2
• = 35,000
• Ratio = 50,000 / 35,000
• = 1.42
 Accounts Receivable turnover
• It measures the ability to collect cash from customers.
• The higher the ratio, the better.
• The low receivable turnover indicates ineffectiveness
in collecting dues from customers.
• If it is too high, it may indicate that credit is too tight,
and may cause to lose sales to customers.
• Formula:
• = Sales Revenue
• Average accounts receivable
 Illustration…
• Suppose the sales revenue of ABC & Co is $800,000
and the average accounts receivable is 40,000.
Compute Accounts receivable turnover.
• = Sales Revenue
• Average accounts receivable
• = 800,000
• 40,000
• = 20
 Accounts Payable Turnover
• Businesses but their supplies and raw materials on
credit, and take time to pay their accounts payable.
• A high account payable turnover ratio means a
business pays its supplies very quickly.
• A low payable turnover ratio means a longer time
period for payments to suppliers.
• Formula:
• = COGS
• Average net Accounts payable
 Illustration…
• Suppose the business has COGS of $500,000 and the average
net accounts payable = $200,000. Compute Accounts Payable
Turnover.

• = COGS
• Average net Accounts payable

=500,00
200,000
= 2.5
 Cash conversion cycle

• If we put the inventory resident period,

receivable collection period and payable
collection period together, we can get to know
that how long it takes for a business to sell its
inventory, collect payments and make
payments to suppliers. This is what is called as
cash conversion cycle.
 Asset Turnover Ratio
• It is another way to examine the efficiency of
the organization to assess the amount of
resources used to generate sales or revenue.
• This can be done on a total assets basis.
• This ratio can be calculated as:
• = Sales
• Average total assets
 Illustration…
• Suppose the business has sales value of $250,000 and the total
assets at the beginning of the year is $500,000 and $250,000 at
the end of the year. Compute the Asset Turnover Ratio.

• = Sales
• Average total assets
= 250,000
(500,000+250,000)/2
=53.33
 Financial Strength Ratio
• They are the indicators of an entity’s abilities to meet its
financial obligations, either in the short term or the long term.
• Short term indicators are usually called liquidity ratios.
• Long term indicators are referred as solvency ratios.
• Working Capital is the term used to describe what a business
has to work with the current assets and the current liabilities.
• It can be calculated as Current assets – Current liabilities.
 Current Ratio
• The most common ratio evaluating current
assets and current liabilities is the current ratio.
• This measures the ability to pay current
liabilities with current assets.
• It can be calculated as:
• = Current assets
• Current liabilities
 Illustration…
• Suppose a Business Organization has $400,000 in its
current assets and $200,000 in its current liabilities.
Compute Current ratio.

• = Current assets
• Current liabilities
• = 400,000
• 200,000
• =2
 Quick Ratio
• A more refined version of current ratio is known as the quick
ratio ( also known as acid test ratio).
• It informs the entity whether a business could pass the “acid
test” of paying all its current liabilities if they came due
immediately.

• Formula:
• =Cash + Short-term investments + Net current receivables
• Current liabilities
 Illustration….
• Suppose an entity has:
• Cash= 10,000Short term investment = 50,000
• Current receivables = 60,000 Outstanding salary = 40,000
• Accounts payable = 10,000 Compute Quick ratio.

• =Cash + Short-term investments + Net current receivables

• Current liabilities
• =10,000 + 50,000 + 60,000
• 40,000 + 10,000
• =2.4
 Debt Ratio
• The relationship between total liabilities and total assets is called
the debt ratio.
• It gives indication of the degree of leverage or gearing of a
company.
• It provides insight on the proportion of assets financed with debt.
• A debt ratio of 1 reveals that debt has financed all the assets.
• The higher the debt ratio, the greater the pressure to pay interest
and principal and vice versa.
• Formula:
• =Total liabilities
• Total assets
 Illustration...
• Suppose a company has $400,000 of its total
liabilities and $800,000 in its assets. Calculate debt
ratio.
• =Total liabilities
• Total assets
• =400,000
• 800,000
• = 0.5
• That means debt finances half the assets.
 Debt Equity ratio
• The alternative way to describe the level of an
entity’s leverage is the debt-to-equity ratio.
• It is calculated as:
• = Total Debt
• Total Equity
• Suppose an entity has debt of $400,000 and
the assets of $700,000. calculate Debt-equity
ratio.
 Solution!!
• Assets = Liabilities + Equity
• 700,000 = 400,000 + Equity
• Equity = 700,000 – 400,000
• = 300,000

• Therefore debt-equity ratio:

• = Total Debt
• Total Equity
• =400,000
• 300,000
• = 1.33
 Times-Interest-Earned Ratio
• This is also referred as interest coverage ratio.
• This ratio measures the number of times
operating income can cover interest expense.
• It can be calculated as:
• = Income from operations
• Interest expense
 Illustration…
• Suppose an entity ‘s interest expense is $ 20,000 and
its total income from operations would be $200,000.
Compute Times-interest-earned ratio.
• = Income from operations
• Interest expense
• = 200,000
• 20,000
• = 10 times
 Profitability Ratios
 Gross Profit Margin
This ratio show the percentage of each sales dollar earned as gross
profit.
Formula:
= Gross profit
Sales
Suppose an entity’s total sales amounts to $400,000 and the gross profit
made is 100,000
The Gross Profit Margin would be
= 100,000
400,000
= 25%
 Operating Profit Margin
• This ratio shows the percentage of each sales dollar earned as
operating profit.
• Formula:
• = Operating Profit
• Sales
• Suppose an entity has same $400,000 sales but the operating profit is
$80,000.
• Operating Profit Margin would be:
• = 80,000
• 400,000
• = 20%
 Net Profit Margin
• This ratio shows the percentage of each sales dollar earned as net
profit.
• Formula:
• = Net Profit
• Sales
Suppose an entity earns the net profit of $65,000 as against it’s
sales of $400,000.
The Net profit Margin would be:
= 65,000
400,000
=16.25%
 Return on Total Assets
• It measures the company’s success in using assets to earn a
profit.
• Formula: (numerator differs)
• = Net profit
• Average Total Assets

Suppose an entity has earned $50,000 net profit with its average
assets of $450,000. the return on total assets would be:
= 50,000
450,000
= 11.11%
 Return on Equity
• This is a popular measure of profitability.
• This shows the relationship between net income and ordinary
shareholders investment in a company.
• Formula:
• =Net profit
• Average equity
• Suppose an entity’s net profit is $50,000 and its average equity is
300,000. ROE will be:
• = 50,000
• 300,000
• = 16.67%
 Investment Ratios
• Earnings per Ordinary Share
• It is the amount of net income earned for each outstanding
ordinary share.
• Formula:
• = Net income – Preference dividends
• weighted average number of ordinary shares outstanding
• Suppose an entity has net income of $48,000 and the shares
outstanding is 10,000. EPS will be:
• = 48,000 – 0
• 10,000
• =$4.80
 Price/Earnings Ratio
• It shows how much an investor is willing to pay for
each unit of earnings.
• Formula:
• = Market price per ordinary share
• Earnings per Share
• Suppose a entity’s MPS is $60 and EPS is $4.8, the
PE ratio will be:
• = 60/ 4.8
• = 12.5
 Dividend Yield
• It is the ratio of dividends per share of stock to the share’s market
price.
• This ratio measures the percentage of a share’s market value returned
annually to the shareholders as dividends.
• Formula:
• = Dividend per ordinary share
• Market price per ordinary share*
• Suppose an entity paid $2 per ordinary share and the market price is
being $60. The dividend yield would be:
• = 2 /60
• = 3.33%
• * it may also be calculated for preference shares
 Book Value per Ordinary Share
• It is simply calculated as:
• = Total shareholders Equity – Preference Equity
• Number of ordinary shares outstanding
• Suppose the total shareholders equity is $500,000 and the
preference equity is $200,000. The number of ordinary shares
outstanding is 20,000 shares. The Book value per ordinary
share would be:
• = 500,000 – 200,000
• 20,000
• = $15
Using the Statement of Cash Flows
 Other information to make investment
decisions
• Economic Value Added
• Usually EVA is used to evaluate operating performance. It combines
accounting and finance to measure whether operations have increased
shareholder wealth.
• Formula:
• = Net income + Interest expense – Capital charge

(beginning balance) Cost of

Capital charge Notes payable+ current maturities of capital
long-term debt + long-term debt +
Shareholders equity
 Limitations of Financial Statement
Analysis
• Limitations of Ratio Analysis
 Does not identify the exact problem.
 Legislations, international affairs, scandals &
other factors can turn up to losses.
 Differences in accounting standards.
Red flags in Financial Statement Analysis

• The following condition may mean very risky:

(a)Earnings Problem
(b)Decreased Cash Flow
(c)Too Much Debt
(d)Inability to Collect Receivables
(e)Buildup of Inventories
(f) Trends of Sales
 Question!
• Which ratio is also known as acid ratio?

a) Cash ratio
b) Current ratio
c) Quick ratio
d) Alternate ratio
 Solution!

c) Quick ratio
 Question!
• Timer interest earned ratio is calculated as

a) Income from operations/ Interest expense

b) Net Profit / Interest expense
c) Net income / Earnings
d) Net income/ total debt
 Solution!
a) Income from operations/ Interest expense
 Question!
• Which among the following are profitability
ratios?

a) Gross Margin
b) Operating Margin
c) Net Margin
d) All of the above
 Solution!
d) All of the above
End of chapter 12